S. HRG. 111–8 

MODERNIZING AMERICA’S FINANCIAL 

REGULATORY STRUCTURE 

HEARING 

BEFORE THE

CONGRESSIONAL OVERSIGHT PANEL 

ONE HUNDRED ELEVENTH CONGRESS 

FIRST SESSION 

JANUARY 14, 2009 

Printed for the use of the Congressional Oversight Panel 

( 


SMARTINEZ on PROD1PC64 with HEARING
MODERNIZING AMERICA’S FINANCIAL REGULATORY STRUCTURE 


SMARTINEZ on PROD1PC64 with HEARING
U.S. GOVERNMENT PRINTING OFFICE

WASHINGTON : 

For sale by the Superintendent of Documents, U.S. Government Printing Office

Internet: bookstore.gpo.gov Phone: toll free (866) 512–1800; DC area (202) 512–1800

Fax: (202) 512–2104 Mail: Stop IDCC, Washington, DC 20402–0001

47–928 2009

S. HRG. 111–8 

MODERNIZING AMERICA’S FINANCIAL 

REGULATORY STRUCTURE 

HEARING 

BEFORE THE

CONGRESSIONAL OVERSIGHT PANEL 

ONE HUNDRED ELEVENTH CONGRESS 

FIRST SESSION 

JANUARY 14, 2009 

Printed for the use of the Congressional Oversight Panel 

( 


SMARTINEZ on PROD1PC64 with HEARING
(II) 

CONGRESSIONAL OVERSIGHT PANEL 

PANEL MEMBERS

ELIZABETH WARREN, Chair 

SEN. JOHN SUNUNU

REP. JEB HENSARLING

RICHARD H. NEIMAN

DAMON SILVERS


SMARTINEZ on PROD1PC64 with HEARING
(III) 

C O N T E N T S 

Page 

Opening statement of Professor Elizabeth Warren .............................................. 1 

Statement of Hon. Jeb Hensarling, U.S. Representative from the State of 

Texas ..................................................................................................................... 2 

Statement of Mr. Damon Silvers ............................................................................ 4 

Statement of Hon. John Sununu, U.S. Senator from the State of New Hampshire ....................................................................................................................... 5 

Statement of Mr. Richard Neiman ......................................................................... 7 

Statement of Mr. Gene Dodaro, Acting Comptroller General of the United 

States Government Accountability Office; accompanied by Mr. Richard J. 

Hillman and Ms. Orice M. Williams ................................................................... 8 

Statement of Ms. Sarah Bloom Raskin, Commissioner, Maryland Office of 

Financial Regulation ............................................................................................ 49 

Response to written question submitted by: Damon Silvers ................................ 70 

Statement of Mr. Joel Seligman, President, University of Rochester ................. 72 

Statement of Dr. Robert Shiller, Arthur M. Okun Professor of Economics, 

Yale University ..................................................................................................... 84 

Statement of Dr. Joseph E. Stiglitz, University Professor, Columbia Business 

School .................................................................................................................... 89 

Statement of Mr. Marc Sumerlin, Managing Director and Co-Founder, The 

Lindsey Group ...................................................................................................... 120 

WITNESS LIST 

Panel One: 

Gene L. Dodaro, Acting Comptroller General of the United States, Government Accountability Office; accompanied by: Richard J. Hillman, 

Managing Director, Financial Markets and Community Investment 

Team, Government Accountability Office, and Orice M. Williams, Director, Financial Markets and Community Investment Team, Government 

Accountability Office ..................................................................................... 8 

Panel Two: 

Sarah Bloom Raskin, Commissioner, Maryland Office of Financial Regulation .............................................................................................................. 49 

Joel Seligman, President, University of Rochester ........................................ 72 

Robert J. Shiller, Ph.D., Arthur M. Okun Professor of Economics, Yale 

University ...................................................................................................... 84 

Joseph E. Stiglitz, Ph.D., University Professor, Columbia Business 

School ............................................................................................................. 89 

Marc Sumerlin, Managing Director and Co-Founder, The Lindsey Group . 120 

Peter J. Wallison, Arthur F. Burns Fellow in Financial Policy Studies, 

American Enterprise Institute ..................................................................... 142 


SMARTINEZ on PROD1PC64 with HEARING

SMARTINEZ on PROD1PC64 with HEARING
(1) 

REGULATORY REFORM HEARING 

WEDNESDAY, JANUARY 14, 2009 

U.S. CONGRESS, CONGRESSIONAL OVERSIGHT PANEL, Washington, DC. 

The panel met, pursuant to notice, at 11:40 a.m. in Room SR– 

253, Russell Senate Office Building, Professor Elizabeth Warren 

presiding. 

OPENING STATEMENT OF PROFESSOR ELIZABETH WARREN, 

CHAIR OF THE CONGRESSIONAL OVERSIGHT PANEL 

Professor WARREN. The Congressional Oversight Panel has two 

duties. Our first, to oversee the expenditure of funds from the socalled ‘‘Troubled Asset Relief Program,’’ requires us to issue monthly reports discussing the management of the $350 billion allocated 

so far by the Congress to the Treasury Department. 

But it is the second function that draws us here today. Congress 

has asked that we deliver in very short order a report ‘‘analyzing 

the current state of the regulatory system and its effectiveness at 

overseeing the participants in the financial system and protecting 

consumers and providing recommendations for improvement, including, among others, whether there are any gaps in existing consumer protection.’’ 

We are grateful to have the assistance of so many thoughtful experts in this task. 

The last time America faced a financial crisis of greater magnitude was in the 1930s. The policymakers who steered the country 

out of that dark hour put in place a regulatory architecture that 

served America for more than half a century. Had those leaders 

chosen a different path, a path without deposit insurance, without 

banking regulation, without a Securities and Exchange Commission, we would be a very different country today. 

Today’s policymakers stand at a similarly important point of inflection. The path they take from here will shape this country deep 

into the 21st Century. What we get right may not only save an 

America that is in danger of losing its economic security, it may 

also shape a new America that is stronger than ever. But what we 

get wrong may batter a weakened country, leaving it staggered and 

vulnerable. We will pay for errors we make here as will our children and our children’s children. 

Alan Greenspan now tells us the very premise of deregulation 

was misplaced and that he was surprised by this crisis. George 

Bush tells us that we must abandon capitalism in order to save it. 


SMARTINEZ on PROD1PC64 with HEARING
2 

These leaders make it clear that the old orthodoxies are dead. 

What they do not make clear is how we go forward. 

The questions we ask today are ultimately very simple. What 

went wrong, and how do we make very sure that these problems 

are not repeated in the future? 

I appreciate that any problem may have multiple causes, and I 

fully understand that financial markets have more twists and 

turns than the back streets of Boston, but underlying the complex 

maneuvering in the current economic system are some basic truths 

about how financial institutions failed the American people and 

how those whose jobs it was to monitor and to regulate those institutions also failed us. 

Now, with the country in crisis, the American people must not 

only bear the broken promises of Wall Street and the regulators 

who were supposed to hold deception and risk in check, they must 

also bear the double-burden of spending their tax dollars to bail out 

those who failed. 

We are not here to discuss regulation as a political issue or regulation as an academic exercise. Regulation is a means to an end, 

not an end in itself. More importantly, it is a means not just to 

help the financial system as a whole but those who give that financial system purpose, American businesses and American families. 

The stakes on financial regulation have not been higher during our 

lifetimes. 

Today, we will hear from a variety of experts as they give their 

perspectives on what went wrong and what can be done to ensure 

future stability. We have purposely solicited witnesses from a wide 

range of ideological perspectives and with a broad diversity of prescriptions for our future. 

On our first panel, we will be joined by Gene Dodaro, the Acting 

Comptroller General of the Government Accountability Office. Mr. 

Dodaro will discuss a recent GAO Report on Regulatory Reform. He 

will be accompanied by Richard Hillman and Orice Williams, also 

with the GAO. 

Our second panel I will introduce just before they start. 

With that, I will yield to my colleague, Congressman Hensarling, 

for his opening statement. 

STATEMENT OF HON. JEB HENSARLING, U.S. REPRESENTATIVE FROM THE STATE OF TEXAS AND MEMBER OF THE 

CONGRESSIONAL OVERSIGHT PANEL 

Representative HENSARLING. Thank you, Madam Chair. We certainly look forward to the testimony of the witnesses. I’m certainly 

impressed again by the variety and expertise that will be brought 

to this panel. 

In a city where it’s difficult to find consensus, I think there is 

at least consensus around the idea that we need regulatory reform 

within our financial markets, but more regulation simply for regulation’s sake will probably do more harm than good. 

Many believe that—look for opportunities to use the present recession to essentially bootstrap a certain ideological agenda and to 

thrust that into the body politic. The battle cry is deregulation has 

caused this recession, only regulation will prevent future recessions. 


SMARTINEZ on PROD1PC64 with HEARING
3 

First, I observe in my own estimation, we haven’t had significant 

deregulation in decades. There have been reforms. There has been 

some modernization. 

Second, I don’t view this as a matter of deregulation versus regulation. Frankly, I think the far more important dichotomy is that 

between smart regulation and dumb regulation. I think smart regulation will help markets become more competitive. I think smart 

regulation will effectively police markets for fraud and misrepresentation. 

I think smart regulation will empower consumers with effective 

disclosure, perhaps in contrast to voluminous disclosure, so that 

those consumers can make rational decisions. I think smart regulation will help reduce systemic risk. 

On the other hand, I think dumb regulation will hamper competitive markets. I think it will stifle innovation that has helped 

put people into homes that otherwise perhaps would never be able 

to afford them. I think dumb regulation creates moral hazard, and 

I think we are unfortunately reaping what has been sown previously as far as dumb regulation is concerned with respect to 

moral hazard. 

I think dumb regulation will remove and minimize personal responsibility from the economic equation to the detriment of our society. I think it needlessly would restrict personal freedom. I think 

dumb regulation is pro-cyclical and ultimately will pass on greater 

costs than benefits to our consumers in our nation. 

Now, I have served in Congress. I’ve had the privilege of serving 

in Congress for the last six years. I spent the previous 10 years in 

private business. I have not observed that regulators are inherently 

more intelligent than regulatees nor have I concluded that regulatory institutions are any more infallible than private businesses 

and private institutions. 

For example, if regulators are so wise, why did IndyMac fail? 

Why did we have the S&L debacle of the early to mid ’80s? And 

in fact, there appears to be now general agreement among most 

economic historians that the Great Depression would have been a 

garden variety recession had it not been for grievous public policy 

errors in monetary policy, trade policy, and tax policy. 

And so, additionally, I would observe that those who are proposing even more restrictive regulatory proposals as a cure to our 

woes, that many of the proposals that are being proffered already 

appear in the EU, among certain other industrialized nations, and 

yet they have not seemed to be insulated from the economic woes 

that befall our nation at this time. 

To state the obvious, families are struggling in this economy. 

They need help. They need public policies that help preserve and 

grow their job opportunities. They need public policies that increase their take-home pay so they can meet their mortgage payments, their health care payments, and they need public policies 

that don’t send the bill for all of this to their children and their 

grandchildren. 

And finally, to the business of this panel, they need reform and 

modernized capital markets regulation. In that regard, I think the 

recommendations that we make to Congress will be very, very important. We must examine all the but-for causes, all the contribVerDate Nov 24 2008 00:38 Apr 01, 2009 Jkt 047928 PO 00000 Frm 00009 Fmt 6633 Sfmt 6633 E:\HR\OC\A928.XXX A928

SMARTINEZ on PROD1PC64 with HEARING
4 

uting causes to our economic turmoil and make sure that we make 

smart regulatory recommendations and be careful that, as we make 

these recommendations, that we are not simply solving the problem 

of this recession and laying the groundwork for an even greater recession to befall us in the years to come. 

We all must be mindful of the Hippocratic Oath, first do no 

harm. It is my hope that our panel will do more good than harm 

with our regulatory recommendations. 

With that, Madam Chair, again I thank you and I yield back the 

balance of my time. 

Professor WARREN. Thank you, Congressman. The Chair recognizes Damon Silvers. 

STATEMENT OF DAMON SILVERS, MEMBER OF THE 

CONGRESSIONAL OVERSIGHT PANEL 

Mr. SILVERS. Yes. Good morning, and thank you, Chairman Warren. 

Today, the Congressional Oversight Panel takes up its mandate 

to examine reforms that will strengthen our financial regulatory 

system and protect our nation from a repeat of the current financial crisis or a worse version of it. 

I am profoundly grateful to the witnesses and the staff for bringing this hearing together on such short notice and in such an effective manner. 

Several themes have emerged already in relation to needed reform, themes involving both regulatory substance and regulatory 

structure. 

We also face a number of complex dilemmas, again involving 

both regulatory substance and regulatory structure. 

I am certain today’s extremely distinguished panels will help us 

formulate specific policy responses to weaknesses in our regulatory 

system and help us think through those more difficult conceptual 

problems that have been brought into focus by the financial crisis. 

As we begin this hearing, let us keep in mind that financial markets are not ends in themselves nor do they exist to make market 

intermediaries wealthy. The purpose of financial markets is to facilitate the transformation of savings into profitable investment, to 

allocate our society’s resources to productive purposes. 

When regulatory systems fail, when financial markets and financial institutions become manufacturers of bubbles and Ponzi 

schemes of one kind or another, then our wealth as a society is dissipated and our society’s needs go unmet. 

With that in mind, I think we have already learned some lessons 

of the financial crisis. First, we as a nation cannot continue a Swiss 

cheese regulatory system. As President-elect Obama has said, and 

I quote, ‘‘We must regulate financial institutions based on what 

they do, not what they are. We must bring the shadow markets 

and shadow institutions into the light of disclosure and accountability.’’ 

Second, we must abandon the idea that sophisticated parties 

should be allowed to act in financial markets without any regulatory oversight. Big sophisticated and yet reckless financial actors 

have done a lot of damage to our financial system and to our economy. 


SMARTINEZ on PROD1PC64 with HEARING
5 

Third, we need strong independent regulators, not weak compromised regulators. Some of this comes down to leadership which 

cannot be legislated, but some of it comes down to structure and 

mission. If we say we don’t want ‘‘enforcement-oriented regulators,’’ 

we should not be surprised when our laws go unenforced. 

Fourth, effective financial regulation is made up of several distinct objectives. We need a regulatory system that facilitates transparency and accountability, that polices safety and soundness when 

there are public guarantees or systemic risk in play and that protects the vast majority of us who are neither expert nor powerful 

when we seek financial services. 

We should learn the lesson of having asked the Federal Reserve, 

a self-regulatory body, to both protect homeowners in the mortgage 

market and ensure the safety and soundness of bank holding companies. We ended up achieving neither goal. Not every regulator 

can serve every regulatory function and some functions are in tension with each other. 

And now for some challenges. What do we do about financial institutions that are both commercial and investment banks and currently receive implicit federal guarantees covering their entire businesses? Do we break them up? How do we address this? Do we try 

to withdraw the implicit guarantee? Do we regulate their entire 

businesses, like they were all just commercial banks? Do we charge 

risk-based premiums for each line of business? This is a genuine 

dilemma. The answer is not obvious. 

Some have suggested that somewhat technical developments in 

finance, such as the rise of mark to market accounting, the widespread availability of short selling, and the prevalence of multilayered securitizations, significantly contributed to the financial 

crisis. 

What each of these developments has in common is that they appear to make financial institutions more responsive to and integrated with financial markets. Is this a good thing or a bad thing? 

To what extent should these developments be limited or reversed? 

Can they be reversed even if we wanted to? 

Finally, we have globalized financial markets. How do we set a 

global regulatory floor? The answer to that question again is not 

obvious. 

I am looking forward to an in-depth examination of these and 

other issues today. 

Thank you. 

Professor WARREN. Thank you, Mr. Silvers. Senator Sununu. 

STATEMENT OF HON. JOHN SUNUNU, FORMER U.S. SENATOR 

FROM THE STATE OF NEW HAMPSHIRE AND MEMBER OF 

THE CONGRESSIONAL OVERSIGHT PANEL 

Senator SUNUNU. Thank you very much, Madam Chair, and good 

morning to all of our witnesses. 

