[Joint House and Senate Hearing, 111 Congress]
[From the U.S. Government Publishing Office]
S. Hrg. 111-466
UNREGULATED MARKETS: HOW REGULATORY
REFORM WILL SHINE A LIGHT
IN THE FINANCIAL SECTOR
=======================================================================
HEARING
before the
JOINT ECONOMIC COMMITTEE
CONGRESS OF THE UNITED STATES
ONE HUNDRED ELEVENTH CONGRESS
FIRST SESSION
__________
DECEMBER 2, 2009
__________
Printed for the use of the Joint Economic Committee
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JOINT ECONOMIC COMMITTEE
[Created pursuant to Sec. 5(a) of Public Law 304, 79th Congress]
HOUSE OF REPRESENTATIVES SENATE
Carolyn B. Maloney, New York, Chair Charles E. Schumer, New York, Vice
Maurice D. Hinchey, New York Chairman
Baron P. Hill, Indiana Jeff Bingaman, New Mexico
Loretta Sanchez, California Amy Klobuchar, Minnesota
Elijah E. Cummings, Maryland Robert P. Casey, Jr., Pennsylvania
Vic Snyder, Arkansas Jim Webb, Virginia
Kevin Brady, Texas Mark R. Warner, Virginia
Ron Paul, Texas Sam Brownback, Kansas, Ranking
Michael C. Burgess, M.D., Texas Minority
John Campbell, California Jim DeMint, South Carolina
James E. Risch, Idaho
Robert F. Bennett, Utah
Gail Cohen, Acting Executive Director
Jeff Schlagenhauf, Minority Staff Director
C O N T E N T S
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Members
Hon. Carolyn B. Maloney, Chair, a U.S. Representative from New
York........................................................... 1
Hon. Kevin Brady, a U.S. Representative from Texas............... 3
Hon. Maurice Hinchey, a U.S. Representative from New York........ 4
Witnesses
Statement of Brooksley Born, Former Chair, Commodity Futures
Trading Commission, Washington, DC............................. 6
Statement of Robert Litan, Senior Fellow in Economic Studies,
Brookings Institution, Vice President of Research and Policy,
Ewing Marion Kauffman Foundation, and Member of The Pew Task
Force on Financial Reform, Washington, DC...................... 7
Statement of James Carr, Chief Operating Officer, National
Community Reinvestment Coalition, Washington, DC............... 9
Statement of Robert K. Steel, Former Under Secretary for Domestic
Finance of the United States Treasury, Chairman of the Board,
Aspen Institute, and Member of The Pew Task Force on Financial
Reform, Washington, DC......................................... 11
Submissions for the Record
Prepared statement of Representative Carolyn B. Maloney.......... 34
Prepared statement of Brooksley Born............................. 34
Prepared statement of Robert Litan............................... 37
Prepared statement of James Carr................................. 44
Prepared statement of Robert K. Steel............................ 67
Letter from Representative Maloney to Robert Litan............... 71
Letter from Representative Maloney to Robert Steel............... 72
Letter from Senator Klobuchar to Brooksley Born, Robert Litan,
James Carr, and Robert Steel................................... 73
Responses from Brooksley Born to Senator Klobuchar............... 75
Responses from Robert Litan to Senator Klobuchar................. 78
UNREGULATED MARKETS: HOW REGULATORY REFORM WILL SHINE A LIGHT
IN THE FINANCIAL SECTOR
----------
WEDNESDAY, DECEMBER 2, 2009
Congress of the United States,
Joint Economic Committee,
Washington, DC.
The committee met, pursuant to call, at 10:38 a.m., in Room
210, Cannon House Office Building, The Honorable Carolyn B.
Maloney (Chair) presiding.
Representatives present: Maloney, Hinchey, Cummings,
Snyder, Brady, and Burgess.
Senators present: Brownback.
Staff present: Paul Chen, Gail Cohen, Colleen Healy,
Michael Neal, Annabelle Tamerjan, Andrew Wilson, Rachel
Greszler, Jeff Schlagenhauf, Ted Boll, and Robert O'Quinn.
OPENING STATEMENT OF THE HONORABLE CAROLYN B. MALONEY, CHAIR, A
U.S. REPRESENTATIVE FROM NEW YORK
Chair Maloney. I would like to call the meeting to order
and thank all the participants for coming.
I want to, first of all, welcome our distinguished panel of
witnesses today as we discuss proposals to regulate the over-
the-counter derivatives market and underregulated credit
markets. The financial crisis and the recession were triggered
in part by the collapse in the price of homes and the resulting
defaults in the mortgages used to purchase them.
In the absence of regulation, financial institutions
aggressively purchased over-the-counter derivatives, such as
mortgage-backed securities, with the expectation that they
would generate high returns with minimal risk. To hedge against
any risk, they also purchased unregulated credit default swaps
that would pay them if the mortgage underlying the derivatives
defaulted. This created an illusion that the assets were risk-
free and a tangled web of counterparties. At its peak this
unregulated market was tied to $680 trillion in assets, an
astonishing amount equal to 50 times U.S. GDP, putting the
stability of the U.S. and the world economy at risk.
This crisis did not have to happen. Many years earlier one
of our distinguished witnesses, Brooksley Born, then Chair of
the CFTC, had the foresight to recognize the dangers of
unchecked growth, lack of transparency, and overleveraging in
the over-the-counter derivatives. Some have called her ``The
Woman Who Knew.'' However, she was ignored by a chorus of
critics who hailed over-the-counter derivatives as the greatest
financial innovation of the decade because they would spread
risk efficiently among market participants.
With the economy booming, regulatory attempts were voted
down. I know this from personal experience, having introduced
two amendments that would have taken steps to regulate this
market; they were roundly and strongly defeated, both of them.
Siding with her critics, Congress passed the Commodity Futures
Modernization Act of 2000, which literally prevented the CFTC
from regulating over-the-counter derivatives. This was a
mistake, and we are acknowledging it now.
Next week on the floor of the House, we will be voting on a
regulatory reform bill that will regulate over-the-counter
derivatives to bring transparency to these complex financial
products and expand the authority of the CFTC and the SEC to
regulate counterparties in derivative transactions.
Many have argued that derivative contracts were the prime
reason AIG needed to be bailed out with taxpayer funds because
the quantity and value of the contracts were never disclosed,
so that the impact of breaking these contracts via possible
bankruptcy was unknowable.
I have confidence that this bill will pass next week. It
should have passed years earlier when Mrs. Born pointed out the
real challenge and danger of not regulating these derivatives.
The House Financial Services Committee and the House
Agriculture Committee are meeting this week to merge their two
versions of the bill that will finally regulate over-the-
counter derivatives and bring the dark market into the light.
The merged bill will promote transparency by requiring that
these previously unregulated derivatives be traded on exchanges
or clearinghouses. Capital and margin requirements will be
established so that financial institutions can no longer make
risky bets. And information about prices and trading values and
volumes will be publicized so that market participants will no
longer be uncertain of the value of their securities. Although
these bills exempt some derivatives from regulation, the
exemptions are an attempt to balance concerns of some
businesses that need customized derivatives and the potential
risk to the financial system.
The House Financial Services Committee has also passed a
bill establishing the Consumer Financial Protection Agency to
shield consumers from deceptive financial practices.
Although our economic recovery is far from complete, the
economy is moving back on track, helped along by the Recovery
Act. Third quarter GDP grew 2.8 percent after contracting for
four consecutive quarters, financial markets have recovered
substantially, and interbank lending is back to its precrisis
level.
Now is the time to act to pass these reforms. The financial
crisis has made clear the need for common-sense regulation of
the financial services industry to ensure stability, safety and
soundness of the system.
I want to thank the witnesses for coming, and I look
forward to hearing their testimony. And I do also want to
acknowledge Mr. Steel, with whom I had the privilege of working
with on many important initiatives for our government. Welcome
to all of you.
[The prepared statement of Representative Maloney appears
in the Submissions for the Record on page 34.]
Chair Maloney. The Chair recognizes Mr. Brady for 5
minutes.
OPENING STATEMENT OF THE HONORABLE KEVIN BRADY, A U.S.
REPRESENTATIVE FROM TEXAS
Representative Brady. Thank you, Madam Chairwoman. Thank
you for hosting this important hearing. Just preparing for it
and reading the testimony was informative in and of itself, so
I am pleased to join you in welcoming today's witnesses.
Many policy mistakes contributed to the global financial
crisis that began on August 9, 2007, and triggered a recession
4 months later. These include the Federal Reserve's overly
accommodative monetary policy from 2002 to 2006; international
imbalances arising largely from China's exchange rate policy
since 1998; President Clinton's initiative to increase
homeownership among low-income families by reducing down
payment requirements and interest costs by making terms more
flexible, increasing the availability of alternative financing
products without sufficient consideration of the ability of
low-income families to meet their nontraditional mortgage
obligations, as well as the continuation of this policy by
President George W. Bush; abuse of the Community Reinvestment
Act through the filing of frivolous objections to bank
acquisitions and mergers by ACORN-affiliated groups to extort
banks into making a large number of risky subprime residential
mortgage loans to low-income families; and finally, inadequate
supervision of the alternative financial system based on loan
securitization and highly leveraged nondepository financial
institutions, especially Fannie Mae and Freddie Mac.
Banks perform the economically valuable, but inherently
risky functions of intermediation and liquidity transformation
by accepting deposits payable on demand and making term loans
to families and small businesses that can't issue commercial
paper and corporate bonds. Due to the nature of their
activities, banks are subject to runs. Runs often become
contagious and may trigger financial panics.
To minimize the risk of financial contagion, while
retaining the enormous economic benefits from intermediation
and liquidity transformation, Congress mandated supervision,
created the Federal Reserve in 1913 to serve as the lender of
last resort, and established Federal deposit insurance in 1933.
By the fall of 2007, the alternative financial system,
which you referenced, composed of Fannie Mae, Freddie Mac,
independent investment banks, finance companies, hedge funds
and off-balance-sheet entities, had assets totaling $12.7
trillion and was essentially performing intermediation and
liquidity transformation functions similar to banks without any
of the safeguards that Congress had established for banks.
Since the financial crisis began, a number of major banks
and other financial institutions have failed, were acquired at
fire sale prices, were placed into conservatorships, or needed
massive Federal assistance to survive. These include AIG, Bank
of America, Bear Stearns, Citigroup, Fannie Mae, Freddie Mac,
Lehman Brothers and Merrill Lynch.
And what are the common threads to these failures or quasi
failures? First, these institutions made bad investment
decisions. Second, these institutions were overly dependent on
short-term liabilities outside of insured deposits to fund
their investments; consequently, these institutions suffered
liquidity crises when their creditors became aware of the
magnitude of the investment losses. These liquidity crises were
essentially the modern version of bank runs in which computer
clicks replaced queues of depositors withdrawing their money.
However, the underwriting of corporate securities and municipal
revenue bonds, which Glass-Steagall had prohibited commercial
banks to do, was not a significant factor in the failures or
near failures.
