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55–899 2010

S. HRG. 111–466 

UNREGULATED MARKETS: HOW REGULATORY 

REFORM WILL SHINE A LIGHT 

IN THE FINANCIAL SECTOR 

HEARING 

BEFORE THE

JOINT ECONOMIC COMMITTEE 

CONGRESS OF THE UNITED STATES 

ONE HUNDRED ELEVENTH CONGRESS 

FIRST SESSION 

DECEMBER 2, 2009 

Printed for the use of the Joint Economic Committee 

( 

(II) 

JOINT ECONOMIC COMMITTEE 

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

HOUSE OF REPRESENTATIVES 

CAROLYN B. MALONEY, New York, Chair 

MAURICE D. HINCHEY, New York 

BARON P. HILL, Indiana 

LORETTA SANCHEZ, California 

ELIJAH E. CUMMINGS, Maryland 

VIC SNYDER, Arkansas 

KEVIN BRADY, Texas 

RON PAUL, Texas 

MICHAEL C. BURGESS, M.D., Texas 

JOHN CAMPBELL, California 

SENATE 

CHARLES E. SCHUMER, New York, Vice 

Chairman 

JEFF BINGAMAN, New Mexico 

AMY KLOBUCHAR, Minnesota 

ROBERT P. CASEY, JR., Pennsylvania 

JIM WEBB, Virginia 

MARK R. WARNER, Virginia 

SAM BROWNBACK, Kansas, Ranking Minority 

JIM DEMINT, South Carolina 

JAMES E. RISCH, Idaho 

ROBERT F. BENNETT, Utah 

GAIL COHEN, Acting Executive Director 

JEFF SCHLAGENHAUF, Minority Staff Director 

(III) 

C O N T E N T S 

MEMBERS

Hon. Carolyn B. Maloney, Chair, a U.S. Representative from New York .......... 1 

Hon. Kevin Brady, a U.S. Representative from Texas ......................................... 3 

Hon. Maurice Hinchey, a U.S. Representative from New York ........................... 4 

WITNESSES

Statement of Brooksley Born, Former Chair, Commodity Futures Trading 

Commission, Washington, DC ............................................................................. 6 

Statement of Robert Litan, Senior Fellow in Economic Studies, Brookings 

Institution, Vice President of Research and Policy, Ewing Marion Kauffman 

Foundation, and Member of The Pew Task Force on Financial Reform, 

Washington, DC ................................................................................................... 7 

Statement of James Carr, Chief Operating Officer, National Community Reinvestment Coalition, Washington, DC ................................................................. 9 

Statement of Robert K. Steel, Former Under Secretary for Domestic Finance 

of the United States Treasury, Chairman of the Board, Aspen Institute, 

and Member of The Pew Task Force on Financial Reform, Washington, 

DC .......................................................................................................................... 11

SUBMISSIONS FOR THE RECORD

Prepared statement of Representative Carolyn B. Maloney ................................ 34 

Prepared statement of Brooksley Born .................................................................. 34 

Prepared statement of Robert Litan ...................................................................... 37 

Prepared statement of James Carr ........................................................................ 44 

Prepared statement of Robert K. Steel .................................................................. 67 

Letter from Representative Maloney to Robert Litan .......................................... 71 

Letter from Representative Maloney to Robert Steel ........................................... 72 

Letter from Senator Klobuchar to Brooksley Born, Robert Litan, James Carr, 

and Robert Steel ................................................................................................... 73 

Responses from Brooksley Born to Senator Klobuchar ........................................ 75 

Responses from Robert Litan to Senator Klobuchar ............................................ 78 

(1) 

UNREGULATED MARKETS: HOW REGULATORY 

REFORM WILL SHINE A LIGHT 

IN THE FINANCIAL SECTOR 

WEDNESDAY, DECEMBER 2, 2009 

CONGRESS OF THE UNITED STATES, 

JOINT ECONOMIC COMMITTEE, 

Washington, DC. 

The committee met, pursuant to call, at 10:38 a.m., in Room 210, 

Cannon House Office Building, The Honorable Carolyn B. Maloney 

(Chair) presiding. 

Representatives present: Maloney, Hinchey, Cummings, Snyder, Brady, and Burgess. 

Senators present: Brownback. 

Staff present: Paul Chen, Gail Cohen, Colleen Healy, Michael 

Neal, Annabelle Tamerjan, Andrew Wilson, Rachel Greszler, Jeff 

Schlagenhauf, Ted Boll, and Robert O’Quinn. 

OPENING STATEMENT OF THE HONORABLE CAROLYN B. 

MALONEY, CHAIR, A U.S. REPRESENTATIVE FROM NEW YORK 

Chair Maloney. I would like to call the meeting to order and 

thank all the participants for coming. 

I want to, first of all, welcome our distinguished panel of witnesses today as we discuss proposals to regulate the over-thecounter derivatives market and underregulated credit markets. The 

financial crisis and the recession were triggered in part by the collapse in the price of homes and the resulting defaults in the mortgages used to purchase them. 

In the absence of regulation, financial institutions aggressively 

purchased over-the-counter derivatives, such as mortgage-backed 

securities, with the expectation that they would generate high returns with minimal risk. To hedge against any risk, they also purchased unregulated credit default swaps that would pay them if the 

mortgage underlying the derivatives defaulted. This created an illusion that the assets were risk-free and a tangled web of counterparties. At its peak this unregulated market was tied to $680 trillion in assets, an astonishing amount equal to 50 times U.S. GDP, 

putting the stability of the U.S. and the world economy at risk. 

This crisis did not have to happen. Many years earlier one of our 

distinguished witnesses, Brooksley Born, then Chair of the CFTC, 

had the foresight to recognize the dangers of unchecked growth, 

lack of transparency, and overleveraging in the over-the-counter 

derivatives. Some have called her ‘‘The Woman Who Knew.’’ However, she was ignored by a chorus of critics who hailed over-theVerDate Nov 24 2008 12:13 Jun 08, 2010 Jkt 054937 PO 00000 Frm 00005 Fmt 6633 Sfmt 6633 C:\DOCS\55899.TXT SHAUN PsN: DPROCT
2 

counter derivatives as the greatest financial innovation of the decade because they would spread risk efficiently among market participants. 

With the economy booming, regulatory attempts were voted 

down. I know this from personal experience, having introduced two 

amendments that would have taken steps to regulate this market; 

they were roundly and strongly defeated, both of them. Siding with 

her critics, Congress passed the Commodity Futures Modernization 

Act of 2000, which literally prevented the CFTC from regulating 

over-the-counter derivatives. This was a mistake, and we are acknowledging it now. 

Next week on the floor of the House, we will be voting on a regulatory reform bill that will regulate over-the-counter derivatives to 

bring transparency to these complex financial products and expand 

the authority of the CFTC and the SEC to regulate counterparties 

in derivative transactions. 

Many have argued that derivative contracts were the prime reason AIG needed to be bailed out with taxpayer funds because the 

quantity and value of the contracts were never disclosed, so that 

the impact of breaking these contracts via possible bankruptcy was 

unknowable. 

I have confidence that this bill will pass next week. It should 

have passed years earlier when Mrs. Born pointed out the real 

challenge and danger of not regulating these derivatives. The 

House Financial Services Committee and the House Agriculture 

Committee are meeting this week to merge their two versions of 

the bill that will finally regulate over-the-counter derivatives and 

bring the dark market into the light. The merged bill will promote 

transparency by requiring that these previously unregulated derivatives be traded on exchanges or clearinghouses. Capital and 

margin requirements will be established so that financial institutions can no longer make risky bets. And information about prices 

and trading values and volumes will be publicized so that market 

participants will no longer be uncertain of the value of their securities. Although these bills exempt some derivatives from regulation, 

the exemptions are an attempt to balance concerns of some businesses that need customized derivatives and the potential risk to 

the financial system. 

The House Financial Services Committee has also passed a bill 

establishing the Consumer Financial Protection Agency to shield 

consumers from deceptive financial practices. 

Although our economic recovery is far from complete, the economy is moving back on track, helped along by the Recovery Act. 

Third quarter GDP grew 2.8 percent after contracting for four consecutive quarters, financial markets have recovered substantially, 

and interbank lending is back to its precrisis level. 

Now is the time to act to pass these reforms. The financial crisis 

has made clear the need for common-sense regulation of the financial services industry to ensure stability, safety and soundness of 

the system. 

I want to thank the witnesses for coming, and I look forward to 

hearing their testimony. And I do also want to acknowledge Mr. 

Steel, with whom I had the privilege of working with on many important initiatives for our government. Welcome to all of you. 

3 

[The prepared statement of Representative Maloney appears in 

the Submissions for the Record on page 34.] 

Chair Maloney. The Chair recognizes Mr. Brady for 5 minutes. 

OPENING STATEMENT OF THE HONORABLE KEVIN BRADY, A 

U.S. REPRESENTATIVE FROM TEXAS 

Representative Brady. Thank you, Madam Chairwoman. 

Thank you for hosting this important hearing. Just preparing for 

it and reading the testimony was informative in and of itself, so I 

am pleased to join you in welcoming today’s witnesses. 

Many policy mistakes contributed to the global financial crisis 

that began on August 9, 2007, and triggered a recession 4 months 

later. These include the Federal Reserve’s overly accommodative 

monetary policy from 2002 to 2006; international imbalances arising largely from China’s exchange rate policy since 1998; President 

Clinton’s initiative to increase homeownership among low-income 

families by reducing down payment requirements and interest 

costs by making terms more flexible, increasing the availability of 

alternative financing products without sufficient consideration of 

the ability of low-income families to meet their nontraditional 

mortgage obligations, as well as the continuation of this policy by 

President George W. Bush; abuse of the Community Reinvestment 

Act through the filing of frivolous objections to bank acquisitions 

and mergers by ACORN-affiliated groups to extort banks into making a large number of risky subprime residential mortgage loans to 

low-income families; and finally, inadequate supervision of the alternative financial system based on loan securitization and highly 

leveraged nondepository financial institutions, especially Fannie 

Mae and Freddie Mac. 

Banks perform the economically valuable, but inherently risky 

functions of intermediation and liquidity transformation by accepting deposits payable on demand and making term loans to families 

and small businesses that can’t issue commercial paper and corporate bonds. Due to the nature of their activities, banks are subject to runs. Runs often become contagious and may trigger financial panics. 

To minimize the risk of financial contagion, while retaining the 

enormous economic benefits from intermediation and liquidity 

transformation, Congress mandated supervision, created the Federal Reserve in 1913 to serve as the lender of last resort, and established Federal deposit insurance in 1933. 

By the fall of 2007, the alternative financial system, which you 

referenced, composed of Fannie Mae, Freddie Mac, independent investment banks, finance companies, hedge funds and off-balancesheet entities, had assets totaling $12.7 trillion and was essentially 

performing intermediation and liquidity transformation functions 

similar to banks without any of the safeguards that Congress had 

established for banks. 

Since the financial crisis began, a number of major banks and 

other financial institutions have failed, were acquired at fire sale 

prices, were placed into conservatorships, or needed massive Federal assistance to survive. These include AIG, Bank of America, 

Bear Stearns, Citigroup, Fannie Mae, Freddie Mac, Lehman Brothers and Merrill Lynch. 

4 

And what are the common threads to these failures or quasi failures? First, these institutions made bad investment decisions. Second, these institutions were overly dependent on short-term liabilities outside of insured deposits to fund their investments; consequently, these institutions suffered liquidity crises when their 

creditors became aware of the magnitude of the investment losses. 

These liquidity crises were essentially the modern version of bank 

runs in which computer clicks replaced queues of depositors withdrawing their money. However, the underwriting of corporate securities and municipal revenue bonds, which Glass-Steagall had prohibited commercial banks to do, was not a significant factor in the 

failures or near failures. 