There are a few goals that I think ought to come out of a hearing 

like this and I appreciate those that are attending today for being 

here. It’s very important because, first and foremost, whether 

you’re a panelist or a member of Congress, you can’t possibly be an 

expert in all these areas. 


SMARTINEZ on PROD1PC64 with HEARING
6 

I hope that our witnesses today will help us understand how we 

got to this point, help us understand the inherent weaknesses in 

the structure of our regulatory system, but equally important, understand the weaknesses in the operation of that system: how you 

can have a good system of regulation, good rules and laws in place, 

good organizational structure. But let’s face it, regulators themselves can fail to identify trends, can fail to see problems, can fail 

to exercise due diligence. So structure is important but the operation of those systems are equally important. Finally, we need to 

consider human behavior, understand how market behavior helps 

drive or create some of the problems we’ve seen both in the real 

estate markets, the securities market, and in the oversight of those 

markets. 

Second, I think our panelists today can really help us understand 

the complexity of our financial services regulatory system and I 

don’t think this can be over-emphasized. 

Our system, by and large, was created incrementally. Many, 

many different pieces of legislation, passed not over a few years, 

but over many decades. Many of the elements of our financial services regulatory system date to the 1930s and 1940s, and that 

means, by definition, that they were not designed expressly for the 

modern financial services system that we see today. 

I think we need to look hard and carefully at that complexity because complexity can create gaps, and complexity can create duplication. Either can cause significant unintended consequences. As a 

further result of the complexity, I think it’s fair to say that the financial services regulatory system is not well understood by many 

members of Congress, especially those that don’t sit on the committees that oversee or have responsibility for this regulatory system. 

We are in a position, given our structure of government, that those 

members of Congress will be responsible for acting on the recommendations of this panel, and acting on the various recommendations that are put forward in public by our panelists 

today. We need to help them to understand that complexity. 

As an example of the incremental way in which our regulatory 

structure is created, we don’t have to go back any farther than the 

well-publicized financial scandals of 2000, 2001, 2002, and the response to that which was Sarbanes-Oxley. That was a well-intentioned piece of legislation. There are many elements in that legislation that are probably of value, but it is clear that that attempt at 

regulatory reform, driven by contemporary events, did little or 

nothing to forestall the crisis that we’re dealing with today. So a 

process of incremental revision has not served us very well in the 

United States. 

Finally, I’d encourage our panelists to be specific. The legislative 

process is about as far removed from academia as you can get. That 

doesn’t mean we shouldn’t be informed by both theory and ideas 

that come from an academic source, but we have to deal with the 

hand that we’ve been dealt which is the current regulatory structure. We need to work from that structure to one that works better 

for all the shareholders and participants. 

So we need to be practical, we need to be specific, and, of course, 

we need to work in a very diligent way. These are issues that the 

panel is going to be addressing in the coming weeks, and these are 


SMARTINEZ on PROD1PC64 with HEARING
7 

issues that the Congress will be dealing with extensively in the 

months ahead. 

Thank you very much. 

Professor WARREN. Thank you, Senator. Mr. Neiman. 

STATEMENT OF MR. RICHARD NEIMAN, MEMBER OF THE 

CONGRESSIONAL OVERSIGHT PANEL 

Mr. NEIMAN. Good morning. I thank all the witnesses for being 

here today. 

We are at an exceptional moment in our nation’s history where 

the financial system is at greater risk than any point in the past 

hundred years. The strain has revealed significant underlying 

weaknesses in the existing supervisory system not only in the U.S. 

but worldwide. 

While regulatory reform is an ongoing process, I believe that 

there are four key areas to include in any immediate action plan. 

I base this on a broad range of experience over my last 30 years, 

having started as an attorney at the OCC, as an attorney within 

financial institutions, as an executive as well as a regulatory consultant and compliance consultant, and now, for the last two years 

as a state bank supervisor. 

I welcome your views on the wide range of issues, but I am especially interested in your recommendations in four key areas. 

First, on consumer protection. In fulfilling our consumer protection responsibilities, our top priority must be to address the 

subprime mortgage defaults and foreclosures that triggered the 

current market turmoil and harmed so many homeowners, neighborhoods and economies. 

Second, the role of the states. As the business of banking institutions has become more national in scope, they often complain that 

it is burdensome to comply with consumer protection regulations in 

50 different states. Federal regulators of banks, thrifts and credit 

unions, therefore, have preempted the consumer protection rules of 

the states who sounded the early warning on predatory lending. 

Preemption issues remain a major concern. 

Third, there are gaps in regulatory coverage, both structurally at 

the agency level but also institutionally at the institution level as 

well as the product level. 

And fourth, systemic risk. I believe that it is crucial at this stage 

that we develop a better mechanism for controlling systemic risk 

across the diverse players and financial services industry. We want 

to encourage innovation that has long given the U.S. an economy 

that is second to none, but we need to strengthen our regulatory 

tools by making sure that all market participants whose failure 

would pose risks to the broader financial system are subject to supervision. 

These issues of regulatory reform affect us all because instability 

in the financial markets affects the broader economy. As we have 

seen in the past few months, financial market instability jeopardizes retirement savings, access to consumer credit and student 

loans and the financing of businesses large and small, the revenues 

of state and local governments, and the fiscal condition of the nation. 


SMARTINEZ on PROD1PC64 with HEARING
8 

Now, as much as many of us agree that this is the right time 

in our nation’s history to address regulatory reform, we must also 

acknowledge that there is no perfect regulatory model. We only 

have to look to the many nations in the world that adopt different 

regulatory schemes and recognize that none of those jurisdictions 

were spared a crisis or problem. 

Therefore, in addition to restructuring our regulatory architecture, we need to have more effective regulations and more effective 

supervision. I believe that the power of this panel really is that we 

bring together a broad expertise with different backgrounds across 

different ideological viewpoints as well as political parties. 

The Panel’s power is also in being able to call out experts like 

yourselves in a broad input, for external input from academics, 

from industry, and from the public. But I think the greatest power 

of this panel is our diversity and to the extent that we can reach 

consensus on these important issues of the day. I think that will 

be very, very meaningful to Congress. 

So again, I thank you all for being here today and I look forward 

to your testimony and questions. 

Professor WARREN. Thank you, Mr. Neiman. We begin then with 

Mr. Dodaro. 

I want to thank you again, Acting Comptroller, for being here 

and for coming to talk with us about your Regulatory Reform Report, and thank you again, Ms. Williams and Mr. Hillman, for 

being with us. 

Mr. Dodaro, I’d like to start with your opening statement. Your 

entire statement will be in the record, of course. So if you would 

hold your oral remarks to five minutes, we’d be grateful. 

STATEMENT OF MR. GENE DODARO, ACTING COMPTROLLER 

GENERAL OF THE UNITED STATES, GOVERNMENT ACCOUNTING OFFICE 

Mr. DODARO. Good morning, Chair Warren, Members of the Congressional Oversight Panel. We are very pleased to be here today 

to assist your deliberations on the financial regulatory system. 

As you mentioned, we issued a report last week. In that report, 

we traced the evolution of the financial regulatory system over the 

last 150 years to lay out and make sure everybody understood the 

incremental nature, as Mr. Sununu mentioned in his opening comments to that system. 

We also outlined developments in the financial markets and institutions that have challenged that regulatory system in the past 

several decades and we lay forth for your consideration, I think it’s 

very relevant to your deliberations, a framework for crafting and 

evaluating proposals to modernize the financial regulatory system 

structure going forward. 

Our basic conclusion was that the current financial regulatory 

structure is outdated, fragmented, and not well suited to the 21st 

Century challenges. There are many issues that we point to in our 

report as to the basis for our conclusion there. I’ll mention three 

this morning. 

First, regulators have struggled and often failed to mitigate the 

systemic risk of large interconnected financial conglomerates or to 

effectively ensure that they manage adequately their own risk. 


SMARTINEZ on PROD1PC64 with HEARING
9 

Second, there have been the emergence of several institutions 

and entities that are less regulated and have posed challenges to 

the system. These include non-bank mortgage lenders, hedge funds, 

and credit agencies. 

Lastly, there have been an array of products put forth on the 

market that are very complex and have challenged both consumers 

and investors and the regulators going forward. Here, I would refer 

to the credit default swaps, collateralized debt obligations, and various mortgage products that have been put forward as well as overthe-counter derivatives, all of which have been less regulated than 

many aspects of the commercial banking sector. 

Now, moving forward and trying to address these vulnerabilities 

is a complex task that needs to be deliberated on and taken with 

care to make sure there aren’t unintended consequences of moving 

forward as well as preserving the inherent benefits of our current 

financial regulatory system, including the ability to foster capital 

formation and economic growth over a period of time. So there 

needs to be a balance and here we need to strive as a nation to 

achieve that balance going forward. 

To assist in this deliberation, we’ve put forth a framework for 

consideration so that it can be looked at as a system and not just 

to make piecemeal changes to it. We list nine characteristics that 

need to be considered. I’ll mention a few critical ones here. 

First, there needs to be clear, explicit goals for the regulatory 

system set in statute to provide consistent guidance over time. Reform also needs to be comprehensive. It needs to address some of 

these regulatory gaps, both in institutions and products, going forward. 

Oversight of systemic-wide issues is another characteristic. No 

one regulator right now is charged with looking at risk across the 

entire system, to monitor it, to provide alerts, or to deal with it in 

advance going forward. That’s an issue that we believe needs attention. 

The system needs to be flexible and adaptable. In this case, you 

need to make sure that innovation is still permitted while managing risk going forward, so that we maintain the benefits of innovation of the system. It needs to be efficient. We need to look at 

the overlapping nature of some of the regulatory organizations that 

have been put in place in time and make the system more streamlined and efficient going forward. 

We need to look at consumer protections again. Disclosures are 

very important as well as financial literacy issues and other key 

factors that should be part of the overall approach here going forward. The independence of the regulators is another very important characteristic to make sure that they’re funded, they’re 

resourced, and they have proper statutory independence to be able 

to do what’s necessary, and we need to protect the taxpayers. We 

need to deal with moral hazards approaches and provide safeguards in place so that the losses, if they occur, are borne by the 

industry and not by the taxpayers going forward. 

We would be happy to answer your questions at this time, and 

again thank you for inviting us to be here. 

[The prepared statement of Mr. Dodaro follows:] 


SMARTINEZ on PROD1PC64 with HEARING
10 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 37 here 47928A.001
11 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 38 here 47928A.002
12 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 39 here 47928A.003
13 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 40 here 47928A.004
14 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 41 here 47928A.005
15 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 42 here 47928A.006
16 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 43 here 47928A.007
17 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 44 here 47928A.008
18 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 45 here 47928A.009
19 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 46 here 47928A.010
20 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 47 here 47928A.011
21 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 48 here 47928A.012
22 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 49 here 47928A.013
23 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 50 here 47928A.014
24 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 51 here 47928A.015
25 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 52 here 47928A.016
26 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 53 here 47928A.017
27 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 54 here 47928A.018
28 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 55 here 47928A.019
29 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 56 here 47928A.020
30 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 57 here 47928A.021
31 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 58 here 47928A.022
32 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 59 here 47928A.023
33 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 60 here 47928A.024
34 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 61 here 47928A.025
35 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 62 here 47928A.026
36 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 63 here 47928A.027
37 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 64 here 47928A.028
38 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 65 here 47928A.029
39 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 66 here 47928A.030
40 

Professor WARREN. Thank you, Mr. Dodaro. I really appreciate it. 

Thank you, and thank the GAO for your thoughtful and detailed 

report. I read it with great interest. It has very, very good ideas 

in it. 

If I can, I want to focus on one in particular to get us started 

with our questions today and that is, you highlight in your report 

how consumer and investor protection has been distributed across 

a range of agencies, at the federal level, federal and state, that 

there are many actors who have some small part of consumer regulation, and that I believe, as you put it, one of the consequences 

of this is it creates a low priority for many of those agencies who 

have other responsibilities and has made for ineffective regulation 

in this area. 

You suggest in your report that one agency devoted to consumer 

financial issues, which would be responsible to the President and 

to Congress and to the American people, might be a solution to this 

problem. 

Can you say more on the consumer side about how one agency, 

it would be a very different way to look at this problem, how it 

might solve some of the problems that you have identified? 

Mr. DODARO. Well, first, our work has shown over a period of 

time that this is an area where, while there are some benefits to 

having multiple people involved looking at this, and I think this is 

one area where having the state involvement as well as the federal 

involvement, to go to Mr. Neiman’s opening comment, is a positive 

development, but there needs to be a better overall structure in 

place across the federal departments and agencies to be able to 

deal with this. 

I’ll ask Rick to elaborate on our work a bit. We don’t actually, 

you know, make a recommendation that this be done but we think 

it has merit, a lot of merit that should be explored going forward. 

Our work has consistently shown, whether we’re looking at credit 

cards, mutual fund fees, or others, that the disclosures to the public aren’t clear. They don’t really understand these issues. Clearly, 

this was an issue with the various mortgage products that were 

put forth on the market in the past. 

We’ve done work saying that the Committee on Financial Literacy that’s set up at the federal level doesn’t have a strategic plan, 

isn’t funded properly to continue to provide, you know, education 

in this field as well. So it has a lot of dimensions. Oftentimes it 

doesn’t get as much attention, as we point out in our report, as necessary. So making it a clear priority, setting up a structure again 

in this overall framework going forward, I think, is a worthy area 

to be very carefully explored by this panel and then the Congress 

as it goes forward. 

Professor WARREN. Mr. Hillman, would you like to add to that? 

Mr. HILLMAN. Yes. I think that the comments that you made are 

right on target from the standpoint that the consumer protections 

are really as fragmented as our regulatory system is currently fragmented and that can cause inconsistencies, overlaps, and gaps in 

ensuring that consumers are best protected, and this current crisis, 

with what has been taking place with the subprime mortgage market and other areas, has clearly demonstrated that there needs to 

be improvements in the consumer protection area. 


SMARTINEZ on PROD1PC64 with HEARING
41 

Moving more towards a single regulator to oversee consumer protection areas is definitely an idea that merits additional attention. 

There are many options with which to establish a new regulatory 

structure. Moving towards a single regulator or moving towards 

what is referred to as regulation by objective or a Twin Peaks 

model where you have a safety and soundness regulator and a consumer protection regulator both afford you opportunities to enhance the visibility of consumer protection issues in a reformed 

regulatory structure. 

So we believe, as a result of our work, that that is a serious issue 

that needs to be debated to determine how best to ensure consumer 

protections are delivered in the most effective means. 

Professor WARREN. All right. Thank you. I’m going to switch 

areas just because our time is very limited. You focused, I thought, 

very helpfully in the report on the importance of identifying and 

regulating systemic risk, obviously a terrible problem right now, 

and others have also talked about this, Chairman Frank, the 

Treasury Department. 

Can I ask you to comment just briefly on the question of whether 

the appropriate entity to identify and regulate systemic risk should 

be placed within the Fed or within a new regulatory body, a new 

regulator to look specifically at systemic risk? Do you have a comment on that, please? 

Mr. DODARO. Yes, there’s various trade-offs associated with making that decision. Obviously the Federal Reserve’s focus on monetary policy is important and they need to maintain their independence in that regard. 

One of the areas that we’ve looked at over the past is how some 

other countries have handled this particular issue. The United 

Kingdom in particular went to a single financial services authority, 

a single regulator, while maintaining the Central Bank functions 

in a separate entity and given the current situation, they are reevaluating some of those issues. 

Part of the issue there is how much the Central Bank really 

needs to know about what’s going on within the financial institutions around the country to put them in a monetary policymaking 

position. So this is an area we don’t have a ready answer for you 

today, but I think it’s an area that needs to be carefully considered 

going forward in the debate because there are some serious tradeoffs associated with providing all of these types of authorities to 

one entity. 

Professor WARREN. Thank you. I appreciate it, and I’m out of 

time. 

Congressman. 

Representative HENSARLING. Thank you, Madam Chair. Mr. 

Dodaro, thank you for appearing today, and thank you again for 

the quality of the work of the GAO. I find the reports to be helpful, 

comprehensive. 

In the report that I have before me, there is a short discussion, 

I guess, of our history of the financial regulatory system, a number 

of observations you have for the framework for this panel and Congress and other policymakers going forward. 

