THE END OF EXCESS (PART ONE): 

REVERSING OUR ADDICTION TO 

DEBT AND LEVERAGE 

HEARING 

BEFORE THE

SUBCOMMITTEE ON 

OVERSIGHT AND INVESTIGATIONS 

OF THE

COMMITTEE ON FINANCIAL SERVICES 

U.S. HOUSE OF REPRESENTATIVES 

ONE HUNDRED ELEVENTH CONGRESS 

SECOND SESSION 

MAY 6, 2010 

Printed for the use of the Committee on Financial Services 

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THE END OF EXCESS (PART ONE): REVERSING OUR 

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THE END OF EXCESS (PART ONE): 

REVERSING OUR ADDICTION TO 

DEBT AND LEVERAGE 

HEARING 

BEFORE THE

SUBCOMMITTEE ON 

OVERSIGHT AND INVESTIGATIONS 

OF THE

COMMITTEE ON FINANCIAL SERVICES 

U.S. HOUSE OF REPRESENTATIVES 

ONE HUNDRED ELEVENTH CONGRESS 

SECOND SESSION 

MAY 6, 2010 

Printed for the use of the Committee on Financial Services 

Serial No. 111–131 

( 

(II) 

HOUSE COMMITTEE ON FINANCIAL SERVICES 

BARNEY FRANK, Massachusetts, Chairman 

PAUL E. KANJORSKI, Pennsylvania 

MAXINE WATERS, California 

CAROLYN B. MALONEY, New York 

LUIS V. GUTIERREZ, Illinois 

NYDIA M. VELA ́ ZQUEZ, New York 

MELVIN L. WATT, North Carolina 

GARY L. ACKERMAN, New York 

BRAD SHERMAN, California 

GREGORY W. MEEKS, New York 

DENNIS MOORE, Kansas 

MICHAEL E. CAPUANO, Massachusetts 

RUBE ́ N HINOJOSA, Texas 

WM. LACY CLAY, Missouri 

CAROLYN MCCARTHY, New York 

JOE BACA, California 

STEPHEN F. LYNCH, Massachusetts 

BRAD MILLER, North Carolina 

DAVID SCOTT, Georgia 

AL GREEN, Texas 

EMANUEL CLEAVER, Missouri 

MELISSA L. BEAN, Illinois 

GWEN MOORE, Wisconsin 

PAUL W. HODES, New Hampshire 

KEITH ELLISON, Minnesota 

RON KLEIN, Florida 

CHARLES WILSON, Ohio 

ED PERLMUTTER, Colorado 

JOE DONNELLY, Indiana 

BILL FOSTER, Illinois 

ANDRE ́ CARSON, Indiana 

JACKIE SPEIER, California 

TRAVIS CHILDERS, Mississippi 

WALT MINNICK, Idaho 

JOHN ADLER, New Jersey 

MARY JO KILROY, Ohio 

STEVE DRIEHAUS, Ohio 

SUZANNE KOSMAS, Florida 

ALAN GRAYSON, Florida 

JIM HIMES, Connecticut 

GARY PETERS, Michigan 

DAN MAFFEI, New York 

SPENCER BACHUS, Alabama 

MICHAEL N. CASTLE, Delaware 

PETER T. KING, New York 

EDWARD R. ROYCE, California 

FRANK D. LUCAS, Oklahoma 

RON PAUL, Texas 

DONALD A. MANZULLO, Illinois 

WALTER B. JONES, JR., North Carolina 

JUDY BIGGERT, Illinois 

GARY G. MILLER, California 

SHELLEY MOORE CAPITO, West Virginia 

JEB HENSARLING, Texas 

SCOTT GARRETT, New Jersey 

J. GRESHAM BARRETT, South Carolina 

JIM GERLACH, Pennsylvania 

RANDY NEUGEBAUER, Texas 

TOM PRICE, Georgia 

PATRICK T. MCHENRY, North Carolina 

JOHN CAMPBELL, California 

ADAM PUTNAM, Florida 

MICHELE BACHMANN, Minnesota 

KENNY MARCHANT, Texas 

THADDEUS G. McCOTTER, Michigan 

KEVIN McCARTHY, California 

BILL POSEY, Florida 

LYNN JENKINS, Kansas 

CHRISTOPHER LEE, New York 

ERIK PAULSEN, Minnesota 

LEONARD LANCE, New Jersey 

JEANNE M. ROSLANOWICK, Staff Director and Chief Counsel 

(III) 

SUBCOMMITTEE ON OVERSIGHT AND INVESTIGATIONS

DENNIS MOORE, Kansas, Chairman 

STEPHEN F. LYNCH, Massachusetts 

RON KLEIN, Florida 

JACKIE SPEIER, California 

GWEN MOORE, Wisconsin 

JOHN ADLER, New Jersey 

MARY JO KILROY, Ohio 

STEVE DRIEHAUS, Ohio 

ALAN GRAYSON, Florida 

JUDY BIGGERT, Illinois 

PATRICK T. MCHENRY, North Carolina 

RON PAUL, Texas 

MICHELE BACHMANN, Minnesota 

CHRISTOPHER LEE, New York 

ERIK PAULSEN, Minnesota 

(V) 

C O N T E N T S 

Page 

Hearing held on: 

May 6, 2010 ....................................................................................................... 1 

Appendix: 

May 6, 2010 ....................................................................................................... 41 

WITNESSES 

THURSDAY, MAY 6, 2010 

Acharya, Viral V., Professor of Finance, Stern School of Business, New York 

University ............................................................................................................. 28 

Brown, Orice Williams, Director, Financial Markets and Community Investment, U.S. Government Accountability Office (GAO) ....................................... 24 

Geanakoplos, John, James Tobin Professor of Economics, Department of Economics, Yale University ....................................................................................... 26 

Hoenig, Thomas M., President and Chief Executive Officer, Federal Reserve 

Bank of Kansas City ............................................................................................ 7 

Walker, David A., John A. Largay Professor, McDonough School of Business, 

Georgetown University ........................................................................................ 30 

Walker, Hon. David M., President and Chief Executive Officer, Peter G. 

Peterson Foundation, and former Comptroller General of the United States 9 

APPENDIX 

Prepared statements: 

Moore, Hon. Dennis .......................................................................................... 42 

Acharya, Viral V. .............................................................................................. 44 

Brown, Orice Williams ..................................................................................... 214 

Geanakoplos, John ............................................................................................ 232 

Hoenig, Thomas M. .......................................................................................... 289 

Walker, David A. .............................................................................................. 308 

Walker, Hon. David M. .................................................................................... 394 

ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD

Moore, Hon. Dennis: 

Federal Reserve Bank of New York Staff Report No. 328, ‘‘Liquidity 

and Leverage,’’ by Tobias Adrian and Hyun Song Shin, dated May 

2008, Revised January 2009 ........................................................................ 420 

Congressional Research Service memorandum dated May 4, 2010 ............. 459 

GAO report entitled, ‘‘Financial Markets Regulation,’’ dated July 2009 ..... 472 

McKinsey Global Institute report entitled, ‘‘Debt and deleveraging: The 

global credit bubble and its economic consequences,’’ dated January 

2010 ................................................................................................................ 608 

Paper entitled, ‘‘Growth in a Time of Debt,’’ by Carmen M. Reinhart 

and Kenneth S. Rogoff, dated January 7, 2010 .......................................... 697 

Biggert, Hon. Judy: 

Written responses to question submitted to Orice Williams Brown ............ 723 

Wall Street Journal article entitled, ‘‘A Fannie Mae Political Reckoning,’’ 

dated May 6, 2010 ......................................................................................... 730 

Bloomberg article entitled, ‘‘Freddie Mac Stock Falls After Seeking $10.6 

Bln From U.S.,’’ dated May 6, 2010 ............................................................ 732 

Article from The New York Times entitled, ‘‘Freddie Mac Seeks Billions 

More After Big Loss,’’ dated May 5, 2010 ................................................... 734 

Page

VI 

Biggert, Hon. Judy—Continued 

Politico article entitled, ‘‘Frank to White House: Fight the GOP,’’ dated 

May 5, 2010 ................................................................................................... 735 

Walker, David A.: 

Forthcoming Journal of Economics and Business article entitled, ‘‘LongRun Credit Growth in the US,’’ dated March 2010 .................................... 738 

(1) 

THE END OF EXCESS (PART ONE): 

REVERSING OUR ADDICTION 

TO DEBT AND LEVERAGE 

Thursday, May 6, 2010 

U.S. HOUSE OF REPRESENTATIVES, 

SUBCOMMITTEE ON OVERSIGHT

AND INVESTIGATIONS, 

COMMITTEE ON FINANCIAL SERVICES, 

Washington, D.C. 

The subcommittee met, pursuant to notice, at 10:05 a.m., in room 

2128, Rayburn House Office Building, Hon. Dennis Moore [chairman of the subcommittee] presiding. 

Members present: Representatives Moore of Kansas, Lynch, 

Klein, Speier, Driehaus; Biggert and Lee. 

Also present: Representative Royce. 

Chairman MOORE OF KANSAS. This hearing of the Subcommittee 

on Oversight and Investigations of the House Financial Services 

Committee will come to order. 

Our hearing this morning is entitled, ‘‘The End of Excess (Part 

One): Reversing Our Addiction to Debt and Leverage,’’ inspired by 

the April 6, 2009, Time cover story, right here, ‘‘The End of Excess: 

Why This Crisis is Good for America,’’ written by Curt Anderson. 

This will be the first in a series of hearing where we will look 

at the key issues exposed by the financial crisis, and the next steps 

to continue improving financial stability in an economic recovery. 

We’ll begin this hearing with members’ opening statements, up 

to 10 minutes per side, and then we’ll hear testimony from our witnesses. 

For each witness panel, members will have up to 5 minutes to 

question our witnesses. 

The Chair advises our witnesses to please keep your opening 

statements to 5 minutes to keep things moving so we can get to 

members’ questions. 

Also, any unanswered question can always be followed up in 

writing for the record. 

Without objection, all members’ opening statements will be made 

a part of the record. 

I now recognize myself for up to 5 minutes for an opening statement. 

The strength of our financial system and economy depends on 

the responsible use of credit and debt built on trust between the 

lender and borrower that payment will be made in the future. 

2 

The word ‘‘credit’’ is derived from the Latin word ‘‘credo,’’ which 

simply means ‘‘I believe.’’ While the financial industry complains 

about a lack of certainty as Congress debates financial regulatory 

reform, there’s a more fundamental lack of trust that the American 

people now have in our financial system. 

To correct these two problems, this lack of certainty and understandable lack of trust, we must enact strong rules of the road this 

year, so the credibility of our financial system can be restored. 

A new law, unfortunately, can’t heal our broken financial system. 

The financial industry must take their own steps to restore faith 

in their business. They must provide services their customers really want, and not use hidden fees or balance sheet tricks to cheat 

their way to the top again. 

We need to empower consumers and investors to make better financial decisions. Government must do its part in setting a good 

example, providing efficient financial oversight with limited resources, and getting on a path to balance the Federal budget so 

we’re not passing a massive debt on to our children and grandchildren. 

