S. HRG. 110–959 

THE STATE OF THE BANKING INDUSTRY 

HEARING 

BEFORE THE

COMMITTEE ON 

BANKING, HOUSING, AND URBAN AFFAIRS 

UNITED STATES SENATE 

ONE HUNDRED TENTH CONGRESS 

SECOND SESSION 

ON 

THE STATE OF THE BANKING INDUSTRY 

TUESDAY, MARCH 4, 2008 

Printed for the use of the Committee on Banking, Housing, and Urban Affairs 

( 

Available at: http://www.access.gpo.gov/congress/senate/senate05sh.html 


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THE STATE OF THE BANKING INDUSTRY 


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50–370 2010

S. HRG. 110–959 

THE STATE OF THE BANKING INDUSTRY 

HEARING 

BEFORE THE

COMMITTEE ON 

BANKING, HOUSING, AND URBAN AFFAIRS 

UNITED STATES SENATE 

ONE HUNDRED TENTH CONGRESS 

SECOND SESSION 

ON 

THE STATE OF THE BANKING INDUSTRY 

TUESDAY, MARCH 4, 2008 

Printed for the use of the Committee on Banking, Housing, and Urban Affairs 

( 

Available at: http://www.access.gpo.gov/congress/senate/senate05sh.html 


dcolon on DSK2BSOYB1PROD with HEARING
(II) 

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS 

CHRISTOPHER J. DODD, Connecticut, Chairman 

TIM JOHNSON, South Dakota 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

EVAN BAYH, Indiana 

THOMAS R. CARPER, Delaware 

ROBERT MENENDEZ, New Jersey 

DANIEL K. AKAKA, Hawaii 

SHERROD BROWN, Ohio 

ROBERT P. CASEY, Pennsylvania 

JON TESTER, Montana 

RICHARD C. SHELBY, Alabama 

ROBERT F. BENNETT, Utah 

WAYNE ALLARD, Colorado 

MICHAEL B. ENZI, Wyoming 

CHUCK HAGEL, Nebraska 

JIM BUNNING, Kentucky 

MIKE CRAPO, Idaho 

ELIZABETH DOLE, North Carolina 

MEL MARTINEZ, Florida 

BOB CORKER, Tennessee 

SHAWN MAHER, Staff Director 

WILLIAM D. DUHNKE, Republican Staff Director and Counsel 

DAWN RATLIFF, Chief Clerk 

SHELVIN SIMMONS, IT DIRECTOR

JIM CROWELL, Editor 


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(III) 

C O N T E N T S 

TUESDAY, MARCH 4, 2008 

Page 

Opening statement of Chairman Dodd .................................................................. 1 

Opening statements, comments, or prepared statements of: 

Senator Bennett ................................................................................................ 4 

Senator Reed ..................................................................................................... 5 

Senator Dole ...................................................................................................... 6 

Senator Bayh .................................................................................................... 7 

Senator Carper ................................................................................................. 7 

WITNESSES 

Sheila C. Bair, Chairman, Federal Deposit Insurance Corporation .................... 8 

Prepared statement .......................................................................................... 65 

Response to written questions of: 

Chairman Dodd ......................................................................................... 288 

Senator Reed .............................................................................................. 295 

Senator Crapo ............................................................................................ 299 

John C. Dugan, Comptroller of the Currency, U.S. Treasury .............................. 10 

Prepared statement .......................................................................................... 87 

Response to written questions of: 

Chairman Dodd ......................................................................................... 300 

Senator Crapo ............................................................................................ 310 

John M. Reich, Director, Office of Thrift Supervision .......................................... 12 

Prepared statement .......................................................................................... 141 

Response to written questions of: 

Chairman Dodd ......................................................................................... 317 

Senator Crapo ............................................................................................ 322 

JoAnn M. Johnson, Chairman, National Credit Union Administration ............. 13 

Prepared statement .......................................................................................... 176 

Response to written questions of: 

Chairman Dodd ......................................................................................... 323 

Senator Crapo ............................................................................................ 330 

Donald L. Kohn, Vice Chairman, Board of Governors, Federal Reserve System ......................................................................................................................... 14

Prepared statement .......................................................................................... 200 

Response to written questions of: 

Chairman Dodd ......................................................................................... 330 

Senator Crapo ............................................................................................ 351 

Thomas B. Gronstal, Iowa Superintendent of Banking, State of Iowa ............... 16 

Prepared statement .......................................................................................... 219 

Response to written questions of: 

Chairman Dodd ......................................................................................... 352 

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

Financial Conditions of the Enterprises ................................................................ 384 


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(1) 

THE STATE OF THE BANKING INDUSTRY 

TUESDAY, MARCH 4, 2008 

U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC. 

The Committee met at 10:08 a.m., in room SD–538, Dirksen Senate Office Building, Senator Christopher J. Dodd (Chairman of the 

Committee) presiding. 

OPENING STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD 

Chairman DODD. The Committee will come to order. My apologies to our witnesses and my colleagues here for being a couple 

minutes late. 

I believe Senator Shelby will try and get by. There is a large Alabama meeting this morning, I think regarding the recent announcement of the fuel tanker issue, and Alabama has a strong interest in that. And for that reason, he will not be here, at least for 

a while this morning. 

What I will do here is I will begin with an opening statement. 

I will turn to any other members who would care to make a brief 

opening comment. I would like to, if we could, get to the questions 

and hear from our witnesses this morning. I want to thank all of 

them for participating. 

The Committee this morning examines the state of the banking 

industry in our Nation. Such an examination by this Committee 

could not be more important or timely, in my view. It is important 

because our first duty, obviously, as legislators on this Committee 

is to ensure that insured depository institutions operate in a safe 

and sound manner. These institutions currently hold over $4.3 trillion in deposits that are insured by the American taxpayer. Therefore, the taxpayer, of course, has a right to know that the appropriate agencies are ensuring that any risks to those deposits are 

being managed prudently and with taxpayers’ ultimate liability in 

mind. 

I well remember sitting on this dais two decades ago—in fact, I 

think Senator Shelby was here, and others—cleaning up the mess 

caused by the reckless and wanton practices in the savings and 

loan industry. Those practices and the regulatory failures that allowed them to occur required a taxpayer bailout of some $150 billion. Those were very difficult days on this Committee. None of us, 

not a single person on this Committee, nor, I would suggest, any 

one of our colleagues, wants to go through that kind of exercise 

again, ever again. That is why this hearing is not only important 

but I think timely as well. 


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Credit markets are experiencing unprecedented disruptions right 

now. The markets for mortgages, credit cards, student loans, auto 

loans, corporate debt, municipal debt—in short, for all of the economic activities that are indispensable to growth and prosperity— 

these markets have chilled and in some cases have frozen entirely. 

These markets have seized up mostly as a direct result of problems 

in the subprime market. Recent estimates indicate that insured depositories and other financial institutions could lose an additional 

$300 to $400 billion due to exposure to mortgages, residential as 

well as commercial. 

It is no surprise, therefore, that many of these institutions have 

sought infusions of over $30 billion in capital from foreign sovereign wealth funds since November last year. The federally insured banks, thrifts, and credit unions of our Nation are not just 

another group of financial intermediaries. Their success or failure 

is not merely of concern to their employees and shareholders. It 

should be and must be a concern for all of us because these institutions in a very real sense form the cornerstone of our Nation’s economic foundation. If these lenders do not or cannot lend, then our 

economy cannot and will not grow, obviously. 

President Kennedy is reported to have once said that if the economy is wrong, then nothing is right. If that is the case, then it is 

no less true that if the banking industry is wrong, then the economy is not right as well. The regulatory agencies that oversee this 

industry, therefore, play an indispensable role not only in the economic activities of the lenders they oversee, but in the economic life 

of our Nation. They do not merely apply and enforce the laws, as 

important as that job is; and they do not only ensure that the deposits which are insured by the American taxpayer are managed 

in a safe and sound manner, though they do that as well; fundamentally, you all serve as the gatekeepers of credit for the entire 

economy of our Nation. That is an awesome responsibility, and the 

men and women who work at our Nation’s financial regulatory 

agencies understand that responsibility, and, by and large, they 

discharge those duties with diligence and with distinction, I would 

add. 

But their dedication is not tantamount to infallibility. That point 

was made a year and a half ago when Senators Allard and Bennett 

convened hearings on irregular practices in the mortgage lending 

industry. I have commended them before—and I do so again this 

morning—for those hearings, which were prescient in many ways. 

The point was made again a year ago when this Committee convened a hearing to examine the turmoil in our Nation’s mortgage 

markets. At that time I detailed what I termed ‘‘the chronology of 

neglect’’ by Federal regulators, principally the Federal Reserve 

under previous leadership. We presented evidence that the Federal 

Reserve examiners knew as far back as late 2003 of the deterioration of lending standards and the origination of adjustable rate and 

nontraditional mortgages. Yet the Fed did nothing to intervene, in 

my view. On the contrary, its Chairman at the time actually encouraged such loans. But then he simultaneously embarked on a 

series of interest rate hikes that would make adjustable rate mortgages less affordable to homeowners. 


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The impact of these policies is now felt, of course, by millions and 

millions of American consumers who face interest rate spikes that 

have led or will lead to foreclosure. It is felt by millions more who 

cannot obtain mortgage credit because the market for subprime 

and jumbo loans has seized up. It is felt by entrepreneurs who cannot obtain loans or other forms of financing because lending institutions are in a virtual credit lockdown. And it is felt by the lenders themselves, obviously, who are struggling in ways that they 

have not struggled in recent memory. 

It is no wonder that the Fed’s own witnesses at a hearing before 

this Committee last year said that, in retrospect, his agency—and 

I quote—‘‘could have done more sooner’’ to address predatory mortgage lending practices. 

Again and again, the question has been asked over the past year, 

as our credit markets have grown increasingly impaired: Where 

were the regulators? Why didn’t they do more? Were they asleep 

at the switch? And when the alarm went off, did they merely hit 

the snooze button? 

Four years ago, Senator Shelby convened an oversight hearing 

similar in purpose to today’s hearing. At the time, the Federal 

agencies represented here this morning hailed innovations in risk 

management that enabled banks to better quantify risks and take 

other corrective measures to contain undue risks. They pointed to 

the second markets and newly developed structured finance products as tools that would help banks more effectively manage and 

diversify their risks. In the words of the then-Comptroller of the 

Currency, bank supervision would provide—and I am quoting—‘‘a 

layer of protection against the challenges posed by our changing 

economy.’’ 

Four years later, we want to know what happened. What happened to the newfangled risk management innovations that were 

supposed to sound an early warning about reckless lending practices? What about the promise of securitization as a way to manage 

credit risk? Where was the layer of supervisory protection against 

excessive risk? Why didn’t you more vigorously enforce good, oldfashioned, common-sense underwriting where a loan is made based 

on a borrower’s ability to pay? And what are you doing now today 

to protect against new risks posed by instruments such as credit 

default swaps, trillions of which are held by the institutions you 

regulate? 

I have read your testimony, and you seem to suggest that you 

will study what went wrong here. You have all said that we need 

to get back to the fundamentals, that we need to return to core 

practices, that we need to revive the way banks manage risk, underwriting, and capital. But studying the problem is not enough, 

and I want to see some meaningful and substantial action from all 

of you as soon as possible. 

Specifically, I want to know what you intend to do to change 

what has been lax oversight of underwriting standards. I want to 

know what steps you intend to take to make sure that we rethink 

the assumptions underlying Basel II prior to its implementation. 

And I want to know what specific changes to the supervision of 

bank risk management you intend to implement moving forward. 


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I intend to reconvene this panel within 60 days to hear your responses to these very important questions. These are legitimate 

questions, important questions, questions that American taxpayers 

have every right to ask and have answered for them. 

We appreciate the willingness of our witnesses, obviously, to appear today to help provide these answers. I am grateful to all of 

you. 

Let me turn to Senator Bennett if he has any opening comments 

he would want to make, and my other colleagues as well, and then 

we will hear the testimony. 

STATEMENT OF SENATOR ROBERT F. BENNETT 

Senator BENNETT. Thank you very much, Mr. Chairman. I think 

you have outlined the problem extremely well. Let me make two 

very quick comments. 

First, in this morning’s Wall Street Journal, in an article that 

references today’s hearings, the authors of the article say, if I may 

quote, ‘‘Today in Washington, D.C., the Senate Banking Committee 

is expected to grill Federal regulators on what went wrong. Did 

banks know how much risk they were taking? Did they know how 

much capital they needed to cushion them from sour loans? Did 

they prepare themselves adequately for the evaporation of liquidity 

or their ability to easily sell their securities or loans? The answer 

to all three questions appears to be no.’’ 

I think that is as good a summary of where we are and why we 

are here, and I add to that this personal anecdote, and I shall not 

disclose the individual because it was a one-on-one conversation between the two of us, and I do not suppose he would want me to 

violate the confidentiality of that conversation. But a very significant official from another country was in my office talking about 

the impact of all of this on the banking system in his country. And 

as he was describing the chain of events that led up to the crisis, 

he said, ‘‘They bought the package’’—speaking of the banks in his 

country, ‘‘They bought the package on the basis of the rating that 

had been given it by nationally recognized rating agencies, and 

they did not know what was in it.’’ And he kind of innocently did 

not realize what he was just saying, and now that they realize that 

in the package there were a bunch of subprime loans and they are 

going to have to change their capital structure to deal with this, 

and then with a sense of urgency and almost terror in his voice, 

he said, ‘‘Senator, the bank in my hometown is going to go bankrupt over this. They bought a package based on AAA ratings, and 

now they are going to go bankrupt.’’ 

And, unfortunately, I did not have any consoling words for him 

or reassurances that it was, in fact, not going to happen. 

So the only additional comment I will make to your excellent 

opening statement, Mr. Chairman, is that this is not confined to 

the United States. This is spreading, and the three questions asked 

in the article very much applied to the foreign official that was in 

my office. The answer to the questions was clearly no, they did not 

know, and we are here to do whatever we can to try to help people 

in the future know what they are buying and what they are doing. 

It would be one thing to say to them, well, they bought a package 

without reading the fine print and they deserve what they got. But 


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they did at least look at the overall risk, looked at the ratings that 

they got, and thought they had done some due diligence. Clearly, 

they did not do enough, and this hearing will help us deal with 

that problem. 

Chairman DODD. Senator Reed. 

STATEMENT OF SENATOR JACK REED 

Senator REED. Well, thank you, Mr. Chairman. I think this is a 

well-timed and very important hearing. You have made some excellent points, and just let me briefly say that there have been estimates recently by UBS that this whole financial crisis is on the 

order of $600 billion, and to date, banks, financial institutions, recognize roughly $160 billion. So we have a long way to go to work 

out this problem. And the difficulties and consequences that Senator Bennett alluded to, small banks across the world and across 

the United States, in communities and organizations and individuals will feel this pain dramatically. 

So I think we have two major challenges. One is to solve this liquidity crisis if we can, or at least prevent it from further exploding, and also make sure we do not repeat what seems to be, in 

hindsight at least, oversights and regulatory gaps that allowed the 

situation to develop. 

It would be great, as the Chairman suggested, if we were still in 

a world of good, old-fashioned underwriting standards where you 

knew your borrower and you kept the paper in your files and you 

had a vested interest in making sure the mortgage was paid and 

the terms were worked out. But in the world of securitization and 

globalization, that seems to be more nostalgic than anything else. 

But in this new world, we have to recognize that perhaps regulation is more important, and that is why I think when we talk about 

Basel II and others, where the framework would be self-evaluation 

by financial institutions and credit rating agencies, we have to take 

a pause, at least, to ensure we do that right. 

As we go forward, I think we have to look at this securitization 

process. It is a financial instrument that is not going to go away, 

or a financial technique that is not going to go away. But, again, 

it puts, I think, more pressure on regulators to get right, to look 

carefully at the off-balance-sheet instruments that banks are holding, and vehicles. And then we have to, I think, have much more 

financial transparency. But the purpose of this hearing I think is 

necessary. 

I have not been here as long as the Chairman or my colleagues, 

but after Enron, I thought we had—and Sarbanes-Oxley, I thought 

we had gone a long way in directing that steps be taken to account 

for off-balance-sheet transactions. That was one of the great problems with Enron. They had all these vehicles, Raptors, et cetera. 

It turns out that, I guess, we did not get it that time. We have got 

to get it this time. I think also 2 years ago, when Congress passed 

legislation giving the Federal Reserve the authority to pass rules 

with respect to what types of paper, what types of mortgage loans, 

what standards, et cetera, that was just recently enacted by regulations by the Fed—many, many years after it should have been put 

in place. So this is an opportunity, once again, to do what I think 

should be done. 


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Thank you. 

Chairman DODD. Senator Dole. 

STATEMENT OF SENATOR ELIZABETH DOLE 

Senator DOLE. Thank you, Chairman Dodd, for holding this important hearing on the state of the banking industry, and I want 

to start off by saying a few words about Sheila Bair, the Chairman 

of the Federal Deposit Insurance Corporation. 

Sheila has a long history of public service that includes working 

as deputy counsel and counsel when my husband was Senate Majority Leader. And, Sheila, I want to thank you for your continued 

service to the public and the vital role that you are playing to assure competence and confidence in this volatile housing and financial market. It is a real pleasure to work with you in a professional 

way and always to see you. 

As we know oh so well, over the past 6 months our financial institutions have been shaken by the subprime lending markets. 

These institutions have been pressured by write-downs, and their 

fourth quarter earnings decreased significantly. The Office of Thrift 

Supervision reported that the thrift industry posted a record $5.2 

billion fourth quarter loss. Additionally, the two biggest banks in 

North Carolina—Bank of America and Wachovia—reported that 

their earnings fell in the fourth quarter by 95 percent and 98 percent, respectively. 

Last week, the FDIC classified 76 banks as problem institutions 

for the fourth quarter of 2007. This is up from 65 in the third quarter, which underscores the growing number of banks that are showing signs of strain. FDIC is taking steps to brace for a potential increase in failed financial institutions. I also applaud the FDIC for 

its prospective thinking and planning for future unforeseen circumstances that could adversely impact our banking infrastructure. 

Additionally, with respect to the current regulation of financial 

institutions, it has come to my attention that some smaller banks 

in particular are overburdened by compliance with Sections 404 

and 302 of the Sarbanes-Oxley corporate accountability law. These 

financial institutions are already highly regulated, and it has become increasingly apparent that these additional regulations, while 

well intended, only increased the cost of doing business. 

Today, I will introduce, Mr. Chairman, the Regulatory Relief and 

Fairness Act, legislation that would allow qualified financial institutions to voluntarily opt out of Sections 302 and 404 of SarbanesOxley. There is companion legislation in the House of Representatives introduced by Congressman Walter Jones. I hope at a minimum the legislation serves as a catalyst for more debate in this 

Committee with respect to comprehensive regulatory relief reform. 

Again, I want to thank all of our witnesses for being here today, 

and I look forward to working with you on these and other important matters. 

Thank you. 

Chairman DODD. Thank you very much. 

Senator Bayh. 


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STATEMENT OF SENATOR EVAN BAYH 

Senator BAYH. Thank you, Mr. Chairman, for holding this hearing on this important topic today, and I particularly want to thank 

you for your intention of having a follow-up hearing in 60 days. As 

you know, very often we have forums like this. We ask questions, 

we get promises and assurances, and then it kind of disappears 

into the void. So I think this is important enough that we stay focused on it, and I want to thank you for that. 

I also want to thank our panel for being here today. I know you 

are all busy. You have important responsibilities, so we are grateful for your time and for your insights. 

Mr. Chairman, I would particularly mention Mr. Dugan. His son, 

Jack, happens to be a classmate of my two boys, and so I assume 

he is a good Comptroller of the Currency, but I know he is a good 

father. And that is perhaps an even higher calling, so I just wanted 

to mention that today. 

Very briefly, Mr. Chairman, I will follow up on something that 

Senator Reed mentioned, and that is the recent UBS estimate of 

additional write-downs, which, if true, could very easily lead to a 

contraction of lending, which would then lead to an even more sluggish economy, which can then drive unemployment up. It sort of 

becomes a self-fulfilling problem that we have. 

So I agree with the comments that have been made that we have 

a short-term and a long-term challenge, and we need to try and 

reconcile these two to make sure that in solving today’s problem we 

do not leave the bigger ones down the road. So we need to move 

aggressively to cauterize this wound, to stabilize the situation, but 

to do so in a way that does not lead to inflation down the road, 

does not lead to risks of moral hazard, weaker currency, these 

kinds of things. 

So I am eagerly awaiting your testimony and your advice about 

how to strike the right balance, and having said all that, Mr. 

Chairman, we are here to listen to them, not to me, and again, I 

thank you for having the hearing. 

Chairman DODD. Thank you very much. 

Senator Hagel, any opening comments? 

Senator HAGEL. No. Thank you, Mr. Chairman. 

Chairman DODD. Senator Carper, any quick opening comments? 

STATEMENT OF SENATOR THOMAS R. CARPER 

Senator CARPER. We welcome you. There has been an effort, as 

you probably know, to move a housing recovery package, and so far 

we have not been successful in doing that. But my hope is that 

under the leadership of Senator Dodd and Senator Shelby, we will 

have another bite at that apple in the next week or two or three. 

And when we do, our Republican friends will have an opportunity 

to offer amendments to that package, germane amendments, and 

we will have an opportunity on our side to offer some amendments 

as well. 

When it comes time to ask questions, one of the things I will be 

doing with the panel is really suggesting some of the amendments 

that we have heard that our Republican friends are interested in 

offering to that package, asking your comments for or against, if 

you have some suggestions how we might improve, and some 


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amendments that our side is interested in offering as well. So that 

would be, I think, helpful to us, particularly if we have a chance 

to get back to the floor and take this package up in earnest. 

Thanks very much. 

Chairman DODD. Thank you, Senator. 

Senator Corker. 

Senator CORKER. Mr. Chairman, thank you for the hearing. I am 

looking forward to hearing the panel and, therefore, will not have 

any opening comments. 

Chairman DODD. Very good. I thank all of my colleagues. 

Let me again welcome our witnesses here and thank all of you 

for taking the time to be with us. 

Sheila, I do not know of a better introduction that could be given 

of you than the one that Senator Dole gave you here, so we maybe 

just want to leave it there. We are delighted to have you before the 

Committee again. 

John Dugan is current Comptroller of the Currency and a welcome member anytime in this room, having sat in the chairs behind me here for some time. So we welcome you back to the Committee as the Comptroller of the Currency. 

John Reich is the current Director of the Office of Thrift Supervision, and we thank you very much, John, for being with us. 

JoAnn Johnson is the Chairman of the National Credit Union 

Administration, and we are pleased to have you with us. 

Donald Kohn is, of course, the Vice Chair of the Federal Reserve, 

and we thank you very much for being here this morning as well. 

And, last, Tom Gronstal, who is the Superintendent of the Iowa 

Division of Banking, is here on behalf of the Conference of State 

Bank Supervisors. You look like Mike. Are you related? 

Mr. GRONSTAL. All Gronstals are related, and we are first cousins. 

Chairman DODD. Mike Gronstal is the leader of the State Senate 

in Iowa. Why would I know that? [Laughter.] 

Anyway, we are pleased to have all of you here with us this 

morning, and, Sheila, we will begin with you, and try and keep it 

to 5—you have all been here before. If you can try and keep it to 

5 or 6 minutes—I do not wave a gavel around here, but—and let 

me also say to all of my colleagues and to the witnesses, all of your 

statements, the full statements, supporting data, material, graphs, 

charts, whatever else you want to add, will be included in the 

record. So whatever else you need to give us will be a part of this 

hearing. 

Sheila. 

STATEMENT OF SHEILA C. BAIR, CHAIRMAN, 

FEDERAL DEPOSIT INSURANCE CORPORATION 

Ms. BAIR. Good morning, Chairman Dodd and Members of the 

Committee. Thank you for the opportunity to testify. 

It is no surprise to anyone that the second half of 2007—— 

Chairman DODD. Would you check and make sure your button is 

on? 

Ms. BAIR. It is no surprise to anyone that the second half of 2007 

was a very tough period for the banking industry. Fourth quarter 

results were heavily influenced by a number of well-publicized 


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write-downs by large banks. Weakness in the housing sector and 

a credit squeeze in financial markets made it a very challenging 

time for many institutions. We can expect these problems to continue throughout 2008. 

Last week, we released our ‘‘Quarterly Banking Profile,’’ which 

analyzes financial results for the entire industry. It was a weak report. Industry earnings were down 27 percent for last year, and 

while in the black, they were the lowest we have seen since 2002. 

Fourth quarter results alone were the lowest we have seen since 

the early 1990s. Higher loan loss provisions, big losses on trading 

activities, and write-downs of goodwill were the main factors that 

dragged down industry earnings during the quarter. 

A substantial part of the sharp decline in fourth quarter earnings 

was concentrated in a handful of institutions. Six large institutions 

accounted for more than half of the total decline. Fortunately, they 

all remain well capitalized. Many community banks are also having 

problems. They, too, are seeing their troubled loans increase and 

their earnings diminish, but less so than the large banks. Overall, 

slightly more than half of the 8,500 banks and thrifts that we insure reported lower fourth quarter earnings and have reported increases in troubled loans. 

Despite a tough economic environment, however, the vast majority of institutions so far are successfully coping with the challenges 

they face. The industry as a whole is coming off a golden period 

of record profits. Because of this financial strength, banks and 

thrifts of all sizes are overwhelmingly very safe and very sound. 

Ninety-nine percent of insured institutions were well capitalized at 

the end of 2007, representing 99.7 percent of all bank assets. Nearly 90 percent were profitable for the year, and insured institutions 

increased regulatory capital by more than $29 billion during the 

fourth quarter to bolster their ability to absorb losses. 

Nevertheless, we are well prepared should there be an uptick in 

bank failures. The Deposit Insurance Fund remains strong, with 

$52.4 billion, and we are beefing up the number of staff with experience in dealing with failed institutions. As for troubled banks, 

there are 76 on our problem list. This is a very small number by 

historical standards when you consider the nearly 1,500 troubled 

banks we had on the list in the early 1990s. And these are small 

banks, with only $22 billion in assets compared with $13 trillion 

in total industry assets. 

As part of our efforts to stay ahead of the curve, our examiners 

are very focused on asset quality as write-offs and loss provisions 

are likely to remain high for the near future. We are focused not 

only on mortgages as the housing downturn continues, but also 

commercial real estate, credit card, and small business lending. 

We have been worried about commercial real estate lending for 

a number of months now. We warned industry, along with other 

regulators, about rising concentrations of these loans, especially for 

construction and development, and issued guidance in December 

2006. Given the weakness in housing markets around the country, 

we are keeping a very close eye on trends in the construction and 

development sector, particularly at banks with high concentrations. 

We also remain concerned about the ongoing rise in foreclosures, 

especially for subprime borrowers. We continue to urge lenders to 


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provide long-term, sustainable, and affordable mortgages. I am encouraged by the greater number of homeowners being helped, according to the Hope Now Alliance. I am also pleased that loan 

modifications as a percentage of total workouts rose in January. 

However, I do remain very concerned about the reliance on repayment plans. These may be unsustainable for borrowers and lead to 

delinquencies down the road and contribute to ongoing borrower 

distress. It is absolutely critical that borrowers have loans they can 

afford over the long term. I am hopeful that loan modifications will 

accelerate. But at the same time, I recognize that additional action 

might be needed to reduce foreclosures and prevent the housing 

market from overshooting as home prices adjust downward. 

Longer term, I firmly believe that by returning to more traditional lending practices, we can better protect consumers and help 

our regulated banking industry regain market share in mortgage 

lending in the process. In addition, there is now widespread recognition of the importance of strong capital to protect banks in 

times of stress as well as the need for transparency to maintain liquidity in the structured finance market. We need to recognize the 

limitations of this risk-based modeling, and we need a commonsense approach for using credit ratings. In short, we need to get 

back to basics in both the primary and secondary mortgage markets. In the long run that will serve us all. 

Thank you very much. 

Chairman DODD. Thank you very much, Sheila. 

John, welcome. 

STATEMENT OF JOHN C. DUGAN, 

COMPTROLLER OF THE CURRENCY, U.S. TREASURY 

Mr. DUGAN. Chairman Dodd and Members of the Committee, 

thank you very much. I am pleased to be here today to testify on 

the condition of the banking system. And, Senator Bayh, thank you 

for those very kind words. 

In general, due to a long period of strong economic growth, exceptionally low credit losses, and strong capital ratios, the national 

banking system has been healthy and vibrant. 

Now, however, the system is being tested. Two powerful and related forces are exerting real stress on banks of all sizes and in 

many different parts of the country. One is the large and unprecedented series of credit market disruptions, still unfolding, that was 

precipitated by declining house prices and severe problems with 

subprime mortgages. The other is the slowdown in the economy, 

which has begun to generate a noticeable decline in credit quality 

in a number of asset classes. The combination of these forces has 

strained the resources of many of the national banks that we regulate. 

Despite these strains, the banking system remains fundamentally sound, in part because it entered this period of stress in such 

strong condition. Thus far national banks have been able to address a number of significant problems that have arisen while continuing to supply credit and other banking services to the U.S. 

economy—although there is no doubt that credit standards have 

tightened. For example, large banks provided liquidity support to 

asset-backed commercial paper conduits and structured investment 


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vehicles, or SIVs, often involving the painful recognition of losses 

to restore more normal funding in these markets. Likewise, banks 

with concentrated positions in collateralized debt obligations 

backed by subprime asset-backed securities have recognized large 

losses, but have also raised large amounts of capital to offset these 

and other losses. And a large national bank holding company entered into an agreement to purchase the Nation’s largest mortgage 

originator, which had been under severe funding stress, and that 

action had a calming effect on the market. 

Despite such efforts, however, significant market disruption 

issues remain to be addressed, such as the potential downgrades of 

monoline insurance companies; significant funding problems in the 

auction rate securities market; and severe constriction in the 

securitization markets for residential mortgage-backed securities, 

commercial mortgage-backed securities, and leveraged loans. 

Likewise, the economic slowdown and problems in the housing 

market have caused banks to increase loan loss reserves significantly for such assets as residential construction and development 

loans, home equity loans, and credit card loans. Indeed, smaller 

banks that have exceptionally large concentrations in commercial 

real estate loans—and there are many of them—face real challenges in those parts of the country where real estate markets have 

slowed significantly. Unlike the unprecedented market disruptions 

of the last 6 months, however, these more traditional credit problems are familiar territory to bankers and regulators. The key to 

addressing them is for bankers to recognize problems early and 

manage through them, and that is exactly what our examiners are 

working with them to do. 

There is also a need to re-emphasize several fundamental banking principles: sound underwriting and robust credit administration 

practices; diversified funding sources and realistic contingency 

funding plans; strong internal controls and risk management systems, including stress-testing, valuations, and disclosures; and 

timely recognition of losses coupled with adequate loan loss reserves and strong capital cushions. In each of these four areas— 

asset quality, liquidity, risk management, and reserves and capital—we remain alert to emerging trends and to findings that may 

trigger additional supervisory action. 

Finally, you asked us to describe our current efforts to address 

foreclosure prevention and mitigation. This is very important for 

the OCC since the nine largest national banks act as servicers for 

about 40 percent of all U.S. mortgages, including a significant 

number of subprime mortgages. The OCC has taken a number of 

steps to encourage national bank lenders and servicers to work constructively with borrowers to avoid foreclosures except when absolutely necessary. We have joined the other banking agencies in 

issuing guidance to that effect. We have strongly supported the efforts of the Hope Now Alliance, and we have supported an amendment to the Community Reinvestment Act regulations that would 

provide CRA credit for foreclosure prevention activities in distressed middle-income neighborhoods. 

We also announced last week a significant new effort regarding 

the reporting of key data on mortgages, including mortgage modifications. We are requiring our largest national bank servicers to 


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provide standardized reports on a range of mortgage metrics, not 

just for subprime adjustable rate mortgages but for all mortgages. 

These data, which are consistent with the Hope Now metrics, will 

provide an important way to track mortgage performance against 

a broad range of indicators. 

Thank you very much. 

Chairman DODD. Thank you very much. 

Mr. Reich. 

STATEMENT OF JOHN M. REICH, DIRECTOR, 

OFFICE OF THRIFT SUPERVISION 

Mr. REICH. Good morning, Chairman Dodd, Members of the Committee. Thank you for the opportunity to testify on behalf of the Office of Thrift Supervision. My written testimony contains fairly 

lengthy and detailed information, but in the few minutes I have 

here, I will highlight just a few points. 

First, the condition of the Nation’s savings associations. My testimony today will be no surprise. Thrift institutions like the entire 

financial services industry are facing serious challenges from the 

mortgage market crisis affecting the broader economy, and I believe that these challenges will persist throughout 2008 and into 

2009. 

During the fourth quarter of 2007, the thrift industry posted a record loss of $5.2 billion in the fourth quarter. Troubled assets 

continued to rise. For all of calendar year 2007, the industry posted 

a profit of $2.9 billion. 

Although good news is scarce in the current landscape, I can tell 

you that the mortgage market’s problems have created an earnings 

issue for thrift institutions, but not a capital issue, and I believe 

that is an important distinction. In addition to earnings, even reduced earnings, capital and loan loss reserves provide the foundation of support for financial institutions during times of challenge, 

and thrift institutions continue to maintain strong capital and continue to set aside significant loan loss reserves. 

I can also report that the OTS is in a strong position to continue 

to carry out our mission of ensuring the safety and soundness of 

thrift institutions and their holding companies and of ensuring 

compliance with consumer protection laws. These laws include prohibitions against unfair or deceptive acts and practices, an area 

where OTS recently issued a proposed rulemaking. 

Since I became OTS Director in 2005, we have increased our 

workforce by more than 15 percent, primarily among our examining force, and our budget is solid. Although the consolidation affecting the entire financial services industry has reduced the number of thrifts that we regulate to approximately 830, assets supervised by OTS have grown by 55 percent over the past 5 years to 

more than $1.5 trillion, and in the last 3 years, more financial institutions have converted to the thrift charter than have converted 

from the thrift charter. This is a noteworthy trend, I believe, which 

speaks to the value that the financial services industry sees in the 

thrift charter. 

The last point I would like to make is that OTS understands the 

enormous impact that home foreclosures can have on Americans 

and the communities where they live. To contribute in a meaningVerDate Nov 24 2008 02:38 Mar 13, 2010 Jkt 050370 PO 00000 Frm 00018 Fmt 6633 Sfmt 6602 E:\HR\OC\A370.XXX A370

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ful way to a solution to this growing problem, we recently suggested a foreclosure prevention proposal that we think merits discussion and debate to help financially stressed homeowners who 

owe more on their homes than they are currently worth. I have 

seen estimates that 30 percent of homeowners who have purchased 

their homes in the last 2 years are in this position of being upside 

down or underwater. Our plan would provide an incentive for 

homeowners in distress whose mortgages are underwater to stay in 

their homes instead of turning in their keys and walking away. It 

is a market-based proposal without the cost and potential moral 

hazard of a Federal bailout. It would also allow the lender or investor to share in the upside when the home again appreciates in 

value once this crisis subsides. 

Under this proposal, the distressed homeowner whose loan was 

previously sold into a securitization would obtain new FHA financing based on the current market value of the home. The servicer 

would receive a partial payoff and would record a negative equity 

certificate equal to the difference between the new FHA loan and 

the currently outstanding loan balance. When the home is sold, the 

certificate owner would recover an amount potentially reaching the 

full value of the certificate, depending on future home price appreciation. Beyond that amount, appreciation would revert to the 

homeowner. 

This proposal is certainly not the only idea to address the rising 

number of foreclosures, but we believe there is significant merit in 

considering this approach as a supplemental component to the efforts that are underway to deal with this crisis. 

With that, Mr. Chairman, I thank you, and I look forward to 

questions. 

Chairman DODD. Thanks very much, and thank you for that testimony. 

Ms. Johnson. 

STATEMENT OF JOANN M. JOHNSON, CHAIRMAN, 

NATIONAL CREDIT UNION ADMINISTRATION 

Ms. JOHNSON. Thank you, Mr. Chairman and Members of the 

Committee, for this opportunity to testify regarding the state of the 

credit union industry in the context of your broader review of how 

financial institutions are performing during the recent turbulence. 

This is a timely and important subject that merits congressional 

oversight. NCUA provides oversight and supervision for 8,100 federally insured credit unions, serving approximately 87 million 

members. 

The financial state of the credit union industry remains strong 

and healthy with financial trends indicating a safe and sound industry. I will outline key data which supports this conclusion and 

also underscores NCUA’s belief that the industry has implemented 

our regulatory guidance regarding the need for increased vigilance 

and more careful management of credit union balance sheets. federally insured credit unions are well capitalized. Net worth stands 

at 11.4 percent, and over 99 percent were at least adequately capitalized. Total assets are at $753 billion, and aggregate net worth 

is $86 billion, the highest dollar amount in history. 


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Lending continues to be a main focus of credit union service to 

members. As of the end of 2007, loans represented almost 70 percent of credit union assets. Within that figure, real estate loans 

comprised just over 51 percent of total loans. 

Credit union mortgage lending is primarily of the traditional variety: 58 percent of mortgages are fixed-rate, and only 2.3 percent 

are interest-only or optional payment loans that have garnered 

much of the recent attention on Capitol Hill and made this hearing, unfortunately, necessary. 

After several years of declines, delinquencies and losses have increased. Overall, loan delinquencies have increased from 0.68 percent to 0.93 percent, and real estate delinquencies now stand at 

0.68 percent. Net charge-offs are 0.08 percent. 