So for the witnesses today, you have raised so many great
points in testimony. I will have a number of questions for the
panel, such as, what changes should be made to the risk-based
capital standards for banks? Should Congress require all U.S.
banks to adopt a system of dynamic provisioning for loss
reserves that proved so successful in maintaining the solvency
of Spanish banks during the financial crisis? Should liquidity
standards be established for banks and other highly leveraged
financial institutions? Should all banks and other highly
leveraged financial institutions be subject to simple limits on
leverage in addition to any risk-based capital standard? Should
Fannie and Freddie be restructured and fully privatized?
Shouldn't any housing subsidy functions that Fannie and Freddie
now perform be transferred to the Federal Housing
Administration and be placed transparently on the Federal
budget? Should highly leveraged, nondepository financial
institutions have access to the Federal Reserve's discount
window; and if so, under what circumstances? And finally, how
should financial derivatives be regulated? Are credit default
swaps uniquely risky, and do they need to be regulated
differently than other financial derivatives?
Members of the panel, I look forward to hearing from your
testimony today.
Thank you, Madam Chairman.
Chair Maloney. Mr. Hinchey.
OPENING STATEMENT OF THE HONORABLE MAURICE D. HINCHEY, A U.S.
REPRESENTATIVE FROM NEW YORK
Representative Hinchey. Thank you very much, Madam
Chairman. And thank you very much, all four of you, gentlemen
and ladies, for being here with us. I very much appreciate the
opportunity to listen to the things that you are going to say.
I am not going to take up very much time here, but I just want
to express that appreciation for you.
As we all know, this country is dealing with one of the
most difficult and damaging economic circumstances that it has
experienced over the course of our history. It is the worst set
of circumstances that we have experienced since 1929. The
unemployment rate itself in this country is now up above 10
percent, and that is just the official unemployment rate. There
are a lot more people who would love to have jobs but can't get
them because of the economic conditions that we are dealing
with. And a lot of that has to do with the sharp decline in the
economy which had to do, in large measure, with the
manipulation of commercial and investment banking and the
elimination by the past Congress to prevent that combination,
that manipulation to take place.
So these are some of the things that we are dealing with,
including a number of other things in regard to the way in
which investment operations are engaged in, including the
effect it has had on the price of oil and gasoline. And so the
price that people have to pay for the necessities that they are
required to have in the context of growing unemployment makes
this situation much more difficult and damaging and even
dangerous to address. But it needs to be addressed, and it
needs to be addressed very, very effectively.
So all of the things that you are going to have to say I am
sure are going to be very important to our ability to engage
this situation in a much more effective way. So I thank you all
very much for being here, and I am anxious to hear what you
have to say.
Chair Maloney. Thank you so very much.
I, too, would like to welcome all the witnesses and to
introduce the panel.
Brooksley Born practiced law for many years in Washington
and was a partner in the firm of Arnold & Porter. From 1996 to
1999, she was Chair of the U.S. Commodity Futures Trading
Commission (CFTC), the Federal Government agency that oversees
the futures and commodity option markets and futures
professionals. While at the CFTC, Ms. Born served as a member
of the President's Working Group on Financial Markets.
Ms. Born is a 2009 recipient of the John F. Kennedy Library
Foundation's Profile in Courage Award presented annually to
public servants who have made courageous decisions of
conscience without regard for the personal or professional
consequences. She received the award in recognition of her
efforts as Chair of the CFTC to urge that the over-the-counter
derivatives market should be subject to Federal oversight and
regulation. The failure to regulate that market is now seen to
be a major cause of the recent financial crisis.
Among other awards, she was recognized as a champion in the
Legal Times' list of the 90 greatest Washington lawyers of the
last 30 years. In 2008, she was the recipient of the American
Lawyer Lifetime Achievement Award for her career-long
leadership in private practice and public service.
She is a graduate of Stanford University and Stanford Law
School, where she was president of the Stanford Law Review and
received the Outstanding Senior Award.
Robert Litan is a senior fellow in economic studies at the
Brookings Institution, where he was previously vice president
and director of economic studies. He is also the vice president
for research and policy at the Kauffman Foundation in Kansas
City, where he oversees the foundation's extensive program for
funding data collection and research relating to economic
growth.
He previously served as the Associate Director of the
Office of Management and Budget, and Deputy Assistant Attorney
General. From 1977 to 1979, he was the regulatory and legal
staff specialist at the President's Council of Economic
Advisors. He holds a B.S. in finance from Wharton. He also has
a law degree from Yale, and a Ph.D. in economics from Yale
University.
James Carr is chief operating officer for the National
Community Reinvestment Coalition, an association of 600 local
development organizations across the Nation dedicated to
improving the flow of capital to communities and promoting
economic mobility. He is also a visiting professor at Columbia
University in the great city of New York. And prior to his
appointment to NCRC, he was senior vice president for financial
innovation, planning and research for the Fannie Mae
Foundation. He has also held positions as Assistant Director
for Tax Policy with the U.S. Senate Budget Committee. He holds
a degree in architecture from Hampton University, a master's of
planning degree from Columbia, and a master's of city and
regional planning from the University of Pennsylvania.
Robert Steel is a former president and CEO of Wachovia. He
served as Under Secretary of the Treasury for Domestic Finance
from 2006 to 2008. Previously he spent almost 30 years at
Goldman Sachs, founding the firm's Equity Capital Markets
Group. He is currently chairman of the board of the Aspen
Institute. He served on the board of Barclay's Bank and
currently serves on the board of Wells Fargo. He is also a past
chairman of the Duke University board of trustees. He holds a
degree from Duke University and an M.B.A. from the University
of Chicago.
I want to thank all of you for coming. I will first
recognize Ms. Born, and then go down the line. You are
recognized for as much time as you may consume.
STATEMENT OF BROOKSLEY BORN, FORMER CHAIR, COMMODITY FUTURES
TRADING COMMISSION, WASHINGTON, DC
Ms. Born. Thank you very much.
Madam Chairman and members of the committee, thank you very
much for inviting me to appear before you to discuss over-the-
counter derivatives.
We have experienced the most significant financial crisis
since the Great Depression, and regulatory gaps, including the
failure to regulate over-the-counter derivatives, have played
an important role in the crisis.
As a result of pressures from a number of the country's
largest financial institutions, Congress passed a statute in
2000 that eliminated virtually all government regulation of the
over-the-counter derivatives market. It was called the
Commodity Futures Modernization Act of 2000. Because of that
statute, no Federal or State regulator currently has oversight
responsibilities or regulatory powers over this market.
The market is totally opaque and is often referred to as
``the dark market.'' It is enormous. In June of this year, the
reported size of the market exceeded $680 trillion in notional
value.
While over-the-counter derivatives have been justified as
vehicles to manage financial risk, they have, in practice,
spread and multiplied risk throughout the economy and caused
great financial harm. Lack of transparency and price discovery,
excessive leverage, rampant speculation, lack of adequate
capital and prudential controls, and a web of interconnections
among counterparties have made the market extremely dangerous.
Warren Buffett has appropriately dubbed over-the-counter
derivatives as ``financial weapons of mass destruction.'' They
include the credit default swaps disastrously sold by AIG and
many of the toxic assets held by our biggest banks. It is
critically important for Congress to act swiftly to impose the
rules necessary to close this regulatory gap and to protect the
American public.
The Commodity Futures Trading Commission and the Securities
and Exchange Commission should be granted primary regulatory
responsibilities for derivatives trading, both on and off
exchange. All standardized and standardizable derivatives
contracts should be traded on regulated derivatives exchanges
and cleared through regulated clearinghouses. These
requirements would allow effective regulatory oversight and
enforcement efforts. They would ensure price discovery,
openness and transparency; reduce leverage and speculation; and
limit counterparty risk.
If any trading in the over-the-counter derivatives is
permitted to continue, such trading should be limited to truly
customized contracts between highly sophisticated parties, at
least one of which requires such a customized contract in order
to hedge its actual business risk.
Furthermore, any continuing over-the-counter derivatives
market should be subject to a robust Federal regulatory regime
requiring transparency. There should be registration,
recordkeeping and reporting requirements for all over-the-
counter derivatives dealers, and they should be subject to
business conduct standards. All over-the-counter trades should
be subject to margin requirements, and all large market
participants should be subject to capital requirements.
Transaction prices and volumes of over-the-counter derivatives
should be publicly reported on an aggregated and timely basis.
And the market should be subject to effective prohibitions
against fraud, manipulation, and other abusive practices.
These measures would go far toward bringing this enormous
and dangerous market under control. They should be adopted and
implemented if we hope to avoid future financial crises caused
by this market. The country cannot afford to delay or weaken
our response to the crisis. If we as a people do not learn from
our experiences and respond appropriately, we will be doomed to
repeat them.
Thank you very much.
[The prepared statement of Brooksley Born appears in the
Submissions for the Record on page 34.]
Chair Maloney. Thank you very much.
Dr. Litan.
STATEMENT OF ROBERT LITAN, SENIOR FELLOW IN ECONOMIC STUDIES,
BROOKINGS INSTITUTION, VICE PRESIDENT OF RESEARCH AND POLICY,
EWING MARION KAUFFMAN FOUNDATION, AND MEMBER OF THE PEW TASK
FORCE ON FINANCIAL REFORM, WASHINGTON, DC
Mr. Litan. Thank you, Chair Maloney and members of the
committee, for inviting me to testify today. I will hit the
highlights of my prepared testimony and the material that
accompanies it.
I am here primarily to present the financial reform
recommendations of the bipartisan Pew Financial Task Force of
which I have had the privilege to be a member.
It has now been more than a year since the near meltdown of
the financial system. Since then, the Congress has worked hard
to develop a comprehensive legislative package to which you,
Chair Maloney, just referred, aimed at preventing a repeat of
these sorry events.
The need for reform could not be greater, and on this I
agree with Brooksley. Fixing the financial system is critical
to restoring faith in our financial institutions and markets,
as well as to strengthening our lending institutions to the
point where they can feel comfortable again lending to
businesses and consumers.
You will find many common elements between our
recommendations and the specifics in the bills that have come
out of the House Financial Services Committee and that are now
being considered in the Senate Banking Committee. Our task
force members came into the process with very different views,
much like the differences you see in Congress. We debated these
views intensely, but calmly, and we listened to each other,
and, frankly, we learned from each other. And at least from my
part, there were a few mind changes, including my own, on some
issues.
While we did not cover the waterfront, and while some
members would have preferred different approaches with respect
to specific recommendations, we came up with a package of
principles and reforms that we believe will be a significant
improvement over the status quo. My co-task force member, Bob
Steel, will elaborate on some of our ideas. Here is my quick
overview, five points.
Number one, we need systemic risk monitoring and regulation
by an oversight council comprised of the relevant financial
agencies. Specifically, this council, on its own initiative or
upon recommendation of the Fed, should add to minimum standards
for capital, liquidity, margins and leverage to prevent or slow
the formation of future asset or credit bubbles.
Second, there are several ways to make sure that no
financial institution is too big or too complex to fail. We can
do this through capital and liquidity requirements that
increase with an institution's size and complexity, and by
mandating that large institutions file and gain regulatory
approval of what are called wind-down plans.
Third, we recommend the consolidation of all current
prudential Federal financial supervision and regulation into a
single regulator. We believe that eliminating gaps and
duplication in our current fragmented regulatory system will be
a significant improvement, but at the same time, we also would
retain the dual banking system under which banks will have the
opportunity to choose between a State and a Federal charter.