In 1978, our combined outstanding debt across the economy, including financial firms, other businesses, households, and local, 

State, and Federal Government was $3.6 trillion, or 157 percent of 

GDP. By the end of last year, that number ballooned to $50.3 trillion, or 353 percent of GDP. This is the highest level of combined 

debt of the United States on record. 

Since 1978, our economy is over 6 times larger than what it was, and we have grown, on average, $404 billion each year; but over 

the same timeframe, our combined debt has grown nearly 4 times 

as fast, adding nearly $1.6 trillion each year on average. 

Even more troubling is the rapid growth of financial sector debt, 

as it grew over 41 times larger than what it was in 1978. As GAO 

noted in its leverage study that we’ll hear about today, Wall Street 

investment banks had leverage ratios of over 30 to 1, compared to 

the largest commercial banks, which averaged leverage of 13 to 1. 

In good times, this means their profits were supercharged, but 

when asset prices fall, excessive leverage accelerates a firm’s failure, as we saw with Bear Stearns and Lehman Brothers. 

Are we addicted to debt and leverage? I’m afraid we might be, 

and unless we take bold new steps on both financial regulatory reform and budget reform soon, it will be very difficult to reverse this 

troubling trend. 

When I came to Congress in 1999—it was the last 2 years of the 

Clinton Administration—we had budget surpluses those 2 years, 

and the first government surpluses in decades. When President 

Clinton left office, the national debt stood at $5.73 trillion. 

Unfortunately, over the next 8 years, our national debt grew at 

a record pace, nearly doubling, and hitting $10.7 trillion. Our economy was on the verge of going off the cliff, as we were still reeling 

from TARP and the financial panic in late 2008, and our economy 

was losing 750,000 jobs a month in early 2009. 

Experts and economists from the left and the right, including 

John McCain’s economic advisor Mark Sandy, implored Congress to 

act with a large stimulus to stabilize the economy, so even though 

it wasn’t popular, the government responded by enacting the ReVerDate Nov 24 2008 12:04 Oct 25, 2010 Jkt 058041 PO 00000 Frm 00010 Fmt 6633 Sfmt 6633 K:\DOCS\58041.TXT TERRIE
3 

covery Act, and TARP was used to implement the financial stability plan. 

What happened next? The economy stabilized, and slowly but 

surely, we are back on track with real economic growth. 

A Republican witness, Professor David Walker, agrees in his testimony, writing, ‘‘Our economy would be rebounding much more 

slowly than it has, if we had not implemented the TARP program.’’ 

Congress has made strong budget reforms, passing the largest 

deficit-reducing legislation since 1993, in the new health care law. 

We have re-implemented statutory pay-go, and the President established a Fiscal Responsibility Commission with a report due at 

year’s end. 

I look forward to hearing from our witnesses on these issues 

today, bringing their experience and expertise on these matters, so 

we can better understand how debt and leverage impacts every single American, and what are the steps we can take to get us back 

to a more stable path of economic growth. 

Chairman MOORE OF KANSAS. I now recognize for 5 minutes the 

ranking member of our subcommittee, my colleague and friend 

from Illinois, Ranking Member Judy Biggert. 

Mrs. BIGGERT. Thank you, Chairman Moore, and thank you for 

convening this important hearing. 

Today’s hearing is entitled, ‘‘The End of Excess (Part One): Reversing Our Addiction to Debt and Leverage.’’ However, I would 

like to add to that. I would add that Washington must reverse its 

addiction to Big Brother government, wasteful Washington spending, and permanent taxpayer-backed government bailouts. 

The denial in Washington must end. Washington must get on the 

side of the American taxpayer, American families, communitybased financial institutions, and American small businesses—the 

job creators in our economy. 

Our Nation’s debt is on an unsustainable track. The denial of 

some lawmakers that Washington take over with bailouts and 

spending that is out of control must end. 

The front page of today’s Washington Post reads, ‘‘Greece’s debtpaying sparks violence.’’ And as we have all seen in the paper, this 

European debt crisis will seem like a drop in the bucket when compared to our Nation’s projected debt, which, by some estimates, will 

reach $15 trillion by the end of 2020, representing 67 percent of 

GDP. 

Levels of debt that are of this nature are not sustainable and 

represent a barrier to the future economic prosperity of our Nation. 

High taxes, inflation, and higher unemployment rates will be the 

byproducts of the current Administration’s fiscal irresponsibility. 

Linked to this irresponsibility is the Administration’s unlimited 

guarantee of the debt of Fannie Mae and Freddie Mac, with trillions in obligations that are guaranteed by our government, our 

taxpayers. 

Freddie Mac announced yesterday that it will need an additional 

$10.6 billion in government funding. That’s $10.6 billion more of 

taxpayers’ money. The latest addition brings the GSE loss to taxpayers to $136 billion. 

And with that, Mr. Chairman, I would like to ask unanimous 

consent to insert in the record three newspaper articles: one from 

4 

Bloomberg, saying, ‘‘Freddie Mac seeks $10.6 billion from Treasury 

following first-quarter loss’’; one from the New York Times, 

‘‘Freddie Mac seeks billions more after big loss’’; and the third from 

Politico, ‘‘Frank to White House: Fight the GOP.’’ 

Chairman MOORE OF KANSAS. Without objection, they will be 

made a part of the record. 

Mrs. BIGGERT. Thank you. 

The Administration has yet to even appoint an inspector general 

to provide objective, independent oversight over the Federal bureaucrats who now control the GSEs, and I know you have had 

that bill to do that. 

It is inconceivable that officials managing these liabilities would 

be allowed to do so without proper transparency, independent oversight, and thorough reporting to Congress and the American people, and it’s unacceptable that the Administration continues to kick 

the can down the road and still has no firm exit strategy to spare 

taxpayers from future losses associated with Fannie and Freddie. 

Republicans are ready to address this problem and get taxpayers 

out of this mess. 

Finally, the risk-takers on Wall Street need to know clear rules 

of the road. The rules must say that there will be no more bailouts 

and no more institutions ‘‘too-big-to-fail.’’ This message should be 

clear. If you run your company into the ground, you’ll be shut 

down. Your creditors and counterparts won’t get a bailout that’s 

paid for by taxpayers, consumers, or community banks and small 

businesses that have had no role in your risky behavior. 

I look forward to the testimony of today’s witnesses. I’m particularly interested in the findings of the GAO study from last July, 

that clearly pointed to the fact that because institutions thought 

that housing asset value, primarily housing prices, would continue 

to rise, institutional leverage increased. 

When these institutions began to experience significant losses 

due to decline in value of mortgage-related and other assets, financial institutions attempted to deleverage and reduce their risk by 

raising new equity, reducing dividend payouts, selling assets, and 

reducing lending. 

Raising capital, however, became increasingly difficult after the 

onset of the crisis, as would-be investors began to have doubts 

about the quality of these firms’ assets, and financial institutions 

began to deleverage by selling assets. 

In the fourth quarter of 2008, broker-dealers reduced assets by 

nearly $785 billion, and banks reduced bank credit by nearly $84 

billion. 

This series of events significantly contributed to our economic crisis. Today, our economy is essentially on thin ice and susceptible 

to even the most moderate economic shocks, according to GAO. 

For this reason, in the reform proposal, H.R. 3310, House Republicans proposed a market stability and capital adequacy board to 

monitor these interactions. 

Congress doesn’t need to bestow more power on the same Washington bureaucrats who didn’t do their job at policing the financial 

industry or protecting consumers in the first place. Regulators need 

to get their act together. We must enact smart financial reforms 

that require coordinated regulatory efforts and bailouts, and bring 

5 

certainty to the marketplace so that investors invest, businesses 

expand, and more jobs are created to put Americans back to work. 

Finally, until our Federal house is in order, our children and 

grandchildren will be the ones who will bear the burdens associated with our Nation’s addiction to excessive borrowing and spending. 

And with that, I yield back. 

Chairman MOORE OF KANSAS. I thank the ranking member. 

I next recognize Mr. Lynch from Massachusetts for 2 minutes, 

sir. 

Mr. LYNCH. Thank you, Mr. Chairman, for holding this hearing, 

and I also want to thank our distinguished panelists for their willingness to come before this committee to help us with our work. 

Mr. Chairman, our Nation’s growing addiction to debt is one that 

has been largely ignored until the collapse of the financial markets 

in the fall of 2007. According to the Federal Reserve, at the end 

of 2009, the combined outstanding debt in the U.S. economy was 

$50.3 trillion. That includes financial industry debt, non-financial 

business debt, household debt, and local, State, and Federal Government debt. 

Since the boom years began in the 1980’s, our debt as a percentage of GDP has risen almost 200 percent, and while a lot of things 

have happened since the early 1980’s, and some of that factor 

might be mitigated, I think the increase in debt has been instructive, as to where we have been and where we’re going. 

As we know all too well, no other industry was as highly leveraged and addicted to debt as the financial system. We have learned 

that Lehman Brothers, and probably other banks, used techniques 

like the Repo 105 to conceal debt, masking just how highly leveraged they actually were from regulators and investors. 

Collateralized debt obligations and other over-the-counter derivatives were multiplying and disguising or transferring debt off the 

balance sheets of companies into opaque markets, such that regulators and market participants could only guess at the total 

amounts involved in these deals. 

The regulatory reform bill that the House passed last year, the 

Wall Street Reform and Consumer Protection Act, would establish 

a stability oversight council to give regulators better tools to monitor and regulate excessive leverage and risk-taking. 

I know my colleague, Mr. Miller, has introduced a bill that mirrors a number of amendments that the Senate is currently considering to their regulatory reform bill, limiting the size of megabanks by setting a cap on any company’s share of total deposits 

and setting minimum equity levels for bank holding companies and 

non-bank financial institutions. 

I think these are steps in the right direction, and I’m looking forward to hearing from our witnesses today on further proposals to 

help wean ourselves from this harmful addiction to debt. 

Thank you, Mr. Chairman. I yield back. 

Chairman MOORE OF KANSAS. I thank the gentleman. 

The Chair next recognizes Ms. Speier from California for 3 minutes. 

Ms. SPEIER. Thank you, Mr. Chairman, and thank you to the witnesses for participating in what is a very important hearing. This 

6 

hearing on the impact of leverage and increasing debt burden is 

profound. I’m struck by the fact that the two sectors that dramatically increased their debt burden leading up to the current economic crisis were the financial sector and consumers, and we know 

that it was the financial institutions that fostered the growth in 

consumer debt through teaser-interest-rate credit cards and loans, 

no-down auto loans, 2/28, and no-doc pick-a-pay payments, mortgages, and home equity loans, all so that they could be packaged 

into bonds and CDOs, and synthetic CDOs, that magically received 

AAA ratings and generated enormous fees and profits. 

