[JPRT, 111th Congress]
[From the U.S. Government Publishing Office]


                     CONGRESSIONAL OVERSIGHT PANEL
                           SPECIAL REPORT ON
                          REGULATORY REFORM *

                               ----------                              
 
                   MODERNIZING THE AMERICAN FINANCIAL 
                           REGULATORY SYSTEM: 
                     RECOMMENDATIONS FOR IMPROVING 
                    OVERSIGHT, PROTECTING CONSUMERS, 
                         AND ENSURING STABILITY 

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]


                February  , 2009.--Ordered to be printed

    * Submitted under Section 125(b)(2) of Title I of the Emergency 
        Economic Stabilization Act of 2008, Pub. L. No. 110-343















   CONGRESSIONAL OVERSIGHT PANEL SPECIAL REPORT ON REGULATORY REFORM

















                                       

                                       

                                       

                                       

                                       

                     CONGRESSIONAL OVERSIGHT PANEL
                           SPECIAL REPORT ON
                          REGULATORY REFORM *

                               __________

                   MODERNIZING THE AMERICAN FINANCIAL
                           REGULATORY SYSTEM:
                     RECOMMENDATIONS FOR IMPROVING
                    OVERSIGHT, PROTECTING CONSUMERS,
                         AND ENSURING STABILITY

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]


                February  , 2009.--Ordered to be printed

    * Submitted under Section 125(b)(2) of Title I of the Emergency 
        Economic Stabilization Act of 2008, Pub. L. No. 110-343

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


















                            C O N T E N T S

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                                                                   Page
  I. Executive Summary................................................1
        1. Lessons From the Past.................................     1
        2. Shortcomings of the Present...........................     2
        3. Recommendations for the Future........................     3
 II. Introduction.....................................................5
III. A Framework for Analyzing the Financial Regulatory System and Its 
     Effectiveness....................................................7
        1. The Promise and Perils of Financial Markets...........     7
        2. The Current State of the Regulatory System............     8
            Failure to Effectively Manage Risk...................     8
            Failure to Require Sufficient Transparency...........    12
            Failure to Ensure Fair Dealings......................    15
        3. The Central Importance of Regulatory Philosophy.......    18
 IV. Critical Problems and Recommendations for Improvement...........21
        1. Identify and Regulate Financial Institutions That Pose 
          Systemic Risk..........................................    21
        2. Limit Excessive Leverage in American Financial 
          Institutions...........................................    23
        3. Modernize Supervision of Shadow Financial System......    27
        4. Create a New System for Federal and State Regulation 
          of Mortgages and other Consumer Credit Products........    30
        5. Create Executive Pay Structures That Discourage 
          Excessive Risk Taking..................................    36
        6. Reform the Credit Rating System.......................    40
        7. Make Establishing a Global Financial Regulatory Floor 
          a U.S. Diplomatic Priority.............................    44
        8. Plan for the Next Crisis..............................    46
  V. Issues Requiring Further Study..................................49
 VI. Acknowledgments.................................................50
VII. About the Congressional Oversight Panel.........................51
VIII.Additional Views................................................52

        Richard H. Neiman........................................    52
        Congressman Jeb Hensarling and former Senator John E. 
          Sununu.................................................    55
Appendix: Other Reports on Financial Regulatory Reform...........    95





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

                  SPECIAL REPORT ON REGULATORY REFORM

                                _______
                                

                February  , 2009.--Ordered to be printed

                                _______
                                

                          I. EXECUTIVE SUMMARY


                        1. LESSONS FROM THE PAST

    Financial crises are not new. As early as 1792, during the 
presidency of George Washington, the nation suffered a severe 
panic that froze credit and nearly brought the young economy to 
its knees. Over the next 140 years, financial crises struck on 
a regular basis--in 1797, 1819, 1837, 1857, 1873, 1893-96, 
1907, and 1929-33--roughly every fifteen to twenty years.
    But as the United States emerged from the Great Depression, 
something remarkable happened: the crises stopped. New 
financial regulation--including federal deposit insurance, 
securities regulation, and banking supervision--effectively 
protected the system from devastating outbreaks. Economic 
growth returned, but recurrent financial crises did not. In 
time, a financial crisis was seen as a ghost of the past.
    After fifty years without a financial crisis--the longest 
such stretch in the nation's history--financial firms and 
policy makers began to see regulation as a barrier to efficient 
functioning of the capital markets rather than a necessary 
precondition for success.
    This change in attitude had unfortunate consequences. As 
financial markets grew and globalized, often with breathtaking 
speed, the U.S. regulatory system could have benefited from 
smart changes. But deregulation and the growth of unregulated, 
parallel shadow markets were accompanied by the nearly 
unrestricted marketing of increasingly complex consumer 
financial products that multiplied risk at every stratum of the 
economy, from the family level to the global level. The result 
proved disastrous. The first warning followed deregulation of 
the thrifts, when the country suffered the savings and loan 
crisis in the 1980s. A second warning came in 1998 when a 
crisis was only narrowly averted following the failure of a 
large unregulated hedge fund. The near financial panic of 2002, 
brought on by corporate accounting and governance failures, 
sounded a third warning.
    The United States now faces its worst financial crisis 
since the Great Depression. It is critical that the lessons of 
that crisis be studied to restore a proper balance between free 
markets and the regulatory framework necessary to ensure the 
operation of those markets to protect the economy, honest 
market participants, and the public.

                     2. SHORTCOMINGS OF THE PRESENT

    The current crisis should come as no surprise. The present 
regulatory system has failed to effectively manage risk, 
require sufficient transparency, and ensure fair dealings.
    Financial markets are inherently volatile and prone to 
extremes. The government has a critical role to play in helping 
to manage both public and private risk. Without clear and 
effective rules in place, productive financial activity can 
degenerate into unproductive gambling, while sophisticated 
financial transactions, as well as more ordinary consumer 
credit transactions, can give way to swindles and fraud.
    A well-regulated financial system serves a key public 
purpose: if it has the power and if its leaders have the will 
to use that power, it channels savings and investment into 
productive economic activity and helps prevent financial 
contagion. Like the management of any complex hazard, financial 
regulation should not rely on a single magic bullet, but 
instead should employ an array of related measures for managing 
various elements of risk. The advent of the automobile brought 
enormous benefits but also considerable risks to drivers, 
passengers, and pedestrians. The solution was not to prohibit 
driving, but rather to manage the risks through reasonable 
speed limits, better road construction, safer sidewalks, 
required safety devices (seatbelts, airbags, children's car 
seats, antilock breaks), mandatory automobile insurance, and so 
on. The same holds true in the financial sector.
    In recent years, however, the regulatory system not only 
failed to manage risk, it also failed to require disclosure of 
risk through sufficient transparency. American financial 
markets are profoundly dependent upon transparency. After all, 
the fundamental risk/reward corollary depends on the ability of 
market participants to have confidence in their ability to 
accurately judge risk.
    Markets have become opaque in multiple ways. Some markets, 
such as hedge funds and credit default swaps, provide virtually 
no information. Even so, disclosure alone does not always 
provide genuine transparency. Market participants must have 
useful, relevant information delivered in an appropriate, 
timely manner. Recent market occurrences involving off-balance-
sheet entities and complex financial instruments reveal the 
lack of transparency resulting from the wrong information 
disclosed at the wrong time and in the wrong manner. Mortgage 
documentation suffers from a similar problem, with reams of 
paper thrust at borrowers at closing, far too late for any 
borrower to make a well-informed decision. Just as markets and 
financial products evolve, so too must efforts to provide 
understanding through genuine transparency.
    To compound the problem associated with uncontained and 
opaque risks, the current regulatory framework has failed to 
ensure fair dealings. Unfair dealing can be blatant, such as 
outright deception or fraud, but unfairness can also be much 
more subtle, as when parties are unfairly matched. Individuals 
have limited time and expertise to master complex financial 
dealings. If one party to a transaction has significantly more 
resources, time, sophistication or experience, other parties 
are at a fundamental disadvantage. The regulatory system should 
take appropriate steps to level the playing field.
    Unfair dealings affect not only the specific transaction 
participants, but extend across entire markets, neighborhoods, 
socioeconomic groups, and whole industries. Even when only a 
limited number of families in one neighborhood have been the 
direct victims of a predatory lender, the entire neighborhood 
and even the larger community will suffer very real 
consequences from the resulting foreclosures. As those 
consequences spread, the entire financial system can be 
affected as well. More importantly, unfairness, or even the 
perception of unfairness, causes a loss of confidence in the 
marketplace. It becomes all the more critical for regulators to 
ensure fairness through meaningful disclosure, consumer 
protection measures, stronger enforcement, and other measures. 
Fair dealings provide credibility to businesses and 
satisfaction to consumers.
    In tailoring regulatory responses to these and other 
problems, the goal should always be to strike a reasonable 
balance between the costs of regulation and its benefits. Just 
as speed limits are more stringent on busy city streets than on 
open highways, financial regulation should be strictest where 
the threats--especially the threats to other citizens--are 
greatest, and it should be more moderate elsewhere.

                   3. RECOMMENDATIONS FOR THE FUTURE

    Modern financial regulation can provide consumers and 
investors with adequate information for making sound financial 
decisions and can protect them from being misled or defrauded, 
especially in complex financial transactions. Better regulation 
can reduce conflicts of interest and help manage moral hazard, 
particularly by limiting incentives for excessive risk taking 
stemming from often implicit government guaranties. By limiting 
risk taking in key parts of the financial sector, regulation 
can reduce systemic threats to the broader financial system and 
the economy as a whole. Ultimately, financial regulation 
embodies good risk management, transparency, and fairness.
    Had regulators given adequate attention to even one of the 
three key areas of risk management, transparency and fairness, 
we might have averted the worst aspects of the current crisis.

    1. Risk management should have been addressed through 
better oversight of systemic risks. If companies that are now 
deemed ``too big to fail'' had been better regulated, either to 
diminish their systemic impact or to curtail the risks they 
took, then these companies could have been allowed to fail or 
to reorganize without taxpayer bailouts. The creation of any 
new implicit government guarantee of high-risk business 
activities could have been avoided.
    2. Transparency should have been addressed through better, 
more accurate credit ratings. If companies issuing high-risk 
credit instruments had not been able to obtain AAA ratings from 
the private credit rating agencies, then pension funds, 
financial institutions, state and local municipalities, and 
others that relied on those ratings would not have been misled 
into making dangerous investments.
    3. Fairness should have been addressed through better 
regulation of consumer financial products. If the excesses in 
mortgage lending had been curbed by even the most minimal 
consumer protection laws, the loans that were fed into the 
mortgage backed securities would have been choked off at the 
source, and there would have been no ``toxic assets'' to 
threaten the global economy.

    While the current crisis had many causes, it was not 
unforeseeable. Correcting the mistakes that fueled this crisis 
is within reach. The challenge now is to develop a new set of 
rules for a new financial system.
    The Panel has identified eight specific areas most urgently 
in need of reform:

          1. Identify and regulate financial institutions that 
        pose systemic risk.
          2. Limit excessive leverage in American financial 
        institutions.
          3. Increase supervision of the shadow financial 
        system.
          4. Create a new system for federal and state 
        regulation of mortgages and other consumer credit 
        products.
          5. Create executive pay structures that discourage 
        excessive risk taking.
          6. Reform the credit rating system.
          7. Make establishing a global financial regulatory 
        floor a U.S. diplomatic priority.
          8. Plan for the next crisis.

    While these are the most pressing reform recommendations, 
many other issues merit further study, the results of which the 
Panel will present in future reports. Despite the magnitude of 
the task, the central message is clear: through modernized 
regulation, we can dramatically reduce the risk of crises and 
swindles while preserving the key benefits of a vibrant 
financial system
    Americans have paid dearly for this latest crisis. Lost 
jobs, failed businesses, foreclosed homes, and sharply cut 
retirement savings have touched people all across the county. 
Now every citizen--even the most prudent--is called on to 
assume trillions of dollars in liabilities spent to try to 
repair a broken system. The costs of regulatory failure and the 
urgency of regulatory reform could not be clearer.
                            II. INTRODUCTION

    The financial crisis that began to take hold in 2007 has 
exposed significant weaknesses in the nation's financial 
architecture and in the regulatory system designed to ensure 
its safety, stability, and performance. In fact, there can be 
no avoiding the conclusion that our regulatory system has 
failed.
    The bursting of the housing bubble produced the first true 
stress test of modern capital markets, their instruments, and 
their participants. The first cracks were evident in the 
subprime mortgage market and in the secondary market for 
mortgage-related securities. From there, the crisis spread to 
nearly every corner of the financial sector, both at home and 
abroad, taking down some of the most venerable names in the 
investment banking and insurance businesses and crippling 
others, wreaking havoc in the credit markets, and brutalizing 
equity markets worldwide.
    As asset prices deflated, so too did the theory that had 
increasingly guided American financial regulation over the 
previous three decades--namely, that private markets and 
private financial institutions could largely be trusted to 
regulate themselves. The crisis suggested otherwise, 
particularly since several of the least regulated parts of the 
system were among the first to run into trouble. As former 
Federal Reserve Chairman Alan Greenspan acknowledged in 
testimony before the House Committee on Oversight and 
Government Reform in October 2008, ``Those of us who have 
looked to the self-interest of lending institutions to protect 
shareholders' equity, myself included, are in a state of 
shocked disbelief.'' \1\
---------------------------------------------------------------------------
    \1\ See Edmund L. Andrews, Greenspan Concedes Error on Regulation, 
New York Times (Oct. 24, 2008). See also House Committee on Oversight 
and Government Reform, Testimony of Alan Greenspan, The Financial 
Crisis and the Role of Federal Regulators, 110th Cong., at 2 (Oct. 23, 
2008) (online at oversight.house.gov/documents/20081023100438.pdf).
---------------------------------------------------------------------------
    The financial meltdown necessitates a thorough review of 
our regulatory infrastructure, the behavior of regulators and 
their agencies, and the regulatory philosophy that informed 
their decisions. At the same time, we must be careful to avoid 
the trap of looking solely backward--preparing to fight the 
last war. Although the crisis has exposed many deficiencies, 
there are likely others that have yet to be uncovered. What is 
more, the vast federal response to the crisis--including 
unprecedented rescues of crippled businesses and a 
proliferation of government guaranties--threatens to distort 
private incentives in the future, further eroding the caution 
of financial creditors and making the job of regulatory 
oversight all the more essential.
    Realizing that far-reaching reform will be needed in the 
wake of the crisis, Congress directed the Congressional 
Oversight Panel (hereinafter ``the Panel'') to submit a special 
report on regulatory reform,

        analyzing the current state of the regulatory system 
        and its effectiveness at overseeing the participants in 
        the financial system and protecting consumers, and 
        providing recommendations for improvement, including 
        recommendations regarding whether any participants in 
        the financial markets that are currently outside the 
        regulatory system should become subject to the 
        regulatory system, the rationale underlying such 
        recommendation, and whether there are any gaps in 
        existing consumer protections.\2\
---------------------------------------------------------------------------
    \2\ Emergency Economic Stabilization Act of 2008, Pub. L. No. 110-
343, at Sec. 125(b)(2).

    Toward this end, part III of this report presents a broad 
framework for analyzing the effectiveness of financial 
regulation, focusing on three critical failures of the current 
system: (1) inadequate private and public risk management, (2) 
insufficient transparency and information, and (3) a lack of 
protection against deception and unfair dealing. These key 
failures of the regulatory system have manifested themselves in 
a plethora of more specific problems, ranging from excessively 
leveraged financial institutions to opaque financial 
instruments falling outside the scope of the jurisdiction of 
any regulatory agency. While this report cannot tackle every 
one of these problems, part IV focuses on eight areas of the 
current financial regulatory system that are in need of 
improvement, offering the Panel's recommendations for each as 
---------------------------------------------------------------------------
follows:

          1. Identify and regulate financial institutions that 
        pose systemic risk.
          2. Limit excessive leverage in American financial 
        institutions.
          3. Modernize supervision of the shadow financial 
        system.
          4. Create a new system for federal and state 
        regulation of mortgages and other consumer credit 
        products.
          5. Create executive pay structures that discourage 
        excessive risk taking.
          6. Reform the credit rating system.
          7. Make establishing a global financial regulatory 
        floor a U.S. diplomatic priority.
          8. Plan for the next crisis.

    Finally, part V of this report points to some additional 
challenges in need of attention over the longer term, several 
of which will be addressed in future reports of the Panel. An 
appendix comprising summaries of other recent reports regarding 
reform of the regulatory system is found at the end of the 
report.
    This report is motivated by the knowledge that millions of 
Americans suffer when the financial regulatory system and the 
capital markets fail. The financial meltdown has many causes 
but one overwhelming result: a great increase in unexpected 
hardships and financial challenges for American citizens. The 
unemployment rate is rising sharply every month, a growing 
number of Americans are facing the prospect of losing their 
homes, retirees are worried about how to afford even basic 
necessities, and families are anxious about paying for college 
and securing a decent start in adult life. The goal of the 
regulatory reforms presented in this report is not to endorse a 
particular economic theory or merely to guide the country 
through the current crisis. The goal is instead to establish a 
sturdy regulatory system that will facilitate the growth of 
financial markets and will protect the lives of current and 
future generations of Americans.
III. A FRAMEWORK FOR ANALYZING THE FINANCIAL REGULATORY SYSTEM AND ITS 
                             EFFECTIVENESS


             1. THE PROMISE AND PERILS OF FINANCIAL MARKETS

    Households, firms, and government agencies all rely on the 
financial system for saving and raising capital, settling 
payments, and managing risk. A dynamic financial system 
facilitates the mobilization of resources for large projects 
and the transfer of resources across time and space and 
provides critical information in the form of price signals that 
help to coordinate dispersed economic activity. A healthy 
financial system, one that allows for the efficient allocation 
of capital and risk, is indispensable to any successful 
economy.
    Unfortunately, financial systems are also prone to 
instability and abuse. Until the dawn of modern financial 
regulation in the 1930s and early 1940s, financial panics were 
a regular--and often debilitating--feature of American life. 
The United States suffered significant financial crises in 
1792, 1819, 1837-39, 1857, 1873, 1893-95, 1907, and 1929-33. 
After the Great Depression and the introduction of federal 
deposit insurance and federal banking and securities 
regulation, the next significant banking crisis did not strike 
for more than forty years. This period of relative stability--
by far the longest in the nation's history--persisted until the 
mid-1980s, with the onset of the savings and loan crisis; 
dealing with that crisis cost American taxpayers directly some 
$132 billion.\3\ The country also suffered a group of bank 
failures that produced the need to recapitalize the FDIC's 
initial Bank Insurance Fund in the early 1990s; suffered a 
stock market crash in 1987; witnessed a wave of foreign 
currency crises (and associated instability) in 1994-95 and 
1997-98; saw the collapse of Long Term Capital Management 
(LCTM) hedge fund in 1998; and faced the collapse of the tech 
bubble in 2001. Financial crisis has now struck again, with the 
subprime-induced financial turmoil of 2007-09.
---------------------------------------------------------------------------
    \3\ On the period of relative financial stability (``the great 
pause''), see David Moss, An Ounce of Prevention: The Power of Sound 
Risk Management in Stabilizing the American Financial System (2009). 
See also Federal Deposit Insurance Corporation, History of the 
Eighties--Lessons for the Future, Volume I: An Examination of the 
Banking Crises of the 1980s and Early 1990s, at 187 (online at 
www.fdic.gov/bank/historical/history/167_188.pdf).
---------------------------------------------------------------------------
    Although every crisis is distinctive in its particulars, 
the commonalities across crises are often more striking than 
the differences. As the financial historian Robert Wright 
explains: ``All major panics follow the same basic outline: 
asset bubble, massive leverage (borrowing to buy the rising 
asset), bursting bubble (asset price declines rapidly), 
defaults on loans, asymmetric information and uncertainty, 
reduced lending, declining economic activity, unemployment, 
more defaults.'' \4\
---------------------------------------------------------------------------
    \4\ See Andrea Young, What Economic Historians Think About the 
Meltdown, History News Network (Oct. 20, 2008) (online at hnn.us/
articles/55851.html).
---------------------------------------------------------------------------
    Nor are financial panics the only cause for concern. 
Financial markets have also long exhibited a vulnerability to 
manipulation, swindles, and fraud, including William Duer's 
notorious attempt to corner the market for United States 
government bonds in 1791-92, the ``wildcat'' life insurance 
companies of the early nineteenth century (which took premiums 
from customers but disappeared before paying any claims), the 
infamous pyramiding scheme of Charles Ponzi in 1920, and the 
highly suspect practices of New York's National City Bank and 
its chairman, Charles Mitchell, in the run-up to the Great 
Crash of 1929. The apparent massive Ponzi scheme of Bernard 
Madoff that has recently unraveled in 2008 is only the latest 
in a long series of such financial scandals.
    Even apart from the most spectacular financial crises and 
crimes, the failure of any individual financial institution--
all by itself--can have devastating consequences for the 
investors and clients who rely on it.\5\ The collapse of a 
bank, insurance company, or pension fund can prove particularly 
damaging, disrupting longstanding financial relationships and 
potentially destroying the safety nets that many Americans have 
spent years carefully building.
---------------------------------------------------------------------------
    \5\ In fact, because of the salutary effects of existing 
regulations, not all failures of financial institutions create the same 
level of damage. For instance, the government has insured consumer 
deposits in financial institutions since the New Deal in recognition of 
the dangers of a loss of depositor confidence. Consequently, it is no 
longer the risk of shareholder losses that cause fear of systemic 
crisis, but rather the risk of financial institutions defaulting on 
fixed obligations.
---------------------------------------------------------------------------
    The good news is that many of these financial risks can be 
significantly attenuated through sound regulation. Well-
designed regulation has the potential to enhance both financial 
safety and economic performance, and it has done so in the 
past. To be sure, the risks of capital market crises cannot be 
eliminated altogether, just as the risk of automobile accidents 
will never entirely disappear, despite rigorous safety 
standards.

             2. THE CURRENT STATE OF THE REGULATORY SYSTEM

    The purpose of financial regulation is to make financial 
markets work better and to ensure that they serve the interests 
of all Americans. There are many important (and sometimes 
competing) goals of financial regulation, ranging from safety 
and stability to innovation and growth. In order to achieve 
these goals, an effective regulatory system must manage risk, 
facilitate transparency, and promote fair dealings among market 
actors. The current system has failed on all three counts.

Failure to effectively manage risk

    As the current financial meltdown makes clear, private 
financial markets do not always manage risk effectively on 
their own. In fact, to a large extent, the current crisis can 
be understood as the product of a profound failure in private 
risk management, combined with an equally profound failure in 
public risk management, particularly at the federal level.
    Failure of private risk management. The risk-management 
lapses in the private sector are by now obvious. In the 
subprime market, brokers and originators often devoted 
relatively little attention to risk assessment, exhibiting a 
willingness to issue extraordinarily risky mortgages (for high 
fees) so long as the mortgages could be sold quickly on the 
secondary market.\6\ Securitizers on Wall Street and elsewhere 
proved hungry for these high-interest-rate loans, because they 
could earn large fees for bundling them, dividing the payments 
into tranches, and selling the resulting securities to 
investors. These securities proved attractive, even to 
relatively risk-averse investors, because the credit rating 
agencies (who were paid by the issuers) awarded their triple-A 
seal of approval to the vast majority of the securities in any 
given issue. The credit rating agencies concluded--wrongly, it 
turns out--that virtually all of the risk of a subprime 
mortgage-backed securitization was concentrated in its lowest 
tranches (e.g., the bottom 15 to 25 percent) and that the 
remainder was exceedingly safe. Nor did the process end there, 
since lower-tranche securities (e.g., those with a BBB rating 
or below) could be aggregated into so-called collateralized 
debt obligations (CDOs) and re-tranched, creating whole new 
sets of AAA and AA securities. Only when the housing market 
turned down and delinquencies and foreclosures started to rise, 
beginning in 2006-07, did the issuers, investors, and rating 
agencies finally recognize how severely they had underestimated 
the key risks involved.\7\
---------------------------------------------------------------------------
    \6\ These mortgages included so-called 2-28s (which were scheduled 
to reset to a sharply higher interest rate after two years) and option-
arms (which allowed customers essentially to set their own payments in 
an initial period, followed by ballooning payments after that). Whether 
or not borrowers could reasonably be expected to repay--based on their 
earning capacity--was no longer always a decisive criterion for 
lending, particularly against the backdrop of rising home prices. Said 
one broker of an elderly client who had lost his home as a result of an 
unaffordable loan, ``It's clear he was living beyond his means, and he 
might not be able to afford this loan. But legally, we don't have a 
responsibility to tell him this probably isn't going to work out. It's 
not our obligation to tell them how they should live their lives.'' See 
Charles Duhigg, When Shielding Money Clashes with Elders' Free Will, 
New York Times (Dec. 24, 2007).
    \7\ Credit card and automobile loans are also securitized and sold 
in various formats. It remains to be seen whether an increased rate of 
default on those loans (which can be expected as the economic slowdown 
deepens) will generate a second wave of severe capital market 
disruptions.
---------------------------------------------------------------------------
    Had these excesses been limited to the subprime market, it 
is unlikely that the initial turmoil could have sparked a full-
blown financial crisis. Unfortunately, the broader financial 
system was in no position to absorb the losses because a great 
many of the leading financial firms were themselves heavily 
leveraged (especially by incurring a large proportion of short-
term debt) and contingent liabilities (including many tied back 
to the housing market). Such leverage had greatly magnified 
returns in good times, but proved devastating once key assets 
began to drop in value. Higher-leverage necessarily meant 
higher risk. As it became clear that not only AAA-rated 
mortgage-backed securities but also AAA-rated financial 
institutions were at risk, trust all but disappeared in the 
marketplace, leaving even potentially solvent financial 
institutions vulnerable to runs by their creditors, who were 
rattled and increasingly operating on a hair trigger.\8\
---------------------------------------------------------------------------
    \8\ See section III.2.
---------------------------------------------------------------------------
    In a sense, no one should have been surprised by the 
turmoil. Unregulated and weakly regulated financial markets 
have historically shown a tendency toward excessive risk taking 
and instability. The reasons for this are worth reviewing.
    To begin with, financial actors do not always bear the full 
consequences of their decisions and therefore are liable to 
take (or impose) more risk than would otherwise seem 
reasonable. For example, financial institutions generally 
invest other people's money and often enjoy asymmetric 
compensation incentives, which reward them for gains without 
penalizing them for losses. Even more troubling, the failure of 
a large financial firm can have systemic consequences, 
potentially triggering a cascade of losses, which means that 
risk taking by the firm can impose costs far beyond its own 
shareholders, creditors, and counterparties. The freezing up of 
the credit markets in 2008-09, because even healthy banks are 
afraid to lend, is an especially serious example of this 
phenomenon.
    A closely related problem is that of contagion or panic, in 
which fear drives a sudden surge in demand for safety and 
liquidity. A traditional bank run by depositors is one 
expression of contagion, but other types of creditors can also 
create a ``run'' on a financial institution and potentially 
weaken or destroy it; for example, short-term lenders can 
refuse to roll over existing loans to the institution, and 
market actors may refuse to continue to deal with it. In fact, 
whole markets can succumb to panic selling under certain 
circumstances. In all of these cases, the fearful depositors, 
creditors, and investors who suddenly decide to liquidate their 
positions may be imposing costs on others, since the first to 
run will generally get their money out whereas the last to do 
so typically will not. More broadly, poorly managed financial 
institutions impose costs on well-managed ones, because of the 
threat of contagion.
    Yet another problem endemic to financial markets is that 
individual borrowers and investors may not always be ideally 
positioned to evaluate complex risks. How can any of us be sure 
that a particular financial agreement or product is safe? 
Ideally, we carefully read the contract or prospectus. But 
given limits on time and expertise (including the expense of 
expert advice), even a relatively careful consumer or investor 
is liable to make mistakes--and potentially large ones--from 
time to time. Virtually all of us, moreover, rely on various 
kinds of shortcuts in assessing risks in daily life--intuition, 
seeking nonexpert outside advice, a trusting attitude toward 
authority, and so on. Although such an approach may normally 
work well, it sometimes fails and is particularly subject to 
manipulation--for example, by aggressive (or even predatory) 
lenders. Such problems were an important contributor to the 
excesses and eventual implosion of subprime mortgage lending. 
In addition, particularly in recent years, it appears that even 
many of the most sophisticated investors--and perhaps even the 
credit rating agencies themselves--had trouble assessing the 
risks associated with a wide array of new and complex financial 
instruments. Complexity itself may therefore have contributed 
to the binge of risk taking that overtook the United States 
financial system in recent years.
    Failure of public risk management. Ideally, state and 
federal regulators should have intervened to control the worst 
financial excesses and abuses long before the crisis took hold. 
Almost everyone now recognizes that the government serves as 
the nation's ultimate risk manager--as the lender, insurer, and 
spender of last resort--in times of crisis. But effective 
public risk management is critical in normal times as well, 
both to protect consumers and investors and to help prevent 
crises from developing in the first place.\9\
---------------------------------------------------------------------------
    \9\ On the government's role as a risk manager, see David Moss, 
When All Else Fails: Government as the Ultimate Risk Manager (2002).
---------------------------------------------------------------------------
    A good example involves bank regulation. Americans have 
faced recurrent banking crises as well as frequent bank 
suspensions and failures for much of the nation's history. The 
problem appeared to ease after the creation of the Federal 
Reserve in 1914 but then returned with a vengeance in 1930-33, 
when a spiraling panic nearly consumed the entire American 
banking system. All of this changed after the introduction of 
federal deposit insurance in June of 1933. Bank runs virtually 
disappeared, and bank failures fell sharply. Critics worried 
that the existence of federal insurance would encourage 
excessive risk taking (moral hazard), because depositors would 
no longer have to worry about the soundness of their banks and 
instead would be attracted by the higher interest rates that 
riskier banks offered. The authors of the 1933 legislation 
prepared for this threat, authorizing not only public deposit 
insurance but also intelligent bank regulation designed to 
ensure the safety and soundness of insured banks. The end 
result was an effective system of new consumer protections, a 
remarkable reduction in systemic risk, and a notable increase 
in public confidence in the financial system. By all 
indications, well-designed government risk management helped 
strengthen the market and prevent subsequent crises.\10\ (See 
figure below: Bank Failures, 1864-2000).
---------------------------------------------------------------------------
    \10\ In fact, significant bank failures did not reappear until 
after the start of bank deregulation in the early 1980s. Bank 
deregulation is often said to have started with the Depository 
Institutions Deregulation and Monetary Control Act of 1980, Pub. L. No. 
96-221, and the Depository Institutions Act of 1982, Pub. L. No. 97-
320.

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

    In our own time, appropriate regulatory measures might have 
proved similarly salutary. Reasonable controls on overly risky 
consumer and corporate lending and effective limits on the 
leverage of major (systemic) financial institutions might have 
been enough, by themselves, to prevent the worst aspects of the 
collapse. Greater regulatory attention in numerous other areas, 
from money market funds and credit rating agencies to credit 
default swaps, might also have made a positive difference. 
However, key policymakers, particularly at the federal level, 
often chose not to expand this critical risk-management role--
to cover new and emerging risks--when they had the chance.
    Looking forward, the need for meaningful regulatory reform 
has now become particularly urgent--not only to correct past 
mistakes, but also to limit the likelihood and the impact of 
future crises and to control the moral hazard that is likely to 
flow from the recent profusion of federal bailouts and 
guaranties. If creditors, employees, and even shareholders of 
major financial institutions conclude that the federal 
government is likely to step in again in case of trouble 
(because of the systemic significance of their institutions), 
they may become even more lax about monitoring risk, leading to 
even greater excesses in the future. For this reason, the 
recent federal actions in support of the nation's largest 
financial institutions, involving more than $10 trillion in new 
federal guaranties, make effective regulation after the crisis 
even more vital. The example set in 1933--of pairing explicit 
public insurance with an effective regulatory mechanism for 
monitoring and controlling moral hazard--must not be forgotten. 
In fact, the need to control the moral hazard created by the 
current financial rescue may be the most important reason of 
all for strengthening financial regulation in the months and 
years ahead.

