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SYSTEMIC RISK: EXAMINING REGULATORS’

ABILITY TO RESPOND TO THREATS

TO THE FINANCIAL SYSTEM

HEARING

BEFORE THE

COMMITTEE ON FINANCIAL SERVICES

U.S. HOUSE OF REPRESENTATIVES

ONE HUNDRED TENTH CONGRESS

FIRST SESSION

OCTOBER 2, 2007

Printed for the use of the Committee on Financial Services

Serial No. 110–65

(

(II)

HOUSE COMMITTEE ON FINANCIAL SERVICES 

BARNEY FRANK, Massachusetts, Chairman

PAUL E. KANJORSKI, Pennsylvania 

MAXINE WATERS, California 

CAROLYN B. MALONEY, New York 

LUIS V. GUTIERREZ, Illinois 

NYDIA M. VELA ́ ZQUEZ, New York 

MELVIN L. WATT, North Carolina 

GARY L. ACKERMAN, New York 

JULIA CARSON, Indiana 

BRAD SHERMAN, California 

GREGORY W. MEEKS, New York 

DENNIS MOORE, Kansas 

MICHAEL E. CAPUANO, Massachusetts 

RUBE ́ N HINOJOSA, Texas 

WM. LACY CLAY, Missouri 

CAROLYN MCCARTHY, New York 

JOE BACA, California 

STEPHEN F. LYNCH, Massachusetts 

BRAD MILLER, North Carolina 

DAVID SCOTT, Georgia 

AL GREEN, Texas 

EMANUEL CLEAVER, Missouri 

MELISSA L. BEAN, Illinois 

GWEN MOORE, Wisconsin, 

LINCOLN DAVIS, Tennessee 

ALBIO SIRES, New Jersey 

PAUL W. HODES, New Hampshire 

KEITH ELLISON, Minnesota 

RON KLEIN, Florida 

TIM MAHONEY, Florida 

CHARLES WILSON, Ohio 

ED PERLMUTTER, Colorado 

CHRISTOPHER S. MURPHY, Connecticut 

JOE DONNELLY, Indiana 

ROBERT WEXLER, Florida 

JIM MARSHALL, Georgia 

DAN BOREN, Oklahoma 

SPENCER BACHUS, Alabama 

RICHARD H. BAKER, Louisiana 

DEBORAH PRYCE, Ohio 

MICHAEL N. CASTLE, Delaware 

PETER T. KING, New York 

EDWARD R. ROYCE, California 

FRANK D. LUCAS, Oklahoma 

RON PAUL, Texas 

PAUL E. GILLMOR, Ohio 

STEVEN C. LATOURETTE, Ohio 

DONALD A. MANZULLO, Illinois 

WALTER B. JONES, JR., North Carolina 

JUDY BIGGERT, Illinois 

CHRISTOPHER SHAYS, Connecticut 

GARY G. MILLER, California 

SHELLEY MOORE CAPITO, West Virginia 

TOM FEENEY, Florida 

JEB HENSARLING, Texas 

SCOTT GARRETT, New Jersey 

GINNY BROWN-WAITE, Florida 

J. GRESHAM BARRETT, South Carolina 

JIM GERLACH, Pennsylvania 

STEVAN PEARCE, New Mexico 

RANDY NEUGEBAUER, Texas 

TOM PRICE, Georgia 

GEOFF DAVIS, Kentucky 

PATRICK T. MCHENRY, North Carolina 

JOHN CAMPBELL, California 

ADAM PUTNAM, Florida 

MICHELE BACHMANN, Minnesota 

PETER J. ROSKAM, Illinois 

KENNY MARCHANT, Texas 

THADDEUS G. McCOTTER, Michigan

JEANNE M. ROSLANOWICK, Staff Director and Chief Counsel 

(III)

C O N T E N T S 

Page 

Hearing held on: 

October 2, 2007 ................................................................................................. 1

Appendix: 

October 2, 2007 ................................................................................................. 43

WITNESSES 

TUESDAY, OCTOBER 2, 2007

Bookstaber, Richard, author, ‘‘A Demon of our Own Design: Markets, Hedge 

Funds, and the Perils of Financial Innovation’’ ................................................. 7

Kuttner, Robert, Editor, The American Prospect .................................................. 12

Pollock, Alex J., Resident Fellow, American Enterprise Institute ...................... 15

Schwarcz, Steven L., Stanley A. Star Professor of Law and Business, Duke 

University School of Law ..................................................................................... 9

APPENDIX 

Prepared statements: 

Waters, Hon. Maxine ........................................................................................ 44

Bookstaber, Richard ......................................................................................... 47

Kuttner, Robert ................................................................................................. 53

Pollock, Alex J. ................................................................................................. 66

Schwarcz, Steven L. ......................................................................................... 72

ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD

Manzullo, Hon. Donald A.: 

Disclosure form, ‘‘The Basic Facts About Your Mortgage Loan’’ .................. 83

(1)

SYSTEMIC RISK: EXAMINING REGULATORS’ 

ABILITY TO RESPOND TO THREATS 

TO THE FINANCIAL SYSTEM 

Tuesday, October 2, 2007

U.S. HOUSE OF REPRESENTATIVES, 

COMMITTEE ON FINANCIAL SERVICES, 

Washington, D.C. 

The committee met, pursuant to notice, at 10:03 a.m., in room 

2128, Rayburn House Office Building, Hon. Barney Frank, [chairman of the committee] presiding. 

Present: Representatives Frank, Waters, Maloney, Watt, 

Hinojosa, McCarthy, Miller of North Carolina, Scott, Cleaver, 

Moore of Wisconsin, Ellison, Klein, Donnelly, Marshall; Bachus, 

Castle, Manzullo, Biggert, Capito, Garrett, Brown-Waite, and 

Neugebauer. 

The CHAIRMAN. The hearing will convene. This hearing is one in 

a series we are having on the question of innovation in the financial system and what is the appropriate response. And I want to 

be very clear that I think overwhelmingly, probably unanimously, 

members of this committee welcome innovation in the financial system. And I believe in the essential rationality of the market system. I don’t think you get innovation unless those innovations do 

some good and meet a need. I don’t think that this is purely random. 

On the other hand, there is a tendency—and I was pleased to see 

Secretary Paulson say essentially that a week or so ago—for innovation to outrun regulation. That’s very sensible. You don’t regulate in the abstract and in anticipation generally. What we have 

been able to do I believe in our financial system over time is to create regulations that allow the financial system to do its work with 

some protections, and we should not lose sight of the fact that an 

important part of the regulation we talk about investor and consumer protection, which is important. 

We obviously have the concern about systemic risk, which today 

is the most important. And I have been saying that it seemed to 

me less important than investor protection, but here we have an 

issue, we see this in some aspects of subprime where investor protection becomes, at the very least, market enhancing, and in some 

cases it may be a necessity for markets. That is, in the current situation, we are confronted with a substantial lack of investor confidence. And simply talking our way out of it doesn’t work. Sensible 

regulation that provides some degree of quality assurance is very 

important if you want to get a market going again. My view is that 

2

if we want to get back into a secondary market for mortgages, and 

I believe the secondary market for mortgages has had enormous 

benefit as well as causing us problems, that can only be done if 

the—in the near term, if the investors have some confidence in the 

quality of what they’re being asked to buy. And that’s one of the 

things we’re working on. I was pleased to see that Chairman 

Bernanke acknowledged that. 

We have been focusing on the subprime issue, and it seems to 

me that’s a clear case of innovation leaving regulation behind. And 

if you look at the regulated set of institutions that make mortgage 

loans—the banks and the credit unions subjected to State bank authorities, the FDIC, the OCC, and others—they did not—the problems weren’t there. The problems arose in the unregulated sector. 

We had a pretty good case study of this. And our job in part legislative leaves the job which the ranking member and the gentleman 

from North Carolina who is here, Mr. Miller, the gentleman, Mr. 

Watt and I started working on 21⁄2 years ago, and we were rudely 

interrupted. But we will restart that up to do—essentially, we 

know that there are regulations in the area of mortgages that have 

worked reasonably well. And to some extent, our job is to write 

those down and apply them to everybody who regulates mortgages. 

We also, as I said, want to put some confidence into the investors 

in the secondary market that they have some quality assurance, 

and that I think goes to the duty of the servicers, the active element in the packaging and selling. 

The question that is harder to answer is what do we do about 

the broader market? We should be very clear. Virtually everybody 

was surprised by the extent to which the problems in the subprime 

market spilled over into the broader market. There are people who 

tell me that they saw it coming. I have asked them for any copy 

of the correspondence in which they notified anybody else. So far, 

nothing. The Fed acknowledges it was surprised. The Treasury was 

surprised. The Financial Services Authority in England was surprised, the EU. No one saw the extent to which this was going to 

spill over, at least no one in the regulatory area. 

That raises the first question: Do they need to have more information? Certainly that ought to be at least a minimum amount 

that we do. I also want to be clear, we are not here focused on the 

particular entity that does the investing. It’s not hedge funds. It’s 

not private equity. It’s not investment banks. It’s the type of investment, particularly the great increase in leverage. A combination of 

technology and other factors have allowed people to do virtually a 

new form of investing. People will tell me maybe it’s always been 

there, but as Marx said, in this case accurately, changes in quantity become changes in quality. And that’s what we have to look at. 

Are there in our financial markets today—is there a degree of leverage that people have lost sight of? We can say that individuals, 

individual entities, know what they have. But do they know what 

everybody else has sufficient to make a judgment? Do they know 

that if they need to get out of a certain instrument, they won’t be 

in a race with a lot of other people trying to do the same thing, 

devaluing what they have? And I am pleased to say that the regulators sense that we really need to take a hard look at this and 

think what it is we have to do. 

3

I also will note one thing, with a little satisfaction. A little less 

than a year ago when I became the chairman of this committee, the 

dominant discussion in the financial press was the need for us to 

deregulate very rapidly lest everybody with more than $100 go to 

England. There was this fear that we were going to be depopulated 

in our financial markets, and we had the McKenzie report from 

Mayor Bloomberg and Senator Schumer. We had the report that 

Secretary Paulson got out of Harvard Law School. 

Clearly, we have to look to our competitive situation. And we’ve 

done some things that we think help with that, and I’ve been a 

supporter of the SEC, for instance, I think this committee in general has, of trying to work with the European authorities to get 

joint accounting, to do other things that will ease transnational operations. 

But I think the tone has shifted. We are still talking about the 

international aspect, but we’ve shifted from a kind of argument 

that we had better deregulate more so that we catch down with 

England, to the notion that the regulators need to work together 

to create some rules. There is an understanding, and in fact, I don’t 

know if there are as many enthusiasts, for instance, in Europe, 

some of them were hit pretty hard by the consequences of our unregulated subprime market. 

So, obviously, regulation should be diminished. This committee is 

working, for instance, with the American bankers and the Financial Services Roundtable to cut down the amount of paper that has 

to be sent to the Treasury, which we think is unnecessary. There 

are other regulations where we have moved to cut back. But on 

this whole question of whether or not the fundamental regulatory 

structure is today adequate to keep the regulators informed of 

what’s going on in these new developments in the financial market, 

that’s very much an open question, and that’s what we are focusing 

on here, and I appreciate the witnesses joining us. 

The gentleman from Alabama is recognized for his opening statement. 

Mr. BACHUS. Thank you, Mr. Chairman. I appreciate you calling 

this hearing on systemic risk. I thought the earlier hearings on systemic risks were very helpful, and how regulators and market participants can manage the risk that is really inherent in a market, 

if ‘‘manage’’ is a good word. I’m not sure it is. 

Since the implosion of Long-Term Capital Management in 1998, 

which required a bailout orchestrated by the Federal Reserve, the 

Treasury Department, and other regulatory bodies, the subject of 

systemic risk posed by the operations of large, complex financial institutions has been a concern of financial regulators, and rightly so. 

Systemic risk is not theoretical, and if not properly contained and 

managed, could threaten the stability and soundness of financial 

markets. There’s always the potential for massive losses at a single 

financial institution to trigger a cascading effect that could impact 

the broader financial markets, and ultimately the global economy. 

The recent instability we’ve seen in global capital markets arising primarily out of problems in subprime mortgage lending in the 

United States have renewed concerns about systemic risk. These 

concerns were underscored by the collapse of large hedge funds operated by Bear Stearns and Goldman Sachs in August, and reports 

4

that other highly leveraged hedge funds had suffered substantial 

losses from investments in residential mortgage-backed securities. 

The fact that hedge funds and other lightly regulated private 

pools of capital operate under a less stringent disclosure regime 

than banks and other regulated entities helped fuel some of the 

concern, and in some cases, bordering on the panic we saw in the 

markets over the summer. This relative lack of transparency complicates the task of identifying and mitigating the types of losses 

at individual firms that could give rise to systemic risk. While the 

financial contagion that many predicted when credit markets first 

began experiencing disruptions 2 months ago has not materialized, 

that is certainly no cause for complacency on the part of either regulators or market participants. For hedge fund investors and 

counterparties, the challenge is to demand a level of financial 

transparency and market discipline that allows for a meaningful 

assessment of the risk involved in the complex trading strategies 

employed by many funds. 

As for financial regulators, they must insist that the institutions 

they oversee are well-capitalized and have the risk management 

systems in place to weather financial shocks and severe market 

downturns. At the same time, regulators must avoid the type of 

heavy-handed market intervention that could stifle innovation and 

actually harm those investors, including public employee and private pension funds, which have enjoyed strong returns from their 

investment in hedge funds in recent years. 

Finally, given the global nature of our financial markets, U.S. 

regulators must work closely with their international counterparts 

to promote cooperation, not competition, among regulatory bodies, 

and ensure that information about potential systemic risk is shared 

promptly. 

The chairman mentioned this committee and its involvement in 

subprime legislation, and I’d like to take this opportunity to commend Mr. Pollock. Your one-page disclosure on subprime lending 

was actually included in the bill that I introduced earlier this year. 

I always try to borrow the best approaches out there, and I thought 

it was something that very much needs to be done. And I think 

there’s pretty much unanimity that it would be of great help to 

homeowners to really see what they’re getting and what their future payments would be. So I commend you for that. 

Let me close by again thanking Chairman Frank for his continued attention to the issue of systemic risk and by welcoming our 

distinguished panel of witnesses to today’s hearing. We look forward to hearing your insights on this important subject. 