I strongly believe that excessive leverage used by the large financial institutions was a major factor in the real estate bubble and 

subsequent financial collapse in 2008. In fact, according to Professor David Moss of Harvard Business School, outstanding debt in 

the financial sector—and this figure is truly mind-blowing—increased from $568 billion in 1980 to more than $17 trillion in 2008. 

Leverage helped firms become ‘‘too-big-to-fail.’’ A firm with $1 billion in capital can have $40 billion in liabilities, which means 

that if it goes down, there are other banks and lenders who need 

$40 billion in repayments if their balance sheets are going to add 

up. 

The banks that survived the crisis best, like JPMorgan, had the 

lowest levels of leverage. The leverage ratio at Bear Stearns 

reached more than 40 to 1 before it failed. By 2007, the leverage 

ratios of many of the major Wall Street investment banks reached 

more than 30 to 1, including Lehman Brothers and Merrill Lynch. 

But these are only their on-balance-sheet levels. These firms also 

gamed their leverage numbers by using off-balance-sheet vehicles 

and tricks, like Repo 105s, to make their balance sheets look better 

than they really were. 

The fact that most of this was short-term debt simply made matters worse, when the real estate bubble burst, and supposedly liquid mortgage-backed securities suddenly became unsellable, causing a downward spiral. 

I feel compelled to set the record straight. We are here today not 

because of overregulation, but because of systemic and systematic 

de-regulation, with the passage of the Gramm-Leach-Bliley Act of 

1999, the Commodities Future Modernization Act in 2000, which 

prohibits Congress from regulating derivatives, and the SEC’s Consolidated Supervised Entities Program in 2004 that led to a relaxation of leverage ratios for investment banks, which then were 12 

to 1. They just lifted it altogether. 

Regulators still had the power to take many actions in the 

months and years leading up to the current crisis, but they didn’t 

believe there was a problem. Up until the bitter end, they asserted 

that there was no bubble and that the market would take care of 

itself. Well, it didn’t. 

I’m gratified that the House Wall Street Reform and Consumer 

Protection Act includes my amendment that would limit debt to equity leverage at systemically risky firms to no more than 15 to 1. 

The regulators could still impose a lower limit. 

I’m delighted that Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, is here. He has said publicly that he 

believes that there must be a leverage ceiling. In fact, he has said 

7 

that 15 to 1 is too generous. I might add that Goldman Sachs is 

presently leveraged at 15 to 1 today, and breaking its own records 

for profits. 

It may be impossible to devise a truly foolproof regulatory regime 

to prevent the next crisis, but we should not again be totally reliant on the wisdom and good intentions of government regulators, 

or voluntary restraint by Wall Street firms. 

I thank the chairman. I yield back. 

Chairman MOORE OF KANSAS. I thank the lady for her statement, and I’m pleased to introduce our first panel of witnesses. 

First, we’ll hear from Mr. Thomas Hoenig, President and CEO of 

the Federal Reserve Bank of Kansas City. Welcome, Mr. President. 

And next, we’ll hear from the Honorable David M. Walker, President and CEO of the Peter G. Peterson Foundation, and former 

Comptroller General of the United States. Welcome to you, sir. 

It’s an honor to have such distinguished current and former public officials before our subcommittee today. 

Without objection, your written statements will be made a part 

of the record. 

Mr. Hoenig, sir, you’re recognized for 5 minutes to provide a brief 

summary of your statement. 

STATEMENT OF THOMAS M. HOENIG, PRESIDENT AND CHIEF 

EXECUTIVE OFFICER, FEDERAL RESERVE BANK OF KANSAS 

CITY 

Mr. HOENIG. Chairman Moore, Ranking Member Biggert, and 

members of the committee, I want to thank you for asking me to 

testify here today, to give me an opportunity to share some of my 

views on the issues around leverage. 

Certainly, among the factors that contributed to this financial 

crisis, there is no question that leverage was key, and the 

unwinding of this leverage contributed to the escalation of this crisis into the worst recession in 75 years, hurting Americans at all 

economic levels. 

I have spent more than 36 years at the Federal Reserve, deeply 

involved in bank supervision, and it has been apparent, to me at 

least, for some time that our Nation’s financial institutions must 

have firm and easily understood leverage requirements. 

Leverage tends to rise when the economy is strong, as investors 

and lenders forget past mistakes and believe that prosperity will 

always continue. If we don’t institute rules now, to contain leverage, another crisis, I can tell you, is inevitable. 

My written testimony addresses the systemic increase, or systematic increase in debt and leverage that has occurred in all major 

sectors of our economy over the past 2 decades. But my comments 

today will focus specifically on what occurred at the largest financial firms, which were the catalysts, in many ways, for this crisis. 

Leverage, of course, is the ability to use debt to build assets as 

a multiple of a firm’s capital base. The leverage of banking organizations has risen steadily since the mid-1990’s. It was not immediately obvious because of the many different ways capital and leverage can be measured. 

In my judgment, the most fundamental measure of a financial institution’s capital is to exclude intangible assets and preferred 

8 

shares and focus only on tangible common equity, that is, ownership capital actually available to absorb losses and meet obligations. 

Looking at tangible common equity, you see that leverage for the 

entire banking industry rose from $16 of assets for each $1 of capital in 1993, to $25 for each $1 of capital in 2007. 

More striking, perhaps, this aggregate ratio was driven most significantly by the 10 largest banking companies. At these firms, assets rose from 18 times capital to 34, over the same period, and 

that does not include their off-balance-sheet activities. 

These numbers, in my opinion, reflect two essential points. First, 

that based on capital levels, the 10 largest banking organizations 

carried fundamentally riskier balance sheets at the start of this crisis than the industry as a whole. Second, their greater leverage reflects a significant funding cost advantage. Not only is debt cheaper 

than equity, but their debt was cheaper than the smaller organizations, because creditors were confident that these firms were too 

big to be allowed to fail. 

This was a gross distortion of the marketplace, providing these 

firms an advantage in making profits, enabling them to build size, 

and then, in the end, leaving others to suffer the pain of their collapse. 

This is not capitalism, but exploitation of an unearned advantage; and the list of victims is long, including families who lost 

homes, workers who lost jobs, and taxpayers who were left to pay 

the tab. 

This increase in leverage in the banking industry spread broadly 

to other sectors of the economy, creating a general excess of credit 

growth over the past 10 years, especially, as you said, among consumers. 

This economy-wide rise in leverage was based on the assumption 

that asset prices would continue to rise, especially those in housing 

this time. When prices fell and defaults and losses mounted, capital 

ratios that had been systematically reduced over time proved grossly inadequate. 

To illustrate, suppose the 10 largest banking organizations had 

been required to confine their leverage to an historically more reasonable level of $15 of tangible assets for every $1 of tangible common equity, rather than the 34 they had. 

Under this historic limit, they would have been forced to hold an 

additional $326 billion of equity, 125 percent more than they actually had, to absorb potential losses; or, they would have had to cut 

back on their growth by nearly $5 trillion; or more likely, the combination of those two. 

The point is, the institutions got away from the fundamental 

principles of sound capital management, and those institutions 

with the highest leverage suffered the most. Financial panic and 

economic havoc quickly followed. 

The process of deleveraging is still under way. Rebuilding capital 

has begun. But during this rebuilding, loans are harder to get, 

which is impeding the economic recovery. 

With this very painful lesson fresh in our mind, now is the time 

to act. I strongly support establishing hard leverage rules that are 

9 

simple, understandable, and enforceable, and that apply equally to 

all banking organizations that operate within the United States. 

As we saw in the years before the crisis, leverage tends to rise 

during the expansion, as past mistakes are forgotten, and pressure 

for growth and higher returns on equity mount. Straightforward leverage and underwriting rules require bankers to match increases 

in assets with increases in capital, and prevent disputes with bank 

examiners over interpretations of the rules. As a result, excess is 

constrained and a countercyclical force is created that moderates 

booms, and forms a cushion when the next recession might occur. 

I firmly believe that, had such rules been in place, we would 

have been spared a good part of the tremendous hardship the 

American people have gone through during the past 2 years. 

Thank you. 

[The prepared statement of Mr. Hoenig can be found on page 289 

of the appendix.] 

Chairman MOORE OF KANSAS. Thank you, Mr. Hoenig. 

The Chair next recognizes the Honorable David M. Walker. 

Sir, you’re recognized for 5 minutes. 

STATEMENT OF THE HONORABLE DAVID M. WALKER, PRESIDENT AND CHIEF EXECUTIVE OFFICER, PETER G. PETERSON FOUNDATION, AND FORMER COMPTROLLER GENERAL 

OF THE UNITED STATES 

Mr. DAVID M. WALKER. Chairman Moore, Ranking Member 

Biggert, and members of the subcommittee, thank you for the opportunity to testify today. 

It’s very important to state at the outset of this hearing that not 

all debt and leverage is bad, however, excess debt and leverage is. 

In addition, individuals, businesses, and countries must not become 

accustomed to taking on debt in order to finance their ongoing operating costs and current wants at the expense of future needs and 

future generations. 

Now, let me turn to the state of the U.S. Government’s finances, 

which is what I was asked to focus my testimony on today. 

It is clear that the United States is a great nation, possibly the 

greatest in the history of all mankind. At the same time, our country is resting on its past successes and its sole superpower status, 

which is temporary, while at the same point in time, ignoring a 

range of leading indicators that clearly demonstrate that we are on 

an imprudent and unsustainable path in many respects. 

This includes matters such as public finance, savings rates, educational performance, health care costs and outcomes, and the state 

of our Nation’s critical infrastructure. 

The truth is, our country’s future standing and the standard of 

living for future generations of Americans is threatened by these 

key sustainability challenges, and given the subject of this hearing 

and series of hearings, I’ll focus my remarks on America’s structural deficits, growing debt burdens, increased reliance on foreign 

lenders, and low savings rates. 

During the first approximately 200 years of our republic’s existence, the Federal Government did not experience significant and 

recurring deficits, unless the country was at war, meaning a deVerDate Nov 24 2008 12:04 Oct 25, 2010 Jkt 058041 PO 00000 Frm 00017 Fmt 6633 Sfmt 6633 K:\DOCS\58041.TXT TERRIE
10 

clared war, was experiencing a depression or recession, or faced 

some other major national emergency. 

However, within the past several decades, both America and too 

many Americans became addicted to spending, deficits, and debt. 

This cultural challenge is real, and it has reached epidemic proportions in Washington, D.C. 

As an example, total Federal debt levels have more than doubled 

in less than 10 years, and they could double again, within the next 

10 years, on our present path. 

Clearly, trillion-dollar deficits are a matter of growing public concern. However, it’s important to understand that today’s deficits do 

not represent the real threat to our ship of state. The real threat 

is the large, known, and growing structural deficits that will exist 

when the economy has recovered, when unemployment is down, 

when the wars are over, and when the crises have long passed. 

These literally threaten the future standing of the United States 

and the future standing of living of Americans; and as we can see, 

that absent dramatic and fundamental spending and tax reforms, 

our Federal debt levels are expected to skyrocket in the future. Believe me, the markets will not allow us to get nearly very far down 

this road. 