So for the witnesses today, you have raised so many great points 

in testimony. I will have a number of questions for the panel, such 

as, what changes should be made to the risk-based capital standards for banks? Should Congress require all U.S. banks to adopt a 

system of dynamic provisioning for loss reserves that proved so successful in maintaining the solvency of Spanish banks during the financial crisis? Should liquidity standards be established for banks 

and other highly leveraged financial institutions? Should all banks 

and other highly leveraged financial institutions be subject to simple limits on leverage in addition to any risk-based capital standard? Should Fannie and Freddie be restructured and fully 

privatized? Shouldn’t any housing subsidy functions that Fannie 

and Freddie now perform be transferred to the Federal Housing 

Administration and be placed transparently on the Federal budget? 

Should highly leveraged, nondepository financial institutions have 

access to the Federal Reserve’s discount window; and if so, under 

what circumstances? And finally, how should financial derivatives 

be regulated? Are credit default swaps uniquely risky, and do they 

need to be regulated differently than other financial derivatives? 

Members of the panel, I look forward to hearing from your testimony today. 

Thank you, Madam Chairman. 

Chair Maloney. Mr. Hinchey. 

OPENING STATEMENT OF THE HONORABLE MAURICE D. 

HINCHEY, A U.S. REPRESENTATIVE FROM NEW YORK 

Representative Hinchey. Thank you very much, Madam 

Chairman. And thank you very much, all four of you, gentlemen 

and ladies, for being here with us. I very much appreciate the opportunity to listen to the things that you are going to say. I am not 

going to take up very much time here, but I just want to express 

that appreciation for you. 

As we all know, this country is dealing with one of the most difficult and damaging economic circumstances that it has experienced over the course of our history. It is the worst set of circumstances that we have experienced since 1929. The unemployment rate itself in this country is now up above 10 percent, and 

that is just the official unemployment rate. There are a lot more 

people who would love to have jobs but can’t get them because of 

the economic conditions that we are dealing with. And a lot of that 

has to do with the sharp decline in the economy which had to do, 

in large measure, with the manipulation of commercial and investVerDate Nov 24 2008 12:13 Jun 08, 2010 Jkt 054937 PO 00000 Frm 00008 Fmt 6633 Sfmt 6633 C:\DOCS\55899.TXT SHAUN PsN: DPROCT
5 

ment banking and the elimination by the past Congress to prevent 

that combination, that manipulation to take place. 

So these are some of the things that we are dealing with, including a number of other things in regard to the way in which investment operations are engaged in, including the effect it has had on 

the price of oil and gasoline. And so the price that people have to 

pay for the necessities that they are required to have in the context 

of growing unemployment makes this situation much more difficult 

and damaging and even dangerous to address. But it needs to be 

addressed, and it needs to be addressed very, very effectively. 

So all of the things that you are going to have to say I am sure 

are going to be very important to our ability to engage this situation in a much more effective way. So I thank you all very much 

for being here, and I am anxious to hear what you have to say. 

Chair Maloney. Thank you so very much. 

I, too, would like to welcome all the witnesses and to introduce 

the panel. 

Brooksley Born practiced law for many years in Washington and 

was a partner in the firm of Arnold & Porter. From 1996 to 1999, 

she was Chair of the U.S. Commodity Futures Trading Commission 

(CFTC), the Federal Government agency that oversees the futures 

and commodity option markets and futures professionals. While at 

the CFTC, Ms. Born served as a member of the President’s Working Group on Financial Markets. 

Ms. Born is a 2009 recipient of the John F. Kennedy Library 

Foundation’s Profile in Courage Award presented annually to public servants who have made courageous decisions of conscience 

without regard for the personal or professional consequences. She 

received the award in recognition of her efforts as Chair of the 

CFTC to urge that the over-the-counter derivatives market should 

be subject to Federal oversight and regulation. The failure to regulate that market is now seen to be a major cause of the recent financial crisis. 

Among other awards, she was recognized as a champion in the 

Legal Times’ list of the 90 greatest Washington lawyers of the last 

30 years. In 2008, she was the recipient of the American Lawyer 

Lifetime Achievement Award for her career-long leadership in private practice and public service. 

She is a graduate of Stanford University and Stanford Law 

School, where she was president of the Stanford Law Review and 

received the Outstanding Senior Award. 

Robert Litan is a senior fellow in economic studies at the Brookings Institution, where he was previously vice president and director of economic studies. He is also the vice president for research 

and policy at the Kauffman Foundation in Kansas City, where he 

oversees the foundation’s extensive program for funding data collection and research relating to economic growth. 

He previously served as the Associate Director of the Office of 

Management and Budget, and Deputy Assistant Attorney General. 

From 1977 to 1979, he was the regulatory and legal staff specialist 

at the President’s Council of Economic Advisors. He holds a B.S. 

in finance from Wharton. He also has a law degree from Yale, and 

a Ph.D. in economics from Yale University. 

6 

James Carr is chief operating officer for the National Community 

Reinvestment Coalition, an association of 600 local development organizations across the Nation dedicated to improving the flow of 

capital to communities and promoting economic mobility. He is also 

a visiting professor at Columbia University in the great city of New 

York. And prior to his appointment to NCRC, he was senior vice 

president for financial innovation, planning and research for the 

Fannie Mae Foundation. He has also held positions as Assistant 

Director for Tax Policy with the U.S. Senate Budget Committee. He 

holds a degree in architecture from Hampton University, a master’s 

of planning degree from Columbia, and a master’s of city and regional planning from the University of Pennsylvania. 

Robert Steel is a former president and CEO of Wachovia. He 

served as Under Secretary of the Treasury for Domestic Finance 

from 2006 to 2008. Previously he spent almost 30 years at Goldman Sachs, founding the firm’s Equity Capital Markets Group. He 

is currently chairman of the board of the Aspen Institute. He 

served on the board of Barclay’s Bank and currently serves on the 

board of Wells Fargo. He is also a past chairman of the Duke University board of trustees. He holds a degree from Duke University 

and an M.B.A. from the University of Chicago. 

I want to thank all of you for coming. I will first recognize Ms. 

Born, and then go down the line. You are recognized for as much 

time as you may consume. 

STATEMENT OF BROOKSLEY BORN, FORMER CHAIR, COMMODITY FUTURES TRADING COMMISSION, WASHINGTON, DC 

Ms. Born. Thank you very much. 

Madam Chairman and members of the committee, thank you 

very much for inviting me to appear before you to discuss over-thecounter derivatives. 

We have experienced the most significant financial crisis since 

the Great Depression, and regulatory gaps, including the failure to 

regulate over-the-counter derivatives, have played an important 

role in the crisis. 

As a result of pressures from a number of the country’s largest 

financial institutions, Congress passed a statute in 2000 that eliminated virtually all government regulation of the over-the-counter 

derivatives market. It was called the Commodity Futures Modernization Act of 2000. Because of that statute, no Federal or State 

regulator currently has oversight responsibilities or regulatory 

powers over this market. 

The market is totally opaque and is often referred to as ‘‘the dark 

market.’’ It is enormous. In June of this year, the reported size of 

the market exceeded $680 trillion in notional value. 

While over-the-counter derivatives have been justified as vehicles 

to manage financial risk, they have, in practice, spread and multiplied risk throughout the economy and caused great financial 

harm. Lack of transparency and price discovery, excessive leverage, 

rampant speculation, lack of adequate capital and prudential controls, and a web of interconnections among counterparties have 

made the market extremely dangerous. Warren Buffett has appropriately dubbed over-the-counter derivatives as ‘‘financial weapons 

of mass destruction.’’ They include the credit default swaps disasVerDate Nov 24 2008 12:13 Jun 08, 2010 Jkt 054937 PO 00000 Frm 00010 Fmt 6633 Sfmt 6633 C:\DOCS\55899.TXT SHAUN PsN: DPROCT
7 

trously sold by AIG and many of the toxic assets held by our biggest banks. It is critically important for Congress to act swiftly to 

impose the rules necessary to close this regulatory gap and to protect the American public. 

The Commodity Futures Trading Commission and the Securities 

and Exchange Commission should be granted primary regulatory 

responsibilities for derivatives trading, both on and off exchange. 

All standardized and standardizable derivatives contracts should 

be traded on regulated derivatives exchanges and cleared through 

regulated clearinghouses. These requirements would allow effective 

regulatory oversight and enforcement efforts. They would ensure 

price discovery, openness and transparency; reduce leverage and 

speculation; and limit counterparty risk. 

If any trading in the over-the-counter derivatives is permitted to 

continue, such trading should be limited to truly customized contracts between highly sophisticated parties, at least one of which 

requires such a customized contract in order to hedge its actual 

business risk. 

Furthermore, any continuing over-the-counter derivatives market 

should be subject to a robust Federal regulatory regime requiring 

transparency. There should be registration, recordkeeping and reporting requirements for all over-the-counter derivatives dealers, 

and they should be subject to business conduct standards. All overthe-counter trades should be subject to margin requirements, and 

all large market participants should be subject to capital requirements. Transaction prices and volumes of over-the-counter derivatives should be publicly reported on an aggregated and timely 

basis. And the market should be subject to effective prohibitions 

against fraud, manipulation, and other abusive practices. 

These measures would go far toward bringing this enormous and 

dangerous market under control. They should be adopted and implemented if we hope to avoid future financial crises caused by this 

market. The country cannot afford to delay or weaken our response 

to the crisis. If we as a people do not learn from our experiences 

and respond appropriately, we will be doomed to repeat them. 

Thank you very much. 

[The prepared statement of Brooksley Born appears in the Submissions for the Record on page 34.] 

Chair Maloney. Thank you very much. 

Dr. Litan. 

STATEMENT OF ROBERT LITAN, SENIOR FELLOW IN ECONOMIC STUDIES, BROOKINGS INSTITUTION, VICE PRESIDENT OF RESEARCH AND POLICY, EWING MARION 

KAUFFMAN FOUNDATION, AND MEMBER OF THE PEW TASK 

FORCE ON FINANCIAL REFORM, WASHINGTON, DC 

Mr. Litan. Thank you, Chair Maloney and members of the committee, for inviting me to testify today. I will hit the highlights of 

my prepared testimony and the material that accompanies it. 

I am here primarily to present the financial reform recommendations of the bipartisan Pew Financial Task Force of which I have 

had the privilege to be a member. 

It has now been more than a year since the near meltdown of 

the financial system. Since then, the Congress has worked hard to 

8 

develop a comprehensive legislative package to which you, Chair 

Maloney, just referred, aimed at preventing a repeat of these sorry 

events. 

The need for reform could not be greater, and on this I agree 

with Brooksley. Fixing the financial system is critical to restoring 

faith in our financial institutions and markets, as well as to 

strengthening our lending institutions to the point where they can 

feel comfortable again lending to businesses and consumers. 

You will find many common elements between our recommendations and the specifics in the bills that have come out of the House 

Financial Services Committee and that are now being considered in 

the Senate Banking Committee. Our task force members came into 

the process with very different views, much like the differences you 

see in Congress. We debated these views intensely, but calmly, and 

we listened to each other, and, frankly, we learned from each other. 

And at least from my part, there were a few mind changes, including my own, on some issues. 

While we did not cover the waterfront, and while some members 

would have preferred different approaches with respect to specific 

recommendations, we came up with a package of principles and reforms that we believe will be a significant improvement over the 

status quo. My co-task force member, Bob Steel, will elaborate on 

some of our ideas. Here is my quick overview, five points. 

Number one, we need systemic risk monitoring and regulation by 

an oversight council comprised of the relevant financial agencies. 

Specifically, this council, on its own initiative or upon recommendation of the Fed, should add to minimum standards for capital, liquidity, margins and leverage to prevent or slow the formation of 

future asset or credit bubbles. 