Thank you. 

The CHAIRMAN. Is there any other member who wishes to make 

an opening statement? Mr. Scott. 

Mr. SCOTT. Thank you very much, Mr. Chairman. I want to 

thank you for having this important hearing because our financial 

system is so very precious, so very important, and we want to make 

sure we learn some things from this crisis that we’re going 

through. 

I’m very interested in learning more about how the President’s 

Working Group on Financial Markets is progressing, on its assessment regarding systemic risk in our financial markets as well as 

5

their processes that might be improved to ensure that our markets 

are secure. That is the important bottom line, that our financial 

markets are secure, and that’s what the American people are looking to this Congress to make sure. 

Questions like, could more have been done to assess, anticipate, 

or even prevent the subprime mortgage crisis? Unfortunately, this 

is a question we can ask, but I believe that at this time we must 

more intently focus on ensuring regulators in the future have the 

necessary tools at their disposal to mitigate future financial market 

crises. Private equity transactions in the United States last year totaled $406 billion, and between 1991 and 2006, private equity created more than $30 billion in profits for their investors. This is our 

system at work. These funds hold unmatched sway over our markets. Eight—I’m sorry—are responsible for more than a third of 

stock trades, control more than $2 trillion worth of assets, and each 

of the top hedge fund managers earned more than $1 billion in 

2006. That is the state of affairs which faces us. 

Now I understand a growing number of market watchers wonder 

whether the system is encouraging hedge funds to take on too 

much risk, and I certainly appreciate and would appreciate hearing 

your comments on this statement and whether or not you believe 

these funds do not warrant increased attention. As a majority of 

hedge funds seek out increasingly exotic but not always so much 

marketable investments, what further action has the President’s 

Working Group taken to somewhat monitor the potential systemic 

risk of these funds? Critics of the hedge fund industry cite investor 

protection and systemic risk as the basis of their concern about 

hedge funds, but the question is, is more regulation really the answer? And if so, what kind of regulation? Granted, many bankers 

and regulators consider this process to be one of the great advances 

in finance over the past 5 years. However, how dependent has this 

new financial system become on hedge funds? 

We have some very, very dynamic issues we’re faced with. I look 

forward to your testimony on some of the issues that I have raised. 

I yield back the balance of my time. Thank you, Mr. Chairman. 

The CHAIRMAN. The gentleman from New Jersey. 

Mr. GARRETT. I thank the chairman, and I also thank the witnesses for coming to testify. While I’m aware that much of today’s 

focus is on the current troubles in the housing market and the concerns of hedge funds and those concerns that the chairman raised, 

I hope that some attention will be directed to our ongoing potential 

problems created by the large portfolios held by Fannie Mae and 

Freddie Mac, particularly since some of the suggestions that we’ve 

heard would enlarge their portfolios, that may be a solution. 

There are basically two options now being discussed—to allow 

the GSEs to help ease the current housing crunch. I believe that 

over the last several weeks, these two options have become somewhat muddled together and there’s some confusion as to how much 

either will help and how much they can really help far in the future. 

The first option under consideration is to increase the conforming 

loan limits for Fannie and Freddie and allow them to securitize 

mortgages over 417. Now these are jumbo mortgages that carry a 

much higher spread and would be really a boon to Fannie and 

6

Freddie to be able to purchase. In his testimony before this committee on September 20th, Chairman Bernanke stated that, ‘‘Raising the conforming loan limit would expand this implied guarantee 

to another portion of the mortgage market, reducing mortgage market discipline further. If, despite these considerations, the Congress 

were inclined to move in this direction, it should assess whether 

such actions could be taken in such a way that would be both explicitly temporary and able to be implemented sufficiently promptly 

to serve its intended purposes.’’ 

Now based on this testimony, the only way that raising the conforming loan limits can help stabilize the current market is if Congress moves quickly and makes it temporary. Well, we know how 

quickly Congress acts. In fact, the time for quick action may have 

already passed. I’ve already seen data that indicates jumbo mortgage rates have declined some and are expected to fall even more 

in the future. In regard to making an increase temporary, well, I 

believe that none of us are so naive as to think that once Fannie 

and Freddie get their teeth into this very lucrative and tasty part 

of the housing market, that they’re ever going to let it go. We just 

passed a 15-year extension to the temporary TRIA program, all by 

making that temporary program permanent. So who’s to say that’s 

not going to occur here? 

The second question discussed for allowing the GSEs to help 

their subprime market is to raise the current caps on the size of 

the portfolios. Currently, the GSEs only participate on the fringes 

of the subprime market, only purchasing the best and most creditworthy subprime mortgages because of the limitations in their 

charter. So raising their portfolio limits will only allow them to buy 

and retain more prime mortgages where there’s no really a credit 

problem, and further exacerbate the current systemic risk posed to 

the broader economy by the complicated hedging of the increased 

interest rates. 

When we talk about giving the GSEs expanded powers and larger shares of the housing market, we should ask ourselves this question: Are these the same GSEs that just this week had some of 

their former top executives cut a deal with the SEC in which they 

will now pay thousand dollars in fines and are barred from ever 

working there in the future? And are these the GSEs that are having such difficultly with their financials that it has taken them 

over 3 years to get them close to be accurate? Would it not really 

be prudent, then, to require them to prove themselves before giving 

them even more power? 

The recent actions taken by the Fed to cut interest rates by 50 

basis points has substantially helped the overall economy rebound 

from the recent downturn. Yesterday the Dow rose by over 190 

points; it’s back over 14,000 for the first time since July. Also, the 

tightening of the underwriting standards, coupled with an increase 

in skepticism of the ratings assigned to the mortgage-backed securities, has allowed the market to basically self-correct a lot of its 

own problems. 

I know that foreclosures and reset data indicates that the worst 

may be yet to come, and that the problems will probably bottom 

out sometime in February or March of next year. However, the 

data also indicates the problem in the longer term is subsiding, and 

7

that the market is self-correcting. So by the time Congress would 

pass substantive legislation trying to help, in all likelihood, it will 

already be too late. 

I believe we should help people suffering from the housing 

crunch and exhaust all options to help keep people out of foreclosure. But I do not feel that we should make statutory changes 

that will have negligible positive effects in the short term and possible negative, long-term lasting and systemic consequences in the 

long term. 

I look forward now to working with my colleagues and the chairman to ensure that we examine all these options at our disposal 

and keep the U.S. housing market the strongest in the world. 

And, again, I thank you and the members of the committee, and 

the witnesses for coming to testify. Thank you. I yield back. 

The CHAIRMAN. Are there any further opening statements? If not, 

we’ll go to the witnesses. I do—I wouldn’t want the witnesses to 

feel that they were prepared for the wrong hearing. Obviously, the 

gentleman from New Jersey feels very strongly. You shouldn’t feel 

that was the subject of the hearing. I mean, you may go ahead and 

talk about the subject of the hearing. I wouldn’t want—none of 

those issues have been involved in this hearing. We will continue 

to debate those in other forums. The gentleman was referencing 

bills that have already passed the House. 

Mr. BACHUS. Mr. Chairman? 

The CHAIRMAN. Yes? 

Mr. BACHUS. I believe part of the point Mr. Garrett was saying 

is the market has corrected itself in the situation. 

The CHAIRMAN. Well, I understand that. But just there were references to specific legislative issues. And I don’t—sometimes witnesses wonder if they were supposed to discuss them. 

We will begin, if there are no further statements, with Mr. 

Bookstaber. 

STATEMENT OF RICHARD BOOKSTABER, AUTHOR, ‘‘A DEMON 

OF OUR OWN DESIGN: MARKETS, HEDGE FUNDS, AND THE 

PERILS OF FINANCIAL INNOVATION’’ 

Mr. BOOKSTABER. Thank you, Mr. Chairman, and members of the 

committee. I thank you for the opportunity to testify today. My 

name is Richard Bookstaber. Until June of this year, I was in 

charge of a long-short equity quantitative hedge fund at FrontPoint 

Partners. Before that, I had quite a bit of experience in the risk 

management area. I was in charge of market risk management at 

Morgan Stanley. I oversaw firm-wide risk management at Salomon 

Brothers, and was there during the LTCM crisis, and then I moved 

to the buy-side and was in charge of risk management at Moore 

Capital Management and then Ziff Brothers investments. I also 

have written a book that recently came out called, ‘‘A Demon of 

Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation. 

My comments today will take some of the themes from that book, 

which in turn is based on a number of the experiences and lessons 

that I learned over the period of time that I worked in risk management and before that in other capacities on Wall Street. 

8

I believe that the threats to the financial system stem largely 

from two increasingly dominant market characteristics. The first is 

the complexity of the market. Complexity basically means that an 

event can propagate in unanticipated ways. And for financial markets, complexity comes through derivatives and other innovative 

products. Many derivatives have nonlinear payoffs, which means 

that a small market move in some situations can lead to really substantial impacts on the derivatives. 

Also, many derivatives lead to unexpected and sometimes unnatural linkages between instruments and markets. We observed 

some of these unnatural linkages during the subprime problems. 

Subprimes were included in a number of CDOs, along with other 

types of mortgages and corporate bonds. And like a kid who brings 

a cold to a birthday party, the subprimes mingling with these other 

instruments led to contagion into these other markets. 

The second characteristic besides complexity that I think is critical to understanding the nature of the market and market crises 

is the tendency for markets to move rapidly into a crisis mode with 

little time or opportunity to intervene. Borrowing a term from engineering, refer to the second characteristic as tight coupling. Examples of tight coupling in other areas of engineering include the 

launching of a space shuttle, a nuclear power plant moving toward 

criticality, or even something as prosaic as the process for baking 

bread. The main point is that during periods in a process that has 

tight coupling, you don’t have time to pull an emergency stop 

switch and convene a committee to figure out what’s going on. 

Things propagate and move from one market to the other because 

of the interconnectedness across the markets. 

In financial markets, tight coupling can come from computerdriven strategies, which is what we saw occur during the portfolio 

insurance issues that caused the crash in 1987. But more commonly, tight coupling comes from the effects of leverage. When 

things go badly for a very highly-leveraged fund, its collateral can 

drop to the point that its lenders can force it to liquidate assets. 

This liquidation can lead to a drop in prices, which leads to the collateral dropping even more, and therefore forcing more sales and 

more liquidation. And the result is a downward cycle, which is the 

sort of thing that we saw with the demise of LTCM in 1998, and 

it also is what we saw with a number of hedge funds in the recent 

past. 

And it can get even worse than that, because just like complexity, leverage can lead to surprising linkages between markets. 

In fact, high leverage in one market can end up devastating another unrelated and perfectly healthy market. This happens because when a market is under stress, it becomes illiquid, and fund 

managers must look to other markets to liquidate. Basically, if you 

can’t sell what you want to sell, you sell what you can. 

We observed this sort of unpredictable type of linkage again during the LTCM crisis. The trigger for LTCM’s failure was the default of the Russian debt market. But interestingly, LTCM had virtually no exposure in Russia. This year, we observed the same sort 

of strange result when the equity quantitative funds somehow 

came under stress as a result of what occurred with the subprime 

mortgages, even though not only did they not hold subprime mortVerDate 0ct 09 2002 16:41 Jan 10, 2008 Jkt 039903 PO 00000 Frm 00012 Fmt 6633 Sfmt 6633 K:\DOCS\39903.TXT HFIN PsN: TERRIE
9

gages, but they tended to be very scrupulously hedged against most 

type of market risks. 

So I believe that the two characteristics, complexity and tight 

coupling, are at the source of market crises ranging from the crash 

in 1987 to the failure of LTCM to the current subprime-related crisis. That means that regulation needs to control level and complexity. 

If we allow leverage to mount and allow new derivatives and 

swaps to grow unfettered and then try to impose regulation on top 

of that, I believe that we will fail to stem market crises. I suggest 

instead that the regulatory system should be actively engaged in 

controlling leverage and in limiting the arms race of innovative 

products. Now this is a difficult approach to regulation. It’s different than the approach taken now. It might be considered 

invasive to the markets. It might face political hurdles that would 

make it impractical to execute. However, I believe that structuring 

effective regulation one way or another will need to address these 

key sources of market crisis head on. 

Let me close, if I can have an extra minute, with an analogy that 

makes my point from the field of biology. The lowly cockroach, I believe, can teach us a few things about how to structure and regulate markets. The cockroach has existed for hundreds of millions of 

years and survived as jungles turned to deserts and deserts turned 

to cities, and it survived using a very simple and coarse defense 

mechanism. The cockroach doesn’t hear. It doesn’t see. It doesn’t 

smell. All it does is it moves in the opposite direction of a gust of 

wind. Now in any particular environment, the cockroach would 

never win the best-designed insect award; but it always seems to 

be good enough to survive. Other insects might be more fine-tuned 

for a particular environment, but are incapable of surviving the inevitable change as one environment moves to another. 

I believe that we need to keep the cockroach in mind when we 

think about how to address systemic risk. We must rethink efforts 

that engineer and fine-tune the markets in an attempt to seek out 

every advantage in the world as we see it today. When faced with 

the inevitable march of events that we cannot even anticipate, simpler financial instruments and less leverage will create a market 

that is more robust and more survivable. 

Thank you. 

[The prepared statement of Mr. Bookstaber can be found on page 

47 of the appendix.] 

The CHAIRMAN. Mr. Schwarcz. 

STATEMENT OF STEVEN L. SCHWARCZ, STANLEY A. STAR PROFESSOR OF LAW AND BUSINESS, DUKE UNIVERSITY SCHOOL 

OF LAW 

Mr. SCHWARCZ. Thank you, Mr. Chairman, and members of the 

committee. My name is Steven Schwarcz, and I am the Stanley A. 

Star professor of law and business at Duke University and the 

founding director of Duke’s Global Capital Markets Center. My testimony today is based on the results of my research over the past 

year on systemic risk, but the research is set forth more fully in 

my paper, ‘‘Systemic Risk,’’ which is a forthcoming draft. 

10

Today I will first describe a conceptual framework based on my 

research in which to think about systemic risk, and then using that 

framework, I’ll try to answer the questions that the committee specifically asks. 

In terms of the framework, the classic example of systemic risk, 

of course, is a bank run. Companies today, though, are able to obtain most of their financing through the capita markets without the 

use of intermediaries. As a result, capital markets are increasingly 

central to any examination of systemic risk. 