Federal spending levels have grown by almost 300 percent net of 

inflation over the past 40 years, and the Federal budget is now 

dominated by mandatory spending programs that grow on autopilot. These mandatory spending programs serve to constrain our 

ability to invest in our children, in critical infrastructure, and other 

areas that help to create a better future. 

As I have traveled the country and appeared to the media promoting the need for fiscal responsibility, many have asked, ‘‘Are we 

Greece?’’ Their question is based on the current challenges being 

experienced by that country, and the answer that I typically give 

is, the United States is not in the same situation as Greece today. 

However, our key public debt ratios will be as bad as Greece’s in 

less than 10 years. And given our present path, we must learn the 

lessons of Greece and past history, if we want to avoid a similar 

crisis of confidence. 

Today’s paper notes, ‘‘Riots in the streets of Greece.’’ This could 

happen in the United States in less than 10 years, on our present 

path. 

Today’s paper notes the dominance of concern in Britain about 

public debt. And as you will see, most Americans don’t realize, including most Members of Congress in all likelihood, that our key 

total public debt ratios exceed Great Britain. They exceed Spain. 

They exceed Ireland. They’re not as bad as Greece, but they’ll be 

there within less than 10 years. 

The truth is the debt to GDP numbers that the Federal Government pushes on the public, tend to understate the Nation’s true leverage. 

For example, current debt held by the public is about 58 percent 

of GDP and rising. However, if you add debt that’s owed to Social 

Security and Medicare and other so-called trust funds, the debt to 

GDP ratio would be about 89 percent. And if you consider the debt 

that’s held by Fannie Mae and Freddie Mac, which many believe 

11 

should be consolidated with the U.S. Government’s financial statements, we’re well over 100 percent, and rising rapidly. 

What about savings rates? Savings rates have declined dramatically, and the net national savings rate has plunged to the lowest 

level since the Great Depression. 

We must recognize reality and understand that the four factors 

that caused the mortgage-related subprime crisis exist for the Federal Government’s own finances: first, specifically, a disconnect between those who benefit from prevailing practices and those who 

will pay the price and bear the burden when the bubble bursts; second, not enough transparency as to the nature, extent, and magnitude of the real risk; third, too much debt, not enough focus on 

cash flow, and overreliance on credit ratings; and finally, a failure 

of existing governance, risk management, oversight, and regulatory 

functions to act until a crisis is at the doorstep. 

In my view, in summary, while America is a great nation, we are 

at a critical crossroads. The decisions that are made, or that fail 

to be made by elected officials over the next 3 to 5 years, especially 

in the fiscal area, will largely determine whether our future is better than our past, or whether our best years are behind us. 

We must move beyond delay and denial, we must start making 

tough choices, and we must do so before we pass a tipping point, 

which is what happened in Greece. 

If you look what happens when you pass a tipping point and you 

lose the confidence of your foreign lenders, interest rates can escalate dramatically, which can set off a chain of events that not only 

would have adverse economic consequences in the United States, 

but dramatic adverse consequences around the world. 

The United States will not default, but we may well have to pay 

much higher interest rates in the future because of not as much 

concern about default, but concern about what is the dollar worth 

that lenders will receive. 

Thank you very much, and I’ll be happy to answer your questions. 

[The prepared statement of Mr. David M. Walker can be found 

on page 394 of the appendix.] 

Chairman MOORE OF KANSAS. Thank you, sir, for your testimony. 

Mr. Hoenig, thank you for testifying today, and for your 36-plus 

years of service with the Fed. You and your staff at the Kansas 

City Fed have been leaders in our community, and an invaluable 

resource as our country has slowly managed our way through the 

financial crisis. 

As both you and Mr. Walker have pointed out, leverage is a double-edged sword and can be responsibly used for productive economic outcomes. But it seems, in the last decade especially, discipline was sacrificed for excessive risk-taking at times. 

Would you elaborate on your point that, ‘‘the greater leverage reflects a significant funding cost advantage,’’ for larger firms? I 

agree with your views that this represents a gross distortion of 

marketplace, and is an exploitation of an unearned advantage. 

Can you help us better understand this point, sir? 

Mr. HOENIG. I hope so. The way I would start, is if you look at 

my final comments, with how much additional capital it would take 

12 

to have what I think is a reasonable leverage ratio in terms of tangible capital, you would have to raise over $300 billion equity. 

Equity is more expensive, and therefore, by not having to raise 

that, to be allowed to have a higher leverage ratio, your cost of 

funding was, in effect, less, because smaller institutions, who are 

not ‘‘too-big-to-fail,’’ of course, don’t have that advantage. 

So you really have biased the outcome towards the largest institutions. They don’t have to raise as much capital; therefore, their 

costs are less; plus, they’re thought to be ‘‘too-big-to-fail.’’ Therefore, their credit costs, as well, are less than you would have in a 

regional bank that everyone knows could be closed if it were to fail. 

So that’s a huge advantage, and it perpetuates the ever-increasing size and consolidation of the financial industry, because, think 

about it. If you’re on that borderline as being thought ‘‘too-big-tofail,’’ you have to go and get a merger partner and get above that 

threshold and bring your costs down. So it has a very perverse incentive system, that I think harms us. 

Chairman MOORE OF KANSAS. Thank you, sir. At the end of your 

testimony, Mr. Hoenig, you note that critics will oppose more conservative capital ratios on the grounds it will restrict growth. You 

admit it will, but the point that everyone seems to miss is that runaway, excessive growth and dependence on leverage and debt is 

unsustainable and dangerous, and puts all Americans at risk. 

We need to return to a more sustainable and responsive—do we 

need to return to a more sustainable and responsible use of leverage and debt; is that correct? 

Mr. HOENIG. Absolutely correct, sir. I’m convinced—I have been 

told many times that, if you put these leverage constraints, you 

make it a rule of, say, 15 to 1, that during the growth period, you 

will constrain growth. 

And my answer is, yes. That’s the nature of sound fiscal management, that your capital requirements limit you. So if you want to 

go out and grow your balance sheet, you have to raise new capital 

to do so, which keeps it sounder, but also keeps the growth from 

running away. 

So, under those conditions, under having firm rules, the capital 

ratios become countercyclical. When you allow them to move, they 

become less restrictive during the growth period and more restrictive during the recession. You get a procyclical outcome. The boom 

is bigger, and the recession is much worse. And that’s what we 

want to avoid. I think this would do it. 

Chairman MOORE OF KANSAS. Thank you, sir. 

Mr. Walker, thanks for your years of public service, and what 

you have done to raise awareness about our long-term budget challenges. 

First, I think you make a great point in your testimony that all 

debt and leverage is not bad, and with its responsible use, it can 

lead to productive economic activity. But like our addiction to foreign oil, and the dangers it poses to our national security, you note 

that, ‘‘our low savings rate and large spending appetite, America 

has become unduly reliant on foreign investors to finance our Federal deficits and debt.’’ 

13 

Would you explain, sir, how our dependence on excessive debt 

may be a threat to our national interests in a little more detail, if 

you would, sir, please? 

Mr. DAVID M. WALKER. Yes, I will. 

First, the fastest-growing expense in the Federal budget today is 

not health care costs, although they do threaten our future. It’s interests costs. Within 12 years, without a risk premium for interest 

rates, the single largest line item in the Federal Government’s 

budget will be interest on the Federal debt, and we get nothing for 

that. 

If we have to start paying a risk premium, say 200 basis points, 

or 2 percent, by 2040, the only thing the Federal Government could 

pay, based on historical revenue levels, is interest on the Federal 

debt. We get nothing for it. 

So the fact is, we have to recognize that, by having excessive leverage, we are crowding out our ability to invest in our future. In 

addition to that, we are increasing the risk of passing a tipping 

point, whereas foreign investors may decide that they want to 

charge us higher interest rates in order to offset any potential risk, 

not as much of default, but of a significant reduction in the value 

of our currency and, therefore, their effective yield. 

We are a great country, and we benefit from the fact that we 

have about 62 percent of the world’s global reserve currency. That 

gives us more rope. It gives us more time. But ultimately, we are 

not exempt from the fundamentals laws of prudent finance; and yet 

we act like we are. 

We’re talking about our future national security, our future 

international standing, and our future standard of living. 

I think we have to recognize reality. There are two kinds of 

taxes: current taxes; and deferred taxes. And to the extent that you 

run large deficits, those represent deferred taxes that will have to 

be paid with interest. 

So this is not just an economic and national security issue; it’s 

a moral issue. 

Chairman MOORE OF KANSAS. Very good point. Thank you for 

your answer to my question, sir. 

The Chair next recognizes Ranking Member Biggert for 5 minutes. 

Mrs. BIGGERT. Thank you, Mr. Chairman. 

Mr. Hoenig, the bill that is before us, the regulatory reform bill 

that Democrats have proposed, isn’t it, if they have the ‘‘too-big-tofail’’ that’s a problem, isn’t it likely that the leverage problems will 

become even worse in the future? 

Mr. HOENIG. If we fail to address the ‘‘too-big-to-fail’’ issue, then 

the leverage issue and the consequence from that will only get 

worse through the next cycle. 

In other words, all the banks are deleveraging right now, because 

of the pressure. But once the economy turns around and we begin 

to expand again, the leverage, the drive for leverage will increase 

as return on equity demands, return to investors becomes of paramount focus by that CEO, and the deleveraging will start again, 

and we will repeat the cycle, in my opinion. 

That’s why we need to have in the legislation, firm leverage rules 

that the rule of law then dictates that, inhibits that from hapVerDate Nov 24 2008 12:04 Oct 25, 2010 Jkt 058041 PO 00000 Frm 00021 Fmt 6633 Sfmt 6633 K:\DOCS\58041.TXT TERRIE
14 

pening, and it will, in fact, inhibit the growth of some of these largest institutions by taking their advantage away. 

Mrs. BIGGERT. What, then, do we do when these—if they have 

funding advantages, and the creditors, since they seem to have a 

different status, the creditors will be more likely, when they monitor, not to be as vigilant when they look at the institution’s leverage, so that it would go up. 

Is that a potential problem, too? 

Mr. HOENIG. As long as we do not address ‘‘too-big-to-fail,’’ that 

is not a potential, but an immediate, real problem. 

The creditors have to be under—that’s why I prefer a rule of law 

that takes away discretion from the bureaucrat or from the policy 

person, so that in the crisis, you don’t have that option to bail out, 

so that you have to take certain steps, controlled, to prevent a financial meltdown as such, but we can do that, and then the creditor knows that they will be in line, and they will get— 

Mrs. BIGGERT. So it would be like an enhanced bankruptcy? 

Mr. HOENIG. That’s correct. An enhanced bankruptcy for a failure process that assures everyone that the largest institution will 

be dismantled if it fails. 

Mrs. BIGGERT. Okay. How has recent Fed policy encouraged the 

use of debt financing? 