Fourth, derivatives markets clearly should be strengthened
by using capital requirements to drive more OTC derivatives to
a central clearinghouse, and eventually exchanges. The
compensation of senior financial executives and risk takers
should be tied to long-term performance, best through very
long-term restricted stock, much like the kind of things that
the Fed has recently proposed. Other ideas for enhancing market
discipline are spelled out in our report.
Finally, we support the creation of a new Consumer
Financial Products Agency.
I look forward your questions.
[The prepared statement of Robert Litan appears in the
Submissions for the Record on page 37.]
Chair Maloney. Thank you.
Mr. Carr.
STATEMENT OF JAMES CARR, CHIEF OPERATING OFFICER, NATIONAL
COMMUNITY REINVESTMENT COALITION, WASHINGTON, DC
Mr. Carr. Good morning, Chair Maloney and other
distinguished members of the committee. On behalf of the
National Community Reinvestment Coalition, I am honored to
speak with you today about the role that consumer financial
protection has played in the current crisis.
I have been asked to discuss today whether the existence of
a consumer financial protection agency modeled on any one of
the proposals--either the administration, the House, or
Senate--could or would have prevented the proliferation of
reckless and irresponsible mortgage lending that triggered the
foreclosure crisis that eventually led to the implosion of the
housing and credit markets.
It is, of course, impossible to answer such a hypothetical
question with certainty. I am convinced, however, that if a
consumer financial protection agency had been in place and
structured with the appropriate regulatory authority, funding
and independence, that such an agency would have prevented the
bulk of the most egregious predatory lending in the markets.
Climbing our way out of the current crisis will require
that financial system regulation be reoriented to serving the
needs of the American public, but given the damage that has
occurred to both the credit markets and the economy in general,
much more than improved consumer financial protections will be
needed to accomplish a full recovery. Those additional actions
would include better managing the foreclosure crisis and
putting America back to work. In the limited time I have this
morning for my opening remarks, I will focus specifically on
consumer protection.
One of the most dispiriting aspects of the current crisis
is that it was largely avoidable. For more than a decade,
financial institutions increasingly engaged in practices
intended to mislead, confuse, or otherwise limit a consumer's
ability to judge the value of financial products offered in the
marketplace. Nowhere was this more evident than in the subprime
home mortgage market. Over the past decade, the subprime market
increasingly specialized in pushing loans that were reckless
and irresponsible, but that produced huge profits for mortgage
brokers, mortgage finance institutions, and Wall Street
investment banks. Excessive mortgage broker fees, irresponsible
loan products, inadequate underwriting, bloated appraisals,
abusive prepayment penalties and fraudulent servicing practices
were all part of the problem. All of these issues were
thoroughly documented, discussed and detailed in academic
articles, news stories, policy papers, and more.
Federal regulatory agencies were fully aware of these
policies and these practices, and they had the authority to
act. They chose not to. And on the rare occasion when they did,
it was to preempt State laws to prevent States from protecting
the rights of their own citizens from abusive financial
practices.
And while most of the costly financial services abuses
occurred in the housing market, predatory financial services
have come to permeate many aspects of the financial system,
including abusive credit and debit card policies, exploitive
overdraft protection practices, unreasonable check processing
procedures, and more.
Repairing the economy requires that we reorient the
financial system toward the mission of promoting economic well-
being for the American public. This means removing the
financial tricks and traps that create unnecessary financial
instability for consumers, and ultimately for the system as a
whole.
The Administration and both Houses of Congress have
proposed or are considering the establishment of a consumer
protection agency that would consolidate the highly fragmented
system of consumer financial protection laws currently enforced
by multiple agencies. Among the proposed agency's many positive
attributes is the fact that it would eliminate the current
practice of regulatory arbitrage whereby financial firms are
allowed to select their regulator, in part based on how poorly
they protect the public. A complementary attribute to the new
agency would be its ability to ensure the same level of quality
in financial products across institutional types.
Opponents of a consumer financial protection agency have
argued that such an agency would undermine the safety and
soundness of the financial system. Yet safety and soundness of
the financial system begins and relies on the integrity and
reliability of the products that are offered to consumers. The
Administration's bill and draft Senate legislation require or
authorize standardized products for financial firms. Arguments
against this requirement or option are that standard products
will stifle innovation. This argument is without merit. The 30-
year fixed-rate mortgage has been, for example, the gold
standard of mortgage products for decades. That product did not
stifle development alternatives; its reliability and safety are
the keys to its success. And the failure to offer low-cost,
fixed-rate 30-year mortgages to those who qualify for it was a
leading contributing factor in the spread of reckless subprime
loans that were the core of the initial foreclosure crisis.
One of the major differences between the President and
Senate's proposals relative to H.R. 3126 deals with the
treatment of the Community Reinvestment Act. Unlike the
President and Senate bill, H.R. 3126 leaves primary regulation
of CRA with the Federal Reserve Board. This is a mistake. Many
financial services providers historically and routinely offer
or deny products at a community level rather than at an
individual level. The excessive concentration of subprime loans
in African American and Latino communities is only one example
of this.
Other major keys to the potential effectiveness of the
proposed agency include it having the breadth of coverage over
financial institutions, independence of operations, product
disclosures that can reasonably be understood by the typical
consumer, and a funding stream that is not susceptible to the
vagaries of shifting political winds or economic downturns. If
structured and empowered properly, this agency can cultivate an
environment of integrity into the financial system. Restoring
trust and confidence in the financial system is essential both
for the American public as well as international investors who
have been harmed by America's failed experiment in poorly
regulated financial institutions.
[The prepared statement of James Carr appears in the
Submissions for the Record on page 44.]
Chair Maloney. Thank you.
Mr. Steel.
STATEMENT OF ROBERT K. STEEL, FORMER UNDER SECRETARY FOR
DOMESTIC FINANCE OF THE UNITED STATES TREASURY, CHAIRMAN OF THE
BOARD, ASPEN INSTITUTE, AND MEMBER OF THE PEW TASK FORCE ON
FINANCIAL REFORM, WASHINGTON, DC
Mr. Steel. Chair Maloney, members of the committee, my name
is Robert Steel, and I am pleased to be here today as a member
of the bipartisan Financial Reform Task Force.
Along with my task force colleague Dr. Litan, I appreciate
the opportunity to discuss our principles and the specific
recommendations needed to achieve them, which we submitted
along with our prepared testimony. We hope our principles and
recommendations are helpful with regard to the financial reform
process.
Our task force began work last summer and has covered a
large amount of ground. We believe we have a solid and
substantial framework, and look forward to further debate,
hearing your reactions, and learning from this.
The task force recommendations reflect many of the topics
now under consideration in the House Financial Services
Committee and the Senate Banking Committee. Further, they share
much in common with the recommendations advanced by Secretary
Paulson and Treasury in June of 2007 in the Blueprint for a
Modernized Financial Regulatory Structure, a report we worked
on while I was at Treasury as Under Secretary for Domestic
Finance.
Given the time constraints today, I would like to highlight
a single crucial recommendation of our work. What has become
known as the ``too big to fail'' problem is in many ways at the
heart of the financial reform effort. There are different ways
to approach this challenge. Congress could arbitrarily limit
the size of financial institutions, they could limit the scope
of their activities, or they could work to ensure that any
failure is less likely to cause a financial crisis. We favor
the latter strategy.
It is the strength of the American system that the
opportunity to succeed carries with it the prospect of
potential failure. To my mind, this system provides the best
possible opportunity for shared prosperity. As a result, our
task force recommends that all financial institutions should be
free to fail, but free to fail in a manner that will not
destabilize the financial system. The task force therefore
recommends three specific things with regard to this issue.
First, a sliding capital scale so that the larger, more
complex, more risky and more systemically important an
institution, the higher the standards for capital, liquidity,
and leverage to which it should be held.
Second, institutions above a certain size should submit for
approval a living will or a funeral plan that will describe in
detail how the firm, were it to fail, could be wound down with
a reduced impact on the overall economy.
Third, a new solution should be adopted for failed or
failing nondepository financial institutions. While the FDIC
should continue to resolve failed or failing banks, we
recommend that for nondepository financial institutions there
be a strengthened bankruptcy process as the presumptive
approach. In exceptional circumstances, only after strong
safeguards have been met should there be an administrative
resolution process as an option of last resort.
This proposed two-stage approach to winding down nonbank
financial institutions brings together two quite desirable
policy objectives: It maintains the market discipline of the
bankruptcy process while at the same time providing the
government with a new tool to protect the financial system in
times of unusual stress. In all cases, moral hazard is reduced
as shareholders, unsecured creditors, and senior management
will bear the burden of the failure.
To create this two-step process, Congress should first
amend the Bankruptcy Code as necessary to make bankruptcy the
presumptive process for managing all failing nondepository
financial institutions. In addition, Congress should create a
new Federal financial institutions bankruptcy court and grant
it sole jurisdiction in the United States for these cases.
In those exceptional circumstances when a bankruptcy would
pose unacceptable systemic risk, a new administrative
resolution process should be created for failing nondepository
financial institutions. This process should be used only after
strong safeguards have been satisfied. Congress should decide
exactly how strong the safeguards are and what form they should
take. For example, Congress could require consultation and
formal agreement between Treasury and the concerned Federal
financial regulatory agencies before the resolution mechanism
was activated.
Congress also could instead opt for a stronger safeguard;
this would empower Congress to make these decisions. There are
several methods by which Congress could insert a higher hurdle.
Let me outline one that our task force considered.
If a failing nondepository institution were judged to be a
threat to the stability of the financial system, the
administration could seek congressional appropriation. While
the administration seeks the appropriation, the firm in
question would enter the bankruptcy process in the proposed
special purpose bankruptcy court. Congress would then have a
limited and fixed number of days in which to make such an
appropriation. A customary stay would apply, and the Fed could
apply financing and collateral, permitting the firm to continue
to operate while Congress deliberated. If Congress did
appropriate, the estate of the firm would be transferred to the
administrative procedure; if it did not, the bankruptcy would
proceed, and the Fed would exercise its collateral once
circumstances permitted.
In closing, we commend the hard work already done by
Members in both Houses of Congress to move this crucial effort
forward. The task force hopes that our efforts will complement
the current work being done on these issues, as well as to
provide additional momentum to the overall financial reform
effort.
While there are unmistakable signs our economy has
stabilized, it is imperative, we believe, that Congress act
with urgency to enact comprehensive and effective reform.
Thank you very much.
[The prepared statement of Robert K. Steel appears in the
Submissions for the Record on page 67.]
Chair Maloney. Thank you very much.
I want to thank all of the panelists. And because this is
the first time that Ms. Born has testified before Congress
since she left public service in the late 1990s, I would like
to direct my first series of questions to her.
Ms. Born, when you were Chairperson of the CFTC, why were
you so concerned about the over-the-counter derivatives market?
Ms. Born. I took office in 1996, and 3 years before that,
the CFTC, my agency, had exempted customized swaps from the
exchange trading requirement of our statute, but it had kept
fraud and manipulation powers over the market.
When I got into office, I learned that the market was
growing exponentially; it was, at that point, at about $30
trillion of notional value. We had no recordkeeping or
reporting requirements, so there was no transparency. I could
not effectively oversee that market for fraud and manipulation,
even though we knew there had been major cases of fraud.