Second, there are several ways to make sure that no financial institution is too big or too complex to fail. We can do this through 

capital and liquidity requirements that increase with an institution’s size and complexity, and by mandating that large institutions 

file and gain regulatory approval of what are called wind-down 

plans. 

Third, we recommend the consolidation of all current prudential 

Federal financial supervision and regulation into a single regulator. 

We believe that eliminating gaps and duplication in our current 

fragmented regulatory system will be a significant improvement, 

but at the same time, we also would retain the dual banking system under which banks will have the opportunity to choose between a State and a Federal charter. 

Fourth, derivatives markets clearly should be strengthened by 

using capital requirements to drive more OTC derivatives to a central clearinghouse, and eventually exchanges. The compensation of 

senior financial executives and risk takers should be tied to longterm performance, best through very long-term restricted stock, 

much like the kind of things that the Fed has recently proposed. 

Other ideas for enhancing market discipline are spelled out in our 

report. 

Finally, we support the creation of a new Consumer Financial 

Products Agency. 

I look forward your questions. 

9 

[The prepared statement of Robert Litan appears in the Submissions for the Record on page 37.] 

Chair Maloney. Thank you. 

Mr. Carr. 

STATEMENT OF JAMES CARR, CHIEF OPERATING OFFICER, 

NATIONAL COMMUNITY REINVESTMENT COALITION, WASHINGTON, DC 

Mr. Carr. Good morning, Chair Maloney and other distinguished 

members of the committee. On behalf of the National Community 

Reinvestment Coalition, I am honored to speak with you today 

about the role that consumer financial protection has played in the 

current crisis. 

I have been asked to discuss today whether the existence of a 

consumer financial protection agency modeled on any one of the 

proposals—either the administration, the House, or Senate—could 

or would have prevented the proliferation of reckless and irresponsible mortgage lending that triggered the foreclosure crisis that 

eventually led to the implosion of the housing and credit markets. 

It is, of course, impossible to answer such a hypothetical question 

with certainty. I am convinced, however, that if a consumer financial protection agency had been in place and structured with the 

appropriate regulatory authority, funding and independence, that 

such an agency would have prevented the bulk of the most egregious predatory lending in the markets. 

Climbing our way out of the current crisis will require that financial system regulation be reoriented to serving the needs of the 

American public, but given the damage that has occurred to both 

the credit markets and the economy in general, much more than 

improved consumer financial protections will be needed to accomplish a full recovery. Those additional actions would include better 

managing the foreclosure crisis and putting America back to work. 

In the limited time I have this morning for my opening remarks, 

I will focus specifically on consumer protection. 

One of the most dispiriting aspects of the current crisis is that 

it was largely avoidable. For more than a decade, financial institutions increasingly engaged in practices intended to mislead, confuse, or otherwise limit a consumer’s ability to judge the value of 

financial products offered in the marketplace. Nowhere was this 

more evident than in the subprime home mortgage market. Over 

the past decade, the subprime market increasingly specialized in 

pushing loans that were reckless and irresponsible, but that produced huge profits for mortgage brokers, mortgage finance institutions, and Wall Street investment banks. Excessive mortgage 

broker fees, irresponsible loan products, inadequate underwriting, 

bloated appraisals, abusive prepayment penalties and fraudulent 

servicing practices were all part of the problem. All of these issues 

were thoroughly documented, discussed and detailed in academic 

articles, news stories, policy papers, and more. 

Federal regulatory agencies were fully aware of these policies 

and these practices, and they had the authority to act. They chose 

not to. And on the rare occasion when they did, it was to preempt 

State laws to prevent States from protecting the rights of their own 

citizens from abusive financial practices. 

10 

And while most of the costly financial services abuses occurred 

in the housing market, predatory financial services have come to 

permeate many aspects of the financial system, including abusive 

credit and debit card policies, exploitive overdraft protection practices, unreasonable check processing procedures, and more. 

Repairing the economy requires that we reorient the financial 

system toward the mission of promoting economic well-being for 

the American public. This means removing the financial tricks and 

traps that create unnecessary financial instability for consumers, 

and ultimately for the system as a whole. 

The Administration and both Houses of Congress have proposed 

or are considering the establishment of a consumer protection 

agency that would consolidate the highly fragmented system of consumer financial protection laws currently enforced by multiple 

agencies. Among the proposed agency’s many positive attributes is 

the fact that it would eliminate the current practice of regulatory 

arbitrage whereby financial firms are allowed to select their regulator, in part based on how poorly they protect the public. A complementary attribute to the new agency would be its ability to ensure the same level of quality in financial products across institutional types. 

Opponents of a consumer financial protection agency have argued that such an agency would undermine the safety and soundness of the financial system. Yet safety and soundness of the financial system begins and relies on the integrity and reliability of the 

products that are offered to consumers. The Administration’s bill 

and draft Senate legislation require or authorize standardized 

products for financial firms. Arguments against this requirement or 

option are that standard products will stifle innovation. This argument is without merit. The 30-year fixed-rate mortgage has been, 

for example, the gold standard of mortgage products for decades. 

That product did not stifle development alternatives; its reliability 

and safety are the keys to its success. And the failure to offer lowcost, fixed-rate 30-year mortgages to those who qualify for it was 

a leading contributing factor in the spread of reckless subprime 

loans that were the core of the initial foreclosure crisis. 

One of the major differences between the President and Senate’s 

proposals relative to H.R. 3126 deals with the treatment of the 

Community Reinvestment Act. Unlike the President and Senate 

bill, H.R. 3126 leaves primary regulation of CRA with the Federal 

Reserve Board. This is a mistake. Many financial services providers historically and routinely offer or deny products at a community level rather than at an individual level. The excessive concentration of subprime loans in African American and Latino communities is only one example of this. 

Other major keys to the potential effectiveness of the proposed 

agency include it having the breadth of coverage over financial institutions, independence of operations, product disclosures that can 

reasonably be understood by the typical consumer, and a funding 

stream that is not susceptible to the vagaries of shifting political 

winds or economic downturns. If structured and empowered properly, this agency can cultivate an environment of integrity into the 

financial system. Restoring trust and confidence in the financial 

system is essential both for the American public as well as interVerDate Nov 24 2008 12:13 Jun 08, 2010 Jkt 054937 PO 00000 Frm 00014 Fmt 6633 Sfmt 6633 C:\DOCS\55899.TXT SHAUN PsN: DPROCT
11 

national investors who have been harmed by America’s failed experiment in poorly regulated financial institutions. 

[The prepared statement of James Carr appears in the Submissions for the Record on page 44.] 

Chair Maloney. Thank you. 

Mr. Steel. 

STATEMENT OF ROBERT K. STEEL, FORMER UNDER SECRETARY FOR DOMESTIC FINANCE OF THE UNITED STATES 

TREASURY, CHAIRMAN OF THE BOARD, ASPEN INSTITUTE, 

AND MEMBER OF THE PEW TASK FORCE ON FINANCIAL REFORM, WASHINGTON, DC 

Mr. Steel. Chair Maloney, members of the committee, my name 

is Robert Steel, and I am pleased to be here today as a member 

of the bipartisan Financial Reform Task Force. 

Along with my task force colleague Dr. Litan, I appreciate the 

opportunity to discuss our principles and the specific recommendations needed to achieve them, which we submitted along with our 

prepared testimony. We hope our principles and recommendations 

are helpful with regard to the financial reform process. 

Our task force began work last summer and has covered a large 

amount of ground. We believe we have a solid and substantial 

framework, and look forward to further debate, hearing your reactions, and learning from this. 

The task force recommendations reflect many of the topics now 

under consideration in the House Financial Services Committee 

and the Senate Banking Committee. Further, they share much in 

common with the recommendations advanced by Secretary Paulson 

and Treasury in June of 2007 in the Blueprint for a Modernized 

Financial Regulatory Structure, a report we worked on while I was 

at Treasury as Under Secretary for Domestic Finance. 

Given the time constraints today, I would like to highlight a single crucial recommendation of our work. What has become known 

as the ‘‘too big to fail’’ problem is in many ways at the heart of the 

financial reform effort. There are different ways to approach this 

challenge. Congress could arbitrarily limit the size of financial institutions, they could limit the scope of their activities, or they 

could work to ensure that any failure is less likely to cause a financial crisis. We favor the latter strategy. 

It is the strength of the American system that the opportunity 

to succeed carries with it the prospect of potential failure. To my 

mind, this system provides the best possible opportunity for shared 

prosperity. As a result, our task force recommends that all financial institutions should be free to fail, but free to fail in a manner 

that will not destabilize the financial system. The task force therefore recommends three specific things with regard to this issue. 

First, a sliding capital scale so that the larger, more complex, 

more risky and more systemically important an institution, the 

higher the standards for capital, liquidity, and leverage to which it 

should be held. 

Second, institutions above a certain size should submit for approval a living will or a funeral plan that will describe in detail 

how the firm, were it to fail, could be wound down with a reduced 

impact on the overall economy. 

12 

Third, a new solution should be adopted for failed or failing nondepository financial institutions. While the FDIC should continue 

to resolve failed or failing banks, we recommend that for nondepository financial institutions there be a strengthened bankruptcy process as the presumptive approach. In exceptional circumstances, only after strong safeguards have been met should 

there be an administrative resolution process as an option of last 

resort. 

This proposed two-stage approach to winding down nonbank financial institutions brings together two quite desirable policy objectives: It maintains the market discipline of the bankruptcy process 

while at the same time providing the government with a new tool 

to protect the financial system in times of unusual stress. In all 

cases, moral hazard is reduced as shareholders, unsecured creditors, and senior management will bear the burden of the failure. 

To create this two-step process, Congress should first amend the 

Bankruptcy Code as necessary to make bankruptcy the presumptive process for managing all failing nondepository financial institutions. In addition, Congress should create a new Federal financial institutions bankruptcy court and grant it sole jurisdiction in 

the United States for these cases. 

In those exceptional circumstances when a bankruptcy would 

pose unacceptable systemic risk, a new administrative resolution 

process should be created for failing nondepository financial institutions. This process should be used only after strong safeguards 

have been satisfied. Congress should decide exactly how strong the 

safeguards are and what form they should take. For example, Congress could require consultation and formal agreement between 

Treasury and the concerned Federal financial regulatory agencies 

before the resolution mechanism was activated. 

Congress also could instead opt for a stronger safeguard; this 

would empower Congress to make these decisions. There are several methods by which Congress could insert a higher hurdle. Let 

me outline one that our task force considered. 

If a failing nondepository institution were judged to be a threat 

to the stability of the financial system, the administration could 

seek congressional appropriation. While the administration seeks 

the appropriation, the firm in question would enter the bankruptcy 

process in the proposed special purpose bankruptcy court. Congress 

would then have a limited and fixed number of days in which to 

make such an appropriation. A customary stay would apply, and 

the Fed could apply financing and collateral, permitting the firm 

to continue to operate while Congress deliberated. If Congress did 

appropriate, the estate of the firm would be transferred to the administrative procedure; if it did not, the bankruptcy would proceed, 

and the Fed would exercise its collateral once circumstances permitted. 

In closing, we commend the hard work already done by Members 

in both Houses of Congress to move this crucial effort forward. The 

task force hopes that our efforts will complement the current work 

being done on these issues, as well as to provide additional momentum to the overall financial reform effort. 

13 

While there are unmistakable signs our economy has stabilized, 

it is imperative, we believe, that Congress act with urgency to 

enact comprehensive and effective reform. 

Thank you very much. 

[The prepared statement of Robert K. Steel appears in the Submissions for the Record on page 67.] 

Chair Maloney. Thank you very much. 

I want to thank all of the panelists. And because this is the first 

time that Ms. Born has testified before Congress since she left public service in the late 1990s, I would like to direct my first series 

of questions to her. 

Ms. Born, when you were Chairperson of the CFTC, why were 

you so concerned about the over-the-counter derivatives market? 

