    [Senate Hearing 111-8]
    [From the U.S. Government Publishing Office]

                                                              S. Hrg. 111-8

              MODERNIZING AMERICA'S FINANCIAL REGULATORY STRUCTURE

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

                                    HEARING

                                   before the

                         CONGRESSIONAL OVERSIGHT PANEL

                         ONE HUNDRED ELEVENTH CONGRESS

                                 FIRST SESSION

                                   __________

                                JANUARY 14, 2009

                                   __________

            Printed for the use of the Congressional Oversight Panel

                         CONGRESSIONAL OVERSIGHT PANEL
                                 Panel Members
                            Elizabeth Warren, Chair
                                Sen. John Sununu
                              Rep. Jeb Hensarling
                               Richard H. Neiman
                                 Damon Silvers

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                                C O N T E N T S

                                  ----------
                                                                       Page
    Opening statement of Professor Elizabeth Warren..................     1
    Statement of Hon. Jeb Hensarling, U.S. Representative from the
      State of Texas.................................................     2
    Statement of Mr. Damon Silvers...................................     4
    Statement of Hon. John Sununu, U.S. Senator from the State of New
      Hampshire......................................................     5
    Statement of Mr. Richard Neiman..................................     7
    Statement of Mr. Gene Dodaro, Acting Comptroller General of the
      United States Government Accountability Office; accompanied by
      Mr. Richard J. Hillman and Ms. Orice M. Williams...............     8
    Statement of Ms. Sarah Bloom Raskin, Commissioner, Maryland
      Office of Financial Regulation.................................    49
    Response to written question submitted by: Damon Silvers.........    70
    Statement of Mr. Joel Seligman, President, University of
      Rochester......................................................    72
    Statement of Dr. Robert Shiller, Arthur M. Okun Professor of
      Economics, Yale University.....................................    84
    Statement of Dr. Joseph E. Stiglitz, University Professor,
      Columbia Business School.......................................    89
    Statement of Mr. Marc Sumerlin, Managing Director and Co-Founder,
      The Lindsey Group..............................................   120

                                  WITNESS LIST

    Panel One:
        Gene L. Dodaro, Acting Comptroller General of the United
          States, Government Accountability Office; accompanied by:
          Richard J. Hillman, Managing Director, Financial Markets
          and Community Investment Team, Government Accountability
          Office, and Orice M. Williams, Director, Financial Markets
          and Community Investment Team, Government Accountability
          Office.....................................................     8
    Panel Two:
        Sarah Bloom Raskin, Commissioner, Maryland Office of
          Financial Regulation.......................................    49
        Joel Seligman, President, University of Rochester............    72
        Robert J. Shiller, Ph.D., Arthur M. Okun Professor of
          Economics, Yale University.................................    84
        Joseph E. Stiglitz, Ph.D., University Professor, Columbia
          Business School............................................    89
        Marc Sumerlin, Managing Director and Co-Founder, The Lindsey
          Group......................................................   120
        Peter J. Wallison, Arthur F. Burns Fellow in Financial Policy
          Studies, American Enterprise Institute.....................   142

                           REGULATORY REFORM HEARING

                                  ----------

                          WEDNESDAY, JANUARY 14, 2009

                                         U.S. Congress,
                                 Congressional Oversight Panel,
                                                        Washington, DC.
        The panel met, pursuant to notice, at 11:40 a.m. in Room
    SR-253, Russell Senate Office Building, Professor Elizabeth
    Warren presiding.

     OPENING STATEMENT OF PROFESSOR ELIZABETH WARREN, CHAIR OF THE
                     CONGRESSIONAL OVERSIGHT PANEL

        Professor Warren. The Congressional Oversight Panel has two
    duties. Our first, to oversee the expenditure of funds from the
    so-called ``Troubled Asset Relief Program,'' requires us to
    issue monthly reports discussing the management of the $350
    billion allocated so far by the Congress to the Treasury
    Department.
        But it is the second function that draws us here today.
    Congress has asked that we deliver in very short order a report
    ``analyzing the current state of the regulatory system and its
    effectiveness at overseeing the participants in the financial
    system and protecting consumers and providing recommendations
    for improvement, including, among others, whether there are any
    gaps in existing consumer protection.''
        We are grateful to have the assistance of so many
    thoughtful experts in this task.
        The last time America faced a financial crisis of greater
    magnitude was in the 1930s. The policymakers who steered the
    country out of that dark hour put in place a regulatory
    architecture that served America for more than half a century.
    Had those leaders chosen a different path, a path without
    deposit insurance, without banking regulation, without a
    Securities and Exchange Commission, we would be a very
    different country today.
        Today's policymakers stand at a similarly important point
    of inflection. The path they take from here will shape this
    country deep into the 21st Century. What we get right may not
    only save an America that is in danger of losing its economic
    security, it may also shape a new America that is stronger than
    ever. But what we get wrong may batter a weakened country,
    leaving it staggered and vulnerable. We will pay for errors we
    make here as will our children and our children's children.
        Alan Greenspan now tells us the very premise of
    deregulation was misplaced and that he was surprised by this
    crisis. George Bush tells us that we must abandon capitalism in
    order to save it. These leaders make it clear that the old
    orthodoxies are dead. What they do not make clear is how we go
    forward.
        The questions we ask today are ultimately very simple. What
    went wrong, and how do we make very sure that these problems
    are not repeated in the future?
        I appreciate that any problem may have multiple causes, and
    I fully understand that financial markets have more twists and
    turns than the back streets of Boston, but underlying the
    complex maneuvering in the current economic system are some
    basic truths about how financial institutions failed the
    American people and how those whose jobs it was to monitor and
    to regulate those institutions also failed us.
        Now, with the country in crisis, the American people must
    not only bear the broken promises of Wall Street and the
    regulators who were supposed to hold deception and risk in
    check, they must also bear the double-burden of spending their
    tax dollars to bail out those who failed.
        We are not here to discuss regulation as a political issue
    or regulation as an academic exercise. Regulation is a means to
    an end, not an end in itself. More importantly, it is a means
    not just to help the financial system as a whole but those who
    give that financial system purpose, American businesses and
    American families. The stakes on financial regulation have not
    been higher during our lifetimes.
        Today, we will hear from a variety of experts as they give
    their perspectives on what went wrong and what can be done to
    ensure future stability. We have purposely solicited witnesses
    from a wide range of ideological perspectives and with a broad
    diversity of prescriptions for our future.
        On our first panel, we will be joined by Gene Dodaro, the
    Acting Comptroller General of the Government Accountability
    Office. Mr. Dodaro will discuss a recent GAO Report on
    Regulatory Reform. He will be accompanied by Richard Hillman
    and Orice Williams, also with the GAO.
        Our second panel I will introduce just before they start.
        With that, I will yield to my colleague, Congressman
    Hensarling, for his opening statement.

    STATEMENT OF HON. JEB HENSARLING, U.S. REPRESENTATIVE FROM THE
     STATE OF TEXAS AND MEMBER OF THE CONGRESSIONAL OVERSIGHT PANEL

        Representative Hensarling. Thank you, Madam Chair. We
    certainly look forward to the testimony of the witnesses. I'm
    certainly impressed again by the variety and expertise that
    will be brought to this panel.
        In a city where it's difficult to find consensus, I think
    there is at least consensus around the idea that we need
    regulatory reform within our financial markets, but more
    regulation simply for regulation's sake will probably do more
    harm than good.
        Many believe that--look for opportunities to use the
    present recession to essentially bootstrap a certain
    ideological agenda and to thrust that into the body politic.
    The battle cry is deregulation has caused this recession, only
    regulation will prevent future recessions.
        First, I observe in my own estimation, we haven't had
    significant deregulation in decades. There have been reforms.
    There has been some modernization.
        Second, I don't view this as a matter of deregulation
    versus regulation. Frankly, I think the far more important
    dichotomy is that between smart regulation and dumb regulation.
    I think smart regulation will help markets become more
    competitive. I think smart regulation will effectively police
    markets for fraud and misrepresentation.
        I think smart regulation will empower consumers with
    effective disclosure, perhaps in contrast to voluminous
    disclosure, so that those consumers can make rational
    decisions. I think smart regulation will help reduce systemic
    risk.
        On the other hand, I think dumb regulation will hamper
    competitive markets. I think it will stifle innovation that has
    helped put people into homes that otherwise perhaps would never
    be able to afford them. I think dumb regulation creates moral
    hazard, and I think we are unfortunately reaping what has been
    sown previously as far as dumb regulation is concerned with
    respect to moral hazard.
        I think dumb regulation will remove and minimize personal
    responsibility from the economic equation to the detriment of
    our society. I think it needlessly would restrict personal
    freedom. I think dumb regulation is pro-cyclical and ultimately
    will pass on greater costs than benefits to our consumers in
    our nation.
        Now, I have served in Congress. I've had the privilege of
    serving in Congress for the last six years. I spent the
    previous 10 years in private business. I have not observed that
    regulators are inherently more intelligent than regulatees nor
    have I concluded that regulatory institutions are any more
    infallible than private businesses and private institutions.
        For example, if regulators are so wise, why did IndyMac
    fail? Why did we have the S&L debacle of the early to mid '80s?
    And in fact, there appears to be now general agreement among
    most economic historians that the Great Depression would have
    been a garden variety recession had it not been for grievous
    public policy errors in monetary policy, trade policy, and tax
    policy.
        And so, additionally, I would observe that those who are
    proposing even more restrictive regulatory proposals as a cure
    to our woes, that many of the proposals that are being
    proffered already appear in the EU, among certain other
    industrialized nations, and yet they have not seemed to be
    insulated from the economic woes that befall our nation at this
    time.
        To state the obvious, families are struggling in this
    economy. They need help. They need public policies that help
    preserve and grow their job opportunities. They need public
    policies that increase their take-home pay so they can meet
    their mortgage payments, their health care payments, and they
    need public policies that don't send the bill for all of this
    to their children and their grandchildren.
        And finally, to the business of this panel, they need
    reform and modernized capital markets regulation. In that
    regard, I think the recommendations that we make to Congress
    will be very, very important. We must examine all the but-for
    causes, all the contributing causes to our economic turmoil and
    make sure that we make smart regulatory recommendations and be
    careful that, as we make these recommendations, that we are not
    simply solving the problem of this recession and laying the
    groundwork for an even greater recession to befall us in the
    years to come.
        We all must be mindful of the Hippocratic Oath, first do no
    harm. It is my hope that our panel will do more good than harm
    with our regulatory recommendations.
        With that, Madam Chair, again I thank you and I yield back
    the balance of my time.
        Professor Warren. Thank you, Congressman. The Chair
    recognizes Damon Silvers.

        STATEMENT OF DAMON SILVERS, MEMBER OF THE CONGRESSIONAL
                            OVERSIGHT PANEL

        Mr. Silvers. Yes. Good morning, and thank you, Chairman
    Warren.
        Today, the Congressional Oversight Panel takes up its
    mandate to examine reforms that will strengthen our financial
    regulatory system and protect our nation from a repeat of the
    current financial crisis or a worse version of it.
        I am profoundly grateful to the witnesses and the staff for
    bringing this hearing together on such short notice and in such
    an effective manner.
        Several themes have emerged already in relation to needed
    reform, themes involving both regulatory substance and
    regulatory structure.
        We also face a number of complex dilemmas, again involving
    both regulatory substance and regulatory structure.
        I am certain today's extremely distinguished panels will
    help us formulate specific policy responses to weaknesses in
    our regulatory system and help us think through those more
    difficult conceptual problems that have been brought into focus
    by the financial crisis.
        As we begin this hearing, let us keep in mind that
    financial markets are not ends in themselves nor do they exist
    to make market intermediaries wealthy. The purpose of financial
    markets is to facilitate the transformation of savings into
    profitable investment, to allocate our society's resources to
    productive purposes.
        When regulatory systems fail, when financial markets and
    financial institutions become manufacturers of bubbles and
    Ponzi schemes of one kind or another, then our wealth as a
    society is dissipated and our society's needs go unmet.
        With that in mind, I think we have already learned some
    lessons of the financial crisis. First, we as a nation cannot
    continue a Swiss cheese regulatory system. As President-elect
    Obama has said, and I quote, ``We must regulate financial
    institutions based on what they do, not what they are. We must
    bring the shadow markets and shadow institutions into the light
    of disclosure and accountability.''
        Second, we must abandon the idea that sophisticated parties
    should be allowed to act in financial markets without any
    regulatory oversight. Big sophisticated and yet reckless
    financial actors have done a lot of damage to our financial
    system and to our economy.
        Third, we need strong independent regulators, not weak
    compromised regulators. Some of this comes down to leadership
    which cannot be legislated, but some of it comes down to
    structure and mission. If we say we don't want ``enforcement-
    oriented regulators,'' we should not be surprised when our laws
    go unenforced.
        Fourth, effective financial regulation is made up of
    several distinct objectives. We need a regulatory system that
    facilitates transparency and accountability, that polices
    safety and soundness when there are public guarantees or
    systemic risk in play and that protects the vast majority of us
    who are neither expert nor powerful when we seek financial
    services.
        We should learn the lesson of having asked the Federal
    Reserve, a self-regulatory body, to both protect homeowners in
    the mortgage market and ensure the safety and soundness of bank
    holding companies. We ended up achieving neither goal. Not
    every regulator can serve every regulatory function and some
    functions are in tension with each other.
        And now for some challenges. What do we do about financial
    institutions that are both commercial and investment banks and
    currently receive implicit federal guarantees covering their
    entire businesses? Do we break them up? How do we address this?
    Do we try to withdraw the implicit guarantee? Do we regulate
    their entire businesses, like they were all just commercial
    banks? Do we charge risk-based premiums for each line of
    business? This is a genuine dilemma. The answer is not obvious.
        Some have suggested that somewhat technical developments in
    finance, such as the rise of mark to market accounting, the
    widespread availability of short selling, and the prevalence of
    multilayered securitizations, significantly contributed to the
    financial crisis.
        What each of these developments has in common is that they
    appear to make financial institutions more responsive to and
    integrated with financial markets. Is this a good thing or a
    bad thing? To what extent should these developments be limited
    or reversed? Can they be reversed even if we wanted to?
        Finally, we have globalized financial markets. How do we
    set a global regulatory floor? The answer to that question
    again is not obvious.
        I am looking forward to an in-depth examination of these
    and other issues today.
        Thank you.
        Professor Warren. Thank you, Mr. Silvers. Senator Sununu.