Bankers Trust, an OTC derivatives dealer, had defrauded Proctor
& Gamble and other customers. We knew there were major cases of
manipulation. Sumitomo Corporation had used over-the-counter
derivatives in copper to manipulate the world price in copper.
We also knew that there was speculation on borrowed money in
the market that was causing some major defaults.
Let me just mention Orange County, California, which had
been speculating on over-the-counter interest rate derivatives
with taxpayer money and was forced into bankruptcy because of
its losses. I was extremely concerned because neither our
agency nor any other Federal agency had a sufficient amount of
information about the market to know the extent to which this
enormous and quickly growing market was threatening the
financial fabric of the country. In fact, while we were
undertaking our inquiry into this market and I was appearing
before a number of committees of Congress discussing whether or
not over-the-counter derivatives should be subject to any
Federal regulation, the Long-Term Capital Management crisis
occurred.
Long-Term Capital Management was an enormous hedge fund
which, unbeknownst to any Federal regulator, had managed to
acquire a position of $1.25 trillion of over-the-counter
derivatives even though it only had $4 billion in capital. Over
a weekend, the Federal Reserve learned that it was about to
collapse, and the Federal Reserve felt that if it collapsed
with that kind of a position in over-the-counter derivatives,
it would threaten the financial stability of the country.
Fifteen of our largest banks and investment banks were its
over-the-counter derivatives counterparties, and they were, at
the request of the Fed, able to come up with hundreds of
millions of dollars each to take over the position and prevent
collapse. But that demonstrated very vividly to me the dangers
of contagion; the way that these instruments spread risk
through the economy; and the danger that the failure of one
institution, because of its trading, would bring down other
institutions because of the connections through counterparty
relationships.
Chair Maloney. I was a member of the Financial Services
Committee at that time, and I remember there was a huge
interest in moving forward with regulation, but then the
economy improved and was booming, and the need for regulation
was ignored, and we went forward with this problem. And look at
the disaster that it caused with the financial crisis. So we
should have acted then, and we are determined, with President
Obama, to enact comprehensive regulatory reform. If we had
acted back then, we would not have had the crisis that we are
in.
My time has expired, and I am delighted to recognize
Senator Brownback.
Senator Brownback. Thank you very much, Chairwoman Maloney.
I am sorry for being late; I had another hearing I was at. This
is a very important one, and I am delighted with the panel that
is here and the topics being covered.
I want to go direct to dealing with large financial
institutions and their failure, and how we handle that as an
overall body, and how we handle that as a government. It seems
like that, to me, is one of the key things that has come out of
this crisis is our inability to handle something that is too
big to fail; and consequently, if it is too big to fail, then
we just have the taxpayer take the risk, and that has a lot of
moral hazard in the marketplace. And if we don't fix it, it
seems like, to me, it builds that moral hazard bigger in the
next round that takes place so that people will say, well, last
time they didn't fix it.
And it also strikes me that these bubbles build faster
quicker. It is almost like financial storms build quicker,
faster, bigger now than they used to. Whether it is the dot.com
bubble and burst and the housing bubble and burst--and I am
concerned we are in a government bubble and burst--that if we
don't get ourselves in position now to be able to deal with
these large institutions and tell them the marketplace will
assume we are going to protect them, and then there will be
more money going to places that it really shouldn't.
I would like to know, I think particularly Dr. Litan and
Mr. Steel, if I could--and maybe others of you want to comment
on this--I missed your testimony, I know that you have
addressed some concerns on this. Tom Hoenig of the Kansas City
Federal Reserve is a man I have worked with a fair amount on
this. Do you generally support the model of what he is putting
forward on this? Or perhaps this is your model and he is just
adopting it, but I would like to get into some of the detail on
this, if there is a kind of a collective thought coming
together of how we structure ourselves to deal with this in the
future.
Mr. Steel. Well, thank you, Senator. In my comments this
morning, I highlighted my perspective that this too-big-to-fail
issue is really at the crux or the crucible of all the issues
that we are thinking about and really is a mission-critical
part of what we are focused on.
With regard to President Hoenig's comments, we are familiar
with the work. I think that the key construct, the philosophy
of his point of view is that resolution should be very painful,
and that if we go through resolution, then whether it is
bondholders, management, shareholders should suffer significant
pain. We echo that same sentiment. He goes into much greater
detail in the actual technicals of how he would organize his
resolution process than we did in our work, but what he seems
to look at is important.
We did offer a different step, though, and talked about a
two-part process that we don't like identifying institutions
that are too big to fail. We believe that there should be a
sliding scale of capital required for important institutions
that takes into account risk, asset size, complexity, et
cetera. We also believe in the living will concept, that every
firm should have a plan as to, if they do get into
difficulties, how that can respond, and that should be filed
and approved with a regulator. And if your plan is not filed
and approved with a regulator, then you have to downsize.
But thirdly, what we have organized that is different than
President Hoenig is that we feel that an enhanced bankruptcy
process should precede resolution. So the first default
position is bankruptcy. If bankruptcy can't work and it is too
systemically important, then we would move to a resolution
process consistent with his.
Senator Brownback. That seems to be a good mixture.
If I could, if we get in another financial crisis, and if
the trajectory of the past is a projection of the future, it
looks like we will, and it will be sooner rather than later,
will the courage exist here to allow those triggers to be
pulled, or are we just caught because these things will, in
likelihood, exacerbate a financial crisis if you let one of
these things go down like we saw with Lehman Brothers.
Mr. Litan. Okay, several comments. We know Dr. Hoenig's
views very well in Kansas City. Part of my life is spent in
Kansas City at the Kauffman Foundation, and Dr. Hoenig is
actually a trustee of our foundation, so we are very familiar
with his views. And I want to echo what Bob just said. We had
the same directional suggestion that he talks about, which is
to make sure the pain is spread.
And when we talk about too big to fail, I would like to
clarify a couple of things. I think there is a lot of confusion
in the public. We are really talking about protecting creditors
in full, because the shareholders get wiped out, and--although
actually in some cases the management did not get wiped out,
but we certainly, on our task force, recommend that people who
are responsible for failures should definitely lose their jobs.
But the key thing to ending too big to fail is to make sure
that unsecured creditors take some hit in some form. And so the
bankruptcy process is clearly one approach to this. You can
also accomplish that same haircut in an administrative process,
but the key is that there be pain.
The second point, I will just elaborate on what Bob said.
There is a huge debate now about whether or not we ought to
preemptively break up institutions in advance. Should we
arbitrarily set up some size and say above it we are just going
to break you up? I am a former antitrust enforcer, and I can
tell you that there are no antitrust principles to make that
decision. We have market definition tests and so forth, but
there is nothing in the antitrust laws that will tell you the
magic size threshold above which you are too big to fail. So
you are going to have to look to some other principles. And our
task force debated that extensively.
We came down where Bob said, which is we would not just
across the board eliminate all too big institutions, because
there are benefits of size, especially in the global market,
but what we do say is that all large institutions ought to file
this funeral plan or this wind-down plan with the regulators.
And the regulators would have the ability, if they are unhappy
with the wind-down plan and believe that it would not protect
the financial system, they would have the authority to chop the
institution up only in that circumstance. So we are against
across-the-board size limits, but otherwise, I stand foursquare
where Bob left his remarks.
Senator Brownback. Thank you.
Chair Maloney. Thank you.
Mr. Hinchey.
Representative Hinchey. First of all, I just want to thank
you very much for what you have said in your testimonies, and
the response that you have given to these questions. And the
complexity of this situation is seen clearly in the context of
the questions, but even more so in the context of the answers
to the questions.
We are dealing with a very, very difficult and dangerous
set of circumstances here economically for the future of this
country. And one of the things that strikes me is the huge
financial institutions, four of them, now hold half of the
mortgages in America, issuing nearly two-thirds of our credit
cards, and hold roughly 40 percent of all bank deposits. That
strikes me as an absolutely fascinating set of circumstances,
and why we allowed that to happen was a very big mistake. And
we allowed it to happen intentionally. We allowed it to happen
intentionally because there was a great interest on the part of
some people to make as much money as possible and engage in
this financial operation in ways that can be most beneficial to
them. And if it had some benefits to others, well, you know,
that might not be so bad. But the fact of the matter is that
hasn't been precisely the case. Because of the size of these
institutions, that is one of the main reasons why the economic
collapse that we experienced came about.
One of the things that strikes me is this whole idea of too
big to fail. If we have a situation where something is too big
to fail, then we are just saying to ourselves, we are just
turning everything over to them; they are going to do whatever
they want, and all of the consequences of that are going to
fall upon everybody else.
So nothing should be too big to fail. And the regulation of
setting forth something that is not going to be too big is also
very important. I think that there ought to be some analysis or
some acceptance of the idea ``too big to exist.'' We should not
allow these institutions that are this size to actually come
into play here and to engage in the circumstances that they
have engaged in, particularly with regard to the way in which
there has been this combined operation of commercial and
investment banks and how that operation in and of itself played
such a significant role in the impact of the economy that began
to fall in the end of 2007.
So, what do you think that we should be doing about that?
What is it that we should be engaged in here?
A number of the pieces of legislation that have come
forward are constructive, they are moving in the right
direction, but they are moving slowly in the right direction. I
think that there are more things that need to be done. We see
what happened back in the 1930s when there was basic
legislation passed that said the combinations that we have seen
and the adverse effects of those combinations and the
manipulation of investment activities, all of that is now much
clearer to us, and we need to stop that from happening in the
future, and that was done. We have gradually weakened that
process, and then we completely eliminated it just a decade
ago. Now we have got to go back to something that is much more
positive.
So maybe you can talk a little bit about that. What can be
done now that is going to not bring about the financial
collapse that so many of us apparently have in mind that is
likely to occur if we continue to allow this set of
circumstances to continue to exist and continue to override the
entire financial circumstances that we have to deal with? What
should we be doing?
Ms. Born, what do you think?
Ms. Born. Let me talk about the area that I know the best,
over-the-counter derivatives, because one of the problems with
these institutions is not only are they too big to fail, but
they are too interconnected to fail; the failure of one will
potentially bring down the others, or at least severely harm
them.
One of the things we can do is bring over-the-counter
derivatives trading out of the preserve of these big banks and
onto exchanges and clearinghouses where we will not have
enormous exposures building up in these banks that could bring
down the banks.
In a clearinghouse situation, where derivatives are
exchange-traded, the clearinghouse rather than an over-the-
counter derivatives dealer--which all these institutions are--
becomes the counterparty to each and every trade. It marks that
trade to market twice a day, and at the end of every day at
least, it calls for margin to be put up by all the traders who
the market has moved against so we never get these enormous
exposures like AIG had.
I think appropriate regulation of derivatives by bringing
everything we possibly can onto regulated exchanges would
certainly help. I do think that there are additional problems
because these institutions not only will remain too big to
fail, but I think they are too big to manage and too big to
supervise.
Thank you.
Chair Maloney. The gentlewoman's time has expired. The
gentleman's time has expired.
Mr. Burgess.
Representative Burgess. Thank you, Madam Chairwoman.
Ms. Born, I wonder if we could just continue on that line
for a moment.
