[Senate Hearing 111-110]
[From the U.S. Government Publishing Office]

                                                        S. Hrg. 111-110



                               before the

                        JOINT ECONOMIC COMMITTEE
                     CONGRESS OF THE UNITED STATES


                             FIRST SESSION


                           FEBRUARY 26, 2009


          Printed for the use of the Joint Economic Committee

51-107                    WASHINGTON : 2009
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                        JOINT ECONOMIC COMMITTEE

    [Created pursuant to Sec. 5(a) of Public Law 304, 79th Congress]

Carolyn B. Maloney, New York, Chair  Charles E. Schumer, New York, Vice 
Maurice D. Hinchey, New York             Chairman
Baron P. Hill, Indiana               Edward M. Kennedy, Massachusetts
Loretta Sanchez, California          Jeff Bingaman, New Mexico
Elijah E. Cummings, Maryland         Amy Klobuchar, Minnesota
Vic Snyder Arkansas                  Robert P. Casey, Jr., Pennsylvania
Kevin Brady, Texas                   Jim Webb, Virginia
Ron Paul, Texas                      Sam Brownback, Kansas, Ranking 
Michael C. Burgess, M.D. Texas           Minority
John Campbell, California            Jim DeMint, South Carolina
                                     James E. Risch Idaho
                                     Robert F. Bennett, Utah

                     Nan Gibson, Executive Director
               Jeff Schlagenhauf, Minority Staff Director
          Christopher Frenze, House Republican Staff Director

                            C O N T E N T S



Hon. Carolyn B. Maloney, Chair, a U.S. Representative from New 
  York...........................................................     1
Hon. Sam Brownback, Ranking Minority, a U.S. Senator from Kansas.     2
Hon. Amy Klobuchar, a U.S. Senator from Minnesota................     4
Hon. Kevin Brady, a U.S. Representative from Texas...............     4
Hon. Michael Burgess, a U.S. Representative from Texas...........     5
Hon. Elijah Cummings, a U.S. Representative from Maryland........     5
Hon. Ron Paul, a U.S. Representative from Texas..................     6


Hon. Paul A. Volcker, Chairman, President's Economic Advisory 
  Board and Former Chairman of the Federal Reserve, Board of 
  Governors, New York, New York..................................     7
Hon. Roger C. Altman, Chairman and CEO, Evercore Partners, Inc., 
  New York, New York.............................................    35
Dr. Adam S. Posen, Deputy Director, Peterson Institute for 
  International Economics, Washington, DC........................    38
Dr. Joseph Mason, Louisiana Bankers Association Endowed Professor 
  of Finance, Louisiana State University and Senior Fellow, The 
  Wharton School, Berwyn, PA.....................................    40

                       Submissions for the Record

Prepared statement of Representative Carolyn B. Maloney..........    54
Prepared statement of Senator Sam Brownback......................    54
Prepared statement of Representative Kevin Brady.................    56
Prepared statement of Paul A. Volcker............................    57
Prepared statement of Roger C. Altman............................    59
Prepared statement of Adam S. Posen..............................    62
Prepared statement of Joseph Mason...............................    71



                      THURSDAY, FEBRUARY 26, 2009

             Congress of the United States,
                          Joint Economic Committee,
                                                    Washington, DC.
    The committee met at 10:00 a.m. in Room 106 of the Dirksen 
Senate Office Building, The Honorable Carolyn B. Maloney 
(Chair) presiding.
    Representatives present: Hinchey, Cummings, Snyder, Brady, 
Paul, and Burgess.
    Senators present: Schumer, Klobuchar, Webb, Brownback, 
Risch, and Bennett.
    Staff present: Nan Gibson, Gail Cohen, Marc Jarsulic, 
Colleen Healy, Justin Ungson, Andrew Wilson, Jeff Schlagenhauf, 
Jeff Wrase, Rachel Greszler, Chris Frenze, Bob Keleher, and 
Robert O'Quinn.


    Chair Maloney. The Committee will come to order. I want to 
welcome my colleagues, and I particularly want to welcome 
former Chairman Volcker and all of our other outstanding 
witnesses, and thank you all for your testimony today.
    Chairman Volcker, when it comes to understanding the 
economy and financial markets, you are in a league with only 
one player. We are tremendously honored that you are the first 
to testify before the Joint Economic Committee this Session.
    Over the past two days, we have heard rather sobering 
testimony from Fed Chairman Bernanke, that even under the best 
of circumstances, our economy remains perhaps a year away from 
making a full recovery.
    The problems plaguing the real economy and the financial 
system, are intertwined, so it is critical that we act as 
swiftly as possible. At the core of the ongoing liquidity 
crisis, is the decline in home prices. Home prices continued 
their free-fall at the fastest pace on record, in December.
    Since the beginning of this crisis, Congress has been 
working on keeping families in their homes. Today, the House 
will consider and pass the Helping Families Save Their Homes 
Act, which will help families stay in their homes, and will 
help stabilize communities by spurring loan modifications and 
avoiding bankruptcy.
    Strong indications are that this downturn could be the 
worst in the post-World War II period, and, Mr. Chairman, you 
have indicated such yourself.
    The current recession, which began in December of 2007, has 
caused massive job loss and decline in economic growth. 
Congress recently passed the nearly $800 billion American 
Recovery and Reinvestment Act, which provides fiscal stimulus 
in the form of aid to state governments, infrastructure 
spending, increased breaks to middle-class workers and 
    This package is designed to stem the real human costs and 
our economic losses, by creating millions of jobs, helping 
families in need, and investing in the future.
    The concern, though, is that the effects of our recovery 
package may be blunted, if the financial crisis lasts too long. 
The Federal Reserve has taken extraordinary steps to maintain 
the operation of our financial and credit markets, but, 
clearly, we need a comprehensive plan to return to well-
functioning markets.
    In his address to Congress on Tuesday night, the President 
pledged to work with Congress to adopt new rules of the road, a 
reformed financial regulatory structure to prevent future 
crises and hold financial executives accountable.
    Our entire regulatory system is in serious need of 
renovation. It failed to properly identify the risks in the 
mortgage-related assets; it did not recognize that these risks 
were being concentrated in highly-leveraged and important 
financial institutions; and it failed to anticipate the dangers 
posed to the financial system as a whole.
    It also failed to provide mechanisms for dealing with the 
failure of important, non-depository financial firms. These 
shortcomings must be addressed, regulators must obtain better 
information, better measurement of system vulnerabilities, and 
the authority necessary to head off threats to financial 
    It is obviously too costly to leave the regulatory system 
as it is.
    As the winter turns to spring, my hope is that these 
efforts will break the downward spiral of our economy and bring 
about a thaw in credit markets, but, even more may be needed to 
be done, and that's what we will be finding out about today.
    I look forward to our witnesses' views on reviving our 
economy and restoring our financial markets. Again, thank you 
very much, Chairman Volcker, for coming, and the Chair 
recognizes Ranking Member Brownback for five minutes.
    [The prepared statement of Representative Maloney appears 
in the Submissions for the Record on page 54.]


    Senator Brownback. Thank you very much, Chairwoman Maloney. 
I appreciate that. Chairman Volcker, it's good to have you 
here. I look forward to your comments and your thoughts.
    I picked up the Wall Street Journal this morning, and, boy, 
I don't like what I see headlining things: ``$318 Billion Tax 
Hit Proposed,'' and an article right underneath it, ``Pair Live 
Large on Fraud,'' saying they misappropriated $553 million; 
lavish homes, horses, and even an $80,000 collectible teddy 
    I don't know where you find a teddy bear of who pays 
something like that, but my point in raising that, is that 
while we're trying to put gas into the tank of the economy, to 
put a $318 billion tax hit, doesn't seem to be the mixture of 
medicines we're talking about.
    That seems to be hitting both the accelerator and the brake 
at the same time. And then the fraud that's in the system, 
really drives people nuts, crazy.
    I want to read to you, a letter that a medical doctor at 
the University of Kansas facility just had published in the 
Economist Magazine. I think he summarizes what most folks 
calling into my office say. This is Dr. Frederick Holmes, 
Kansas City, Kansas, who said this, quote:
    ``Responsible people and responsible institutions have not 
hurled themselves lemming-like, into the abyss of ruin. Despite 
the death knell sounded throughout the media, most people and 
most banks did not encumber themselves with mountains of 
unsecured debt.
    In the conservative heartland of America, we've avoided the 
razzle-dazzle of sophistication and computerized modeling when 
managing our finances. I have entrusted a locally-owned bank in 
Kansas City with my money for more than 40 years, and it has 
been a good steward of my modest wealth.
    Last year, the Chief Executive posted a brief notice on the 
bank's website, to reassure depositors. It read, 'When the 
siren song of the subprime mortgage market came along, we took 
the long view and turned a deaf ear.'
    I'm going to leave my money with the folks at this bank for 
the next 40 years, for they seem to have the intelligence and 
common sense largely absent in the leadership of large banks.''
    Now, that summarizes a lot of what I get, calls in my 
office, and then they see articles like this in the Wall Street 
Journal and other newspapers, and they think that this has not 
been handled right, it's big money center banks that are doing 
this to us; it hasn't been appropriately reviewed, regulatory-
wise, and now they're going to take more money out in taxes.
    This doesn't seem to be the prescription for us to come out 
of a deep recession. It's been and is a very difficult 
recession, there's just no question about it. People are 
hurting. We're getting people laid off in a number of 
industries and places across my state. It has not been good.
    But it doesn't seem like the idea of raising taxes, is a 
good idea at this point in time. It doesn't seem like that this 
has been properly regulated in the big money center banks, in 
particular, and it seems like Wall Street has driven this onto 
Main Street, more than anything else that's been seen.
    What I hope to hear from you, is, are these accurate, and 
how is it that we get at the big center bank issues that don't 
make people across the country pay for it, that didn't do some 
of these sophisticated investment techniques that have driven 
us down so hard and far, and don't require them to pay the 
bill, the people that are on Main Street paying the taxes.
    Now, I appreciated, over the years, your thoughts and your 
writings and your comments, and I hope they are full of wisdom, 
as well, today, as they have been in the past. Thank you, 
    [The prepared statement of Senator Sam Brownback appears in 
the Submissions for the Record on page 54.]
    Chair Maloney. Senator Klobuchar, for one minute.

                     SENATOR FROM MINNESOTA

    Senator Klobuchar. Thank you very much, Madam Chairwoman. 
Thank you, Chairman Volcker, for being here.
    I just want to follow up on something that the Senator 
said, which is that there are banks that are solid, including 
some large banks, including many of the banks in Minnesota. I 
wrote the other day that some of these credit unions and the 
smaller banks in my state, are sort of clutching their sensible 
briefcases, trying to keep their feet planted in the heartland, 
with all the debris swirling around them, saying, Toto, we're 
not in Kansas anymore. I thought you'd appreciate that, Senator 
Brownback. [Laughter.]
    Senator Klobuchar. But the truth is, how do we restore the 
confidence in the market, when we know that some of these major 
banks, many out of Wall Street, are in such trouble, when 
others aren't? So much of this, to me, seems that we need to 
restore the trust in the market, the confidence in the market, 
because we know that the current situation doesn't just hurt 
banks; it hurts people who can't get a mortgage or people who 
can't get an auto loan or kids that can't get a student loan.
    So, that's what I'm looking forward to hearing about today, 
as well as the changes to the financial regulation of the 
market that we need to make.
    Thank you very much.
    Chair Maloney. Thank you. I recognize Congressman Brady 
from the House, for five minutes.


    Representative Brady. Thank you, Madam Chairman. I'd like 
to welcome Chairman Volcker, as well. I think it's widely 
agreed that nothing else we do will matter much, until the 
issue of how to dispose of toxic bank assets is resolved.
    Neither the Bush nor the Obama Administrations has devised 
a solution to this admittedly difficult problem. The recent 
Treasury proposal has not been well received, because it did 
not clearly address this issue.
    The Economist Magazine, for example, said it looked 
``depressingly like TARP I--timid, incomplete, and short on 
detail.'' The lack of specifics has undermined confidence and 
contributed to financial market instability. A better approach 
is needed to help foster recovery.
    Madam Chairman, in the interest of time, I'd like to insert 
my complete statement. I do believe, as Senator Brownback does, 
that the dramatic increase in the deficit, our record-setting 
and dangerous debt, along with the inability to really address 
the core of this crisis, is really moving us into terribly 
risky areas, and I'm eager to hear Chairman Volcker's guidance 
on how we move forward.
    [The prepared statement of Representative Kevin Brady 
appears in the Submissions for the Record on page 56.]
    Chair Maloney. Thank you very much. Congressman Snyder for 
one minute, and welcome to the Committee.
    Mr. Snyder. Thank you, Madam Chair. I hear myself talk all 
the time, I look forward to hearing Chairman Volcker.
    Chair Maloney. Congressman Burgess, for one minute.


    Representative Burgess. Thank you, Madam Chairwoman. I hear 
myself talk all the time, too, and I can't get enough of it. 
    Representative Burgess. Chairman Volcker, I appreciate you 
being here with us this morning. I appreciate you sharing your 
testimony with us beforehand.
    I was struck by the paragraph toward the end of the second 
page, where you talked about repeating the story of how we got 
to where we are today. I need to say that the fundamental 
lesson of the crisis is that future policies should be alert to 
and take appropriate measures to deal with persistent economic 
    Mr. Chairman, I just hope you'll address, when you give us 
your testimony, does the--and I won't go through the entire 
litany, because Chairman Brady just did,--but the $700 billion 
on TARP, the $787 billion of the stimulus, the $650 billion 
healthcare down payment we're going to be required to approve, 
the $75 billion you paid for housing, the $75 billion that's 
coming for Iraq, does this represent, in and of itself, a 
persistent destabilizing effect on the economy?
    Is this, in fact, a deficit bubble that we're going to have 
to witness the carnage that occurs when that, in fact, bursts? 
The most fundamental thing that people back in my District want 
to know, is, you can have so much regulation, but if nobody 
enforces the regulation, what good is it?
    There's malfeasance out there. How are we going to 
demonstrate to the American people, that once and for all, 
someone is going to be held accountable for what has been the 
greatest train robbery in American history? I yield back.
    Chair Maloney. Mr. Cummings, for one minute.


    Representative Cummings. Thank you very much, Madam 
Chairlady, and, welcome, Chairman Volcker. I'm anxiously 
looking forward to hearing your testimony.
    I represent a District like my colleagues, where so many 
people are losing their homes, they've lost their savings, 
they're losing their houses, can't get loans, businesses going 
out of business, and I know that--I'm sure that you won't say 
that you know all the answers, but your opinion is well 
    We need to try to figure out a way to use the money that we 
are spending, effectively and efficiently. I think the American 
people will be patient, but they will be patient, only if they 
know that we are good stewards of their money.
    I hope that you will shed some light on what you think will 
help us, the kind of policies that will help us become or be 
efficient and effective with their funds. With that, I yield 
    Chair Maloney. Thank you. Mr. Paul, for one minute.


    Representative Paul. Thank you, Madam Chairman. I, too, 
hear my voice all the time, and I'm sure the rest of you are 
tired of hearing it.
    But, nevertheless, I will take a moment. In California, 
they worry about the big one, the big earthquake, and I think, 
financially, the big one is here--the very big one.
    And nobody seems to know what to do about it, and I think 
it's because they don't quite understand how it came about. 
It's been building, the bubble has been building since 1971, 
but it has exploded.
    I visualize it as we in the Congress and the Federal 
Reserve are there with a tiny little pump, pumping into a 
bubble that has a huge hole, and the longer you pump, the 
poorer this country is going to get, and there will be no 
solution. Even a bigger pump is not going to solve the problem.
    In the past year, we have run up a debt of an additional 
$1.5 trillion. We've created about $9 trillion worth of credit 
in the financial system, and it hasn't done any good.
    We have to reassess what we're doing, because I think we're 
on the wrong track.
    Chair Maloney. Thank you very much. Senator Bennett, for 
one minute.
    Senator Bennett. Thank you very much, Madam Chairman. 
Chairman Volcker, you were one of the architects of our 
recovery from the Great Inflation, you are a student of the 
Great Depression, and I look forward to hearing what you have 
to say now, with the great whatever it is we ultimately decide 
to call this mess. Thank you.
    Chair Maloney. Thank you. I would like to welcome Chairman 
Volcker. Paul Volcker is a man who needs no introduction.
    He has an impressive record of achievement and service. 
It's very long, but let me just say he is very important. He is 
currently the Chairman of the President's Economic Advisory 
Board, and the former Chairman of the Federal Reserve Board of 
    In the course of his career, Mr. Volcker worked in the 
Federal Government for almost 30 years, culminating in two 
terms as Chairman of the Board of Governors of the Federal 
Reserve System, from 1979 to 1987.
    He divided the earlier stages of his career between the 
Federal Reserve Bank of New York, the Treasury Department, and 
the Chase Manhattan Bank.
    Educated at Princeton, Harvard, and the London School of 
Economics, Mr. Volcker is a Professor of International Economic 
Policy at Princeton University, and was the first Henry Kaufman 
Visiting Professor at the Stearn School of Business at New York 
    Thank you very, very much for coming, and please proceed 
with your testimony.