Failure to require sufficient transparency

    While allowing financial institutions to take on too much 
risk, federal and state regulators at the same time have 
permitted these actors to provide too little information to 
protect investors and enable markets to function honestly and 
efficiently. Because financial information often represents a 
public good, it may not be adequately provided in the 
marketplace without government encouragement or mandate. 
Investors without access to basic financial reporting face 
serious information asymmetries, potentially raising the cost 
of capital and compromising the efficient allocation of 
financial resources.\11\ Truthful disclosures are also 
essential to protect investors. Essential disclosure and 
reporting requirements may therefore enhance efficiency by 
reducing these informational asymmetries. The broad 
availability of financial information also promises to boost 
public confidence in financial markets. As former Securities 
and Exchange Commission (SEC) Chairman Arthur Levitt has 
observed, ``the success of capital is directly dependent on the 
quality of accounting and disclosure systems. Disclosure 
systems that are founded on high-quality standards give 
investors confidence in the credibility of financial 
reporting--and without investor confidence, markets cannot 
thrive.'' \12\
---------------------------------------------------------------------------
    \11\ Modern economic research has shown that markets can only 
function efficiently--that Adam Smith's ``invisible hand'' only works 
to the extent that the information processed by the markets is accurate 
and complete. See Joseph E. Stiglitz, Globalization and Its Discontents 
(2002) at ch. 3, n. 2 and accompanying text. On information asymmetry 
and the cost of capital, see Douglas Diamond and Robert Verrecchia, 
Disclosure, Liquidity, and the Cost of Capital, Journal of Finance, at 
1325-1359 (Sept. 1991). See also S. P. Kothari, The Role of Financial 
Reporting in Reducing Financial Risks in the Market, in Building and 
Infrastructure for Financial Stability, at 89-102 (Eric. S. Rosengren 
and John S. Jordan eds., June 2000).
    \12\ See id. at 91.
---------------------------------------------------------------------------
    From the time they were introduced at the federal level in 
the early 1930s, disclosure and reporting requirements have 
constituted a defining feature of American securities 
regulation (and of American financial regulation more 
generally). President Franklin Roosevelt himself explained in 
April 1933 that although the federal government should never be 
seen as endorsing or promoting a private security, there was 
``an obligation upon us to insist that every issue of new 
securities to be sold in interstate commerce be accompanied by 
full publicity and information and that no essentially 
important element attending the issue shall be concealed from 
the buying public.'' \13\
---------------------------------------------------------------------------
    \13\ See James M. Landis, The Legislative History of the Securities 
Act of 1933, George Washington Law Review, at 30 (1959).
---------------------------------------------------------------------------
    Historically, embedding a flexible approach to jurisdiction 
has made for strong, effective regulatory agencies. When the 
SEC was founded, during the Depression, Congress armed the 
commission with statutory authority based upon an extremely 
broad view of what constituted a security and gave it wide 
latitude in determining what disclosures were necessary from 
those who sought to sell securities to the public. There was a 
similar breadth of coverage and flexibility in substantive 
approach in the Investment Advisors Act and the Investment 
Company Act, which together governed money managers. These 
broad grants of jurisdiction led to the SEC's having regulatory 
authority over most capital-market transactions outside the 
banking and insurance systems until the end of the 1970s.
    However, the financial markets have outpaced even the 
broadest grants of regulatory authority. Starting in the 1980s, 
skilled market operators began to exploit what had previously 
seemed to be merely insignificant loopholes in this system--
exceptions that had always existed in the regulation of 
investment management. The increasing importance of 
institutional intermediaries in the capital markets exacerbated 
this tendency. By the 1990s, the growth of over-the-counter 
derivative markets had created unregulated parallel capital-
market products. This trend has continued in recent years, with 
the SEC allowing the founding of publicly traded hedge-fund and 
private-equity management firms that do not have to register as 
investment companies.
    Over subsequent years, the reach of the SEC and its 
reporting requirements were gradually expanded. Securities 
traded over the counter, for example, were brought into the 
fold beginning in 1964. The SEC targeted ``selective 
disclosure'' in 2000 with Regulation Fair Disclosure (Reg FD), 
a new weapon in the ongoing fight against insider activities. 
Two years later, Congress passed the Sarbanes-Oxley Act, which 
aimed to bolster the independence of the accounting industry 
and required top corporate executives to personally certify key 
financial statements.\14\
---------------------------------------------------------------------------
    \14\ See Chris Yenkey, Transparency, Democracy, and the SEC: 70 
Years of Securities Market Regulation, in Transparency in a New Global 
Order: Unveiling Organizational Visions (Christina Garsten and Monica 
Lindh de Montoya eds., 2007).
---------------------------------------------------------------------------
    By the time the crisis struck in 2007-08, however, one of 
the most common words used to describe the American financial 
system was ``opaque.'' Hedge funds, which squeeze into an 
exemption in the Investment Company Act of 1940, face almost no 
registration or reporting requirements; moreover, a modest 
attempt by the SEC to change this situation was struck down in 
federal court in 2006. Similarly, over-the-counter markets for 
credit default swaps and other derivative instruments remain 
largely unregulated and, say critics, constitute virtually the 
polar opposite of open and transparent exchange. (According to 
news reports, an attempt by Brooksley Born, the former 
chairperson of the Commodity Futures Trading Commission, to 
regulate OTC-traded derivatives in 1997-98, was blocked by Fed 
Chairman Alan Greenspan, Treasury Secretary Robert Rubin, and 
others, allegedly on the grounds that such regulation could 
precipitate a financial crisis. In any event, Congress in 2000 
prohibited regulation of most derivatives.) \15\ In addition, 
the proliferation of off-balance-sheet entities (conduits, 
structured investment vehicles [SIVs], etc.) and the rapid 
growth of highly complex financial instruments (such as CDOs) 
further undermined clarity and understanding in the 
marketplace. The financial consultant Henry Kaufman maintains 
that leading financial institutions actively ``pushed legal 
structures that made many aspects of the financial markets 
opaque.'' \16\ Moreover, starting in 1994, with the Central 
Bank of Denver decision,\17\ the courts have severely limited 
the ability of investors to police transparency failures 
involving financial institutions working with public companies. 
This failure was extended in the Supreme Court's Stoneridge 
decision,\18\ closing off liability to investors even in cases 
in which financial institutions were participants in a 
fraudulent scheme.
---------------------------------------------------------------------------
    \15\ Peter S. Goodman, The Reckoning: Taking Hard New Look at a 
Greenspan Legacy, New York Times (Oct. 8, 2008).
    \16\ Henry Kaufman, How the Credit Crisis Will Change the Way 
America Does Business: Huge Financial Companies Will Grow at the 
Expense of Borrowers and Investors, Wall Street Journal (Dec. 6, 2008).
    \17\ Central Bank of Denver, N.A. v. First Interstate Bank of 
Denver, N.A., 511 U.S. 164 (1994).
    \18\ Stoneridge Investment Partners, LLC v. Scientific-Atlanta, 
Inc., 128 S. Ct. 761 (2008). See also Congressional Oversight Panel, 
Testimony of Joel Seligman, Reforming America's Financial Regulatory 
Structure, at 5 (Jan. 14, 2009) (online at cop.senate.gov/documents/
testimony-011409-seligman.pdf).
---------------------------------------------------------------------------
    There are of course legitimate questions about how far 
policymakers should go in requiring disclosure--where the line 
should be drawn between public and proprietary information. But 
particularly given the breakdown that has now occurred, it is 
difficult to escape the conclusion that America's financial 
markets have veered far from the goal of transparency, 
fundamentally compromising the health and vitality of the 
financial sector and, ultimately, the whole economy.
    Why our regulatory system failed to expand the zone of 
transparency in the face of far-reaching financial innovation 
is a question that merits careful attention. At least part of 
the answer, once again, appears to be that key regulators 
preferred not to expand the regulatory system to address these 
challenges, or simply believed that such expansion was 
unnecessary. In 2002, for example, Federal Reserve Chairman 
Alan Greenspan explained his view on ``the issue of regulation 
and disclosure in the over-the-counter derivatives market'' 
this way:

          By design, this market, presumed to involve dealings 
        among sophisticated professionals, has been largely 
        exempt from government regulation. In part, this 
        exemption reflects the view that professionals do not 
        require the investor protections commonly afforded to 
        markets in which retail investors participate. But 
        regulation is not only unnecessary in these markets, it 
        is potentially damaging, because regulation presupposes 
        disclosure and forced disclosure of proprietary 
        information can undercut innovations in financial 
        markets just as it would in real estate markets.\19\
---------------------------------------------------------------------------
    \19\ The Federal Reserve Board, Remarks by Chairman Alan Greenspan 
before the Society of Business Economists, London, U.K. (Sept. 25, 
2002) (online at www.federalreserve.gov/BoardDocs/Speeches/2002/
200209252/default.htm).

    Subsequent developments--including the effective failure 
(and rescue) of American International Group, Inc. (AIG), as a 
result of massive exposure in the credit default swaps market--
raise serious questions about this hands-off view. The abuses 
in the mortgage markets, and especially in the subprime 
mortgage market, are a good example, but so are abuses 
throughout the range of consumer credit products. The challenge 
now is to develop a plan not only to bring much-needed sunlight 
into the most opaque corners of the financial system but to 
ensure appropriate regulatory adaptation to new financial 
innovation in the future.

Failure to ensure fair dealings

    The current regulatory system has not only allowed for 
excessive risk and an insufficient degree of transparency, but 
it has also failed to prevent the emergence of unfair dealings 
between actors. Overt lies are dishonest, of course, and lying 
may trigger legal liability. But fair dealing involves more 
than refraining from outright lying. Deception and 
misdirection, are the antithesis of fair dealing. When the 
legal system permits deception and misdirection it undermines 
consensual agreements between parties, the very foundation of a 
market economy designed to serve all individuals.
    Deceptive or misleading dealings can occur in any setting, 
but they are most likely to occur when the players are 
mismatched. When one player is sophisticated, has ample 
resources, and works regularly in the field while the other is 
a nonspecialist with limited resources and little experience, 
the potential for deception is at its highest. A credit card 
contract, for example, may be a relatively simple, 
straightforward agreement from which both issuer and customer 
may benefit. Or it may be a thirty-plus page document that is 
virtually incomprehensible to the customer. In the latter case, 
the issuer who can hire a team of lawyers to draft the most 
favorable language may carefully measure every nuance of the 
transaction, while the customer who has little time or 
sufficient expertise to read--much less negotiate--such a 
contract is far less likely to appreciate the risks associated 
with the deal.
    Similarly, in the subprime mortgage market prospective 
borrowers were often led to believe that a scheduled interest-
rate reset would never affect them because they had been told 
that they could ``always'' refinance the property at a lower 
rate before the reset took effect. Similarly, studies show that 
payday loan customers, while generally aware of finance 
charges, are often unaware of annual percentage rates.\20\ In 
one survey, of those who took on tax refund anticipation loans, 
approximately half of all respondents were not aware of the 
substantial fees charged by the lender.\21\ One authority on 
consumer credit has catalogued a long list of ``tricks and 
traps,'' particularly in the credit card market, designed to 
``catch consumers who stumble or mistake those traps for 
treasure and find themselves caught in a snare from which they 
cannot escape.'' \22\ While each of these contracts may meet 
the letter of the law, deals that are structured so that one 
side repeatedly does not understand the terms do not meet the 
definition of fair dealing.
---------------------------------------------------------------------------
    \20\ See NFI, Gregory Elliehausen, Consumers' Use of High-Price 
Credit Products: Do They Know What They Are Doing?, at 29 (2006) 
(Working Paper No. 2006-WP-02); Credit Research Center, Georgetown 
University, Gregory Elliehausen and Edward C. Lawrence, Payday Advance 
Credit in America: An Analysis of Customer Demand, at 2 (2001) (online 
at www.cfsa.net/downloads/analysis_customer_demand.pdf).
    \21\ See Elliehausen, supra note 20, at 31.
    \22\ Senate Committee on Banking, Housing and Urban Affairs of the 
United States Senate, Testimony of Elizabeth Warren, Examining the 
Billing, Marketing, and Disclosure Practices of the Credit Card 
Industry, and Their Impact on Consumers, 110th Cong., at 1 (Jan. 25, 
2007) (online at banking.senate.gov/public/_files/warren.pdf). The list 
of tricks and traps includes ``universal default, default rates of 
interest, late fees, over-limit fees, fees for payment by telephone, 
repeated changes in the dates bills are due, changes in the locations 
to which bills should be mailed, making it hard to find the total 
amount due on the bill, moving bill-reception centers to lengthen the 
time it takes a bill to arrive by mail, misleading customers about 
grace periods, and double cycle billing.'' Id. at 3.
---------------------------------------------------------------------------
    The available evidence suggests that the costs of deceptive 
financial products are high, quickly climbing into the billions 
of dollars annually.\23\ But the problem is not limited to 
monetary loss--many people are stripped not only of their 
wealth, but also of their confidence in the financial 
marketplace. They come to regard all financial products with 
suspicion, including those on fair terms and those that could 
be beneficial to them.
---------------------------------------------------------------------------
    \23\ Oren Bar-Gill and Elizabeth Warren, Making Credit Safer, 
University of Pennsylvania Law Review (Nov. 2008) (summarizing studies 
showing the high costs of consumer errors on checking accounts, credit 
cards, payday loans and refund anticipation loans).
---------------------------------------------------------------------------
    As the recent crisis has shown, the effects of deceptive 
contracts can have wide ripple effects. For example, deceptive 
mortgages have led to lender foreclosures on residential 
housing--foreclosures that cost taxpayers money and threaten 
the economic stability of already imperiled neighborhoods.\24\ 
A recent housing report observed: ``Foreclosures are costly--
not only to homeowners, but also to a wide variety of 
stakeholders, including mortgage servicers, local governments 
and neighboring homeowners . . . up to $80,000 for all 
stakeholders combined.'' \25\ Lenders can lose as well, 
forfeiting as much as $50,000 per foreclosure, which translates 
to roughly $25 billion in total foreclosure-related losses in 
2003.\26\ A city can lose up to $19,227 per house abandoned in 
foreclosure in lost property taxes, unpaid utility bills, 
property upkeep, sewage, and maintenance.\27\ Many foreclosure-
related costs fall on taxpayers, who ultimately must shoulder 
the bill for services provided by their local governments.
---------------------------------------------------------------------------
    \24\ See Joint Economic Committee, Sheltering Neighborhoods from 
the Subprime Foreclosure Storm, at 15-16 (Apr. 2007) (online at 
jec.senate.gov/index.cfm?FuseAction= Files.View&FileStore_id=8c3884e5-
2641-4228-af85-b61f8a677c28) (hereinafter ``JEC Report''). See also 
Nelson D. Schwartz, Can the Mortgage Crisis Swallow a Town?, New York 
Times (Sept. 2, 2007) (online at www.nytimes.com/2007/09/02/business/
yourmoney/02village.html); U.S. Department of the Treasury, Remarks by 
Secretary Henry M. Paulson, Jr. on Current Housing and Mortgage Market 
Developments at Georgetown University Law Center (Oct. 16, 2007) 
(online at www.treasury.gov/press/releases/hp612.htm) (``Foreclosures 
are costly and painful for homeowners. They are also costly for 
mortgage servicers and investors. They can have spillover effects into 
property values throughout a neighborhood, creating a downward cycle we 
must work to avoid.'').
    \25\ JEC Report, supra note 24, at 17. See also Dan Immergluck and 
Geoff Smith, The External Costs of Foreclosure: The Impact of Single-
Family Mortgage Foreclosures on Property Values, Housing Policy Debate, 
at 69-72 (2006) (finding that a single-family home foreclosure causes a 
decrease in values of homes within an eighth of a mile--or one city 
block--by an average of 0.9 percent, or approximately $1,870 when the 
average home sale price is $164,599, and 1.44 percent in low- and 
moderate-income communities, or about $1,600 when the average home sale 
price is $111,002).
    \26\ See, e.g., Desiree Hatcher, Foreclosure Alternatives: A Case 
for Preserving Homeownership, Profitwise News and Views, at 2 (Feb. 
2006) (online at www.chicagofed.org/community_development/files/
02_2006_foreclosure_alt.pdf).
    \27\ See JEC Report, supra note 24, at 15.
---------------------------------------------------------------------------
    The burdens of credit-market imperfections are not spread 
evenly across economic, educational, or racial groups. The 
wealthy tend to be insulated from many credit traps, while the 
vulnerability of the working class and middle-class increases. 
For those closer to the economic margins, a single economic 
mistake--a credit card with an interest rate that unexpectedly 
escalates to 29.99 percent or misplaced trust in a broker who 
recommends a high-priced mortgage--can trigger a downward 
economic spiral from which no recovery is possible. There is 
ample evidence that African Americans and Hispanics have been 
targets for certain deceptive products, much to their injury 
and to the injury of a country that prizes equality of 
opportunity for all its citizens.\28\
---------------------------------------------------------------------------
    \28\ See, e.g., Consumer Federation of America, Allan J. Fishbein 
and Patrick Woodall, Exotic or Toxic? An Examination of the Non-
Traditional Mortgage Market for Consumers and Lenders, at 24 (May 2006) 
(online at www.consumerfed.org/pdfs/Exotic_Toxic_ 
Mortgage_Report0506.pdf); U.S. Department of Housing and Urban 
Development and U.S. Department of the Treasury, Curbing Predatory Home 
Mortgage Lending, at 35 (2000) (online at www.huduser.org/publications/
hsgfin/curbing.html); Center for Community Change, Bradford Calvin, 
Risk or Race? Racial Disparities and the Subprime Refinance Market, at 
6-8 (May 2002) (online at butera-andrews.com/legislative-updates/
directory/Background-Reports/
Center%20for%20Community%20Change%20Report.pdf); Paul Calem, Kevin 
Gillen and Susan Wachter, The Neighborhood Distribution of Subprime 
Mortgage Lending, Journal of Real Estate Finance and Economics, at 401-
404 (Dec. 2004). Another study, based on the Federal Reserve data, 
found that ``African-American and Latino borrowers are at greater risk 
of receiving higher-rate loans than white borrowers, even after 
controlling for legitimate risk factors.'' Center for Responsible 
Lending, Debbie Gruenstein Bocian, Keith S. Ernst and Wei Li, Unfair 
Lending: The Effect of Race and Ethnicity on the Price of Subprime 
Mortgages, at 3 (May 31, 2006) (online at www.responsiblelending.org/
pdfs/rr011exec-Unfair_Lending-0506.pdf). A third study by the Survey 
Research Center at the University of Michigan found that black 
homeowners are significantly more likely to have prepayment penalties 
or balloon payments attached to their mortgages than nonblack 
homeowners, even after controlling for age, income, gender, and 
creditworthiness. Michael S. Barr, Jane K. Dokko, and Benjamin J. Keys, 
Who Gets Lost in the Subprime Mortgage Fallout? Homeowners in Low- and 
Moderate-Income Neighborhoods (Apr. 2008) (online at ssrn.com/
abstract=1121215). And a fourth study, by Susan Woodward, found that 
black borrowers pay an additional $415 in mortgage fees and Latino 
borrowers pay an additional $365 in mortgage fees. Urban Institute, 
Susan Woodward, A Study of Closing Costs for FHA Mortgages, at ix 
(2008).
---------------------------------------------------------------------------
    When businesses sell deceptive products, they not only 
injure their customers but also injure their competitors, who 
are forced to adopt similar practices or face losing their 
markets. The result is a downward spiral, a race to the bottom 
in which those who offer the most slyly deceptive products 
enjoy the greatest profits while entire industries and markets 
are corrupted and cease to provide efficient and mutually 
beneficial transactions. The same phenomenon operates on a more 
macroeconomic level: some investment banks that may have had 
initial doubts about packing subprime loans were drawn into a 
downward spiral, abandoning their standards of investment 
quality in a race for the same profits that other firms 
appeared to be making.
    Assuring fair dealing is not the same as assuring that no 
one makes a mistake. Buyers and sellers of financial services 
can miscalculate. They can fail to save, take unwise gambles, 
or simply buy too much. Personal responsibility will always 
play a critical role in dealing with financial products, just 
as personal responsibility remains essential to the responsible 
use of any physical product. Fair dealing assures only that 
deception and misdirection will not bring a person to ruin, 
while it leaves room to maximize the opportunities for people 
to chart their own economic futures, free to succeed and free 
to fail.
    The government can play a unique role in assuring that 
repeat dealings in circumstances of substantial imbalances of 
power and knowledge are nonetheless fair dealings. Regulation 
can assure a more level playing field, one in which the terms 
of an agreement, for example, are clear and easily understood. 
When terms are clear, individuals are more likely to compare 
options, which in turn drives far greater market efficiency. 
More importantly, when terms are clear, individuals are better 
able to assess investment risks and are thus empowered to make 
decisions that are more beneficial for themselves.
    By limiting the opportunities for deception and allowing 
for the necessary trust to develop between interconnected 
parties, regulation can enhance the vitality of financial 
markets. Historically, new regulation has often served this 
role. For example, as the money manager Martin Whitman has 
observed, far from stifling the markets, the new regulations of 
the Investment Company Act of 1940 enabled the targeted 
industry to flourish:

          It ill behooves any successful money manager in the 
        mutual fund industry to condemn the very strict 
        regulation embodied in the Investment Company Act of 
        1940. Without strict regulation, I doubt that our 
        industry could have grown as it has grown, and also be 
        as prosperous as it is for money managers. Because of 
        the existence of strict regulation, the outside 
        investor knows that money managers can be trusted. 
        Without that trust, the industry likely would not have 
        grown the way it has grown.\29\ 
---------------------------------------------------------------------------
    \29\ Letter from Third Avenue Funds Chairman of the Board Martin J. 
Whitman to Shareholders, at 6 (Oct. 31, 2005) (online at 
www.thirdavenuefunds.com/ta/documents/sl/shareholderletters-05Q4.pdf).

    Markets built on fair dealing produce benefits for all 
Americans on both sides of the transactions.

           3. THE CENTRAL IMPORTANCE OF REGULATORY PHILOSOPHY

    The magnitude of the current financial crisis makes clear 
that America's system of financial regulation has failed. As a 
result, there is now growing interest in reforming the 
essential structure of financial regulation in the United 
States. (See the appendix for a summary of other recent reports 
on regulatory reform.) Critics highlight the inherent problems 
of vesting regulatory authority in a large number of separate 
agencies at both the state and federal levels, each responsible 
for isolated elements of a vast financial architecture. 
Although this complex regulatory system benefits from 
competition across governmental bodies, it also suffers from 
the problem of ``regulatory arbitrage'' (a situation in which 
regulated firms play regulators off against one another) as 
well as numerous gaps in coverage.
    Structural and organizational problems are certainly 
important, and are taken up in section III, below. But at root, 
the regulatory failure that gave rise to the current crisis was 
one of philosophy more than structure. In too many cases, 
regulators had the tools but failed to use them. And where 
tools were missing, regulators too often failed to ask for the 
necessary authority to develop what was needed.
    Markets are powerful and robust institutions, and a healthy 
respect for free market activity has served this nation well 
since its founding. At the same time, the best tradition in 
American policy has always been pragmatic. History has 
consistently shown that markets cannot be counted upon to 
regulate themselves or to function efficiently in the absence 
of regulation. While the price mechanism calibrates supply and 
demand, it cannot prevent bank runs, abusive lending or Ponzi 
schemes without regulation. The current financial meltdown 
proves these points in an especially severe way.
    Excesses and abuse are all too common in a system without 
regulation. Government thus has a vital role to play. As 
President Lincoln once wrote: ``The legitimate object of 
government, is to do for a community of people, whatever they 
need to have done, but can not do, at all, or can not, so well 
do, for themselves--in their separate, and individual 
capacities.'' \30\
---------------------------------------------------------------------------
    \30\ Abraham Lincoln, Speeches and Writings, 1832-1858: Speeches, 
Letters, and Miscellaneous Writings, at 301 (Don Edward Fehrenbacher 
ed., 1989).
---------------------------------------------------------------------------
    Lincoln's vision of government goes beyond correcting 
abuses to improving the welfare of ``a community of people.'' 
Regulators must never lose sight of the fact that the well-
being of Americans is their goal, and that the welfare of the 
people has never been best served by extreme political 
ideologies. Franklin Roosevelt perhaps put it best: the 
question, he said, is ``whether individual men and women will 
have to serve some system of government or economics, or 
whether a system of government and economics exists to serve 
individual men and women.'' \31\ Not only is this pragmatic 
approach democratic, asking regulation and the market to serve 
the American people, but it also places the American people at 
the foundation of the economy. If Americans are secure and 
flourishing, the financial system will be secure and 
flourishing as well. If Americans are in crisis or face 
considerable risks, so too will the financial system. Success 
is defined by the quality of life Americans have, not by the 
impersonal metrics of any theory of government or economics.
---------------------------------------------------------------------------
    \31\ Franklin Roosevelt, Remarks to the Commonwealth Club (Sept. 
23, 1932) (online at www.americanrhetoric.com/speeches/
fdrcommonwealth.htm).
---------------------------------------------------------------------------
    Well-conceived financial regulation has the potential not 
only to safeguard markets against excesses and abuse but also 
to strengthen markets as foundations of innovation and growth. 
Creativity and innovation are too often channeled into 
circumventing regulation and exploiting loopholes. Smart 
financial regulations can redirect creative energy from these 
unproductive endeavors to innovations that increase efficiency 
and address the tangible risks people face.\32\ As discussed 
above, the decades following the New Deal regulatory reforms 
were the longest period without a serious finanial crisis in 
the nation's history; they were also a period of unusually high 
average real economic growth.
---------------------------------------------------------------------------
    \32\ Congressional Oversight Panel, Testimony of Joseph E. 
Stiglitz, Reforming America's Financial Regulatory Structure, at 3 
(Jan. 14, 2009) (online at cop.senate.gov/documents/testimony-011409-
stiglitz.pdf).
---------------------------------------------------------------------------
    In April 2008, former Federal Reserve Chairman Paul Volcker 
commented on these developments in a speech to the Economic 
Club of New York:

          [T]oday's financial crisis is the culmination, as I 
        count them, of at least five serious breakdowns of 
        systemic significance in the past twenty-five years--on 
        the average one every five years. Warning enough that 
        something rather basic is amiss.
          Over that time, we have moved from a commercial bank-
        centered, highly regulated financial system, to an 
        enormously more complicated and highly engineered 
        system. Today, much of the financial intermediation 
        takes place in markets beyond effective official 
        oversight and supervision, all enveloped in unknown 
        trillions of derivative instruments. It has been a 
        highly profitable business, with finance accounting 
        recently for 35 to 40 percent of all corporate profits.
          It is hard to argue that the new system has brought 
        exceptional benefits to the economy generally. Economic 
        growth and productivity in the last twenty-five years 
        has been comparable to that of the 1950s and '60s, but 
        in the earlier years the prosperity was more widely 
        shared.
          The sheer complexity, opaqueness, and systemic risks 
        embedded in the new markets--complexities and risks 
        little understood even by most of those with management 
        responsibilities--has enormously complicated both 
        official and private responses to this current mother 
        of all crises. . . .
          Simply stated, the bright new financial system--for 
        all its talented participants, for all its rich 
        rewards--has failed the test of the market place. . . .
          In sum, it all adds up to a clarion call for an 
        effective response.\33\
---------------------------------------------------------------------------
    \33\ Paul A. Volcker, Address to the Economic Club of New York, at 
1-2 (Apr. 8, 2008) (online at econclubny.org/files/
Transcript_Volcker_April_2008.pdf). In his address, Volcker recalled 
the financial troubles of New York City in 1975--that having been the 
last time he addressed the Economic Club of New York (then as President 
of the Federal Reserve Bank of New York). Volcker noted in his 2008 
address, ``Until the New York crisis, the country had been free from 
any sense of financial crisis for more than forty years.'' Id. at 1.

    As Volcker himself went on to observe, there is no going 
back to the ``heavily regulated, bank dominated, nationally 
insulated markets'' of the past.\34\ At the same time, given 
the enormity of the current crisis and the evident failure of 
financial markets to regulate themselves, it is imperative that 
Congress take up the challenge of fashioning appropriate 
regulation for the twenty-first century--to stabilize and 
strengthen the nation's financial markets in the face of 
extraordinary innovation and globalization. For this to work, 
we must first remind ourselves that government has a vital role 
to play, not in replacing financial markets or overwhelming 
them with rules, but in bolstering financial markets through 
judicious regulation. Rooted in the principles of sound risk 
management, transparency, and fairness, new financial 
regulation can succeed, and must succeed.
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    \34\ Id. at 3.
       IV. CRITICAL PROBLEMS AND RECOMMENDATIONS FOR IMPROVEMENT

    The sweeping nature of the current financial crisis points 
to the need for a thorough review of financial regulation and, 
ultimately, for significant regulatory reform. As discussed in 
part III, financial regulation is particularly necessary to 
manage risk, facilitate transparency, and ensure fair dealings. 
The current system has failed on all counts, and as a result, 
numerous discrete problems have emerged. This report focuses on 
the following most critical of these problems:

          1. Systemic risk is often not identified or regulated 
        until crisis is imminent.
          2. Many financial institutions carry dangerous 
        amounts of leverage.
          3. The unregulated ``shadow financial system'' is a 
        source of significant systemic risk.
          4. Ineffective regulation of mortgages and other 
        consumer credit products produces unfair, and often 
        abusive, treatment of consumers, but also creates risks 
        for lending institutions and the financial system.
          5. Executive pay packages incentivize excessive risk.
          6. The credit rating system is ineffective and 
        plagued with conflicts of interest.
          7. The globalization of financial markets encourages 
        countries to compete to attract foreign capital by 
        offering increasingly permissive regulatory laws that 
        increase market risk.
          8. Participants, observers, and regulators neither 
        predicted nor developed contingency plans to address 
        the current crisis.

    This section addresses each problem in turn, and provides 
recommendations for improvement.

1. IDENTIFY AND REGULATE FINANCIAL INSTITUTIONS THAT POSE SYSTEMIC RISK

Problem with current system: Systemic risk is often not 
identified or regulated until crisis is imminent

    Today, there is no regulator with the authority to 
determine which financial institutions or products pose a 
systemic risk to the broader economy. In 2008, Bear Stearns, 
Fannie Mae, Freddie Mac, AIG, and Citigroup all appear to have 
been deemed too big--or, more precisely, too deeply embedded in 
the financial system--to fail. The decisions to rescue these 
institutions were often made in an ad hoc fashion by regulators 
with no clear mandate to act nor the proper range of financial 
tools with which to act.
    This is the wrong approach. Systemic risk needs to be 
managed before moments of crisis, by regulators who have clear 
authority and the proper tools. Once a crisis has arisen, 
financial regulation has already failed. The underlying problem 
can no longer be prevented, it can only be managed, often at 
the cost of extraordinary expenditures of taxpayer dollars.

Action item: Mandate that a new or existing agency or an 
interagency task force regulate systemic risk within the 
financial system on an ongoing basis

    A much better approach would be to identify the degree of 
systemic risk posed by financial institutions, products, and 
markets in advance--that is, in normal times--and to regulate 
them accordingly. Providing proper oversight of such 
institutions would help to prevent a crisis from striking in 
the first place, and it would put public officials in a much 
better position to deal with the consequences should a crisis 
occur.\35\
---------------------------------------------------------------------------
    \35\  See Moss, supra note 3.
---------------------------------------------------------------------------
    To make this possible, Congress and the President should 
designate a body charged with identifying the degree of 
systemic risk posed by financial institutions, products, and 
markets. This body could be an existing agency, such as the 
Board of Governors of the Federal Reserve System, a new agency, 
or a coordinating body of existing regulators.\36\
---------------------------------------------------------------------------
    \36\ Vesting that authority in an existing agency, such as the 
Board of Governors of the Federal Reserve, would require attention to 
the issues of transparency and accountability that the Panel will 
consider further when it looks at regulator structure.
---------------------------------------------------------------------------
    The need for a body to identify and regulate institutions 
with systemic significance is a necessary response to two clear 
lessons of the current financial crisis: (1) systemic risk is 
caused by institutions that are not currently covered or 
adequately covered by the financial services regulatory system; 
and (2) in a crisis the federal government may feel compelled 
to stabilize systemically significant institutions. However, no 
regulatory body currently has the power to identify and 
regulate systemically significant nonbank institutions. 
Consequently, Congress should authorize legitimate, coherent 
governmental powers and processes for doing so.
    The systemic regulator should have the authority to require 
reporting of relevant information from all institutions that 
may be systemically significant or engaged in systemically 
significant activities. It should have a process for working 
with the regulatory bodies charged with the day-to-day 
oversight of the financial system. Finally, it should have 
clear authority and the proper tools for addressing a systemic 
crisis.
    The regulator should operate according to the philosophy 
that systemic risk is a product of the interaction of 
institutions and products with market conditions. Thus, the 
regulator would oversee structures described in the next two 
action items that address a continuum of systemic risk by 
increasing capital and insurance requirements as financial 
institutions grow. This approach seeks to maximize the 
incentives for private parties to manage risk while recognizing 
and acting upon the fact that as financial institutions grow 
they become more ``systemically significant.''
    Finally, creating a systemic risk regulator is not a 
substitute for ongoing regulation of our capital markets, 
focused on safety and soundness, transparency, and 
accountability. The agencies charged with those missions must 
be strengthened while we at the same time address the problem 
of systemic risk.

Action item: Impose heightened regulatory requirements for 
systemically significant institutions to reduce the risk of 
financial crisis

    Precisely because of the potential threat they pose to the 
broader financial system, systemically significant institutions 
should face enhanced prudential regulation to limit excessive 
risk taking and help ensure their safety. Such regulation might 
include relatively stringent capital and liquidity 
requirements, most likely on a countercyclical basis; an 
overall maximum leverage ratio (on the whole institution and 
potentially also on individual subsidiaries); well-defined 
limits on contingent liabilities and off-balance-sheet 
activity; and perhaps also caps on the proportion of short-term 
debt on the institution's balance sheet. The systemic regulator 
should consider the desirability of capping any taxpayer 
guarantee and whether to require systemically significant firms 
to purchase federal capital insurance under which the bank, in 
return for a premium payment, would receive a certain amount of 
capital in specified situations.\37\
---------------------------------------------------------------------------
    \37\ See Moss, supra note 3.
---------------------------------------------------------------------------
    Whether such enhanced oversight for systemically 
significant institutions should be provided by a new systemic 
regulator or by existing regulatory agencies is a question that 
requires further study and deliberation.

Action item: Establish a receivership and liquidation process 
for systemically significant nonbank institutions that is 
similar to the system for banks

    The current bankruptcy regime under the Bankruptcy Code 
does not work well for systemically significant nonbanks 
institutions. Recent experience with the failure of Bear 
Stearns & Co. and Lehman Brothers Inc. has indicated that there 
are gaps in the system for handling the receivership or 
liquidation of systemically significant financial institutions 
that are not banks or broker-dealers and are therefore subject 
to the Bankruptcy Code. Two problems are evident: (1) Because 
the federal bankruptcy system was not designed for a large, 
systemically significant financial institution, financial 
regulators may feel the need to prop up the ailing institution 
in order to avoid a messy and potentially destructive 
bankruptcy process, and (2) the Bankruptcy Code's provisions 
for distribution of the assets of a bankrupt financial 
institution do not take into account the systemic 
considerations that regulators are obligated to consider.
    The Panel recommends that systemically significant nonbank 
financial institutions be made subject to a banklike 
receivership and liquidation scheme. We note that the 
bankruptcy regime under the Federal Deposit Insurance Act has 
generally worked well.

     2. LIMIT EXCESSIVE LEVERAGE IN AMERICAN FINANCIAL INSTITUTIONS

Problem with current system: Excessive leverage carries 
substantial risks for financial institutions

    Leverage within prudent limits is a valuable financial 
tool. But excessive leverage in the financial sector is 
dangerous and can pose a significant risk to the financial 
system. In fact, it is now widely believed that overleveraging 
(i.e., relying on an increasingly steep ratio of borrowing to 
capital) at key financial institutions helped to convert the 
initial subprime turmoil in 2007 into a full-blown financial 
crisis in 2008.
    Recent estimates suggest that just prior to the crisis, 
investment banks and securities firms, hedge funds, depository 
institutions, and the government-sponsored mortgage enterprises 
(primarily Fannie Mae and Freddie Mac) held assets worth nearly 
$23 trillion on a base of $1.9 trillion in capital, yielding an 
overall average leverage ratio of approximately 12:1. We must, 
however, consider this figure carefully, because average 
leverage varied widely for different types of financial 
institutions. The most heavily leveraged, as a class, were 
broker-dealers and hedge funds, with an average leverage ratio 
of 27:1; government sponsored enterprises were next, with an 
average ratio of 23.5:1.35. Commercial banks were toward the 
low end, with an average ratio of 9.8:1, and savings banks have 
the lowest average ratio at 8.7:1.
    Financial institutions pursue leverage for numerous 
reasons. All bank lending, for example, is leveraged, because a 
certain amount of capital is permitted to support a much larger 
volume of loans. And the leverage of financial institutions is 
generally procyclical, meaning that it tends to increase when 
asset prices are rising (when leverage seems safer) and tends 
to decline when they are falling (when leverage seems more 
dangerous).\38\
---------------------------------------------------------------------------
    \38\ Tobias Adrian and Hyun Song Shin, Liquidity, Monetary Policy, 
and Financial Cycles, Current Issues in Economics and Finance, at 1-7 
(Jan./Feb. 2008). Some have argued that high leverage--especially 
short-term debt--may have a positive governance impact by imposing 
tough discipline on the management of financial institutions. K. 
Kashyap, Raghuram G. Rajan, and Jeremy Stein, Rethinking Capital 
Regulation (Aug. 2008) (online at www.kc.frb.org/publicat/sympos/2008/
KashyapRajanStein.08.08.08.pdf) (paper prepared for Federal Reserve 
Bank of Kansas City symposium on ``Maintaining Stability in a Changing 
Financial System'' in Jackson Hole, Wyoming). Given the experiences of 
the last year, however, this theory requires a good deal more research.
---------------------------------------------------------------------------
    For an institution with high debt and a relatively small 
base of capital, returns on equity are greatly magnified. 
Unfortunately, high leverage can also prove destabilizing 
because it effectively magnifies losses as well as gains. If a 
firm with $10 billion in assets is leveraged 10:1, then a loss 
of just 3 percent ($300 million) on total assets translates 
into a 30 percent decline in capital (from $1 billion to $700 
million), raising the bank's leverage ratio to nearly 14:1. The 
challenge is obviously far more extreme for a firm with 
leverage of 30:1, as was typical for leading investment banks 
prior to the crisis. Here, a 3 percent ($300 million) loss on 
total assets translates into a 90-percent decline in capital 
(from $333 million to $33 million) and a new leverage ratio of 
nearly 300:1. To get back to leverage of 30:1, that firm would 
either have to raise $300 million in new equity (to bring 
capital back to its original level) or collapse its balance 
sheet, selling more than 95 percent ($9.37 billion) of its 
assets and paying off an equivalent amount of debt.\39\
---------------------------------------------------------------------------
    \39\ This illustration was inspired by: Brandeis University 
Rosenberg Institute of Global Finance and University of Chicago 
Initiative on Global Markets, David Greenlaw, et al., Leveraged Losses: 
Lessons from the Mortgage Market Meltdown (2008) (U.S. Monetary Forum 
Report No. 2) (online at research.chicagogsb.edu/igm/docs/
USMPF_FINAL_Print.pdf); David Scharfstein, Why Is the Crisis a Crisis 
(Dec. 2, 2008) (slide presentation prepared for Colloquium on the 
Global Economic Crisis, Harvard Business School).
---------------------------------------------------------------------------
    Although raising $300 million in new equity would seem 
vastly preferable to selling $9.37 billion in assets, the 
problem is that financial institutions with depleted capital 
often find it difficult to raise new equity, particularly in 
times of general financial distress. If sufficient new capital 
is not available and the weakened firms are ultimately forced 
to dispose of assets under firesale conditions, this can 
depress asset prices further, generating additional losses 
across the financial system (particularly in the context of 
mark-to-market accounting). In the extreme, these sales can set 
off a vicious downward spiral of forced selling, falling 
prices, rising losses and, in turn, more forced selling.