Ms. Born. I took office in 1996, and 3 years before that, the 

CFTC, my agency, had exempted customized swaps from the exchange trading requirement of our statute, but it had kept fraud 

and manipulation powers over the market. 

When I got into office, I learned that the market was growing ex- ponentially; it was, at that point, at about $30 trillion of notional 

value. We had no recordkeeping or reporting requirements, so there 

was no transparency. I could not effectively oversee that market for 

fraud and manipulation, even though we knew there had been 

major cases of fraud. Bankers Trust, an OTC derivatives dealer, 

had defrauded Proctor & Gamble and other customers. We knew 

there were major cases of manipulation. Sumitomo Corporation had 

used over-the-counter derivatives in copper to manipulate the 

world price in copper. We also knew that there was speculation on 

borrowed money in the market that was causing some major defaults. 

Let me just mention Orange County, California, which had been 

speculating on over-the-counter interest rate derivatives with taxpayer money and was forced into bankruptcy because of its losses. 

I was extremely concerned because neither our agency nor any 

other Federal agency had a sufficient amount of information about 

the market to know the extent to which this enormous and quickly 

growing market was threatening the financial fabric of the country. 

In fact, while we were undertaking our inquiry into this market 

and I was appearing before a number of committees of Congress 

discussing whether or not over-the-counter derivatives should be 

subject to any Federal regulation, the Long-Term Capital Management crisis occurred. 

Long-Term Capital Management was an enormous hedge fund 

which, unbeknownst to any Federal regulator, had managed to acquire a position of $1.25 trillion of over-the-counter derivatives 

even though it only had $4 billion in capital. Over a weekend, the 

Federal Reserve learned that it was about to collapse, and the Federal Reserve felt that if it collapsed with that kind of a position in 

over-the-counter derivatives, it would threaten the financial stability of the country. Fifteen of our largest banks and investment 

banks were its over-the-counter derivatives counterparties, and 

they were, at the request of the Fed, able to come up with hundreds of millions of dollars each to take over the position and prevent collapse. But that demonstrated very vividly to me the dangers of contagion; the way that these instruments spread risk 

14 

through the economy; and the danger that the failure of one institution, because of its trading, would bring down other institutions 

because of the connections through counterparty relationships. 

Chair Maloney. I was a member of the Financial Services Committee at that time, and I remember there was a huge interest in 

moving forward with regulation, but then the economy improved 

and was booming, and the need for regulation was ignored, and we 

went forward with this problem. And look at the disaster that it 

caused with the financial crisis. So we should have acted then, and 

we are determined, with President Obama, to enact comprehensive 

regulatory reform. If we had acted back then, we would not have 

had the crisis that we are in. 

My time has expired, and I am delighted to recognize Senator 

Brownback. 

Senator Brownback. Thank you very much, Chairwoman 

Maloney. I am sorry for being late; I had another hearing I was at. 

This is a very important one, and I am delighted with the panel 

that is here and the topics being covered. 

I want to go direct to dealing with large financial institutions 

and their failure, and how we handle that as an overall body, and 

how we handle that as a government. It seems like that, to me, is 

one of the key things that has come out of this crisis is our inability to handle something that is too big to fail; and consequently, if 

it is too big to fail, then we just have the taxpayer take the risk, 

and that has a lot of moral hazard in the marketplace. And if we 

don’t fix it, it seems like, to me, it builds that moral hazard bigger 

in the next round that takes place so that people will say, well, last 

time they didn’t fix it. 

And it also strikes me that these bubbles build faster quicker. It 

is almost like financial storms build quicker, faster, bigger now 

than they used to. Whether it is the dot.com bubble and burst and 

the housing bubble and burst—and I am concerned we are in a government bubble and burst—that if we don’t get ourselves in position now to be able to deal with these large institutions and tell 

them the marketplace will assume we are going to protect them, 

and then there will be more money going to places that it really 

shouldn’t. 

I would like to know, I think particularly Dr. Litan and Mr. 

Steel, if I could—and maybe others of you want to comment on 

this—I missed your testimony, I know that you have addressed 

some concerns on this. Tom Hoenig of the Kansas City Federal Reserve is a man I have worked with a fair amount on this. Do you 

generally support the model of what he is putting forward on this? 

Or perhaps this is your model and he is just adopting it, but I 

would like to get into some of the detail on this, if there is a kind 

of a collective thought coming together of how we structure ourselves to deal with this in the future. 

Mr. Steel. Well, thank you, Senator. In my comments this morning, I highlighted my perspective that this too-big-to-fail issue is 

really at the crux or the crucible of all the issues that we are thinking about and really is a mission-critical part of what we are focused on. 

With regard to President Hoenig’s comments, we are familiar 

with the work. I think that the key construct, the philosophy of his 

15 

point of view is that resolution should be very painful, and that if 

we go through resolution, then whether it is bondholders, management, shareholders should suffer significant pain. We echo that 

same sentiment. He goes into much greater detail in the actual 

technicals of how he would organize his resolution process than we 

did in our work, but what he seems to look at is important. 

We did offer a different step, though, and talked about a two-part 

process that we don’t like identifying institutions that are too big 

to fail. We believe that there should be a sliding scale of capital required for important institutions that takes into account risk, asset 

size, complexity, et cetera. We also believe in the living will concept, that every firm should have a plan as to, if they do get into 

difficulties, how that can respond, and that should be filed and approved with a regulator. And if your plan is not filed and approved 

with a regulator, then you have to downsize. 

But thirdly, what we have organized that is different than President Hoenig is that we feel that an enhanced bankruptcy process 

should precede resolution. So the first default position is bankruptcy. If bankruptcy can’t work and it is too systemically important, then we would move to a resolution process consistent with 

his. 

Senator Brownback. That seems to be a good mixture. 

If I could, if we get in another financial crisis, and if the trajectory of the past is a projection of the future, it looks like we will, 

and it will be sooner rather than later, will the courage exist here 

to allow those triggers to be pulled, or are we just caught because 

these things will, in likelihood, exacerbate a financial crisis if you 

let one of these things go down like we saw with Lehman Brothers. 

Mr. Litan. Okay, several comments. We know Dr. Hoenig’s 

views very well in Kansas City. Part of my life is spent in Kansas 

City at the Kauffman Foundation, and Dr. Hoenig is actually a 

trustee of our foundation, so we are very familiar with his views. 

And I want to echo what Bob just said. We had the same directional suggestion that he talks about, which is to make sure the 

pain is spread. 

And when we talk about too big to fail, I would like to clarify a 

couple of things. I think there is a lot of confusion in the public. 

We are really talking about protecting creditors in full, because the 

shareholders get wiped out, and—although actually in some cases 

the management did not get wiped out, but we certainly, on our 

task force, recommend that people who are responsible for failures 

should definitely lose their jobs. But the key thing to ending too big 

to fail is to make sure that unsecured creditors take some hit in 

some form. And so the bankruptcy process is clearly one approach 

to this. You can also accomplish that same haircut in an administrative process, but the key is that there be pain. 

The second point, I will just elaborate on what Bob said. There 

is a huge debate now about whether or not we ought to preemptively break up institutions in advance. Should we arbitrarily set 

up some size and say above it we are just going to break you up? 

I am a former antitrust enforcer, and I can tell you that there are 

no antitrust principles to make that decision. We have market definition tests and so forth, but there is nothing in the antitrust laws 

that will tell you the magic size threshold above which you are too 

16 

big to fail. So you are going to have to look to some other principles. And our task force debated that extensively. 

We came down where Bob said, which is we would not just 

across the board eliminate all too big institutions, because there 

are benefits of size, especially in the global market, but what we 

do say is that all large institutions ought to file this funeral plan 

or this wind-down plan with the regulators. And the regulators 

would have the ability, if they are unhappy with the wind-down 

plan and believe that it would not protect the financial system, 

they would have the authority to chop the institution up only in 

that circumstance. So we are against across-the-board size limits, 

but otherwise, I stand foursquare where Bob left his remarks. 

Senator Brownback. Thank you. 

Chair Maloney. Thank you. 

Mr. Hinchey. 

Representative Hinchey. First of all, I just want to thank you 

very much for what you have said in your testimonies, and the response that you have given to these questions. And the complexity 

of this situation is seen clearly in the context of the questions, but 

even more so in the context of the answers to the questions. 

We are dealing with a very, very difficult and dangerous set of 

circumstances here economically for the future of this country. And 

one of the things that strikes me is the huge financial institutions, 

four of them, now hold half of the mortgages in America, issuing 

nearly two-thirds of our credit cards, and hold roughly 40 percent 

of all bank deposits. That strikes me as an absolutely fascinating 

set of circumstances, and why we allowed that to happen was a 

very big mistake. And we allowed it to happen intentionally. We 

allowed it to happen intentionally because there was a great interest on the part of some people to make as much money as possible 

and engage in this financial operation in ways that can be most 

beneficial to them. And if it had some benefits to others, well, you 

know, that might not be so bad. But the fact of the matter is that 

hasn’t been precisely the case. Because of the size of these institutions, that is one of the main reasons why the economic collapse 

that we experienced came about. 

One of the things that strikes me is this whole idea of too big 

to fail. If we have a situation where something is too big to fail, 

then we are just saying to ourselves, we are just turning everything over to them; they are going to do whatever they want, and 

all of the consequences of that are going to fall upon everybody 

else. 

So nothing should be too big to fail. And the regulation of setting 

forth something that is not going to be too big is also very important. I think that there ought to be some analysis or some acceptance of the idea ‘‘too big to exist.’’ We should not allow these institutions that are this size to actually come into play here and to engage in the circumstances that they have engaged in, particularly 

with regard to the way in which there has been this combined operation of commercial and investment banks and how that operation in and of itself played such a significant role in the impact 

of the economy that began to fall in the end of 2007. 

So, what do you think that we should be doing about that? What 

is it that we should be engaged in here? 

17 

A number of the pieces of legislation that have come forward are 

constructive, they are moving in the right direction, but they are 

moving slowly in the right direction. I think that there are more 

things that need to be done. We see what happened back in the 

1930s when there was basic legislation passed that said the combinations that we have seen and the adverse effects of those combinations and the manipulation of investment activities, all of that 

is now much clearer to us, and we need to stop that from happening in the future, and that was done. We have gradually weakened that process, and then we completely eliminated it just a decade ago. Now we have got to go back to something that is much 

more positive. 

So maybe you can talk a little bit about that. What can be done 

now that is going to not bring about the financial collapse that so 

many of us apparently have in mind that is likely to occur if we 

continue to allow this set of circumstances to continue to exist and 

continue to override the entire financial circumstances that we 

have to deal with? What should we be doing? 

Ms. Born, what do you think? 

Ms. Born. Let me talk about the area that I know the best, overthe-counter derivatives, because one of the problems with these institutions is not only are they too big to fail, but they are too interconnected to fail; the failure of one will potentially bring down the 

others, or at least severely harm them. 

One of the things we can do is bring over-the-counter derivatives 

trading out of the preserve of these big banks and onto exchanges 

and clearinghouses where we will not have enormous exposures 

building up in these banks that could bring down the banks. 

In a clearinghouse situation, where derivatives are exchangetraded, the clearinghouse rather than an over-the-counter derivatives dealer—which all these institutions are—becomes the 

counterparty to each and every trade. It marks that trade to market twice a day, and at the end of every day at least, it calls for 

margin to be put up by all the traders who the market has moved 

against so we never get these enormous exposures like AIG had. 

I think appropriate regulation of derivatives by bringing everything we possibly can onto regulated exchanges would certainly 

help. I do think that there are additional problems because these 

institutions not only will remain too big to fail, but I think they are 

too big to manage and too big to supervise. 

Thank you. 

Chair Maloney. The gentlewoman’s time has expired. The gentleman’s time has expired. 

Mr. Burgess. 