What I don’t necessarily see, though, is an analysis from GAO on 

the significant ‘‘but for’’ factors that have led us to the economic 


SMARTINEZ on PROD1PC64 with HEARING
42 

turmoil that we see today. I think we’re all believers of the adage 

that those who do not learn the lessons of history are condemned 

to repeat them. So am I missing that from this work? Was that not 

in the scope of the work or has GAO come to some conclusions 

about the primary ‘‘but for’’ causes of our present economic turmoil? 

Mr. DODARO. Well, the report does focus on some of the developments that have happened in the financial marketplace that have 

challenged the regulators, but it was not within the scope of it to 

talk about all the underlying economic situations that have gone 

before there. 

I would ask if my colleague Ms. Williams could elaborate on that. 

Ms. WILLIAMS. No. I think it’s accurate that we did not specifically set out in this report to lay out the reasons for the current 

economic turmoil in the market. We simply used this as an additional data point, in addition to other problems that have existed 

in the markets over several decades to illustrate this is yet another 

example that points to serious questions about the regulatory 

structure. 

Representative HENSARLING. In dealing with the issue of consumer protection, on page 18 of your report, you state, ‘‘Many consumers that received loans in the last few years did not understand 

the risk associated with taking out their loans.’’ 

After first being elected as a member of Congress, my wife and 

I purchased what we referred to as an old, expensive condominium 

in the Alexandria area. My five- and six-year-old referred to it as 

the itty-bitty teeny-tiny house. 

When faced with the real estate closure of that condominium, I 

remember being given a voluminous amount of documents, almost 

none of which I’ve read, notwithstanding the fact that I’ve actually 

had a short, un-illustrious legal career and had to read that stuff 

at one time. 

I remember asking the real estate agent who actually reads this 

stuff, and the answer was about one out of a hundred home purchasers. I said, ‘‘Well, who’s the one?’’ And they stated a first-year 

law student at one of the local law schools. 

[Laughter.] 

Representative HENSARLING. My question is, should consumers 

know what mortgage products they sign and can they know? Is 

there a concept—is it possible for regulators to have/promote effective disclosure, again as opposed to what I would refer to as voluminous disclosure? Has the GAO concluded that consumers can 

and should understand the risk associated with their mortgage 

products? 

Mr. DODARO. First, we’ve made a number of recommendations; 

I’ll ask Mr. Hillman to elaborate on those, in a series of products 

over time, about making the disclosures more understandable to 

consumers. There’s ways to do research on this, to do some testing 

as to what the consumers would really understand and put in 

place. 

As I’ve also grown to appreciate over time, some of the disclosures are in, as you mentioned, teeny-tiny condominium—or in 

teeny-tiny print—so they’re even hard to read, but there are a 

number of ways that we believe and have recommended that the 


SMARTINEZ on PROD1PC64 with HEARING
43 

disclosures could be improved over time, and I also, though, would 

not also overlook the issue of financial literacy training to the population at large over a period of time. 

Representative HENSARLING. I see my time is winding down. I’d 

like to try to squeeze in at least one more question here. 

Did the GAO look at the enforcement mechanisms that are in 

place to deal with mortgage fraud? According to FINCEN, Financial Crimes Enforcement Network, mortgage fraud has increased 

something along the lines of 1,400 percent in this decade. A lot of 

predatory lending, frankly a lot of predatory borrowing. I think according to FINCEN a majority of the mortgage fraud occurred from 

borrowers misrepresenting their income, misrepresenting their assets, misrepresenting their occupancy. 

Anecdotally, I’ve spoken with a number of U.S. Attorneys, Assistant U.S. Attorneys. They’re focused on terrorism. Unless you’re into 

seven and eight figures fraud, they don’t even look at it. 

So has the GAO undertaken a look at what would it mean to 

simply enforce some of the antifraud regulations that are on the 

books today? 

Professor WARREN. Mr. Dodaro, we’re out of time. So I’m just 

going to ask you to limit yourself to just a sentence on this, if you 

could, or Mr. Hillman. 

Mr. HILLMAN. I’d be pleased to respond and your question again 

is right on target. 

We have not done any specific work as relates to the elements 

of mortgage fraud and the growing nature of that, but we have recently completed two pieces of work in the Bank Secrecy Act area 

which looks at the extent to which depository institutions are preparing suspicious activity reports and currency transaction reports 

to help law enforcement agencies tackle that problem and try to determine the most efficient means for depository institutions to comply with the Bank Secrecy Act. 

Representative HENSARLING. Thank you. Thank you, Madam 

Chair. 

Professor WARREN. Thank you, Congressman. Mr. Silvers. 

Mr. SILVERS. Again, let me express my thanks to the GAO for 

your assistance to our panel in our brief period of existence and for 

your own work on the TARP Program. 

Your report and your comments before us this morning refer at 

some length to unregulated both financial institutions and financial 

products. This follows, I think, a long series of GAO reports dating 

back to Long Term Capital Management in relation to some of 

these same issues. 

Could you expand on your thinking in that area and with particular reference to the proposition some have raised, including, I 

think, some witnesses that will follow you, that many of these 

products and funds are essentially well-known things in new legal 

garb and ought to be regulated based on economic content rather 

than legal form? 

So, for example, a credit default swap looks a lot like bond insurance. 

Mr. DODARO. I think basically, and I’ll ask Ms. Williams to elaborate on this a little bit, you know, our work in this area dates back 


SMARTINEZ on PROD1PC64 with HEARING
44 

to the 1994 report where we raised questions about the derivatives 

and the development at that period of time. 

I think this is an area where there needs to be—and whatever 

changes are made to the regulatory framework, you can deal with 

the existing set of institutions and products now, but looking forward is really the challenge, I believe, going forward. As new products are developed, there needs to be some attention made by the 

regulators to make a gauge as to what the risk would be, whether 

it fits in to an already-existing regulatory screen and make a conscious decision of how it should be regulated, and then also monitor 

that very carefully going forward and make proposals, if they don’t 

already have the authority. 

So I think the challenge really there is how to address new products going forward as well as dealing with what we already have. 

Mr. SILVERS. Can I, before you ask our colleague to contribute? 

Are you suggesting that you would support regulatory frameworks, 

like for example the ′33 and ′34 securities laws, that give broad jurisdiction, broad conceptual jurisdiction to regulators who follow 

the activity rather than approaches that sort of wall regulators in 

around particular legal forms? 

Mr. DODARO. Yeah. Yes, I mean, there needs some authorities on 

a risk-based basis. You don’t want to go too far in such a way that 

it stifles innovation, but there has to be a risk assessment tool built 

in that we think would provide a better safeguard going forward. 

Ms. WILLIAMS. And just to add, we have several elements that 

really speak to that. That’s what we’re getting at when we talk 

about the need for comprehensive regulation as well as flexible and 

nimble and that’s to allow the structure to adjust as entities and 

products morph and to be able to follow the economic substance of 

the product and also look to the institution and gauge its impact 

on the overall financial system and not be locked into a statutory 

definition. 

Mr. SILVERS. Would I be correct, in following up with that, that 

you would look in this respect to regulation, for example, with a 

particular financial product or institution that currently is outside 

the regulatory scheme, that you would look both at, for example, 

transparency, accountability and capital requirements as required 

by the particular activity going on? Am I clear in what I’m asking? 

Ms. WILLIAMS. I would think that would have to be part of the 

debate. As you decide how far to go with regulating that particular 

entity, based on its risk to the system, you would have to evaluate 

if it would be appropriate for all of those items that you listed to 

be applied. 

Mr. SILVERS. And there’s really two levels here. One is in the individual regulatory scheme that would be put in place, but also this 

entity that would focus on systemic risk would also have some responsibilities in this area and to coordinate with the individual regulatory entities. 

Coming to the systemic risk question, one item in the debate 

that’s not, I think, been entirely clear and focused but seems quite 

important to me is the approach to systemic risk regulation, whether one essentially tries to identify systemically-significant institutions ex-ante, in advance, and regulate them with special—bring 

special regulatory tools to bear in advance or whether you—whethVerDate Nov 24 2008 00:38 Apr 01, 2009 Jkt 047928 PO 00000 Frm 00050 Fmt 6633 Sfmt 6602 E:\HR\OC\A928.XXX A928

SMARTINEZ on PROD1PC64 with HEARING
45 

er it is better not to do that, whether it’s better to essentially act— 

determine who’s systemically significant in midst of crisis, which is, 

I think, essentially what we’ve done recently, what’s your thinking 

about that question? 

Mr. DODARO. Two thoughts. One, I think in putting a new regulatory structure in place right now, there has to be a recognition 

of these large financial conglomerate entities that do in fact right 

now have significance to the system at large and there has to be 

an appropriate structure put in place to deal with that going forward, recognizing we’re in a global environment and we need to 

have those entities to be competitive, but it shouldn’t be static. 

I think one thing that’s really surprised everybody is the speed 

in which these things have happened and you can’t wait to be in 

a reactive posture. That is just not going to serve us well. We need 

to put a durable system in place that’s going to be able to recognize 

what we already know but yet be flexible enough to be proactive 

going forward if we’re really going to mitigate things, given the 

current globalized environment. 

Mr. SILVERS. Thank you. 

Professor WARREN. Thank you. Senator Sununu. 

Senator SUNUNU. Mr. Dodaro, I’m going to give you an opportunity here now to give us some good news. 

[Laughter.] 

Senator SUNUNU. In your evaluation of the regulatory system 

and the events that led up to the current crisis, what did you find 

that operated effectively? What seemed to be working, and what 

best practices within our regulatory structure should we look to expand or reinforce? 

Mr. DODARO. Well, I think, you know, basically we have a regulatory system, you know, where the regulators are, you know, developing mechanisms to try to coordinate with one another to deal 

with some of the things. So I think the dialogue among the regulators has improved, although it hasn’t gotten to the point of where 

we would recognize that it’s the most effective and efficient way to 

be able to handle the system going forward. 

I think in the current environment and dealing with the situation, the regulators have, you know, acted, I think, to try to deal 

with and stem and mitigate the effects of the current system going 

forward with the tools that they have at their disposal to be able 

to do that and to have acted, you know, in order to try to deal with 

some of the issues going forward. 

There are a lot of very talented people in the financial regulatory 

area. We have a lot of, you know, well-intended systems in place 

to be able to do this. In areas where there’s been traditional oversight, for example, in the commercial banking industry, we think 

some of those things have worked, you know, effectively over time, 

you know, given some of the incremental changes that you mentioned. 

I would ask just Rick or Orice if I’ve missed anything. I don’t 

want to miss any good news. 

Mr. HILLMAN. I’d just like to reiterate what Gene was saying in 

that, given the fragmented regulatory structure that we currently 

have in place, one of the major benefits of that fragmented structure is that these individual regulators have deep pools of knowlVerDate Nov 24 2008 00:38 Apr 01, 2009 Jkt 047928 PO 00000 Frm 00051 Fmt 6633 Sfmt 6602 E:\HR\OC\A928.XXX A928

SMARTINEZ on PROD1PC64 with HEARING
46 

edge and an understanding of their individual markets that they’re 

overseeing. So in this particular financial crisis, given the more effective coordination that has taken place across regulators, between 

the Department of the Treasury and the Federal Reserve, including 

the Federal Deposit Insurance Corporation, in their particular 

areas of expertise and the authority that they provide, this has allowed for a more concerted strategy to address the case-by-case 

problems that have been confronting our financial markets over 

this past summer. 

Senator SUNUNU. In Recommendation Number 5, you talk about 

the importance of eliminating overlap. Could you give us an example of specific areas where you saw this overlap and perhaps some 

of the problems it created? 

Mr. DODARO. Basically, the one area where we’ve recommended 

that it be dealt with is in the banking area. Right now, you have 

five entities that have responsibilities at the federal level and in 

that regard, I think there’s some merit of looking at that. In the 

futures and the security areas, the SEC and the Commodities Future Trading Commission could be considered for consolidation as 

well. Those would be the two primary areas that we would highlight as meriting consideration. 

Senator SUNUNU. On the issue of consumer safety, Mr. Hillman 

used the phrase ‘‘working to ensure that consumers are best protected’’ and talked a little bit about the Twin Peaks Model which 

separates this responsibility for consumer protection. 

But that can create significant problems in that there are elements of consumer protection or consumer services that could and 

would have a direct effect on the safety and soundness of the institution. It would be a mistake to have an agency or an organization 

responsible for those consumer protection initiatives without also 

having an obligation and a responsibility to think through exactly 

what the effect on this regulation would be on safety and soundness. 

How do you reconcile that problem and how can you advocate a 

Twin Peaks Model if it separates those two obligations and responsibilities? 

Mr. HILLMAN. The work that we have done in looking at various 

alternative regulatory structures suggests to us that there are definite strengths and weaknesses across a whole series of possible options for reforming our regulatory structure and there really, quite 

frankly, is no silver bullet. 

Looking at the Twin Peaks Model where you have oversight by 

objective, looking at safety and soundness issues or looking at consumer protection issues, it does afford the opportunity to enhance 

the visibility from a consumer protection standpoint, but your comments are very on target when you suggest that separating consumer protection from the safety and soundness issue can cause 

problems. 

One area, for example, that could be a problem has to do with 

really assessing reputational risk. There’s issues associated with 

the operations of enterprises and institutions that can cause 

reputational risk and also harm investors and you really need to 

look at that at a holistic level. So there’s strengths and weaknesses 

to each approach. 


SMARTINEZ on PROD1PC64 with HEARING
47 

Mr. DODARO. And I think at a minimum, there needs to be clarity of the goals and objectives that are put in place for whatever 

system’s put in place and part of the reason we created the nine 

characteristics is that there’s a tendency to want to gravitate to a 

quick organizational fix by either centralizing or decentralizing 

something. Often that doesn’t work. It’s not as simple as that 

might seem, even appealing as it may be. 

This is one area where once you set what kind of structure you 

want in place, even if you don’t go to a centralized approach, you 

need to make clear what the responsibilities would be and in the 

framework in which you’re talking about, and I think that’s an 

area where I’d want to make sure that, you know, our message 

that the minimum requirements need to be really clearly spelled 

out as to what you expect and what this Congress expects in this 

area. 

Senator SUNUNU. Thank you. 

Professor WARREN. Thank you. Mr. Neiman. 

Mr. NEIMAN. Yes, I’d like to follow up on that line of questioning 

because in your written testimony, you do note that unfair consumer lending practices can have safety and soundness implications and I agree with that assertion. And you also noted that if 

consumer protection and safety and soundness responsibilities were 

housed in different agencies, that appropriate mechanisms for 

interagency coordination would be required. 

Now, do you have any specific recommendations for processes to 

overcome those operational challenges or does the fact argue in 

favor of keeping consumer protection and prudential supervision 

within the same agency? 

Mr. DODARO. Well, a lot would depend—I’ll ask Rick, who’s been 

focusing on our work here, to comment. A lot would depend on 

what type of other changes are made in the system to the financial 

regulatory apparatus that would be put in place. So you’d have to 

consider that in arriving at the answer. 

But Rick? 

Mr. HILLMAN. There’s definite trade-offs that take place, depending upon which option you end up choosing. If you’re looking at a 

bifurcation of safety and soundness in consumer protection issues, 

it’s definitely going to put a premium on coordination and communication and collaboration between those entities that have those 

responsibilities. 

If you put it in one organization, you have the opportunity to 

share expertise and information across those two important issues 

but then you may lose focus as to what you’re really looking to 

achieve. 

So depending upon whichever structure you ultimately move to, 

Gene is absolutely right, we need to establish what goals need to 

be in place to ensure effective consumer protection and have those 

goals drive down the regulatory process to achieve them. 

Mr. NEIMAN. In that same section you talk about overlapping jurisdiction of regulators and to a certain extent in certain areas it 

can be burdensome, but in other areas it can provide appropriate 

checks and balances. From my experience as a state regulator, I 

have seen that play an important role where we work very cooperatively and serve with our countervailing federal regulators. 


SMARTINEZ on PROD1PC64 with HEARING
48 

You also indicate that with respect to enforcement activities, that 

is a less burdensome area, and where I assume what you’re getting 

at is more cops on the beat rather than less is important. 

Would you elaborate on the balance between checks and balances 

and overburdensome regulatory overlap? 