      STATEMENT OF HON. JOHN SUNUNU, FORMER U.S. SENATOR FROM THE
        STATE OF NEW HAMPSHIRE AND MEMBER OF THE CONGRESSIONAL
                            OVERSIGHT PANEL

        Senator Sununu. Thank you very much, Madam Chair, and good
    morning to all of our witnesses.
        There are a few goals that I think ought to come out of a
    hearing like this and I appreciate those that are attending
    today for being here. It's very important because, first and
    foremost, whether you're a panelist or a member of Congress,
    you can't possibly be an expert in all these areas.
        I hope that our witnesses today will help us understand how
    we got to this point, help us understand the inherent
    weaknesses in the structure of our regulatory system, but
    equally important, understand the weaknesses in the operation
    of that system: how you can have a good system of regulation,
    good rules and laws in place, good organizational structure.
    But let's face it, regulators themselves can fail to identify
    trends, can fail to see problems, can fail to exercise due
    diligence. So structure is important but the operation of those
    systems are equally important. Finally, we need to consider
    human behavior, understand how market behavior helps drive or
    create some of the problems we've seen both in the real estate
    markets, the securities market, and in the oversight of those
    markets.
        Second, I think our panelists today can really help us
    understand the complexity of our financial services regulatory
    system and I don't think this can be over-emphasized.
        Our system, by and large, was created incrementally. Many,
    many different pieces of legislation, passed not over a few
    years, but over many decades. Many of the elements of our
    financial services regulatory system date to the 1930s and
    1940s, and that means, by definition, that they were not
    designed expressly for the modern financial services system
    that we see today.
        I think we need to look hard and carefully at that
    complexity because complexity can create gaps, and complexity
    can create duplication. Either can cause significant unintended
    consequences. As a further result of the complexity, I think
    it's fair to say that the financial services regulatory system
    is not well understood by many members of Congress, especially
    those that don't sit on the committees that oversee or have
    responsibility for this regulatory system. We are in a
    position, given our structure of government, that those members
    of Congress will be responsible for acting on the
    recommendations of this panel, and acting on the various
    recommendations that are put forward in public by our panelists
    today. We need to help them to understand that complexity.
        As an example of the incremental way in which our
    regulatory structure is created, we don't have to go back any
    farther than the well-publicized financial scandals of 2000,
    2001, 2002, and the response to that which was Sarbanes-Oxley.
    That was a well-intentioned piece of legislation. There are
    many elements in that legislation that are probably of value,
    but it is clear that that attempt at regulatory reform, driven
    by contemporary events, did little or nothing to forestall the
    crisis that we're dealing with today. So a process of
    incremental revision has not served us very well in the United
    States.
         Finally, I'd encourage our panelists to be specific. The
    legislative process is about as far removed from academia as
    you can get. That doesn't mean we shouldn't be informed by both
    theory and ideas that come from an academic source, but we have
    to deal with the hand that we've been dealt which is the
    current regulatory structure. We need to work from that
    structure to one that works better for all the shareholders and
    participants.
        So we need to be practical, we need to be specific, and, of
    course, we need to work in a very diligent way. These are
    issues that the panel is going to be addressing in the coming
    weeks, and these are issues that the Congress will be dealing
    with extensively in the months ahead.
        Thank you very much.
        Professor Warren. Thank you, Senator. Mr. Neiman.

     STATEMENT OF MR. RICHARD NEIMAN, MEMBER OF THE CONGRESSIONAL
                            OVERSIGHT PANEL

        Mr. Neiman. Good morning. I thank all the witnesses for
    being here today.
        We are at an exceptional moment in our nation's history
    where the financial system is at greater risk than any point in
    the past hundred years. The strain has revealed significant
    underlying weaknesses in the existing supervisory system not
    only in the U.S. but worldwide.
        While regulatory reform is an ongoing process, I believe
    that there are four key areas to include in any immediate
    action plan. I base this on a broad range of experience over my
    last 30 years, having started as an attorney at the OCC, as an
    attorney within financial institutions, as an executive as well
    as a regulatory consultant and compliance consultant, and now,
    for the last two years as a state bank supervisor.
        I welcome your views on the wide range of issues, but I am
    especially interested in your recommendations in four key
    areas.
        First, on consumer protection. In fulfilling our consumer
    protection responsibilities, our top priority must be to
    address the subprime mortgage defaults and foreclosures that
    triggered the current market turmoil and harmed so many
    homeowners, neighborhoods and economies.
        Second, the role of the states. As the business of banking
    institutions has become more national in scope, they often
    complain that it is burdensome to comply with consumer
    protection regulations in 50 different states. Federal
    regulators of banks, thrifts and credit unions, therefore, have
    preempted the consumer protection rules of the states who
    sounded the early warning on predatory lending. Preemption
    issues remain a major concern.
        Third, there are gaps in regulatory coverage, both
    structurally at the agency level but also institutionally at
    the institution level as well as the product level.
        And fourth, systemic risk. I believe that it is crucial at
    this stage that we develop a better mechanism for controlling
    systemic risk across the diverse players and financial services
    industry. We want to encourage innovation that has long given
    the U.S. an economy that is second to none, but we need to
    strengthen our regulatory tools by making sure that all market
    participants whose failure would pose risks to the broader
    financial system are subject to supervision.
        These issues of regulatory reform affect us all because
    instability in the financial markets affects the broader
    economy. As we have seen in the past few months, financial
    market instability jeopardizes retirement savings, access to
    consumer credit and student loans and the financing of
    businesses large and small, the revenues of state and local
    governments, and the fiscal condition of the nation.
        Now, as much as many of us agree that this is the right
    time in our nation's history to address regulatory reform, we
    must also acknowledge that there is no perfect regulatory
    model. We only have to look to the many nations in the world
    that adopt different regulatory schemes and recognize that none
    of those jurisdictions were spared a crisis or problem.
        Therefore, in addition to restructuring our regulatory
    architecture, we need to have more effective regulations and
    more effective supervision. I believe that the power of this
    panel really is that we bring together a broad expertise with
    different backgrounds across different ideological viewpoints
    as well as political parties.
        The Panel's power is also in being able to call out experts
    like yourselves in a broad input, for external input from
    academics, from industry, and from the public. But I think the
    greatest power of this panel is our diversity and to the extent
    that we can reach consensus on these important issues of the
    day. I think that will be very, very meaningful to Congress.
        So again, I thank you all for being here today and I look
    forward to your testimony and questions.
        Professor Warren. Thank you, Mr. Neiman. We begin then with
    Mr. Dodaro.
        I want to thank you again, Acting Comptroller, for being
    here and for coming to talk with us about your Regulatory
    Reform Report, and thank you again, Ms. Williams and Mr.
    Hillman, for being with us.
        Mr. Dodaro, I'd like to start with your opening statement.
    Your entire statement will be in the record, of course. So if
    you would hold your oral remarks to five minutes, we'd be
    grateful.

    STATEMENT OF MR. GENE DODARO, ACTING COMPTROLLER GENERAL OF THE
              UNITED STATES, GOVERNMENT ACCOUNTING OFFICE