    Chairman Volcker. Thank you very much, Madam Chairwoman, 
Members of the Committee. It's a--I hesitate to say ``a 
pleasure'' to be here, given the circumstances, but I welcome 
the chance to testify before you.
    There's no secret that we live in a difficult time of 
enormous complexities, complications and risks, and a depressed 
economy. You've set out a very ambitious title for these 
hearings, ``Strategies for Both Short-Term and Long-Term 
Change,'' and I will try to address that a bit, and then look 
forward to the conversation.
    But I'm sure we all agree that the purpose of all this, is 
to develop approaches that will not again leave markets so 
vulnerable that a breakdown can again threaten the national and 
world economies. That is what has happened now and it's what we 
don't want to happen in the future.
    But in approaching this, I want to step back from the 
immediate financial crisis, to emphasize that this is not just 
a financial crisis; it is an economic crisis, in the sense that 
this country was proceeding for some years--I don't know as I 
want to go back to 1971, Mr. Paul, but we can go back a decade 
or so, when we began spending, as a nation, much more than we 
were producing and much more than we were able to produce.
    The inevitable result of that, was heavy reliance on 
borrowing from abroad. It took place in an atmosphere where 
personal savings in the country disappeared, and that process, 
which was supported by a lot of cheap imports from China and 
elsewhere in Asia, also supported by the willingness of those 
countries to buy U.S. securities, so interest rates were low, 
we didn't have any inflation, we were spending like crazy, 
what's so bad about that?
    You know, everybody likes to consume, and there wasn't any 
strong urge to do something about it. But gradually--or not so 
gradually, it built up more and more debt, inevitably, and that 
debt eventually had weaker and weaker foundations, partly 
because of the great art of financial engineering, and, in 
particular, in the housing market, the debt was built up on 
weaker and weaker mortgages.
    That all came back to haunt us, in effect, when the economy 
turned, house prices were no longer going up; they leveled off 
and came down, and the mess that we're in, was triggered.
    So I just want to emphasize that this is not just a--it is, 
indeed, a crisis of Wall Street; it's a crisis of financial 
markets, but it reflects the fact that we had a tremendous 
buildup of debt, a lack of savings in the country, and too much 
reliance on fragile debt.
    Now, I noted that this buildup in debt was facilitated and 
extended by the modern alchemy of financial engineering. People 
went into financial markets and made a lot of money. They 
developed mathematical techniques that were supposed to diffuse 
and limit risk. It turned out, in practice, in the end, in many 
cases, to magnify and ensure risks, and that was certainly true 
in the subprime mortgage market.
    We lost transparency, risk management failed, and at the 
same time, I think, highly aggressive compensation practices 
encouraged risk-taking, right in the face of misunderstood and 
almost incomprehensible debt instruments.
    That was the dynamic of this process--a combination of 
tremendous incentive to take risk, and complexities and 
obscurities as to what those risks were.
    So, obviously, as we look ahead, we need more discipline, 
financial management, better risk management, and reform of 
compensation practices.
    Now, let me say that as this crisis has evolved, it's 
exposed all sorts of other weaknesses, weaknesses in 
accounting, weaknesses in credit-rating agencies, weaknesses in 
other market practices.
    I won't go into detail, but I think it's fair to say that 
fair-value accounting rules were inconsistently applied. They 
have contributed to a downward spiraling of valuations in our 
liquid markets. Credit-rating agencies clearly failed in 
analyzing some of these complex new instruments.
    We have weaknesses in clearance, settlements, and 
collateral arrangements for obscure derivative contracts that 
grew up very rapidly in recent years.
    These are technical issues that are very difficult to deal 
with through legislation, but we have to pay attention to them 
and they do need to be resolved.
    You've already pointed out the concern, the legitimate 
concern about lapses in financial regulation and supervision. 
They certainly permitted institutional weaknesses to fester, 
the regulators failed to identify exceptional risks, they 
failed to deal adequately with conflicts of interest, and as 
was pointed out in the press again this morning, they did not 
expose large--huge, personal scandals, even after warnings.
    So that's going to require close attention by the 
Administration and the Congress, and I will be surprised if you 
do not conclude that very substantial changes have to be made.
    Taken together, the need for change is both obvious and 
wide-ranging. In approaching the challenge, I do urge that all 
these matters be considered in the context of a considered 
judgment about the appropriate role and functioning of the 
financial system as a whole, in the years ahead.
    At the most general level, I'm certain we would all like to 
see a diverse, competitive, predominantly privately-owned and 
managed institutions and markets able to efficiently and 
flexibly meet the needs of global, national, local businesses, 
governments, and individuals.
    That sentence is a mouthful, but I took it directly from 
the recent report of the Group of 30, setting out a framework 
for financial stability, which you and your staff may have 
seen. We issued it recently. It does point out the extent of 
the challenges ahead, if we're going to end up with a reformed 
financial system, and I recommend it to you.
    It makes a lot of recommendations--18 general 
recommendations, some of them with a corollary. It does not 
cover all the specific things we could talk about. It doesn't 
make recommendations at this stage, about how the 
administrative structure should be reformed, what the Federal 
Reserve should do, what the Comptroller of the Currency should 
do, the SEC, and so forth.
    That's important, but I think the most important thing is 
that we have some judgment about what the system should look 
like, so we know what we're aiming for and what should be 
    I do think the report makes some points that are common 
ground among almost all people that have looked at this. There 
is agreement that all banking organizations have to come within 
the framework of an official safety net.
    The natural corollary is regulation and supervision, and, 
beyond that, it's also recognized that a few of the banks, and 
possibly some other financial organizations, are so large and 
their operations so intertwined in complex relationships with 
other institutions, as to entail systemic risk.
    In other words, the functioning of the financial system, as 
a whole, could be jeopardized in the event of a sudden and 
disorderly failure. Consequently, those institutions should be 
subject to particularly high international standards, directed 
towards maintaining their safety and soundness.
    Now, as I see it, and as the philosophy of the report 
represents, these banking organizations should be predominantly 
relationship-oriented. Their function is to provide essential 
financial services to individuals, businesses of all sizes, and 
    To help assure their stability and continuity, and to limit 
potential conflicts of interest, strong restrictions in risk-
prone capital market activities, hedge funds, equity funds, 
proprietary trading, and the like, would be enforced--strong 
    At the same time, trading- and transaction-oriented 
financial institutions that operate primarily in the capital 
markets, could be less intensively regulated, although I think 
there is a need for stronger registration and reporting 
    In instances where the institutions are so large or 
otherwise so complex as to be systemically relevant, capital 
leveraging and liquidity requirements would be imposed.
    Now, implicit in this approach, is the need for strong 
cooperation and coordination among national authorities and 
regulators. Some approaches--accounting standards, capital 
liquidity requirements, registration and reporting procedures--
should be internationally agreed and consistent in application. 
That's necessary to minimize regulatory arbitrage and any 
tendency by particular countries or financial centers, to seek 
competitive advantage by tolerating laxity in oversight.
    Now, all of this will take time, if the necessary consensus 
is to be achieved and a comprehensive, rather than piecemeal 
approach is taken. I also recognize that a coherent vision of 
the future should help guide the emergency responses to the 
present crisis, and, even more important, the steps, difficult 
steps that will be taken as the truly extraordinary measures 
now in place, are relaxed and ended.
    So I hope that will proceed, and I welcome the opportunity 
to participate in your deliberations.
    [The prepared statement of Paul Volcker appears in the 
Submissions for the Record on page 57.]
    Chair Maloney. Thank you so much, Chairman Volcker, for 
your testimony. Chairman Volcker, before we get to our 
questions, could you just comment on any positive aspects that 
you see in our economy? Do you have any good news for us in 
economic recovery? Government's been working very hard.
    Chairman Volcker. Some silver lining is behind all those 
dark clouds, and, in fact, there are a few. In recent weeks, we 
have seen some relaxation of the tensions in the securities 
markets, broadly defined.
    Interest rates have come down in those areas, a number of 
corporations have successfully been able to finance in the 
long-term markets. The short-term market, where the authorities 
have been very active, have been showing some signs of life, 
resuscitation in the commercial paper markets, so, in those 
areas, a certain amount of confidence seems to be returning.
    In the banking area, obviously, you still have a lot of 
tension, concern, declining stock prices, and so forth, so I'm 
not beginning to say that the crisis is over, but in some areas 
of the market, you can see a relaxation of the tension, which 
is very helpful.
    Now, you do, as I read in the papers--Chairman Bernanke was 
testifying yesterday--you can get this kind of spiraling 
situation where the weakness of the economy itself brings more 
pressure on the banks. The more pressure the banks have, the 
less they can lend or are willing to lend, which weakens the 
economy, so we still have to deal with that threat.
    Chair Maloney. Thank you. Yesterday, Chairman Bernanke 
testified before the Financial Services Committee, and he 
testified that he considers nationalization to occur when the 
government wipes out the shareholders, 100 percent, and takes 
over a bank, and that he did not envision taking such draconian 
measures with respect to any financial institutions in the 
United States.
    Could you comment on what lessons we learned from history 
about the effectiveness of government investment in private 
financial institutions, short of nationalization, such as in 
Japan, as compared with examples of countries that have gone 
100 percent, such as Norway or Sweden, and just your general 
comments on nationalization?
    Chairman Volcker. Well, ``nationalization'' has kind of 
become a dirty word, a very emotional word, anyway, and people 
use the word without defining very carefully, what they mean. 
Chairman Bernanke had one definition yesterday, of 100 percent 
    But let me say, in general, nobody--very few people are in 
favor of government ownership of businesses or financial 
institutions. I certainly am not and I don't want to look 
towards that kind of an organization of the marketplace.
    I don't think that's at issue. The question is, what degree 
of government support is necessary at this particular point in 
    Some of these institutions, some of the banking 
institutions, have clearly got a capital problem. They've got 
some bad loans, their capital has been depleted. The best thing 
that could happen, is they go into the markets and recapitalize 
    Right now, that is not really feasible in many cases. 
Because they have to be recapitalized, I think we ought to look 
to the private markets to do it, to the extent possible, but if 
that's not possible, I'm afraid we have to look to the 
government to fill the gap, temporarily.
    We have to have--I would not call that ``nationalization;'' 
I would call that capital restructuring, which is necessary and 
which the government may, and already has participated.
    You'd like to see that as little as possible, but if it's 
necessary, I think that is an approach that has to be 
understood and not only tolerated, but, in a sense welcomed as 
a way of temporarily maintaining the stability of the system.
    Some of these institutions are already subject to 
substantial governmental control; you see that every day. The 
government is so involved in guaranteeing assets and 
guaranteeing liabilities and controlling what they do in some 
respects, what they sell, what they buy, we're living with more 
government control and influence than we would like to see, and 
we want to get away from that when we can.
    Chair Maloney. One of the problems is the so-called toxic 
assets that the financial institutions have. There are a number 
of approaches that have been put forward, such as public/
private partnerships to address this. Do you have any comments 
on how you feel this challenge should be handled?
    Chairman Volcker. Well, I think, in some cases, some way of 
removing or isolating the bad loans, is desirable and necessary 
to restore confidence and the full-scale effective operation of 
these banking institutions.
    Now, it's very easy for me to make that sweeping statement, 
and then you asked me how to implement that and you have 
questions, which I do think can be dealt with, but it will take 
government support and participation.
    But I think there are various methods that have been 
discussed for removing some of those assets from a bank, at a 
determined price, which is obviously going to be less than 
their initial value, and you get those assets removed and into 
what is sometimes colloquially called ``the bad bank.''
    You develop a technique for financing that bank, dispose of 
the assets over a period of time, and then leave the rest of 
the bank, the bank itself, the so-called ``good bank,'' in a 
position where it may be able to raise capital on its own, 
because its bad assets or some of them, a large proportion of 
them, will be taken out.
    If they can't be, the question of some government 
participation in the capital restructuring, naturally enters. I 
think that's the essence of some of the proposals and programs 
put out yesterday by the Treasury.
    Chair Maloney. My time has expired. Senator Brownback?
    Senator Brownback. Thank you very much Chairwoman. Thank 
you very much, Mr. Volcker, and I appreciate your historical 
knowledge and perspective.
    Yesterday, Chairman Bernanke talked about this negative 
feedback loop, and you mentioned it today. Do you see 
particular weak points in the feedback loop, that we should try 
to target in on, to break it?
    Because that's what I'm seeing now, as well, is that we've 
got one is feeding the other, downward in this spiral. Are 
there places that you can look at to go to break that feedback 
    Chairman Volcker. Yes, there are. Now, how effective and 
how workable they are, obviously, we're seeing in practice, but 
there are really three areas that are important:
    The first was the stimulus bill that tried to keep the 
economy higher than it otherwise would be, and, therefore, slow 
down the adverse feedback loop that you describe.
    The second is, and where we have not been successful so 
far, is going directly to the mortgage problem where this 
crisis really centered at the beginning, and the problem if 
declining house prices and failures of the mortgages and the 
inability of many people to maintain surface on their 
    Here's where you have, obviously, a very real human problem 
coinciding with the market problem of a general threat to the 
financial system.
    Now, you have a new program there proposed by the 
Administration. We'll see how that works. I hope it works with 
some success.
    Then, finally, we get to what we're talking about, which 
is, can you break the loop by defending the stability of the 
institutions that are threatened by the slowdown in the economy 
and the impact on their own assets, and that's what we're 
talking about in recapitalizing the banking system.
    Senator Brownback. You broke the big inflation period, and 
you were one of the key architects of that. By the way, I was 
one of the key persons dealing with the pain from some of that.
    I shouldn't say one--I was one of the very small people 
dealing with much pain. I was a young lawyer----
    Chairman Volcker. Short pain, I hope, for long benefit.
    Senator Brownback. I mean, it was a very real thing, 
because I was representing a number of farmers and small banks, 
and they had borrowed money at high interest rates and the land 
continued to inflate underneath them, and all that broke, and, 
boy, there was--we lost over 100 banks across Kansas in that 
    It worked, but it was very painful in the process. But my 
point on asking this and about the Depression, is, what's the 
historical model that you look at, that says it's most akin to 
where we are now?
    Chairman Volcker. Well, in terms of the banking situation, 
for better or worse, in fact, quite a few examples.
    The big one, I suppose, was in Japan, where they had a 
situation very similar to ours, in that they had an economy 
that had been operating at a very high level with great 
confidence, but they built up both very high stock values, as 
we did in the 1990s, and then even higher real estate values.
    They both collapsed, in their case, at the same time.
    And they had even sharper declines that what we've had, 
both in stock prices and in real estate values, where real 
estate values, I think, there, went down by 75 percent, at 
least in urban areas.
    And they struggled with that for some years, because it was 
a great shock to the banking system, they did not have highly-
engineered open markets; they didn't have a subprime mortgage 
market, but they had a banking system that was reliant on loans 
that were backed by assets, particularly real estate assets.
    The assets collapsed, so the banks came under great 
pressure. The government had to eventually come in and provide 
them with new capital.
    They did not take as forcible action as we were just 
talking about, in terms of taking out the bad assets and in 
recognizing the failures of a lot of companies. A lot of people 
have said that--pointed out that that's not an example we want 
to follow.
    I would also point out that they had a lot of intervention, 
and the economy, while it did not do well, did not go into a 
Great Depression, either, or a great recession. We just kind of 
sat there sluggishly for a decade.
    Senator Brownback. And I don't think they--did they 
increase taxes in that period of time?
    Chairman Volcker. I think at one point, they did. They got 
very worried about the budget deficit, and increased----
    Senator Brownback. Is that a way for us to go?
    Chairman Volcker. I would think not, in general, but I--you 
know, you can talk about specific taxes, and you might want to 
make changes, but if you're talking about a broad-based tax 
increase, I don't think anybody's talking about a broad-based 
tax increase at this point.
    Senator Brownback. That was the headline in the Wall Street 
Journal today.
    Chairman Volcker. Well----
    Senator Brownback. A large increase in taxes, which----
    Chairman Volcker. That startled me when I saw the headline, 
too, but then I saw the next sub-headline, and it said, over 
ten years. So that's dividing $800 billion or whatever it is, 
by ten, that's $300 billion. What was it? I can't remember.
    Whatever it was, you divide by ten and it doesn't look 
quite so formidable.
    Chair Maloney. Your time is expired. Congressman Snyder?
    Mr. Snyder. Thank you, Madam Chair. I also think that the 
proposal was not a broad-based tax increase; I think it's very 
targeted to those who have done very, very well in this last 
    Chairman Volcker, I wanted to ask you, every once in 
awhile, we see news footage of a volcano that decides to put 
out a massive amount of lava, and the lava flow is coming down 
the mountain and the pitiful efforts of humanity to try to stop 
a lava flow, and the lava always wins, it seems to me that the 
lava in this particular situation, is our helper, that the lava 
flow that's coming, is the drive of people to support 
themselves, to make a living, to produce products to sell to 
other people, and that that's what's coming down the mountain, 
if we can just figure out a way to make the changes we need, 
the lava flow will take care of itself.
    My question is, do you see anything in the list of items 
you went through in a very articulate manner this morning, 
anything out there that's not solvable?
    Chairman Volcker. No, but I think some of it is, indeed, 
very complicated. It certainly is solvable, but it's going to 
take--it has taken much more government intervention than we 
would ordinarily like to see, quite obviously, and it's going 
to take--I think we at least have to be prepared for the fact 
that it's going to take more government money, particularly in 
helping with the recapitalization of these financial 
    But, yes, I certainly think it is solvable, and I think we 
can do it in a way that we emerge from this with a more solid 
financial system that, for many, many years, I'm inclined to 
say, for my lifetime--and that's not very impressive anymore; 
it's not as impressive as it used to be--for your lifetime, a 
lifetime of anybody in this room, we wouldn't be faced with 
this kind of crisis once again, revealing structural weaknesses 
in the financial system. We ought to repair it--not just repair 
it; we ought to reorganize it.
    Mr. Snyder. With the result being not that we just somehow 
get through this, but that we set the table----
    Chairman Volcker. Absolutely.
    Mr. Snyder.--for potentially remarkable economic growth, 
not only here, but around the world and see more than few 
hundred million people lifted out of poverty.
    Chairman Volcker. The one thing I would plead in that 
respect, is, we have to take emergency actions. We're taking 
emergency actions, we're going to take more emergency actions, 
but when it comes to reorganizing the financial system, let's 
take our time.
    Now, I don't want to overemphasize that. I don't think we 
should do it piecemeal. We ought to have some vision of what 
the financial system ought to look like, and it's not entirely 
in the control of this country. I a globalized world, it's 
going to have to be--some parts of it are going to have to be 
uniform, more or less, some more, some less, but around the 
world, and we ought to come to some kind of vision that is 
reasonably shared.
    Then we can put the pieces together, and I hope we can do 
that fairly soon, but we can't do it--you're not going to do it 
in the first half of this year, and I don't think we should 
    Mr. Snyder. You had mentioned several things in your 
written and oral statements that you describe as technical 
issues and some accounting rule things that I think you stated 
and most of us would agree, would not be appropriate for 
legislative solutions.
    Do you have any apprehension that we may, indeed, try some 
legislative solutions in some areas that we should stay the 
hell out of?
    Chairman Volcker. Yes.
    Mr. Snyder. Are you going to let us know when you see that 
    Chairman Volcker. Well, I think accounting is one area 
where the temptation is to kind of march in and sweep away, I 
don't know, mark-to-market accounting or something. It's a 
complex technical area and I think changes have to be made.
    I'm a bit prejudiced here, organizationally, because I used 
to be Chairman of the International Accounting Standards 
Committee, which appoints the Board, which makes the accounting 
standards, and I don't necessarily agree with all those 
standards, and I think they have to be looked at, but they have 
to be looked at in a kind of professional way, that maybe isn't 
very conducive to the immediate political process.
    So I hope that's one area where you would keep the gun in 
the holster.
    Mr. Snyder. Stay away.
    Chairman Volcker. Yes.
    Mr. Snyder. I think there has been a remarkably smooth 
transition in our national security apparatus from one 
Administration to the other. I think probably Secretary Gates 
staying on, was a key to that, but my impression is that it has 
gone very, very smoothly throughout the Pentagon and in the 
    My question is, are you satisfied with how smooth the 
transition has been in these areas that we're talking about 
today, from one Administration to the other, or are there 
things that could be done with more alacrity?
    Chairman Volcker. Well, in general, I think it's been 
smooth in the sense that some of the key positions were filled 
soon with competent people, and people well understood the 
    There is an area that I think is--I don't know, but 
``shameful'' is the word that comes to mind. The Secretary of 
the Treasury is sitting there without a Deputy, without any 
Under Secretaries, with no--so far as I know, no Assistant 
Secretary responsible in substantive areas, at a time of 
obviously very severe crisis. He shouldn't be sitting there 
    Now, various things have contributed to this, I guess, 
including vetting procedures, but it really is an unfortunate 
situation that I believe the Treasury Department, which I was 
once in and I thought it was the best job I ever had and have 
great pride in that institution, but just in recent years, has 
been weakened before the transition, and it deserves some 
attention and rebuilding, and new strength.
    You can't be the leading economic power in the world, with 
all the problems we have, and have a weak Treasury.
    Chair Maloney. Thank you. Your time has expired. That was 
an excellent point, Mr. Chairman. Congressman Brady?
    Representative Brady. Thank you, Chairman, and thank you, 
Mr. Chairman, for being here today.
    I have two questions. Your comment in your opening remarks, 
was that this was an economic crisis, brought upon us by 
spending more than we are producing, a tremendous buildup of 
debt, lack of personal savings, and reliance on foreign debt.
    All of those we seem to be doing more of on steroids. If 
that was the path to the economic crisis, how does running down 
that road faster solve the problem?
    Chairman Volcker. Well, it won't, that's for sure, but you 
have a very difficult balancing to do. We weren't saving 
enough, we were spending too much.
    Now, you get into this crisis, and people flip right to the 
other direction, understandably. They're worried, they're 
concerned, they're losing their jobs, so, suddenly, they stop 
spending and are trying to save more, and in terms of a smooth 
economic adjustment, there's a risk of going too far in the 
other direction.
    We've got to build up the savings, we've got to have less 
consumption, relative to economic activity, and not less 
consumption in absolute amounts.
    And these changes tend to come in spurts. This spurt is 
downward. So, you've got to take action that somehow looks 
contrary, as you say, to hold it up so that it doesn't go too 
fast in the wrong direction.
    Representative Brady. Does that same scenario apply to 
government, when we're spending far more than we are producing, 
when we are building up a tremendous amount of debt, when we're 
relying on foreign debt, does the same risk that applies in the 
private market, apply in government?
    Chairman Volcker. Yes. I think it's less fragile at this 
point, with the government building up the debt. It's a 
byproduct, I guess, of the support that the private economy 
needs, but you are emphasizing, I think, what I would certainly 
agree with, that during this period, we've got to pay attention 
to how we get the federal spending back into some reasonable 
relationship with what we're willing to tax.
    And I think the President is conscious of that. He had some 
meetings about that earlier this week, but, you know, it's--
that may be one area where this Board that I have been 
appointed Chairman of, that we could start and may want to look 
at. What can we do to reinforce a sense that we really can get 
spending back on track as this emergency recedes?
    Representative Brady. Well, I would certainly like to help 
with any of those measures.
    Let me ask you about TARP II. You know, when the initial 
plan was laid out, it was not well received by economists or 
the financial markets. It may have, in fact, added to turmoil.
    You were named shortly beforehand, as head of the 
President's Economic Recovery Advisory Board. Did your panel 
have enough time to thoroughly analyze it and evaluate it?
    Chairman Volcker. That was before we were appointed, the 
first TARP, but, anyhow, we have not been active yet. We're 
just getting active. We had nothing to do with that.
    Representative Brady. Is it important that the 
Administration start clarifying that? I mean, do you have any 
insight today on details? How are we going to take those, 
isolate those bad loans, remove those toxic assets?
    That seems to be what everyone knows needs to be done; the 
question is, what is going to be done?
    Chairman Volcker. My impression is, that's under very 
active discussion in the Administration, as well as outside the 
Administration. The question is, there are complexities beyond 
my particular knowledge, in terms of law and authority and so 
forth and getting it done.
    I believe it can be done, and I hope it will be done 
expeditiously. And that will require, when you talk about--talk 
to or whatever--I think it is quite possible and may be 
desirable, in doing it cleanly and effectively, to provide a 
certain amount of government capital to make that process 
    It's difficult to do it, I think, without government 
support, either in the form of guarantees or cash, or maybe 
both. We've got to get some organization able to hold those 
assets, and they're not going to get financed, unless there is 
some feeling that they are financeable.
    Representative Brady. I think many of us were hoping that 
you had had some impact on that financial plan, or are having 
some impact on it.
    Chairman Volcker. Well, I think that, you know, discussions 
are ongoing. I think that the quicker it gets resolved, the 
    Representative Brady. Right, thank you, Chairman, very 
    Chair Maloney. Thank you. Congressman Cummings?
    Representative Cummings. Thank you, Madam Chair. Chairman 
Volcker, yesterday, it was reported by Bloomberg News, that 
Chairman Bernanke said that if the government ended up with a 
substantial share of Citibank stock, adequate oversight of Citi 
could be accomplished by the government, through the regulatory 
process and through the exertion of shareholder rights.
    Chairman Bernanke is quoted as saying ``It may be the case 
that the government will have a substantial minority share in 
Citi or other banks, but again, we have the tools, between 
supervisory oversight, shareholder rights, and other tools, to 
make sure that we get the good results we want in terms of 
improved performance.''
    If the government were exerting shareholder rights to 
accomplish its objectives, Chairman Volcker, would that 
constitute a form of nationalization, and would it be adequate 
to protect taxpayers' investments in these institutions?
    Chairman Volcker. Well, my own feeling is, calling that 
``nationalization,'' which is an emotive term, apparently, may 
be misleading, in terms of what is really going on.
    There is undoubtedly government influence and there will be 
government influence and there will be more government 
influence. That's true, the influence, is true today and it's 
going to continue.
    But it is--I would put it in a characterization as 
government support for recapitalization.
    That sounds less threatening, somehow, than 
``nationalization.'' It doesn't imply we're doing this as a 
permanent, desirable method of running the economy or running 
the financial system. It is not.
    We want to do it to speed the return to a privately-
capitalized system.
    Representative Cummings. And if the regulatory process and 
the exertion of shareholders' rights, are truly adequate to 
accomplish the good results we want in terms of improved 
performance, why is the regulatory oversight not apparently 
working now to increase lending and to prevent banks from 
receiving aid from doing things like going on these junkets and 
paying for Cheryl Crowe and things of that nature?
    Chairman Volcker. Well, in terms of the lending, I think 
the principal problem is that an insecure bank faced with what 
it sees as insecure borrowers, is not a very eager lender. It's 
a problem of lack of good borrowers, confident borrowers, as 
well as weak banks and worried bankers.
    And so you can attack one end of this by cleaning up the 
banks, the way we described, some key banks, and I think that 
will help, but it's part of a general economic problem to 
create an environment in which people want to borrow and 
demonstrably can show the kind of support that makes it 
justifiable to lend.
    I'm sure there are instances now where perfectly solid 
borrowers are unable to get money. But there aren't as many of 
those as there used to be.
    And there are weak banks that don't want to go back in the 
hole, so to speak.
    Representative Cummings. Mr. Chairman, that leads me to 
this point: You know, a lot of our constituents don't 
understand what you just said. They don't understand that.
    They look at all of this money flowing into these banks, 
and they believe that there should be a connection between 
their hard-earned taxpayer dollars flowing into their banks, 
and their ability to get credit to educate their kids, to, you 
know, keep their businesses going or whatever, and are you 
saying that it's unreasonable for them to assume that there 
will be a connection there?
    Chairman Volcker. I think there is a connection, but it's a 
connection that will work out over time, by strengthening the 
banks, as well as the economy. There is not an easy connection 
to say, you know, a million dollars is going into Bank X, and, 
immediately, directly related, that a million dollars is going 
out to borrowers of Bank X.
    You know, the money all goes into the bank, generally. You 
can't tag those dollars.
    Representative Cummings. I understand that, and my time is 
running out, but I think this is it; I think people are not--I 
don't think they expect that million dollars to be loaned out, 
but they expect maybe $250,000 to be loaned out, and they can 
hold on to the 750.
    Chairman Volcker. Well, fair enough, but I can't trace 
that, either. But you want that money to be lent out over time, 
but it's got to be part of a process of stabilizing the bank.
    Until you get the bank stabilized and confident, the money 
isn't going to flow very well, so the whole object is to 
restore some stability to the banking system and some 
confidence to the banking system, and you've got to do it in an 
atmosphere where the economy out there isn't very good, to say 
the least.
    I think that's the basic object. Going to people, going to 
your constituencies and saying it's kind of a vague, just hold 
on a bit and we hope to get on top of this, isn't the best 
story you can give them. I think that's, unfortunately, the 
    And I think it's understandable that to get those bank 
loans made, you've got to get the banks in better shape.
    Representative Cummings. Thank you very much.
    Chair Maloney. The gentleman's time has expired. 
Congressman Burgess?
    Representative Burgess. Thank you, Madam Chair. Chairman 
Volcker, let me just pick up on what Mr. Cummings was asking 
you because there's no question there's a crisis of 
credibility. We in Congress deal with very low approval 
ratings, certainly bankers right now have very low approval 
    As the Administration knew, the public is stipulating 
confidence in the Administration, but Bill Moyers recently 
introduced Simon Johnson, formerly the Chief Economist of the 
International Monetary Fund, and Mr. Moyers said that the new 
Treasury Chief of Staff was formerly a lobbyist from Goldman 
Sachs, and I'm quoting now, ``The new Secretary of State, was, 
until last year, an executive of Citigroup; another CFO from 
Citigroup is now an Assistant to the President, and the Deputy 
National Security Advisor for International Economic Affairs 
and one of his deputies, also came from Citigroup. One new 
member of the President's Economic Recovery Advisory Board, 
comes from UBS, which is being investigated for helping rich 
clients evade taxes,'' end quote.
    Now, Mr. Johnson noted that most of these appointees were 
well intentioned but with backgrounds that will make it hard 
for them to be totally objective about the bank bailouts.
    Now, to Mr. Cummings's point, if our constituents ask us 
why so many former bank officials should be given these 
important positions in the Administration, what do we tell 
    Chairman Volcker. Well, you've got to tell them that, 
obviously, to deal with this very complex situation, you have 
to have people that deal with financial markets and have 
experience in financial markets.
    I'm not going to get into which particular individuals 
those should be or which banks they come from, and I think they 
should come from a variety of sources, for, partly, the reasons 
you suggest, to give a sense of confidence and rounded 
    But, beyond that, I don't know what I can say. These are 
areas of difficulty and complexity that are recent enough, so 
you don't have a lot of people out there that are necessarily 
very imbued with all the problems that exist, and they're going 
to have the best ideas of getting out of it. But you hope to 
get the best you can.
    Representative Burgess. And I would certainly agree that 
you don't want to exclude people who have the expertise. We see 
that all time in the energy industry and the pharmaceutical 
industry where we seem to have----
    Chairman Volcker. It may be that--you know, I referred to 
the problems of getting a Treasury man, that the rules about 
backgrounds and conflicts of interest and so forth, is probably 
one of the factors inhibiting getting the Agency speedily 
    So, you know, it's kind of a hard balancing act.
    Representative Burgess. Well, with the crisis in 
confidence, though, it's important to get those things right.
    Chairman Volcker. I agree with that.
    Representative Burgess. Now, when Senator Brownback was 
asking you questions, I think he referenced the crisis in the 
economy in the 1980s, shortly after your tenure, when the 
savings and loans collapsed around the country.
    I was a young physician in North Texas at the time, and it 
was a very, very painful time, as I recall. But you pointed out 
that it was relatively short, I mean, as far as episodes of 
pain go, and that there was a significant prolonged benefit in 
North Texas, probably 25 years of sustained economic growth and 
really only until the last couple of months, where the 
recession in the rest of the country caught up with North 
    You also outlined the situation in Japan, where a similar 
set of circumstances and the recovery and the growth just never 
happened, because of perhaps some differences in approach.
    So I would just ask, at this point where our approach seems 
to be more like Japan's today, should we be perhaps more like 
your approach and the person who followed you at the FDIC, the 
approach back in the 1980s, to the savings and loan problem?
    Chairman Volcker. Well, let me tell you what I think the 
big distinction is between the problem we have now and those 
incidents that you referred to earlier. The Texas crisis, if I 
may call it that, certainly began on my watch. It wasn't quite 
completed on my watch, but it was there.
    The Texas banking system collapsed, as you recall. The four 
or five big Texas banks, didn't exist after the crisis, and the 
savings and loans subsequently came under great pressure.
    Now, what happened? It was a tough time for Texas for 
awhile, but it wasn't a tough time in the United States, and 
Texas is a big state, but it's not the whole United States.
    And the crisis took place in the environment of a growing 
environment and a pretty stable economy, and that helped to get 
out of the crisis relatively quickly.
    Japan is a big country and it was more difficult, but, 
still, Japan is not the United States. Now you have a crisis 
that goes right across the United States, and the problem is 
not just across the United States; it's in the whole world.
    Production is declining outside the United States, from a 
high level; it's declining more rapidly than anything I've seen 
in my lifetime. Now, the level of activity is still pretty 
good, but they are in recession and we're in recession.
    So when everybody's in recession, it's much harder to get 
the momentum to get out. There's no other place you can grab to 
to hang on, so to speak, there's no big sea of stability out 
there, it's rough seas all over.
    And that is--I think it's unique in the post-World War II 
period, to have this degree of recession right around the 
world. I think you're going to have a decline in GNP around the 
world this year, which will be a small decline, because China 
and India are still growing, but it's very unusual to have a 
decline in economic activity right around the world.
    That makes it harder for us to climb out. That's why it 
takes so much force, so much money, so much effort here, 
because we're fighting the headwind.
    Chair Maloney. Thank you. Congressman Paul?
    Representative Paul. Thank you, Madam Chairman. Chairman 
Volcker, some of your comments sort of frighten me, not because 
you remind us that we're in an economic and financial crisis--
and I'm satisfied that you admit that, especially since it's a 
reflection of the monetary and financial system that we've been 
working with for so long--but some of the suggestions you make 
give me some concern.
    But I did date our current problem from 1971. I won't 
quibble over the dates, but 1971, to me, was significant, 
because it ended the monetary order of the Bretton Woods 
Agreement, and that was a major, major event. That was a gold 
exchange standard and it was flawed and it failed.
    In 1971, we, as a nation and as a world financial system, 
we accepted a paper dollar as the reserve dollar of the world. 
And I think that's related to a concern that you have and I 
have, and every single economist I've ever talked to in 
Treasury or in the Federal Reserve, have expressed the same 
concern, and that is the current account deficit, which, again, 
didn't start in the 1970s, as much as exploded in the 1980s and 
the 1990s.
    We're the biggest debtor nation in the history of the 
world, and we recognize that, but where the difficulty comes, 
is to understand why we got there. I put the blame on the 
dollar standard, because we became the privileged nation, that 
we were allowed to print the gold. The world accepted it and 
they still do, to a large degree, and they're still taking our 
    But I think the handwriting on the wall now, is that that 
system has ended and all the inflating and all the manipulation 
and all the spending, will not put that system back together 
    So there's a lot of people now thinking about coming up 
with that replacement, and that's what I'm concerned about. I 
want to study and understand and maybe have some influence on 
    There's a few of us, and there's a growing number who 
believe in the free market, sound money, and national 
sovereignty, and believe that you can have a world economy 
without violating any of those principles.
    But in your next to the last paragraph, is where I find 
some frightening things, because you talk about a strong 
coordination among national authorities, unified accounting 
standards and liquidity requirements, and internationally-
agreed to, and it has to be comprehensive and not piecemeal.
    Now, that invites a lot of questions, to me. Is this going 
to be a super IMF? Are we going to revive the SDRs? Who's going 
to issue the credit? What will happen to the Dollar? Who has 
the authority?
    These are major things. I'd like to know what kind of 
discussions are going on internationally right now, to devise a 
standard, and are you a participant in these international 
negotiations to come up with this new system?
    Chairman Volcker. Well, I think the answer to that question 
is, no, no. I mean, I don't know of any coherent or regular 
discussions going on officially and a very few going on 
unofficially, in terms of the construction of the monetary 
    Now, the comments that you quoted from my testimony, are 
directed toward, I suppose what you might think of as secondary 
considerations, how you regulate whatever system you have, how 
you regulate banks and other institutions and financial 
systems. It's kind of a lower level of generality.
    The questions that you raise, are relevant questions. I 
agree with much of your description. We may not agree upon 
remedies, but I'll tell you, I don't think anybody is very 
seriously thinking about that right now. Nobody's talking about 
a super IMF.
    They have been talking, until recently, about the IMF not 
having much to do. We suddenly changed that in the regulatory 
area, where they may have some responsibility.
    I would like to see the questions you're raising, debated. 
That's not what I meant to raise in this statement.
    Representative Paul. But do you think they're--so you think 
there is a need. Do you think the system we have today is over 
and done with and that we can't patch it together and just more 
trillions of dollars of credit by the Fed and more debt by the 
Congress is going to solve this problem?
    Chairman Volcker. I think there are problems with the 
present international monetary system that have not received 
sufficient attention. I'll leave it at that.
    Representative Paul. That's ducking it a little bit.
    Chairman Volcker. Yes, yes, I agree, because I can't tell 
you the answers are apparent, but make no mistake about it; 
this is a unique moment in economic history, where the world is 
going on the basis of fiat currencies. That's what economists 
like, and they thought it was a good idea, and let currencies 
float up and down, and don't get constricted by gold or other 
artificial arrangements. But it's a little tricky.
    If you're going to run on a world of fiat currency, you 
better pay attention to the stability of that currency and the 
maintainability of the currency, and I think we are inclined to 
forget about that.
    Representative Paul. It just may be that----
    Chair Maloney. The gentleman's time has expired. Senator 
    Senator Bennett. Thank you very much, Madam Chairman. 
Chairman Volcker, we're going to great lengths to try to remove 
the toxic assets from the balance sheets of the various 
institutions, or, failing that--that was the first description 
of what TARP would do--failing that, substitute capital in 
these institutions, so that their balance sheets look stronger.
    Let me walk through an alternative scenario that's 
presented to me, and get your reaction. And I will reduce it to 
the smallest possible example, a single mortgage.
    And let's put a dollar figure on it of $400,000, and it's a 
mortgage that's going bad, and whether it goes into foreclosure 
or whatever, it's under water, and the most that it could be 
refinanced for, would be $300,000.
    And if it goes into foreclosure, it probably gets sold on 
the open market, if it's sold at all, for $150,000 to $200,000.
    And then the problem comes that bits of that mortgage are 
now in packages that are in London and Los Angeles and Chicago 
and Kuala Lumpur and wherever all else, so that all through the 
system, no one knows what their package is worth.
    Now, if that mortgage were refinanced, and, therefore, 
retired, all of those institutions that own a bit or piece of 
that mortgage, suddenly get well, as far as the value of that 
mortgage is concerned, because it's gone.
    Is that a true statement?
    Chairman Volcker. Well, are you saying that that mortgage 
    Senator Bennett. If the mortgage is refinanced.
    Chairman Volcker. Refinanced.
    Senator Bennett. In other words, it's paid off.
    Chairman Volcker. Yeah, well, the creditor, presumably, is 
getting less than he expected when he made the mortgage.
    Senator Bennett. Yes.
    Chairman Volcker. He might be making more than he can 
reasonably expect now.
    Senator Bennett. But the mortgage is paid off by a 
    Chairman Volcker. Right.
    Senator Bennett. Does that mean that the toxic assets 
disappear on the balance sheets of all of the institutions, 
that particular toxic asset?
    Chairman Volcker. Well, I don't think so. You may end up 
with good assets, if you did that, generally, but the value of 
those assets would be less than the stated value of the so-
called toxic, so you would have lost capital someplace along 
this line.
    Senator Bennett. Okay, now, let me follow through on my 
time here and get it right. Let's say the mortgage is 
refinanced at $400,000, but at a vastly lower interest rate, so 
that the individual paying the mortgage could now afford it.
    That means that the original mortgage disappears completely 
and no one down the chain loses any money; is that not true?
    Chairman Volcker. Well, they lose money, because they're 
making lower interest than the other than what they thought 
they were going to make.
    They may be gaining compared to the present situation, yes.
    Senator Bennett. A 30-year mortgage is traditionally 
retired in seven years, so somewhere, the mortgage disappears.
    The thing that is intriguing to me, is the possibility that 
by making housing mortgages available at a significantly lower 
rate, let us say three percent, so that the homeowner who is 
currently under water, says, okay, I can keep paying on the 
$400,000 mortgage at three percent, so I will refinance, so the 
original mortgage is paid off, therefore, the toxic asset 
disappears from everybody's balance sheet, and we're now in a 
situation where everybody has paper whose value they know. 
Wouldn't that have a significant impact on stabilizing bank's 
balance sheets?
    Chairman Volcker. If you could do that amid all the 
technical and legal complications of dealing with these 
mortgages that are buried, as you point out, in big instruments 
where there are thousands and thousands of mortgages in every 
particular security, and you get through all the restrictions 
on how those mortgages can be refinanced under the rules under 
which the big securities are put together, yes. Now you've got 
a political problem. Who are you going to help?
    Are you just going to help those in trouble, or are you 
going to help everybody? And if you help everybody, it's 
getting pretty expensive.
    You probably get as many as I do, but at least twice a 
week, somebody writes me about a scheme for how to, one way or 
another, do the kinds of things you're talking about.
    And some of them look very attractive to me, so I send them 
off to somebody who's supposed to know more about it than I do, 
and the Administration, as you know, came up with their 
judgment as to how to approach this.
    And they have come up with a scheme which they think is 
less costly and more effective, by dealing directly with 
reducing interest rates on particular mortgages, according to 
some formula as to what's affordable.
    Is that best way to do it?
    They concluded, that's the best way to do it. I haven't got 
any reason to question that at this point, but it's not the 
most sweeping thing that could be done.
    What you're suggesting, is much more sweeping, also much 
more costly.
    Senator Bennett. My time has expired, but, I, too, asked 
somebody who's smarter than I am, because I just asked you. 
Thank you. [Laughter.]
    Chair Maloney. Thank you, Senator. We are very pleased that 
the Vice Chairman, Senator Schumer, has joined us, and the 
Chair recognizes him for five minutes.
    Vice Chairman Schumer. Well, thank you, Madam Chairperson, 
and first let me wish you luck. You won't need it; I know 
you're going to do a great job as Chair. I thoroughly enjoyed 
my tenure as Chair, and I'm very confident that you're going to 
do a great job at a time when this Committee is more important 
and more relevant than ever before.
    Thank you, Chairman Volcker, for your years of service to 
the country and for everything else that you have done.
    My first question is a broad question. You know, we're all 
looking to point a finger of blame at this particular person or 
that particular person, for this crisis.
    I think there's plenty of blame on individuals, but in the 
broad--there's plenty of blame that should go to individuals, 
no question.
    But in the broad brush, you could look at this crisis and 
say the following, the broadest brush, at least, that I see it: 
When a country, year after year, consumes more than it 
produces, imports more than it exports, borrows more than it 
saves, the chickens always come home to roost.
    You may not be able to predict how they come home to roost, 
but they do, because it is unsustainable to continue to do 
that, if economics means anything.
    And so my question to you, is this: When, let's hope and 
pray we get out of this financial mess that we're in, how does 
America get back to those old values?
    Is it inevitable that in an affluent society, we lose and 
we just become, in a sense, a giant, stuffing our face with 
cake all the time, so to speak?
    Are there government policies that we should be looking at 
now, that help us get back to that?
    Will the pendulum just swing back inevitably and get us 
    I mean, this, to me, I think, is the fundamental question 
for America, even deeper, and while not immediately more 
important, in the long run, more important than how do you get 
out of this economic crisis that we're in.
    If we go back to our old ways, we'll be in another economic 
crisis soon enough.
    Chairman Volcker. Well, I sit here and I listen to you and 
the thought that comes to mind, is, you put the point that I 
was trying to put, quite eloquently, and the reason you're a 
Senator and I'm not, is that you can put it more eloquently and 
understandably than I can.
    But you have identified----
    Vice Chairman Schumer. Thank you. Out of the more simple 
minds, who knows?
    Chairman Volcker. Not at all. At this level, it is a simple 
problem which needs to be understood.
    Now, part of getting back to a sustainable trend and 
equilibrium, is simply having gone through this horrible 
experience, I think people, for a while, anyway----
    Vice Chairman Schumer. For awhile.
    Chairman Volcker.--will not return to where they were. In 
fact, the dangers we discussed a little bit earlier, in one 
context, you may swing too far, and we probably will swing too 
far for awhile, and we've got to get back into something 
    The other stuff is--it's not just window dressing; it's 
important, but what protections can we build into the system, 
when those animal spirits become a little bit too buoyant in 
the future?
    I think there are protections we can build in, and this is 
the time we ought to do it, while the memory is very fresh. 
Now, I say that this is the time, but I don't want to do it 
next month, as I said; I want to take a little time to think 
about it.
    But that is the aim of this whole reform effort. How do we 
develop a free and open financial system, but nonetheless one 
that more effectively puts the brakes on in a timely way, which 
we obviously missed this time around.
    Vice Chairman Schumer. Do you have any more specific 
thoughts on some of the things we ought to do?
    Chairman Volcker. Well, I----
    Vice Chairman Schumer. And I may have missed them, and if 
    Chairman Volcker. No, but there are so many, but what I----
    Vice Chairman Schumer. Give us three of the most important.
    Chairman Volcker. Yeah, well, my personal philosophy, which 
is reflected in this report that the G-30 put out, is, banks 
ought to go back into the banking business.
    That maybe is a very old fashioned idea, but I think we 
ought to have a core--recent events show how dependent we are 
on banks as kind of custodians of they system, keepers of the 
system, and let's not get the distracted by the glamour of 
speculating in the capital markets, and so they go back to 
    Interestingly, Citibank seems to be saying that.
    Vice Chairman Schumer. Yes.
    Chairman Volcker. That they now realize they went off in 
some area of Wonderland, and they want to go back to the 
basics, and they've got a great franchise in commercial 
    So I would like to see that put into the system pretty 
firmly. We have a lot of room for innovation and flexibility, 
outside the banking system, but let's keep the core of it 
solid, active, competitive, and I think that would help in 
terms of what you're talking about.
    Make those banks self-reliant on their own credit 
appraisal, instead of blaming it all on Standard and Poor's and 
Moody's or whatever. That's the cultural change that's 
    Now, there are a lot of things. What do we do about the 
credit rating agencies?
    We talked about accounting, we talked about, you know, some 
of the plumbing of the system.
    Vice Chairman Schumer. What about things like--and my time 
is up, but leverage?
    Any limits on leverage?
    Chairman Volcker. Well, we certainly think those banks are 
going to be regulated, and leverage would be one area where 
that would show up. I also think we've got a leverage problem 
outside the banking system, when you get the hedge funds and 
maybe equity funds. Some of those have gotten pretty far and 
wild, too, and may need some leverage requirements there and 
capital requirements there.
    Vice Chairman Schumer. Right. Thank you, Madam Chair.
    Chair Maloney. The gentleman's time has expired. Some of 
the Senators indicating that they were voting and wanted to 
return, so if the Chairman would allow us, we could go to 
another set of questions. Do you have the time?
    Chairman Volcker. Yes.
    Chair Maloney. I'd like to follow up on Senator Schumer's 
question on the bank of the future, and how do you see the bank 
of the future, given the fact that we are part of a world 
economy and have to be part of their international banking 
standards, and do you think that the European style of 
universal banks that are mixing banking and commerce, that are 
the big megabanks, will become the dominant model, or do you 
think it will be more like Citibank, our original megabank, 
which has sold off brokerage and insurance and is now back to 
Citibank with a more focused attention on commercial banking?
    And how do you see the bank of the future, and do you think 
we need to regulate that to make that happen, and could you 
just elaborate further on the bank of the future in America and 
    Chairman Volcker. Well, you raise the phrase, ``universal 
bank,'' which means different things to different people. If 
``universal bank'' means what you described, that they can also 
have commercial--be part of a commercial firm, and operate 
throughout the capital markets and be pretty free to do pretty 
much anything, that's not what I'm talking about.
    I'm talking about more going back something like the 
traditional commercial banks.
    I'm not talking about going back and putting on Glass-
Stiegel. I think at this stage, the ability of a commercial 
bank to do underwriting for its clients and to give advice, is 
not an unreasonable activity, and they should be able to do 
    The distinction I make, is, are they serving the customer 
or not?
    Are they playing in the market, speculating in the market, 
transacting in the market, in a kind of impersonal market, 
where the particular person they're transacting with, doesn't 
mean much; it's just a transaction, it's not a customer 
    The banks ought to be devoted to their customer 
relationships, primarily, and then the other people can go and 
do their thing in the capital markets.
    If you combine the two, they become--they're both big and 
diversified to the extent they're doing all these capital 
market activities at the same time they're doing a more 
traditional banking business. They are so hard to manage, 
nobody's been very successful at managing them.
    And they are filled with conflicts of interest, and I want 
to reduce the conflicts of interest and I would like to make it 
more manageable.
    Chair Maloney. Thank you very much. Congressman Burgess?
    Representative Burgess. Thank you. Chairman, Senate 
Majority Leader Harry Reid recently said that the things are 
being turned around and we're getting very close to stabilizing 
the banking industry. Do you think that was an accurate 
    Chairman Volcker. Who said that?
    Representative Burgess. Harry Reid, the Senate Majority 
Leader, Harry Reid.
    Chairman Volcker. Well, I think how close we are to 
stabilizing the banking system, will turn on things that are 
happening in the next few weeks, perhaps. You know that the 
Treasury made a proposal yesterday, which is a step in that 
    But we did a lot of talking about how to take the bad 
assets out of the banking system, and I think we need to take 
some steps there, before we say that we're really on track 
toward stabilizing the banking system.
    Representative Burgess. Some of the discussion we've had 
this morning, has centered around the amount of debt that the 
country is taking on. A couple of weeks ago, I took a trip down 
to the Bureau of Public Debt.
    I didn't even know it existed. I watched the auction of 
three-year Treasury Bills, and I think there were $32 billion 
worth of Bills that were sold in about 30 minutes that 
    It was certainly startling revelation when you realize that 
our paper is being sold all over the world. I guess the good 
news is that it's still selling and that the interest rate is 
    But, recently, our Secretary of State Hillary Clinton, 
visited China and asked the Chinese to continue investing in 
United States Treasury securities. I think we had another story 
from the Financial Times, a couple of weeks ago, where one of 
the Chinese ministers said, we don't really like you, but we 
have to keep buying your Treasuries, because that's safest 
place to go.
    So are we on kind of a path where, just like in the Cold 
War, we were worried about mutually-assured destruction, the 
Chinese still have to buy our Treasuries and we still have to 
sell them on the world market?
    Chairman Volcker. Well, the signs that you are--the 
anecdotes that you are repeating here, are a sign of a stressed 
financial system. We shouldn't have to have a Secretary of 
State asking people to buy Treasury securities; we want people 
buying them because they want to buy them, not because of some 
political quid pro quo.
    And to the extent we are extended, it is a sign that we are 
stressed and we ought to take that as a warning and reinforce 
what we've been saying this morning about basic policies that 
have to be followed to get rid of some of this debt or limit 
some of this debt and get the banks back on a solid footing, so 
that people are lined up to buy Treasury securities, because 
they continue to think it's a best bet.
    Representative Burgess. Would that include a serious 
reassessment of the amount of federal spending that we're 
    Chairman Volcker. Yes, without question, that is an 
important symptom that people are looking at. They understand 
that we're in exceptional circumstances now that takes some 
spending. We need a stimulus program, we need all this money to 
help the banks and other institutions.
    Dr. Burgess please show us how we can, over a three-, four-
, five-year period, get back into a sustainable budgetary 
position with a reasonable flow of taxes.
    That's a great challenge for President Obama. Clearly, he 
recognizes it, and that's why he called this meeting the other 
    But to demonstrate it, to make it fully credible, you know, 
some action has to be taken. I would like to see some attack on 
one element over this, over a long period of time, over years, 
which is Social Security, which has been sitting around. I 
think it is a solvable problem.
    If we got at it, I think that would be reassuring. That's 
just one element that people worry about.
    But there are others, and we ought to have a good review of 
federal spending and get rid of the programs we don't need 
anymore. But there are a lot of things in civilian programs and 
certainly in the Defense Department, that probably deserve a 
good housecleaning.
    Representative Burgess. Thank you.
    Vice Chairman Schumer [presiding]. Mr. Snyder?
    Mr. Snyder. Thank you, Mr. Chairman. Chairman Volcker, I 
wanted to ask a two-part question, and this is my only 
questions, because I'm going to have to run to go vote.
    You mentioned the worldwide nature of this problem and the 
challenges that we have. We have examples of large economies 
around the world, that are not doing well right now, that are 
export-driven, and exports have dropped off dramatically. Japan 
comes to mind.
    Another--in contrast, India, which has, obviously, a large 
economy, a lot of their economic growth has been driven by 
their huge domestic market, and they obviously are having some 
dropoff, too, perhaps not as--certainly not as dramatic as 
other nations.
    I think the United States is somewhere in the middle of 
that. We have both a big domestic market, but we're also very 
    I'd like you to comment on how the solutions may impact 
differently, a domestic-driven, versus export-driven economy, 
and then any thoughts you may have about--there are some 
members of Congress now that are advocating that this is the 
time to rewrite trade agreements and probably not in their 
words, but, I would say, become more protectionist. What are 
you thoughts about that?
    Chairman Volcker. On the first question about export-
driven, as compared to more domestic-driven economies, I think, 
as a broad generalization, the globalization of finance and 
economics, has led to more exports and more imports. The more 
dependent you are on exports, the nature of this particular 
economic crisis is you're in more trouble than those countries 
that aren't so dependent upon exports. We see that over and 
over again. India is one major example, as you cited of less 
export dependence.
    I do not think, by the nature of this problem, you're going 
to get anyplace by putting on trade restrictions. I keep saying 
this is an international problem and everything we do, reflects 
on others and what they do, reflects on us.
    Trying to get out of this, by an individual country cutting 
down on imports, you're going to find your exports are going to 
be damaged, directly or indirectly, too, and the temptation is 
to do that, but I don't think you're going to make much 
progress, and it's going to have very strong inflammatory 
political repercussions as well.
    So, I would urge the Congress to be very careful about 
putting on import restrictions. It's much harder now than it 
used to be. It's much more troublesome to put on the 
restrictions, simply because the world economy is so much more 
    There isn't much we produce in the United States that 
doesn't depend on imports at some place along the line, and 
vice versa; our exports depend upon a variety of imports. So 
it's a very--I don't like to think of it as being fragile, 
ordinarily it's not fragile, but it's a very interconnected 
world that is very hard to improve by trying to jump in and put 
restrictions on exports of imports, generally, or even in 
particular industries.
    Mr. Snyder. Thank you, Mr. Chairman.
    The Chairman [presiding]. I've returned, Chairman Volcker. 
Senator Bennett?
    Senator Bennett. Thank you very much. Chairman Volcker, 
you've touched on this a little bit, but let's return to it.
    We will get out of this and what do we want as our 
regulatory framework, when we do?
    As I understand Secretary Paulson's template that he laid 
down, there were three primary goals: One was the stability of 
the structural viability of the system as a whole.
    The second one was the safety and soundness of individual 
banks, and the third one was the transparency and efficiency of 
markets. And, moving next, the assumption is, the primary 
responsibility of the first, would fall to the Fed, the second 
to the FDIC, and the third, to the SEC.
    Now, that's easy to describe in a single paragraph. The 
devil is not only in the details, but the details are devilish.
    So would you address that whole question?
    Do you agree that those are the three areas we should start 
trying to fill, and then, to the degree that you can, from your 
own experience, the suitability of the Fed, the FDIC and the 
SEC, or if there is another regulatory regime, in your view, 
that might be created to deal with this, or if some of the 
other regulatory structure that might disappear, if we went to 
those three big ones, that you think would be a mistake and 
that they should be saved?
    Just kind of range over this whole subject and visit it 
with us, if you would.
    Chairman Volcker. It's a very relevant question, and I must 
say, a very unfair question, Senator. I've been trying to avoid 
pronouncing on that particular subject. We wrote a whole report 
that evaded those issues, but let me give you some comments.
    I am rather attracted by Secretary Paulson's broad 
philosophy here, although it was not very clear, deliberately, 
as to how you would apply it in practice. I describe it maybe 
slightly differently than you do.
    You put the third category as transparency, and that's part 
of it. I think of that as a variety of what I would call 
business practices--the Truth in Lending rules and Truth in 
Mortgages that the Federal Reserve has, all the traditional 
concerns of the SEC, the CFTC, transparency.
    You know, one thing that people comment on, is these big 
CDOs that you referred to earlier, are sold in the market like 
a security, but they're not subject to the normal security 
    So that is one area. The safety and soundness thing, is the 
other area, and I think there's something to be said by that 
being conducted by a different agency, rather than all one 
agency. They're all mixed up and jumbled up now.
    The SEC, I think it's fair to say, has not done a very good 
job on the safety and soundness side, but that hasn't been 
their bag over the years, and they like to concentrate on the 
other side.
    And I don't know that the banking agencies have done as 
good a job as they can do on what I call business practices.
    Where you fit the systemic regulator in that picture, is 
not so clear. I understand the concept, I understand the need, 
but it's one of the reasons why I haven't wanted to put out my 
own plan or thought, because I think there are different ways 
you can do it, and I think we ought to have some debate on how 
best to do it.
    And some of it, at least, gets involved, I think, in 
international considerations, so we want to work with other 
countries on it. So I'm not ready to reveal my secret, inward 
thoughts on how that might look in the end, but I do think that 
framework is an interesting way to approach it.
    Senator Bennett. I think it's where we start, but, clearly, 
we need all of the kinds of details, and I'm delighted that 
you're willing to think about it.
    Chairman Volcker. What I would like to do, you know, I 
really think I'm a little afraid the Congress will go ahead and 
legislate on that, without thinking through what kind of a 
system they want, and I'd rather have it go the other way, that 
we reach some consensus on what kind of a system we should 
have, and then this is the way we're going to regulate it.
    Senator Bennett. Thank you.
    Senator Klobuchar. Senator Bennett, since you asked such a 
stellar question, if you want to do one more, it's fine, then 
I'll go ahead.
    Senator Bennett. Since you just arrived, you go ahead.
    Senator Klobuchar. Okay, all right. Well, Chairman Volcker, 
I was listening with great interest yesterday when the 
President outlined his principles and what he wants to get 
done, and then to your answer about doing this comprehensive--I 
don't want to put words in your mouth, but you would prefer to 
have sort of the regulatory system set up first, and then you 
look at how you regulate it.
    Chairman Volcker. Right.
    Senator Klobuchar. Okay.
    Chairman Volcker. I would not call it the regulatory 
system, but the financial system.
    Senator Klobuchar. Right, right, the financial system.
    Chairman Volcker. Right, exactly, yes.
    Senator Klobuchar. So do you think one financial 
institution should be taking the lead in developing and 
implementing this new regulatory framework, or should the 
oversight be distributed among agencies, or how would you most 
like it to look?
    Chairman Volcker. I'm going to give an advertisement here 
for the Group of 30. We issued a report on that subject without 
a recommendation, earlier. We're just describing what different 
countries do, and it is very different.
    One approach is putting everything in one agency, and the 
British are the exemplars of that, and that, for awhile, was 
considered the direction in which to go. That was the preferred 
    The shine has been taken off that a bit, given the problems 
that the British have had, and, particularly, the problems they 
had in coordinating a response to the crisis.
    The other possible way, is more along the lines that 
Secretary Paulson proposed; have a separate safety and 
soundness, prudential regulator for everybody, and a separate 
regulator, SEC, CFTC-type for what I call business practices.
    And there are several countries that have adopted that. The 
American system is by far the messiest; it's the biggest; we've 
got more agencies involved with conflicting and overlapping 
responsibilities than anybody else.
    I used to think that was something of a strength. I still 
think so. It makes life very difficult at times, but there is 
some point and a little competition among agencies, so that 
they don't become overbearing.
    There is a problem, if you have one agency, even on the 
prudential side, should that be the Federal Reserve?
    This is why I don't want to reach a judgment. If it's the 
Federal Reserve, you've got a very different Federal Reserve 
than we've had historically, where the focus has been on 
monetary policy and, above all else, protecting its 
independence and so forth.
    Well, it's a little different, if they're going to have 
thousands and thousands of bank examiners crawling over all 
financial institutions around the United States, and I'm not 
sure we want that.
    That's why I'm reluctant to give the answer to Senator 
Bennett at this point, but those are the issues, we should talk 
about it, and you arrive at a different answer.
    I'm just repeating myself, but you arrive at a different 
answer, depending upon how you think the financial system 
should look.
    Senator Klobuchar. Right, and I completely understand this 
idea of taking our time to decide how we want it to look, and 
then how it should be regulated.
    But one of the issues that I confront, is that our 
financial institutions, the confidence issue and the trust in 
them, is eroding, and some of it, as I pointed out in my brief, 
one-minute opening there, is unwarranted. You know, some of our 
small banks are doing well, our credit unions.
    We have some healthy large banks out there, as well, and 
they're actually being brought down by this uncertainty right 
now, whether it's about the stress test or about the way things 
are going to be regulated, and I'm just curious about that 
urgency of making things clear, versus trying to look at this 
so comprehensively.
    How can we, as we look at this comprehensively and say it 
takes awhile to set up this new regulatory system, how can we 
in the meantime, try to bring back that confidence in at least 
our healthy banks and healthy credit unions?
    Chairman Volcker. Well, again, you know, I'm being maybe 
totally unrealistic, but when we take these particular actions 
of saving particular institutions, recapitalizing particular 
institutions, or guaranteeing particular institutions, let's be 
careful in doing that, that we're not doing things that we're 
going to be sorry about in the future.
    Now, one area that just happens to have been a longtime 
hobby horse of mine, I don't want to combine banks with 
commercial firms. Which is longstanding American policy.
    There are some exceptions, but they are relatively small 
exceptions. Now, the temptation is--and I think we've reached 
that a little bit now--you take emergency action that seemed to 
be nice to permit some institutions to become part of the 
Federal Reserve or part of the safety net, even though they are 
connected with commercial institutions.
    And there are non-banking institutions that are very 
heavily engaged in commercial operations, that apparently would 
like to control some banks, and they say, we've got money, so 
let us do it.
    Well, that's great, but we're violating----
    Senator Klobuchar. Yes.
    Chairman Volcker [continuing]. The way we want the system 
to develop over time.
    Senator Klobuchar. And that's why I'm so concerned about 
some of the stock going down in some of these healthier banks, 
that that will be the end result, if we don't clarify what the 
rules are and act somewhat quickly to get this done.
    Chairman Volcker. Now, we can qualify those rules for the 
moment, without deciding who the regulator is going to be.
    Senator Klobuchar. That's true, through this stress test 
and getting it done quickly, so that would be, to characterize 
what you're saying, to get that done, so we can sort of set 
some sanity in the market.
    Chairman Volcker. For the time being, we have to live with 
the institutions we have, and we've got banking. They're 
working together, I think, pretty well, that's my impression.
    Senator Klobuchar. Well, the other piece of this, which is 
an easy answer, is that you put different people in charge, and 
sometimes things can improve, you put bigger emphasis on--and 
this is, again, in the meantime, because I do think we have to 
make structural changes, but the whole Madoff scandal, the fact 
that that wasn't caught, it's a combination of structure, but 
sometimes it can be other people's emphasis, who are in charge 
of the agencies.
    Chairman Volcker. I think that's right; it's a failure of 
supervision that had nothing to do with whether you had a 
unified regulator or a lot of separate regulators, and there, 
the responsibility, the agency involved, is pretty clear.
    In other cases of lapses, it might be a different agency, 
but we're not going to cure that by moving around the pieces on 
the chess board.
    Senator Klobuchar. I wanted to just go back to--I'm going 
to ask maybe one or two more. The Group of 30's report for 
laying out a financial framework for financial stability that 
you chaired, the report included a conclusion that a few banks 
will still need to be so large that their failure would pose a 
systemic risk, or in other words, they would be too big to 
    And while the report calls for elevated oversight and 
regulation of the big banks, you believe it is an acceptable 
level of risk, to have institutions operating, whose singular 
failure can trigger this kind of collapse that we were so 
fearful of?
    Chairman Volcker. Well, we want to have a system that 
minimizes the threat of collapse, so you don't have to take 
these extraordinary measures. But it means they're going to 
have, I think, an extraordinary degree of supervision.
    And the danger will be that supervision will become too 
heavy-handed, and that those institutions won't be able to 
compete effectively. Now, this is one reason why we want to get 
some consensus internationally.
    There are two things you can accomplish internationally: 
You can get some consensus, I hope and believe, on how you 
supervise these mega-institutions, because they are operating 
all over the world.
    Senator Klobuchar. Yes, they're operating internationally.
    Chairman Volcker. And also, I think you now have some 
possibility of doing something that hasn't been possible, of 
dealing with the tax havens and the regulatory havens. The 
Europeans are pretty hot on that, and we ought to be pretty hot 
on it, and between the us, I think we can do something about 
    Senator Klobuchar. Exactly. So those are two areas you 
think we could accomplish something internationally?
    Chairman Volcker. Right.
    Senator Klobuchar. How about the credit rating agencies and 
what happened with them here when they were rating things as 
gold, and then the next day, they went under; what do you think 
we could do about that?
    Chairman Volcker. You've got Mr. Altman testifying here? 
    Chairman Volcker. I'm going to turn that question over to 
    Senator Klobuchar. Okay.
    Chairman Volcker. You know, it's a very difficult area, and 
I've been scratching my head. I think it's fair to say that 
that is one area where our recommendations in this report, were 
rather obscure, because we didn't come to any very definite 
conclusion as to how to deal with that.
    There are obviously things you can do in the realm of 
transparency and so forth, but I don't think there's an easy 
answer, by saying you have a different model for how they're 
paid. Maybe you'd want to do that, but it's not easy.
    There are a number of approaches that can be taken. Do we 
want more competition?
    I think the answer is probably yes. Do we want to 
facilitate more credit rating agencies of a different type, 
that are paid by the lenders, rather than the borrowers?
    I think the answer to that is yes, too, but I'm not sure 
it's viable, economically, so I am demonstrating that I don't 
have settled views on this area.
    Senator Klobuchar. You know, early on in--and this will be 
my last question here, and then I think we're going to recess 
for the Chair to return, and she'll be here shortly.
    But when I spoke, I talked about these small banks that 
have been, for the most part, staying out of these high-flying 
deals, and then you have some of the large banks that are, by 
all accounts, much healthier than some of the other banks, that 
not all banks are the same, not all banks made the same kind of 
    Do you envision that we could have a situation where small 
banks are doing fine, you've got some of the large banks that 
can rely on the private capital; that maybe they'd take some of 
the TARP funding in the past, because they were asked to, but 
that's not necessarily they did it because the other ones or 
they were told to, but they basically can stand on their own 
legs, while you have certain of these institutions, a select 
few, that are either under temporary receivership or are just 
getting more of these funds on loan--is that possible to 
imagine there could be differences between these large banks?
    Chairman Volcker. Well, I don't know about the difference 
between large banks, but I think there are differences between 
the small banks and the large banks, in the sense that the FDIC 
has kind of established procedures that work pretty well for 
dealing with small banks.
    When it gets to be a very big bank, it kind of taxes the 
resources and methods of the FDIC, and so they need, to some 
degree, different treatment, and I think that's what will 
emerge here.
    Senator Klobuchar. Right, and I understand that. I'm just 
looking at, as we go forward with this stress test, as the 
Administration does, I'm one to believe, just knowing some of 
the banks in our state, that there are differences between the 
large banks, you know.
    There are banks that didn't have the pavement crumple under 
them, and go to Washington with a tin cup, when all of this 
happened, and then there are other banks that made some really 
bad decisions that there may be a good reason to decide to keep 
them going, because they're too big to fail, as was pointed out 
    And I just would like some acknowledgement that there are 
differences between these large banks----
    Chairman Volcker. Well, you're certainly right about that, 
but just in the small banks, an obvious point, but when the 
small banks get in trouble, it's much easier to merge a small 
bank, than it is to merge a big bank.
    Senator Klobuchar [presiding]. That's for sure. All right, 
very good. Well, thank you, Chairman Volcker.
    We're going to temporarily recess this hearing, unless you 
have more questions or comments, Senator Bennett?
    [No response.]
    Senator Klobuchar. We'll recess until the Chairman returns. 
Thank you very much. The hearing is temporarily recessed.
    Chair Maloney. I'd like to convene the second panel. I 
apologize; we had votes, but that's where many of the members 
are. They are on their way back. I see Congressman Hinchey 
    I want to thank very much, the distinguished members of the 
second panel. Roger Altman has had an outstanding career in 
both the public and private sector.
    He served two tours of duty in the U.S. Treasury 
Department, initially serving President Carter as Assistant 
Secretary for Domestic Finance, and later serving President 
Clinton as Deputy Secretary during a time of great economic 
positive actions.
    Since 1996, Mr. Altman has served as Chairman and Chief 
Executive Officer of Evercore Partners, which is now the most 
active investment banking boutique in the world, with offices 
in the U.S., Europe, and Latin America.
    Previously, he was Vice Chairman of the Blackstone Group, 
and responsible for its investment banking business, and his 
initial Wall Street career involved Lehman Brothers, where he 
eventually became co-head of investment banking, a member of 
the firm's Management Committee, and of its Board of Directors.
    He is a member of the Council on Foreign Relations. He 
received an AB from Georgetown University and an MBA from the 
University of Chicago. Welcome.
    Dr. Adam Posen is Deputy Director of the Peterson Institute 
for International Economics in Washington, D.C. where he has 
been a Senior Fellow since 1997.
    His research focuses on macroeconomics, policy, and 
performance, European and Japanese political economy, and 
central banking issues. He is a widely-cited expert on monetary 
    He has been a visiting scholar at central banks worldwide, 
including, on multiple occasions, at the Federal Reserve Board 
and the European Central Bank.
    From 1994 to 1997, he was an economist at the Federal 
Reserve Bank of New York, where he advised senior management on 
monetary strategies, the G-7 economic outlook, and European 
monetary unification.
    Dr. Posen received his PhD and his AB from Harvard 
University, where he was a National Science Foundation Graduate 
    Dr. Joseph Mason is the Herman Moyse, Jr. Louisiana Bankers 
Association Chair of Banking at School of Business of the 
Louisiana State University, Senior Fellow at the Wharton 
School, and a financial industry and monetary policy 
    Dr. Mason formerly taught at Georgetown University and at 
Drexel University, and before that, was a financial economist 
at the Office of the Comptroller of the Currency here in 
Washington, D.C.
    Dr. Mason's research primarily investigates liquidity in 
thinly-traded assets and illiquid market conditions.
    I welcome all the panelists and recognize Mr. Altman. Thank 
you all for coming.