Those relatively low numbers indicate that credit unions have 

positioned themselves to withstand the current economic uncertainty and related mortgage problems. To make certain that continues, NCUA has played a proactive and aggressive role in issuing 

supervisory guidance regarding lending. Since 1995, NCUA has 

issued guidance on risk-based lending and specific mortgage lending guidance that has identified potential problem areas, particularly regarding subprime lending, credit risk management, due diligence, and stringent evaluation of third-party relationships. 

Home equity lines of credit, or HELOCs, and so-called exotic 

mortgage products such as interest-only and payment-optional, 

were also covered by this guidance. As in the past, and most recently in concert with my fellow regulators, joint guidance regarding workout arrangements, subprime lending, and loss mitigation 

was issued. 

All of this was aimed at increasing credit union awareness of the 

potential pitfalls inherent in a rapidly changing and complex lending landscape. It also served as a constant reminder to the industry 

of NCUA’s vigilant posture when it comes to identifying and managing risk. While NCUA appreciates the desire of credit unions to 

serve their members as fully as possible, we recognize that there 

is no substitute for strong supervision that enhances safe and 

sound operations. 

Federally insured credit unions remain financially strong. They 

have implemented NCUA guidance related to real estate and other 

lending and, as a result, are positioned to weather the current economic turbulence. While data shows that the industry is not entirely insulated from the adverse impact of the mortgage situation, 

it also supports the conclusion that strong risk management and 

prudent standards, closely supervised by an engaged regulator, will 

ensure continued success. 

Thank you very much for the opportunity. 

Chairman DODD. Thank you very much, Ms. Johnson. 

Mr. Kohn. 

STATEMENT OF DONALD L. KOHN, VICE CHAIRMAN, 

BOARD OF GOVERNORS, FEDERAL RESERVE SYSTEM 

Mr. KOHN. Thank you, Mr. Chairman. Chairman Dodd, Members 

of the Committee, I appreciate the opportunity to appear before you 

today. 


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As you know the Federal Reserve has supervisory and regulatory 

authority over a wide range of financial institutions and activities, 

including supervision of bank holding companies and state-member 

banks, as well as responsibility to ensure fair and equitable treatment of consumers in their financial transactions. And all these are 

important components of our broader mandate to help maintain 

overall stability in financial markets. 

The U.S. banking system is facing some challenges, but remains 

in sound overall condition, having entered the period of recent financial turmoil with solid capital and strong earnings. The problems in the mortgage and housing markets have been highly unusual, and clearly some banking organizations have managed their 

exposures poorly, suffering losses as a result. But in general these 

losses should not threaten their viability. We, along with the other 

banking agencies, have been working with banking organizations 

to identify and rectify shortcomings in risk management that have 

led to losses and to ensure that the banking system continues to 

be safe and sound. 

Our efforts also include helping to minimize any excessive financial impact on those consumers affected by recent market disturbances. Bank holding companies have seen their profitability decline 

in recent months due to sizable write-downs and substantially 

higher provisions for loan losses. 

Liquidity has also been under pressure at some of the largest 

bank holding companies, in some cases reflecting difficulties 

securitizing some assets and the need to bring on balance sheet 

some assets that had been previously securitized. In some cases, 

asset write-downs and unplanned increases in assets have placed 

pressure on capital ratios and caused some banking organizations 

to take a more cautious approach to extending credit. 

State-member banks are facing similar challenges, but also entered the recent period of financial disturbance in sound condition. 

In this environment, we have been focusing supervisory efforts 

on those institutions most exposed to residential and commercial 

real estate and other sectors that have come under pressure. We 

are also attentive to those institutions that would suffer most from 

a prolonged period of deterioration in economic conditions. Our attention remains on the financial condition of the banking organizations, including the adequacy of the liquidity capital loan loss reserves and their consequent ability to cope with additional losses. 

We are also evaluating risk management practices closely, including scrutinizing governance and controls, given some of the 

risk management lapses in those areas. 

Supervisors will be looking at the capacity of a firm as a whole 

to manage all its risks and to integrate risk assessments into the 

overall decisionmaking by senior management. Additional emphasis on enhancing stress-testing is also appropriate to focus more 

bank attention on risks that have a low probability of occurrence 

but severe potential costs. 

Particular areas of supervisory focus include residential mortgage lending, consumer protection, bank liquidity and capital positions, consumer non-mortgage lending, commercial real estate, and 

commercial lending. While residential mortgage lending has, unfortunately, presented substantial problems for many homeowners 


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and communities, it has also created challenges for banking organizations. Accordingly, it is receiving much supervisory attention. 

For example, the Federal Reserve and other banking agencies 

have encouraged mortgage lenders and mortgage servicers to pursue prudent loan workouts to assist borrowers having difficulty 

meeting their payment obligations through such measures as modification of loans, deferral of payments, extension of loan maturities, 

capitalization of delinquent amounts, conversion of ARMs into 

fixed-rate mortgages or fully indexed, fully amortizing ARMs. 

Our reserve banks are working closely with local community 

groups to identify opportunities for workouts and to educate both 

borrowers and lenders. We are also carefully monitoring those 

areas that are most likely to be adversely affected by residential 

real estate, such as construction loans and non-mortgage consumer 

lending, and taking appropriate action. We have implemented supervisory strategies to ensure that we have the proper examination 

staff assessing commercial real estate, ready to address banking 

problems. 

Finally, as part of a responsible and proactive supervisory approach, and as we have done in the past, we are conducting critical 

assessments of our own supervisory programs, policies, and practices. This is a prudent step and is consistent with longstanding 

Federal Reserve practice. Our intent is to identify opportunities for 

improving our own processes both within the current environment 

and as preparation for future supervisory challenges. 

It will take some time for the banking industry to work through 

this current set of challenges and for financial markets to recover 

from recent strains. The Federal Reserve will continue to work 

with other U.S. banking agencies and the Congress to help ensure 

that bank safety and soundness is maintained. 

Thank you, Mr. Chairman. 

Chairman DODD. Thank you very much, Mr. Kohn, for that testimony. It was very helpful. 

Mr. Gronstal, welcome. 

STATEMENT OF THOMAS B. GRONSTAL, 

IOWA SUPERINTENDENT OF BANKING, STATE OF IOWA 

Mr. GRONSTAL. Thank you. Good morning, Chairman Dodd and 

distinguished Members of the Committee. As Iowa Superintendent 

of Banking, I am pleased to testify today on behalf of CSBS on the 

condition of the Nation’s banking industry, and specifically the 

challenges facing the State banking system. 

The collapse of the housing finance market has resulted in the 

collapse of investor confidence in bond ratings, bond insurers, collateral valuation of asset-backed securities, and the impact has 

spread to trust preferred securities issued by banks, auction rate 

certifications issued by student loan secondary markets, and a general depreciation of asset-backed securities held in banks’ portfolios. 

A few lessons the State regulators would highlight from this experience are: one, that good underwriting is consumer protection; 

two, consumer protection is investor protection; and, three, transparency is in the interest of all parties. We believe these lessons 

should be applied to policies ranging from the preemption of State 


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consumer protection laws all the way to Basel II. Also, as other 

witnesses have testified, the slowdown in the economy is beginning 

to reveal weaknesses in the commercial real estate sector. We will 

continue to work with our Federal counterparts to supervise the industry performance in this sector. 

As I highlight in my written testimony, State regulators are prepared to handle a greater number of bank failures than we have 

had to in the last several years. But based on current information 

and conditions, we do not expect widespread failures. Obviously, a 

significant change in the economy could change that outlook. 

I would note that while a manageable number of bank failures 

has a limited impact on the national economy, any bank failure is 

very disruptive to the local economy and the consumers in our communities and States. 

Two additional areas where we think problems could arise are 

reverse mortgages and agricultural lending. Reverse mortgages are 

ripe for consumer abuse and fraud and could present some longterm accounting and valuation issues. CSBS has developed a seminar to help State mortgage examiners learn about the fast developing reverse mortgage market. Currently, the ag sector is experiencing a combination of high oil and commodity prices, similar to 

the conditions of the 1970s. The value of farmland is directly correlated to the price of commodities. We could be witnessing the development of a bubble in agricultural real estate. 

The problems we are currently experiencing in the banking industry were triggered by the weakening of the housing market and 

the ensuing credit crunch. 

CSBS contends that an enhanced regulatory regime for the mortgage industry is absolutely necessary to ensure legitimate lending 

practices, provide adequate consumer protections, and to once 

again instill both consumer and investor confidence in the housing 

market. 

To that end, CSBS and ARMR launched the nationwide mortgage licensing system. The system is more than a database. It 

serves as the foundation of modern mortgage regulation by providing transparency for regulators, industry, investors, and consumers. While much has been done recently by Federal and State 

regulators to enhance supervision of the residential mortgage industry, State officials have also been very active in addressing the 

increasing foreclosures. 

In July 2007, the State Foreclosure Prevention Working Group, 

composed of Attorneys General and bank regulators from 11 States 

and CSBS, was formed to work with participants in the subprime 

mortgage industry so borrowers could retain their homes with affordable mortgages. Beginning in November, the working group collaborated with the industry, the FDIC, and the Federal Reserve to 

develop a uniform data reporting format to measure the extent of 

the foreclosure problem and the servicers’ efforts to respond. Last 

month, the working group issued the ‘‘Analysis of Subprime Mortgage Servicing Performance’’ report. It is my sense that many 

servicers are making positive efforts, but that we are still losing 

the larger battle to stem the tide of unnecessary foreclosures. More 

must be done to assist those Americans who are fighting to save 

their homes. 


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CSBS looks forward to continuing to work with the Federal regulators and Congress to address the needs and the regulatory demands of an ever evolving financial system fostering the strongest 

economy possible while protecting consumers, minimizing regulatory burden, and ensuring access to the broadest range of financial opportunity. 

Thank you for the opportunity to testify today, and I look forward to any questions you may have. 

Chairman DODD. Well, thank you very, very much, and let me 

thank all of our witnesses. I appreciate your brevity as well in allowing us to get to the questions here this morning. 

What I will do is I will turn the clocks on here for about—let me 

see, not too many of us here—7 or 8 minutes so we get a decent 

amount of time for the first round of questioning. There are a lot 

of issues to be raised. 

Obviously, as Senator Bennett pointed out, there is a fundamental question sort of raised this morning by the Wall Street 

Journal that will probably be a subject of all of our questions to one 

degree or another. But let me, if I can, begin by talking about 

Basel II, because this is a big issue. It is the center of a lot of attention in various articles here. 

The current problems in the market highlight, I think, the critical importance of adequate capital standards for banks. That is 

the core issue in many, many ways—although not the only one. I 

think the risk management as well, and there are other questions 

here, but obviously the core element of having adequate capital 

standards is fundamental. And with the upcoming implementation 

of Basel II—and I gather, and those of you deeply involved in this 

can correct me, but I gather just in terms of how fast this is moving that while I think there was some talk about spring, it is probably a greater likelihood it is probably more in the fall before they 

will begin to move. So we have got a little time here to look at this 

and respond to it, if we can. 

There is a potential for some major changes in the capital requirements that banks will face. There have been some concerns 

raised that the structure of Basel II would lead to some serious 

problems—I think you have all heard this—especially in the current environment we are in. Specifically, there have been concerns 

raised about the reliance of Basel II on internal bank models of 

risk, models which failed during the recent crisis that we have experienced in the market. A recent piece written here by Harold 

Benink and George Kaufman in last week’s Financial Times reveals—the headline, ‘‘Turmoil reveals the inadequacy of Basel II.’’ 

And let me quote from the article. It says, ‘‘A more fundamental 

problem is that Basel II creates perverse incentives to underestimate credit risk because the banks are allowed to use their own 

models for assessing risk and determining the amount of regulatory capital. They may be tempted to be overoptimistic about 

their risk exposure in order to minimize required regulatory capital 

and to maximize return on equity.’’ 

I would like each of you to respond to that concern, if you would, 

and then a follow-up question with regard to it is whether Basel 

II, if it had been in effect—let’s move the calendar in the opposite 

direction. Let’s assume it had been in effect in the last couple of 


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years. What impact would Basel II, as proposed, have been on the 

current situation in your views? Would we be looking at a better 

or a worse situation if Basel II were in place? And, again, as background here, we obviously know what happened at this recent financial institution in England here where you had it was able— 

this one bank said it was able—‘‘enabled them to increase our 2007 

interim dividend by 30 percent.’’ You may have all read this report. 

‘‘And going forward, our dividend pay amount rate increases to 50 

percent of underlying EPS from around 40 percent. Future capital 

planning, including reduction of capital assets, will allow us to return capital to shareholders through a share buyback program. The 

medium-term outlook for the company is very positive.’’ That was 

Adam Applegarth, the Northern Rock Bank on June 30th of last 

year, and as all of you know, shortly afterwards they became insolvent, were nationalized, had the largest run since 1866. 

So despite the positive predictions here under Basel II, I am very 

interested in how each of you would respond to the question. What 

would our situation look like today had Basel II been in place? 

Then, of course, responding, if you can, to the concerns raised by 

Mr. Benink and Mr. Kaufman. Sheila, we will begin with you. 

Ms. BAIR. The FDIC institutionally has had longstanding questions and concerns about the use of internal models to derive capital under Basel II, and my personal view is that we are taking a 

very go-slow approach in implementation so we will have plenty of 

time to make adjustments as we try to look through some of those 

issues. 

The problem with model-driven capital is that it relies on past 

performance, and when you have new higher-risk products that 

were developed and performed during a very favorable economic 

environment, your past performance is not going to tell you how 

they are truly going to perform when our economic circumstances 

change. And that is exactly what we saw with mortgages. 

Our QIS impact study, the QIS, the Quantitative Impact 

Study—— 

Chairman DODD. Shouldn’t that be a part of it? I mean, if past 

performance has been sort of rosy, shouldn’t you be anticipating 

these matters here if things do not go well, as well as if things are 

going well? 

Ms. BAIR. You should absolutely stress test. But, again, models 

are only as good as the data you put into them, and these models 

rely on historical data. That is one of the issues we have had. 

The Quantitative Impact Study showed that there would have 

been a 73-percent median reduction risk-based capital for residential mortgage lending, and for home equity lending it would have 

been 79 percent. And, again, that was because there was benign 

historical data being fed into the models when the QIS studies 

were done. 

So I think it would have put us in worse shape, and I think not 

only would we have had lower capital going into this, but I think 

we would have had banks—banks already having to raise capital— 

that would have had to raise it a lot more. So you have a pro-cyclicality with these reduced capital levels using models for benign economic times that spike up sharply. 


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So we think this has always been a crucial issue, a critical issue 

with the Basel II advanced approaches. I think there are many 

good elements of Basel II, also. I think it is important that there 

are other aspects of it that are positive. We will also go out for 

comment on the Basel II Standardized Approach, which does not 

use internal models but has more of a bucket system where for 

each asset category you have hard and fast floors under each bucket. And, of course, nobody is talking at this point about getting rid 

of the leverage ratio, which would be our fail-safe under all these 

new frameworks. 

Chairman DODD. Well, I should have said—and I want to get to 

my question quickly. I do not want anyone here to walk out of this 

room with the assumption that the Chairman of this Committee is 

hostile to Basel II. I think there are some very, very positive elements of Basel II. The question is: Are we rushing ahead a little 

too fast without thinking about these other implications? 

So I have a positive attitude about Basel II. I am just concerned 

about how some of this may work. 

John. 

Mr. DUGAN. Mr. Chairman, as I do on some of these issues with 

my colleague, I have a little different take on this. No. 1, the losses 

that we have really seen happened in the Basel I world, not a 

Basel II world, which is not directly responsive to your question. 

I think on the Basel II question, there are some things that I 

think it clearly would have done better and will do better. I think 

it factors more risk management processes into the capital framework, and that is a good thing. I think it does a better job with 

not creating incentives between off-balance-sheet and on-balancesheet risk. They are treated more equally under that program. 

And with respect to the notion of dealing with historical data, 

while that is an issue with respect to Basel II, it was more of an 

issue when we only had benign data going into it because of all the 

benign credit issues that had gone on. We have taken care of that 

problem. There are a lot of losses now, that would be fed into the 

system. It is taken into account in how the data adjusts to those 

actual events and causes more capital to be raised. I think it is 

quite an open question, given the current events, whether capital 

in the system would go up, not down, as a result of what has happened. 

But having said all of that, I think there are some very specific 

things that happened that really need a look in the Basel II process, particularly with these ABS CDOs that were based by 

subprime-related securities. Senator Bennett referred earlier to the 

credit ratings. The irony of this whole situation is that the most 

highly rated securities, the ones that were thought to be least likely to default, are where a huge share of the losses have been concentrated. And the securities with the highest rating get the least 

attention from management, from regulators, and from our capital 

regime. The fact of the matter is the AAA in this context performed 

much differently, and much worse, than AAA in any other type of 

security we have ever witnessed before. There has to be a need to 

look at that, and one of the places we need to look at it is whether 

the Basel II capital risk weights for this particular kind of security 


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need to be adjusted. I think that is extremely important going forward, along with some other measures. 

The last point I will make is, although the rule is final, it is quite 

a deliberate pace that is going on in the United States. Firms have 

3 years to begin the first parallel year of running, which is not actually the year you get on it. There is another year, and then there 

is a 3-year transition period. No firm has actually even started 

that: the first firm may begin this summer. I think it will be staggered over time, and meanwhile we do have these systems of floors 

in place to fine-tune things as we go along. But you are raising 

very good questions that need to be looked at and adjusted as we 

go forward. 

Chairman DODD. John or JoAnn, do you have any comments on 

this? I want to hear the Fed’s point of view on this, but I want to 

also hear if you have any thoughts on this. Yes, go ahead. 

Ms. JOHNSON. I would like to add just a point. While credit 

unions do not fall under Basel, we do have a risk-based capital proposal on the table for Congress to take a look at it, and I would 

ask your serious consideration because this would give us as a regulator a real tool to identify problems more quickly, and it would 

help the credit unions manage their risk more effectively. And it 

is our risk-based capital, prompt correct action proposal. We have 

been working for over 31⁄2 years on it, but we need legislative action in order to get it done. 

So I would just please ask for your serious consideration. It 

would really give us a tool as a regulator. 

Chairman DODD. John, do you want to comment? 

Mr. REICH. Mr. Chairman, I would like to make a comment. I 

began my banking career about 47 years ago, and I grew up in a 

generation of bankers who believed that you cannot have too much 

capital and you cannot have too much money in your loan loss reserves. I still believe that today. 

When I entered the Basel discussion as a banking regulator 

about 21⁄2 years ago, I was a skeptic about Basel II. I am still sort 

of skeptical today, but I feel a lot more comfortable today about it 

than I did 21⁄2 years ago, and one of the reasons is that I have been 

talking with my fellow regulators at this table about Basel II over 

the past 21⁄2 years, and I know that there is one thing that we are 

all committed to, and I believe that every single individual is committed to making whatever changes need to be made between now 

and full implementation in 2012. 

We also have the authority, which is not discussed a great deal, 

in Pillar 2 of Basel II for the regulators to have the latitude and 

the flexibility to require whatever additional levels of capital we 

think are necessary over and above what the models predict. So we 

are not totally dependent on the models. Our examiners in the field 

and their supervisors in our regional offices will be reviewing capital, will be reviewing the risk profiles of these institutions. And if 

we feel they need more capital over and above what the models call 

for, we will call for that additional capital. 

Chairman DODD. Let me just, Mr. Kohn, in asking you to respond to this, let me pick up on something that John Dugan said 

that I will just take a little issue with. John mentioned about how 

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try. It was not true in Europe. Europe was operating under Basel 

II. And the quote I had from that British bank here was under 

Basel II regulations. 

Again, I am a supporter of Basel—this thing moving forward, but 

it seems to me here that looking at what has occurred here under 

a regime that we are talking about adopting here raises some questions. And why shouldn’t I be concerned about Basel II, having 

watched what happened in Europe and why that couldn’t be here, 

and why it would be worse if, in fact, Basel II had been in place 

over the last several years? 

Mr. KOHN. Mr. Chairman, I think they are implementing Basel 

II this year in Europe, not last year, so—— 

Chairman DODD. Wasn’t this effective—wasn’t that British bank 

under those rules? Am I wrong about that? 

Mr. DUGAN. It had the parallel running year, but the final—— 

Chairman DODD. The parallel year—— 

Ms. BAIR. They had approved the reductions that were referenced, and they were promising a dividend based on the reduction—the anticipated reduction risk-rated assets, which had been 

approved. 

Mr. KOHN. And I think to pick up on a point that John Dugan 

made, some of the issues in Europe and to some lesser extent in 

the United States involved capital arbitrage, moving things off of 

balance sheets because it was less capital-intensive to do that. And 

one of the things that Basel II does is it tries to even that out. It 

tries to reduce the capital incentive to move something off your balance sheet. And I think moving it off the balance sheet clearly gave 

banks a sense that they did not need to manage that risk as intensely as they would have if it was directly on their balance sheet, 

and a lot of that stuff ended up coming back onto their balance 

sheet. 

So I think from some very important perspectives, Basel II actually addresses some of the issues that have come to light in the 

most recent turmoil. That is not to say it is perfect. It is a huge 

step in the right direction, and I appreciate, Mr. Chairman, your 

support for this basic structure because I think it is an important 

step forward to make the capital requirements more risk sensitive 

so there is less of this arbitrage opportunities for banks. 

John pointed out one in the securitization area. It is heavy reliance on the credit rating agencies. I think we need to take a look 

at that and how close that reliance is. But there are a lot of safeguards here. There is the Pillar 2 safeguard. The banks cannot implement these models before the supervisors have looked at them 

and given their OK that these are good models. 

There is the phase-ins that Sheila and John talked about. There 

will be a year of parallel running. Then there will be a 3-year 

phase-in, and changes can be made at any time. And John Reich 

is absolutely right. The regulators are committed to make this 

work for a safe and sound U.S. banking system. We will have a period of years to watch how the implementation is occurring and to 

make adjustments if necessary. 

So I think it is important to move forward, recognizing the issues 

and keep a careful eye on how it is working out. But I think at the 


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end, we will have a better capital system in 4 years than we had 

last year. 

Chairman DODD. And I hesitate to ask anyone at the Fed a simple yes or no question, knowing your resistance to those kind of answers. [Laughter.] 

But would we have been better off or worse off had Basel II been 

in place under the recent crisis? 

Mr. KOHN. The honest answer is I do not know. I think in many 

respects—in some respects we would have been better off, and I do 

not think we would have been worse off if the whole implementation process had been moved back 2 or 3 years, so we had the same 

safeguards in place, and if we started implementing in 2004 with 

the same safeguards that are in place in 2008 and 2009, I do think 

on balance we would have been better off. 

Chairman DODD. Do you have any comments on this, Tom? I 

have taken a lot of time on this question. 

Mr. GRONSTAL. Thank you. I think the answer to your second 

question is that we probably would have had lower dollar amounts 

of capital per asset, and that makes it more challenging to deal 

with issues when times get rough. Being a banker in the 1980s out 

on the prairie in Iowa, there is no substitute for capital when 

things get rough. 

So I think we would agree that we do not want to see capital 

standards reduced, and we want to make sure that as Basel II is 

implemented that it provides an opportunity for regulators to make 

sure that we can require institutions to have adequate capital at 

all times. 

Chairman DODD. Well, thank you very much. I took a long 

time—I apologize—going through that. I took a lot more than 8 or 

10 minutes. I should have realized with this many witnesses that 

was naive of me to assume I could do that. 

Richard, do you want to jump in here? 

Senator SHELBY. I will, briefly. I know I have not—I have been 

gone. Thank you, and I welcome all of you. I will get right to a 

question. 

Comptroller Dugan, are you confident that banks have not 

outsourced their due diligence and risk analysis to credit rating 

agencies? And is that a problem? It seems to be a concern to a lot 

of people? 

Mr. DUGAN. Senator, it did not take long for you to get right to 

the heart of the matter, as always. I do think there is an issue with 

credit rating agencies. I have spoken on this recently. I would not 

go so far as to say that banks have outsourced it lock, stock, and 

barrel. But I think that in the recent round we have seen the very 

high credit ratings for a certain class of securities, these 

collateralized debt obligations, based on subprime asset-backed securities which were not only rated AAA but were considered senior 

to AAA securities. I think there was an undue reliance generally 

on that rating, and even with some of the most sophisticated 

banks, as they packaged these, there was an undue reliance on the 

credit ratings. That should not happen, particularly with larger institutions that have the wherewithal and are in the business of 

making credit assessments. I think this is one of the fundamental 


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lessons that has come out of this that we will be going back to our 

banks quite forcefully on. 

Senator SHELBY. You are going to have to, aren’t you? 

Mr. DUGAN. Yes. 

Senator SHELBY. Chairman Bair, it is my understanding that you 

currently have 76 institutions on the FDIC’s problem list. In addition, there appear to be strong indications that further deterioration is occurring outside of mortgage lending, specifically in the 

construction lending, tied to new homebuilding and home equity 

lending. 

In your written testimony, you suggest several differences between this down cycle in the housing market and the period in the 

early 1990s. I believe you suggested the biggest differences between 

then and now is capital, which Senator Dodd, Chairman Dodd, was 

asking earlier. Even though banks are better capitalized, do you expect to see a gradual increase in the number of troubled financial 

institutions? 

Ms. BAIR. Well, it is hard to predict the future, but certainly 

credit losses are going to continue to tick up, and so my guess is 

that we would see some increase in the troubled bank list. But I 

think we will still be easily within historical norms. I do not think 

it will be anything we cannot handle. Historically, banks fail. They 

used to fail a lot more than the numbers now. 

Senator SHELBY. And this cycle will be no different, will it? 

Ms. BAIR. No, it will not be. We went 21⁄2 years without a bank 

failure. That was aberrational, frankly. It is common for a small 

number of banks to fail each year. The FDIC has a very good 

record. No insured depositors ever lost a penny of insured deposits. 

We almost always find another institution to acquire the insured 

deposits, so there is virtually no interruption in access to the 

money. 

So people should not worry. This is easily within historical 

norms. 

Senator SHELBY. I know you cannot put a number on it, but 

would it be out of the question to say that it is possible 100 banks 

would fail? You do not want to do that? 

Ms. BAIR. I would think that would be surprising. We have 

76—— 

Senator SHELBY. There are 76 on the—— 

Ms. BAIR. Most of those will not fail. The historical average 

is—— 

Senator SHELBY. You will work around it. 

Ms. BAIR [continuing]. 13 percent of those on the troubled bank 

list actually fail, which is a very small percentage. So it would be 

very, very surprising if we saw numbers at that level. 

Senator SHELBY. How do you feel about the adequacy of the 

FDIC fund, and what size is it currently? 

Ms. BAIR. We are at $52.4 billion. Our reserve ratio is 1.22 percent. We have got an assessment of 5 to 7 basis points on insured 

deposits which will bring us to our target ratio of 1.25 next year. 

So I am feeling we have a strong fund. It is a highly liquid fund. 

We have strong staff resources. We have strong contingency plans 

to be prepared for any eventuality. So I think that we have very 


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good resources and are very in strong shape, and people really 

should not worry. 

Senator SHELBY. Governor Kohn, do you believe that our money 

center banks, some of our largest banks that the Fed supervises 

through the bank holding company, will have to have a lot more 

capital than some have been getting additional capital? 

Mr. KOHN. Senator, I do not think that the level of capital that 

they currently have is inadequate to safeguard their fundamental 

safety and soundness. But I do think that there are a couple 

that—— 

Senator SHELBY. You say inadequate or adequate? 

Mr. KOHN. The level of capital that they have is adequate. 

Senator SHELBY. Adequate, OK. 

Mr. KOHN. To be clear, to safeguard their fundamental safety 

and soundness. They are not threatened in that regard. I do think 

that raising capital will enable them to participate in the rebound, 

will enable them to be more active lenders as the economy recovers. So there are some whose activities would be constrained if they 

do not raise more capital. Their viability is not threatened, but 

they will be smaller institutions than if they raise capital. 

Senator SHELBY. Do you have some of your larger holding companies on so-called watch lists? I know you watch them all. You have 

to say. 

Mr. KOHN. It is fair to say we do watch them all, and we are actively engaged in conversations with all of them about how they see 

their way forward. 

Senator SHELBY. Are you deeply concerned about any or maybe 

concerned about a few? 

Mr. KOHN. We are talking to all of them, Senator. 

Senator SHELBY. OK. Thank you, Senator Dodd. 

Chairman DODD. Thank you very much. 

Senator Reed. 

Senator REED. Well, thank you very much, Mr. Chairman, and 

thank you, ladies and gentlemen, for your stewardship and your 

dedication. I appreciate it very much. 

Let me selectively ask a common question, which—starting with 

Sheila Bair. Capital levels, liquidity, and dividend policy of your 

regulated institutions. Capital, is it adequate? Is there sufficient liquidity, or do you see a problem in that regard? And what about 

dividends policy in the sense that if there is a real push to ride out 

hard times, should banks be giving dividends at the rate they are? 

And then I will go to Mr. Dugan, then Mr. Kohn. 

Ms. BAIR. Ninty-nine percent of our banks are well capitalized. 

That represents 99.7 percent of bank assets. So the overwhelming 

majority of banks, large and small, are well capitalized. We have 

about $270 billion in excess capital. That is an additional cushion 

that we can rely on. So, yes, I think banks are in a very, very 

strong capital position. 

Regarding liquidity, we are fortunate in the United States to 

have multiple funding sources. Deposits is one. The capital market 

is not as robust as it once was. But we have the Federal Home 

Loan Bank System that helps support mortgage lending through a 

variety of funding mechanisms that can be used. We require, as do 


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the other primary regulators, to have contingency liquidity planning, and I think that works pretty well. 

We are in more challenging times, but I think we are taking the 

supervisory steps that we need to take, and the very strong capital 

levels I think will serve us well. 

I am sorry. What was the third—— 

Senator REED. The third one is dividend policy. Are you reviewing dividends, the dividends—— 

Ms. BAIR. Dividend policy, well, I think it is important—I was a 

little surprised at the level of dividends last year, but I think certainly that is one easy area to cut back on. So, again, if we get into 

a more challenging environment—— 

Senator REED. And let me inject one other factor. We are looking 

today at the climate, but the estimates that we are seeing—the 

UBS one I mentioned in my opening statement of a $600 billion 

write-down. I mean, capital is adequate today. Is it adequate in 

that sort of Category 5 hurricane effect? 

Ms. BAIR. Yes. I think banks are raising additional capital. They 

will continue to do so. I think it is important to point out the UBS 

estimates relate to all financial institutions. 

Senator REED. Across the world. 

Ms. BAIR. A lot of these exposures are outside the insured depository institutions, so I think that is a much smaller exposure for assets actually held in the bank in terms of the structured finance 

products that they were talking about. 

Senator REED. Mr. Dugan, same series of questions. 

Mr. DUGAN. I agree with Sheila with respect to our national 

banks, which are some of the very largest banks, as well as some 

of the smallest banks, that capital is indeed adequate. We did have 

some issues that were more than earnings events that hit capital, 

but banks were able to successfully raise capital to more than offset those losses. There is a chart in my testimony that talks about 

that. That is a good thing because it means that the market is still 

prepared to invest in the basic business model of U.S. banks. 

Second, having said that, I will say you raise a very good question. As things change, there may be needs for more capital, and 

I think it is important that banks be ready to raise more, not just 

for today, but to prepare for additional things that are happening. 

As Governor Kohn mentioned, if banks want to be more forward 

leaning in participating in the rebound, they are going to have to 

have some extra capital. 

Senator REED. And just that the alternative to raising capital— 

because there might be costs to doing that—is you shrink basically 

your lending activities and your—— 

Mr. DUGAN. Precisely. That is the part of the tradeoff that we 

worry about. I am going to take it a little out of order because I 

want to talk about dividends second because it is related to capital. 

You are right that there are a lot of dividends being paid out, and 

if you retained them, you would have more capital. But there is a 

tradeoff there. The fact is banks have been very good and very able 

to go and raise capital, in part because they pay dividends. And if 

you were to cut all the dividends, you would not so easily be able 

to raise capital in the markets. There is that tradeoff that goes on. 


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I think several institutions, including some large ones, have 

made the judgment that it is prudent to cut dividend levels, not 

completely but some in order to husband more capital. We think 

that is perfectly appropriate and prudent given—— 

Senator REED. Do you engage in that dialog, Mr. Dugan? 

Mr. DUGAN. Yes, we do engage in a dialog. 

Last, on liquidity, I would say the same thing as Sheila, that 

given all that happened and the tremendous stresses in market liquidity in particular, commercial banks fared actually pretty well 

because of their diversified funding sources and deposits. You mentioned the Northern Rock situation earlier. One of the reasons they 

had such problems is their whole business model was built on the 

securitization markets. I think banks had pretty good contingency 

liquidity plans. We spent a lot of time on that. Could they have 

used some more liquidity given the depth of this thing? Yes. Does 

that mean we need to look harder at this and update some of the 

liquidity things we are doing? Absolutely. 

Senator REED. Let me jump to Governor Kohn now, the same series of questions, but you have a much more challenging responsibility because you have not just a bank in your portfolio, you have 

an investment desk and trading desk and the modern bank holding 

companies. So the same series of questions: capital, liquidity, and 

dividend policy. 

Mr. KOHN. OK. I agree with the comments of my colleagues. I 

think our institutions are well capitalized, but as I noted to Senator Shelby, I think they need to pay attention to the possibility 

of raising more capital to protect against downside risks and to 

take advantage of the opportunities that are there. 

I would say on dividend policy, looking at your dividend policy 

ought to be an essential component of looking at all the sources of 

capital and which sources you think will serve your bank holding 

company best over long periods of time. So I think dividend policies 

definitely should be on the table, as they have been for a number 

of institutions already. 

With regard to liquidity, liquidity was adequate, but it was 

strained from time to time. And it was not so much that the banks 

could not get liquidity, but the degree of stress on the banks was 

so great and so much greater than they anticipated that they started hoarding it and were unwilling to lend it in the market. So we 

saw pressures in term funding markets. Banks were holding onto 

the liquidity, unwilling to lend for a month, 2 months, 3 months. 

And that was disruptive to the markets. 

So I think two points: one is the banks themselves need to do a 

better job of preparing for some of these worst-case outcomes in 

terms of stress tests and where liquidity is going to be so that they 

are better prepared for such a situation. But the other point is the 

Federal Reserve, seeing this strain and this stress, itself took actions to relieve it, to make the Federal Reserve a more open source 

of liquidity for banks. We reduced the penalty on our discount rate 

from a percentage point to 50 basis points in August, and we started a new auction facility where banks could borrow money from the 

Federal Reserve against a wide range of collateral. We started this 

in December, and that has been pretty successful. Banks have 

taken advantage of this, and I think it has helped to relieve some 


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of the tensions in funding markets. But it required actions, I think, 

both on the part of the banks and on the part of the central banks 

to relieve the pressure on liquidity. 

Senator REED. Thank you. My time has expired, Mr. Chairman. 

If you will indulge me for one other question, this goes back to the 

line of questioning that the Chairman raised about Basel II. Very 

briefly, since I am imposing on my colleagues, if there is not fundamental reform of the credit rating agencies, is it sensible to move 

forward to Basel II since the credit rating agencies—and I am simplifying this greatly—and self-policing by the banks are the two 

elements, significant elements of Basel II? Unless we fix the credit 

rating agencies, are we inviting another problem? And I say that 

knowing that it is the SEC’s responsibility, not your responsibility. 

Sheila. 

Ms. BAIR. Well, I think we do rely far to much on external ratings, at least for structured finance products. And in the corporate 

debt market, there is enough transparency in the information 

about the underlying asset quality that it is OK. 

We have suggested—and we will have a question along these 

lines, I believe, when we go out for comment on the standardized 

approach as to whether use of a rating, at least for structured finance, should be conditioned on the availability of information 

about the underlying assets or whether we should affirmatively require banks to get that information to do their own independent 

analysis. 

So I think we are so heavily reliant on ratings that to just stop 

I think would be very difficult. But we have been thinking in terms 

of requiring additional transparency and analysis before you could 

use the rating, which I think would help provide some greater discipline on the rating process. 

Senator REED. Anyone else? John. 

Mr. DUGAN. I believe the rating agencies are doing some fundamental things to look at how they rate structured credit, particularly asset-based securities structured credit, and there are things 

that we can do as regulators, regardless of how they rate those 

things, to regulate how our institutions treat those rated securities 

as a matter of capital and so forth. 

I think it should not stop us from moving forward with Basel II, 

but there do need to be some changes made. 

Senator REED. And Mr. Kohn. 

Mr. KOHN. I think the credit rating agencies do need to be more 

transparent about how they rate and the underlying assets that 

they are rating so that people who are using their ratings can look 

through the ratings to the underlying assets. And they are moving 

in that direction, but I think there is a lot of progress that needs 

to be made. And I think this issue of the structured finance is very 

important. A corporate bond with a AAA rating will behave very 

differently in the market than a piece of structured finance with 

a AAA rating. And people need to understand that. They cannot 

rely just on the AAA rating. And I think the credit rating agencies 

need to consider very carefully and probably move toward 

supplementing one rating that just is the probability of default, 

which is the AAA, with another rating, which says something 

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ket conditions, because it is a very different instrument than the 

ordinary corporate bond, and people need to understand that. 

Senator REED. Thank you. 

Thank you, Mr. Chairman. 