When you talk about the appropriate regulation of
derivatives and the requiring a margin to be put up, is that
not the case now? That mark-to-market twice a day and requiring
a margin call to be made at least at some point on a daily
basis, is that not the case now?
Ms. Born. That is not the case with any of the over $600
trillion in notional amount of over-the-counter derivatives. It
is only the case on the regulated futures and option exchanges.
Representative Burgess. How difficult would it be to create
that system? We have got an enormous financial regulatory
system already in place, and we are being asked to create yet
another new superstructure. Is there not the capability within
the existing financial regulatory structure today to do just
what you are describing.
Ms. Born. Yes. I think we have a wonderful prototype of
what we need to do on the futures and option exchanges.
Bringing as much of the standardized trading as possible onto
exchange will take care of the problem for a lot of the market,
because a great deal of the market is standardized contracts.
Now, I think the only legitimate, economically justifiable
over-the-counter trades which justify the exposure the American
public has to the harm from that market are hedging contracts,
where large commercial entities are trying to hedge complex
business risk. I think it is legitimate to continue that
market, but I think there have to be capital requirements
imposed on all the participants in that market; there have to
be margin, collateral, and marking to market requirements in
order to make that market safe. But you should realize we have
no experience in successfully or effectively regulating an
over-the-counter derivatives market. Our only experience with
effectively regulating derivatives has been on exchange, and
that has been effective since 1935.
Representative Burgess. Well, let me ask you a question
that I posed to Walter Lukken 2 years ago when we got into all
the difficulty with the futures speculation. And that is, what
are the tools that I guess in this case the CFTC needs that it
lacks in order to create the type of reality that you are
describing here? Does the CFTC possess the tools today, or is
there something legislatively that the CFTC needs or some other
regulatory body needs in order to make what you described
reality?
Ms. Born. In 2000, Congress forbid the CFTC or any other
Federal regulator to oversee the over-the-counter derivatives
market at all. So that has to be overturned. You have to give
authority to the CFTC as the most experienced and expert
federal regulatory body, and the SEC with respect to securities
derivatives, to oversee these markets. And you need to require
that standardized contracts go onto exchanges and
clearinghouses.
Representative Burgess. Now, Mr. Lukken two summers ago
said that the CFTC did still possess those capabilities but
only in the case of an emergency. Now, in the summer of 2008,
with four airlines declaring bankruptcy and the price of oil
going up $16 in an hour, whatever it was, per barrel, I
suggested to him that that was an emergency and that he ought
to exercise those powers if he had them. But you are saying
even in an emergency environment, those powers no longer exist?
Ms. Born. They do not. They have not existed since 2000
with respect to the over-the-counter market. There are powers
that have not been exercised until recent days, during the last
10 years, by the CFTC with respect to exchange trading and
regulated clearing that allow actions to be taken to reduce
excessive speculation. And it is my view that the CFTC really
fell down on the job by failing its mandate to ensure against
excessive speculation on the markets. I think that summer
before last, there were tremendous bubbles in agricultural
products and energy products, and it was because excessive
speculation was being tolerated by the regulator and by the
exchanges when it should not have been.
Representative Burgess. What are some of the potential
pitfalls from creating this type of regulatory environment that
you are envisioning?
Ms. Born. I think it exists right now for exchange-traded
derivatives, or at least it certainly did when I was chair of
the CFTC in the late 1990s. There were requirements that
everybody trading on a regulated exchange declare whether--
ahead of time, whether they were speculating or hedging, and
speculators had special accounts that were designated as
speculative accounts. They had special requirements like
position limits imposed on them, by both the exchanges and the
regulator. The CFTC had powers to step in and order a reduction
of positions, order that a speculator who was abusing the
system close out its positions entirely or pay extra margins,
or any number of regulatory tools that were in the CFTC's
toolbox.
Representative Burgess. Is there enough transparency in the
market as it has evolved today with the unregulated over-the-
counter exchanges to be able to provide that same type of
oversight, or will it require creating a new financial
regulatory system?
Ms. Born. I think it is very----
Chair Maloney. The gentleman's time has expired. You may
answer the last question.
Ms. Born [continuing]. I think it is very important that as
much of the over-the-counter trading as possible, all the
standardized trades, go onto exchange so that they are
transparent. I also think, if there are any continuing
speculative trades in the over-the-counter market, which I
don't think there is any justification for, that position
limits should be imposed on those through a regulatory regime
like is proposed in pending legislation.
Representative Burgess. Thank you.
Chair Maloney. Thank you very much.
This is an incredibly busy Congress, and I have just been
called to the floor to manage a bill of mine that will bring
transparency and accountability to the $700 billion in TARP
funds, and that is an important bill and I have to go to the
floor. But I would like to ask Dr. Litan and Mr. Steel to
respond in writing, your ideas on too-big-to-fail and
alternatives were very important. We have passed out a bill
from the committee, which will be going to the floor, which
allows government to basically dismantle too-big-to-fail.
And I would like to ask, how would this impact on the
global economy if the too-big-to-fail large institutions become
the norm in other countries. Would this put us at an economic
disadvantage? And to comment on this proposal in writing. I
think it is critically important and I would like to study it
further.
I do want to say that, Brooksley Born, you are one of my
heroines. I think you deserve the Nobel Prize for speaking out
and being courageous and pointing out what needed to be done.
If we had listened to you, we would not have had this financial
crisis.
I have a series of important questions that I would like to
get on the record. Mr. Hinchey has agreed to help me get them
on the record, or I think they are important in our review, as
we move forward in financial comprehensive regulatory reform. I
regret I have to leave.
[A letter from Representative Maloney to Robert Litan
appears in the Submissions for the Record on page 71.]
[A letter from Representative Maloney to Robert Steel
appears in the Submissions for the Record on page 72.]
Chair Maloney. I recognize Mr. Cummings for five 5 minutes.
And Mr. Hinchey will assume the chair.
Representative Cummings. Thank you very much, Madam Chair.
Ms. Born, a moment ago you said something to the effect
that not only were some institutions, large institutions, they
fall into the too-big-to-fail category, but they are too big to
control, something like that. And I found that all of our--on
the Government Reform Committee when we dealt with AIG, a lot
of times the left hand didn't have a clue as to what the right
hand was doing, and it was just incredible to me. But listening
to your testimony, I take it that you feel that the House bill
certainly does not go far enough; is that right?
Ms. Born. I have just been focusing on the over-the-counter
derivatives treatment. And in terms of the House bill on that,
I do think that the end-user exemption for standardized
contracts from exchange trading is unwise. I think that all
standardized contracts should be required to be traded on
exchange.
Representative Cummings. You know, Mr. Carr, the conduct of
the credit-rating agencies during the financial crisis is
extremely disturbing, and perhaps most disheartening is the
destruction that has been done to the assets of public pension
plans around the country. These public servants have lost their
retirement security, threatened by the fact that the pension
boards were required to hold assets that were later found to be
inaccurately rated by these agencies.
The proposals in Congress have done a good job of
addressing many of the conflicts and disclosure issues that
have plagued the rating agencies. In your opinion, have the
proposals gone far enough?
Mr. Carr. Thank you for the question. The National
Community Reinvestment Coalition does not have a specific
position on any one of the specific rating agency proposals,
but we do believe that something like a public utility might be
a very useful structure. We have documented quite extensively,
as you know--which is probably why the question came our way--
about the way in which the rating agencies were stamping
investment grade on products that were obviously junk bonds for
years.
So most of our work, Congressman, has really been focused
on the front end of that question, which is documenting the
abuses in the system, but not necessarily moving to the back
end to structure the appropriate legal resolutions.
Representative Cummings. Do you have an opinion on that,
Mr. Litan?
Mr. Litan. Yes. The issue of credit-rating agencies is
incredibly complex. No one disagrees--at least none of the
experts disagree--that they were at the heart of the crisis,
among many other causes. And what they were doing that clearly
contributed to the crisis is that they were rating instruments
on the basis of very limited histories and then extrapolating
that they would have AAA ratings, and we all know now that that
was deeply mistaken. By the way, so too, similar mistakes were
made by bond insurers.
So the question is what to do. Our task force at Pew
debated this extensively. I can't tell you there is a silver
bullet to fixing the rating agencies. What we end up
recommending is to replace the letter grades that they now give
with a suggestion, if not a requirement, that the rating
agencies tell us what we really want to know; which is, what is
their estimated probability of default of this bond? And then
have an agency or at least private sector organizations track
these predictions so that the investing public knows how good
these forecasts are, and then the U.S. Government can have a
choice. If it sees an agency that is consistently
overestimating the likelihood that a bond is going to survive
or, conversely, is underestimating the default probability, the
government could either decertify the agency or it could impose
penalties. But there ought to be some price to be paid for
consistently going out to the public with over-optimistic
ratings.
Now, my own personal view on the public utility model is--
and I am not sure we extensively debated this within the task
force--I am not wildly enthusiastic about it. You have got to
remember that all of our bank regulators, all of them, had
major failures. And so I don't have a lot of confidence that
another government agency or utility commission is going to do
any better in predicting these future events than our bank
regulators did.
Representative Cummings. My time is running out. But when I
listen to the testimony in Government Reform of the rating
agencies, there is something that is very difficult to
legislate, and that is integrity. And a lot of the things that
were done, I know they may have been dealing with limited
information, but we had testimony that showed that there were
folks who were just not being honest. And maybe that is why you
were having such a problem trying to come up with a solution.
Mr. Litan. Well, the core of the problem is that there is
an inherent conflict, as you know, in the agencies. And because
the way the market has developed, people can free-ride on the
information. And so the only way they can stay in business up
to now is by charging the people who issue the bonds, and that
is right there a blatant conflict. And, frankly, given the
state of the market, I am not sure we know how to fix it,
except all we can do maybe is think of ways of penalizing these
guys when they blow it.
Representative Hinchey [presiding]. Thank you, Mr.
Cummings. Mr. Brady.
Representative Brady. Thank you, Mr. Chairman. A lot of
good questions asked today, and a lot more to be asked on the
liquidity resolution bankruptcy, just sort of a whole best
approach on too-big-to-fail and how we move forward on all
these issues.
I wanted to ask the panel, in no particular order, just
your thoughts on credit default swaps. To a layman not in the
financial services business, it seems like the fact that banks
sold these credit default swaps to each other contributed to
the contagion effects during the financial crisis. It seemed,
in effect, banks were able to rent a higher credit rating for
lower capital reserves during this process.
So one question is: Did the Basel II risk-based capital
standards encourage banks to actually trade credit default
swaps by allowing them to substitute the higher credit rating
for lower--swap that for the lower credit rating of the
borrower? And did the trading of credit default swaps among
banks, in the end, have the unintended consequence of lowering,
of reducing the capital in the banking system as a whole?
And then I am going to follow up on a thought on are credit
default swaps a legitimate financial product? So let's open it
up.
Ms. Born. Let me just start, since credit default swaps are
a kind of over-the-counter derivative, and they certainly
played a very important role in this latest financial crisis.
They were used by banks and investment banks and other
institutions to insure mortgage securitizations and other debt
securitizations that perhaps otherwise would not have gotten a
high rating. But, beyond that, they were used by many
institutions, including the investment banks and banks, to
speculate in the stability of other institutions, the stability
of the mortgage market, the stability of the credit markets.