    Mr. Altman. Thank you, Madam Chair, and thank you for 
inviting me to testify this morning. I'm going to try to make 
five simple points, which essentially summarize my testimony 
and keep my remarks brief:
    First, one point about the origins of this financial 
crisis: One reads constantly that the housing collapse and the 
subprime mortgage crisis were the cause of this problem, and I 
don't think that's correct.
    I think those were a symptom, and, rather, the combination 
of extremely low interest rates and extremely high levels of 
liquidity, actually were the root cause.
    We had extremely low interest rates following 9/11 and the 
subsequent recession, with the Federal Funds Rate remaining 
around one percent for three years.
    We had enormous liquidity on account of the so-called 
global savings glut, to quote Chairman Bernanke, which 
particularly built up in certain developing countries like 
China, Singapore, and the Persian Gulf oil states, and the 
combination of those two, if allowed to continue long enough, 
always is lethal, and here, also was lethal.
    So the point is that the authorities will have to be much 
more vigilant in the future, when this combination of extremely 
low interest rates for a long period of time, and extremely 
high liquidity for a long period of time, again presents 
itself, because that is at the bottom of all of this.
    My second point is that this financial collapse has ushered 
in the first balance sheet-driven recession in 60 years. 
Unfortunately, the nature of that means that we are consigned 
to a sub-normal recovery. It is, unfortunately, axiomatic.
    It's a balance sheet-driven recession in the sense that 
American households lost so far, about a quarter of their net 
worth from the peak of only less than two years ago, in other 
words, around $13 trillion.
    It's a balance sheet-driven recession, because we all know 
what's happened to the balance sheets in the financial sector 
of our economy. And even the federal balance sheet, after this 
interim period of stimulus and monetary ease, will have to be 
adjusted towards contraction, in order to avoid causing unease 
amidst the public, amidst the world financial markets, the 
foreign exchange markets, and so forth.
    So, if you ask yourself how long will it take for the 
consumer's balance sheet to be made healthy again, for the 
financial sector's balance sheet to be become healthy again, as 
it relates to normal lending, the answer, unfortunately, is a 
fairly long period of time, and not consistent with any 
recovery, other than something approaching a U-shaped recovery.
    The third point, on the credit crisis itself, I want to 
echo a small point that Chairman Volcker made, which is, there 
is some good news. If you divide the credit markets into two 
parts, just to oversimplify it, and say one is the enormous 
public credit markets, which, of course, trade every day and so 
forth, and the other is the banking system, the public credit 
markets have show some signs of thaw.
    There is some good news there. The commercial paper market 
has struggled to begin to function again, the so-called high-
grade corporate market, the same, some of the key spreads in 
the short-term public credit markets have narrowed a lot.
    And I think the Fed is particularly to be commended for 
beginning to thaw out that market. The banking system, on the 
other hand, is going to remain incapacitated for some time, 
surely through 2009, as we all know.
    The fourth point, the federal policy response so far, I 
really think it has been close to heroic. Of course, it isn't 
perfect, and if you gave the authorities a chance to redo their 
decisions on Lehman Brothers, on AIG, perhaps on the original 
rollout of the TARP, I think they might do those differently, 
but, in general, I think the federal response has been quick, 
large, and rather creative.
    After all, $9 trillion of liquidity and guarantees, have 
been provided to the credit markets through a whole host of 
instruments, as you know, and I do believe that history will 
judge us rather well, even though it will take quite awhile to 
work this out, as it did judge us well, in retrospect, on the 
working out of the savings and loan crisis 20 years ago.
    Finally, on the Obama initiatives themselves, they've only 
been in office for 38 days, I believe, and they've rolled out 
four of the biggest initiatives we've ever seen. Of course, the 
stimulus program, we all know about it, but if you step way 
back, this was passed very quickly and it does meet all the 
necessary tests of speed, size, temporary and targeted.
    The improvement that they have made in the TARP, which they 
are now calling the Capital Assistance Program, I think are 
important, such the advent of the stress test, the requirement 
for specific lending targets, the limits on buybacks, 
dividends, acquisitions, and compensation.
    Then the core of this is the public/private partnership. We 
don't have the details yet, but this is an important idea; it's 
a rather courageous idea, Madam Chair, because it will not be a 
popular one.
    Why won't it be popular? Because it probably, as well see 
in the details, involves the Federal Reserve making term loans 
to investors like hedge funds and private equity firms, in 
order to try to enable them to purchase distressed assets or 
toxic assets from the institutions that have too many of them.
    That's a difficult idea, but it's the right idea. And I 
might say that with all the talk about nationalization, I'm 
happy to see that it seems to be cooling down a little bit, 
because that is not a particularly attractive idea.
    Of course, there are cataclysmic circumstances under which 
it might be the very last resort, but, fundamentally, our 
government is not equipped to manage institutions of this size. 
Nationalization would cause the weak to get weaker, because 
business customers and talent, among other things, would be 
hard to retain.
    It would take, I think, a lot longer than people say, to 
re-privatize them. There would be a temptation to conflate 
policy goals with fixing these institutions, which would delay 
their reprivatization.
    A Swedish example is not comparable, and, finally, you 
don't need to nationalize the institutions to change the 
managements or boards of directors.
    I'll stop there, in an effort to keep it short, but those 
are the main points I would like to make this morning.
    [The prepared statement of Roger C. Altman appears in the 
Submissions for the Record on page 59.]
    Chair Maloney. Thank you for your testimony and your public 
service. Dr. Posen?