Mr. DODARO. Yeah. I think the real goal would be to capitalize 

and build upon those things that are working well right now and 

that provide those checks and balances. 

I think, you know, our view on overlapping regulations is more 

at the federal level than it would be between the Federal Government and at the state level. So I’d want to clarify that. I think 

there’s distinct advantages of having the states be involved in this 

process going forward. We think there are opportunities at the federal level. So you need to preserve the checks and balances. 

It’s a big system. It’s complicated. It’s moving fast. States give 

you a decentralized sort of eyes and ears on the ground across the 

country and I think you don’t want to lose that ability to be able 

to do that going forward, but that’s our—most of the focus is at the 

federal level. 

Mr. NEIMAN. Thank you. 

Mr. HILLMAN. And particularly to your point on the checks and 

balances, while GAO has not made any proposals suggesting how 

to reform the financial services sector, we have suggested, though, 

that we need to seriously look at some consolidation of the financial 

services sector and that is not to say that we are trying to eliminate competition across regulators. That would be an inconsistent 

reaction to what our view is. 

You know, competition across regulator agencies helps to ensure 

innovative structures within the federal and state levels and in 

some form would likely be benefited by preserving the regulatory 

competition that exists. The question is, though, is there too much 

competition now across the many organizations that exist? 

Mr. NEIMAN. Have you addressed in any way the issues around 

federal preemption of state laws, particularly state consumer laws? 

Mr. HILLMAN. We acknowledged in prior work concerns associated with federal preemption, particularly as it relates to the Office 

of Comptroller of the Currency, and in steps taken earlier this decade to limit visitorial powers associated with states’ interaction 

with national banks and as a result of that work had suggested 

that the OCC could do a much better job of determining how they 

could best incorporate state banking authorities and powers within 

the confines of what they were referring to with their visitorial 

powers. 

Mr. DODARO. We’d be happy to provide that for your record consideration. 

Mr. NEIMAN. Thank you. 

Professor WARREN. Thank you. Thank you, Mr. Neiman. 

That’s going to conclude the testimony for Panel 1. The press of 

time bumps into the magnitude of the task that we have undertaken. 

I want to ask if you would be willing to answer written submissions from the panel on the record that we would send to you in 

the next few days. 


SMARTINEZ on PROD1PC64 with HEARING
49 

Mr. DODARO. We’d be happy to assist this panel in its important 

task in any way we can. Certainly. 

Professor WARREN. Thank you, Acting Comptroller Dodaro, and 

thank you, Ms. Williams. Thank you, Mr. Hillman. The panel appreciates your taking the time in coming here. 

Mr. DODARO. Thank you very much. 

Professor WARREN. Thank you again. We now call the second 

panel, if you’ll come forward, please. 

Thank you. I’m pleased to welcome our second panel of witnesses. We are joined by Sarah Bloom Raskin, Commissioner of the 

Maryland Office of Financial Regulation, by Joel Seligman, President of the University of Rochester, Robert J. Shiller, the Arthur 

M. Okun Professor of Economics at Yale University, Joseph 

Stiglitz, University Professor, Columbia Business School, Marc 

Sumerlin, Managing Director and Co-Founder of The Lindsey 

Group, and Peter J. Wallison, Arthur F. Burns Fellow in Financial 

Policy Studies of the American Enterprise Institute. 

Welcome to all of you. I will dispense with more and just say, can 

we start? Each of you will have your full statements on the record, 

of course. If I can ask you to limit your oral remarks to five minutes, and we’ll start with Ms. Raskin. 

STATEMENT OF MS. SARAH BLOOM RASKIN, COMMISSIONER, 

MARYLAND OFFICE OF FINANCIAL REGULATION 

Ms. RASKIN. Thank you. Good morning, Madam Chair and Members of the Panel. My name is Sarah Bloom Raskin, and I am 

Maryland’s Commissioner of Financial Regulation. 

I’m pleased to be today to share a state perspective on regulatory 

restructuring. While changing our regulatory system will be complex, four simple concepts should guide us. In evaluating any proposed reform of our financial regulatory system, we must ask (1) 

does it enhance transparency, (2) does it enhance accountability, (3) 

does it promote the public interest, and (4) does it address systemic 

risks? 

We often hear that the consolidation of financial regulation at 

the federal level is the modern response to the challenges of our financial system. I want to challenge this idea. 

The 6,000+ state chartered banks now control less than 30 percent of the assets in our banking system, but they make up 70 percent of all U.S. banks. Thus, while these institutions may be smaller than the international organizations now making headlines and 

winning bail-outs, they are absolutely critical to the communities 

they serve. 

Since the enactment of nationwide banking, the states have developed a highly-coordinated system of state-to-state and state-tofederal bank supervision. This is a model that embodies the American dynamic of both vertical and horizontal checks and balances, 

an essential dynamic that has been sharply missing from certain 

areas of federal financial regulation with devastating consequences 

for all of us. 

Remember the ultimate Madisonian theory behind separated 

powers. This design would restrain ambitions, prevent capture by 

specific factions and avert corruption. The very definition of tyranny, Madison thought, was the collapse of all powers into one. 


SMARTINEZ on PROD1PC64 with HEARING
50 

The problems we face today do not come from regulatory federalism, but, rather, from the convergence of regulatory centralization and good old-fashioned regulatory capture. Bank regulators 

like to say that our job is to take away the punch bowl once the 

party really gets going, but our federal banking regulators made 

themselves the ruling chaperons of the party and worked with 

their friends on Wall Street to spike the punch bowl. 

The current crisis has thus revealed shocking defects in regulatory and political will in Washington. Perhaps it is true, as the 

GAO asserts, that the gaps in our divided regulatory structure 

made it more difficult to understand the gravity of the risks that 

were building in the system. Perhaps. But the disasters we have 

experienced are not failures of structure. They are failures of execution, political will, and policy. 

I do not want to discount the need for significant regulatory 

changes and we outline these gaps in our submitted testimony, but 

those reforms will not address the underlying problems if we fail 

to understand and address why the federal system did not adequately respond. 

From the state perspective, it’s not been clear for many years exactly who was hosting the party, who was chaperoning and who the 

special guests were. The nation’s largest and most influential financial institutions have themselves been major contributing factors in our regulatory system’s failure to respond to this crisis. 

From our foxholes at the state level, we have watched the regulatory apparatus in Washington show tell-tale signs of classic regulatory capture, political, economic and intellectual capture, by the 

regulated industry. 

If this is right, a consolidation of regulatory authority at the federal level would only exacerbate rather than relieve our troubles. 

From this standpoint, many of the policies of TARP and other federal responses to contain this crisis interfere with our ability to 

prevent the next crisis. 

It would be like saying in the wake of Hurricane Katrina and its 

aftermath that the solution is to get rid of local fire departments 

and first responders and centralize more authority and power in 

FEMA. Regulatory capture becomes more rather than less likely 

with a consolidated regulatory structure. 

It was the states that attempted to check the unhealthy evolution of the mortgage market and apply needed consumer protections to the tidal wave of subprime lending. It was the states and 

the FDIC that were a check on the flawed assumptions of the Basel 

II Capital Accord. 

Professor WARREN. Ms. Raskin, your time is up. Can I ask you 

to conclude? 

Ms. RASKIN. Yes, I’ll finish up. The lesson of this crisis should 

be that these checks need to be enhanced, multiplied and reinforced, not eliminated. 

If we’ve learned nothing else from this experience, we’ve learned 

that big organizations have big problems and as you consider your 

responses to this crisis, I ask that you consider reforms that promote diversity and create new incentives for the smaller, less-troubled elements of our financial system rather than rewarding the 

largest and most reckless. At the state level, we’re constantly purVerDate Nov 24 2008 00:38 Apr 01, 2009 Jkt 047928 PO 00000 Frm 00056 Fmt 6633 Sfmt 6602 E:\HR\OC\A928.XXX A928

SMARTINEZ on PROD1PC64 with HEARING
51 

suing methods of supervision and regulation. I appreciate your 

work toward this goal and I thank you for inviting me to share my 

views today. 

[The prepared statement of Ms. Raskin follows:] 


SMARTINEZ on PROD1PC64 with HEARING
52 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 95 47928A.031
53 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 96 47928A.032
54 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 97 47928A.033
55 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 98 47928A.034
56 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 99 47928A.035
57 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 100 47928A.036
58 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 101 47928A.037
59 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 102 47928A.038
60 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 103 47928A.039
61 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 104 47928A.040
62 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 105 47928A.041
63 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 106 47928A.042
64 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 107 47928A.043
65 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 108 47928A.044
66 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 109 47928A.045
67 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 110 47928A.046
68 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 111 47928A.047
69 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 112 47928A.048
70 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 001 47928A.125
71 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 002 47928A.126
72 

Professor WARREN. Thank you, Ms. Raskin. President Seligman. 

STATEMENT OF JOEL SELIGMAN, PRESIDENT, UNIVERSITY OF 

ROCHESTER 

Mr. SELIGMAN. Professor Warren, Members of the Panel, I’m delighted to join you. 

There is today an urgent need for a fundamental restructuring 

of federal financial regulation, primarily based on three overlapping causes. 

First, an ongoing economic emergency, initially rooted in the 

housing and credit markets, which has been succeeded by the collapse of several leading investment and commercial banks and insurance companies, dramatic deterioration of our stock market indices and now a rapidly-deepening recession. 

Second, serious breakdowns in the enforcement and fraud deterrence missions of federal financial regulation, notably in recent 

months, as illustrated by matters involving Bear Stearns and the 

four then independent investment banks subject to the SEC’s 

former Consolidated Supervised Entity Program, the government 

creation of conservatorships for Fannie Mae and Freddie Mac, the 

Bernie Madoff case, and, more generally, a significant decline in 

the number of prosecutions for securities fraud, at least in 2008. 

Third, a misalignment between federal financial regulation and 

financial firms and intermediaries. The structure of financial regulation that was developed during the 1930s has simply not kept 

pace with fundamental changes in finance. 

Against this backdrop, I would offer the following broad principles to guide consideration of a restructuring of federal financial 

regulation. 

First, make a fundamental distinction between emergency rescue 

legislation which must be adopted under intense time pressure and 

the restructuring of our financial regulatory system which will be 

best done after systematic hearings and background reports. 

Second, the scope of any systematic review of financial regulation 

should be comprehensive. This not only means that obvious areas 

of omission today, such as credit default swaps and hedge funds, 

need to be part of the analysis but also means, for example, our 

historic system of state insurance regulation should be re-examined 

as well as current securities laws exemptions for areas, including 

municipal securities. 

A re-examination also is urgently needed of the adequacy of the 

current regulation of credit rating agencies and the scope of investment adviser exemptions. In a world in which financial holding 

companies can move resources internally with breathtaking speed, 

a partial system of federal regulation runs an unacceptable risk of 

failure. 

The fact that the Federal Government provided over $100 billion 

to insurance giant AIG alone suggests that insurance regulation is 

no longer purely a state matter. 

Third, Congress especially should focus on the structure of financial regulation rather than addressing specific standards at too 

great a level of granularity. 

With respect to structure, I would propose consideration of a revitalized approach to federal financial regulation that, at the highVerDate Nov 24 2008 00:38 Apr 01, 2009 Jkt 047928 PO 00000 Frm 00078 Fmt 6633 Sfmt 6602 E:\HR\OC\A928.XXX A928

SMARTINEZ on PROD1PC64 with HEARING
73 

est level, designates the Federal Reserve System as the apex or supervisory agency for all financial regulation with the expressed 

mission to address and minimize systemic risk. This is not a Twin 

Peaks model. This is more a holding company structure where the 

company must have comprehensive access to data and confidence 

in examinations to be able to address the problems of systematic 

risk which are not limited to any area. 

Second, to preserve the expertise necessary to industry-specific 

regulation, I would nonetheless suggest consolidating industry-specific regulatory areas—agencies in areas such as banking and 

thrifts, securities and commodities, to preserve expert examination, 

inspection and enforcement roles. 

Particular attention should be devoted to revitalizing enforcement, including the effective use of private rights of action and selfregulatory organizations to complement the role of the federal regulatory agencies. 

And third, effectively allocate unregulated areas so that we eliminate today’s regulatory holes. 

Let me suggest in closing that there is a wise caution that a 

member of your panel suggested before. While I believe that any 

new system of federal financial regulation should be comprehensive, the fragility we have seen in global financial markets in recent months inevitably will reduce for a time willingness to rely 

solely on self-interests of the market to provide optimal behavior. 

As SEC Chair Christopher Cox memorably wrote when the Commission disbanded the Consolidated Supervisory Entity Programs, 

‘‘Voluntary regulation does not work.’’ 

The challenge in a new order will be also to avoid the tendency 

to over-regulate. Independent regulatory agencies, such as the 

SEC, have shown talent in customizing congressional enactments 

often enacted in times of crisis to achieve the best balance between 

investors and industries. That talent today also is urgently needed. 

[The prepared statement of Mr. Seligman follows:] 


SMARTINEZ on PROD1PC64 with HEARING
74 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 118 47928A.049
75 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 119 47928A.050
76 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 120 47928A.051
77 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 121 47928A.052
78 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 122 47928A.053
79 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 123 47928A.054
80 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 124 47928A.055
81 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 125 47928A.056
82 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 126 47928A.057
83 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 127 47928A.058
84 

Professor WARREN. Thank you, President Seligman. Dr. Shiller. 

STATEMENT OF DR. ROBERT SHILLER, ARTHUR M. OKUN 

PROFESSOR OF ECONOMICS, YALE UNIVERSITY 

Dr. SHILLER. I have written two books about what we should do 

in this crisis. One of them called Subprime Solution came out in 

September and one of them with George Akerlof called Animal 

Spirits will come out next month. 

I cannot summarize all of the things I said in those books, but 

basic point, I think that we need to democratize finance and we 

need to develop new financial institutions. This is a time when we 

have to have the spirit of the New Deal about us, that we are going 

to create something that will bring us into the 21st Century. 

In my brief remarks, the point is that we have to go for specific 

ideas, not just rearranging the regulators. It’s not about saying no, 

it’s about coming up with something new. So I want to give some 

examples of new ideas. 

One of them is from the Squam Lake Working Group which advises academics. It goes back to an idea of Mark Flannery, and the 

idea is that firms or banks particularly should be encouraged to 

issue a new kind of debt which we call regulatory convertible debt. 

Regulators get involved in telling companies they can issue this 

debt and it will count as capital. It will convert to equity if a trigger is reached which could be merely that the regulator decides 

that we’re in a financial crisis or it could be based on some objective trigger. 

But the point is that the capital that banks have would be automatically increased by converting debt to equity at a time of crisis. 

This is very different than having TARP come in with public money 

and contribute it to capital at a time of crisis and it would prevent 

the kind of—this is really central because it would prevent the kind 

of downward spiral that created the crisis we’re in. This is financial 

innovation that works at the fundamental problem of systemic vulnerability. 

Now some other ideas. One is from my book. We ought to—the 

government ought to be subsidizing personal financial advice. This 

is expensive, but it is important. The crisis was substantially due 

to errors that people made and I would track that back to the fact 

that they were not getting advice. 

The cheap thing to do is financial education. That can be really 

cheap. All we have to do is think of a curriculum and put it on the 

Web, but that doesn’t work for many people. They cannot read the 

complicated brochures alone. They need someone to help them. 

Third idea. It’s really yours, Elizabeth. The idea of a financial 

products safety commission. I’ll let you explain that, but I think, 

once again, it is about democratizing finance, about having someone representing the individual. 

Fourth point. I think the real fundamental problem which 

underlies this crisis is a failure of risk management and so instead 

of saying no to new financial derivatives, we have to make them 

work better for everyone and I think that means expanding the 

scope of our financial markets. Notably, real estate is a risk which 

is underlying this crisis and is not hedgeable, it’s not manageable, 

and the kinds of securities that we’ve developed to manage such 


SMARTINEZ on PROD1PC64 with HEARING
85 

risks entail unfortunate counterparty risk and systemic risk. So we 

have to think about how to make it possible for a broader array of 

risks to be managed. 

Finally, I talk about in my Subprime Solution book a new mortgage institution that we could create which would be helpful in 

managing the risks of families. I call it a continuous work-out 

mortgage. 

