[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



                  U.S. GOVERNMENT PRINTING OFFICE
55-899                    WASHINGTON : 2010
-----------------------------------------------------------------------
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov  Phone: toll free (866) 512-1800; (202) 512ï¿½091800  
Fax: (202) 512ï¿½092104 Mail: Stop IDCC, Washington, DC 20402ï¿½090001


                        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

                              ----------                              

                                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.

    [GRAPHIC] [TIFF OMITTED] T5899.001
    
    [GRAPHIC] [TIFF OMITTED] T5899.002
    
    [GRAPHIC] [TIFF OMITTED] T5899.003
    
    [GRAPHIC] [TIFF OMITTED] T5899.004
    
    [GRAPHIC] [TIFF OMITTED] T5899.005
    
    [GRAPHIC] [TIFF OMITTED] T5899.006
    
    [GRAPHIC] [TIFF OMITTED] T5899.007
    
    [GRAPHIC] [TIFF OMITTED] T5899.008
    
    [GRAPHIC] [TIFF OMITTED] T5899.009
    
    [GRAPHIC] [TIFF OMITTED] T5899.010
    
    [GRAPHIC] [TIFF OMITTED] T5899.011
    
    [GRAPHIC] [TIFF OMITTED] T5899.012
    
    [GRAPHIC] [TIFF OMITTED] T5899.013
    
    [GRAPHIC] [TIFF OMITTED] T5899.014
    
    [GRAPHIC] [TIFF OMITTED] T5899.015
    
    [GRAPHIC] [TIFF OMITTED] T5899.016
    
    [GRAPHIC] [TIFF OMITTED] T5899.017
    
    [GRAPHIC] [TIFF OMITTED] T5899.018
    
    [GRAPHIC] [TIFF OMITTED] T5899.019
    
    [GRAPHIC] [TIFF OMITTED] T5899.020
    
    [GRAPHIC] [TIFF OMITTED] T5899.021
    
    [GRAPHIC] [TIFF OMITTED] T5899.022
    
    [GRAPHIC] [TIFF OMITTED] T5899.023
    
    [GRAPHIC] [TIFF OMITTED] T5899.024
    
    [GRAPHIC] [TIFF OMITTED] T5899.025
    
    [GRAPHIC] [TIFF OMITTED] T5899.026
    
    [GRAPHIC] [TIFF OMITTED] T5899.027
    
    [GRAPHIC] [TIFF OMITTED] T5899.028
    
    [GRAPHIC] [TIFF OMITTED] T5899.029
    
    [GRAPHIC] [TIFF OMITTED] T5899.030
    
    [GRAPHIC] [TIFF OMITTED] T5899.031
    
    [GRAPHIC] [TIFF OMITTED] T5899.032
    
    [GRAPHIC] [TIFF OMITTED] T5899.033
    
    [GRAPHIC] [TIFF OMITTED] T5899.034
    
    [GRAPHIC] [TIFF OMITTED] T5899.035
    
    [GRAPHIC] [TIFF OMITTED] T5899.036
    
    [GRAPHIC] [TIFF OMITTED] T5899.037
    
    [GRAPHIC] [TIFF OMITTED] T5899.038
    
    [GRAPHIC] [TIFF OMITTED] T5899.039
    
    [GRAPHIC] [TIFF OMITTED] T5899.040
    
    [GRAPHIC] [TIFF OMITTED] T5899.041
    
    [GRAPHIC] [TIFF OMITTED] T5899.042
    
    [GRAPHIC] [TIFF OMITTED] T5899.043
    
  

                                  