Mr. HOENIG. In the sense of the last of this past cycle, I’m on 

the record as saying that when you keep interest rates exceptionally low for an extended period, you are encouraging credit, because of course, it’s cheaper to borrow than to raise equity, it’s 

more convenient, and therefore, you encourage credit. So you add 

to the incentives by keeping interest rates lower than they would 

otherwise be under normal market supply and demand conditions. 

So that’s one of the issues we have to confront. 

Mrs. BIGGERT. Thank you. 

Mr. Walker, then, you point out some alarming numbers, and 

alarming other things, too. And thank you for your testimony. I 

hope you don’t scare everybody to death. 

Regarding the Federal debt, when you account for the debt owed 

to Social Security, Medicare, and the total GSE liabilities, what 

should be done regarding the GSE debt? 

In other words, you talk about mandatory spending, and we have 

to reduce that? Really, discretionary spending is not near the 

amount of the mandatory. But how does the GSE liability fit in 

there, and what should be done with their debt, and can we continue to really continue to fund Fannie and Freddie as we’re doing 

now? 

Mr. DAVID M. WALKER. First, in my personal view, the debt 

that’s owed to the Social Security and Medicare trust funds should 

be deemed to be a liability. 

On one hand, we hold it out as an asset of the trust funds. We 

tell the beneficiaries of those programs that you can count on it, 

it’s guaranteed by the full faith and credit of the United States 

Government, both as to principal and interest. We won’t default on 

it. But yet, right now, it’s not considered a liability. 

And so, therefore, if it was, and by the way, it is part of the total 

debt subject to the debt ceiling limit, our current debt to GDP ratio 

would be 89 percent, and rising rapidly. 

15 

The issue of Fannie Mae and Freddie Mac is a little different. We 

do account for transactions, such as the $100 billion plus that we 

have already provided to them. The Treasury has now effectively 

guaranteed trillions of dollars of Fannie Mae and Freddie Mac 

debt. That’s a contingent liability. But now, the Federal Government essentially controls Fannie Mae and Freddie Mac, and one of 

the questions that’s going to have to be answered for this year’s financial statements is, should they be consolidated into the financial statements of the United States Government. 

Current accounting allows for that not to happen if it’s temporary. It’s not so clear to me how temporary this situation is, and 

so it’s something that’s very serious and we need to focus on it. 

Bottom line, we’re in worse shape than we tell people, and we 

need to recognize reality, that we’re not exempt from the fundamentals of prudent finance. We also need to do what it takes to 

avoid what’s happening in Europe right now. 

Mrs. BIGGERT. Thank you. My time is up. I yield back. 

Chairman MOORE OF KANSAS. Thank you. 

The Chair next recognizes, Mr. Lynch, from Massachusetts. Sir, 

you have 5 minutes. 

Mr. LYNCH. Thank you, Mr. Chairman. 

I want to thank you both for your willingness to come before the 

committee here today, and I also thank you for the frankness of 

your testimony; and I share a lot of the same sentiments about 

where we’re heading. 

One of the particular areas I think that—let’s go to the ‘‘too-bigto-fail’’ discussion. We talked about the 10 banks that really exceeded, by everyone’s estimate, the existing capital structure regulation, and they accomplished that. We had regulations in place 

about how much leverage there could be for these banks. 

What they did is, they used derivatives, they used these special 

purpose vehicles, used them by several names, but basically, in 

many cases, they contained these collateralized debt obligations, or 

collateralized loan obligations, and they moved that debt off their 

balance sheet. 

And that way, they were able to stay within the regulatory 

framework, at least nominally, until it hit the fan, and these folks 

had to take all that stuff back on their balance sheets because 

there were no buyers, and those investments basically deteriorated. 

That practice allowed these banks to become ‘‘too-big-to-fail,’’ in 

my opinion. 

I’m just wondering what you think about the Senate version of 

financial services reform, and also the House version, where we put 

some limits on these derivatives, we have established exchanges, 

which provides for transparency, we have provided for clearinghouses, and I’m a little bit nervous, because it still allows these 

clearinghouses to be owned by these 10 banks. As a matter of fact, 

5 of the banks own 97 percent of all the clearinghouses, and that 

troubles me greatly. 

But there’s also a dark market that is maintained, for unilateral 

trading of these complex derivatives that go on between individuals. And so, I’m nervous about the perpetuation of this practice 

of moving stuff off the balance sheet, and that has allowed this leverage to go on. 

16 

I would just like to hear from each of you whether or not you 

think my fears are unfounded, or perhaps you might suggest a way 

of getting at that. 

Thank you. 

Mr. HOENIG. I think your fears are well-founded. I think the 

amount of off-balance-sheet activities with certain kinds of derivatives and synthetic derivatives have contributed to this crisis. I 

think that would be hard to refute, actually. 

I do believe that the legislation should provide, number one, for 

better disclosure and for requiring these institutions to keep a portion of that on their balance sheet, whether it’s 5 percent or 10 percent, so that you can monitor, and they have some skin in the 

game, if you will, to monitor that off-balance-sheet activity. That’s 

number one. 

Number two, on your exchanges, I’m very strongly supportive of 

a clearinghouse, but even exchanges, where you bring it to the 

light of day. A market discovery price is more available, people can, 

not behind the scenes this dark market manipulate to, say, push 

something so they can gain in a short position, and so forth. 

I know there’s a lot of discussion right now in the Senate on 

those particular industry players, but I think that can be dealt 

with, and the main objective should be to get transactions in the 

open, that is, a clearly regulated exchange or clearinghouse—it has 

rules that it abides by—would be the best outcome for the American people, and for the financial industry, actually. 

Mr. DAVID M. WALKER. I think, clearly, with regard to the private sector, there’s no question that there need to be tougher capital requirements, that also give appropriate consideration to derivatives. 

In addition, there needs to be more transparency, no question, 

and better oversight than historically has been the case. 

But let me remind you that you’re correct, Congressman Lynch, 

that these special purpose entities and the use of derivatives didn’t 

serve to mitigate risk but to enhance risk, which was part of the 

problem. 

The Federal Government has special purpose entities, too. 

They’re called trust funds. And one could argue that GSEs might 

be deemed to be special purpose entities, too. 

So we need to practice what we preach. We need to do what we 

need to do with regard to institutions and instruments that represent systemic risk, but we also need to put our own financial 

house in order, and make sure that we’re leading by example, and 

practicing what we preach. 

Mr. LYNCH. Thank you. I yield back. 

Chairman MOORE OF KANSAS. Thank you, sir. 

The Chair next recognizes Mr. Driehaus for 5 minutes. 

Mr. DRIEHAUS. Thank you very much, Mr. Chairman. Thank you 

for holding this hearing. 

And I appreciate the testimony of the two witnesses. I think it’s 

an issue that, while we talk about it from time to time on the surface, very rarely do people dig down and try to get toward solutions 

when it comes to our indebtedness. 

I was very interested, Mr. Walker, specifically, in some of the solutions that you had focused on in your testimony, one of those 

17 

being the issue of tax expenditures, which I think the vast majority 

of Americans pay very little attention to. This idea that we, as the 

Federal Government, forego over $1 trillion in tax revenue is very 

serious. 

I describe it as a revenue stream that looks like Swiss cheese, 

because of all of the carveouts that exist, not just—and it happens 

in the States as well as in the Federal Government. 

But what ends up happening is the rates that are then applied 

don’t really bring in the revenue that it’s suggested that they otherwise might. Instead, you have a situation where government is 

picking winners and losers in the economy, which only leads to a 

declining revenue stream. 

The challenge, though, is that anytime you try to close one of 

those loopholes, anytime you try to close one of those intentional 

carveouts, you’re accused of raising taxes. 

As you look at The President’s Commission to Address the Deficit 

and the Debt, how do we treat the Tax Code, especially tax expenditures, so that they’re no longer being viewed as political football, 

but that we have a long-term, sustainable tax policy that businesses in the United States can actually count on, while actually 

lowering the rates, in my opinion, because I think you can close a 

lot of loopholes, and dramatically lower the rates. 

But I would be very interested in your comments. 

Mr. DAVID M. WALKER. First, there are two kinds of spending. There’s front-door spending, which is about $3.8 trillion for this 

year. And there’s back-door spending, which is the revenue that we 

lose because of tax preferences, deductions, exemptions, exclusions, 

credits, etc., over $1 trillion a year. 

They’re not in the budget. They’re not in the financial statements. They’re not part of appropriations. And they’re not systematically reviewed for reauthorization. That has to change. 

We have to take a hard look at them to understand whether or 

not their future focused, results oriented, to try to understand who 

is benefitting from them. And, in many cases, quite frankly, they 

fuel problems. 

For example, the largest tax preference is the exclusion from individual income and payroll taxes of employer provided and paid 

health care. That fuels health care cost increases. It creates great 

inequities between the haves and the have-nots. 

So I think it’s important that be on the table. It has to be part 

of comprehensive tax reform. 

And, quite frankly, I think ultimately the Federal Government is 

going to have to employ a special process, possibly with outside experts, to go through a disciplined, independent review of major 

spending programs, both front-door and back-door, and to make 

recommendations on what the Congress should consider doing to 

put us on a more prudent and sustainable path. 

There’s no question that we need comprehensive tax reform, and 

that if we broaden the base, we can keep rates low and, in fact, 

potentially even lower, especially on the corporate side, for competitiveness reasons. 

At the same point in time, I can also tell you that, because of 

a very simple principle, math, taxes are going up. There’s no way 

that we can solve our structural fiscal imbalance solely on the 

18 

spending side—although my personal view is we have to do more 

on the spending side of reprioritization and constraint than on the 

revenue side—but we’re going to have to have more revenues. 

And the longer we wait to come to the realization that we have 

to make tough choices on both sides, the bigger the change is going 

to have to be, the less transition time, and the more risk of passing 

a tipping point. 

Mr. DRIEHAUS. Would you support a systemic process within the 

Congress, a litmus test, if you will, so that any Member, coming 

before the Ways and Means Committee or any other committee, 

with a tax expenditure, would have to meet a set of criteria in 

order for the tax expenditure to even be considered? 

Mr. DAVID M. WALKER. Absolutely. I think we need a set of criteria for direct spending and indirect spending. 

Believe it or not, this country has been in existence since 1789, 

and it has never had a strategic plan. 

Believe it or not, this country doesn’t have a set of outcome-based 

indicators—economic, safety, security, social, environmental—to assess what’s working and what’s not, and how do we compare to others. 

Believe it or not, we have never gone through a systematic review of major tax preferences or spending programs to find out 

whether they’re future-focused, delivering results, affordable, and 

sustainable. 

It’s about time. 

Mr. DRIEHAUS. Mr. Hoenig, I don’t know if you have any comments on tax— 

Mr. HOENIG. I would answer one thing, though, that plays on 

this, that I think is important. 

If we don’t address the issues, front-door, back-door, the issues 

you’re bringing up, I’m absolutely confident that there will be 

mounting pressure on the Federal Reserve system to help finance 

this through monetization of debt, and the outcome for that for this 

country is inflation at some point in the future. And of course, that 

is a tax. 

Mr. DRIEHAUS. Yes. 