        Mr. Dodaro. Good morning, Chair Warren, Members of the
    Congressional Oversight Panel. We are very pleased to be here
    today to assist your deliberations on the financial regulatory
    system.
        As you mentioned, we issued a report last week. In that
    report, we traced the evolution of the financial regulatory
    system over the last 150 years to lay out and make sure
    everybody understood the incremental nature, as Mr. Sununu
    mentioned in his opening comments to that system.
        We also outlined developments in the financial markets and
    institutions that have challenged that regulatory system in the
    past several decades and we lay forth for your consideration, I
    think it's very relevant to your deliberations, a framework for
    crafting and evaluating proposals to modernize the financial
    regulatory system structure going forward.
        Our basic conclusion was that the current financial
    regulatory structure is outdated, fragmented, and not well
    suited to the 21st Century challenges. There are many issues
    that we point to in our report as to the basis for our
    conclusion there. I'll mention three this morning.
        First, regulators have struggled and often failed to
    mitigate the systemic risk of large interconnected financial
    conglomerates or to effectively ensure that they manage
    adequately their own risk.
        Second, there have been the emergence of several
    institutions and entities that are less regulated and have
    posed challenges to the system. These include non-bank mortgage
    lenders, hedge funds, and credit agencies.
        Lastly, there have been an array of products put forth on
    the market that are very complex and have challenged both
    consumers and investors and the regulators going forward. Here,
    I would refer to the credit default swaps, collateralized debt
    obligations, and various mortgage products that have been put
    forward as well as over-the-counter derivatives, all of which
    have been less regulated than many aspects of the commercial
    banking sector.
        Now, moving forward and trying to address these
    vulnerabilities is a complex task that needs to be deliberated
    on and taken with care to make sure there aren't unintended
    consequences of moving forward as well as preserving the
    inherent benefits of our current financial regulatory system,
    including the ability to foster capital formation and economic
    growth over a period of time. So there needs to be a balance
    and here we need to strive as a nation to achieve that balance
    going forward.
        To assist in this deliberation, we've put forth a framework
    for consideration so that it can be looked at as a system and
    not just to make piecemeal changes to it. We list nine
    characteristics that need to be considered. I'll mention a few
    critical ones here.
        First, there needs to be clear, explicit goals for the
    regulatory system set in statute to provide consistent guidance
    over time. Reform also needs to be comprehensive. It needs to
    address some of these regulatory gaps, both in institutions and
    products, going forward.
        Oversight of systemic-wide issues is another
    characteristic. No one regulator right now is charged with
    looking at risk across the entire system, to monitor it, to
    provide alerts, or to deal with it in advance going forward.
    That's an issue that we believe needs attention.
        The system needs to be flexible and adaptable. In this
    case, you need to make sure that innovation is still permitted
    while managing risk going forward, so that we maintain the
    benefits of innovation of the system. It needs to be efficient.
    We need to look at the overlapping nature of some of the
    regulatory organizations that have been put in place in time
    and make the system more streamlined and efficient going
    forward.
        We need to look at consumer protections again. Disclosures
    are very important as well as financial literacy issues and
    other key factors that should be part of the overall approach
    here going forward. The independence of the regulators is
    another very important characteristic to make sure that they're
    funded, they're resourced, and they have proper statutory
    independence to be able to do what's necessary, and we need to
    protect the taxpayers. We need to deal with moral hazards
    approaches and provide safeguards in place so that the losses,
    if they occur, are borne by the industry and not by the
    taxpayers going forward.
        We would be happy to answer your questions at this time,
    and again thank you for inviting us to be here.
        [The prepared statement of Mr. Dodaro follows:]
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        Professor Warren. Thank you, Mr. Dodaro. I really
    appreciate it.
        Thank you, and thank the GAO for your thoughtful and
    detailed report. I read it with great interest. It has very,
    very good ideas in it.
        If I can, I want to focus on one in particular to get us
    started with our questions today and that is, you highlight in
    your report how consumer and investor protection has been
    distributed across a range of agencies, at the federal level,
    federal and state, that there are many actors who have some
    small part of consumer regulation, and that I believe, as you
    put it, one of the consequences of this is it creates a low
    priority for many of those agencies who have other
    responsibilities and has made for ineffective regulation in
    this area.
        You suggest in your report that one agency devoted to
    consumer financial issues, which would be responsible to the
    President and to Congress and to the American people, might be
    a solution to this problem.
        Can you say more on the consumer side about how one agency,
    it would be a very different way to look at this problem, how
    it might solve some of the problems that you have identified?
        Mr. Dodaro. Well, first, our work has shown over a period
    of time that this is an area where, while there are some
    benefits to having multiple people involved looking at this,
    and I think this is one area where having the state involvement
    as well as the federal involvement, to go to Mr. Neiman's
    opening comment, is a positive development, but there needs to
    be a better overall structure in place across the federal
    departments and agencies to be able to deal with this.
        I'll ask Rick to elaborate on our work a bit. We don't
    actually, you know, make a recommendation that this be done but
    we think it has merit, a lot of merit that should be explored
    going forward.
        Our work has consistently shown, whether we're looking at
    credit cards, mutual fund fees, or others, that the disclosures
    to the public aren't clear. They don't really understand these
    issues. Clearly, this was an issue with the various mortgage
    products that were put forth on the market in the past.
        We've done work saying that the Committee on Financial
    Literacy that's set up at the federal level doesn't have a
    strategic plan, isn't funded properly to continue to provide,
    you know, education in this field as well. So it has a lot of
    dimensions. Oftentimes it doesn't get as much attention, as we
    point out in our report, as necessary. So making it a clear
    priority, setting up a structure again in this overall
    framework going forward, I think, is a worthy area to be very
    carefully explored by this panel and then the Congress as it
    goes forward.
        Professor Warren. Mr. Hillman, would you like to add to
    that?
        Mr. Hillman. Yes. I think that the comments that you made
    are right on target from the standpoint that the consumer
    protections are really as fragmented as our regulatory system
    is currently fragmented and that can cause inconsistencies,
    overlaps, and gaps in ensuring that consumers are best
    protected, and this current crisis, with what has been taking
    place with the subprime mortgage market and other areas, has
    clearly demonstrated that there needs to be improvements in the
    consumer protection area.
        Moving more towards a single regulator to oversee consumer
    protection areas is definitely an idea that merits additional
    attention. There are many options with which to establish a new
    regulatory structure. Moving towards a single regulator or
    moving towards what is referred to as regulation by objective
    or a Twin Peaks model where you have a safety and soundness
    regulator and a consumer protection regulator both afford you
    opportunities to enhance the visibility of consumer protection
    issues in a reformed regulatory structure.
        So we believe, as a result of our work, that that is a
    serious issue that needs to be debated to determine how best to
    ensure consumer protections are delivered in the most effective
    means.
        Professor Warren. All right. Thank you. I'm going to switch
    areas just because our time is very limited. You focused, I
    thought, very helpfully in the report on the importance of
    identifying and regulating systemic risk, obviously a terrible
    problem right now, and others have also talked about this,
    Chairman Frank, the Treasury Department.
        Can I ask you to comment just briefly on the question of
    whether the appropriate entity to identify and regulate
    systemic risk should be placed within the Fed or within a new
    regulatory body, a new regulator to look specifically at
    systemic risk? Do you have a comment on that, please?
        Mr. Dodaro. Yes, there's various trade-offs associated with
    making that decision. Obviously the Federal Reserve's focus on
    monetary policy is important and they need to maintain their
    independence in that regard.
        One of the areas that we've looked at over the past is how
    some other countries have handled this particular issue. The
    United Kingdom in particular went to a single financial
    services authority, a single regulator, while maintaining the
    Central Bank functions in a separate entity and given the
    current situation, they are re-evaluating some of those issues.
        Part of the issue there is how much the Central Bank really
    needs to know about what's going on within the financial
    institutions around the country to put them in a monetary
    policymaking position. So this is an area we don't have a ready
    answer for you today, but I think it's an area that needs to be
    carefully considered going forward in the debate because there
    are some serious trade-offs associated with providing all of
    these types of authorities to one entity.
        Professor Warren. Thank you. I appreciate it, and I'm out
    of time.
        Congressman.
        Representative Hensarling. Thank you, Madam Chair. Mr.
    Dodaro, thank you for appearing today, and thank you again for
    the quality of the work of the GAO. I find the reports to be
    helpful, comprehensive.
        In the report that I have before me, there is a short
    discussion, I guess, of our history of the financial regulatory
    system, a number of observations you have for the framework for
    this panel and Congress and other policymakers going forward.
        What I don't necessarily see, though, is an analysis from
    GAO on the significant ``but for'' factors that have led us to
    the economic turmoil that we see today. I think we're all
    believers of the adage that those who do not learn the lessons
    of history are condemned to repeat them. So am I missing that
    from this work? Was that not in the scope of the work or has
    GAO come to some conclusions about the primary ``but for''
    causes of our present economic turmoil?
        Mr. Dodaro. Well, the report does focus on some of the
    developments that have happened in the financial marketplace
    that have challenged the regulators, but it was not within the
    scope of it to talk about all the underlying economic
    situations that have gone before there.
        I would ask if my colleague Ms. Williams could elaborate on
    that.
        Ms. Williams. No. I think it's accurate that we did not
    specifically set out in this report to lay out the reasons for
    the current economic turmoil in the market. We simply used this
    as an additional data point, in addition to other problems that
    have existed in the markets over several decades to illustrate
    this is yet another example that points to serious questions
    about the regulatory structure.
        Representative Hensarling. In dealing with the issue of
    consumer protection, on page 18 of your report, you state,
    ``Many consumers that received loans in the last few years did
    not understand the risk associated with taking out their
    loans.''
        After first being elected as a member of Congress, my wife
    and I purchased what we referred to as an old, expensive
    condominium in the Alexandria area. My five- and six-year-old
    referred to it as the itty-bitty teeny-tiny house.
        When faced with the real estate closure of that
    condominium, I remember being given a voluminous amount of
    documents, almost none of which I've read, notwithstanding the
    fact that I've actually had a short, un-illustrious legal
    career and had to read that stuff at one time.
        I remember asking the real estate agent who actually reads
    this stuff, and the answer was about one out of a hundred home
    purchasers. I said, ``Well, who's the one?'' And they stated a
    first-year law student at one of the local law schools.
        [Laughter.]
        Representative Hensarling. My question is, should consumers
    know what mortgage products they sign and can they know? Is
    there a concept--is it possible for regulators to have/promote
    effective disclosure, again as opposed to what I would refer to
    as voluminous disclosure? Has the GAO concluded that consumers
    can and should understand the risk associated with their
    mortgage products?
        Mr. Dodaro. First, we've made a number of recommendations;
    I'll ask Mr. Hillman to elaborate on those, in a series of
    products over time, about making the disclosures more
    understandable to consumers. There's ways to do research on
    this, to do some testing as to what the consumers would really
    understand and put in place.
        As I've also grown to appreciate over time, some of the
    disclosures are in, as you mentioned, teeny-tiny condominium--
    or in teeny-tiny print--so they're even hard to read, but there
    are a number of ways that we believe and have recommended that
    the disclosures could be improved over time, and I also,
    though, would not also overlook the issue of financial literacy
    training to the population at large over a period of time.
        Representative Hensarling. I see my time is winding down.
    I'd like to try to squeeze in at least one more question here.
        Did the GAO look at the enforcement mechanisms that are in
    place to deal with mortgage fraud? According to FINCEN,
    Financial Crimes Enforcement Network, mortgage fraud has
    increased something along the lines of 1,400 percent in this
    decade. A lot of predatory lending, frankly a lot of predatory
    borrowing. I think according to FINCEN a majority of the
    mortgage fraud occurred from borrowers misrepresenting their
    income, misrepresenting their assets, misrepresenting their
    occupancy.
        Anecdotally, I've spoken with a number of U.S. Attorneys,
    Assistant U.S. Attorneys. They're focused on terrorism. Unless
    you're into seven and eight figures fraud, they don't even look
    at it.
        So has the GAO undertaken a look at what would it mean to
    simply enforce some of the antifraud regulations that are on
    the books today?
        Professor Warren. Mr. Dodaro, we're out of time. So I'm
    just going to ask you to limit yourself to just a sentence on
    this, if you could, or Mr. Hillman.
        Mr. Hillman. I'd be pleased to respond and your question
    again is right on target.
        We have not done any specific work as relates to the
    elements of mortgage fraud and the growing nature of that, but
    we have recently completed two pieces of work in the Bank
    Secrecy Act area which looks at the extent to which depository
    institutions are preparing suspicious activity reports and
    currency transaction reports to help law enforcement agencies
    tackle that problem and try to determine the most efficient
    means for depository institutions to comply with the Bank
    Secrecy Act.
        Representative Hensarling. Thank you. Thank you, Madam
    Chair.
        Professor Warren. Thank you, Congressman. Mr. Silvers.
        Mr. Silvers. Again, let me express my thanks to the GAO for
    your assistance to our panel in our brief period of existence
    and for your own work on the TARP Program.
        Your report and your comments before us this morning refer
    at some length to unregulated both financial institutions and
    financial products. This follows, I think, a long series of GAO
    reports dating back to Long Term Capital Management in relation
    to some of these same issues.
        Could you expand on your thinking in that area and with
    particular reference to the proposition some have raised,
    including, I think, some witnesses that will follow you, that
    many of these products and funds are essentially well-known
    things in new legal garb and ought to be regulated based on
    economic content rather than legal form?
        So, for example, a credit default swap looks a lot like
    bond insurance.
        Mr. Dodaro. I think basically, and I'll ask Ms. Williams to
    elaborate on this a little bit, you know, our work in this area
    dates back to the 1994 report where we raised questions about
    the derivatives and the development at that period of time.
        I think this is an area where there needs to be--and
    whatever changes are made to the regulatory framework, you can
    deal with the existing set of institutions and products now,
    but looking forward is really the challenge, I believe, going
    forward. As new products are developed, there needs to be some
    attention made by the regulators to make a gauge as to what the
    risk would be, whether it fits in to an already-existing
    regulatory screen and make a conscious decision of how it
    should be regulated, and then also monitor that very carefully
    going forward and make proposals, if they don't already have
    the authority.
        So I think the challenge really there is how to address new
    products going forward as well as dealing with what we already
    have.
        Mr. Silvers. Can I, before you ask our colleague to
    contribute? Are you suggesting that you would support
    regulatory frameworks, like for example the ,33 and ,34
    securities laws, that give broad jurisdiction, broad conceptual
    jurisdiction to regulators who follow the activity rather than
    approaches that sort of wall regulators in around particular
    legal forms?
        Mr. Dodaro. Yeah. Yes, I mean, there needs some authorities
    on a risk-based basis. You don't want to go too far in such a
    way that it stifles innovation, but there has to be a risk
    assessment tool built in that we think would provide a better
    safeguard going forward.
        Ms. Williams. And just to add, we have several elements
    that really speak to that. That's what we're getting at when we
    talk about the need for comprehensive regulation as well as
    flexible and nimble and that's to allow the structure to adjust
    as entities and products morph and to be able to follow the
    economic substance of the product and also look to the
    institution and gauge its impact on the overall financial
    system and not be locked into a statutory definition.
        Mr. Silvers. Would I be correct, in following up with that,
    that you would look in this respect to regulation, for example,
    with a particular financial product or institution that
    currently is outside the regulatory scheme, that you would look
    both at, for example, transparency, accountability and capital
    requirements as required by the particular activity going on?
    Am I clear in what I'm asking?
        Ms. Williams. I would think that would have to be part of
    the debate. As you decide how far to go with regulating that
    particular entity, based on its risk to the system, you would
    have to evaluate if it would be appropriate for all of those
    items that you listed to be applied.
        Mr. Silvers. And there's really two levels here. One is in
    the individual regulatory scheme that would be put in place,
    but also this entity that would focus on systemic risk would
    also have some responsibilities in this area and to coordinate
    with the individual regulatory entities.
        Coming to the systemic risk question, one item in the
    debate that's not, I think, been entirely clear and focused but
    seems quite important to me is the approach to systemic risk
    regulation, whether one essentially tries to identify
    systemically-significant institutions ex-ante, in advance, and
    regulate them with special--bring special regulatory tools to
    bear in advance or whether you--whether it is better not to do
    that, whether it's better to essentially act--determine who's
    systemically significant in midst of crisis, which is, I think,
    essentially what we've done recently, what's your thinking
    about that question?
        Mr. Dodaro. Two thoughts. One, I think in putting a new
    regulatory structure in place right now, there has to be a
    recognition of these large financial conglomerate entities that
    do in fact right now have significance to the system at large
    and there has to be an appropriate structure put in place to
    deal with that going forward, recognizing we're in a global
    environment and we need to have those entities to be
    competitive, but it shouldn't be static.
        I think one thing that's really surprised everybody is the
    speed in which these things have happened and you can't wait to
    be in a reactive posture. That is just not going to serve us
    well. We need to put a durable system in place that's going to
    be able to recognize what we already know but yet be flexible
    enough to be proactive going forward if we're really going to
    mitigate things, given the current globalized environment.
        Mr. Silvers. Thank you.
        Professor Warren. Thank you. Senator Sununu.
        Senator Sununu. Mr. Dodaro, I'm going to give you an
    opportunity here now to give us some good news.
        [Laughter.]
        Senator Sununu. In your evaluation of the regulatory system
    and the events that led up to the current crisis, what did you
    find that operated effectively? What seemed to be working, and
    what best practices within our regulatory structure should we
    look to expand or reinforce?
        Mr. Dodaro. Well, I think, you know, basically we have a
    regulatory system, you know, where the regulators are, you
    know, developing mechanisms to try to coordinate with one
    another to deal with some of the things. So I think the
    dialogue among the regulators has improved, although it hasn't
    gotten to the point of where we would recognize that it's the
    most effective and efficient way to be able to handle the
    system going forward.
        I think in the current environment and dealing with the
    situation, the regulators have, you know, acted, I think, to
    try to deal with and stem and mitigate the effects of the
    current system going forward with the tools that they have at
    their disposal to be able to do that and to have acted, you
    know, in order to try to deal with some of the issues going
    forward.
        There are a lot of very talented people in the financial
    regulatory area. We have a lot of, you know, well-intended
    systems in place to be able to do this. In areas where there's
    been traditional oversight, for example, in the commercial
    banking industry, we think some of those things have worked,
    you know, effectively over time, you know, given some of the
    incremental changes that you mentioned.
        I would ask just Rick or Orice if I've missed anything. I
    don't want to miss any good news.
        Mr. Hillman. I'd just like to reiterate what Gene was
    saying in that, given the fragmented regulatory structure that
    we currently have in place, one of the major benefits of that
    fragmented structure is that these individual regulators have
    deep pools of knowledge and an understanding of their
    individual markets that they're overseeing. So in this
    particular financial crisis, given the more effective
    coordination that has taken place across regulators, between
    the Department of the Treasury and the Federal Reserve,
    including the Federal Deposit Insurance Corporation, in their
    particular areas of expertise and the authority that they
    provide, this has allowed for a more concerted strategy to
    address the case-by-case problems that have been confronting
    our financial markets over this past summer.
        Senator Sununu. In Recommendation Number 5, you talk about
    the importance of eliminating overlap. Could you give us an
    example of specific areas where you saw this overlap and
    perhaps some of the problems it created?
        Mr. Dodaro. Basically, the one area where we've recommended
    that it be dealt with is in the banking area. Right now, you
    have five entities that have responsibilities at the federal
    level and in that regard, I think there's some merit of looking
    at that. In the futures and the security areas, the SEC and the
    Commodities Future Trading Commission could be considered for
    consolidation as well. Those would be the two primary areas
    that we would highlight as meriting consideration.
        Senator Sununu. On the issue of consumer safety, Mr.
    Hillman used the phrase ``working to ensure that consumers are
    best protected'' and talked a little bit about the Twin Peaks
    Model which separates this responsibility for consumer
    protection.
        But that can create significant problems in that there are
    elements of consumer protection or consumer services that could
    and would have a direct effect on the safety and soundness of
    the institution. It would be a mistake to have an agency or an
    organization responsible for those consumer protection
    initiatives without also having an obligation and a
    responsibility to think through exactly what the effect on this
    regulation would be on safety and soundness.
        How do you reconcile that problem and how can you advocate
    a Twin Peaks Model if it separates those two obligations and
    responsibilities?
        Mr. Hillman. The work that we have done in looking at
    various alternative regulatory structures suggests to us that
    there are definite strengths and weaknesses across a whole
    series of possible options for reforming our regulatory
    structure and there really, quite frankly, is no silver bullet.
        Looking at the Twin Peaks Model where you have oversight by
    objective, looking at safety and soundness issues or looking at
    consumer protection issues, it does afford the opportunity to
    enhance the visibility from a consumer protection standpoint,
    but your comments are very on target when you suggest that
    separating consumer protection from the safety and soundness
    issue can cause problems.
        One area, for example, that could be a problem has to do
    with really assessing reputational risk. There's issues
    associated with the operations of enterprises and institutions
    that can cause reputational risk and also harm investors and
    you really need to look at that at a holistic level. So there's
    strengths and weaknesses to each approach.
        Mr. Dodaro. And I think at a minimum, there needs to be
    clarity of the goals and objectives that are put in place for
    whatever system's put in place and part of the reason we
    created the nine characteristics is that there's a tendency to
    want to gravitate to a quick organizational fix by either
    centralizing or decentralizing something. Often that doesn't
    work. It's not as simple as that might seem, even appealing as
    it may be.
        This is one area where once you set what kind of structure
    you want in place, even if you don't go to a centralized
    approach, you need to make clear what the responsibilities
    would be and in the framework in which you're talking about,
    and I think that's an area where I'd want to make sure that,
    you know, our message that the minimum requirements need to be
    really clearly spelled out as to what you expect and what this
    Congress expects in this area.
        Senator Sununu. Thank you.
        Professor Warren. Thank you. Mr. Neiman.
        Mr. Neiman. Yes, I'd like to follow up on that line of
    questioning because in your written testimony, you do note that
    unfair consumer lending practices can have safety and soundness
    implications and I agree with that assertion. And you also
    noted that if consumer protection and safety and soundness
    responsibilities were housed in different agencies, that
    appropriate mechanisms for interagency coordination would be
    required.
        Now, do you have any specific recommendations for processes
    to overcome those operational challenges or does the fact argue
    in favor of keeping consumer protection and prudential
    supervision within the same agency?
        Mr. Dodaro. Well, a lot would depend--I'll ask Rick, who's
    been focusing on our work here, to comment. A lot would depend
    on what type of other changes are made in the system to the
    financial regulatory apparatus that would be put in place. So
    you'd have to consider that in arriving at the answer.
        But Rick?
        Mr. Hillman. There's definite trade-offs that take place,
    depending upon which option you end up choosing. If you're
    looking at a bifurcation of safety and soundness in consumer
    protection issues, it's definitely going to put a premium on
    coordination and communication and collaboration between those
    entities that have those responsibilities.
        If you put it in one organization, you have the opportunity
    to share expertise and information across those two important
    issues but then you may lose focus as to what you're really
    looking to achieve.
        So depending upon whichever structure you ultimately move
    to, Gene is absolutely right, we need to establish what goals
    need to be in place to ensure effective consumer protection and
    have those goals drive down the regulatory process to achieve
    them.
        Mr. Neiman. In that same section you talk about overlapping
    jurisdiction of regulators and to a certain extent in certain
    areas it can be burdensome, but in other areas it can provide
    appropriate checks and balances. From my experience as a state
    regulator, I have seen that play an important role where we
    work very cooperatively and serve with our countervailing
    federal regulators.
        You also indicate that with respect to enforcement
    activities, that is a less burdensome area, and where I assume
    what you're getting at is more cops on the beat rather than
    less is important.
        Would you elaborate on the balance between checks and
    balances and overburdensome regulatory overlap?
        Mr. Dodaro. Yeah. I think the real goal would be to
    capitalize and build upon those things that are working well
    right now and that provide those checks and balances.
        I think, you know, our view on overlapping regulations is
    more at the federal level than it would be between the Federal
    Government and at the state level. So I'd want to clarify that.
    I think there's distinct advantages of having the states be
    involved in this process going forward. We think there are
    opportunities at the federal level. So you need to preserve the
    checks and balances.
        It's a big system. It's complicated. It's moving fast.
    States give you a decentralized sort of eyes and ears on the
    ground across the country and I think you don't want to lose
    that ability to be able to do that going forward, but that's
    our--most of the focus is at the federal level.
        Mr. Neiman. Thank you.
        Mr. Hillman. And particularly to your point on the checks
    and balances, while GAO has not made any proposals suggesting
    how to reform the financial services sector, we have suggested,
    though, that we need to seriously look at some consolidation of
    the financial services sector and that is not to say that we
    are trying to eliminate competition across regulators. That
    would be an inconsistent reaction to what our view is.
        You know, competition across regulator agencies helps to
    ensure innovative structures within the federal and state
    levels and in some form would likely be benefited by preserving
    the regulatory competition that exists. The question is,
    though, is there too much competition now across the many
    organizations that exist?
        Mr. Neiman. Have you addressed in any way the issues around
    federal preemption of state laws, particularly state consumer
    laws?
        Mr. Hillman. We acknowledged in prior work concerns
    associated with federal preemption, particularly as it relates
    to the Office of Comptroller of the Currency, and in steps
    taken earlier this decade to limit visitorial powers associated
    with states' interaction with national banks and as a result of
    that work had suggested that the OCC could do a much better job
    of determining how they could best incorporate state banking
    authorities and powers within the confines of what they were
    referring to with their visitorial powers.
        Mr. Dodaro. We'd be happy to provide that for your record
    consideration.
        Mr. Neiman. Thank you.
        Professor Warren. Thank you. Thank you, Mr. Neiman.
        That's going to conclude the testimony for Panel 1. The
    press of time bumps into the magnitude of the task that we have
    undertaken.
        I want to ask if you would be willing to answer written
    submissions from the panel on the record that we would send to
    you in the next few days.
        Mr. Dodaro. We'd be happy to assist this panel in its
    important task in any way we can. Certainly.
        Professor Warren. Thank you, Acting Comptroller Dodaro, and
    thank you, Ms. Williams. Thank you, Mr. Hillman. The panel
    appreciates your taking the time in coming here.
        Mr. Dodaro. Thank you very much.
        Professor Warren. Thank you again. We now call the second
    panel, if you'll come forward, please.
        Thank you. I'm pleased to welcome our second panel of
    witnesses. We are joined by Sarah Bloom Raskin, Commissioner of
    the Maryland Office of Financial Regulation, by Joel Seligman,
    President of the University of Rochester, Robert J. Shiller,
    the Arthur M. Okun Professor of Economics at Yale University,
    Joseph Stiglitz, University Professor, Columbia Business
    School, Marc Sumerlin, Managing Director and Co-Founder of The
    Lindsey Group, and Peter J. Wallison, Arthur F. Burns Fellow in
    Financial Policy Studies of the American Enterprise Institute.
        Welcome to all of you. I will dispense with more and just
    say, can we start? Each of you will have your full statements
    on the record, of course. If I can ask you to limit your oral
    remarks to five minutes, and we'll start with Ms. Raskin.