    Mr. Posen. Thank you, Chairwoman Maloney, for the 
invitation. It's a great honor to be able to go on after Paul 
    I think I have to have a much more narrow focus, which will 
end up putting me much more in opposition with the last two 
points of the previous testimony, and which I hope will be 
useful to the Committee. And the reason I go on this narrow 
focus, is partly because the staff asked me to, but partly 
because I think the previous discussion ignores what's really 
going on, which is that we are in the midst of a real banking 
crisis and talking about what will happen in the future, some 
years down the road or even some months down the road, is 
    And it is costing our people national wealth and jobs and 
security right now, and it is within the power of both Congress 
and the Administration, to stop it right now, and there are 
proven ways to do this.
    The good news is that Sweden is relevant, Japan is 
relevant, the savings and loan crisis is relevant. There's a 
core dynamic to every banking crisis, and we know what that 
dynamic is and we know how to respond to it.
    So let me try to recap for you, what those aspects are, and 
make some notes on the places where I think the Obama 
Administration's proposals so far do and do not live up to best 
    The first point is, we do have to recognize that the money 
is gone from the banking system, and right now, we're in a very 
strange private/public hybrid state.
    And in this situation, Paul Volcker spoke about how much 
government intervention there already is. We can't pretend that 
there's a choice between government not knowing how to manage 
institutions, government already is backing and guaranteeing 
these institutions to an extraordinary degree.
    And what we know from the experience with Fannie and 
Freddie, among many other countries and many other times, is, 
these kinds of public/private hybrids are worse than the 
institutions that are cleanly public or cleanly private.
    Basically, the managers and shareholders who remain in 
control, play games with the public's money. If they win, they 
retain the profits and they retain their jobs and they retain 
their shares, and if they lose, the losses go to the taxpayer.
    So when the Secretary of the Treasury says these banks will 
then have six months after another two months of stress testing 
to get new capital, they are putting us all at risk for an 
extended period and we are likely to see much larger losses, as 
well as a drag on the economy, as well as an ongoing risk of a 
collapse, unplanned, by one of these institutions.
    These are half measures, and we should not settle for that.
    The second point is, therefore, we should take what is 
being called the ``stress test,'' and without hesitation, go 
through the banking system and mercilessly decide who shall and 
who shall die.
    Here, I agree very much with the written testimony of Mr. 
Altman. There's a standard way to triage banks. You basically 
say, there are some that either have enough capital or very 
close to it; you give them a little pat on the back and you 
send them on their way, and they generally get a boost from 
being shown to be better than the others.
    There are some that are small, short of capital, but 
clearly viable, with relatively clean bad assets. You sell 
those off quickly, you may merge this company with another one, 
and that's doable.
    The third category are the banks that are truly insolvent, 
and here, there's two subcategories: There are small ones, like 
Indy Mac, you close them.
    There's large ones that are systemically important. Those 
are the ones that are, of course, the problem, and those are 
the only banks that we should be talking about nationalization.
    Now, what do we mean by ``nationalization''? As has been 
said, it's a red-flag word, people get very scared of it, we 
can go into that in the discussion.
    Essentially, it means the government, on behalf of the 
taxpayers, takes control of the voting rights and the profits, 
and probably replaces many of the current board and top 
    And the reason you do this, is the same logic as when you 
do a merger or acquisition in the private sector. You have a 
company to restructure and you're putting up the capital, you 
want control and you want the upside on the other end. The 
American taxpayer deserves no less.
    It is actually relatively feasible to do that, and you can 
talk about temporary nationalization. No one in their right 
mind, wants governments controlling banks for a length of time. 
I've been criticizing the Europeans about this for a long time, 
but it also is not so unprecedented, and if we can determine 
the world price for corn, because of ethanol, if we can bail 
out GM and Chrysler, we can manage to deal with a couple of 
    Finally, we should be moving forward with an RTC model, and 
this actually is the other point where I must differ with Mr. 
Altman and my friends in the Administration. This attempt to 
create this complex private/public, non-bad, aggregator, 
pseudo-bank-bank to get through the banking system, problems 
and bad assets, is too clever, by half.
    I appreciate the motivations. They want to make sure 
there's less taxpayer money up front, in part, because they 
don't want to go to you all, and they want to get what they 
call ``price discovery,'' which is, accurately, get some basis 
for pricing these assets.
    It, however, will not work. They are not fundamentally 
changing the nature of any of these assets, if they do not own 
them. So the only value of these assets, the change, is 
whatever subsidy the government transfers by guarantees to 
these private investors.
    Therefore, you're basically subsidizing them to take the 
stuff. To whatever degree there is limited price discovery, 
there will be what economists call ``lemons problem;'' the 
private actors will buy the good stuff and they will leave the 
taxpayer and the government with the bad stuff, which then will 
have less of an up side, and we will have given away the up 
side on the good stuff.
    There is also an additional advantage, if we keep it as a 
wholly-owned government RTC, because there are all these 
sliced-and-diced securitized mortgages and other things out 
there, and that is the real reason many of these securities are 
toxic, because you're so removed and it's un-transparent from 
those, and only the government, by buying a majority or 
supermajority share of the outstanding assets in these various 
classes, can then go through the laborious work of putting them 
back together.
    The analogy is, when the EPA buys a Superfund site. That 
real estate is useless to people, they can't live on it, but if 
you send in the right people and detoxify it, that real estate 
is then worth something again.
    But you actually have to do the cleanup; you can't say, I'm 
going to give you a mortgage on this toxic waste dump and 
you're going to want to live there. That is effectively what is 
being proposed at present, with this private/partnership 
scheme, which forgoes much else.
    I will skip over a remark about the size of banks. That was 
raised earlier. I'm happy to talk about this.
    I would just say one more thing in terms of urgency. It is 
clear that whatever the good intentions of the Obama 
Administration are, they are not proceeding with the level of 
urgency regarding the banking crisis that I think we need.
    Essentially, it can be done within a couple of years; it 
can be done if we start now, probably mostly within 18 months. 
The fact is, we have 18 months till the stimulus package runs 
    The only way the U.S. is different from all these other 
countries' banking crises, is, we're able to borrow money to 
offset the misery of doing a bank cleanup. The banking crisis 
is the same, and if we don't get the banking crisis fixed 
before the stimulus runs out, we're just going to be more 
miserable at the other end. Thank you very much for the time 
    [The prepared statement of Adam S. Posen appears in the 
Submissions for the Record on page 62.]
    Chair Maloney. Thank you very much. Dr. Mason?

                           BERWYN, PA

    Dr. Mason. Thank you, Chairman Maloney, Ranking Member 
Brownback, Members of the Committee.
    My testimony outlines three primary suggestions for short- 
and long-term change. The macroeconomic understanding of 
financial crises that we're dealing with here, is that they 
don't cause recessions, but they prolong and deepen them.
    So, until the crisis is resolved, fiscal and monetary 
policy will merely push on a string. Among the key weaknesses 
I'm going to discuss, are classic problems like too-big-to-
fail, insufficient accounting transparency, and textbook asset 
market overhang.
    The unifying theme of all these, is restoring credibility 
of the U.S. financial system.
    On the subject of too-big-to-fail, the too-big-to-fail 
doctrine has yet to be resolved for nearly 20 years now. The 
latest incarnation has been justified by what we're now calling 
systemic importance of some institutions over others.
    Systemic importance, however, is a specious and potentially 
dangerous concept. In fact, the systemic nature of today's 
problem lies only in the degree to which large banks managed to 
enter business arrangements that they themselves and regulators 
were reluctant to monitor.
    Merely ignoring risk, does not make it justifiably 
systemic. In fact, the systemic risk debate is distracting from 
the real issue.
    Too-big-to-fail hinders economic growth when it embeds 
value-destroying lending in our financial system.
    There's a lot of talk about ``the banks'' lately. There are 
three classes of banks in the system right now, as Dr. Posen 
discussed: The insolvent, the marginally solvent, and the 
    Insolvent banks, regardless of their purported systemic 
importance, are value-destroying institutions that need to be 
closed. If insolvent banks were car companies, they would be 
relying on worn machinery and ill-trained staff, to produce 
East German Trabants that break down as soon they leave the 
production line.
    In fact, the loan products these banks created, did break 
down almost immediately after they were produced, exhibiting 
early payment defaults and often involved payments and fees 
that a borrower could not afford.
    The mortgage delinquencies we see today, are, therefore, 
the result of faulty management, bad supervisory systems, 
faulty proprietary software, and ineffective employee training 
at these institutions, not mere exogenous economic shocks. The 
banks that produced those products, are insolvent as a result, 
and need to be broken up, not supported.
    While the economy does need loans to fuel economic growth, 
it needs high-quality, value-creating loans, that borrowers 
stand a chance of repaying. Government recapitalization 
programs with appropriate limits on management and insistence 
on institutional reform, can possibly benefit marginally-
solvent institutions that present the possibility of supporting 
economic growth by creating, rather than destroying value.
    Still, while marginally-capitalized banks can be 
stabilized, their mere stability will not significantly fuel 
economic growth. Policy, therefore, needs to focus on relieving 
the economy of the value-destroying loans produced by the now 
insolvent banks, financially and operationally restructuring 
the marginally-solvent banks, and, thirdly, building economic 
growth upon the lending platforms of value-creating, solvent 
banks that are still open.
    But that leads to the issue of transparency. Who are these 
solvent banks? We can't tell. Commonly produced, standardized 
financial ratios, are meaningless in today's markets, and, 
without information, investors don't know the value of their 
holdings, they can't sell those holdings, and they can't 
rationally allocate funds derived from those sales, if they 
    Without funds, firms can't invest in new projects that 
create economic value, that is, jobs, income, and growth.
    Nonetheless, FASB continues to adhere to a policy of 
reporting a single value for every asset. But in a off-balance-
sheet world of contingent claims backed by fuzzy reputational 
risk and statistically modeled values for Level II and III 
mark-to-market assets, a single value is not only inadequate 
for accounting purposes; it's grossly misleading.
    Investors want to know the entire exposure to off-balance-
sheet items and the range of statistical model values that can 
be reasonably expected to apply to Level II and III assets, 
that is, the standard errors of the estimates.
    Such information allows investors, including all manner of 
bank counterparties, to truly stress-test firms' financial 
characteristics on their own in a transparent way, without 
being filtered through Treasury's secrecy and interpretation.
    That still leaves the problem of market overhang. Asset 
market overhang is today being perpetuated by a dogmatic policy 
approach to home ownership and archaic bank regulations that 
stand in the way of quick recovery.
    If we view the housing crisis as merely one of occupancy, 
rather than ownership, policy solutions are readily at hand. 
The common understanding of the problem, is that foreclosed 
homes are dumped on the market at fire sale prices, and those 
prices push values down in surrounding neighborhoods.
    But while focusing on the foreclosure part of the problem, 
we're missing the important part: the fire sale that pushes 
down asset prices. Fire sale prices result not because lenders 
want to sell at a loss, but because they are forced to do so. 
They do not have the legal ability to manage real estate and 
that ability could greatly relieve pressures on home pricing.
    But even without such pressure, we still have a big hole in 
the loan servicing market. Loan servicing is a wildly 
subjective industry. Right now, forthcoming research and news 
reports are already showing that many companies claiming to be 
special servicers are really run by the same managers that 
owned the failed subprime mortgage companies, entering the 
business to fleece borrowers further and collect the thousand 
dollars per head fee offered under the most recent housing 
    Even worse, modification frauds have been reported to be 
proliferating throughout the country, praying on the same 
uninformed consumer that got the unaffordable subprime loan.
    The fact is, servicing quality matters; it's crucial to 
loan value, and, of course, borrower success in repaying the 
loan. But the servicing industry needs to be kept in check.
    Investors and borrowers alike, are at the mercy of a 
servicer who's making a judgment call as to whether a mortgage 
is salvageable or not. Moreover, that judgment call is made 
with virtually no direct oversight.
    So, as regulators are learning, servicer accountability and 
reporting is woefully inadequate and, unfortunately, absent 
from the discussion right now. It needs to be paid a great deal 
of attention.
    But in closing, I want to say that it's very fitting today 
to have Chairman Volcker before us on the first panel. The 
Chairman presided over a Federal Reserve at a time when we 
first learned of natural rates in the economy.
    We learned then that attempts to push unemployment below 
natural levels, created perverse economic effects. The recent 
push to drive home ownership rates to 100 percent, and 
substitute debt for income, has had similar perverse effects.
    As before, the only way out, is to move through the 
downturn. I only hope we can learn from Chairman Volcker's 
example, and exhibit the courage to do so. Thank you.
    [The prepared statement of Joseph Mason appears in the 
Submissions for the Record on page 71.]
    Chair Maloney. Thank you very much. I thank all of the 
panelists for your very important testimony.
    Mr. Altman, as the former Deputy Secretary of the Treasury 
during the RTC challenge--and I believe you managed the RTC 
challenge--could you share with us, some insights between that 
challenge and the challenge we confront now, any differences, 
and if you could respond to some of the points that Dr. Posen 
put forward, that taxpayers may be called upon to assume too 
much of the loss in the toxic assets, and his particular 
proposal that is similar to the Sweden approach, and your 
response to it? Again, thank you very much for your time and 
for being here.
    And thank you for giving us some positive indicators from 
the private sector. That was very good to hear.
    Mr. Altman. The RTC case, first of all, is one we can learn 
a lot from and probably has not been delved into as much as it 
should as a guide to what we may be doing now from a public 
policy point of view.
    You may remember, and other Members may remember, that at 
the time the RTC was the most popular--excuse me, unpopular 
organization ever created. It was hugely unpopular. Absolutely 
no one liked it. And it was the object of not just criticism 
but investigations, and so forth.
    Now the conventional wisdom at least is that the U.S. 
addressed the savings and loan crisis in general, and also 
through the RTC, swiftly, effectively, and that it is a model 
for how to address a financial crisis of that type.
    I said in my testimony that I think that despite the 
enormous challenges we face today in the depths of this crisis, 
I do think that the United States, if you step away back and 
think of this in broad historical terms, is addressing this 
crisis swiftly and creatively and that ultimately history will 
render a similar verdict as it has now done mostly on the S&L 
    However, what are the cautionary lessons from the RTC 
experience? First of all, it took the RTC--and this is 
partially a response to Dr. Posen's point on a bad bank--it 
took the RTC, Chairwoman Maloney, a long time to get up and 
running because that is the nature of things. If someone said 
to me: Well, how long did it take? And I was not there in the 
early two or three years. You know the Clinton Administration 
came into being in 1993 and the RTC was formed some time around 
1990. But it took about three years for it to become fully 
operational. Because it was building a large institution from 
    So if we were to go the bad-bank route--and I think it is a 
close debate; I mean, I want to say that Dr. Posen made good 
points, it is a close debate as between for example the public/
private partnership approach the Administration has put forward 
and a more aggressive approach towards a so-called bad, or 
aggregators bank--but if we were to do that, it would take, it 
would simply take a long time to make that operational.
    You would be talking about building an enormous financial 
institution from absolutely ground zero. It does not mean it is 
a bad idea, it just means that it is not something that would 
come into being effectively very quickly.
    I think the other point I would make about the RTC is that 
it was very widely criticized at the time for the first several 
rounds of auctions where it sold, quote, ``bad assets'' into 
the market as it was statutorily charged to do, and some of 
those who purchased them in the early auctions ended up making 
a lot of money.
    You probably remember that controversy. But in retrospect, 
was that really a problem? The assets were auctioned. In the 
early going there were not many buyers because the market for 
those assets that were so distressed had not developed very 
well. And so the early buyers who took considerable risk ended 
up doing very well.
    In general I do not think that is a huge problem. And so if 
we were to set up this public/private partnership and, yes, the 
nature of it is that the investors will receive preferential 
financing in order to incentivize them to participate. And if 
the investors ultimately do well, as long as the ground rules 
are clear and the restraints are sufficient, I do not think 
that is something to be feared or to be--or to do everything 
possible to avoid.
    But I would basically say in regard to the points that Dr. 
Posen made, it is a close argument. If we go the public 
partnership--public/private partnership route, the taxpayer 
will have to participate very strongly in the profits. So if 
this turns out to be, as I believe it will, that the Federal 
Reserve provides term financing to investors, and those 
investors or organizations like hedge funds and private equity 
firms and so forth, the taxpayer will have to be eligible for a 
high percentage of the profits that those organizations get. 
That is the only fair way to do it.
    I think that is how it would have to be set up, and that is 
how I would answer Dr. Posen's point on that.
    Chair Maloney. Thank you very much.
    Congressman Brady.
    Representative Brady. Thank you, Madam Chairman.
    I do think the RTC looks much better today than it did when 
it existed. I was in Texas running a Chamber of Commerce. We 
had many of the banks that failed in the community, and I will 
tell you the RTC in my view, in real-life, delayed the economic 
recovery of our communities.
    They had no real knowledge of the value of the properties 
they were holding. They were very slow to respond. We brought 
purchasers, we brought investors, couldn't get answers for 
literally, I do not exaggerate, years on properties.
    And there was no transparency. It was like a black hole. I 
do think, having gone through it once, I think if it were to be 
revived there are some dramatic lessons that we can learn from 
how it can be applied.
    Because the end result was the taxpayers did not lose 
dollars, and eventually those properties got transferred. But 
there is a lot to learn from that experience.
    I do think--I agree with all of you--the sooner we force 
these assets, bad assets, to the surface the quicker we are 
going to get consumer confidence back in the economy.
    I really appreciated the testimony from all three 
witnesses. Dr. Mason, you talked about how existing policy 
proposals have been all about suppressing information, 
information about bank conditions, other sources of risk, even 
about government programs. And you talk about the fact that 
investors want more. They want more information here, and you 
talk about investors wanting to know the range of statistical 
model values.
    In other words, investors want to stress-test financial 
characteristics on their own. They want the ability to 
determine this value. How do you go about doing that? And 
rather than having the government apply a stress test and then, 
do certain actions, you are talking about increasing 
information dramatically, significantly, so investors can run 
those stress tests.
    How do you do that?
    Dr. Mason. Well to get at this, I'll start by saying I 
testified previously on FASB reform and I made the point there 
that unlike previous crises the assets that we are dealing with 
here are structured finance assets. Over the last two years we 
have learned kind of Securitization 101 which involved the idea 
that the bank sells loans into a pool, and then the pool funds 
its purchase of the assets from the bank via securitized bonds.
    That is Securitization 101. We need to get to 
Securitization 102, which is that that sale was never really 
complete; that there were side agreements. There were 
contractual agreements, too, but the additional side agreements 
that could never be contracted to stipulated that, if anything 
happens adversely to this loan pool's performance, I as the 
bank will take it back and I'll make it good for investors.
    That is incredibly important. Because over the years from 
the mid-1990s on bank regulators allowed this over and over 
again in violation of their own regulatory policies. FASB 
enshrined us in their own rules such that a greater degree of 
this activity could go on.
    So at the end of the day you get a ratings agency who comes 
in and rates this. And quite rationally they look at it and 
they say, well, the condition of the loans in this pool doesn't 
really matter; what matters is whether this bank is going to 
support it at the end of the day. And since the bank always 
will because it wants to issue next month, and the month after 
that, and the month after that, and the month after that, then 
we can call it whatever we want to: AAA. And this is all just a 
big farce.
    So finally we have come home to the end game in this where 
the bank does not support it anymore. So now both the bank 
investors as well as the asset-backed securities' investors 
want to know, Mr. Bank, how much did you sell? How much do you 
have out there that people want supported?
    If you're not going to be able to sell any more, which 
banks cannot right now, then how much does your capital support 
both in your contractual obligations to support these pools, 
and any additional obligations you have to the government under 
TARP to increase lending or anything else?
    Banks do not have the capital ability to expand. When you 
live in a world where you make a loan and you sell it out the 
back door, you do not keep the capital on your balance sheet to 
make a loan and keep it in the bank. And that is why we are at 
a standstill right now.
    You cannot reasonably expect these banks, when you give 
them capital to shore them up just to basic solvency, to lend 
if they cannot push the loan out the back door. The Fed 
facilities are for secondary market securitizations. There 
really is no market to sell this into.
    If we wanted to talk for an hour, I could give you example 
after example from securitization history from the early 1990s 
to the present where we have seen this demonstrated time and 
again. It is not unknown to the industry.
    Representative Brady. Thank you, Madam Chairman.
    Dr. Mason. But this is the way the world works.
    Chair Maloney. Thank you. Congressman Hinchey.
    Mr. Hinchey. Thanks very much. And thank you, gentlemen, 
for being here and for the very interesting testimony and the 
comments and responses to questions that you have given. I 
appreciate it.
    It is a very interesting problem that we are dealing with, 
and one that is very serious and very difficult. Over the 
course of the last several months there have been some shifting 
changes in ways in which this needs to be dealt with, and 
focusing on this wide spread and worsening financial crisis. It 
is not getting better. It is continually getting worse, as you 
pointed out.
    Last September of course we remember the Bush 
Administration and Secretary Paulson came in and asked for $700 
billion to deal with the banking crisis and thought that, in 
their expression to the Congress, that that would be a major 
contribution to taking care of the problem.
    But it was not very long after that bailout legislation was 
passed that they shifted the strategy and started something 
called the Capital Purchase Program, and several other capital 
infusion programs.
    The effect of that has been very interesting. Over the past 
few months the Federal Reserve, for example, engaged in huge 
lending facilities, and over the course of the last year and a 
half they have expanded the balance sheet from just under--just 
over, actually, just over $900 billion to now almost $2 
    With the new lending program the Fed announced over the 
past few months that we are likely to see the assets expand by 
an additional $1.6 trillion. At the same time we are still 
afraid that the major banks left standing will continue to 
become insolvent.
    The crisis they are facing affecting credit and credit 
variously, in various ways, and of course a general way, has a 
general effect on the economy.
    So what we are seeing now is the impact on households and 
small businesses. They cannot borrow. They cannot borrow, they 
cannot spend. They are having a direct effect on output, 
economic output, and obviously an economic effect on 
    As the incomes of households and firms are going down, and 
they are continuing to do so, default rates on existing debts 
are going up, and potential borrowers are becoming less credit 
    So we need to really face up to this issue, not just 
specifically with regard to individual aspects of it but we 
have got to look at this whole thing very, very carefully. So I 
am wondering what you might suggest to us is the root cause of 
the general financial crisis, and what Congress should do to 
address and solve the crisis that the banks are facing and the 
impact that the bank crisis is having on the economy generally.
    What are the orders of priority perhaps that we should be 
dealing with?
    Mr. Altman. Well, Congressman, I said it in my testimony 
that I thought the root cause of it was not, as so many people 
say, the twin housing and mortgage collapse, but rather that 
that was a symptom, and that the root cause was a combination 
which I would argue would always be lethal if allowed to 
continue long enough--and in this case it did--of extremely low 
interest rates and extremely high levels of liquidity.
    Because if you think about it, if you have enormous 
liquidity which we saw build up in locations like China, 
Singapore, and the Persian Gulf oil states and then recycled 
back to the West, particularly the U.S., and that liquidity is 
facing very low yields because the levels of interest rates 
were so low given the Federal Reserve's stance, it is like 
water running downhill. It seeks out higher yields.
    And the way you find higher yields is to look for weaker 
credits, because the weaker the credit the higher the rate that 
credit has to pay. It is one of the iron laws of finance.
    So these giant amounts of money were seeking out weaker 
credits. Well, they sought them out everywhere but the easiest 
way to find them was in the mortgage market, which is one of 
the deepest and most liquid in the world, and of course the 
weak part of the mortgage market is subprime.
    But it was that combination of very low interest rates and 
high liquidity which drove this crisis through. So housing 
prices, which had averaged 1.4 percent rates of appreciation 
for 30 years, because of the huge amounts flowing into the 
mortgage market which then allowed so many homes to be acquired 
which might not otherwise have been, rose ultimately to 11 
percent. We had an 11 percent increase in home price 
appreciation at the peak. And of course it was not sustainable, 
and the rest is history. So that is my view on what the root 
cause was.
    As for how we should address it, I happen to think that in 
the past year--and particularly the Obama Administration in the 
past month and a half--is addressing it very, very 
aggressively. These four steps--the Stimulus Plan, the Adjusted 
TARP, it's been substantially adjusted; the proposed public/
private partnership, and we'll have to see the details on that; 
and then the attack on the mortgage and housing problem which 
has been laid out now--represents a very aggressive program. 
And I think it is a good one.
    Is it perfect? No, it is not perfect, but it is a sound and 
good one which, to lay out in 38 days is a pretty Herculean 
achievement in my book.
    Mr. Hinchey. Well I appreciate what you just said in 
response to that, and I think that the example that you use in 
the answer to the question is consistent with what you said in 
your testimony which I think is very factual and seriously a 
part of the problem. We have seen it in the past. We see it 
    But we have also seen major manipulations of investment, 
and falsification of information in the context of bonds, huge 
ones, huge falsification, huge bonds, and a lot of that has to 
do with the repeal of the Glass-Steagall Act and the way in 
which the whole manipulation of financial investment then was 
just brought into play.
    So I am just wondering. Maybe Dr. Posen might want to 
comment on that and give us some insight.
    Mr. Posen. Thank you, Congressman.
    If you ask a central banker like me what is wrong, I will 
say monetary policy was right, regulation was wrong. If you ask 
a private banker or a Treasury person, he or she will tell you 
monetary policy was wrong and regulation was right. So 
obviously you have to sort your way through the biases.
    But essentially unbidden from that I would have started out 
with a variant of what you said as the root cause. It was not 
so much we deregulated excessively, it was that regulation was 
not allowed to keep up with financial developments for the last 
15 to 20 years. And supervision was actively discouraged for 
much of that time.
    Ned Gramlich, the late former Federal Reserve Governor, has 
documented this very clearly in how the Federal Reserve let us 
down in the mortgage market. There has been good reporting 
about the opposition to having any sort of regulation over 
    There was the failure to decide to let SIVs, various off-
balance-sheet vehicles be taken seriously as part of the 
mandate. I mean, essentially what happened was you had the 
Sandy Weills of the world coming to see Alan Greenspan in the 
mid-1990s and saying, look, there is an uneven playing field. 
It is what Krugman now calls the Shadow Banking System. Here 
(indicating one level) and we are here (indicating another 
level), and I want to compete. Give me an even playing field.
    And the way that could have been dealt with was to bring it 
more into line, and including putting more regulations on the 
advantaged part of the field, the nonbanks.
    Instead what happened was everything was done to use 
Federal Reserve and supervisory discretion to ease the 
regulations on the traditional banks. And so that ultimately 
was the core of the problem.
    Monetary ease certainly helped. But if there had not been 
monetary ease you would still have had much of the same 
outcome. It is only if there had been extreme monetary 
tightening could you have prevented that.
    So where do we go from here? Actually it is funny, given 
the differences in analysis. I actually very much agree with 
Mr. Altman in terms of what are the components of the 
    We have the Stimulus. I commend the Congress and the 
Administration for getting it through. It is not perfect, but 
it is good. That will put some check on how far down things go, 
and that buys us time.
    We are going to do some kind of asset assessment on the 
banks, and we are going to have some form of getting the bad 
assets off the books. Again, we can disagree about the 
particular ways. My concerns are more about what the taxpayer 
gets in return, and what is the accountability. But in the end, 
if you do a bad job of it it is only money. But the important 
thing is getting that stuff off the banks.
    Another piece of it, I am less concerned frankly about 
direct interventions in the housing market. Another piece of it 
though is we do have to do the kind of long-term down payments 
other Members on this committee were talking about to Chairman 
Volcker and that the President spoke about the other night, 
because that is what allows us to keep the interest rates 
anchored so we can fund the things we need to fund.
    So in point of fact, the disagreements matter a great deal 
for what happens when you all sit down to restructure the 
system going forward, but there is a very wide range of 
economists and policymakers and business people from right to 
left who largely agree on the prescriptions, and there is a 
good reason for that.
    Chair Maloney. Thank you.
    Mr. Hinchey. Thank you.
    Chair Maloney. Secretary Volcker talked about moving 
forward and how we would face this financial restructuring, and 
he mentioned it should not be done in a piecemeal way, but in 
an overcomprehensive way, and how possibly capping leverage, or 
restricting leverage, and having functional responsibilities of 
banks returning to their primary responsibility, whether it is 
commercial banking, insurance companies just doing insurance.
    Would you comment, starting with Mr. Altman, on how you see 
the restructuring that we confront going forward?
    Mr. Altman. Well Chairman Volcker I thought made a very, 
very important point, which was that we need a broad overhaul 
of all financial regulation. And I might say it seems to me 
that the Administration and the Congress are going to put one 
in place.
    But, that we should start from a full-fledged blueprint 
rather than try to do it, as he said, piecemeal. Because this 
is regulatory reform of the most complex and most important 
    Chair Maloney. Um-hmm.
    Mr. Altman. There are a series of proposals, or frameworks 
which have been put forward, most particularly the Group of 30 
Framework with Chairman Volcker himself chaired and the report 
that he had with him today, which I am sure my fellow panelists 
also have read--it is a really good starting point--but Tim 
Geitner testified on this extensively a couple of times here 
before the Congress as President of the Federal Reserve Bank of 
New York, and his testimony really provides an important 
blueprint there.
    And of course Secretary Paulson laid out a blueprint 
himself almost a year ago--it was March of 2008--under very 
different circumstances, but some parts of that, like merging 
some of the regulatory agencies will still stand the test of 
    This is going to be a very big job, I would think the 
number one job for the two Banking Committees, and it is 
probably going to be tough and long, because there are so many 
vested interests at stake, and it is very complicated. But if 
you stop and think about it, we have had the greatest 
regulatory failure in the modern era here, the single greatest.
    Put aside any other regulatory example, this is the 
greatest failure we have ever seen. And it is really quite 
across the board. And it is the greatest cry, so to speak, for 
regulatory overhaul any of us will ever see.
    So we need to do this right. I suspect it will take most of 
2009 to do this, from a legislative point of view. It could 
even slip into 2010. But we really need to do it right. And it 
is a big, difficult job. We have nine separate financial 
regulators. That does not make sense.
    We ended up having two banking systems--one what we think 
of conventionally as the banking system; one, as Dr. Posen 
referred to, as the Shadow Banking System, that ended up being 
just as big as the other one, but it was unregulated. It was 
highly leveraged. It financed itself primarily on a short-term 
basis. And it was the source of most of these problems, not all 
of them but a lot of them.
    Investments banks, mortgage finance companies, and so 
forth. So we need to have, as Mr. Volcker and others have said, 
for institutions that are, you can call them systemically 
important, you can call them important participants in the 
money market, they need to be subject to the same regulatory 
framework from the point of view of prudential supervision, and 
they need to be subject to the same regulator.
    That is probably the single starting point. But this is 
going to be very complicated and very, very important, because 
we cannot allow a collapse like this to occur again.
    Chair Maloney. Thank you.
    Dr. Posen, and then Dr. Mason, for your comments.
    Mr. Posen. Thank you, Chairwoman Maloney.
    I want to pick up exactly where Dr. Altman left off, Mr. 
Altman left off--Secretary Altman, whatever--Roger---- 
    Mr. Posen. Very gracious. This being the biggest regulatory 
failure and it cutting across a wide range of points, and I may 
actually preempt a bit Professor Mason because I want to pick 
up on a couple of things he said in his opening remarks.
    Which is, a lot of this had to do with too-big-to-fail, or 
too-systemic-to-fail, and fears about that.
    And (b), a lot of this had to do with the central bank and 
the supervisors having too much discretion. I mean, that was 
sort of the underlying theme of many of the questions asked of 
Chairman Volcker before and being asked now, which is:
    Okay, we have a lot of rules in place. Some of them were 
not enforced. We had a lot of inconsistency across regulatory 
agencies. We had a general sentiment over a certain number of 
years not to overregulate, or oversupervise, and whoever was in 
office adhered to that.
    And so I think moving forward the Congress and the 
Administration have to think about a very fundamental change 
not just in the structure but in the nature of it.
    We have to move even more, to my mind, to a rules-based 
system with very simple, very clear rules: that you do not get 
a lot of discretion to enforce in some black-box way. And we 
can go into the value and risk models and all these things that 
the banks were allowed to do for self-enforcement.
    In addition, I think one of the things which was raised in 
the G-30 Report, which I also commend, is the idea that if you 
take too-big-to-fail seriously you have to take seriously the 
fact that you do not want to have banks that are necessarily 
that big.
    I think in the end there is a sentence there, and Chairman 
Volcker's testimony today where he backs off that a little bit 
and says, well, but you will inevitably have a certain number 
of very large institutions, systemically important institutions 
and you just have to watch them extra carefully.
    I am not entirely sure that we have to make that 
compromise. I think, no, there are not anti-monopoly reasons to 
break up large institutions, but if, God forbid, as I fear may 
happen, the U.S. Government ends up owning significant shares 
of a number of systematically important institutions, it is 
going to have to make a choice about the structure anyway. And 
it may be possible to break those up as part of the reselling 
them back to the private sector.
    Chair Maloney. Thank you. Professor Mason.
    Dr. Mason. Thank you. I am going to pick up on a little bit 
of both, what both of you said with respect especially to rules 
and to functionality.
    Really I view the source of this crisis as originating back 
with the imposition of Basel I and attempting to regulate by a 
rule which we called a ``regulatory capital ratio.''
    When that happened, in fact on the tail end of a recession, 
a lot of banks could not make that regulatory capital cutoff 
and they also could not find new capital so they found 
securitization as a very handy way to reduce assets instead to 
manage the regulatory rule.
    So any time government lays down a rule, Wall Street 
immediately puts to work thousands if not millions of attorneys 
to figure out how to get around that rule and arbitrage that 
somehow. And I think that is a very important element that 
needs to be built into any new regulatory framework, just the 
admission that millions of minds are going to think about how 
to arbitrage this and they probably will figure it out. And so 
the new regulatory system has to be flexible and dynamic in 
order to keep pace with the Street.
    In terms of functionality, I see functionality as beginning 
with what Chairman Volcker talked about, which is really going 
back to First Principles and really, really basic First 
    Imagine if we are setting this system up for the first 
time. We think of a financial system as having an array of 
institutions, some of which take a lot of risk and operate 
unregulated and do whatever they want, and others are very 
constrained in the public interest.
    We need to decide who those institutions are and what they 
are going to be called. Once we set that up, then we have 
certain gravitational conditions you can call them, basically 
risk can travel from regulated to nonregulated firms but it 
probably should not be flowing the other direction; otherwise, 
you are setting up a regulatory arbitrage and the kind of 
problems that got us to the current crisis.
    So identify what those risks are and how they are supposed 
to flow. Then, when you have a regulated commercial banking 
system that is funding itself in an unregulated market system, 
you know risk is probably flowing the wrong way and you stop 
    This also gives us a way to think about fungibility of 
risk. Risk can transform. In fact, in what I described earlier 
about securitization, we had risk being transformed from 
contracted credit risk claims to uncontracted reputational risk 
    We need to think really hard about, again, how financial 
institutions are working to get around the rules so that we can 
always at least keep pace with them in the debate.
    One thing I noticed through my years at OCC is that the 
Street has many more attorneys than the regulators do. They are 
always going to be out in front. That is fine. But we can still 
do a much better job of keeping pace. Looking back through the 
industry we can point to industry expressing concerns with all 
the weaknesses that are faced with us today to regulators who 
refuse to listen.
    Chair Maloney. Thank you very much. I just would like to 
announce that Members may submit their statements and questions 
for the record.
    I thank all the panelists, and the meeting is adjourned. 
Thank you.
    [Whereupon, at 1:08 p.m., Thursday, February 26, 2009, the 
meeting was adjourned.]
                       SUBMISSIONS FOR THE RECORD