Mr. HOENIG. And it’s the most regressive tax we can put on the 

American people. 

So it’s important, I agree so much with Mr. Walker, that we address this starting now in some systematic fashion, or we will pay 

dearly a generation, or a lot sooner than that, ahead of us. 

Mr. DRIEHAUS. Thank you, Mr. Chairman. 

Chairman MOORE OF KANSAS. We have a little bit of time left. 

If it’s okay with the witnesses, if you’re okay with this, we’re going 

to each ask one more question, if that’s all right, if people have the 

questions. 

Mr. Hoenig, when considering a leverage ratio cap of 15 to 1, 

would you include off-balance-sheet assets in that number, and 

how do those get considered in monitoring leverage? 

Mr. HOENIG. What I would tend to do is require a portion of the 

off-balance-sheet to be counted on the balance sheet. 

If you originate it and push it out, you keep a portion of it, and 

then your leverage against that. 

19 

Because I think the fact that you constrain the leverage to that 

very hard number, and keep a fair amount of the off-balance-sheet 

then in your calculation, you will constrain the use of off-balancesheet activities. Otherwise, it becomes very complex. 

One of the issues in our past crisis around capital is, frankly, the 

Basel capital standards, which were so complex that they were 

gamed almost immediately by the institution that wanted to leverage out. 

So the simpler, the more direct, the better. 

Mr. DAVID M. WALKER. If I may, Mr. Chairman— 

Chairman MOORE OF KANSAS. Mr. Walker, yes, sir. 

Mr. DAVID M. WALKER. —on that. 

First, to me there’s a difference between how do you treat them 

for capital requirements and for regulatory purposes, and what do 

you do with them from an accounting standpoint. 

I don’t think that Congress should set accounting standards. We 

could be in real trouble if that happens. But I do think that you 

have to give consideration, as has been mentioned, about what do 

you do for purposes of capital requirements and regulatory heft. 

Chairman MOORE OF KANSAS. Thank you, sir. 

The Chair next recognizes the ranking member, Ms. Biggert, if 

you have a question. 

Mrs. BIGGERT. Thank you, Mr. Chairman. 

This testimony has been really, really good. Thank you. 

Could you just, each of you, say what would be the first three 

things that you would do right now, that we can do immediately, 

to stop the bleeding, to stop the debt increase? 

We’ll start with you, Mr. Walker. 

Mr. DAVID M. WALKER. First, tell the American people the truth, 

which is what we’re trying to do, about where we are, where we’re 

headed, how do we compare to other nations, the benefits of acting 

sooner rather than later, the dramatic kind of changes we’re going 

to have to make, and the potential adverse consequences to our 

country and their families if we don’t. 

That means engaging the American people outside the Beltway 

in ways that haven’t been done, representative groups. And frankly, we’re going to fund, along with the MacArthur Foundation and 

the Kellogg Foundation, an effort to do so in 19 cities around the 

country on June 26th of this year, but that’s just a beginning. 

We also are publishing this Citizens’ Guide and distributing it, 

and each of you have a copy. 

Secondly, I think next year, we should reform Social Security to 

make it solvent, sustainable, secure, and more savings-oriented. It’s 

a lay-up. You can miss a lay-up. But it’s a high-percentage shot. 

I think there’s pretty much a parameter of what needs to be done 

there. Social Security is not our biggest problem, but it would be 

a credibility enhancer and a confidence builder. 

Secondly, next year, I think we should enact statutory budget 

controls—spending constraints, etc.—that will take effect once we 

hit certain triggers relating to economic growth and unemployment. 

And then, beyond that, I think that we need to set the table for 

what will be very tough choices for health care cost reduction, 

which the last bill really didn’t do much on, and for comprehensive 

20 

tax reform that will improve the economic growth, enhance our 

competitive posture, and generate more revenues. 

Those things, I think, are going to have to be done together, because they’re going to involve very tough choices and you’re going 

to have to do tradeoffs and probably deal with it as a package. 

Mrs. BIGGERT. Thank you. 

Mr. Hoenig? 

Mr. HOENIG. I would add—I think those are great suggestions— 

I think there needs to be brought forward to the American people 

a realization that we have to engage in a shared sacrifice, if you 

will, that we’re all going to have to take a hit, because I find that 

we all want to do this, but not for our particular area, our particular project. And there has to be this education, communication 

that would take that forward. 

I think that has to also be incorporated into the congressional 

process. In other words, we are going to take this forward as a 

Congress, not as a party, and so we can deal with this. 

And then I do agree, we need to put budget constraints on ourselves that force us then to then face up to these shared sacrifices 

and these cuts and these taxes that are ours to face. 

Mrs. BIGGERT. Thank you. 

Chairman MOORE OF KANSAS. Shared sacrifice. What a radical 

notion. That’s really something I agree with. 

You’re recognized, Mr. Lynch, for up to 5 minutes. 

Mr. LYNCH. Thank you. Thank you, Mr. Chairman. 

Mr. Walker, you’re passing comment regarding the recently 

passed health care bill, and I cannot ignore that. 

I’m one person who voted against that for precisely the reason 

that you raised, that the idea at the beginning of the health care 

debate was that, since we were paying 3 times as much as any 

other nation on health care, that we would squeeze down the costs 

and use the savings to pay for some health care for the people who 

weren’t covered. 

And I know I disagree with a lot of my colleagues on this, but, 

it’s sort of like throwing an anchor to a drowning man, from a 

budgetary standpoint, committing $1 trillion when we have all 

these problems on our plate. 

Mr. Hoenig, I read your comment on that, and I think both of 

you have said that we have to realize that the rules of finance 

apply to us, and that goes for the Fed, that goes for Treasury, and 

that goes for the people in Congress, and to the President, that the 

rules of finance apply to us. 

And sometimes around here, we act like there’s no connection at 

all to what we do and what we pass and someone who’s going to 

have to pay the bill somewhere down the road. 

I read recently, in my clips here, I can’t track it down, but 

Moody’s—and this was regarding the discussion with Greece and 

Spain and Portugal and Ireland, and Moody’s—someone at Moody’s 

made a statement that the United States ought to be careful, because based on the amount of debt that we’re acquiring here, and 

the track that we’re on, that we could lose our AAA bond rating, 

and that would be devastating, to increase greatly the cost of our 

borrowing, and the loss in confidence in the United States. 

21 

And I was wondering if you could comment on that, and what 

the repercussions might be if the financial markets, given how 

we’re running our business here, called the United States of America, if there were loss of confidence and we were to lose that AAA 

bond rating. 

Mr. HOENIG. I think your concern is very legitimate. And I— 

whether it’s a financial institution or a company or the U.S. Government, I have a saying that, based on my experience, once there 

is a shred of doubt, it’s too late. 

Mr. LYNCH. Right. 

And so, we’re now in a position where we see this wave coming 

at us, and we can do something about it. But once it gets to our 

shores, if you will, and this doubt enters, then we will see it reflected in our interest rates, in our value of our currency, and in 

our future wealth. 

So we need to do it now. Doubt is going to be the outcome, and 

that will be a very expensive proposition for us all. 

Mr. DAVID M. WALKER. About a year ago, the major rating agencies downgraded the outlook for Great Britain to maintain its AAA 

credit rating. It didn’t downgrade their rating. It downgraded the 

outlook. 

Our ratios on total public debt are worse than Great Britain. If 

we fully accounted for the trust fund obligations and other activities, even with regard to the Federal level, they’re worse. 

And so I think the fact of the matter is, we benefit from having 

62 percent of the world’s global reserve currency, and secondly, 

home team bias. Most rating agencies are based here. 

And in my view, there’s absolutely no question, on the path that 

we’re on, one would have to seriously question how long we will retain a AAA credit rating under our current path. We shouldn’t get 

to that point. 

And that’s why, last month, we surveyed about 100 top former 

leaders, from Congress, the Executive Branch, and the Federal Reserve. Chairs and ranking members of Finance, Ways and Means, 

the Budget Committees, Treasury Secretaries, Fed Reserve Board 

members, Treasury Secretaries, OMB directors, CBO directors. 

There was 100 percent agreement, with a 60 percent response 

rate roughly, that we’re on an unsustainable path. Super-majority 

agreement that we must take concrete actions within 1 to 2 years 

to avoid the risk of passing a tipping point. Numbers like that are 

clear and compelling. 

So we have to move past denial. We have to move past delay. We 

need a plan, and we have to start acting. 

Mr. LYNCH. Thank you both. 

I yield back. 

Chairman MOORE OF KANSAS. Thank you, sir. 

Mrs. BIGGERT. Mr. Chairman, could I ask unanimous consent to 

allow Mr. Royce from California to—he’s a member of the general 

committee, but— 

Chairman MOORE OF KANSAS. Certainly. Without objection, it is 

so ordered. 

Mr. Royce, you’re recognized for 5 minutes. 

Mr. ROYCE. I appreciate it, Mr. Chairman. 

I had a question for Mr. Hoenig. 

22 

In a recent book co-authored by two economists, Rogarth and 

Reinhart, they note the painful consequences of the rising government debt load that often follows financial implosion, or a financial 

crisis. And despite vocal warnings from economists, the United 

States is following the pattern that they set out, rather blindly. 

We were overleveraged prior to the financial crisis, but the Federal Reserve and the U.S. Government have lent or spent or guaranteed about $8.2 trillion to prop up the economy in the last 2 

years. 

And a quarter—you also throw into the mix here that Chairman 

Bernanke has said our budget deficits and the budget proposal put 

forward by the Administration, going forward, is unsustainable. So 

we don’t see things getting better with these trillion dollar deficits 

that we are budgeting for now. 

The IMF and the OECD are projecting that the stock of public 

debt in advanced economies is going to double and reach an average level of 100 percent of GDP in the coming years. 

So I would ask you, we have been through a financial crisis 

where much of the private sector debt was simply transferred to 

the Federal Government. In essence, that’s the bottom line. And 

that’s contributed, then, to these unsustainable Federal deficits. 

So where does this road lead; and do you foresee a financial crisis 

that now morphs instead into a sovereign debt crisis here in the 

United States? 

Mr. HOENIG. I think that the steps that were taken in the crisis 

to staunch it, to end it, were taken aggressively. I think now we 

have to be prepared to reverse that, and we need to do it carefully 

and systematically, but we need to reverse it. 

These debt levels that we have been talking about here this 

morning, whether it’s the financial institutions, the Federal Government, and even the Federal Reserve’s balance sheet, need to be 

addressed and reduced. And I think that’s paramount. 

Or, as Rogarth and Reinhart have shown, we will compromise 

our future and, as we have been talking here this morning, it will 

as well, and I think, as I said earlier, there will be increasing pressure. 

If this isn’t addressed sooner and systematically, and people 

don’t have confidence that we’re going to address it, then we will 

see pressure for the Federal Reserve to monetize more of this debt, 

inflationary pressures will rise, and there will be a strong impact 

on the dollar, long-term, and on our Nation’s wealth. 