Chairman DODD. Thank you, Jack, very much. There are some 

related issues, by the way, on the credit rating agencies. I appreciate Jack bringing it up again on this, the parallelism in terms of 

how various instruments are rated. There have been some articles 

written about that that are worthy, and I am going to take advantage, again, just to the issue that Jack has raised and your responses to it. But I said at the outset here about reconvening this 

group in 30 or 60 days. I know you are all studying these things, 

but what can the private institutions do? What do you need to do 

as regulators? And what, if anything, do we need to do up here to 

provide additional authority for regulators to implement regulations in these areas? 

So I am very interested in getting down to the nitty-gritty here. 

What specific steps need to be taken? I think we can study this 

stuff endlessly, but my sense of urgency about this I think is very 

strong, and so I would like to get back fairly quickly with you on 

some very specific ideas on how we move forward. 

With that, Senator Bennett. 

Senator BENNETT. Thank you very much, Mr. Chairman. This 

has been a very interesting hearing, and I keep groping through 

my notes to try to come up with a worthwhile question that is responsive to your response, so if I might wander through some of 

my notes and then get your comments. 

Mr. Dugan, you talked about the models that were used. Models 

are stupid. They do not do nuance. And the question is: At what 

level should the judgment come in, human judgment that says, 

well, the model may say this—your point was well taken that all 

of the data fed into the model was optimistic because we had had 

a good time, so the model will naturally project optimistic results. 

Now we are going to feed a bunch of bad data into the model, and 

the model is going to tell us the future is going to be terrible. And 

at some point, we need to inject some judgment in this. And I do 

not know whether that is at your level or whether it is something 

that the banks should do and you folks just look at. 

My fundamental question as a policymaker dealing with this is: 

Where are we going? Are we going to work our way through this 

in the next 6 to 9 to 12 months? This was a bubble that burst. 

When the inventory overhang gets sold off, is it going to go away? 

Mr. Gronstal, you send chills down my back when you say ag 

land is on the edge of having the same kind of bubble, because 

there has been tremendous bidding up of the value of agricultural 

land. And are we focusing so much on, gee, the banking system 

that we are not seeing that there is a potential out there—and this, 

again, comes back to the question of judgment of what are we 

doing. 

A comment was made, I think by Governor Kohn, about it all 

froze up. Everybody was so anxious about getting capital into their 

institutions that they were unwilling to lend. And people who had 

absolutely nothing to do with subprime or housing suddenly could 


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not get credit. And I certainly heard about that, and I am sure a 

number of Members of the Committee did. 

So as I try to find out where we are going here, what is going 

to happen in the future, in addition to all of the things we have 

talked about—we need to fix the rating agencies, we need to 

change this, that, and the other—what do you see in terms of the 

economy? The Chairman quoted President Kennedy about if the 

economy is not right, there isn’t anything that is right. How 

invasive is this crisis in terms of other areas just—other areas besides the question of the safety and soundness of banks? This is a 

judgment call, but you are all very knowledgeable, more knowledgeable perhaps than we. And I am sure you have thought about 

this and just share with us your sense of where we are and how 

soon there is going to be a rebound and how vulnerable are we to 

other problems and how badly is the economy hurt by all of this. 

Respond, if you will. 

Mr. KOHN. Quite a set of questions, Senator. 

I think there is no—— 

Senator BENNETT. They have all been spawned by listening to 

you. 

Mr. KOHN. Right. There is no question that the turmoil in the 

markets has had effects beyond the mortgage market, as you say. 

Banks conserving liquidity and capital and concerned about the 

economic outlook, as you have enunciated, have become more cautious in their lending and not just in mortgage markets. But we 

survey the banks four times a year. Our last survey was at the end 

of January. And across the board, for every kind of lending, significant proportions of the banks said they were tightening terms and 

standards for making those loans. 

Now, to some extent, this is welcome because I think lenders and 

borrowers did not fully appreciate the risks out there. The risk was 

underpriced, as many of us said, for the last several years. The 

very benign economic environment of the mid-2000s led people to 

get too complacent about the risks, and particularly about the possibility of an adverse event like an unwind in the mortgage market 

spilling over to other markets. 

So I think to a certain extent the correction that is occurring in 

the markets is a necessary correction. But I do think that it is 

painful while we are going through it. It is not going to go away 

quickly. The economy has been hurt. That is why the Federal Reserve has been lowering interest rates, to cushion the effect on the 

economy of the tightening of credit that is going on throughout the 

economy as well as the decline in the housing market. 

So our effort has been to provide an offset to this general restriction of credit in order to keep the economy moving forward. 

Our outlook, as our Chairman testified before this Committee— 

last week, I guess—is that we will see a period of very slow growth, 

very sluggish economy. We have already had a fourth quarter 

which barely grew, according to the Bureau of Economic Analysis, 

and I think a lot of people anticipate that we are going to be in 

the neighborhood or just above zero for a quarter or two now. And 

in a sense, there is not much that we can do about that because 

policy acts with a lag. 


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But I do think we have tried to position ourselves with the extra 

push from fiscal policy that you folks, the House, and the President 

put together for the second half of the year, that the economy is 

in a position to rebound later this year. I think that at the same 

time, as Chairman Bernanke pointed out, I think there are downside risks to this forecast, and a lot of it comes from the financial 

market dynamics that we are talking about today. 

If lenders become much, much more cautious because they are 

protecting themselves against very serious outcomes, not just a period of sluggish growth, that can have elements of a self-fulfilling 

prophecy in it that will damp spending. As spending is damped, 

they become more cautious. 

We are very conscious of this, and that is part of the calculus in 

our monetary policy to try to think about whether we have adequate insurance against this downside risk to the economy. 

I think progress is being made in the financial market. It looks 

very shaky. Every day there is some more bad news. I do not know 

what has happened today—other than this set of testimonies, and 

I hope that is not bad news. But I think there are some signs out 

there that we are working through the problem. There is greater 

transparency by firms with problems on their books. There is capital coming into the system that several of my colleagues have 

mentioned here on the panel, so people are raising capital. They 

are being much more open about what the issues are. I think part 

of this problem is about uncertainty. So increased transparency by 

lenders, by others with problems on their books is going to be very 

helpful to letting people know what the downside risks are, how to 

price them in, and I do think the markets have gone to a point 

where they are anticipating some pretty adverse kinds of outcomes 

in the housing market and in the economy to a certain extent. So 

they are in the process of pricing in the downside risks. 

So my hope is that as they see the economy has stabilized, as 

they see the conditions are in place for a rebound next year, that 

confidence will return, trading return, and I think in the end, a 

year from now, we will have a safer financial market, one in which 

risk is priced better than it was a couple years ago, one in which 

there are fewer of these conduits and other kind of off-balancesheet structures that have risks associated that people did not anticipate. So it will be a safer system. Banks will play probably a 

larger role in that system. Complex instruments will be less complex, more transparent. Credit rating agencies will do a better job. 

But it is not going to be easy getting from here to there. 

Senator BENNETT. I am conscious of the time. I do not want to 

impose on—— 

Mr. DUGAN. I would just add a couple things because I think that 

was really an excellent answer. I think everybody is quite focused 

on this. I would say three things. 

One, as Don suggested, I think there is an awful lot of attention 

being paid to working through the particular problems that are 

being raised. And while it seems like we have an endless stream 

of them, some of them the banking system has made significant 

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ing problem. The Federal Reserve and central banks were quite aggressive with liquidity, and it made a real difference. 

There are other problems that are more in transit, and monoline 

insurance is one of those. We also have some more intractable 

problems about the residential securitization markets that are 

going to take more time and will lead to questions about house 

prices. I think there is an awful lot of attention being paid to what 

is going to happen to house prices. 

The last point I would make is it is true that underwriting standards, at least at our banks, have definitely gotten tighter. But they 

are still making loans, and credit has been expanding, not contracting. It has not expanded to the same degree. It has definitely 

cut back, but it has not been a wholesale scaling back and contraction. I just want to make sure we underline that point. 

Senator BENNETT. Thank you. 

Thank you, Mr. Chairman. 

Chairman DODD. Thank you very much. Very good question here. 

Senator Casey. 

Senator CASEY. Mr. Chairman, thank you very much, and I want 

to thank the witnesses who are here for your testimony and for 

your service. 

I wanted to direct your attention, first of all, to the subprime crisis, and I know we have talked about this in great detail. But I 

wanted to, first of all, ask Chairwoman Bair about parts of her testimony. In particular, I am looking at pages 16 through 18 where 

you address subprime borrowing, and I am just going to highlight 

part of your testimony and ask you to respond. 

When you talk on page 17 about strategies here to deal with this 

problem, you talk about servicers should do the following: No. 1, 

identify loans facing likely default; No. 2, develop broad templates 

for restructuring these loans into long-term sustainable loans with 

fixed rates for at least 5 years; three, proactively initiate that process. And then you go on from there, and you talk later about the 

concerns that servicers have about potentially legal liability, and 

you also mention pursuing other strategies. 

Give me your assessment as to where we are—when I say ‘‘we,’’ 

I mean the Congress, the administration, the various strategies 

across the country, the Hope Now Alliance, the whole effort nationally. Where do you think we are? What are we not doing, and what 

do we have to do to make progress to dig people out of this hole 

that they are in? 

Ms. BAIR. Well, I think voluntary loan modifications are helping—they are ticking up. I am encouraged by the numbers that 

came out yesterday. I think we need more granular reporting to be 

able to fully assess how much they are helping. 

We also need to focus beyond the reset problem. There is still a 

reset problem, notwithstanding lower interest rates. But we had 

very weak originations in 2006 and the first part of 2007, so a lot 

of those loans started going delinquent before the resets. And, of 

course, with declining home prices, a lot of people are underwater 

now, and so they are dealing with unaffordable mortgages and they 

are owing a lot more than their property is worth. 


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So you get into a situation where we were initially worried about 

forced foreclosures of people who have subprime hybrid ARMs. Now 

we need to worry about people just giving up and walking away. 

So I think we need multiple strategies, and they need to be systematic because of the volume of the problem. And we do believe 

that that is consistent with the servicers’ responsibilities. Most of 

these loans obviously have been securitized, and are owned by 

securitization trusts. But we believe systematic approaches are allowed by the pooling and servicing agreements that govern the 

servicers’ obligation, and in point of fact are required to the extent 

that a loan-by-loan process is not feasible and is just going to lead 

to more foreclosures, which will end up costing the pool more. But 

it needs to be systematic, and servicers need to staff up. I think 

some of them are, but they need to provide standard benchmarks 

whether a debt-to-income analysis or standard loan-to-value ratios, 

whatever they are going to use, to make that clear to the staff that 

are dealing with the borrowers who are coming and looking for 

modifications. And borrowers in turn need to proactively interact 

with servicers. 

Whether it will be enough, as the housing market goes down, I 

do not know. I think the jury is still out. We internally are thinking about other potential options that might be pursued. When I 

testified at this Committee in late January, I talked about the need 

to write down principal amounts of many of these loans to make 

them affordable and Congress made that a much more feasible option by passing the Debt Forgiveness Act in December so that a 

principal write-down would no longer lead to a tax liability on the 

part of the borrower. 

That is going to be increasingly a tool that servicers should use. 

I believe there are ways to structure those principal write-downs 

so that there can be some type of shared equity agreement with the 

borrowers so that if the property starts going back up, there would 

be a way for the investment pool to share in some of that subsequent appreciation. 

So I think we need to be looking at market-based solutions at 

this point, and keeping the pressure on for servicers to use systematic approaches, not loan-by-loan approaches, to deal with this, 

using the full panoply of tools available. Whether it will be enough, 

I do not know. I think we need a month or two more of data. I 

think, back to Senator Bennett’s question, a lot of this is being 

driven by the housing market. How much home prices continue 

going down and how fast they go down I think will be a key indicator of whether we need to start being more proactive in terms of 

government intervention, but I do not think we are there yet. 

Senator CASEY. Thank you, and I wanted to also ask a similar 

question to the Comptroller. I was happy that in your testimony, 

when you addressed the subprime mortgage crisis, what borrowers 

are facing, and the interplay between lenders and borrowers and 

servicers and borrowers, that you mentioned and highlighted counseling. I think the Congress moved with record speed in getting the 

$180 million approved, and that was done before the end of the 

year. 

The recent legislation which the Democratic side of the aisle was 

pushing very hard last week and will continue to push added anVerDate Nov 24 2008 02:38 Mar 13, 2010 Jkt 050370 PO 00000 Frm 00039 Fmt 6633 Sfmt 6602 E:\HR\OC\A370.XXX A370

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other $200 million to that. I am happy that you talk about that, 

and I am happy that the Treasury has highlighted it. I would urge 

you, using your skills as an advocate, to urge other Members of the 

U.S. Senate to make this counseling priority much more urgent 

and much more important. But I wanted to give you the opportunity to weigh in on this question about—not just about counseling, of course, but just overall how we are approaching this crisis. 

Mr. DUGAN. Well, I agree with much of what Chairman Bair 

said. I think we do have a situation where 97 or 98 percent of 

Americans who hold mortgages are still paying their mortgages on 

time. We still have a situation where we have relatively low levels 

of unemployment in the country. We do have more aggressive actions being taken by servicers, but we do not know how effective 

that is yet because we have not had enough time to look at it and 

the metrics have not been good enough yet. We do not know yet 

how deep the house price decline is going to be, so I think the jury 

is still out somewhat. 

As I mentioned in my testimony, we are requiring our largest 

banks, who service about 40 percent of the entire mortgage market, 

to do a much more detailed set of reporting of mortgage metrics on 

an apples-to-apples basis as a way to measure what kind of improvement is happening. That is not just with respect to subprime 

adjustable rate mortgages, but to all mortgages. 

The other factor is, because interest rates have come down, the 

reset problem, which has not gone away, has definitely improved, 

and that is a good thing. 

It is a mixed bag, and I think we are paying very close attention 

and monitoring our servicers. We will continue to do that. I know 

Congress will do the same, so I think the jury is still out. 

Senator CASEY. Thank you very much. 

Chairman DODD. Thank you very much, Senator. I am going to 

in the next go-round—those are very good questions Senator Casey 

has raised here, and I would note that this morning, apparently in 

a speech that the Chairman of the Federal Reserve has given to 

the community bankers this morning suggesting maybe something 

along the lines we have talked about earlier that the American Enterprise Institute and others have advocated, that I have been talking about, and that is this homeownership preservation idea, using 

existing platforms with very distressed mortgages. 

It is a complicated issue. The devil is in the details in those 

ideas. It sounds wonderful in the first couple of sentences, and then 

you start talking about how you actually do this, and it gets a little 

more complicated. But, nonetheless, I appreciate the Chairman’s at 

least acknowledging—and I am going to come back at my round 

here and ask all of you maybe to comment on that concept and idea 

and whether or not we should not at least be thinking about rather 

than waiting for something to happen. But I will raise that. 

Senator Corker. 

Senator CORKER. Mr. Chairman, I thank you, and being so lowranking, I have the opportunity to hear a lot of great questions, 

and certainly some wonderful testimony by these panelists. I do 

think that this hearing has come at an excellent time. I really do. 

And I thank you for having it. 


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I think that what we have seen is that the banking industry in 

general is very strong, and I think that is good for us to know. I 

think that we are all out seeing and hearing about a lot of problems. But the fact is that due to the great work of our panelists 

and just responsible bankers across our country, and lenders, we 

are actually in a really strong place. And I think that is a message 

that we all need to soak in and know as we think about what we 

might do in the future as it relates to housing and other issues. 

You know, the cheap and easy credit—and I do not mean to demean it, but, you know, today 10-year treasuries are at 354 and, 

you know, real estate valuations are simply a measure of what interest rates are. I mean, when interest rates are low, commercial 

values increase tremendously. It is hard for me to believe that commercial real estate has been selling at 5 percent caps, 6 percent 

caps, just ridiculously high prices. And there is no question there 

are going to be write-downs. People have made a lot of money over 

the last several years, and the chickens are going to come home to 

roost here in the near future. I think we all understand that. 

The same thing I think we have all seen happen with housing 

is that people buy housing based on what the mortgage payments 

are. Let’s face it. And when rates are low, they will pay more for 

housing, and we have gone through an incredible time of rising 

home prices. As a matter of fact, a few years ago we were all concerned and reading daily in Wall Street about the overheated housing market. And even though the Chairman, doing a great job, 

pointed out that housing prices had dropped 10 percent, we are 

still just back to some levels in 2006 that were at that time incredibly high. So I think your testimony today is very good to take 

into—is very good to help us with the perspective of where we are, 

and it is amazing that the banking system is so strong. 

I think it is also interesting to note that the folks who are involved in CDOs, as you have mentioned, they have already taken 

their hits. And in many cases, they took too aggressive of hits, and 

it is those folks that did lending the old-fashioned way—they actually kept it on their balance sheet—those are the ones you are 

going to be dealing with here in the near future. They have not yet 

taken their write-downs. They will be taking—those that actually 

loaned money the old-fashioned way, the way we all used to borrow 

it. 

So I guess I have really two questions. One of the things that I 

see in these cycles is we get exuberant real estate, the best thing 

there is in the world, and everybody invests in it and everybody 

loans money toward it. And then when problems occur, some of the 

organizations that you actually represent—and I think the Governor used the word I was going to use—actually create a self-fulfilling prophecy. What happens is you begin to clamp down, bankers are afraid to make loans, especially with no offense to you, OCC 

in particular goes in and all of a sudden commercial lenders are 

not in the marketplace the way they were. They no longer are looking—you all fill out these forms that they have to fill out. Their 

credit is rated. 

I would like for each of you to respond to that, because I am concerned that you, in fact, could end up being the greatest problem 


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that we have by helping create a self-fulfilling prophecy by causing 

these banks to tighten down more so than necessary. 

Mr. DUGAN. Senator, that is certainly not our intent. As Chairman Dodd referred earlier, I sat behind this dais—not on the dais 

but behind it—and sat through all the hearings of a lot of bank 

failures in the 1980s and early 1990s from problems with commercial real estate. 

I also was in Government at that time when people were complaining about regulators acting too stringently, including the 

OCC. One of the issues that people have pointed to was that, in 

fact, the regulators—partly because they were overwhelmed—waited too long to move in on some of these problems until they got too 

big. When they had to act, they had to act strongly. And it was 

criticized as being too tight. 

We have tried to get out ahead of that. When we get into an 

economy and part of the credit cycle, we begin to experience losses, 

bankers cannot turn a blind eye to that. They are going to experience losses, and they have to be realistic about the problems of 

their assets on their books. But we want them to be realistic. We 

do not want to make those write-downs. We want them to make 

realistic judgments, and to have realistic appraisals about what is 

going on in the commercial real estate market. We want to work 

with them. We want to work through these issues when they are 

smaller so that we can work through them instead of waiting until 

they get too large, and then the actions we take have a more dramatic effect. 

That is an art, not a science. We have been quite forward leaning 

and proactive in trying to get bankers to understand that and to 

take good, strong measures about how they manage the risk in 

these times. 

The one thing that is different this time around—and it is a significant difference—is that community bankers in particular have 

much bigger concentrations of their entire balance sheet in commercial real estate assets, and that can make it more difficult. It 

does not take as big a problem to cause as big a problem. But we 

are very mindful of this balance, and, again, our consistent message is bankers need to be realistic about the actual value of the 

assets in their portfolio and take realistic write-downs and provisions as they occur. We do not want to overdo it, but there has to 

be a measure of realism, or else the problem will get worse. 

Senator CORKER. And I think it is not so much the write-downs 

as much as the future lending practices as a result of people having 

fears. And I would just say to you we are getting calls from board 

members, you know, who are concerned because the OCC is coming 

in and causing things to have to fit into a different and smaller box 

than in the past. And I would just urge you—it sounds like to me 

you are very sensitive to the issue, but I would just urge you not 

to exacerbate the problem by causing—and you have got a lot of 

folks who work with you throughout the country. Some are more 

exuberant than others, if you will. But I think that in itself could 

be a big factor as to whether we move through this period of slowed 

growth in better ways or not better ways. 

Mr. DUGAN. Senator, we work very hard to have a measured, 

even way that we do things with our examiners. I do not think 


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there is any issue in our community and mid-sized line of business 

that we spend more time on than having a consistent message 

about this. 

To the extent that there are problems that you hear about that 

you want to pass along to us, please do that, because, as problems 

occur, we want to hear about them. There is also a question of 

when there are problems, people are going to complain at times, 

and we understand that, too. We have to do our job. 

Senator CORKER. And, again, my comments are really focused 

more on the past and the fact that I do think the OCC has in the 

past exacerbated problems instead of helping them. And it sounds 

like you are very sensitive, and I appreciate that. 

I wonder if—I guess I am out of time. I will wait until the—— 

Chairman DODD. No, no. You have got a couple more seconds. 

Senator CORKER. Let me just on the transparency issue, the 

issue of transparency, these complex financial instruments—which 

were great as long as nobody had to actually own them. You could 

make fees selling them to each other, and everybody was having 

a great time until somebody had to actually value those. 

I was up at the stock exchange—I have mentioned this once before—a couple weeks ago and noticed they are setting up a mechanism where you can actually in real time instantly value the debt 

instruments you have on your books. And I am just wondering if— 

you know, to have the same kind of transparency and valuation 

that we have in equity markets. I am wondering if any of you have 

comments about that or other things that might occur to keep 

these complex vehicles in the future from being—the values made 

up, if you will, and fees really being generated to banks simply by 

trading them with each other, slicing and dicing and selling them 

back and forth to each other. 

Mr. DUGAN. I will start. Valuation, of course, is a critical issue 

that we have seen. Part of the problem has been when all trading 

stops in an asset that is itself very complicated because it is based 

on a whole waterfall of different cash-flows from many different underlying mortgage-backed securities, it is very difficult to get that 

instant value when you do not have market prices to look at. And 

part of the problem that we have seen is not that people relied on 

very complex models that were problematic. Quite the opposite, it 

is that they did not have very good, robust models that were complex enough and sophisticated enough to really accurately measure 

what these things were worth when there was not a market price 

for them. That is one of the things that we are spending a great 

deal of time looking at. The whole issue of valuation and transparency and how we deal with them has played a critical role in 

the disruptions. 

Senator CORKER. Thank you. 

Mr. KOHN. I agree, Senator, and I think that to some extent the 

market is in the process of taking care of this. The participants in 

the market understand that part of the problem here was the complexity and opacity of the instruments. As I said before, it made it 

very difficult to look through the credit rating agencies’ analysis to 

the underlying instrument. 

So I think going forward, at least for a while, we will have instruments that are easier to value and to market. But I think it 


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is very important that, as regulators, we not impede and, if anything, encourage that movement by the credit rating agencies, by 

the banks, that they be able to have an independent assessment of 

what the value of the assets are and not rely on the credit rating 

agencies, for example. So I think that is an important part of what 

we need to do here. 

The valuation question is very hard, as the Comptroller said, 

when there is not a market or not even a closely related market. 

I think it is important, to go back to a previous comment he made, 

that these things be valued realistically and that people looking at 

the banks, the investment banks, have confidence that they are 

valuing them realistically and are not inflating those values. And 

it is really up to the banks, the investment banks, to be transparent enough about their valuation methodologies to convince people that is it, and that will begin to restore confidence in the markets. 

Ms. BAIR. I would just add that I think some public pricing 

mechanism would have been very valuable. I think it is very difficult to mark-to-market when there is no market. And I think we 

should all give further thought to whether regulated exchange type 

mechanisms could lend themselves to some of these instruments 

that now are privately traded. But I do not think any public market would function given the lack of information about these instruments. The core of the problem is lack of transparency, getting 

information out of that underlying asset quality so investors can 

make an intelligent pricing decision, and then some type of public 

trading mechanism might work. 

Senator CORKER. Thank you, Mr. Chairman. 

Chairman DODD. Senator, thank you very, very much, and as the 

panel can see, your job now is to find that pathway between Senator Corker and Senator Dodd in how you respond to all these 

questions here. But I appreciate Bob’s contribution to the Committee, very knowledgeable and a very great asset to the Committee. 

Senator Schumer. 

Senator SCHUMER. Thank you, and thank all of you for being 

here and for the difficult job you have to do. 

I have 3 different areas I would like to question. I would like to 

go back a little to the credit rating agencies. Senator Reed did a 

few questions on that. 

But I still scratch my head about how these credit rating agencies operated because many of us knew there were problems in the 

mortgage market and what was happening, particularly with 

subprimes. I mean, we knew them on an anecdotal basis. And the 

credit rating agencies just seemed to sort of rubber stamp them. 

And I guess their model was housing prices will increase, it does 

not—how could credit rating agencies just automatically give AAAs 

to no doc—you know, to a whole bunch of securities that contain 

no doc loans? You do not know if the person has the ability to pay. 

You do not know any of these things. 

And so, I would like to come back to this area of credit rating 

agencies. They just seem, to me, to have—from an outsider—to 

have just sort of gone through things in a mechanistic type way. 

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flicts of interest. I mean, you pay the credit rating agency—the 

issuer pays, and pays after they get the rating. Well, what does 

that say? 

And so my question to you is does this model of credit rating 

agencies not work? Are you recommending to your institutions that 

they rely less on the credit rating agencies? 

On the one hand you have simple mortgages where they messed 

it up. And on the other hand, as you just talked about, they have 

these very complicated financial instruments that I do not know if 

they understood. 

You know, when CEOs of banks tell me they do not understand 

these complicated documents, somebody in the middle of the bank 

does. Do the credit rating agencies understand them? 

Something is really wrong. And I think ultimately, when we look 

back on this, we are going to see that the banks relied, the credit 

rating agency, boom, they give the Good Housekeeping Seal of Approval, and everyone just goes ahead on their merry way. 

Don’t we need a fundamental re-examination of A) how the credit 

agencies function, maybe going back to the old model, where the 

investor paid rather than the issuer paid. And second, aren’t you 

telling your banks now that they are going to have to do much 

more of their own examination rather than just rely on the credit 

rating agencies? 

Sheila Bair. 

Ms. BAIR. Well, I think a lot of those issues, we do not regulate 

the rating agencies—— 

Senator SCHUMER. I know you do not. 

Ms. BAIR. I think certainly we would be—— 

Senator SCHUMER. The institutions you—— 

Ms. BAIR [continuing]. The banks have been having—— 

Senator SCHUMER [continuing]. Regulate reliably—— 

Ms. BAIR. Yes, and we are certainly highly supportive of the 

steps that the rating agencies have taken on their own, as well as 

steps the SEC has been taking and may plan to take in the future. 

As a bank regulator and as an insurer of all banks, I am very 

uncomfortable with continuing to allow banks to set capital based 

on external ratings for structured finance when we do not know 

what the underlying asset quality is. The rating agencies use mathematical models. They never looked at underlying asset quality. 

Senator SCHUMER. Exactly. 

Ms. BAIR. For some of these, it would take weeks and hundreds 

of thousands of pages to even find the underlying assets because 

they have been sliced and diced so many times. 

So we need to get back to basics. And again, the core is that you 

need to know what the underlying assets are ultimately backing 

those securities. And if you do not have that information, you cannot price. 

Senator SCHUMER. And they did not. And they did not have that 

information. 

Ms. BAIR. They relied on mathematical models. So even if you 

were over-collateralized, basically the risk was that the higher 

tranches would not be covered—it was all done with the math. 

Senator SCHUMER. Governor Kohn, do you want to comment on 

this? 


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Mr. KOHN. Yes, I do. I am sorry, do you want to go ahead? 

Senator SCHUMER. Go ahead, Mr. Gronstal. 

Mr. GRONSTAL. State regulators, as we evaluate bank management, we hold them accountable for understanding what investments they make. And when they make errors, we make them 

charge it off. And I think that is pretty much the same way the 

Federal regulators do with their banks. 

And these were very complex instruments and I think—— 

Senator SCHUMER. The mortgages were not complex. 

Mr. GRONSTAL. No, the mortgages were not, but the securities, 

the way they got packaged up—— 

Senator SCHUMER. With all due respect, when people walked into 

my office and told me the mortgage they were sold, I said you will 

never be able to pay that back. Your monthly payment exceeds 

your annual income. 

Mr. GRONSTAL. Unfortunately, a lot of people relied on the loan 

officer to tell them how much they could afford. And the loan officer was compensated on the size of the loan. So there was kind of 

a perverse incentive to make the loan too big. 

Senator SCHUMER. Right. Governor Kohn. 

Mr. KOHN. Yes, Senator, we are telling our banks to rely less on 

the credit rating agencies and to look at the underlying collateral, 

the underlying securities, and make their own judgments. 

And I think, as Comptroller Dugan said, there was just too much 

of that reliance before. 

I think, I am not sure that there is an alternative to the issuer 

pays model. What I was told was that the investor pays model was 

in effect until the Xerox machine was invented, and then it was 

really impossible to control. 

Senator SCHUMER. And they were private. The investor paid was 

not made public. And you do want some kind of public rating available. 

Mr. KOHN. That is right, and those ratings are used. So I think 

there is probably, in the end, no alternative to the issuer pays 

model. But I know that the SEC and other regulators are looking 

carefully at this conflict of interest question that you raised. The 

credit rating agencies have an interest in doing a good job. They 

have their reputation on the line. But obviously, that was not 

enough. 

Senator SCHUMER. No, they got very sloppy, obviously. 

Mr. KOHN. They got very sloppy and they were not really looking—they were taking other people’s word for what was in those 

packages. And they were not drilling down and doing their own inspection. 

Senator SCHUMER. Exactly. You have sort of—— 

Mr. KOHN. They need to find—they need either to take total responsibility themselves for looking at what is happening at the 

originator level, or they need to find another way of putting more 

pressure on the people who are packaging—— 

Senator SCHUMER. It was almost a catch-22. The agencies relied 

on the banks for it, and the banks relied on the credit agencies. 

And look where we are now. 

OK, second area I would like to—my time is limited and I know 

you have fully opined on this, Comptroller. 


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And that relates, Senator Dodd asked some questions on Basel 

II. And here is the dilemma we face: these markets are now international. All the problems in the U.S. have affected a lot of western 

banks outside. And yet the standards, even with the efforts of 

Basel II, are not international. You have still efforts by countries 

to have an easier system of regulation so that money will flow in 

that direction because it is cheaper if there is less regulation, fewer 

capital requirements. 

And you sort of get a race to the bottom and then that ultimately 

leads to the undoing of the financial system, which we have seen 

now. 

So how do you balance the need for some stringent regulation— 

admittedly some of you have stated that Basel II did not do the job 

or will not do the job. Obviously, it is not to blame because it has 

not happened yet in America, although it is in Europe. 

But how do you balance, how do you get sort of one international 

standard here, which is what we need, without individual countries 

sort of playing one-upmanship with one another? Isn’t that the fundamental problem we face here? Because in good times, everyone 

is going to want to reduce the standard. And then in bad times, 

that reduced standard affects everybody, whether you have reduced 

the standard or not. 

Go ahead, Comptroller, and then Ms. Bair. 

Mr. DUGAN. I think the whole point of Basel is to have some 

international minimum standards that everybody has that you cannot go below. Then there are questions about how much people add 

on in different areas. 

I actually think there has been progress to raise that across the 

board. Basel II is a step in the right direction, as we talked about 

earlier, because it is more related to risk, but it does have some 

issues that we have to address. 

I think it is fundamental to keep those efforts going. Personally, 

based on many discussions that I have had with international supervisors, it is not a race to the bottom. I think there really is an 

effort—— 

Senator SCHUMER. So you think the framework can work? 

Mr. DUGAN. Absolutely. And I would say the biggest single difference between my being in Government this time than 15 years 

ago is there is much more cooperation and much more awareness 

that we have to have and work toward a common set of minimum 

standards because this is a global world. 

Senator SCHUMER. Exactly. We are one international economy. 

No one can build a wall. Ms. Bair. 

Ms. BAIR. Well, I am concerned that the models serve an approach under the Basel II framework that actually is going to feed 

into more of this race to the bottom competition because it is much 

more subjective. 

First, under Pillar 1, you rely on each individual bank’s own internal models to set capital. Those are validated by the individual 

supervisors of that country. We have been told that if the models 

are too low we can correct them under Pillar 2. Again, that gets 

back to supervisory discretion. So not only is it jurisdiction by jurisdiction, it is bank by bank. 


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We have called for some international agreement on hard and 

fast supplemental capital standards, dare I say it—an international 

leverage ratio—or something like that. But something hard and 

fast that will set a minimum for all banks. 

The Financial Times ran an editorial a few weeks ago showing 

that a lot of major European banks are critically undercapitalized 

by our own PCA standards. This is something that everybody 

should be—— 

Senator SCHUMER. Despite Basel II. 

Ms. BAIR. Yes. 

Senator SCHUMER. Exactly, because they were seeking an advantage, I guess, each individual country or regulator. 

Ms. BAIR. There is a tendency, which is why Chairman Dodd 

mentioned the inherent conflict of using internal models to set capital. Because sure, if you lower your capital, you are going to increase your return on equity. Absolutely. 

Chairman DODD. I said it was like modeling weather reports. If 

you only use sunny days, you are going to set sunny day modeling. 

You have got to stress those models. 

Senator SCHUMER. But during the sunny days, the sunny day 

user has an advantage over the cloudy day people. 

Mr. REICH. Senator Schumer, I would like to add that as a member of the Basel Committee I have sensed, in the last year particularly, with the losses that some major foreign banks have taken in 

the past year, that there is much greater acceptance of the members of the Committee from our foreign regulatory counterparts to 

accept more stringent controls and additions to Basel II. 

Senator SCHUMER. I will just conclude here—my time is expired. 

But if there were ever a time to get everybody to sort of agree to 

have that minimum standard without, as Ms. Bair points out, the 

ability to go below it and get around it, now is the time because 

we have seen the—I agree with Ms. Bair here. There is something 

of a race to the bottom despite Basel II. 

And if we can now sort of tighten that up, now is the ideal time 

to do it because people have suffered from the lax standards I see. 

I am just going to have the record note that Governor Kohn was 

nodding his head in agreement. 

Mr. KOHN. Up and down. 

Senator SCHUMER. Thank you, Mr. Chairman. 

Chairman DODD. Thank you very much. Senator Carper. 

Senator CARPER. Thanks, Mr. Chairman. And our thanks to all 

of you for being here today. 

I wonder if you are going to be testifying on Thursday. We have 

a hearing on GSE-regulatory reform? No? OK. 

I said earlier, when we were giving our opening statements, that 

our leadership brought forward a package that is designed to help 

with housing recovery. We had an opportunity to vote whether or 

not to proceed to that legislation last week. We could not get to 60 

votes to proceed. 

And in the days that have followed, we have seen an effort on 

the part of our leadership in this Committee and others to try to 

find out how we can construct a package that has buy-in not just 

from Democrats but Republicans, as well. And also from the Administration. 


dcolon on DSK2BSOYB1PROD with HEARING
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I just want to run through quickly maybe the 6 major elements 

of the proposals cobbled together by the Democratic leadership and 

just ask you to just tell me whether or not you think it is a good 

idea. 

And then I am going to do the same thing with some other ideas, 

some from our Republican friends, and just ask you to see whether 

or not you think—without getting into a lot of detail—whether or 

not that might be a good idea, as well. 

One of the proposals is to increase pre-foreclosure counseling funds by about $200 million nationwide. If you think that is a good 

idea or you do not, just tell me. Just start, Ms. Bair. 

Ms. BAIR. Well, I think counseling is a very good idea. I know 

NeighborWorks has gotten a significant infusion already. So my 

only caveat would be how much they can use, how quickly, and 

how effectively. But certainly, the modification process is a highly 

complex one and we need intensive counseling and help. 

So I think to the extent you are increasing borrower leverage to 

be able to negotiate a loan modification, that the counseling process 

is helpful. 

We do not have a position on the dollar amount, though. 

Senator CARPER. OK. Is there anybody at the table that has a 

different opinion than that that Ms. Bair has expressed? 

Mr. REICH. I do not have a different opinion, but I am on the 

board of NeighborWorks and I know that they have been working 

very hard in recent weeks to allocate the $180 million that was appropriated to a variety of counseling agencies around the country. 

It is a challenge to make certain that those funds go to the appropriate organizations who have the capacity to counsel many people. So the addition of another $200 million on top of the $180 million in a short period of time might be a bit problematic. 

Senator CARPER. OK, thank you for that thought. 

The second ingredient is to allow housing finance agencies to 

issue bonds for refinancing. They can already issue bonds that are 

used for first-time home buyer programs, to use to develop multifamily rental housing. 

But this is a little different. First, I think this is one actually the 

Administration favors, too, in testimony before us by Secretary 

Paulson a couple of weeks ago. Your thoughts on whether or not 

that is a meritorious idea? 

Ms. BAIR. Well, yes. This is not my area of expertise, tax policy, 

but I know I have certainly read the Administration’s statement on 

this and know of the bipartisan support. So yes, intuitively it 

seems like a good idea. 

Senator CARPER. OK. Does anybody have a different view? 

Mr. DUGAN. Senator, I just have not looked at these particular 

policies and I must say I am quite uncomfortable passing judgment 

on how much—— 

Senator CARPER. I understand and you were fair to say that. You 

are fair to say that. 

My other proposal is to provide an additional $4 billion in CDBG 

funds to purchase foreclosed homes. We have actually allocated in 

our budget for this year, I want to say about $3.6 billion. So this 

would actually be more than we have already allocated for the current fiscal year. 


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Does anybody think that is a particularly good or bad idea? Anybody at all? Mr. Kohn? Do people call me Governor? 

Mr. KOHN. Fine. 

Senator CARPER. They call me that, too. Do you like it? 

Mr. KOHN. Like John, we—— 

Senator CARPER. I still like it. 

Mr. KOHN. We have not looked at these issues so it is hard to 

have an opinion without—— 

Senator CARPER. All right. Fair enough. I understand. 