Action item: Adopt one or more regulatory options to strengthen 
risk-based capital and curtail leverage

    The goal of enhanced capital requirements is to limit 
excessive risk taking during boom times and reducing the need 
for dangerous ``fire sales'' during downturns. Several common 
criteria must be met by proposals for enhanced capital 
requirements. Above all, any such proposals must operate in a 
way that does not restrict prudent leverage or produce other 
unintended consequences. Moreover, they must recognize that 
proper risk adjustment can prove particularly vexing: the 
appropriateness of a leverage ratio depends on the safety of 
the assets the leverage supports, both directly and in the 
context of the business as a whole. Determining that safety 
level is anything but easy, as the current crisis shows. 
Finally, any proposal must recognize that no one solution will 
fit the entire financial sector (or perhaps even all 
institutions of one type within the financial sector).
    A number of valuable ideas have been proposed as ways to 
strengthen capital and curtail excessive leverage, including 
the following:
    Objectives-based capital requirements. Under this approach, 
capital requirements should be applied not simply according to 
the type of institution (commercial bank, broker-dealer, hedge 
fund, etc.) but on the basis of regulatory objectives (for 
example, guard against systemic risk, etc.). For example, 
required capital ratios could be made to increase progressively 
with the size of the firm's balance sheet, so that larger 
financial institutions face a lower limit on leverage than 
smaller ones (on the assumption that larger firms have greater 
systemic implications and ultimately become ``too big to 
fail''). Required capital ratios could also be made to vary 
with other variables that regulators determine to be salient, 
such as the proportion of short-term debt on an institution's 
balance sheet or the identity of the holders of its 
liabilities.
    Leverage requirements. Beyond risk-based capital 
requirements, there is also a strong argument for unweighted 
capital requirements, to control overall leverage. Stephen 
Morris and Hyun Song Shin suggest that these ``leverage 
requirements'' are necessary to limit systemic risk, by 
reducing the need for dangerous asset fire sales in a 
downturn.\40\ FDIC Chairperson Sheila Bair has been 
particularly insistent on this point, declaring in 2006, for 
example, that ``the leverage ratio--a simple tangible capital 
to assets measure--is a critically important component of our 
regulatory capital regime.'' \41\ It should be noted that the 
current crisis may be exacerbated because leverage ratios are 
not a common feature of banking regulation in Europe; any 
approach to curtailing leverage in a globalized financial 
system must implement such standards on a global basis.
---------------------------------------------------------------------------
    \40\ Brookings Institute, Stephen Morris and Hyun Song Shin, 
Financial Regulation in a System Context, at 21-26 (2008) (online at 
www.brookings.edu/economics/bpea//media/Files/Programs/ES/BPEA/
2008_fall_bpea_papers/2008_fall_bpea_morris_shin.pdf). See also id. at 
23 (``Instead of risks on the asset side of the balance sheet, the 
focus is on the liabilities side of balance sheets, and the potential 
spillover effects that result when financial institutions withdraw 
funding from each other. Thus, it is raw assets, rather than risk-
weighted assets that matter.'').
    \41\ Federal Deposit Insurance Corporation, Remarks by Sheila C. 
Bair, Chairman before the Conference on International Financial 
Instability: Cross-Border Banking and National Regulation, Federal 
Reserve Bank of Chicago and the International Association of Deposit 
Insurers (Oct. 5, 2006) (online at www.fdic.gov/news/news/speeches/
archives/2006/chairman/spoct0606.html).
---------------------------------------------------------------------------
    Countercyclical capital requirements. To help financial 
institutions prepare for the proverbial rainy day and manage 
effectively in a downturn, it has been proposed that capital 
(and provisioning) requirements be made countercyclical--that 
is, more stringent when asset prices are rising and less 
stringent when they are falling. Since the procyclicality of 
financial institution leverage likely intensifies the ups and 
downs in asset markets, countercyclical capital requirements 
could serve as a valuable automatic stabilizer, effectively 
leaning against the wind. One approach could involve a 
framework that raises capital adequacy requirements by a ratio 
linked to the growth of the value of bank's assets in order to 
tighten lending and build up reserves when times are good. 
Spain's apparently favorable experience with ``dynamic 
provisioning'' in its banking regulation serves as a model for 
many related proposals.\42\ Joseph Stiglitz takes the idea one 
step further, suggesting that a ``simple regulation would have 
prevented a large fraction of the crises around the world--
speed limits restricting the rate at which banks can expand, 
say, their portfolio of loans. Very rapid rates of expansion 
are typically a sign of inadequate screening.'' \43\ Similarly, 
because rapid increases in leverage appear to precede periods 
of financial turmoil, capital requirements could be tailored to 
discourage particularly quick buildups of leverage.
---------------------------------------------------------------------------
    \42\ See, e.g., Spanish Steps: A Simple Way of Curbing Banks' 
Greed, Economist (May 15, 2008) (online at www.economist.com/
specialreports/displaystory.cfm?story_id=11325484).
    \43\ House Financial Services Committee, Testimony of Joseph 
Stiglitz, The Future of Financial Services Regulation, 110th Cong. 
(Oct, 21, 2008) (online at financialservices.house.gov/hearing110/
stiglitz102108.pdf). Stiglitz also notes that there are ``several 
alternatives to speed limits imposed on the rate of expansion of 
assets: increased capital requirements, increased provisioning 
requirements, and/or increased premia on deposit insurance for banks 
that increase their lending (lending in any particular category) at an 
excessive rate can provide incentives to discourage such risky 
behavior.'' Id.
---------------------------------------------------------------------------
    Liquidity requirements. To further address the problem of 
financial firms being forced to sell illiquid assets into a 
falling market, some commentators have proposed that regulators 
could impose liquidity requirements in addition to capital 
requirements, so that financial firms would have to hold a 
certain proportion of liquid assets as well as a liquidity 
buffer that could be used in a crisis. Armed with sufficient 
supply of liquid assets (such as treasury bills), firms could 
safely sell these assets in a downturn without placing downward 
pressure on the prices of less liquid assets, which would 
contribute to systemic risk.\44\
---------------------------------------------------------------------------
    \44\ Liquidity requirements can mitigate contagion, and can play a 
similar role to capital buffers in curtailing systemic failure. In some 
cases, liquidity may be more effective than capital buffers in 
forestalling systemic effects. When asset prices are extremely 
volatile, for example during periods of major financial distress, even 
a large capital buffer may be insufficient to prevent contagion, since 
the price impact of selling into a falling market would be very high. 
Liquidity requirements can mitigate the spillover to other market 
participants generated by the price impact of selling into a falling 
market. Moreover, because financial institutions do not recognise the 
indirect benefits of adequate liquidity holdings on other network 
members (and more generally on system resilience), their liquidity 
choices will be suboptimal. As a result, liquidity and capital 
requirements need to be imposed externally, in relation to a bank's 
contribution to systemic risk.
    Bank of England, Rodrigo Cifuentes, Gianluigi Ferrucci, and Hyun 
Song Shin, Liquidity Risk and Contagion (2005) (Working Paper No. 264) 
(online at www.bankofengland.co.uk/publications/workingpapers/
wp264.pdf).
    U.S. bank regulators monitor a bank's liquidity as part of their 
Uniform Financial Institutions Ratings (CAMELS) System. See, e.g., 
Board of Governors of the Federal Reserve System, Commercial Bank 
Examination Manual, Sec. 2020.1.
---------------------------------------------------------------------------
    These and other proposals will need to be thoughtfully 
reviewed, bearing in mind that leverage is not a consistent 
phenomenon, but rather varies across financial institutions, 
regulatory structures, and different types of leveraged 
situations. The current crisis provides two lessons to inform 
this review. First, options to curtail excessive leverage must 
proceed as a top priority and an integral part of the 
restructuring of the regulation of American financial 
institutions. Second, reforms in this area must reflect the 
primary lesson of the crisis: that no asset types, however 
labeled, and no transaction patterns, however familiar, are 
inherently stable.

          3. MODERNIZE SUPERVISION OF SHADOW FINANCIAL SYSTEM

Problem with current system: The unregulated ``shadow financial 
system'' is a source of significant systemic risk

    Since 1990, certain large markets and market intermediary 
institutions have developed outside the jurisdiction of 
financial market regulators. Collectively, these markets and 
market actors have become known as the shadow financial 
system.\45\ The key components of the shadow financial system 
are unregulated financial instruments such as over-the-counter 
(OTC) derivatives, off-balance-sheet entities such as conduits 
and SIVs,\46\ and nonbank institutions such as hedge funds and 
private equity funds. While the shadow financial system must be 
brought within any plan for systemic risk management, that 
alone would be insufficient. Routine disclosure-based capital-
market regulation and routine safety-and-soundness regulation 
of financial institutions will not function effectively unless 
regulators have jurisdiction over the shadow financial system 
and are able to enforce common standards of transparency, 
accountability, and adequate capital reserves.
---------------------------------------------------------------------------
    \45\ See, e.g., Bill Gross, Beware Our Shadow Banking System, 
Fortune (Nov. 28, 2007) (online at money.cnn.com/2007/11/27/news/
newsmakers/gross_banking.fortune); Nouriel Roubini, The Shadow Banking 
System is Unraveling, Financial Times (Sept. 21, 2008) (online at 
www.ft.com/cms/s/0/622acc9e-87fl-11dd-b114-0000779fd18c.html).
    \46\ Off-balance sheet entities are a significant part of the 
shadow financial system, and are addressed in part in our earlier 
recommendations on leverage, and in part should be the subject of a 
more extended technical inquiry into reforming Financial Accounting 
Standard 140.
---------------------------------------------------------------------------
    As a result of the growth of the shadow financial system, 
it is nearly impossible for regulators or the public to 
understand the real dynamics of either bank credit markets or 
public capital markets. This became painfully clear during the 
collapse of Bear Stearns and the subsequent bankruptcy of 
Lehman Brothers, and the collapse of AIG. In the case of Bear 
Stearns, key regulators expressed the view that as a result of 
that firm's extensive dealing with hedge funds and in the 
derivatives markets, the systemic threat posed by a disorderly 
bankruptcy could prove quite severe, though difficult to 
predict with any certainty.\47\ Six months later, Lehman 
Brothers was allowed to file for protection under Chapter 11, 
the only major financial firm to be allowed to do so in the 
United States during the financial crisis. Lehman's bankruptcy 
resulted in substantial systemwide disruption, particularly as 
a result of credit default swap obligations triggered by 
Lehman's default on its debt obligations. The unregulated 
nature of several financial markets involved in this crisis 
contributed to the inability of regulators to understand the 
unfolding problems and act responsively.
---------------------------------------------------------------------------
    \47\ In a speech on August 22, 2008, Federal Reserve Chairman Ben 
Bernanke spoke frankly about the potential for a Bear Stearns failure 
to echo throughout the financial system: ``Although not an 
extraordinarily large company by many metrics, Bear Stearns was deeply 
involved in a number of critical markets, including (as I have noted) 
markets for short-term secured funding as well as those for over-the-
counter (OTC) derivatives. One of our concerns was that the 
infrastructures of those markets and the risk- and liquidity-management 
practices of market participants would not be adequate to deal in an 
orderly way with the collapse of a major counterparty. With financial 
conditions already quite fragile, the sudden, unanticipated failure of 
Bear Stearns would have led to a sharp unwinding of positions in those 
markets that could have severely shaken the confidence of market 
participants. The company's failure could also have cast doubt on the 
financial conditions of some of Bear Stearns's many counterparties or 
of companies with similar businesses and funding practices, impairing 
the ability of those firms to meet their funding needs or to carry out 
normal transactions. As more firms lost access to funding, the vicious 
circle of forced selling, increased volatility, and higher haircuts and 
margin calls that was already well advanced at the time would likely 
have intensified. The broader economy could hardly have remained immune 
from such severe financial disruptions.''
    Board of Governors of the Federal Reserve System, Chairman Ben S. 
Bernanke Remarks on Reducing Systemic Risk before the Federal Reserve 
Bank of Kansas City's Annual Economic Symposium (Aug. 22, 2008) (online 
at www.federalreserve.gov/newsevents/speech/bernanke20080822a.htm).

Action item: Ensure consistency of regulation for instruments 
---------------------------------------------------------------------------
currently operating in the shadow financial system

    Extending the reach of financial regulation to cover the 
shadow financial system is necessary in order to accurately 
measure and manage risk across the markets. A consistent 
regulatory regime will also reduce the ability of market 
players to escape regulation by using complex financial 
instruments and to secure higher yields by masking risk through 
information asymmetries.
    The Panel urges Congress to consider shifting the focus of 
existing regulation toward a functional approach. While the 
details would need to be worked out by empowered regulators, 
the principle is simple: hedge funds and private equity funds 
are money managers and should be regulated according to the 
same principles that govern the regulation of money managers 
generally. At a minimum, Congress must grant the SEC the clear 
authority to require hedge fund advisors to register as 
investment advisors under the Investment Advisors Act. If they 
venture into writing insurance contracts or providing credit to 
others, hedge funds' activities in these areas need to be 
regulated according to the principles governing insurance or 
lending. An over-the-counter derivative can be almost any kind 
of contract synthesizing almost any kind of economic act--such 
instruments need to be regulated according to what they do, not 
what they are called.
    While further study is needed, proposals for regulating 
more consistently instruments currently in the shadow financial 
system include: applying capital requirements to firms engaged 
in making credit or insurance commitments through derivatives; 
requiring transparency around derivatives contracts tied to 
publicly traded securities; and holding hedge funds and private 
equity funds to a single, well-understood federal standard of 
fiduciary duty as other money managers are. However, regulating 
the shadow markets does not necessarily mean treating a hedge 
fund in the same manner as a mutual fund, or a credit default 
swap between institutions in the same manner as an insurance 
policy sold to retail consumers. Functional regulation can mean 
applying the same principles and not necessarily producing 
identical regulatory outcomes.

Action item: Increase transparency in OTC derivatives markets

    The Panel also recommends implementing new measures to 
improve transparency in the shadow financial system. Lack of 
transparency in the shadow financial system contributed to 
failures of risk management and difficulty in pricing assets 
and assessing the health of financial institutions. 
Transparency can be enhanced in several ways; several options 
are presented below:
    Regulated clearinghouses. A clearinghouse is an entity that 
provides clearance and settlement services with respect to 
financial products. It acts as a central counterparty with 
respect to trades that it clears. When the original parties to 
the trade introduce it to the clearinghouse for clearing, the 
original trade is replaced by two new trades in which the 
clearinghouse becomes the buyer to the original seller and the 
seller to the original buyer.
    Proposals for clearinghouses generally involve the 
clearinghouse itself taking on credit risk. Such credit risk 
raises the issue of how to provide adequate capital in case of 
a default. One method for doing so involves taking the 
``margin'' to secure performance of each trade. Another method 
involves daily marks-to-market to reduce risk arising from 
price fluctuations in the value of the contract. Others have 
proposed guaranty funds, in which each of the clearing members 
of the clearinghouse puts up a deposit to cover its future 
liabilities. Most central counterparty proposals also involve 
``mutualization of risk,'' in which the guaranty fund deposits 
of all clearing members may be used to cover a default by one 
member if the defaulting member's margin payments and guaranty 
fund contribution are insufficient to cover the loss. Finally, 
a clearinghouse may have the right to call for further 
contributions from members to cover any losses.
    In addition to regulators risk management principles, a 
clearinghouse structure may also involve inspection by federal 
officials for the purposes of detecting and punishing 
fraudulent activity and public reporting of prices, volumes and 
open interest.\48\
---------------------------------------------------------------------------
    \48\ See President's Working Group on Financial Markets, Policy 
Objectives for the OTC Derivatives Market (Nov. 14, 2008) (online at 
www.treas.gov/press/releases/reports/policyobjectives.pdf).
---------------------------------------------------------------------------
    Exchange-traded derivatives. As an alternative to 
clearinghouses, regulators can require that all standardized--
and standardizable--OTC derivatives contracts be traded on 
regulated derivatives markets. These markets would be governed 
by the same standards that guide designated contract markets 
under the Commodity Exchange Act (CEA). CEA-governed exchanges 
must fully disclose the terms of the contracts traded and rules 
governing trading, and must also publicly report prices, 
volumes and open interest. The exchange would maintain detailed 
records to be inspected by federal regulators and would be 
empowered with the ability to deter, detect, and punish 
fraudulent activity. Intermediaries participating in the 
exchange would face registration, reporting, and capital 
adequacy requirements as well. Finally, the exchanges could 
still make use of clearinghouses to minimize counterparty risk.
    Public reporting requirements. SEC Chairman Christopher Cox 
has proposed requiring CDS market participants to adhere to a 
public disclosure regime that would allow regulators to monitor 
market risk and potential market abuse. Cox's proposals 
include: (1) public reports of OTC transactions to improve 
transparency and pricing, and (2) reporting to the SEC 
derivatives positions that affect public securities.\49\
---------------------------------------------------------------------------
    \49\ Christopher Cox, Swapping Secrecy for Transparency, New York 
Times (Oct. 18, 2008) (online at www.nytimes.com/2008/10/19/opinion/
19cox.html).
---------------------------------------------------------------------------

 4. CREATE A NEW SYSTEM FOR FEDERAL AND STATE REGULATION OF MORTGAGES 
                   AND OTHER CONSUMER CREDIT PRODUCTS

Problem with current system: Ineffective regulation of 
mortgages and other consumer credit products has produced 
unfair, and often abusive, treatment of consumers, which 
destabilizes both families and the financial institutions that 
trade in those products

    For decades, default rates on traditional home mortgages 
were low; profits to mortgage lenders were steady. Millions of 
Americans used mortgages to enable them to buy homes and retain 
homes. Over time, however, a number of mortgage lenders and 
brokers began offering higher-priced, higher-profit--and higher 
risk--mortgages to millions of families.\50\ Unlike the low-
risk ``prime'' mortgages of the 1940s through the 1990s, the 
new ``subprime'' offered much bigger payouts for lenders and, 
ultimately, for the investors to whom the lenders sold these 
mortgages, but they also created higher costs and greater risks 
for consumers. For example, a family buying a $175,000 home 
with a subprime loan with an effective interest rate of 15.6 
percent would pay an extra $420,000 during the 30-year life of 
the mortgage--that is, over and above the payments due on a 
prime 6.5 percent mortgage. While investors were attracted to 
the bigger returns associated with these subprime mortgages, 
many overlooked the much bigger risks of default that have now 
become glaringly apparent.
---------------------------------------------------------------------------
    \50\ See Federal Reserve Board, Christopher J. Mayer, Karen M. 
Pence, and Shane M. Sherlund, The Rise in Mortgage Defaults, at 2 
(2008) (Finance and Economics Discussion Series No. 2008-59) (online at 
www.federalreserve.gov/Pubs/feds/2008/200859/200859pap.pdf) 
(``According to data from the Mortgage Bankers Association, the share 
of mortgage loans that were `seriously delinquent' (90 days or more 
past due or in the process of foreclosure) averaged 1.7 percent from 
1979 to 2006 . . . But by the second quarter of 2008, the share of 
seriously delinquent mortgages had surged to 4.5 percent.''). For 
detailed historical data on prime and subprime mortgages, see Mortgage 
Bankers Association, National Delinquency Survey (online at 
www.mbaa.org/ResearchandForecasts/productsandsurveys/
nationaldelinquencysurvey.htm).
---------------------------------------------------------------------------
    The new subprime mortgages were marked by exotic, and often 
predatory, new features, such as two year teaser rates that 
permitted marketing of mortgages to individuals who could not 
have qualified for credit at the enormous required rate 
increase in year three, or so-called ``liars'' or ``no-doc'' 
loans based on false paperwork about a borrower's financial 
situation. Terms such as these virtually guaranteed that the 
mortgages would default, and families would lose their homes, 
unless the real estate price inflation continued. These 
mortgages were especially cruel for new, especially lower-
income, home buyers. The data show, however, that a substantial 
number of middle-income families (and even some upper-income 
families) with low default risk signed up for subprime loans 
that were far more expensive than the prime mortgages for which 
they qualified.
    The complexity of subprime mortgage products made 
understanding the costs associated with an offered mortgage, 
let alone comparing several mortgage products, almost 
impossible. The high proportion of people with good credit 
scores who ended up with high-cost mortgages raises the specter 
that some portion of these consumers were not fully cognizant 
of the fact that they could have borrowed for much less.\51\ 
This conclusion is further corroborated by studies showing that 
subprime mortgage prices cannot be fully explained by borrower-
specific and loan-specific risk factors.\52\ These difficulties 
were further exacerbated by sharp selling practices and delayed 
disclosure of relevant documents. Buyers were steered to 
overpriced mortgages by brokers or other agents who represented 
themselves as acting in the borrower's best interests, but who 
were taking commissions from subprime lenders to steer them to 
riskier mortgages.\53\ In other cases, lenders would not make 
relevant documents available until the closing date. In all of 
these respects, the mortgage market simply failed consumers.
---------------------------------------------------------------------------
    \51\ In 2002, for example, researchers at Citibank concluded that 
at least 40 percent of those who were sold high interest rate, subprime 
mortgages would have qualified for prime-rate loans. Lew Sichelman, 
Community Group Claims CitiFinancial Still Predatory, Origination News, 
at 25 (Jan. 2002) (reporting on new claims of CitiFinancial's predatory 
practices after settlements with state and federal regulators). Freddie 
Mac and Fannie Mae estimate that between 35 percent and 50 percent of 
borrowers in the subprime market could qualify for prime market loans. 
See James H. Carr & Lopa Kolluri, Predatory Lending: An Overview, in 
Fannie Mae Foundation, Financial Services in Distressed Communities: 
Issues and Answers, at 31, 37 (2001). See also Lauren E. Willis, 
Decisionmaking and the Limits of Disclosure: The Problem of Predatory 
Lending: Price, Maryland Law Review, at 730 (2006). A study by the 
Department of Housing and Urban Development of all mortgage lenders 
revealed that 23.6 percent of middle-income families (and 16.4 percent 
of upper-income families) who refinanced a home mortgage ended up with 
a high-fee, high-interest subprime mortgage. U.S. Department of Housing 
and Urban Development, Randall M. Scheessele, Black and White 
Disparities in Subprime Mortgage Refinance Lending, at 28 (2002) 
(Working Paper No. HF-014) (online at www.huduser.org/Publications/pdf/
workpapr14.pdf). A study conducted for the Wall Street Journal showed 
that from 2000 to 2006, 55 percent of subprime mortgages went to 
borrowers with credit scores that would have qualified them for lower-
cost prime mortgages. Rick Brooks and Ruth Simon, Subprime Debacle 
Traps Even the Very Credit Worthy; As Housing Boomed, Industry Push 
Loans to a Broader Market, Wall Street Journal (Dec. 3, 2007) (study by 
First American Loan Performance for the Journal). By 2006, that 
proportion had increased to 61 percent. Id. None of these studies is 
definitive on the question of overpricing because they focus 
exclusively on FICO scores, which are critical to loan pricing but are 
not the only factor to be considered in credit risk assessment. 
However, they suggest significant market problems.
    \52\ Joint Center for Housing Studies, Harvard University, Ren S. 
Essene and William Apgar, Understanding Mortgage Market Behavior: 
Creating Good Mortgage Options for All Americans, at 2 (2007) (online 
at www.jchs.harvard.edu/publications/finance/mm07-1_mortgage_market 
_behavior.pdf) (quoting Fishbein and Woodall, supra note 28, at 24); 
Howard Lax, et al., Subprime Lending: An Investigation of Economic 
Efficiency, Housing Policy Debate, at 533 (2004).
    \53\ See, e.g., Howell E. Jackson and Jeremy Berry, Kickbacks or 
Compensation: The Case of Yield Spread Premiums (Jan. 2002) (online at 
www.law.harvard.edu/faculty/hjackson/pdfs/january_draft.pdf). In some 
neighborhoods these brokers went door-to-door, acting as ``bird dogs'' 
for lenders, looking for unsuspecting homeowners who might be tempted 
by the promise of extra cash. Other families were broadsided by extra 
fees and hidden costs that didn't show up until it was too late to go 
to another lender. One industry expert described the phenomenon: ``Mrs. 
Jones negotiates an 8% loan and the paperwork comes in at 10%. And the 
loan officer or the broker says, `Don't worry, I'll take care of that, 
just sign here.' '' Dennis Hevesi, A Wider Loan Pool Draws More Sharks, 
New York Times (Mar. 24, 2002).
---------------------------------------------------------------------------
    Although mortgage documents include a raft of legally-
required disclosures, those disclosures are a long way from a 
meaningful understanding of the loan transaction--and a much 
longer distance from supporting competitive markets. Many of 
the same points can be made for credit cards and other consumer 
financial products. In all of these cases consumers have little 
access to the key information they need to make responsible 
decisions. The result is a market in which people fail to 
assess risks properly, over-pay, and get into financial 
trouble. As the current crisis shows, these effects are not 
confined to those who buy the credit products. The high risk 
that consumers could not pay back their loans was multiplied by 
the bundling and re-bundling of millions of the loans into 
asset-backed securities. That rebundling, in turn, spread the 
risk further, to the investment portfolios of other financial 
institutions, pension funds, state and local governments, and 
other investors for whom such risk was not appropriate. 
Ultimately, the widespread marketing of high-cost, high-risk 
consumer products has contributed to the destabilizing of the 
entire economy.
    If, for example, a home buyer had been required to 
demonstrate an ability to pay the long-term mortgage rate 
rather than the teaser rate, home owners--and the country--
would have been spared the specter of millions of foreclosures 
when payment resets made the monthly payment unaffordable. 
Moreover it would have been impossible to offer flawed 
investment products based on such mortgages.
    State regulators have a long history as the first-line of 
protection for consumers. For example, states first sounded the 
alarm against predatory lending and brought landmark 
enforcement actions against some of the biggest subprime 
lenders, including Household, Beneficial Finance, AmeriQuest, 
and Delta Funding. But states are sometimes pressured to offer 
no more consumer protection than is offered on the federal 
level so that financial firms do not leave their state 
regulator for a more favorable regulatory environment (taking 
the fee revenues they provide with them).\54\ Moreover, the 
same competition for business that exists at the state level 
also exists at the federal level. Federal regulators face the 
possibility of losing business both to state regulators or to 
other federal regulatory agencies. At the federal level, this 
problem is exacerbated by direct financial considerations. The 
budgets of the OCC and OTS, for example, are derived from the 
number and size of the financial institutions they regulate, 
which means that a bank's threat to leave a regulator has 
meaningful consequences.\55\ As Professor Arthur Wilmarth has 
testified, ``Virtually the entire [Office of the Comptroller of 
the Currency] budget is funded by national bank fees, and the 
biggest national banks pay the highest assessment rates. . . . 
The OCC's unimpressive enforcement record is, unfortunately, 
consistent with its strong budgetary incentive in maintaining 
the loyalty of leading national banks.'' \56\
---------------------------------------------------------------------------
    \54\ In any of these situations, of course, the state from which 
the financial institution switches its charter is deprived of 
substantial revenue, and the new chartering jurisdiction gains 
substantial revenue.
    \55\ Michael Schroeder, Bank Regulator Cleans House, Wall Street 
Journal (Aug. 19, 2005) (``Bank consolidation has created competition 
among regulators. The OCC has been a winner in wooing banks to choose 
it as their regulator, helping to keep its coffers flush. Bank fees 
finance its $519 million annual budget, not taxpayer money.'').
    \56\ See, e.g., Senate Committee on Banking, Housing, and Urban 
Affairs, Testimony of Arthur E. Wilmarth, Jr., Review of the National 
Bank Preemption Rules, 108th Cong. (Apr. 7, 2004) (online at 
banking.senate.gov/public/_files/wilmarth.pdf); Christopher L. 
Peterson, Federalism and Predatory Lending: Unmasking the Deregulatory 
Agenda, Temple Law Review, at 70-74, 77-84 (2005).
---------------------------------------------------------------------------
    This has caused much of the regulatory scheme to come 
unraveled. State usury laws have eroded; according to recent 
research, at least 35 states have amended their usury laws to 
make it legal to charge annual interest rates exceeding 300 
percent in connection with consumer credit products.\57\ Many 
states were apparently also unwilling to deal with subprime 
mortgages. In 2006, fully half-52 percent--of subprime 
mortgages originated with companies that were subject only to 
state regulation.\58\ And now, as the mortgage crisis deepens, 
the National Association of Attorneys General has a highly 
visible working group on foreclosures, but only about half of 
the states participate.
---------------------------------------------------------------------------
    \57\ Christopher L. Peterson, Usury Laws, Payday Loans and 
Statutory Sleight of Hand: Salience Distortion in American Credit 
Pricing Limits, Minnesota Law Review, at 1139 (2008).
    \58\ Greg Ip and Damian Palleta, Regulators Scrutinized in Mortgage 
Meltdown, Wall Street Journal (Mar. 27, 2007).
---------------------------------------------------------------------------
    In addition, the authority of the states to deal with 
consumer protection for credit products has been sharply 
limited by interpretations in federal law. First, the Supreme 
Court has ruled that the usury laws of a national bank's state 
of incorporation controlled its activities nationwide. The 
decision naturally produced the pressures for repeal of state 
usury protections noted above. Second, the Office of the 
Comptroller of the Currency and federal courts have interpreted 
the National Banking Act to pre-empt action by state regulators 
to apply state consumer protection laws to national banks or to 
operating subsidiaries of national banks; virtually all of the 
nation's large banks--and most of those receiving federal 
assistance under the TARP--are national banks. The OCC's action 
was prompted by the attempt of Georgia to apply its Fair 
Lending Act to all banks within its jurisdiction. Yet, despite 
promises to Congress and the states, federal regulators have 
made the problem worse by failing to provide any significant 
supervision or regulation of their own.\59\
---------------------------------------------------------------------------
    \59\ See, e.g., Watters v. Wachovia Bank, 550 U.S. 1 (2007). See 
also Elizabeth R. Schiltz, The Amazing, Elastic, Ever-Expanding 
Exportation Doctrine and Its Effect on Predatory Lending Regulation, 
Minnesota Law Review (2004); Cathy Lesser Mansfield, The Road to 
Subprime ``HEL'' Was Paved with Good Congressional Intentions: Usury 
Deregulation and the Subprime Home Equity Market, South Carolina Law 
Review (2000).

Action item: Eliminate federal pre-emption of application of 
---------------------------------------------------------------------------
state consumer protection laws to national banks

    Preemption affects states' consumer protection initiatives 
in three main respects:
    1. Standards: The ability of states to set consumer 
protection laws and the scope of coverage for those laws.
    2. Visitation: The ability of states to examine financial 
institutions for compliance with consumer protection laws.
    3. Enforcement: The ability of states to impose penalties 
for violations of consumer protection laws.
    Visitation and enforcement are closely connected but 
distinct.
    Given the critical role of state consumer protection, 
Congress should amend the National Banking Act to provide 
clearly that state consumer protection laws can apply to 
national banks and to reverse the holding that the usury laws 
of a national bank's state of incorporation govern that bank's 
operation through the nation.