Whether systemic risk should be regulated can be viewed as a 

subset of the question of whether it’s appropriate to regulate financial risk. Now the primary justification for doing that is to maximize economic efficiency. Without regulation, the externalities— 

the third-party harmful effects—caused by systemic risk would not 

be prevented or internalized. 

Now this reflects, I believe, a type of what is called a tragedy of 

the commons. This is an event in which the benefits of exploiting 

finite capital resources accrue to individual market participants, 

each of which is motivated to maximize use of the resource, whereas the costs of the exploitation are distributed among an even 

wider class of persons, in this case ordinary people who are harmed 

by unemployment and poverty. 

I considered a number of regulatory approaches, of which I’ll discuss a few today. One approach is disclosure. Disclosure, of course, 

has been viewed traditionally as the primary market regulatory 

mechanism. However, I argue that because of the tragedy of the 

commons, requiring additional disclosure would do little to deter 

systemic risk. Investors already can negotiate the type of disclosure 

they need when they deal with hedge funds or so forth who act as 

counterparties, but in terms of disclosing risk that affects third 

parties, investors may not care. 

Further commentators, including Mr. Bookstaber, have argued 

that imposing additional disclosure requirements may even backfire. The efficacy of disclosure also is limited, and Mr. Bookstaber 

also said this, by the increasing complexity of transactions in markets. And I have researched and written an article called, ‘‘Rethinking the Disclosure Paradigm in a World of Complexity,’’ in 

which I look at the increasing complexity of financial instruments, 

and what it means in terms of the ability to achieve transparency. 

So I conclude that disclosure at least itself is a weak regulatory approach. 

Another approach I look at is ensuring liquidity, and the most 

practical way to do this is through a lender or market maker of last 

resort. A market maker or lender of last resort could be an expensive proposition because you have two costs. You have moral hazard, and you have the potential shift of cost to taxpayers. I show 

in my research that these costs are controllable. 

Another approach is market discipline. Under this approach, the 

regulators’ job is to ensure that market participants exercise the 

type of diligence that enables the market to work efficiently, and 

this is the approach presently taken by the Executive Branch. This 

approach, though, I argue is inherently suspect. Again, you have 

the problem of the tragedy of the commons that no firm has sufficient incentive to limit its own risk to avoid risk to third parties, 

11

and also regulators have a mixed track record of ensuring that participants in fact maintain market discipline, and I argue that this 

is a behavioral psychology effect. So I look at market discipline as 

a potential supplement to other regulatory approaches. 

In terms of recommendations, I propose that there be created a 

lender/market-maker of last resort, that to minimize moral hazard, 

the market-maker/lender of last resort could adopt a policy of constructive ambiguity; that is that no third party would know when 

the lending or the market making would occur. And also, I show 

how this can be done in a way that only minimally transfers risk—

transfers cost, I should say—to taxpayers. And this approach 

should be supplemented by market discipline approach. And to the 

extent none of those works, then you always have potential for ad 

hoc approaches. 

Now let me address the committee’s specific questions. One is, 

what are the major challenges facing the U.S. financial regulators? 

And the immediate challenge of course is to instill additional investor confidence in the financial markets. I argue that the recent 

monetary policy actions by the Fed are helpful, but they primarily 

impact banks, not financial markets, and that one, to the extent 

necessary, there should be a lender of last resort set up to deal 

with the situation with the markets’ collapse, similar to the tight 

coupling suggested by Mr. Bookstaber. 

Two, what challenges will regulators face going forward? I believe regulators need to come to grips with changing market realities in at least two ways. They should shift their focus from banks 

more to financial markets, to address the reality of financial 

disintermediation, the shifting from bank finance to capital market 

finance. And second, they should begin thinking more seriously 

about the increasing problem of complexity. 

The third question is, do regulators have the tools they need to 

meet these challenges? And I propose that the Fed or some other 

governmental entity be given the power to act as, or at least to arrange for, a market-maker/lender of last resort along the lines discussed. And also because financial markets and institutions increasingly cross sovereign borders, that the Federal Reserve be 

given any necessary authority to work with regulators outside the 

United States, including the possibility of establishing an international lender or market-maker of last resort. 

The next question the committee asked is what changes, if any, 

should be contemplated to our regulatory system? And again, I repeat what I said before, that the Fed be given that authority to 

work both domestically and internationally, including as a lender 

of last resort. 

And the fifth question is what powers or information could have 

allowed regulators to anticipate and prevent the current subprime 

mortgage crisis and its impact on the broader financial system? I 

believe it would have been possible through a lender/market-maker 

of last resort to mitigate the impact of that crisis on the broader 

financial system. And, furthermore, I think that if the collapse 

were more severe, a lender or market-maker of last resort would 

have been even more important. 

I am less than certain, however, what powers or information 

could have allowed regulators to anticipate and prevent the current 

12

subprime mortgage-related crisis. Now Alan Blinder in his Sunday 

Op Ed in the Sunday Times tries to identify what caused the mortgage crisis. But I believe that even if one could identify that, there 

are infinite other ways that crises could occur in the future, and 

trying to regulate all of them would dampen the economy. I will 

give you an example. The underlying cause of the subprime mortgage crisis was that mortgage loans turned out in retrospect to be 

undercollateralized, given the drop in home prices. One could consider, for example, imposing going forward a restriction on these 

types of loans, akin perhaps to what the Fed did in response to the 

problems you had in the 1920’s and 1930’s, the Great Depression. 

And that is the margin regulations, G, U, T, and X. This would basically require for mortgage lenders additional collateral so that 

you didn’t have a collateral shortage. For example, in a securities 

context of those regulations, you have two-to-one collateral coverage of margin stock to margin loans. You could say, for example, 

that you would have additional collateral coverage of home mortgage loans. 

The problem I have with something like that, although I think 

it would be very effective to limit the risk going forward, is that 

you impede homeownership, basically, and you would also impose 

a high administrative cost. So one has to be very circumspect as 

to any regulation. 

And finally, it is easy to rush to incorrect conclusions. Also on 

Sunday, Blinder criticized the rating agencies being paid by the 

issuers, a supposed conflict of interest, and arguing that if students 

paid him directly for grading their work, his dean would be outraged. But that’s misleading. Because for rating agencies, the rating is universally independent of the fee, and so one needs to be 

very careful not to make false analogies. 

Thank you. 

[The prepared statement of Professor Schwarcz can be found on 

page 72 of the appendix.] 

The CHAIRMAN. Thank you. 

And Mr. Kuttner. 

STATEMENT OF ROBERT KUTTNER, EDITOR, THE AMERICAN 

PROSPECT 

Mr. KUTTNER. Thank you, Mr. Chairman, for this invitation. My 

name is Robert Kuttner. I’m an economics journalist, editor, author, former investigator for the Senate Banking Committee, and 

I have a book coming out in a few weeks that addresses the systemic risks of financial innovation coupled with deregulation and 

the hazards of periodic bailouts. 

In my research, I reviewed the abuses of the 1920’s, and the efforts in the 1930’s to create a stable financial system. The Senate 

Banking Committee in the celebrated Pecora hearings of 1933 and 

1934 laid bare the abuses of the 1920’s and devised the groundwork for modern financial regulation. If you revisit the Pecora 

hearing records, I think you will be startled by the sense of deja 

vu and the parallels to today’s excesses. 

Although the particulars are different and some of today’s innovations are highly technical, financial history suggests that the 

risks and abuses are enduring. They are variations on a few hearty 

13

perennials: Excess leverage, conflicts of interest, nontransparency, 

misrepresentation, and engineered euphoria. In the 1920’s, such 

practices as stock pools, margin lending, pyramiding of holding 

companies, and the repackaging of dubious loans and bonds all promoted by middlemen with conflicts of interest, created asset bubbles and ultimately lead to the great crashes. 

In the 1930’s, Congress barred these abuses through regulations 

that required transparency, eliminated excess leverage, abolished 

holding company pyramids, limited margin accounts and prohibited 

insider self-dealing out of the conflicts of interests. But thanks to 

deregulation, many of these abuses were repeated in the scandals 

of the 1990’s where the malfactors were auditors and accountants 

and stock analysts, and it remains to be seen what role the bond 

rating agencies have played in the current crisis. 

Securitized credit. Some people think this is an innovation of the 

past 30 years. In fact, it was absolutely central to the abuses of the 

1920’s, and those abuses led Congress to separate investment 

banking from commercial banking in the Glass-Steagall Act. Since 

repeal of Glass-Steagall in 1999, trillion-dollar superbanks have 

been able to reenact the same kind of structural conflicts of interest. 

Though these entities are only partly government-guaranteed 

and supervised, they are nonetheless treated as too big to fail. And 

anybody familiar with derivatives or hedge funds knows that margin limits, although they’re still on the books, are for little people. 

Private equity, which might be better named private debt, gets its 

astronomically high rate of return on equity through the use of borrowed money. As in the 1920’s, the game continues only as long as 

assets continue to inflate. 

Now there’s one enormous difference. The economy did not crash 

with the stock market collapse of 1989 or of 2000, 2001. And while 

there are other differences, the primary difference is that in the 

late 1920’s, the Federal Reserve had neither the tools nor the expertise nor the self-confidence to act decisively in a credit crunch. 

Today when speculative meltdowns risk hurting the larger economy, the Fed floods the market with cash and lowers target shortterm rates. 

This was the case in the Third World loan losses of the 1980’s, 

the currency speculation losses of 1997, and of course the collapse 

of long-term capital management in 1998. Even though Chairman 

Greenspan had expressed worry 2 years and several thousand 

points earlier that irrational exuberance was creating a stock market bubble, the big losses led Greenspan to keep cutting rates despite his foreboding that the cheaper money would only pump up 

asset bubbles and invite still more speculation. 

I just read Chairman Greenspan’s fascinating memoir in which 

he confirms both this rescue philosophy and his strong support for 

free markets and deep antipathy to regulation. But I don’t see how 

you can have it both ways. If you believe that markets are self-regulating and self-correcting, then you should logically let markets 

live with the consequences. On the other hand, if you were going 

to let markets—if you’re going to rescue markets from their excesses on the very reasonable ground that a crash threatens the 

larger system, then you have an obligation, I think, to act prophyVerDate 0ct 09 2002 16:41 Jan 10, 2008 Jkt 039903 PO 00000 Frm 00017 Fmt 6633 Sfmt 6633 K:\DOCS\39903.TXT HFIN PsN: TERRIE
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lactically to head off the wildly speculative behavior in the first 

place. Otherwise, the Fed is just an enabler. 

The point is not that the Fed should let the whole economy collapse in order to teach speculators a lesson. The point is that the 

Fed needs to remember its other role as regulator. Financial regulation is too often understood as merely protecting investors. If investors are consenting adults, who needs regulators? But of course 

the other purpose is to protect the system from moral hazard and 

catastrophic risk. 

As these hearings proceed, here are the issues that I think require further exploration. First, which innovations of financial engineering truly enhance economic efficiency and which ones mainly 

enrich middlemen, strip assets, reallocate wealth, and increase system risk? 

Secondly, which techniques and strategies of regulation do we 

need to moderate these new systemic risks that were at the heart 

of the financial crisis of the 1920’s, the 1990’s, and the zeroes? 

Again, there are recurring abuses: Lack of transparency, excessive 

leverage, and conflicts of interest. Those in turn suggest remedies: 

Greater disclosure, either to regulators or to the public; requirement of increased reserves in direct proportion to how opaque and 

difficult to value are the assets held by banks; some restoration of 

the laws against conflicts of interest once provided by GlassSteagall; and tax policies to discourage dangerously high leverage 

ratios in whatever form. 

Finally, a third big question to be addressed is the relationship 

of financial engineering to corporate governance. Ever since Berle 

and Means, it has been conventional to point out that corporate 

management is not adequately responsible to shareholders. Since 

the first leveraged buyout boom, advocates of hostile takeovers 

have proposed a radically libertarian solution to the Berle Means 

problem. Let a market for corporate control hold managers accountable by buying, selling, and recombining entire companies. There 

have to be better strategies to hold managers accountable. 

One last parallel. I am chilled, as I’m sure you are, Mr. Chairman, every time I hear a public official or a Wall Street eminence 

utter the reassuring words, ‘‘the economic fundamentals are 

sound.’’ Those same words were used by President Hoover and the 

captains of finance in the cold winter of 1929. They didn’t restore 

confidence. 

The fact is, the economic fundamentals are sound if you look at 

the real economy. It is the financial economy that is dangerously 

unsound. And as every student of economy history knows, depressions, ever since the South Sea bubble, originate in excesses in the 

financial economy and go on to ruin the real economy. Not all innovations are constructive. 

It remains to be seen whether we have dodged the bullet for now. 

If markets do calm down, then we have bought precious time. The 

worst thing of all would be to conclude that markets have self-corrected once again. The Fed has really ridden to the rescue once 

again, and the worst thing of all would be to take no action and 

let the bubble economy continue to fester. 

Thank you very much. 

15

[The prepared statement of Mr. Kuttner can be found on page 53 

of the appendix.] 

The CHAIRMAN. Thank you, Mr. Kuttner. 

Mr. Pollock. 

STATEMENT OF ALEX J. POLLOCK, RESIDENT FELLOW, 

AMERICAN ENTERPRISE INSTITUTE 

Mr. POLLOCK. Mr. Chairman, Ranking Member Bachus, and 

members of the committee, thank you for your kind comments on 

my proposal in your opening remarks. My own career has included 

many credit cycles which involved issues of systemic risk, starting 

in my case with the credit crunch of 1969, the commercial paper 

panic of 1970, the real estate investment trust collapse of 1975, 

and so on to the current subprime mortgage and housing bust, with 

numerous others in between. I have also studied the long history 

of such events. 

I expect, Mr. Kuttner, that you and I disagree on many things, 

but we agree on the importance of looking at these historical patterns. Systemic risk always makes me think of a memorable saying 

of John Maynard Keynes, that a prudent banker is one who goes 

broke when everybody else goes broke. As Keynes suggests, prudence means doing what everybody else is doing, and that’s a key 

component in financial booms and busts. 