There is an issue on bankruptcy. Initially the proposal on bankruptcy or cram down was pretty broad and it was prospective, not 

retroactive. I did not just focus on subprime mortgages, but it was 

very broad. 

It has been modified so that the proposal would apply only to 

current subprime mortgages. The judge could reduce the interest 

rate to prime plus a reasonable premium for risk. The judge could 

extend the life of the mortgage, I am told, by some 30 years. 

Does any of that make sense to you as part of what we are trying 

to get at here? We have had some concerns raised that if we provide for this kind of opportunity in bankruptcy that we run the risk 

of raising the cost of mortgages, that the interest rate might go up 

for primary residences. That is the caution that we have heard. 

Any thoughts? 

Mr. REICH. I would share that caution, and as well be concerned 

about the potential impact on investors returning to the market. 

Senator CARPER. Senator Martinez and Senator—— 

Chairman DODD. Just to point out, if I can—and I appreciate 

John Reich talking about that—there is a history to that provision 

that goes back to the 1970s, where that was the negotiation that 

went on with the lending institutions, to provide money to otherwise risky borrowers in exchange for that was to provide some protection under the bankruptcy act. 

So the history—I am not necessarily endorsing a continuation of 

it, but sometimes we mention these things in a vacuum and do not 

appreciate there is a history and a rationale for that. 

Senator CARPER. I understand. Thank you. 

I think Senator Martinez has a proposal that addresses appraisals. If you have any thoughts on this, we would appreciate it. His 

amendment would tighten the standards currently in place for appraisals. The amendment would require a written appraisal and 

physical visits before granting a mortgage, ending the current practice of drive-by appraisals. 

Does that make any sense in the context of a mortgage or housing recovery package? 

Mr. REICH. It makes sense in the context of what acceptable 

banking practice ought to be. I think most community banks try to 

do those things today. 

Senator CARPER. Senator Feinstein has a proposal to license 

mortgage brokers. And that is just a thumbnail sketch. Does that 

strike any of you as part of the package of things that we should 

consider doing, to license mortgage brokers? 

Mr. GRONSTAL. From a CSBS standpoint, we think that is an appropriate thing to do. And that is why we have developed the naVerDate Nov 24 2008 02:38 Mar 13, 2010 Jkt 050370 PO 00000 Frm 00050 Fmt 6633 Sfmt 6602 E:\HR\OC\A370.XXX A370

dcolon on DSK2BSOYB1PROD with HEARING
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tional mortgage licensing system. So we think that is something 

that we need to support. 

Senator CARPER. All right, thank you. Yes, Mr. Dugan. 

Mr. DUGAN. Senator, we would agree that an effective licensing 

system for mortgage brokers is an important component of this, because I think one of the problems that we had underlying all of this 

is the ability to get even underwriting standards, not just for those 

loans underwritten by banks and banking organizations that are 

subject to our supervision or to State bank regulator supervision, 

but to get the same standards to apply to non-banks and to brokers 

that work in the origination process and are not subject to the 

same regulation and supervision. 

An effective licensing scheme could help that process. I am not 

sure it is a complete solution but it is something that could be helpful if implemented correctly. 

Senator CARPER. All right, thanks. Ms. Bair. 

Ms. BAIR. I would—yes, I think that would be extremely helpful. 

I used to work on the securities side, as you know. And when I contrast the extensive licensing and continuing education regime for 

securities brokers and their elaborate system of self-regulation and 

compare it to what we have on the mortgage brokers side, it is a 

very stark contrast. So if you want to have a $2,000 mutual fund investment, the protections there are much, much stronger than if you want to buy a 

$300,000 house. So I think that is absolutely an area of concern, 

and it goes beyond what the regulators could do. 

So I think I would absolutely urge action in that area. 

Senator CARPER. I would just say to our leaders on this Committee, if we were in a position to go back and revisit this issue 

of a housing recovery package, the last provision there is actually 

a Feinstein and Martinez proposal that sounds like it might—— 

Chairman DODD. I will tell you, it is also one we have introduced 

in our own legislation we have drafted here as a comprehensive, 

addressing the question. 

What we are trying to do is something here, if at all possible, to 

raise—of course, to deal with some emergency steps that we might 

take. Some of these ideas are far more far-reaching here. Very meritorious, but I think the goal of trying to get something done, a narrow idea, is what we are still working on. And hopefully maybe we 

can get something done before the Easter break. 

As the Senator knows, I have a deep interest in getting something up. But our ability to do that is going to depend on whether 

or not we get some comity and some agreement on these principles. 

Some of these ideas, while I am supportive of them, I realize they 

are going to be rather contentious and are included in a larger 

package. But I want to wait until we maybe do that under a way 

so we get it done, if we do not sacrifice getting something done. 

But let me, if I can, I appreciate—— 

Senator CARPER. Thank you. 

Chairman DODD. I just want to raise a couple of questions. Senator Shelby has a couple of questions, as well for us. 

Let me step out of—you know, it seems to me here, as I am looking at all of this, there are 3 sets of issues we are dealing with. 

One, how do we avoid this from happening again, and the kind of 


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steps we can take? How do we deal with the problems that people 

have, whatever they may be, that are suffering as a result of the 

problem? That is, dealing with foreclosures. 

What we are not seem to be addressing is the problem. We are 

dancing around this, trying to shut the door to make sure it does 

not happen again, and how do you address the issues that people 

are affected by this? 

I want to raise with you, Governor Kohn, if I can, an idea. This 

is just an idea, and something that you might have heard about 

yourself. And that is how do we—the freezing up of credit. How do 

we sort of unleash this credit freezing issue, which is at the heart 

of it in my view? More than anything else, that is the heart of this 

issue. 

And one idea that was suggested, trying to get people to think 

out of the box a little bit here, is to make available to the discount 

window private investment institutions, provided they be subject to 

Federal regulation, provide the necessary collateral and the like, so 

it just would not be the member banks that would access to it. 

This is a rather radical idea, to some extent. But to the extent 

you could send positive optimistic messages here about releasing 

the kind of—the rigidity that the credit markets face here. What 

is your reaction to something like this? Have you heard of this? 

Others may have raised this. 

And if not that, are there some other thoughts that we ought to 

be considering? That we all ought to be considering as a way of trying to deal with the problem, other than just, of course, making 

sure we shut the door so that it does not happen again and dealing 

with those who are affected by it, how do you deal with the central 

question that will bring us to some quicker conclusion to all of this? 

Mr. KOHN. I certainly have heard proposals to open the discount 

window to a broader array than just depository institutions. Technically, it is possible now—— 

Chairman DODD. You have the authority now to do that. It would 

not require legislation, would it? 

Mr. KOHN. Under Section 13.3 of the Federal Reserve Act, we 

can make loans to individuals, partnerships, and corporations 

under unusual and exigent circumstances by a vote of no fewer 

than 5 members of the Board of Governors. 

And we have not made any such loans since the 1930s. So Congress saw this as an emergency very, very unusual situation that 

they did not want us using. 

I would be very cautious about opening that window up more 

generally. I think the banks have access to the discount window 

but the quid pro quo, in some sense, or the control—there is a 

moral hazard issue here, having them have access. And the control 

on that is this panel, right? You have an extensive amount of bank 

examination supervision. You have constricted their activities in a 

number of ways relative to investment banks. 

I do not think that liquidity is the problem for the investment 

banks, or liquidity is the issue behind restarting these markets 

right now. I think it is about confidence. It is about the underlying 

economy. It is about the housing market. So I am not going to 

trade these securities until I can have some confidence that I can 


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estimate the losses embodied in them, that I can price them in a 

way that will be sustainable. 

Chairman DODD. I agree with that. It is kind of a chicken and 

an egg though, too, a little bit, isn’t it? I mean, you get confidence, 

in a sense, if you also have access and liquidity. 

Mr. KOHN. Right. But I think it is also more of a capital problem, 

not so much capital in the banks, per se. But just the whole sense 

of losses and potential losses if the economy deteriorates further. 

So I do not think opening up credit to the investment banks will 

really be that helpful in the end and could carry some very major 

costs. 

Chairman DODD. Well, I certainly agree with your cautionary 

note in all of this, and what is why I raised it and framed it the 

way I did. It is an idea that has been kicking around. 

Anyone else have any reaction to this at all? John, do you have 

any reaction to this? 

Mr. DUGAN. As an old Treasury guy, too, I do have a reaction, 

which is you have to be very careful about giving out the Government’s credit except to institutions that you really pay very close 

supervisory attention to. I would maybe even be more cautious 

than Don about this. 

And I think he is right. I think the issue has not been primarily 

about getting access to liquidity. It has been about what is going 

to happen to house prices. That is what everybody is looking at, before they go back into the housing market. 

I would just echo the very extreme note of caution. 

Chairman DODD. Well, let me also just, if I can, I mentioned earlier this issue of jumping back to the issue of what do we do about 

those who are facing foreclosure. And as you all know, we have 

resets coming along here. I am hopeful that the Hope Now Alliance 

is going to work. 

There are some reports this morning that we may be getting 

more done than we had hoped. Certainly, the last year was not terribly encouraging. But obviously, if things are picking up a bit, that 

can be helpful. 

But the numbers could increase here. And now it looks as though 

a significant percentage of these foreclosures are not just in the 

subprime but prime and credit-worthy borrowers that are facing 

these problems, as well. 

And I want to raise the issue again of this idea—and again, I do 

not want to put words in the Chairman of the Federal Reserve— 

I did not read his speech yet. But I gather something along the 

lines of maybe being a bit more aggressive on this issue than just 

the Hope Now Alliance would indicate may have value here, including the idea that I have raised and others have raised. 

Chairman Barney Frank is talking about some ideas over there 

that are not dissimilar to the ones we are talking about. 

And again, you can wait for this to happen and try and do something. But again, the idea of putting something in place that requires some real work, because there are legitimate issues that get 

raised when you start talking about establishing—whether you are 

using a separate entity or utilizing one of the GSEs or using FHA. 

In any case, the details of this get very, very complicated. 


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And my concern is that if we wait too long and we find this problem getting worse and try to deal with it on that level, that we may 

miss an opportunity to step up. And I just would like to get, those 

of you who are interested in commenting on this idea. As I pointed 

out earlier, the American Enterprise Institute and others have testified favorably about the idea. 

Sheila, do you want to comment on this? And just run down the 

table quickly. 

Ms. BAIR. Well, yes, I think we should be looking at all options. 

I really do. I think the jury is still out on whether we will need 

to set up something quite major. But I think your thinking is right, 

whether it is a new agency or FHA or one of the current GSEs. If 

that greater level of Government intervention is necessary, this is 

something that we should all be thinking about now. 

But I do not think we are there yet in recognizing it. 

I would say, as another former Treasury person, that if we do set 

something up the moral hazard is significant. The risk of gaming 

is significant. And I would strongly recommend a mechanism to 

pay for it, hopefully paid by the people who would actually be using 

it and benefiting. 

Chairman DODD. John, do you have any comment? 

Mr. DUGAN. I agree with Sheila and I do not really have much 

to add to that, particularly since, as you said, I have not really 

looked at the particulars of it. We are not—thankfully—yet anywhere near what we were in the 1930s when we had a much bigger 

proportion of people foreclosing their homes. We have still got a relatively small part of the overall population of mortgage holders. 

The jury is still out, before you engage in this. 

And also, it will take a long time to get it up and running, and 

that is part of your point I know. But I do think in the meantime 

we should not lose our focus on the other things that we are doing. 

But I share Sheila’s thoughts. 

Chairman DODD. Anybody else? 

Mr. REICH. At OTS, we have been—— 

Chairman DODD. You have been particularly good on that. I want 

to thank you, by the way, John. Your ideas, while I am not signing 

on to every dotted I and crossed t, I appreciate the effort of thinking about some ideas like this. 

Mr. REICH. Well, and it is not—to be honest, it is not fully developed yet. 

Chairman DODD. I know. 

Mr. REICH. We put it out last week. We are talking with people 

at this table. We have a meeting tomorrow with securitizers and 

another meeting Thursday with regulators. 

But trying to find a way to use existing programs, existing delivery channels without creating a new entity that would deal with 

those people who are under water in their mortgages. 

Mr. KOHN. I think the message of the Chairman’s speech—and 

I had only myself a chance to read it very quickly—is that, consistent with Sheila’s first comment, all options should be on the 

table and we should continue to think about these things. 

But I agree with the cautions that the others noted. I think looking at existing programs and how to do it better, perhaps to expand 


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them, the FHA for example, is probably more efficient, more effective. 

I think one of the issues we are dealing with here is—and people 

mentioned this earlier—on the borrower’s side, getting the borrowers to contact their lenders has been very difficult. There are 

a lot of fears there, I am sure, about what you will find. 

And I do not have a quick fix for this, but the people I have 

talked to involved in this have said that one of the barriers to scaling up this process is having borrowers call in. The Federal Reserve Banks are very involved, working with community groups, 

lenders and borrowers, trying to get the word out. It is not a magic 

bullet to fix this. 

But I think we just need to work on all fronts to get these borrowers and lenders together. 

Chairman DODD. Tom. 

Mr. GRONSTAL. I think it is obvious that until we can figure out 

what residential properties are worth in individual markets, it is 

going to be very difficult to decide how much can be loaned against 

them. And it is just going to take time to work through that. 

Chairman DODD. Let me again, I do not want to get anecdotal, 

but just in Connecticut now, I think it was ranking like number 8 

in the States with the foreclosure issue. We had almost 50,000 of 

them in Connecticut last year. I have mentioned before some 6,000 

just in one city, potentially, in the city of Bridgeport, Connecticut. 

And we are getting calls in our office, and I use their words, it 

is anecdotal. But the run-around by the Hope Alliance. 

And I really use this forum here, even some of the consultants 

involved in this are raising some issues about how well this working, going to the very point you talk about. If that confidence is not 

there of that borrower to call and feel as though there is going to 

be some effort made here—I am not suggesting that every one of 

these callers deserve, necessarily, to get the help. But nonetheless, 

I have to raise the issue here that people need to make the calls. 

But when that call comes in, they need to have a person on the 

other end of that line that is going to be sitting there and very receptive to trying to help work things out. So I want to mention that 

to you. 

Senator Shelby. 

Senator SHELBY. Thank you, Chairman Dodd. 

In a speech delivered last week, Comptroller Dugan discussed 

how banks, credit rating agencies, and regulators all failed to adequately assess the risk presented by collateralized debt obligations. 

Comptroller Dugan noted that regulators neglected to properly 

scrutinize super senior tranches of certain collateralized debt obligations which are now being drastically revalued and causing large 

losses for banks, as all of you know. 

He also indicated that bank underwriting standards were inadequate. 

Governor Kohn, would you explain—you are not only a member 

of the Board of Governors, the Vice Chairman of the Fed, but you 

are a big bank regulator. Would you explain why the Federal Reserve failed to take steps before the advent of the current market 

turmoil to make sure that banks under your supervision fully understood the risk presented by structured finance products, did not 


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overly rely on credit ratings when making loans, or that banks simply followed sound underwriting practices? 

I know that where we are today, but a lot of people believe that 

the Fed was asleep at the switch in dealing with a lot of the big 

banks that you supervise. 

Mr. KOHN. Senator, I think we have been aware for some time 

that risk was not being appropriately priced, that people were taking risks that they were not adequately insuring against, and that 

risk management systems in these various institutions varied 

greatly across institution and we—— 

Senator SHELBY. What did you do about it, though? 

Mr. KOHN. We have been—— 

Senator SHELBY. If you were aware of it, as a supervisor of the 

banks? 

Mr. KOHN. We have been working with the other supervisors to 

evaluate those risk management systems. And we started before 

this turmoil broke out, and to try and draw some conclusions about 

how these systems needed to be improved. 

So I think we were not looking maybe at specific instruments 

and whether they were being value rated, but whether the systems 

were in place. And that is really—because that is what is going to 

protect us against the next issue. So just honing in on a particular 

instrument is not going to be helpful when there is another thing 

out there somewhere. 

So I think it is the systems we need to pay attention to. 

Senator SHELBY. Well, what happened to the basic bank prudent 

lending in this area? 

Mr. KOHN. I think people got complacent. 

Senator SHELBY. Got carried away? 

Mr. KOHN. Absolutely. Because of this period of good macroeconomic performance, low—I mean, as Chairman Bair was saying, 

we had no bank failures for several years. This is a highly unusual 

situation. 

Chairman DODD. Would you apply that word complacent to the 

Fed, as well as to the bankers? 

Mr. KOHN. I think the Fed was less complacent, but I do not 

know that we fully appreciated all of these risks out there. I am 

not sure anybody did, to be perfectly honest. 

There were—— 

Senator SHELBY. Well, why didn’t you, though? 

Mr. KOHN. I think we recognized that—— 

Senator SHELBY. Senator Dodd used the word complacent. You 

know, when good times are rolling along, people do become complacent. 

Mr. KOHN. And a number of us gave speeches warning against 

this. And our supervisors were aware of that. Certainly, there is a 

lot of conversation back and forth about that. And I think they 

were moving in the direction of trying to correct this, trying to 

make the banks aware. 

It is a very hard sell to the banks. 

Senator SHELBY. It is a hard sell to the banks, yes. But you are 

the supervisor of all—— 

Mr. KOHN. That is right. 

Senator SHELBY [continuing]. The bank holding companies. 


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Mr. KOHN. That is right. 

Senator SHELBY And you are also the central bank. So you have 

not just a little bit of power, but a lot of power. 

Mr. KOHN. I agree 

Senator SHELBY. Were you reluctant—not just you personally. 

Was the Fed reluctant to use their power? Were they afraid of the 

banks that they regulate? 

Mr. KOHN. No. 

Senator SHELBY. Well, what were they? What happened? 

Mr. KOHN. I think some banks did not take adequate steps. Now 

we are doing a study, as I noted in my testimony, of lessons 

learned. We did not perform flawlessly. I absolutely agree with 

that. 

And I think perhaps when we get finished with this, one of the 

lessons that we will have learned is we need to be more forceful 

in these types of situations. 

Chairman DODD. Can I pick up on Senator Shelby’s question and 

add on to this thing? At the very time, just going back, you had 

promoting of the adjustable rate mortgages out of the Fed. You 

were raising interest rates at the time. Wasn’t anybody—this is not 

a complicated set of questions. 

You are pushing ARMs and you are raising rates. It seems to me, 

you have got a perfect storm on the horizon here, that you had to 

be aware of the potential of that. Any answer to that, looking back 

and saying maybe that was not wise? 

Mr. KOHN. I am not sure that we were pushing ARMs. One person made a speech suggesting that. 

But I do think consumers, households, the structure of interest 

rates anticipated the rise in rates and people should have been able 

to see that if they were borrowing at a low rate now, when that 

reset after a year or 3 years or 5 years, it was going to be at a 

higher rate. 

So it is obvious that people did not see that. It is obvious that 

the lenders did not take appropriate account of the affordability of 

the loans when they were being made, as they reset. 

I think, as several of us have mentioned today, a problem was 

that people were counting on those house prices to rise forever. 

And therefore, especially in the mortgage market, the due diligence 

about whether these loans could be repaid under other circumstances just was not undertaken. 

Senator SHELBY. Senator Dodd and I have both been on this 

Committee quite a while, and I chaired it for 2 terms of Congress. 

But we were here during the thrift debacle. And we worry about 

it. I have talked to Chairman Bair. I have talked to all of you at 

different times about this. 

We have a responsibility, here in the Senate, dealing with everything of the bank. But you have that responsibility at the Fed, and 

the others. But I believe the Fed was asleep. 

I want to pick up, and I am glad that my colleague from Rhode 

Island came in here because I was going to pick up on something 

that he brought up the other day that I think is very important. 

We were talking about Basel II. 

He asked—and I have the transcript here at the hearing where 

Chairman Bernanke was here. And I will quote, can I quote you? 


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Senator REED. Yes. 

Senator SHELBY. In fact—and I will quote the record. This is 

Senator Reed, in addressing this to Chairman Bernanke: ‘‘It has 

been reported that Northern Rock—’’ which you are all familiar 

with ‘‘—the British banking institution that failed, that has now 

been nationalized by the British government was able to lower 

their risk-weighted assets by 44 percent under Basel II. The CEO 

of Northern Rock, at that time, described it as the benefits of 

Basel.’’ 

This is, again, the words of Senator Reed, my colleague. And I 

suspect he is not describing it as that certainly—the Prime Minister is not describing it as the benefits of Basel now. 

You know, we were talking about models and liquidity and capital and everything. One of my concerns about Basel II, and I have 

talked to all of you about it, is that a lot of the banks wanted— 

including some of our banks—wanted to lower their capital. 

I know they want to create risk models to better use their capital. You want them to do this. We do, too. 

But I have said this many times up here in this Committee, I 

do not know of any financial institution that is well capitalized, 

and well regulated, and well managed that has ever gone under. 

You know, I appreciate my colleague from Rhode Island raising 

this issue. 

Is that a concern of all of you, dealing with Basel II, as you go 

through the regulations working together to make this work? It is 

of mine, sitting up here on the Banking Committee. 

Governor Kohn. 

Mr. KOHN. I think we have put a number of safeguards into 

place to avoid the kinds of outcomes that you are concerned about 

and that concern us, as well. We have a leverage ratio in place to 

put a minimum level of capital in there. We have oversight under 

Pillar 2 over the general capital levels of the institutions and can 

raise them if we think they are inadequate. There is a phase-in period of 3 years and we have agreed to take a hard look at the end 

of the third year and we will be looking at it constantly as we go 

through to see what the effects are. 

I completely agree with you, Senator, banks that are well capitalized, well managed do not fail. And it is our responsibility to make 

sure that what we put in place strengthens the capital and 

strengthens the management. And that is what we are determined 

to do. 

Senator SHELBY. Chairman Bair, do you have any comment? 

Ms. BAIR. Yes, I share your passion for capital. 

Senator SHELBY. Since you have the funds to bail out anybody, 

I think you will guard those zealously. Go ahead. 

Ms. BAIR. Yes, we share your passion for capital. It is our main 

line of defense against bank insolvencies, absolutely. 

And again, I think having clear transparent standards not only 

help assure that we have well-capitalized banks but also help address competitive disparities that might arise if you have more subjective standards. 

So I think we are taking a very slow, cautious approach to implementation of Basel II. We are also going to be proceeding with the 


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standardized approach under Basel II, which is much more like the 

current risk-based framework but more granular. 

And so I think over this transition period we will work together 

to come up with the right result. But I could not agree with you 

more, this should not be about lowering capital. 

Senator SHELBY. John. 

Mr. DUGAN. I guess I would say 2 things. One, just to come back 

to the point that the losses that we have seen really have been in 

a Basel I world, even with respect to Europe because they really 

were not on the system until this year. 

I think Basel II has many things in it that will improve risk 

management and regulation and supervision. You are absolutely 

right, it is not perfect, and it has the safeguards that we have. 

Senator SHELBY. But there is no substitute for capital, is there? 

Mr. DUGAN. There absolutely is no substitute for capital. But you 

want to have enough of it and you want to have it reflect risk. And 

if you are taking a lot of risk, you want more capital in the system. 

And so I think that is absolutely critical. 

That is the point of Basel II. And if we get it wrong, then we will 

have not enough capital for the risk we are taking. But if we get 

it right, the more risk we have, the more capital it will have. 

That is what we should be striving to get to, in my opinion. And 

I think we are making strides to go down that path. 

The only other thing I will say about the Northern Rock situation, to be perfectly honest, is the big problem they had was a liquidity problem because they did not have a deposit insurance system in the U.K. like ours, and they had an old-fashioned bank run. 

And as I said many times—— 

Senator SHELBY. First time in 100 years. 

Mr. DUGAN. That is right. We have a lot of problems in our bank 

system, but one thing we know how to deal with—— 

Senator SHELBY. 150 years 

Mr. DUGAN [continuing]. Is failing banks. We know a lot about 

how to deal with failing banks, sadly. And so we tend not to have 

bank runs, even though we have more failing banks, because we 

have a quite well-developed deposit insurance system that makes 

people confident that even if their bank fails their deposits will be 

safe. That is a bedrock of our system. 

Senator SHELBY. John, you oversee a lot of our smaller banks. 

Capital is important, is it not? Management is important. Risks are 

important. We understand all of that. 

Do you have anything to add to this? 

Mr. REICH. Well, I said earlier, Senator Shelby, I think you were 

not in the room, that when I started my banking career 46 years 

ago that I grew up in a generation of bankers who believe that you 

cannot have too much capital and you cannot have too much in 

your loan loss reserves. One of my concerns that I think today’s environment is highlighting is the fact that some of our institutions 

may be challenged to raise their loan loss reserves as high as they 

should be because of SEC and accounting rules that do not give 

them as much flexibility as I think they need. 

Senator SHELBY. Can I ask one last question, Mr. Chairman? I 

appreciate your indulgence. 


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Getting back to the rating agencies—and Senator Schumer, I 

think, raised some important questions here. 

We are all troubled, as you are, by the faulty inadequate—gosh, 

ratings. And now all the downgrades. You know all the other. What 

went up is coming down, as we all know it does. 

And some of the rating people have told me at times, well, they 

just give an opinion. You know, free speech, so to speak. 

My gosh, you know, that opinion—one, it is paid for, I believe by 

the wrong people. Second, it is relied upon not only by people who 

invest but a lot of our institutions that you regulate can hold investment grade securities. 

So we have got a circle here and I do not know how to break it. 

And I know you cannot legislate ethics. But you can put some 

things in place that will cut out a lot of obvious conflicts. That is 

a problem for us, I know, and also perhaps a problem for you, as 

regulators. 

Mr. KOHN. I think there is 2 things we can do to ameliorate the 

situation. One is to insist that our institutions place less reliance 

on the credit ratings and look at the underlying. But second is to 

push those credit rating agencies to reform as much as they possibly can and to do a better job and to push them to note that 

structured finance is different from other kinds of things. And to 

make sure that the purchasers of structured finance—not only 

banks, but pension funds, whatever. I think a lot of folks looked at 

the AAA and said it is as good as a AAA bond. And it was not. 

It is a very different instrument in which you are adding together a whole bunch of different loans. You get rid of the risk of 

individual loans to some extent, but you increase the risk that if 

the whole economy moves, the whole package of loans will move 

down together. And that is what happened there. And I think the 

purchasers did not recognize that risk, and the credit rating agencies did not do a good job of warning people. 

Senator SHELBY. Thank you. Thank you, Mr. Chairman. 

Chairman DODD. Thank you very much. 

I just, on this point before turning to Senator Reed—and I know 

a couple of you have to get going. We have been here a long time. 

But Senator Shelby pointed out, when we were here in the S&L, 

we were talking about 1,000 banks in the S&L crisis. We are talking here, at least some numbers talk about—we are talking about 

foreclosure rates—but as many as 44 to 50 million homes could be 

adversely affected. 

We are looking at prices dropping. When prices drop, values 

drop. When foreclosures occur, values drop of otherwise people who 

are very current in their obligations. Crime rates go up actually 2 

percent in neighborhoods where that occurs. 

There is some significant and profound implications of all of this. 

And 1,000 banks is one thing. Talking about this issue makes that 

problem pale, in many ways. $150 billion bailout was not insignificant but the payer of last resort is the American taxpayer in all 

of this. And so while others may have been complacent and so forth 

and looking around, the American taxpayer pays an awful price for 

this if we do not get this right. 

And so I want to underscore the points that have been raised, 

and just to say—and I have got a couple of other questions and I 


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will come back after Senator Reed. But that whole idea that you 

are the cops. You are the ones that are on the beat here, so to 

speak. When cops are not on the beat, they are not watching it and 

keeping an eye on it here, we end up where we are to a large extent. 

So I want to come back, as I say, in a few days we are all studying all of this. But I want some more specific answers on what we 

are going to do, what you are going to do, what the institutions 

have to do. 

Jack, let me turn to you. 

Senator REED. Well, thank you, Mr. Chairman. And thank you 

again for your excellent today. 

Senator Shelby pointed out some concerns about Basel II that I 

expressed previously. But there is another concern, and that is 

sometimes I get the impression that we are not searching collectively with our global colleagues for the best regulatory system. We 

are responding to competitive pressures, perceptions within our 

banking community that there is much more flexibility overseas 

and if we do not move down that Basel road we are going to be 

left behind, we are going to see financial institutions redeploy to 

London, to elsewhere in the globe. 

And here again, the analogy of the regulator, the policeman, 

whatever, is that I think you have a special role to play to ensure 

that these competitive pressures, which are very powerful for financial institutions who are lobbying you prodigiously on these 

new rules, do not overwhelm sound regulatory practice in terms of 

capital ratios and all the other aspects. 

So that is another concern which I do not think is articulated 

enough, but it is a reality. People come in to see us and they can 

talk about ratios and capital levels and everything else. But they 

are afraid of being left behind in a global race, which I hope is not 

to the bottom. And your role is to prevent it from going in that direction. 

I was struck at your testimony, Governor Kohn. You talked about 

recent events indicate that bank management, in many cases, was 

not fully aware of the latent risk contained in various structures 

and financial instruments. Which raises a question which Senator 

Shelby raised—and I will raise it slightly different. To what extent 

did the Federal Reserve understand those latent risks? To what extent you should have done it earlier? To what extent—and this 

might be the perennial question of any regulator—you should have 

substituted your judgment for the judgment of very talented, very 

intelligent, and extremely well compensated individuals? 

Can you address that? 

Mr. KOHN. I think these are all questions we are asking ourselves, Senator, and I do not have definitive answers to them. I 

think we did recognize the risk, in a general way, somewhat better 

than the banks did. We tried to warn people in speeches and in 

conversations that we thought that they were taking risks and not 

being appropriately rewarded for them or controlling them. We 

tried to work with the banks. 

But I think it is quite possible that we could have been more 

forceful. We probably did not recognize it to the extent that it 

ended up existing. These are very unusual events. There are no exVerDate Nov 24 2008 02:38 Mar 13, 2010 Jkt 050370 PO 00000 Frm 00061 Fmt 6633 Sfmt 6602 E:\HR\OC\A370.XXX A370

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cuses here. But I think it would have been hard to see a year ago 

where we are today. But that does not mean that both the Federal 

Reserve and the institutions that regulate should not have been 

taking steps to ensure against the remote possibility of a very adverse event. And it is obvious that we did not. 

Senator REED. Well, I think that is a very candid and a very sincere response. In your reflection, which you are doing now—and I 

suspect you are—you have to ask some questions about the culture 

of regulation at the Fed. Because you pointed out how you communicate, through speeches, through sitting down and sort of having 

conversations with your regulated institutions. That might not be 

the most effective way to make a point when there is literally billions of dollars at stake if they pursue a policy that they judge 

might be prudent and you judge reckless and you are trying to discuss it. So I know you are going to reflect on that respect. 

Mr. Dugan, you had a comment? 

Mr. DUGAN. Yes, if I could just add, I would say a couple of 

things. One, I do think that we were very much aware of the loosening of underwriting standards in the subprime market, and we 

spoke out about it. We had had some very bad experiences at the 

OCC with national banks and subprime loans, not so much in 

mortgages but in other places. And we were very reluctant to allow 

a lot of subprime lending, mortgage lending, to go on in the institutions we supervised. And as a result, there was not as much of it 

by a long shot being originated inside not just national banks but 

state and national banks. 

I think a lot more of the looser part of it was in entities completely outside the banking system, that went to Wall Street. 

Senator REED. But were your banks buying this paper? 

Mr. DUGAN. That is going to get to the second part. 

So then I think you look at where were we with respect to the 

things that have caused the biggest losses. And that is the speech 

that I was talking about that Senator Shelby referred to. 

This stuff got packaged into some very complex instruments and 

then got rated according to super senior tranches, that got very 

high ratings, and then lower ratings. 

The normal way any of us would look at that, is to look at the 

more risky tranches and pay more attention to them, and pay less 

attention to the least risky tranches. 

And I think it is fair to say that bank management, the most sophisticated people among the bank structurers and the bank regulators, were lulled into a sense of complacency by these very high 

ratings. In fact, the AAA rated asset-backed CDOs are the thing 

that really needs the focus because, as Governor Kohn said, they 

behaved differently. AAA ended up meaning something very different in that context than they meant elsewhere. And I think that 

is one of the places we need to focus. 

I also think that we ought to be careful about not throwing all 

credit ratings out. It is true that a lot of what we do focuses on 

credit ratings. But in a lot of ways, including the standardized approach that Chairman Bair was talking about, we are very focused 

on credit ratings. 

The part that really caused the big huge losses was the super 

senior tranches of ABS, of subprime related collateralized debt obliVerDate Nov 24 2008 02:38 Mar 13, 2010 Jkt 050370 PO 00000 Frm 00062 Fmt 6633 Sfmt 6602 E:\HR\OC\A370.XXX A370

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gations. And that is what we really need to focus on, on how that 

is treated, how it is rated, what kind of capital applies to it. 

And the last point I will make is that we could have done a better job—and the banks certainly could have done a better job. Even 

though this was thought to be a relatively risk-free instrument, 

some institutions piled a ton of it up on their balance sheet and 

made a real concentration. 

Others just abided by the notion that they were not going to put 

as many of their eggs into that one basket. And that very simple 

principle about concentration risk is what caused the really big 

losses, not just at commercial banks but at investment banks and 

foreign banks. And that is a basic principle that we have to look 

at in the risk management when we come back to some of the 

things that you were talking about, Senator. 

Senator REED. Thank you. Let me make, if I may, 2 brief points 

and then yield back. One is that last April, at the request of Senator Dodd, I chaired a hearing on the merging subprime crisis. I 

think some might have been here in attendance. But the problem then was $19 billion worldwide. It is now $160 billion, growing to $400 billion or $600 billion. One of the things 

that struck reading about Hope Now is that most of the relief that 

has been provided so far is to conventional mortgage holders, the 

best credit risk. The real problem that is facing us is when these 

alternates and subprimes start resetting, which is beginning. But 

we have not reached the middle of it yet. 

So we are looking at a wave that is coming toward us, not one 

that has passed by us. I think that has to strengthen or focus our 

options. 

The second point that Governor Kohn made is about one of the 

presumptions—it was not jut financial institutions, it was everybody in this country—housing prices are always going up. I ask 

you, we have evidence now that that assumption is invalid. 

But if that was the fundamental assumption that was motivating 

homeowners, lenders, everyone, we have to move I think much 

more aggressively to reinforce or reestablish that assumption; i.e., 

that housing prices will not decline precipitously. 

It goes back to what Senator Dodd is talking about. Until we 

really aggressively and quickly shore up the housing values in this 

country, the basic assumption that we have operated with, everybody, for the last decade or more, maybe 50 years, has formed all 

sorts of economic decisions from the sublime, the intricate 

securitizations, to whether your child is going to be able to afford 

college because you can borrow from your house. 

If we do not stop this decline quickly—and that is why I think 

Hope Now is not effective, it is just not face enough—we are going 

to see more pain and it is going to get worse and it is going to accelerate and will probably reach and maybe exceed that $600 billion mark, which would be unfortunate. 

Thank you. 

Chairman DODD. Thank you, Jack, very, very much. You have 

said the point eloquently here. That is why there is a sense of urgency about this because, as you all point out here, the implications of this now, the domino effect of this is obviously going beyond just the housing issue here. It is affecting so much more. 


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Senator Carper. 

Senator CARPER. Thanks. You all have been very generous with 

your time and this has been, I think, an uncommonly good hearing, 

helpful for me and I suspect for my colleagues, as well. 

Chairman DODD. All hearings in this Committee are all uncommonly good. 

Senator CARPER. I can think of many one or 2 in the last 8 years 

that did not quite rise to that standard, but this has been uncommonly good. 

I want to thank you for walking me through the housing recovery 

package and some of the proposed amendments to it. I realize you 

are operating with less than full knowledge about some of the provisions, so thank you for bearing with me. You provided some real 

constructive comments to us. 

Two or 3 weeks ago Secretary Paulson was before us. The question I asked of him on housing recovery package, what are the Administration’s priorities. He said the first priority, GSE regulatory 

reform. Second priority, FHA modernization. The third priority is 

this piece where we allow housing finance agencies to issue bonds 

for refinancing. Those are his top three priorities. 

The Chairman and the Ranking Member have been working and 

their staffs have been working to try to get this to closure with the 

House of Representatives on FHA modernization. My hope is that 

we are almost there. 

The third element that I mentioned in the administration’s priorities, there seems to be agreement, bipartisan agreement between 

the legislative and the executive branch. 

That leaves us with the third being GSE regulatory reform, and 

the last time—it has been a couple of years since we actually—and 

we have had a hearing on it this year, but we actually voted on 

this stuff about—what was it? Two years ago, I think. And we 

ended up taking pretty much a party line vote, as I recall. It is 

something that we do not oftentimes do here. But we were unable 

to come to a consensus, and if we do not have consensus on an 

issue like that, it is hard to get floor time, and we just do not legislate in the full Senate. 

There is going to be a hearing—the Chairman has set it as a priority, one of his early priorities for this year—to finish our work 

on GSE regulatory reform. And toward that end, we have another 

hearing that is scheduled for this Thursday. You all are not going 

to be there, but you are here today. And I am just going to ask you 

to give us some advice as we prepare hopefully to move to mark 

up legislation on providing regulatory reform for our GSEs. 

There is actually a fair amount that we agree on today that we 

did not a couple of years ago, and I will mention some of the elements of agreement we agree on: combining OFHEO and the Federal Finance Board; we agree on the need for the independence of 

the regulator from the appropriations process. We agree on independent litigation authority for the regulator. Currently, I think 

they have to go through the Department of Justice for that authority. We agree on right of receivership to place these entities in receivership if that is deemed appropriate. We agree on combining 

the mission oversight and the new product authority under one 

world-class regulator. We did not always agree on that. We agree 


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on the need for flexibility for the regulator to set capital standards. 