Action item: Create a single federal regulator for consumer 
credit products

    The need for a uniform federal law to create a meaningful 
baseline of protections is clear. It is essential that one 
regulatory agency have the responsibility and accountability 
for drafting, implementing, and overseeing effective consumer 
credit product protection rules. Without a uniform set of 
minimum standards, regulatory arbitrage among state--and 
federal--regulators will continue, and no regulator or agency 
will have the authority and responsibility to protect 
consumers.
    The new federal regulator must be responsible for 
establishing minimum standards for disclosure and transparency, 
reviewing consumer credit products (in a manner set by statute) 
in light of those standards to eliminate unfair practices, and 
promoting practices that encourage the responsible use of 
credit. This regulator should assure that consumers are not 
misled by the terms of the sales pitches for credit products 
and that they have the information needed to make informed and 
thoughtful purchasing decisions. The statement of purposes of 
the legislation creating the new agency, and the standards 
governing its actions, would include the need to balance 
consumer protection with the legitimate need of financial 
institutions to create fair products and maintain the flow of 
credit to the national economy.
    Creation of a single federal regulator would produce a 
single, national floor for consumer financial products. Some 
state regulators might conclude that their citizens require 
better protection, and they might put other constraints on the 
institutions that want to do business in their states. This 
proposal leaves them free to do so. The regulatory agency 
simply assures that all Americans, regardless of where they 
live, can count on basic protection. Regulations that apply to 
all products of a certain kind--e.g., mortgages, credit cards, 
payday loans--without any exceptions are far more comprehensive 
than those based on the kind of institution that issued them--
federally chartered, state charted, thrift, bank, etc. Because 
such baselines are inescapable, the impact of regulatory 
arbitrage is sharply undercut. A financial institution cannot 
escape the restrictions on mortgage disclosures, for example, 
by reincorporating from a federal bank to a state bank. Any 
issuer of home mortgages must meet the minimum federal 
standards.
    One option is to make the new federal regulator an 
independent agency within the financial regulatory community. 
This approach would have several advantages. A single regulator 
would have the opportunity to develop significant expertise in 
consumer products. Consumer protection would be a priority 
rather than one issue among many competing with a myriad of 
other regulatory priorities that have consistently commanded 
more attention in financial institution regulatory agencies. An 
agency devoted to consumer protection can make it a first 
priority to understand the functioning of financial products in 
the consumer marketplace. Expertise can also be concentrated 
from around the country. A single group of regulators can 
develop greater expertise to ensure that products are 
comprehensible to customers and that they are protected from 
unfair business practices. Such expertise can also be 
transferred from one product to another. As financial products 
become more functionally intertwined--for example, home equity 
lines of credit that operate like credit cards--an agency can 
develop the needed cross-expertise and more nuanced rules.
    Another option is to place the new regulator within the 
Federal Reserve Board. The Board is the umbrella supervisor of 
bank holding companies, and it directly supervises state-
chartered banks that choose to become members of the Federal 
Reserve System. It was given specific authority to deal with 
deceptive mortgages more than forty years ago.\60\ Congress 
voted repeatedly to expand the Board's power to provide 
stronger consumer protection.\61\
---------------------------------------------------------------------------
    \60\ Truth in Lending Act (TILA), Pub. L. No. 90-321 (1968), at 
Sec. 105(a) (codified as amended at 15 U.S.C. Sec. 1601 et seq.) (``The 
Board shall prescribe regulations to carry out the purposes of this 
title.''). The Federal Reserve Board implements TILA through its 
Regulation Z. 12 C.F.R. pt. 226. See also Home Ownership and Equity 
Protection Act of 1994 (HOEPA), Pub. L. No. 103-325 (codified at 15 
U.S.C. Sec. 1639) (amending TILA).
    \61\ Congress has amended TILA to improve consumer credit 
protection. See, e.g., Fair Credit and Charge Card Disclosure Act of 
1988, Pub. L. No. 100-583 (codified at 15 U.S.C. Sec. 1637). In 1994, 
Congress amended TILA again to address predatory lending in the 
mortgage market. HOEPA, supra note 60.
---------------------------------------------------------------------------
    Placing the new regulator within the Board would keep 
safety and soundness and consumer protection responsibilities 
together, on the ground that each responsibility, if properly 
implemented, could complement and re-enforce the other. 
Choosing that option, however, would require changes to the 
Federal Reserve Act to make consumer protection one of the 
Fed's primary responsibilities, on a par with bank supervision. 
It would also depend on a new understanding and attitude by the 
Board toward its execution of its consumer protection mission.
    Federal Reserve Chairman Ben Bernanke has acknowledged that 
although the powers of the Fed to deal with mortgage abuses 
were ``broad,'' \62\ the Board has for years been slow to 
act,\63\ and the actions it took were inadequate.\64\ Its power 
under TILA and HOEPA to issue regulations binding upon all 
mortgage lenders gave it the capacity to halt the lending 
practices that inflated the housing bubble and that led 
millions of home owners toward eventual foreclosure, but the 
Fed failed to do so.
---------------------------------------------------------------------------
    \62\ In 2007, Chairman Bernanke said the Board would ``consider 
whether other lending practices meet the legal definition of unfair and 
deceptive and thus should be prohibited under HOEPA.'' Board of 
Governors of the Federal Reserve System, Chairman Ben S. Bernanke 
Remarks on The Subprime Mortgage Market before the Federal Reserve Bank 
of Chicago's 43rd Annual Conference on Bank Structure and Competition 
(May 17, 2007) (online at www.federalreserve.gov/newsevents/speech/
bernanke20070517a.htm). In 2008, recognizing that its authority under 
HOEPA is ``broad,'' the Board strengthened Regulation Z. 73 Fed. Reg. 
44,522 (July 30, 2008).
    \63\ It was not until the end of 2001, after the volume of subprime 
loans had increased nearly 400 percent, that the Board restricted more 
abusive practices and broadened the scope of mortgages covered by 
HOEPA. See 66 Fed. Reg. 65,604, 65,605 (Dec. 20, 2001).
    \64\ The Fed updated Regulation Z in response to HOEPA in March 
1995. 60 Fed. Reg. 15,463. It also amended Regulation C, ``Home 
Mortgage Disclosure,'' in 2002. 67 Fed. Reg. 7222. Nonetheless, neither 
regulation was strong enough to head off the mortgage abuses that 
continued to accelerate through 2008.
---------------------------------------------------------------------------
    Similarly, in areas such as credit card regulation, only 
when Congress threatened to take away powers, did the Fed 
finally act.\65\ Barney Frank, Chairman of the House Financial 
Services Committee, explained that the failure of the Fed to 
act was longstanding: ``When Chairman Bernanke testified before 
us a few weeks ago . . . he said something I hadn't heard in my 
28 years in this body, a Chairman of the Federal Reserve Board 
uttering the words, `consumer protection.' It had not happened 
since 1981.'' \66\
---------------------------------------------------------------------------
    \65\ See, e.g., Jane Birnbaum, Credit Card Overhauls Seem Likely, 
New York Times (July 5, 2008) (``Representative Barney Frank, Democrat 
of Massachusetts and chairman of the House Financial Services 
Committee, said the Federal Reserve acted last fall after the House 
approved legislation that would have transferred some of the Fed's 
regulatory power to other agencies. `At that point, I said use it or 
lose it,' Mr. Frank recalled. `And subsequent to that, the Fed began 
using its authority, and is now proposing rules similar to those in our 
credit card bill.' '')
    \66\ House Financial Services Committee, Subcommittee on Financial 
Institutions and Consumer Credit, Statement of Chairman Barney Frank, 
The Credit Cardholders' Bill of Rights: Providing New Protections for 
Consumers, 110th Cong. 5-6 (2008).
---------------------------------------------------------------------------
    Currently, the staffing, the budgets, the expertise and the 
primary responsibilities of the Fed necessarily reflect the 
critical functions it performs: setting monetary policy and 
controlling the money supply, consolidated supervision of bank 
holding companies and the financial institutions those holding 
companies own to assure the safety and soundness of those 
groups, supervision of state-chartered member-banks in 
coordination with state regulators, and oversight of the 
federal reserve banks. Under this option the Fed would be 
required to accept consumer protection as a responsibility that 
is the equal of its other responsibilities, staff and budget 
for that function and, makes its operations in the area 
transparent. These responsibilities should be subject to 
specific oversight by a designated Board member.
    Wherever it is placed, the success of the new regulator 
would depend in part on a statutory outline of the manner in 
which it would be related to the various financial institution 
regulatory agencies, and how those agencies would relate to one 
another, in dealing with consumer credit products. The agencies 
that are responsible for assuring the safety and soundness of 
the financial institutions would be able to pursue those goals 
without interference. The point of the single regulatory 
authority would be only to assure that both financial 
institutions and non-financial institutions that issue consumer 
credit products must play on a level field, all meeting the 
minimum standards established by the federal agency. No one 
issuer could gain advantage by moving to a different regulator.

   5. CREATE EXECUTIVE PAY STRUCTURES THAT DISCOURAGE EXCESSIVE RISK 
                                 TAKING

Problem with current system: Executive pay packages incentivize 
excessive risk

    Executive pay is a key issue in modernizing the financial 
regulatory system. However, the common focus on the themes of 
inequality and ``pay for performance'' misses the unnecessary 
risk that many compensation schemes introduce into the 
financial sector. Altering the incentives that encourage this 
risk through the tax code, regulation, and corporate governance 
reform will help mitigate systemic risk in future crises.
    Executive compensation has been one of the most 
controversial issues in American business since the late 1980s. 
In response to criticism that executives' and shareholders' 
interests did not sufficiently align,\67\ executive 
compensation packages began to contain more and more stock 
options, to the point where options now represent the lion's 
share of a high-ranking executive's pay.\68\
---------------------------------------------------------------------------
    \67\ Steven Balsam, An Introduction to Executive Compensation, at 
161 (2002).
    \68\ According to academic literature, between 1992 and 2002, the 
inflation-adjusted value of employee options granted by firms in the 
S&P 500 increased from an average of $22 million per company to $141 
million per company, rising as high as $238 million per company in 
2000. One academic study we referenced showed that, whereas in 1992 
share options accounted for only 24 percent of the average pay package 
for these CEOs, by 2002 options comprised approximately half of the 
typical CEO's total compensation. The practice of granting option 
awards has not been limited to the top echelon of company executives. 
The percentage of option grants to all employees has grown steadily as 
well, if not at the same pace as the very top-most strata of corporate 
executives.
    Senate Committee on Homeland Security and Governmental Affairs, 
Permanent Subcommittee on Investigations, Testimony of John W. White, 
Concerning Tax and Accounting Issues Related to Employee Stock Option 
Compensation, 110th Cong. (June 5, 2007) (online at idea.sec.gov/news/
testimony/2007/ts060507jww.htm) (internal citations omitted).
---------------------------------------------------------------------------
    Much criticism of executive pay has had its origins in the 
increase in the ratio of the pay of public company executives 
to average worker pay, from 42:1 in 1982 to over 400:1 in the 
early years of this decade.\69\ Recent executive pay scandals, 
such as those associated with the backdating of stock options, 
have centered on efforts by executives to disconnect pay from 
performance without informing investors.\70\ Numerous accounts 
of executive pay in the context of the financial crisis of 
2007-08 have focused on large severance packages, often 
described as once again disconnecting pay from performance.\71\
---------------------------------------------------------------------------
    \69\ Jeanne Sahadi, CEO Pay: Sky High Gets Even Higher, 
CNNMoney.com (Aug. 30, 2005) (online at money.cnn.com/2005/08/26/news/
economy/ceo_pay).
    \70\ See, e.g., U.S. Securities Exchange Commission, SEC Charges 
Former Apple General Counsel for Illegal Stock Option Backdating (Apr. 
24, 2007) (online at www.sec.gov/news/press/2007/2007-70.htm).
    \71\ The most prominent example is that of Angelo Mozilo, the 
former Chief Executive Officer of Countrywide Financial Corporation. 
Countrywide was rescued from bankruptcy by being acquired by Bank of 
America, which is now itself seeking additional financial assistance 
from the TARP. Mozilo realized more than $400 million in compensation 
from 2001 to 2007, most of it in the form of stock related compensation 
that he received and cashed out during the period. Executive 
Incentives, Wall Street Journal (Nov. 20, 2008) (online at 
online.wsj.com/public/resources/documents/st_ceos_20081111.html). 
Similarly, three of Merrill Lynch's top executives realized a combined 
$200 million in bonuses shortly before Bank of America absorbed that 
firm. Andrew Clark, Banking Crisis: Merrill Lynch Top Brass Set to 
Share $200m, The Guardian (Sept. 17, 2008) (online at 
www.guardian.co.uk/business/2008/sep/17/merrilllynch. 
executivesalaries).
---------------------------------------------------------------------------
    However, even before the current crises, many criticized 
such incentive plans for encouraging excessive focus on the 
short term at the expense of consideration of the risks 
involved.\72\ This short-term focus led to unsustainable stock 
buyback programs, accounting manipulations, risky trading and 
investment strategies, or other unsustainable business 
practices that merely yield short-term positive financial 
reports.
---------------------------------------------------------------------------
    \72\ CFA Centre for Financial Market Integrity and the Business 
Roundtable Institute for Corporate Ethics, Breaking the Short-Term 
Cycle: Discussion and Recommendations on How Corporate Leaders, Asset 
Managers, Investors, and Analysts Can Refocus on Long-Term Value, at 9-
10 (2006) (online at www.darden.virginia.edu/corporate-ethics/pdf/
Short-termism_Report.pdf).
---------------------------------------------------------------------------
    Executive pay should be designed, regulated, and taxed to 
incentivize financial executives to prioritize long-term 
objectives, and to avoid both undertaking excessive, 
unnecessary risk and socializing losses with the help of the 
federal taxpayer.

Action item: Create tax incentives to encourage long-term-
oriented pay packages

    Financial firm packages typically have a number of features 
that introduce short-term biases in business decision making. 
Most equity-linked compensation is either in the form of 
performance bonuses, typically awarded on an annual basis, and 
options on restricted stock, typically awarded in the form of 
grants with three-year vesting periods, and no restrictions on 
sale after vesting. These structures, together with the typical 
five-years-or-less tenure of public company CEOs, often lead to 
a focus on investment horizons of less than three years.\73\
---------------------------------------------------------------------------
    \73\ Id.
---------------------------------------------------------------------------
    Altering the tax treatment of executive compensation 
packages in the interests of encouraging stability, lessening 
risks, and orienting finance executives toward long-term goals 
represents a relatively simple step toward solving the 
incentive problem. Such a change could result from revising 
applicable tax rates, changing the treatment of compensation as 
income versus capital gains, or other relatively simple 
measures.

Action item: Encourage financial regulators to guard against 
asymmetric pay packages in financial institutions, such as 
options combined with large severance packages

    Asymmetric links between compensation and risk create 
incentives for executives to pursue potentially systemically 
threatening high-risk-high-reward strategies without sufficient 
regard for the downside potential. Encouraging regulators to 
spot and discourage compensation packages that excessively 
insulate executives from losses will help resolve this 
asymmetry and promote stability.
    Stock options create incentives that are tied to stock 
price, but the overall compensation package's asymmetric link 
to stock price actually helps encourage more dramatic risk 
taking. As the price of the underlying stock declines, the 
option holders become less sensitive to further declines in 
value of the underlying stock, and more interested in the 
possibility of achieving dramatic gains, regardless of the risk 
of further losses.\74\
---------------------------------------------------------------------------
    \74\ Lucian Bebchuk and Jesse Fried, Pay Without Performance: The 
Unfulfilled Promise of Executive Compensation, 139 (2004).
---------------------------------------------------------------------------
    A number of common features of executive pay practice that 
further protect executives against downside risk exacerbate 
this asymmetry problem. Among these features are the prevalence 
of option repricing when the underlying company stock falls 
below the option strike price for sustained periods of time and 
large severance packages paid to failed executives.
    While asymmetries in executive compensation are potentially 
harmful in the context of any company, they create particular 
difficulties in the context of regulated financial 
institutions. Most regulated financial institutions are the 
beneficiaries of explicit or implicit guarantees. The FDIC 
insurance system is an explicit guarantee to some depositors, 
which in the current crisis has been extended to all bank debt. 
The current Treasury and Federal Reserve rescues of Fannie Mae, 
Freddie Mac, and AIG, and the recent TARP actions in relation 
to Citigroup and Bank of America--and perhaps all nine major 
TARP recipient banks--all raise issues of implicit guarantees. 
These guarantees provide regulators with an opportunity to 
ensure that problematically asymmetrical compensation plans do 
not reappear in these institutions.

Action item: Regulators should consider requiring executive pay 
contracts to provide for clawbacks of bonus compensation for 
executives of failing institutions

    Financial system regulators should consider revoking bonus 
compensation for executives of failing institutions that 
require federal intervention. Whether the federal government 
promises to support the institution before a crisis develops, 
as with Fannie Mae and Freddie Mac, or after, as with TARP 
recipients, the prospect of losing bonus compensation could 
deter risky practices that make the federal rescue more 
probable.
    The cases of the Fannie Mae and Freddie Mac seem 
particularly relevant. In both companies, executive pay in the 
course of the 1990s moved from a model focused on corporate 
stability to a model focused on stock price maximization 
through asymmetric, short-term incentives.\75\ It appears that 
this change fed pressures to increase margins in ways that were 
only possible by engaging in riskier investment practices.\76\ 
This approach to executive pay is inconsistent with federal 
guarantees of solvency; inevitably, if it is not abandoned, 
taxpayers will end up paying for imprudent risk taking by 
improperly incentivized executives.
---------------------------------------------------------------------------
    \75\ Federal Reserve Bank of St. Louis, William R. Emmons and 
Gregory E. Sierra, Executive Compensation at Fannie Mae and Freddie Mac 
(Oct. 26, 2004) (Working Paper No. 2004-06) (online at papers.ssrn.com/
sol3/papers.cfm?abstract_id=678404).
    \76\ Id.
---------------------------------------------------------------------------
    As the financial crisis has developed, there has been a 
fair amount of discussion of clawbacks of executive pay. The 
Sarbanes-Oxley Act of 2002 required clawbacks of executive pay 
awarded as a result of fraudulent financial statements.\77\ 
Similar clawback provisions could help restore symmetry and a 
longer-term perspective to executive compensation systems. As 
such, regulators should consider adding them to the tools at 
their disposal.
---------------------------------------------------------------------------
    \77\ Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, at Sec. 304.

Action item: Encourage corporate governance structures with 
---------------------------------------------------------------------------
stronger board and long-term investor oversight of pay packages

    The Associated Press recently reported that ``even where 
banks cut back on pay, some executives were left with seven- or 
eight-figure compensation that most people can only dream 
about. Richard D. Fairbank, the chairman of Capital One 
Financial Corp., took a $1 million hit in compensation after 
his company had a disappointing year, but still got $17 million 
in stock options. The McLean, Va.-based company received $3.56 
billion in bailout money on Nov. 14.'' \78\
---------------------------------------------------------------------------
    \78\ Frank Bass and Rita Beamish, Study: $1.6B of Bailout Funds 
Given to Bank Execs, Associated Press (Dec. 21, 2008).
---------------------------------------------------------------------------
    Corporate governance regulations should strengthen the role 
of boards and long-term shareholders in the executive pay 
process with the goal of encouraging executive pay practices 
that align executives' interests with the long-term performance 
of the businesses they manage.
    The twin problems of asymmetric and short-term-focused 
executive pay have been the subject of a number of reform 
efforts by business groups. Such reform recommendations have 
come from the Conference Board, in its report on the origins of 
the financial crisis,\79\ and from the Aspen Institute's 
Principles for Long Term Value Creation,\80\ endorsed by the 
U.S. Chamber of Commerce and the Business Roundtable, as well 
as by the Council of Institutional Investors and the AFL-CIO.
---------------------------------------------------------------------------
    \79\ Conference Board, Linda Barrington, Ellen S. Hexter, and 
Charles Mitchell, CEO Challenge 2008: Top 10 Challenges--Financial 
Crisis Edition (Nov. 2008) (online at www.conference-board.org/
publications/describe.cfm?id=1569).
    \80\ Aspen Institute, Long-Term Value Creation: Guiding Principles 
for Corporations and Investors (2008).
---------------------------------------------------------------------------
    Financial regulators should encourage these efforts 
wherever possible and provide assistance wherever practicable.

                   6. REFORM THE CREDIT RATING SYSTEM

Problem with current system: The credit rating system is 
ineffective and plagued with conflicts of interest

    The major credit rating agencies played an important--and 
perhaps decisive--role in enabling (and validating) much of the 
behavior and decision making that now appears to have put the 
broader financial system at risk. In the subprime-related 
market specifically, high ratings for structured financial 
products--especially mortgage-backed securities (MBS), 
collateralized debt obligations (CDO), and CDOs that invested 
in other CDOs (frequently referred to as CDO-squared, or 
CDO\2\)--were essential for ensuring broad demand for these 
products. High ratings not only instilled confidence in 
potentially risk-averse investors, but also helped satisfy 
investors' regulatory requirements, which were often explicitly 
linked to ratings from the major credit rating agencies. By 
2006, Moody's business in rating structured financial products 
accounted for 44 percent of its revenues, as compared to 32 
percent from its traditional corporate-bond rating 
business.\81\ It has also been reported that ``roughly 60 
percent of all global structured products were AAA-rated, in 
contrast to less than 1 percent of corporate issues.'' \82\ 
Financial firms, from Fannie Mae to AIG, also benefited greatly 
from having high credit ratings of their own--especially AAA--
allowing them not only to borrow at low rates on the short-term 
markets to finance longer-term (and higher yielding) 
investments but also to sell guaranties of various sorts, 
effectively ``renting out'' their credit rating.
---------------------------------------------------------------------------
    \81\ Harvard Business School, Joshua D. Coval, Jakib Jurek, and 
Erik Stafford, The Economics of Structured Finance, at 4 (2008) 
(Working Paper No. 09-060) (online at papers.ssrn.com/sol3/
papers.cfm?abstract_id=1287363).
    \82\ Id.
---------------------------------------------------------------------------
    Numerous explanations have been offered for credit rating 
agencies' apparent mistakes, including conflicts of interest, 
misuse of complex models, and their quasi-public status as 
nationally recognized statistical rating organizations 
(NRSROs).
    Regarding conflicts of interests, worrisome is the rating 
agencies' practice of charging issuers for their ratings, a 
practice that began at Fitch and Moody's in 1970 and at 
Standard & Poor's a few years later.\83\ Although the practice 
of collecting payments from issuers has long provoked 
criticism, market observers often downplayed these concerns, 
suggesting that ``the agencies have an overriding incentive to 
maintain a reputation for high-quality, accurate ratings.'' 
\84\ Others, however, claim that the ``issuer pays'' model 
biases ratings upward and also encourages ``ratings shopping'' 
by issuers, which in turn provokes a race to the bottom on the 
part of the rating agencies, each willing to lower quality 
standards to drum up more business.\85\
---------------------------------------------------------------------------
    \83\ Richard Cantor and Frank Packer, The Credit Rating Industry, 
FRBNY Quarterly Review, at 4 (Summer-Fall 1994). See also Claire Hill, 
Regulating the Rating Agencies, Washington University Law Quarterly, at 
50 (2004).
    \84\ Cantor and Packer, supra note 81, at 4.
    \85\ House Committee on Oversight and Government Reform, Testimony 
of Jerome S. Fons, Credit Rating Agencies and the Financial Crisis, 
110th Cong., at 3 (Oct. 22, 2008) (online at oversight.house.gov/
documents/20081022102726.pdf).
---------------------------------------------------------------------------
    Beyond the ratings themselves, credit rating agencies also 
charge issuers for advice, including pre-rating assessments (in 
which issuers learn what ratings will likely be under various 
hypothetical scenarios) and risk-management consulting. In some 
cases, credit rating agency analysts subsequently go to work 
for the companies they had been rating.\86\ This revolving-door 
practice creates not only the potential for conflicts of 
interest but also for gaming of the system, since former 
employees of the rating agencies presumably know how best to 
exploit weaknesses in the agencies' risk assessment models.
---------------------------------------------------------------------------
    \86\ John P. Hunt, Credit Rating Agencies and the `Worldwide Credit 
Crisis': The Limits of Reputation, the Insufficiency of Reform, and a 
Proposal for Improvement, Columbia Business Law Review, at 32-33 (2009) 
(papers.ssrn.com/sol3/papers.cfm?abstract_id=1267625).
---------------------------------------------------------------------------
    Many critics charge that it was the models themselves--and 
overreliance on them--that got the credit rating agencies into 
trouble in recent years, particularly in assigning ratings to 
structured financial products. ``Instead of focusing on actual 
diligence of the risks involved, demanding additional issuer 
disclosures, or scrutinizing collateral appraisers' 
assessments,'' writes one skeptic, ``rating agencies primarily 
relied on mathematical models that estimated the loss 
distribution and simulated the cash flows of RMBS [residential 
mortgage backed securities] and CDOs using historical data.'' 
\87\
---------------------------------------------------------------------------
    \87\ Jeffrey David Manns, Rating Risk after the Subprime Mortgage 
Crisis: A User Fee Approach for Rating Agency Accountability, North 
Carolina Law Review (forthcoming), at 32-33 (papers.ssrn.com/sol3/
papers.cfm?abstract_id=1199622) (accessed Jan. 4, 2009).
---------------------------------------------------------------------------
    Many of the models involved excessively rosy assumptions 
about the quality of the underlying mortgages, ignoring the 
fact that these mortgages (especially subprime mortgages) were 
far riskier than ever before and were in fact becoming steadily 
riskier year by year.\88\ Credit rating agency modeling of 
mortgage-related securities may also have involved mistaken 
assumptions about the independence of the underlying 
mortgages--including the assumption that defaults would not be 
highly correlated across a broad bundle of mortgages or 
mortgage-related securities.\89\ By extension, many of the 
rating agencies' models may also have involved overly 
optimistic assumptions about the direction of housing prices 
(that is, that they would not fall by much, if at all). When 
asked on a conference call in March 2007 about how a 1 to 2 
percent decline in home prices over an extended period of time 
would affect Fitch's modeling of certain subprime-related 
securities, a Fitch representative conceded, ``The models would 
break down completely.'' \90\
---------------------------------------------------------------------------
    \88\ U.S. Securities and Exchange Commission Office of Compliance 
Inspections and Examinations, Summary Report of Issues Identified in 
the Commission Staff's Examinations of Select Credit Rating Agencies, 
at 33 (July 2008) (online at www.sec.gov/news/studies/2008/
craexamination070808.pdf) (hereinafter ``Summary Report'') (``In 
addition to the recent growth in subprime origination, there has also 
been a growth in the risk factors associated with subprime mortgages. 
Studies indicate that the percentage of subprime loans with less-than-
full documentation, high combined loan to total value (CLTVs), and 
second liens grew substantially between 1999 and 2006. Notably, while 
2/28 adjustable rate mortgages comprised just 31 percent of subprime 
mortgages in 1999, they comprised almost 69 percent of subprime loans 
in 2006. Further, 40-year mortgages were virtually non-existent prior 
to 2005, but they made up almost 27 percent of the subprime loans in 
2006. These data provide evidence that the majority of subprime 
origination occurred within the last five years, and the loans 
containing very high risk combinations are even more recent.''). The 
SEC report also documented that, at one major credit rating agency, 
``the average percentage of subprime RMBS in the collateral pools of 
CDOs it rated grew from 43.3 percent in 2003 to 71.3 percent in 2006.'' 
Id. at 7. Given these dramatic changes in the mortgage market, basing 
models on historical mortgage data may have proved particularly 
problematic.
    \89\ Indeed, a significant degree of independence was essential, 
since ``CDOs rely on the power of diversification to achieve credit 
enhancement.'' Coval, et al., supra note 81, at 10.
    \90\ See id. at 23.
---------------------------------------------------------------------------
    Yet another problem plaguing the rating agencies' models 
was the practice of embedded structuring by issuers, according 
to which CDOs would themselves become inputs into new CDOs 
(CDO2). ``With multiple rounds of structuring,'' 
three finance professors explain, ``even minute errors at the 
level of the underlying securities, which would be insufficient 
to alter the security's rating, can dramatically alter the 
ratings of the structured finance securities.'' \91\
---------------------------------------------------------------------------
    \91\ Id. at 10.
---------------------------------------------------------------------------
    Of particular concern from a regulatory standpoint is the 
extent to which state and federal (and even global) financial 
regulations are linked to private credit ratings--and, in fact, 
to ratings issued by just a handful of specially designated 
credit rating agencies, the NRSROs). To the extent that leading 
credit rating agencies enjoy a protected status and virtually 
guaranteed demand as a result of their regulatory significance, 
they may face diminished incentives to maintain the quality of 
their ratings.
    The SEC has recently undertaken a number of reforms aimed 
at the operations of the NRSROs pursuant to the passage of the 
Credit Rating Agency Reform Act of 2006 (the Rating Agency 
Act),\92\ which granted the SEC authority to implement 
registration, recordkeeping, financial reporting, and oversight 
rules with respect to registered credit rating agencies. Before 
this grant of authority to the SEC, NRSROs were essentially 
unregulated. Pursuant to its new regulatory authority, the SEC 
has registered ten firms; \93\ instituted examinations of 
NRSROs' practices; \94\ and proposed rules designed to enhance 
accountability, transparency, and competition.\95\ The Rating 
Agency Act and the SEC's recent regulatory activity are 
positive developments. However, since 2006 the financial crisis 
has revealed the extent of the harmful consequences of the 
deep-seated conflicts of interest and distorted incentives 
associated with the credit ratings firms. With the knowledge 
that the contours of reform of credit rating agency regulation 
must take into account the SEC's actions, we propose the 
following recommendations.
---------------------------------------------------------------------------
    \92\ Credit Rating Agency Reform Act of 2006, Pub. L. No. 109-291.
    \93\ U.S. Securities Exchange Commission, Nationally Recognized 
Statistical Rating Organizations (online at www.sec.gov/divisions/
marketreg/ratingagency.htm) (accessed Jan. 26, 2008) (hereinafter ``SEC 
NRSRO Web site''). These ten include the old line firms Moody's, 
Standard & Poor's, and Fitch. Id.
    \94\ Senate Committee on Banking, Housing, and Urban Affairs, 
Testimony of Christopher Cox, Turmoil in U.S. Credit Markets: The Role 
of the Credit Rating Agencies, 110th Cong. (Apr. 22, 2008) (online at 
www.sec.gov/news/testimony/2008/ts042208cc.htm).
    \95\ SEC NRSRO Web site, supra note 93.

Action item: Adopt one or more regulatory options to address 
---------------------------------------------------------------------------
conflicts of interest and incentives

    To address conflicts of interest, the SEC or a new 
regulatory body (see below) could impose limits on the 
proportion of revenues of rating agencies that are derived from 
issuers, though there is disagreement about whether alternative 
revenue sources would prove sufficient.\96\ Alternatively, for 
each rating, issuers could be required to pay into a pool, from 
which a rating agency would be chosen at random.\97\ Here, the 
challenge would be to maintain the quality of ratings after 
severing the link between pay and performance. One could also 
imagine the introduction of grace periods in which credit 
rating analysts could not take jobs with their clients. While 
this too would limit conflicts of interest, it might also 
interfere with the recruiting of high-quality credit analysts 
at the rating agencies.
---------------------------------------------------------------------------
    \96\ House Committee on Oversight and Government Reform, Testimony 
of Sean J. Egan, Credit Rating Agencies and the Financial Crisis, 110th 
Cong., at 9 (Oct. 22, 2008) (online at oversight.house.gov/documents/
20081022102906.pdf).
    \97\ David G. Raboy, Concept Paper on Credit Rating Agency 
Incentives (Jan. 9, 2009) (unpublished working paper on file with the 
Panel).
---------------------------------------------------------------------------
    To improve incentives, the SEC or some other regulatory 
body should further encourage additional competition by 
progressively expanding the ranks of the NRSROs.\98\ Other 
options would include additional disclosure requirements or 
prohibitions on rating agencies' use of nonpublic 
information.\99\ Since rating agencies currently face little if 
any legal liability for malfeasance in the production of 
ratings, a number of experts have proposed strategies for 
imposing liability on credit rating agencies to ensure 
appropriate accountability.\100\ Although such reforms might 
well prove helpful, they would be unlikely to solve the 
underlying problem by themselves.
---------------------------------------------------------------------------
    \98\ Hill, supra note 83, at 86-87.
    \99\ Egan, supra note 96, at 8.
    \100\ Senate Committee on Banking, Housing, and Urban Affairs, 
Testimony of Frank Partnoy, Assessing the Current Oversight and 
Operation of Credit Rating Agencies, 109th Cong., at 5 (Mar. 7, 2006) 
(online at banking.senate.gov/public/_files/partnoy.pdf).

Action item: Reform the quasi-public role of NRSROs and 
---------------------------------------------------------------------------
consider creating a Credit Rating Review Board

    Perhaps the most pressing issue of all from a regulatory 
standpoint is the NRSRO designation itself. Particularly given 
all of the concerns that have been raised about the credit 
rating agencies and their poor performance leading up to the 
current crisis, state and federal policymakers will need to 
reassess whether they can continue to rely on these private 
ratings as a pillar of public financial regulation.\101\ In 
fact, it may be time to consider the possibility of 
eliminating, or at least dramatically scaling back, the NRSRO 
designation and replacing it with something else.\102\
---------------------------------------------------------------------------
    \101\ A recent SEC report acknowledged, ``The rating agencies' 
performance in rating these structured finance products raised 
questions about the accuracy of their credit ratings generally as well 
as the integrity of the ratings process as a whole.'' Summary Report, 
supra note 88, at 2).
    \102\ Frank Partnoy has suggested linking regulation instead to 
market-based measures of risk, such as credit spreads or the prices of 
credit default swaps. Partnoy, supra note 100, at 80-81.
---------------------------------------------------------------------------
    One option would be to create a public entity--a Credit 
Rating Review Board--that would have to sign off on any rating 
before it took on regulatory significance. Even if an asset was 
rated as investment grade by a credit rating agency, it could 
still not be added to a bank or pension fund portfolio, for 
example, unless the rating was also approved by the review 
board. Ideally, the board would be given direction by lawmakers 
to favor simpler (plain vanilla) instruments with relatively 
long track records. New and untested instruments might not make 
the cut. Of course, such new instruments could still be 
actively bought and sold in the private marketplace. Only 
regulated transactions that currently require ratings would be 
affected. Two key advantages of this approach are that it would 
permit a dramatic opening of the market for private credit 
ratings and at the same time discontinue the unsuccessful 
outsourcing of vital regulatory monitoring.
    Another, substantially different, option for the design of 
such a Credit Rating Review Board would be to model the board 
in part on the Public Company Accounting Oversight Board 
(PCAOB), a not-for-profit corporation that was created by the 
Sarbanes-Oxley Act to oversee the auditors of public 
companies.\103\ Under this model, the Credit Rating Review 
Board would not rate instruments ex ante, but instead audit 
ratings after the fact, perhaps on an annual basis, to ensure 
that rating agencies are sufficiently disclosing their rating 
methodologies, the ratings agencies' methodologies are sound, 
and the rating agencies are adhering to their methodologies. 
Depending on the course of the SEC's rulemaking, the Credit 
Rating Review Board could coordinate with or assume some of the 
SEC's authority to regulate conflicts of interest and inspect, 
investigate, and discipline NRSROs.
---------------------------------------------------------------------------
    \103\ See Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, at 
Sec. Sec. 101-109.
---------------------------------------------------------------------------

    7. MAKE ESTABLISHING A GLOBAL FINANCIAL REGULATORY FLOOR A U.S. 
                          DIPLOMATIC PRIORITY

Problem with current system: The globalization of financial 
markets encourages countries to compete to attract foreign 
capital by offering increasingly permissive regulatory laws 
that increase market risk

    The rapid globalization of financial markets in recent 
decades has created a new set of problems for national 
regulators and exposed market participants to an additional 
element of risk. Capital is able to flow freely across 
international borders, while regulatory controls are bound to 
domestic jurisdictions. Private actors, therefore, have the 
benefit of seeking out regulatory climates that best 
accommodate their financial objectives. Countries, in turn, bid 
for capital flows by adjusting their tax and regulatory 
schemes, as well as their legal infrastructure and employment 
laws. While New York and London tout their preeminence as 
financial capitals, Tokyo, Hong Kong, Singapore, Bahrain, and 
Doha, Qatar have all become financial hubs. At the same time, 
certain offshore tax havens, such as the Cayman Islands, the 
Bahamas, and the Channel Islands have developed local 
industries catering to the financial services needs of 
foreigners. Often, the sole comparative advantage offered by 
these locations is the opportunity to profit from ``regulatory 
arbitrage.'' The consequence is a global race to the bottom 
whereby deregulation is pursued to the detriment of market 
stability.
    Meanwhile, global markets have become increasingly 
interconnected. From 1990 to 2000, the total dollar amount of 
crossborder securities holdings where non-U.S. investors held 
U.S. securities, or vice versa, grew from approximately $1.5 
trillion to approximately $6.9 trillion.\104\ Today, U.S. 
issuers raise debt and equity funding in local markets all over 
the world. Conversely, foreign issuers who previously looked to 
the liquidity of the United States capital markets now find 
equally liquid pools of capital in Europe and Asia.
---------------------------------------------------------------------------
    \104\ Securities Industry Association, Securities Industry Fact 
Book, at 80 (2002) (online at www.sifma.org/research/statistics/other/
2002Fact_Book.pdf).
---------------------------------------------------------------------------
    When financial turmoil strikes issuers or borrowers in one 
country, it is equally likely to have adverse consequences 
beyond national borders. The subprime mortgage crisis of 2008 
caused widespread havoc outside the United States, beginning 
with a small thrift in England and sweeping over the world. At 
the same time the United States government initiated its $700 
billion bailout plan, the United Kingdom established a facility 
to make additional capital available to eight of its largest 
banks and building societies, the governments of France, 
Belgium, Luxembourg and the Netherlands made large capital 
infusions to bail out major banks operating in those countries, 
and the government of Iceland was forced to take over the three 
largest banks there.\105\ Stock markets worldwide plunged. 
Investors large and small suffered.
---------------------------------------------------------------------------
    \105\ Steven Erlanger and Katrin Bennhold, Governments on Both 
Sides of the Atlantic Push to Get Banks to Lend, New York Times (Nov. 
6, 2008).
---------------------------------------------------------------------------
    The abiding lesson is that booms and busts can no longer be 
restricted to their country of origin. Nations must embark on 
aggressive diplomatic efforts to address the collective risks 
posed by today's globalized financial markets.