      STATEMENT OF MS. SARAH BLOOM RASKIN, COMMISSIONER, MARYLAND
                     OFFICE OF FINANCIAL REGULATION

        Ms. Raskin. Thank you. Good morning, Madam Chair and
    Members of the Panel. My name is Sarah Bloom Raskin, and I am
    Maryland's Commissioner of Financial Regulation.
        I'm pleased to be today to share a state perspective on
    regulatory restructuring. While changing our regulatory system
    will be complex, four simple concepts should guide us. In
    evaluating any proposed reform of our financial regulatory
    system, we must ask (1) does it enhance transparency, (2) does
    it enhance accountability, (3) does it promote the public
    interest, and (4) does it address systemic risks?
        We often hear that the consolidation of financial
    regulation at the federal level is the modern response to the
    challenges of our financial system. I want to challenge this
    idea.
        The 6,000+ state chartered banks now control less than 30
    percent of the assets in our banking system, but they make up
    70 percent of all U.S. banks. Thus, while these institutions
    may be smaller than the international organizations now making
    headlines and winning bail-outs, they are absolutely critical
    to the communities they serve.
        Since the enactment of nationwide banking, the states have
    developed a highly-coordinated system of state-to-state and
    state-to-federal bank supervision. This is a model that
    embodies the American dynamic of both vertical and horizontal
    checks and balances, an essential dynamic that has been sharply
    missing from certain areas of federal financial regulation with
    devastating consequences for all of us.
        Remember the ultimate Madisonian theory behind separated
    powers. This design would restrain ambitions, prevent capture
    by specific factions and avert corruption. The very definition
    of tyranny, Madison thought, was the collapse of all powers
    into one.
        The problems we face today do not come from regulatory
    federalism, but, rather, from the convergence of regulatory
    centralization and good old-fashioned regulatory capture. Bank
    regulators like to say that our job is to take away the punch
    bowl once the party really gets going, but our federal banking
    regulators made themselves the ruling chaperons of the party
    and worked with their friends on Wall Street to spike the punch
    bowl.
        The current crisis has thus revealed shocking defects in
    regulatory and political will in Washington. Perhaps it is
    true, as the GAO asserts, that the gaps in our divided
    regulatory structure made it more difficult to understand the
    gravity of the risks that were building in the system. Perhaps.
    But the disasters we have experienced are not failures of
    structure. They are failures of execution, political will, and
    policy.
        I do not want to discount the need for significant
    regulatory changes and we outline these gaps in our submitted
    testimony, but those reforms will not address the underlying
    problems if we fail to understand and address why the federal
    system did not adequately respond.
        From the state perspective, it's not been clear for many
    years exactly who was hosting the party, who was chaperoning
    and who the special guests were. The nation's largest and most
    influential financial institutions have themselves been major
    contributing factors in our regulatory system's failure to
    respond to this crisis.
        From our foxholes at the state level, we have watched the
    regulatory apparatus in Washington show tell-tale signs of
    classic regulatory capture, political, economic and
    intellectual capture, by the regulated industry.
        If this is right, a consolidation of regulatory authority
    at the federal level would only exacerbate rather than relieve
    our troubles. From this standpoint, many of the policies of
    TARP and other federal responses to contain this crisis
    interfere with our ability to prevent the next crisis.
        It would be like saying in the wake of Hurricane Katrina
    and its aftermath that the solution is to get rid of local fire
    departments and first responders and centralize more authority
    and power in FEMA. Regulatory capture becomes more rather than
    less likely with a consolidated regulatory structure.
        It was the states that attempted to check the unhealthy
    evolution of the mortgage market and apply needed consumer
    protections to the tidal wave of subprime lending. It was the
    states and the FDIC that were a check on the flawed assumptions
    of the Basel II Capital Accord.
        Professor Warren. Ms. Raskin, your time is up. Can I ask
    you to conclude?
        Ms. Raskin. Yes, I'll finish up. The lesson of this crisis
    should be that these checks need to be enhanced, multiplied and
    reinforced, not eliminated.
        If we've learned nothing else from this experience, we've
    learned that big organizations have big problems and as you
    consider your responses to this crisis, I ask that you consider
    reforms that promote diversity and create new incentives for
    the smaller, less-troubled elements of our financial system
    rather than rewarding the largest and most reckless. At the
    state level, we're constantly pursuing methods of supervision
    and regulation. I appreciate your work toward this goal and I
    thank you for inviting me to share my views today.
        [The prepared statement of Ms. Raskin follows:]
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        Professor Warren. Thank you, Ms. Raskin. President
    Seligman.

     STATEMENT OF JOEL SELIGMAN, PRESIDENT, UNIVERSITY OF ROCHESTER

        Mr. Seligman. Professor Warren, Members of the Panel, I'm
    delighted to join you.
        There is today an urgent need for a fundamental
    restructuring of federal financial regulation, primarily based
    on three overlapping causes.
        First, an ongoing economic emergency, initially rooted in
    the housing and credit markets, which has been succeeded by the
    collapse of several leading investment and commercial banks and
    insurance companies, dramatic deterioration of our stock market
    indices and now a rapidly-deepening recession.
        Second, serious breakdowns in the enforcement and fraud
    deterrence missions of federal financial regulation, notably in
    recent months, as illustrated by matters involving Bear Stearns
    and the four then independent investment banks subject to the
    SEC's former Consolidated Supervised Entity Program, the
    government creation of conservatorships for Fannie Mae and
    Freddie Mac, the Bernie Madoff case, and, more generally, a
    significant decline in the number of prosecutions for
    securities fraud, at least in 2008.
        Third, a misalignment between federal financial regulation
    and financial firms and intermediaries. The structure of
    financial regulation that was developed during the 1930s has
    simply not kept pace with fundamental changes in finance.
        Against this backdrop, I would offer the following broad
    principles to guide consideration of a restructuring of federal
    financial regulation.
        First, make a fundamental distinction between emergency
    rescue legislation which must be adopted under intense time
    pressure and the restructuring of our financial regulatory
    system which will be best done after systematic hearings and
    background reports.
        Second, the scope of any systematic review of financial
    regulation should be comprehensive. This not only means that
    obvious areas of omission today, such as credit default swaps
    and hedge funds, need to be part of the analysis but also
    means, for example, our historic system of state insurance
    regulation should be re-examined as well as current securities
    laws exemptions for areas, including municipal securities.
        A re-examination also is urgently needed of the adequacy of
    the current regulation of credit rating agencies and the scope
    of investment adviser exemptions. In a world in which financial
    holding companies can move resources internally with
    breathtaking speed, a partial system of federal regulation runs
    an unacceptable risk of failure.
        The fact that the Federal Government provided over $100
    billion to insurance giant AIG alone suggests that insurance
    regulation is no longer purely a state matter.
        Third, Congress especially should focus on the structure of
    financial regulation rather than addressing specific standards
    at too great a level of granularity.
        With respect to structure, I would propose consideration of
    a revitalized approach to federal financial regulation that, at
    the highest level, designates the Federal Reserve System as the
    apex or supervisory agency for all financial regulation with
    the expressed mission to address and minimize systemic risk.
    This is not a Twin Peaks model. This is more a holding company
    structure where the company must have comprehensive access to
    data and confidence in examinations to be able to address the
    problems of systematic risk which are not limited to any area.
        Second, to preserve the expertise necessary to industry-
    specific regulation, I would nonetheless suggest consolidating
    industry-specific regulatory areas--agencies in areas such as
    banking and thrifts, securities and commodities, to preserve
    expert examination, inspection and enforcement roles.
        Particular attention should be devoted to revitalizing
    enforcement, including the effective use of private rights of
    action and self-regulatory organizations to complement the role
    of the federal regulatory agencies.
        And third, effectively allocate unregulated areas so that
    we eliminate today's regulatory holes.
        Let me suggest in closing that there is a wise caution that
    a member of your panel suggested before. While I believe that
    any new system of federal financial regulation should be
    comprehensive, the fragility we have seen in global financial
    markets in recent months inevitably will reduce for a time
    willingness to rely solely on self-interests of the market to
    provide optimal behavior.
        As SEC Chair Christopher Cox memorably wrote when the
    Commission disbanded the Consolidated Supervisory Entity
    Programs, ``Voluntary regulation does not work.''
        The challenge in a new order will be also to avoid the
    tendency to over-regulate. Independent regulatory agencies,
    such as the SEC, have shown talent in customizing congressional
    enactments often enacted in times of crisis to achieve the best
    balance between investors and industries. That talent today
    also is urgently needed.
        [The prepared statement of Mr. Seligman follows:]
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        Professor Warren. Thank you, President Seligman. Dr.
    Shiller.

     STATEMENT OF DR. ROBERT SHILLER, ARTHUR M. OKUN PROFESSOR OF
                       ECONOMICS, YALE UNIVERSITY

        Dr. Shiller. I have written two books about what we should
    do in this crisis. One of them called Subprime Solution came
    out in September and one of them with George Akerlof called
    Animal Spirits will come out next month.
        I cannot summarize all of the things I said in those books,
    but basic point, I think that we need to democratize finance
    and we need to develop new financial institutions. This is a
    time when we have to have the spirit of the New Deal about us,
    that we are going to create something that will bring us into
    the 21st Century.
        In my brief remarks, the point is that we have to go for
    specific ideas, not just rearranging the regulators. It's not
    about saying no, it's about coming up with something new. So I
    want to give some examples of new ideas.
        One of them is from the Squam Lake Working Group which
    advises academics. It goes back to an idea of Mark Flannery,
    and the idea is that firms or banks particularly should be
    encouraged to issue a new kind of debt which we call regulatory
    convertible debt. Regulators get involved in telling companies
    they can issue this debt and it will count as capital. It will
    convert to equity if a trigger is reached which could be merely
    that the regulator decides that we're in a financial crisis or
    it could be based on some objective trigger.
        But the point is that the capital that banks have would be
    automatically increased by converting debt to equity at a time
    of crisis. This is very different than having TARP come in with
    public money and contribute it to capital at a time of crisis
    and it would prevent the kind of--this is really central
    because it would prevent the kind of downward spiral that
    created the crisis we're in. This is financial innovation that
    works at the fundamental problem of systemic vulnerability.
        Now some other ideas. One is from my book. We ought to--the
    government ought to be subsidizing personal financial advice.
    This is expensive, but it is important. The crisis was
    substantially due to errors that people made and I would track
    that back to the fact that they were not getting advice.
        The cheap thing to do is financial education. That can be
    really cheap. All we have to do is think of a curriculum and
    put it on the Web, but that doesn't work for many people. They
    cannot read the complicated brochures alone. They need someone
    to help them.
        Third idea. It's really yours, Elizabeth. The idea of a
    financial products safety commission. I'll let you explain
    that, but I think, once again, it is about democratizing
    finance, about having someone representing the individual.
        Fourth point. I think the real fundamental problem which
    underlies this crisis is a failure of risk management and so
    instead of saying no to new financial derivatives, we have to
    make them work better for everyone and I think that means
    expanding the scope of our financial markets. Notably, real
    estate is a risk which is underlying this crisis and is not
    hedgeable, it's not manageable, and the kinds of securities
    that we've developed to manage such risks entail unfortunate
    counterparty risk and systemic risk. So we have to think about
    how to make it possible for a broader array of risks to be
    managed.
        Finally, I talk about in my Subprime Solution book a new
    mortgage institution that we could create which would be
    helpful in managing the risks of families. I call it a
    continuous work-out mortgage.
        This would be a mortgage that would automatically adjust
    the payment the way a work-out does in response to objective
    factors, continuously and automatically. That is, for example,
    if we fall into a recession or we see a big drop in home
    prices, there would be a formula written into a mortgage
    contract that would automatically adjust down the payment and
    the principal.
        If we had had such a thing in place today, it would have
    prevented a lot of economic suffering. Instead of having
    families go through months or years of difficulty in paying
    their mortgage and then running out of money and going in
    begging for help, we would have had them helped automatically.
    These are the kinds of ideas that I think we have to think
    about. It's ideas that are innovations and that represent
    creative new solutions to the problems that we've seen.
        [The prepared statement of Dr. Shiller follows:]
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        Professor Warren. Thank you, Dr. Shiller. Two books, five
    minutes.
        Dr. Stiglitz.

