[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
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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
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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.]