Action item: Build alliances with foreign partners to create a 
global financial regulatory floor

    Given the ease with which money moves across international 
borders, it is difficult for one country to adopt a system to 
provide adequate regulation of the capital markets, as well as 
adequate consumer protection, unless all major participants in 
the global economy have agreed to coordinated action 
beforehand. Otherwise, regulatory arbitrage and the resulting 
race to the bottom are inevitable. To assure the stability of 
the markets, it is therefore imperative for U.S. financial 
market regulators, as well as the State Department, to work 
together to encourage greater harmonization of regulatory 
standards, as well as broad adoption of a floor of recognized 
``prudent regulatory measures.''
    Better coordination of regulation and surveillance, while 
difficult to achieve, will result in better-regulated entities 
that are less likely to cause damages to global markets and 
other market participants. It is also likely to result in more 
efficient and less costly regulation for regulated entities.

Action item: Actively participate in international 
organizations that are designed to strengthen communication and 
cooperation among national regulators

    Financial services regulators have created a number of 
organizations to share ideas and information regarding 
financial services entities and markets. These include the 
Basel Committee on Bank Supervision (BCBS), the Senior 
Supervisors Group (SSG), and the International Organization of 
Securities Commissions (IOSCO). The SSG, for one, meets 
regularly to discuss supervisory matters and to issue 
recommendations for better supervision.\106\
---------------------------------------------------------------------------
    \106\ Senior Supervisors Group, Observations on Risk Management 
Practices in the Recent Market Turbulence (Mar. 6, 2008) (online at 
www.newyorkfed.org/newsevents/news/banking/2008/
ssg_risk_mgt_doc_final.pdf).
---------------------------------------------------------------------------
    The SSG also periodically sponsor ``colleges of 
supervisors,'' in which supervisors from several countries that 
have jurisdiction over part of the operations of a globally 
active financial services firm will convene to discuss issues 
regarding regulation of the firm. Established linkages between 
regulators with different perspectives on a particular entity 
facilitate information-sharing that enables all supervisors to 
better understand the risks facing the entity. These 
relationships also ensure better coordination during times of 
stress. These efforts should be expanded to include 
consideration of systemically important financial institutions, 
in order to develop a better understanding of the risk profiles 
of such institutions and to improve their ability to intervene 
where the risk profile increases to potentially destabilizing 
levels.

                      8. PLAN FOR THE NEXT CRISIS

Problem with current system: Participants, observers, and 
regulators neither predicted nor developed contingency plans to 
address the current crisis

    Despite calls for caution from some quarters, very few 
observers predicted the severity of the current collapse in the 
housing, debt, and equity markets, or the massive decline in 
economic activity. Those commentators who most vocally raised 
doubts about the sustainability of housing prices, the pace of 
derivatives growth, or lax regulation were largely dismissed as 
fearmongers, or as simply ``not getting it.'' \107\
---------------------------------------------------------------------------
    \107\ See, e.g., Meet Dr. Doom, IMF Survey, at 308 (Oct. 16, 2006) 
(online at www.imf.org/EXTERNAL/PUBS/FT/SURVEY/2006/101606.pdf).
---------------------------------------------------------------------------
    Traditional measures of financial and economic exposure, 
such as bank capitalization, troubled loans, stock prices, and 
money supply growth, indicated only moderate exposure to a 
sharp asset price collapse and a severe recession.\108\ Yet 
there was a compelling case for concern based on a closer 
examination of the multiple layers of leverage invested in 
housing assets and their derivatives.\109\ More broadly, 
stagnant household productivity, the pace of financial product 
innovation and the increased leverage on Wall Street might all 
have set off alarm bells.\110\
---------------------------------------------------------------------------
    \108\ See, e.g., id.
    \109\ Government Accountability Office, Financial Regulation: A 
Framework for Crafting and Assessing Proposals to Modernize the 
Outdated U.S. Financial Regulatory System, at 16-23 (2009) (online at 
www.gao.gov/new.items/d09216.pdf) (discussing overleveraging and 
financial interconnectedness as contributing to a risky financial 
environment immediately preceding the current crisis).
    \110\ Id.
---------------------------------------------------------------------------
    Indeed, some analysts see systemic collapses as inherently 
more likely in complex, interdependent systems such as our 
modern financial environment.\111\ While most destructive 
outcomes are deemed to be so unlikely, based on historical 
comparisons, that they are not worth considering, recent 
analysis indicates on the contrary that complex systems produce 
these ``outlier'' results on a counterintuitively regular 
basis.\112\
---------------------------------------------------------------------------
    \111\ Id. at 18-19.
    \112\ See, e.g., Nassim Nicholas Taleb, The Black Swan: The Impact 
of the Highly Improbable (2007); Daniel G. Goldstein and Nassim 
Nicholas Taleb, We Don't Quite Know What We Are Talking About When We 
Talk About Volatility (Mar. 28, 2007) (online at ssrn.com/
abstract=970480).
---------------------------------------------------------------------------
    Current institutions are not likely to fare better in the 
future. Governments, industry, Wall Street, and academia 
typically employ economists with similar training and 
backgrounds to create their forecasts, leading to procyclical 
optimism and convergence of economic forecasts. In particular, 
economists have a truly dismal record in predicting the onset 
of recessions and asset crashes.\113\ Given the risk of a 
similar collapse in the future and the lack of formal processes 
in business or government requiring that the truly dismal 
scenarios be assessed, the current system will likely face 
similar risks not long after the present crisis is resolved.
---------------------------------------------------------------------------
    \113\ Even where outside advisory groups have been set up to 
counsel the Government regularly on economic issues, as the Conseil 
d'Analyse Economique (CAE) does in France, there is a marked similarity 
of backgrounds among their membership. Conseil d'Analyse Economique, 
Membres du Conseil (online at www.cae.premier-ministre.gouv.fr) 
(accessed Jan. 26, 2009). This may help explain why these bodies did 
not produce even minority viewpoints warning of the current financial 
crash; CAE did not produce a report on the subprime mortgage crisis 
until September, 2008. Conseil d'Analyse Economique, Rapports du 
Conseil d'analyse economique (online at www.cae.premier-
ministre.gouv.fr) (accessed Jan. 26, 2009).

Action item: Create Financial Risk Council of outside experts 
to report to Congress and regulators on possible looming 
---------------------------------------------------------------------------
challenges

    To promote better planning, financial experts should be 
aiming to identify the problems of the future, much as the 
military does. To this end, the Panel recommends establishing a 
Financial Risk Council featuring a truly diverse group of 
opinions, a formal mechanism whereby the concerns, both 
individual and collective, of this group will be regularly 
brought to the attention of Congress and financial regulators, 
with a focus on precisely those low-likelihood, huge-magnitude 
developments that consensus opinion will dismiss.
    The council should consider all potential domestic and 
foreign threats to the stability of the U.S. financial systems. 
These sources of threat should include, but not be limited to: 
(1) Economic shocks and recessions; (2) asset booms and busts; 
(3) fiscal, trade, foreign exchange, and monetary imbalances; 
(4) infrastructure failures, natural disaster, and epidemics; 
(5) institutional mismanagement; (6) crime, fraud; and 
terrorism; (7) legislative and regulatory failure; and (8) 
failed product and process innovation.
    Strong, independent thinking among the membership of the 
Council will be critical: Every effort should be made to avoid 
an optimistic consensus that there are no major threats 
looming. To that end, Council members should represent a 
diverse array of stakeholders, with a record of speaking their 
minds.
    The council would be required to publish regular reports to 
Congress and to select among various techniques for identifying 
threats. These approaches might include:

    1. Wargaming: Teams represent various market, government, 
regulatory, and subversive constituents. A control team sets up 
the initial environment and introduces destabilizing changes. 
The teams respond in real time and the control group feeds the 
impacts of their decisions into the environment. Subsequent to 
the wargame, there is an examination of outcomes, the level of 
constituent preparedness, and the quality of the risk 
management processes.

    2. Strategic scenario analysis: An analytic team works 
backward from worst-case financial crisis outcomes to identify 
the potential triggering factors and preventative or mitigating 
solutions. This approach prevents the ``it couldn't happen'' 
mindset.

    3. Nonlinear modeling/``black swan'' sensitivity analysis: 
An analytic team assumes previously unseen levels for key 
variables in order to destabilize financial models and observes 
break points and systemic failures.
    A Financial Risk Council composed of strong, divergent 
voices should avoid overly optimistic consensus and 
conventional wisdom, keeping Congress appropriately concerned 
and energized about known and unknown risks in a complex, 
highly interactive environment.
                   V. ISSUES REQUIRING FURTHER STUDY

    There are several important questions regarding financial 
regulatory reform that are beyond the scope of this Report, and 
will require further attention.
    First, the Panel has identified three highly technical 
issues relating to the financial regulatory system, and 
recommends that the relevant regulatory agencies take up 
specialized review of these questions. These are:

    1. Accounting rules: Further study is required to identify 
needed reforms of the current accounting rules, particularly 
with connection to systemic risk. Among the issues that should 
be considered are mark-to-market accounting, mark-to-model 
accounting, fair-value accounting, issues of procyclicality, 
accounting for contingent liabilities, and off-balance-sheet 
items.
    2. Securitization: Further study is required to consider 
the logic and limits of securitization, and reform options such 
as requiring issuers to retain a portion of offering, phased 
compensation based on loan or pool performance, and other 
requirements.
    3. Short-selling: In light of recent imposed limits, 
regulation of short-selling should be further studied and long-
term policies should be developed.

    Second, the Panel plans to address regulatory architecture 
more thoroughly in a subsequent report, including the issues of 
co-regulation, universal banking, regulatory capture, the 
revolving door problem, bankruptcy and receivership issues 
involving financial institutions, and the division of 
regulatory responsibilities.
                          VI. ACKNOWLEDGMENTS

    The Panel owes a debt of gratitude to many people who 
helped produce this report. Our deepest thanks go to Professor 
David Moss of Harvard Business School, who played a key role in 
conceptualizing and drafting the report. He was ably assisted 
by Melanie Wachtell, who worked long hours both to direct the 
underlying research efforts and to help pull the final draft 
together. The Panel is also grateful to Christopher Caines for 
his meticulous and thoughtful editing of this report. We 
express our thanks to Professor Arthur Wilmarth, Professor 
Patricia McCoy, Professor Ronald Mann, Professor Julio 
Rotemberg, Professor David Scharfstein, and Dr. Robert Litan, 
all of whom read portions of the draft and made helpful 
comments. Ganesh Sitaraman and Jonathan Lackow offered 
important drafting assistance. Thanks are also due to Abbye 
Atkinson, Brett Arnold, Cole Bolton, Marc Farris, Arthur 
Kimball-Stanley, Gregory Lablanc, Eric Nguyen, Adam Pollet, 
Walter Rahmey, Chris Theodoridis, Patrick Tierney, and Chieh-
Ting Yeh, who contributed careful and detailed research to this 
undertaking.
    The Panel also gratefully acknowledges the assistance of 
Christine Sgarlata Chung, assistant clinical professor of law 
and director of the Securities Arbitration Clinic at Albany Law 
School, and David P. McCaffrey, distinguished teaching 
professor at Albany-SUNY, the co-directors of the Center for 
Financial Market Regulation, in preparing the summaries of 
prior reports on regulatory reform contained in the appendix 
and the longer summaries of those reports that may be found on 
the Panel's Web site, cop.senate.gov.
    The Panel is also grateful to the following individuals who 
generously provided their time and expertise to the preparation 
of this report: Tobias Adrian, Professor Edward Balleisen, Dean 
Baker, Brandon Becker, Pervenche Beres, Professor Bruce 
Carruthers, Professor Lord Eatwell, Douglas Engmann, former 
Senator Phil Gramm, Professor Michael Greenberger, Professor 
Joseph Grundfest, Michael Jamroz, Robert Kelly, Professor Naomi 
Lamoreaux, Professor Stan Liebowitz, Professor Andrew Lo, David 
Raboy, Professor Hal Scott, L.W. Seidman, Professor Jay 
Westbrook, Professor Luigi Zingales, Professor Todd Zywicki, 
and the Squam Lake Working Group on Financial Regulation 
(including Martin Baily, Andrew Bernard, John Campbell, John 
Cochrane, Doug Diamond, Darrell Duffie, Ken French, Anil 
Kashyap, Rick Mishkin, Raghu Rajan, David Scharfstein, Matt 
Slaughter, Bob Shiller, Hyun Song Shin, Jeremy Stein, and Rene 
Stulz). The Panel thanks the following institutions and 
organizations for their contributions: Business Roundtable 
(including John Castellani and Tom Lehner), the Chicago Board 
Options Exchange, the Financial Industry Regulatory Authority, 
the Council of Institutional Investors (including Anne Yerger, 
Amy Borrus, and Jeff Mahoney), the Consumer Federation of 
America (and Barbara Roper), the International Swaps and 
Derivatives Association (and Robert Pickel), and the National 
Consumer Law Center (including Lauren Saunders and Margot 
Saunders). The Panel also benefited from the guidance of David 
Einhorn, Sarah Kelsey, Arthur Levitt, Alex Pollock, Professor 
Robert Merton, and Lawrence Uhlick.
              VII. ABOUT THE CONGRESSIONAL OVERSIGHT PANEL

    In response to the escalating crisis, on October 3, 2008, 
Congress provided the U.S. Department of the Treasury with the 
authority to spend $700 billion to stabilize the U.S. economy, 
preserve home ownership, and promote economic growth. Congress 
created the Office of Financial Stabilization (OFS) within 
Treasury to implement a Troubled Asset Relief Program (TARP). 
At the same time, Congress created the Congressional Oversight 
Panel to ``review the current state of financial markets and 
the regulatory system.'' The Panel is empowered to hold 
hearings, review official data, and write reports on actions 
taken by Treasury and financial institutions and their effect 
on the economy. Through regular reports, the Panel must oversee 
Treasury's actions, assess the impact of spending to stabilize 
the economy, evaluate market transparency, ensure effective 
foreclosure mitigation efforts, and guarantee that Treasury's 
actions are in the best interests of the American people. In 
addition, Congress has instructed the Panel to produce a 
special report on regulatory reform that will analyze ``the 
current state of the regulatory system and its effectiveness at 
overseeing the participants in the financial system and 
protecting consumers.''
    On November 14, 2008, Senate Majority Leader Harry Reid and 
the Speaker of the House Nancy Pelosi appointed Richard H. 
Neiman, Superintendent of Banks for the State of New York, 
Damon Silvers, Associate General Counsel of the American 
Federation of Labor and Congress of Industrial Organizations 
(AFL-CIO), and Elizabeth Warren, Leo Gottlieb Professor of Law 
at Harvard Law School to the Panel. With the appointment on 
November 19 of Congressman Jeb Hensarling to the Panel by House 
Minority Leader John Boehner, the Panel had a quorum and met 
for the first time on November 26, 2008, electing Professor 
Warren as its chair. On December 16, 2008, Senate Minority 
Leader Mitch McConnell named Senator John E. Sununu to the 
Panel, completing the Panel's membership.
    Congressman Hensarling and former Senator Sununu did not 
approve this report. Their alternative view is included in the 
following section.

                         VIII. ADDITIONAL VIEWS

                           Richard H. Neiman

    I am pleased to support the Panel's special report on 
regulatory reform, which begins to address some of the most 
critical issues facing our nation, such as improving consumer 
protection, reducing systemic risk, eliminating regulatory 
gaps, and enhancing global co-ordination of supervision. These 
are precisely the issues we need to address in these 
unprecedented times, when Americans are losing their homes, and 
the financial system and our economy are at greater risk than 
at any time since the Depression.
    Addressing any one of these issues individually would be a 
challenge; compiling a report that addresses them all within 
nine short weeks was a herculean task. Given the diversity of 
backgrounds and ideological views of the Panel members, the 
fact that we have reached agreement on the critical issues and 
on many action items to address those issues is truly 
remarkable.
    As the only regulator on the panel, I find it appropriate 
to highlight certain issues of particular importance and to 
which I bring a unique perspective.

 STATES MUST BE ALLOWED TO INCREASE THEIR ROLE IN PROTECTING CONSUMERS

    States have long strived to protect their citizens from 
harmful financial products and should continue to carry out 
this vital role. States, like New York, sounded an early alarm 
on subprime lending by adopting anti-predatory lending 
legislation and reaching landmark settlements with the nation's 
top mortgage bankers, providing hundreds of millions of dollars 
in consumer restitution and improving industry practices.
    Rather than join with the states, however, the OCC and the 
OTS thwarted state efforts, by claiming broad field preemption 
and then failing to adopt measures that protected consumers. 
This federal overreach caused gaps in consumer protection 
standards, as more protective state laws were set aside without 
being replaced by appropriate national standards or equivalent 
enforcement efforts.
    I want to underscore the Panel's recommendation to 
eliminate federal preemption of state consumer laws and confirm 
the ability of states to examine and enforce compliance with 
federal and state consumer protection laws. The recommendations 
will restore the appropriate balance between federal and state 
regulators and provide the basis for a ``New Federalism.'' It 
will draw on what is best about our current dual banking 
system, close gaps in consumer protection, and maximize the 
effectiveness of the joint resources of state and federal 
regulators.

  THE FEDERAL RESERVE BOARD SHOULD SET MINIMUM FEDERAL STANDARDS FOR 
                          CONSUMER PROTECTION

    The Panel's report calls for the establishment of a single 
federal regulator that would have overarching consumer 
protection responsibilities, such as setting national minimum 
standards. We need to establish adequate baseline consumer 
protections for all Americans. Under this proposal, states 
could adopt more stringent requirements than the federal body, 
as local conditions warranted, and could regulate consumer 
protection standards in the absence of federal action. This 
would allow states to serve as incubators to develop innovative 
regulatory solutions. Laws that are tried first at the state 
level and found successful often serve as the model for laws at 
the national level.
    The national minimum standards should go beyond required 
disclosures and extend to substantive regulation of consumer 
financial products. Disclosure alone does not address the 
issues that gave rise to the current crisis. We need to address 
key issues, including affordability, suitability, and the duty 
of care owed by financial services providers to consumers.
    While I wholeheartedly support a heightened emphasis on 
consumer issues, I believe the functions of consumer protection 
should not be separated from the role of safety and soundness. 
Loans that take unfair advantage of consumers adversely affect 
the safety and soundness of financial institutions. Regulators 
must consider an institution's activities holistically, to 
detect emerging problems and have adequate tools to respond. 
Too narrow a mission could lead to myopic, impractical 
regulations, increasing the likelihood of negative unintended 
consequences and threatening to undermine the safety and 
soundness of financial institutions. Assigning the consumer 
protection function to a new stand-alone agency with a limited 
mandate would create yet another federal bureaucracy, at a time 
when I believe we need to be streamlining and avoiding counter-
productive regulatory turf wars.
    I recognize that the Federal Reserve Board may have been 
slow to take up consumer protection responsibilities placed on 
it by Congress. However, I believe that the current crisis has 
demonstrated to the Fed the importance of consumer protection 
to the health of our financial institutions and the economy as 
a whole.

       THE FEDERAL RESERVE BOARD SHOULD BE THE SYSTEMIC REGULATOR

    The Panel's report correctly identifies the need for a 
federal systemic risk regulator, and I concur with proposals, 
such as those by the Group of Thirty, that this role be 
performed by a country's central bank.
    The current crisis has demonstrated that the Federal 
Reserve Board, our nation's central bank, is ideally suited to 
harness the tools available to it to address systemic risk. The 
Fed has played a pivotal role in designing and implementing 
solutions to the current financial crisis and has gained 
unparalleled insight into risks presented by non-banking as 
well as banking institutions. However, the Fed still has no 
explicit authority over many non-banking organizations that 
meet the definition for being ``systemically significant.'' The 
Fed's function in setting monetary policy, as well as 
supervising banking organizations and providing discount window 
facilities, strategically places it at the heart of the 
nation's regulatory nerve center. Creating new agencies to 
perform these broader systemic tasks would needlessly duplicate 
existing functions, dilute current levels of expertise and fail 
to take advantage of the wealth of experience accumulated by 
the Fed. The Federal Reserve's mission could easily be updated 
to formally incorporate these tasks into a broader mandate. I 
am confident that result would be a healthier, more vibrant 
financial system.

        WE NEED TO RESTORE THE CONFIDENCE OF THE AMERICAN PUBLIC

    As the Panel's report states, we need to restore a proper 
balance between free markets and the regulatory framework, in 
order to ensure that those markets operate to protect the 
economy, honest market participants and the public. I look 
forward to working with Congress to address the issues the 
report identifies, so that we can restore the confidence of the 
American public in the financial services system.
      CONGRESSMAN JEB HENSARLING AND FORMER SENATOR JOHN E. SUNUNU


                                PREFACE

    As part of the Economic Emergency Stabilization Act of 2008 
(Pub. L. No. 110-343), Congress required that the newly 
established Congressional Oversight Panel (the Panel) prepare a 
report ``analyzing the current state of the regulatory system 
and its effectiveness at overseeing the participants in the 
financial system and protecting consumers, and providing 
recommendations for improvement, including recommendations 
regarding whether any participants in the financial markets 
that are currently outside the regulatory system should become 
subject to the regulatory system, the rationale underlying such 
recommendation, and whether there are any gaps in existing 
consumer protections.'' Even in an environment where dozens of 
organizations have already offered their own perspective on the 
economic crisis and regulatory reform, assembling such a 
document in the short time the Panel has been in operation 
would be a daunting task. Adding to the challenge, the Panel is 
a diverse group which possessed a dedicated, but minimal staff 
well into the middle of January. As a result, much of the work 
drafting the Panel Report was given to individuals outside its 
operation.
    Building consensus over such a broad range of economic 
questions would be difficult in any event. The timing and 
process for preparing this document, unfortunately, made it 
more so. Given the differences that remain regarding our views 
of the systemic weaknesses that led to the crisis, and, more 
important, policy recommendations for reform, we have chosen 
not to support the Panel Report as presented. Instead, we 
provide here a more concise statement of the underlying causes 
of the current financial crisis and a series of recommendations 
for regulatory modernization. While there are several points in 
the Panel Report with which we agree, we also provide a summary 
of several areas where our disagreement led us to oppose the 
final product.
    This statement is organized into several sections:

          1. Introduction
          2. Observations on Current State of Financial 
        Regulation
          3. Underlying Causes of the Credit Crisis
          4. Recommendations for Financial Service Regulatory 
        Modernization and Reform
          5. Differences with Congressional Oversight Panel 
        Recommendations

    In preparing this summary, we drew heavily from several 
sources, which presented a range of views, but in which we also 
shared many common themes and recommendations. These include 
the Group of 30's Financial Reform: A Framework for Financial 
Stability, the Committee on Capital Markets Regulation's 
Recommendations for Reorganizing the U.S. Financial Regulatory 
Structure, the GAO's A Framework for Crafting and Assessing 
Proposals to Modernize the Outdated U.S. Financial Regulatory 
System, and the Department of the Treasury's Blueprint for a 
Modernized Financial Regulatory Structure. Others playing an 
influential role in helping frame the often complicated policy 
questions engendered by this work include the scholars at the 
American Enterprise Institute (AEI), particularly Peter 
Wallison and Alex Pollock, as well as those at George Mason 
University's Mercatus Center, including Professor Todd Zywicki, 
Houman B. Shadab, and Satya Thallam.
    If one theme emerged among others in these differing 
perspectives on the challenges ahead, it is that our pursuit 
should not be simply to identify new rules or areas in which to 
regulate, but to build a structure and system that is modern 
and appropriate to the institutions and technologies being used 
every day. A well-designed system should enhance market 
discipline, minimize risks to taxpayers, and avoid the pitfalls 
of unintended consequences. We hope our recommendations are 
true to these objectives.

                              INTRODUCTION

    Since the collapse and rescue of Bear Stearns in March 
2008, legislators, regulators, and financial market 
participants have found themselves enmeshed in a discussion of 
whether the financial system needs to be saved, and, if so, how 
best to save it. In October 2008, Congress passed the Emergency 
Economic Stabilization Act (EESA), which made available $700 
billion for the purpose of purchasing mortgage-backed 
securities from financial institutions in hope of stabilizing 
the financial system. Shortly after Congress voted to make 
these funds available, the Treasury Department changed course 
and instead decided to purchase capital in the nation's 
financial institutions to free up credit markets.
    Recent events--including additional losses by the nation's 
financial institutions, new Treasury programs to support two of 
the country's largest financial firms, and reports that the 
sums spent thus far on recapitalizing financial institutions 
have had only modest impact--demonstrate that while identifying 
problems in a marketplace might be easy, the task of isolating 
those problems, diagnosing their cause, and discerning how best 
to address them remains challenging. The conversation over how 
best to revive the financial system continues, and despite its 
urgency, it is essential that the participants in that 
conversation not rush to act in pursuit of a plan that fails to 
solve the problems we face, or makes them worse.
    Beyond the pressing challenges to stabilize our economic 
system, however, is the broader question of how best to oversee 
our financial system. If reorganization is to be done 
responsibly, it will demand an extraordinary amount of study, 
research, thought, and discussion, beginning with a careful, 
unbiased consideration of what exactly led to the crisis that 
now threatens our financial system. The observations and 
recommendations contained in these views should therefore be 
viewed as a preliminary contribution to the debate, not the 
final word. If not for reasons of modesty, then for reasons of 
prudence and responsibility, readers should be cautioned that 
this represents the opening round of a longer conversation 
regarding the future of our financial system.
    While the rapid escalation of the credit crisis last fall 
forced Congress to forgo a more deliberative process in 
considering policy options to respond, it is widely 
acknowledged now by both proponents and opponents of 
congressional action that properly addressing this crisis will 
involve a more carefully crafted response than the broadly 
defined powers given to Treasury under the $700 billion EESA. 
The stakes are no less important in regulating our financial 
system, for the consequences of mistakes made in rushing to fix 
a problem not fully understood will sow the seeds of even 
greater problems in the future.
    As a precursor for constructive reform, policy makers must 
first avoid a reflexive urge to simply write new rules. In the 
wake of the largest financial crisis since the Great 
Depression, some have called immediately to ``reregulate'' the 
financial system to prevent calamities like this from occurring 
again. Those that believe that regulation is the only answer, 
however, ignore the significant ways in which government 
intervention magnified our existing problems. In fact, there 
are few, if any, segments of the economy in which government 
regulates, intervenes, and legislates as heavily as it does in 
the financial and housing sectors. Before embracing more 
government regulation as the only answer, such advocates should 
consider the many ways in which government regulation itself 
can be part of the problem. The history of financial regulation 
is replete with such examples as either regulators or 
regulation have simply failed or made matters worse.
    In fact, the hallmark of past efforts to regulate the 
financial system has been that government regulation frequently 
fails. History has also repeatedly shown us that adding rigid 
new government regulations in the midst of a crisis to solve 
existing problems may be like the old military adage of armies 
being prepared to fight the last war. For example:

          1. For decades, banking regulators tried to fix 
        deposit prices nationally through ``Regulation Q,'' 
        which effectively denied savers significant amounts of 
        interest and, in turn, imperiled thrifts and banks as 
        deposits fled when interest rates were high. As with 
        all government regulation, Reg Q was grounded in the 
        belief that government mandates could manage market 
        forces and keep banks safer.
          2. Twenty years ago, in response to the failure of 
        1,600 commercial banks in the savings and loan crisis, 
        the federal government enacted the Federal Deposit 
        Insurance Corporation Improvement Act of 1991 (Pub. L. 
        No. 102-242) (FDICIA), which significantly tightened 
        bank and S&L regulation in an attempt to generate 
        stability. However, the tougher restrictions of FDICIA 
        did not fix the problem, and the savings and loan 
        crisis ended up costing American taxpayers over $120 
        billion.\114\
---------------------------------------------------------------------------
    \114\ Timothy Curry and Lynn Shibut, The Cost of the Savings and 
Loan Crisis: Truth and Consequences, FDIC Banking Review (December 
2000) (online at www.fdic.gov/bank/analytical/banking/2000dec/
brv13n2_2.pdf).
---------------------------------------------------------------------------
          3. More recently, state and federal legislation 
        mandated the use of credit ratings from a few rating 
        agencies, which effectively transformed these agencies 
        into a government-sponsored cartel. What began as an 
        impulse to bring safety and objectivity to the 
        regulation of broker-dealers ended by creating a 
        concentrated point of failure, jeopardizing the entire 
        financial system.
          4. Finally, there is the example of the Federal 
        Reserve's effort to use monetary policy to avoid the 
        recessionary effects of the tech bubble's bursting, 
        only to find that in doing so, it had helped create the 
        housing bubble.

    In addition to its demonstrated failure in preventing 
financial collapse, regulation imposes significant costs on the 
financial system in several ways. For example, rather than 
increasing stability and enhancing safety, regulation can 
invite chaos and encourage otherwise irrational risk taking 
among market participants who falsely believe that government 
will act as a guardian angel to protect them. Market 
participants thus underprice risk because they conjecture 
government has managed the risks that market participants would 
otherwise have had to assess. However, in reality, any 
government--from our current one to the most heavy-handed of 
all totalitarian central planners--can never completely 
regulate a market given its resource constraints and the 
ingenuity of individual entrepreneurs with a proper profit 
motive.
    Regulation can also reduce competition because its costs 
are more easily borne by large companies than by small ones. 
Large companies also have the ability to influence regulators 
to adopt regulations that favor their operations over those of 
smaller competitors. This is particularly true when regulations 
add costs that smaller companies cannot bear. Take, for 
example, the continuing decline in the number of community 
banks, the locally owned and operated institutions at the heart 
of many small towns and cities across the county. In 2004, the 
Federal Deposit Insurance Corporation (FDIC) released a report 
on the future of banking that found that although community 
banks still make up a majority of the banking industry, the 
number of community banks had been cut almost in half since 
1985. The report also found that their deposit share has also 
declined significantly in that time frame as large banks 
extended their geographic reach.\115\ Regulation also may keep 
low cost producers or international competitors out of 
regulated markets.
---------------------------------------------------------------------------
    \115\ Tim Critchfield with Tyler Davis, Lee Davison, Heather 
Gratton, George Hanc, and Katherine Samolyk, Community Banks: Their 
Recent Past, Current Performance, and Future Prospects (2004) (online 
at www.fdic.gov/bank/analytical/future/fob_03.pdf) (hereinafter ``FDIC 
Future of Banking Study'').
---------------------------------------------------------------------------
    Regulation can also harm consumers in the form of higher 
costs, less innovation, and fewer choices. Regulatory costs are 
passed along to consumers through higher prices for services or 
products. For an example, one need only look at their monthly 
telephone bill to see firsthand how the cost of various 
government regulations imposed on phone services are directly 
passed on to consumers in the form of new fees. Since the 
application of regulations over a population is generally 
universal but the direct benefits are often only individually 
realized, many regulations end up imposing costs on all 
consumers for the benefit of a limited few. Additionally, the 
associated cost of some regulations end up exceeding their 
value by adding costs to the process of developing new products 
or new services. There are countless examples of this 
phenomenon in the insurance industry, where it can take years 
to achieve the regulatory approval needed to roll out a new 
product offering or, in some bewildering cases, to enact rate 
reductions for the benefit of consumers if the reduction is 
approved at all.\116\
---------------------------------------------------------------------------
    \116\ John Kennedy, Gov. Crist, State Regulators Reject State 
Farm's 7 Percent Rate Reduction, Chicago Tribune (July 31, 2007) 
(online at www.chicagotribune.com/business/sfl-
0731statefarm,0,3467689.story).
---------------------------------------------------------------------------
    Instead of creating new regulatory hurdles, a superior 
approach to better protect consumers and preserve wealth-
creating opportunities is to enhance and reinforce wise 
regulation while bolstering private sector market discipline. 
This belief was well articulated in March 2000, when Gary 
Gensler, then Under Secretary for Domestic Finance in President 
Clinton's Treasury Department and currently President Obama's 
nominee to chair the Commodity Futures Trading Commission 
(CFTC), testified before the House Financial Services Committee 
regarding systemic risk in our capital markets. Over the course 
of his remarks, Gensler explained that instead of advocating 
for new or increased regulations, the approach supported by 
Treasury emphasized the formative role of the private sector in 
protecting market participants:

          The public sector has three roles. . . . Promoting 
        market discipline means crafting government policy so 
        that creditors do not rely on governmental intervention 
        to safeguard them against loss.
          Transparency is the necessary corollary to market 
        discipline. The government cannot impose market 
        discipline, but it can enhance its effectiveness by 
        promoting transparency. Transparency lessens 
        uncertainty and thereby promotes market stability.
          Promoting competition in financial markets lessens 
        systemic risk. The task of public policy must be to 
        ensure the stability and integrity of the market 
        system. In any sector of the financial market, the 
        dominance of one or two firms can lessen competition 
        and the efficiency of the market pricing mechanism. In 
        addition, the entry of a subsidized financial 
        institution into a market may motivate other firms to 
        take on greater risks and weaken their operating 
        results.\117\
---------------------------------------------------------------------------
    \117\ House Financial Services Committee, Subcommittee on Capital 
Markets, Securities, and Government Sponsored Enterprises, Testimony of 
Gary Gensler, Securities and Government Sponsored Enterprises, 106th 
Cong. (Mar. 22, 2000) (online at financialservices.house.gov/banking/
32200gen.htm).

    Under Secretary Gensler had the right idea then, and his 
words should help provide the framework for the structural 
changes to our regulatory regime that we are now considering.