                 Prepared Statement of Carolyn Maloney
    Good morning. I want to welcome former Chairman Volcker and our 
other witnesses and thank you all for your testimony today. Chairman 
Volcker, when it comes to understanding the economy and financial 
markets, you are in a league with only one player.
    Over the past two days, we have heard rather sobering testimony 
from Fed Chairman Bernanke that, even under the best of circumstances, 
our economy remains perhaps a year away from making a full recovery. 
The problems plaguing the real economy and the financial system are 
intertwined, so it is critical that we act as swiftly as possible.
    At the core of the ongoing liquidity crisis is the decline in home 
prices. Home prices continued their free-fall at the fastest pace on 
record in December. Since the beginning of this crisis, Congress has 
been working on keeping families in their homes. We are now working 
closely with the new Administration to reverse the deepening decline in 
home prices. Today, the House will consider H.R. 1106, the Helping 
Families Save Their Homes Act, which is designed to spur loan 
modifications and avoid bankruptcy for homeowners.
    Strong indications are that this downturn could be the worst in the 
post-World War II period. The current recession, which began in 
December 2007, has caused massive job loss and a precipitous decline in 
economic growth. Congress recently passed the nearly $800 billion 
American Recovery and Reinvestment Act (ARRA), which provides fiscal 
stimulus in the form of aid to state governments, infrastructure 
spending, increased unemployment insurance and food stamps, and tax 
breaks to middle class workers and families. This package is designed 
to stem the real human costs and our economic losses by creating 
millions of jobs, helping families in need, and investing for the 
    The concern is that effects of our recovery package may be blunted 
if the financial crisis lasts too long. The Federal Reserve has taken 
extraordinary steps to maintain the operation of our financial and 
credit markets, but clearly, we need a comprehensive plan to return to 
well-functioning markets. In his address to Congress Tuesday night, the 
President pledged to work with Congress to adopt new ``rules of the 
road''--a reformed financial regulatory structure to prevent future 
crises and hold financial executives accountable.
    Our entire regulatory system is in serious need of renovation. It 
failed to properly identify risky mortgage-related assets. It did not 
recognize that these risks were being concentrated in highly-leveraged 
and important financial institutions. And it failed to anticipate the 
dangers posed to the financial system as a whole by these 
concentrations of risk. It also failed to provide mechanisms for 
dealing with the failure of important non-depository financial firms.
    These shortcomings must be addressed. Regulators must obtain better 
information, better measures of systemic vulnerability, and the 
authority necessary to head off threats to financial stability. It is 
obviously too costly to leave the regulatory system as it is.
    As winter turns to spring, my hope is that these efforts will break 
the downward spiral of our economy and bring about a thaw in credit 
markets, but even more may need to be done.
    I look forward to our witnesses views on reviving our economy and 
restoring our financial markets.
              Prepared Statement of Senator Sam Brownback
    Thank you Chairwoman Maloney for arranging today's important 
hearing and thank you Chairman Volker and members of our second panel 
for testifying today.
    Our economy is in the midst of a serious recession and many 
Americans are suffering from job losses, home losses, and uncertainty 
about their retirement savings, their jobs, and their children's 
future. Unfortunately, in addition, our financial system remains a 
    I would like to begin by assuring every American that I am acutely 
aware of the pain and suffering that they feel. I also would like to 
assure them that, as always before, we will join together to confront 
our challenges head-on and emerge strong.
    Given the severity of the economic downturn that we face, and 
efforts already under way to try to offset the downturn, it is 
absolutely clear to me that the very last thing we want to do is raise 
taxes. We know from experiences in the Great Depression and elsewhere 
that moves to stimulate an economy can easily be overwhelmed when the 
government also tries to raise taxes to shore up its budget. 
Unfortunately, in the midst of our current economic difficulties, there 
are those who wish to raise taxes using class-warfare rhetoric.
    We cannot afford ``tax cuts for the rich,'' according to the 
rhetoric. Yet, we know that, because of complexities in our tax code, 
there are many small business owners who declare business income as 
personal income, and many of those fall into the category of ``the 
rich.'' Those small business owners often plow their incomes back into 
their businesses and, by most definitions, are hardly people you would 
think of as rich. By increasing taxes on those business owners under 
the guise of ``taxing the rich,'' we are going to end up taxing small 
business owners who will respond by reducing their business activities, 
reducing their employment of workers, and reducing their investments 
necessary to keep their businesses running and growing.
    We also cannot afford, under the rhetoric of eliminating ``tax cuts 
for the rich,'' to increase taxes on income from capital, such as 
dividends. It might be comforting to some to think that increasing 
dividend taxes will somehow get even with rich fat-cat stockowners. But 
we know that higher dividend taxes will hurt many people not ordinarily 
thought of as rich, like a retired couple counting day-to-day on 
dividend income from stock investments that they made over a lifetime 
of work.
    It is not the time to increase taxes, but the looming financial 
imbalances in our entitlement programs and significant spending aimed 
at ``stimulus'' and financial stability mean that we continue to pile 
up debt, which threatens long-run economic growth. Overconsumption, 
indebtedness, and speculation contributed to the current crisis, and 
yet the government is currently traveling down the same road with 
massive amounts of deficit-financed spending, speculating on success of 
an expansion of government and long-term spending under the guise 
ofstimulus. We need to cut the rate of growth of government spending 
and live within our governmental means.
    In the face of a severe downturn in the economy, and a downturn 
that has accelerated in recent months, and in the face of significant 
declines in stock values and homeowner wealth, it is almost 
inconceivable that there are those who wish to raise taxes. What will 
increased taxes on small business owners do to job creation? What will 
increased taxes on dividends and other forms of capital income do to 
stock values and the portfolios of every American family? Now is 
clearly not the time to increase taxes.
    In our financial system, the time has come to restructure the 
system and our regulations to prevent recurrence of a crisis like the 
one we are experiencing. One thing seems clear: we need to prevent 
speculative and highly leveraged excesses from threatening the 
stability of our entire national and global financial system. We are 
currently grappling with institutions that are deemed ``too big to 
fail.'' They have become so big, and so complex, and so intertwined 
with more stable institutions that we fear that they cannot be allowed 
to fail or the entire system will collapse.
    The large institutions engaged in highly leveraged, complex, and 
risky investments with the understanding that: on the upside, they win; 
on the downside, they will be backstopped by taxpayers because their 
institutions are too big to fail. That means private gains on the 
upside and public losses on the downside. And that is not a desirable 
or acceptable system.
    I am interested in what Chairman Volker and other panelists have to 
say on how we can restructure the financial system to avoid the ``heads 
we win, tails the taxpayers lose'' situation that has developed.
    I would also like to close by noting a recent letter sent by a 
medical doctor on the University of Kansas faculty to The Economist 
magazine regarding speculation in banking. Dr. Frederick Holmes of 
Kansas City, Kansas writes that:

        . . . responsible people and responsible institutions have not 
        hurled themselves, lemming-like, into the abyss of ruin. 
        Despite the death knell sounded throughout the media, most 
        people and most banks did not encumber themselves with 
        mountains of unsecured debt. In the conservative heartland of 
        America we have avoided the razzle-dazzle of ``sophistication'' 
        and ``computer-modelling'' when managing our finances.
        I have entrusted a locally owned bank in Kansas City with my 
        money for more than 40 years, and it has been a good steward of 
        my modest wealth. Last year the chief executive posted a brief 
        notice on the bank's website to reassure depositors. It read, 
        ``When the siren song of the subprime-mortgage market came 
        along we took the long view and turned a deaf ear.'' I am going 
        to leave my money with the folks at this bank for the next 40 
        years, for they seem to have the intelligence and common sense 
        largely absent in the leadership of large banks.

    There are many people in the heartland who are genuinely and 
rightly upset that they are now being asked to support the highly 
leveraged speculative bets placed by the big institutions that are 
``too big to fail.'' I am interested in determining how we can prevent 
this from happening again.
            Prepared Statement of Representative Kevin Brady
    I would like to join in welcoming the witnesses appearing before us 
today. Current financial and economic conditions pose serious 
challenges to policy makers.
    It is widely agreed that nothing else we do will matter much until 
the issue of how to dispose of toxic bank assets is resolved, but 
neither the Bush nor Obama administrations have devised a solution to 
this admittedly difficult problem. The recent Treasury proposal has not 
been well received because it did not clearly address this issue. The 
Economist magazine, for example, said that it looked ``depressingly'' 
like TARP I: ``timid, incomplete, and short on detail.'' The lack of 
specifics has undermined confidence and contributed to financial market 
instability. A better approach is needed to help foster recovery.
    The collapse of the credit boom and fall in related asset values 
has already wiped out many trillions of dollars of wealth held by both 
households and financial institutions, while plunging the economy into 
a deep recession. It also appears that the financial position of the 
federal government will deteriorate sharply over the next decade. The 
Congress has passed a partisan stimulus bill that relies heavily on 
deficit spending to boost the economy. However, as economist John 
Taylor noted in a recent paper presented at the annual American 
Economic Association meetings, ``there is little empirical evidence 
that government spending is a way to end a recession or accelerate a 
    The 2009 budget situation was projected to deteriorate 
dramatically, but the stimulus legislation makes the situation even 
worse. Federal spending is expected to increase to at least $3.7 
trillion, an increase of $685 billion or 23 percent in a single year. 
Federal spending as a percentage of GDP is set to increase from 20.9 
percent to 25.7 percent, a post WWII high. The huge increase in federal 
spending, along with a fall off in revenue, will push the deficit to at 
least $1.4 trillion in 2009, a record level and a staggering 200 
percent increase over its level of the previous year. The real budget 
outlook is actually considerably worse because the CBO calculations do 
not include a number of items that will further enlarge the deficits.
    The enormous increases in deficit spending will push the publicly 
held debt from $5.8 trillion in fiscal 2008 to $7.4 trillion in 2009. 
The publicly held debt as a percent of GDP is expected to increase from 
40.8 percent in 2008 to 51.8 percent in 2009, a large 11 percentage 
point increase in only one year. Moreover, the added spending of the 
stimulus bill will push this debt-to-GDP ratio to about 60 percent by 
2011. One recent paper released by the Brookings Institution suggested 
that $1 trillion annual deficits could persist for each of the next ten 
years under what the authors consider to be optimistic economic 
    The prospect of borrowing over a trillion dollars for questionable 
programs thrown together with little procedural deliberation has 
rightly given the American people pause. However, bailouts for the 
financial sector, auto industry, and others could add trillions to the 
projected debt in coming years. According to a recent Bloomberg report, 
``. . . the stimulus package the U.S. Congress is completing would 
raise the government's commitment to solving the financial crisis to 
$9.7 trillion, enough to pay off more than 90 percent of the nation's 
home mortgages. . . .'' Nearly $8 trillion of this total reflects 
lending and guarantees provided by the Federal Reserve and Federal 
Deposit Insurance Corporation (FDIC). Clearly, trillions of dollars of 
exposure to distressed borrowers does not enhance the financial 
position of the U.S. government.
    In a recent influential paper, economists Carmen Reinhart and 
Kenneth Rogoff examine the history of financial crises. Among their 
findings is that the debt of the central government jumps an average of 
86 percent in the years following a financial crisis. This would 
translate into a level of $11 trillion for U.S. publicly held debt in a 
few years. Unfortunately, current trends suggest we are well on our way 
to this kind of outcome.
    The U.S. Treasury is expected to raise as much as $2 trillion in 
2009 to finance the extraordinary financial demands placed by 
recession, growing bailouts, and stimulus measures on the government. 
Similar steps by other major countries will intensify the upward 
pressures on interest rates. The recent increases in long-term mortgage 
rates are especially troubling given the condition of the housing 
    Furthermore, the looming retirement of the baby boom generation 
will cause entitlement spending to accelerate faster and faster in 
coming decades. It is widely recognized that without policy changes, 
long-term imbalances in entitlement programs will cause publicly held 
federal debt to balloon out of control. In 2007, the Congressional 
Budget Office (CBO) projected under an extended baseline scenario that 
publicly held federal debt will eventually climb to 239 percent of GDP 
without policy changes.
    One risk is that the high levels of deficit spending and debt 
accumulation may signal to global financial markets that the United 
States is unwilling to resolve its long-term budgetary problems. As a 
result, U.S. interest rates could increase significantly. As the recent 
paper released by Brookings notes, ``. . . Recent trends in credit 
default swap markets show a clearly discernable uptick in the perceived 
likelihood of default on 5-year U.S. senior Treasury debt, a notion 
that was virtually unthinkable in the past . . . although fiscal policy 
problems are usually described as medium- and long-term issues--the 
future may be upon us much sooner than previously expected.''
    The bottom line is that the fiscal position of the federal 
government is deteriorating significantly and the outlook is fairly 
grim. The looming possibility of large bailouts could add trillions of 
dollars to the national debt. The truth is that this country simply 
cannot afford to make further spending commitments and must consider 
entitlement reforms and other measures to restrain the growth of 
runaway deficit spending. American families cannot afford policies that 
ignore surging federal spending, lay the groundwork for higher taxes 
and inflation, and undermine the prospects for future economic and 
employment growth.
                 Prepared Statement of Paul A. Volcker
    Madame Chairwoman and Members of the Joint Economic Committee:
    It is no secret that we are living in a difficult time for the 
economy, with unprecedented complexities, complications and risks for 
financial markets and financial institutions. You have entitled this 
hearing ``Restoring the Economy: Strategies for Short-term and Long-
term change''. I appreciate the invitation to address those issues, but 
I am sure you understand that any brief statement may elicit as many 
questions as answers. In the circumstances, I will proceed by making a 
few points that I consider highly relevant in the effort to achieve 
recovery, greater stability, and protection against a future financial 
crisis. We must not again leave the markets so vulnerable that a 
breakdown will again threaten the national and world economies.
    1. My first point is to emphasize an essential longer-term reality.
    The present crisis grew out a serious and unsustainable imbalance 
in the United States and world economies. Specifically, over recent 
years, until the outset of the recession, Americans spent more than our 
country produced or was capable of producing at full employment. That 
spending, reflected in exceptionally high levels of consumption 
generally and in housing in particular, was made possible by a high 
level of imports, a collapse in personal savings, and large trade and 
current account deficits. The consequence was the nation became 
dependent on borrowing abroad hundreds of billions of dollars a year.
    For a while it was all quite comfortable. Imports from China and 
elsewhere satisfied our strong consumption proclivities without 
inflationary pressures. China, Japan and other countries were eager to 
export and willing to acquire and hold trillions of U.S. dollars, 
keeping our currency strong and helping to keep our interest rates low.
    The trouble was it could not last. The process came to be dependent 
upon an enormous build-up of domestic as well as international debt, 
facilitated by the low interest rates and sense of ``easy money''. The 
bulk of that debt came to be mortgage-related. It was supported by the 
strong increase in housing prices, giving the illusion of wealth 
creation. When housing prices leveled off and then declined, the 
weakest mortgages--so-called subprime--came under pressure, and the 
highly engineered over-extended financial structure began to unravel. 
As the financial crisis broadened, the recession was triggered.
    I repeat that story because the first and most fundamental lesson 
of the crisis is that future policy should be alert to, and take 
appropriate measures to deal with, persistent and ultimately 
destabilizing economic imbalances. I realize that is a large and 
continuing challenge of international as well as domestic proportions, 
but it is the essence of prudent economic management.
    2. Secondly, I turn to the problem in financial markets.
    The rising debt, particularly mortgage credit, was facilitated and 
extended by the modern alchemy of financial engineering. Mathematic 
techniques that have developed in an effort to diffuse and limit risk 
turned out in practice to magnify and obscure risks, partly because, in 
all their complexity and opacity, transparency was lost. Risk 
management failed. At the same time, highly aggressive compensation 
practices encouraged risk taking in the face of misunderstood and 
sometimes almost incomprehensible debt instruments.
    As we look ahead, the obvious lesson is the need for more 
disciplined financial management generally and better risk management 
in particular. Plainly, review and reform of compensation practices are 
particularly difficult matters that defy rigid specification.
    3. As the financial crisis evolved, weaknesses in accounting, 
credit rating agencies and other market practices were exposed.
    ``Fair value'' accounting rules were inconsistently applied and 
have contributed to downward spiraling valuations in illiquid markets. 
Credit rating agencies failed to analyze collective debt obligations 
with sufficient vigor. Clearance, settlement and collateral 
arrangements for obscure derivative contracts created uncertainty and 
need clarification.
    These are all highly technical issues, not readily dealt with by 
legislation. They do need to be resolved as part of a comprehensive 
reform process.
    4. More directly of governmental concern are the lapses in 
financial regulation and supervision that permitted institutional 
weaknesses to fester, failed to identify exceptional risks and deal 
adequately with conflicts of interest, and did not expose large 
personal scandals after warnings.
    This area will require, and I'm sure will receive, close attention 
by the Administration and the Congress in the period ahead. I will be 
surprised if you do not conclude that substantial changes will need to 
be made in the administrative structures for oversight of the financial 
    Taken together, the need for change is both obvious and wide 
ranging. In approaching the challenge, I do urge that all these matters 
be considered in the context of a considered judgment about the 
appropriate role and functioning of the financial system in the years 
    At the most general level, I am certain we all would like to see a 
``diverse, competitive, predominantly privately owned and managed 
institutions and markets, able to efficiently and flexibly meet the 
needs of global, national and local businesses, governments, and 
    Those words are taken directly from a recent report of the Group of 
30 setting out a Framework for Financial Stability. It points up the 
challenge of making those broad generalities a strong and lasting 
operational reality. I chaired that effort and naturally recommend it 
to you.
    The Report makes some eighteen broad recommendations, touching upon 
most of the points I enumerated earlier. One area it does not cover are 
specific proposals for restructuring the agencies responsible for 
regulation and supervision. I believe judgment and legislation in that 
area should logically follow and not proceed judgment about the overall 
design of the financial system.
    The G-30 Report recognizes what I believe is common ground among 
most analysts. Specifically, all banking organizations should come with 
the framework of an official safety net, with the natural corollary of 
regulation and supervision. It is also recognized that a few of the 
banks (and possibly some other financial organizations) will be so 
large, and their operations so intertwined in complex relationships 
with other institutions, as to entail ``systemic risk''. In other 
words, the functioning of the financial system as a whole could be 
jeopardized in the event of a sudden and disorderly failure. 
Consequently, those institutions should be subjected to particularly 
high international standards directed toward maintaining their safety 
and soundness.
    Taken together these banking organizations should be predominantly 
``relationship-oriented'', providing essential financial services to 
individuals, businesses of all sizes, and governments. To help assure 
their stability and continuity and limit potential conflicts of 
interest, strong restrictions on risk-prone capital market activities--
e.g., hedge funds, equity funds, and proprietary trading--would be 
    At the same time, trading and transaction-oriented financial 
institutions operating primarily in capital markets could be less 
intensively regulated, although stronger registration and reporting 
requirements would be appropriate. In instances where the institutions 
are so large or otherwise so complex as to be ``systemically'' 
relevant, capital, leveraging and liquidity requirements would be 
    Implicit in this approach is the need for strong cooperation and 
coordination among national authorities and regulators. Some 
approaches--accounting standards, capital and liquidity requirements, 
and registration and reporting procedures--should be internationally 
agreed and consistent in application to minimize regulatory arbitrage 
and any tendency by particular countries or financial centers to seek 
competitive advantage by tolerating laxity in oversight.
    All this will take time if the necessary consensus is to be 
achieved and a comprehensive rather than a piece-meal approach is 
taken. I also recognize that a coherent vision of the future should 
help guide the emergency responses to the present crisis and, even more 
important, the steps taken as the truly extraordinary measures now in 
place are relaxed and ended.
    Let that debate proceed. I will, of course, welcome the opportunity 
to participate in your deliberations.
                 Prepared Statement of Roger C. Altman
    Madam Chair and Members of the Committee, thank you for inviting me 
to testify before you this morning.
    This is a historic and deeply challenging moment in the annals of 
finance and public policy. It is historic because the Western financial 
system is experiencing shocks which virtually no one foresaw, no one 
imagined, and few truly understand. It is deeply challenging because, 
while the finance and monetary authorities have launched very 
aggressive interventions over the past year, it is not yet clear 
whether these will successfully stabilize the financial system. My view 
is that these efforts have been well-conceived and will prevail. It may 
not be evident that they have done so, however, until 2010.
True Origins of the Crisis
    We all have read and heard endless analyses of how this collapse 
occurred. But one widespread misperception still persists.
    Conventional wisdom attributes the current crisis to the twin 
collapse of housing prices and the subprime mortgage market in the U.S. 
This is not correct. The underlying cause was an invariably lethal 
combination of extremely low interest rates and extremely high levels 
of liquidity.
    Low interest rates reflected the Federal Reserve's overly 
accommodative monetary policy after September 11, 2001 and the 
recession of 2001 and 2002. The federal funds rate was held to 1% for 
nearly three years.
    The extreme liquidity reflected what Chairman Ben Bernanke has 
called the ``global savings glut.'' Namely, enormous financial 
surpluses realized by several developing countries, most notably China, 
Singapore, and the Persian Gulf oil states.
    Facing low yields, this mountain of liquidity naturally sought 
higher returns and this led it to weaker credits. Huge amounts of 
capital thus flowed into the subprime mortgage sector--the 2005 and 
2006 volumes were six times the long-term historical average--and 
towards weak borrowers of all types in the U.S., Europe, and elsewhere 
around the globe. As with all financial bubbles, historical default 
rates on these poor credits and other key lessons of history were 
    The flood of mortgage money pushed home prices up at unprecedented 
rates. The 30-year average annual appreciation rate had been 1.4 
percent, but soared to 7.6 percent by the middle of the decade and 
ultimately reached 11 percent at the peak.
    The rest is history. But, my point is,that low interest rates and 
high liquidity caused this bubble, not home prices and subprime 
A Subpar Economic Recovery
    This is the first balance sheet-driven recession in over sixty 
years and, unfortunately, that factor mandates a sub-normal recovery.
    In the modern era, recessions have typically reflected a sequence 
of overheating, inflationary pressures, monetary tightening, a slowdown 
in the credit-sensitive industries and then a broader slowdown.
    However, the current downturn reflects plummeting asset values, 
which have injured household balance sheets, financial sector balance 
sheets, and ultimately will harm even the federal balance sheet. The 
net worth of consumers has fallen so dramatically that they cannot 
spend; the capital of banks and like institutions has fallen so sharply 
that they cannot lend; and the federal balance sheet has now been 
stretched to the point that the government will have no choice but to 
eventually undertake contractionary actions to repair it.
    The reason the recovery will be delayed and lengthy--U shaped--is 
that these balance sheets cannot recover quickly. First, the consumer 
balance sheet. Households have lost nearly $15 trillion since mid-2007, 
or a fifth of their net worth. They have retrenched by cutting 
discretionary spending, which is why personal consumption expenditures 
have been dropping so fast. In turn, the savings rate has risen and now 
stands at approximately three percent. In the long run, a higher 
savings rate is desirable. But, right now, it is accelerating the 
downward spiral of job losses and falling incomes that is driving 
people to save in the first place.
    An important psychological element also applies. In recent years, 
household incomes were stagnant, but spending rose anyway in proportion 
to the so-called positive wealth effect. Consumers knew that their home 
and financial asset values were higher and felt flush. Now, this 
perception has reversed sharply. It will take a long time for consumer 
balance sheets and consumer confidence to be restored.
    A second factor mitigating against a normal recovery is the damaged 
balance sheets of our banking sector. Since the peak, losses among U.S. 
financial institutions and investors have reached nearly $1 trillion. 
But, there could be another $1 trillion in losses to come. This is why 
financial institutions are not lending. Adjusted for such losses, they 
have little or no true capital.
    Eventually, the federal balance sheet will also become a 
restraining factor. Weakness in revenues, the stimulus bill and 
continued financial rescue spending will likely move the fiscal 2009 
deficit over $1.5 trillion, or more than 10% of GDP. In addition, the 
Federal Reserve is pursuing a zero interest rate policy, as it should. 
But, such growing deficits and extreme monetary ease can only be 
maintained for so long without provoking anxiety in world capital 
markets, foreign exchange markets, and among the American public. As a 
result, the U.S. government will likely shift to deficit reduction 
strategies and monetary tightening by 2011, which will then have a 
contractionary effect on the economy.
The Continuing Credit Crisis
    The credit freeze outside the banking system has begun to thaw 
slightly. But, the crisis within the banking system may be at its low 
    Beyond the depository and lending system, the public markets seem 
to have passed their lows: the TED spread has fallen 350 basis points 
since its October peak, commercial paper issuances have improved 
modestly, and both high grade corporate bond spreads and high grade 
corporate bond issuances are slowly recovering. But, this represents 
only a small thaw, as the securitization and high yield markets are 
still frozen.
    The banking system continues to deteriorate. A rare, severe 
downward spiral is currently in motion; as the value of financial 
assets fall, institutions must further mark down their held assets. 
These losses reduce their underlying capital and weaken their balance 
sheets. The so called ``hole''--the deficiency of tangible equity 
compared to the true market value of those assets--only grows. This 
explains why the market equities of Citigroup and Bank of America have 
shrunk to $10 billion and $19 billion, respectively. For example, with 
residential real estate, commercial real estate, and business values 
themselves continuing to fall, there is little tangible equity in 
Citigroup. As long as these values continue falling, its balance sheet 
will continue to weaken.
    As a result, the amounts of capital needed to properly shore up the 
banking system are still growing. This system may well remain 
incapacitated through the end of 2009, even if public credit markets 
continue to experience gradual improvement.
The Federal Policy Response to Date
    The actions of the Treasury Department and the Federal Reserve over 
the past 18 months have been commendable. They have not been perfect, 
of course. Given a second chance, they might make different decisions 
on Lehman Brothers, AIG, and the original presentation of the TARP. But 
these two agencies, together with the FDIC, have provided strong 
    First, they have injected or guaranteed a total of $9 trillion in 
credit market support. Second, they have responded with creativity, 
from the Fed's guarantee for money market funds and commercial paper, 
to the rescues of Fannie Mae and Freddie Mac, to the nearly 400 
separate institutions that have received TARP funds to date, and to the 
FDIC's guarantees of large swaths of Citigroup and Bank of America 
    It is worth noting that the RTC was a very unpopular institution 
during the savings and loan crisis of the late 1980s and early 1990s. 
But, in retrospect, the government established it swiftly and managed 
it expeditiously during those years. Now, the U.S. approach to that 
crisis is considered successful. This time, the challenge is greater, 
and the recovery will be slower. But, in my view, history will render 
the same verdict.
The New Obama Initiatives
    Although the new Administration has held office for only 38 days, 
it has already launched four new initiatives to attack this economic 
and financial crisis.
    The first was the $787 billion stimulus package. It wasn't perfect 
and could not have been. But few argue with the necessity for big 
fiscal stimulus under current conditions. Yes, with the economy likely 
declining for the first three quarters of 2009, and possibly all four 
quarters, it will be hard to discern an impact this year. But, most 
economists forecast that GDP will decline materially less this year 
than had the stimulus package not been enacted. We don't yet know, of 
course, whether this $787 billion will turn out to be a sufficient 
amount. If it isn't, a second round of stimulus may be necessary, 
perhaps in mid-2010.
    The second initiative is the Capital Assistance Program, the new 
term for capital infusions into financial institutions from the TARP. 
The Administration has made a series of improvements relative to the 
Bush approach. For one, banks with assets exceeding $100 billion will 
be subjected to a financial ``stress test'' to determine their 
financial condition in a downside scenario. Presumably, this will have 
the effect of dividing them into three categories: those healthy enough 
to forego federal capital; those too weak to survive even with federal 
assistance; and those who need assistance but can be stabilized as a 
result. The Obama Administration will also designate clear lending 
requirements in exchange for federal capital, as well as place limits 
on dividends, buybacks, acquisitions of other wealthy institutions, and 
executive compensation. Finally, the new program will purchase 
convertible preferred shares, not straight preferred shares. This 
allows it to turn its investment into pure equity for the benefit of 
the assisted institution.
    Thirdly, the new Administration has decided to pursue a Public/
Private Investment Fund to incentivize private capital to acquire toxic 
assets. This is both the right financial approach and a courageous 
idea, because it will not be popular. We do not yet know the details, 
but it likely involves providing federal loans to hedge funds, private 
equity funds, and similar investors. These loans will likely come from 
the Federal Reserve, thus not requiring legislative approval. They will 
likely be provided on a non-recourse basis to investors at an initial 
amount of $500 billion, with the potential to expand to $1 trillion as 
needed. It will likely take three to four months for this complex 
partnership to become operational. For example, the TALF facility, 
which was announced in November is just now commencing operations.
    The public/private approach addresses two key needs. First, it 
removes distressed assets from the balance sheets of weakened lenders, 
and second, it allows the private market to price those assets. But 
structuring this facility correctly will be a challenge. Taxpayers must 
share strongly in the profits realized by investors. The financing 
provided must be large enough to allow for active bidding on the toxic 
assets but not so large as to encourage overpricing them. And private 
investors will likely require floor protection from the FDIC and 
Treasury on any assets purchased. Furthermore, it is also unclear 
whether subsidized bids on toxic assets will be sufficient to induce a 
healthy volume of selling on the part of lenders, or whether those sale 
prices would trigger even larger losses, requiring additional capital 
infusions from the Treasury.
    This approach is preferable to nationalization, which has been so 
widely discussed in recent days.
    It is important to define nationalization, before a true discussion 
of its pros and cons can properly be had. The right definition, it 
seems to me, is 100% federal ownership of a financial institution.
    It is also important, given the enormous uncertainties of the 
moment, to avoid categorical statements. At this moment, the U.S. 
cannot categorically rule out nationalizations. There are possible 
circumstances which are so cataclysmic as to leave no other 
    But, that is the only circumstance in which we should resort to 
this step. Here's why:

      Our government is not equipped to manage large financial 
institutions. For example, post-nationalization, most envision 
transferring an institution's toxic assets to a new formed federal 
institution: an aggregator bank, or ``bad'' bank. But, twenty years 
ago, it took years for the RTC to become fully operational. It would 
take a similarly long time here.
      Any nationalized institution would be further weakened by 
virtue of that step. Retaining business customers and key talent would 
be difficult during a period of federal ownership. Those institutions 
which remains in private hands would benefit, at the expense of the 
federalized ones.
      The temptation to direct nationalized institutions 
towards public policy goals, however commendable, would be severe, 
e.g., ``green lending.'' Such a focus would be inconsistent with the 
goal of swiftly returning a nationalized entity to profitability and 
financial soundness.
      It would take longer to re-privatize a nationalized 
institution than many estimates that I have seen. Once taken over, our 
capital markets will see the institutions as weakened. Such markets 
will be slow to embrace efforts to re-sell them to investors, except at 
fire sale prices.
      The oft-cited Swedish example of bank nationalization is 
not particularly comparable. By American standards, Sweden is a small 
country, and these were two small institutions.
      It also is not necessary to nationalize in order to 
change senior management or the Board of any federally assisted 
institution. The Treasury has that power today. If it has furnished 
substantial TARP funds, it can simply request that the management or 
Board, or both, be replaced, as a condition of continuing the 
investment. Any institution would comply.

    The final initiative is that towards the mortgage and foreclosure 
crisis. This was long overdue.
    The new plan is designed to make three impacts: (1) more 
flexibility for Fannie Mae and Freddie Mac to acquire and to 
restructure mortgages; (2) greater overall capacity to restructure 
existing mortgage loans and ease debt service for distressed 
homeowners; and (3) the ability to write down principal amounts of 
mortgages in the context of bankruptcy.
    The Fannie and Freddie changes would permit refinancings where the 
mortgage value exceeds 80% of the underlying home value, provided that 
it doesn't exceed 105% of the value. This could allow several million 
homeowners to refinance at lower rates, lower their mortgage debt 
service and stay in their homes. We should see a considerable increase 
in related refinancings.
    Further, the Obama proposal provides cash incentives for mortgage 
servicers to restructure mortgages. The goal is to lower the debt 
service to income ratio, in as many cases as possible, to the low 30% 
range, including through principal reductions. It is not clear how many 
servicers will participate in this plan but it is the right step 
because it addresses borrowers who are at risk but may not yet be 
    The mortgage and foreclosure crisis is difficult to address because 
millions of individual loan modification transactions are required. 
Unfortunately, it is just as time consuming to restructure a small 
mortgage, as it is to modify a huge one. Therefore, we face a big 
``retail'' problem. Namely, how to actually interact with such a large 
number of homeowners and their mortgages. There is no magic solution 
here, and even the impacts of this new initiative may take some time to 
be felt. But, it was necessary.
                 Prepared Statement of Adam S. Posen\1\
    \1\ Adam Posen is Deputy Director of the Peterson Institute for 
International Economics. He is a member of the Panel of Economic 
Advisers to the Congressional Budget Office, and has been a consultant 
to the US Council of Economic Advisers, State, and Treasury 
Departments, to the IMF, and to central banks worldwide. The views 
expressed here are solely his own. Contact: [email protected]
    Chairwoman Maloney, Members of the Committee, thank you very much 
for inviting me to testify today at this critical juncture in American 
economic policymaking. I am especially honored to be following the 
testimony of Paul Volcker, one of the greatest public servants this 
country has had in the economic sphere, to whose wisdom we all would do 
well to listen.
    Today, we face extreme financial fragility and as a result serious 
risks to our economy's prospects for a sustainable recovery from its 
current troubles. Congress must grapple with difficult choices about 
America's banks, and make those choices soon. Making the right choices 
now will require money upfront, large amounts of taxpayer money, and 
thus it is necessary as well as right for Congress to lead on this 
issue. But making the right policy choices now will restore US economic 
growth much sooner, at much lower cost, on a more sound basis, than 
trying to kick the trouble down the road or waiting for events to force 
the issue. Members of this committee are well-familiar with such 
warnings, usually with respect to far off economic problems. This time 
and this problem, however, are costing our citizens jobs and homes and 
hard-earned savings right here and now. And the correct policy response 
right now will make all the difference.
    Luckily, although the scale of the banking problem that we now face 
is unfamiliar to us, the kind of banking problem we face today is 
familiar, and in fact well-understood. We have seen this before in the 
US in the mid-198os Savings and Loan crisis, in Japan's post-bubble 
Great Recession of the 1990s, in the Nordic countries from 1992-1995, 
and many times in many other countries. It is reasonable to ask why 
these kinds of crises keep happening, and how to prevent them in 
future--I would be happy to discuss that, but that is of lesser 
importance to our current circumstances. It is also reasonable to ask 
why economists who did not foresee the current crisis can be trusted to 
give advice with great assurance now that the crisis has hit. I would 
say this is analogous to the doctor who does not foresee that his 
patient's common cold will turn into pneumonia (or at least saw it as 
quite unlikely), but knows how to treat the pneumonia once it occurs.
    So today I would like to advise you on how to cure our financial 
pneumonia, rather than letting it runs its course, before it causes 
permanent damage or leads to hospitalization of our economy. And the 
prescriptions I will give are based on many prior cases, particularly 
what worked to bring financial recovery in the US in 1989 and in Japan 
in 2001, which are the ones most similar to our current condition.\2\ 
In brief, I would urge the Congress to have the US government:
    \2\ I draw on a wide range of research by myself and others. A good 
overview is given in Japan's Financial Crisis and Its Parallels with US 
Experience, eds. Ryoichi Mikitani and Adam Posen, PIIE, 2001.

      Recognize that the money is gone from the banking system, 
and banks already are in a dangerous public-private hybrid state;
      Immediately evaluate the solvency and future viability of 
individual banks;
      Rapidly sort the banks into those that can survive with 
limited additional capital, and those that should be closed, merged, or 
      Use government ownership and control of some banks to 
prepare for rapid resale to the private sector, while limiting any 
distortions from such temporary ownership;
      Buy illiquid assets on the RTC model, and avoid getting 
hung up on finding the `right price' for distressed assets or trying to 
get private investment up front, which will only delay matters and 
waste money;
      When reselling and merging failed banks, do so with some 
limit on bank sizes;
      And do all of this before the stimulus package's benefits 
run out in mid-2010.

    This set of decisive actions is feasible and can be rapidly 
implemented, and follows a proven path to the resolution of banking 
crises. Implementing this program should spare us the fate of 
squandering additional national wealth and of postponing recovery for 
years that resulted from policy half-measures in Japan in the 19905 and 
in the United States in the 1980s. Similar policy frameworks were 
adopted and resolved those crises in the end, but only after delay cost 
    Recognize that the money is gone from the banking system, and banks 
already are in a dangerous public-private hybrid state. There are 
statements in the press of late by bank managers and unnamed 
administration sources that some major banks currently under suspicion 
of insolvency actually have sufficient capital, or, slightly less 
dubiously, would have sufficient capital if only they were not forced 
to mark their assets to current low market values. These statements 
should treated with extreme skepticism if not disdain. There are 
certainly some American banks that are either solvent, or sufficiently 
close to solvency that they can be returned to viability at little 
cost, despite the severe recession and market declines. But I agree 
with the vast majority of independent analysts and the obvious market 
verdict that sadly for many of our largest banking institutions 
solvency is but a far-off aspiration at present.
    And it is the present condition that matters. In the mid-1980s in 
the US and most of the 1990s in Japan, bank supervisors engaged in 
regulatory forebearance, meaning they held off intervening in or 
closing banks with insufficient capital in hopes time would restore 
asset values and heal the wounds. One can easily imagine the incentives 
for the bank supervisors, well-documented in historical cases and the 
economic data, not to have a prominent bank fail on their watch. The 
problem, also evident in these historical cases and in the economic 
data, is that top management and shareholders of banks know that 
supervisors have this interest, and respond accordingly. The managers 
and shareholders do everything they can to avoid outright failing, 
which fits their own personal incentives.
    That self-preservation, not profit-maximization, strategy by the 
banks usually entails calling in or selling off good loans, so as to 
get cash for what is liquid, while rolling over loans to bad risks or 
holding on to impaired assets, so as to avoid taking obvious losses, 
and gambling that they will return to value. The result of this dynamic 
is to create the credit crunch of the sort we are seeing today, and to 
only add to the eventual losses of the banks when they get 
recognized.\3\ The economy as a whole, and non-financial small 
businesses in particular, suffer in order to spare the positions of 
current bank shareholders and top management (and on the firing line 
bank supervisors).
    \3\ Arguably, repeated forebearance of this kind when major 
American banks previously made poor decisions about emerging market 
lending and regional real estate booms, also contributed to getting us 
in to the terrible situation of today, by encouraging the largest banks 
to believe that they would always be bailed out without having to take 
the worst losses.
    The guarantees that the US government has already extended to the 
banks in the last year, and the insufficient (though large) capital 
injections without government control or adequate conditionality also 
already given under TARP, closely mimic those given by the Japanese 
government in the mid-1990s to keep their major banks open without 
having to recognize specific failures and losses. The result then, and 
the emerging result now, is that the banks' top management simply burns 
through that cash, socializing the losses for the taxpayer, grabbing 
any rare gains for management payouts or shareholder dividends, and 
ending up still undercapitalized. Pretending that distressed assets are 
worth more than they actually are today for regulatory purposes 
persuades no one besides the regulators, and just gives the banks more 
taxpayer money to spend down, and more time to impose a credit crunch.
    These kind of half-measures to keep banks open rather than 
disciplined are precisely what the Japanese Ministry of Finance engaged 
in from their bubble's burst in 1992 through to 1998, and over that 
period the cost to the Japanese economy from bad lending quadrupled 
from 5% to over 20% of Japanese GDP. In addition, this `convoy' system, 
as the Japanese officials called it, punished any better capitalized 
and managed banks that remained by making it difficult for them to 
distinguish themselves in the market; falsely pumping up the apparent 
viability of bad banks will do that. That in turn eroded the incentive 
of the better and more viable banks to engage in good lending behavior 
versus self-preservation and angling for government protection.
    I believe, regrettably, that is what is happening now in the US 
under the current half-measures. This is why further government 
intervention in the banking system, based on recognizing real losses 
and insolvencies is to be welcomed, not feared. So long as American 
banks have partial government guarantees and public funds to play with, 
but retain current shareholders and top management, they have perverse 
incentives and losses will mount. Think of Fannie Mae and Freddie Mac 
gambling with taxpayer dollars when having government guarantees but 
private claims on the profits and thus incentives for management and 
shareholder self-preservation. Hybrids are a good technology for 
autos--public-private hybrids are a terrible form for financial 
institutions. Thus, bending over backwards to keep all of the banking 
system in private hands without changing their management, while 
extending further government guarantees and investments is a recipe for 
disaster on the public's accounts.
    Immediately evaluate the solvency and future viability of 
individual banks. The first step to ending these perverse incentives, 
and getting us away from the destructive undercapitalized private-
public hybrid banking we now suffer under, is to get the books in order 
without hesitation about declaring banks insolvent based on current 
valuations. It was that kind of aggressive, intrusive, and published 
honest evaluation by Japanese officials of their banks in 2002 that was 
the first policy step in finally ending their banking crisis. Treasury 
Secretary Timothy Geithner has acknowledged the need for evaluations, 
and will shortly be implementing `stress tests' on the 20 largest US 
banks. Unfortunately, it remains to be seen whether the supervisors and 
regulators sent in to make these evaluations will be sufficiently 
merciless in discounting the value of current assets. The 
administration has given conflicting signals on this point so far. Much 
of the opening rhetoric in the Secretary's statements on the matter is 
tough, which I applaud.
    The statement that the stress tests will be implemented in a 
`forward-looking' manner, however, potentially opens the door to 
backsliding. We are in the midst of a very severe recession, and a huge 
asset price decline, when most things that could have gone wrong have 
gone wrong. So it seems reasonable that the current situation is about 
the most stress that bank balance sheets could be expected to come 
under; and why bother considering worse situations, since all too many 
banks will fail the tests under the present stresses. In the US in the 
1980s with the savings and loans, and in Japan in the 199os with all 
their banks, forward-looking (by other names) assessments ended up 
being forms of forebearance. When the assessments took into account 
future periods when conditions would be calmer and asset values would 
be higher than they were during the crises, they gave the banks an 
unjustified reprieve.
    Granting such a self-defeating lifeline would also seem to be 
consistent with the repeated administration statements that they wish 
to keep the examined banks not only open and lending, but under 
continued private--and thus current--shareholder and management 
control. If this is the case, and I hope I am worrying unduly, it would 
be a grievous mistake. The fact that bank shares for many suspect banks 
have stopped dropping with the announcement of these programs, however, 
is another signal that many believe the stress tests will be beneficial 
to current bank shareholders. This stabilization if not bump in bank 
share prices cannot be based on a belief that the suspect banks will be 
revealed by the stress tests to be in truly better shape than the 
market believed them to be up until now, for then the private money 
sitting on the sidelines would be moving to acquire the (in that case) 
undervalued banks.
    Another red herring, that I also fear indicates reluctance to do 
what is needed, are the occasional statements that the process will 
take several weeks or more, and will be difficult to implement given 
staffing constraints and complexity of the balance sheets. There is no 
shortage of unemployed financial analysts looking for consulting work, 
and there is no need to be all that caught up in getting precisely the 
`right' price on various distressed assets (as I will explain). The 
implementation difficulties of such evaluations are surmountable, as 
they were in other countries such as Japan that had a new unproven 
Financial Services Agency in place when it got tough in 2002, and here 
at home when the first Bush administration took on the S&L crisis in 
1989-1991. Furthermore, what have the bank supervisors of the FDIC, the 
Federal Reserve Bank of New York, et al, been doing for the last 
several years if not getting some sense of these banks' balance sheets? 
The Treasury cannot make public claims that the banks' balance sheets 
will be revealed to be better than expected, based on supervisory 
information, at the same time that it claims that making the 
evaluations of the balance sheets will be daunting.
    So strict immediate evaluations of bank balance sheets are agreed 
upon in at least form. Regrettably, there is some risk that the 
forward-looking stress tests may indeed be yet another transfer of 
taxpayer dollars to current bank shareholders. The people's 
representatives in Congress should not stand for this. If it turns out 
that Congressional insistence on tough love for the banks merely 
stiffens the spine of the Treasury, FDIC, and Federal Reserve to do 
what they intended to do anyway, so much the better. Their apparent 
reluctance to pull the trigger on tough evaluations may be based on 
fears in the administration that such forced write-offs would require 
the unpopular steps of another injection of public funds and/or round 
of closures, either way involving some government ownership of those 
banks. Those fears can be forestalled through your committee clearly 
stating that this kind of tough evaluation is in the public interest, 
and the benefits outweigh the costs. You and your colleagues can and 
should make the stress tests work.
    Rapidly sort the banks into those that can survive with limited 
additional capital, and those that should be closed, merged, or 
temporarily nationalized. Banks think with their capital. As discussed, 
when their capital is too low, the incentives for their top management 
and shareholders are perverted, and contrary to the public interest. 
Simply giving capital to all the banks that are judged to need some, 
however, is a mistake. It spends taxpayer money we do not need to 
spend, and it rewards bad behavior by treating all banks equally, no 
matter how much capital they squandered. It is better to triage the 
banks quickly into categories by their viability on the basis of 
capitalization.\4\ This is what the Swedish government did rapidly with 
great success in 1992, when their banking crisis hit, and is what the 
Japanese government got around to finally doing in 2002, when their 
banking resolution became serious.
    \4\ We are already sorting banks on the basis of systemic risk by 
virtue of stress testing the largest, and thus probably most 
systemically important, banks first. No one worries about closing small 
banks, usually.
    The capitalization criteria should not be simply whether the net 
position after strict balance sheet evaluation is above or below zero, 
i.e., solvency. As we learnt during the Savings and Loan crisis, and as 
therefore reflected in FDICIA, which allows supervisors to take over 
banks which have capital ratios of 2%, by the time you get to zero it 
is too late (of course, right now, the problem is that capital ratios 
will already be well below zero for many of the largest banks). So the 
three categories should be:

        1. Banks with clearly positive capital that only need a 
        topping-up to return to health and healthy behaviors;
        2. Banks with low or slightly negative capital where removal of 
        limited bad assets could restore viability; and,
        3. Banks with clearly negative capital and large, difficult to 
        unwind, portfolios of bad assets.