     STATEMENT OF JOSEPH E. STIGLITZ, PH.D., UNIVERSITY PROFESSOR,
                        COLUMBIA BUSINESS SCHOOL

        Dr. Stiglitz. Thank you for holding these hearings.
        I feel quite strongly that part of the reason that our
    financial system has performed so poorly is inadequate
    regulation and regulatory structures. There's a lack of
    confidence in our financial system which is well earned, but
    how can there be restoration of confidence when all we have
    done is to pour more money into the banks? We have changed
    neither the regulatory structures, the incentive systems, nor
    even those who are running these institutions.
        While everyone talks of the need for better regulation, the
    devil is in the details. Some have pushed for cosmetic reforms
    instead of the real reforms that we need. Those who engage in
    deceptive financial practices will push for deceptive
    regulatory reform.
        It is hard to have a well-functioning modern economy
    without a sound financial system. However, financial markets,
    as has already been said, are not an end in themselves but a
    means. They are supposed to mobilize savings, allocate capital,
    and manage risk, transferring it from those less able to bear
    it to those more able.
        By contrast, our financial markets have encouraged
    excessive consumption and have misallocated capital. Instead of
    managing risk, they created it. These problems have occurred
    repeatedly and are pervasive. This is only the latest and
    biggest of our bail-outs, each of which reflects a failure of
    our financial system to fulfill its basic functions, including
    ascertaining creditworthiness.
        The problems are systemic and systematic. These failures
    are in turn related to three more fundamental problems. Markets
    only work well when there are well-designed incentives, a high
    level of transparency, and effective competition. America's
    financial markets fail on all accounts.
        Markets only work well when private returns are aligned
    with social returns. Incentives matter, but when incentives are
    distorted, we get distorted behavior. Our banks have incentives
    designed to encourage excessive risk-taking and short-sighted
    behavior. Lack of transparency is pervasive in financial
    markets and is in part the result of flawed incentive
    structures. Indeed, those in the financial markets have
    resisted improvements, such as more transparent disclosure of
    the cost of stock options. This provided incentives for bad
    accounting.
        Failure to enforce strong competition laws results in
    institutions that are so large they are too big to fail and
    almost too big to be bailed out. That provides an incentive to
    engage in excessively risky practices.
        When financial markets fail, as they have done, the costs
    are enormous. There are, as economists put it, severe
    externalities. The losses include not only the budgetary costs
    in the hundreds of billions of dollars but also costs to the
    entire economy, totaling in the trillions, before we have fully
    recovered. The damage to our standing in the world is
    inestimable.
        Good regulation can increase the confidence of investors in
    markets and serve to attract capital to financial markets. It
    can also encourage real innovation. Much of our financial
    market's creativity was directed to circumventing regulations,
    taxes, and accounting standards. Accounting was so creative
    that no one, not even the banks, knew their financial position.
        Meanwhile, the financial system didn't make the innovations
    which would have addressed the real risks people face, such as
    how to stay in their homes when interest rates changed or
    economic conditions changed. Professor Shiller has shown how
    it's easy to come up with innovations of this kind. Not only
    did they not do this, but they also resisted these kinds of
    innovations.
        In short, regulations can help markets work better. We need
    regulations to ensure the safety and soundness of individual
    financial institutions and the financial system as a whole to
    protect consumers, maintain competition, ensure access to
    finance for all, and maintain overall economic stability. They
    need to focus both on practices and products.
        It has been commonplace to emphasize the need for more
    transparency, which is why any retreat from mark to market
    would be a mistake, but we should realize that lack of
    transparency is a symptom of deeper problems. Even if
    transparency issues were fully addressed, much more needs to be
    done.
        For instance, even if there were full transparency, some of
    the products the financial markets created were so complex that
    not even their creators fully understood their risk properties.
    We have to ensure that incentive structures do not encourage
    excessively-risky short-sighted behavior. We need to reduce the
    scope of conflicts of interest which are rife within the
    financial system. Securitization, for all the virtues of
    diversification, has introduced new asymmetries in information,
    forcing originators of mortgages to bear some of the risk and
    mitigate some of the resulting moral hazard.
        Derivatives and similar financial products should neither
    be purchased nor produced by banks, unless they have been
    approved for specific uses by a financial products safety
    commission and unless their use conforms to the guidelines
    established. They should be instruments for laying off risk,
    not instruments for gambling. Regulators should encourage the
    move to standardized products; greater reliance on standardized
    products, rather than tailor-made products, may increase both
    transparency and efficiency of the economy.
        Professor  Warren. Dr. Stiglitz, can I ask you to wrap up
    your opening remarks?
        Dr. Stiglitz. Okay. There are a large number of other
    reforms that I talk about in my written testimony.
        Let me just conclude by saying TARP has failed partly
    because of the failure to do anything about regulation. We need
    to impose conditionality on the use of the funds if we are to
    have any confidence that the next tranche of funds have better
    outcomes than the last tranche of funds.
        We need, as Professor Shiller pointed out, to encourage
    more innovation. One way of thinking about this is if we had
    taken $700 billion and created a new institution which had used
    a normal leverage of 10:1, we could have created a flow of
    credit of $7 trillion. We would have done far better if we had
    started fresh, rather than bailing out the failed institutions
    of the past.
        Now, no one has proposed that, but the point I wanted to
    make is that we are putting an awful lot of money in the
    system. We have had repeated bail-outs, not just the S&L bail-
    out, but also the Mexican, Indonesian, and Korean bail-outs of
    the financial markets. These were not bail-outs of the
    countries: They represent failed lending practices of our
    financial institutions.
        Unless we impose better, smarter regulation, we will have
    another one of these encounters in a short period of time.
        [The prepared statement of Dr. Stiglitz follows:]
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        Professor Warren. Thank you, Dr. Stiglitz. Mr. Sumerlin.

       STATEMENT OF MR. MARC SUMERLIN, MANAGING DIRECTOR AND CO-
                       FOUNDER, THE LINDSEY GROUP

        Mr. Sumerlin. Madam Chair, Members of the Panel, thank you
    very much.
        My name is Marc Sumerlin. I'm Managing Director of The
    Lindsey Group, an economic consulting firm. Previously, I was
    Deputy Director of the National Economic Council in 2001 and
    2002.
        We are in the midst of an economic contraction that is
    currently mirroring the worst months of the 1974 recession, one
    of the sharpest post-World War II periods of decline for our
    country. Despite all of the actions to date, it has been
    impossible to completely stop the deterioration because the
    economy is deleveraging and in fact needs to shed leverage
    after a decade of excessive borrowing.
        Credit market liabilities in the United States soared from
    250 percent of GDP in 1997 to 350 percent of GDP in 2007,
    reaching over $50 trillion. Over this time, the economy has
    suffered from the rapid deflation of two asset bubbles. While
    both consumers and the financial sector still need to reduce
    their debt burden, a central goal of the emergency policies has
    been to slow the pace of deleveraging to minimize the negative
    feedback loops that occur during a sharp economic downturn.
        The goals of longer-term reform strategies are quite
    different and should focus on preventing excessive leverage
    from happening in the next cycle. In thinking about reform of
    the regulatory structure, I believe it is imperative to
    consider the proper role of monetary policy as well.
        In my written testimony, I have described in detail where I
    believe policy across government failed in the past. Now, I'd
    like to focus on three broad recommendations, all centered on
    preventing excessive leverage from building up again.
        The first recommendation is for the Federal Reserve to take
    a more active role in preventing asset and credit bubbles from
    forming in the first place, as I believe is mandated under the
    Federal Reserve Act.
        During the 1990s, there emerged a widespread belief that
    central bankers had learned from their inflationary mistakes of
    the past and that another end-of-history moment had arrived
    where everyone could relax or at least prosper.
        There was a new consensus view that monetary policies
    should effectively target a low level of goods and services
    inflation while ignoring asset prices, except to the extent
    that they signal a change in future inflation. Not only would
    asset bubbles in credit not be resisted but policymakers
    believed they should aggressively lower interest rates after an
    asset bubble pop to mitigate the damage. This created an
    asymmetric bias that traders referred to as the ``Greenspan
    Put.'' This bias towards easing monetary policy also created a
    bias towards over-valued assets that would eventually collapse
    under their own weight. In fact, financial bubbles are
    dependent on an accommodative monetary policy in the first
    place.
        The Federal Reserve needs to take a more active role in
    promoting financial stability. While the Fed has from creation
    adopted the lender of last resort role, it has not always
    embraced the policy of mitigating boom-bust cycles in asset
    prices, but under the Federal Reserve Act, the Central Bank is
    obligated to ``maintain long run growth of monetary and credit
    aggregates commensurate with the economy's long-run potential
    to increase production.''
        This gives the Federal Reserve a responsibility to prevent
    asset bubbles since they are fueled by excess credit.
        The second recommendation is to shift housing policy from
    subsidizing leverage to promoting equity, as the Central Bank
    was not the only part of government that was complicit in the
    housing and credit bubble.
        Government housing policy has been designed to directly
    subsidize leverage. The most expensive housing policy the U.S.
    has is the tax deduction on mortgage interest payments, which
    lowers borrowing costs. This is why realtors commonly refer to
    your interest payments as your ``tax deduction.''
        Both the Clinton and the Bush Administration have pushed
    various programs that supported easier access to housing credit
    and lower downpayments which, by definition, create leverage.
    At the same time, the private sector seemed determined to outdo
    the government's lead at the peak of the bubble.
        In 2005, a remarkable 43 percent of all first-time
    homeowners put zero down or took out a mortgage in excess of
    the value of the home. It's worth emphasizing here that buying
    a house without a downpayment is not homeownership. It is
    renting with risk. To the extent possible, government subsidies
    to leverage should be replaced with broader programs that help
    build equity, such as downpayment matches for new homeowners.
        My last recommendation is to support a binding limit on the
    amount of leverage that is permitted by banks and other
    financial institutions that act as banks. A large part of the
    financial system, most notably commercial banks, under the
    regulation of the FDIC, already has a limit on their leverage.
    These banks are subject to a simple leverage ratio that caps
    their assets relative to their capital. Notably, investment
    banks were not subject to this limit.
        For covered banks, if the leverage ratio drops below four
    percent, the FDIC must start supervisory intervention and if
    the leverage ratio drops below two percent, the bank is
    considered critically undercapitalized and is shut down. This
    system means that any bank that is leveraged more than 25:1
    will be under intense regulatory scrutiny. Banks hate these
    simple calculations because they cannot easily be skirted,
    which is the very point.
        It is worth remembering that banks are inherently risky
    entities. John Maynard Keynes once quipped that ``a prudent
    banker is one that fails at the same time that all other
    bankers fail.'' But this inherent riskiness is why banks need
    more limits in other parts of the economy.
        A binding leverage ratio is a simple, transparent, and
    blunt form of regulation, all attributes that could make it a
    useful form to bank regulators around the world.
        Professor Warren. Mr. Sumerlin, could I just ask you to
    finish? You're over time.
        Mr. Sumerlin. Absolutely. The last point I would make,
    adding to that, is at the same time, all efforts have to be
    made to move off-balance sheet activity back on balance sheet,
    as will soon be required under FAS-140, and I'd just like to
    make one more note, that both the housing and credit bubble
    were exacerbated by the psychology of a bull market, which is
    important to always keep in perspective, which adversely
    affected the judgment of homebuyers, market participants, and
    regulators.
        Thank you very much.
        [The prepared statement of Mr. Sumerlin follows:]
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        Professor Warren. Thank you, Mr. Sumerlin. And Mr.
    Wallison.