And I believe we agree on some restrictions on the size of the GSE 

portfolios. Those are pretty much the areas I think on—some of the 

areas, major areas on which we have agreement now. 

Would you have any advice to us, as we hopefully prepare to 

move on to actually introduce legislation and begin marking up it, 

on GSE regulatory reform? The elements that I have mentioned I 

think are pretty much common knowledge. Are any of those that 

are especially important? Are there other things that we should be 

focused on as we take up our work? 

Ms. BAIR. I used to work at Treasury when GSE reform started. 

I think the health, the safety, the stability of the GSEs is extremely important, especially in times like these when you have 

more and more mortgages becoming distressed, and they may be 

called upon increasingly to fulfill their guarantees. So I think it is 

very important, and I am encouraged by all the areas of agreement, 

and I would hope it could get done. 

I would also just add editorially that I would hope the GSEs, especially Fannie and Freddie, could take a more proactive role in 

supporting loan modifications as huge holders, portfolio holders, of 

mortgages, as well as those who hold substantial amounts of MBS. 

I think as major investors as well as their role as GSEs could play 

a very instrumental role in getting the market moving even more 

aggressively to modify loans. And I know there are aspects of the 

pooling and servicing agreements that impact conforming loans 

that may be an issue. But I would hope that that could be worked 

out, and that might also be something you would want to take a 

look at. 

Senator CARPER. Great. Thanks very much. 

Mr. Dugan. 

Mr. DUGAN. Generally, I think that the focus on the safety and 

soundness side is the part that we would stress—I think it is in 

the interests of the GSEs and of all parties to get comprehensive 

reform passed that provides a strong supervisory structure like 

what we have with the Federal bank regulators. Without going into 

all the details, I think that is really the kind of fundamental issue 

to get right, particularly, as we are in this period where all their 

assets are mortgages based on house prices. There are significant 

credit issues and other issues there, and you want to make sure 

you have a regulatory structure that is up for that task. I think it 

is important to get this right. 

Senator CARPER. All right. Thank you. 

Mr. Reich. 

Mr. REICH. I do not know that I have anything substantive to 

add to that. You obviously have a number of areas that you agree 

on. I am supportive personally of all of the areas that the two parties are in agreement with, and I am hopeful that you will pass a 

bill. 

Senator CARPER. All right. Thank you. 

Ms. Johnson, anything you would like to add? 

Ms. JOHNSON. Nothing additional to add. Just to say good luck. 

Senator CARPER. Thanks. We might need it. 

Governor. 


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Mr. KOHN. I think that it is very, very important that you reach 

agreement and get this done. I think the GSEs, as Chairman Bair 

was saying, could play an important role in helping the recovery 

of the housing market. But I would be very hesitant to see them 

greatly expand their role without appropriate and proper supervision, and of the nature, as Comptroller Dugan was saying, of the 

sort of oversight that the bank regulatory agencies have over commercial banks to protect the safety and soundness of those institutions if they were to expand. I think getting this done could build 

confidence in those institutions, and putting a structure in place in 

which they can expand, raise capital and expand, would be a very 

constructive step. 

Senator CARPER. Thank you, sir. 

Mr. GRONSTAL. To the extent that debt issued by the Government-sponsored enterprises is part of the broader capital markets, 

it is important that we improve the transparency there so that we 

can improve the confidence of the investors in our entire capital 

market system, because that is a big piece of the problem. 

Senator CARPER. All right. Thanks. 

Mr. Chairman, thanks for letting me get that question. I would 

just say, Mr. Chairman, in closing, I know an idea that you have 

been fleshing out focuses on these mortgages underwater or upside 

down, and the ideas that Mr. Reich has outlined and noodling with 

for, I think, to good effect in the last several weeks, I think there 

is a lot of promise—— 

Chairman DODD. I commended Mr. Reich about that. I did not 

agree with him on everything, but I commended him. And let me 

just say on the GSE issue, again, you know, there were those who 

had ideas on GSEs at Fannie and Freddie back a couple of years 

ago; had they been adopted, this problem would be a lot worse 

today. A strong regulator is absolutely essential. All of us agree on 

that here. I am determined to get a bill done, but I want to make 

sure we do it right as well. The idea there is a 30-year or 40-year 

fixed-rate mortgage in this country, which is unique in the world, 

exists because of Fannie Mae and Freddie Mac. And the idea that 

some are brought to the table on the issue I think would do us 

some real damage. But I am interested in getting a bill done here. 

We will get that done, too. 

Senator SHELBY. Mr. Chairman? 

Chairman DODD. Yes. 

Senator SHELBY. I have to add a few things. 

We are all, I hope, interested in GSE reform, but I believe that 

we have to take into consideration the thin capital structure of the 

GSEs, the systemic risk to the taxpayer, the product approval and 

so forth. I believe the GSEs have served a good purpose, but we 

want them to continue to serve a good purpose, and we do not want 

to, I believe, hopefully, to put the taxpayer at risk on all this. And 

I do believe they need a strong regulator, and they need somebody 

who is going to talk to them about capital, too. 

I think we had a strong bill several years ago. Obviously, they 

had a stronger lobby than our strong bill. 

Thank you, Mr. Chairman. 

Chairman DODD. Let me raise one other question here, and, 

again, I am deeply appreciative of the time here. But this credit deVerDate Nov 24 2008 02:38 Mar 13, 2010 Jkt 050370 PO 00000 Frm 00066 Fmt 6633 Sfmt 6602 E:\HR\OC\A370.XXX A370

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fault swap issue is one that is lurking here that requires some comment, I think, before we complete. 

According to some recent reports, the potential exposure of our 

financial institutions to losses from credit default swaps on 

collateralized debt obligations backed by subprime collateral could 

be significant. The New York Times reported late last month that 

the top 25 commercial banks held credit default swaps, some including subprime collateral, worth $14 trillion. American International Group, AIG, reported last week that it had lost $5.3 billion 

in the fourth quarter of last year doing par to a $15.5 billion writedown based on insurance the company had written for these CDOs. 

AIG’s experience is only the latest example of some trends to downgrades and write-downs related to these derivatives. 

I would just ask each of you here, in the course of examinations, 

how did the bank regulators review the valuation of significant assets such as CDOS in determining an institution’s capital adequacy? And did the regulators perform an independent analysis of 

the value booked by the institution, or did it routinely accept the 

valuation of complex major assets? Governor Kohn. 

Mr. KOHN. The truth is I do not know the answer to whether we 

did our own independent evaluation of those things. I know that 

we valued the risk management systems and whether things were 

being marked to market and whether there was collateral behind 

the changing values, so that whether the banks were protecting 

themselves if the value of the CDS changed and they were collecting the margin for that. And I believe they are. 

So I think we looked at how the banks were protecting themselves and managing that risk. I do not know whether we did independent valuations—I question whether we would do independent 

valuations. As long as the risk management systems are in place, 

that is probably not necessary. But I do not know the—— 

Chairman DODD. Are you concerned, is the Fed watching this 

credit default swap issue? 

Mr. KOHN. Yes. 

Chairman DODD. It is a very technical issue and one that—I 

have sat and listened to people at some length talk about it and 

how it works and how these things get sliced and diced down the 

line, and then at the end of that line, who actually owns the policy—— 

Mr. KOHN. Right, and I think it—— 

Chairman DODD. Someone has got to know that, though. This 

is—— 

Mr. KOHN. But in one sense, I believe the New York Times article was misleading because it implied that someone could trade— 

a counterparty could trade, and you would have a new 

counterparty, and the first person who may be purchased—if Person A purchased from Person B, Person B could transfer that to 

Person C without telling Person A. That is not true. 

Chairman DODD. Well, I tell you, I am not going to talk about 

who, but I sat with a major figure at a major private investment 

house who said that is exactly how it works. 

Mr. KOHN. No, they cannot—— 

Chairman DODD. That is exactly what happens. I mean, I—— 


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Mr. KOHN. Well, that is not the way the market is supposed to 

work, and I do not believe that is the way the market works for 

the most part. There was a problem in that regard several years 

ago, and the Federal Reserve Bank of New York, working with the 

entities in the market, got together and said this business of assigning this liability without notifying the person was not acceptable, and the market agreed and that practice has been stopped. 

Chairman DODD. John, do you want to comment on this? 

Mr. DUGAN. Yes, I would say a couple of things. We also participated in that exercise, which really was about the mechanics of 

how these worked, because it is quite complicated, how they clear, 

how they settle. I think there are a couple things to bear in mind. 

No. 1 is that the notional values are huge, but they are a little 

misleading. Generally, banks tend to run, not perfectly, matched 

books that offset one position with another kind of position. They 

do not typically use it to offset their own credit risk positions. That 

is a very important point in how these things are structured. 

There are certain kinds of credit default swaps that involve socalled correlation and hybrid risk types of products where there are 

more risks involved in that, and we do pay a significant amount 

of attention to it. 

There are also still some mechanical issues about when you have 

more credit default swaps out than you have underlying bonds that 

you are using as a reference in how they are settled. This is an 

issue that has been raised by a number of people, both in the private and public sectors, as something that does need to be resolved 

over time. And the New York Fed and others have been paying a 

great deal of attention to it, but it is very much on the radar screen 

of the regulators as we look at this very important part of the market that has developed over the years. It is a very important part 

of our supervisory strategy. 

Chairman DODD. Is it something we ought to be more concerned 

about than we are? 

Mr. DUGAN. I think that you are appropriately asking questions 

about it and monitoring the situation, and we are doing the same. 

But I do not think it is something that we are suggesting in any 

way is setting off alarm bells. 

Chairman DODD. OK. Sheila, do you want to comment on this? 

Ms. BAIR. Well, a couple of things. The good news about this is 

that the exposure is concentrated mostly in the very large institutions, but the 5,200 banks that we regulate virtually have no exposure to this market at all. 

I think it is also an example of where the monolines, like the rating agencies, got into an area that they really did not understand 

and were being a counterparty to transactions that they did not 

really understand, and then people relied on their AAA credit rating. So I think it all intertwines and cascades back on us. 

So I think there may be further write-downs because of this. I 

do not really know. But I think based on the numbers we have 

been able to generate working with the primary regulators, this is 

something that the banks can absorb if it happens, and, again, it 

is concentrated in the very large institutions. 

Chairman DODD. Yes, I am sorry. Go ahead. 


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Ms. JOHNSON. I would just like to add that only 2 out of 28 of 

our corporate credit unions invest in CDOs, and it is a very small 

part of their investment portfolio, less than 1 percent of the total 

investments. But we have stepped up our monitoring and stresstesting, and currently they are performing well. 

Chairman DODD. I said the last question. Just if any one of you 

here could comment on this, we went through this issue back a few 

years ago with FASB during the Sarbanes-Oxley effort here, coming up with a different way. A lot of the same questions being 

raised about the credit rating agencies were raised about FASB, 

some of the inherent conflicts. 

Does the FASB model that we ended up adopting here have 

any—does that have any relevancy to this question of the credit 

rating agencies in terms of a resolution of that in your mind? Or 

is it just so different in terms of how FASB operates and how—I 

mean, obviously they are very different entities. But it occurred to 

me there we ended up with FASB. Originally, as you will recall, 

it was totally financed by the very people, obviously, that were 

helping their accounting, so the inherent conflict, we changed that. 

Obviously, it is a public entity in a sense, as opposed to a credit 

rating agency. But any value of examining that as a comparison? 

You are saying no. 

Mr. KOHN. I am saying I do not know, actually. 

Chairman DODD. John. 

Mr. DUGAN. I really do not know. I have never looked at it. It 

is an SEC type question as an oversight. 

Ms. BAIR. I think it is probably working pretty well as compared 

to other things. There may be other priorities we need to look at. 

Chairman DODD. Richard. 

Senator SHELBY. I just have an observation. You know, in accounting when you are doing an audit, you are looking for the truth 

as you understand it, the truth of the financial system that this 

company has. And if you are looking at a bank, you are a regulator, 

you are looking at their assets and liabilities and their risk and 

how they manage risk. Do they have enough capital or have they 

really bitten off a lot more than they can chew and swallow? 

FASB has certain accounting rules, and I know they are different 

from what you have to deal with every day. But somebody has to 

understand these financial instruments. And if you do not understand them—I am not saying you do not, but, you know, they are 

very complicated—who does understand them? And how do you 

regulate institutions that hold a lot of these instruments that have 

been sliced, diced, you know, here and there, without really understanding them, without understanding the risk on those books, so 

to speak? 

I know it is a dicey proposition, but finance has moved down a 

road that very few people understand. But then it comes back to 

the fundamentals, and it is sitting in your lap now, and maybe the 

American people’s lap, too. It is not nice. 

Thank you. 

Chairman DODD. Well, thank you. We have kept you a long time, 

but, again, I think you saw by the participation of the Members 

here on both sides the interest in the subject matter. 


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Tom, we appreciate very much the State perspective being here. 

It is a very valuable, added element in all of this, and I am grateful 

to you, Dr. Kohn, as well for coming, I know back and forth—we 

have had the Fed up here a lot over the last few weeks, and I am 

very sensitive to the idea that you have got a lot of other things 

to do other than just testify. But it means an awful lot to have all 

of you here. 

As I said at the outset, I want to get back now—a lot of these 

hearings, it can end up in the ether, but I am very interested. I 

did not press this, John, but you talked about some of the forward 

thinking that you have had going on in your shop, and I want to 

see some of that forward thinking, how we are addressing these 

questions. This is really the nub of it. The questions raised in the 

Wall Street Journal this morning that Senator Bennett talked 

about in his opening comments are really at the heart of this. From 

our perspective here, obviously we watch what happens very carefully with the private institutions, but it is the regulators, including the State regulators, here who play such a critical role. You are 

the backstop. These are subject matters that very few people understand, including, I would say this respectfully, our colleagues 

here. Despite their good intentions to really understand the totality 

of all of this, not to have a stovepipe mentality about it, sort of 

looking at these things in sort of separate funnels, failing to recognize the interrelationships that occur here and how all of this is 

critically important to our economic success. But we count on you. 

That is where really this has to be. And Jack Reed’s point here, the 

culture of how you approach your public responsibilities, your regulatory responsibilities, are critically important. 

So I look forward to having you back here. We will work out 

schedules and times so it accommodates your busy schedules. But 

we are very grateful to you for your presence here today. 

The Committee stands adjourned. 

[Whereupon, at 1:31 p.m., the hearing was adjourned.] 

[Prepared statements, responses to written questions, and additional material supplied for the record follow:] 


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RESPONSE TO WRITTEN QUESTIONS OF CHAIRMAN DODD 

FROM SHEILA C. BAIR 

ANTI-UNION REGULATION

Q.1. Last year, the Department of Labor issued a regulation drastically expanding the personal financial information union officers 

and employees must submit to the Department The new LM–30 

rule will require more than 150,000 union volunteers, employees, 

and their families to report the terms of mortgages, car loans, and 

even student loans. To determine whether they must report such 

interests, these individuals must ascertain (1) whether the bank 

providing a loan does any business with the person’s union, or (2) 

whether the bank does 10 percent of its business with firms whose 

employees are in the same union. The regulation requires individuals to write to banks asking for this info, and, then, if banks won’t 

provide such information, to contact the Department of Labor for 

assistance. In the meantime, individuals are required to make good 

faith estimates of the bank’s business with their unions and unionized firms. 

• Given your agency’s expertise in the regulation and practices 

of banks, do you believe that banks are able—and willing—to 

inform their customers whether they do business with particular unions and how much of their ‘‘business’’ and ‘‘business 

receipts’’ are with particular unionized firms? 

• Are banks obligated or prohibited by any federal or state law 

to disclose to their customers how much ‘‘business’’ or ‘‘business receipts’’ they have with particular unionized firms? Can 

banks simply refuse to answer these written inquiries? 

• What type of administrative burden will this LM–30 rule, and 

the hundreds of thousands of resulting inquiries, place on 

banks and are banks currently prepared to respond to these inquiries? 

• If banks don’t provide this non-public information, is there any 

‘‘information reasonably available’’ to the public that union officers, employees, and members could use to make good faith estimates? 

A.1. The Labor-Management Reporting and Disclosure Act 

(LMRDA) requires public disclosures of certain financial transactions and financial interests of labor organization officers and 

employees (other than employees performing clerical or custodial 

services exclusively) and their spouses and minor children. It is our 

understanding that the purpose of this disclosure is, among other 

things, to make public any actual or potential conflict between the 

personal financial interests of a labor organization officer or employee and his or her obligations to the labor organization and its 

members. 

The U.S. Department of Labor’s Office of Labor-Management 

Standards (OLMS) issued a final rule in 2007 implementing section 

202 of LMRDA. See 72 FR 36106 (July 2, 2007). The final rule revised Form LM–30, Labor Organization Officer and Employee Report and its instructions. The final rule became effective for fiscal 

years beginning August 16, 2007, although no reporting is due 


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under the rule until November 16, 2008. See 72 FR. 38484 (July 

13, 2007). 

The FDIC understands that financial institutions are expressly 

relieved of any reporting responsibilities of payments or loans 

under section 203 of the LMRDA (see 72 FR at 36119 and 36136). 

Therefore, banks are not required to report customer information. 

The final rule deals with Form LM–30, which requires reporting 

by the union officers and employees covered under the LMRDA. 

The final rule, as revised, does not require union officers to report 

most bona fide loans, interest, or dividends from financial institutions. However, the final rule may require that union officers report these types of transactions if the bank does a specified level 

of business with a company that employs members of the same 

union. The OLMS is the agency responsible for implementation and 

interpretation of this regulation and the FDIC defers to its determination of the exact parameters of the categories where union employees are required to report bank loans. 

We know of no federal law that either requires or forbids a financial institution from informing its customers whether they deal 

with businesses that are unionized and what union represents the 

employees of those businesses, assuming that no customer information is disclosed. We see nothing in the Department of Labor rule 

that would require financial institutions to make those disclosures. 

We note, however, that banks typically build certain reporting 

codes into their information management systems to facilitate the 

creation of both regulatory related filings, such as call reports, as 

well as internal management reports. The basis for distinguishing 

and reporting based upon the type of union-related activity at issue 

here would not be a part of this reporting framework thereby creating issues regarding the practicality of disclosure. 

The FDIC will continue to analyze the impact of the final rule 

on our supervised banks as we approach the November 2008 reporting deadline. 

COMMERCIAL REAL ESTATE

Q.2. In December 2006, three agencies, the FRB, OCC, and FDIC, 

issued final guidance highlighting the risks to banks from concentrations in commercial real estate. In issuing the guidance, the 

regulators specifically emphasized that they were not setting any 

limits on banks’ commercial real estate lending. Yet now we understand from the Comptroller of the Currency and the Chair of the 

FDIC that over a third of community banks have commercial real 

estate concentrations exceeding 300 percent of their capital. 

• Are any community banks going to fail because of their overexposure to commercial real estate, including commercial real 

estate mortgage backed securities? 

• Was it the correct policy not to set concentration limits in the 

guidance? 

• What are examiners doing when they find these levels of concentrations? 

• What off-balance sheet vehicles are banks using to invest in 

commercial real estate? 


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• Are the regulators approving these kinds of transactions? 

A.2. As noted in the FDIC’s testimony, weakness in the housing 

market will affect institutions with significant exposures to commercial real estate (CRE) loans—particularly construction and development loans. Given deteriorating conditions and excess supply 

in certain housing markets such as Florida, California, Arizona, 

and Nevada, construction and development lending could cause 

some community banks to fail in 2008 and 2009. While we do not 

currently anticipate a sharp increase in failures, the protracted nature of real estate downturns may challenge the earnings capacity 

and capital levels of institutions with concentrated exposure to construction and development projects. At present, the various sectors 

of the commercial real estate market including apartments, office 

buildings, retail, and industrial have performed adequately and are 

not expected to cause bank failures in the near term. However, if 

we experience a significant economic downturn, commercial real estate mortgages could cause losses for insured institutions that may 

lead to failures. 

The December 2006 interagency commercial real estate guidance 

provided an appropriate, timely message to the industry regarding 

risk management standards, loan concentration reporting thresholds, and capital adequacy. Bankers are very aware of the monitoring thresholds stated in the guidance, and the document positively influenced commercial real estate credit risk management. 

The establishment of specific concentration limits would have been 

prescriptive and could have caused an unintentional aversion to 

commercial real estate lending. A limit on commercial real estate 

lending would have had negative consequences for the market and 

exacerbated the credit availability challenges in the current environment. 

In March 2008, the FDIC issued a Financial Institution Letter 

(FIL) to all banks under its supervision re-emphasizing the importance of strong capital and loan loss allowance levels, and robust 

credit risk-management practices for state nonmember institutions 

with significant concentrations of CRE loans, and construction and 

development loans. The FIL recommends that state nonmember 

banks with significant CRE loan concentrations increase or maintain strong capital levels, ensure that loan loss allowances are appropriately strong, manage portfolios closely, maintain updated financial and analytical information, and bolster loan workout infrastructures. 

FDIC examinations of institutions with significant commercial 

real estate loan concentrations, as defined by the 2006 interagency 

guidance, focus on each bank’s credit risk management program, 

internal measurement and reporting on concentrations, examiner 

review of individual credit relationships, and an assessment of capital and loan loss reserve adequacy. Examiners undertake a thorough review of commercial real estate lending policies and underwriting processes and gain an understanding of management’s risktaking philosophy. Departures from prudent policies, underwriting, 

risk selection, or concentration management may be subject to examiner criticism. Significant deficiencies related to commercial real 

estate loan concentrations sometimes result in formal or informal 

enforcement actions. 


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From an investment standpoint, banks are generally limited in 

their acquisitions of commercial real estate to property that will 

only be used as bank premises. There are certain exceptions to this 

limitation that are permitted under the investment authorities for 

national banks. Otherwise, a bank must apply to the FDIC (under 

section 24 of the Federal Deposit Insurance Act (FDI Act)) for permission to invest in commercial real estate on the balance Sheet. 

An off-balance sheet investment in commercial real estate would be 

unusual. 

From a lending standpoint, commercial real estate loans or interests therein are typically originated and held directly by the bank, 

or a bank subsidiary, on the bank’s balance sheet. Off-balance 

sheet holdings of interests in commercial real estate loans are generally rare and limited to the largest institutions: that securitize 

such loans. In a commercial mortgage backed security, a bank that 

securitizes commercial real estate loans sells the loans (on a nonrecourse basis) to a trust that then distributes these credits on to 

third party investors. Depending on the governing securitization 

documents, the bank that originated a commercial real estate loan 

could be liable for the loan’s performance under certain circumstances, as well as be required to prudently carry out the duties of special servicer if the bank retained servicing. It is theoretically possible that sold loans could be put-back to the originating 

bank if the governing documents or courts permitted such recourse. 

Such situations are relatively rare. The bank regulators do not approve securitization transactions, which are accounted for as loan 

sales. Large institutions that trade credit derivatives also could 

have a commercial real estate credit exposure off-balance sheet. 

However, most derivative positions are now booked on the balance 

sheet according to accounting rules. 

BASEL II

There was extensive conversation on what would have been the 

capital status of banks going into this crisis period had Basel II 

capital standards been in effect. Fed Vice-Chairman Kohn said that 

if, ‘‘we had the same safeguards in place, and if we started implementing in 2004 with the same safeguards that are in place in 

2008 and 2009, I do think on balance we would have been better 

off.’’ Mr. Gronstal answered differently, stating: ‘‘I think the answer to your second question is that we probably would have had 

lower dollar amounts of capital per asset, and that makes it more 

challenging to deal with issues when times get rough.’’ 

Q.3.a. Can you explain in writing, whether you believe that banks 

would have had more or less capital in place for this current down 

turn had Basel II been implemented during the time frame that 

Vice-Chairman Kohn mentioned in his response? Can you also explain why you believe that to be the case, citing any empirical data 

on both the effects of Basel II on capital requirements and what 

we have experienced during this economic crisis, as it relates to assets? 

A.3.a. I believe that banks would have had less capital in place for 

the current downturn had Basel II been implemented during 2004. 

The U.S. Quantitative Impact Study-4 (QIS-4) estimated the adVerDate Nov 24 2008 02:38 Mar 13, 2010 Jkt 050370 PO 00000 Frm 00297 Fmt 6602 Sfmt 6602 E:\HR\OC\A370.XXX A370

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vanced approaches would reduce capital requirements for mortgages and home equity loans by 73 percent to 80 percent. In addition, for certain securitization exposures, the advanced approaches 

slash the capital requirements significantly compared to the current rules and would have encouraged banks to hold more highly 

rated collateralized debt obligations (CDOs) and other complex securities that have caused losses in the tens of billions of dollars for 

large financial institutions. For many of these exposures, the capital requirements are reduced by almost two thirds—from 1.6 percent to 0.56 percent of face value. 

There is every reason to assume that banking organizations 

would have reduced their actual regulatory capital holdings in an 

amount commensurate with this reduction in minimum capital requirements. A case in point is given by Northern Rock, the British 

bank with assets of about $200 billion that was recently nationalized. We understand that the British regulators provided banks 

that were interested, and deemed ready, the opportunity to implement certain aspects of the advanced approaches in 2007. In reference to the 44 percent reduction in risk-weighted assets Northern 

Rock reported using the advanced methodologies for its retail portfolio, its CEO wrote: 

We are pleased to have achieved approval for use of our Basle II rating 

systems. This means that the benefits of Basle II enable us to increase our 

2007 interim dividend by 30 percent. Going forward our dividend payout 

rate increases to 50 percent of underlying EPS from around 40 percent. Future capital planning, including the reduction of capital hungry assets, will 

allow us to return capital to shareholders through a share buyback programme. The medium term outlook for the Company is very positive. 

—CEO Adam Applegarth, Northern Rock Interim Results, June 30, 2007. 

Q.3.b. During the discussion of Basel II, Comptroller Dugan told 

the Committee: ‘‘The irony of this whole situation is that the very 

high—most highly rated best securities, the ones that were thought 

to be least likely to default was where all the—a huge share of the 

losses have been concentrated.’’ Given Basel II’s reliance on ratings 

of securities, does this observation give you reason for concern over 

the current Basel II structure? If so, what do you recommend be 

done; if not, why not? 

A.3.b. The unprecedented downgrades and massive losses incurred 

by banks on AAA rated structured securities such as CDOs and 

asset backed securities (ABS) are a prime example why models 

cannot be relied upon to set capital requirements that are meant 

to protect and preserve the solvency of our nation’s financial institutions. The models used to assign a AAA rating to these securities 

were no more than estimates that attempted to apply past performance to predict future events. However, the assumptions used to assign these ratings did not capture the true stresses that accompanied the current credit market crisis. 

In some cases, the models that failed the ratings agencies are 

similar to the models used by banks to set capital requirements on 

a wide range of exposures under Basel II. What is even more troubling is that these AAA rated structured securities that played a 

prominent role in contributing to the hundreds of billions of dollars 

in write-downs have been awarded sizable capital reductions under 

Basel II. Under the new rules, the capital requirement for these securities is a mere fraction of the losses incurred to date with banks 


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only required to set aside 56 cents for every $100 in exposures. 

Under the existing U.S. rules that apply to all but the largest 

banks, the capital requirement for these same securities is $1.60 

for every $100 in exposures. 

The Basel Committee has acknowledged some of the deficiencies 

with the Basel II framework, especially as it relates to the complex 

structured securities discussed above. However, the lesson to be 

learned from the credit market turmoil should be applied well beyond CDOs. The major issue is that the models did not perform 

adequately, and Basel II is heavily reliant upon models for determining capital requirements. Fixing the risk weights on complex 

securities is a good start but that alone will not address the larger 

scale problems with Basel II. 

In this respect, U.S. bank regulation benefits considerably from 

our statutory framework of Prompt Corrective Action (PCA), including regulatory constraints on bank balance sheet leverage. The 

PCA framework provides abase of capital to absorb losses in the 

event the risk-based models are overly optimistic and helps limit 

the exposure of governmental safety nets during difficult times. In 

addition, a leverage ratio, or similar clear-cut supplementary capital requirement to complement the risk-based approaches and constrain excessive leverage, would greatly benefit the effectiveness of 

global financial regulation. 

As you know, the regulation issued by U.S. banking, agencies 

does not allow any bank to exit its risk-based capital floors until 

the completion of an interagency study on the impact of the new 

advanced approaches. This interagency study will be extremely important in that it provides a structured process for the agencies to 

evaluate potential weaknesses of these new rules and decide how 

to address them. 

TOO BIG TO FAIL

Q.4. I am concerned about the potential ramifications of the failure 

of a very large institution. Is your agency prepared today to handle 

the failure of a large systemically significant insured financial institution? What steps are you taking to prepare for this contingency? 

A.4. The FDIC has been taking a number of steps to ensure our 

ability to handle the failure of a large financial institution. For example, several years ago we started a project to facilitate the 

claims process at the very largest and most complex banks. This 

includes a process to hold some fraction of large deposit accounts 

in the event of failure, to have the ability to produce depositor data 

for the FDIC in a standard format, and to be able to automatically 

debit uninsured deposit accounts to share losses with the FDIC. In 

January 2008 we issued a notice of proposed rulemaking to solicit 

comments in consideration of a final rule. We hope to issue a final 

rule as early as mid-year. 

In recent months, the FDIC also has begun hiring additional 

staff to ensure that we are prepared for any type of increased bank 

resolution activity: This hiring is a mix of temporary appointments 

that can lapse once any problems are addressed, retirees who can 

provide ‘‘experience from past failures, and new skill sets (such as 


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1 HOPE NOW mortgage servicers cover almost two-thirds of the mortgage industry for both 

prime and subprime loans. All data are from their release of quarterly 2007 and 2008 data at: 

http://www.csbs.org/Content/NavigationMenu/Home/StateForeclosureApril2008.pdf. 

capital markets expertise) that are relevant to resolving troubled 

institutions in today’s market. 

Finally, the FDIC has been working with other regulators to improve information sharing processes and procedures regarding troubled financial institutions to ensure that all of us have the information we need to fulfill our roles in the event-of bank failures. Our 

participation as part of the President’s Working Group is a welcome improvement to this communication. 

DATA ON LOAN MODIFICATION

Q.5. Please provide comprehensive data on mortgage delinquencies, 

foreclosures, repayment plans and modifications for the mortgages 

being serviced by the institutions you regulate for the past 12 

months. Please provide this information by the following loan categories: subprime, Alt-A, and prime. Please describe the types of 

repayment plans and modifications that servicers are employing 

and the numbers of loans in each category. 

A.5. Because most FDIC-supervised institutions do not service 

securitized loan pools, we do not collect data for the categories requested. Nevertheless, the available data so far seems to indicate 

that too many modifications involve repayment plans that only act 

to defer problems rather than create long-term sustainable mortgages. 

Publicly available data from the HOPE NOW Alliance estimate 

that, on an industry-wide basis, mortgage servicers provided loan 

workout plans for over 2 million loans during 2007 and first quarter 2008. Subprime loans account for the majority of these workouts, at 60 percent of the total. Prime loans account for the remainder; there is no breakout for Alt-A loans. Loan workouts have numbered nearly three times more than foreclosure sales.1

The following tables summarize borrower foreclosure sales and 

loan workout plans on an industry-wide basis from first quarter 

2007 through first quarter 2008. 

FORECLOSURE SALES 

[Thousands of residential loans] 

2007 Q1 2007 Q2 2007 Q3 2007 Q4 2008 Q1 Total 

Foreclosure Sales: 

Total ......................................................................... 110 117 135 151 205 718 

Prime ....................................................................... 48 49 54 60 84 295 

Subprime ................................................................. 62 89 82 92 121 426 

BORROWER LOAN WORKOUT PLANS 

[Thousands of residential loans] 

2007 Q1 2007 Q2 2007 Q3 2007 Q4 2008 Q1 Total 

Borrower Workout Plans: *

Total ......................................................................... 324 340 399 475 503 2,041 

Prime ....................................................................... 135 132 150 173 206 796 

Subprime ................................................................. 189 208 248 301 296 1,242 


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BORROWER LOAN WORKOUT PLANS—Continued 

[Thousands of residential loans] 

2007 Q1 2007 Q2 2007 Q3 2007 Q4 2008 Q1 Total 

Formal Repayment Plans Initiated: 

Total ......................................................................... 271 275 323 333 323 1,525 

Prime ....................................................................... 111 102 120 136 159 628 

Subprime ................................................................. 160 173 203 197 165 898 

Loan Modifications Completed: 

Total ......................................................................... 54 65 76 141 179 515 

Prime ....................................................................... 24 30 30 37 48 169 

Subprime ................................................................. 29 35 46 104 132 346 

*Workout plans are the sum of formal repayment plans initiated and loan modifications completed. 

Note: Numbers may not add due to rounding. 

Source: HOPE NOW Alliance. 

According to the Mortgage Bankers Association’s National Delinquency Survey, the performance of prime mortgages deteriorated 

from the prior quarter. In fourth quarter 2007, 5.82 percent of all 

mortgage loans were 30 days or more past due. The percentage of 

all mortgages that were seriously delinquent (loans that are 90 

days or more past due or in the process of foreclosure) was 3.62 

percent The survey reported that 3.24 percent of conventional 

prime mortgages were 30 days or more past due. The percentage 

of prime mortgages that were seriously delinquent was 1.67 percent. 

Delinquency and foreclosure rates for subprime mortgages continue to rise. In fourth quarter 2007, 17.31 percent of subprime 

mortgages were 30 days or more past due, while 14.44 percent of 

these mortgages were seriously delinquent. Subprime ARMs continue to experience the. greatest stress. In fourth quarter 2007, 

20.02 percent of subprime ARMs were 30 days or more past due, 

while 20.43 percent of these mortgages were seriously delinquent. 

The Mortgage Bankers Association does not provide a breakout for 

Alt-A loans. 

At FDIC-insured banks and thrifts, the ratio of noncurrent (90 

days or more past due or on nonaccrual) 1–4 family residential 

mortgage loans increased to 2.06 percent in fourth quarter 2007. 

This level is double that of one year ago, when the ratio was 1.05 

percent, and is the highest noncurrent level since at least 1991. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED 

FROM SHEILA C. BAIR 

Q.1. How accurate and predictive were the risk models used by 

banks and ratings agencies in identifying the risks now unfolding 

in the current market turmoil? 

A.1. Banks, ratings agencies, and regulators vastly underestimated 

the risks in mortgage markets and in complex highly-rated securities. Even today, it is difficult to quantify these risks. Models did 

not forecast the significant deterioration in the credit markets, nor 

did they predict the fact that adverse events would be highly correlated, making a bad situation worse. The models failed to capture 

what is referred to as ‘‘tail risk,’’ the risk of loss associated with 

extreme events. Yet it is those same events that can threaten the 

solvency of our financial system. The models that will be used by 

banks in determining capital requirements under the advanced apVerDate Nov 24 2008 02:38 Mar 13, 2010 Jkt 050370 PO 00000 Frm 00301 Fmt 6602 Sfmt 6602 E:\HR\OC\A370.XXX A370

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proaches are based largely on the same models that are used by 

the ratings agencies that failed to capture the massive losses in the 

credit markets. 

Q.2.a. If the advanced approaches could have been put in effect immediately after they were published by the Basel Committee in 

June, 2004: Would banks using these approaches have been required to hold more capital against their mortgage portfolios? 

A.2.a. No. The U.S. Quantitative Impact Study–4 (QIS–4) estimated the advanced approaches would reduce median capital requirements for mortgages and home equity loans by 73 percent and 

80 percent respectively. If banks had been allowed to implement 

such reductions in capital requirements for their mortgages, they 

would have been much more vulnerable going into the current 

problems. 

The QIS–4 result likely reflects that the formula underlying the 

advanced approach mortgage capital requirements was developed 

during a period of benign credit conditions and historically robust 

house price appreciation. Banks calculate their mortgage capital requirements in the advanced approaches by inputting certain key 

parameters (probability of default (PD), loss given default (LGD) 

and exposure at default (EAD)) for the various pools of mortgages 

they hold, reflective of their own historical credit loss experience 

for similar mortgages, into a function prescribed in regulation. 

Some have argued that the advanced approaches would require 

more capital than QIS–4 estimated. No one has disputed, to our 

knowledge, that any reasonable approach to estimating historical 

mortgage credit losses over a long period of time prior to the current crisis would result in PI, LGD and EAD values that, if input 

into the advanced formula, would result in extremely large reductions in mortgage capital requirements compared to Basel I levels. 

The problem with this result, as we have seen in the current environment, is that perceptions of minimal risk based on historical 

statistics can induce lenders to change underwriting standards and 

develop new products that may sharply elevate losses compared to 

historical norms. 

Q.2.b. Would the advanced approaches have generated sufficient 

capital requirements to account for the risks present in highly 

rated CDOs and other complex securities that have caused losses 

in the tens of billions for large financial institutions? 

A.2.b. No. The advanced approaches reduce the capital requirements significantly compared to the current rules and could well 

have encouraged banks to hold more AAA-rated CDOs. For many 

of these exposures, the capital requirements are reduced by almost 

two thirds from 1.6 percent to 0.56 percent of face value, or equivalently from a 20 percent risk weight down to a 7 percent risk 

weight. This result is not unique to CDOs. Under the advanced approaches most AAA-rated securities are expected to receive this 

same reduction in capital requirements. The new framework thus 

risks giving banks an incentive to rely on ratings to an even greater extent than before. 

The Basel Committee recently announced that it will revisit the 

7 percent risk weight for certain types of resecuritized assets such 

as CDOs. While worthwhile, it is noted that this effort should be 


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considered a response to current events rather than an aspect of 

the advanced approaches that would have forestalled or mitigated 

the development of those events. 