Representative Burgess. Thank you, Madam Chairwoman. 

Ms. Born, I wonder if we could just continue on that line for a 

moment. 

When you talk about the appropriate regulation of derivatives 

and the requiring a margin to be put up, is that not the case now? 

That mark-to-market twice a day and requiring a margin call to be 

made at least at some point on a daily basis, is that not the case 

now? 

18 

Ms. Born. That is not the case with any of the over $600 trillion 

in notional amount of over-the-counter derivatives. It is only the 

case on the regulated futures and option exchanges. 

Representative Burgess. How difficult would it be to create 

that system? We have got an enormous financial regulatory system 

already in place, and we are being asked to create yet another new 

superstructure. Is there not the capability within the existing financial regulatory structure today to do just what you are describing. 

Ms. Born. Yes. I think we have a wonderful prototype of what 

we need to do on the futures and option exchanges. Bringing as 

much of the standardized trading as possible onto exchange will 

take care of the problem for a lot of the market, because a great 

deal of the market is standardized contracts. 

Now, I think the only legitimate, economically justifiable overthe-counter trades which justify the exposure the American public 

has to the harm from that market are hedging contracts, where 

large commercial entities are trying to hedge complex business 

risk. I think it is legitimate to continue that market, but I think 

there have to be capital requirements imposed on all the participants in that market; there have to be margin, collateral, and 

marking to market requirements in order to make that market 

safe. But you should realize we have no experience in successfully 

or effectively regulating an over-the-counter derivatives market. 

Our only experience with effectively regulating derivatives has 

been on exchange, and that has been effective since 1935. 

Representative Burgess. Well, let me ask you a question that 

I posed to Walter Lukken 2 years ago when we got into all the difficulty with the futures speculation. And that is, what are the tools 

that I guess in this case the CFTC needs that it lacks in order to 

create the type of reality that you are describing here? Does the 

CFTC possess the tools today, or is there something legislatively 

that the CFTC needs or some other regulatory body needs in order 

to make what you described reality? 

Ms. Born. In 2000, Congress forbid the CFTC or any other Federal regulator to oversee the over-the-counter derivatives market at 

all. So that has to be overturned. You have to give authority to the 

CFTC as the most experienced and expert federal regulatory body, 

and the SEC with respect to securities derivatives, to oversee these 

markets. And you need to require that standardized contracts go 

onto exchanges and clearinghouses. 

Representative Burgess. Now, Mr. Lukken two summers ago 

said that the CFTC did still possess those capabilities but only in 

the case of an emergency. Now, in the summer of 2008, with four 

airlines declaring bankruptcy and the price of oil going up $16 in 

an hour, whatever it was, per barrel, I suggested to him that that 

was an emergency and that he ought to exercise those powers if he 

had them. But you are saying even in an emergency environment, 

those powers no longer exist? 

Ms. Born. They do not. They have not existed since 2000 with 

respect to the over-the-counter market. There are powers that have 

not been exercised until recent days, during the last 10 years, by 

the CFTC with respect to exchange trading and regulated clearing 

that allow actions to be taken to reduce excessive speculation. And 

19 

it is my view that the CFTC really fell down on the job by failing 

its mandate to ensure against excessive speculation on the markets. I think that summer before last, there were tremendous bubbles in agricultural products and energy products, and it was because excessive speculation was being tolerated by the regulator 

and by the exchanges when it should not have been. 

Representative Burgess. What are some of the potential pitfalls from creating this type of regulatory environment that you are 

envisioning? 

Ms. Born. I think it exists right now for exchange-traded derivatives, or at least it certainly did when I was chair of the CFTC in 

the late 1990s. There were requirements that everybody trading on 

a regulated exchange declare whether—ahead of time, whether 

they were speculating or hedging, and speculators had special accounts that were designated as speculative accounts. They had special requirements like position limits imposed on them, by both the 

exchanges and the regulator. The CFTC had powers to step in and 

order a reduction of positions, order that a speculator who was 

abusing the system close out its positions entirely or pay extra 

margins, or any number of regulatory tools that were in the 

CFTC’s toolbox. 

Representative Burgess. Is there enough transparency in the 

market as it has evolved today with the unregulated over-thecounter exchanges to be able to provide that same type of oversight, or will it require creating a new financial regulatory system? 

Ms. Born. I think it is very—— 

Chair Maloney. The gentleman’s time has expired. You may answer the last question. 

Ms. Born [continuing]. I think it is very important that as much 

of the over-the-counter trading as possible, all the standardized 

trades, go onto exchange so that they are transparent. I also think, 

if there are any continuing speculative trades in the over-thecounter market, which I don’t think there is any justification for, 

that position limits should be imposed on those through a regulatory regime like is proposed in pending legislation. 

Representative Burgess. Thank you. 

Chair Maloney. Thank you very much. 

This is an incredibly busy Congress, and I have just been called 

to the floor to manage a bill of mine that will bring transparency 

and accountability to the $700 billion in TARP funds, and that is 

an important bill and I have to go to the floor. But I would like 

to ask Dr. Litan and Mr. Steel to respond in writing, your ideas 

on too-big-to-fail and alternatives were very important. We have 

passed out a bill from the committee, which will be going to the 

floor, which allows government to basically dismantle too-big-tofail. 

And I would like to ask, how would this impact on the global 

economy if the too-big-to-fail large institutions become the norm in 

other countries. Would this put us at an economic disadvantage? 

And to comment on this proposal in writing. I think it is critically 

important and I would like to study it further. 

I do want to say that, Brooksley Born, you are one of my heroines. I think you deserve the Nobel Prize for speaking out and 

20 

being courageous and pointing out what needed to be done. If we 

had listened to you, we would not have had this financial crisis. 

I have a series of important questions that I would like to get 

on the record. Mr. Hinchey has agreed to help me get them on the 

record, or I think they are important in our review, as we move forward in financial comprehensive regulatory reform. I regret I have 

to leave. 

[A letter from Representative Maloney to Robert Litan appears 

in the Submissions for the Record on page 71.] 

[A letter from Representative Maloney to Robert Steel appears in 

the Submissions for the Record on page 72.] 

Chair Maloney. I recognize Mr. Cummings for five 5 minutes. 

And Mr. Hinchey will assume the chair. 

Representative Cummings. Thank you very much, Madam 

Chair. 

Ms. Born, a moment ago you said something to the effect that 

not only were some institutions, large institutions, they fall into 

the too-big-to-fail category, but they are too big to control, something like that. And I found that all of our—on the Government Reform Committee when we dealt with AIG, a lot of times the left 

hand didn’t have a clue as to what the right hand was doing, and 

it was just incredible to me. But listening to your testimony, I take 

it that you feel that the House bill certainly does not go far enough; 

is that right? 

Ms. Born. I have just been focusing on the over-the-counter derivatives treatment. And in terms of the House bill on that, I do 

think that the end-user exemption for standardized contracts from 

exchange trading is unwise. I think that all standardized contracts 

should be required to be traded on exchange. 

Representative Cummings. You know, Mr. Carr, the conduct 

of the credit-rating agencies during the financial crisis is extremely 

disturbing, and perhaps most disheartening is the destruction that 

has been done to the assets of public pension plans around the 

country. These public servants have lost their retirement security, 

threatened by the fact that the pension boards were required to 

hold assets that were later found to be inaccurately rated by these 

agencies. 

The proposals in Congress have done a good job of addressing 

many of the conflicts and disclosure issues that have plagued the 

rating agencies. In your opinion, have the proposals gone far 

enough? 

Mr. Carr. Thank you for the question. The National Community 

Reinvestment Coalition does not have a specific position on any one 

of the specific rating agency proposals, but we do believe that 

something like a public utility might be a very useful structure. We 

have documented quite extensively, as you know—which is probably why the question came our way—about the way in which the 

rating agencies were stamping investment grade on products that 

were obviously junk bonds for years. 

So most of our work, Congressman, has really been focused on 

the front end of that question, which is documenting the abuses in 

the system, but not necessarily moving to the back end to structure 

the appropriate legal resolutions. 

21 

Representative Cummings. Do you have an opinion on that, 

Mr. Litan? 

Mr. Litan. Yes. The issue of credit-rating agencies is incredibly 

complex. No one disagrees—at least none of the experts disagree— 

that they were at the heart of the crisis, among many other causes. 

And what they were doing that clearly contributed to the crisis is 

that they were rating instruments on the basis of very limited histories and then extrapolating that they would have AAA ratings, 

and we all know now that that was deeply mistaken. By the way, 

so too, similar mistakes were made by bond insurers. 

So the question is what to do. Our task force at Pew debated this 

extensively. I can’t tell you there is a silver bullet to fixing the rating agencies. What we end up recommending is to replace the letter grades that they now give with a suggestion, if not a requirement, that the rating agencies tell us what we really want to know; 

which is, what is their estimated probability of default of this 

bond? And then have an agency or at least private sector organizations track these predictions so that the investing public knows 

how good these forecasts are, and then the U.S. Government can 

have a choice. If it sees an agency that is consistently overestimating the likelihood that a bond is going to survive or, conversely, 

is underestimating the default probability, the government could 

either decertify the agency or it could impose penalties. But there 

ought to be some price to be paid for consistently going out to the 

public with over-optimistic ratings. 

Now, my own personal view on the public utility model is—and 

I am not sure we extensively debated this within the task force— 

I am not wildly enthusiastic about it. You have got to remember 

that all of our bank regulators, all of them, had major failures. And 

so I don’t have a lot of confidence that another government agency 

or utility commission is going to do any better in predicting these 

future events than our bank regulators did. 

Representative Cummings. My time is running out. But when 

I listen to the testimony in Government Reform of the rating agencies, there is something that is very difficult to legislate, and that 

is integrity. And a lot of the things that were done, I know they 

may have been dealing with limited information, but we had testimony that showed that there were folks who were just not being 

honest. And maybe that is why you were having such a problem 

trying to come up with a solution. 

Mr. Litan. Well, the core of the problem is that there is an inherent conflict, as you know, in the agencies. And because the way 

the market has developed, people can free-ride on the information. 

And so the only way they can stay in business up to now is by 

charging the people who issue the bonds, and that is right there 

a blatant conflict. And, frankly, given the state of the market, I am 

not sure we know how to fix it, except all we can do maybe is think 

of ways of penalizing these guys when they blow it. 

Representative Hinchey [presiding]. Thank you, Mr. Cummings. Mr. Brady. 

Representative Brady. Thank you, Mr. Chairman. A lot of 

good questions asked today, and a lot more to be asked on the liquidity resolution bankruptcy, just sort of a whole best approach on 

too-big-to-fail and how we move forward on all these issues. 

22 

I wanted to ask the panel, in no particular order, just your 

thoughts on credit default swaps. To a layman not in the financial 

services business, it seems like the fact that banks sold these credit 

default swaps to each other contributed to the contagion effects 

during the financial crisis. It seemed, in effect, banks were able to 

rent a higher credit rating for lower capital reserves during this 

process. 

So one question is: Did the Basel II risk-based capital standards 

encourage banks to actually trade credit default swaps by allowing 

them to substitute the higher credit rating for lower—swap that for 

the lower credit rating of the borrower? And did the trading of 

credit default swaps among banks, in the end, have the unintended 

consequence of lowering, of reducing the capital in the banking system as a whole? 

And then I am going to follow up on a thought on are credit default swaps a legitimate financial product? So let’s open it up. 

Ms. Born. Let me just start, since credit default swaps are a 

kind of over-the-counter derivative, and they certainly played a 

very important role in this latest financial crisis. They were used 

by banks and investment banks and other institutions to insure 

mortgage securitizations and other debt securitizations that perhaps otherwise would not have gotten a high rating. But, beyond 

that, they were used by many institutions, including the investment banks and banks, to speculate in the stability of other institutions, the stability of the mortgage market, the stability of the 

credit markets. And because of this highly speculative, highly leveraged trading that is essentially gambling on the creditworthiness of products, when there was a downturn there was an enormous crash, the most obvious entity being AIG that lost hundreds 

of billions of dollars and had to be bailed out. 