And because of this highly speculative, highly leveraged
trading that is essentially gambling on the creditworthiness of
products, when there was a downturn there was an enormous
crash, the most obvious entity being AIG that lost hundreds of
billions of dollars and had to be bailed out.
Representative Brady. Just sort of drawing sort of a little
narrower focus. Was the end result of all that, that in effect
we reduced the capital in the banking system? By the use of
credit default swaps, we created----
Ms. Born. I think the capital----
Representative Brady [continuing]. We really needed?
Ms. Born [continuing]. The capital requirements that we
were using for the banking system were demonstrably inadequate
in light of what happened.
Mr. Litan. I can address that issue specifically on the
capital requirements. Before I do, though, I would say I would
not ban credit default swaps. If subject to the appropriate
institutional design regulation, they are the functional
equivalent of insurance, and there is no reason we should ban
insurance.
But your question raises the issue, were these CDS
instruments used to effectively lower bank capital
requirements? The answer is yes. Because under the Basel rules,
the Basel committee outsourced the capital requirements, in
effect, to the rating agencies. So that if you got a AAA on a
security or other kind of instrument, you got a lower capital
charge.
We did not debate this extensively in the task force, but
my own personal view, and I have been writing about this for 10
years, is that this whole risk-rating system was nuts. I would
have preferred a simple leverage ratio. And this idea that we
can outsource the capital requirements and bank risk
assessments to the rating agencies who had this inherent
conflict, in essence led to too little capital in the banking
system. It was a big mistake. And so, going forward, I would
get away from this risk rating.
Representative Brady. Mr. Steel.
Mr. Steel. Nothing to add.
Representative Brady. I will conclude with this. I think
there is a legitimate role for this. One of the concerns I have
is, as an insurance product, clearly when the market goes sour
the claims hit in clusters. That is when the assets have the
lowest market value. It seems like this is a product that it
seems nearly impossible to--if you set aside adequate reserves,
the price of the product itself would almost be of no longer
use in the market.
The alternative of that is to have the Federal Government
be the depositor or the--you know, insurer for all of that--
which I don't think that is where Congress wants to go.
Certainly, I don't.
Any thoughts on that that you can give? My time is up, Mr.
Chairman. But, Mr. Steel, any thoughts?
Mr. Steel. Well, I thought that the gem of what you said
was that if the--there is a moral to the story. If the
appropriate capital requirement makes the product too
expensive, then maybe we shouldn't have the product, I think is
kind of the circle, the way that I would follow your logic. And
so if we have these types of products, we have to make sure
that they are reviewed and that supervisors and regulators
understand them, so that we do have the right amount of
capital.
Representative Brady. Great. I really do appreciate all of
you being here today. Very helpful.
Representative Hinchey. Mr. Snyder.
Representative Snyder. Thank you, Mr. Chairman. And I
appreciate you all being here. I missed most of your all's
opening statements, but I don't think you covered this so far.
I think I will direct my question to you, Mr. Steel. I
don't come out on the financial services industry and I am not
on the Financial Services Committee. I am a family doctor. But
the idea, the concept of having a living will for institutions
that most Americans think have neither hearts nor souls
intrigues me, and I wanted you to amplify on that a little bit,
if you would.
I don't understand how that would work. They would file a
document that I assume, in order for it to have any meaning,
would have to have sufficient detail, but I would think would
rapidly get out of date, or if it had any kind of detail in it,
about how they would unwind. If it had lots of detail in it, I
suspect competitors--I assume these would be public documents.
Or would they be private documents?
Mr. Steel. Private.
Representative Snyder. Private documents. But I assume that
there would be issues with them needing to come back and say,
well, in the full disclosure we have changed--sold these assets
already.
And also in your statement you say, ``could be wound down
with reduced impact on the overall economy.'' Institutions
really don't have an obligation to watch out for the world or
U.S. economy or a State's economy. They have an obligation to
watch out for institutions. So they are not going to file a
document that says--I wouldn't think. I mean, I don't know what
their fiduciary duty is. I assume it is to the people who own
the business.
Would you amplify for me on what this document would look
like, how long would it be? I just don't understand how it
would have any real value.
Mr. Steel. Sure. I think that what we have found was that
in this tumult the last period of time, that I believe that the
two ingredients in short supply were capital and risk-
management skills, in hindsight. And this is a personal
perspective. And that we, in our report from our task force,
talk about a series of things that can be done to address these
issues. And key among them is this idea of an engagement with
your regulator, where you have to have a tough conversation
about, if you hit a turbulent or a period of stress, how would
you deal with it, and that you have a plan. And I wouldn't--and
I think that is the idea. And it should be an engagement with
your regulator. And if you can't describe that and if you can't
make your regulator comfortable that you have--you choose your
analogy, an evacuation plan, a living will, that kind of idea.
If you don't have a plan, then the regulator says: You are
really not the person to be managing this institution of this
complexity, this size and this risk level. And that is the type
of engagement.
And while my own perspective, because I haven't used this
analogy before--I think there were elements of this to the
recent stress test--would be that type of engagement. I would
invite my colleague, Mr. Litan, if he would like to add
something.
Representative Snyder. I don't understand the kind of
detail that we would have to have. It would be like at a time
when things are going to go well, okay, what are you going to
do when things go wrong? And if something goes wrong, then they
will come back and say, we didn't know that was going to
happen.
Mr. Steel. I think the idea of the analogy of the stress
test is looking at your liquidity characteristics,
understanding the correlation of assets, and having a plan
that--if you had to move quickly, how would you respond, would
be the essence of it.
Mr. Litan. And I will elaborate. It is not just to respond
to stress, but how are you going to unwind yourself and
dismember yourself in the event that you have to be liquidated
or sold off? Who is going to lose money, which creditors, in
what order and so forth. And I want to make this concrete for
you. Do you know how many subsidiaries Citigroup has? Twenty-
five hundred. All right? Now, they happen to be exceptional.
But Deutsche Bank has roughly the same number, and a lot of the
other banks, big banks, have lots of subsidiaries. My suspicion
is, I am not sure the general counsel of Citigroup knows all
2,500 subsidiaries that bank has.
So, to be specific, if you are forced every year to write
down to your regulator a plan that says how you are going to
unwind this enormous elaborate mess, and you don't even
understand it yourself, and, by the way, the board doesn't
understand it, then the agency has got to have the authority to
help you consolidate your complexity. And I think the sheer act
of----
Representative Snyder. I wanted to ask--so let's take that
as an example, the 2,500.
Mr. Litan [continuing]. Right.
Representative Snyder. So are you saying that--I am number
2,500, I am a little bank sitting someplace--that CitiBank has
a piece of the action, and it is all going to be private, and
then word will get around, you are the first to go? I don't
understand how this operates.
Mr. Litan. No. First, these are living wills that are
disclosed only to the regulator, and----
Representative Snyder. So they will have a document that
says this is the order in which we are going to get rid of
them. We never liked that one anyway. But it will be kept from
those people and those shareholders?
Mr. Litan [continuing]. Well, in the case of Citigroup, I
think most all of them are wholly owned subsidiaries. They are
created in different jurisdictions. It is not clear who is
responsible in the event of failure. There has to be a plan to
say who is responsible for these different entities. And I will
tell you, I mean, I will be blunt. I am not claiming this is
going to be the magic answer. But, at a minimum, what the wind-
down plans do is two things:
First, if the institution gets in trouble, they are the
first draft of the resolution when the institution either ends
up in bankruptcy court or ends up at the FDIC or its
equivalent. Okay? That is the first thing.
And the second thing is that by having to prepare these
plans every year and stare into the abyss, all right, just the
sheer act of doing that is a mind-expanding exercise.
As a doctor, Congressman, you can analogize the preparation
of the wind down plan to an annual physical exam. Back to the
Citigroup example, the directors would then go to the general
counsel and say, you mean you have got 2,500 companies and you
don't even know all their names? How are we going to dismember
these entities in case this organization goes under? And then
you go back to the general counsel and you say, rationalize
this for me, and then tell us exactly who is going to take the
loss and so forth. That is a very instructive conversation to
have.
Representative Snyder. Thank you.
Representative Hinchey. Thanks very much.
I just wanted to mention the over-the-counter derivatives
markets and the role that they played in this economic crisis
and see what you think about that. One of the most interesting
aspects of it is the energy derivatives market, over the
counter, and the way in which that was carried out and the way
it is still carried out, without any oversight of the Commodity
Futures Trading Commission. There is no oversight, no
examination. And this is one of the reasons why we have seen
the price of energy, gasoline, oil, go up so dramatically.
What do you think should be the proper steps that could be
taken now to deal with this situation of these over-the-counter
derivatives markets, so-called over-the-counter derivatives
markets? It is interesting, the name is very interesting, over
the counter. Mr. Carr, would you want to talk about that?
Mr. Carr. Congressman, I feel like I walked into the wrong
hearing. I was asked to talk about the Consumer Financial
Protection Agency, for which we have lots of views. We
certainly do have views on too-big-to-fail in the derivatives
markets, but we don't have any formal positions on that. Our
time is really being consumed with trying to figure out the
consumer side of the puzzle.
Representative Hinchey. Okay. Ms. Born.
Ms. Born. I would be happy to respond to that. I think,
first of all, that it is true that both on-exchange energy
futures and options and the over-the-counter trades in energy
have been used by speculators to manipulate the energy markets
in the last few years, and that it is critically important to
the economic well-being of this country to get that under
control.
I would bring all the standardized contracts onto regulated
exchanges where there are a lot of regulatory tools to limit
speculation when it gets excessive. I would also require, with
respect to any remaining over-the-counter derivatives trades,
that they be reported to the regulator. I would not allow any
over-the-counter speculative trades; but if you are going to
allow them, there should be position limits that can be imposed
by the regulators on both over-the-counter positions and
exchange-traded positions.
Representative Hinchey. Dr. Litan.
Mr. Litan. Okay. I am now going outside the bounds of what
our task force debate was, so I will just give you my own
personal views. I am going to address the whole issue of just
derivatives generally, not just energy.
I certainly agree that what we ought to do is have
recording of all these trades on trade registries. Where there
is collateral, the collateral ought to be held by third
parties. This is something our task force was very strong
about. If you go back to AIG, their collateral was not held in
a third-party account.
When it comes to moving things to clearinghouses and
exchanges, yes, we are for migrating it, but we would use
capital requirements to induce that. So in effect what we would
say is if you are a big bank and you have an OTC position that
is not on a clearinghouse or an exchange, you have a much
higher capital charge. So we would give very strong incentives
for the geniuses on Wall Street to develop standardized
instruments to go onto exchanges and to clearinghouses. But we
wouldn't mandate it, instead using capital as a way of
migrating these infringements. So we end up moving in the same
direction that Brooksley talks about.
The reason why the clearinghouses are so important is that
they eliminate the situation where as AIG is bilaterally
responsible to its counterparties, and instead has obligations
only to the clearinghouse. But then the clearinghouse needs to
be regulated. You have to make sure that the clearinghouse has
adequate capital and liquidity; otherwise, you have got a
potential systemic problem. You can't make systematic risk go
away, but you can certainly make it more visible and make it
more controllable if you concentrate the risk.