To put these in context, maximum, long-term growth and the 

greatest economic wellbeing for ordinary people depends on market 

innovation and experimentation. But these, of course, make the future more uncertain. Markets for financial instruments by definition place a current price on future, thus inherently uncertain, 

events. That much is obvious, but it’s easy to forget this when addressing the results of a bust with the benefit of hindsight, when 

it seems like you would have had to be stupid to make the mistakes that smart people actually did make. 

In the boom, many people succeed, just as many people succeeded in the long housing boom just past. This success gets extrapolated and makes lenders and investors and regulators confident of the ‘‘new era.’’ Investor confidence leads to underestimation of future uncertainties, notably in a leveraged sector, and 

there comes to be a lot of investing long and borrowing short. 

Risky, illiquid assets get to be financed by very risk-averse, shortterm lenders, like commercial paper buyers and repo dealers, and 

in a previous day, unsecured bank depositors. 

These short-term lenders are likely to behave like the depositors 

of Britain’s Northern Rock, that is to say, in the manner of the 

Plank Curve. I hope you can see this, ladies and gentleman. This 

is the Plank Curve. It is the pattern of credit available in a panic. 

You can see it goes like this and then it drops off the end. It’s 

called the Plank Curve because it is the pattern of a man walking 

the plank. 

We know for certain that markets will create both long-term economic growth and cyclical booms and busts. Markets are recursive. 

Regulations change the market. Models of financial behavior themselves change the market, and thereby become less effective or obsolete, as did the subprime credit models of both investors and the 

rating agencies. 

16

One way to go broke when everyone else does is to use models 

with the same assumptions that everyone else has. This should 

make us skeptical of the model-based regulatory approach currently popular as Basel II. 

The great economic historian, Charles Kindleberger, surveying 

several centuries of financial history, observed that financial crises 

and scandals occur on average about once every 10 years regardless 

of what legislators or regulators do. The lessons are all learned 

after the fact. 

Every bust is followed by hopes that the reforms have solved the 

problem. For example, in 1914, the then-Comptroller of the Currency announced that with the creation of the new Federal Reserve, ‘‘financial and commercial crises or panics seem to be mathematically impossible.’’ Of course in time, the next bust arrives 

nonetheless. 

Although this should make us skeptical of excessive claims about 

what regulation can do, it doesn’t mean that we shouldn’t have reforms. Greater disclosure certainly makes sense. The subprime 

mortgage bust suffered from inadequate disclosures all the way 

from the consumer, as was mentioned a little bit ago, to the ultimate investor levels and at a good many places in between. The 

role of the credit rating agencies is part of this issue. I think we 

should be working on ways to make investor-paid rating agencies 

a greater force in this key information providing sector. 

A particular disclosure reform pertinent to private pools of capital would be to require symmetrical disclosure of short and long 

equity concentrations. Concentrated short positions in a company’s 

stock should be disclosed publicly in exactly the same way as long 

positions are. 

And it would certainly be a good idea to make whatever deal 

with the Senate is necessary to enact regulatory reform of the 

housing GSEs. 

Good times, a long period of profits, and an expansionary economy induce financial actors, regulators, and observers to take readily tradable markets, otherwise called ‘‘liquidity,’’ too much for 

granted, so liquidity comes to be thought of as how much you can 

borrow. When the crisis comes, it’s found that liquidity is about 

what happens when you can’t borrow, except from some government instrumentality. 

At this point, we have arrived at why central banks exist. The 

power of the government with its ability to compel, borrow, tax, 

print money, and credibly guarantee the payment of claims can intervene to break the everybody-stops-taking-risk-at-once psychology 

of systemic risk. The key is to assure that this intervention is temporary, as are credit panics by nature. 

As historically recent examples of government interventions in 

housing busts, since 1970, we’ve had the Emergency Home Finance 

Act of 1970, the Emergency Housing Act of 1975, the Emergency 

Housing Assistance Act of 1983, and the Emergency Housing Assistance Act of 1988. And I don’t count the Hurricane Katrina 

Emergency Housing Act of 2005, since that’s a special case. 

As Walter Bagehot wrote, ‘‘Every great crisis reveals the excessive speculations of many houses which no one before suspected.’’ 

The current bust is true to type, and we are seeing and will conVerDate 0ct 09 2002 16:41 Jan 10, 2008 Jkt 039903 PO 00000 Frm 00020 Fmt 6633 Sfmt 6633 K:\DOCS\39903.TXT HFIN PsN: TERRIE
17

tinue to see large losses revealed. As everybody gets used to the 

idea that these losses have happened, I think liquidity will return 

reasonably quickly to markets for prime instruments. I agree with 

Congressman Garrett that we don’t need Fannie and Freddie in the 

prime jumbo market. 

One insightful observer has predicted that the panic about credit 

markets will be a memory by Thanksgiving. For prime markets, I 

believe he’s right. However, the severe problems with subprime 

mortgages and securities made out of them related defaults and 

foreclosures, and most importantly, falling house prices, will continue past then. The interesting times we’re experiencing in the 

wake of the bursting of the housing bubble does have a good way 

yet to run. 

Thank you for the opportunity to share these views. 

[The prepared statement of Mr. Pollock can be found on page 66 

of the appendix.] 

The CHAIRMAN. Thank you, Mr. Pollock. Let me begin with you. 

You say of your 90 percent, 10 percent policy mix, and you say 

when the system hits its inevitable periodic crisis, about 10 percent 

of the time the intervention is necessary. What kinds of intervention? For instance, I assume, as you acknowledge—not acknowledge, as you note, this is one of those times. What sorts of intervention have been and are appropriate now since you say we are in 

one of those 10 percent times? 

Mr. POLLOCK. Thank you very much, Mr. Chairman, for reading 

my testimony about what I call the Cincinnatian Doctrine, which 

is this 90 percent/10 percent. 

The CHAIRMAN. Why Cincinnatian? 

Mr. POLLOCK. If I may have a minute to explain. 

The CHAIRMAN. Sure. 

Mr. POLLOCK. Cincinnatus— 

The CHAIRMAN. Yes. 

Mr. POLLOCK. —the great Roman hero, left the plough to save 

the state—became temporary dictator of Rome. 

The CHAIRMAN. Right. 

Mr. POLLOCK. And after he saved the state by expelling the barbarians, he resigned his dictatorship and went back to his farm. 

The CHAIRMAN. Why 90/10? 

Mr. POLLOCK. Excuse me? 

The CHAIRMAN. Was that like 10 percent of his life? I just didn’t 

understand the 90/10. 

Mr. POLLOCK. No, no. 

The CHAIRMAN. I thought maybe because he was a farmer, he 

was getting 90 percent parity. 

Mr. POLLOCK. There are, of course, agricultural busts as well, 

Mr. Chairman. 

The CHAIRMAN. All right. Why Cincinnatus? I just didn’t get the 

name. 

Mr. POLLOCK. That is why Cincinnatus. 

The CHAIRMAN. All right. 

Mr. POLLOCK. Of course, George Washington, who also could 

have been king and instead went back to his farm, had Cincinnatus 

as— 

18

The CHAIRMAN. Well, he was more of a politician than 

Cincinnatus. He stayed a while. 

Mr. POLLOCK. Well, then he came back, of course. Anyway, 90/

10 is because about once every 10 years is the time of the bust. Appropriate actions— 

The CHAIRMAN. I’ve always found that the more remote people 

are in time, the easier it is to impute total purity to their motives. 

But let’s get back— 

Mr. POLLOCK. That’s very true. The less well we know them, Mr. 

Chairman. 

The CHAIRMAN. What kinds of interventions would you say 

should have been, and are now, relevant to this 10 percent crisis? 

Mr. POLLOCK. We are clearly with the subprime bust in this 10 

percent period. We’ve had the central bank intervening, as it did 

with discount— 

The CHAIRMAN. What forms of intervention do you think are appropriate, the ones that have happened? Are there things that happened that shouldn’t have, or has everything been done correctly? 

Mr. POLLOCK. I think the actions of the Fed were quite appropriate and seemed to have been successful in returning the prime 

markets to much more normal functioning, which we’re seeing. I do 

think, as we discussed in the previous hearing, that in the current 

subprime bust, the ways to refinance subprime ARMs in particular 

are appropriate interventions, using the FHA, for example. 

I had the honor of proposing to you when I was last here that 

Fannie and Freddie might be used to acquire in segregated special 

portfolios refinanced subprime ARMs. I think that would be an appropriate intervention in this 10 percent period. 

My point with the 90/10 is that all of these things should be temporary. The lessons will be learned by all, government and market, 

and when we get past the— 

The CHAIRMAN. Let me just say, on that, I appreciate with regard to the Fed, obviously those are temporary. And a special 

Fannie/Freddie subprime would be. The FHA proposal from the Administration and what we’ve done would be permanent. Should 

that be—I mean, that is letting the FHA from now on deal with 

people with weaker credit. Is there any reason to limit that, going 

forward? 

Mr. POLLOCK. If you look at subprime delinquencies and FHA delinquencies, Mr. Chairman, they are quite similar in the fixed-rate 

area—almost half of subprime loans are fixed-rate loans. And fixedrate subprime delinquencies actually are not that much more than 

FHA delinquencies. And of course, total FHA delinquencies are 

well up into double digits. So I wouldn’t support lowering the credit 

standards of the FHA by a lot. But I would support their temporary ability to refinance subprime— 

The CHAIRMAN. Okay. I understand that. What the Administration asked for was a permanent change, so I appreciate your noting 

a difference there. 

Let me just say to Mr. Kuttner that I think he—I was glad to 

see he hit on what I think is a central point, and that is Mr. Greenspan has been criticized by some who say that he should have 

acted with regard to the stock market exuberance and also 

subprime by deflating the entire economy. And when he said he 

19

shouldn’t have done that, you and I agree, and that of course would 

have exacerbated what is America’s number one economic problem 

now, which is the increasing inequality where wage earners are 

falling further and further behind. 

But as you note, implicitly, when you get into that debate, that 

assumes that the choices are either deflating the entire economy or 

letting problems happen, that there is only a macro response, and 

that is of course the case for sensible regulation, that among the 

arguments for regulation is that it gives you a third choice, and 

that you don’t have to choose between this bringing about a recession or tolerating abuses. And because of Mr. Greenspan’s role, and 

I think, frankly, some of my friends on the liberal side were so 

eager to criticize him, that they fell into that trap without realizing 

what the consequences were, and there was an alternative. 

Let me just, finally, to Mr. Schwarcz and Mr. Bookstaber, I note 

what seem to be some similarity between your argument about the 

government as a provider of funding for last resort. Is that accurate? The question is, is it just lending? Mr. Bookstaber, you talked 

about maybe buying up the assets. Mr. Schwarcz, are there differences—I mean, there’s a good degree of congruence there, and 

I think that’s—I welcome that, because we don’t always get a lot 

of specific suggestions from people, and I thank you. 

Will you both talk about that, that area of whether there is congruence or maybe some shading of difference? 

Mr. BOOKSTABER. I look at it a little differently. I call it a liquidity provider of last resort, but I think we’re thinking along the 

same lines. 

The CHAIRMAN. By the way, leave the label aside. We’ll come up 

with the most perfumed name possible though. You just describe 

the substance. 

Mr. BOOKSTABER. The reason this happens is if you look at the 

dynamics of what occurs in most crises, LTCM is sort of the poster 

child for it, but we see it with other crises, especially when it’s 

hedge-fund oriented. There’s a market shock that occurs, and a 

highly levered hedge fund, because of that market shock, now has 

to essentially sell assets because it’s collateral is below the margin 

or haircut required by the lender. 

The selling of the assets drops the market even more, which requires even more liquidation, and you just get this cycle. People 

who are astute in the business, for example, Citadel, then recognize 

that the reason this market is down 50 percent— 

The CHAIRMAN. I don’t want to—I mean that was the thrust of 

your testimony. I guess the shading—is whether it’s all loans or 

would you have purchases as well. And I’d be interested in Mr. 

Schwarcz’s view. 

Mr. SCHWARCZ. Let me respond. I think that what Mr. 

Bookstaber is saying is you would potentially have both, which is 

what I’m saying as well. I referred to a lender/market-maker of last 

resort, which—I could have said liquidity provider. 

The CHAIRMAN. You’re lending, knowing full well that this loan 

may never be repaid and you’re in effect going to be buying it. 

Mr. SCHWARCZ. Well, it would be repaid, and let me give an example. Presently you do have a lender of last resort in interVerDate 0ct 09 2002 16:41 Jan 10, 2008 Jkt 039903 PO 00000 Frm 00023 Fmt 6633 Sfmt 6633 K:\DOCS\39903.TXT HFIN PsN: TERRIE
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national context, the IMF. And the IMF, of course, makes loans in 

a country debt crisis situation. 

The argument, I know, of former Treasury Secretary Rubin is 

that governments do not lose money on this. And generally that’s 

true because those loans are ultimately repaid. And I think it 

would be true as well that the— 

The CHAIRMAN. Just a final question from me, and I appreciate 

the indulgence. Is there a difference when the lender of last resort, 

the provider of liquidity, whatever, is it the Fed in both cases, let 

me ask you, or are we talking about a new entity to do that? 

Mr. SCHWARCZ. Well, I think that the Fed—in my research I look 

at possibilities. I think the Fed is the most logical— 

The CHAIRMAN. Okay. That’s good. ‘‘Yes’’ is a good answer sometimes. 

Mr. SCHWARCZ. Yes. 

The CHAIRMAN. And the question then would be when the Fed 

or whomever is doing this, do they have—I mean do they start out 

constantly saying, ‘‘Well, am I going to lend or am I going to buy,’’ 

or is it kind of they go into it and play it by ear as they go into 

it? 

Mr. SCHWARCZ. I think it will depend on the situation. If there 

is an institution that is failing, say LTCM, and if there’s not a private arrangement it would probably be a loan if the private market— 

The CHAIRMAN. And let me ask the both of you, what about the—

one of the arguments we’ll get is what about moral hazards being 

created by this. Go ahead, Mr. Bookstaber. 

Mr. BOOKSTABER. What I’m thinking is in a fairly limited context 

where you’re looking at hedge funds. And there will be no moral 

hazard because in that case you’re actually buying up the assets 

of the firm— 

The CHAIRMAN. And putting them out of business? 

Mr. BOOKSTABER. And they’re out of business, but you stop the 

dominoes from propagating out. 