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

        Mr. Wallison. Thank you.
        I'm very pleased to have this opportunity to testify today
    and I assume my prepared remarks will be----
        Professor Warren. Of course.
        Mr. Wallison [continuing]. Put in the record. My testimony
    actually will focus mostly on safety and soundness regulation,
    but I'd be happy to answer questions about any other kind of
    regulation.
        With the limited and disastrous exception of the major
    investment banks, the Federal Government has never regulated
    the safety and soundness of financial institutions for which it
    does not assume some financial responsibility. There are sound
    and strong reasons for this.
        First, regulation itself introduces moral hazard.
    Participants in the financial markets may believe that
    government supervision reduces the likelihood of missteps or
    failure and this impairs market discipline.
        Second, regulation also impairs competition, suppresses
    innovation, increases consumer costs, and enhances the
    likelihood that taxpayers will be called upon to bail out
    regulated companies.
        Third, there is no policy reason why the government should
    take responsibility for preventing the failure of financial
    institutions that it does not back. In general, business
    failures are good for the economy and the financial system.
    They remove bad management and bad business models and make
    room for good management and business models. If regulation is
    in fact effective in preventing bad management from failing--
    which is doubtful in any case--it would be preserving bad
    management and business models.
        Fourth, regulation is apparently not effective in
    preventing business failures. We can see that from the current
    financial crisis in which heavily-regulated commercial banks
    are in the most trouble. In fact, given the disastrous
    conditions of the banks, it is difficult to understand why
    anyone would be calling for the regulation of other
    participants in the financial system.
        If regulation does not prevent failures, why impose its
    costs on consumers and taxpayers?
        Nevertheless, only a recently-landed Martian would not
    realize that there is a major move afoot in Congress to broaden
    the scope of regulation to include other participants in the
    financial markets.
        The ostensible reasons for this are usually two.
    Regulation, it is said, will improve transparency and reduce
    systemic risk. As outlined in my prepared testimony, neither
    reason is persuasive. Transparency itself is a reasonable goal,
    but it is not worth the tangible and intangible costs of
    regulation when institutions are dealing solely with
    sophisticated counterparties. These counterparties can fend for
    themselves and know what questions to ask.
        As to reducing systemic risk, there are no examples of the
    failure of a non-regulated institution causing systemic risk,
    including LTCM, Lehman and AIG or any of the hedge funds that
    have closed their doors this year.
        Lehman's failure did not cause systemic risk. No
    institution failed or was threatened with failure because
    Lehman collapsed. The market freeze-up after Lehman was not
    caused by losses coming from Lehman's failure but by a sudden
    recognition on the part of banks and others around the world
    that their counterparties might be very weak and unstable and
    that the U.S. Government could not be expected to rescue them.
        Accordingly, the proponents of new regulation, based on the
    danger of systemic risk, should explain why it is suddenly
    necessary.
        Finally, it would be a very bad idea to empower some
    agency, the Federal Reserve or anyone else, to identify
    systemically-significant institutions and regulate them as
    such. This would have very adverse effects on competition. By
    creating the impression that some institutions are too big to
    fail--which is what it means to be designated as systemically
    significant--such a policy would create an unlimited number of
    Fannies and Freddies that would have huge competitive
    advantages over others in the same industry.
        As we can see from bank regulation, traditional financial
    supervision does not work anyway and will not prevent financial
    failure. To be sure, there are some areas where regulation is
    necessary, especially when financial institutions, like
    commercial banks, are backed by the Federal Government. The
    GSEs are another example.
        Accordingly, in my prepared testimony, I recommend a few
    major changes in traditional regulation for these cases of
    necessary regulation. The purpose of these reforms is to
    enhance market discipline and make regulation counter-cyclical
    rather than pro-cyclical as it is today.
        To assist creditors and counterparties, I suggest that
    regulators should work with analysts and the regulated industry
    to create metrics or indicators of risk-taking. These would be
    published regularly and help potential creditors understand the
    risks that regulated institutions are assuming.
        Professor Warren. One more paragraph.
        Mr. Wallison. This would make market discipline much more
    effective. I also recommend various steps that will make
    regulation counter-cyclical, including changes to fair value
    accounting, requirements for regulators to consult market
    sources for risk assessments, requirements for capital
    increases when asset values are rising, and the enhancement of
    the role of short sellers and hedge funds.
        Thank you very much.
        [The prepared statement of Mr. Wallison follows:]
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        Professor Warren. Thank you, Mr. Wallison. In fact, Mr.
    Wallison, I'll just come back to you, so you'll get a chance to
    talk some more.
        I was struck by your comment when you said regulation
    doesn't prevent failures, see the recent bank failures.
        Mr. Wallison. Yes.
        Professor Warren. But I also listened to Ms. Raskin and Ms.
    Raskin, if I made my notes right, said in effect that federal
    regulators were captured and they really did a pretty lousy job
    whereas the state regulators were watching, the state
    regulators saw it, and they waved as many flags as they could.
    But failure seems to accompany those who are governed by
    regulators who are not independent or, to say it another way,
    non-regulation regulation seems to lead to failure.
        Can you respond to Ms. Raskin's point?
        Mr. Wallison. Sure. I think I can. I have no faith, of
    course, as I suggested in my oral testimony, in regulators per
    se. I don't think they're any smarter than the people that they
    are regulating and in fact they are always relatively behind
    the curve. We assume that regulators are actually overseeing
    risk-taking, and they are not.
        The only group that actually is interested in preventing
    risk-taking are creditors. Creditors are not benefited by risk-
    taking. And as a result, we ought to do everything we can to
    assure that creditors get the information about the risks that
    the institutions are taking so that they can make appropriate
    choices in lending money or withholding money from financial
    institutions, especially regulated institutions.
        Professor Warren. Sir, I just want to make sure I'm
    understanding the point. Regulators are not smart enough to
    regulate or they simply won't regulate?
        Mr. Wallison. Oh, I think they would love to regulate. In
    fact, they--for the larger institutions here in the United
    States, the larger banks, there are regulators in those
    institutions 100 percent of the time.
        Professor Warren. Maybe that was Ms. Raskin's point.
        Mr. Wallison. Yes, of course, but I'm saying that no
    regulation is going to be satisfactory if we are relying simply
    on government people going in and looking at what the
    institutions are doing.
        The ones who are really effective at regulation are the
    ones who have the incentive to do so, I believe, and those are
    the creditors, the people who are asked to lend the money or
    make deposits in those institutions or be counterparties in
    transactions. They need the information that they are not
    getting from the institutions to decide whether risks are being
    taken.
        Professor Warren. Ms. Raskin, maybe I could give you a
    chance to respond as a regulator.
        Ms. Raskin. Yes, thank you. I do believe that regulation
    works. I think that there are systems in place currently that
    primarily permit a great deal of coordination between state
    regulators and federal regulators.
        We have seen through recent history that regulators have
    been very nimble at the state level, have been very precise in
    dealing with the problems that have arisen, particularly the
    number of foreclosures, that we've been dealing with on a
    massive level at the state level.
        So I do believe that regulation works. I urge, though, the
    panel to consider when they design a new system for organizing
    the regulatory boxes that checks and balances be considered,
    that accountability be built in and that mechanisms be adopted
    that permit coordination among the different regulators.
        Professor Warren. President Seligman, I have the sense
    you'd like to respond to this.
        Mr. Seligman. Effective regulation can increase confidence
    in our markets. We've seen, for example, during the time of the
    SEC the percentage of investors in this country grow from 1.5
    percent to approximately 50 percent, the value of equity and
    debt in this country grow from 90 billion to close to 12.6
    trillion.
        At the same time what you referred to as non-regulation
    regulation can undermine this confidence and the classic recent
    illustration that has so far been reported upon is Bear Stearns
    where you had too few individuals involved in administering the
    SEC's Consolidated Supervisory Entity Program. When problems
    were flagged, they did not go up the chain of command. You had
    certain wrong rules, and I commend to your attention the report
    of the SEC's Office of Inspector General on Bear Stearns which
    documents that you have to have people who believe in
    regulation to administer it if you're going to in turn prevent
    financial misconduct.
        Professor Warren. Thank you very much. I'm nearly out of
    time. So I'm going to go to Congressman Hensarling.
        Representative Hensarling. Thank you, Madam Chair. I again
    thank the panel.
        Mr. Wallison and Mr. Sumerlin, I think you both wrote about
    Fannie and Freddie in your testimony. I'm not sure I heard it
    or saw it in the other testimony.
        Mr. Wallison, in your testimony, you speak about Fannie and
    Freddie were largely responsible for the vast inflation of the
    housing bubble, and Mr. Sumerlin, I believe you write in your
    testimony that the GSEs, Fannie and Freddie, encouraged loans
    to people who could not afford them and essentially helped
    destabilize our housing market in direct contrast with their
    mission.
        I would like to give you two gentlemen, starting with you,
    Mr. Wallison, an opportunity to elaborate on your thoughts on
    precisely the role of Fannie and Freddie in our economic
    turmoil and also speak, if you would, specifically to their
    affordable housing mission. Mr. Wallison.
        Mr. Wallison. Fannie and Freddie represent an effort on the
    part of Congress to achieve a national housing goal without
    appropriating funds. Instead, what Congress did was used two
    private companies to make loans that they might not otherwise
    have made, except for certain housing goals that they were
    required to meet.
        As a result, Fannie and Freddie contributed about 40
    percent of all the subprime and Alt-A loans that we are
    currently struggling with in our economy by buying loans from
    originators that would not otherwise have been marketable. That
    distorted our financial system and has ultimately been the
    cause of the tremendous losses that we are going to suffer in
    housing.
        Representative Hensarling. Mr. Sumerlin.
        Mr. Sumerlin. During the 1990s, both of the GSEs
    continually lowered their downpayment requirements of what type
    of loans they would buy.
        Now, when the loan went below a 20 percent downpayment, it
    still had to have some form of mortgage insurance, but loans
    were being securitized through Fannie and Freddie that did have
    lower and lower downpayments. This is, as you know from my
    testimony, something that I believe is a problem when you have
    excess leverage to homeowners.
        During, the peak of the housing boom, they were operating,
    just as were private firms, in buying and thereby aiding
    mortgages that should never have been given. I think the GSEs,
    given their link to government, do tend, when they do
    something, to put more of a stamp of approval on it, than when
    other people do and therefore they had a special role to be
    even more diligent and the GSEs had--from the beginning, were
    undercapitalized and had an incentive problem where they could
    essentially privatize profits and socialize losses and that's
    the framework for taking on----
        Representative Hensarling. Is it your opinion that but for
    their government sanction duopoly status that they would not
    have been able to do what they did?
        Mr. Sumerlin. They certainly would not have been able to do
    what they did with the scale they did. I mean, they existed on
    that scale because of their link to the Federal Government.
        Representative Hensarling. Mr. Sumerlin, also in your
    testimony, you speak extensively, I believe, on the Federal
    Reserve policies, particularly in dealing with our last
    financial crisis after the dot-com bubble and 9/11, and I think
    on Page 8 of your testimony, I had not realized this, for three
    straight years, the Fed fund rate was essentially negative, as
    you put it, the equivalent of free money.
        I think there was a body of work that would suggest that
    the seeds for this financial crisis were, frankly, sown in
    trying to deal with the aftermath of the last financial crisis.
        Would you speak a little bit more extensively about your
    view of the role of the Federal Reserve's easy money policy
    enabling the crisis that we find ourselves in?
        Mr. Sumerlin. I think that once you get yourself into a
    boom-bust cycle, you start doing emergency policies and other
    things to mitigate the current problems and you don't always
    know where you're going to end up.
        Once we had the enormous tech bubble where the PE ratio,
    the S&P, for instance, got up to 45, about three times its
    historic average, and then in 2001, when--starting in March of
    2000, we had about $5 trillion in asset losses and the
    government starts to react to that, and deflating asset bubbles
    can be very vicious economic events, and part of the reaction
    to that was the Federal Reserve from 2002-2003-2004, real
    interest rates, meaning adjusted for inflation, were
    effectively zero, which is like free money.
        Part of the other issue was the Federal Reserve, by being
    completely transparent that it was going to take a very gradual
    path that lowered bond volatility. Volatility, and other sort
    of things, which encouraged financial entities to take on more
    risk and in some cases, some financial entities, like pension
    funds insurers, they need a seven percent, eight percent
    nominal return, and when you're operating in a very low nominal
    return world, they start to leverage up to try to hit the
    return they need to meet their internal targets.
        Professor Warren. Thank you, Mr. Sumerlin. Thank you. We're
    over time. Congressman, thank you.
        Mr. Silvers.
        Mr. Silvers. Thank you, Madam Chair. President Seligman, I
    understand you have some time constraints here. I would
    appreciate it if you would in writing advise us as to specific
    steps to strengthen the Securities and Exchange Commission in
    light of your testimony. Specifically, though, my question to
    you is there's been some talk about unified consumer protection
    financial services in a regulatory body.
        Do you view the types of substantive consumer protection
    that we see in insurance, mortgages, credit cards, as being
    easily mergable with the sort of disclosure-based investor
    protection that the SEC does?
        Mr. Seligman. I think it's a tough analysis that has to be
    done. I do think, for example, a potential merger of the SEC
    and CFTC makes good sense for a number of reasons. I do think
    there needs to be very thoughtful analysis as to whether or not
    certain aspects of insurance should be subject to federal
    regulation.
        I do think, however, that when you try to create one
    consumer and investor agency across the board you risk
    dissipating the expertise necessary to effective regulation and
    what I'm very much concerned about when I look at the
    experience, whether it's of the SEC or other agencies, when
    their mandate becomes too broad, they tend not to be able to
    focus on everything equally well. There is a real value to
    expertise.
        The countervailing challenge, and it's been well
    illustrated in the recent past, is regulatory arbitrage and,
    for example, when you have five depository institution
    regulators, the ability of those regulated to pick and choose
    which format they'll be subject to does create a kind of
    tendency towards a race to the bottom.
        So it's going to take very, very systemic analysis. It
    shouldn't be done quickly. You need to have sufficient
    hearings. You need to have sufficient reports so you can reach
    the appropriate outcomes.
        Mr. Silvers. Thank you. Ms. Bloom Raskin, you are the only
    member of our panel who is actually involved in the housing
    crisis and the foreclosure crisis in any direct way right now
    in your capacity.
        Can you shed light on the relative responsibility in your
    view, based on what you've seen, of the GSEs and GSE-financed
    mortgages on the one hand and of the non-GSE entirely private
    sector firms on the other that were so much encouraged in the
    last eight years?
        Ms. Raskin. I'd be happy to and that's--it's an excellent
    question.
        What I can speak to certainly is the work that we have been
    doing in Maryland regarding the foreclosure crisis and we
    identified quite early that mortgage servicers were in fact a
    linchpin to working through a lot of the problems of loan
    modification and the need for sustainable mortgage
    modification, and to that extent, what we have done, and I
    think states are very well positioned to do, is to work
    individually, and it's hard work, it's a lot of heavy lifting,
    but to work individually with mortgage servicers which we have
    done.
        We have hammered out agreements one by one with them in
    which we require certain operational fixes being made within
    the relationship between the borrower and the servicer and we
    have worked very hard in that regard.
        We have also put in place a monthly reporting system by
    which we collect data on a monthly basis from the mortgage
    servicers that are doing business within our state and in this
    way we have been able to track modification efforts and we've
    been able to measure the sustainability of those modifications.
        This to me are--these are two examples of how we have been
    able to work on a local level without really the involvement of
    the GSEs and Fannie and Freddie but with the servicers over
    whom we do have some regulatory authority.
        Mr. Silvers. Thank you. Professor Stiglitz, in your written
    testimony, you raised a question of whether the Federal Reserve
