[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

                              ----------                              


                      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.]

                                  
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