Representative Brady. Just sort of drawing sort of a little narrower focus. Was the end result of all that, that in effect we reduced the capital in the banking system? By the use of credit default swaps, we created—— 

Ms. Born. I think the capital—— 

Representative Brady [continuing]. We really needed? 

Ms. Born [continuing]. The capital requirements that we were 

using for the banking system were demonstrably inadequate in 

light of what happened. 

Mr. Litan. I can address that issue specifically on the capital requirements. Before I do, though, I would say I would not ban credit 

default swaps. If subject to the appropriate institutional design regulation, they are the functional equivalent of insurance, and there 

is no reason we should ban insurance. 

But your question raises the issue, were these CDS instruments 

used to effectively lower bank capital requirements? The answer is 

yes. Because under the Basel rules, the Basel committee 

outsourced the capital requirements, in effect, to the rating agencies. So that if you got a AAA on a security or other kind of instrument, you got a lower capital charge. 

We did not debate this extensively in the task force, but my own 

personal view, and I have been writing about this for 10 years, is 

that this whole risk-rating system was nuts. I would have preferred a simple leverage ratio. And this idea that we can outsource 

23 

the capital requirements and bank risk assessments to the rating 

agencies who had this inherent conflict, in essence led to too little 

capital in the banking system. It was a big mistake. And so, going 

forward, I would get away from this risk rating. 

Representative Brady. Mr. Steel. 

Mr. Steel. Nothing to add. 

Representative Brady. I will conclude with this. I think there 

is a legitimate role for this. One of the concerns I have is, as an 

insurance product, clearly when the market goes sour the claims 

hit in clusters. That is when the assets have the lowest market 

value. It seems like this is a product that it seems nearly impossible to—if you set aside adequate reserves, the price of the product 

itself would almost be of no longer use in the market. 

The alternative of that is to have the Federal Government be the 

depositor or the—you know, insurer for all of that—which I don’t 

think that is where Congress wants to go. Certainly, I don’t. 

Any thoughts on that that you can give? My time is up, Mr. 

Chairman. But, Mr. Steel, any thoughts? 

Mr. Steel. Well, I thought that the gem of what you said was 

that if the—there is a moral to the story. If the appropriate capital 

requirement makes the product too expensive, then maybe we 

shouldn’t have the product, I think is kind of the circle, the way 

that I would follow your logic. And so if we have these types of 

products, we have to make sure that they are reviewed and that 

supervisors and regulators understand them, so that we do have 

the right amount of capital. 

Representative Brady. Great. I really do appreciate all of you 

being here today. Very helpful. 

Representative Hinchey. Mr. Snyder. 

Representative Snyder. Thank you, Mr. Chairman. And I appreciate you all being here. I missed most of your all’s opening 

statements, but I don’t think you covered this so far. 

I think I will direct my question to you, Mr. Steel. I don’t come 

out on the financial services industry and I am not on the Financial Services Committee. I am a family doctor. But the idea, the 

concept of having a living will for institutions that most Americans 

think have neither hearts nor souls intrigues me, and I wanted you 

to amplify on that a little bit, if you would. 

I don’t understand how that would work. They would file a document that I assume, in order for it to have any meaning, would 

have to have sufficient detail, but I would think would rapidly get 

out of date, or if it had any kind of detail in it, about how they 

would unwind. If it had lots of detail in it, I suspect competitors— 

I assume these would be public documents. Or would they be private documents? 

Mr. Steel. Private. 

Representative Snyder. Private documents. But I assume that 

there would be issues with them needing to come back and say, 

well, in the full disclosure we have changed—sold these assets already. 

And also in your statement you say, ‘‘could be wound down with 

reduced impact on the overall economy.’’ Institutions really don’t 

have an obligation to watch out for the world or U.S. economy or 

a State’s economy. They have an obligation to watch out for instituVerDate Nov 24 2008 12:13 Jun 08, 2010 Jkt 054937 PO 00000 Frm 00027 Fmt 6633 Sfmt 6633 C:\DOCS\55899.TXT SHAUN PsN: DPROCT
24 

tions. So they are not going to file a document that says—I 

wouldn’t think. I mean, I don’t know what their fiduciary duty is. 

I assume it is to the people who own the business. 

Would you amplify for me on what this document would look 

like, how long would it be? I just don’t understand how it would 

have any real value. 

Mr. Steel. Sure. I think that what we have found was that in 

this tumult the last period of time, that I believe that the two ingredients in short supply were capital and risk-management skills, 

in hindsight. And this is a personal perspective. And that we, in 

our report from our task force, talk about a series of things that 

can be done to address these issues. And key among them is this 

idea of an engagement with your regulator, where you have to have 

a tough conversation about, if you hit a turbulent or a period of 

stress, how would you deal with it, and that you have a plan. And 

I wouldn’t—and I think that is the idea. And it should be an engagement with your regulator. And if you can’t describe that and 

if you can’t make your regulator comfortable that you have—you 

choose your analogy, an evacuation plan, a living will, that kind of 

idea. If you don’t have a plan, then the regulator says: You are 

really not the person to be managing this institution of this complexity, this size and this risk level. And that is the type of engagement. 

And while my own perspective, because I haven’t used this analogy before—I think there were elements of this to the recent stress 

test—would be that type of engagement. I would invite my colleague, Mr. Litan, if he would like to add something. 

Representative Snyder. I don’t understand the kind of detail 

that we would have to have. It would be like at a time when things 

are going to go well, okay, what are you going to do when things 

go wrong? And if something goes wrong, then they will come back 

and say, we didn’t know that was going to happen. 

Mr. Steel. I think the idea of the analogy of the stress test is 

looking at your liquidity characteristics, understanding the correlation of assets, and having a plan that—if you had to move quickly, 

how would you respond, would be the essence of it. 

Mr. Litan. And I will elaborate. It is not just to respond to 

stress, but how are you going to unwind yourself and dismember 

yourself in the event that you have to be liquidated or sold off? 

Who is going to lose money, which creditors, in what order and so 

forth. And I want to make this concrete for you. Do you know how 

many subsidiaries Citigroup has? Twenty-five hundred. All right? 

Now, they happen to be exceptional. But Deutsche Bank has roughly the same number, and a lot of the other banks, big banks, have 

lots of subsidiaries. My suspicion is, I am not sure the general 

counsel of Citigroup knows all 2,500 subsidiaries that bank has. 

So, to be specific, if you are forced every year to write down to 

your regulator a plan that says how you are going to unwind this 

enormous elaborate mess, and you don’t even understand it yourself, and, by the way, the board doesn’t understand it, then the 

agency has got to have the authority to help you consolidate your 

complexity. And I think the sheer act of—— 

Representative Snyder. I wanted to ask—so let’s take that as 

an example, the 2,500. 

25 

Mr. Litan [continuing]. Right. 

Representative Snyder. So are you saying that—I am number 

2,500, I am a little bank sitting someplace—that CitiBank has a 

piece of the action, and it is all going to be private, and then word 

will get around, you are the first to go? I don’t understand how this 

operates. 

Mr. Litan. No. First, these are living wills that are disclosed 

only to the regulator, and—— 

Representative Snyder. So they will have a document that 

says this is the order in which we are going to get rid of them. We 

never liked that one anyway. But it will be kept from those people 

and those shareholders? 

Mr. Litan [continuing]. Well, in the case of Citigroup, I think 

most all of them are wholly owned subsidiaries. They are created 

in different jurisdictions. It is not clear who is responsible in the 

event of failure. There has to be a plan to say who is responsible 

for these different entities. And I will tell you, I mean, I will be 

blunt. I am not claiming this is going to be the magic answer. But, 

at a minimum, what the wind-down plans do is two things: 

First, if the institution gets in trouble, they are the first draft of 

the resolution when the institution either ends up in bankruptcy 

court or ends up at the FDIC or its equivalent. Okay? That is the 

first thing. 

And the second thing is that by having to prepare these plans 

every year and stare into the abyss, all right, just the sheer act of 

doing that is a mind-expanding exercise. 

As a doctor, Congressman, you can analogize the preparation of 

the wind down plan to an annual physical exam. Back to the 

Citigroup example, the directors would then go to the general counsel and say, you mean you have got 2,500 companies and you don’t 

even know all their names? How are we going to dismember these 

entities in case this organization goes under? And then you go back 

to the general counsel and you say, rationalize this for me, and 

then tell us exactly who is going to take the loss and so forth. That 

is a very instructive conversation to have. 

Representative Snyder. Thank you. 

Representative Hinchey. Thanks very much. 

I just wanted to mention the over-the-counter derivatives markets and the role that they played in this economic crisis and see 

what you think about that. One of the most interesting aspects of 

it is the energy derivatives market, over the counter, and the way 

in which that was carried out and the way it is still carried out, 

without any oversight of the Commodity Futures Trading Commission. There is no oversight, no examination. And this is one of the 

reasons why we have seen the price of energy, gasoline, oil, go up 

so dramatically. 

What do you think should be the proper steps that could be 

taken now to deal with this situation of these over-the-counter derivatives markets, so-called over-the-counter derivatives markets? 

It is interesting, the name is very interesting, over the counter. Mr. 

Carr, would you want to talk about that? 

Mr. Carr. Congressman, I feel like I walked into the wrong 

hearing. I was asked to talk about the Consumer Financial Protection Agency, for which we have lots of views. We certainly do have 

26 

views on too-big-to-fail in the derivatives markets, but we don’t 

have any formal positions on that. Our time is really being consumed with trying to figure out the consumer side of the puzzle. 

Representative Hinchey. Okay. Ms. Born. 

Ms. Born. I would be happy to respond to that. I think, first of 

all, that it is true that both on-exchange energy futures and options 

and the over-the-counter trades in energy have been used by speculators to manipulate the energy markets in the last few years, and 

that it is critically important to the economic well-being of this 

country to get that under control. 

I would bring all the standardized contracts onto regulated exchanges where there are a lot of regulatory tools to limit speculation when it gets excessive. I would also require, with respect to 

any remaining over-the-counter derivatives trades, that they be reported to the regulator. I would not allow any over-the-counter 

speculative trades; but if you are going to allow them, there should 

be position limits that can be imposed by the regulators on both 

over-the-counter positions and exchange-traded positions. 

Representative Hinchey. Dr. Litan. 

Mr. Litan. Okay. I am now going outside the bounds of what our 

task force debate was, so I will just give you my own personal 

views. I am going to address the whole issue of just derivatives 

generally, not just energy. 

I certainly agree that what we ought to do is have recording of 

all these trades on trade registries. Where there is collateral, the 

collateral ought to be held by third parties. This is something our 

task force was very strong about. If you go back to AIG, their collateral was not held in a third-party account. 

When it comes to moving things to clearinghouses and exchanges, yes, we are for migrating it, but we would use capital requirements to induce that. So in effect what we would say is if you 

are a big bank and you have an OTC position that is not on a clearinghouse or an exchange, you have a much higher capital charge. 

So we would give very strong incentives for the geniuses on Wall 

Street to develop standardized instruments to go onto exchanges 

and to clearinghouses. But we wouldn’t mandate it, instead using 

capital as a way of migrating these infringements. So we end up 

moving in the same direction that Brooksley talks about. 

The reason why the clearinghouses are so important is that they 

eliminate the situation where as AIG is bilaterally responsible to 

its counterparties, and instead has obligations only to the clearinghouse. But then the clearinghouse needs to be regulated. You have 

to make sure that the clearinghouse has adequate capital and liquidity; otherwise, you have got a potential systemic problem. You 

can’t make systematic risk go away, but you can certainly make it 

more visible and make it more controllable if you concentrate the 

risk. 