So it’s— 

Mr. ROYCE. That is the concern of a number of economists, that 

the path of least resistance here might be runaway fiscal deficits 

which will then be monetized by the Federal Reserve. 

I think you recently gave a speech highlighting the possibility 

that Congress could soon be knocking on the Fed’s door to monetize 

the debt. 

Mr. HOENIG. Right. 

Mr. ROYCE. Are you concerned with the precedent that has been 

set by the Fed in this regard, because last year, the Fed bought 

$1.8 trillion of Treasury securities and agency debt? 

And the other issue that I just asked about, which comes out of 

that same book by Rogarth and Reinhart, is that the buildup of exVerDate Nov 24 2008 12:04 Oct 25, 2010 Jkt 058041 PO 00000 Frm 00030 Fmt 6633 Sfmt 6633 K:\DOCS\58041.TXT TERRIE
23 

cessive debt, they say, inevitably leads to stagnant economic 

growth going forward, which you alluded to. Clearly, there is the 

need for deleveraging that lies ahead for our economy, both in government and privately held debt, and instead, we seem to be piling 

on, especially if you look at the increases in all of the agency 

spending, the appropriations, the separate appropriations bills, 

which go up by double digits. 

Do you foresee a stagnant economy, as long as this level of debt 

remains? What’s your forecast here? 

Mr. HOENIG. First of all, yes, I am concerned by the precedent 

set, and I think we need to, that’s why I say we need to reverse 

that quickly to bring our balance sheet back down. We need to do 

it systematically and carefully, but we need to do it. 

If we don’t, and we get ourselves into an environment of growing 

debt, unsustainable, as Mr. Walker had pointed out, and we then 

put pressure to monetize it, which would cause us to have inflation, 

we will endanger our economy and stagnation is a possibility. It’s 

unavoidable, if we don’t take action now. 

Mr. ROYCE. Thank you, Mr. Hoenig. 

Mr. DAVID M. WALKER. Congressman, if I can respond quickly? 

Mr. ROYCE. Absolutely. 

Mr. DAVID M. WALKER. First, on my testimony, I talked about 

the four parallels between the factors that caused the mortgage-related subprime crisis and the Federal Government’s own finances. 

We need to learn lessons from that. 

Secondly, with regard to the book you’re referring to, I think it 

refers to the fact that once you have debt equal to about 90 percent 

of the economy, then it has an adverse effect on economic growth; 

and once you get to 100, it’s very troubling. 

If you count the Social Security and Medicare debt, we’re at 89 

percent, and growing rapidly. That doesn’t count the GSEs and 

things of that nature. 

And then lastly, you can’t monetize your way out of this problem, 

and let me tell you why: because, while monetizing your way out, 

which creates an inflation risk, might help deal with the current 

debt, and lessen the burden of the current debt, the real threat to 

the future of this country is the $45 trillion in off-balance-sheet obligations, $38 trillion for Medicare alone, that grows faster than inflation and faster than the economy. 

You have to make tough choices. You need to do it within 2 

years, at least to start, or else we could be facing something that 

we don’t want to see in this country. 

Mr. ROYCE. Thank you. 

Chairman MOORE OF KANSAS. I thank the gentleman. 

And I would, at this time, like to thank our panel members here, 

Mr. Hoenig and Mr. Walker, for your testimony, and for answering 

our questions. It has been a very, very good exchange, and I very 

much appreciate that. 

I’m advised that votes will be called in the very near future, 

probably in the next 5 to 10 minutes, and I would like to excuse 

the first panel, and again thank you for your testimony and your 

service, and ask the second panel members to be seated so we can 

maybe just get at least preliminarily started here, and then move 

on. 

24 

Thank you again. 

I’m pleased to introduce our second panel of witnesses, and 

please work with me and forgive me if I mispronounce any names 

here. 

First, we will hear from Ms. Orice Williams Brown, Director, Financial Markets and Community Investment at GAO. 

Next, will be Professor John Geanakoplos, James Tobin Professor 

of Economics at Yale University. 

Then, we’ll hear from Professor Viral Acharya—excuse me. Will 

you pronounce it, sir? Okay—Professor of Finance, Stern School of 

Business at New York University. 

And finally, we’ll hear from another David Walker, a different 

David Walker, Professor David A. Walker, who is the John Largay 

Professor at the McDonough School of Business at Georgetown University. 

Without objection, your written statements will be made a part 

of the record. 

Ms. Williams Brown, you’re recognized, ma’am, for 5 minutes. 

STATEMENT OF ORICE WILLIAMS BROWN, DIRECTOR, FINANCIAL MARKETS AND COMMUNITY INVESTMENT, U.S. GOVERNMENT ACCOUNTABILITY OFFICE (GAO) 

Ms. WILLIAMS BROWN. Thank you. 

Chairman Moore, Ranking Member Biggert, and members of the 

subcommittee, I appreciate the opportunity to testify before you 

this morning on the role of leverage in the recent financial crisis. 

As you know, the Emergency Economic Stabilization Act of 2008 

mandated that GAO study the role of leverage in the crisis. My 

statement today is based on that report. 

While the report covers a wide range of issues, I would like to 

highlight a few key points concerning how leverage is defined, its 

cyclical nature, how it’s constrained, and regulatory limitations. 

The buildup of leverage during the market expansion, and the 

rush to reduce leverage or deleverage when market conditions deteriorated, was common with this and past financial crises. 

Leverage traditionally has referred to the use of debt instead of 

equity to fund an asset, and has been measured by the ratio of 

total assets to equity on the balance sheet. But the recent crisis revealed that leverage can also be used to increase an exposure to a 

financial asset without using debt, such as by using derivatives. 

Given the variety of strategies to achieve leverage, no single 

measure can capture all aspects of leverage. 

Our findings concerning the role of leveraging and deleveraging 

in the recent crisis reveal that leverage steadily increased within 

the financial sector before the crisis began in mid-2007, and banks, 

securities firms, and others sought to deleverage and reduce their 

risk during the crisis. 

While this work, which builds upon the work of others, suggests 

that efforts taken to deleverage by selling assets and restricting 

new lending could have contributed to the crisis, others noted that 

the crisis was the result of prices reverting to their fundamental 

values after a period of overvaluation. 

25 

These varying perspectives illustrate the complexity of the crisis, 

and, given the range of assets involved, are not necessarily contradictory. 

Moreover, some argue that leverage created vulnerabilities in the 

market that increased the severity of the crisis. 

In addition, subsequent disorderly deleveraging by financial institutions may have compounded the crisis. 

For example, some studies suggest the efforts taken by financial 

institutions to deleverage by selling financial assets could cause 

prices to spiral downward during times of market stress, and exacerbate a financial crisis. 

Second, the studies suggest that the deleveraging by restricting 

new lending could slow economic growth. However, other theories 

also provide possible explanations for the sharp price declines observed in certain assets. 

The issues raise questions about how leverage is constrained, 

which varies by type of institution. 

For example, for federally regulated institutions, regulators can 

limit leverage through minimum-risk-based capital, leverage ratios, 

and liquidity requirements. However, for other institutions such as 

hedge funds, market discipline supplemented by regulatory oversight of institutions that transact with them, conserve to constrain 

their use of leverage. 

The crisis revealed limitations in the regulatory approaches used 

to restrict leverage. 

For example, regulatory capital measures did not always fully 

capture certain risks, which resulted in some institutions not holding capital commensurate with their risk and facing capital shortfalls when the crisis began. Moreover, regulators faced challenges 

in countering cyclical leverage trends. 

The crisis also revealed that, with multiple regulators responsible for individual markets or institutions, none has clear responsibility to assess the potential effect of the buildup of system-wide 

leverage or the collective effect of institutions’ deleveraging activities. 

Finally, a lesson of the crisis is that an approach to supervision 

that focuses narrowly on individual institutions can miss broader 

problems that are accumulating in the financial system. In that regard, regulators need to focus on system-wide risks to and weaknesses in the financial system, not just individual institutions. 

In closing, I would like to note that, since the onset of the crisis, 

regulators have continued to re-evaluate capital standards, namely, 

Basel II, and the countercyclical nature of leverage and capital. 

However, efforts to monitor leverage must include a mechanism 

to evaluate the amount of leverage in the system, in order to better 

identify and mitigate potential systemic risk. 

Mr. Chairman, Ranking Member Biggert, this concludes my oral 

statement, and I would be happy to answer any questions at the 

appropriate time. 

[The prepared statement of Ms. Williams Brown can be found on 

page 214 of the appendix.] 

Chairman MOORE OF KANSAS. Thank you for your testimony. 

The Chair next recognizes Professor Geanakoplos. 

You’re recognized, sir, for 5 minutes. 

26 

STATEMENT OF JOHN GEANAKOPLOS, JAMES TOBIN PROFESSOR OF ECONOMICS, DEPARTMENT OF ECONOMICS, 

YALE UNIVERSITY 

Mr. GEANAKOPLOS. Thank you for inviting me to talk today about 

managing leverage, managing the leverage cycle. 

For a long time, we have recognized the need to manage interest 

rates. That’s what the Federal Reserve does. But we don’t have a 

regulator to manage leverage. And I have written about this for 10 

or 15 years. 

I wasn’t the first one to think of this idea. Shakespeare, 400 

years ago, in The Merchant of Venice, explained, in a negotiation 

over a loan, you had to figure out not only the interest rate but also 

the collateral. And if we ask, which did Shakespeare think was the 

more important, nobody can remember the rate of interest that 

Shylock charged, but everybody remembers the collateral, the 

pound of flesh. 

The play ends, by the way, with the regulatory authority of the 

court deciding not to change the interest, not to change the principal, but to change the collateral. It should have been a pound of 

flesh, but not a drop of blood. And that’s what I’m advocating 

today, that we manage leverage, and not manage—pay so much attention to interest rates. 

I’m talking about securities leverage. When you have a house at 

20 percent downpayment, that means a 5 to 1 leverage, the cash 

divided into the amount of assets. That’s what I’m talking about. 

The reason I wrote about this is, there’s a puzzle in economics: 

how could it be that one supply-equals-demand equation determines two things, the interest rate and the leverage, or the amount 

of collateral? In my theory, it does. I resolved that problem. 

So leverage is important for three reasons, two of which people 

know: The more leveraged you are, the riskier your situation. If the 

asset changes by 1 percent, your profits go up by 5 percent, if you 

leverage 5 to 1. Also, there’s no recourse aspect of collateral. You 

can walk away from your house, and if the house goes to zero, you 

lose the $20 you put down. 

But there’s a third aspect of leverage that didn’t get so much attention, which is the main thing I have called attention to, which 

is that, with a lot of leverage, a very few people can own all the 

assets, and the implication of that is, the more leverage in the 

economy, the higher the asset prices; the less leverage, the lower 

the assets prices. 

The reason for that is, if you think of people, the buyers, on a 

continuum for the most enthusiastic at the top to the least enthusiastic, wherever the price is, the people above who are going to 

think that it’s a good deal, and they’ll be buyers; the people who 

are less optimistic will think that it’s a bad price, and they’ll be 

sellers. 