Representative Hinchey. Mr. Steel, do you have anything
else to say about that?
Mr. Steel. No. I think he described the perspective that we
had in our committee. So that is fine.
Representative Hinchey. Ms. Born, do you think that that is
enough? Don't you think that there is some additional
regulation to stop the manipulation of the prices of something
that is essential to people across this country, like energy
prices?
Ms. Born. Absolutely. I think that the tools that the CFTC
has now with respect to exchange-traded oil futures are
necessary for the entire market. And I think that as much as
possible, oil derivatives should be on a regulated exchange so
that there are the tools to limit excessive speculation.
Unfortunately, the summer before last the CFTC failed to do
that even with respect to the exchanges, although they had
power to do it. They could have required speculators on
exchange to reduce their positions. They could have required
them to eliminate their positions. They could have required
them to pay extra margin, as is being suggested. And I think to
the extent there is allowed any speculative trading over the
counter, those should be the powers--there should be full
oversight, full reporting, and powers to impose position
limits.
Representative Hinchey. And to stop it.
Ms. Born. Absolutely. I think reporting should allow the
CFTC to put together, aggregate, the positions an entity has on
exchange and off exchange, and even in the physical market, so
that the CFTC can assess whether the position is too big, and
it can say reduce it or eliminate it. And if there is an
emergency, it can tell all the speculators to reduce their
position.
Representative Hinchey. Do you all have time to stay for a
few more minutes? Dr. Snyder.
Representative Snyder. Thank you, Mr. Chairman. I wanted to
give each of you a chance to predict the future for us as you
look ahead and you follow this debate that is going on in
Congress and amongst the American people with all the different
players that are involved in this discussion of what kind of
regulatory network we need.
When we finally have the President put ink on paper and
sign into law major changes--and I think that will happen
sometime next year--what is your greatest fear that we will
leave out? What do you think the most likely mistake is, or
mistakes, that we as a Congress and an administration will
make?
Do you want to start, Ms. Born?
Ms. Born. Yes. And I will just talk about the over-the-
counter derivatives area, which is what I know the best. The
biggest concern I have is that some of the bills currently have
exemptions for standardized contracts that can easily be traded
on exchange but they are permitted to stay over the counter. I
don't think there is any justification for that. I think that
creates a loophole that can cripple this effort and really not
result in effective regulation.
I would eliminate the end-user exemption for standardized
contracts. I would eliminate the foreign currency exemptions
some of the bills have on standardized contracts. I would
eliminate the provision that suggests that contracts can be
traded over the counter if one party is not an eligible member
of a clearinghouse. Essentially, that seems particularly
frivolous to me, because our clearinghouses have traditionally
had clearing members acting as intermediaries for entities that
aren't members. So that is not a relevant position. I am afraid
that legislation could leave room for a vast and underregulated
over-the-counter market through these exemptions.
Representative Snyder. Mr. Litan.
Mr. Litan. So we have five principles that the Pew
Commission has recommended, and I am not going to differentiate
among all of them. We think all five should be in there. And if
any of them aren't, I guess we would feel that Congress would
be making a mistake.
Here's my personal view about what I would counsel the
Congress, and even be so bold as to say to the President of the
United States: Don't oversell this bill when it is passed.
Don't use the word ``never again.'' Because the fact is that
capitalist systems are inherently susceptible to crises.
In fact, there is a new book out by Ken Rogoff, the former
chief economist of the IMF, and a Maryland professor, Carmen
Reinhart, that documents exhaustively the frequency of crises
over hundreds of years in many countries.
I am old enough to remember 1991, the banking crisis, LTCM,
savings and loan. That is sort of how I cut my teeth in
academia and so forth. I have been through this. I have seen
this movie before. This movie will happen again.
The best that we can hope for, and this is what I think we
should tell the American people, is that this bill will reduce
the frequency and the severity of future crises, and that is
the best we can do. Because there will always be new
instruments and new markets that will get out of control. And
hopefully, if we have a systemic risk monitor, we will
attenuate those bubbles, but we are never going to prevent
them. And let's just don't overpromise.
Representative Snyder. Mr. Carr, the biggest mistake you
think Congress will make.
Mr. Carr. Absolutely. I believe that the false positives in
the condition of the banking industry as well as the economy
may lead policymakers not to do the really bold and
transformational systemic redesign that is needed.
The reason I say that is if you look at the current
intervention--in fact, a lot has been said that we have been
pulled from the edge of an abyss, we are no longer there, you
know, the financial system is recovering.
Well, let's look at what we really did: We made too-big-to-
fail bigger. At the same time, lending among those institutions
is going down, even though their earnings appear to be going
up. The FDIC's fund is depleted. If you look at the reality of
unemployment, it is growing, with more than a third of the
unemployed long-term unemployed. Food insecurity is growing.
Poverty is growing. The fact of the matter is that, while the
economy is technically out of recession, America is in deep
depression, or at least millions of Americans are.
So I guess my bottom line is that we haven't come out of
the woods yet. And we need to stay focused on the fact that the
financial system is not working for the American public, it is
not well regulated, it is not well supervised. And the fact
that we are now away from the abyss does not mean that we can't
make a U-turn and head back in that direction if we don't make
the changes that are essential.
Representative Snyder. Mr. Steel, your personal opinion.
Mr. Steel. Yes. Well, my personal opinion is tied up in the
Pew Report, but I will go past that. I think really what I am
going to refer to is the methodology by which we developed our
perspective. We took, a dozen or 15 of us, that had very, very
different views, and we focused on what we thought were the
five key issues: systemic risk, too-big-to-fail, prudential
regulation, consumer protection, and strengthening the
marketplace. And what we found was we all found ways we could
compromise. And I think there is a dueling tension between
wanting to encourage the way in which our economy can be so
strong and resilient, but also yet wanting to have regulation.
And getting that tension right and having long meetings to
discuss this and listening to each other was the right way. And
it is the tension between those two forces that I think is the
right thing that you are going to have to measure. And getting
it wrong would be to lean too much left or too much right on
that point, but instead trying to basically not be too
ideological, but trying to understand what can work would be my
recommendation.
Representative Snyder. Thank you for your testimony. And,
Dr. Litan, I want you to know that never again will I use the
phrase ``never again.''
Representative Hinchey. Before we end, I just want to ask
one last kind of general question, and that has to do with the
history of the economic circumstances that this country has had
to deal with.
We know that up until 1929, there were problems with the
economy that would occur every 10, 15 years or so, but they
were always managed, they were never deeply serious, but they
were routine. But over time there was this sort of organization
of the banking industry and the growing manipulation of
investment circumstances, things of that nature. All of that
brought about a big collapse in 1929.
Then, in 1933, we had the Glass-Steagall Act. The Glass-
Steagall Act seemed to be something very, very effective. It
stabilized the economy for a long period of time. We didn't
have another collapse until 2007, I think, and the kind of
experiences we are going through now, which are very, very
tenuous and could be much more damaging over time. So the
repeal of that Glass-Steagall Act is something that really
bothered me a lot personally. I thought it was a big mistake at
the time, and God knows it seems to have been.
What do you think about that? Do you think that we should
be bringing back that form of regulation? Do you think that
there should be this activity of oversight with regard to
investment and consumer banking, and the manipulation of
regulations that occurred so abundantly that really manipulated
this economic condition that we are experiencing now?
Mr. Litan. All right. I don't know if I am going to make
you feel any better, but I don't read history this way. I think
the bulk of the economic historians identify the critical
pieces of legislation which helped save the country during the
depression as, A, deposit insurance; and B, all the SEC rules
and so forth that we adopted. Glass-Steagall was incidental to
all of this. One of the interesting historical facts is that
the cosponsor of Glass-Steagall, Senator Carter Glass, went to
the floor of Congress 2 years later and said, ``I want to
repeal the act. It was a mistake.'' But by then it was too
late.
Let's roll the clock forward today.
Representative Hinchey. It wasn't too late. It could have
been repealed.
Mr. Litan. I know. But there was no momentum for it. It
happened, and you know, you have been in Congress long enough
to know that it is hard to reverse things.
Representative Hinchey. My opinion, that the momentum was
that it was showing itself to be effective, that it was having
good positive effects. But you disagree.
Mr. Litan. Yes, I disagree with that. And, by the way, it
is not just my view. I think if you took a random sample of
most economic historians, they would say the same thing.
But let's go forward. Let's look at this crisis. I would
posit that even if we had separated commercial and investment
banking, it wouldn't have made any difference if we hadn't
fixed all this other stuff, you know, the stuff that Brooksley
has talked about, that Jim talked about, and so forth. Because
if we look at the institutions that got into trouble, it wasn't
because of Glass-Steagall. Merrill Lynch, Goldman Sachs, Morgan
Stanley, and other big institutions were not basically
financial conglomerates, they were investment banks, and they
underwrote a lot of the securities that helped get us into
trouble.
Likewise, if you look at the big banks, it is true that
Bank of America had an investment banking affiliate, but it was
a minor thing. The only really true ``financial conglomerate''
in this entire system was Citigroup. But the rest of the big
banks that got into trouble were not really mixing commercial
and investment banking in any great degree.
So I don't view the Gramm-Leach-Bliley Act which eliminated
the vestiges of Glass-Steagall, which by the way up until then
had been largely removed anyhow through regulation by the
Federal Reserve, I don't view that as really a precipitating
cause of this crisis.
Now, it is a separate issue which you raised earlier: Did
Gramm-Leach-Bliley allow some institutions to become larger, so
big that they became too-big-to-fail? Well, if you look at
these names that I just rattled off, they are all pretty big
even as investment banks or as commercial banks.
So I conclude by looking at the recommendation of the Pew
Task Force which says, let's look at an institution and see if
its wind-down plan is not satisfactory, then selectively force
the divorce that you are talking about. But I wouldn't actually
mandate it by law.
And, by the way, as a practical matter, there really, as I
said, aren't that many integrated financial institutions
anyhow. That is sort of one of the ironies of Gramm-Leach-
Bliley. We thought that there would be all these financial
conglomerates, and it turns out there weren't many of them.
Representative Hinchey. Any other comment on that?
Ms. Born. Let me just mention that I do think it is a
worthwhile exercise to look again at the activities we permit
large financial institutions that have insured deposits to
engage in. It wasn't Gramm-Leach-Bliley that let our banks like
JP Morgan act as over-the-counter derivatives dealers, but it
was the banking regulators who did that years before Glass-
Steagall was eliminated. But that added an enormous amount of
risk to those institutions.
I think you could look at proprietary trading by large
financial institutions that have insured deposits and ask
yourselves, is that the kind of activity we want to be going on
in an institution that the taxpayer is insuring?
So I do think there are issues. I agree with Bob that it
wasn't only Glass-Steagall in the 1930s that protected the
economy. It was the idea that there should be regulation of
securities and securities exchanges, that there should be
regulation of futures exchanges, that there should be deposit
insurance, and several other things that, all together, had
given us a long period of time of relative stability before
this current crash. And a lot of that has been dismantled
either through statutes like the Commodity Futures
Modernization Act of 2000, or by the failure of regulators to
actually exercise their powers and enforce the laws that they
have been entrusted with.
Representative Hinchey. Anyone else?