Mr. SCHWARCZ. And there could be moral hazard certainly in 

terms of markets, but the idea would be to purchase assets in the 

market to prevent the collapse but still do so at a sufficient discount to impose pain on those— 

The CHAIRMAN. I think that’s very important, a little bottom 

feeding by the Fed. 

Mr. Kuttner, quickly. 

Mr. KUTTNER. I would just put more emphasis on prevention 

rather than on— 

The CHAIRMAN. Well, I understand that—I’m all for prevention—

but that doesn’t mean I don’t go to the doctor when I need an operation. The gentleman from Alabama. 

Mr. BACHUS. Thank you. First I’d like the record to show that 

Chairman Frank and I, neither one of us have farms—unlike 

George Washington or Cincinnatus—so I don’t suppose we’ll be 

leaving any time soon. 

Mr. Pollock, there are persistent rumors that there is going to 

be—in the Judiciary Committee this week or next week, there is 

going to be an emergency mortgage bankruptcy bill, and one of the 

21

provisions in that bill will allow bankruptcy judges to reduce loan 

principals, reduce interest rates, and extend loan terms. 

Do you believe this would disrupt the market for mortgagebacked securities, any fear of that? Would it discourage lenders in 

the future from making loans? Would it—the liquidity crisis seems 

to be passing. Would that not just bring it back? 

Mr. POLLOCK. Congressman, since the chairman has said yes is 

a good answer, yes, I think it would hurt the market, and yes, it 

would cut future access to home finance because the house itself 

and the ability to pledge it is the principal thing that a mortgage 

borrower brings to the transaction. 

Mr. BACHUS. Thank you. Professor Schwarcz, this international 

lender of last resort, discuss—one of the questions I was going to 

ask about is moral hazard, but you’ve sort of explained that away 

by saying that these assets, you could turn around and sell them 

for more money. But if that were the case, wouldn’t private parties 

also come in and buy those? Why would you need a quasi-government agency? 

Mr. SCHWARCZ. In a perfect market you are correct, the third 

parties would come in and buy them. I guess you have two problems. Problem number one is that people or institutions or thirdparty buyers are going to be very hesitant to come in, and that is 

both a psychological thing and it also goes to the institutional 

structure. 

Institutions are worked by people, and a person who is going to 

make a decision is going to be unlikely to want to have the institution buy into a market when the market is dropping and everyone 

is saying, ‘‘Let’s abandon the market.’’ People tend to go with the 

herd. You have a certain herd mentality and this could deter buying. Individuals in institutions also may find it safer to conform to 

the herd view even if they believe there is value there. 

So a lender of last resort would take a more objective position. 

That would be the argument. 

Mr. BACHUS. Mr. Bookstaber, is that how you pronounce your 

name? 

Mr. BOOKSTABER. Bookstaber. 

Mr. BACHUS. Bookstaber, I’m sorry. 

Both of you have talked about this lender of last resort. Do you 

subscribe to an international lender of last resort like the professor 

or does that create some problems? 

Mr. BOOKSTABER. Well, I haven’t thought of it in an international 

context. 

Mr. BACHUS. You what? 

Mr. BOOKSTABER. I haven’t thought of it in an international context, so I couldn’t really say. The cases I’ve looked at have tended 

to be domestic. The examples I use are Citadel’s purchase of 

Sowood and Amaranth. 

Mr. BACHUS. Let me ask you this. Professor Schwarcz, you actually said it wouldn’t be predictable, you’d do it sometimes, you 

wouldn’t do it other times. You know, allowing a governmental or 

quasi-governmental agency to bail some folks out, intervene in 

some cases and not in others, doesn’t that—couldn’t that breed favoritism or unequal treatment? 

22

You’re a law school professor. Does it bother you that you might 

be picking winners and losers? 

Mr. SCHWARCZ. I think if you picked winners and losers on a 

basis as to who they were, that would bother me. 

Mr. BACHUS. You’d obviously know who you were bailing out. 

Mr. SCHWARCZ. Right, but I mean in terms of saying we’re going 

to decide to bail out these types of entities but not those types of 

entities. I think one needs to decide it on an ad hoc basis to see 

what the effect is going to be of a failure on the markets and then 

to make a case-by-case determination. 

I agree with you that it’s not a perfect solution. These are all second best solutions here. 

Mr. BACHUS. Mr. Bookstaber. 

Mr. BOOKSTABER. Yes, the way I would see it occurring in most 

circumstances, it would be a bailout of the market in the sense that 

it would prevent the market from cascading into crisis, but it 

wouldn’t be a bailout of the firm. 

Mr. BACHUS. But you do it sometimes, you don’t do it other 

times? You know, you were with Goldman Sachs. 

Mr. BOOKSTABER. Yes, I agree that there would always be some 

judgment. And as Professor Schwarcz is saying it wouldn’t be so 

much an issue of the failure of the firm, it would be the question 

of whether there’s a fear that the firm’s failure would propagate 

out to affect other markets. 

Mr. BACHUS. Professor Schwarcz, you mentioned that the IMF, 

I think you seemed to imply they always get paid back, that the 

World Bank—I mean I actually have had the debt relief bill, I 

sponsored that bill, and the reason it was debt relief is because a 

lot of those countries were not paying it back. And a lot of the 

loans didn’t go to the benefit of the country, they went to what I 

would term insiders with the World Bank or the IMF or a lot of 

times corporations, you know, which—it was really a subsidy to the 

corporation. The country or the citizens didn’t receive any benefits. 

I wish you’d kind of look at that whole history of debt relief. I 

think you might—you know, the idea that they always get paid 

back. 

Mr. SCHWARCZ. Sir, I was trying to quote Secretary Rubin, 

former Secretary Rubin on that. My view, and I have said this in 

writing, is that the IMF, the way it does its lending of last resort 

is not a way to be necessarily modeled because it does a number 

of things wrong, including it charges a lower interest rate than its 

own cost of funds, but I propose a situation that solves that. 

Mr. BACHUS. In fact, a lot of the poverty in a lot of these third 

world countries is the result of the massive debt that they owe, and 

it really caused tremendous long-term problems, a real headache. 

Mr. SCHWARCZ. That is correct. 

Mr. BACHUS. May I just close by saying this international lender 

of last resort, how do we go to the taxpayers of the United States 

and ask them to finance this? Wouldn’t they rather sort of finance 

a road in front of their house or the school down the block as opposed to funding loans by some international agency? 

Mr. SCHWARCZ. I agree with that, that other things being equal 

they might. But the question is going to be—the funding would 

occur only in those situations where the potential for market colVerDate 0ct 09 2002 16:41 Jan 10, 2008 Jkt 039903 PO 00000 Frm 00026 Fmt 6633 Sfmt 6633 K:\DOCS\39903.TXT HFIN PsN: TERRIE
23

lapse would be so severe that it would really outweigh other uses 

of the money. And that would have to be determined, again, on a 

case-by-case basis. 

But the rationale for having a lender or international lender of 

last resort in place is because the collapse of markets can be so 

quick, the so-called tight coupling that Mr. Bookstaber mentioned, 

that you may be faced with a sudden collapse no matter what 

you’ve done to try to prevent the problem from arising. 

And in that case I think the lender of last resort is probably the 

best solution. 

Mr. BACHUS. Yes, I guess what I’m thinking about, we talked 

about Russia, which didn’t have disclosure, so all of a sudden we 

bail out a country because they didn’t have disclosure or because 

they didn’t have sound practices. So the countries that have done 

a better job end up bailing out those countries who haven’t. 

Mr. BOOKSTABER. When I think of this, I’m thinking of it not so 

much in an IMF, country bailout or loan mode. I think the best example of this is to look back at LTCM, and we went a different 

route. But remember, Warren Buffett almost bought all the assets 

of LTCM, and if he had done so, the crisis would have ended right 

then because he could have held those assets, which clearly were 

priced very low because of this liquidity event. 

So, what if Warren Buffett isn’t around to do it, and as Professor 

Schwarcz has mentioned, in these situations often everybody scurries for the sidelines. If the government can say, here’s a fund that 

is close enough to cause a systemic problem that, rather than allowing it to cascade, we’ll walk in and buy the assets for pennies 

on the dollar, you now are out of business. We have assets that 

probably, once you adjust for liquidity, are under their true value. 

For the same reason that Citadel bailed out, so to speak, Amaranth, and hopefully turned a profit from it, I think more often 

than not if the government had a liquidity provider of last resort, 

at the end of the day, the taxpayers would end up making money 

from it. 

Mr. BACHUS. Of course, you know, the government usually 

doesn’t turn a profit. Thank you. 

Mr. BOOKSTABER. Thank you. 

Ms. WATERS. [presiding] Thank you very much. I’ll recognize myself for 5 minutes. I’d like to thank all of our panelists for being 

here today. 

We have spent quite a bit of time in this committee dealing with 

the home foreclosure disaster, and I suppose I could ask you a lot 

of questions about our regulatory agency and why they have not 

been stronger and more aggressive in monitoring what was going 

on with our financial institutions, or I could talk about our attempts to do something about predatory lending in this committee 

and do away with prepayment penalties, and I could talk about 

these exotic products that were advanced, the interest-only, the nodoc loans and all of that, but I really do know the answers already, 

and I know that we don’t have a lot of regulations. 

There is a resistance to regulations. The financial institution is 

extremely powerful, and I had an opportunity to serve on another 

subcommittee of this committee, the Subcommittee on Financial Institutions and Consumer Credit, but I declined. I declined, and I’m 

24

chairing the Subcommittee on Housing and Community Opportunity, because I thought I could get something done there. I did 

not think that I could get anything done on Financial Institutions. 

They are just so powerful, so influential, and the regulatory agencies are not at all willing to cross them and to come up with strong 

regulations, so I’m not going to bother you with that. 

I want to talk to Mr. Kuttner. I have long been a fan of yours, 

and I’d like to ask you what we can do to prevent the impending 

crisis, the collapse of the market. What can be done at this point? 

Mr. KUTTNER. Thank you very much, Madam Chairwoman. I 

think the Fed did what it had to do, but I think going forward the 

proverbial ounce of prevention is where we ought to be emphasizing our public policy. 

That is to say, without the benefit of hindsight, because people 

were criticizing it at the time, you can say that the underwriting 

practices of these subprime lenders never should have been permitted. 

Had the Fed not stonewalled in the issuance of regulations under 

the 1994 Homeownership Equity Opportunity Protection Act, there 

would have been underwriting standards in place. Just the fact 

that some consenting adult can be found to buy the paper is not 

a good justification to allow predatory lending practices. 

And by the same token, the most unscrupulous lender’s willingness to make a loan is not a substitute for a low-income housing 

policy. It just creates heartbreak later on. So I think a lot of these 

mortgages ought to be refinanced. 

It is up to Congress to decide whether that is done through FHA 

or the GSEs or some other entity. I think someone needs to decide 

which of these borrowers were innocent victims of predators and 

which of them were a bit predatory themselves, which of them 

were speculators themselves. 

The ones who are innocent victims ought to be permitted to get 

refinancings that save their homes, and going forward, the predators should be put out of business. We have had the homeownership rate in this country trickle upwards, but we need a real housing policy to encourage first-time homeownership and not one 

based on speculation. 

Ms. WATERS. If I may interrupt you for a moment, I’ve been trying to focus on the servicers. Those entities that are collecting the 

money, doing the foreclosing, the late payments, all of that, I supposes some are independent, some are owned by—I don’t know if 

Countrywide, for example, did their own servicing. 

Oh, and as I have asked about the ability for the servicers to renegotiate these loans, rearrange them in some way, I am being told 

that some of the servicers are saying, but we are liable. We are liable, and if we make arrangements that fail, we can be held liable 

by the company that we are working for. 

Do you know anything about these servicers and what potential 

we have to enter there in order to readjust these loans? 

Mr. KUTTNER. Well, I think there are some bad actors in this industry, but I think there is a structural problem with the way 

securitized mortgage credit creates an incentive against workouts. 

If the lender is the originator and also the holder of the paper, 

the lender is more inclined to do a workout. If there’s a whole chain 

25

with middlemen each extracting a fee at each link in the chain 

they actually make more money by letting the foreclosure go forward. 

I did some research on whether securitization of mortgage credit 

actually helps lenders, and I think by the time you look at the fee 

extracted by the mortgage broker, the fee extracted by the mortgage banker, the fee extracted by the investment bank that packages the loans into securities, and the fee extracted by the bond 

rating agency, the borrower is no better off, and the borrower may, 

in fact, be at a higher risk. 

So I think the whole system of securitized credit and the role 

played by these middlemen and the greater hazard that it creates 

in the event of foreclosure is ripe for broader investigation. 

Ms. WATERS. Thank you very much. I will now recognize Mr. 

Garrett for 5 minutes. 

Mr. GARRETT. Thank you. I think I’ll take up where the ranking 

member was finishing off, and that goes back to the issue of the 

lender of last resort. Maybe I’ll start on the other end of the table 

there, since I don’t think Mr. Pollock has weighed in on that. 

In a sense, don’t we already have a couple of lenders of last resort in existence now? And one, correct me if my analogy is wrong, 

but one would be the Fed, by doing what it did that, in essence, 

facilitated that? And although the chairman thinks that this was 

an inappropriate word to bring up during this discussion, GSEs, 

aren’t they also a—if they’re doing their job or, I should say, if 

they’re doing what they proclaim to do, although the evidence 

would say that they actually don’t do this after times of trouble like 

this? 

And after 9/11, the evidence would show to the contrary that 

they do not get actually into the market but they’re supposed to. 

Aren’t they the other lender of last resort that we actually have 

right now? 

Mr. POLLOCK. Congressman, I agree with that. Certainly to be a 

completely capable lender of last resort, you have to be able to 

print money; the Fed is the only one that can do that. That is to 

say, just write in your books, ‘‘this is money,’’ and it is the definition of the Fed. 

But it also is very helpful if you can sell debt, which is treated 

as a government liability, which is what the GSEs, Fannie and 

Freddie and the Federal Home Loan Banks do. This was the pattern if you look historically in the times of crisis when various organizations were set up to finance the bust and try to stop debt deflation, such as the Reconstruction Finance Corporation or the 

Homeowner’s Loan Corporation. 