Q.2.c. Would the advanced approaches have provided a regulatory 

capital incentive for banks to avoid the use of off-balance sheet conduit financing arrangements such as SIVs? 

A.2.c. No. The advanced approaches require no capital for bank 

SIV structures in which the bank has no legal commitment to support such entities. In recent months we have seen banks around 

the world take large volumes of assets back on their balance 

sheets—assets that were held in SIVs or other conduits. In many 

cases it appears there was no contractual legal obligation for banks 

to do this and, consequently, the banks were not required to hold 

capital against these exposures. There is nothing in Basel II that 

would require banks to hold capital before the fact against off-balance sheet entities in cases where the bank has no contractual 

legal obligation to provide support. After the bank has provided 

support, supervisors can determine the bank has de facto risk exposure and can require capital, yet even this is not a hard and fast 

requirement. 

The advanced approaches treatment of off-balance sheet entities 

where the bank does have a legal obligation to provide support also 

is of interest. Historically, Basel I provided a loophole where banks 

were required to hold capital against off-balance sheet liquidity facilities with maturities of one year or more but were not’ required 

to hold capital where the liquidity facilities had maturities of less 

than one year. Not surprisingly, many banks began using 364-day 

maturity renewable liquidity facilities to avoid the capital requirement. The U.S. banking agencies closed this loophole in 2004. Outside the U.S., however, the loophole remained open, and Basel II 

does have the advantage in those countries of closing that loophole. 

With respect to the amount of capital required for off-balance 

sheet exposures, extreme caution is warranted in asserting Basel 

II is an improvement. FDIC calculations based on the QIS–4, for 

example, showed that the total amount of capital required for offbalance sheet exposures was considerably less under the advanced 

approaches than under the current rules. This reflects the greater 

flexibility banks have in the advanced approaches both to model 

the amount of their exposure and to use their own risk estimates 

to determine the appropriate risk weight for the exposure. 

Q.2.d. Would the advanced approaches have provided a regulatory 

capital incentive for banks to avoid excessive dependence on bond 

insurers? 

A.2.d. No. The advanced approaches give significant new capital 

relief for banks entering into credit default swaps with bond insurers. Under the advanced approaches, banks would be able to gain 

significant capital benefits under the assumption that they can 

transfer significant amounts of their credit risk to insurance companies and other parties through complex structures such as credit 

derivatives. The new rules also provide capital benefits that assume that there is very little correlation between the creditworthiness of the insurer and that of the banks’ exposure. During the recent credit market turmoil, we have witnessed a significant deterioVerDate Nov 24 2008 02:38 Mar 13, 2010 Jkt 050370 PO 00000 Frm 00303 Fmt 6602 Sfmt 6602 E:\HR\OC\A370.XXX A370

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ration in the creditworthiness of many of the financial guarantors 

that banks rely upon to cover losses. Further, the fortunes of both 

the banks’ exposures and that of the insurer appear to be tied 

much more closely than we had anticipated. Under these conditions, the capital requirements might not fully be capturing that 

connection and might not fully reflect this risk. 

Q.2.e. Would the advanced approaches have required banks to hold 

more capital against commercial real estate? 

A.2.e. No. The QIS–4 estimated banks would have to hold about 

half the capital (median decline) against their commercial real estate (CRE) exposures. As described above for mortgages, banks calculate their CRE capital requirements by inputting their own estimates of the PDs, LGDs and EADs applicable to their CRE exposures into supervisory formulas. The capital requirements generated by such formulas depend upon these inputs, which in turn 

are heavily influenced by historical credit loss experience. 

The roughly 50 percent median reduction in capital requirements 

for CRE estimated by the QIS–4 was surprising to many observers 

because CRE is historically a relatively risky bank asset class. 

However, a large reduction in CRE capital requirements is exactly 

what the advanced approaches can be expected to deliver during a 

period of strong economic conditions. If such a reduction in CRE 

capital requirements had been put into effect in the years leading 

up to the current crisis, banks would be much less well positioned 

to deal with credit losses. 

Q.2.f. Would the advanced approaches have required banks to hold 

more capital against leveraged commercial loans? 

A.2.f. Capital for C&I loans, in general, declined (median) in the 

QIS–4 by about a third. In addition, please see our answers to 

questions 2a and 2e. 

Q.2.g. Would the advanced approaches have required more capital 

overall, so that large banks would have been better capitalized 

going into the current market turmoil? 

A.2.g. No. The median decline in risk-based capital requirements 

reported by the 26 U.S. banks in QIS–4 was 26 percent, with a 

number of banks reporting declines of 30 percent to 50 percent. 

Significant reductions in capital requirements were reported across 

all major loan categories with the exception of credit cards. Significant reductions in capital requirements also were reported for 

securitization exposures. The 26 percent median reduction in capital requirements includes the effect of Basel II’s new capital 

charge for operational risk, indicating that the additional capital 

reported for the new charge was swamped by the large reductions 

in capital requirements for credit risk. The 26 percent median reduction in capital requirements did not include the effect of a 1.06 

‘‘scaling factor’’ applied to the credit risk charge under the final 

rule that would dampen these reported capital reductions but not 

qualitatively change the overall result of large reductions in capital 

requirements. 

To reiterate points made in responses to earlier questions, had 

large U.S. banks been permitted during the years leading up to the 

current crisis to implement reductions in capital requirements of 


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the magnitudes suggested by the advanced approaches, the banking system would be much more vulnerable today. 

Q.3. Would banks reduce their actual capital in response to the advanced approaches? 

A.3. Yes. We believe the evidence suggests banks would use the 

leeway available to them under the advanced approaches to reduce 

their capital. 

A comparison of the capital levels of large European banks 

versus large U.S. banks provides strong evidence that banks will 

reduce their capital levels when given a regulatory opportunity to 

do so. Ratios of tier 1 capital to balance sheet assets of large European banks typically are in the range of two percent to four percent, with the very largest institutions typically being closer to two 

percent. These banks have no direct regulatory constraint on financial leverage. U.S. banks, in contrast, do face leverage ratio requirements under the Prompt Corrective Action regulations, and 

the insured banks hold tier 1 capital well in excess of five percent 

of balance sheet assets as a direct result of these regulations. 

Capital regulation matters a great deal for the capital banks actually hold. Throughout the development of Basel II, most banks 

involved in the discussions understood Basel II and especially the 

advanced approaches to be an opportunity to lower their capital requirements. This accounts for the almost universal endorsement by 

large banks of the core elements of Basel II, which was tempered 

when constraints on capital reductions became part of the U.S. discussions. 

A case in point is given by Northern Rock, the British bank with assets of about $200 billion that was recently nationalized. We understand that the British regulators provided banks that were interested, and deemed ready, the opportunity to implement certain 

aspects of the advanced approaches in 2007. In reference to the 44 

percent reduction in risk-weighted assets Northern Rock reported 

using the advanced methodologies for its retail portfolio, its CEO 

wrote: 

We are pleased to have achieved approval for use of our Basle II rating 

systems. This means that the benefits of Basle II enable us to increase our 

2007 interim dividend by 30 percent. Going forward our dividend payout 

rate increases to 50 percent of underlying EPS from around 40 percent. Future capital planning, including the reduction of capital hungry assets, will 

allow us to return capital to shareholders through a share buyback programme. The medium term outlook for the Company is very positive.—CEO 

Adam Applegarth, Northern Rock Interim Results, June 30, 2007. 

Q.4. Would the advanced approach require banks to raise capital 

substantially during a downturn? 

A.4. The advanced approaches capital requirements could rise 

sharply during a downturn compared to pre-downturn levels. This 

could cause banks to be either out of regulatory compliance or 

forced to raise substantial capital when they are least able to do 

so. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO 

FROM SHEILA C. BAIR 

Q.1. Although not all the items that you suggested were included 

in this package and there might need to be a few tweaks, are there 


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any items in this package that your agency cannot support or are 

these all items that would increase regulatory efficiency without. 

compromising safety and soundness and important consumer protections? 

A.1. With one exception discussed below, the package of regulatory 

burden relief amendments generally does not raise significant safety and soundness or consumer protection concerns for the FDIC. In 

addition, our staff has identified a few technical issues that may 

merit further staff-to-staff discussion. FDIC staff will contact your 

staff to address issues regarding the bill’s provisions that would 

eliminate the current statutory requirement for notice to the FDIC 

of certain public welfare investments by banks. We also would like 

to discuss some technical drafting suggestions to avoid unintended 

consequences from the bill’s provisions regarding the applicability 

of section 404 of the Sarbanes-Oxley Act to small banks. 

The one provision the FDIC does not support is the proposal to 

raise the small institutions exception threshold for annual examinations from less than $500 million to less than $1 billion in total 

assets. Current law requires the banking agencies to conduct a fullscale, on-site examination of the depository institutions under their 

jurisdiction at least every 12 months. There is an exception for certain small institutions (i.e., institutions with total assets of less 

than $500 million) that requires examinations of these qualifying 

smaller institutions at least every 18 months. At this time, the 

FDIC would not support raising the threshold and extending the 

examination cycle for institutions of $500 million or more. The 

threshold was only raised to $500 million in late 2006 and it would 

be useful to have more experience with this change, especially in 

the current challenging economic times, before considering expanding the exception. 

Q.2. Since all of these items have been vetted and reviewed in past 

hearings before the Banking Committee, is there any reason to not 

move quickly forward with a package along these lines? 

A.2. With the exception of the issues regarding increasing the exception threshold for annual exams for small institutions, it is likely that remaining issues regarding the regulatory relief proposal 

could be resolved fairly easily. In addition, we would recommend 

consideration of items from the legislative package provided to you 

by the FDIC in response to your previous request that should help 

reduce regulatory burden and improve regulatory efficiency. 

RESPONSE TO WRITTEN QUESTIONS OF CHAIRMAN DODD 

FROM JOHN C. DUGAN 

ANTI-UNION REGULATION

Q.1. Last year, the Department of Labor issued a regulation drastically expanding the personal financial information union officers 

and employees must submit to the Department. The new LM–30 

rule will require more than 150,000 union volunteers, employees, 

and their families to report the terms of mortgages, car loans, and 

even student loans. To determine whether they must report such 

interests, these individuals must ascertain (1) whether the bank 

providing a loan does any business with the person’s union, or (2) 


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2 72 Fed. Reg. 36106 (July 2, 2007). 

3 Id. at 36119. 

whether the bank does 10 percent of its business with firms whose 

employees are in the same union. The regulation requires individuals to write to banks asking for this info, and, then, if banks won’t 

provide such information, to contact the Department of Labor for 

assistance. In the meantime, individuals are required to make good 

faith estimates of the bank’s business with their unions and unionized firms. 

• Given your agency’s expertise in the regulation and practices 

of banks, do you believe that banks are able—and willing—to 

inform their customers whether they do business with particular unions and how much of their ‘‘business’’ and ‘‘business 

receipts’’ are with particular unionized firms? 

• Are banks obligated or prohibited by any federal or state law 

to disclose to their customers how much ‘‘business’’ or ‘‘business receipts’’ they have with particular unionized firms? Can 

banks simply refuse to answer these written inquiries? 

• What type of administrative burden will this LM–30 rule, and 

the hundreds of thousands of resulting inquiries, place on 

banks and are banks currently prepared to respond to these inquiries? 

• If banks don’t provide this non-public information, is there any 

‘‘information reasonably available’’ to the public that union officers, employees, and members could use to make good faith estimates? 

A.1. On July 2, 2007, the Department of Labor’s Office of LaborManagement Standards (OLMS) published a final rule revising 

Form LM–30 Labor Organization Officer and Employee Report and 

its instructions (Final Rule).2 The Final Rule is effective for fiscal 

years beginning August 16, 2007, and the first reports on the revised LM–30 must be made 90 days after the end of the fiscal year. 

Thus, no reporting is due until November 2008. 

Form LM–30 is used by officers and employees of labor organizations subject to the Labor-Management Reporting and Disclosure 

Act of 1959 (LMRDA). The LMRDA requires public disclosure of 

certain financial interests held, income received, and transactions 

engaged in by labor organization officers and employees and their 

spouses and minor children. Financial institutions do not have to 

report payments or loans under section 203 of the LMRDA.3 Therefore, national banks are not required to report customer information under the LMRDA. 

Under the final rule, union officers are not required to report 

most loans, interest, or dividends from financial institutions. However, the following loans must be reported: 

• A loan to a union official from a financial institution that is an 

employer whose employees the official’s labor organization represents or is actively seeking to represent. 


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4 A ‘‘trust in which a labor organization is interested’’ is a trust or other fund or organization 

(1) that was created or established by a labor organization, or one or more of the trustees or 

one or more members of the governing body is selected or appointed by a labor organization, 

and (2) a primary purpose of which is to provide benefits for the members of such labor organization or their beneficiaries. 

• A loan to a union official from a financial institution that is a 

trust in which the official’s labor organization is interested.4

• A loan to a union official from a financial institution that is: 

(1) a business that buys from, sells, or otherwise deals with the 

official’s labor organization; (2) a business that buys from, 

sells, or otherwise deals with a trust in which the official’s 

labor organization is interested; or (3) a business a substantial 

part of which (10% or more) consists of buying from, selling to, 

or otherwise dealing with an employer whose employees the official’s labor organization represents or is actively seeking to 

represent. 

In January of this year, the AFL–CIO filed a lawsuit against the 

Labor Department challenging the Final Rule under the Administrative Procedure Act. The lawsuit is pending in the U.S. District 

Court for the District of Columbia (Case 1:08–cv–00069). The lawsuit challenges five aspects of the Final Rule’s modifications to the 

LM–30, one of which is the treatment of loans from financial institutions. The AFL–CIO claims that the LMRDA does not support 

the requirement that loans be reported on the LM–30 if the institution deals with the borrower’s labor organization or a trust in 

which that organization is interested or does a substantial part of 

its business with employers whose employees the labor organization represents or seeks to represent. The AFL–CIO has filed a motion for summary judgment, and the parties have completed briefing on that motion. 

Given that these issues are in active litigation in which we are 

not involved, we are simply not in a position to comment on any 

of the requirements for reporting of bank loans on the LM–30. 


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NEW COMPREHENSIVE OCC REPORT ON MORTGAGE 

PERFORMANCE 

REMARKS BY JOHN C. DUGAN, COMPTROLLER OF THE CURRENCY, 

BEFORE THE AMERICAN SECURITIZATION FORUM, JUNE 11, 2008 

It’s a pleasure to be here with all of you this morning. The American Securitization Forum brings together key participants in 

securitization markets, which have financed an extraordinary 

amount of economic activity over the last several decades. Many of 

the roughly 1,700 national banks that the OCC supervises play 

outsized roles in these markets, as loan originators, servicers, 

structurers, trustees, dealers, distributors, and investors—and 

that’s not an exhaustive list. They have been deeply involved in the 

growth of securitization, and nowhere has that been more apparent 

than in the phenomenal growth of residential mortgage securitization markets. 

For example, in 2007, national banks originated about 45 percent 

of all home mortgages in the United States. They also act as 

servicers for about 44 percent of all U.S. mortgages. About 90 percent of the mortgages they service are held by third parties via 

securitization by Fannie Mae, Freddie Mac, and other financial institutions. National banks also hold a substantial amount of both 

mortgage securities and first mortgages on their balance sheets, 

which together total over $1.7 trillion. In short, over the last 20 

years, national banks have become much more centrally involved 

in the mortgage business, and as a result, the OCC has become 

much more centrally involved in the supervision of these activities. 

Needless to say, against this backdrop, the mortgage market disruptions of the last year have been exceptionally challenging for 

both national banks and their supervisor. Fortunately, the banks 

we supervise were well capitalized going into this turmoil. In addition, their diversified businesses and strong deposit franchises have 

been real sources of strength, and they have benefited from the fact 

that they hold and service a disproportionately small share of 

subprime mortgages—only about 10 percent. Still, several national 

banks have sustained exceptionally large losses from mortgage-related assets—which they have offset by successfully raising capital—and mortgage exposure and mortgage involvement remain 

substantial across the national banking system. 

THE NEED FOR BETTER METRICS

As mortgage delinquencies and foreclosures have climbed, the 

OCC has intensified our already heavy focus on mortgage supervision. In this context, we began to realize that the substantial 

amount of mortgage data we had previously collected from our 

banks was not giving us a sufficiently granular look at declining 

mortgage performance. At the same time, given their leading role 

as mortgage servicers, national banks began to receive numerous 

and differing requests for data about mortgage performance and 

mortgage modifications from organizations around the country, including members of Congress, news organizations, and state and 

local governments. 


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We also came to realize that there were some significant limitations with the mortgage performance data reported by other organizations and trade associations. These other sources often used 

differing definitions of ‘‘prime,’’ ‘‘subprime,’’ ‘‘Alt-A,’’ and ‘‘delinquency.’’ This lack of standardized definitions made comparisons 

difficult across different studies. The same was true with respect 

to the different ways in which both institutions and data collectors 

described ‘‘mortgage mitigations,’’ with some counting any contact 

with a borrower about payment reduction or relief as a mitigation 

in process, while others did not count mitigation efforts until a particular mitigation plan had been formally implemented. And virtually none of the data had been subjected to a rigorous process to 

check for consistency and completeness—they were typically responses to surveys that produced aggregate, unverified results from 

individual firms. That lack of loan-level validation raised real questions about the precision of the data, at least for our supervisory 

purposes. 

In this context, the OCC realized we had a real opportunity to 

improve the way that mortgage performance could be measured, 

producing better information for our particular supervisory purposes, and better information for policymakers, other regulators, 

market participants, and the public at large. That is, we realized 

that a relatively small number of our largest national banks—nine, 

to be exact—conducted over 90 percent of servicing activities engaged in by our entire national banking population. These banks 

service about 40 percent of all U.S. home mortgages outstanding. 

They are large and have in place the kind of information systems 

that allow them to produce significant amounts of data that can be 

tailored to particular requests. And perhaps most important, we as 

their primary federal regulator could require them to take several 

important steps: report to us loan-level data on roughly 23 million 

loans for homes in every state in the country, totaling $3.8 trillion; 

report such data in a common format, using standardized definitions; and validate the data submitted. 

So, we seized this opportunity. The participating banks immediately understood both our needs and the value of producing more 

precise information using common metrics and definitions. They 

have worked closely with us and the third-party data aggregator 

we hired to begin reporting the extraordinary volume of information we have requested in the format we have established. And the 

aggregator has worked closely with us to translate key parts of 

that data into a report that can be issued to the public. 

OCC’S FIRST MORTGAGE METRICS REPORT

Today, I am pleased to unveil findings from the first OCC Mortgage Metrics Report, which covers loan-level mortgage information 

for the last two calendar quarters, from October 1, 2007, to March 

31, 2008. In the future, we plan to issue a Mortgage Metrics Report 

each quarter. 

Before I summarize key results from this first report, let me explain how it differs from other reports and data collection efforts, 

and how it addresses concerns that I previously identified. 

First, OCC Mortgage Metrics are comprehensive. They reflect activities of many of the industry’s largest mortgage servicers—not 


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just holders of the mortgages. In addition, the metrics capture information on all mortgages, not just subprime. 

Second, the report is based on ‘‘loan-level’’ data. In contrast with 

other reports that rely on surveys of lenders or interpretations of 

data, we collected 64 specific pieces of information on more than 23 

million loans for each month of the reporting period. These include 

such data elements as credit score, interest rate, unpaid balance, 

property value, and payment history. This loan-level data can be 

analyzed more rigorously and in a wider variety of ways than information obtained through surveys. 

Third, our Mortgage Metrics use terms and definitions that are 

standardized. Today, if you simply ask lenders how many subprime 

loans they have, you’ll get answers based on different definitions, 

because certain loans in one lender’s subprime book may be another bank’s Alt-A. Indeed, at the large national banks we supervise, the dividing line for prime, subprime, and Alt-A loans can 

vary widely across a range of credit scores and other characteristics 

of the loan and borrower. Our standardized Mortgage Metrics 

eliminate these disparities. 

For example, the three categories of creditworthiness in the report—prime, Alt-A, and subprime—are defined using FICO credit 

scores at the time of loan origination. We use the following 

breakpoints that have often, but not always, been used by industry 

analysts: prime—660 and above; Alt-A—620 to 659; and 

subprime—below 620. Some may quibble with this particular segmentation, but the point is that they are the same quantifiable criteria used in every case, and as a result, ‘‘subprime’’ will mean the 

same thing for each servicer and each loan. 

The metrics also establish a common—and conservative—definition for ‘‘newly initiated’’ loss mitigation actions. A payment plan 

or loan modification won’t count unless the servicer and borrower 

have entered into an agreement. This results in fewer loss mitigation actions reported, but a better picture, we believe, of the actual 

occurrence of such actions. 

Now, let me hasten to add that our new OCC metrics are not 

perfect. There has definitely been some ‘‘noise,’’ especially in this 

large initial data collection looking backward for six months. For 

example, 20 percent of the loans fell into an ‘‘other’’ category, which 

meant that a credit score was unavailable. The inability to obtain 

such scores typically reflects problems with the flow of information 

through the systems that produce the data—purchased loan portfolios, for example, that came with databases that can’t easily be 

read by the servicer’s computer system. Now that the new data collection system has been established, we expect this problem to decline on a ‘‘go forward’’ basis as servicers realize that they will need 

this data whenever they acquire servicing portfolios in the future. 

In addition to the ‘‘noise’’ in the overall data set, we need to be 

cautious about identifying trends in a six-month sample. Month-tomonth data may be quite volatile and subject to fairly strong seasonal effects that can only be discerned from a longer time series 

that permits year-to-year comparisons. So observed changes month 

to month should be taken with a grain of salt. 

Before turning to key results of the report, let me provide another important caveat: some of the conclusions we report here may 


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seem different from conclusions that have been widely reported 

elsewhere—but there are good reasons for these differences. As I 

said previously, we believe the data is more precise than data reported in some other studies, and it reflects a huge proportion of 

the mortgages outstanding in the country. It obviously does not 

capture all mortgages, however, and it is not a statistically random 

sample. 

The particular population of mortgages held and serviced by 

these nine national banks has some different characteristics than 

the overall population of mortgages. This difference can cause different results. For example, the proportion of subprime loans in the 

pool is smaller than in the general population—national banks 

service only about 25 percent of all subprime mortgages, but they 

service 40 percent of all mortgages outstanding. Similarly, the 

prime mortgages serviced by national banks include a disproportionately high number of conforming loans sold to the GSEs—about 

66 percent, compared to 43 percent for the industry overall. 

Finally, the standardized definitions produce different results. 

Other studies that don’t break out Alt-A separately will lump these 

loans in either the prime category—thereby elevating delinquency 

and foreclosure ratios for those loans—or the subprime category— 

where it will have the opposite effect. 

In short, while there are good reasons for the differences, the 

summary data from this first Mortgage Metrics report in some 

cases vary significantly from comparable categories recently reported in other surveys. 

SIGNIFICANT FINDINGS

So, with that quite long wind-up, what does this first report tell 

us? Here are six key findings. 

First, one somewhat surprising finding is that the overall mortgage servicing portfolio of the nine banks reflects credit quality 

that is relatively satisfactory and relatively stable. For example, 

the number of current and performing loans remained at about 94 

percent over the entire six-month period. Serious delinquencies, 

which we define as bankrupt borrowers who are 30 days delinquent 

and all delinquencies greater than 60 days, increased just one 

tenth of a percentage point during the period, from 2.1 percent to 

about 2.2 percent. This overall quality and stability likely reflects 

the differences in the national bank servicing portfolio that I described above. 

Second: Among the three segments of loans, we found, not surprisingly, that the majority of serious delinquencies was concentrated in the highest risk segment—subprime mortgages. 

Though these mortgages constituted less than 9 percent of the total 

portfolio, they sustained twice as many delinquencies as either 

prime or Alt-A mortgages. 

The third finding concerns loss mitigation actions, which for purposes of this report include only loan modifications and payment 

plans. Consistent with other reports, payment plans predominated, 

outnumbering loan modifications in March by more than four to 

one. But loan modifications increased at a much faster rate during 

the period. 


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Servicers also indicated they are working with Fannie Mae, 

Freddie Mac, the Federal Housing Administration, and private investors to develop and offer new loss mitigation options. In fact, 

mortgage servicers reported several alternative loss mitigation actions not included in this analysis that we plan to include in future 

reports, including HomeSaver Advance, FHASecure, partial claims, 

new subsidy programs, and refinances with principal forgiveness. 

These actions provide banks additional alternatives to mitigate 

their risks and work with troubled borrowers. 

Fourth: Although subprime mortgages made up less than 9 percent of the portfolio, they accounted for 43 percent of all loss mitigation actions at the end of March. Indeed, for these borrowers in 

that month, total loss mitigation actions exceeded newly initiated 

foreclosure proceedings by a margin of nearly 2 to 1. 

Fifth: As in other studies, our report confirms that foreclosures 

in process are plainly on the rise, with the total number increasing 

steadily and significantly through the reporting period from 0.9 

percent of the portfolio to 1.23 percent. Interestingly, the number 

of new foreclosures has been quite variable. While one month does 

not make a trend, new foreclosures in March declined to 45,696, 

down 21 percent from January’s high and down about 4.5 percent 

from the start of the reporting period last October. Similarly, the 

ratio of new foreclosures to serious delinquencies was lower in 

March than in either January or October. 

Sixth and finally, the data also show that seriously delinquent 

subprime loans had fewer new foreclosure starts than seriously delinquent prime or Alt-A mortgages. Why would troubled prime 

loans have more foreclosure starts than troubled subprime loans? 

One possible explanation is that the national emphasis on developing alternatives and assistance programs has been targeted to 

subprime borrowers, allowing a higher percentage of these borrowers to stave off foreclosure. 

VALUE OF MORTGAGE METRICS

These are just a few of the key findings from the first report, 

which will be available on our Web site. I urge you to review it 

yourselves for other information that you may find useful. That’s 

exactly what we are doing, both with this and the other data we 

have collected, since we believe it will serve a variety of useful purposes. 

For example, the data will help us develop supervision policy and 

strategies. Examiners will be able to use the information to identify 

anomalies; compare national bank trends to the industry; evaluate 

asset quality and loan-loss reserve needs; and evaluate the effectiveness of loss mitigation actions. Over time, it will allow us to 

drill down to look at trends in performance based on origination 

channels or key credit characteristics. This in turn will help us 

more fully assess losses, loan modifications, payment plans, and recovery efforts. 

In the future, I hope that the standard definitions and methodology used in this report will be applied more broadly to an even 

larger proportion of the pool of outstanding mortgages. The more 

we can use standardized metrics across the board, the better we 

can measure, monitor, and manage mortgage risk. 


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1Section numbers correspond with the section numbers in the Crapo amendment to the ILC 

legislation, which is the most recent version of the text of the provisions that we have seen. 2Pub. L. No. 109–351, § 305, 120 Stat. 1966, 1971–72 (Oct. 13, 2006). 

With this thought very much in mind, we have shared these 

standard definitions with the Office of Thrift Supervision, which 

has also begun requiring the thrifts it supervises to make similar 

monthly reports. If we could combine our results in future reports, 

the coverage would extend to 60 percent of all outstanding mortgages. We would also be interested in sharing the definitions and 

methodologies with other interested data collectors, like the state 

task force that is gathering data from a range of providers. 

Going forward, we think it makes sense to have a national standard for mortgage reporting. The American Securitization Forum is 

in a position to help advance this process, and I would encourage 

you to join us in working toward a common and uniform mortgage 

reporting regime in the U.S. 

While we think these metrics are useful, we know they are not 

perfect. We welcome input by other regulators and industry participants to refine and improve them going forward. In the end, we 

will all benefit from having more accurate and standardized mortgage metrics to make better business and policy decisions, and to 

avoid needless foreclosures. 

Thank you very much. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO 

FROM JOHN C. DUGAN 

Q.1. Although not all the items that you suggested were included 

in this package and there might need to be a few tweaks, are there 

any items in this package that your agency cannot support or are 

these all items that would increase regulatory efficiency without 

compromising safety and soundness and important consumer protections? 

Since all of these items have been, vetted and reviewed in past 

hearings before the Banking Committee, is there any reason to not 

move quickly forward with a package along these lines? 

A.1. We have reviewed the regulatory burden relief amendments 

proposed by Senator Crapo in the amendment to the ILC legislation that the Senator filed, but did not offer, at the markup of that 

legislation held on February 13, 2008. Our comments follow: 

• Depository Institution Community Development Investments 

(Sec. 4) 1

This amendment would restore the original scope of national 

banks’ public welfare investment authority pursuant to 12 U.S.C. 

§ 24(Eleventh). Although the Financial Services Regulatory Relief 

Act of 2006 (FSRRA) 2 increased the permissible amount of national 

banks’ public welfare investments, it also narrowed the applicable 

standard to require that such investments ‘‘benefit primarily’’ lowand moderate-income communities or families. As a result, national 

banks’ ability to make public welfare investments, that would help 

economically distressed or underserved middle-income areas has 

been curtailed. The amendment would restore the original language of section 24(Eleventh) so that the applicable standard would 


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3See Letter from John C. Dugan, Comptroller of the Currency, to Senator Mike Crapo, January 25, 2008 (identifying 4 items for inclusion in regulatory relief legislation). See also Remarks 

by John C. Dugan Before the National Ass’n of Affordable Housing Lenders, Washington, D.C., 

February 12, 2008, available at www.occ.gov/ftp/release/2008-14a.pdf. 4 See Testimony of Julie L. Williams, First Senior Deputy Comptroller and Chief Counsel, 

Before the Committee on Banking, Housing and Urban Affairs, U.S. Senate, March 1, 2006, at 

pp. 9–10 (OCC Testimony) (noting high cost of compliance with section 404 for smaller banks). 5Pub. L. No. 109–351, § 201, 120 Stat. at 1968–69. 

once again be that investments must be ‘‘designed primarily to promote the public welfare.’’ 

The OCC strongly supports the amendment,3 and we.are grateful 

for Senator Crapo’s inclusion of it in this package, as well as his 

support for its inclusion in other legislative vehicles in this Congress. 

• Gramm-Leach-Bliley Act Amendment (See. 6). 

This amendment would eliminate the annual privacy notice requirement for those financial institutions that do not disclose nonpublic personal information to any nonaffiliated third party in a 

manner that would be subject to a consumer’s right to opt out 

under the Gramm-Leach-Bliley Act (GLBA) or the Fair Credit Reporting Act (FCRA) and that have not changed their disclosure 

policies since the most recent previous annual notice. The OCC 

supports this amendment. We note, as a technical matter, that the 

cross-reference to section 603 of the FCRA should read ‘‘section 

603(d)(2)(A)(iii)’’ in order to capture precisely the non-transaction 

or experience information that is subject to customer opt-out. 

• Sarbanes–Oxley Act Amendment Relating to Community Bank 

Exceptions (Sec. 7) 

This amendment would except from the requirements of section 

404 of the Sarbanes-Oxley Act (pertaining to auditor attestation of 

management’s assessment of internal controls) insured banks with 

consolidated assets of $1 billion or less. The OCC supports this 

Amendment.4

• Examination Schedule for Certain Community Banks (Sec. 8) 

The OCC supports this amendment, which would raise from $500 

million to $1 billion the asset-size threshold for banks to qualify for 

the expanded 18-month examination cycle authorized pursuant to 

the Federal Deposit Insurance Act. 

• Repeal of Delay of Certain Authority of the Board of Governors 

of the Federal Reserve System (Sec. 16) 

The OCC supported the amendment authorizing the Federal Reserve Board to pay interest on reserves, which was enacted as section 201 of the FSRRA.5 We defer to the Board with respect to the 

elimination of the 5-year delayed effective date that was incorporated in section 201 and that would be repealed by this provision. 

• Authority for Interest on Demand Deposits (Sec. 17) 

The OCC supports this amendment, which would repeal the prohibition against banks’ and Thrifts’ offering interest on demand deposit accounts, effective 2 years after enactment. 

• Interest-Bearing Transaction Accounts Authorized for All Businesses (Sec. 18) 


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1These two amendments are identical to those submitted to Senator Crapo earlier this year. 

See Letter from John C. Dugan, Comptroller of the Currency, to Senator Mike Crapo, January 

25, 2008 (identifying items for inclusion in regulatory relief legislation). 

The OCC supports this amendment, which would expand from 6 

to 24 the number of permissible transfers made per month from 

money market deposit accounts. We note that the amendment 

would authorize the Federal Reserve Board to establish a greater 

number of transfers by rule or order and would permit ‘‘the Board 

to determine that such an account is not a ‘‘transaction account’’ 

for purposes of section 19 of the Federal Reserve Act (subjecting 

‘‘transaction accounts’’ to reserve requirements). We defer to the 

Board with respect to these grants of discretionary authority. 

We agree that all of the above-mentioned items would increase 

regulatory efficiency without compromising safety and soundness 

or consumer protections, and we see no reason to delay a legislative 

package that includes them. 

The OCC takes no position with respect to the provisions relating 

to the authorities of Federal savings associations (sections 5, 9, and 

10), and we express no view with respect to the provisions relating 

to credit unions (sections 11, 12, 13, 14, and 15). 

Finally, should the Committee wish to entertain additional 

amendments for inclusion in a regulatory burden relief legislative 

package, we have attached legislative language that would implement the two additional provisions that were recommended in 

Comptroller Dugan’s letter to Senator Crapo of January 25, 2008. 

These provisions are: (1) the repeal of the state opt-in requirement 

for de novo branching and of the 5-year state age requirement; and 

(2) the elimination of the ‘‘place of 5,000’’ requirement from national banks’’ general insurance agency sales authority. The attached legislative language is identical to the language provided 

with the January 25 letter. 

MAY 13, 2008. 

ADDITIONAL OCC REGULATORY BURDEN RELIEF SUGGESTIONS 1

1. Repeal the State Opt-In Requirement for De Novo Branching 

and Repeal the 5-Year State Age Requirement 

2. Delete the ‘‘place of 5,000’’ requirement from national banks’ 

general insurance agency sales authority 

1. SEC ll. EASING RESTRICTIONS ON INTERSTATE BRANCHING AND 

MERGERS. 

(a) DE NOVO INTERSTATE BRANCHES OF NATIONAL BANKS.—Section. 5155(g) of the Revised Statutes of the United States (12 

U.S.C. 36(g)) is amended— 

(1) in paragraph (1), by striking ‘‘paragraph (2)’’ each place 

that it appears and inserting ‘‘paragraph (3)’’; and 

(2) by inserting after paragraph (1) the following new paragraph and renumbering the remaining paragraphs. accordingly: 

‘‘(2) STREAMLINED PROCEDURES FOR CERTAIN BANKS.— 

‘‘(A) IN GENERAL.—The requirements in paragraph (1)(A) 

shall not apply to the establishment and operation of a de 

novo branch by a national bank if— 


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‘‘(i) the bank is a subsidiary of a bank holding company which is operating as a bank holding company 

subject to the supervision and regulation of the Board 

of Governors of the Federal Reserve System under the 

Bank Holding Company Act of 1956 (12 U.S.C. 1841, 

et seq.); or 

‘‘(ii) the bank is not controlled by a company for purposes of the Bank Holding Company Act of 1956. 

‘‘(B) DEFINITIONS.—For purposes of this paragraph, the 

terms ‘subsidiary’, ‘bank holding company’, and ‘company’ 

have the same meaning given to such terms in section 2 

of the Bank Holding Company Act of 1956 (12 U.S.C. 

1841).’’ 

(b) DE NOVO INTERSTATE BRANCHES OF STATE NONMEMBER

BANKS.—Section 18(d)(4) of the Federal Deposit Insurance Act (12 

U.S.C. 1828(d)(4)) is amended— 

(1) in subparagraph (A), by striking ‘‘subparagraph (B)’’ each 

place that it appears and inserting ‘‘subparagraph (C)’’; and 

(2) by inserting after subparagraph (A) the following new 

subparagraph and redesignating the following subparagraphs 

accordingly: ‘‘(B) STREAMLINED PROCEDURES FOR CERTAIN BANKS.— ‘‘(i) IN GENERAL.—The requirements in subparagraph. (A)(i) shall not apply to the establishment and, 

operation of a de novo branch by an insured state nonmember bank if— 

‘‘(I) the bank is a subsidiary of a bank holding 

company which is operating as a bank holding 

company subject to the supervision and regulation 

of the Board of Governors of the Federal Reserve 

System under the Bank Holding Company Act of 

1956 (12 U.S.C. 1841, et seq.); or 

‘‘(II) the bank is not controlled by a company for 

purposes of the Bank Holding Company Act of 

1956. 

‘‘(ii) DEFINITIONS.—For purposes of this paragraph, 

the terms ‘subsidiary’, ‘bank holding company’, and 

‘company’ have the same meaning given to such terms 

in section 2 of the Bank Holding Company Act of 1956 

(12 U.S.C. 1841).’’ 

(c) DE NOVO INTERSTATE BRANCHES OF STATE MEMBER BANKS.— 

The 3rd undesignated paragraph of section 9 of the Federal Reserve Act (12 U.S.C. 321) is amended by adding at the end the following new sentences: ‘‘A State member bank may establish and 

operate a de novo branch in a host State (as such terms are defined 

in section 18(d) of the Federal Deposit Insurance Act) on the same 

terms and conditions and subject to the same limitations and restrictions as are applicable to the establishment of a de novo 

branch of a national bank in a host State under section 5155(g) of 

the Revised Statutes of the United States, Section 5155(g) shall be 

applied for purposes of the preceding sentence by substituting 

‘Board of Governors of the Federal Reserve System’ for ‘Comptroller of the Currency’ and ‘State member bank’ for ‘national 

bank’.’’. 