This would be a mortgage that would automatically adjust the 

payment the way a work-out does in response to objective factors, 

continuously and automatically. That is, for example, if we fall into 

a recession or we see a big drop in home prices, there would be a 

formula written into a mortgage contract that would automatically 

adjust down the payment and the principal. 

If we had had such a thing in place today, it would have prevented a lot of economic suffering. Instead of having families go 

through months or years of difficulty in paying their mortgage and 

then running out of money and going in begging for help, we would 

have had them helped automatically. These are the kinds of ideas 

that I think we have to think about. It’s ideas that are innovations 

and that represent creative new solutions to the problems that 

we’ve seen. 

[The prepared statement of Dr. Shiller follows:] 


SMARTINEZ on PROD1PC64 with HEARING
86 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 133 47928A.059
87 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 134 47928A.060
88 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 135 47928A.061
89 

Professor WARREN. Thank you, Dr. Shiller. Two books, five minutes. 

Dr. Stiglitz. 

STATEMENT OF JOSEPH E. STIGLITZ, PH.D., UNIVERSITY 

PROFESSOR, COLUMBIA BUSINESS SCHOOL 

Dr. STIGLITZ. Thank you for holding these hearings. 

I feel quite strongly that part of the reason that our financial 

system has performed so poorly is inadequate regulation and regulatory structures. There’s a lack of confidence in our financial system which is well earned, but how can there be restoration of confidence when all we have done is to pour more money into the 

banks? We have changed neither the regulatory structures, the incentive systems, nor even those who are running these institutions. 

While everyone talks of the need for better regulation, the devil 

is in the details. Some have pushed for cosmetic reforms instead of 

the real reforms that we need. Those who engage in deceptive financial practices will push for deceptive regulatory reform. 

It is hard to have a well-functioning modern economy without a 

sound financial system. However, financial markets, as has already 

been said, are not an end in themselves but a means. They are supposed to mobilize savings, allocate capital, and manage risk, transferring it from those less able to bear it to those more able. 

By contrast, our financial markets have encouraged excessive 

consumption and have misallocated capital. Instead of managing 

risk, they created it. These problems have occurred repeatedly and 

are pervasive. This is only the latest and biggest of our bail-outs, 

each of which reflects a failure of our financial system to fulfill its 

basic functions, including ascertaining creditworthiness. 

The problems are systemic and systematic. These failures are in 

turn related to three more fundamental problems. Markets only 

work well when there are well-designed incentives, a high level of 

transparency, and effective competition. America’s financial markets fail on all accounts. 

Markets only work well when private returns are aligned with 

social returns. Incentives matter, but when incentives are distorted, we get distorted behavior. Our banks have incentives designed to encourage excessive risk-taking and short-sighted behavior. Lack of transparency is pervasive in financial markets and is 

in part the result of flawed incentive structures. Indeed, those in 

the financial markets have resisted improvements, such as more 

transparent disclosure of the cost of stock options. This provided incentives for bad accounting. 

Failure to enforce strong competition laws results in institutions 

that are so large they are too big to fail and almost too big to be 

bailed out. That provides an incentive to engage in excessively 

risky practices. 

When financial markets fail, as they have done, the costs are 

enormous. There are, as economists put it, severe externalities. The 

losses include not only the budgetary costs in the hundreds of billions of dollars but also costs to the entire economy, totaling in the 

trillions, before we have fully recovered. The damage to our standing in the world is inestimable. 


SMARTINEZ on PROD1PC64 with HEARING
90 

Good regulation can increase the confidence of investors in markets and serve to attract capital to financial markets. It can also 

encourage real innovation. Much of our financial market’s creativity was directed to circumventing regulations, taxes, and accounting standards. Accounting was so creative that no one, not 

even the banks, knew their financial position. 

Meanwhile, the financial system didn’t make the innovations 

which would have addressed the real risks people face, such as how 

to stay in their homes when interest rates changed or economic 

conditions changed. Professor Shiller has shown how it’s easy to 

come up with innovations of this kind. Not only did they not do 

this, but they also resisted these kinds of innovations. 

In short, regulations can help markets work better. We need regulations to ensure the safety and soundness of individual financial 

institutions and the financial system as a whole to protect consumers, maintain competition, ensure access to finance for all, and 

maintain overall economic stability. They need to focus both on 

practices and products. 

It has been commonplace to emphasize the need for more transparency, which is why any retreat from mark to market would be 

a mistake, but we should realize that lack of transparency is a 

symptom of deeper problems. Even if transparency issues were 

fully addressed, much more needs to be done. 

For instance, even if there were full transparency, some of the 

products the financial markets created were so complex that not 

even their creators fully understood their risk properties. We have 

to ensure that incentive structures do not encourage excessivelyrisky short-sighted behavior. We need to reduce the scope of conflicts of interest which are rife within the financial system. 

Securitization, for all the virtues of diversification, has introduced 

new asymmetries in information, forcing originators of mortgages 

to bear some of the risk and mitigate some of the resulting moral 

hazard. 

Derivatives and similar financial products should neither be purchased nor produced by banks, unless they have been approved for 

specific uses by a financial products safety commission and unless 

their use conforms to the guidelines established. They should be instruments for laying off risk, not instruments for gambling. Regulators should encourage the move to standardized products; greater 

reliance on standardized products, rather than tailor-made products, may increase both transparency and efficiency of the economy. 

Professor WARREN. Dr. Stiglitz, can I ask you to wrap up your 

opening remarks? 

Dr. STIGLITZ. Okay. There are a large number of other reforms 

that I talk about in my written testimony. 

Let me just conclude by saying TARP has failed partly because 

of the failure to do anything about regulation. We need to impose 

conditionality on the use of the funds if we are to have any confidence that the next tranche of funds have better outcomes than 

the last tranche of funds. 

We need, as Professor Shiller pointed out, to encourage more in- novation. One way of thinking about this is if we had taken $700 

billion and created a new institution which had used a normal leVerDate Nov 24 2008 00:38 Apr 01, 2009 Jkt 047928 PO 00000 Frm 00096 Fmt 6633 Sfmt 6602 E:\HR\OC\A928.XXX A928

SMARTINEZ on PROD1PC64 with HEARING
91 

verage of 10:1, we could have created a flow of credit of $7 trillion. 

We would have done far better if we had started fresh, rather than 

bailing out the failed institutions of the past. 

Now, no one has proposed that, but the point I wanted to make 

is that we are putting an awful lot of money in the system. We 

have had repeated bail-outs, not just the S&L bail-out, but also the 

Mexican, Indonesian, and Korean bail-outs of the financial markets. These were not bail-outs of the countries: They represent 

failed lending practices of our financial institutions. 

Unless we impose better, smarter regulation, we will have another one of these encounters in a short period of time. 

[The prepared statement of Dr. Stiglitz follows:] 


SMARTINEZ on PROD1PC64 with HEARING
92 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 143 here 47928A.062
93 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 144 here 47928A.063
94 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 145 here 47928A.064
95 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 146 here 47928A.065
96 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 147 here 47928A.066
97 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 148 here 47928A.067
98 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 149 here 47928A.068
99 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 150 here 47928A.069
100 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 151 here 47928A.070
101 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 152 here 47928A.071
102 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 153 here 47928A.072
103 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 154 here 47928A.073
104 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 155 here 47928A.074
105 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 156 here 47928A.075
106 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 157 here 47928A.076
107 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 158 here 47928A.077
108 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 159 here 47928A.078
109 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 160 here 47928A.079
110 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 161 here 47928A.080
111 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 162 here 47928A.081
112 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 163 here 47928A.082
113 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 164 here 47928A.083
114 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 165 here 47928A.084
115 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 166 here 47928A.085
116 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 167 here 47928A.086
117 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 168 here 47928A.087
118 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 169 here 47928A.088
119 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 170 here 47928A.089
120 

Professor WARREN. Thank you, Dr. Stiglitz. Mr. Sumerlin. 

STATEMENT OF MR. MARC SUMERLIN, MANAGING DIRECTOR 

AND CO-FOUNDER, THE LINDSEY GROUP 

Mr. SUMERLIN. Madam Chair, Members of the Panel, thank you 

very much. 

My name is Marc Sumerlin. I’m Managing Director of The 

Lindsey Group, an economic consulting firm. Previously, I was Deputy Director of the National Economic Council in 2001 and 2002. 

We are in the midst of an economic contraction that is currently 

mirroring the worst months of the 1974 recession, one of the sharpest post-World War II periods of decline for our country. Despite all 

of the actions to date, it has been impossible to completely stop the 

deterioration because the economy is deleveraging and in fact 

needs to shed leverage after a decade of excessive borrowing. 

Credit market liabilities in the United States soared from 250 

percent of GDP in 1997 to 350 percent of GDP in 2007, reaching 

over $50 trillion. Over this time, the economy has suffered from the 

rapid deflation of two asset bubbles. While both consumers and the 

financial sector still need to reduce their debt burden, a central 

goal of the emergency policies has been to slow the pace of 

deleveraging to minimize the negative feedback loops that occur 

during a sharp economic downturn. 

The goals of longer-term reform strategies are quite different and 

should focus on preventing excessive leverage from happening in 

the next cycle. In thinking about reform of the regulatory structure, I believe it is imperative to consider the proper role of monetary policy as well. 

In my written testimony, I have described in detail where I believe policy across government failed in the past. Now, I’d like to 

focus on three broad recommendations, all centered on preventing 

excessive leverage from building up again. 

The first recommendation is for the Federal Reserve to take a 

more active role in preventing asset and credit bubbles from forming in the first place, as I believe is mandated under the Federal 

Reserve Act. 

During the 1990s, there emerged a widespread belief that central 

bankers had learned from their inflationary mistakes of the past 

and that another end-of-history moment had arrived where everyone could relax or at least prosper. 

There was a new consensus view that monetary policies should 

effectively target a low level of goods and services inflation while 

ignoring asset prices, except to the extent that they signal a change 

in future inflation. Not only would asset bubbles in credit not be 

resisted but policymakers believed they should aggressively lower 

interest rates after an asset bubble pop to mitigate the damage. 

This created an asymmetric bias that traders referred to as the 

‘‘Greenspan Put.’’ This bias towards easing monetary policy also 

created a bias towards over-valued assets that would eventually 

collapse under their own weight. In fact, financial bubbles are dependent on an accommodative monetary policy in the first place. 

The Federal Reserve needs to take a more active role in promoting financial stability. While the Fed has from creation adopted 

the lender of last resort role, it has not always embraced the policy 


SMARTINEZ on PROD1PC64 with HEARING
121 

of mitigating boom-bust cycles in asset prices, but under the Federal Reserve Act, the Central Bank is obligated to ‘‘maintain long 

run growth of monetary and credit aggregates commensurate with 

the economy’s long-run potential to increase production.’’ 

This gives the Federal Reserve a responsibility to prevent asset 

bubbles since they are fueled by excess credit. 

The second recommendation is to shift housing policy from subsidizing leverage to promoting equity, as the Central Bank was not 

the only part of government that was complicit in the housing and 

credit bubble. 

Government housing policy has been designed to directly subsidize leverage. The most expensive housing policy the U.S. has is 

the tax deduction on mortgage interest payments, which lowers 

borrowing costs. This is why realtors commonly refer to your interest payments as your ‘‘tax deduction.’’ 

Both the Clinton and the Bush Administration have pushed various programs that supported easier access to housing credit and 

lower downpayments which, by definition, create leverage. At the 

same time, the private sector seemed determined to outdo the government’s lead at the peak of the bubble. 

In 2005, a remarkable 43 percent of all first-time homeowners 

put zero down or took out a mortgage in excess of the value of the 

home. It’s worth emphasizing here that buying a house without a 

downpayment is not homeownership. It is renting with risk. To the 

extent possible, government subsidies to leverage should be replaced with broader programs that help build equity, such as downpayment matches for new homeowners. 

My last recommendation is to support a binding limit on the 

amount of leverage that is permitted by banks and other financial 

institutions that act as banks. A large part of the financial system, 

most notably commercial banks, under the regulation of the FDIC, 

already has a limit on their leverage. These banks are subject to 

a simple leverage ratio that caps their assets relative to their capital. Notably, investment banks were not subject to this limit. 

For covered banks, if the leverage ratio drops below four percent, 

the FDIC must start supervisory intervention and if the leverage 

ratio drops below two percent, the bank is considered critically 

undercapitalized and is shut down. This system means that any 

bank that is leveraged more than 25:1 will be under intense regulatory scrutiny. Banks hate these simple calculations because they 

cannot easily be skirted, which is the very point. 

It is worth remembering that banks are inherently risky entities. 

John Maynard Keynes once quipped that ‘‘a prudent banker is one 

that fails at the same time that all other bankers fail.’’ But this inherent riskiness is why banks need more limits in other parts of 

the economy. 

A binding leverage ratio is a simple, transparent, and blunt form 

of regulation, all attributes that could make it a useful form to 

bank regulators around the world. 

Professor WARREN. Mr. Sumerlin, could I just ask you to finish? 

You’re over time. 

Mr. SUMERLIN. Absolutely. The last point I would make, adding 

to that, is at the same time, all efforts have to be made to move 

off-balance sheet activity back on balance sheet, as will soon be reVerDate Nov 24 2008 00:38 Apr 01, 2009 Jkt 047928 PO 00000 Frm 00127 Fmt 6633 Sfmt 6602 E:\HR\OC\A928.XXX A928

SMARTINEZ on PROD1PC64 with HEARING
122 

quired under FAS–140, and I’d just like to make one more note, 

that both the housing and credit bubble were exacerbated by the 

psychology of a bull market, which is important to always keep in 

perspective, which adversely affected the judgment of homebuyers, 

market participants, and regulators. 

Thank you very much. 

[The prepared statement of Mr. Sumerlin follows:] 


SMARTINEZ on PROD1PC64 with HEARING
123 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 178 here 47928A.090
124 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 179 here 47928A.091
125 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 180 here 47928A.092
126 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 181 here 47928A.093
127 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 182 here 47928A.094
128 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 183 here 47928A.095
129 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 184 here 47928A.096
130 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 185 here 47928A.097
131 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 186 here 47928A.098
132 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 187 here 47928A.099
133 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 188 here 47928A.100
134 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 189 here 47928A.101
135 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 190 here 47928A.102
136 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 191 here 47928A.103
137 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 192 here 47928A.104
138 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 193 here 47928A.105
139 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 194 here 47928A.106
140 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 195 here 47928A.107
141 


SMARTINEZ on PROD1PC64 with HEARINGInsert graphic folio 196 here 47928A.108
142 

Professor WARREN. Thank you, Mr. Sumerlin. And Mr. Wallison. 

STATEMENT OF MR. PETER J. WALLISON, ARTHUR F. BURNS 

FELLOW IN FINANCIAL POLICY STUDIES, AMERICAN ENTERPRISE INSTITUTE 

Mr. WALLISON. Thank you. 

I’m very pleased to have this opportunity to testify today and I 

assume my prepared remarks will be—— 

Professor WARREN. Of course. 

Mr. WALLISON [continuing]. Put in the record. My testimony actually will focus mostly on safety and soundness regulation, but I’d 

be happy to answer questions about any other kind of regulation. 

With the limited and disastrous exception of the major investment banks, the Federal Government has never regulated the safety and soundness of financial institutions for which it does not assume some financial responsibility. There are sound and strong 

reasons for this. 

First, regulation itself introduces moral hazard. Participants in 

the financial markets may believe that government supervision reduces the likelihood of missteps or failure and this impairs market 

discipline. 

Second, regulation also impairs competition, suppresses innovation, increases consumer costs, and enhances the likelihood that 

taxpayers will be called upon to bail out regulated companies. 

Third, there is no policy reason why the government should take 

responsibility for preventing the failure of financial institutions 

that it does not back. In general, business failures are good for the 

economy and the financial system. They remove bad management 

and bad business models and make room for good management and 

business models. If regulation is in fact effective in preventing bad 

management from failing—which is doubtful in any case—it would 

be preserving bad management and business models. 

Fourth, regulation is apparently not effective in preventing business failures. We can see that from the current financial crisis in 

which heavily-regulated commercial banks are in the most trouble. 