    The first category should receive their capital topping up from 
public fund injections through preferred shares or other loans of 
liquid non-voting capital. This format, combined with a clean-bill of 
health from credible inspections, should lead to rapid repayment of 
these banks' public funds. Yes, this is what was tried in the early 
days of the crisis and TARP; that did not work because it was wishful 
thinking at best to do so for all the major banks indiscriminately 
before credible balance sheet evaluations were completed. But for those 
banks within striking distance of solidly positive capital ratios, this 
is the right way to go.
    The second category of banks likely includes many of the mid-to 
large-size, but not the largest size, banks in our system. These are 
banks that cannot get back to clearly positive capitalization, once 
their bad assets are fairly written off, but whose balance sheets can 
be rapidly cleaned up by bad asset sales and whose capital needs are 
not overwhelming. Banks in this category are usually sold off, in part 
or whole, to other banks, or are merged with stronger banks combined 
with some injection of public capital. As part of this process, current 
top management is usually replaced (perhaps `naturally' in a merger 
process), and current shareholders' equity is diluted (though 
discounted purchases of bank components, public minority ownership of 
some common equity, or both).
    It is the third category that grabs the political attention, and 
that unfortunately is likely to include some of our most systemically 
important banks. Clearly insolvent banks with no rapid way to sell off 
their assets at a discount would be unwound in an orderly fashion under 
FDICIA, but in essence liquidated over time if they were small and did 
not present a systemic risk. That has already happened during this 
cycle to a few American institutions, such as Indymac, and even in 
Japan's lost decade, some minor institutions (like Hokkaido Tokushokku 
bank, Japan's number 19 or 20 by size in 1998 when it was allowed to 
fail) were wrapped up in this fashion, despite the general reluctance 
to close banks. Obviously, the issue is what to do about systemically 
important large institutions with difficult to unwind balance sheets. 
And this is the category for which temporary nationalization of the 
insolvent banks is the right answer.
    In short, nationalization is only relevant for a part of the 
banking system under crisis, even for only a part of the technically 
insolvent banks, but it is necessary for the most systemically 
important banks that are insolvent. These banks must be kept in 
operation and have their positions and bad assets unwound in deliberate 
fashion. They also must have top management replaced and current 
shareholders wiped out. This is because the amount of capital required 
to restore them back to functionality is so large, and the process of 
restructuring their balance sheet so complex, with both having the 
potential to influence markets for other banks' equity and asset 
prices, that only the government can do it. There will likely be 
private buyers a plenty for such a bank when the recapitalization and 
unwinding process is complete, but not before the restructuring begins.
    In a corporate takeover that requires significant restructuring of 
the acquired company, new private owners will always demand majority 
voting control and removal of current top management who are 
accountable for the accumulated problems. The American taxpayer would 
be ill-served to receive anything less for putting in the vast amount 
of money needed to restructure and recapitalize these failed private 
entities. And the American taxpayer, just like any acquirer of 
distressed assets, deserves to reap the upside from their eventual 
resale. That basic logic is why failed banks that are too systemically 
important to shut down should be nationalized temporarily. That is what 
the Japanese government ended up doing with Long Term Credit Bank and 
Nippon Credit Bank, two of Japan's systemically most important banks at 
the start of the 1990s, and thus unable to be simply shut down.
    Use government ownership and control of some banks to prepare for 
rapid resale to the private sector, while limiting any distortions from 
such temporary ownership. Nationalization of some banks is solely the 
damage-limiting option under the current crisis circumstances. It beats 
the alternative of taxpayer handouts to the banks without sufficient 
conditionality, leaving financial fragility undiminished. 
Nationalization has its costs, however, beyond the upfront money 
provided and risks assumed by the government. No one in their right 
mind wants the US or any government owning banks for any longer than 
absolutely necessary.\5\ The Mitterand government nationalized French 
banks in the early 1980s as a matter of socialist ideology, not 
necessity, intending to keep the banks in the public sector--and that 
was a huge mistake. The resultant misallocation of capital interfered 
with innovation and discipline in the French economy, and reduced the 
annual rate of growth in productivity and GDP by a three or four tenths 
of a percent, which compounded over several years makes a huge 
difference.\6\ But that was an unneeded governmental takeover of viable 
banks kept in place for a long period. The key is that government 
control is kept temporary, with sell offs of distressed assets and 
viable bank units back to the private sector to commence as soon as 
possible, some of which can begin almost immediately.
    \5\ I have been on the record attacking state ownership and 
subsidization of banks in Europe for years. See, for example, Adam S. 
Posen, ``Is Germany Turning Japanese?'', Peterson Institute for 
International Economics Working Paper # 03-5 (condensed version 
published in The National Interest under the title ``Frog in a Pot'', 
Spring 2003). That is completely different than temporary bank 
    \6\ There is a vast and empirically robust literature on the effect 
of differing financial systems on economic growth, led by the 
contributions of Jerry Caprio, Stijn Claessens, and Ross Levine, with 
their numerous co-authors, from which I take this simplified estimate.
    The historical record suggests that this kind of turnaround is not 
so difficult to achieve. That is what was seen with what became Shinsei 
bank in Japan (purchased by American investors after Long-Term Credit 
Bank was nationalized and cleaned-up) as well as with the top five 
banks in Sweden in 1992-95. In both Japan and Sweden, most nationalized 
banks were re-privatized within two years, all within three. And in all 
these cases there were private buyers when the governments were ready 
to privatize the banks, something that did not exist for these failing 
institutions before the government undertook restructuring. As is well-
known, in these cases the responsible governments made back at least 
80% of their costs, in the Swedish case turning significant profits for 
the taxpayers.
    Furthermore, these banks continued most of their day-to-day 
operations during the nationalization period, retaining most personnel 
except top management. Given government majority ownership, it is 
possible to set up independent management, just as boards representing 
owners, public or private, always delegate to managers of complex 
organizations. New managers could be easily brought in from the amongst 
the many bank executives who specialized in traditional lending and 
banking, and ended up on the outs when American banks emphasized 
investment banking and other bonus-based securities businesses in 
recent years. The new managers could even be incentivized properly, the 
way we should consider incentivizing all bank managers: with long-term 
stock options instead of annual bonuses (some combination of public 
service motivations, very high upside potential, and facing 
unemployment would yield sufficient numbers).
    Of course, there will be some pressures for politically-driven 
lending, but transparency arrangements could go a long way to limiting 
that--and it is difficult to imagine that remaining shareholders and 
top management of banks in the current public-private hybrid situation 
would not have every (destructive) incentive to politically pander in 
hopes of keeping their job and their stake. The difference in 
efficiency and politicization of lending between the current situation 
and full nationalization of some banks will not be all that great 
(which is what was seen with the zombie banks in Japan in the late 
1990s, and our Savings and Loans in the mid- to late 1980s, just 
pandering to politically connected borrowers in order to stay open as 
private concerns).
    Importantly, the existence of nationalized banks in banking systems 
that still had private banks operating as well did not lead to 
excessive pressures on their private competitors, let alone significant 
shifts of business or deposits away from those private banks. This can 
be seen today in the United Kingdom where the government's large 
ownership stakes in some major banks such as RBS and HBOS has not led 
to closures of or runs on the remaining private banks; in Switzerland, 
where the de facto public takeover and guarantee of UBS has not 
noticeably harmed still private Credit Suisse; and in Germany and 
France, where private banking firms have continued to operate despite 
the ongoing presences of Credit Lyonnais and the Sparkassen as 
government subsidized and part-owned entities.
    Again, nationalization is not cost free, for over time such public 
ownership arrangements do eat away at the private banks profitability 
and proper allocation of credit, which in turn hurts productivity and 
income growth. But additional inaction today regarding the fragile US 
banks leaving current management in charge has the prospect of rapidly 
adding several full-percentage points of GDP to the total of bad loans 
and losses in just the span of months, which is a much bigger cost. It 
also risks a failure of a major financial institution without warning, 
before the government can respond, which would have large negative 
repercussions in the current environment--nationalization wins out on 
the stability criteria as well, versus our status quo, in the short-
run. Japan in 1998 demonstrated the unfortunate lesson that half-
measures stopping short of nationalization backfire, when it gave the 
private banks more capital, only to find them running out of money and 
having accumulated further bad assets when a new more actively 
reformist government took power three years later.
    Buy illiquid assets on the RTC model, and avoid getting hung up on 
finding the `right price' for distressed assets or trying to get 
private investment up front, which will only delay matters and waste 
money. To complete the full restructuring of the nationalized banks, or 
for that matter even the more minor capital topping off of the viable 
banks, when starting from honest evaluations of balance sheets, someone 
has to get the bad assets off of the banks' books. The utility of so 
doing is widely recognized. The Treasury has proposed setting up a 
complicated not-bad- but-aggregator public-private entity to serve this 
purpose. As with the stress tests, if the current US Treasury only says 
such things to sugar coat a tougher less passive intent in practice, so 
much the better. The American government should be benefitting the 
taxpayer by paying as conservatively low price as possible for our 
banking system's distressed assets, and if that means having to 
increase the capital injections on one hand to make up for the write-
offs from low prices on the other, in terms of net public outlay it is 
little different, but more of the future claims on the bad assets' 
value is kept in US taxpayers' hands. As Alan Greenspan has observed, 
if we nationalize the banks, we do not need to worry about the 
    \7\ Quoted in the Financial Times, February 18, 2009.
    The Treasury's proposal for creating a complex public-private 
aggregator bank instead of a wholly publicly-owned simple RTC-like bad 
bank is motivated by two aspirations: to mobilize `smart money' 
currently sitting on the sidelines to share the upfront costs of buying 
the bad assets; to generate price discovery about what the bad assets 
are really worth, particularly for illiquid assets for which there is 
no market. These are well-motivated aspirations, but in my opinion 
penny wise and pound foolish with taxpayer funds at best, and simply 
unattainable at worst. It is worth noting that there is no historical 
precedent for making such an attempt for price discovery and costs 
sharing with the accumulated bad assets. Simple publicly-owned RTC-like 
entities sufficed in the Swedish and Japanese cases, and of course in 
the US Savings and Loan case that set the precedent. A new and clever 
approach always could be an improvement in theory, but this particular 
one seems to share with the reverse auction ideas of the initial TARP 
proposal a desire to be too clever by half.
    It is just as arbitrary to set prices for the bad assets by 
deciding how much guarantee or subsidy the private investors receive 
from the government to induce them to get back into the game, as it 
would be to go into the banks and just pay what the markets are 
offering or zero right now. There will not be any price discovery 
through private sector means by undertaking such a program because the 
only difference between these assets unwanted now and then is the value 
of the government guarantee (subsidy) on offer. Private investors are 
obviously not buying the distressed assets now, which they could at the 
current low price, so the price will be set by the amount of the US 
government's transfer to these private buyers. At best, this gets the 
toxic assets off of the various banks' balance sheets, but at a far 
higher eventual cost to the taxpayer than would arise if the government 
purchased them outright and recouped the entire upside when there is 
eventual restructuring of and then real demand for these assets later. 
It is again Congress' role to stand up for the American taxpayer, to 
say to the administration that they should not fear having to put up 
more money upfront if in the end it will save the taxpayer significant 
money to do so now.
    At worst, employing such a complicated scheme trying to hold 
restructuring up until meaningful prices somehow emerge (when the only 
change in the assets is a government subsidy with purchase) leads to a 
worse outcome. Uncertainty hangs over our banking system for longer, 
with all the noted perverse incentives for good and bad banks that 
induces. Possibility of a disorderly outright bank failure persists 
since the illiquid assets are not rapidly moved off of the balance 
sheets of some of the most vulnerable banks. The US government ends up 
overpaying for some assets in terms of guarantees and subsidies versus 
simply buying them at today's low values, but only manages to sell the 
more liquid and attractive upside assets to the voluntary private 
participants. In short, the US taxpayer gets left with the lower future 
return lemons, while paying for the privilege of having private 
investors get the assets with the most upside potential. Eventually, 
there has to be a wholly public RTC-type bad bank anyway, but now only 
for the worst remaining parts of the portfolio.
    A wholly public simple RTC-type bad bank approach not only avoids 
these risks, but offers an advantage that the public-private hybrid 
(again a bad idea) aggregator bank does not. In fact, the additional 
complexity, and thus toxicity or illiquidity, of today's securitized 
assets versus what our original RTC or Japan's or Sweden's faced is an 
additional argument for having them all be bought by the US government 
outright: If the US government buys most or all of entire classes of 
currently illiquid assets from the banks, it would have a supermajority 
or i00% stake in most of the securitized assets that have been at the 
core of our problems in this area. That would make it feasible to 
reassemble sliced and diced securities, going back to the underlying 
investments (such as mortgages). This would detoxify most of these 
assets, making them attractive for resale by unlocking their underlying 
value, removing the source of their illiquidity, and thus offering the 
possibility of significant upside benefit entirely for the US taxpayer 
when sold back to the private sector. It would be an actual value-added 
transformation, not just an attempt to game the pricing.
    In theory, a set of private sector investors or public-private 
partnership also could do this kind of reassembly voluntarily, but in 
practice the coordination problems are insurmountable, as seen in the 
complete lack of market for these assets at present. The use of the 
word `toxic' to describe these assets leads to an apt and valid 
analogy: Just as the EPA can go to a Superfund site, one on which no 
one can currently live and no private entity is willing/able to clean 
up, it can literally detoxify that real estate by changing its 
underlying nature, and then have it come back on the market at a good 
value. The Treasury and FDIC can do the same with these currently toxic 
securities--if the US government has ownership and puts up the funding 
and effort to do the clean-up. Without a wholly public RTC initially 
owning the supermajorities, such a literal detoxification of the assets 
is impossible. And without that kind of fundamental change in the 
nature of the bad assets on the banks' books, it is difficult to see 
any reason for private smart money to buy them except to pick up a 
sufficiently large government subsidy. A hedge fund or sovereign wealth 
fund or private equity firm with cash is not staying out of these 
markets for distressed assets at present just because the prices have 
not yet `fallen enough'; such investors are staying out because the 
assets are indeed toxic with indeterminate prices.
    When reselling and merging failed banks, do so with some limit on 
bank sizes. One aspect of the financial crisis so far is that it has 
put pressure on banks and supervisors to increase concentration in the 
US banking system. When the government for understandable reasons will 
treat bigger banks as systemically important, and thus subject to 
bailouts and guarantees, it advantages them over smaller banks in the 
eyes of some potential depositors and borrowers. In addition, in each 
successive wave of banking fragility we have had up until now, US bank 
supervisors have tended to encourage stronger banks to merge with or 
buy up weaker banks--which is indeed in line with the standard crisis 
response best practice I outlined above, but also has contributed to 
greater concentration of the US banking system into fewer bigger 
businesses. The deregulation of interstate branching has also played a 
role. In each case, concentration was a side effect of well-motivated 
policies, and never became a major problem on its own terms (obviously 
many smaller and community banks continue to do business just fine).
    We now approach a situation, however, where the US government will 
have capital stakes in a large portion of the US banking system, biased 
towards larger investments in the bigger institutions, and where there 
will be additional instances after triaging the banking system that 
seem to require mergers. Given that structural leverage over the US 
banking system inherent in upcoming decisions, and the sheer scale of 
the potential upcoming further consolidation, it is time to consciously 
put a limit on4his process. As Paul Volcker has pointed out in the 
recent G30 Report, if we get into trouble with banks being 
simultaneously too big to manage their portfolio risks and too big to 
be allowed to fail, we probably should not have banks that big.\8\ This 
is not a matter of the normal anti-trust consumer protection against 
monopoly, since these developments have largely benefitted consumers on 
the usual pricing and choice criteria, but of other public interests at 
    \8\ Federal Reserve Bank of Minneapolis President Gary Stern has 
been calling attention to this potential problem for some years now. 
More recently, my PIIE colleague William Cline has written about it as 
    Economically speaking, there is no clear logic to encouraging banks 
to be as big as possible. Years and years of empirical research by 
well-trained economists in the US and abroad have been unable to 
establish any robust evidence of economies of scale or of scope in 
banking services. In other words, banks do not perform their key 
functions more efficiently or cheaply when they produce them in greater 
volume, and banks do not gain profitable synergies by expanding their 
range of services and products.\9\ There was another reasonable theory 
that larger banks might be able to diversify their risks across a 
broader and more varied portfolio than smaller banks, and thus be more 
stable--the developments of the last two years in the US, United 
Kingdom, Switzerland and elsewhere, as well as those seen in Japan's 
highly concentrated banking system in the 1990s, however, reject that 
hypothesis rather dramatically (as do more formal econometric studies).
    \9\ In some trivial sense, back office consolidation of certain 
types of processing of transactions could yield economies of scale, but 
even attempts to find evidence for these have proven unsuccessful--
perhaps because so many of those services are available on an 
outsourced and competitive basis these days.
    Finally, some people concerned with US economic competitiveness 
have argued that larger banks confer advantages, either because they 
allow for easier large-scale funding of US export industries, or 
because they allow US banks to compete better for market share in 
global finance, and thus export financial services. Unlike the previous 
two testable hypotheses, which were confronted with rigorous data 
analysis, these competitiveness claims have not been seriously studied. 
But the major threat to financing for American non-financial companies 
is market disruption caused by systemic bank failures, not limits on 
the credit available to them in normal times, and the export of 
financial services has been no more in the US national interest than 
picking any other single `strategic industry,' a thoroughly discredited 
    \10\ Some top US economic officials during the 19905 and earlier 
this decade sincerely believed that financial liberalization was in the 
economic self-interest of developing countries and thus was in the 
foreign policy interest of the United States. That is probably valid, 
and I am broadly sympathetic to that view, subject to some important 
cautions raised by Dani Rodrik, Joseph Stiglitz and others. But some of 
these officials then took that to mean that promoting the export of 
financial services by US financial institutions, and opening of foreign 
markets to US financial institutions' investment and sales were in the 
US foreign policy--as well as export--interest. This was an unnecessary 
step, and one that is backfiring on the US reputation now that our 
financial `model' and aggressive advocacy thereof is being blamed 
(excessively, but not entirely unfairly) for the current global crisis.
    So the Treasury, FDIC, and Federal Reserve should show some regard 
for excessive bank size and concentration in the US banking system when 
they are required to make decisions about banking structure upon 
returning parts of the system to fully private control. They cannot 
duck this, for even a non-decision to go with the likely outcomes of 
other priorities would result in defaulting to greater bank 
concentration at the end of the process. Unfortunately, unlike with 
regard to other aspects of the banking crisis resolution framework I 
have outlined, there is no well-established practice for how to deal 
with this issue.
    I would suggest that two guidelines be employed: First, when any of 
the fully nationalized banks, which are likely to include among them 
some of the largest of current US banks, are brought back to market 
from public ownership, they be broken up, whether along functional or 
geographic lines. This has the additional advantage of allowing some 
parts of the temporarily nationalized banks to return to private hands 
sooner, and the return of investment to the US taxpayer also to arrive 
sooner. There will be some component operating units of the largest 
failed banks whose own sub-balance sheets can be cleaned up rather 
quickly. Second, preference be given to mergers of equals for the 
publicly recapitalized but not nationalized banks that normally would 
be encouraged by regulators to be merged or taken over by other banks. 
Since this group of banks is likely to be of a smaller average size 
than the nationalized group, this should be feasible. While it remains 
for Congress to pass regulation to determine the rules of how the US 
banking system should be structured in future, I believe that current 
law does give our bank supervisors enough authority and discretion over 
mergers of banks, especially for those involving a distressed 
institution, that this guideline can be followed when the bank clean-up 
moves forward in the near term (as it must).
    And do all of this before the stimulus package's benefits run out. 
Implementing the preceding framework for resolving the US banking 
crisis will restore financial stability, as quickly as possible, at the 
lowest cost possible (though still high) to American taxpayers.\11\ The 
experience of other countries, notably of Japan in the 1990s, but also 
of the US itself in the 1980s, is highly relevant to today's dangerous 
situation. Those historical examples show not only the right way to 
resolve our banking problems, but also that the rapidity and 
sustainability with which the US economy will recover from its present 
financial crisis is directly dependent upon our willingness to tackle 
these problems aggressively--including in some instances temporarily 
nationalizing banks. When the US government engaged in regulatory 
forebearance with undercapitalized S&L's in the mid-1980s, and when the 
Japanese government similarly pandered to its bankers and dawdled 
through the entire 1990s, the losses grew larger, and the problems 
persisted. When the US government truly took on the Savings and Loan 
crisis in 1989-1991, and when the Japanese government truly confronted 
its banking crisis in 2001-2003, following this framework, the 
financial uncertainty was lifted and growth was restored.
    \11\ See for example what I recommended for Japan in 2001, which 
was largely and successfully implemented by Japanese financial services 
minister Heizo Takenaka in 2002-03 (``Japan 2001: Decisive Action or 
Financial Panic,'' http://www.iie.com/publications/pb/
pb.cfm?ResearchID=72). Many current senior US economic officials, such 
as Treasury Secretary Geithner and NEC Chair Summers, advocated the 
same for Japan and for the Asian countries during the 1997-1998 
financial crisis there.
    The only thing that makes the US different from other countries 
facing banking crises has nothing to do with the nature of our banking 
problems. What is special about the US in this context is the fortunate 
fact that we as a nation we are rich enough, with enough faith in our 
currency, to be able to engage in fiscal stimulus to soften the blow to 
the real economy while the bank clean-up is done. Emerging markets and 
even most smaller advanced economies generally have to engage in 
austerity programs, further cutting growth, at the same time that they 
tackle their banking crises in order to be able to pay for the clean-
up. This gives us a window of opportunity, but the clock is ticking.
    If we can resolve the US banking crisis in the next 18 months 
before the stimulus runs out of impact on the economy, the private 
sector will be ready to pick up the baton from the public sector--
demand will grow, and recovery will be sustained. And following the 
common framework I have set out, it would be feasible to resolve most 
of our financial problems, if not return the entire banking system back 
to private ownership, within that time frame if we start right now. If 
we fail to move aggressively enough on our banking problems, this 
window will close because even the United States cannot afford to 
engage in deficit spending indefinitely--as President Obama rightly 
explained to Congress and the nation on Tuesday night. In that case, 
when the fiscal stimulus runs out, the private sector will be unable to 
grow strongly on its own, because the banking problems will prevent it 
from doing so. Japan showed us that fiscal stimulus indeed works in the 
short-term, but growth cannot be restored to a self-sustaining path 
without resolution of an economy's banking problems.
    I ask the members of this Committee to carefully scrutinize and 
oversee the proposed programs of the US Treasury for banking crisis 
resolution. If those programs live up to their associated rhetoric, and 
are thus tough enough on the current shareholders and top management of 
our undercapitalized banks, we can in 2011 be like Japan in 2003, at 
the beginning of a long and much needed economic recovery. If unneeded 
complexity of the bad bank construct, excessive reliance on and 
generosity to private capital, and unjustified reluctance to 
temporarily nationalize some US banks, turn the proposed bank clean-up 
programs into only half-measures, then we will be like Japan in 1998--
squandering national wealth and leaving our economy in continuing 
decline, only to have to take the full measures a few years down the 
road when in greater debt. I am hopeful that the Obama Administration 
with strong congressional oversight will do what it is need in time.
                 Prepared Statement of Joseph R. Mason
    Thank you Chairman Maloney and members of the committee for the 
opportunity to testify on this very important topic. I am pleased to 
appear before you to discuss ``Restoring the Economy: Strategies for 
Short-term and Long-term Change.'' I am Joseph Mason, Hermann Moyse, 
Jr./Louisiana Bankers Association Professor of Finance at Louisiana 
State University and Senior Fellow at The Wharton School, and these are 
my personal views.
    The Committee asked panelists to opine on both short- and long-term 
changes that can help restore the economy. The written testimony that 
follows outlines three primary suggestions in each regard, focusing on 
financial market reforms that set the stage for economic growth. The 
macroeconomic understanding of financial crises is that they do not 
cause recessions, but merely prolong and/or deepen them. Recessions are 
therefore possible without a financial crisis, but once an economy is 
in recession, recovery is virtually impossible with a financial crisis. 
Until the crisis is resolved, therefore, fiscal and monetary policies 
push on a string.
    In the short-term, resolving the crisis will require humility and 
hard work. The United States still has the most advanced financial 
system in the world, but the crisis resulted because the system got too 
far in front of regulatory capabilities. Among the key weaknesses that 
caused the crisis are classic problems like banks that consider 
themselves too-big-to-fail, insufficient accounting transparency to 
support regulatory and investment needs, and textbook asset market 
overhang in housing markets. Luckily, those problems are relatively 
easy to resolve in the short run, even if doing so will take courage 
and flexibility. While existing policy attempts to address some of 
these issues get close to helping, slight changes in approach can 
achieve success in a much more straightforward and effective manner.
    The long run will be much harder, requiring significant efforts to 
fix old and build new regulatory structures and set the stage for U.S. 
economic growth. Much of the work will not be glamorous. Before one 
brick can be laid in the new financial structure, there needs to be a 
discussion of basic regulatory principals that will serve as the mortar 
of the construct. Much additional work will lie with international 
bodies, wherein I expect participants will build upon existing unitary 
principals of oversight laid down nearly two decades ago to develop 
standards and procedures for resolving failed financial institutions, 
providing bridge financing and oversight, and disposing of their 
assets. Global imbalances in economic growth potential are already 
spurring the development of trade blocs and agreements worldwide, 
presenting both opportunities and threats to U.S. markets. U.S. 
diplomacy abroad will go a long way toward smoothing some of those 
sentiments, and regulatory changes at home can help U.S. businesses 
adapt strategically to fast-moving changes in global markets and stay 
    The unifying theme of all of my suggestions is restoring 
credibility to the U.S. financial system. Out of every crisis, it must 
be recognized, arises an opportunity to improve. The objective at the 
end of the exercise--which may be decades away--must always be kept in 
sight: set a firm foundation for improved financial markets and 
economic growth potential so that the necessary restructuring becomes 
known more for its own success than the crisis that spurred us to 
I. Restoring the Economy in the Short-run: Resolving the Financial 
    As mentioned above, the key problems of the current credit crisis 
are banks that consider themselves too-big-to-fail, insufficient 
accounting transparency to support regulatory and investment needs, and 
textbook asset market overhang in housing markets.
            A. End Too-big-to-fail
    The too-big-to-fail doctrine has been around for some twenty years 
now and has yet to be resolved. The latest incarnation has been 
justified by ``systemic'' importance of some institutions over others. 
Systemic importance, however, is a specious and potentially 
disingenuous concept. There is no accepted definition of systemic risk, 
save that which points to a fundamentally unquantifiable transmission 
of risk through the financial system, akin to contagion.
    Unlike contagion, however, there need not be a non-fundamental 
mechanism at work in systemic risk--merely one that is left unmonitored 
so that it passes risk to the entire financial system. Hence, to an 
aggressive systemic risk regulator, everything is likely to look like 
systemic risk. Moreover, markets with systemic risk protection will 
find little need to monitor counterparty exposures, creating severe 
moral hazard conditions. (See, for instance, Peter J. Wallison, 
``Casting the Fed as a Systemic Risk Regulator,'' AEI Financial 
Services Outlook, February 24, 2009).
    Indeed, the ``systemic'' nature of today's problems lies only in 
the degree to which large banks managed to enter business arrangements 
that banks and regulators, alike, were reluctant to monitor. Today, 
there are two big impediments to placing insolvent banks in 
receivership, thereby prompting claims of too-big-to-fail. First, 
regulators would have to acknowledge that they did not understand the 
extent or importance of bank off-balance sheet commitments. Regulators 
expressly allowed contracts to be written that are triggered by 
receivership, but now does not know which and how many or who will gain 
and, especially, who will lose if the institutions fails. In reality, 
the situation may be more similar to that of Continental Illinois in 
1984, when the OCC said it feared spillover that would cause many banks 
to fail--a fear that was later revealed to be grossly exaggerated. 
Regulators today do not have the necessary information not because it 
is impossible to obtain, but because they have not heretofore sought 
such information, reasoning that off-balance sheet arrangements did not 
matter. Future crises are therefore probably not best avoided by 
allowing a systemic risk regulator to stand ready to make excuses for 
regulatory laxity.
    Second, and equally important, regulators today have not yet 
managed to transfer servicing rights successfully out of a failed 
institution. Mortgage bank failures in the late 1990s followed an 
almost identical path to the larger-scale disruptions we are seeing 
today. Failure typically occurred at the end of a chain of events 
wherein subprime mortgage providers lowered underwriting standards to 
fuel growth. The resulting diminished loan quality, however, hurt their 
securitizations and resulted in financial losses in both on- and off-
balance sheet arrangements. Struggling to survive without 
securitization, firms flooded the whole loan sale market, causing 
precipitous declines in whole loan prices. Stock prices of subprime 
lenders plummeted and highly leveraged companies could not repay debt. 
Without funding sources other than securitization, financially stressed 
issuers had no alternative but to file Chapter 11. By the end of the 
decade, few subprime originators remained. (Moody's, ``Bullet Proof 
Structures Revisited: Bankruptcies and a Market Hangover Test 
Securitizations' Mettle,'' 20020830 at 12.)
    Both off-balance sheet risks and servicing rights transfer 
difficulties are known-unknowns, known by the industry but ``unknown'' 
by regulators. Merely ignoring risk does not make it systemic once the 
denial becomes evident.
    Today we all know a great deal more about bank operations and 
values than we did previously. Even without resorting to custom-
designed stress tests (which cannot be developed to deliver any useful 
degree of accuracy in a matter of weeks, but take years to 
parameterize), we know that there are three classes of banks in the 
system right now: the insolvent; the marginally solvent; and the 
solvent. Policy needs to focus on relieving the economy of the value-
destroying loans produced by the now-insolvent banks, financially and 
operationally restructuring the marginally solvent banks, and building 
economic growth upon the lending platforms of value-creating solvent 
    Insolvent banks--regardless of their purported systemic 
importance--are value destroying institutions that need to be closed. 
If insolvent banks were car companies, they would be relying on worn 
machinery and ill-trained staff to produce East-German Trabants that 
break down as soon as they leave the production line. In fact, the loan 
products these banks created did break down almost immediately after 
they were produced, in that they exhibited early-payment defaults and 
often involved payments and fees that the borrower could not afford. 
The mortgage delinquencies we see today are therefore the result of 
faulty management, bad supervisory systems, ineffective proprietary 
software, and ill-targeted employee training, not mere exogenous 
economic shocks, and the banks that produced those products are 
insolvent as a result. Insolvent institutions therefore need to be shut 
down in the public interest: while the economy needs loans to fuel 
economic growth it needs high-quality value-creating loans that 
borrowers stand a chance of repaying, not value-destroying loans that 
disrupt economic activity even further.
    Marginally solvent banks face difficulties, but maintain some 
redeeming assets that suggest they possess going concern values worthy 
of being maintained. That is, the majority of marginal bank portfolios 
consist of value-creating loans that benefit economic growth. 
Government recapitalization programs with appropriate limits on 
management and insistence on institutional reforms can possibly, 
therefore, benefit marginally solvent institutions and present a chance 
of supporting economic growth by creating, rather than destroying, 
    Still, merely stabilizing marginally solvent banks will not support 
growth. To fuel growth, solvent institutions needing neither government 
assistance nor intervention can utilize government funds to finance the 
purchase of failed-bank assets to relieve asset market overhang as well 
as make new loans. To deny solvent institutions additional capital to 
address the economic situation is to penalize them for creating 
economically value-creating assets. Policy needs to focus, therefore, 
on relieving the economy of the value-destroying loans produced by the 
now-insolvent banks, restructuring the marginally solvent banks, and 
building upon the existing value creating business platforms of solvent 
banks to foster sound economic growth.
    In summary, it is crucial to dismantle the too-big-to-fail doctrine 
for the good of the American banking system. No firm is ever too-big-
to-fail. While some firms may be too misunderstood for regulators to 
effectively manage the failure and subsequent disposition of assets, 
the misunderstanding is fundamentally different from too-big-to-fail 
and not an excuse worth of justifying a lasting or fundamentally 
irreconcilable systemic risk exemption. Hence, other short-term 
policies address transparency so that the firms can be better 
understood and flexible means of asset disposition policy that have 
been heretofore overlooked.
            B. Increase Investor and Regulatory Transparency
    The key problem with financial markets right now is that commonly-
produced standardized financial ratios are meaningless. Without 
information, investors do not know the value of their holdings, cannot 
sell those holdings, and cannot rationally allocate funds derived from 
those sales if they could.\1\ Without funds, firms cannot invest in new 
projects that create economic value--that is, jobs, income, and 
economic growth. Nonetheless, existing policy proposals have all been 
about suppressing information: information about bank conditions, about 
other sources of risk, and even about government programs meant to 
address the situation.
    \1\ . . . and with interest rates near zero have no incentive to 
look very far for opportunities to sell, anyway.
    Unfortunately, financial reporting is thought of as an 
excruciatingly boring policy topic.\2\ More unfortunately, however, 
financial reporting is crucial to any well-functioning financial 
system. Without restoring financial reporting, we cannot hope to end 
too-big-to-fail (nay, too-misunderstood-to-fail) and we cannot expect 
to reinvigorate investment and economic growth.
    \2\ Only the chair and ranking member attended Senate Banking, 
Housing, and Urban Affairs Committee, Subcommittee on Securities, 
Insurance, and Investment hearings on FASB reform on September 18, 
    The breakdown of financial reporting began with off-balance sheet 
regulatory arbitrages affected in the early 1990s in response to Basel 
I.\3\ As bank conditions began to be evaluated on the basis of a 
capital/asset ratio on the tail end of a recession, banks seeking to 
raise their capital/asset ratio faced with the dilemma of whether to 
raise capital or reduce assets at a time when capital was prohibitively 
expensive. Hence, most sought to reduce assets through securitization, 
    \3\ Some also note the use of securitization to avoid interest rate 
risk in the 1980s. While that purpose was certainly useful, 
securitization did not really take off until the regulatory arbitrage 
became valuable.
    Often, however, the lion's share of risk was not transferred in the 
securitization. Rather, sellers retained first-loss residual and 
mezzanine interests in the loans and offered further representations 
and warranties supporting the sale. Some of those representations and 
warranties were explicit, some implicit. Implicit representations and 
warranties are now referred to by the industry as ``reputational 
risk,'' which has been cited as the reason some sellers repurchased 
entire deals of SIVs and ARSs, as well as other investments, in the 
past year.
    As discussed in my Senate Banking, Housing, and Urban Affairs 
Committee (Subcommittee on Securities, Insurance, and Investment) 
testimony from September 18, 2008, as early as 1987, Moody's pointed 
out that, ``. . . the practices developed by the accounting and 
regulatory world . . . do not fully capture the true economic risks of 
a securitized asset sale to the originator's credit quality.'' (Moody's 
Investors Service, ``Asset Securitization and Corporate Financial 
Health,'' December 1987, p. 3) Hence, long ago market insiders fully 
realized that standard accounting rules do not apply to securitizing 
    In 1997, Moody's Investors Service wrote that, ``. . . the simple 
act of securitizing assets can affect the appearance of the income 
statement and balance sheet in a profound manner without, in many 
cases, significantly altering the underlying economics of the 
[seller].'' (Alternative Financial Ratios for the Effects of 
Securitization, Moody's Investors Service, September 1997, p. 1) With 
securitization, therefore, reported earnings are overstated and 
reported balance sheet leverage is understated while there may be 
little, if any, risk transference.
    Moreover, it became common over time for sellers to voluntarily 
provide informal support to preserve the performance and bond ratings 
of their structured transactions. (Moody's Investor's Service, ``The 
Costs and Benefits of Supporting ``Troubled'' Asset-Backed Securities: 
Has the Balance Shifted?'' January 1997) As the practice became 
accepted by regulators and the marketplace, ratings agencies could 
indeed rate any of these bonds AAA without reference to fundamental 
loan pool characteristics or securitization structure because any 
seller with going concern value would support the pool to maintain its 
``reputational risk'' so it could issue again next period. Of course, 
it would be egregious to maintain that securitization transfers no risk 
at all. As we have seen recently, in the event of catastrophic asset 
quality problems the seller may choose NOT to support a troubled deal, 
notwithstanding even any legal--much less reputational--responsibility 
to do so. That is why investors right now want to know how much more is 
out there in off-balance sheet exposure that can still threaten the 
firm's ability to ``reputationally'' support their securities. 
Unfortunately, those answers are not easily found, even for 
professional investment analysts.
    Those off-balance sheet arrangements were also the first to utilize 
mark-to-market (really, mark-to-model) accounting features under the 
guise of gain-on-sale accounting. Gain-on-sale accounting led to 
tremendous industry disruptions in the late 1990s. FASB'S August 11, 
2005, Revision of Exposure Draft Issued June 10, 2003, ``Accounting for 
Transfers of Financial Assets, an amendment of FASB Statement No. 
140,'' (Financial Accounting Series No. 1225-001), explains gain-on-
sale roughly as follows: In order to facilitate ``gain-on-sale 
accounting,'' the firm (1) estimates the value of the thing they want 
to sell with a financial model. Then, the firm (2) receives some money 
and other items in the actual sale of that thing. Next, in what is the 
really arbitrary aspect of gain-on-sale accounting, the firm gets to 
(3) record the difference between their own valuation of the thing that 
they sold and the value of the cash and other items received in the 
sale as cash revenue.
    Difficulties in the high-LTV home-equity loan crisis of the late 
1990s were largely attributable to aggressive gain-on-sale accounting. 
According to Moody's:

        In the late 1990's, several subprime home equity and auto 
        lenders encountered financial difficulty arising in part from 
        explosive growth patterns, in part from using securitization as 
        a source of funds, and in part from overly aggressive use of 
        gain on sale accounting. Such accounting methodology made these 
        companies look much stronger financially on paper than they 
        actually were. Companies that used gain on sale accounting 
        included, among subprime mortgage issuers, Contifinancial 
        Corp., Southern Pacific Funding Corp., Cityscape, and United 
        Companies Financial Corp. . . . Once the effect of gain on sale 
        accounting was removed from financial statements, leverage 
        ratios were often high. These companies also had weak capital 
        positions compared to more diversified finance companies. 
        (Moody's Investors Service, ``Bullet Proof Structures 
        Revisited: Bankruptcies and a Market Hangover Test 
        Securitizations' Mettle,'' August 30, 2002, p. 14)

    The problem with gain-on-sale accounting, therefore, is that the 
revenue booked is not real cash. Hence, many recently-failed mortgage 
companies and similar firms associated with previous securitization 
fiascos have never been cash-flow positive in their entire corporate 
lives. When firms, realizing the risks of gain-on-sale accounting and 
the false earnings conditions they represented to investors, sought to 
pull back from gain-on-sale and become more conservative, they were 
told by FASB that any willing conservatism would be considered earnings 
manipulation. Thus, the financial world was recently littered with 
hundreds of firms with exceedingly high stock values that had never 
actually earned positive cash profits in a manner typical of a classic 
    Both off-balance sheet exposures and mark-to-market accounting 
argue for a more robust financial reporting environment than is that 
envisaged by the Financial Accounting Standards Board (FASB). In the 
Senate Banking, Housing, and Urban Affairs Committee, Subcommittee on 
Securities, Insurance, and Investment hearings on FASB reform on 
September 18, 2008, FASB abjectly refused to even consider advocating 
any deviation from an accounting system based on a single value for any 
particular item or firm. But in an off-balance sheet world of 
contingent claims and statistically modeled values for level 2 and 3 
``mark-to-market'' assets, a single value is not only inadequate, it is 
grossly misleading.
    Investors want to know the entirety of off-balance sheet exposures 
right now--knowing that the commercial banking industry is leveraged 
not at the 12:1 reported on balance sheet, but at roughly 185:1 off 
balance sheet--but are not able to get the information from existing 
sources.\4\ That does not mean that FASB should reverse policy and 
disallow off-balance sheet treatment, putting off-balance sheet 
exposures completely back on-balance sheet, only that the off-balance 
sheet exposures need to be completely and systematically reported 
somewhere in the financial statements.
    \4\ Even SEC Regulation AB was arbitraged when banks hid the 
required information on the internet. Try working with the following 
link (not linked to any of Countryside's corporate web site and with no 
main page to change reporting periods or otherwise run scenarios an 
investor might be interested in) for some of the data behind 
Countrywide's deals: http://www.countrywidedealsdata.com/
    But investors also want more. Investors also want to know the range 
of statistical model values that can be reasonably expected to apply to 
level 2 and 3 assets--that is, the standard errors of the estimates. 
Such ranges will allow investors to ``stress test'' firm financial 
characteristics on their own, in a clearly transparent way without 
being filtered through Treasury's secrecy and interpretation.
    It is important to realize that the investors I have been talking 
about include all bank ``counterparties.'' Outside investors today can 
evaluate banks no better than banks can evaluate one another's 
counterparty risk. Hence, transactions have shut down in today's opaque 
financial reporting environment. Guarantees and other second-best 
solutions will only alleviate counterparty risk concerns as long as the 
guarantor (even the Federal government) remains willing, credible, and 
solvent. Hence, the key objective has to be to restore financial market 
transparency as soon as humanly possible so that markets can once again 
work without the aid of outside guarantees.
            C. Deal with Asset Market Overhang
    The above discussion of financial reporting suggests that even if 
financial market prices are well-established, they are not presently 
communicated through credible financial reporting mechanisms. In 
today's housing markets, however, values of foreclosed and vacant 
houses are far from certain. Hence, alleviating the stock of unsold and 
unoccupied homes in today's housing market should be a key concern. 
Unfortunately, dogmatic ``home ownership'' policy and archaic bank 
regulations stand in the way of quick recovery. If we view the housing 
crisis as merely one of occupancy rather than ownership, policy 
solutions are readily at hand.
    The common understanding of the problem is that foreclosed homes 
are dumped on the market at fire sale prices and those prices push 
values down in surrounding neighborhoods.\5\ But while focusing on the 
foreclosure part of the problem we are missing the important part: the 
fire sale that pushes down prices. Fire sale prices result not because 
lenders want to sell at a loss, but because lenders--usually commercial 
banks--are prohibited from managing the real estate except for the 
brief period of time during which it is on the market.
    \5\ Although I do not need to go into it here, the common 
understanding is flawed: a foreclosed home is often of lower value than 
an occupied home because it has deteriorated in condition due to lack 
of maintenance and sometimes willful destruction of the previous 
    Consider what would happen if the bank could rent the home out and 
wait for market recovery. The bank would replace the cash flow from the 
loan with a slightly lower cash flow from rental income. While the bank 
would still book losses from legal costs and a lower rental income cash 
flow, fire sale losses could be avoided. Lastly, the bank can sell the 
home in the market upturn several years hence and possibly recoup some 
of the losses in the failed loan.\6\
    \6\ Bank ownership could be limited to seven years to ensure that 
banks do not end up being primarily real estate development companies.
    Consider the additional social advantages if the bank could rent 
the home to the existing occupants. If the financial conditions of the 
renter improved with economic recovery, the bank may also have a ready 
buyer in the existing occupant, as well. Occupants would have more of 
an incentive to maintain the property and foreclosed owners would have 
less incentive to destroy the property in reaction to bank actions. 
Occupants would most likely buy the house back from the bank at a 
market-determined value later on, relieving the need for government 
guess work in the middle of a crisis.
    Such regulatory changes are a simple way to ensure that home owners 
affected by the crisis do not get hurt again, something current 
modification proposals do not adequately address. In fact, forthcoming 
research shows that many companies claiming to be special servicers--
but really run by the same managers that owned failed subprime mortgage 
companies--are already entering the business to fleece borrowers and 
collect the $1,000 per head fee offered under the most recent housing 
plan. Even worse, modification frauds have proliferated throughout the 
country, preying on the same uninformed consumer that got the 
unaffordable subprime loan.
    The fact is servicer quality matters, and servicer quality matters 
even more when loans become distressed. A defaulted borrower that re-
establishes payment on their loan usually does so because of some 
element of trust between them and the servicer that leads to 
establishing a payment plan the borrower believes is advantageous to 
both parties. The servicer may work on the borrower's behalf as part of 
that plan, assembling a program combining elements of bankruptcy, 
selling other assets, or consolidating other loans. If the borrower is 
still unable to make the payments, the servicer maintains a good 
relationship with the borrower through the foreclosure process to 
preserve the value of the home and liquidating the collateral to 
collect money owed to the investor. (Fitch, ``Scratch & Dent: This Is 
Not Your Father's MBS,'' 20051213 at 8)
    But the servicing industry already has a checkered past. In the 
1990s subprime mortgage servicers were plagued with problems: 
aggressive growth strategies led to expanded underwriting guidelines; a 
significant increase in correspondent lending led to inflated property 
appraisals; and predatory practices both in underwriting and servicing 
led to rampant lawsuits. Many of the players that were market leaders--
such as ContiMortgage, IMC Mortgage, United Companies, and The Money 
Store--went out of business long ago. (Fitch, ``Rating U.S. Residential 
Subprime Mortgage Securities,'' at 1)
    According to Elizabeth McCaul, former Superintendant of Banks for 
the State of New York, some areas of weakness in the servicing industry 
in recent years leading up the present crisis included ``. . . a lack 
of focus on the strength of the originator/servicer, and improper 
analysis of the substitution of good loans for bad. We have seen re-
aging policies not being properly analyzed. In fact, investment in this 
area has been largely driven by mathematical formulations without 
enough qualitative analysis of operations and financial strength. For 
example, we have conducted reviews of portfolios and seen residuals on 
balance sheets that do not reflect enough financial strength to 
continue operations effectively. If the shop is closed, the Trustee 
comes in, the re-aging practices (and other practices) are halted. . . 
delinquencies roll in, and the rest, as you know, is history.'' 
(McCaul, Elizabeth, ``What's Ahead for the US Residential Mortgage 
Market,'' Speech at ASF 2007 conference by Elizabeth McCaul of 
Promontory Capital, former Superintendent of Banks for the State of New 
York, February 2, 2007 at www.SIFMA.org)
    According to Bank of America, ``Payment deferral will not help 
people who inflated incomes or recklessly bought properties they could 
not afford (by some estimates, 70% of stated income loans contain 
inflated by 50% or more).'' (Bank of America, ``Subprime Mortgage 
Finance Weekly: Subprime Loan Modifications--not a Panacea,'' May 25, 
2007, p. 4.) Deferring payments for such borrowers may just squeeze the 
last pennies out of the borrowers' pockets. If the borrower has no true 
hope of owing the home, even with the deferment plan, the program may 
be judged to be predatory. Even if such remedies are targeted across 
the pool of borrowers evenly, if protected class members adversely 
select to participate in such programs the outcome could be judged to 
harbor disparate impact. Worse yet, if the borrower does not maintain 
the house or destroys the house knowing that they cannot truly afford 
the home, the ultimate loss in foreclosure is larger than if the lender 
had foregone the mitigation. (Mason, Joseph R., Mortgage Loan 
Modification: Promises and Pitfalls, October 3, 2007. Available at 
SSRN: http://ssrn.com/abstract=1027470) Hence, according to Moody's, 
modifications that are used properly are obviously a very good tool. 
But, ``. . . the one thing you don't want to do is to defer the 
    The investor (and borrower) is therefore at the mercy of the 
servicer who is making a ``. . . judgment call as to whether a mortgage 
is salvageable or not, and that varies depending on market 
conditions,'' as well as personal conditions of the borrower and their 
intentions. (Moody's, ``Sub-Prime Mortgages: An Integrated Look into 
Credit Issues Today and What to Expect,'' Transcript of a 
teleconference held on Friday, 9 March 2007 at 16; Mason, Joseph R., 
Mortgage Loan Modification: Promises and Pitfalls, October 3, 2007. 
Available at SSRN: http://ssrn.com/abstract=1027470)
    Moreover, that judgment call is made with virtually no direct 
oversight. In most cases, prior to a servicer's default, the is trustee 
not required to investigate accuracy of information stated in any 
document it receives, unless it receives a written request from 
insurers or holders of minimum percentage of outstanding certificates 
to do so. Of course, a conundrum arises because insurers and investors 
have little reason to assume such a written request is necessary 
without some investigation of the accuracy of information in the 
documents. The point is the investor has to completely trust the 
servicer to act on their behalf, often in substantially unverifiable 
dimensions. (Heller-Ehrman, ``The Subprime Mortgage Crisis-Overview of 
Civil Litigation Claims,'' Presentation from Navigating the Credit 
Crisis Conference, Wednesday, March 5, 2008)
    Even if the trustee were to undertake such an investigation, 
however, the standard of service required of the contractual 
arrangements is vaguely defined. Typical provisions require the 
servicer to follow accepted servicing practices and procedures as it 
would employ ``in its good faith business judgment'' and which are 
``normal and usual in its general mortgage servicing activities'' and/
or certain procedures that such servicer would employ for loans held 
for its own account. (Heller-Ehrman, ``The Subprime Mortgage Crisis-
Overview of Civil Litigation Claims,'' Presentation from Navigating the 
Credit Crisis Conference, Wednesday, March 5, 2008)
    Servicing, therefore, is a crucial aspect of value to all consumer 
loan securitizations but it is not very well understood by regulators 
or investors. The problem is that servicer accountability and reporting 
to investors and regulators is woefully inadequate. Adequate 
information to evaluate servicer quality rarely exists, and where it 
does it is not consistently or widely distributed. Hence, regulators 
can do a great service to both the industry and borrowers in today's 
financial climate by insisting that servicers report adequate 
information to assess not only the success of major modification 
initiatives, but also overall performance. The increased investor 
dependence on third-party servicing that has accompanied securitization 
necessitates substantial improvements to investor reporting in order to 
support appropriate administration and, where helpful, modification of 
consumer loans in both the public and private interest.
II. Restoring the Economy in the Long-run: Building Tomorrow's Growth
    While the key challenge to implementing the short-term elements 
above are primarily inflexible dogma and courage, the challenge to 
long-term elements will be that of staying focused on the problems long 
after the crisis has passed. Nonetheless, fundamental changes to 
domestic and international regulatory structures will be key to 
maintaining U.S. financial market competitiveness, and policies that 
can streamline productivity gains through removing outmoded regulations 
and other impediments to growth can help increase U.S. economic 
competitiveness overall. Again, however, I cannot stress enough that 
focus will be the key. Hence, the short-and medium term need to be 
devoted to setting a foundation of shared bipartisan understanding of 
the issues the policies that need to be addressed. Only with a 
foundation of genuine shared understanding and agreement can the policy 
discussion last long enough--most likely this will take several 
political administrations--to reach meaningful solutions.
            A. Lay Down a Firm Foundation for Domestic Regulatory 
    Using the analogy of the ``financial architecture,'' the primary 
foundation lies in the fact that even the best architects cannot expect 
to create buildings that plumbers, electricians, and carpenters cannot 
build. Certain physical limitations of the financial system need to be 
addressed on a mundane fundamental level before we can think about the 
form of the regulatory system that we expect to arise. Changing titles 
of key regulatory officials, in the manner of a typical corporate 
reorganization, will not lead to effective change. As James Aitken of 
UBS is fond of saying, ``start with the plumbing.'' To that I would add 
that not only is the plumbing the hardest thing to change afterward, 
but flow is a natural concept that is impossible to fight and back-ups 
really stink!
    The starting point is the basic concept of and appropriate role for 
financial regulation. There will always be a portion of the financial 
system in which highly risky products are traded with freedom and there 
should always be a portion where risk is kept within certain well-
monitored acceptable levels. Hence, there will always exist a continuum 
of regulated and unregulated institutions (whether we like it or not--
black markets work, too). If we push regulation to hitherto unregulated 
institutions, new unregulated institutions will be developed to operate 
in the unregulated portion of the continuum. Hedge funds arose in this 
regard, and new institutions will develop behind them.
    That starting point leads to the recognition that one key principal 
violated in the recent crisis is akin to the gravity that causes water 
to flow downhill: while it is fine for non-regulated financial 
institutions to invest and fund themselves via regulated institutions, 
if the system allows regulated institutions to fund themselves and 
invest in non-regulated products you have a recipe for disaster. We 
should want risk to travel from regulated to non-regulated firms, but 
we should try to prevent risk from travelling the other direction. When 
banks funded lending via private unregulated securitization markets, 
banks began to rely crucially on a set of unregulated financial 
institutions that were not fully developed and are therefore prone to 
volatility and upset--the recipe for the disaster we are seeing.
    That leads to a second observation: risk never goes away. Pooling 
loans to serve as collateral for a securitization does not create 
diversification any more than buying more shares of the same firm. 
Tranching mortgage- or asset-backed securities also does not reduce 
risk, it only moves it to the most junior bond claimants--usually the 
banks, themselves, that hold the residuals and mezzanine stakes.
    The point is that in a world based on financial engineering, risk 
is increasingly fungible. For instance, where risk seems to disappear 
on a contractual basis, it reappears on a reputational basis. It is 
straightforward, therefore, to propose that reputational risk is 
valuable. Moreover, however, reputational risk is fairly easily defined 
in terms of game theory: reputational risk exists when there is a cost 
of cooperating and that cooperation is necessary to continue the game 
to the next period (i.e., bailing out securitized investors like those 
in SIVs and ARSs). It is straightforward to propose, therefore, that 
firms should hold capital to cover the probable cost of cooperation.
    The starting points of acknowledging roles for risky and less risky 
institutions and the evolution of institutions to meet market needs 
also lead to an acknowledgement that financial innovation will always 
be with us. Hence, we need a system flexible enough to monitor new 
developments and relate their importance to the gravity and fungibility 
conditions discussed above. From 2001 through 2008, Mark Adelson (now 
at S&P) archived panel notes at structured finance industry conferences 
around the world that described how the industry has long been 
concerned with many of the issues that are causing the present crisis. 
(see http://www.adelsonandjacob.com/publications.html) Regulators, 
however, failed to listen to discussion within the industry, choosing 
instead to ignore the developments until the scale of difficulties rose 
to a national economic crisis that demanded their attention.
    This failure to monitor financial innovation and new financial 
institutions--along with the specious nature of the currently proposed 
systemic risk regulatory approach--leads to consideration of a much 
more effective monitoring role for all regulatory agencies, tracking 
innovation and new financial institutions to ensure that they do not 
move unregulated risk into regulated institutions by transforming it 
into previously unmonitored forms.
    Finance is a fast-evolving field. Financial regulators therefore 
need to be proactive in their approach, so that they are not 
``surprised'' enough for unmonitored risks to become anything that 
could even loosely be considered ``systemic'' in the first place.
            B. Start Building a More Comprehensive International 
                    Regulatory Structure
    Currently, other dogmatic and inflexible approaches are driving a 
wedge between European and U.S. regulation, and both are leaving the 
rest of the world behind. Instead, it makes sense in an increasingly 
global world to work with other countries to further develop unified 
standards set under the Foreign Bank Supervision Enhancement Act of 
1991 (FBSEA) that can deal not only with prudential supervision of 
banks in particular, but financial institutions and their failures more 
    According to the Federal reserve Bank of New York, foreign banking 
institutions, which include foreign bank branches, agencies, and U.S.-
chartered bank subsidiaries, hold approximately one-fourth of all 
commercial banking assets in the United States. In December 2006, 
foreign banking organizations operated or controlled 188 branches, 133 
agencies, 62 U.S. commercial banks, and 8 Edge or Agreement 
corporations. Foreign banking institutions held about $216 billion in 
commercial and industrial loans, roughly 18 percent of the total in the 
United States.
    FBSEA laid down responsibilities for prudential supervision of 
foreign banking institutions largely in response to the Bank of Credit 
and Commerce International (BCCI) scandal, in which it was found that 
no regulatory agency took responsibility for BCCI's prudential 
supervision. FBSEA laid down rules of assigning prudential supervision 
authority among different countries. FBSEA also stipulated that 
although branches may receive deposits of any size from foreigners, 
they may accept deposits only in excess of $100,000 (wholesale 
deposits) from U.S. citizens and residents.\7\ Similar provisions exist 
across European countries, limiting domestic deposit insurance 
liabilities to foreign depositors.
    \7\ Furthermore, as a result of the FBSEA, deposits in any foreign 
bank branch established after December 19, 1991, are not covered by 
U.S. deposit insurance; deposit insurance is now offered only to U.S.-
chartered depository institutions. Foreign agencies specialize in 
making commercial loans to finance international transactions, and they 
may accept only short-term deposits related to such transactions.
    Unfortunately, FBSEA has remained frozen in time as the global 
financial system has changed. In fact, we have learned from the current 
crisis that while it is important to limit deposit insurance fund 
liability across borders, it is equally if not more important to deal 
with asset resolutions across borders. For instance, with some 18 
percent of U.S. commercial and industrial loans, the failure of a 
foreign bank can have dire ramifications for U.S. businesses. 
Furthermore, in the event of a deposit insurance payout at the foreign 
bank, foreign deposit insurance authorities' dealings with U.S. 
borrowers could be important to U.S. regional or national economic 
performance. Even more complex, will foreign bank U.S. asset proceeds 
be used to pay amounts due to U.S. depositors, or do those satisfy 
foreign bank home country insured depositors first?
    Resolving global financial crises in a global marketplace means 
coordinating regulatory approaches to sell banks and bank assets across 
borders. Hence, we need to develop a Foreign Financial Asset Resolution 
Enhancement Act to effectively deal with other countries' regulatory 
systems that manage both bank and non-bank assets and smooth regulatory 
frictions that can interfere with orderly resolutions of financial 
assets, worldwide. This initiative becomes more crucial day by day, as 
too-big-to-fail becomes too-big-to-save when financial institutions 
become larger than not only their safety nets, but also their home 
country domestic economies.
            C. Increase U.S. Economic Competitiveness
    All of the above initiatives ultimately increase U.S. economic 
competitiveness. Increased international diplomacy regarding foreign 
bank resolutions can also create ties that break through foreign 
nationalist pressures and nascent trade blocs that are developing as 
countries try to insulate themselves from the global crisis. Those 
diplomatic efforts will help to maintain trade patterns that foster 
U.S. manufacturing and therefore economic growth.
    Smart regulation in the financial sector will reduce unnecessary 
impediments to growth in U.S. financial markets, maintaining U.S. 
preeminence as having the most transparent and efficient markets in the 
world. Undertaking a broad-based review of the U.S. financial reporting 
will reveal obvious avenues for improvement--such as changing bank 
regulatory call report classifications for brokered deposits and 
developing increasingly relevant consolidated bank holding company-
level Y-9 reports of off-balance sheet risk--that will lead to more 
sensible regulatory rulemaking in the new financial marketplace.
III. Summary and Conclusions
    This written testimony offers three primary suggestions for short- 
and long-term strategies to restore the economy and fostering long-term 
growth. Again, my testimony focuses primarily, but not exclusively, on 
financial market reforms. The reason for that focus lies in the 
macroeconomic understanding that financial crises do not cause 
recessions, but merely prolong and deepen them. Recessions are 
therefore possible without a financial crisis, but once an economic is 
in recession recovery is virtually impossible with a financial crisis 
    As stated above, in the short-term, resolving the crisis will 
require humility and hard work. The United States still has the most 
advanced financial system in the world, but over the last several 
decades the growth of that system outpaced U.S. regulatory 
capabilities. Among the key weaknesses that caused the crisis are 
relatively well-understood shortcomings like too-big-to-fail, 
insufficient accounting transparency, and asset market overhang. We 
already have several decades of economic research that we can use to 
resolve those problems in the short run, even if doing so will take 
courage and flexibility. Nonetheless, while existing policy attempts to 
address some of these issues get close, slight changes in approach can 
achieve success in a much more straightforward and effective manner.
    For instance, the House introduced Bond Rating legislation as HR 
6482 last summer, but that bill was not put to vote due to the 
financial market crises of the period. Such legislation will be 
crucially important to moving the industry forward. But even dogmatic 
shifts such as focusing on the far more obtainable goal of housing 
occupancy instead of home ownership can help get our economy moving 
quickly again with a lower probability of home buyers getting hurt 
    As stated above, reform in the long run will be much harder, 
requiring significant efforts to fix old and build new regulatory 
structures and set the stage for U.S. economic growth. Much of the work 
will not be glamorous. Before one brick can be laid in the new 
financial structure, there needs to be a hard discussion of regulatory 
principals that will serve as the mortar of the construct. Much 
additional work is necessary to develop international diplomatic 
relations around existing unitary principals of oversight to develop 
standards and procedures for resolving failed financial institutions, 
providing bridge financing and oversight and disposing of their assets. 
Global imbalances in economic growth potential are already spurring the 
development of trade blocs and agreements worldwide, presenting both 
opportunities and threats to U.S. markets. U.S. financial diplomacy 
abroad will go a long way toward smoothing some of those sentiments, 
and U.S. businesses will have to adapt strategically to fast-moving 
changes in global markets to stay competitive.
    The binding principals of any regulatory reform process--which is a 
large part of what we have at hand here--are ``do no harm'' and ``leave 
the industry cleaner than when you arrived.'' Hence, we have before us 
both the opportunity and motivation to improve our economy and our 
nation. Let us embark on setting a firm foundation for improved 
financial markets and economic growth potential so that the necessary 
restructuring becomes known more for its own success than the crisis 
that motivated the changes.
    In conclusion, it is fitting that today's panel includes the 
Honorable Paul Volcker, who Chaired the Federal Reserve at a time when 
we first learned of ``natural rates'' in economics. We learned then 
that attempts to push unemployment below natural levels creates 
perverse economic dynamics, like stagflation. The recent push to drive 
home ownership rates to one hundred percent and substitute debt for 
income has had similar perverse effects. As Chairman Volcker showed us 
back then, the only way out of the perverse dynamics is to move through 
the downturn. I hope we learn form Chairman Volcker's example and 
exhibit the courage to book the losses, learn our lessons, and move 
back to meaningful and robust economic growth.