Representative Hinchey. Mr. Steel, do you have anything else 

to say about that? 

Mr. Steel. No. I think he described the perspective that we had 

in our committee. So that is fine. 

Representative Hinchey. Ms. Born, do you think that that is 

enough? Don’t you think that there is some additional regulation 

27 

to stop the manipulation of the prices of something that is essential 

to people across this country, like energy prices? 

Ms. Born. Absolutely. I think that the tools that the CFTC has 

now with respect to exchange-traded oil futures are necessary for 

the entire market. And I think that as much as possible, oil derivatives should be on a regulated exchange so that there are the tools 

to limit excessive speculation. 

Unfortunately, the summer before last the CFTC failed to do 

that even with respect to the exchanges, although they had power 

to do it. They could have required speculators on exchange to reduce their positions. They could have required them to eliminate 

their positions. They could have required them to pay extra margin, as is being suggested. And I think to the extent there is allowed any speculative trading over the counter, those should be the 

powers—there should be full oversight, full reporting, and powers 

to impose position limits. 

Representative Hinchey. And to stop it. 

Ms. Born. Absolutely. I think reporting should allow the CFTC 

to put together, aggregate, the positions an entity has on exchange 

and off exchange, and even in the physical market, so that the 

CFTC can assess whether the position is too big, and it can say reduce it or eliminate it. And if there is an emergency, it can tell all 

the speculators to reduce their position. 

Representative Hinchey. Do you all have time to stay for a 

few more minutes? Dr. Snyder. 

Representative Snyder. Thank you, Mr. Chairman. I wanted 

to give each of you a chance to predict the future for us as you look 

ahead and you follow this debate that is going on in Congress and 

amongst the American people with all the different players that are 

involved in this discussion of what kind of regulatory network we 

need. 

When we finally have the President put ink on paper and sign 

into law major changes—and I think that will happen sometime 

next year—what is your greatest fear that we will leave out? What 

do you think the most likely mistake is, or mistakes, that we as 

a Congress and an administration will make? 

Do you want to start, Ms. Born? 

Ms. Born. Yes. And I will just talk about the over-the-counter 

derivatives area, which is what I know the best. The biggest concern I have is that some of the bills currently have exemptions for 

standardized contracts that can easily be traded on exchange but 

they are permitted to stay over the counter. I don’t think there is 

any justification for that. I think that creates a loophole that can 

cripple this effort and really not result in effective regulation. 

I would eliminate the end-user exemption for standardized contracts. I would eliminate the foreign currency exemptions some of 

the bills have on standardized contracts. I would eliminate the provision that suggests that contracts can be traded over the counter 

if one party is not an eligible member of a clearinghouse. Essentially, that seems particularly frivolous to me, because our clearinghouses have traditionally had clearing members acting as intermediaries for entities that aren’t members. So that is not a relevant position. I am afraid that legislation could leave room for a 

28 

vast and underregulated over-the-counter market through these exemptions. 

Representative Snyder. Mr. Litan. 

Mr. Litan. So we have five principles that the Pew Commission 

has recommended, and I am not going to differentiate among all of 

them. We think all five should be in there. And if any of them 

aren’t, I guess we would feel that Congress would be making a mistake. 

Here’s my personal view about what I would counsel the Congress, and even be so bold as to say to the President of the United 

States: Don’t oversell this bill when it is passed. Don’t use the word 

‘‘never again.’’ Because the fact is that capitalist systems are inherently susceptible to crises. 

In fact, there is a new book out by Ken Rogoff, the former chief 

economist of the IMF, and a Maryland professor, Carmen Reinhart, 

that documents exhaustively the frequency of crises over hundreds 

of years in many countries. 

I am old enough to remember 1991, the banking crisis, LTCM, 

savings and loan. That is sort of how I cut my teeth in academia 

and so forth. I have been through this. I have seen this movie before. This movie will happen again. 

The best that we can hope for, and this is what I think we should 

tell the American people, is that this bill will reduce the frequency 

and the severity of future crises, and that is the best we can do. 

Because there will always be new instruments and new markets 

that will get out of control. And hopefully, if we have a systemic 

risk monitor, we will attenuate those bubbles, but we are never 

going to prevent them. And let’s just don’t overpromise. 

Representative Snyder. Mr. Carr, the biggest mistake you 

think Congress will make. 

Mr. Carr. Absolutely. I believe that the false positives in the 

condition of the banking industry as well as the economy may lead 

policymakers not to do the really bold and transformational systemic redesign that is needed. 

The reason I say that is if you look at the current intervention— 

in fact, a lot has been said that we have been pulled from the edge 

of an abyss, we are no longer there, you know, the financial system 

is recovering. 

Well, let’s look at what we really did: We made too-big-to-fail bigger. At the same time, lending among those institutions is going 

down, even though their earnings appear to be going up. The 

FDIC’s fund is depleted. If you look at the reality of unemployment, it is growing, with more than a third of the unemployed 

long-term unemployed. Food insecurity is growing. Poverty is growing. The fact of the matter is that, while the economy is technically 

out of recession, America is in deep depression, or at least millions 

of Americans are. 

So I guess my bottom line is that we haven’t come out of the 

woods yet. And we need to stay focused on the fact that the financial system is not working for the American public, it is not well 

regulated, it is not well supervised. And the fact that we are now 

away from the abyss does not mean that we can’t make a U-turn 

and head back in that direction if we don’t make the changes that 

are essential. 

29 

Representative Snyder. Mr. Steel, your personal opinion. 

Mr. Steel. Yes. Well, my personal opinion is tied up in the Pew 

Report, but I will go past that. I think really what I am going to 

refer to is the methodology by which we developed our perspective. 

We took, a dozen or 15 of us, that had very, very different views, 

and we focused on what we thought were the five key issues: systemic risk, too-big-to-fail, prudential regulation, consumer protection, and strengthening the marketplace. And what we found was 

we all found ways we could compromise. And I think there is a 

dueling tension between wanting to encourage the way in which 

our economy can be so strong and resilient, but also yet wanting 

to have regulation. And getting that tension right and having long 

meetings to discuss this and listening to each other was the right 

way. And it is the tension between those two forces that I think 

is the right thing that you are going to have to measure. And getting it wrong would be to lean too much left or too much right on 

that point, but instead trying to basically not be too ideological, but 

trying to understand what can work would be my recommendation. 

Representative Snyder. Thank you for your testimony. And, 

Dr. Litan, I want you to know that never again will I use the 

phrase ‘‘never again.’’ 

Representative Hinchey. Before we end, I just want to ask one 

last kind of general question, and that has to do with the history 

of the economic circumstances that this country has had to deal 

with. 

We know that up until 1929, there were problems with the economy that would occur every 10, 15 years or so, but they were always managed, they were never deeply serious, but they were routine. But over time there was this sort of organization of the banking industry and the growing manipulation of investment circumstances, things of that nature. All of that brought about a big 

collapse in 1929. 

Then, in 1933, we had the Glass-Steagall Act. The Glass-Steagall 

Act seemed to be something very, very effective. It stabilized the 

economy for a long period of time. We didn’t have another collapse 

until 2007, I think, and the kind of experiences we are going 

through now, which are very, very tenuous and could be much 

more damaging over time. So the repeal of that Glass-Steagall Act 

is something that really bothered me a lot personally. I thought it 

was a big mistake at the time, and God knows it seems to have 

been. 

What do you think about that? Do you think that we should be 

bringing back that form of regulation? Do you think that there 

should be this activity of oversight with regard to investment and 

consumer banking, and the manipulation of regulations that occurred so abundantly that really manipulated this economic condition that we are experiencing now? 

Mr. Litan. All right. I don’t know if I am going to make you feel 

any better, but I don’t read history this way. I think the bulk of 

the economic historians identify the critical pieces of legislation 

which helped save the country during the depression as, A, deposit 

insurance; and B, all the SEC rules and so forth that we adopted. 

Glass-Steagall was incidental to all of this. One of the interesting 

historical facts is that the cosponsor of Glass-Steagall, Senator CarVerDate Nov 24 2008 12:13 Jun 08, 2010 Jkt 054937 PO 00000 Frm 00033 Fmt 6633 Sfmt 6633 C:\DOCS\55899.TXT SHAUN PsN: DPROCT
30 

ter Glass, went to the floor of Congress 2 years later and said, ‘‘I 

want to repeal the act. It was a mistake.’’ But by then it was too 

late. 

Let’s roll the clock forward today. 

Representative Hinchey. It wasn’t too late. It could have been 

repealed. 

Mr. Litan. I know. But there was no momentum for it. It happened, and you know, you have been in Congress long enough to 

know that it is hard to reverse things. 

Representative Hinchey. My opinion, that the momentum was 

that it was showing itself to be effective, that it was having good 

positive effects. But you disagree. 

Mr. Litan. Yes, I disagree with that. And, by the way, it is not 

just my view. I think if you took a random sample of most economic 

historians, they would say the same thing. 

But let’s go forward. Let’s look at this crisis. I would posit that 

even if we had separated commercial and investment banking, it 

wouldn’t have made any difference if we hadn’t fixed all this other 

stuff, you know, the stuff that Brooksley has talked about, that Jim 

talked about, and so forth. Because if we look at the institutions 

that got into trouble, it wasn’t because of Glass-Steagall. Merrill 

Lynch, Goldman Sachs, Morgan Stanley, and other big institutions 

were not basically financial conglomerates, they were investment 

banks, and they underwrote a lot of the securities that helped get 

us into trouble. 

Likewise, if you look at the big banks, it is true that Bank of 

America had an investment banking affiliate, but it was a minor 

thing. The only really true ‘‘financial conglomerate’’ in this entire 

system was Citigroup. But the rest of the big banks that got into 

trouble were not really mixing commercial and investment banking 

in any great degree. 

So I don’t view the Gramm-Leach-Bliley Act which eliminated 

the vestiges of Glass-Steagall, which by the way up until then had 

been largely removed anyhow through regulation by the Federal 

Reserve, I don’t view that as really a precipitating cause of this crisis. 

Now, it is a separate issue which you raised earlier: Did GrammLeach-Bliley allow some institutions to become larger, so big that 

they became too-big-to-fail? Well, if you look at these names that 

I just rattled off, they are all pretty big even as investment banks 

or as commercial banks. 

So I conclude by looking at the recommendation of the Pew Task 

Force which says, let’s look at an institution and see if its winddown plan is not satisfactory, then selectively force the divorce that 

you are talking about. But I wouldn’t actually mandate it by law. 

And, by the way, as a practical matter, there really, as I said, 

aren’t that many integrated financial institutions anyhow. That is 

sort of one of the ironies of Gramm-Leach-Bliley. We thought that 

there would be all these financial conglomerates, and it turns out 

there weren’t many of them. 

Representative Hinchey. Any other comment on that? 

Ms. Born. Let me just mention that I do think it is a worthwhile 

exercise to look again at the activities we permit large financial institutions that have insured deposits to engage in. It wasn’t 

31 

Gramm-Leach-Bliley that let our banks like JP Morgan act as overthe-counter derivatives dealers, but it was the banking regulators 

who did that years before Glass-Steagall was eliminated. But that 

added an enormous amount of risk to those institutions. 

I think you could look at proprietary trading by large financial 

institutions that have insured deposits and ask yourselves, is that 

the kind of activity we want to be going on in an institution that 

the taxpayer is insuring? 

So I do think there are issues. I agree with Bob that it wasn’t 

only Glass-Steagall in the 1930s that protected the economy. It was 

the idea that there should be regulation of securities and securities 

exchanges, that there should be regulation of futures exchanges, 

that there should be deposit insurance, and several other things 

that, all together, had given us a long period of time of relative stability before this current crash. And a lot of that has been dismantled either through statutes like the Commodity Futures Modernization Act of 2000, or by the failure of regulators to actually 

exercise their powers and enforce the laws that they have been entrusted with. 