In fact, given the disastrous conditions of the banks, it is difficult 

to understand why anyone would be calling for the regulation of 

other participants in the financial system. 

If regulation does not prevent failures, why impose its costs on 

consumers and taxpayers? 

Nevertheless, only a recently-landed Martian would not realize 

that there is a major move afoot in Congress to broaden the scope 

of regulation to include other participants in the financial markets. 

The ostensible reasons for this are usually two. Regulation, it is 

said, will improve transparency and reduce systemic risk. As outlined in my prepared testimony, neither reason is persuasive. 

Transparency itself is a reasonable goal, but it is not worth the 

tangible and intangible costs of regulation when institutions are 

dealing solely with sophisticated counterparties. These counterparties can fend for themselves and know what questions to ask. 

As to reducing systemic risk, there are no examples of the failure 

of a non-regulated institution causing systemic risk, including 

LTCM, Lehman and AIG or any of the hedge funds that have 

closed their doors this year. 


SMARTINEZ on PROD1PC64 with HEARING
143 

Lehman’s failure did not cause systemic risk. No institution 

failed or was threatened with failure because Lehman collapsed. 

The market freeze-up after Lehman was not caused by losses coming from Lehman’s failure but by a sudden recognition on the part 

of banks and others around the world that their counterparties 

might be very weak and unstable and that the U.S. Government 

could not be expected to rescue them. 

Accordingly, the proponents of new regulation, based on the danger of systemic risk, should explain why it is suddenly necessary. 

Finally, it would be a very bad idea to empower some agency, the 

Federal Reserve or anyone else, to identify systemically-significant 

institutions and regulate them as such. This would have very adverse effects on competition. By creating the impression that some 

institutions are too big to fail—which is what it means to be designated as systemically significant—such a policy would create an 

unlimited number of Fannies and Freddies that would have huge 

competitive advantages over others in the same industry. 

As we can see from bank regulation, traditional financial supervision does not work anyway and will not prevent financial failure. 

To be sure, there are some areas where regulation is necessary, especially when financial institutions, like commercial banks, are 

backed by the Federal Government. The GSEs are another example. 

Accordingly, in my prepared testimony, I recommend a few major 

changes in traditional regulation for these cases of necessary regulation. The purpose of these reforms is to enhance market discipline and make regulation counter-cyclical rather than pro-cyclical as it is today. 

To assist creditors and counterparties, I suggest that regulators 

should work with analysts and the regulated industry to create 

metrics or indicators of risk-taking. These would be published regularly and help potential creditors understand the risks that regulated institutions are assuming. 

Professor WARREN. One more paragraph. 

Mr. WALLISON. This would make market discipline much more 

effective. I also recommend various steps that will make regulation 

counter-cyclical, including changes to fair value accounting, requirements for regulators to consult market sources for risk assessments, requirements for capital increases when asset values are 

rising, and the enhancement of the role of short sellers and hedge 

funds. 

Thank you very much. 

[The prepared statement of Mr. Wallison follows:] 


SMARTINEZ on PROD1PC64 with HEARING
144 


SMARTINEZ on PROD1PC64 with HEARINGInsert offset folio 203 here 47928A.109
145 


SMARTINEZ on PROD1PC64 with HEARINGInsert offset folio 204 here 47928A.110
146 


SMARTINEZ on PROD1PC64 with HEARINGInsert offset folio 205 here 47928A.111
147 


SMARTINEZ on PROD1PC64 with HEARINGInsert offset folio 206 here 47928A.112
148 


SMARTINEZ on PROD1PC64 with HEARINGInsert offset folio 207 here 47928A.113
149 


SMARTINEZ on PROD1PC64 with HEARINGInsert offset folio 208 here 47928A.114
150 


SMARTINEZ on PROD1PC64 with HEARINGInsert offset folio 209 here 47928A.115
151 


SMARTINEZ on PROD1PC64 with HEARINGInsert offset folio 210 here 47928A.116
152 


SMARTINEZ on PROD1PC64 with HEARINGInsert offset folio 211 here 47928A.117
153 


SMARTINEZ on PROD1PC64 with HEARINGInsert offset folio 212 here 47928A.118
154 


SMARTINEZ on PROD1PC64 with HEARINGInsert offset folio 213 here 47928A.119
155 


SMARTINEZ on PROD1PC64 with HEARINGInsert offset folio 214 here 47928A.120
156 


SMARTINEZ on PROD1PC64 with HEARINGInsert offset folio 215 here 47928A.121
157 


SMARTINEZ on PROD1PC64 with HEARINGInsert offset folio 216 here 47928A.122
158 

Professor WARREN. Thank you, Mr. Wallison. In fact, Mr. 

Wallison, I’ll just come back to you, so you’ll get a chance to talk 

some more. 

I was struck by your comment when you said regulation doesn’t 

prevent failures, see the recent bank failures. 

Mr. WALLISON. Yes. 

Professor WARREN. But I also listened to Ms. Raskin and Ms. 

Raskin, if I made my notes right, said in effect that federal regulators were captured and they really did a pretty lousy job whereas 

the state regulators were watching, the state regulators saw it, and 

they waved as many flags as they could. But failure seems to accompany those who are governed by regulators who are not independent or, to say it another way, non-regulation regulation seems 

to lead to failure. 

Can you respond to Ms. Raskin’s point? 

Mr. WALLISON. Sure. I think I can. I have no faith, of course, as 

I suggested in my oral testimony, in regulators per se. I don’t think 

they’re any smarter than the people that they are regulating and 

in fact they are always relatively behind the curve. We assume 

that regulators are actually overseeing risk-taking, and they are 

not. 

The only group that actually is interested in preventing risk-taking are creditors. Creditors are not benefited by risk-taking. And 

as a result, we ought to do everything we can to assure that creditors get the information about the risks that the institutions are 

taking so that they can make appropriate choices in lending money 

or withholding money from financial institutions, especially regulated institutions. 

Professor WARREN. Sir, I just want to make sure I’m understanding the point. Regulators are not smart enough to regulate or 

they simply won’t regulate? 

Mr. WALLISON. Oh, I think they would love to regulate. In fact, 

they—for the larger institutions here in the United States, the 

larger banks, there are regulators in those institutions 100 percent 

of the time. 

Professor WARREN. Maybe that was Ms. Raskin’s point. 

Mr. WALLISON. Yes, of course, but I’m saying that no regulation 

is going to be satisfactory if we are relying simply on government 

people going in and looking at what the institutions are doing. 

The ones who are really effective at regulation are the ones who 

have the incentive to do so, I believe, and those are the creditors, 

the people who are asked to lend the money or make deposits in 

those institutions or be counterparties in transactions. They need 

the information that they are not getting from the institutions to 

decide whether risks are being taken. 

Professor WARREN. Ms. Raskin, maybe I could give you a chance 

to respond as a regulator. 

Ms. RASKIN. Yes, thank you. I do believe that regulation works. 

I think that there are systems in place currently that primarily 

permit a great deal of coordination between state regulators and 

federal regulators. 

We have seen through recent history that regulators have been 

very nimble at the state level, have been very precise in dealing 

with the problems that have arisen, particularly the number of 


SMARTINEZ on PROD1PC64 with HEARING
159 

foreclosures, that we’ve been dealing with on a massive level at the 

state level. 

So I do believe that regulation works. I urge, though, the panel 

to consider when they design a new system for organizing the regulatory boxes that checks and balances be considered, that accountability be built in and that mechanisms be adopted that permit coordination among the different regulators. 

Professor WARREN. President Seligman, I have the sense you’d 

like to respond to this. 

Mr. SELIGMAN. Effective regulation can increase confidence in 

our markets. We’ve seen, for example, during the time of the SEC 

the percentage of investors in this country grow from 1.5 percent 

to approximately 50 percent, the value of equity and debt in this 

country grow from 90 billion to close to 12.6 trillion. 

At the same time what you referred to as non-regulation regulation can undermine this confidence and the classic recent illustration that has so far been reported upon is Bear Stearns where you 

had too few individuals involved in administering the SEC’s Consolidated Supervisory Entity Program. When problems were 

flagged, they did not go up the chain of command. You had certain 

wrong rules, and I commend to your attention the report of the 

SEC’s Office of Inspector General on Bear Stearns which documents that you have to have people who believe in regulation to 

administer it if you’re going to in turn prevent financial misconduct. 

Professor WARREN. Thank you very much. I’m nearly out of time. 

So I’m going to go to Congressman Hensarling. 

Representative HENSARLING. Thank you, Madam Chair. I again 

thank the panel. 

Mr. Wallison and Mr. Sumerlin, I think you both wrote about 

Fannie and Freddie in your testimony. I’m not sure I heard it or 

saw it in the other testimony. 

Mr. Wallison, in your testimony, you speak about Fannie and 

Freddie were largely responsible for the vast inflation of the housing bubble, and Mr. Sumerlin, I believe you write in your testimony 

that the GSEs, Fannie and Freddie, encouraged loans to people 

who could not afford them and essentially helped destabilize our 

housing market in direct contrast with their mission. 

I would like to give you two gentlemen, starting with you, Mr. 

Wallison, an opportunity to elaborate on your thoughts on precisely 

the role of Fannie and Freddie in our economic turmoil and also 

speak, if you would, specifically to their affordable housing mission. 

Mr. Wallison. 

Mr. WALLISON. Fannie and Freddie represent an effort on the 

part of Congress to achieve a national housing goal without appropriating funds. Instead, what Congress did was used two private 

companies to make loans that they might not otherwise have made, 

except for certain housing goals that they were required to meet. 

As a result, Fannie and Freddie contributed about 40 percent of 

all the subprime and Alt-A loans that we are currently struggling 

with in our economy by buying loans from originators that would 

not otherwise have been marketable. That distorted our financial 

system and has ultimately been the cause of the tremendous losses 

that we are going to suffer in housing. 


SMARTINEZ on PROD1PC64 with HEARING
160 

Representative HENSARLING. Mr. Sumerlin. 

Mr. SUMERLIN. During the 1990s, both of the GSEs continually 

lowered their downpayment requirements of what type of loans 

they would buy. 

Now, when the loan went below a 20 percent downpayment, it 

still had to have some form of mortgage insurance, but loans were 

being securitized through Fannie and Freddie that did have lower 

and lower downpayments. This is, as you know from my testimony, 

something that I believe is a problem when you have excess leverage to homeowners. 

During, the peak of the housing boom, they were operating, just 

as were private firms, in buying and thereby aiding mortgages that 

should never have been given. I think the GSEs, given their link 

to government, do tend, when they do something, to put more of 

a stamp of approval on it, than when other people do and therefore 

they had a special role to be even more diligent and the GSEs 

had—from the beginning, were undercapitalized and had an incentive problem where they could essentially privatize profits and socialize losses and that’s the framework for taking on—— 

Representative HENSARLING. Is it your opinion that but for their 

government sanction duopoly status that they would not have been 

able to do what they did? 

Mr. SUMERLIN. They certainly would not have been able to do 

what they did with the scale they did. I mean, they existed on that 

scale because of their link to the Federal Government. 

Representative HENSARLING. Mr. Sumerlin, also in your testimony, you speak extensively, I believe, on the Federal Reserve policies, particularly in dealing with our last financial crisis after the 

dot-com bubble and 9/11, and I think on Page 8 of your testimony, 

I had not realized this, for three straight years, the Fed fund rate 

was essentially negative, as you put it, the equivalent of free 

money. 

I think there was a body of work that would suggest that the 

seeds for this financial crisis were, frankly, sown in trying to deal 

with the aftermath of the last financial crisis. 

Would you speak a little bit more extensively about your view of 

the role of the Federal Reserve’s easy money policy enabling the 

crisis that we find ourselves in? 

Mr. SUMERLIN. I think that once you get yourself into a boombust cycle, you start doing emergency policies and other things to 

mitigate the current problems and you don’t always know where 

you’re going to end up. 

Once we had the enormous tech bubble where the PE ratio, the 

S&P, for instance, got up to 45, about three times its historic average, and then in 2001, when—starting in March of 2000, we had 

about $5 trillion in asset losses and the government starts to react 

to that, and deflating asset bubbles can be very vicious economic 

events, and part of the reaction to that was the Federal Reserve 

from 2002–2003–2004, real interest rates, meaning adjusted for inflation, were effectively zero, which is like free money. 

Part of the other issue was the Federal Reserve, by being completely transparent that it was going to take a very gradual path 

that lowered bond volatility. Volatility, and other sort of things, 

which encouraged financial entities to take on more risk and in 


SMARTINEZ on PROD1PC64 with HEARING
161 

some cases, some financial entities, like pension funds insurers, 

they need a seven percent, eight percent nominal return, and when 

you’re operating in a very low nominal return world, they start to 

leverage up to try to hit the return they need to meet their internal 

targets. 

Professor WARREN. Thank you, Mr. Sumerlin. Thank you. We’re 

over time. Congressman, thank you. 

Mr. Silvers. 

Mr. SILVERS. Thank you, Madam Chair. President Seligman, I 

understand you have some time constraints here. I would appreciate it if you would in writing advise us as to specific steps to 

strengthen the Securities and Exchange Commission in light of 

your testimony. Specifically, though, my question to you is there’s 

been some talk about unified consumer protection financial services 

in a regulatory body. 

Do you view the types of substantive consumer protection that 

we see in insurance, mortgages, credit cards, as being easily 

mergable with the sort of disclosure-based investor protection that 

the SEC does? 

Mr. SELIGMAN. I think it’s a tough analysis that has to be done. 

I do think, for example, a potential merger of the SEC and CFTC 

makes good sense for a number of reasons. I do think there needs 

to be very thoughtful analysis as to whether or not certain aspects 

of insurance should be subject to federal regulation. 

I do think, however, that when you try to create one consumer 

and investor agency across the board you risk dissipating the expertise necessary to effective regulation and what I’m very much 

concerned about when I look at the experience, whether it’s of the 

SEC or other agencies, when their mandate becomes too broad, 

they tend not to be able to focus on everything equally well. There 

is a real value to expertise. 

The countervailing challenge, and it’s been well illustrated in the 

recent past, is regulatory arbitrage and, for example, when you 

have five depository institution regulators, the ability of those regulated to pick and choose which format they’ll be subject to does create a kind of tendency towards a race to the bottom. 

So it’s going to take very, very systemic analysis. It shouldn’t be 

done quickly. You need to have sufficient hearings. You need to 

have sufficient reports so you can reach the appropriate outcomes. 

Mr. SILVERS. Thank you. Ms. Bloom Raskin, you are the only 

member of our panel who is actually involved in the housing crisis 

and the foreclosure crisis in any direct way right now in your capacity. 

Can you shed light on the relative responsibility in your view, 

based on what you’ve seen, of the GSEs and GSE-financed mortgages on the one hand and of the non-GSE entirely private sector 

firms on the other that were so much encouraged in the last eight 

years? 

Ms. RASKIN. I’d be happy to and that’s—it’s an excellent question. 

What I can speak to certainly is the work that we have been 

doing in Maryland regarding the foreclosure crisis and we identified quite early that mortgage servicers were in fact a linchpin to 

working through a lot of the problems of loan modification and the 


SMARTINEZ on PROD1PC64 with HEARING
162 

need for sustainable mortgage modification, and to that extent, 

what we have done, and I think states are very well positioned to 

do, is to work individually, and it’s hard work, it’s a lot of heavy 

lifting, but to work individually with mortgage servicers which we 

have done. 

We have hammered out agreements one by one with them in 

which we require certain operational fixes being made within the 

relationship between the borrower and the servicer and we have 

worked very hard in that regard. 

We have also put in place a monthly reporting system by which 

we collect data on a monthly basis from the mortgage servicers 

that are doing business within our state and in this way we have 

been able to track modification efforts and we’ve been able to measure the sustainability of those modifications. 

This to me are—these are two examples of how we have been 

able to work on a local level without really the involvement of the 

GSEs and Fannie and Freddie but with the servicers over whom 

we do have some regulatory authority. 

Mr. SILVERS. Thank you. Professor Stiglitz, in your written testimony, you raised a question of whether the Federal Reserve as currently structured is an appropriate umbrella regulator. 

I think, Mr. Sumerlin, you also have some concerns about the 

Fed in your testimony you gave this morning. 