         OBSERVATIONS ON CURRENT STATE OF FINANCIAL REGULATION

    The United States has the most robust, accessible, and 
sound financial structure of any country in the world. That 
structure has provided unparalleled opportunities for millions, 
from seasoned market participants to casual investors to 
hardworking teachers and nurses hoping to live out the American 
dream. The success of our structure has been based on market 
discipline coupled with an appropriate level of regulation that 
fosters competition, transparency, and accountability.
    Yet recently, this approach has been attacked by a small 
but vocal chorus claiming that two decades of financial 
deregulation has initiated the crisis that our financial system 
is now facing. These advocates of expanded government power 
contend that for years, government has been hard at work 
repealing all aspects of regulation in our financial sector. 
However, while such rhetoric might elicit some populist appeal, 
such claims do not bear scrutiny because the facts simply do 
not exist to support them.
    One frequent argument heard from many critics is that the 
Gramm-Leach-Bliley Act (P.L. 106-102), which repealed the 
Depression-era Glass-Steagall Act's separation of investment 
and commercial banking, was somehow responsible for the current 
credit crisis. To the contrary, a wide variety of experts 
across the political spectrum have dismissed that claim as ``a 
handy scapegoat''\118\ at best. When asked in October 2008 if 
Gramm-Leach-Bliley was a mistake, Alice M. Rivlin, the former 
director of both the Congressional Budget Office and the Office 
of Management and Budget, testified: ``I don't think so, I 
don't think we can go back to a world in which we separate 
different kinds of financial services and say these lines 
cannot be crossed. That wasn't working very well. . . . We 
can't go back to those days, we have got to figure out how to 
go forward.'' \119\ Even former President Bill Clinton remarked 
in a 2008 interview that ``I don't see that signing that bill 
had anything to do with the current crisis.'' \120\ If 
anything, Gramm-Leach-Bliley has played a significant role in 
attenuating the severity of this crisis by allowing commercial 
banks to merge with floundering investment banks--like JPMorgan 
Chase and Bear Stearns, Bank of America and Merrill Lynch, and 
Goldman Sachs and Morgan Stanley--actions that would have been 
explicitly prohibited had the Glass-Steagall Act still been in 
effect.
---------------------------------------------------------------------------
    \118\ David Leonhardt, Washington's Invisible Hand, New York Times 
(Sept. 26, 2008).
    \119\ House Financial Services Committee, Oral Remarks of Alice 
Rivlin, The Future of Financial Services Regulation, 110th Cong. (Oct. 
21, 2008) (online at financialservices.house.gov/hearing110/
hr102108.shtml).
    \120\ Bill v. Barack on Banks, Wall Street Journal (Oct. 1, 2008) 
(online at online.wsj.com/article/SB122282635048992995.html).
---------------------------------------------------------------------------
    Although the advocates for expanded government power would 
have you believe otherwise, a careful examination of the 
historical record points toward the conclusion that regulation 
of the financial services sector has at least held constant if 
not substantially increased in recent years. One need only 
think about the sprawling regulatory mandate that the Sarbanes-
Oxley Act (P.L. 107-204) imposed upon our financial system. 
Intended to toughen financial reporting requirements in the 
wake of the Enron scandal, Sarbanes-Oxley has created many 
needed reforms but its burden has also resulted in many 
companies taking their business--and their money--overseas. The 
result has been a flow of capital away from the U.S., capital 
which could have helped to shore-up American banks. In addition 
to Sarbanes-Oxley, over the last twenty years the federal 
government has implemented a wide array of new regulations on 
banks, mortgage lenders, and other financial services 
companies. These new regulations include:

    1. The Federal Deposit Insurance Corporation Improvement 
Act of 1991 (P.L. 102-242), which was designed to improve bank 
supervision, examinations, and capital requirements.
    2. The Home Ownership and Equity Protection Act (HOEPA) of 
1994 (P.L. 103-325), which mandates enhanced disclosures by 
lenders who make certain high-cost refinancing loans to 
borrowers.
    3. The 1989 and 2002 expansions of the mandated data 
furnished by lenders under the Home Mortgage Disclosure Act 
(HMDA).
    4. The 2001 Bank Secrecy Act amendments made by the USA 
PATRIOT Act (P.L. 107-56), which enhanced anti-terrorist and 
money laundering record-keeping requirements for banks.
    5. The Fair and Accurate Credit Transactions Act of 2003 
(P.L. 108-159), which created new information sharing, 
indentify theft protection, and consumer disclosure mandates.
    6. The Bankruptcy Abuse Prevention and Consumer Protection 
Act of 2005 (P.L. 109-8), which required lenders to provide new 
disclosures regarding credit offers and interest rates.
    7. Various other Truth in Lending Act (TILA)/Regulation Z 
regulations and other federal banking agency guidance regarding 
lending, offers of credit, and consumer protections.

    In fact, instead of wholesale deregulation, the case can be 
made that government has made concerted efforts to strengthen 
the very regulations that helped set the stage for the current 
financial crisis. To take one obvious example, there has been a 
strengthening of the Community Reinvestment Act, which has 
encouraged banks to make mortgage loans to borrowers who 
previously would have been rejected as non-creditworthy. Also, 
the Department of Housing and Urban Development's (HUD) 
affordable housing mandates for the government-sponsored 
enterprises (GSEs) were steadily increased from the 1990s 
through 2008, adding new targets and rules that compelled 
Fannie and Freddie to take certain loan purchasing actions to 
stay in compliance. Additionally, U.S. bank regulators are 
moving to quickly implement new capital requirements through 
the Basel II capital accord, which was less than two years old 
when plans for its adoption were announced on September 30, 
2005. These untested rules will replace the Basel I rules that 
generally assigned lower capital charges for housing assets, 
which tended to increase the leveraging of housing-related 
assets, making our financial system less stable.\121\
---------------------------------------------------------------------------
    \121\ Risk-based Capital Standards: Advanced Capital Adequacy 
Framework--Basel II, 72 Fed. Reg. 69,288 (Dec. 7, 2007) (to be codified 
at 12 C.F.R. pts. 3, 208, 225, 325, 559, 560, 563, 567) (online at 
www.setonresourcecenter.com/register/2007/Dec/07/69288A.pdf).
---------------------------------------------------------------------------
    Furthermore, proponents of the ``regulation is the cure'' 
argument must bear in mind that the most egregious financial 
failures have occurred not in the unregulated financial markets 
of hedge funds and over-the-counter derivatives, but in the 
highly regulated world of commercial and investment banking, 
where regulation has been the most burdensome. The former U.S. 
investment banks--which bought the so-called toxic assets that 
have been identified as one of the root causes of the financial 
crisis--were regulated by the Securities and Exchange 
Commission (SEC). Yet that supervision was insufficient to 
prevent the collapse of Bear Stearns or Lehman Brothers, two of 
this nation's largest investment banks, or the charter 
transformation of two other large investment banks, Goldman 
Sachs and Morgan Stanley, into bank holding companies. The 
credit rating agencies that blessed these products with AAA 
ratings were also regulated by the SEC, yet that supervision 
was not enough to prevent the inaccurate evaluations and gross 
errors in judgment of those agencies.
    This nation's highly regulated commercial banks, subject to 
regulation by several agencies similarly snapped up large 
quantities of these assets, all while supposedly under the 
oversight and supervision of their regulators. Yet the results 
of this country's heavy regulation of commercial banks have 
also been abysmal. Wachovia, formerly the nation's fourth 
largest bank, was regulated by the Comptroller of the Currency 
(OCC). Countrywide Financial was a national bank under OCC 
supervision until mid-2007, and then it became a federal thrift 
regulated by the Office of Thrift Supervision (OTS). Washington 
Mutual, IndyMac and Downey Savings and Loan Association were 
all also federal thrifts regulated by the OTS. All five were 
well regulated. And the housing market collapse caused all five 
to fail.\122\
---------------------------------------------------------------------------
    \122\ Binyamin Appelbaum and Ellen Nakashima, Banking Regulator 
Played Advocate Over Enforcer, Washington Post (Nov. 23, 2008.) (online 
at www.washingtonpost.com/wp-dyn/content/article/2008/11/22/
AR2008112202213_pf.html).
---------------------------------------------------------------------------
    By contrast, many of the less stringently regulated actors 
in the financial system, such as hedge funds and other private 
pools of capital, and less stringently regulated products, such 
as derivatives and swaps traded over the counter, seem to have 
weathered the crisis better than their highly regulated 
counterparts. While investors in some of those products have 
lost money, and some of the companies engaged in those lines of 
business have closed their doors, these failures did not 
produce massive systemic risk concerns that required federal 
intervention placing taxpayer dollars at risk.
    These observations lead to the clear point that heavy 
regulation, despite the outsized claims made for its 
effectiveness in avoiding crisis, will not solve our problems. 
As financial historian Bernard Shull stated in a 1993 paper on 
the matter:

          Comprehensive banking reform, traditionally including 
        augmented and improved supervision, has typically 
        evoked a transcendent, and in retrospect, unwarranted 
        optimism. The Comptroller of the Currency announced in 
        1914 that, with the new Federal Reserve Act, 
        ``financial and commercial crises or panics . . . Seem 
        to be mathematically impossible.'' Seventy-five years 
        later, confronting the S&L disaster with yet another 
        comprehensive reform . . . The Secretary of the 
        Treasury proclaimed ``two watchwords guided us as we 
        undertook to solve this problem: Never Again.'' \123\
---------------------------------------------------------------------------
    \123\ Bernard Shull, The Limits of Prudential Supervision: Economic 
Problems, Institutional Failure and Competence (1993) (online at 
www.levy.org/download.aspx?file=wp88.pdf&
pubid=378).

    More than fifteen years after Shull's paper, many stand 
ready to march down the same well-worn path, clinging to the 
belief that heavy-handed regulation holds the answer. Those 
claims should be rejected. There is a better and more effective 
path to choose.

                 A BRIEF HISTORY OF THE SUBPRIME CRISIS

    To some observers, the turmoil in the U.S. financial 
markets, caused by severe dislocations in the country's housing 
markets, has heralded the end of the free-market system. But 
with all due respect to the critics of capitalism, the economic 
crisis in which the country now finds itself reflects not the 
failure of the free-market system, but more so the result of 
decades of misguided government policies that interfered with 
the functioning of that system. While recent events demonstrate 
a need for regulatory reform, modernization, and improvement, 
the larger lesson is that a number of well-meaning but clearly 
misguided government policies distorted America's housing 
markets, which in turn produced grave consequences for the 
financial system and the underlying economy.
    In a rush to be seen as doing ``something'' in response, 
the advocates of expanded government power have brought forward 
a range of old proposals to regulate, reregulate, and 
overregulate any and every aspect of our economy. We believe a 
more practical approach would be to identify and correct the 
government policies that inflated the housing bubble underlying 
this crisis and then decide what change is necessary. Thus, the 
essential debate is not between deregulation and re-regulation, 
but instead between wise regulation and counterproductive 
regulation. Wise regulation helps make markets more competitive 
and transparent, empowers consumers with effective disclosure 
to make rational decisions, effectively polices markets for 
force and fraud, and reduces systemic risk. Counterproductive 
regulation hampers competitive markets, creates moral hazard, 
stifles innovation, and diminishes the role of personal 
responsibility in our economy. It is also procyclical, passes 
on greater costs than benefits to consumers, and needlessly 
restricts personal freedom.
    Those who simply advocate for reregulation because they 
claim that the free markets have failed ignore the various ways 
that government itself helped set the stage for the current 
financial crisis. The housing sector--where the difficulties 
confronting our markets started--is not a deregulated, free-
market in any sense of the word. This country's housing market 
is overloaded with substantial government components, including 
the regulatory roles of large government agencies; implicit and 
explicit government guarantees supporting the underwriting, 
issuance, and securitization of mortgages; and a cluster of 
mandates aimed at achieving universal home ownership. Indeed, 
the crisis this country finds itself facing does not stem from 
deregulation (since little has taken place over the last couple 
of decades) or even the mistakes of participants in the free 
market (although many harmful mistakes were committed), but 
instead from the myriad ways in which government initiatives 
interfered with the functioning of private markets.
    Our observations have led us to conclude that there are at 
least five key factors that led to the current crisis:

          1. A highly accommodative monetary policy that 
        lowered interest rates dramatically, kept them low, and 
        inflated the housing bubble.
          2. Broad federal policies designed to expand home 
        ownership in an ``off-budget'' fashion, which 
        encouraged lending to those who could not afford home 
        ownership.
          3. The moral hazard inherent in Fannie Mae and 
        Freddie Mac, the two failed GSEs, which exploited their 
        congressionally granted duopoly status to benefit from 
        privatized profits earned against socialized risks 
        taken.
          4. An anticompetitive government sanctioned credit 
        rating oligopoly that misled investors and failed in 
        its responsibility to provide accurate, transparent 
        assessments of risk.
          5. Failures throughout the mortgage securitization 
        process that resulted in the abandonment of sound 
        underwriting practices.

    Monetary Policy. The Federal Reserve set the stage for a 
wave of mortgage borrowing by keeping credit conditions too 
loose for too long earlier this decade. In response to the 
bursting of the high-tech bubble in 2000, the Federal Reserve 
began lowering interest rates in early 2001 to cushion the 
economic fallout. These highly accommodative policies were 
maintained in response to the 2001 recession and the economic 
shock of the 9-11 terrorist attacks. The target for the federal 
funds rate--the benchmark interbank lending rate in the U.S.--
was lowered to just 1 percent by mid-2003, and maintained at 
that level until mid-2004.\124\ The real funds rate--which is 
the difference between the funds rate set by the Federal 
Reserve and expected inflation--demonstrates just how 
aggressively the Federal Reserve was in conducting monetary 
policy during this period. The real funds rate dropped from 4 
percent in late 2000 to -1.5 percent by early 2003.\125\
---------------------------------------------------------------------------
    \124\ Federal Reserve Board, Open Market Operations (online at 
www.federalreserve.gov/fomc/fundsrate.htm) (accessed Jan. 26, 2009).
    \125\ Mark Zandi, Financial Shock: A 360+ Look at the Subprime 
Mortgage Implosion, and How to Avoid the Next Financial Crisis (2009).
---------------------------------------------------------------------------
    The Federal Reserve's decision to cushion the economic blow 
from the dramatic collapse in equity prices unleashed a wave of 
cheap credit on a housing market that was already experiencing 
a boom cycle. By mid-2003, the interest rate on a conventional 
thirty-year mortgage dipped to an all-time low of just 5.25 
percent, fueling demand in the housing market thanks to 
mortgage credit that had become cheap and plentiful in light of 
the Federal Reserve's rate cuts.\126\ As a result of demand and 
cheap credit, new home construction rose to a twenty-five-year 
high in late 2003, and remained at historic levels for two 
years.\127\
---------------------------------------------------------------------------
    \126\ Federal Reserve Bank of St. Louis, Economic Research (online 
at research.stlouisfed.org/fred2/series/MORTG/).
    \127\ Remarks of John B. Taylor at the Symposium of Housing, 
Housing Finance, and Monetary Policy sponsored by the Federal Reserve 
Bank of Kansas City in Jackson Hole, Wyoming (Sept. 2007) (online at 
www.kc.frb.org/PUBLICAT/SYMPOS/2007/PDF/Taylor_0415.pdf).
---------------------------------------------------------------------------
    It has been widely reported that over the last fifty years, 
there has not been a single year in which the national average 
home value had fallen despite some regional declines and 
various economic troubles and recessions. The allure of this 
statistic was so appealing that even former Federal Reserve 
Chairman Alan Greenspan and current Chairman Ben Bernanke at 
various points attested to it in defense of our housing 
markets. In fact, a 2004 report by top economists from Fannie 
Mae, Freddie Mac, the National Association of Realtors, the 
National Association of Home Builders, and the Independent 
Community Bankers of America entitled America's Home Forecast: 
The Next Decade for Housing and Mortgage Finance even concluded 
that ``there is little possibility of a widespread national 
decline since there is no national housing market.'' \128\ This 
widely held belief augmented Federal Reserve monetary policy 
and further inflated the housing bubble.
---------------------------------------------------------------------------
    \128\ David Leonhardt and Vikas Bajaj, Drop Foreseen in Median 
Price of U.S. Homes, New York Times (Aug. 26, 2007) (online at 
www.nytimes.com/2007/08/26/business/
26housing.html?ei=5090&en=9bd44f2f8b0ef4f4&ex=1345780800&partner=rssuser
land&emc=rss&pagewanted=all).
---------------------------------------------------------------------------
    Even with the brisk pace of home construction, demand still 
outstripped supply, pushing home prices even higher. Between 
1995 and 2002, in the midst of the housing boom, home prices 
appreciated between 2 percent and 5 percent a year. By 2004 and 
2005, at the height of the bubble, home prices were 
appreciating at nearly 15 percent per year. Between 1997 and 
2006, real home prices for the U.S. as a whole increased 85 
percent. Another measure of the unsustainable inflation that 
took place in housing prices is the relationship between house 
prices and rents. Over the past twenty-five years, the price-
to-rent ratio was roughly 16.5. In 2003, at the start of the 
bubble, the price-to-rent ratio was 18.5. It then quickly grew 
to an all-time peak of 25 by the end of 2005.\129\
---------------------------------------------------------------------------
    \129\ Zandi, supra note 125; Robert J. Shiller, The Subprime 
Solution: How Today's Global Financial Crisis Happened, and What to Do 
About It (2008).
---------------------------------------------------------------------------
    The bubble grew as cheap credit and sharply increasing home 
prices fueled the frenzy of first-time homeowners eager to buy 
into a market before prices got out of reach. It also 
encouraged current homeowners to purchase bigger homes or to 
buy additional properties for investment purposes. Federal 
Reserve economists have estimated that the share of investment 
real estate purchases jumped to roughly 17 percent in 2005 and 
2006 at the height of the housing boom, up from just more than 
6 percent a decade earlier.\130\
---------------------------------------------------------------------------
    \130\ Robert B. Avery, Kenneth P. Brevoort, and Glenn B. Canner, 
The 2006 HMDA Data, Federal Reserve Bulletin (Dec. 2007).
---------------------------------------------------------------------------
    These double digit increases in housing prices not only 
stimulated demand among home buyers who wanted to get into the 
housing market before they were priced out or were eager to 
invest on rising home prices, they also created an environment 
in which lenders, securitizers, and investors believed that it 
was impossible to make a bad loan. The consequences should have 
been foreseeable. Borrowers bought bigger, more expensive 
homes, betting that perpetually rising housing prices would 
allow them to refinance their mortgages at a later date while 
benefiting from ongoing appreciation in housing values. Lenders 
assumed that even if buyers defaulted, rising house prices 
would allow them to sell the home for more than the amount owed 
by the borrower.
    Economists have consistently identified the Federal 
Reserve's accommodative monetary policy as one cause of the 
current financial crisis. For example, John B. Taylor, a 
professor of economics at Stanford and the creator of the 
``Taylor rule'' guideline for monetary policy, has said the 
Federal Reserve made a mistake by keeping interest rates so 
low. According to Taylor's formula, the Federal Reserve should 
have raised interest rates much sooner than it did given the 
economic conditions at the time. Taylor himself has said that 
``a higher funds path would have avoided much of the housing 
boom. . . . The reversal of the boom and thereby the resulting 
market turmoil would not have been as sharp.''\131\ Given the 
key role that the Federal Reserve's monetary policy has played 
in contributing to the credit crisis we now face, it must be 
acknowledged that those decisions had a major impact on market 
conditions and helped to influence how investors chose to 
allocate their capital in our economy.
---------------------------------------------------------------------------
    \131\ Taylor, supra note 127.
---------------------------------------------------------------------------
    Federal Policy to Expand Home Ownership. For well over 
twenty years, federal policy has promoted lending and borrowing 
to expand homeownership, through incentives such as the home 
mortgage interest tax exclusion, the Federal Housing 
Administration (FHA), and discretionary spending programs such 
as HUD's HOME block grant program. But perhaps the most 
damaging initiative undertaken by the federal government was 
the effort to pressure private financial institutions to 
subsidize home ownership through the Community Reinvestment Act 
(CRA). Undertaken with the best of intentions--expanding home 
ownership among poor and underserved communities--the 
unintended consequences of the CRA clearly demonstrate that 
government's attempts to manipulate market behavior to achieve 
social goals often lead to harmful results.
    Enacted in 1977, the CRA encouraged banks to extend credit 
to ``underserved'' populations by requiring that banks insured 
by the federal government ``help meet the credit needs of its 
entire community.'' To ensure that banks are meeting this 
mandate, each federally insured bank is periodically examined 
by its federal regulator. As a result of its enactment, bank 
lending to low- and moderate-income families has increased by 
80 percent.\132\
---------------------------------------------------------------------------
    \132\ U.S. Department of the Treasury, The Community Reinvestment 
Act after Financial Modernization: A Baseline Report (Apr. 2000).
---------------------------------------------------------------------------
    In 1997, Wall Street firms, the GSEs, and the CRA converged 
in a landmark event: the first securitization of CRA loans, a 
$384-million offering guaranteed by Freddie Mac.\133\ Over the 
next 10 months, Bear Stearns issued $1.9 billion of CRA 
mortgages, backed by Fannie or Freddie, and between 2000 and 
2002 this business accelerated in dramatic fashion as Fannie 
Mae issued $20 billion in securities backed by CRA 
mortgages.\134\ By encouraging lenders and underwriters to 
relax their traditional underwriting practices, the CRA, 
investment firms and the GSEs saddled American taxpayers with 
the consequences of mortgages that borrowers cannot repay.
---------------------------------------------------------------------------
    \133\ First Union Capital Markets Corp., Bear, Stearns & Co. Price 
Securities Offering Backed By Affordable Mortgages Unique Transaction 
to Benefit Underserved Housing Market (Oct. 20, 1997).
    \134\ Fannie Mae Increase CRA Options, ABA Banking Journal (Nov. 1, 
2000).
---------------------------------------------------------------------------
    Equally problematic are reports that some of these CRA-
inspired loans are mortgages that borrowers can repay, but 
choose not to, given that the property that secures these loans 
is now worth less than the amount outstanding. Whether 
borrowers cannot or will not repay, the irony is that these 
lower-income home buyers--those who were supposed to benefit 
from the government's actions--are now defaulting at a rate 
three times that of other borrowers. With these defaults, the 
damage to homeowners, neighborhoods, state and local 
governments as the tax base shrinks, and now to all American 
taxpayers, is enormous.
    In the course of this crisis, there has been some heated 
discussion over the role CRA loans have played in contributing 
to our current woes. Proponents of CRA-like mandates have 
maintained that only a small portion of subprime mortgage 
originations are related to the CRA, and those CRA loans that 
have been written are performing in a manner similar to other 
types of subprime loans. Such claims, however, miss the 
fundamental point that critics of the CRA have made: though 
they may be small in volume, CRA loan mandates remain large in 
precedent because they inherently required lending institutions 
to abandon their traditional underwriting standards in favor of 
more subjective models to meet their government mandated CRA 
obligations.
    For example, in April of 1993, the Boston Federal Reserve 
Bank, under the leadership of future Freddie Mac Chairman Dick 
Syron, published an influential best practices guide called 
Closing the Gap: A Guide To Equal Opportunity Lending. The 
guide made several recommendations to lending institutions on 
various ways they could increase their low-income lending 
practices. Some of these recommendations, which encouraged 
institutions to abandon the traditional lending and 
underwriting policies used to ensure the quality of loans made, 
included:

          1. ``Special care should be taken to ensure that 
        standards are appropriate to the economic culture of 
        urban, lower-income, and nontraditional consumers.''
          2. ``Policies regarding applicants with no credit 
        history or problem credit history should be reviewed. 
        Lack of credit history should not be seen as a negative 
        factor. . . . In reviewing past credit problems, 
        lenders should be willing to consider extenuating 
        circumstances.''
          3. Institutions can ``work with the public sector to 
        develop products that assist lower-income borrowers by 
        using public money to reduce interest rates, provide 
        down payment assistance, or otherwise reduce the cost 
        of the mortgage.''
          4. ``A prompt and impartial second review of all 
        rejected applications can help ensure fairness in the 
        lending decision and prevent the loss of business 
        opportunities. . . . This process may lead to changes 
        in the institution's underwriting policies. . . . In 
        addition, loan production staff may find that their 
        experience with minority applicants indicates that the 
        institution's stated loan policy should be modified to 
        incorporate some of the allowable compensating 
        factors.'' \135\
---------------------------------------------------------------------------
    \135\ Boston Federal Reserve, Closing the Gap: A Guide to Equal 
Opportunity Lending (Apr. 1993) (online at www.bos.frb.org/commdev/
commaff/closingt.pdf).