Representative Hinchey. Anyone else? 

Mr. Carr. I was just going to comment that I also would agree 

with much of what Bob said, and really just remind the committee 

that while the back end of the process, the derivatives, the investment banks, and on and on and on, played an important role. The 

point of the spear of the meltdown of the mortgage market happened at a more simple place, which was the interaction between 

the brokers and the lenders and the consumers. And had the products that they were offering not been literally designed not to be 

sustainable, we would not have had much of the process here. Our 

current laws, had they been enforced, could have eliminated much, 

if not the bulk of the unfair and deceptive lending practices that 

brought the housing and credit markets down. 

Mr. Steel. Your original question, sir, was about the business 

model of large financial institutions. And I think my own instinct 

is while further study is always a good idea, is that in today’s marketplace the distinction between lending, securities, and insurance 

is blurred to such a degree that you can make it whatever you 

want it. And trying to design business models that put people in 

one lane of those activities will not be successful; and, therefore, I 

wouldn’t spend a lot of time doing it. And I would focus on having 

strong regulators who look at the business, understand it, apply 

capital standards, and move along that way, as opposed to trying 

to design the business model. Because someone will find a way 

around the business model that you try to prescribe. And I just 

think that is the likelihood and ultimate outcome. 

Representative Hinchey. Well, I thank you all very, very 

much. Thanks for being here, and thanks for everything that you 

have said. We very much appreciate it. 

[Whereupon, at 12:28 p.m., the committee was adjourned.] 

(33) 

SUBMISSIONS FOR THE RECORD 

34 

PREPARED STATEMENT OF CAROLYN MALONEY, CHAIR, JOINT ECONOMIC COMMITTEE

Good morning. I want to welcome our distinguished panel of witnesses today as 

we discuss proposals to regulate the over-the-counter derivatives market and underregulated credit markets. 

The financial crisis and the ensuing recession were triggered by the collapse in 

the price of homes and the resulting defaults in the mortgages used to purchase 

them. Without interference from regulators, financial institutions aggressively purchased over-the-counter derivatives, such as mortgage-backed securities, with the 

expectation that they would generate high returns with minimal risk. To hedge 

against any risk, they also purchased unregulated credit default swaps that would 

pay them if the mortgages underlying the derivatives defaulted. This created a tangled web of counterparties. 

This crisis didn’t have to happen. One of our distinguished witnesses, Brooksley 

Born, had the foresight to recognize the dangers of unchecked growth, lack of transparency, and overleveraging in the over-the-counter derivatives market back in the 

late 1990s. As Chair of the CFTC, she advocated regulating this market, which at 

its peak was tied to over $680 trillion in assets—approximately 50 times the U.S 

GDP! However, she was ignored and silenced by a chorus of critics who hailed overthe-counter derivatives as the greatest financial innovation of the decade because 

they would spread risk efficiently among market participants. 

With the economy booming, her fears seemed exaggerated. Siding with her critics, 

Congress passed the Commodity Futures Modernization Act of 2000, which prevented the CFTC from regulating the over-the-counter market. Ironically, the Act’s 

stated purpose was ‘‘to reduce systemic risk in the markets for futures and overthe-counter derivatives.’’ 

During the current crisis, the lack of transparency and regulation in the over-thecounter market spread panic within the financial community when the housing bubble burst. Banks could not tell which banks were teetering on bankruptcy and which 

weren’t because the positions they had taken in the over-the-counter market were 

unknown. A crisis of confidence erupted and a contagion of fear and uncertainty 

spread. Credit markets became crippled as banks held onto their assets and stopped 

lending. 

The House Financial Services Committee and House Agriculture Committee are 

meeting this week to merge their versions of the bill that will finally regulate the 

over-the-counter market. The merged bill will promote transparency by requiring 

that these previously unregulated derivatives be traded on exchanges or clearinghouses. Capital and margin requirements will beestablished so that financial institutions can no longer make risky bets. And information about prices and trading 

volumes will be publicized so that market participants will no longer be uncertain 

of the value of their securities. 

Although these bills exempt some derivatives from regulation, the exemptions are 

an attempt to balance concerns of some businesses that need customized derivatives 

and the potential risk to the financial system. 

The House Financial Services Committee has also passed a bill establishing the 

Consumer Financial Protection Agency to shield consumers from deceptive financial 

practices. People will no longer have to deal with mortgage lenders who prey on 

those with poor credit histories by offering them subprime mortgages under unfair 

terms. 

Although our economic recovery is far from complete, there is a growing understanding that the economy is moving back on track, helped along by the Recovery 

Act. Third quarter GDP grew 2.8 percent, after contracting for four consecutive 

quarters. Financial markets have recovered substantially and interbank lending is 

back to its pre-crisis level. 

However, Congress cannot repeat its past mistake of turning a blind eye to the 

over-the-counter market. Even as our economy and financial markets stabilize, Congress cannot afford to once again embrace the misguided notion that this market 

can regulate itself. Now is the time to act. 

I thank the witnesses for coming before the committee this morning and I look 

forward to hearing your testimonies. 

PREPARED STATEMENT OF BROOKSLEY BORN, FORMER CHAIR, COMMODITY FUTURES

TRADING COMMISSION

Madam Chair and Members of the Committee: 

Thank you for inviting me to appear before you to discuss the over-the-counter 

derivatives market. 

35 

When I was Chairperson of the Commodity Futures Trading Commission more 

than a decade ago, I spoke out about the dangers posed by the rapidly growing and 

unregulated over-the-counter derivatives market and called for effective federal 

oversight. I was aware that powerful interests in the financial community were opposed to any examination of that market. Yet I spoke out because, as the head of 

the federal regulatory agency with the greatest experience and expertise in derivatives markets, I felt a duty to let the public, Congress and the other financial regulators know the potential threats to our financial stability. I strongly believed that 

the lack of transparency and the absence of government oversight of over-thecounter derivatives had to be remedied by the adoption of appropriate regulation. 

My voice was not popular. The financial markets had been expanding, innovation 

was thriving, and the country was prosperous. The financial services industry argued that markets had proven themselves to be self-regulating and that the role of 

government in market oversight and regulation should be reduced or eliminated. 

All of us have now paid a large price for that fallacious argument. We have experienced the most significant financial crisis since the Great Depression, and regulatory gaps, including the failure to regulate over-the-counter derivatives, have 

played an important role in the crisis. We have now spent hundreds of billions of 

taxpayer dollars to deal with the financial crisis, and the American people have experienced massive losses of jobs, homes, savings and businesses. 

As a result of pressures from a number of the country’s largest financial institutions, Congress passed a statute in 2000 that eliminated virtually all government 

regulation of the over-the-counter derivatives market, the Commodity Futures Modernization Act of 2000. Because of that statute, no federal or state regulator currently has oversight responsibilities or regulatory powers over this market. 

The market is totally opaque and is often referred to as ‘‘the dark market.’’ It is 

enormous. At its height a year and a half ago in June 2008 the reported size of the 

market exceeded $680 trillion in notional value or more than ten times the gross 

domestic product of all the countries in the world. As of June 2009 the market reportedly still exceeded $600 trillion in notional value. 

While over-the-counter derivatives have been justified as vehicles to manage financial risk, they have in practice spread and multiplied risk throughout the economy and caused great financial harm. Lack of transparency and price discovery, excessive leverage, rampant speculation, lack of adequate capital and prudential controls, and a web of interconnections among counterparties have made the market 

extremely dangerous. Warren Buffet has appropriately dubbed over-the-counter derivatives ‘‘financial weapons of mass destruction.’’ They include the credit default 

swaps disastrously sold by AIG and many of the toxic assets held by our biggest 

banks. They spurred the housing and credit bubbles and accelerated the contagion 

as the bubbles burst and the crisis spread. A number of the financial firms that 

failed or have required extraordinary government support during the recent crisis 

were among the world’s major over-the-counter derivatives dealers, including AIG, 

Bear Steams, Lehman Bros., CitiGroup, Merrill Lynch, Bank of America, Morgan 

Stanley, Goldman Sachs, and J.P. Morgan. 

This over-the-counter market continues to be unregulated and to pose grave dangers to the economy. It is critically important for Congress to act swiftly to impose 

the rules necessary to close this regulatory gap and to protect the public. As time 

passes and the economy appears to be stabilizing, there is a danger that the sense 

of urgency to adopt these important reforms may diminish. We now have a unique 

opportunity—a narrow window of time—to fashion and implement a comprehensive 

regulatory scheme for these instruments. 

Existing U.S. laws governing the futures and options markets provide a worthy 

model for regulating the closely related instruments traded in the over-the-counter 

derivatives market. The Commodity Futures Trading Commission and the Securities 

and Exchange Commission should have primary regulatory responsibilities for derivatives trading, both on and off exchange. As with futures and options, all standardized and standardizable derivatives contracts should be traded on regulated derivatives exchanges and cleared through regulated derivatives clearing operations. 

A regulatory regime based on the requirements established in the Commodity Exchange Act for designated contract markets and derivatives clearing operations 

should apply to such trading and clearing. These requirements would allow effective 

government oversight and enforcement efforts; ensure price discovery, openness and 

transparency; reduce leverage and speculation; and limit counterparty risk. While 

central clearing would mitigate counterparty risk, central clearing alone is not 

enough. Exchange trading is also essential in order to provide price discovery, transparency and meaningful regulatory oversight of trading and intermediaries. 

In my view, there should be no statutory exceptions from the rule that all standardized and standardizable contracts should be traded on exchange rather than 

36 

over-the-counter. Some large corporations are arguing that they should be permitted 

to continue to trade standardized contracts over-the-counter because they wish to 

avoid paying the cash margins required for exchange-traded contracts. Such an exception is unwarranted. Large corporations will benefit from the price discovery, 

transparency and regulatory oversight of exchange trading, which generally should 

lead to lower prices for trades. Moreover, creditworthy corporations should be able 

to obtain lines of credit as needed to meet their margin requirements for exchange 

trading. 

The over-the-counter market is necessarily much less transparent and much more 

difficult to regulate than an exchange market. If any trading in over-the-counter derivatives is permitted to continue, such trading should be limited to truly customized, non-fungible contracts between highly sophisticated parties at least one of 

which requires such a customized contract in order to hedge actual business risk. 

Such customized contracts by their nature cannot be traded on an exchange or 

cleared by a clearinghouse. While customized over-the-counter contracts may serve 

an economically useful purpose by allowing businesses to hedge complex business 

risks, there is no adequate justification for allowing purely speculative customized 

contracts to be traded in the more dangerous over-the-counter market. Therefore, 

at least one party to every over-the-counter contract should be required to certify 

and be able to demonstrate that it is using a customized contract to hedge a bona 

fide business risk. So limiting the over-the-counter market would reduce the potential risks created by that market. 

Furthermore, any continuing over-the-counter market should be subject to a robust federal regulatory regime requiring transparency and protections against 

abuses and catastrophic defaults. There should be registration, recordkeeping and 

reporting requirements for all over-the-counter derivatives dealers, and they should 

be subject to business conduct standards, including requirements to disclose contract 

terms, pricing and risks to their customers. All over-the-counter trades should be 

subject to margin requirements, and all large market participants should be subject 

to capital requirements. In addition, transaction prices and volumes of over-thecounter derivatives should be publically reported on an aggregated and timely basis. 

The market should be subject to prohibitions against fraud, manipulation and other 

abusive practices. 

These measures would go far toward bringing this enormous and dangerous market under control. They should be adopted and implemented if we hope to avoid future financial crises caused by this market. The country cannot afford to delay or 

weaken our response to the crisis. If we as a people do not learn from our experiences and respond appropriately, we will be doomed to repeat them. 

Thank you very much. 

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