All of these things were set up to be able to sell debt, which was 

taken by the market actually as government debt. Once you have 

that, then you can fulfill this role. 

I’d say, Congressman, in my view we do not want any such organization buying assets, at least unless we get into a real bust like 

the 1930’s, in which you are willing to do things you might not do 

otherwise. I think that such operations should be limited to lending 

and should be accompanied by, as was pointed out by some of my 

colleagues on the panel, a replacement of the management which 

26

got the organizations into the trouble where they needed the lender 

of last resort financing. 

Mr. GARRETT. And if Mr. Schwarcz or others want to chime in 

on this point, I think you made the comment, correct me if I’m 

quoting you wrong, that in this frame of the discussion—whereas, 

well, we may not actually want to have the choice for the tax dollars, and the example was fixing the hole in front of my street. I 

think it was the example somebody said in there before as far as 

the lender of last resort, where the dollars go to. 

Of course, whether it’s that little project or the bigger picture, 

when it is the Fed, that is—as I’m describing it, as the lender of 

last resort stepping in, and when they do what they do and which 

then theoretically or in actuality has a downward pressure on the 

dollar, so now our dollars are less, doesn’t that actually also have 

a hit-it-home impact upon those other tax dollar expenses as well 

because now we actually—the dollar is less? 

So in order to fix that hole at home in front of my street, for the 

government to do that, there’s actually less of an ability for the 

government to provide those other functions because of the actions 

over here by the Fed acting on that matter? Is that clear? 

Mr. SCHWARCZ. Well, I’m—let me, I guess, respond in two ways. 

First, your question, your original question was, don’t we already 

have a lender of last resort in terms of the Fed, and we could. I 

don’t think the Fed has the powers presently to act in the role as 

I envision it and as I think Mr. Bookstaber, although I shouldn’t 

speak for him, but I believe he envisions it. 

What they’ve done in terms of their so-called liquidity injections 

really are—that’s a misnomer. They have of course, you know, lowered the discount rate and the Fed funds rate, and these are rates 

in terms of bank borrowings. 

All I’m suggesting is that the Fed be given the authority, and 

they have to decide when to use it, so they can do things like purchase securities in markets that are collapsing. And that of course, 

that power would be used with a great deal of discretion because 

you’d want to—I think Mr. Pollock said this—use it only when the 

market was truly collapsing. 

Whether it would, in fact, have been used in these circumstances 

now I’m not 100 percent sure whether it would have done that. 

Mr. GARRETT. I don’t have much time. I guess I’ll close on this. 

I’ll take one of your comments home with me tonight. I think you 

said that everything we do is—these proposals are second best. 

Mr. SCHWARCZ. That is correct. 

Mr. GARRETT. And I’ll take the other comment as well in this 

area from Mr. Pollock in that we’ve had these things since the 

statement in 1914 that the Fed is going to resolve these problems 

into the future. Every decade we have them and sometimes more 

than once in a decade. And that, despite the fact of all the work 

that Congress has done. 

And I don’t see that, from the examples or the testimony here—

Mr. Kuttner gave the example, the only differences, I think, in the 

last period of time would be expiration and repealing of GlassSteagall and involvement of the Fed more recently. But that was 

really the most significant difference that we saw in the last cycle. 

So other than that, Congress has repeatedly gotten into the action, 

27

tried to resolve their issue, and regardless, 10 years later or within 

the next decade we still get into this. 

So maybe the best thing is to really go slow before we pick up 

one of these second bests because we may just be picking something that is going to even exacerbate the problem ever forward because we know—I think everyone will agree on this, we will have 

another, we will have another crisis within the next 10 years or so. 

Does everybody agree on that one? 

Mr. SCHWARCZ. Mr. Garrett, may I just quickly respond? One of 

the things about the lender of last resort is that it’s—the potential 

is out there. It could solve any problem, irrespective of its cause. 

Trying to address, I think, the cause, is almost like fighting the 

last war because the next problem will be different. 

Mr. GARRETT. Mr. Kuttner is shaking his head, ‘‘no.’’ 

Mr. KUTTNER. I really disagree, and I think if we have more hazard with the Fed bailing out the systemic effects of speculation as 

it has done with the 50-basis-point cut, I think to allow the Fed to 

buy individual securities issued by private actors would be even 

more inducing of moral hazard, and I would rather see more preventive regulation going in. 

Mr. POLLOCK. Mr. Kuttner and I certainly agree on the Fed not 

buying assets. You know, Congressman, I agree with your statement. 

Mr. GARRETT. Thank you. 

Mr. BOOKSTABER. Again, I think there may be—again, I can’t 

speak for Mr. Schwarcz completely, but I think although we hadn’t 

talked before this, we’re on the same wavelength. And there is a 

distinction between being a liquidity provider of last resort and the 

traditional role of the Fed or the IMF in being a lender of last resort. 

If essentially you see a market that’s in crisis and the reason it’s 

in crisis is because there’s huge liquidity demands, somebody is 

forced to sell. And you can walk in and say, ‘‘You need to sell those 

assets, and I’ll buy them from you, for pennies on the dollar,’’ and 

that stops the crisis from then cascading out. 

The person who caused the problem is still out of business, therefore there’s not a moral hazard problem, but you’ve done what the 

market with its particular temperament and risk aversion in times 

of crisis wouldn’t do, unless you happen to have a Citadel around 

or a Buffett around that has the deep pockets and is willing to 

walk in and do it. 

Mr. SCHWARCZ. And may I just— 

The CHAIRMAN. No, you may not. We have gone over time. 

Mr. Miller. 

Mr. MILLER OF NORTH CAROLINA. Thank you, Mr. Chairman. 

Mr. Pollock, it is good to see you again. 

In answer to Mr. Bachus’s question about whether a bankruptcy 

court should be able to modify the terms of a home mortgage you 

said—and his question was wouldn’t that make things worse, your 

short answer was yes. 

Every other form of secured debt is subject to modification and 

bankruptcy; only home mortgages are not. That went into the 

bankruptcy code in 1978. I have looked to try to find what the rationale was. Near as I can tell, it was just a sloppy compromise on 

28

the Senate side, which isn’t to say that we don’t—excuse me, in the 

other body, which isn’t to say we don’t have sloppy compromises 

also. 

But the lending industry opposed any kind of modification in 

bankruptcy. Consumer advocate supporters of the bankruptcy bill 

at that time wanted everything to be modified in bankruptcy. Can 

you explain to me the rationale, if you see one, between home mortgages and mortgages on investment properties or any other kind of 

secure debt? 

Mr. POLLOCK. Congressman, this is obviously a question that has 

been debated quite a bit, and reasonable men can disagree. 

I think the difference is that the home loan is far and away the 

biggest and the most important form of debt, and you want to give 

people the right truly to hypothecate the house if people are able 

to borrow as they are, in the mortgage system as it is, extremely 

large amounts to become homeowners. That seems to be a valuable 

right to have. 

Mr. MILLER OF NORTH CAROLINA. Why is the right different from 

that of an investment property where people also borrow substantial amounts of money? Why should a bankruptcy court—in a hearing in the Judiciary Committee a couple of weeks ago the head of 

the Financial Services Roundtable said, ‘‘You’re right.’’ 

It wasn’t me asking the question. It may have been Mr. Watt 

asking the question—said that none of those should be rewritten. 

Mr. POLLOCK. I would go that way on investment properties, 

Congressman. Indeed, as you suggest, I don’t think investment 

properties in particular should be modified. 

Mr. MILLER OF NORTH CAROLINA. You don’t think any sort of secure debt should be modified in a bankruptcy court? 

Mr. POLLOCK. In bankruptcy. However, I do think that we ought 

to have ways, as we’ve previously discussed, of refinancing mortgages where we’re in the negotiating space in which the haircut 

taken by the lender is less than the cost would be to proceed 

through foreclosure. You can create a win-win refinancing. That I 

do favor. 

Mr. MILLER OF NORTH CAROLINA. Mr. Kuttner, you were a student of history in this area. In 1934, Congress allowed for modification of mortgages on family farms. The Depression began on the 

farm before it began in the factory. 

When farm prices collapsed in the 1920’s, farmers borrowed to 

try to get through, and when farm prices did not improve they had 

no way to pay the mortgages. And Congress enacted legislation. It’s 

called the Frasier-Lenke Act of 1934 that allowed the bankruptcy 

court to limit the amount secured by a family farm to the value of 

the farm and then set an interest rate that reasonably reflected 

what the risk was of that borrower. 

Did credit collapse for farm mortgages? Did grass grow in the 

street? Well, actually, at that point grass was growing in the 

streets, but what was the result of that and do you see a rationale 

for a distinction? 

Mr. KUTTNER. Yes, I do. Of course, that wasn’t all that Congress 

did. Congress enacted the Homeowner’s Loan Act. Congress invented the modern long-term self-amortizing mortgage. Congress 

intervened in the free market in a number of ways to get mortgage 

29

markets functioning again and to prevent millions of people from 

losing their homes. And that’s what it took to get normal markets 

functioning again. 

So I think there is a role both for modification of bankruptcy law 

and for refinancings that allow folks to keep their homes. And if 

it can be a win-win situation, that’s fine. If it simply requires the 

private mortgage lender to be taken out of the picture and the Federal Government to use the Federal borrowing rate to underwrite 

some of these refinancings, that’s okay too because I think the 

mortgage lending industry, particularly the predatory part of it, deserves more than a haircut; it deserves a scalping, and we should 

act so that this doesn’t happen again anytime soon. 

Mr. MILLER OF NORTH CAROLINA. Mr. Chairman, I’m not sure I 

have the time to begin another line of questioning. 

The CHAIRMAN. Go ahead. 

Mr. MILLER OF NORTH CAROLINA. Mr. Pollock, when we last 

spoke—I guess it was last week or the week before, we talked 

about the duties or whether there should be a duty by broker or 

loan originator, a loan officer. And I told you of rate sheets that 

we had seen that showed a grid. Down one side was loan to value, 

down the other side was a credit score for the borrower, and you 

followed it across and you found the interest rate that borrower 

qualified for. And then there was a footnote, and it said for every 

point above that that the borrower paid that the loan provided for, 

if there was also a prepayment penalty that the broker would get 

an additional half-point payment from the lender, called a yield 

spread premium. 

I viewed that as a conflict of interest. Mr. Kuttner spoke of conflicts of interest as being part of the problem. You seem to be less 

offended by it and used the analogy of a used car salesman. Do you 

think a mortgage broker is simply a used car salesman? 

Mr. POLLOCK. I think a mortgage broker is a salesman, and that 

should be understood by the borrower. 

Mr. MILLER OF NORTH CAROLINA. And so the borrower was simply a chump to have believed what the broker told them? 

Mr. POLLOCK. Congressman, my view is that borrowers and ordinary people deal successfully all the time with salesmen of all varieties. But as you know, I think they need to be told the truth about 

the deal being offered. 

Mr. MILLER OF NORTH CAROLINA. There are actually other relationships. Not every relationship we have in society is a ‘‘buyer beware.’’ The law has long recognized that there are certain kinds of 

relationships where we are entitled to trust the person we’re dealing with, for instance, a lawyer. 

And usually what marks those relationships is that there is a 

disparity in knowledge and power. And one way that you create, 

you put that burden on yourself, a fiduciary, is you tell the person 

you’re dealing with, ‘‘Look, I’m on your side; this is complicated; I 

know it, you don’t know it; I’ll be on your side; I’ll do what’s best 

for you.’’ If you say that you have created a greater obligation than 

what a used car salesman has, which everyone knows is a buyerbeware relationship. 

Why is there not a greater expectation, given the disparity of 

knowledge, given the disparity in power, given what brokers hold 

30

themselves out to be, for a broker than there is for a used car 

salesman? 

Mr. POLLOCK. Congressman, I think it actually would be a very 

good idea for a set of mortgage brokers, and I think there is such 

a set, to create themselves as fiduciaries. 

There is a very interesting organization called Upfront Brokers 

organized by a friend of mine, where these brokers say to the customers exactly what you’re suggesting and pledge to act that way, 

as agents for the customer, not agents for the lender. 

I think that’s a very healthy thing to have in the market. I hope 

it expands. 

The CHAIRMAN. The gentlewoman from Illinois. 

Mrs. BIGGERT. Thank you, Mr. Chairman. Just to go back to the 

securitization, which I think is the next step in the chain here, it 

has been an important tool in providing liquidity to the mortgage 

market and has really led to an explosion, I think, for residential 

mortgage-backed securities. 

As with any investment, there is a potential to make money or 

to lose money. And I think as many of the investors are now finding out the hard way, they can lose money. 

But some have suggested that third parties such as the investors 

should be held liable for contributing to the problems in the 

subprime market. Shouldn’t the market determine who is rewarded 

and who should be punished? Isn’t that enough when the investors 

lose money on the investments? 

And I’d like to know what you see as the short- and long-term 

implications of imposing such liability. Mr. Pollock, I will start with 

you. 

Mr. POLLOCK. I don’t think we should impose liability on the investors in mortgage-backed securities for the very reasons you 

mentioned, Congresswoman. 

Clearly the market has punished a lot of people already. The 

danger point is when the flight of short term creditors happens on 

my Plank Curve shape and then it takes some kind of stabilizing 

intervention. Past that, I think the market discipline is in fact 

working right now. 

A lot of jobs are being lost. A lot of loss is being taken and companies closing, as you say. 

Mrs. BIGGERT. Thank you. Mr. Kuttner. 

Mr. KUTTNER. Well, I think this is not a case where the market 

self-corrected. This is a case where the Fed came in with a 50-

basis-point bailout that it would not have otherwise done, which 

may be having really hazardous effects on the dollar, that was necessitated by a credit crunch that could have been prevented had 

the Fed issued regulations under existing law. 

And I think the toleration of speculative underwriting standards 

based on a kind of black hole in the rating process and the assumption that someone is going to be induced to buy the paper because 

they think mistakenly that the reward justifies the risk has created 

a whole climate of moral hazard that is not worth the candle. 

So I think if you believe, and I don’t mean you personally, I 

mean if one believes that this is the market self-correcting, one has 

to first define the Federal Reserve as something other than part of 

31

the government. The market did not self-correct. That’s why the 

Fed had to make heroic interventions. 

Mrs. BIGGERT. Well, there has been a lot of criticism that the 

regulators didn’t do enough and should have acted sooner. 