    as currently structured is an appropriate umbrella regulator.
        I think, Mr. Sumerlin, you also have some concerns about
    the Fed in your testimony you gave this morning.
        In order, Professor Stiglitz, could you comment on what
    changes might be necessary to the Fed for it to play the role
    some envisioned for it?
        Dr. Stiglitz. First, let me say I share the view of several
    people on the panel that the Fed was too easily captured by the
    spirit of the bubble that was going on. The metaphor that was
    given of a punch bowl that was spiked is, I think, absolutely
    correct.
        That's why I think it's important to make sure that the Fed
    becomes more representative and much more explicit about its
    mandate. In the United States and around the world, there has
    been focus only on inflation. There have been explicit
    discussions not to worry about assets and I think Mr. Sumerlin
    is exactly right, that the Fed needs to understand that
    financial instability is far more of a risk for long-term
    economic growth than an increase in inflation from two percent
    to 2.5 percent.
        Professor Warren. Can I ask you just to wrap up just
    because we're over time?
        Dr. Stiglitz. Okay. The single most important thing is to
    make sure, like they do in Sweden, for instance, that there are
    representatives on the Federal Reserve Board of people whose
    views may not be quite consistent with those in the investment
    community, such as from the labor community.
        Professor Warren. Thank you. Senator Sununu.
        Senator Sununu. Thank you, Madam Chair. Listening to the
    testimony and some of the answers to questions, I want to begin
    with an observation. I believe that Mr. Wallison's point--that
    even in areas where he would agree that regulation should be
    imposed because of a government guarantee, the regulators can
    still cause significant problems--is not at odds with the
    points made by Mr. Seligman and Mrs. Raskin.
        In fact, I think the points that you made reinforce this
    point. There may be other areas where there's disagreement, but
    the example of the SEC's Consolidated Capital Rule, and the
    example of regulatory capture--and let's name names, at the
    OTS--these are two of the oldest and, one might argue, most
    experienced federal regulators that took specific action or
    failed to take specific action that made this crisis much
    worse.
        I think we need to be cognizant of that and actually use
    that as a basis for the recommendations that we make. I also
    think that speaks directly to Mr. Wallison's concern about the
    way in which existing regulatory structure can make the problem
    worse. Now, they could also help deal with problems, and I
    believe that they should.
        I'd like to go to Mr. Seligman, though, not to talk about
    the CFTC/SEC consolidation to which I'll come back. You
    mentioned something else--a federal voice for insurance
    regulation and the concept of a federal charter, an optional
    federal charter for insurance, which the Treasury Blueprint
    also discussed.
        How do you think that a federal voice for insurance
    regulation might work? Do you think it's necessary, given the
    national scope and the global scope of some of these insurance
    companies that we see today? AIG is obviously high profile but
    there are many others. But equally important to the other
    panelists, those in closest proximity to you, can we still
    maintain a meaningful voice for state regulation in an
    environment where we have an optional federal charter or
    federal insurance charter?
        Mr. Seligman. I think there are two separate reasons you
    should look hard at a new federal role with respect to
    insurance.
        The absolutely imperative one now is systematic risk; that
    is, there are aspects of at least certain insurance
    corporations which required ultimate federal rescue packages
    which, because of counterparties, were viewed as of similar
    consequence to commercial banks and investment banks.
        There is a separate point, and that is that insurance
    regulation may be anachronistic. It is the only major financial
    sector which is essentially purely at the state level. This
    creates, among other things, potential competitive
    disadvantages in the global economy. It creates the kind of
    problems that the Securities Acts in the 1930s or certain of
    the banking legislation has addressed through preemptive
    mechanisms and federal mechanisms.
        It seems to me what we ultimately would be most wisely
    moving towards was federal insurance regulation above certain
    thresholds, perhaps on an optional basis but more wisely I
    would suggest on a mandatory basis, through a chartering
    mechanism and state insurance regulation on a residual basis,
    the way you have it in----
        Senator Sununu. Mandatory based on the aggregate assets of
    the insurance company or mandatory based on the size of the
    policy?
        Mr. Seligman. I think that is the kind of question we need
    to systematically review. I don't want to shoot from the hip on
    it, but I will suggest to you that I know there are a number of
    leaders of major insurance companies right now who would
    suggest to you that it is easier to deal potentially with one
    federal regulator than 55 state and similar regulators that
    they now have to address and that to have one set of standards
    would potentially give them competitive advantages in a global
    economy.
        Senator Sununu. Do you still see a role for meaningful
    participation by the states to provide----
        Mr. Seligman. Absolutely. State securities regulation is
    absolutely vital for a number of reasons. It enhances the
    enforcement. It deals with local problems. It is a laboratory
    by which new ideas can originate, but at the same time for
    firms, either in interstate commerce or above certain
    thresholds, the notion that we would continue to rely on state
    securities regulation today would be dysfunctional.
        Senator Sununu. On the recommendation that the SEC and CFTC
    be combined, what do you--and I know this is an area where
    you've done a great deal of work--but what would you identify
    as the most specific obstacles to combination and how do you
    recommend we overcome those obstacles?
        Professor Warren. And since we're out of time, could I ask
    for just a condensed answer since I know this is in your
    testimony?
        Mr. Seligman. Very simply, in a sentence, that the
    oversight committees in Congress for securities and commodities
    regulation are separate.
        Senator Sununu. It's a turf war.
        Mr. Seligman. It is a turf war. It is not principled. It is
    not wise.
        Senator Sununu. I don't know if that makes the problem of
    consolidation easy or more difficult.
        Mr. Seligman. Unfortunately, you do know.
        Professor Warren. Thank you. Thank you, Senator.
        Mr. Neiman. I'd like to stay with Professor Seligman and
    follow up on your ideas for the role of the Federal Reserve as
    an apex agency, as a systemic regulator.
        If you could expand upon that as to why the Federal Reserve
    is the appropriate entity, and how would it operate differently
    than we are seeing the Fed operate in our current environment?
        Mr. Seligman. It has been the emergency entity since at
    least the 1987 market crash time after time. What it doesn't
    have is the right information flows, confidence in the
    underlying examinations, so that it can anticipate problems and
    try to obviate risk.
        You have three choices ultimately: the President's Working
    Group, the Department of the Treasury, or the Fed. The Fed has
    been the one that operationally seems most competent to address
    this.
        What you want is not a Twin Peaks Model which suggests that
    at a similar level you both have safety and solvency and
    investor/consumer protection. What you want is a very different
    type of approach where you have one agency that unequivocally
    receives all relevant information and can address systematic
    risk and respond to it the way the Fed implicitly has been
    doing for some time now but properly armed so that they've got
    confidence in information flows.
        And second, then you want to preserve industry expertise in
    a series of agencies. While it's a very crude and imperfect
    analogy, what was done with intelligence services after 9/11
    where you have a national intelligence director but separate
    intelligence agencies is a better model than the Twin Peaks.
        Mr. Neiman. Thank you. Mrs. Raskin, it's a pleasure that
    you were able to join us and have a fellow regulator here and
    in fact it's probably a unique experience where a panel is made
    up, the sole regulator is the state regulator. So welcome.
        Some have suggested that the dual banking system might make
    it more difficult to prevent or manage crises and to Mr.
    Seligman's point, the response to 9/11, we moved to a more
    coordinated approach by creating a consolidated agency.
        Is that comparison apt? And what are your thoughts on the
    risks associated with moving toward a consolidated approach,
    the opportunity if you had a single regulator of missing red
    flags and eliminating checks and balances?
        Ms. Raskin. Well, I think it's a very apt analogy and I
    think that the dual banking system has actually been the savior
    here in mitigating even greater harm that could be coming from
    the financial crisis that we are now all living through.
        So I believe that the checks and balances that are in place
    by virtue of that system are a good example and a good model
    for study as we move forward in deciding what a regulatory, a
    new regulatory system might look like. So I do think that the
    state examiners, the state supervisory role has been an
    important check. I think that state-chartered institutions, by
    virtue generally of their size, have been able to be a good
    shock absorber to a lot of the systemic risk consequences we've
    been experiencing.
        Mr. Neiman. Thank you. Dr. Shiller, I was very interested
    in your concept of the continuing work-out loan and would
    probably want to follow up with you after, but in the minute we
    have left, have you done any analysis or research around the
    unintended, possible unintended consequences of that in terms
    of impact on the market, the ability of lenders to hedge their
    risk? Could it result in higher interest rate loans, shorter-
    term loans, and what would be the impact and expected reaction
    to the marketplace?
        Dr. Shiller. Well, my proposal is a market-based solution
    and it involves the government only as a regulator that would
    make this possible.
        You're asking questions that are difficult. How would
    market prices be impacted by an institution like this? In terms
    of mortgage rates, it's possible that a continuous work-out
    mortgage would have a higher interest rate because you're
    getting some kind of insurance, but it shouldn't be considered
    a bad thing if people have to pay a higher interest rate.
    They're getting a kind of risk protection.
        But on the other hand, we don't know how much higher
    because it affects the whole economy and the whole systemic
    risk to the economy. So having something that protects mortgage
    borrowers built into the initial mortgage improves the
    resilience of the whole economy and in the long run it might
    produce even lower mortgage rates.
        Mr. Neiman. Have you seen any other jurisdictions,
    countries, or financial institutions that have adopted it?
        Dr. Shiller. This has not been adopted in any country as
    far as I know, but we are coming into a new century and things
    have to change and I think it's entirely plausible that as our
    financial markets develop, we will build in more protections
    for people and this is the trend we've seen in the past and I
    expect it to continue in the future.
        Mr. Neiman. Thank you.
        Professor Warren. Thank you. Thank you, Mr. Neiman. We're
    going to do a second round of questions, if you'll bear with
    us, and I wanted to start, if we could, with Dr. Stiglitz.
        I was captured by your remark and I know there's a
    reference to it as well in your testimony, that TARP has failed
    and it has failed in part because of the failure to put any
    conditions on how the money has been distributed. And you talk
    about the counter factual. If we had taken $700 billion and
    simply infused it in a new institution, how the world would
    look a little different right now.
        You make the point about imposing conditions on extending
    TARP funds. Can you just elaborate on that, Dr. Stiglitz? What
    would be your top three recommendations?
        Dr. Stiglitz. Yes. I listed in my testimony a number of
    recommendations. Obviously, there's broad consensus that the
    notion of our pouring money into these banks and having the
    money pour out in the form of dividends or bonuses, or in the
    form of acquisition of other healthy banks does not lead to
    more lending. That would be an obvious condition.
        A second set of conditions is that there are a large number
    of practices that everybody has identified as having
    contributed to the problem: Bad incentive structures, bad
    lending practices, exploitive anticompetitive practices in
    credit markets, and predatory lending.
        We are now in effect partial owner of the banking system of
    these large banks and yet we're like a ``slum lord.'' We're
    condoning these actions by providing money and allowing the
    banks to continue some of these very bad consumer and investor
    practices.
        A third thing I would do picks up on what the Commissioner
    said. We have some banks that are in better shape than others.
    These are the banks that actually were spending more of their
    time actually lending to small- and medium-size enterprises.
    These include community banks and many of the banks that are
    regulated by the states.
        They should have been the ones getting a disproportionate
    share of the money, not the banks with gambling propensities
    that have proven their incompetency or those that prided
    themselves on having moved out of the ``storage'' business and
    lending business into the moving business.
        We've been subsidizing this moving business. We should have
    been focusing on lending and asking what parts of the financial
    sector will get the flow of credit restored. Finally, we need
    to do something about the foreclosures.
        Professor Warren. Good. Thank you. That's very valuable.
    Thank you.
        I want to ask, and I'll spread this across people, if you
    have different thoughts, to talk about the massive failure in
    the credit rating agencies that gave us the AAA ratings to
    instruments with enormously high risk, these private credit
    rating agencies that the government simply embraced and gave
    legal consequences to that.
        Can you speak to structurally how we might alter that, how
    we might think about a different way to do this? Did I see you
    shake your head no, President Seligman?
        Mr. Seligman. No, I didn't mean to shake my head no, but
    what I--you have a Hobson's choice at the moment. You either
    are going to have credit ratings paid for by users or
    providers. We have a system where credit ratings at the moment
    are paid for by providers. It creates a conflict of interest.
    It does create a situation where the oversight until very
    recently has not been as systematic as it should be.
        You now have the SEC engaged in a catch-up effort with a
    significant report recently and some proposals which will be
    considered in the next Administration.
        The choices that are also on the table that you may want to
    think about, one has been the notion of the SEC placing less
    reliance on credit ratings and before we go there, we have to
    think through very carefully what happens then. That will mean
    more reliance in effect on those who provide information to the
    marketplace and not having any outside evaluation.
        Second, the notion of the government being engaged in
    credit rating strikes me as not a thoughtful or appropriate one
    for the same reasons that we rejected merit regulation in the
    1930s in the securities industry.
        Professor Warren. Dr. Stiglitz, could you add on this?
        Dr. Stiglitz. Yes, I think that it is a very difficult
    problem. The current system is flawed in the incentives that
    underlie the way the credit rating agencies work. They were
    also very much taken up with the same flawed models that the
    banks were using, and so it was partly their incentives and
    partly their analytic frameworks.
        In other areas, like medicine, we rely on governments to
    rate products and see whether they are safe enough to be used
    and to identify the circumstances in which they can be used.
        It seems to me that that analogy is appropriate for
    financial products as well.
        Professor Warren. Thank you very much. We're on time here.
    Congressman Hensarling.
        Representative Hensarling. Thank you, Madam Chair.
    Professor Shiller, I actually--your book on the Subprime
    Solution is one of six presently sitting on my desk. I haven't
    read it yet. I look forward to reading it. At least you made a
    few bucks off of me.
        I think I heard in your testimony, I think you said that
    you advocate federal subsidies of financial literacy, and I
    certainly share your enthusiasm for the broader subject of
    promoting financial literacy within our country. I'd probably
    prefer the incentive structure as opposed to the subsidy
    structure.
        But I ask the question. As there are various policy
    proposals pending within Congress that some would argue would
    essentially bail out a huge universe of borrowers who may not
    have known about the mortgage products that they signed up for,
    maybe they should have known, but what incentive do they have
    to become financially literate if we essentially absolve them
    of personal responsibility?
        Dr. Shiller. Well, I think we are going through a national
    tragedy right now of foreclosures and in many cases these
    people didn't know what they were getting into and so I think
    that part of our civil society is that we have to bail out many
    of these people. But I think that it's really important at this
    time to think about the longer term and to think about how we
    can change the system.
        Right now, we have a system in which most people get no
    financial advice from a disinterested party. They get advice
    from sales people of one sort or another who have an incentive
    to sell them their product.
        What I would like to see is a system in which people are
    getting advice from someone who signs a statement of loyalty to
    the client and announces that he or she will not take
    commissions or kickbacks of any form and that this would be a
    long-term relationship a person could develop, like with a
    physician but with a financial advisor, who you could go to and
    say should I really take this mortgage, is this really good for
    me?
        That's something that is a costly thing. I think the
    government should subsidize it and that it would ultimately
    improve the whole atmosphere of----
        Representative Hensarling. Well, and again, I share your
    enthusiasm for financial literacy, and I certainly can't do it
    justice, but I know Thomas Jefferson at one time said something
    along the lines of if you disagree with how your neighbor is
    acting within the marketplace, we shouldn't try to restrict his
    freedom, we should inform his discretion.
        So I certainly agree with that, but it seems to me when it