In order, Professor Stiglitz, could you comment on what changes 

might be necessary to the Fed for it to play the role some envisioned for it? 

Dr. STIGLITZ. First, let me say I share the view of several people 

on the panel that the Fed was too easily captured by the spirit of 

the bubble that was going on. The metaphor that was given of a 

punch bowl that was spiked is, I think, absolutely correct. 

That’s why I think it’s important to make sure that the Fed becomes more representative and much more explicit about its mandate. In the United States and around the world, there has been 

focus only on inflation. There have been explicit discussions not to 

worry about assets and I think Mr. Sumerlin is exactly right, that 

the Fed needs to understand that financial instability is far more 

of a risk for long-term economic growth than an increase in inflation from two percent to 2.5 percent. 

Professor WARREN. Can I ask you just to wrap up just because 

we’re over time? 

Dr. STIGLITZ. Okay. The single most important thing is to make 

sure, like they do in Sweden, for instance, that there are representatives on the Federal Reserve Board of people whose views may not 

be quite consistent with those in the investment community, such 

as from the labor community. 

Professor WARREN. Thank you. Senator Sununu. 

Senator SUNUNU. Thank you, Madam Chair. Listening to the testimony and some of the answers to questions, I want to begin with 

an observation. I believe that Mr. Wallison’s point—that even in 

areas where he would agree that regulation should be imposed because of a government guarantee, the regulators can still cause significant problems—is not at odds with the points made by Mr. Seligman and Mrs. Raskin. 


SMARTINEZ on PROD1PC64 with HEARING
163 

In fact, I think the points that you made reinforce this point. 

There may be other areas where there’s disagreement, but the example of the SEC’s Consolidated Capital Rule, and the example of 

regulatory capture—and let’s name names, at the OTS—these are 

two of the oldest and, one might argue, most experienced federal 

regulators that took specific action or failed to take specific action 

that made this crisis much worse. 

I think we need to be cognizant of that and actually use that as 

a basis for the recommendations that we make. I also think that 

speaks directly to Mr. Wallison’s concern about the way in which 

existing regulatory structure can make the problem worse. Now, 

they could also help deal with problems, and I believe that they 

should. 

I’d like to go to Mr. Seligman, though, not to talk about the 

CFTC/SEC consolidation to which I’ll come back. You mentioned 

something else—a federal voice for insurance regulation and the 

concept of a federal charter, an optional federal charter for insurance, which the Treasury Blueprint also discussed. 

How do you think that a federal voice for insurance regulation 

might work? Do you think it’s necessary, given the national scope 

and the global scope of some of these insurance companies that we 

see today? AIG is obviously high profile but there are many others. 

But equally important to the other panelists, those in closest proximity to you, can we still maintain a meaningful voice for state regulation in an environment where we have an optional federal charter or federal insurance charter? 

Mr. SELIGMAN. I think there are two separate reasons you should 

look hard at a new federal role with respect to insurance. 

The absolutely imperative one now is systematic risk; that is, 

there are aspects of at least certain insurance corporations which 

required ultimate federal rescue packages which, because of 

counterparties, were viewed as of similar consequence to commercial banks and investment banks. 

There is a separate point, and that is that insurance regulation 

may be anachronistic. It is the only major financial sector which is 

essentially purely at the state level. This creates, among other 

things, potential competitive disadvantages in the global economy. 

It creates the kind of problems that the Securities Acts in the 

1930s or certain of the banking legislation has addressed through 

preemptive mechanisms and federal mechanisms. 

It seems to me what we ultimately would be most wisely moving 

towards was federal insurance regulation above certain thresholds, 

perhaps on an optional basis but more wisely I would suggest on 

a mandatory basis, through a chartering mechanism and state insurance regulation on a residual basis, the way you have it in—— 

Senator SUNUNU. Mandatory based on the aggregate assets of 

the insurance company or mandatory based on the size of the policy? 

Mr. SELIGMAN. I think that is the kind of question we need to 

systematically review. I don’t want to shoot from the hip on it, but 

I will suggest to you that I know there are a number of leaders of 

major insurance companies right now who would suggest to you 

that it is easier to deal potentially with one federal regulator than 

55 state and similar regulators that they now have to address and 


SMARTINEZ on PROD1PC64 with HEARING
164 

that to have one set of standards would potentially give them competitive advantages in a global economy. 

Senator SUNUNU. Do you still see a role for meaningful participation by the states to provide—— 

Mr. SELIGMAN. Absolutely. State securities regulation is absolutely vital for a number of reasons. It enhances the enforcement. 

It deals with local problems. It is a laboratory by which new ideas 

can originate, but at the same time for firms, either in interstate 

commerce or above certain thresholds, the notion that we would 

continue to rely on state securities regulation today would be dysfunctional. 

Senator SUNUNU. On the recommendation that the SEC and 

CFTC be combined, what do you—and I know this is an area where 

you’ve done a great deal of work—but what would you identify as 

the most specific obstacles to combination and how do you recommend we overcome those obstacles? 

Professor WARREN. And since we’re out of time, could I ask for 

just a condensed answer since I know this is in your testimony? 

Mr. SELIGMAN. Very simply, in a sentence, that the oversight 

committees in Congress for securities and commodities regulation 

are separate. 

Senator SUNUNU. It’s a turf war. 

Mr. SELIGMAN. It is a turf war. It is not principled. It is not wise. 

Senator SUNUNU. I don’t know if that makes the problem of consolidation easy or more difficult. 

Mr. SELIGMAN. Unfortunately, you do know. 

Professor WARREN. Thank you. Thank you, Senator. 

Mr. NEIMAN. I’d like to stay with Professor Seligman and follow 

up on your ideas for the role of the Federal Reserve as an apex 

agency, as a systemic regulator. 

If you could expand upon that as to why the Federal Reserve is 

the appropriate entity, and how would it operate differently than 

we are seeing the Fed operate in our current environment? 

Mr. SELIGMAN. It has been the emergency entity since at least 

the 1987 market crash time after time. What it doesn’t have is the 

right information flows, confidence in the underlying examinations, 

so that it can anticipate problems and try to obviate risk. 

You have three choices ultimately: the President’s Working 

Group, the Department of the Treasury, or the Fed. The Fed has 

been the one that operationally seems most competent to address 

this. 

What you want is not a Twin Peaks Model which suggests that 

at a similar level you both have safety and solvency and investor/ 

consumer protection. What you want is a very different type of approach where you have one agency that unequivocally receives all 

relevant information and can address systematic risk and respond 

to it the way the Fed implicitly has been doing for some time now 

but properly armed so that they’ve got confidence in information 

flows. 

And second, then you want to preserve industry expertise in a 

series of agencies. While it’s a very crude and imperfect analogy, 

what was done with intelligence services after 9/11 where you have 

a national intelligence director but separate intelligence agencies is 

a better model than the Twin Peaks. 


SMARTINEZ on PROD1PC64 with HEARING
165 

Mr. NEIMAN. Thank you. Mrs. Raskin, it’s a pleasure that you 

were able to join us and have a fellow regulator here and in fact 

it’s probably a unique experience where a panel is made up, the 

sole regulator is the state regulator. So welcome. 

Some have suggested that the dual banking system might make 

it more difficult to prevent or manage crises and to Mr. Seligman’s 

point, the response to 9/11, we moved to a more coordinated approach by creating a consolidated agency. 

Is that comparison apt? And what are your thoughts on the risks 

associated with moving toward a consolidated approach, the opportunity if you had a single regulator of missing red flags and eliminating checks and balances? 

Ms. RASKIN. Well, I think it’s a very apt analogy and I think that 

the dual banking system has actually been the savior here in mitigating even greater harm that could be coming from the financial 

crisis that we are now all living through. 

So I believe that the checks and balances that are in place by virtue of that system are a good example and a good model for study 

as we move forward in deciding what a regulatory, a new regulatory system might look like. So I do think that the state examiners, the state supervisory role has been an important check. I 

think that state-chartered institutions, by virtue generally of their 

size, have been able to be a good shock absorber to a lot of the systemic risk consequences we’ve been experiencing. 

Mr. NEIMAN. Thank you. Dr. Shiller, I was very interested in 

your concept of the continuing work-out loan and would probably 

want to follow up with you after, but in the minute we have left, 

have you done any analysis or research around the unintended, 

possible unintended consequences of that in terms of impact on the 

market, the ability of lenders to hedge their risk? Could it result 

in higher interest rate loans, shorter-term loans, and what would 

be the impact and expected reaction to the marketplace? 

Dr. SHILLER. Well, my proposal is a market-based solution and 

it involves the government only as a regulator that would make 

this possible. 

You’re asking questions that are difficult. How would market 

prices be impacted by an institution like this? In terms of mortgage 

rates, it’s possible that a continuous work-out mortgage would have 

a higher interest rate because you’re getting some kind of insurance, but it shouldn’t be considered a bad thing if people have to 

pay a higher interest rate. They’re getting a kind of risk protection. 

But on the other hand, we don’t know how much higher because 

it affects the whole economy and the whole systemic risk to the 

economy. So having something that protects mortgage borrowers 

built into the initial mortgage improves the resilience of the whole 

economy and in the long run it might produce even lower mortgage 

rates. 

Mr. NEIMAN. Have you seen any other jurisdictions, countries, or 

financial institutions that have adopted it? 

Dr. SHILLER. This has not been adopted in any country as far as 

I know, but we are coming into a new century and things have to 

change and I think it’s entirely plausible that as our financial markets develop, we will build in more protections for people and this 


SMARTINEZ on PROD1PC64 with HEARING
166 

is the trend we’ve seen in the past and I expect it to continue in 

the future. 

Mr. NEIMAN. Thank you. 

Professor WARREN. Thank you. Thank you, Mr. Neiman. We’re 

going to do a second round of questions, if you’ll bear with us, and 

I wanted to start, if we could, with Dr. Stiglitz. 

I was captured by your remark and I know there’s a reference 

to it as well in your testimony, that TARP has failed and it has 

failed in part because of the failure to put any conditions on how 

the money has been distributed. And you talk about the counter 

factual. If we had taken $700 billion and simply infused it in a new 

institution, how the world would look a little different right now. 

You make the point about imposing conditions on extending 

TARP funds. Can you just elaborate on that, Dr. Stiglitz? What 

would be your top three recommendations? 

Dr. STIGLITZ. Yes. I listed in my testimony a number of recommendations. Obviously, there’s broad consensus that the notion 

of our pouring money into these banks and having the money pour 

out in the form of dividends or bonuses, or in the form of acquisition of other healthy banks does not lead to more lending. That 

would be an obvious condition. 

A second set of conditions is that there are a large number of 

practices that everybody has identified as having contributed to the 

problem: Bad incentive structures, bad lending practices, exploitive 

anticompetitive practices in credit markets, and predatory lending. 

We are now in effect partial owner of the banking system of 

these large banks and yet we’re like a ‘‘slum lord.’’ We’re condoning 

these actions by providing money and allowing the banks to continue some of these very bad consumer and investor practices. 

A third thing I would do picks up on what the Commissioner 

said. We have some banks that are in better shape than others. 

These are the banks that actually were spending more of their time 

actually lending to small- and medium-size enterprises. These include community banks and many of the banks that are regulated 

by the states. 

They should have been the ones getting a disproportionate share 

of the money, not the banks with gambling propensities that have 

proven their incompetency or those that prided themselves on having moved out of the ‘‘storage’’ business and lending business into 

the moving business. 

We’ve been subsidizing this moving business. We should have 

been focusing on lending and asking what parts of the financial 

sector will get the flow of credit restored. Finally, we need to do 

something about the foreclosures. 

Professor WARREN. Good. Thank you. That’s very valuable. 

Thank you. 

I want to ask, and I’ll spread this across people, if you have different thoughts, to talk about the massive failure in the credit rating agencies that gave us the AAA ratings to instruments with 

enormously high risk, these private credit rating agencies that the 

government simply embraced and gave legal consequences to that. 

Can you speak to structurally how we might alter that, how we 

might think about a different way to do this? Did I see you shake 

your head no, President Seligman? 


SMARTINEZ on PROD1PC64 with HEARING
167 

Mr. SELIGMAN. No, I didn’t mean to shake my head no, but what 

I—you have a Hobson’s choice at the moment. You either are going 

to have credit ratings paid for by users or providers. We have a 

system where credit ratings at the moment are paid for by providers. It creates a conflict of interest. It does create a situation 

where the oversight until very recently has not been as systematic 

as it should be. 

You now have the SEC engaged in a catch-up effort with a significant report recently and some proposals which will be considered in the next Administration. 

The choices that are also on the table that you may want to 

think about, one has been the notion of the SEC placing less reliance on credit ratings and before we go there, we have to think 

through very carefully what happens then. That will mean more reliance in effect on those who provide information to the marketplace and not having any outside evaluation. 

Second, the notion of the government being engaged in credit rating strikes me as not a thoughtful or appropriate one for the same 

reasons that we rejected merit regulation in the 1930s in the securities industry. 

Professor WARREN. Dr. Stiglitz, could you add on this? 

Dr. STIGLITZ. Yes, I think that it is a very difficult problem. The 

current system is flawed in the incentives that underlie the way 

the credit rating agencies work. They were also very much taken 

up with the same flawed models that the banks were using, and 

so it was partly their incentives and partly their analytic frameworks. 

In other areas, like medicine, we rely on governments to rate 

products and see whether they are safe enough to be used and to 

identify the circumstances in which they can be used. 

It seems to me that that analogy is appropriate for financial 

products as well. 

Professor WARREN. Thank you very much. We’re on time here. 

Congressman Hensarling. 

Representative HENSARLING. Thank you, Madam Chair. Professor Shiller, I actually—your book on the Subprime Solution is 

one of six presently sitting on my desk. I haven’t read it yet. I look 

forward to reading it. At least you made a few bucks off of me. 

I think I heard in your testimony, I think you said that you advocate federal subsidies of financial literacy, and I certainly share 

your enthusiasm for the broader subject of promoting financial literacy within our country. I’d probably prefer the incentive structure as opposed to the subsidy structure. 

But I ask the question. As there are various policy proposals 

pending within Congress that some would argue would essentially 

bail out a huge universe of borrowers who may not have known 

about the mortgage products that they signed up for, maybe they 

should have known, but what incentive do they have to become financially literate if we essentially absolve them of personal responsibility? 

Dr. SHILLER. Well, I think we are going through a national tragedy right now of foreclosures and in many cases these people didn’t 

know what they were getting into and so I think that part of our 

civil society is that we have to bail out many of these people. But 


SMARTINEZ on PROD1PC64 with HEARING
168 

I think that it’s really important at this time to think about the 

longer term and to think about how we can change the system. 

Right now, we have a system in which most people get no financial advice from a disinterested party. They get advice from sales 

people of one sort or another who have an incentive to sell them 

their product. 

What I would like to see is a system in which people are getting 

advice from someone who signs a statement of loyalty to the client 

and announces that he or she will not take commissions or kickbacks of any form and that this would be a long-term relationship 

a person could develop, like with a physician but with a financial 

advisor, who you could go to and say should I really take this mortgage, is this really good for me? 

That’s something that is a costly thing. I think the government 

should subsidize it and that it would ultimately improve the whole 

atmosphere of—— 

Representative HENSARLING. Well, and again, I share your enthusiasm for financial literacy, and I certainly can’t do it justice, 

but I know Thomas Jefferson at one time said something along the 

lines of if you disagree with how your neighbor is acting within the 

marketplace, we shouldn’t try to restrict his freedom, we should inform his discretion. 

So I certainly agree with that, but it seems to me when it comes 

to financial literacy, there would be no greater course than actually 

having foreclosure proceedings initiated against you and yet we 

know that even those who are having their mortgages reworked 

under various programs, the repeat rate of default, I believe and 

I don’t have the statistic at my fingertip, is somewhere in the 

neighborhood of 40 percent. So that’s still somewhat question. I’m 

not sure there could have been a more effective course in financial 

literacy than that. 

If I could, let me change subjects here. Mr. Wallison, in your testimony, I don’t think we’ve touched upon this subject previously, 

and that is the subject of mark to market. 

Certainly again as a philosophical and principle position, I believe that more transparency is better than less transparency. I 

think the opaque quality of a number of these very complicated investment vehicles have exacerbated our problem, but how do you 

mark something to market when there isn’t a market, and isn’t the 

accounting rule itself that’s the problem or is it really the intersection of mark to market with certain of our regulatory capital standards? 