Mr. KUTTNER. Yes. 

Mrs. BIGGERT. How would they know? I mean looking back it’s 

easy to say, well, we saw that the signs were there. 

Mr. KUTTNER. You know, there were all kinds of serious people 

warning that this was a disaster waiting to happen, and when Congress legislated on this in 1994 it wasn’t just to protect consumers. 

It was also a lot of concern for systemic risks. 

We had a member of the Board of Governors, recently deceased, 

playing the role of Cassandra on this, and he wasn’t listened to. So 

it’s not like Monday morning quarterbacking. There were people 

who saw this coming, and we should have acted before it happened. 

Mrs. BIGGERT. Thank you. Anyone else? Mr. Schwarcz? 

Mr. SCHWARCZ. I don’t—I think your question was whether investors should be punished in some way. 

Mrs. BIGGERT. Or be held—is there any liability? 

Mr. SCHWARCZ. Right. I think I agree with Mr. Pollock that their 

liability already is the loss of a portion of their investment, and I 

don’t see anything inherently wrong or inappropriate in what the 

investors do. 

Part of the problem of course is that our system thrives on innovation and change, and innovation and change always creates a potential for problems, and I would be very hesitant to create negative incentives. 

Mrs. BIGGERT. Do you think—and I agree with you that we really 

need the creativity and the innovation, and particularly with the 

hedge funds it really is a competitive issue for the United States. 

Do you think if we attempt to regulate and perhaps over-regulate, 

would you expect to see the hedge funds leave for Europe or other 

friendly confines? 

Mr. SCHWARCZ. I have looked at it in terms of regulating disclosure, increasing disclosure. I have indicated that because of the 

tragedy of the commons I’m not sure that more disclosure would 

really change how parties would behave vis-a-vis systemic risk because counterparties who—people who deal with hedge funds as 

counterparties already will get the information they need to make 

their investment decision. 

To the extent they find information that could create harm to 

third parties and not to them necessarily or not directly to them, 

they will ignore that information. So I’m not sure how much is to 

be gained by regulating hedge funds. 

Mrs. BIGGERT. Thank you. I yield back. 

The CHAIRMAN. The gentlewoman from New York. 

Mrs. MALONEY. Thank you, Mr. Chairman, and I thank all of the 

participants for their testimony. It is very good to see you again, 

Mr. Pollock 

Mr. Bookstaber, I was interested in your comments on the reducing leverage and market complexity in your statement at the end, 

suggesting that the regulatory system actively engage in controlling leverage. I’d like you to elaborate on that. 

32

And related to that, I am concerned about reports of major institutions that not only have exposure to direct loses in credit and 

asset-backed products but which also may have significant creditderivative exposure, meaning that they have to pay out to the investors in the event of a downgrade or of a negative event affecting 

credit. 

And the Fed acted in a way you would like them, and in 2005 

they expressed concern about a lack of transparency in this market 

due to flaws in the mechanics of processing the transactions. I 

guess that means that no one knows what anyone is owing to 

whom or what the product is really worth. 

In your view can regulators ascertain the true risk exposures 

from credit derivatives of the institutions they supervise? And what 

information would they need to do that? 

It ties into your overall theme, how do we bring in knowing 

what’s out there? There’s a sense that no one knows what the credit is, and you see that in the LIBOR rates that remain so high. 

Mr. BOOKSTABER. I think this is a central issue. 

From somebody who has been in the risk-management area, it is 

extremely troubling that some of the key data, the sort that is Risk 

Management 101 type of data, are simply not available. 

We don’t know the web of counterparties for swaps or credit default swaps, who owes what to whom. And if some entity goes 

bankrupt how will that filter out to affect others? We don’t even 

know by hedge fund type the amount of leverage hedge funds have 

and whether the leverage is going up or not. 

So again, I don’t know the issues of how this information is garnered, but certainly as a starting point you would want to know 

that. You would want to know— 

Mrs. MALONEY. But what information should we be asking for in 

order to be able to answer these questions? 

Mr. BOOKSTABER. I think in the ideal world what you would 

want to know from all the banks and investment banks, you would 

want to know what the counterparties are for all the transactions 

they are in and similarly for hedge funds. 

And for hedge funds you’d want to know the degree of leverage 

that they have and be able to look at it historically, just as a starting point. 

Mrs. MALONEY. I’d like to go back to the LIBOR rates, which is 

the global rate at which banks lend to each other. It’s remained 

very high, despite the cuts by the central banks like the Fed. 

One interpretation of this high LIBOR rate might be that while 

banks may be perfectly happy to borrow at discounted rates from 

central banks, they are reluctant to lend to each other because of 

just what you said. They don’t really know, and I would like to 

know, do you agree? Is that why that is happening, and does this 

reluctance, in your opinion, mean that banks see something disturbing in each other’s credit quality? And are the banks concerned 

that the fallout from the current credit squeeze is still not being 

fully reflected on the balance sheets of credit quality of their fellow 

banks? Why does it remain so high when all of this is happening, 

in your interpretation? 

And I invite Mr. Pollock and the others to join in. 

33

Mr. BOOKSTABER. I agree with the statements that you’re making, that the banks understand the fragility of the ratings and the 

fragility basically of the counterparty system. And that would be 

one of any number of different causes for what we’re observing 

right now in the LIBOR rate and the general disinterest in providing credit. 

Mrs. MALONEY. I’d also like to ask you, do you think that depositories and investment banks should be required to market their 

own securities and holdings as aggressively as they value the collateral against loans and credit of their customers? 

Mr. BOOKSTABER. You are hitting a lot of critical points. I think 

the mark-to-market is—there are basically different levels of markto-market, the most extreme being what some people have termed 

‘‘mark to make-believe,’’ and I think mark-to-market based on ratings is not too far behind that. 

So at a minimum, getting back to the sort of information you’d 

want, you would like to know, both for hedge funds and investment 

banks, when profits and returns are mentioned how much of it is 

realized versus unrealized, and if it’s unrealized, what is the marking convention that’s been used, and is it being applied consistently. 

Mrs. MALONEY. Mr. Pollock. 

Mr. POLLOCK. Thank you, Congresswoman. 

I mentioned in my testimony, coming back to the point on the 

LIBOR rate, that one of the characteristics of credit busts generally 

is that we get a lot of what’s effectively lending long and borrowing 

short, and the short money is typically provided by lenders who are 

highly risk averse. 

Operators who are running short-term money desks are not in 

the business of taking much risk. So when the crisis comes and no 

one is sure who is broke and who isn’t, which is the uncertainty 

and the penumbra of fear in a crisis, you see the short-term money 

pull back very fast. That’s a regularity. 

We’re seeing instances of that, as you suggest, in the LIBOR 

rate. As the losses come out and are reported, as the market sorts 

out who is broke and who isn’t, we’ll see that correct. I think that 

will correct fairly quickly. 

The CHAIRMAN. The gentleman from Illinois. 

Mr. MANZULLO. Well, thank you. I’m sorry that I missed the testimony. I’ve been trying to catch snippets back in the office, and 

I’ve been able to read through some of this right here. I guess I 

have more of a theoretical question, knowing that you gentlemen 

don’t get involved in theories, that everything is absolute and that 

you can predict with great experience how people are going to react 

in the world, but it appears that we have—every 10 years we have 

a problem like this. And I guess the first question is if we know 

we’re going to have a problem like this every 10 years, Mr. Pollock, 

why do we have to repeat it again 10 years from now, which means 

that I would need the wisdom of all four of you to let us know what 

we could do now so it doesn’t reoccur, if any of you want to try to 

answer that question. 

Mr. POLLOCK. Congressman, I’ll try, since you have called on me. 

Mr. MANZULLO. All right. Okay. 

34

Mr. POLLOCK. That is the great paradox or conundrum, that not 

only over decades, but over centuries, these patterns repeat. Every 

time we have a problem we enact reforms and do controls and then 

problems emerge yet again. The reason for that is precisely that finance is really about human behavior and human behavior is not 

predictable, as you suggest, Congressman. And it is not mechanistic. It’s organic and recursive, to use a technical term. And we’re 

always finding new ways to become very confident investors, to run 

up leverage and short-term debt and then be surprised when it 

doesn’t work out the way that the optimistic players thought. That 

seems to be a regularity of human nature when enmeshed in financial systems. 

Mr. MANZULLO. Well, Mr. Greenspan says that the housing problem is over, so maybe we could take his wisdom. Who is shaking 

their head over there? Yes, sir. Anybody want to—go ahead. 

Mr. KUTTNER. I’m not sure it’s quite accurate to say we have a 

problem every 10 years no matter what we do. I mean the regulatory schema that was invented in the 1930’s really was quite 

solid for 40 or 50 years, and that was in the era when there was 

bipartisan support for the premise that finance should be regulated 

and well-disciplined so that the real economy could flourish. 

And it wasn’t until we started dismantling some of that and not 

keeping up with the innovations that we started having the big 

time problems. And I think as we have deregulated more and not 

kept up with the innovations, the problems are occurring at a rate 

more frequent than every 10 years. 

The late 1990’s was a period of multiple problems, currency speculation, long-term capital management. We had the dot com bust. 

It’s only 7 years later and now we’re having a big problem again. 

I think that correlates with the fact that we’ve deregulated. So I 

don’t accept the premise that we should just say, ‘‘Well, this is 

going to occur every 10 years no matter what we do.’’ I do think 

even though mistakes are made, Congress does have the ability to 

head off the worst. 

Mr. POLLOCK. The regulation will change the form. We should be 

precise about the 1930’s. As far as housing finance goes, the extremely heavily regulated housing finance system created in the 

1930’s was in trouble already by the mid-1960’s and of course collapsed utterly in the 1980’s. 

Mr. KUTTNER. But 50 years as these things go, and this was a 

period where the rate of homeownership expanded from 40 percent 

on the even of World War II to 64 percent by the mid-1960’s, that’s 

a stunning, unrivaled record. If I could bet on a system that would 

last 30 or 40 years, I would take the bet. 

Mr. POLLOCK. We’ll have fun talking about the history another 

time. 

Mr. SCHWARCZ. I would respond that there’s a pattern based in 

human behavior, which I described in my testimony as alternating 

optimism and skittishness, which reflects the availability bias, the 

tendency of a recent crisis to be the most—the one that people really see. And so part of the pattern is that once the crisis fades people start getting more risk prone, and once the crisis occurs, they 

become overly risk averse and then the markets fail. 

35

It is very hard to prevent this human behavior, and one of the 

reasons why a liquidity provider of last resort is needed is that it 

can stand there and be available irrespective of what the cause of 

the problem is. 

Mr. BOOKSTABER. I would say that things are even worse than 

what you’re suggesting because I believe that the number of crises 

has accelerated over the course of the last decade or two, even at 

the same time that actual underlying economic risk, the exogenous 

risk, has reduced, which means that more and more of the crises 

that we’re seeing are really endogenous to the financial market. 

I’d also say that one of the problems that we have with financial 

crises is that they’re inherently unpredictable because what causes 

the crisis depends on who owns what, who’s under pressure and 

what else they happen to own when they are under pressure. 

So it changes, the likely candidates for market crisis change 

every time somebody changes their positions. 

The CHAIRMAN. The gentleman from Georgia, but I would ask 

the gentleman to give me just 45 seconds. I did want to comment. 

There was reference to the analogy between the mortgage broker 

and the used car salesman, which frankly baffles me. Used car 

salesmen work for used car agencies. Brokers are freelancers. The 

difference between walking into an establishment and talking to an 

employee of that establishment and hiring an independent contractor who presumably is picking and choosing certainly ought to 

be big enough to say they’re different 

Now there may or may not be other arguments that apply, but 

the notion that you should assume that the consumer thinks he’s 

in the same relationship with an employee of a business he walks 

into and an independent contractor just baffles me. That has to be 

the worst analogy I’ve ever heard. 

Mr. Pollock, did you want to respond? 

Mr. POLLOCK. I do, Mr. Chairman, thank you. 

My analogy was to salesmen in general. 

The CHAIRMAN. Okay. I thought you said used car salesman. 

Then it had nothing to do with you. 

Mr. POLLOCK. That was mentioned by the Member. 

The CHAIRMAN. Okay. Well, if you were talking about a freefloating salesman, if there was a profession of used car sales agent 

who held herself out as someone who would help you get the best 

used car anywhere, that would be different, but I have heard the 

used car analogy from other people, and I would say, yes, there is 

a difference between a sales person whom you know works for a 

particular company and someone who holds him or herself out as 

an agent to get you the best deal. 

The gentleman from Georgia. I appreciate it. 

Mr. CLEAVER. To any of you and each of you, if you could comment on this, you would say that investor protection and systemic 

risk really form the basis of the concerns that we have with hedge 

funds, is that correct? Pretty much? And with that being the case, 

I think the question has to be, is more regulation the answer. And 

how far down does the impact go? 

My specific question is, what impact, for example, would taxing 

private equity firms have on some of our smaller firms, minority 

owned, black owned firms, firms owned by women, many of whom 

36

are backed by these private equity firms? Would there be an 

undesired consequence on some of these smaller firms if we move 

with a form of taxing carried interest, for example, which is being 

bandied about? 

But I think I would like to get some thorough discussion on what 

might we do or not do? But let’s put these smaller businesses, African American owned businesses, many of these businesses who are 

in real estate who invest in lower income areas, can you give me 

some answer to the concerns that many of these smaller businesses 

have? 

That in our quest to hit these folks and put these kinds of—and 

also, if you would, kind of let us examine the impact of what we 

are doing in regulating hedge funds and specifically taxing them 

and specifically the carried interest, and what impact this has on 

African American owned businesses, minority and small owned 

businesses, many of whom are backed heavily by these private equity firms. 

Mr. Kuttner. 

Mr. KUTTNER. Well, let’s take these separately. I think with 

hedge funds, there is a regulatory problem of a lot of this being a 

kind of a black box and regulators not being able to know what the 

balance sheet risk is for the banks and the investment banks that 

are funding these folks. I think there, the remedy is one part disclosure and one part a limitation on leverage. 

I think the tax issue is a separate issue. It’s an equity question, 

is it reasonable that a billionaire, who makes his money from socalled carried interest, which simply means that his income is 

treated as capital gains, even though the man on the street would 

view it as ordinary income, is it reasonable that that person should 

pay income tax at a lower rate than the janitor who cleans out his 

office? 