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(d) CONFORMING AMENDMENTS.— (1) FEDERAL DEPOSIT INSURANCE ACT.—Section 44(a) of the 

Federal Deposit Insurance Act (12 U.S.C. 1831u(a)) is amended 

by striking paragraphs (5) and (6); and 

(2) BANK HOLDING COMPANY ACT.—Section 3(d) of the Bank 

Holding Company Act of 1956 (12 U.S.C. 1842(d)) is amended— 

(A) in paragraph (1)— 

(i) by striking subparagraphs (B) and (C); and 

(ii) by redesignating subparagraph (D) as subparagraph (B); and 

(B) in paragraph (5), by striking ‘‘subparagraph (B) or 

(D)’’ and inserting ‘‘subparagraph (B)’’. 

EXPLANATION

This section would amend section 5155(g) of the Revised Statutes 

of the United States (12 U.S.C. § 36(g)), section 18(d)(4) of the Federal Deposit Insurance Act (FDIA) (12 U.S.C. § 1828(d)(4)), section 

9 of the Federal Reserve Act (12 U.S.C. § 321), and section 3(d)(1) 

of the Bank Holding Company Act (BHCA) (12 U.S.C. § 1842(d)(1)) 

to ease certain restrictions on interstate banking and branching. 

Under the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (Riegle-Neal Act), an out-of-state national or 

state bank may establish a de novo branch in a state only if that 

state has adopted legislation affirmatively ‘‘opting in’’ to de novo 

branching. 

This amendment would repeal the requirement for certain national and state banks that a state must opt-in to de novo branching to allow this form of interstate branching in the state. The language of this amendment is different from the version that was included in Sec. 401 of H.R. 3505 and may offer a solution to the 

issues concerning permitting state-nonmember-bank industrial loan 

companies (ILCs) controlled by commercial companies to engage in 

unrestricted de novo branching that has impeded the enactment of 

this amendment in past Congresses. As explained below, ILCs controlled by commercial companies that are not supervised or regulated by the Federal Reserve Board (Fed) under the BHCA would 

not be allowed to engage in de novo branching without the state 

opt-in requirement under the amendment. 

This amendment would repeal the requirement that a state must 

adopt an ‘‘opt-in’’ statute to permit the de novo branching form of 

interstate expansion but it would repeal the requirement only for 

those national or state banks that are organized in one of two 

ways. First, the amendment would exempt a national or state bank 

from the state opt-in requirement if it is a subsidiary of a bank 

holding company which is operating as a bank holding company 

under the supervision and regulation of the Fed in accordance with 

the BHCA. Second, a national or state bank would be exempt from 

the state opt-in requirement if it is not controlled by a ‘‘company’’ 

for purposes of the BHCA. Thus, the amendment would repeal the 

state opt-in requirement for any national or state bank that is a 

subsidiary of a bank holding company or is not controlled by any 

company under the BHCA Banks that are subsidiaries of supervised bank holding companies or banks that are independent and 


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are not controlled by a company would be able to engage in interstate de novo branching without being subject to the state opt-in 

requirement. 

Neither of the two exempt forms of organization, however, would 

apply to a bank, such as an ILC that’ is controlled by a commercial 

company. While an ILC is a state nonmember bank, it is exempt 

from the definition of a ‘‘bank’’ under the BHCA if certain conditions are satisfied and, as a result, its parent company is not subject to the BHCA and may be a commercial firm. These commercial 

firms are companies for purposes of the BHCA but, because they 

do not control a ‘‘bank’’ under the BHCA’s definition of ‘‘bank’’, they 

do not operate as bank holding companies under the Federal Reserve Board’s (Fed) supervision and regulation and are not subject 

to the restrictions on commercial operations that apply to regulated 

and supervised bank holding companies. Neither of the exemptions 

in the amendment would apply to ILCs controlled by commercial 

firms and they would not be able to engage in unrestricted de novo 

branching under the amendment. 

The amendment also would repeal the state age requirement for 

interstate mergers. The Riegle-Neal Act permits a state to prohibit 

an out-of-state bank or bank holding company from acquiring an 

in-state bank unless the state bank has been in existence for a 

minimum period of time (which may be as long as five years). This 

additional limitation on bank acquisitions by out-of-state banking 

organizations is no longer necessary if interstate de novo branching 

generally is permitted for most banks under the amendment described above. 

Under the Riegle-Neal Act, interstate expansion through bank 

mergers generally is subject to a state ‘‘opt-out’’ that had to be in 

place by June 1, 1997. While two states ‘‘opted out’’ at the time, 

interstate bank mergers are now permissible in all 50 states. By 

contrast, de novo branching by banks requires states to pass legislation to affirmatively ‘‘opt-in’’ to permit out-of-state banks to establish new branches in the state and only approximately 23 states 

have opted in (17 of which require reciprocity). As a result, banks 

in many cases must structure artificial and unnecessarily expensive transactions in order to simply establish a new branch across 

a state border. However, Federal thrifts are not similarly restricted 

and generally may branch interstate without the state law ‘‘opt-in’’ 

requirements that are imposed on banks. Also, repeal of the state 

age requirement would remove a limitation on bank acquisitions by 

out-of-state banking organizations that is no longer necessary if 

interstate de novo branching generally is permitted. 

Enactment of this amendment would enhance competition in 

banking services with resulting benefits for bank customers. Moreover, it will ease burdens on banks that are planning interstate expansion through branches and would give banks greater flexibility 

in formulating their business plans and in making choices about 

the form of their interstate operations. Community banks that seek 

to serve customers across state lines would especially benefit since 

they lack the resource base available to larger banks that is required to structure the more complicated transactions now required 

to accomplish that result. 


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2To qualify to have a financial subsidiary to engage in general insurance agency activities 

without the place of 5,000 restriction, the national bank and each depository institution affiliate 

must be well capitalized and well managed, and the national bank’s aggregate consolidated total 

assets of all of its financial subsidiaries is subject to a cap. In addition, certain other safeguards 

apply, including a requirement that, for purposes of determining regulatory capital, the national 

bank must deduct its outstanding equity investment in its financial subsidiaries from its total 

assets and tangible equity, must deduct the investment from its total risk-based capitals, and 

may not consolidate the assets and liabilities of a financial subsidiary with those of the bank. 

A national bank that ceases to continue to satisfy these requirements is subject to sanctions 

by the OCC, including divestiture. A national bank and its insured depository institution affiliates also are subject to CRA rating requirements when the bank acquires control of a financial 

subsidiary or engages in new activities in the subsidiary. 12 U.S.C. §§ 24a; 1831w. 3The GLBA financial subsidiary requirements and safeguards apply only to insured state 

banks engaging as principal in national bank permissible financial activities in a subsidiary. 

If the state bank is engaged in agency activities in a subsidiary, such as selling insurance as 

agent, none of the requirements and safeguards apply under GLBA. Id at § 1831w. Moreover, 

the requirement that a state bank must obtain the approval of the FDIC to engage directly or 

through a subsidiary in activities that are impermissible for a national bank or its subsidiary 

also applies only to activities conducted as principal and, thus, because of the less risky nature 

of agency activities, the FDIC is not required to approve state bank insurance agency activities. 

Id. at § 1831a. 

4See The Conference of State Bank Supervisors, A Profile of State Chartered Banking Twentieth Edition 2004/2005 Section III 9–12 (2005). 5 Item #137 in the Matrix of Financial Services Regulation Relief Proposals compiled by Sen. 

Crapo’s staff in the 109th Congress would have given the Fed the authority to permit all bank 

holding companies, including those bank holding companies that do not elect or may not be eligi2. SEC.ll. DELETING THE ‘‘PLACE OF 5,000’’ REQUIREMENT FROM NATIONAL BANKS’ GENERAL INSURANCE AGENCY SALES AUTHORITY. 

The 11th undesignated paragraph of section 13 of the Federal 

Reserve Act (12 U.S.C. 92) is amended by striking ‘‘located and 

doing business in any place the population of which does not exceed 

five thousand inhabitants, as shown by the last preceding decennial census,’’. 

EXPLANATION

Under current law, unlike state banks, national banks cannot engage in general insurance agency activities unless the bank is ‘‘located and doing business in any place the population of which does 

not exceed five thousand inhabitants, as shown by the last preceding decennial census’’ (‘‘place of 5,000 restriction’’), or unless the 

national bank establishes a financial subsidiary. The GrammLeach-Bliley Act (GLBA) generally provides authority for financial 

subsidiaries of national banks to engage in general insurance agency activities subject to the capital, managerial, CRA requirements, 

and other safeguards in GLBA that, apply to the establishment and 

operation of financial subsidiaries under GLBA.2 These requirements do not apply to state banks engaged in insurance agency activities.3 The Conference of State Bank Supervisors reports that all 

states but one permit their banks to sell insurance as agent and 

only a very few impose the place of 5,000 restriction that applies 

to all national banks.4 There is no safety and soundness reason to 

competitively disadvantage national banks and subject them to the 

place of 5,000 restriction or require that these less risky agency activities must be conducted in a financial subsidiary subject to the 

capital deduction requirements and other safeguards while most 

state banks can engage in the same agency activity without these 

restrictions. This amendment would repeal the place of 5,000 restriction and permit national, banks to sell insurance as agent in 

the same manner as state banks without the GLBA financial subsidiary requirements.5 Notably, nothing in this amendment would 


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ble to become financial holding companies, to engage in general insurance agency activities 

through a nonbank affiliate. Both bank holding companies and national banks are subject to 

the place of 5,000 restriction or must rely on the authority in GLBA to engage in broad, general 

insurance agency sales activities subject to the requirements and restrictions that apply to financial holding companies and financial subsidiaries, respectively. The OCC opposed Item #137 

unless the amendment above is also adopted similarly permitting national banks to engage in 

general insurance agency activities. 

affect the functional regulation of insurance activities as provided 

by GLBA. 

RESPONSE TO WRITTEN QUESTIONS OF CHAIRMAN DODD 

FROM JOHN M. REICH 

Q.1. Last year, the Department of Labor issued a regulation drastically expanding the personal financial information union officers 

and employees must submit to the Department. The new LM–30 

rule will require more than 150,000 union volunteers, employees, 

and their families to report the terms of mortgages, car loans, and 

even student loans. To determine whether they must report such 

interests, these individuals must ascertain (1) whether the bank 

providing a loan does any business with the person’s union, or (2) 

whether the bank does 10 percent of its business with firms whose 

employees are in the same union. The regulation requires individuals to write to banks asking for this info, and, then, if banks won’t 

provide such information, to contact the Department of Labor for 

assistance. In the meantime, individuals are required to make good 

faith estimates of the bank’s business with their unions and unionized firms. 

Given your agency’s expertise in the regulation and practices of 

banks, do you believe that banks are able—and willing—to inform 

their customers whether they do business with particular unions 

and how much of their ‘‘business’’ and ‘‘business receipts’’ are with 

particular unionized firms? 

Are banks obligated or prohibited by any federal or state law to 

disclose to their customers how much ‘‘business’’ or ‘‘business receipts’’ they have with particular unionized firms? Can banks simply refuse to answer these written inquiries? 

What type of administrative burden will this LM–30 rule, and 

the hundreds of thousands of resulting inquiries, place on banks 

and are banks currently prepared to respond to these inquiries? 

If banks don’t provide this non-public information, is there any 

‘‘information reasonably available’’ to the public that union officers, 

employees, and members could use to make good faith estimates? 

A.1. The Labor-Management Reporting and Disclosure Act 

(LMRDA) requires public disclosures of certain financial transactions and financial interests of labor organization officers and 

employees (other than employees performing clerical or custodial 

services exclusively) and their spouses and minor children. It is our 

understanding that the purpose of this disclosure is, among other 

things, to make public any actual or potential conflict between the 

personal financial interests of a labor organization officer or employee and his or her obligations to the labor organization and its 

members. 

The U.S. Department of Labor’s Office of Labor-Management 

Standards (OLMS) issued a final rule in 2007 implementing section 


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202 of LMRDA. See 72 FR 36106 (July 2, 2007). The final rule revised Form LM–30, Labor Organization Officer and Employee Report, and its instructions. The final rule became effective for fiscal 

years beginning August 16, 2007, although no reporting is due 

under the rule until November 16, 2008. See 72 FR 38484 (July 13, 

2007). 

OTS understands that financial institutions are expressly relieved of any reporting responsibilities of payments or loans under 

section 203 of the LMRDA (see 72 FR at 36119 and 36136). Therefore, savings associations are not required to report customer information. 

The final rule deals with Form LM–30, which requires reporting 

by the union officers and employees covered under the LMRDA. 

The final rule, as revised, does not require union officers to report 

most bona fide loans, interest, or dividends from financial institutions. However, the final rule may require that union officers report these types of transactions if the bank does a specified level 

of business with a company that employs members of the same 

union. The OLMS is the agency responsible for implementation and 

interpretation of this regulation, and OTS defers to OLMS’s determination of the exact parameters of the categories where union employees are required to report bank loans. 

We know of no federal law that either requires or forbids a financial institution from informing its customers whether they deal 

with businesses that are unionized and what union represents the 

employees of those businesses, assuming that no customer information is disclosed. We see nothing in the Department of Labor rule 

that would require financial institutions to make those disclosures. 

We note that savings associations typically build certain reporting 

codes into their information management systems to facilitate the 

creation of both regulatory related filings, such as Thrift Financial 

Reports, as well as internal management reports. The basis for distinguishing and reporting based upon the type of union-related activity at issue here may not be a part of this reporting framework, 

thereby creating issues regarding the practicality of disclosure. 

OTS will continue to analyze the impact of the final rule on our 

supervised savings associations as we approach the November 2008 

reporting deadline. 

Q.2. In December 2006, three agencies, the FRB, OCC, and FDIC, 

issued final guidance highlighting the risks to banks from concentrations in commercial real estate. In issuing the guidance, the 

regulators specifically emphasized that they were not setting any 

limits on banks’ commercial real estate lending. Yet now we understand from the Comptroller of the Currency and the Chair of the 

FDIC that over a third of community banks have commercial real 

estate concentrations exceeding 300 percent of their capital. 

• Are any community banks going to fail because of their overexposure to commercial real estate, including commercial real 

estate mortgage backed securities? 

• Was it the correct policy not to set concentration limits in the 

guidance? 

• Why did the OTS decline to join in issuing the final guidance, 

even after the OTS joined in the proposed guidance? 


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• What are examiners doing when they find these levels of concentrations? 

• Are banks using off-balance sheet vehicles to invest in commercial real estate? If so, please describe. Are the regulators approving these kinds of transactions? 

A.2. While OTS has observed an increase in the commercial real 

estate portfolios at some of our institutions, we have not seen any 

indication that there is an overexposure that would result in failure, particularly at community banks. In anticipation of the risk 

associated with this type of lending, our examiners utilize both onsite and offsite monitoring of these exposures at our institutions. 

On January 4, 2006, OTS joined the Office of the Comptroller of 

the Currency, the Federal Reserve Board and the Federal Deposit 

Insurance Corporation in publishing proposed CRE guidance in the 

Federal Register for notice and comment. When the comment period ended, OTS had received approximately 1300 comment letters 

from savings associations, banks, trade associations, and individuals. 

Comments centered on three themes: the overly broad scope of 

the guidance, specifically that low risk multifamily and non-speculative construction loans be excluded from the CRE definition; the 

inappropriateness of rigid thresholds used to identify institutions 

with CRE concentrations because actual concentration risk varies 

so much with the type of CRE lending and an institution’s risk 

management practices; and the potential chilling effect of the supervisory thresholds on community banks’ lending practices. 

OTS significantly revised the Guidance to address concerns expressed through the comment process. The primary focus of the 

final Guidance issued by OTS is the expectation that savings associations actively engaged in CRE lending, especially those that are 

entering or rapidly expanding CRE lending, should: 

(1) Perform an internal self-assessment of exposure to concentration risk; continually monitor potential exposure to such risk; and 

report any such identified concentration risk to senior management 

and the board of directors; and 

(2) Implement risk management policies and procedures appropriate to the size of the portfolio, as well as the level and nature 

of concentrations and the associated risks, to monitor and manage 

those risks effectively. 

Although the guidance issued by the other Agencies contains numerical screens to be used for supervisory oversight, OTS decided 

not to include such screens in its guidance for several reasons. 

OTS’s experience recognizes that concentration risks may be 

present at levels well below the other Agencies’ thresholds. While 

savings associations are uniquely subject to a 400 percent of capital 

statutory investment limit on nonresidential real estate lending, 

through existing guidance and practice, OTS expects savings associations to continuously assess and manage concentration risk. 

OTS conducts quarterly monitoring of savings associations’ portfolio composition to assess each association’s exposure to concentration risk. Accordingly, OTS determined that inclusion of numerical 

thresholds in the guidance was unnecessary for savings associations and could result in unintended consequences and confusion in 


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the industry. On December 14, 2006, OTS issued separate CRE 

guidance to the industry it supervises. Even in the current economic environment, we continue to believe that this was the correct 

policy to establish for the thrift industry. 

Finally, OTS has not observed any institutions using off-balance 

sheet vehicles to invest in commercial real estate and have not received any applications to engage in this type transaction. 

Q.3. There was extensive conversation on what would have been 

the capital status of banks going into this crisis period had Basel 

II capital standards been in effect. Fed Vice-Chairman Kohn said 

that if, ‘‘we had the same safeguards in place, and if we started implementing in 2004 with the same safeguards that are in place in 

2008 and 2009, I do think on balance we would have been better 

off.’’ Mr. Gronstal answered differently, stating: ‘‘I think the answer to your second question is that we probably would have had 

lower dollar amounts of capital per asset, and that makes it more 

challenging to deal with issues when times get rough.’’ 

Can you explain in writing, whether you believe that banks 

would have had more or less capital in place for this current down 

turn had Basel II been implemented during the time frame that 

Vice-Chairman Kohn mentioned in his response? Can you also explain why you believe that to be the case, citing any empirical data 

on both the effects of Basel II on capital requirements and what 

we have experienced during this economic crisis, as it relates to assets? 

During the discussion of Basel II, Comptroller Dugan told the 

Committee: ‘‘The irony of this whole situation is that the very 

high—most highly rated best securities, the ones that were thought 

to be least likely to default was where all the—a huge share of the 

losses have been concentrated.’’ Given Basel II’s reliance on ratings 

of securities, does this observation give you reason for concern over 

the current Basel II structure? If so, what do you recommend be 

done; if not, why not? 

A.3. It is OTS’s view that applying the Basel II Advanced Approaches Final Rule as if it were in place going into the crisis period carries too many subjective empirical and supervisory assumptions for it to be a meaningful exercise. In fact, doing so discounts 

the critical safeguards the federal banking agencies included in the 

rule. Only in the U.S. did we include a 4-year implementation period. We include a first year parallel run, followed by 3 years with 

capital floors. At each step, a bank can only move on with supervisory approval. 

In addition, each of the agencies has committed to make necessary framework changes along the way to maintain capital levels 

commensurate with risk, to ensure safe and sound banking system. 

This is truly an evergreen rule. While developed during a benign 

economic period, the agencies have been adamant about making 

changes, as needed, to anticipate a stress period. Today banks are 

still building the framework by which they will estimate potential 

loss. We anticipate that the current experience with real stress, as 

opposed to theoretical assumptions, should yield even more rigorous loss estimates as we move through the years of implementation. Finally, the agencies have also committed to undertake a 


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study of the Advanced Approach after we obtain sufficient data 

from the parallel run period. That study will provide the basis for 

any refinements to the framework or the regulation. 

In response to questions about ratings, the agencies, as part of 

the international effort of the Basel Committee on Banking Supervision, have already begun studying the causes of and potential responses to the limitations of bank reliance on ratings, especially 

within the securitization framework. We are also nearing the time 

when the agencies will bring forward a Notice of Proposed Rulemaking to introduce a Basel II Standardized Approach to the U.S. 

In that proposal, we will specifically seek comments on use of ratings for risk-based capital purposes. 

In sum, long before any new capital framework is in place and 

fully operational for any banks or thrifts, the agencies will be able 

to assess the current crisis in hindsight, and make whatever refinements are necessary to Basel II capital standards to ensure the 

continuation of a safe and sound U.S. banking system. 

Q.4. I am concerned about the potential ramifications of the failure 

of a very large institution. Is your agency prepared today to handle 

the failure of a large systemically significant insured financial institution? What steps are you taking to prepare for this contingency? 

A.4. OTS is continually monitoring the safety and soundness of our 

largest thrift institutions by maintaining a continuous examination 

presence at these institutions. This approach allows OTS to receive 

real time information regarding the health and risk exposures of 

these institutions. OTS actively works with the FDIC to address 

any risk of failure of the institutions we supervise. In addition to 

continuing communications with the FDIC, OTS shares Thrift Financial Report data, examination data and other institution data 

with the FDIC to insure that any information that could indicate 

an increased potential for failure is analyzed in a timely manner 

and would allow sufficient opportunity for the FDIC to take necessary steps in the event of a failure. 

Q.5. Please provide comprehensive data on mortgage delinquencies, 

foreclosures, repayment plans and modifications for the mortgages 

being serviced by the institutions you regulate for the past 12 

months. Please provide this information by the following loan categories: subprime, Alt-A, and prime. Please describe the types of 

repayment plans and modifications that servicers are employing 

and the numbers of loans in each category. 

A.5. OTS, along with the other federal banking agencies, issued a 

Statement on Working with Borrowers on April 17, 2007, communicating our supervisory expectation that institutions we supervise 

work with borrowers having financial difficulty repaying their 

mortgages. Since that issuance, and as a part of our ongoing supervisory process, OTS contacted its six largest servicers in March of 

this year to establish and initiate a nationwide horizontal review 

of mortgage loan servicing data. We believe it is necessary to obtain this comprehensive mortgage data to assure that we have a 

detailed, current, and on-going picture of mortgage loan performance and loan modification efforts. 


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OTS believes it is important to obtain key mortgage performance 

metrics across a broad spectrum of products, and therefore, our 

data collection request covers mortgages held on book by savings 

associations and their subsidiaries, in addition to loans serviced for 

others. In particular, the scope of the mortgage data we are requesting is not limited to subprime mortgages serviced for mortgages in securitization pools. The mortgage data we are seeking 

uses common definitions and data elements for asset quality 

metrics (delinquency measures, foreclosures, etc.), loss and foreclosure mitigation actions taken, and segmentation by credit quality risk indicators (such as FICO scores). With this approach, we 

will have data that are consistent, comparable, and reliable. 

We also believe it is important to build upon, and not conflict 

with, the mortgage data collection efforts of the HOPE NOW Alliance, whose members constitute a broad cross-section of industry 

and community organizations working to tackle the foreclosure crisis. In order to achieve that objective, we have retained the HOPE 

NOW Alliance data aggregator, McDash Analytics, LLC, to process 

the data submissions for us. The servicers submit the requested 

data to McDash Analytics. McDash compiles the information and 

provides reports directly to the OTS. We will receive our initial 

data reports from McDash in May. 

In advance of receiving the data from each of our servicers, 

OTS’s preliminary discussions with several of our servicers indicate 

that loan workout activity at our institutions has increased dramatically over the past twelve months. The servicers indicate that 

the activity is inherently costly and does not always result in successful loan modifications. However, the public perception of the 

willingness of lenders to work with borrowers has grown, resulting 

in a much better response rate of borrowers to outreach efforts. 

Several of our servicers have indicated that early contact and 

open communications with borrowers is the most critical step in 

helping to prevent default. It allows the servicer to understand a 

borrower’s specific needs and circumstances in order to prescribe a 

viable solution. There are several approaches that are being utilized to reach out to borrowers including personalized resource 

mailings, telephone calls to delinquent borrowers, and the use of 

automated commitments to pay. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO 

FROM JOHN M. REICH 

Q.1. Although not all the items that you suggested were included 

in this package and there might need to be a few tweaks, are there 

any items in this package that your agency cannot support or are 

these all items that would increase regulatory efficiency without 

compromising safety and soundness and important consumer protections? 

A.1. Removing unnecessary regulatory obstacles that hinder customer service, innovation, competition, and performance in our financial services industry, and that also impede job creation and 

economic growth in the general economy, is an important and continuing objective of OTS. Although we have accomplished much in 

recent years to streamline and eliminate some of the burdens faced 


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by the thrift industry, there remain many other areas for improvement. OTS is committed to reducing regulatory burden wherever it 

has the ability to do so, consistent with safety and soundness and 

compliance with law, and without undue impact on existing consumer protections. We support proposed legislation that advances 

this objective. 

Q.2. Since all of these items have been vetted and reviewed in past 

hearings before the Banking Committee, is the reason to not move 

quickly forward with a package along these lines? 

A.2. OTS encourages Congress to take swift action. These issues 

have been thoroughly vetted and there is no reason not to move 

forward in a timely fashion. It is incumbent on us to remain committed to reducing regulatory burden whenever we have the ability 

to do so, consistent with safety and soundness, and without undue 

impact on existing consumer protections. OTS would strongly support proposed legislation that advances this objective. 

RESPONSE TO WRITTEN QUESTIONS OF CHAIRMAN DODD 

FROM JOANN M. JOHNSON 

Q.1. What is the extent of losses to the Share Insurance Fund in 

2007, particularly in the 4th quarter of 2007? How does that compare to previous years? To what extent do those losses result from 

those failures? 

A.1. In 2007 the National Credit Union Share Insurance Fund 

(NCUSIF) incurred charges of $40.8 million. To fund specific and 

non-specific reserves the NCUSIF expensed $186.4 million in 2007, 

with $161 million occurring in the fourth quarter. Three credit 

unions conserved in 2007 accounted for $178.2 million of total expenses. Even with the higher level of actual charges and increased 

reserve expense in 2007, the NCUSIF finished the year with a 1.29 

percent equity ratio, which closely approximates the targeted 1.30 

percent level set by the NCUA Board. 

The Table below reflects the NCUSIF’s expenses, charges, and 

reserve balance for the last 7 years. 

In millions 2001 2002 2003 2004 2005 2006 2007 

Provision for Reserve Expense ...... $0 $12.5 $38.0 ($3.4 ) $20.9 $2.5 $186.4 

Actual Charges to the NCUSIF ...... $4.7 $16.0 $8.8 $6.2 $15.6 $5.3 $40.8 

Reserve Balance ............................ $51.0 $47.5 $76.7 $67.1 $73.0 $70.2 $215.8 

As part of our continual analysis of the NCUSIF, NCUA stress 

tests the Fund under various catastrophic scenarios. The analysis 

completed in late 2007 shows the Fund performing favorably under 

the various scenarios, confirming the strength of the NCUSIF. The 

charges for 2007 are significantly below the stress levels we employ. The actual charges in 2007 are also significantly below the 

last period of significant economic downturn. The loss per thousand 

dollars of insured shares for 2007 was $0.07 versus the actual 

range from 1991–1993 of $0.42 to $0.60. 

Q.2. With respect to Norlarco, how did such a significant and problematic situation develop so quickly? Was NCUA aware of the situation, or of any warning signs, before the failure occurred? 


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A.2. The problem did not develop rapidly, but instead over approximately a 20 month time horizon, from October 2004 through June 

2006. NCUA was aware of the situation at Norlarco Credit Union, 

a state chartered institution, and were using progressive enforcement steps to resolve the problems which included documents of 

resolution, state directives, a cease and desist order, and then ultimately conservatorship. 

The FAM Program. Norlarco Credit Union had experience dealing with First American Mortgage, (FAM) a residential construction loan broker and servicer, for loans made within Colorado. 

These activities were reviewed as part of a June 2004 examination 

conducted jointly with the Colorado state regulator. When FAM 

began brokering and servicing loans in Florida, Norlarco Credit 

Union had already developed a relationship with and trust in the 

quality of services provided. With the establishment of the Florida 

program in October 2004 came a guarantee by both the homebuilder and FAM. The credit union had an understanding that the 

loans made were short term, fully guaranteed and carried a higher 

return than would be received through a similar short term investment. Actual delinquency did not begin to show in these loans until 

early 2007. 

NCUA Supervision. Annually, NCUA examines approximately 18 

percent of state chartered federally insured credit unions based on 

insurance risks. In the case of Norlarco, NCUA saw an increase in 

loan participations sold in late 2004 and that led the Agency to put 

this credit union on the 2005 examination list. In August 2005, as 

part of our work on another case, we determined that Norlarco had 

funded over 1,000 loans in Florida. During NCUA’s joint examination conducted with the Colorado state regulator in October 2005, 

we discovered that the credit union had entered into a funding 

commitment with FAM for $30 million per month. NCUA’s focused 

on improving the credit union’s risk concentration and liquidity. 

Normal monitoring in March 2006 showed improvements in liquidity after the funding agreement was ceased. NCUA performed a supervision contact in May 2006 that revealed a prevalence of maturity extensions and led to questions surrounding the builder guarantees. At that contact, NCUA directed the credit union to cease 

funding any new residential construction loans. The growth in the 

portfolio after this contact was only through loans already in the 

pipeline after the credit union was required to cease and completion of loan commitments for homes already started. 

NCUA’s February 2007 contact set in place more stringent required board actions based on the problems identified with the various contracts, FAM’s inability to honor their guarantees, the decrease in housing values in Florida, and new management’s lack of 

understanding of the program risks. NCUA also required the credit 

union to report all the loans as member business loans unless they 

could show affirmative proof that they were not investor owned 

properties. In April 2007, due to unsafe and unsound management 

practices being initiated to keep the loans artificially shown as non 

delinquent, the state issued a cease and desist order. A major component of that order was a full contract review of all participation, 

FAM, builder, and borrower contracts that had yet to be completed 

despite prior directives to do so. The preliminary review showed 


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significant risk and led to the state regulator’s conservatorship action in May 2007. As part of the conservatorship action, NCUA decided to continue funding loans till houses were complete. The rationale for doing so was the higher salability of finished homes 

versus incomplete construction loans. 

In summary, a combination of factors impacted the rapid development of the situation at Norlarco Credit Union. The credit union 

used a third party mortgage broker to originate residential construction loans (RCL) throughout the country, primarily to members in one of their two associational groups in their field of membership. By using a third party, the credit union was able to amass 

a significant portfolio in a relatively short period of time. 

The type of loan granted was often inaccurately captured in the 

RCL loan applications processed by the third party underwriter. 

Credit union management did not exercise sufficient oversight of 

the program to validate whether the loans were for an individual’s 

principal or secondary residence, or for speculative investment purposes. 

It was not until near the end of this program that the real estate 

prices in Florida experienced a dramatic and rapid decline that resulted in speculative investors defaulting on their commitments. 

Q.3. To what extent were the losses a result of member business 

lending? 

A.3. Predominantly, the Florida loans made by Norlarco Credit 

Union were presented by the mortgage broker as owner-occupied 

properties. Following NCUA’s January 2007 examination contact, 

NCUA required the credit union to report all the loans as member 

business loans proven otherwise. This resulted in approximately 

80% of the portfolio being reclassified as member business loans for 

investor properties. The loans were all for residential construction 

and not for commercial construction properties. 

Irrespective of the classification, these loans were residential 

property loans, and the collapse of the Florida real estate market 

was the largest factor in the failure. 

Q.4. In cases where the development of the concentration of highrisk assets occurs within relatively short periods—and in this situation it appears to have developed over a matter of months—how 

does NCUA respond before failures become likely? 

A.4. NCUA’s overall regulatory philosophy calls for effective not excessive regulation and supervision. Consequently, NCUA pursues a 

progressive approach to enforcement actions. NCUA balances aggressive supervision against the adverse effects on credit union innovation. Credit unions are in business to take reasonable and prudent risks in serving their members. NCUA is mindful of the need 

for vigilant supervision in the context of allowing credit unions to 

provide consumer-oriented financial services. 

During much of the Norlarco Credit Union situation, the highrisk nature of the assets was obscured by a guarantee contract, the 

short term nature of the loans, and the home value appreciation in 

the Florida market. Levels of delinquency and loan losses were 

masked by unilateral extensions made by the loan servicer, a practice that is not unusual in construction lending and were not in 

and of themselves unsafe and unsound practices. The fact that the 


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loans were primarily investor properties, and therefore at higher 

risk than the owner-occupied properties (as reported) was not uncovered by NCUA until a more detailed loan was done as part of 

an examination. 

NCUA’s initial source of information about an insured credit 

union is the quarterly call report. Review and analysis of trends 

contained in Norlarco’s Call Report established the need for the 

credit union to be part of a more stringent joint examination program, in conjunction with the state regulator. Through off-site 

monitoring NCUA increased the level of supervision over Norlarco 

Credit Union as its balance sheet, income statement and off-balance sheet commitment deteriorated. Although the institution 

failed due to a ‘‘perfect storm’’ of circumstances, it is a case where 

our off-site supervision combined with on-site examination supported the increased enforcement actions taken by both the state 

regulator and NCUA. 

The credit unions associated with the Florida loans represented 

isolated instances of credit union failing to manage a third party 

loan program that grew very quickly, resulting in a high concentration of real estate loans at a time when real estate values suffered 

a precipitous decline. NCUA issued guidance in December 2007 

and April 2008 to credit unions and field staff addressing third 

party due diligence and oversight. 

Q.5. In light of Norlarco, what new efforts is NCUA making to 

identify such credit unions with such rapidly increasing levels of 

risk? 

A.5. NCUA has intensified its review of emerging trends in credit 

union risk profiles. NCUA compiles quarterly risk reports and develops custom analysis based on aggregate trends in order to identify credit unions with increasing potential exposure. Field staff 

also regularly reviews risk reports in an effort to identify emerging 

risks in the credit unions they supervise. Changes to NCUA risk 

reports focus on growth in loan categories, share accounts, and borrowings in an effort to identify credit unions in the early stages of 

programs such as those involving the Florida loans. 

Additional emphasis is also being placed on reviewing third party 

arrangements and loan participation sales and purchases, as evidenced by recent examiner and industry guidance. 

ANTI-UNION REGULATION

Q.6. Last year, the Department of Labor issued a regulation drastically expanding the personal financial information union officers 

and employees must submit to the Department. The new LM–30 

rule will require more than 150,000 union volunteers, employees, 

and their families to report the terms of mortgages, car loans, and 

even student loans. To determine whether they must report such 

interests, these individuals must ascertain (1) whether the bank 

providing a loan does any business with the person’s union, or (2) 

whether the bank does 10 percent of its business with firms whose 

employees are in the same union. The regulation requires individuals to write to banks asking for this info, and, then, if banks won’t 

provide such information, to contact the Department of Labor for 

assistance. In the meantime, individuals are required to make good 


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faith estimates of the bank’s business with their unions and unionized firms. 

A.6. With respect to credit unions, the new LM–30 rule requires a 

labor organization (‘‘union’’) officer or employee (‘‘official’’) to report 

bona fide loans, interest or dividends that he or she receives from 

a credit union in which his or her union ‘‘is interested.’’ General Instructions for ‘‘Form LM–30 Labor Organization Officer and Employee Report’’ (‘‘Instructions’’) at 5. An official’s union ‘‘is interested’’ in a credit union if it either ‘‘created or established’’ the 

credit union or ‘‘selected or appointed’’ one or more of its directors 

AND ‘‘a primary purpose’’ of the credit union is to benefit the 

union’s members. Instructions at 13; 29 C.F.R. 404.1(j) (2008); 72 

FR 36106, 36118, 36158 (July 2, 2007). 

Our research indicates that sponsoring unions have a dominating 

‘‘interest’’ in a minimal proportion of all insured credit unions. To 

date, there are 63 union-sponsored insured credit unions (according 

to their names), which are generally quite small in terms of asset 

size. Of those, the sponsoring union can arguably be credited with 

having ‘‘created or established’’ the credit union only when the 

union is its sole sponsor (i.e., has a single common bond of association among the sponsor’s members). Similarly, the credit union can 

arguably be credited with having ‘‘a primary purpose’’ of benefiting 

the sponsoring union’s members only when the union is the credit 

union’s sole sponsor. In either case, credit union directors are never 

‘‘selected or appointed’’ by a sponsor; they are elected by the membership. The small asset size of union-sponsored credit unions suggests that the majority of union-sponsored credit unions are each 

sponsored by a single union that may have a dominating ‘‘interest’’ 

in the credit union. 

The new LM–30 rule imposes a further reporting requirement 

when the source of loans, interest or dividends received by a union 

official is a ‘‘business’’ that transacts business with a union or a 

unionized firm. The LM–30 Instruction defines a ‘‘business’’ entity 

as a ‘‘vendor of goods or provider of services’’ regardless whether 

it ‘‘employs employees or otherwise meets the definition of ‘employer’.’’ Assuming a credit union in which a union has an interest 

meets this definition of a ‘‘business,’’ a union official who is required to report credit union loans dividends and interest also must 

determine and report whether: (1) Ten percent or more of the credit 

union’s business consists of buying or selling or otherwise dealing 

with an employer whose employees are represented by the official’s 

union; or (2) Any part of the credit union’s business consists of buying, selling or otherwise dealing with the official’s union or a trust 

in which union has an interest. 

It is conceivable that a credit union would make loans, pay dividends on deposits or sell services to, or lease space from, an entity 

whose own employees are represented by the official’s union, the 

sponsoring union itself, or to a pension trust controlled by the 

union. In these instances, a union official would be subject to the 

burden of collecting information from his or her credit union, and 

reporting, about the type and extent of these transactions. As our 

answers below suggest, it would be far more practical and efficient 

for the Department of Labor to assume responsibility for collecting 

information about a credit union’s dealings with unions and unionVerDate Nov 24 2008 02:38 Mar 13, 2010 Jkt 050370 PO 00000 Frm 00333 Fmt 6602 Sfmt 6602 E:\HR\OC\A370.XXX A370

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ized firms, instead of imposing that burden on union officials who 

generally are not privy to that information. 