    Taken in isolation, the good intentions of these 
recommendations is plain; taken together, however, it is also 
clear that lenders were being urged to abandon proven safety 
and soundness underwriting standards in favor of new outcome-
based underwriting standards. Again, the salient point is not 
to debate the notion of could or should more be done to make 
affordable loans available to underserved communities. The 
question is what damage is done to the overall stability of an 
institution when it alters its lending guidelines to comply 
with a government mandate to advance a social policy.
    Similarly, banks were urged by other private sector parties 
to ignore traditional lending guidelines, this time in the 
pursuit of greater and faster profit. In May of 1998, Bear 
Stearns published an article with guidance on why and how 
lenders should package CRA loans into mortgage backed 
securities.\136\ That document advised lenders that: 
``Traditionally rating agencies view LTV (loan-to-value ratios) 
as the single most important determinant of default. It is most 
important at the time of origination and less so after the 
third year.'' Bear Stearns also encouraged lower lending 
standards by arguing that when ``explaining the credit quality 
of a portfolio to a rating agency or GSE, it is essential to go 
beyond credit scores,'' and that ``the use of default models 
traditionally used for conforming loans have to be adjusted for 
CRA affordable loans.'' While such advice might have been 
important to maximizing profitability, Bear Stearns' guidance 
is yet one more example of how the conflict between a social 
policy mandate like the CRA and the fiscal requirements of 
basic safety and soundness operations led to a dangerous 
diminution in lenders' traditional underwriting standards.
---------------------------------------------------------------------------
    \136\ Dale Westhoff, Packaging CRA Loans into Securities, Mortgage 
Banking (May 1, 1998) (online at www.allbusiness.com/personal-finance/
real-estate-mortgage-loans/677967-1.html).
---------------------------------------------------------------------------
    The GSEs. Standing at the center of the American system of 
mortgage finance are the two now-failed government-chartered 
behemoths created to expand homeownership opportunities: the 
Federal National Mortgage Association (Fannie Mae) and the 
Federal Home Loan Mortgage Corporation (Freddie Mac). Market 
participants have long understood that this government created 
duopoly was implicitly, though not explicitly, backed by the 
federal government. This ``implied guarantee'' flowed from 
several factors, including the very existence of a government 
charter that effectively sanctioned this duopoly, access to a 
Treasury line of credit, and exemption from payment of state 
and local taxes. Although Fannie and Freddie were nominally 
designed to be competitors, in practice this implied guarantee 
allowed the two largely to work in unison as a cartel to set 
and maintain prices in the market.
    The dangers inherent in such an implied guarantee were 
twofold. First, their unique status allowed Fannie and Freddie 
to borrow funds in the marketplace at subsidized rates. 
Ostensibly, these funds would be used to purchase mortgages 
from lenders, fulfilling their mission to provide liquidity in 
the secondary mortgage markets. For over a decade, however, the 
GSEs continued to build enormous investment portfolios, earning 
profits by arbitraging the difference between their low, 
subsidized borrowing costs and the higher yields in their 
portfolio's ever riskier assets. Beginning in 1990, their 
investment portfolios grew tenfold, from $135 billion to $1.5 
trillion,\137\ allowing many of their shareholders and 
executives to become personally wealthy thanks to the GSEs' 
subsidized borrowing costs while the American taxpayer assumed 
most of the risk.
---------------------------------------------------------------------------
    \137\ U.S. Department of the Treasury, Remarks of Assistant 
Secretary for Financial Institutions Emil W. Henry Jr., before the 
Housing Policy Council of the Financial Services Roundtable (June 26, 
2006) (online at www.ustreas.gov/press/releases/js4338.htm).
---------------------------------------------------------------------------
    Second, their implied guarantee created a false sense of 
security and standards for the products they purchased and 
securitized. This perception played a major role in the 
proliferation of GSE-backed subprime and Alt-A securities, 
providing a de facto government seal of approval for even the 
riskiest loans as market participants believed these securities 
were appropriately priced and represented minimal risk. Their 
predominance in the mortgage market meant that Fannie and 
Freddie's business practices--credit rating, underwriting, risk 
modeling--were seen as the ``gold standard'' in the industry, 
despite flaws that later became apparent.
    For its part, Congress substantially magnified these 
potential risks by charging the GSEs with a mission to promote 
homeownership and thus inflating the supply of credit available 
to fund residential mortgages. The GSEs' congressional mandate 
and their access to cheap funding allowed the government to 
pressure Fannie and Freddie to expand homeownership to 
historically credit-risky individuals without the burden of an 
explicit on-budget line item at taxpayer expense, a budget goal 
long sought by housing advocates. For instance, in 1996, the 
HUD required that 42 percent of Fannie's and Freddie's mortgage 
financing should go to borrowers with income levels below the 
median for a given area.\138\ HUD revised those goals again in 
2004, increasing them to 56 percent of their overall mortgage 
purchases by 2008.\139\ In addition, HUD required that 12 
percent of all mortgage purchases by Fannie and Freddie be 
``special affordable'' loans made to borrowers with incomes 
less than 60 percent of an area's median income, and ultimately 
increased that target to 28 percent for 2008.\140\
---------------------------------------------------------------------------
    \138\ Russell Roberts, How Government Stoked the Mania, Wall Street 
Journal (Oct. 3, 2008).
    \139\ Id.
    \140\ Id.
---------------------------------------------------------------------------
    These ``affordable housing'' goals and other federal 
policies succeeded at increasing the homeownership rate from 64 
percent in 1994 to an all-time high of 69 percent in 2005.\141\ 
However, they did so at a great cost. To meet these 
increasingly large government mandates, Fannie and Freddie 
began to buy riskier loans and encouraged those who might not 
be ready to buy homes to take out mortgages. This GSE-
manufactured demand boosted home prices to an artificially high 
level and fostered enthusiasm for the wave of exotic mortgage 
products that began to flood the market.
---------------------------------------------------------------------------
    \141\ Id.
---------------------------------------------------------------------------
    For example, in 1999, under pressure from the Clinton 
Administration to expand home loans among low- and moderate-
income groups, Fannie Mae introduced a pilot program in fifteen 
major markets encouraging banks to extend mortgage credit to 
persons who lacked the proper credit histories to qualify for 
conventional loans. The risks of such a program should have 
been apparent to all. The New York Times, in a prescient 
comment on the program at the time, remarked: ``In moving, even 
tentatively, into this new area of lending, Fannie Mae is 
taking on significantly more risk, which may not pose any 
difficulties during flush economic times. But the government-
subsidized corporation may run into trouble in an economic 
downturn, prompting an economic rescue.'' \142\
---------------------------------------------------------------------------
    \142\ Steven A. Holmes, Fannie Mae Eases Credit to Aid Mortgage 
Lending, New York Times (Sept. 30, 1999).
---------------------------------------------------------------------------
    During this period, the government also began to push 
Fannie and Freddie into the subprime market. In 1995, HUD 
authorized Fannie and Freddie to purchase subprime securities 
that included loans to low-income borrowers and allowed the 
GSEs to receive credit for those loans toward their mandatory 
affordable housing goals. Subprime lending, it was thought, 
would benefit many borrowers who did not qualify for 
conventional loans. Fannie and Freddie readily complied, and as 
a result, subprime and near-prime loans jumped from 9 percent 
of securitized mortgages in 2001 to 40 percent in 2006.\143\
---------------------------------------------------------------------------
    \143\ Roberts, supra note 138.
---------------------------------------------------------------------------
    Fannie's and Freddie's heavy involvement in subprime and 
Alt-A mortgages increased following their accounting scandals 
in 2003 and 2004 in an attempt to curry favor with Congress and 
avoid stricter regulation. Data from these critical years 
before the housing crisis hit show Fannie and Freddie had a 
large direct and indirect role in the market for risky mortgage 
loans. In 2004 alone, Fannie and Freddie purchased $175 billion 
in subprime mortgage securities, which accounted for 44 percent 
of the market that year. Then, from 2005 through 2007, the two 
GSEs purchased approximately $1 trillion in subprime and Alt-A 
loans, and Fannie's acquisitions of mortgages with less than 
10-percent down payments almost tripled.\144\
---------------------------------------------------------------------------
    \144\ American Enterprise Institute, Peter Wallison and Charles 
Calomiris, The Last Trillion-Dollar Commitment: The Destruction of 
Fannie Mae and Freddie Mac (Sept. 30, 2008).
---------------------------------------------------------------------------
    Without question, the purchase and securitization of such 
loans by Fannie and Freddie was a clear signal and incentive to 
all loan originators to write more subprime and Alt-A loans 
regardless of their quality. As a result, the market share of 
conventional mortgages dropped from 78.8 percent in 2003 to 
50.1 percent by 2007 with a corresponding increase in subprime 
and Alt-A loans from 10.1 percent to 32.7 percent over the same 
period.\145\ The message, as The New York Times noted, was 
clear: ``[T]he ripple effect of Fannie's plunge into riskier 
lending was profound. Fannie's stamp of approval made shunned 
borrowers and complex loans more acceptable to other lenders, 
particularly small and less sophisticated banks.''\146\ Soon, 
Fannie and Freddie became the largest purchasers of the higher-
rated (AAA) tranches of the subprime pools that were 
securitized by the market. This support was essential both to 
form these investment pools and market them around the world. 
Fannie and Freddie thus played a pivotal role in the growth and 
diffusion of the mortgage securities that are now crippling our 
financial system.
---------------------------------------------------------------------------
    \145\ Joint Center for Housing Studies, The State of the Nation's 
Housing (2008) (online at www.jchs.harvard.edu/publications/markets/
son2008/index.htm).
    \146\ Charles Duhigg, Pressured to Take More Risk, Fannie Reached 
Tipping Point, New York Times (Oct. 5, 2008).
---------------------------------------------------------------------------
    Fannie and Freddie also played a leading role in weakening 
the underwriting standards that had previously helped ensure 
that borrowers would repay their mortgages. For instance, in 
May 2008, Fannie and Freddie relaxed the down payment criteria 
on the mortgages they buy, accepting loans with down payments 
as low as 3 percent.\147\ And in recent years both companies 
markedly stepped up their guarantees on Alt-A loans, which 
often did not require the verification of income, savings, or 
assets for potential borrowers. Between 2005 and the first half 
of 2008, Fannie guaranteed at least $230 billion worth of these 
risky loans, more than three times the amount it had guaranteed 
on all past years combined. However, these poorly underwritten 
loans are now increasingly turning sour amid the housing 
downturn, especially those concentrated in California, Florida, 
Nevada, and Arizona, where the housing bubble was particularly 
large and real estate speculation was rampant.\148\
---------------------------------------------------------------------------
    \147\ Fannie Mae Relaxes Loan Down Payment Requirements, Reuters 
News Service (May 19, 2008).
    \148\ James R. Hagerty, Fannie, Freddie Share Spotlight in Mortgage 
Mess, Wall Street Journal (Oct. 16, 2008).
---------------------------------------------------------------------------
    To preserve their government-granted duopoly powers and 
maintain unfettered access to cheap funds, Fannie and Freddie 
spent enormous sums on lobbying and public relations. According 
to the Associated Press, they ``tenaciously worked to nurture, 
and then protect, their financial empires by invoking the 
political sacred cow of homeownership and fielding an army of 
lobbyists, power brokers and political contributors.'' \149\ 
Fannie and Freddie's lobbyists fought off legislation that 
might shrink their investment portfolios or erode their ties to 
the federal government, raising their borrowing costs. In fact, 
Franklin D. Raines, Fannie Mae's former chairman, once told an 
investor conference that ``we manage our political risk with 
the same intensity that we manage our credit and interest rate 
risk.'' \150\ Raines's statement was undoubtedly true: over the 
past ten years, Fannie and Freddie spent more than $174 million 
on lobbying.\151\
---------------------------------------------------------------------------
    \149\ Tom Raum and Jim Drinkard, Fannie Mae, Freddie Mac Spent 
Millions on Lobbying, Associated Press (July 17, 2008).
    \150\ Wallison and Calomiris, supra note 144.
    \151\ Fannie Mae, Freddie Mac Spent Millions on Lobbying, 
Associated Press (July 17, 2008).
---------------------------------------------------------------------------
    As long as times were good, the GSEs were able to point to 
their affordable housing goals to distract attention from the 
inherent risk their business model posed. But, for more than a 
decade, alarms have been sounded about the precarious position 
of the GSEs. For example, in Congress, as far back as 1998, GSE 
reform advocates like former Rep. Richard Baker were voicing 
their concerns over ``the risks and potential liabilities that 
GSEs represent.'' \152\ In 2000, Rep. Baker demonstrated he was 
far ahead of the curve when he observed that by ``improving the 
existing regulatory structure of the housing GSEs in today's 
good economic climate, we can reduce future risk to the 
taxpayer and the economy.'' \153\ That year, the House 
Financial Services Committee held no fewer than six hearings on 
the subject of GSE reform, with at least five more over the 
following two years.\154\ Yet from 2000 to 2005, although at 
least eight major GSE reform bills were introduced in Congress, 
Fannie and Freddie exerted enough influence that only one, the 
Federal Housing Finance Reform Act of 2005, ever gained enough 
support to be passed by either body, but it ultimately did not 
become law.\155\
---------------------------------------------------------------------------
    \152\ House Financial Services Committee, Statement of Rep. Richard 
Baker, Joint Hearing on Government Sponsored Enterprises, 105th Cong. 
(July 16, 1997) (online at financialservices.house.gov/banking/
71697bak.htm).
    \153\ House Financial Services Committee, Subcommittee on Capital 
Markets, Securities, and Government Sponsored Enterprises, Statement of 
Rep. Richard Baker, Housing GSE Regulatory Reform Hearing, 106th Cong. 
(March 22, 2000) (online at financialservices.house.gov/banking/
32200bak.htm).
    \154\ House Financial Services Committee, Archived Hearings (online 
at http://financialservices.house.gov/archive_hearings.html).
    \155\ H.R. 1461, 109th Cong. (2005)
---------------------------------------------------------------------------
    Others in government shared similar concerns. In 1997, the 
General Accountability Office cautioned in its testimony before 
the House Financial Services Committee that ``the outstanding 
volume of federally assisted GSE credit is large and rapidly 
increasing.'' \156\ As referenced above, then-Treasury Under 
Secretary Gensler testified in March 2000 that ``the 
willingness of a GSE to purchase a mortgage has become a far 
more significant factor in deciding whether to originate that 
mortgage.'' Gensler went on to state that as the GSEs continue 
to grow, ``issues of potential systemic risk and market 
competition become more relevant,'' and concluded that the 
current moment was ``an ideal time to review the supervision 
and regulation of the GSEs.'' \157\ In 2004, then-Federal 
Reserve Chairman Alan Greenspan warned in his testimony before 
the Senate Banking, Housing, and Urban Affairs Committee that 
``the current system depends on the risk managers at Fannie and 
Freddie to do everything just right. . . . But to fend off 
possible future systemic difficulties, which we assess as 
likely if GSE expansion continues unabated, preventive actions 
are required sooner rather than later.'' \158\
---------------------------------------------------------------------------
    \156\ House Financial Services Committee, Subcommittee on Capital 
Markets, Securities, and Government Sponsored Enterprises, Testimony of 
Jim Bothwell of the Government Accountability Office, Joint Hearing on 
Government Sponsored Enterprises, 105th Cong. (July 16, 1997) (online 
at financialservices.house.gov/banking/71697gao.htm).
    \157\ Gensler, supra note 117.
    \158\ Senate Committee on Banking, Housing, and Urban Affairs, 
Testimony of Alan Greenspan, Proposals for Improving the Regulation of 
the Housing Government Sponsored Enterprises, 108th Cong. (Feb. 24, 
2004) (online at www.access.gpo.gov/congress/senate/pdf/108hrg/
21980.pdf).
---------------------------------------------------------------------------
    Outside of Congress, more red flags were flown over the 
obvious weaknesses of the GSE model. At another House Financial 
Services Committee hearing on GSEs in 2000, low-income housing 
advocate John Taylor of the National Community Reinvestment 
Coalition warned that the lack of a strong regulatory agency 
for Fannie and Freddie ``threatens the safety and soundness of 
the GSEs.'' \159\ At the same hearing, community activist Bruce 
Marks of the Neighborhood Assistance Corporation of America 
expressed his fears that without enhanced regulatory control 
over Fannie and Freddie, the GSEs might participate ``in 
potentially profitable but also potentially risky investments 
[sic] schemes [that] pose potential risks for the housing and 
banking industry and for the economy in general.'' \160\
---------------------------------------------------------------------------
    \159\ House Financial Services Committee, Subcommittee on Capital 
Markets, Securities, and Government Sponsored Enterprises, Testimony of 
John Taylor, Hearing on Improving Regulation of Housing GSEs, 106th 
Cong. (June 15, 2000) (online at financialservices.house.gov/banking/
61500tay.htm).
    \160\ House Financial Services Committee, Subcommittee on Capital 
Markets, Securities, and Government Sponsored Enterprises, Testimony of 
Bruce Marks, Hearing on Improving Regulation of Housing GSEs, 106th 
Cong. (June 21, 2000) (online at financialservices.house.gov/banking/
62100mar.htm).
---------------------------------------------------------------------------
    Unfortunately, despite all the evidence of systemic risk 
and repeated efforts to consolidate, strengthen, and increase 
regulatory oversight of Fannie and Freddie, calls for reform 
mostly fell on deaf ears. One reason why reform efforts failed 
was that the GSEs and their ardent defenders in Congress have 
spent the better part of the last decade first ignoring, then 
rejecting, then attempting to contradict the mounting evidence 
that the whole system was in danger. In 2001, Fannie Mae itself 
attempted to dispel the need for any change, declaring before 
Congress that ``we operate successfully under the most rigorous 
of safety and soundness regimes; we are subject to a high level 
of market discipline and provide the marketplace with world-
class disclosures.'' \161\ Freddie Mac, for its part, used the 
same hearing to proclaim that their ``superior risk management 
capabilities, strong capital position and state-of-the-art 
information disclosure make Freddie Mac unquestionably a safe 
and sound financial institution.'' \162\
---------------------------------------------------------------------------
    \161\ House Financial Services Committee, Subcommittee on Capital 
Markets, Securities, and Government Sponsored Enterprises, Testimony of 
J. Timothy Howard of Fannie Mae, Hearing on Reforming Fannie Mae and 
Freddie Mac, 107th Cong. (July 11, 2001) (online at 
financialservices.house.gov/media/pdf/071101th.pdf).
    \162\ House Financial Services Committee, Subcommittee on Capital 
Markets, Securities, and Government Sponsored Enterprises, Testimony of 
Mitchell Delk of Freddie Mac, Hearing on Reforming Fannie Mae and 
Freddie Mac, 107th Cong. (July 11, 2001) (online at 
financialservices.house.gov/media/pdf/071101md.pdf).
---------------------------------------------------------------------------
    After their credibility eroded from their accounting 
scandals, Fannie and Freddie increasingly relied on elected 
officials to fight attempts at reform. In 2003, Rep. Barney 
Frank famously remarked at a hearing on a pending GSE reform 
bill: ``I believe there has been more alarm raised about 
potential [GSE] un-safety and unsoundness than, in fact, 
exists. . . . I do not want the same kind of focus on safety 
and soundness that we have in OCC and OTS. I want to roll the 
dice a little bit more in this situation towards subsidized 
housing.'' \163\ In 2004, Senator Chris Dodd called Fannie and 
Freddie ``one of the great success stories of all time,'' \164\ 
while in 2005 Senator Chuck Schumer confessed that perhaps 
``Fannie and Freddie need some changes, but I don't think they 
need dramatic restructuring in terms of their mission.'' \165\ 
The scope of this head-in-the-sand mentality was perhaps most 
completely embodied by Rep. Maxine Waters who, in 2002, 
categorically rejected the need for any GSE reform bill, 
proclaiming at a House Financial Services Committee hearing on 
the matter ``If it is not broken, why fix it?'' \166\
---------------------------------------------------------------------------
    \163\ House Financial Services Committee, Oral remarks of Rep. 
Barney Frank, Hearing on H.R. 2575, The Secondary Mortgage Market 
Enterprises Regulatory Improvement Act, 108th Cong. (Sept. 25, 2003) 
(online at financialservices.house.gov/media/pdf/108-54.pdf).
    \164\ What They Said About Fan and Fred, Wall Street Journal (Oct. 
2, 2008).
    \165\ Id.
    \166\ House Financial Services Committee, Statement of Rep. Maxine 
Waters, Hearing on Housing Government Sponsored Enterprises, 107th 
Cong. (July 16, 2002) (online at financialservices.house.gov/media/pdf/
071602wa.pdf).
---------------------------------------------------------------------------
    Although it is fair to say that no one ought to be blamed 
for lacking the ability to predict the future, the fact remains 
that for more than a decade there were clear, discernable, and 
announced warnings that Fannie and Freddie were growing too big 
and that if left unchecked would eventually collapse beneath 
their own weight. Too many public policy makers failed to heed 
those warnings, or knowingly disregarded them, and as a result 
taxpayers have now been left to pick up the pieces by taking on 
hundreds of billions of dollars worth of risk. Ironically, when 
the housing bubble finally burst, the resulting wave of 
foreclosures stemming from loans the GSEs forced into the 
market will likely end up reducing homeownership rates across 
the country, a direct contradiction to the stated purpose of 
Fannie and Freddie that their supporters for so long sought to 
advance.
    Credit Rating Agencies. In order to sell subprime 
securities to investors, those securities first had to be rated 
by the credit rating agencies. Like so many other players, the 
credit rating agencies were caught up in the pursuit of fees 
generated from the real estate boom. This overwhelming desire 
to maximize their profits from the housing bubble is perhaps 
best captured by an e-mail message from a Standard & Poor's 
official who wrote that ``We rate every deal. It could be 
structured by cows and we would rate it.'' \167\ To perform 
their work, these agencies made extensive use of sophisticated 
modeling in an attempt to predict risk and the likelihood of 
default on loans. However, much like everyone else, the credit 
rating agencies falsely assumed that housing prices would never 
go down nationwide, which meant that their elaborate 
mathematical models were defective from the start. When 
mortgage defaults accelerated and home prices began to plummet, 
securities based on those loans that were once highly rated 
were downgraded to junk causing a wave of financial turmoil for 
scores of market participants at every level.
---------------------------------------------------------------------------
    \167\ House Committee on Oversight and Government Reform, Hearing 
on Credit Rating Agencies and the Financial Crisis, 110th Cong. (Oct. 
22, 2008) (online at oversight.house.gov/documents/20081023162631.pdf).
---------------------------------------------------------------------------
    But the failure of the credit rating agencies would not 
have generated the disastrous consequences that it did had that 
failure not been compounded by further misguided government 
policies, which had effectively allowed the credit rating 
agencies to operate as a cartel. For decades, federal financial 
regulators have required that regulated entities heed the 
ratings of a select few rating agencies. For example, since the 
1930s regulators have not allowed banks to invest in bonds that 
are below ``investment grade,'' as determined by the select few 
rating agencies as recognized by the government. Although the 
goal of having safe bonds in the portfolios of banks may be a 
worthy one, bank regulators essentially delegated a major 
portion of their safety assessments to the opinions of these 
rating agencies.
    This delegation of authority by bank regulators was further 
compounded in 1975, when the SEC also delegated its safety 
judgments regarding broker-dealers to the credit rating 
agencies. As an attempted safeguard against unqualified 
agencies from participating in the process, the SEC created a 
new Nationally Recognized Statistical Rating Organization 
(NRSRO) designation for qualified entities, and immediately 
grandfathered the three large rating agencies into this 
category. Following the SEC, other financial regulators soon 
adopted the NRSRO category for their delegations, assuming this 
government stamp of approval would ensure the continued quality 
of the ratings produced by those agencies.
    Over the next 25 years, the SEC allowed only four more 
rating firms to achieve the NRSRO designation, but mergers 
among the NRSROs eligible to issue ratings recognized by the 
regulators shrunk the number of NRSROs back to three by year-
end 2000. In 2006, Congress passed legislation (Pub. L. No. 
109-291) to address part of this situation which required that 
the SEC cease being a barrier to entry for legitimate rating 
agencies, and gave it limited regulatory powers over the 
NRSROs. Although the SEC has designated six additional NRSROs 
since 2000,\168\ competition and transparency in the ratings 
agency system remains inadequate. The SEC has never developed 
criteria for the designation and, once designated, NRSROs have 
for too long been allowed to operate without further scrutiny 
by the SEC for competence or accuracy.
---------------------------------------------------------------------------
    \168\ AEI Center for Regulatory and Market Studies, Lawrence J. 
White, Lessons from the Debacle of '07-'08 for Financial Regulation and 
Its Overhaul (Jan. 2009) (Working Paper No. 09-01).
---------------------------------------------------------------------------
    By adopting this NRSRO system, the SEC thus established an 
insurmountable barrier to entry into the rating business, 
eliminating market competition among the rating agencies. No 
one could be surprised that once they were spared the market 
discipline, the quality of the work by protected rating 
agencies would diminish.
    Market Behavior. Government policies that dominated and 
distorted the nation's housing market clearly set the stage for 
the housing crisis. But there were also significant mistakes 
made by private-sector participants at each step of the 
originate-to-distribute model of mortgage financing which 
compounded the government's failure. The benefits of this 
system--such as lower financing costs and the efficient 
distribution of risk--were significant. Over time, however, the 
belief that home prices would continue their relentless, upward 
path distorted began to distort decision making at every step 
along the path.
    The belief that real estate prices would only go up led 
borrowers, originators, lenders, securitizers, and investors to 
conclude that these investments were risk free. As a result, 
the traditional underwriting standards, based on the borrower's 
character, capacity to repay, and the quality of collateral 
were abandoned. What many failed to realize was that those 
standards were designed not only to protect the participants in 
the system from the consequences of a bubble, but also to 
protect the underlying financial system itself.
    Borrowers. Building on that belief that housing prices 
could never go down, borrowers were encouraged to borrow as 
much as possible and buy as much house as they possibly could, 
or else invest in other properties that could always later be 
resold for a profit. The result was that borrowers often ended 
up with mortgage products that they failed to understand, that 
they could not afford, or that ended up exceeding the value of 
the property securing the mortgage. Those concerns were less 
important as property values continued to rise, since borrowers 
could always refinance or sell to benefit from the continued 
appreciation of the property. However, when property values 
began to fall, in many cases borrowers soon realized that the 
economically rational course of action for them was to mail in 
their keys to the mortgage servicer and simply walk away. Since 
mortgages are non-recourse loans, doing so meant that someone 
else was bearing the downside risk. While the vast majority of 
borrowers continue to honor their commitments and pay their 
mortgages, for many of those who put little or no money down 
their mortgages became a ``heads I win, tails you lose'' 
proposition.
    Mortgage Originators. Because mortgage originators were 
compensated on the quantity rather than the quality of loans 
they originated, there was little incentive to care if the 
loans they originated would perform. The compensation of 
mortgage brokers was also tied to the interest rates and fees 
paid by customers, which created a financial incentive for some 
brokers to direct borrowers to loans that may not have 
otherwise been in their best interest. For example, some 
originators who advocated for certain subprime loans received 
commissions that were more than twice as high as the 
commissions they would have received for higher-quality loans. 
This incentives model put a much higher premium on quantity 
over quality, which only diminished the safety and soundness of 
the entire system as even more risks were externalized while 
profits were internalized.
    Mortgage Fraud. Integral to understanding the root causes 
of our current credit crisis is an acknowledgement of the 
rampant mortgage fraud that took place in the mortgage industry 
during the boom years. Fueled by low interest rates and soaring 
home values, the mortgage industry soon attracted both 
unscrupulous originators as well as disingenuous borrowers, 
resulting in billions of dollars in losses. As early as 2004, 
FBI officials in charge of criminal investigations foresaw that 
mortgage fraud had the potential to mushroom into an epidemic. 
In 2008, the Department of Treasury's Financial Crimes 
Enforcement Network (FinCEN) announced a 44 percent increase in 
Suspicious Activity Reports from financial institutions 
reporting mortgage fraud, with some 37,313 mortgage fraud 
reports filed in 2006, and 52,868 mortgage fraud reports filed 
in 2007. According to FinCEN, mortgage loan fraud was the third 
most prevalent type of suspicious activity reported, lagging 
behind only money laundering and check fraud. From 2000 to 
2007, FinCEN found that the reporting of suspected mortgage 
loan fraud had increased an astounding 1400 percent from 3,515 
cases in 2000 to 52,868 cases in 2007.\169\
---------------------------------------------------------------------------
    \169\ Financial Crimes Enforcement Network, FinCEN Assessment 
Reveals Suspected Mortgage Loan Fraud Continues to Rise (Nov. 3, 2007).
---------------------------------------------------------------------------
    Unfortunately, law enforcement officials failed to stop the 
epidemic that they had accurately diagnosed because they did 
not devote adequate resources to the problem. Even though the 
FBI and the Justice Department are charged with the 
responsibility of investigating and prosecuting illegal 
activities by originators, lenders, and borrowers, the focus of 
those agencies was trained on national security and other 
priorities. As a result, inadequate attention was paid to many 
of the white-collar crimes that contributed to the financial 
crisis. For example, by 2007, the number of agents pursuing 
mortgage fraud shrank to around 100.\170\ By comparison, the 
FBI had about a thousand agents deployed on banking fraud 
during the S&L bust of the 1980s and 1990s. Although the FBI 
later increased the number of agents working on mortgage fraud 
to 200, others have pointed out that the agency might have 
averted much of the problem had it heeded its own warning about 
widespread mortgage fraud.\171\
---------------------------------------------------------------------------
    \170\ Richard B. Schmitt, FBI Saw Threat of Loan Crisis, Los 
Angeles Times (Aug. 25, 2008).
    \171\ Id.
---------------------------------------------------------------------------
    Lenders. The belief that housing prices would rise forever, 
coupled with the ability to package loans for sale to 
investors, profoundly changed the way in which lenders 
underwrote loans. While underwriting had traditionally been 
based on the borrower's ability to repay a loan, as measured by 
criteria such as employment history, income, down payment, 
credit rating, and loan-to-value ratios, rising home prices 
pushed lenders to abandon these criteria. Little concern was 
paid to the risks of this change, given that in a worst-case 
scenario, servicers could always foreclose upon a property to 
satisfy the mortgage in full. As a result, lenders pioneered 
new mortgage products, such as no-doc and low-doc loans, low- 
and no-down-payment loans, and innovations that took rising 
home prices for granted. That is not to say that these exotic 
products are illegitimate; each may have its own appropriate 
use for borrowers in specific circumstances. But the broad 
application of these tailored products to any person in any 
circumstance invariably led to some borrowers receiving loans 
that were wholly inappropriate for their needs and capacity to 
repay. The ability to securitize these loans further degraded 
lending standards by allowing lenders to shift the risk of 
nonperforming mortgages onto the investors that purchased 
securities built around these products. In a world in which 
lenders could securitize even the most poorly underwritten of 
mortgages, what mattered most to lenders was that the loan did 
not default within an agreed-upon period--typically 90 or 180 
days. Whatever happened after that time was someone else's 
problem.
    Securitizers. Securitizers pooled mortgages of all types 
and quality together to create complex and often opaque 
structured products from these loans, such as mortgage-backed 
securities (MBS) and collateralized debt obligations (CDO). 
Securitizers knew that some portion of the mortgages they 
securitized would fail, but they believed that by structuring 
these mortgages into securities with different levels of risk, 
they could effectively eliminate any risk from those defaults 
with the guarantee of safer, performing loans. This belief grew 
from the assumption that others along the chain--the mortgage 
brokers and lenders--had adequately underwritten the loans so 
that any defaults would be manageable, and that housing prices 
would never go down. Those false assumptions belied the fact 
remains that in any finance model, you can never eliminate risk 
from a system of lending; at best, you can hope to control it 
by offsetting smaller sections of riskier loans with larger 
sections of safer loans. But that risk, while controlled, is 
always there, a lesson which the entire financial system is 
currently experiencing firsthand.
    Investors. Like so many others, private investors in 
pursuit of risk-free investments failed to appreciate that if 
housing prices could go up, they could also go down. Rather 
than performing their due diligence on these mortgage-backed 
securities, many investors put their faith in the rating 
agencies and other proxies, and did not fully appreciate the 
risks they faced. Some large institutions further compounded 
their mistakes by holding their mortgage investments off-
balance-sheet, using a loophole set forth in the regulatory 
capital requirements that permitted them to hold low-risk 
investments in special investment vehicles or conduits. And 
other large institutions--such as the former investment banks--
availed themselves of an exemption granted by the SEC that 
permitted them to ignore traditional debt-to-net capital 
ratios--traditionally 12:1--and lever up as much as 40:1.\172\ 
It was in this way that the once highly sought but ultimately 
poorly underwritten mortgages came to be the ``troubled 
assets'' that have now caused the collapse of so many in our 
financial system. Using first the assumption, and by 2008 the 
proof, that the government would deem certain institutions that 
had gambled on these assets to be too big or too interconnected 
to fail, these institutions and their creditors succeeded in 
making the taxpayer the ultimate bag holder for the risks they 
took, demonstrating yet again that the standard governing the 
housing boom and bust was ``heads I win, tails you lose.''
---------------------------------------------------------------------------
    \172\ Stephen Labaton, Agency's '04 Rule Let Banks Pile on New 
Debt, New York Times (Oct. 2, 2008).
---------------------------------------------------------------------------
    Mark-to-Market Accounting. The boom and bust nature of the 
housing and financial markets in recent years was amplified by 
the application of financial accounting standards that required 
financial institutions to write down their MBS assets to 
``market value'' even if no market existed. As a result, 
institutions that held mortgage-backed securities found 
themselves facing the withdrawal of financing, often forcing 
them to sell these assets at distressed or liquidation prices, 
even though the underlying cash flows of these portfolios might 
not have been seriously diminished. In a liquidity-starved 
market, more and more distressed sales took place, further 
pulling down asset prices. These declining prices in turn 
created more lender demands for additional collateral to secure 
their loans, which in turn resulted in more distressed sales 
and further declines in asset values as measured on a mark-to-
market basis. The result was a procyclical engine which 
magnified every downward price change in a recursive spiral, 
all of which might have otherwise been avoided had the mark-to-
market standard provided better guidance on how to value assets 
in non-functioning markets.
    Summary. The financial crisis which has unfolded over the 
past two years has numerous causes, and decisions made in the 
private sector were, in many cases, unwise. But the failure of 
government policy and the market distortions it caused stand at 
the center of the crisis. Whether by the Federal Reserve's 
engineering an artificially low interest rate, Congress's well-
intentioned but misguided efforts to expand home ownership 
among less creditworthy borrowers, or the GSEs' securitization 
and purchase of risky mortgage-backed securities, the federal 
government bears a significant share of the responsibility for 
the challenges that confront us today.
    To address these challenges, what is needed most is not 
simply reregulation or expanded regulation, but a modernized 
regulatory system that is appropriate to the size, global 
reach, and technology used by today's most sophisticated 
financial service firms. At a time when our nation's economy 
desperately needs to attract new investment and restore the 
flow of credit to where it can be used most productively, we 
must at all costs avoid regulatory changes under the label 
``reform'' that have the unintended consequence of further 
destabilizing or constricting our economy. We should carefully 
consider the so-called lessons of the subprime crisis to be 
sure that whatever changes we adopt actually address the 
specific underlying causes of the crisis. These reforms should 
require the participants in the financial system to bear the 
full costs of their decisions, just as they enjoy the benefits. 
They should also enhance market forces, add increased 
transparency, and strip away counterproductive government 
mandates.
    Perhaps above all, we should avoid creating a system in 
which market participants rely upon an implicit or explicit 
government guarantee to bear the risk for economic transactions 
gone wrong. If the events of the past two years have 
demonstrated anything, it is that whenever government attempts 
to subsidize risk--from efforts to stabilize home prices to the 
latest government-engineered rescues of financial institutions 
deemed too big to fail--those efforts are usually costly, 
typically ineffectual, and often counterproductive. We should 
all know by now that whenever government subsidizes risk, 
either by immunizing parties from the consequences of their 
behavior or allowing them to shift risk to others at no cost, 
we produce a clear moral hazard that furthers risky behavior, 
usually with disastrous consequences.
    Any regulatory reform program must recognize the ways in 
which government is part of the problem, and should guard 
against an overreaction that is certain to have unintended 
consequences. Perhaps Harvard economist Edward L. Glaeser put 
it best: ``We do need new and better regulations, but the 
current public mood seems to be guided more by a taste for 
vengeance than by a rational desire to weigh costs and 
benefits. Before imposing new rules, we need to think clearly 
about what those rules are meant to achieve and impose only 
those regulations that will lead our financial markets to 
function better.'' \173\
---------------------------------------------------------------------------
    \173\ Edward L. Glaeser, Better, Not Just More, Regulation, 
Economix (Oct. 28, 2008) (available at economix.blogs.nytimes.com).
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             RECOMMENDATIONS FOR FEDERAL REGULATORY REFORM

    Developing an agenda for reform is an inherently 
controversial enterprise. As with any suggested change, some 
will stand to benefit while others might be forced to adjust to 
the new realities of a different regulatory scheme. The 
recommendations contained here are not immune from this charge, 
and there will invariably be disagreement over the advantages 
and disadvantages of some of these proposals. However, we 
believe that the following recommendations remain true to our 
objectives of helping to make markets more competitive and 
transparent, empowering consumers with effective disclosure to 
make rational decisions, effectively policing markets for force 
and fraud, and reducing systemic risk.
    In considering the appropriateness of each item, the devil 
will always be in the details regarding how any of these 
recommendations might be enacted. Even the best idea, if poorly 
implemented, would lose many of the potential benefits it might 
otherwise yield. Thus, these recommendations are best 
understood as conceptual proposals rather than specific 
instructions for how to improve our regulatory system.
    Given the limited time and resources available to the Panel 
to conduct this review, in many cases there are still 
unanswered questions about certain aspects of these reforms and 
in some cases even a few qualified reservations between the 
authors. Nevertheless, we believe that each proposal contains 
clear benefits for our economy, and has been structured to 
avoid the potential for unintended consequences. They deserve 
open consideration and debate in the public arena, and the 
opportunity to stand or fall on their own merits--a fitting 
tribute to the competitive free-market system that we are 
dedicated to strengthening and preserving.

                 1. REFORM THE MORTGAGE FINANCE SYSTEM

    The current financial crisis originated in the mortgage 
finance system, and much of the resulting turmoil can be traced 
to government interventions in the housing sector which helped 
fuel a classic asset bubble. Reform must begin with Fannie Mae 
and Freddie Mac, the GSEs whose influence drove the 
deterioration of underwriting standards, growth in subprime 
mortgage backed securities, and whose subsidized structure will 
result in hundreds of billions of dollars in taxpayer losses. 
The mortgage origination market itself should also be improved 
by establishing clearer standards, transparency, and 
enforcement.

1.1  Re-charter the housing GSEs as mortgage guarantors, removing them 
        from the investment business

    At the center of the need for reform are Fannie Mae and 
Freddie Mac. As Charles Calomiris and Peter Wallison of AEI 
recently wrote: ``Many monumental errors and misjudgments 
contributed to the acute financial turmoil in which we now find 
ourselves. Nevertheless, the vast accumulation of toxic 
mortgage debt that poisoned the global financial system was 
driven by the aggressive buying of subprime and Alt-A 
mortgages, and mortgage-backed securities, by Fannie Mae and 
Freddie Mac. The poor choices of these two GSEs--and their 
sponsors in Washington--are largely to blame for our current 
mess.'' \174\
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    \174\ Blame Fannie Mae and Congress for the Credit Mess, Wall 
Street Journal (Sept. 23, 2008).
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    The GSEs fueled the housing bubble through their ever 
expanding appetite for increasingly risky investments that they 
held in their massive portfolios. They financed these 
investments by borrowing at low, subsidized rates, and over 
time the firms became ever more dependent on their high yields 
to meet their earning targets. At one time, Fannie and Freddie 
accounted for more default risk than all other U.S. 
corporations combined--default risk implicitly backed by the 
federal government.\175\ These risks to the taxpayer and the 
financial system were obvious, and should have been dealt with 
long ago.
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    \175\ Peter Wallison, Regulating Fannie Mae and Freddie Mac (May 
13, 2005) (online at www.aei.org/publications/pubID.22514/
pub_detail.asp).
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    Now that the GSEs have been taken into conservatorship, 
Congress has the opportunity to ensure that the damage they 
inflicted will never be repeated. This can be accomplished in 
one of two ways. One option is for Congress to phase out the 
GSEs' government charter and privatize them over a reasonable 
period of time following a model similar to that of the 
successful Sallie Mae privatization a decade ago. Legislation 
to that effect was introduced in the 110th Congress and will 
likely be re-introduced in the current Congress. These firms 
can and should compete effectively in the financial service 
marketplace on a level playing field without implicit or 
explicit taxpayer guarantees.
    Alternatively, Congress could opt to recharter the GSEs as 
government entities whose only mandate is to guarantee and help 
securitize mortgages. Such a structure would remove them 
entirely from the investment business by prohibiting them from 
maintaining massive investment portfolios which have proven to 
be a tremendous source of systemic risk. In either alternative, 
Congress must avoid a return to the flawed public purpose/
private ownership model that permitted the GSEs' shareholders 
to profit at taxpayer expense.

1.2  Simplify mortgage disclosure

    The events of the past year have made painfully clear that 
the vitality of our financial system depends on a well-
functioning housing market in which borrowers are able and 
willing to abide by the terms of the mortgage contracts into 
which they have entered. Unfortunately, the needless complexity 
involved in obtaining a mortgage appears designed to keep 
borrowers from fully understanding these important agreements. 
One way to minimize this complexity is to place essential 
information for borrowers in a simple, one-page document that 
makes clear what borrowers need to know before they enter into 
what will be for many the biggest financial transaction they 
will ever undertake. This information will permit borrowers to 
make an appropriate decision regarding the costs and 
affordability of borrowing to buy a house. This one-page 
document would include such items as monthly payments, interest 
rate, fees, and possible changes in the amount of payments for 
adjustable rate mortgages including the maximum possible 
interest rate on the loan and the maximum monthly payment in 
dollars. The one-page document should also include the warning 
that home values can go down as well as up, and that the 
consumer is responsible for making the mortgage payments even 
when the price goes down.

1.3  Establish minimum equity requirements for government guaranteed 
        mortgages

    Because federally guaranteed mortgages put the taxpayer on 
the hook for any potential associated losses, the taxpayer 
needs to be protected from opportunistic borrowers that might 
otherwise walk away from a mortgage if housing prices fall. One 
way to protect the taxpayer is require the borrower to provide 
a bigger downpayment. If the taxpayer is going to take on risk, 
it is only fair that the borrower share in that risk as well.
    FHA loans currently require at least a 3.5 percent 
downpayment, which is clearly too low. The minimum downpayment 
for all government-insured or securitized mortgages should be 
raised immediately to at least 5 percent, and to as much as 10 
percent or higher, over the next several years as market 
conditions improve. Lest the advocates of government-subsidized 
mortgages in which taxpayers bear the risk complain that 5 
percent is too high, it bears pointing out that would still be 
four times as lenient as the 20 percent standard that was in 
place two decades ago.

1.4  Allow Federal Reserve mortgage lending rules to take effect and 
        clarify the enforcement authority for mortgage origination 
        standards

    In July 2008, the Federal Reserve approved a comprehensive 
final rule for home mortgage loans that was designed to improve 
lending and disclosure practices. The new Federal Reserve rule 
was designed to prohibit unfair, abusive or deceptive home 
mortgage lending practices, and it applies to all mortgage 
lenders, not just those supervised and examined by the Federal 
Reserve.
    The final Federal Reserve rule adds four protections for 
``higher priced mortgage loans,'' which encompasses virtually 
all subprime loans. The final rule:

          1. Prohibits lenders from making loans without regard 
        to a borrower's ability to repay the loan.
          2. Requires creditors to verify borrowers' income and 
        assets.
          3. Bans prepayment penalties for loans in which the 
        payment can change during the first four years of the 
        loan (for other higher-priced loans, a prepayment 
        penalty period cannot last for more than two years).
          4. Requires creditors to establish escrow accounts 
        for property taxes and homeowner's insurance for all 
        first-lien mortgage loans.

    In addition, the Federal Reserve issued the following 
protections for all loans secured by a consumer's principal 
dwelling:

          1. Creditors and mortgage brokers are prohibited from 
        coercing a real estate appraiser to misstate a home's 
        value.
          2. Companies that service mortgage loans are 
        prohibited from engaging in certain practices, such as 
        pyramiding late fees.
          3. Servicers are required to credit consumers' loan 
        payments as of the date of receipt and provide a payoff 
        statement within a reasonable time of request.
          4. Creditors must provide a good faith estimate of 
        the loan costs, including a schedule of payments, 
        within three days of a consumer applying for a mortgage 
        loan.

    Finally, the rule sets new advertising standards, which 
require additional information about rates, monthly payments, 
and other loan features. It also bans seven advertising 
practices it considers deceptive or misleading, including 
representing that a rate or payment is ``fixed'' when it can 
change.
    These new rules represent a change in federal regulation 
that, regardless of whether or not one agrees with the degree 
to which consumers might benefit from all of these rules, will 
significantly alter the way in which the mortgage lending 
industry operates. Thus, before policymakers succumb to the 
desire to write additional rules and regulations, they should 
allow the Federal Reserve's new guidelines to take effect, 
monitor their impact upon mortgage origination, and clarify the 
authority for enforcing these new federal standards. 
Additionally, for these new rules to work effectively, they 
must be appropriately enforced. In particular, Congress should 
ensure that federal and state authorities have the appropriate 
powers to enforce these laws, both in terms of resources and 
actual manpower, for all mortgage originators.

1.5  Enhance securitization accountability standards

    The advent of securitization has been a tremendous boon to 
the mortgage industry, and countless millions of Americans have 
directly or indirectly benefited from the liquidity it has 
created. Nevertheless, the communicative nature of loans in the 
securitization process has helped diminish accountability among 
market participants, eroding the quality of many loans. Thus, 
to restore accountability, minimum standards should be set for 
all loans that are to be securitized so that securitizers 
retain some risk for nonperforming loans.
    One proposal would be to link the compensation securitizers 
receive for packaging loans into mortgage-backed securities to 
the performance of those loans over a five year period, rather 
than the six-month put-back period that is the current 
standard. This change in compensation would thus give the 
securitizer an economic stake in the loan's long-term 
performance, aligning the securitizer's incentives with those 
of borrowers, investors, and the broader economy. Further, 
consideration should be given to applying additional 
limitations on the ability to securitize loans that carry with 
them an explicit government guarantee.