Mr. Carr. I was just going to comment that I also would
agree with much of what Bob said, and really just remind the
committee that while the back end of the process, the
derivatives, the investment banks, and on and on and on, played
an important role. The point of the spear of the meltdown of
the mortgage market happened at a more simple place, which was
the interaction between the brokers and the lenders and the
consumers. And had the products that they were offering not
been literally designed not to be sustainable, we would not
have had much of the process here. Our current laws, had they
been enforced, could have eliminated much, if not the bulk of
the unfair and deceptive lending practices that brought the
housing and credit markets down.
Mr. Steel. Your original question, sir, was about the
business model of large financial institutions. And I think my
own instinct is while further study is always a good idea, is
that in today's marketplace the distinction between lending,
securities, and insurance is blurred to such a degree that you
can make it whatever you want it. And trying to design business
models that put people in one lane of those activities will not
be successful; and, therefore, I wouldn't spend a lot of time
doing it. And I would focus on having strong regulators who
look at the business, understand it, apply capital standards,
and move along that way, as opposed to trying to design the
business model. Because someone will find a way around the
business model that you try to prescribe. And I just think that
is the likelihood and ultimate outcome.
Representative Hinchey. Well, I thank you all very, very
much. Thanks for being here, and thanks for everything that you
have said. We very much appreciate it.
[Whereupon, at 12:28 p.m., the committee was adjourned.]
SUBMISSIONS FOR THE RECORD
Prepared Statement of Carolyn Maloney, Chair, Joint Economic Committee
Good morning. I want to welcome our distinguished panel of
witnesses today as we discuss proposals to regulate the over-the-
counter derivatives market and under-regulated credit markets.
The financial crisis and the ensuing recession were triggered by
the collapse in the price of homes and the resulting defaults in the
mortgages used to purchase them. Without interference from regulators,
financial institutions aggressively purchased over-the-counter
derivatives, such as mortgage-backed securities, with the expectation
that they would generate high returns with minimal risk. To hedge
against any risk, they also purchased unregulated credit default swaps
that would pay them if the mortgages underlying the derivatives
defaulted. This created a tangled web of counterparties.
This crisis didn't have to happen. One of our distinguished
witnesses, Brooksley Born, had the foresight to recognize the dangers
of unchecked growth, lack of transparency, and overleveraging in the
over-the-counter derivatives market back in the late 1990s. As Chair of
the CFTC, she advocated regulating this market, which at its peak was
tied to over $680 trillion in assets--approximately 50 times the U.S
GDP! However, she was ignored and silenced by a chorus of critics who
hailed over-the-counter derivatives as the greatest financial
innovation of the decade because they would spread risk efficiently
among market participants.
With the economy booming, her fears seemed exaggerated. Siding with
her critics, Congress passed the Commodity Futures Modernization Act of
2000, which prevented the CFTC from regulating the over-the-counter
market. Ironically, the Act's stated purpose was ``to reduce systemic
risk in the markets for futures and over-the-counter derivatives.''
During the current crisis, the lack of transparency and regulation
in the over-the-counter market spread panic within the financial
community when the housing bubble burst. Banks could not tell which
banks were teetering on bankruptcy and which weren't because the
positions they had taken in the over-the-counter market were unknown. A
crisis of confidence erupted and a contagion of fear and uncertainty
spread. Credit markets became crippled as banks held onto their assets
and stopped lending.
The House Financial Services Committee and House Agriculture
Committee are meeting this week to merge their versions of the bill
that will finally regulate the over-the-counter market. The merged bill
will promote transparency by requiring that these previously
unregulated derivatives be traded on exchanges or clearinghouses.
Capital and margin requirements will beestablished so that financial
institutions can no longer make risky bets. And information about
prices and trading volumes will be publicized so that market
participants will no longer be uncertain of the value of their
securities.
Although these bills exempt some derivatives from regulation, the
exemptions are an attempt to balance concerns of some businesses that
need customized derivatives and the potential risk to the financial
system.
The House Financial Services Committee has also passed a bill
establishing the Consumer Financial Protection Agency to shield
consumers from deceptive financial practices. People will no longer
have to deal with mortgage lenders who prey on those with poor credit
histories by offering them subprime mortgages under unfair terms.
Although our economic recovery is far from complete, there is a
growing understanding that the economy is moving back on track, helped
along by the Recovery Act. Third quarter GDP grew 2.8 percent, after
contracting for four consecutive quarters. Financial markets have
recovered substantially and interbank lending is back to its pre-crisis
level.
However, Congress cannot repeat its past mistake of turning a blind
eye to the over-the-counter market. Even as our economy and financial
markets stabilize, Congress cannot afford to once again embrace the
misguided notion that this market can regulate itself. Now is the time
to act.
I thank the witnesses for coming before the committee this morning
and I look forward to hearing your testimonies.
__________
Prepared Statement of Brooksley Born, Former Chair, Commodity Futures
Trading Commission
Madam Chair and Members of the Committee:
Thank you for inviting me to appear before you to discuss the over-
the-counter derivatives market.
When I was Chairperson of the Commodity Futures Trading Commission
more than a decade ago, I spoke out about the dangers posed by the
rapidly growing and unregulated over-the-counter derivatives market and
called for effective federal oversight. I was aware that powerful
interests in the financial community were opposed to any examination of
that market. Yet I spoke out because, as the head of the federal
regulatory agency with the greatest experience and expertise in
derivatives markets, I felt a duty to let the public, Congress and the
other financial regulators know the potential threats to our financial
stability. I strongly believed that the lack of transparency and the
absence of government oversight of over-the-counter derivatives had to
be remedied by the adoption of appropriate regulation.
My voice was not popular. The financial markets had been expanding,
innovation was thriving, and the country was prosperous. The financial
services industry argued that markets had proven themselves to be self-
regulating and that the role of government in market oversight and
regulation should be reduced or eliminated.
All of us have now paid a large price for that fallacious argument.
We have experienced the most significant financial crisis since the
Great Depression, and regulatory gaps, including the failure to
regulate over-the-counter derivatives, have played an important role in
the crisis. We have now spent hundreds of billions of taxpayer dollars
to deal with the financial crisis, and the American people have
experienced massive losses of jobs, homes, savings and businesses.
As a result of pressures from a number of the country's largest
financial institutions, Congress passed a statute in 2000 that
eliminated virtually all government regulation of the over-the-counter
derivatives market, the Commodity Futures Modernization Act of 2000.
Because of that statute, no federal or state regulator currently has
oversight responsibilities or regulatory powers over this market.
The market is totally opaque and is often referred to as ``the dark
market.'' It is enormous. At its height a year and a half ago in June
2008 the reported size of the market exceeded $680 trillion in notional
value or more than ten times the gross domestic product of all the
countries in the world. As of June 2009 the market reportedly still
exceeded $600 trillion in notional value.
While over-the-counter derivatives have been justified as vehicles
to manage financial risk, they have in practice spread and multiplied
risk throughout the economy and caused great financial harm. Lack of
transparency and price discovery, excessive leverage, rampant
speculation, lack of adequate capital and prudential controls, and a
web of interconnections among counterparties have made the market
extremely dangerous. Warren Buffet has appropriately dubbed over-the-
counter derivatives ``financial weapons of mass destruction.'' They
include the credit default swaps disastrously sold by AIG and many of
the toxic assets held by our biggest banks. They spurred the housing
and credit bubbles and accelerated the contagion as the bubbles burst
and the crisis spread. A number of the financial firms that failed or
have required extraordinary government support during the recent crisis
were among the world's major over-the-counter derivatives dealers,
including AIG, Bear Steams, Lehman Bros., CitiGroup, Merrill Lynch,
Bank of America, Morgan Stanley, Goldman Sachs, and J.P. Morgan.
This over-the-counter market continues to be unregulated and to
pose grave dangers to the economy. It is critically important for
Congress to act swiftly to impose the rules necessary to close this
regulatory gap and to protect the public. As time passes and the
economy appears to be stabilizing, there is a danger that the sense of
urgency to adopt these important reforms may diminish. We now have a
unique opportunity--a narrow window of time--to fashion and implement a
comprehensive regulatory scheme for these instruments.
Existing U.S. laws governing the futures and options markets
provide a worthy model for regulating the closely related instruments
traded in the over-the-counter derivatives market. The Commodity
Futures Trading Commission and the Securities and Exchange Commission
should have primary regulatory responsibilities for derivatives
trading, both on and off exchange. As with futures and options, all
standardized and standardizable derivatives contracts should be traded
on regulated derivatives exchanges and cleared through regulated
derivatives clearing operations. A regulatory regime based on the
requirements established in the Commodity Exchange Act for designated
contract markets and derivatives clearing operations should apply to
such trading and clearing. These requirements would allow effective
government oversight and enforcement efforts; ensure price discovery,
openness and transparency; reduce leverage and speculation; and limit
counterparty risk. While central clearing would mitigate counterparty
risk, central clearing alone is not enough. Exchange trading is also
essential in order to provide price discovery, transparency and
meaningful regulatory oversight of trading and intermediaries.
In my view, there should be no statutory exceptions from the rule
that all standardized and standardizable contracts should be traded on
exchange rather than over-the-counter. Some large corporations are
arguing that they should be permitted to continue to trade standardized
contracts over-the-counter because they wish to avoid paying the cash
margins required for exchange-traded contracts. Such an exception is
unwarranted. Large corporations will benefit from the price discovery,
transparency and regulatory oversight of exchange trading, which
generally should lead to lower prices for trades. Moreover,
creditworthy corporations should be able to obtain lines of credit as
needed to meet their margin requirements for exchange trading.
The over-the-counter market is necessarily much less transparent
and much more difficult to regulate than an exchange market. If any
trading in over-the-counter derivatives is permitted to continue, such
trading should be limited to truly customized, non-fungible contracts
between highly sophisticated parties at least one of which requires
such a customized contract in order to hedge actual business risk. Such
customized contracts by their nature cannot be traded on an exchange or
cleared by a clearinghouse. While customized over-the-counter contracts
may serve an economically useful purpose by allowing businesses to
hedge complex business risks, there is no adequate justification for
allowing purely speculative customized contracts to be traded in the
more dangerous over-the-counter market. Therefore, at least one party
to every over-the-counter contract should be required to certify and be
able to demonstrate that it is using a customized contract to hedge a
bona fide business risk. So limiting the over-the-counter market would
reduce the potential risks created by that market.
Furthermore, any continuing over-the-counter market should be
subject to a robust federal regulatory regime requiring transparency
and protections against abuses and catastrophic defaults. There should
be registration, recordkeeping and reporting requirements for all over-
the-counter derivatives dealers, and they should be subject to business
conduct standards, including requirements to disclose contract terms,
pricing and risks to their customers. All over-the-counter trades
should be subject to margin requirements, and all large market
participants should be subject to capital requirements. In addition,
transaction prices and volumes of over-the-counter derivatives should
be publically reported on an aggregated and timely basis. The market
should be subject to prohibitions against fraud, manipulation and other
abusive practices.
These measures would go far toward bringing this enormous and
dangerous market under control. They should be adopted and implemented
if we hope to avoid future financial crises caused by this market. The
country cannot afford to delay or weaken our response to the crisis. If
we as a people do not learn from our experiences and respond
appropriately, we will be doomed to repeat them.
Thank you very much.
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