Mr. WALLISON. Well, Congressman, it’s both in a way. The reason I mentioned mark to market in my prepared remarks is that 

the problem we have today is that fair value accounting is a problem when there is no market, but it’s also a problem when there 

is a market. It’s highly pro-cyclical. When asset values are going 

up, it is possible to write up your assets and look much more profitable, borrow that much more money and increase the bubble that 

is developing. 

On the way down, when everyone is panicked and running for 

the doors and doesn’t want to buy anything, then fair value accounting works in the opposite direction and—— 


SMARTINEZ on PROD1PC64 with HEARING
169 

Representative HENSARLING. In the five seconds I have left, what 

would be your proposal? 

Mr. WALLISON. Well, I think we ought to modify fair value accounting so that it tends to be counter-cyclical; that is, when assets 

are going up, it should not allow increases in asset values on balance sheets, and when asset values are falling, when there’s a 

panic going on, we should limit the degree to which they can be 

written down, or have to be written down; or allow institutions to 

treat these assets as held to maturity which is a much safer way 

to value these assets. 

Representative HENSARLING. Thank you. 

Professor WARREN. Thank you. Mr. Silvers. 

Mr. SELIGMAN. Could I just add one—— 

Professor WARREN. Yes, President Seligman. 

Mr. SELIGMAN. You might want to take a look at a very recentlyreleased SEC Office of Chief Accountant Report on Fair Value Accounting which does focus on impairment issues. It’s actually somewhat similar to some of the points that Peter Wallison just made. 

Professor WARREN. Thank you, President Seligman. Mr. Silvers. 

Mr. SILVERS. Thank you, Madam Chair. There have been several 

comments made in the written testimony and I believe this morning by panelists about the issue of incentives and particularly in 

relationship to executives of institutions that are ‘‘systemically significant,’’ where there may be a public guarantee of some sort sitting around. 

I’d be curious to know. I am familiar with the recommendations 

from the Aspen Institute on both time horizons and symmetry, 

avoiding asymmetry in compensation. I would hope the panel 

might comment for a moment, starting with Professor Seligman, on 

both are these good ideas and how would one implement them in 

a regulatory and tax structure. 

Mr. SELIGMAN. I’m not clear precisely what the specific recommendations you’re referring to. If you want to focus on executive 

compensation which—— 

Mr. SILVERS. I’m interested in executive compensation as an 

issue of incentives around time horizons and around asymmetry, 

meaning the incentives to take large risks if you’re not fully exposed to the down side. 

Mr. SELIGMAN. We have seen throughout the 1990s and into the 

21st Century clear problems with respect to executive compensation, ranging from the initial treatment of stock options some 15– 

16 years ago. The back-dating of options has been a scandal and 

it’s being referred to in a number of enforcement cases, but it got 

way out of hand. Disclosure and the ability of shareholders to understand what compensation levels are is a perennial challenge and 

there have been proposals, including by the President-elect, that 

there should be at least advisory votes on the part of shareholders 

to address this area. 

It’s one that requires attention. It’s one that I think should be 

clearly on the priority list for the SEC as it comes into its new Administration. 

Dr. STIGLITZ. I think it’s very clear from any analytic perspective 

that the incentive structures that are commonplace do encourage 

short-sighted and excessive risk-taking behaviors. 


SMARTINEZ on PROD1PC64 with HEARING
170 

I think it would be easy, for instance, to base pay not on performance in one year but on performance over a longer time. Making 

a longer-term horizon would be a relatively easy change. 

Let me just emphasize one more point, which is that when pay 

is related to stock performance, it has a further effect of encouraging bad accounting standards. That was what we saw in Enron. 

It was not fixed in Sarbanes-Oxley, and so the problems go deeper 

in that these incentive systems actually encourage distorted information, which really undermines the transparency, efficiency, and 

confidence in our economy. 

Mr. SILVERS. Secondly, the panel—much of the testimony we’ve 

heard this morning has talked about regulatory gaps. 

I would like panelists to react to the proposition that we ought 

to regulate activity based on what it is economically and that we 

ought to have transparency requirements, accountability requirements, and capital requirements in relation to that activity based 

on what it is. If it’s insurance and we call it a credit default swap, 

perhaps we ought to regulate it like insurance. 

Comments? 

Mr. SELIGMAN. You know, I thought the point of the GAO report 

makes sense. Start with what are your objectives and if part of it 

is systemic risk avoidance and reduction, then the gaps are seen 

in a particular perspective. You simply can’t afford to have large 

hidden aspects of our economy, whether it’s credit default swaps or 

other aspects of OTC derivatives, hedge funds, or what have you, 

and that strikes me as one way in which you get at this. 

A second issue, though, is almost the behavioral arbitrage issue; 

that is, in effect if you’re a hedge fund manager, you’re unregulated, but if you’re an investment advisor, you’re regulated by the 

SEC, you create an incentive structure to move towards the unregulated segment of the economy and you, frankly, frustrate the 

ability for examination and understanding what’s going on. 

I suspect, though I do not know for sure, that when the ultimate 

books are written on Bernie Madoff, you will discover that most of 

the activity took place not in his registered broker-dealer operations but in ‘‘exempt investment advisor or hedge fund operations,’’ and in effect this was an example of behavioral arbitrage 

where you had someone move to unregulated areas and we saw in 

retrospect a very large price was paid. 

Professor WARREN. Thank you. Senator Sununu. 

Senator SUNUNU. Thank you. 

Professor WARREN. Thank you, President Seligman. I know that 

you have a plane to catch. We appreciate your being here and you 

are excused. Thank you. 

Senator SUNUNU. Mr. Wallison, you talked about devising regulation that was counter-cyclical and you mentioned the requirements 

or rules regarding accounting for assets as an example. 

Could you give a few other examples of recommendations that 

you would make that you think could be implemented realistically 

in the next few months that would also reinforce this counter-cyclical approach to regulation? 

Mr. WALLISON. I think the central problem of pro-cyclicality is a 

problem of human nature. We are always euphoric when things are 

getting better, when asset prices are going up. We then become 


SMARTINEZ on PROD1PC64 with HEARING
171 

very negative when things reverse and asset prices are going down. 

Regulators are going to be subject to the same problem; that is, 

when things are looking good, they are not going to stop the party, 

even though they are supposed to take the punch bowl away. They 

will not stop the party. Congress doesn’t want them to stop the 

party. 

We should have a law that requires the regulated institutions to 

add capital at a time when asset prices are going up, when things 

look very good. 

It’s kind of a counter-cyclical capital requirement—not the kind 

of capital requirement we have in prompt corrective action, that 

the FDIC enforces for banks, where they require increasing institutional restrictions as capital declines. This would be increasing capital requirements as the institutions become more profitable, because we know that at some point in the future, things will reverse, the bubble will burst, and we are going to be faced with institutions not having enough capital. 

Senator SUNUNU. Would you interpret the risk-weighted capital 

approach of Basel II as being pro-cyclical in this regard? 

Mr. WALLISON. You know, there are so many things wrong with 

Basel II,—— 

Senator SUNUNU. Okay. 

Mr. WALLISON [continuing]. I don’t even want to—— 

Senator SUNUNU. I only have two and a half minutes here. 

Mr. WALLISON. Yeah. 

Senator SUNUNU. That’s fine. We can talk about that later and 

develop some comments for the record. 

Mr. WALLISON. Okay. 

Senator SUNUNU. Mr. Sumerlin, you talked about capital standards and having them binding, having them clearer, less subject to 

subjective interpretation. 

Can you expand on that a little bit, talk about what kind of a 

system for setting capital ratios would make sense, what kind of 

changes we need to make, and whether those capital ratios should 

be based on institutional activity or size or other parameters? 

Mr. SUMERLIN. I mean part of how I look at this is I look at what 

regulations do I think worked and I think the leverage ratio of the 

FDIC was helpful. 

It would work in a similar way to what Mr. Wallison described 

where, if during good times you wanted to buy a lot more assets, 

you’d have to put in more capital and, you know, my preference for 

regulation is I like it to be blunt, simple, enforceable, and to be sort 

of a backstop and so that you don’t discourage sort of the types of 

new innovation that Mr. Shiller’s talking about, but there is something there that catches you and says no, you don’t get to lever up 

50:1 and that’s why I like this very simple leverage ratio just because I think it did prevent what might have been broader problems during a bubble. 

If I could just make one more point on the mark to market idea? 

You know, my own view is there is a price for everything and that 

price sometimes might be zero and you might not like it, but there 

is a price. 

Now, with mark to market, I think one of the problems with it 

is it’s a point estimate and so I would favor some sort of lengthVerDate Nov 24 2008 00:38 Apr 01, 2009 Jkt 047928 PO 00000 Frm 00177 Fmt 6633 Sfmt 6602 E:\HR\OC\A928.XXX A928

SMARTINEZ on PROD1PC64 with HEARING
172 

ening of time where you’re averaging prices over a longer period 

and that would smooth out in both the upside and the downside, 

and if you look at even quarterly accounting right now what happens when a bank has to report its quarterly earnings, it will expand its activities in between the quarter and then they’ve got to 

get the balance sheet down, get the balance sheet down, get the 

balance sheet down for the report and so we do need to get away 

from sort of the snapshot in time type of—— 

Senator SUNUNU. Let me ask you one question about a statistic 

I think you used in your testimony, but it came as a shock to me, 

even having looked at a lot of this material. It was that in 2005 

43 percent of the people in America who purchased a home with 

a mortgage put no money down. 

Mr. SUMERLIN. Forty-three percent of first-time homebuyers. 

Senator SUNUNU. In 2005, 43 percent of all first-time homebuyers. 

Mr. SUMERLIN. Of all first-time homebuyers. 

Senator SUNUNU. Put no money down. 

Mr. SUMERLIN. Yes. 

Senator SUNUNU. To the best of your knowledge, did any state 

or federal regulators anywhere prohibit that or try to create a regulation that might have discouraged that kind of behavior which I 

think most people would fairly describe as somewhat speculative? 

Mr. SUMERLIN. I’m not aware of it. There’s nothing that worked. 

I’ll put it that way. 

Senator SUNUNU. Ms. Raskin, do you know of anything that 

might have—— 

Professor WARREN. Senator Sununu, you’re over time now. 

Senator SUNUNU. I wanted to give her a chance to respond. She 

might have better information—— 

Professor WARREN. Sure. 

Senator SUNUNU [continuing]. Than Mr. Sumerlin. 

Ms. RASKIN. Clearly that practice has all but evaporated, truth 

be told. The good thing, I think, is that a lot of states have now 

passed laws that prohibit what are called stated income loans, 

loans in which there is no documentation at all provided and 

there’s no basis upon which the borrower has shown an ability to 

repay. 

Senator SUNUNU. Thank you. 

Professor WARREN. Thank you. Mr. Neiman. 

Mr. NEIMAN. Thank you. Dr. Stiglitz, in your testimony you talk 

about the idea of ring fencing, to put greater standards in place for 

systemically-significant institutions and commercial banks that 

serve consumers and pension funds, and separating those out from 

business activities that serve high net worth and capital markets 

activities. 

Can we draw such a bright line? Is that function—is it practical, 

and I’d like you to just kind of elaborate on how that would actually be implemented or deployed? 

Dr. STIGLITZ. It can’t be perfectly implemented, but I think it’s 

absolutely necessary that we do something along those lines because we can’t be fully comprehensive in our regulation. Our financial markets are too complex. 


SMARTINEZ on PROD1PC64 with HEARING
173 

On the other hand, we know that we have to have far better regulation of our commercial banks, which are systemically important. 

If we don’t, the system will have another crisis, such as the one we 

currently have. 

We have to move towards some degree of ring fencing. In a way 

we do that already; that is to say, we don’t want our banks to invest too much in a gambling institution or something like that. 

The question is can we go further, and I think the answer is 

clearly yes. If we have an unregulated, highly-leveraged institution, 

like a hedge fund, operating out of a secret bank account, we 

should say to the banks that they should not be lending to those 

kinds of institutions, which are supportive of corruption and tax 

evasion. 

This is a matter of degree, but I think we can work much more 

towards ring fencing these core financial institutions. 

Mr. NEIMAN. Thank you. Mr. Wallison you’ve written a lot about 

the role that CRA and the GSEs have played in contributing to the 

crisis, and as you probably would not be surprised, I come at it that 

the CRA was not a contributor and the data that I have seen in 

terms of origination showed the majority of those originations came 

from non-bank entities who were not subject to CRA. 

Have you seen or are relying on data that would support your 

basis of the role that CRA played in contributing? 

Mr. WALLISON. The role that CRA played in contributing to our 

current problem was simply a role in reducing the quality of the 

mortgages. That’s why we got to the point where Marc Sumerlin 

was mentioning that 43 percent of the people who bought homes 

initially in 2005 had no downpayment. The purpose of CRA was to 

force banks to make loans to people who could not otherwise get 

mortgages. 

I believe that we should have a homeownership policy, as we do 

in this country, and it might require subsidies. But in the case of 

CRA it just required banks to make loans they wouldn’t have otherwise made, and that forced them to reduce the quality of the 

mortgages. It’s the only way they could do it. And so, what began 

with CRA continued through the rest of the economy. It was picked 

up by all kinds of other people who were making loans, unregulated lenders as they are called, and Fannie and Freddie bought 

many of those loans, over a trillion dollars of those loans. $1.6 trillion of these bad loans are on Fannie and Freddie’s balance sheet. 

It is not CRA—— 

Mr. NEIMAN. How much? 

Mr. WALLISON. $1.6 trillion of subprime and Alt-A mortgages are 

on Fannie Mae and Freddie Mac’s balance sheets. 

Mr. NEIMAN. Subprime and Alt-A? 

Mr. WALLISON. Subprime and Alt-A. That’s right. 

Professor WARREN. These are not originations, though. 

This is including the amount that they were required to buy later 

on, is that right? 

Mr. WALLISON. They were required to by their affordable housing 

regulations to buy these mortgages. 

Professor WARREN. Not by the regulations. They’ve been required 

by Congress to purchase. 


SMARTINEZ on PROD1PC64 with HEARING
174 

Mr. WALLISON. Well, through the affordable housing regulations, 

Congress—— 

Professor WARREN. No. 

Mr. WALLISON [continuing]. Did not insist on—— 

Professor WARREN. No, not through originations. That’s the question I’m asking about trying to sort this out. I’m sorry, Mr. 

Neiman. 

Mr. WALLISON. My whole point is simply that CRA did not add 

materially to the number of such mortgages. They were very small, 

about three percent. What CRA did was start the process of making mortgages of lower quality and that’s the central problem we 

have today. 

It is true that we’ve had a big inflationary bubble because, perhaps, of the low interest rates that the Federal Reserve approved 

for a long period of time. But what’s different about this bubble is 

that the mortgages that are causing problems are very poor quality 

mortgages. Otherwise, we wouldn’t have this financial crisis. 

Mr. NEIMAN. Just to follow up on one point, the way we’ve seen 

it operating throughout neighborhoods throughout the country, is 

so much of that was originated by non-bank entities, not subject to 

CRA. I’m not making any apologies for the large commercial banks, 

investment banks, who participated—who funded that through the 

securitization process, but it was not CRA that was driving that. 

It was the securitization process and the misaligned incentives and 

over-reliance on credit. 

Mr. WALLISON. And Fannie and Freddie bought them. 

Professor WARREN. I want to thank you all for being here. I have 

special thanks that I need to acknowledge publicly to the Senate 

Committee on Commerce, Science and Transportation for lending 

us this lovely room for our hearing, but I especially want to thank 

all of our witnesses for coming. 

Mrs. Raskin, Dr. Shiller, Dr. Stiglitz, Mr. Sumerlin, and Mr. 

Wallison, we appreciate your taking the time to prepare your testimony, to come here, and I hope you will be willing to answer questions that the panel submits in writing and have those questions 

be on the record. 

We appreciate your help very much and with that, this hearing 

is adjourned. 

[Whereupon, at 11:40 a.m., the hearing was adjourned.] 

Æ 


SMARTINEZ on PROD1PC64 with HEARING