    comes to financial literacy, there would be no greater course
    than actually having foreclosure proceedings initiated against
    you and yet we know that even those who are having their
    mortgages reworked under various programs, the repeat rate of
    default, I believe and I don't have the statistic at my
    fingertip, is somewhere in the neighborhood of 40 percent. So
    that's still somewhat question. I'm not sure there could have
    been a more effective course in financial literacy than that.
        If I could, let me change subjects here. Mr. Wallison, in
    your testimony, I don't think we've touched upon this subject
    previously, and that is the subject of mark to market.
        Certainly again as a philosophical and principle position,
    I believe that more transparency is better than less
    transparency. I think the opaque quality of a number of these
    very complicated investment vehicles have exacerbated our
    problem, but how do you mark something to market when there
    isn't a market, and isn't the accounting rule itself that's the
    problem or is it really the intersection of mark to market with
    certain of our regulatory capital standards?
        Mr. Wallison. Well, Congressman, it's both in a way. The
    reason I mentioned mark to market in my prepared remarks is
    that the problem we have today is that fair value accounting is
    a problem when there is no market, but it's also a problem when
    there is a market. It's highly pro-cyclical. When asset values
    are going up, it is possible to write up your assets and look
    much more profitable, borrow that much more money and increase
    the bubble that is developing.
        On the way down, when everyone is panicked and running for
    the doors and doesn't want to buy anything, then fair value
    accounting works in the opposite direction and----
        Representative Hensarling. In the five seconds I have left,
    what would be your proposal?
        Mr. Wallison. Well, I think we ought to modify fair value
    accounting so that it tends to be counter-cyclical; that is,
    when assets are going up, it should not allow increases in
    asset values on balance sheets, and when asset values are
    falling, when there's a panic going on, we should limit the
    degree to which they can be written down, or have to be written
    down; or allow institutions to treat these assets as held to
    maturity which is a much safer way to value these assets.
        Representative Hensarling. Thank you.
        Professor Warren. Thank you. Mr. Silvers.
        Mr. Seligman. Could I just add one----
        Professor Warren. Yes, President Seligman.
        Mr. Seligman. You might want to take a look at a very
    recently-released SEC Office of Chief Accountant Report on Fair
    Value Accounting which does focus on impairment issues. It's
    actually somewhat similar to some of the points that Peter
    Wallison just made.
        Professor Warren. Thank you, President Seligman. Mr.
    Silvers.
        Mr. Silvers. Thank you, Madam Chair. There have been
    several comments made in the written testimony and I believe
    this morning by panelists about the issue of incentives and
    particularly in relationship to executives of institutions that
    are ``systemically significant,'' where there may be a public
    guarantee of some sort sitting around.
        I'd be curious to know. I am familiar with the
    recommendations from the Aspen Institute on both time horizons
    and symmetry, avoiding asymmetry in compensation. I would hope
    the panel might comment for a moment, starting with Professor
    Seligman, on both are these good ideas and how would one
    implement them in a regulatory and tax structure.
        Mr. Seligman. I'm not clear precisely what the specific
    recommendations you're referring to. If you want to focus on
    executive compensation which----
        Mr. Silvers. I'm interested in executive compensation as an
    issue of incentives around time horizons and around asymmetry,
    meaning the incentives to take large risks if you're not fully
    exposed to the down side.
        Mr. Seligman. We have seen throughout the 1990s and into
    the 21st Century clear problems with respect to executive
    compensation, ranging from the initial treatment of stock
    options some 15-16 years ago. The back-dating of options has
    been a scandal and it's being referred to in a number of
    enforcement cases, but it got way out of hand. Disclosure and
    the ability of shareholders to understand what compensation
    levels are is a perennial challenge and there have been
    proposals, including by the President-elect, that there should
    be at least advisory votes on the part of shareholders to
    address this area.
        It's one that requires attention. It's one that I think
    should be clearly on the priority list for the SEC as it comes
    into its new Administration.
        Dr. Stiglitz. I think it's very clear from any analytic
    perspective that the incentive structures that are commonplace
    do encourage short-sighted and excessive risk-taking behaviors.
        I think it would be easy, for instance, to base pay not on
    performance in one year but on performance over a longer time.
    Making a longer-term horizon would be a relatively easy change.
        Let me just emphasize one more point, which is that when
    pay is related to stock performance, it has a further effect of
    encouraging bad accounting standards. That was what we saw in
    Enron. It was not fixed in Sarbanes-Oxley, and so the problems
    go deeper in that these incentive systems actually encourage
    distorted information, which really undermines the
    transparency, efficiency, and confidence in our economy.
        Mr. Silvers. Secondly, the panel--much of the testimony
    we've heard this morning has talked about regulatory gaps.
        I would like panelists to react to the proposition that we
    ought to regulate activity based on what it is economically and
    that we ought to have transparency requirements, accountability
    requirements, and capital requirements in relation to that
    activity based on what it is. If it's insurance and we call it
    a credit default swap, perhaps we ought to regulate it like
    insurance.
        Comments?
        Mr. Seligman. You know, I thought the point of the GAO
    report makes sense. Start with what are your objectives and if
    part of it is systemic risk avoidance and reduction, then the
    gaps are seen in a particular perspective. You simply can't
    afford to have large hidden aspects of our economy, whether
    it's credit default swaps or other aspects of OTC derivatives,
    hedge funds, or what have you, and that strikes me as one way
    in which you get at this.
        A second issue, though, is almost the behavioral arbitrage
    issue; that is, in effect if you're a hedge fund manager,
    you're unregulated, but if you're an investment advisor, you're
    regulated by the SEC, you create an incentive structure to move
    towards the unregulated segment of the economy and you,
    frankly, frustrate the ability for examination and
    understanding what's going on.
        I suspect, though I do not know for sure, that when the
    ultimate books are written on Bernie Madoff, you will discover
    that most of the activity took place not in his registered
    broker-dealer operations but in ``exempt investment advisor or
    hedge fund operations,'' and in effect this was an example of
    behavioral arbitrage where you had someone move to unregulated
    areas and we saw in retrospect a very large price was paid.
        Professor Warren. Thank you. Senator Sununu.
        Senator Sununu. Thank you.
        Professor Warren. Thank you, President Seligman. I know
    that you have a plane to catch. We appreciate your being here
    and you are excused. Thank you.
        Senator Sununu. Mr. Wallison, you talked about devising
    regulation that was counter-cyclical and you mentioned the
    requirements or rules regarding accounting for assets as an
    example.
        Could you give a few other examples of recommendations that
    you would make that you think could be implemented
    realistically in the next few months that would also reinforce
    this counter-cyclical approach to regulation?
        Mr. Wallison. I think the central problem of pro-
    cyclicality is a problem of human nature. We are always
    euphoric when things are getting better, when asset prices are
    going up. We then become very negative when things reverse and
    asset prices are going down. Regulators are going to be subject
    to the same problem; that is, when things are looking good,
    they are not going to stop the party, even though they are
    supposed to take the punch bowl away. They will not stop the
    party. Congress doesn't want them to stop the party.
        We should have a law that requires the regulated
    institutions to add capital at a time when asset prices are
    going up, when things look very good.
        It's kind of a counter-cyclical capital requirement--not
    the kind of capital requirement we have in prompt corrective
    action, that the FDIC enforces for banks, where they require
    increasing institutional restrictions as capital declines. This
    would be increasing capital requirements as the institutions
    become more profitable, because we know that at some point in
    the future, things will reverse, the bubble will burst, and we
    are going to be faced with institutions not having enough
    capital.
        Senator Sununu. Would you interpret the risk-weighted
    capital approach of Basel II as being pro-cyclical in this
    regard?
        Mr. Wallison. You know, there are so many things wrong with
    Basel II,----
        Senator Sununu. Okay.
        Mr. Wallison [continuing]. I don't even want to----
        Senator Sununu. I only have two and a half minutes here.
        Mr. Wallison. Yeah.
        Senator Sununu. That's fine. We can talk about that later
    and develop some comments for the record.
        Mr. Wallison. Okay.
        Senator Sununu. Mr. Sumerlin, you talked about capital
    standards and having them binding, having them clearer, less
    subject to subjective interpretation.
        Can you expand on that a little bit, talk about what kind
    of a system for setting capital ratios would make sense, what
    kind of changes we need to make, and whether those capital
    ratios should be based on institutional activity or size or
    other parameters?
        Mr. Sumerlin. I mean part of how I look at this is I look
    at what regulations do I think worked and I think the leverage
    ratio of the FDIC was helpful.
        It would work in a similar way to what Mr. Wallison
    described where, if during good times you wanted to buy a lot
    more assets, you'd have to put in more capital and, you know,
    my preference for regulation is I like it to be blunt, simple,
    enforceable, and to be sort of a backstop and so that you don't
    discourage sort of the types of new innovation that Mr.
    Shiller's talking about, but there is something there that
    catches you and says no, you don't get to lever up 50:1 and
    that's why I like this very simple leverage ratio just because
    I think it did prevent what might have been broader problems
    during a bubble.
        If I could just make one more point on the mark to market
    idea? You know, my own view is there is a price for everything
    and that price sometimes might be zero and you might not like
    it, but there is a price.
        Now, with mark to market, I think one of the problems with
    it is it's a point estimate and so I would favor some sort of
    lengthening of time where you're averaging prices over a longer
    period and that would smooth out in both the upside and the
    downside, and if you look at even quarterly accounting right
    now what happens when a bank has to report its quarterly
    earnings, it will expand its activities in between the quarter
    and then they've got to get the balance sheet down, get the
    balance sheet down, get the balance sheet down for the report
    and so we do need to get away from sort of the snapshot in time
    type of----
        Senator Sununu. Let me ask you one question about a
    statistic I think you used in your testimony, but it came as a
    shock to me, even having looked at a lot of this material. It
    was that in 2005 43 percent of the people in America who
    purchased a home with a mortgage put no money down.
        Mr. Sumerlin. Forty-three percent of first-time homebuyers.
        Senator Sununu. In 2005, 43 percent of all first-time
    homebuyers.
        Mr. Sumerlin. Of all first-time homebuyers.
        Senator Sununu. Put no money down.
        Mr. Sumerlin. Yes.
        Senator Sununu. To the best of your knowledge, did any
    state or federal regulators anywhere prohibit that or try to
    create a regulation that might have discouraged that kind of
    behavior which I think most people would fairly describe as
    somewhat speculative?
        Mr. Sumerlin. I'm not aware of it. There's nothing that
    worked. I'll put it that way.
        Senator Sununu. Ms. Raskin, do you know of anything that
    might have----
        Professor Warren. Senator Sununu, you're over time now.
        Senator Sununu. I wanted to give her a chance to respond.
    She might have better information----
        Professor Warren. Sure.
        Senator Sununu [continuing]. Than Mr. Sumerlin.
        Ms. Raskin. Clearly that practice has all but evaporated,
    truth be told. The good thing, I think, is that a lot of states
    have now passed laws that prohibit what are called stated
    income loans, loans in which there is no documentation at all
    provided and there's no basis upon which the borrower has shown
    an ability to repay.
        Senator Sununu. Thank you.
        Professor Warren. Thank you. Mr. Neiman.
        Mr. Neiman. Thank you. Dr. Stiglitz, in your testimony you
    talk about the idea of ring fencing, to put greater standards
    in place for systemically-significant institutions and
    commercial banks that serve consumers and pension funds, and
    separating those out from business activities that serve high
    net worth and capital markets activities.
        Can we draw such a bright line? Is that function--is it
    practical, and I'd like you to just kind of elaborate on how
    that would actually be implemented or deployed?
        Dr. Stiglitz. It can't be perfectly implemented, but I
    think it's absolutely necessary that we do something along
    those lines because we can't be fully comprehensive in our
    regulation. Our financial markets are too complex.
        On the other hand, we know that we have to have far better
    regulation of our commercial banks, which are systemically
    important. If we don't, the system will have another crisis,
    such as the one we currently have.
        We have to move towards some degree of ring fencing. In a
    way we do that already; that is to say, we don't want our banks
    to invest too much in a gambling institution or something like
    that.
        The question is can we go further, and I think the answer
    is clearly yes. If we have an unregulated, highly-leveraged
    institution, like a hedge fund, operating out of a secret bank
    account, we should say to the banks that they should not be
    lending to those kinds of institutions, which are supportive of
    corruption and tax evasion.
        This is a matter of degree, but I think we can work much
    more towards ring fencing these core financial institutions.
        Mr. Neiman. Thank you. Mr. Wallison you've written a lot
    about the role that CRA and the GSEs have played in
    contributing to the crisis, and as you probably would not be
    surprised, I come at it that the CRA was not a contributor and
    the data that I have seen in terms of origination showed the
    majority of those originations came from non-bank entities who
    were not subject to CRA.
        Have you seen or are relying on data that would support
    your basis of the role that CRA played in contributing?
        Mr. Wallison. The role that CRA played in contributing to
    our current problem was simply a role in reducing the quality
    of the mortgages. That's why we got to the point where Marc
    Sumerlin was mentioning that 43 percent of the people who
    bought homes initially in 2005 had no downpayment. The purpose
    of CRA was to force banks to make loans to people who could not
    otherwise get mortgages.
        I believe that we should have a homeownership policy, as we
    do in this country, and it might require subsidies. But in the
    case of CRA it just required banks to make loans they wouldn't
    have otherwise made, and that forced them to reduce the quality
    of the mortgages. It's the only way they could do it. And so,
    what began with CRA continued through the rest of the economy.
    It was picked up by all kinds of other people who were making
    loans, unregulated lenders as they are called, and Fannie and
    Freddie bought many of those loans, over a trillion dollars of
    those loans. $1.6 trillion of these bad loans are on Fannie and
    Freddie's balance sheet.
        It is not CRA----
        Mr. Neiman. How much?
        Mr. Wallison. $1.6 trillion of subprime and Alt-A mortgages
    are on Fannie Mae and Freddie Mac's balance sheets.
        Mr. Neiman. Subprime and Alt-A?
        Mr. Wallison. Subprime and Alt-A. That's right.
        Professor Warren. These are not originations, though.
        This is including the amount that they were required to buy
    later on, is that right?
        Mr. Wallison. They were required to by their affordable
    housing regulations to buy these mortgages.
        Professor Warren. Not by the regulations. They've been
    required by Congress to purchase.
        Mr. Wallison. Well, through the affordable housing
    regulations, Congress----
        Professor Warren. No.
        Mr. Wallison [continuing]. Did not insist on----
        Professor Warren. No, not through originations. That's the
    question I'm asking about trying to sort this out. I'm sorry,
    Mr. Neiman.
        Mr. Wallison. My whole point is simply that CRA did not add
    materially to the number of such mortgages. They were very
    small, about three percent. What CRA did was start the process
    of making mortgages of lower quality and that's the central
    problem we have today.
        It is true that we've had a big inflationary bubble
    because, perhaps, of the low interest rates that the Federal
    Reserve approved for a long period of time. But what's
    different about this bubble is that the mortgages that are
    causing problems are very poor quality mortgages. Otherwise, we
    wouldn't have this financial crisis.
        Mr. Neiman. Just to follow up on one point, the way we've
    seen it operating throughout neighborhoods throughout the
    country, is so much of that was originated by non-bank
    entities, not subject to CRA. I'm not making any apologies for
    the large commercial banks, investment banks, who
    participated--who funded that through the securitization
    process, but it was not CRA that was driving that. It was the
    securitization process and the misaligned incentives and over-
    reliance on credit.
        Mr. Wallison. And Fannie and Freddie bought them.
        Professor Warren. I want to thank you all for being here. I
    have special thanks that I need to acknowledge publicly to the
    Senate Committee on Commerce, Science and Transportation for
    lending us this lovely room for our hearing, but I especially
    want to thank all of our witnesses for coming.
        Mrs. Raskin, Dr. Shiller, Dr. Stiglitz, Mr. Sumerlin, and
    Mr. Wallison, we appreciate your taking the time to prepare
    your testimony, to come here, and I hope you will be willing to
    answer questions that the panel submits in writing and have
    those questions be on the record.
        We appreciate your help very much and with that, this
    hearing is adjourned.
        [Whereupon, at 11:40 a.m., the hearing was adjourned.]