    2. MODERNIZE THE REGULATORY STRUCTURE FOR FINANCIAL INSTITUTIONS

    It has become a cliche to observe that if one were 
designing a regulatory system from scratch, one would not come 
up with the patchwork system of agencies with overlapping 
jurisdictions and conflicting mandates. The U.S. financial 
regulatory system is fractured among eleven federal primary 
regulatory agencies in addition to scores of state regulatory 
agencies. The system developed over a 200-year period, during 
which institutions largely lacked the ability to transact 
business nationwide, let alone globally. Insurance, securities, 
and bank products were sold by different institutions, and 
little cross-market competition existed.
    During the past thirty years, changes in size and 
technology have opened financial markets to buyers and sellers 
around the globe, transaction times are now measured in 
fractions of a second, and consumers have been given access to 
a broad range of valuable products from a single provider. 
Innovations in products and technology, and the global nature 
of financial markets are here to stay. An unnecessarily 
fragmented and outdated regulatory system imposes costs in 
several ways: inefficiencies in operation, limitations on 
innovation, and competition restraints that are difficult to 
justify.

2.1  Consolidate federal financial services regulation

    The benefits of a more unified federal approach to 
financial services regulation have been a constant theme in 
proposals for regulatory reform, some of which were under 
consideration and announced before the onset of the current 
financial crisis. For example, the Group of 30, in its very 
first recommendation, called for ``government-insured deposit 
taking institutions'' to be subject to ``prudential regulation 
and supervision by a single regulator.'' \176\ The Committee on 
Capital Markets Regulation has similarly called for a 
consolidated U.S. Financial Services Authority (USFSA) that 
``would regulate all aspects of the financial system including 
market structure and activities and safety and soundness.'' 
\177\ Treasury's Blueprint for a Modernized Financial 
Regulatory Structure recommends a Prudential Financial 
Regulatory Agency (PFRA) with oversight over ``financial 
institutions with some type of explicit government guarantee 
associated with their business operations.'' \178\
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    \176\ The Group of 30, Financial Reform: A Framework for Financial 
Stability (Jan. 15, 2009) (online at www.group30.org/pubs/
recommendations.pdf).
    \177\ The Committee on Capital Markets Regulation, Recommendations 
for Reorganizing the U.S. Financial Regulatory Structure (Jan. 14, 
2009) (online at www.capmktsreg.org/pdfs/CCMR%20-
%20Recommendations%20for%20Reorganizing%20the%20US%20Regulatory%20 
Structure.pdf).
    \178\ U.S. Department of Treasury, Blueprint for a Modernized 
Financial Regulatory Structure (Mar. 31, 2008) (online at 
www.ustreas.gov/press/releases/reports/Blueprint.pdf) (hereinafter 
``Blueprint'').
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    The current regulatory structure for oversight of federally 
chartered depository institutions is highly fragmented, with 
supervision spread among at least five agencies including the 
OCC, OTS, FDIC, National Credit Union Administration (NCUA), 
and the Federal Reserve. Thus, Congress should streamline 
oversight of these federally chartered and insured 
institutions.

2.2  Modernize the federal charter for insured depository institutions

    There are many kinds of insured depositories operating 
under unique charters including national banks, thrifts, state 
chartered members of the Federal Reserve system, state 
chartered nonmembers, credit card banks, federal and state 
credit unions, and state charted industrial loan corporations. 
While this vast array of institution type may have had a sound 
historical basis, changes in the national economy and 
regulatory landscape have made many of these differences 
functionally obsolete. Although regulatory competition can 
prove beneficial, the current state of duplicative banking 
regulation has several negative consequences as well, including 
unnecessary consumption of federal regulatory resources, 
consumer transparency, and differences in charters for largely 
similar institutions, which can lead to unfair competitive 
advantages for institutions governed by certain charters over 
others.
    In particular, the OCC and the OTS play a very similar role 
for two classes of depository institutions which were once were 
quite different in nature, but now compete for the same 
customers, offering similar services. The thrift charter was 
originally instituted to foster the creation of financial 
services organizations to encourage home ownership by ensuring 
a wide availability of home mortgage loans. Due to a number of 
national policy changes that have been instituted over the last 
several decades to encourage homeownership and the decreasing 
share thrifts have of the residential mortgage market in 
relation to commercial banks, a unique thrift charter is no 
longer necessary to meet this goal. Moreover, the constraints 
of the thrift charter limit the diversification of thrifts' 
loan portfolios, which only exacerbates their ability to remain 
financially healthy in a weak real estate market.
    Many individuals and organizations reviewing the current 
regulatory landscape have come to the conclusion that these 
agencies, and their corresponding federal thrift, and federal 
bank charters should be unified. In fact, back in 1994, former 
Federal Reserve Governor, John P. LaWare recommended combining 
the OCC with the OTS.\179\ Similarly, in 1996, the GAO 
recommended that primary supervisory responsibilities of the 
OTS, OCC, and the FDIC be consolidated into a new, independent 
Federal Banking Commission.\180\
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    \179\ Walter W. Eubanks , U.S. Congressional Research Service, 
RL33036, Federal Financial Services Regulatory Consolidation: An 
Overview (July 10, 2008), at 14.
    \180\ Government Accountability Office, U.S. and Foreign Experience 
May Offer Lessons for Modernizing U.S. Structure (Nov. 1996) (online at 
www.gao.gov/archive/1997/gg97023.pdf).
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    Congress should consider other steps to modernize and 
rationalize the federal charter system. Each class of charter 
should be reviewed for purpose, structure, cost and distinct 
characteristics. Unnecessary differences are potential sources 
of confusion, conflict, or taxpayer risk, and should be 
eliminated wherever possible.

2.3  Consolidate the SEC and CFTC

    Similar to the rationalization that is needed in banking 
regulation, consolidation of securities regulation in the U.S. 
through the merger of the SEC and the CFTC should also be 
undertaken. Most countries have vested the power to oversee all 
securities markets in one agency, and for good reason--more 
efficient, consistent regulation that protects consumers in a 
more uniform manner. As the Treasury Blueprint states: 
``Product and market participant convergence, market linkages, 
and globalization have rendered regulatory bifurcation of the 
futures and securities markets untenable, potentially harmful, 
and inefficient. The realities of the current marketplace have 
significantly diminished, if not entirely eliminated, the 
original rationale for the regulatory bifurcation between 
futures and securities markets.'' \181\
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    \181\ Blueprint, supra note 178.
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    It further notes that: ``Jurisdictional disputes have 
ensued as the increasing complexity and hybridization of 
financial products have made `definitional' determination of 
agency jurisdiction (i.e., whether a product is appropriately 
regulated as a security under the federal securities laws or as 
a futures contract under the CEA) increasingly problematic. 
This ambiguity has spawned a history of jurisdictional 
disputes, which critics claim have hindered innovation, limited 
investor choice, harmed investor protection, and encouraged 
product innovators and their consumers to seek out other, more 
integrated international markets, engage in regulatory 
arbitrage, or evade regulatory oversight altogether.'' \182\
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    \182\ Id.
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    In testimony before this panel, Joel Seligman, President of 
the University of Rochester and a leading authority on 
securities law, agreed, stating, a ``pivotal criterion to 
addressing the right balance in designing a regulatory system 
is one that reduces as much as is feasible regulatory 
arbitrage. Whatever the historical reasons for the existence of 
a separate SEC and CFTC, the costs of having a system where in 
borderline cases those subject to regulation may choose their 
regulator is difficult to justify.'' \183\
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    \183\ Seligman, supra note 18.
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    The most significant obstacle to this proposal is a 
political one. Congressional oversight of the two agencies is 
split between two committees in both the House and Senate. 
Consolidation would most likely mean that one committee would 
lose out, leading to a classic turf war. Since the nature of 
futures trading has evolved significantly over the years, and 
is now dominated by non-agricultural products, the Senate 
Banking and House Financial Services Committees would be the 
appropriate venue for all congressional securities oversight.

2.4  Establish an optional federal charter for national insurance firms

    The U.S. federal financial service regulatory 
infrastructure contains no agency or organization responsible 
for oversight of national insurance firms. As far back as 1871, 
regulators saw the need for uniform national standards for 
insurance. That year, former New York Insurance Commissioner, 
George W. Miller, who founded the National Association of 
Insurance Commissioners (NAIC), made the following statement: 
``The Commissioners are now fully prepared to go before their 
various legislative committees with recommendations for a 
system of insurance law which shall be the same in all States, 
not reciprocal but identical, not retaliatory, but uniform.'' 
\184\ That need for uniform standards has grown quite 
considerably during the past 138 years.
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    \184\ House Financial Services Committee, Subcommittee on Capital 
Markets, Securities, and Government Sponsored Enterprises, Testimony of 
Rep. Sue Kelly, NARAB & Beyond: Achieving Nationwide Uniformity in 
Agent Licensing, 107th Cong. (May 16, 2001) (online at 
financialservices.house.gov/media/pdf/051601ke.pdf).
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    Congress should institute a federal charter that may be 
utilized by insurance firms to underwrite, market, and sell 
products on a national basis. While individual state insurance 
regulators have effectively managed state guarantee pools, as 
well as safety and soundness within their jurisdiction, they 
simply are not equipped to effectively oversee a global firm 
such as AIG, which had 209 subsidiaries at the time the federal 
government acted to prevent its collapse in the fall of 2008. 
Of the 209 subsidiaries, only twelve fell under the 
jurisdiction of the New York insurance commissioner, which was 
effectively AIG's primary regulator.\185\
---------------------------------------------------------------------------
    \185\ John Sununu, et al., Insurance Companies Need a Federal 
Regulator, Wall Street Journal (Sept. 23, 2008) (online at 
online.wsj.com/article/SB122212967854565511.html).
---------------------------------------------------------------------------
    By allowing insurance firms to choose between a unified 
national charter or maintaining operations under existing state 
regulation, Congress can build upon the success of state 
guarantee pools and maintain state jurisdiction over premium 
taxes. A national charter would also allow regulators to take a 
comprehensive view of the safety and soundness of large 
insurance companies and to better understand the potential 
risks they may pose to the strength of the broader U.S. 
economy. Lastly, a federal insurance regulator would be able to 
implement effective consumer protection, provide a clear 
federal voice to coordinate global insurance regulation with 
foreign counterparts, and ensure appropriate access for U.S. 
insurance companies in overseas markets.

  3. STRENGTHENING CAPITAL REQUIREMENTS AND IMPROVING RISK MANAGEMENT

    The experience of the past two years demonstrates that our 
financial system was far more susceptible to shocks from the 
housing sector than it should have been, as a result of capital 
requirements that were insufficient to sustain financial 
institutions in time of stress. Those weaknesses were in turn 
further exacerbated by certain standards and practices, such as 
a heavy reliance on credit rating agencies and the application 
of mark-to-market accounting standards. To ensure that our 
financial system can better withstand these kinds of shocks, 
capital requirements should be strengthened and risk management 
should be enhanced.

3.1  Strengthen capital requirements for financial institutions

    One of the key lessons that has emerged from this crisis is 
that our financial institutions did not have adequate capital 
reserves to weather the turmoil in the housing market due in 
large part to the fact that many of the assets they held were 
inextricably linked to this market. One way to address this 
problem would be to ensure that regulators can demand that 
financial institutions increase their capital during flush 
times. Those reserves could then serve as a cushion during bad 
times when capital is much harder to raise. The provisioning 
requirements would be based on the health of the economy as a 
whole, thus building upon systemic strength and buffering 
against systemic weakness.
    These countercyclical requirements would be quite different 
from those governing the regulatory capital that financial 
institutions are required to hold today. The current capital 
rules for lending are out of date, subject to manipulation, and 
do not accurately reflect the risks associated with lending 
activities. That said, there are also significant flaws and 
risks associated with the new capital rules called for by the 
Basel II regime.
    Much of the initial modeling now available suggests that 
average capital requirements for banks subject to Basel II 
methodologies would decrease. The determination to allow the 
largest and most complex banks to use internally developed, 
historical models for the purpose of determining capital risk 
charges merits further and closer scrutiny. Given the current 
financial crisis and the federal guaranty on deposits that 
banks enjoy, weak capital requirements called for by Basel II 
could leave taxpayers on the hook yet again.

3.2  End conduits and off-balance-sheet accounting for bank assets

    Apart from its procyclicality, Basel II permitted banks and 
other financial institutions to keep assets such as mortgage-
backed securities off their books in conduits or structured 
investment vehicles on the grounds that these assets were high-
quality and low-risk. Even if such an assessment were 
accurate--and the past two years have demonstrated that it was 
not--off-balance-sheet arrangements such as this permit 
financial institutions to game the regulatory requirements in 
place. These off-balance-sheet arrangements were made even more 
dangerous by the perception that their liabilities were 
implicitly guaranteed by the institutions that sponsored them, 
which permitted even greater leverage to build before the 
credit crisis hit. Thus, all assets and liabilities of a 
financial institution should be held on the balance sheet. If 
nothing else, one of the lessons of this credit crisis is the 
necessary steps should be taken to eliminate the notion of an 
``implicit guarantee'' of anything in our markets.

3.3  Adjust the application of mark-to-market accounting rules

    Fair value accounting should be revised and reformed. As 
things stand now, the accounting rules magnify economic stress 
and can have serious procyclical effects. When markets turn 
sour or panic, assets in a mark-to-market accounting system 
must be repeatedly written down, causing financial institutions 
to appear weaker than they might otherwise be. A superior 
accounting system would not require financial institutions to 
write down their assets at a time when prices have fallen 
precipitously during a rapid downturn as in the collapse of a 
bubble. Thus, alternative asset valuation procedures--such as 
discounted cash flow--should be used, and it should be made 
easier for financial institutions to declare assets as held-to-
maturity during these periods. In normal markets, prices will 
fluctuate within a limited range, and will rise slowly if at 
all. But in times of crisis--such as the one we are facing--
write-downs beget fire sales, which beget further write-downs.
    In late September 2008, the SEC released guidelines that 
allowed companies greater flexibility in valuing assets in a 
nonfunctioning market. Such changes are encouraging. Moving 
forward, accounting rules have to provide transparency and the 
most accurate depiction of economic reality as possible. It is 
for the best that the development of accounting rules should 
not be conducted in the political arena. However, it is clear 
that the rules need to be improved, taking into account the 
lessons learned from recent events. Ultimately, greater 
transparency and accuracy in accounting standards are necessary 
to restore investor confidence.

3.4  Eliminate the credit rating agencies' cartel

    The failure of the credit rating agencies in the financial 
crisis could not be more apparent. Much like the GSEs, the 
credit rating agencies benefited from a unique status conferred 
upon them by the government. They operated as an effective 
oligopoly to earn above-market returns while being spared 
market discipline in instances where their ratings turned out 
to be inaccurate. The special status of the rating agencies 
should be ended so as to open the ratings field to competition 
from new entrants and to encourage investors and other users of 
ratings not to rely upon a ratings label as a substitute for 
due diligence.

3.5  Establishing a clearinghouse for credit default swaps

    Despite recent criticism heaped upon them, the thriving 
credit default swaps (CDS) market demonstrates the valuable 
role that innovation plays in improving the functioning of our 
financial markets. Through the use of CDS, investors and 
lenders can hedge their credit exposures more efficiently, 
thereby freeing up additional credit capacity, which has in 
turn enabled banks to expand credit facilities and reduce costs 
of funds for borrowers. CDS have enabled asset managers and 
other institutional investors to adjust their credit exposures 
quickly and at a lower cost than alternative investment 
instruments, and have enabled market participants to better 
assess and manage their credit. CDS have also enabled market 
participants to value illiquid assets for which market 
quotations might not be readily available.
    Despite their many benefits and the crucial role that CDS 
have come to play in the financial system in managing risk, 
legitimate concerns have arisen regarding the transparency of 
the system and the management of counterparty risk. To address 
these concerns, the Federal Reserve, the CFTC, and the SEC have 
recently agreed on general principles to provide consistent 
oversight of one or more clearinghouses for CDS trades. The 
proposed guidelines will result in more public information on 
potential risks being provided to counterparties and investors, 
as well as the mitigation of any systemic losses caused by 
potential fallout from the CDS market.
    These principles constitute a valuable first step in 
creating a CDS clearinghouse and will further improve a product 
that has thus far proven invaluable in managing risk when 
prudently used. A properly structured clearinghouse, 
capitalized by its members, spreads the risk of default and 
fosters market stability by acting as the sole counterparty to 
each buyer and seller. A clearinghouse will allow performance 
risk to be isolated to net exposure, rather than related to the 
much larger gross positions in the market.
    A number of reforms have already reduced risk in the CDS 
market. The CDS market has already dramatically increased 
margin, mark-to-market and collateral requirements for hedge 
funds and other investment institutions on the other side of 
any trade. And at the behest of the New York Federal Reserve 
and other regulators, record keeping has improved; trade 
confirmations, for example, now must be tendered quickly. 
Buyers of CDS protection now also must formally approve any 
switch of their coverage from one insurer to another. 
Previously, the insured might not know who was its latest 
counterparty.
    A clearinghouse, however, may not be appropriate for the 
most complex and unique over-the-counter derivatives. Moreover, 
because a clearinghouse arrangement spreads risk to other 
market participants, it could encourage excessive risk taking 
by some, especially if risks associated with more exotic 
products are not priced properly due to information asymmetry. 
Policy makers and regulators should continue to work with the 
private sector to facilitate a CDS clearinghouse that provides 
greater transparency and reduces systemic risk in the broader 
financial markets.

                        4. ADDRESS SYSTEMIC RISK

4.1  Consolidate the work of the President's Working Group and the 
        Financial Stability Oversight Board to create a cross-agency 
        panel for identifying and monitoring systemic risk

    Systemic risk can materialize in a broad range of areas 
within our financial system: at both depository and 
nondepository institutions, within either consumer or 
commercial markets, as a result of poor fiscal or monetary 
policy, or initiated by domestic or global activity. Thus, it 
is impractical, and perhaps a dangerous concentration of power, 
to give one single regulator the power to set or modify any and 
all standards relating to such risk. Systemic risk oversight 
and management must be a collaborative effort, bringing 
together the leading authorities for addressing safety and 
soundness, managing economic policy, and ensuring consumer 
protection.
    One alternative to a single systemic risk regulator would 
be to develop a panel of federal agencies to consider jointly 
these important questions. The Presidential Working Group (PWG) 
was established after the stock market crash of 1987 to make 
recommendations for enhancing market integrity and investor 
confidence. Similarly, the Financial Stability Oversight Board 
(FSOB) was established under the EESA in 2008 as a cross-agency 
group to oversee the Troubled Assets Relief Program (TARP) and 
evaluate the ways in which funds might be used to enhance 
market stability. Both groups include the Treasury, the Federal 
Reserve, and the SEC. The PWG adds the CFTC, while the FSOB 
includes the Housing Secretary and the Director of the Federal 
Housing Finance Agency (FHFA), which oversees the housing GSEs.
    While the quarterly evaluation of TARP operations provided 
by the FSOB will continue through the life of the program, the 
broad mission and structure of these two organizations are, in 
many respects, redundant. Moreover, they represent the 
collaborative, cross-agency structure that would best provide 
insight in to the practices, policies, and trends that might 
contribute to systemic risk within the financial system.
    By combining and refocusing the efforts of these two 
organizations, Congress can establish a body with the requisite 
tools to identify, monitor, and evaluate systemic risk. The 
panel can make specific legislative recommendations, as well as 
encourage immediate action consistent with the significant 
regulatory powers already vested in its members.
    A Panel comprised of the Federal Reserve, the Treasury, the 
primary regulator of federally insured depository institutions, 
and the combined SEC/CFTC, would have authority to access 
detailed financial information from regulated financial 
institutions, require disclosure of information necessary to 
evaluate risk, and require that financial institutions to 
undertake corrective actions to address systemic weakness.

           DISAGREEMENT WITH PANEL REGULATORY RECOMMENDATIONS

    In far too many areas, the Panel Report offers 
recommendations or policy options that are rife with moral 
hazard and the potential for unintended consequences. Given 
that some of the principal causes of this financial crisis 
include the moral hazard embedded in the charter of Fannie Mae 
and Freddie Mac, market-distorting housing mandates like the 
CRA, and the unintended consequences of a credit rating agency 
certification process which restricted competition, we must be 
particularly mindful of these risks. In some cases, a 
highlighted action may appear benign, but the more detailed 
summary includes proposals or policy ``options'' that cannot be 
supported.
    Other sections, such as those dealing with systemic risk 
and leverage, include highly proscriptive proposals that would 
be difficult, if not impossible to implement outside the walls 
of academia. Finally, the Panel Report all but ignores the 
critical role played by the Federal Reserve's highly 
accommodative monetary policy, and the host of troubles created 
by the government charter and implicit backing of the GSEs. 
Avoiding discussion of such important components of the crisis 
will inevitably lead one to set the wrong priorities for 
reform. While not exhaustive, the following represents a list 
of the more significant disagreements held with the Panel 
Recommendations for Improvement:

    1. The Panel Report calls for a ``body to identify and 
regulate institutions with systemic significance'' and 
``[i]mpose heightened regulatory requirements for systemically 
significant institutions.'' The recommendations suggest that 
firms designated as such are to be subjected to unique capital 
and liquidity requirements, as well as special fees for 
insurance. Although it is important that regulators work to 
identify, monitor, and address systemic risk, such explicit 
actions are more likely to have unintended and severe negative 
consequences.
    Publicly identifying ``systemically significant 
institutions'' will create significant moral hazard, the cost 
of which will far outweigh any potential regulatory benefits. 
Consider the two possible effects of being identified as such. 
First, in one case, the cost and burdens of additional capital 
and regulatory requirements (as recommended) place a firm at a 
competitive disadvantage relative to its peers. Thus, the 
competitive strength of a systemically significant firm is 
impaired, raising the probability of a business failure--an 
undesirable outcome.
    In the alternative case, the market may view designation as 
a de facto guarantee of public support during times of 
financial stress. The firm attains a beneficial market status, 
and enjoys advantages such as a lower cost of capital in the 
public markets. The costs of failure are thus socialized, while 
profits remain in private hands (much as was the case for the 
GSEs, Fannie Mae and Freddie Mac). Recent events make clear 
that this scenario is perhaps an even more undesirable outcome 
than the former.
    Unfortunately, these are the only two practical outcomes of 
any designation--either markets will view it as a competitive 
burden or as a competitive advantage. It is unrealistic to 
argue that such a ``significant'' designation would be viewed 
as competitively neutral. Moreover, it is unreasonable to 
assume that government will manage the potential moral hazard 
more effectively than was done in the case of the GSEs.

    2. The Panel Report recommends the formation of ``a single 
federal regulator for consumer credit products.'' Such an 
action would isolate the activity of creating and enforcing 
consumer protection standards from oversight of safety and 
soundness in financial institutions.
    The regulation of any federal financial firm requires the 
balancing of multiple policy choices and should be done by one 
institution. Experience has shown us with the GSE model that 
having two stated goals, one for safety and soundness and one 
for social policy, inherently will lead to conflict. Since the 
new consumer product regulator would be able to affect all 
financial institutions, eventually those rules will conflict 
with a bank's profitability, capital levels, and ultimately, 
solvency. Under this Panel proposal, an independent agency 
would have power to impose regulations that could well 
undermine the health of banks, but would not be responsible for 
the safety and soundness of those banks.
    This balance is of particular significance within 
institutions that have been provided with explicit taxpayer 
funded guarantees, such as FDIC insurance. By placing both 
responsibilities with the same regulator, greater assurance is 
provided that taxpayer interests will not be placed in jeopardy 
by regulations that unnecessarily weaken capital or competitive 
position.

    3. The Panel Report broadly calls for the adoption of new 
regulations ``to curtail leverage.'' While the recommendation 
implies that regulators across the spectrum of financial 
institutions set inappropriate standards for leverage, this 
simply is not the case.
    Few, if any, observers of the current crisis have argued 
that capital standards set by the FDIC and other federal and 
state banking regulators overseeing depository institutions 
were set at dangerously low levels. To the extent that FDIC 
insured institutions have become troubled, it has been largely 
the result of deteriorating loan quality. Thousands of such 
institutions across the country remain strong and healthy. 
Raising their capital standards now in an effort to ``curtail 
leverage'' would be highly procyclical and would sharply limit 
the availability of credit for consumers and businesses.
    Without question, there were some financial firms, notably 
non-depository institutions such as broker-dealers, that were 
allowed to raise their leverage ratios substantially in recent 
years. The SEC ruling issued in 2004, which allowed alternative 
net capital requirements for broker-dealers, contributed 
significantly to the failures of both Bear Sterns and Lehman 
Brothers. The regulatory decision to rely on internal models 
for risk weighting assets appears, in retrospect, to have been 
a major miscalculation.
    Moreover, prudent regulators may wish to consider adopting 
capital policies that are more counter-cyclical as well, to 
encourage the building of stronger reserves during good times 
and ensure greater stability in periods of financial stress. 
Blanket mandates to ``curtail leverage,'' however, will only 
restrict access to credit and limit successful lending models 
where they are needed most.

    4. The Panel Report argues that: ``Hedge funds and private 
equity funds are money managers and should be regulated 
according to the same principles that govern the regulation of 
money managers generally.'' The recommendation fails to 
recognize the important distinctions between investment firms 
and fails to explain why these distinctions should be ignored.
    There exist clear and dramatic differences between managing 
capital allocation on behalf of a $5 billion pension fund, and 
investing funds placed in a personal IRA or 401k. Under current 
law, private equity, venture capital, and hedge funds may not 
be marketed to retail investors. While they remain subject to 
all regulations regarding trading and exchange rules and 
regulations, they are not subject to the marketing and 
registration requirements designed to protect smaller, 
unsophisticated investors, because they do not serve that 
market.
    Suggesting that more regulation should be imposed on these 
entities in light of the current crisis ignores the fact that 
even under the tremendous financial upheaval of the past year, 
no major hedge funds have declared bankruptcy, and taxpayers 
have been exposed to no losses resulting from failed hedge fund 
or private equity investment activity.
    Finally, it may be worth noting that several high-profile 
hedge fund management firms were among the first to publicly 
and accurately assess the dangers inherent in the housing 
finance system, mortgage backed securities, and Fannie Mae and 
Freddie Mac.

    5. The Panel Report call for Congress to ``[e]liminate 
federal pre-emption of application of state consumer protection 
laws to national banks.'' Such a change would effectively 
defeat the purpose of a uniform federal charter for insured 
depository institutions.
    As previously mentioned, the regulation of any federal 
financial firm requires the balancing of multiple policy 
choices and should be done by one institution. By giving state 
regulators the power to affect bank profitability, capital 
levels, and solvency standards, this proposal would greatly 
enhance risk and curtail innovation in our system. Under the 
Panel proposal, states would not be responsible for the safety 
and soundness of federally chartered banks, but would have 
authority to impose regulations that could well undermine the 
health of those banks.
    Allowing states to impose their own consumer protection 
laws also undermines the fundamental purpose of a federal 
banking charter. Congress established federal financial 
charters to enable firms to offer products and services on a 
uniform national basis. Standardization of products and 
services lowers costs, and acts as an incentive for innovation 
by enabling new products to be brought to market sooner. 
Allowing every state to impose its own set of product or 
business standards on national banks would represent a step 
backwards, away from strong well-balanced federal regulation 
that allows national firms to compete effectively with global 
peers.

    6. The Panel Report calls for new ``tax incentives to 
encourage long-term-oriented pay packages,'' which would 
represent an unprecedented intervention in the operation of 
private employment markets.
    The Federal Government should not structure the tax code to 
reward, penalize or manipulate compensation. Congress attempted 
to do this in the Omnibus Reconciliation Act of 1993, Pub. L. 
No. 103-66, which contained the so-called ``Million-Dollar Pay 
Cap.'' \186\ It not only failed to achieve the stated goals of 
its authors, it had unintended consequences: by raising taxes 
on cash compensation, more firms chose to compensate executives 
with large packages of stock options, resulting in numerous 
high-profile multimillion-dollar ``pay days'' when the options 
were exercised.
---------------------------------------------------------------------------
    \186\ Omnibus Reconciliation Act of 1993, Pub. L. No. 103-66, at 
Sec. 13211.
---------------------------------------------------------------------------
    Compensation committees should establish executive pay 
policies that are fair, encourage sound long-term decisions, 
and are fully disclosed to shareholders and the public. Using 
the tax code to design an ideal pay structure will certainly 
have unintended negative consequences, as has been demonstrated 
by past action, nor will it be successful in deterring 
companies from paying their employees what they wish to attract 
and retain the best available talent.

    7. The Panel Report calls upon Congress to ``consider 
creating a Credit Rating Review Board'' which would be given 
the sole power to approve ratings required by pension fund 
managers and others to purchase investment securities.
    The credit rating system is badly in need of reform, but 
the main weakness in the current system has been the existence 
and operation of, effectively, a duopoly--a status created by 
the restraints of the government certification process. Giving 
a government operated Credit Review Board the power to sign off 
on all credit ratings brings the system to a single point of 
failure, and becomes a significant source of systemic risk. 
Improving the credit rating system will require more 
competition, an elimination of conflicts, and accountability. 
Regulators can facilitate this accountability by tracking the 
default levels of rated securities over time, and publicly 
disclosing the best and worst rating agency performance.
         APPENDIX: OTHER REPORTS ON FINANCIAL REGULATORY REFORM

    Other reports on financial regulatory reform that are 
comparable to this report in various respects are itemized in 
the following list and then briefly summarized in the table 
below. Reports in both list and table appear in reverse 
chronological order by the name of the issuing organization. In 
the list, each item is followed by a short-form reference in 
brackets.
    Group of 30 (G-30). Financial Reform: A Framework for 
Financial Stability. January 15, 2009. http://www.group30.org/
pubs/pub_1460.htm. [G-30 January 2009]
    Committee on Capital Markets Regulation. Recommendations 
for Reorganizing the U.S. Financial Regulatory Structure. 
January 14, 2009. http://www.capmktsreg.org/. [CCMR January 
2009]
    Robert Kuttner, Prepared for Demos. Financial Regulation 
After the Fall. January, 2009. http://www.demos.org/pubs/
reg_fall_ 1_8_09%20(2).pdf). [Kuttner/Demos January 2009]
    United States Government Accountability Office (GAO). 
Financial Regulation: A Framework for Crafting and Assessing 
Proposals to Modernize the Outdated U.S. Financial Regulatory 
System. (GAO-09-216). January, 2009. http://www.gao.gov/
new.items/d09216.pdf. [GAO January 2009]
    North American Securities Administrators Association. 
Proceedings of the NASAA Financial Services Regulatory Reform 
Roundtable. December 11, 2008. http://www.nasaa.org/content/
Files/Proceedings_NASAA_Regulatory_Reform_Roundtable.pdf. 
[NASAA December 2008]
    President's Working Group on Financial Markets (PWG). 
Progress Update on March Policy Statement on Financial Market 
Developments. October, 2008. http://www.ustreas.gov/press/
releases/reports/q4progress%20update.pdf. [PWG October 2008]
    Group of 30 (G-30). The Structure of Financial Supervision: 
Approaches and Challenges in a Global Marketplace. October, 
2008. http://www.group30.org/pubs/pub_1428.htm. [G-30 October 
2008]
    Financial Stability Forum (FSF). Report of the Financial 
Stability Forum on Enhancing Market and Institutional 
Resilience and the Follow-Up on Implementation. April 7, 2008 
and October 10, 2008. http://www.fsforum.org/about/
overview.htm. [FSF April 2008 and October 2008]
    Basel Committee on Banking Supervision. Principles for 
Sound Liquidity Risk Management and Supervision. September, 
2008. http://www.bis.org/publ/bcbs144.htm. [Basel Liquidity 
Risk Management September 2008]
    Professor Lawrence A. Cunningham, for Council of 
Institutional Investors. Some Investor Perspectives on 
Financial Regulation Proposals. September, 2008. http://
www.cii.org/UserFiles/file/Sept2008 MarketRegulation.pdf. 
[Cunningham/CII September 2008]
    The Counterparty Risk Management Policy Group (CRMPG) III. 
Containing Systemic Risk: The Road to Reform. August 6, 2008. 
http://www.crmpolicygroup.org/docs/CRMPG-III.pdf. [CRMPG III 
August 2008]
    Institute of International Finance (IIF). Final Report of 
the IIF Committee on Market Best Practices: Principles of 
Conduct and Best Practice Recommendations--Financial Services 
Industry Response to the Market Turmoil of 2007-2008. July, 
2008. http://www.ieco.clarin.com/2008/07/17/iff.pdf. [IIF July 
2008]
    Securities Industry and Financial Markets Association 
(SIFMA). Recommendations of the Securities Industry and 
Financial Markets Association Credit Rating Agency Task Force. 
July, 2008. http://www.sifma.org/capital_markets/docs/SIFMA-
CRA-Recommendations.pdf. [SIFMA July 2008]
    United States Securities and Exchange Commission Staff. 
Summary Report of Issues Identified in the Commission Staff's 
Examination of Select Credit Rating Agencies. July, 2008. 
http://www.sec.gov/news/studies/2008/craexamination070808.pdf. 
[SEC Staff July 2008]
    International Organization of Securities Commissions 
Technical Committee (IOSCO). Report on the Subprime Crisis. 
May, 2008. http://www.iosco.org/library/pubdocs/pdf/
IOSCOPD273.pdf. [IOSCO Subprime Crisis May 2008]
    International Organization of Securities Commissions 
Technical Committee (IOSCO). The Role of Credit Rating Agencies 
in Structured Finance Markets. May, 2008. http://www.iosco.org/
library/pubdocs/pdf/IOSCOPD270.pdf. [IOSCO CRA May 2008]
    President's Working Group on Financial Markets (PWG). 
Policy Statement on Financial Market Developments. March, 2008.
http://www.ustreas.gov/press/releases/hp871.htm. [PWG March 
2008]
    Senior Supervisors Group (SSG). Observations on Risk 
Management Practices in the Recent Market Turbulence. March 6, 
2008. http://www.newyorkfed.org/newsevents/news/banking/2008/
ssg_ risk_mgt_doc_final.pdf. [SSG March 2008]
    United States Department of the Treasury. Blueprint for a 
Modernized Financial Regulatory Structure. March, 2008. http://
www.treas.gov/press/releases/reports/Blueprint.pdf. [Treasury 
March 2008]
    Financial Services Roundtable (FSR). The Blueprint for U.S. 
Financial Competitiveness. November, 2007. http://
www.fsround.org/cec/blueprint.htm. [FSF April 2007 and October 
2007]
    United States Chamber of Commerce Commission on the 
Regulation of U.S. Capital Markets in the 21st Century. Report 
and Recommendations of the Commission on the Regulation of U.S. 
Capital Markets in the 21st Century. March 2007. http://
www.uschamber.com/publications/reports/0703capmarkets comm.htm. 
[Chamber of Commerce March 2007]
    Mayor Michael Bloomberg and Senator Charles Schumer, with 
McKinsey & Company and New York City Economic Development 
Corporation. Sustaining New York's and the U.S.' Global 
Financial Services Leadership. January, 2007. http://
schumer.senate.gov/SchumerWebsite/pressroom/special_reports/
2007/NY_REPORT %20_FINAL.pdf. [Bloomberg/Schumer January 2007]
    Committee on Capital Markets Regulation (CCMR). Interim 
Report of the Committee on Capital Markets Regulation. 
November, 2006. http://www.capmktsreg.org/.[CCMR November 2006]

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