Now, on the question of whether this hurts small businesses, my 

study of this field suggests to me that there are a couple of different kinds of animals here, both parading under the name of private equity. You have the kind of firm that does provide equity 

sometimes to small businesses, and that’s a very valued player in 

our financial system. 

You have other players who also call themselves private equity, 

who are mainly borrowing money to buy and sell assets and extract 

as much fee income and as much asset income as they can. 

I think those very short term round trips should be heavily 

taxed. I think someone who is mainly in the business of extracting 

wealth should be treated as different from someone who is investing long and benefitting the community. And it’s always the case 

that the small business person, the minority businessman, the lowincome homeowner is used as the poster child for practices that 

may be unsavory, and I think we really need to distinguish different kinds of financial players who merit different treatment. 

Mr. CLEAVER. I want to just get—and Mr. Schwarcz, we’ll get to 

you, but I want to make sure in my time that I really get on the 

record a good response to this. 

I want to just share something which was brought to my attention in my office but also from Financial Week, which says that a 

coalition of minority and women businesses have come out against 

37

efforts to tax private equity. The Access to Capital Coalition comprises a number of private equity and real estate firms, including 

smaller firms which focus on investing in low- and moderate-income areas. 

And as one who is very interested in building wealth in the minority communities, can you give me a response? Is this something 

they should not be concerned about? Or is this a legitimate concern 

that this group has that we should be concerned about? 

Yes, sir, Mr. Pollock? 

Mr. POLLOCK. Congressman, my view, and here perhaps Mr. 

Kuttner and I agree, is that carried interest is, in fact, a bonus and 

it ought to be taxed the way other bonuses are taxed. 

Mr. CLEAVER. Excuse me, you said what should be taxed? 

Mr. POLLOCK. Carried interest is, in fact, a management bonus. 

Mr. CLEAVER. Could you tell us exactly what that is? 

Mr. POLLOCK. It means that in exchange for the performance of 

your managerial responsibilities, as measured by some criteria you 

are given by your employer a payment. So I think it should be 

taxed the same way managers’ bonuses are taxed. And I don’t 

think you really have to worry at all about the impact on smaller 

businesses and so on. I don’t think there will be any. 

Mr. CLEAVER. So the worry is unfounded? 

Mr. POLLOCK. That is my belief, yes, sir. 

Mr. BOOKSTABER. One way to think of it is that my incentive is 

still to maximize return. If somebody is paying me 20 percent of 

the return versus 10 percent of the return that I can get through 

the funds, the private equity fund or the hedge fund, I am still 

going to do the same thing. It is just that I won’t make as much 

money. 

So the effect, really, of the carried interest incurred as ordinary 

income is that now my bonus is taxed so effectively I am only getting 10 percent, say, rather than 20 percent of the return that I 

generate for the fund. 

Mr. CLEAVER. So everyone here supports the tax on carried interest? 

Mr. SCHWARCZ. Well, I would say that I have not studied that 

issue sufficiently to come to a view. And the issue is consequences. 

Any regulation can have potential undesired consequences. 

Part of this also goes to the issue of reducing leverage. I think 

that was implicit in your question. Let me simply say that I have 

looked at the issue of reducing leverage, and it is a very complex 

issue. I would urge that if there is any consideration given to reducing leverage by regulation that it be carefully studied, because 

I think it could be a very expensive and potentially negative proposition, which could limit, you know, economic ingenuity and innovation. 

Mr. CLEAVER. In conclusion, my final point, gentlemen, is do you 

believe that our financial system now has become overly dependent 

on hedge funds? 

Mr. SCHWARCZ. Hedge funds, of course, have a bad rap. Perhaps 

some of it is deserved. But they do have the potential to spread 

risk, and I think they have been spreading the risk, reducing the 

risk to any given player, and that actually reduces systemic risk. 

38

Mr. KUTTNER. I disagree. I think hedge funds increase systemic 

risk to a far greater degree than is often recognized. The bets are 

often in the same direction and I think further disclosure would not 

be a bad thing. 

Britain is not known as a nation that is hostile to hedge funds, 

but the largest hedge funds in Britain are required to make disclosures to their regulatory authority that our hedge funds are not. 

And the economy got along very, very well in the boom years of 

the last century without hedge funds. 

Mr. CLEAVER. Thank you. I understand my time is up. 

Thank you, Mr. Chairman. 

The CHAIRMAN. The gentlewoman from Wisconsin. 

Ms. BEAN. Thank you, Mr. Chairman, and I thank the distinguished panel for coming here. I have been very fascinated by your 

testimony, and very confused. But thank you for trying to present 

in sort of layman’s terms that some of us can really understand. 

Your engineering analogies and certainly your cockroaches have 

been very, very informative. 

And what I am hearing really is a wide range, and I just want 

to get some clarity here. You know, we hear everything from Mr. 

Pollock, you know, where trying to re-regulate or trying to regulate 

too much, you know, it is not possible, as you say, to design society. 

And no matter what regulatory system we may implement, we are 

not going to avoid these financial booms and busts. 

And I hear from another of our speakers, from Mr. Kuttner, that 

perhaps the lack of transparency and the excesses of leverage and 

conflicts of interest, things that would in fact speak to our re-regulating, as it creates these moral hazards that we need to do. 

And then in between, I am listening to folks like Mr. Bookstaber, 

who gave us the engineering and cockroach—gave me the creeps 

analysis, that I am confused when you say, sort of in between, I 

get more mixed up when you say that regulation may add to the 

complexity of this and we may have unintended consequences. 

And then when we talk about the lender of last resort, we talk 

about some sort of shell game where you have these funds but, you 

know, it is put together in a constructive ambiguity where people 

don’t know whether you are going to bail them out or not. And so 

my question is, after reiterating all of your testimony, my question 

really is, do you think that it is really possible to mix some of these 

things that you have said and not over-regulate to the point that 

we harm our ability to be competitive and put good products together, but do some common sense kinds of things? 

You know, this notion that we have some idea of what is going 

to happen, that we have stuff that is so highly leveraged that I 

think you might all agree that investors don’t necessarily care 

about the systematic impact that they are making; they only care 

about whether they are right up to the margin and whether they 

are going to get the highest return possible. Would it be possible 

to price this risk and make them pay premiums into this fund of 

last resort? 

I heard you, Mr. Pollock, say that only people who could print 

money could be the lender of last resort. But would it be possible, 

number one, to make people who want to be high rollers pay a 

huge premium for these risks, as one thing to do? Disclosure is not 

39

enough, but what is wrong with some disclosure? Is it possible to 

put a package together that sort of meets all of the essentials? And 

certainly ends some of the conflicts of interest like—like the waiting agency being paid by the investors? 

Mr. POLLOCK. Shall we just go in— 

Ms. BEAN. Yes, go for it. 

Mr. BOOKSTABER. I don’t know the complexities of enacting regulation. But it seems to me that of the various proposals that were 

put forward, and I think some of my colleagues would share, the 

one that seems almost immediate to me is trying to get more data. 

I think we truly do face substantial risk of a crisis through credit 

default swaps and through the interweaved counter-parties. And 

we don’t know who is who. 

I think we have seen what would happen with the quantitative 

funds in August. We don’t know how levered people are, and therefore how susceptible they are to crisis. So if I were going to start 

from the top and go down the list, the one that I would think is 

the easiest to start with is identify and try to get the critical data. 

Ms. BEAN. Okay, Mr. Schwarcz? 

Mr. SCHWARCZ. I think your suggestion is a good one. And on 

page 6 of my photocopied testimony, I say that any shifting of costs 

to taxpayers could be controlled. Rather than using taxation to establish a pool of funds from which a lender of last resort can make 

advances or investments, the pool can be funded, for example, by 

charging premiums to market participants, not unlike insurance. I 

assume deposit insurance, for example, is financed this way. So I 

agree with you. 

Ms. BEAN. All Right, thank you. Mr. Kuttner. 

Mr. KUTTNER. Yes. I think we should certainly start with a great 

deal more required disclosure, so that we can find out just how serious these problems are. So the extent that some of this information is proprietary and competitive, it could be disclosed to the SEC 

or the Federal Reserve. 

But I think at the end of the day, we are going to have to act 

to make certain practices illegal because the benefit doesn’t outweigh the risk. 

Ms. BEAN. Okay, Mr. Pollock, last but not least. 

Mr. POLLOCK. Okay, thank you Congresswoman. First of all, let 

me say, if I may, I really enjoyed your summary of our various positions. The essential framework, we are talking about today the 

relationship between systemic risk and regulation, is a long-debated question. 

In my testimony, I did suggest several things which could be 

done, including promotion of investor paid rating agencies, one of 

the things you mentioned. And, of course, as you know, on the simplest and post commonsensical level, I have suggested a much better disclosure for the consumer, which I hope you have seen and 

like. 

The CHAIRMAN. The gentleman from Illinois has a supplemental 

question, then I will have one comment, and we will be out of here. 

Mr. MANZULLO. Thank you. My question dealt with the Pollock 

two-page disclosure. 

I practiced law from 1970 until I was sworn in as a Member of 

Congress in January of 1993, and I closed probably 1,500 real esVerDate 0ct 09 2002 16:41 Jan 10, 2008 Jkt 039903 PO 00000 Frm 00043 Fmt 6633 Sfmt 6633 K:\DOCS\39903.TXT HFIN PsN: TERRIE
40

tate transactions. And we could close them in a relatively short period of time, then along came RESPA in 1975 or 1976. Of course, 

out in the country, it took 3 years for news to get there, and the 

real estate transaction should have closed 3 days before we were 

meeting so people would have the opportunity to shop. 

And now you go to a real estate closing and it has to be a stack 

this thick. People have no idea what is going on. They go through— 

The CHAIRMAN. This is a supplemental question. 

Mr. MANZULLO. Absolutely. My question is, Mr. Pollock, you have 

a two-page disclosure, and I think the Washington Post commended you on that. Will that make that much of a difference? 

Will people read it? Will they understand it? 

Mr. POLLOCK. I think they will. We have done a good bit of discussions and trying this out on people. It is the only thing that 

really speaks to the consumer’s problem, that problem itself, what 

does this mean for me? So I think it will. Not for everybody, but 

for a very large number of people, Congressman. 

Mr. MANZULLO. Chairman, with your permission, could I have included as part of the record the two-page disclosure? 

The CHAIRMAN. Certainly. 

Mr. MANZULLO. Thank you. 

The CHAIRMAN. It has been in before, but we will append it to 

that question. I just want to make two quick comments. 

One, I noticed, Mr. Pollock, you talked about the housing every 

10 years or so. We are 19 years into your 10-year cycle, I just 

would note. And people might say, well, that is because the Republicans were in power. Well, they were during one of those cycles, 

at least in part, in 1983, and ascended to the presidency. But no 

one that I know of has proposed one of those housing bills. 

We have talked about some of us getting back into the affordable 

housing business. But there has been no emergency housing bill of 

that sort proposed for 19 years and none pending even now. 

Mr. POLLOCK. Thank you, Mr. Chairman, for your detailed attention to my comments. It was 10 years on average over time. 

The CHAIRMAN. If you look back, it was 1983, 1988, there were 

less than 10 years, there were four between 1970 and 1988. And 

we have gone 19 years. One thing, if we do run into it, and we have 

made things different, we still think we need to improve the supply 

on a general basis. 

The other thing I would say is this with regard to you pass these 

things and they don’t make any difference, sometimes they do. In 

1988 and 1989, we had the terrible crisis, 1987, 1989, in the S&L. 

We passed legislation that included bailing out the depositors, not 

on the whole but the stockholders or the bond holders. We did 

make good our promise to depositors. 

And since that time, that bill was passed, I think, in 1989, we 

have not had a serious problem with the S&Ls. And not only that, 

we were worried about a potential domino effect in the commercial 

banks and we passed FIDICIA, I believe was the name of it, in 

1990, and we had in the period since then great success, and there 

has in fact been a far lower incidence of bank failures since then. 

So that package of legislation, and Chairman Gonzales was presiding at the time in cooperation with the Treasury Department, 

which was then under Republicans, so the notion that it never 

41

works when you have these things and you try, I would point to 

the S&L and commercial bank twin bills of the late 1980’s and 

early 1990’s as a very successful response. And the record since 

then has really been very good. 

Mr. POLLOCK. Mr. Chairman, I would never wish to be understood as saying that legislation never makes a difference. Of course 

it can make a difference— 

The CHAIRMAN. That would be the thrust I would take from your 

testimony— 

Mr. POLLOCK. But the point I was trying to make is the busts 

and the systemic risks come along anyway. They tend to come— 

The CHAIRMAN. Well, they did not in the banking area— 

Mr. POLLOCK. Oh, no, I understand. But in the market in general, they tend to come from different directions. 

The CHAIRMAN. I will re-read your testimony, but I would say the 

thrust of it predating your refinement of it right now would suggest 

that it was a futile operation. I think it was unduly pessimistic 

paced on the record, to be honest. 

The gentlewoman from Wisconsin had something to say? 

Ms. BEAN. Thank you so much, Mr. Chairman. 

I forgot which one it was in your testimony that I read that 

talked about the risks and costs of systemic failure as it filters 

down to people, loss of jobs and so on. I know that my sister 

worked for TWA and folks committed suicide and so on when they 

lost jobs. Is there a way to price this kind of risk? That’s my question. 

Mr. SCHWARCZ. I have certainly spoken to that issue in my testimony and in the paper. In the paper itself, I attempt to do some 

calculations which attempt to price that. But I admit very much it’s 

highly speculative and I conclude that I am—I simply look at it 

and say, if one looks at this, one could come to certain views. It 

is a way of thinking about it. But I couldn’t find a clear way of pricing it. 

The CHAIRMAN. I thank the panel. It has been very useful. And 

luckily, a lot of members left. It seems like the fewer members we 

have, the better, sometimes, the conversation. 

I am reminded of Washington Irving and the Knickerbocker history when he said, the ship sailed around the bend and crashed 

and we will never know what happened because there were too 

many survivors. 

As we have fewer people, we can sometimes focus better. Thank 

you. 

[Whereupon, at 12:26 p.m., the hearing was adjourned.] 

(43)

A P P E N D I X

October 2, 2007

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