Q.7. Given your agency’s expertise in the regulation and practices 

of banks, do you believe that banks are able—and willing—to inform their customers whether they do business with particular 

unions and how much of their ‘‘business’’ and ‘‘business receipts’’ 

are with particular unionized firms? 

(The questions were framed in reference to banks; our answers refer to credit 

unions.) 

A.7. Credit unions may be willing to identify unions, and firms 

they know to be unionized, with whom they do business depending 

on the type of business. If the business between a credit union and 

a union or unionized firm consists of the union’s or firm’s member 

account activity (e.g., loans, deposits), a credit union would not be 

authorized to disclose that information to anyone but the union’s 

or firm’s authorized representative of record. If the business between a credit union and a union or unionized firm consists of the 

credit union’s purchase of goods or services from such a firm or the 

leasing of space from such union, a credit union would be permitted 

to disclose that information to a member upon request, but may not 

be identified by vendor. 

Q.8. Are banks obligated or prohibited by any federal or state law 

to disclose to their customers how much ‘‘business’’ or ‘‘business receipts’’ they have with particular unionized’ firms? Can banks simply refuse to answer written inquiries? 

A.8. NCUA is not aware of any Federal law that prohibits insured 

credit unions from disclosing member account information. However, Article XVI, section 2, of the Federal Credit Union Standard 

By-Laws requires credit union officials to ‘‘hold in confidence all 

transactions . . . with its members and all information respecting 

their personal affairs, except when permitted by state or federal 

law.’’ No federal law authorizes credit unions to provide a union official who is a credit union member information about the type and 

extent of business between the credit union and its union sponsor 

or a unionized firm. A credit union that would disclose such information without authorization risks developing an unwanted reputation for not holding member financial information in confidence. 

Q.9. What type of administrative burden will this LM–30 rule, and 

the hundreds of thousands of resulting inquiries, place on banks 

and banks currently prepared to respond to these inquiries? 

A.9. The administrative burden on credit unions of retrieving responsive information and responding to inquiries will depend on a 

particular credit union’s human and technological resources. A 

credit union that well-staffed and whose automated recordkeeping 

system is sophisticated will be equipped to respond in a timely 

fashion. The relatively small asset size of union-sponsored credit 

unions suggests that they would have minimal resources to devote 

to fielding members’ inquiries about the type and extent of the 

credit union’s business with unions and unionized firms. 

Q.10. If banks don’t provide this non-public information, is there 

any ‘‘information reasonably available’’ to the public that union ofVerDate Nov 24 2008 02:38 Mar 13, 2010 Jkt 050370 PO 00000 Frm 00334 Fmt 6602 Sfmt 6602 E:\HR\OC\A370.XXX A370

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ficers, employees, and members could use to make good faith estimates? 

A.10. Generalized financial data about the type and extent of credit 

union business dealings is available to a credit union’s members 

from its financial statement, annual report and quarterly Call Reports. However, this data is unsuitable for making ‘‘good faith estimates’’ of credit union’s business with unions and unionized firms 

(accounts, transactions, etc.) because it does not distinguish the 

type and extent of business transacted with such unions and firms. 

DATA ON LOAN MODIFICATION

Q.11. Please provide comprehensive data on mortgage delinquencies, foreclosures, repayment plans and modifications for the 

mortgages being serviced by the institutions you regulate for the 

past 12 months. Please provide this information by the following 

loan categories: subprime, Alt-A, and prime. Please describe the 

types of repayment plans and modifications that servicers are employing and the numbers of loans in each category. 

A.11. Credit union mortgage delinquency and foreclosures increased in 2007, but the results are consistently stronger than the 

overall mortgage industry performance. Below is the data on mortgage delinquencies for Federal Credit Unions. 

12/31/2006 12/31/2007 

1st mortgage fixed rate delinquency .............................................................................. 0.25% 0.43% 

1st mortgage adjustable rate delinquency ..................................................................... 0.23% 0.46% 

Other real estate fixed rate delinquency ........................................................................ 0.29% 0.59% 

Other real estate adjustable rate delinquency ............................................................... 0.34% 0.78% 

1st mortgage loan net loss ratio .................................................................................... 0.02% 0.02%

Other real estate net loss ratio ...................................................................................... 0.06% 0.17% 

Foreclosed real estate outstanding on balance sheet and % of outstanding RE 

Loans ........................................................................................................................... $75,008,594 

0.06% 

$162,688,249 

0.11% 

Below is the data on mortgage delinquencies for all Federally Insured Credit Unions, including federally-insured state-chartered 

credit unions who NCUA insures, but where primary regulatory responsibility lies with the state regulator. 

12/31/2006 12/31/2007 

1st mortgage fixed rate delinquency .............................................................................. 0.28% 0.48% 

1st mortgage adjustable rate delinquency ..................................................................... 0.33% 0.69% 

Other real estate fixed rate delinquency ........................................................................ 0.28% 0.67% 

Other real estate adjustable rate delinquency ............................................................... 0.36% 0.80% 

1st mortgage loan net loss ratio .................................................................................... 0.02% 0.02%

Other real estate net loss ratio ...................................................................................... 0.06% 0.19% 

Foreclosed real estate outstanding on balance sheet and % of outstanding RE 

Loans ........................................................................................................................... $164,121,956 

0.07% 

$331,862,670 

0.12% 

NCUA does not gather information regarding repayment plans or 

modifications for mortgages serviced by credit unions, or categorize 

mortgage loans by subprime, Alt-A, or Prime. NCUA is presently 

reviewing the mortgage and other lending data we gather and are 

considering making changes to gather additional information as appropriate. 


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RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO 

FROM JOANN M. JOHNSON 

Q.1. Although not all the items that you suggested were included 

in this package and there might need to be a few tweaks, are there 

any items in this package that your agency cannot support or are 

these all items that would increase regulatory efficiency without 

compromising safety and soundness and important consumer protections? 

A.1. The credit union-related items contained in the regulatory relief amendment referenced are appropriate and would be subject to 

NCUA regulatory and supervisory oversight if enacted into law. 

Q.2. Since all of these items have been vetted and reviewed in past 

hearings before the banking committee, is there any reason to not 

move quickly forward with a package along these lines? 

A.2. NCUA supports the prompt passage of the regulatory relief 

amendment contemplated by Senator Crapo. 

RESPONSE TO WRITTEN QUESTIONS OF CHAIRMAN DODD 

FROM DONALD L. KOHN 

ANTI-UNION REGULATION

Last year, the Department of Labor issued a regulation drastically expanding the personal financial information union officers 

and employees must submit to the Department. The new LM–30 

rule will require more than 150,000 union volunteers, employees, 

and their families to report the terms of mortgages, car loans, and 

even student loans. To determine whether they must report such 

interests, these individuals must ascertain (1) whether the bank 

providing a loan does any business with the person’s union, or (2) 

whether the bank does 10 percent of its business with firms whose 

employees are in the same union. The regulation requires individuals to write to banks asking for this info, and, then, if banks won’t 

provide such information, to contact the Department of Labor for 

assistance. In the meantime, individuals are required to make good 

faith estimates of the bank’s business with their unions and unionized firms. 

Q.1. Given your agency’s expertise in the regulation and practices 

of banks, do you believe that banks are able—and willing—to inform their customers whether they do business with particular 

unions and how much of their ‘‘business’’ and ‘‘business receipts’’ 

are with particular unionized firms? 

A.1. Pursuant to section 326 of the USA PATRIOT Act, all banks 

are required to have and maintain a written customer identification program (CIP) that is designed to allow the bank to form a 

reasonable belief as to the true identity of the bank’s customers. 

See 31 U.S.C. 5318(1); 12 C.F.R. 208.63(b)(2). In addition, banks 

often track the type and amount of business relationships they 

have with particular individuals or businesses for their own business or risk-management purposes or for supervisory purposes 

(e.g., to monitor the amount of ‘‘covered transactions’’ with affiliates 

to ensure compliance with section 23A of the Federal Reserve Act, 

12 U.S.C. 371c). 


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Banks should be able to identify whether they have a customer 

relationship with a particular union, union member or business entity. It is unlikely, however, that a bank would have reason to 

know what (if any) labor organizations represent the employees of 

an unaffiliated business customer. 

Typically, banks consider both the identity of their customers 

and the amount of business they receive from particular customers 

as confidential and proprietary. The federal securities laws, however, require a publicly traded company to disclose in its annual report on Form 10–K the name of any customer if (i) sales to the customer represent 10 percent or more of the public company’s consolidated revenues, and (ii) the loss of the customer would have a material adverse effect on the public company and its subsidiaries 

taken as a whole. See SEC Form 10–K, Part I, Item 1; Regulation 

S-K, 17 C.F.R. 229.101. Thus, if a bank is, or is part of, a publicly 

traded company and its relationships with a particular firm 

(whether unionized or not) met these thresholds, the bank or its 

parent company would have to disclose the name of the firm and 

its relationships with the bank or parent company in its annual filing with the Securities and Exchange Commission. 

Q.2. Are banks obligated or prohibited by any federal or state law 

to disclose to their customers how much ‘‘business’’ or ‘‘business receipts’’ they have with particular unionized firms? 

A.2. Other than the provisions of the federal securities laws noted 

above, I am not aware of any federal law that would as a general 

matter obligate or prohibit a bank from disclosing to a union official the amount of business that the bank receives from a particular business entity. For example, the privacy provisions of the 

Gramm-Leach-Bliley Act would not apply in the situation you describe because a unionized firm likely would not be a ‘‘consumer’’ 

for purposes of these provisions. See 12 C.F.R. 216.3(e)(1) (defining 

a ‘‘consumer’’ as an individual who has obtained a financial product 

or service for personal, household or family purposes). Similarly, 

the Right to Financial Privacy Act (12 U.S.C. 3401 et seq.) applies 

only to the provision of financial information to the U.S. government regarding individuals or partnerships comprised of five or few 

individuals. See 12 U.S.C. 3401(4) and (5). I understand that the 

Department of Labor’s Form LM–30 and related rules also do not 

obligate a bank to disclose to a union official the amount of business the bank has with a unionized firm. 

The terms of a bank’s agreement with a customer or applicable 

state law may restrict the ability of a bank to disclose information 

about a particular customer’s business with the bank to another 

customer. 

Q.3. What type of administrative burden will this LM–30 rule, and 

the hundreds of thousands of resulting inquiries, place on banks 

and are banks currently prepared to respond to these inquiries? 

A.3. The revised Form LM–30 was adopted by the Department of 

Labor in August 2007, and a covered individual is required to file 

the revised Form LM–30 for any fiscal year of the individual that 

begins on or after August 16, 2007. Because many covered individuals use the calendar year as their fiscal year, many individuals 

will not have to file a revised Form LM–30 until after December 


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31, 2008. Accordingly, it is too soon to tell how many inquiries 

banks may receive related to the revised form and the ability of 

banks to handle these inquiries. 

Q.4. If banks don’t provide this non-public information, is there 

any ‘‘information reasonably available’’ to the public that union officers, employees, and members could use to make good faith estimates? 

A.4. As noted above, the federal securities laws require public companies to annually disclose the name of any customer if sales to the 

customer represent 10 percent or more of the public company’s consolidated revenues and the loss of the customer would have a material adverse effect on the public company and its subsidiaries taken 

as a whole. 

COMMERCIAL REAL ESTATE

In December 2006, three agencies, the FRB, OCC and FDIC, 

issued final guidance highlighting the risks to banks from concentrations in commercial real estate. In issuing the guidance, the 

regulators specifically emphasized that they were not setting any 

limits on banks’ commercial real estate lending. Yet now we understand from the Comptroller of the Currency and the Chair of the 

FDIC that over a third of community banks have commercial real 

estate concentrations exceeding 300 percent of their capital. 

Q.5. Are any community banks going to fail because of their overexposure to commercial real estate, including commercial real estate mortgage backed securities? 

A.5. On the whole, community banks entered the current period of 

financial stress with strong capital ratios. Moreover, most community banks maintain manageable exposures to commercial real estate and continue to perform well. However, some institutions have 

recently begun to face financial difficulties related to overexposure 

to commercial real estate. These difficulties could be exacerbated 

by weakening economic fundamentals and deterioration of the commercial real estate market and a very small number of these banks 

will likely fail. However, while it appears that we may be entering 

a period when we could experience a higher level of bank failures 

than we have seen in the recent past, it is important to note that 

an increase in the rate of failures from its historically low level 

would not call into question the fundamental safety and soundness 

of the overwhelming majority of community banks. 

Q.6. Was it the correct policy not to set concentration limits in the 

guidance? 

A.6. I believe it was correct. Numerical limits could deprive creditworthy borrowers of loans and banks of sound and profitable lending opportunities. Further, they can provide banks a false sense of 

security that inhibits appropriate risk management activities when 

their concentrations fall below the stated limits. For supervisors, 

the issue was whether banks’ risk management practices were adequate to manage the CRE concentration risks. As past market cycles have shown, banks with high CRE concentrations that have 

strong risk management practices are better prepared to respond 

to deterioration in market conditions, minimizing their losses. 


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The primary message of the CRE concentration guidance was a 

reminder to banks on the importance of sound risk management 

practices when a bank has a CRE concentration or is growing its 

CRE lending activity. While the guidance contained broad numeric 

screens to identify banks with potential CRE concentration risk, 

the criteria is not viewed as a safe harbor. There may be instances 

when a bank’s risk management systems will be identified for further supervisory analysis when concentration levels are below the 

criteria, based on factors such as weaknesses in CRE loan underwriting, concentrations in specific CRE lending activity or geographic markets, or rapid growth. Indeed, the risk profile of banks 

identified with CRE concentrations can differ substantially depending on the bank’s specific risk management practices. Therefore, 

the intent of the screens is to encourage a dialogue between the examiners and an institution’s management about the level and nature of CRE concentration risk. The absence of a specific limit or 

limits on CRE lending does not present a barrier to our examiners 

in addressing CRE concentration risk at a particular bank. 

Q.7. What are examiners doing when they find these levels of concentrations? 

A.7. Examiners review a bank’s CRE concentration from a risk-focused perspective. In evaluating the presence of any CRE concentration risk, examiners review the bank’s CRE portfolio, considering diversification across property types, geographic dispersion, 

underwriting standards, level of pre-sold or other types of take-out 

commitments on construction loans, and liquidity. 

An examiner will assess the effectiveness of a bank’s risk management practices, including: strategic plans, board and management oversight, lending policies, credit administration, market 

analysis, management information systems and reports, and portfolio level analyses (e.g., stress testing and scenario analysis). To 

support the overall assessment of a bank’s CRE lending activity 

and loan portfolio, examiners perform transaction level testing of 

individual credits and identify any specific weaknesses in underwriting practices. When weaknesses are identified, we expect the 

bank to improve its risk management practices as discussed in the 

CRE concentration guidance and we will monitor the bank’s 

progress for addressing weaknesses. 

Board and Reserve Bank staff have identified and are closely 

monitoring state member banks at risk for deterioration due to 

CRE exposures and concentration levels. Based on this priority, examiners will be conducting targeted, on-site reviews of the bank’s 

CRE loan portfolio, the adequacy of loan loss reserves, and an assessment of the bank’s reliance on CRE lending for revenue and future earnings. Supervision staff is also enhancing the off-site monitoring of banks with high CRE concentrations, particularly those 

banks that experienced a recent supervisory rating downgrade. Finally, the Federal Reserve has been conducting specific examiner 

training on the CRE concentration guidance at each Reserve Bank, 

focusing on the key elements of sound risk management practices 

and prudent underwriting practices for CRE lending. 


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Q.8. What off-balance sheet vehicles are banks using to invest in 

commercial real estate? Are the regulators approving these kinds 

of transactions? 

A.8. With reference to commercial real estate activity, large institutions are primarily using off-balance sheet vehicles to structure and 

distribute commercial mortgage backed securities (CMBS), not to 

make investments. Investments in CMBS and retained 

securitization exposures are typically held on balance sheet. CMBS 

issuance in the market grew substantially in the past several years 

as institutions made greater use of the ‘‘originate-to-distribute’’ 

business model. The 2007 U.S. CMBS issuance of approximately 

$200 billion closely matched 2006 activity, despite a substantial 

drop in volume in the second half of the year. This year, the volume of U.S. CMBS issuance has declined significantly as investors 

have become much more cautious. 

Examiners do not approve specific CMBS transactions, but they 

do closely monitor regulated institutions’ CMBS risk management 

practices in order to assess their ability to manage the risks associated with both issuances and investments. The sophistication of an 

institution’s CMBS risk management practices should be commensurate with the nature and volume of its activity. An institution 

with significant CMBS activity would be expected to have a comprehensive, formal strategy for managing risks, including contingency plans to respond to a reduced market demand that might 

make it difficult to securitize loans being warehoused on the bank’s 

balance sheet. Currently, Federal Reserve examiners are reviewing 

the pricing and valuation processes of several large institutions to 

ascertain whether their processes are in line with our safety and 

soundness expectations. Given the current market turbulence, 

some of these assets have become more difficult to value precisely, 

but preliminary observations suggest that institutions have been 

diligent in fairly valuing these securities. 

DISCOUNT WINDOW

Governor Kohn at the hearing on March 4th, I asked you about 

your thoughts on opening the Fed’s discount window lending to 

non-banks. You responded: ‘‘So Congress saw this as an emergency 

very, very unusual situation that they did not want us using. I 

would be very cautious about opening that window up more generally. I think the banks have access to the discount window but 

the quid pro quo, in some sense, or the control—there is a moral 

hazard issue here, having them have access. And the control on 

that is this panel, right? You have an extensive amount of bank examination supervision. You have constricted their activities in a 

number of ways relative to investment banks. I do not think that 

liquidity is the problem for the investment banks, or liquidity is the 

issue behind restarting these markets right now.’’ 

In the subsequent weeks, one major investment bank failed due 

to liquidity problems and the Federal Reserve Board of Governors 

voted to authorize lending from the discount window to investment 

banks. 

Q.9. Vice-Chairman Kohn, in light of the recent facts, can you explain your answer that liquidity was not the problem for investVerDate Nov 24 2008 02:38 Mar 13, 2010 Jkt 050370 PO 00000 Frm 00340 Fmt 6602 Sfmt 6602 E:\HR\OC\A370.XXX A370

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ment banks? Further, can you please inform the Committee what, 

if any, supervisory measures the Board has implemented with respect to investment banks’ ability to access the discount window? 

What additional measures would be appropriate, and does the 

Board need additional authority to implement such measures? 

A.9. When I testified on March 4, financial markets were severely 

strained and liquidity pressures were clearly evident in uncollateralized wholesale funding markets. Nonetheless, investment banks 

had been able to manage reasonably well to that point, largely because they relied heavily on secured funding against high quality 

collateral in repo markets. Historically, borrowing against high 

quality collateral in the repo market has been a stable and reliable 

funding source for investment banks and other financial firms. In 

mid-March, however, these markets came under intense pressure 

as lenders came to question the value of collateral they were accepting in repo transactions and also became very concerned about 

counterparty credit risk. Many lenders applied higher haircuts on 

the collateral taken in repo transactions, and pulled back from 

lending to particular counterparties altogether. In response to 

these unusual and exigent circumstances, the Federal Reserve exercised the emergency authorities I discussed with you at the hearing to establish two facilities—the Primary Dealer Credit Facility 

(PDCF) and the Term Securities Lending Facility (TSLF)-aimed at 

supporting the liquidity of primary dealers and, indirectly, the liquidity of the broader financial markets. In addition, the Federal 

Reserve judged it appropriate to provide funding to Bear Stearns 

to prevent a disorderly failure that likely would have had significantly adverse consequences for our financial system and economy. 

All the primary dealers eligible to borrow from the Federal Reserve under the PDCF or to transact with the Federal Reserve 

under the TSLF are subject to supervision and regulation by the 

SEC. In addition, the parent companies of nearly all of these primary dealers are subject to consolidated supervision—either by the 

Federal Reserve in the case of dealers that are owned by a U.S. 

bank holding company, a foreign bank supervisory agency in the 

case of dealers that are owned by a foreign bank, or the SEC in 

the case of dealers that are not affiliated with banks. While the 

special lending facilities for primary dealers are in place, the Federal Reserve is working closely with the SEC to ensure that we 

have access to necessary supervisory information, and this coordination has been very effective. 

Q.10. Vice-Chairman Kohn, you also said: ‘‘I do not think opening 

up credit to the investment banks will really be that helpful in the 

end and could carry some very major costs.’’ You subsequently 

voted to do just that. Can you please explain whether the Fed’s action was helpful in the end? What costs came along with the action? And how is the Fed making sure that the taxpayer will not 

bear any costs associated with any of the Fed’s recent actions? 

A.10. The Federal Reserve’s actions were essential to avert a financial crisis that likely would have had serious repercussions for the 

U.S. economy. Had Bear Stearns defaulted on its obligations, already disrupted financial markets would have been thrown into 

further turmoil, prices in key markets would have been affected as 


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counterparties scrambled to lower risk, and the viability of other 

dealers would have been called into question. The actions we took 

do have the potential to exacerbate moral hazard; that is, that the 

incentives for primary dealers and their investors to effectively 

manage their liquidity risks could be weakened to the extent that 

they expect the Federal Reserve to establish emergency lending facilities in any future financial crisis. Although the potential for 

moral hazard should be carefully analyzed and considered by policymakers, it seems more likely that the example of Bear Stearns— 

in which shareholders and management suffered considerable 

losses—and the broader distress in financial markets will serve as 

a potent reminder to primary dealers and other leveraged market 

participants about the importance of prudent liquidity risk management. In particular, in developing their liquidity management 

plans, primary dealers and others must now attach considerable 

weight to scenarios in which their access to funding in the repo 

market is sharply curtailed. Of course, the Federal Reserve, the 

SEC, and other regulatory agencies will be working to reinforce 

that message. 

As to the potential for taxpayer losses associated with the Federal Reserve’s recent actions, all credit extended to primary dealers 

under the PDCF and all transactions with primary dealers under 

the TSLF are fully secured by investment-grade securities with 

ample haircuts applied to market valuations. In addition, the 

March 14 loan to Bear Stearns was repaid on March 17 without 

loss to the taxpayer. There are also substantial protections for taxpayers associated with the prospective $29 billion extension of credit by the Federal Reserve to be made in connection with the acquisition of Bear Stearns by JPMorgan Chase & Co. The collateral for 

the loan will be in the form of investment-grade securities and performing credit facilities, JPMorgan Chase will bear the first $1 billion of losses on the collateral pool, the Federal Reserve will be able 

to liquidate the collateral over a long-term horizon, and we have 

hired a professional independent investment adviser to manage the 

collateral pool so as to maximize the returns to the Federal Reserve 

and the taxpayer. 

BASEL II

There was extensive conversation on what would have been the 

capital status of banks going into this crisis period had Basel II 

capital standards been in effect. Fed Vice-Chairman Kohn said that 

if, ‘‘we had the same safeguards in place, and if we started implementing in 2004 with the same safeguards that are in place in 

2008 and 2009, I do think on balance we would have been better 

off.’’ Mr. Gronstal answered differently, stating: ‘‘I think the answer to your second question is that we probably would have had 

lower dollar amounts of capital per asset, and that makes it more 

challenging to deal with issues when times get rough.’’ 

Q.11. Can you explain in writing, whether you believe that banks 

would have had more or less capital in place for this current down 

turn had Basel II been implemented during the time frame that 

Vice-Chairman Kohn mentioned in his response? Can you also explain why you believe that to be the case, citing any empirical data 


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on both the effects of Basel II on capital requirements and what 

we have experienced during this economic crisis, as it relates to assets? 

A.11. The Basel II framework is designed to more closely align regulatory capital requirements with actual risks and to further 

strengthen banking organizations’ risk-management practices. 

While it is difficult to quantify the level of capital banks would 

have had in place in 2007 if they had implemented Basel II in 

2004, Basel II implementation would have placed banks in a 

stronger position by requiring them to institute more robust risk 

management practices that kept pace with changes in financial 

markets and business models. The system and infrastructure requirements under Basel II may have provided banks better and 

timelier access to important data as well as to validated measures 

of risk. 

The Basel II framework requires banks to develop robust data 

series on defaults, losses and recoveries that include an economic 

downturn. These data inputs are filtered through a prudential capital framework specified by supervisors, and which requires consideration of how exposures will perform during economic downturn 

conditions. This will induce a major upgrade in banks’ risk management systems which, had these enhancements been achieved 

before the crisis, would have helped put banks on a more sound 

footing. Banks will only be able to use their internal measures of 

risk for regulatory capital requirements after rigorous supervisory 

review; the use of transitional safeguards during the first years of 

Basel II implementation will help ensure there are no sudden 

drops in capital levels and that bank inputs are robust. 

In addition, Basel II reduces incentives for regulatory capital arbitrage and includes enhanced public disclosure requirements. The 

greater transparency provided by the disclosure requirements creates more opportunities for market discipline to foster best practices in the banking industry. Banks also are required to assess the 

capital needed to support their overall risk profiles including liquidity and reputational risk which have been significant in the 

current turmoil. Taken together, the three pillars of Basel II (minimum capital, risk management and supervisory oversight, and 

market transparency) strengthen capital regulation by providing 

multiple perspectives on banks’ risk and the adequacy of their capital cushions. 

Q.12. During the discussion of Basel II, Comptroller Dugan told 

the Committee: ‘‘The irony of this whole situation is that the very 

high—most highly rated best securities, the ones that were thought 

to be least likely to default was where all the—a huge share of the 

losses have been concentrated.’’ Given Basel II’s reliance on ratings 

of securities, does this observation give you reason for concern over 

the current Basel II structure? If so, what do you recommend be 

done; if not, why not? 

A.12. The Basel Committee has committed to adjust the Basel II 

capital requirements in light of recent market events. Specifically, 

the Basel Committee is, among other things, revising the capital 

treatments for re-securitizations, liquidity facilities to ABCP conduits, CDO securities, and securitizations in the trading book, as 


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well as for default and event risk. The Federal Reserve strongly 

supports and is actively participating in reassessment of the regulatory capital requirements for securitization exposures under the 

Basel II framework and making any adjustments that may be appropriate. Consistent with the recommendations of the President’s 

Working Group on Financial Markets, U.S. authorities are also reviewing their use of credit ratings in regulations. 

TOO BIG TO FAIL

Q.13. I am concerned about the potential ramifications of the failure of a very large institution. Is your agency prepared today to 

handle the failure of a large systemically significant insured financial institution? What steps are you taking to prepare for this contingency? 

A.13. For several years, the Federal Reserve has been working 

closely with the FDIC and other relevant supervisors to examine 

and understand the issues that would be associated with the resolution of a large insured bank, and to explore options for resolving 

these issues to prepare for such a contingency. These efforts have 

involved, among other things, numerous meetings and exchanges of 

information with the FDIC as well as with the Department of the 

Treasury, including the OCC and OTS. These discussions have focused on how a least cost resolution could be implemented for a 

large insured bank, and how moral hazard could be minimized if 

a determination were made, in accordance with the requirements 

of the Federal Deposit Insurance Act, to invoke the so-called systemic risk exception to the least cost requirement. In addition, the 

Federal Reserve has worked with the FDIC and Department of the 

Treasury to develop a protocol describing the general types of information that would be useful to the agencies in considering whether 

to recommend that the systemic risk exception be invoked in a particular instance, and we have that protocol in place today. These 

efforts and others, such as simulation exercises, will continue to enhance the Federal Reserve’s contingency planning for the resolution of a large, systemically significant insured bank. 

Moreover, the Federal Reserve worked cooperatively with the 

FDIC, OCC and OTS to develop a new memorandum of understanding describing the situations under which the FDIC would 

have access to information at an insured depository institution 

prior to failure to facilitate appropriate contingency planning and 

prepare for the possible processing of deposit insurance claims. To 

further improve the FDIC’s ability to plan for and handle a large 

bank resolution, the Federal Reserve continues to support the 

FDIC’s ongoing rulemaking efforts to address, in advance of a large 

bank failure, resolutions issues such as streamlining the claims 

process and clarifying how sweep accounts will be handled in a resolution. 

In addition to these domestic efforts, the Federal Reserve has 

participated on numerous international groups, sponsored by the 

Basel Committee on Banking Supervision (BCBS), the Financial 

Stability Forum (FSF), and the Governors of the G–10 central 

banks, to explore issues related to the failure of a large, internationally active bank. 


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DATA ON LOAN MODIFICATION

Q.14. Please provide comprehensive data on mortgage delinquencies, foreclosures, repayment plans and modifications for the 

mortgages being serviced in the institutions you regulate for the 

past 12 months. Please provide this information by the following 

loan categories: subprime, Alt-A, and prime. Please describe the 

types of repayment plans and modifications that servicers are employing and the numbers of loans in each category. 

A.14. The Federal Reserve Board (the Board) collects extensive 

data on mortgages, however, institutions’ regulatory filings do not 

require a breakdown of mortgage exposure based on categories 

such as prime, subprime, or alt-A. These terms are not uniformly 

defined across banking organizations. To respond to the question, 

the Board has compiled information available from its supervisory 

activities and has surveyed a number of supervised institutions. 

These institutions are both state member banks and non-bank subsidiaries of bank holding companies, which are not supervised by 

the other agencies. The institutions were chosen based on the size 

of their mortgage servicing portfolios, with the nine largest 

servicers selected. Together, these institutions’ servicing portfolios 

represent a significant portion of mortgage loans serviced by entities directly supervised by the Federal Reserve. The data have been 

provided directly from supervised institutions without examiner 

validation and should be used for informational purposes only. 

Discussion of loss mitigation strategies 

The surveyed lenders employ a range of loss mitigation strategies 

including modifications, repayment plans, forbearance agreements, 

deed-in-lieu transactions, and short sales. Below is a brief discussion of each of these strategies, as described by the surveyed lenders. 

• Modification plans change the terms of the note, including reducing the interest rate, conversion from an adjustable rate to 

a fixed rate, deferring payments, waiving a portion of the 

amount due, capitalization of past due amounts, or extension 

of the maturity date. Lenders provide both permanent and 

temporary modifications depending on specific borrower circumstances. A temporary modification can be made permanent 

at any time if the situation changes. Approval is usually subject to verification of income, assets and liabilities. Lenders report that the verification process is typically the most time consuming part of helping troubled borrowers. Upon receipt of the 

appropriate verifications, modifications are usually processed 

in about two weeks. 

• Repayment plans are often employed when it is necessary for 

the customer to demonstrate the willingness and ability to pay 

a reduced amount after a period of sporadic payment history 

prior to completion of a more permanent modification. These 

types of repayment plans are generally less formal in nature 

in anticipation of a more formal written modification. 


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• Forbearance agreements are generally drafted after a foreclosure action has commenced and have specific terms and 

timeframes. 

• Deed-in-lieu of foreclosures and short sales terminate the borrower’s ownership of the property without the expense and 

time consumption of a formal foreclosure process and are negotiated transactions between the borrower and the lender. In a 

deed-in-lieu of foreclosure, the borrower turns over the deed to 

the lender. Settlement terms for any deficiency amount are negotiated on a case-by-case basis. In a short sale transaction, 

the borrower agrees to sell the property to a third party but 

the proceeds are not sufficient to fully repay the debt and settlement of any unpaid balance is negotiated on a case-by-case 

basis. 

Discussion of the data 

The surveyed institutions were asked to provide information 

using defined credit score ranges. These ranges are believed to be 

consistent with those used by the other agencies in their response 

to this request and are consistent with the loan modification reporting standards used by the HOPE NOW alliance and other data 

collection services. The lenders who participated in the survey provided data for the six month period beginning October 2007 and 

ending March 2008. The lenders reported servicing more than $400 

billion of loans to over 3.3 million borrowers. During the survey period, the dollar amount of loans originated with credit scores less 

than 620, as well as loans originated with credit scores between 

620 and 660, each represented about 10 percent of the total dollar 

volume of surveyed loans. Loans originated with credit scores 

greater than 660 represented over two thirds of the portfolio, and 

the remaining amount was originated using a methodology other 

than a reported credit score. The attached tables present the data 

provided by the lenders and detail information by both dollar 

amount and by number of borrowers. As mentioned, the tables are 

further segmented by credit score and provide detailed information, 

by month, on current loans, delinquent loans, and foreclosure 

starts, as well as information on loss mitigation and loan modification activities. 


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RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO 

FROM DONALD L. KOHN 

Q.1. Although not all the items that you suggested were included 

in this package and there might need to be a few tweaks, are there 

any items in this package that your agency cannot support or are 

these all items that would increase regulatory efficiency without 

compromising safety and soundness and important consumer protections? 

A.1. As you know, the Board has worked closely with your office, 

other members of Congress and supervisors, banking organizations 

and consumer organizations to develop numerous regulatory relief 

amendments. Many of the amendments supported by the Board 

were included in the Financial Services Regulatory Relief Act of 

2006 (FSRRA), of which you were a chief sponsor. At your request, 

the Board in November 2007 also provided you with three new regulatory relief amendments as well as a technical amendment. 

One of the Board’s priority regulatory relief items which was not 

enacted as part of FSRRA is included as section 17 of the package 

you introduced. This amendment would promote efficiency in our 

financial system by repealing the provisions in current law that 

prohibit depository institutions from paying interest on demand deposits. The Board continues to strongly support this amendment. 

The amendments included in your package also would remove 

the provisions in FSRRA that delay, until October 1, 2011, the effective date of the amendments in that act that provide the Federal 

Reserve both the ability to pay interest on balances held by depository institutions at a Reserve Bank and greater flexibility in setting reserve requirements. Having the ability to implement these 

authorities more promptly if appropriate would be beneficial. 

The Board continues to have concerns with the amendment included as section 5, which would raise, from $500 million to $1 billion, the asset threshold below which an insured depository institution may qualify for an extended 18–month examination cycle. The 

Board has not taken a position on the other amendments included 

in your package. 

Q.2. Since all of these items have been vetted and reviewed in past 

hearings before the Banking Committee, is there any reason to not 

move quickly forward with a package along these lines? 

A.2. The Board strongly supports efforts by Congress to identify 

those provisions of the federal banking laws that may be removed 

or modified without undermining the important public policy goals 

of financial regulation, including the safety and soundness of banking organizations, financial stability, and consumer protection. The 

Board and its staff would be pleased to work with you as you and 

your colleagues move forward in developing appropriate regulatory 

relief legislation. 


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RESPONSE TO WRITTEN QUESTIONS OF CHAIRMAN DODD 

FROM THOMAS B. GRONSTAL 

BASEL II QUESTION FOR THE FDIC, FED, OCC, OTS, CSBS

Q.1. There was extensive conversation on what would have been 

the capital status of banks going into this crisis period had Basel 

II capital standards been in effect. Fed Vice-Chairman Kohn said 

that if, ‘‘we had the same safeguards in place, and if we started implementing in 2004 with the same safeguards that are in place in 

2008 and 2009, I do think on balance we would have been better 

off.’’ Mr. Gronstal answered differently, stating: ‘‘I think the answer to your second question is that we probably would have had 

lower dollar amounts of capital per asset, and that makes it more 

challenging to deal with issues when times get rough.’’ 

Can each of you explain in writing, whether you believe that 

banks would have had more or less capital in place for this current 

down turn, had Basel II been implemented during the time frame 

that Vice-Chairman Kohn mentioned in his response. Can you also 

explain why you believe that to be the case, citing any empirical 

data on both the effects of Basel II on capital requirements and 

what we have experienced during this economic crisis, as it relates 

to assets. 

During the discussion of Basel II, Comptroller Dugan told the 

Committee: ‘‘The irony of this whole situation is that the very 

high—most highly rated best securities, the ones that were thought 

to be least likely to default was where all the—a huge share of the 

losses have been concentrated.’’ Given Basel II’s reliance on ratings 

of securities, does this observation give you reason for concern over 

the current Basel II structure? If so, what do you recommend be 

done; if not, why not? 

A.1. The models and assumptions which drive the calculation of 

capital under Basel II were developed during a period of extraordinary economic growth and asset value appreciation. Given the 

historic low level of risk for residential mortgage loans, it is highly 

likely that most models would generate a lower level of required 

capital. The data from QIS–4 revealed significant declines in minimum required capital for residential mortgages and home equity 

lines of credit. Obviously, these asset categories have become a tremendous source of loss for the financial system. The only asset category to see an increase in capital allocation in QIS–4 was credit 

cards. Without the ability to detect and measure soft information 

impacting credit quality (i.e. changes in underwriting practices), it 

is likely that Basel II banks would be holding less capital heading 

into the current economic environment. 

Basel II must be re-evaluated in the context of the current market. The current crisis has challenged our long-held assumptions on 

the safety of residential mortgage loans and the reliance on the 

judgment of rating agencies. We can and should apply these lessons to other asset categories. One of the lessons learned from this 

crisis should be the importance and necessity of a minimum leverage ratio as part of our capital rules. 


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353 

DATA ON LOAN MODIFICATION

Q.2. Please provide comprehensive data on mortgage delinquencies, 

foreclosures, repayment plans and modifications for the mortgages 

being serviced by the institutions you regulate for the past 12 

months. Please provide this information by the following loan categories: subprime, Alt-A, and prime. Please describe the types of 

repayment plans and modifications that servicers are employing 

and the numbers of loans in each category. 

A.2. As we discussed in testimony, working through a joint initiative with the state attorneys general, we are collecting loan modification data from 13 subprime servicers. The last report was 

issued in April. A copy is included as part of our response. 


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