If you allow leverage in the system, the marginal guy, the guy 

on the threshold of buying or selling, his opinion is determining the 

price. If leverage goes up, you need fewer people at the top to buy 

all the assets. The marginal guy, on the threshold, is higher, and 

so the price now reflects his opinion, which is a higher opinion, because he’s a more optimistic person. That’s why prices go up when 

there’s more leverage. 

27 

The reason for this heterogeneity between people more if some 

people are more risk-tolerant, some people like to live in the houses 

more, many reasons, some people are more optimistic. 

So the leverage cycle is that there’s too much equilibrium leverage in normal times, and therefore, too high asset prices, and then 

suddenly there’s too little leverage in a crisis, and therefore, too 

low asset prices. And this bouncing up and down of asset prices is 

very harmful to the economy. 

The crisis always begins the same way. There’s bad news, but it’s 

not just bad, it’s scary. For example, they tell you your plane is 10 

minutes late. Well, 10 minutes isn’t so bad. It’s that you start to 

worry maybe it’s going to be an hour or two late. A bank announces it’s going to lose $5 billion. That’s not the end of the world. But if it’s going to lose $5 billion, maybe it will lose 

$10 billion. And that’s what you’re worried about. 

Or delinquencies in the home—homeowner delinquencies go from 

1 percent to 5 percent. The real problem is people now think they 

might go to 30 percent. 

So the next stage is, the lenders get nervous, and they cut lending, and they increase margins, and leverage starts to collapse, and 

then the optimistic buyers, when the prices are going down, they 

lose all their money. 

So a price might go down from 95 to 69, not because anybody 

thinks their own information justified—the bad news isn’t enough 

for anyone to think it should go down that far. 

But the optimists who bought at the beginning, the top 13 percent, say, when the price starts to go down, they get wiped out. 

Then the next group, who’s going to buy after the crash, the next 

group are not only not as optimistic, but they can’t borrow the 

money to buy it. So it takes a lot more of them to buy it. 

And so the marginal buyer goes way down, way below where he 

was before, and the price is lower, not because of the bad news 

alone, but because of these, the bankruptcy of the optimists and 

also because leverage is so far down. 

So that’s my theory. And this has recurred over and over again, 

in 1994, 1998, 2007. 

So just to show you some data, there’s a famous graph. That 

green curve, which is Schiller’s home price data, it went from 2000 

at 100, 90 percent up, to 190, and then dropped to 130. And he 

called it irrational exuberance. 

But if you look at the downpayments, the purple, it went from, 

measured from the top, 14 percent down to 2.7 percent down, and 

then to 20 percent down. It reached the peak at exactly the same 

time. 

If you look at toxic mortgage security prices, they collapsed, went 

from 100 to 60, and now they’re going back up to 80. 

If you look at the blue line, that measures downpayment again, 

in reverse direction, you see that leverage suddenly collapsed, and 

leverage went back up, and that’s why prices are going back up. 

So, the leverage cycle was worse this time than all the previous 

times—I’m just going to go 20 more seconds—worse this time than 

all the previous times because the leverage wasn’t just a few financial institutions, but millions upon millions of homeowners, and so 

we had a double leverage cycle, millions of people plus our financial 

28 

institutions, and also we introduced CDS, which is another way to 

leverage. 

So, what should we do about the leverage cycle? The most important thing to do is monitor leverage, securities leverage. 

Go to all the big financial institutions and ask, ‘‘What is the 

downpayment you’re requiring for housing, for securities that people are buying,’’ and publish that data every month, and also measure people’s leverage. Put CDFs on exchange and regulate leverage 

in normal times. Don’t let banks make 2 percent downpayment 

loans on houses and banks lending on mortgage securities. 

The last thing is, people keep—this is my last slide—people talk 

about monitoring leverage with the 15 percent rule that has been 

advocated by the previous panelists. In my opinion, that’s a mistake. We should be looking at leverage at the securities level, not 

at the investor leverage. What’s the downpayment on securities? 

Leverage can move from one institution to another. If you require 

15 percent for some institutions, it will move to some other place. 

People can lie about their leverage. You can’t lie about what the 

downpayment is, because there are two people you can check what 

the downpayment was. 

Thirdly, and most importantly maybe, leverage at the investor 

level goes in the wrong direction. When there’s a crisis, and it’s 

hard to get a loan, and the downpayments go way up, the bank, 

the investor leverage looks like it’s going up, because their equity 

is disappearing, so debt to equity is going up, just when the leverage is actually collapsing in the system. And also, there’s less pressure on a regulator to monitor security leverage. 

So I went over. Thank you. 

[The prepared statement of Professor Geanakoplos can be found 

on page 232 of the appendix.] 

Chairman MOORE OF KANSAS. Thank you, sir, for your testimony. 

The Chair will next recognize Mr. Acharya—is that correct, sir— 

for up to 5 minutes. 

And I would advise the people in the room here that votes have 

been called. We have about 10 to 12 minutes, I think, for votes. So 

if we can get both of these last remaining witnesses for 5 minutes 

each, we would appreciate that. 

Sir, you’re recognized. 

STATEMENT OF VIRAL V. ACHARYA, PROFESSOR OF FINANCE, 

STERN SCHOOL OF BUSINESS, NEW YORK UNIVERSITY 

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

subcommittee. 

Along with my colleagues at the Stern School of Business, New 

York University, I have co-edited two books on the financial crisis 

and co-authored research papers that help understand how the financial sector escalated its leverage before the crisis, and what can 

be done about it in future. Much of what I say today is based on 

this research. 

We seem to witness, on a somewhat regular basis, episodes in 

which financial intermediaries are all overextending credit, and are 

themselves funded with excess leverage. When the economic cycle 

turns downward, they fail in a wholesale manner requiring massive government interventions. 

29 

While leverage has its bright side in expanding finance for 

households and the real economy, its dark side is precisely this 

boom-and-bust cycle. Unfortunately, this dark side has become enduring. 

With each cycle comes in place, more government intervention 

and guarantees of financial sectors debt, some explicit, such as deposit insurance, and others implicit, such as ‘‘too-big-to-fail,’’ or 

‘‘too-systemic-to-fail.’’ 

The result is that financial firms find it cheap to borrow and post 

their returns without sufficient regard for risks. 

One of the most salient such episodes was the period since 2004, 

during which the financial sector in the United States, and in 

many parts of the Western world, grew its balance sheet at an unprecedented speed, and did so mainly through leverage. 

There were three primary failures, in my view, that led to this 

escalation of leverage: one, access to government guarantees that 

were not paid for, especially for the commercial banks and Government-Sponsored Enterprises; two, ineffective enforcement that allowed bank regulation to be arbitraged—that is, circumvented by 

a sophisticated financial sector; and three, in case of investment 

banks and the insurance sector, simply poor design of regulation. 

The end effect of these failures was that large and complex financial institutions, 10 of which owned over 50 percent of the financial 

sector’s assets, operated at historically high leverage, in some cases 

exceeding 25 to 1, or, in other words, $24 of leverage on a $25 balance sheet. 

Much of this leverage was undertaken in the shadow banking 

world, the less-regulated, or unregulated part of the financial sector. 

This part of the financial sector consists of off-balance-sheet entities that are connected to, but do not appear on bank balance 

sheets, borrowing and lending between financial firms, including 

through repos, or repurchase agreements, and the over-the-counter 

derivatives. 

Much of this leverage was also short-term in nature, to be rolled 

over each night or week, and yet it funded long-term and illiquid 

assets, such as subprime loans. 

This exposed the financial system to great risk from a secular 

economic downturn, and because the leverage was highly opaque, 

when financial firms failed, uncertainty about how losses would 

transmit to others paralyzed the system. In the end, the government and the Federal Reserve ended up bearing much of the 

losses. 

What can be done to deal better with this boom-and-bust cycle 

of leverage in the financial sector? 

In the interest of time, I’ll focus only on those regulatory options 

that directly deal with leverage in good times. 

First, current capital regulation does not take into account the 

leverage structure of a financial firm’s balance sheet. This major 

shortcoming should be addressed, for instance, by imposing a tax 

on leverage, or better, by introducing upper limits on leverage, 

such as 15 to 1, as has been employed successfully in other countries such as Canada; or better still, by embedding leverage inforVerDate Nov 24 2008 12:04 Oct 25, 2010 Jkt 058041 PO 00000 Frm 00037 Fmt 6633 Sfmt 6633 K:\DOCS\58041.TXT TERRIE
30 

mation in supervisory tests to assess whether banks can withstand 

extreme losses in economic downturns. 

Second, the regulation of the shadow banking world needs to be 

brought in line with the on-balance-sheet regulation of financial 

firms. Any attempt to regulate leverage that ignores the shadow 

banking world would only lead to further growth of off-balancesheet forms of leverage. 

In addition, greater transparency of the shadow banking world 

needs to be legislated so that regulators and market participants 

have timely and accurate information to understand and, if needed, 

restrict and discipline the leverage of financial firms. 

And last, but not least, the government should plan for a graceful exit from the large number of guarantees provided to the financial sector, not just as part of the rescue package in 2008, but from 

well before. In particular, reform of the financial sector should also 

include reform of the Government-Sponsored Enterprises. 

I’ll be happy to provide more detailed proposals on these during 

the question-and-answer period. Thank you, Mr. Chairman. 

[The prepared statement of Professor Acharya can be found on 

page 44 of the appendix.] 

Chairman MOORE OF KANSAS. Thank you, sir. Mr. Walker, you 

are recognized for 5 minutes. And votes again have been called, but 

I think we have time for your testimony. 

We’re going to hear your testimony, then we’re going to take a 

break for votes, and we’ll be back for questions. 

STATEMENT OF DAVID A. WALKER, JOHN A. LARGAY PROFESSOR, McDONOUGH SCHOOL OF BUSINESS, GEORGETOWN 

UNIVERSITY 

Mr. DAVID A. WALKER. Thank you. 

Chairman Moore, Ranking Member Biggert, and subcommittee 

members, thank you for this opportunity to testify in front of the 

House Financial Services Oversight and Investigations Subcommittee. 

I’m David A. Walker, the John A. Largay Professor in the 

McDonough School of Business at Georgetown University. 

Large firms that are managing their risk effectively are not necessarily too big, and our economy needs their services. Some mismanaged firms needed greater regulation. Some aggravated the financial crisis, and many of those have already failed. Breaking up 

a large firm that shows unreasonable risk would be much preferred 

to future bailouts. 

There are three recommendations I would like to offer to the 

committee: one, merge the Office of Thrift Supervision into the Office of the Comptroller of the Currency, as soon as possible; two, 

do not subject small insured depository institutions to unnecessary 

additional capital restrictions—Basel I and Basel II are more than 

sufficient; and three, assign consumer financial protection responsibility to the FDIC, without creating a new agency and an additional bureaucracy. 

For the record, I submitted copies of two papers: a peer-reviewed 

study on long-run credit growth in the United States, co-authored 

with Dr. Thomas Durkin, former senior economist with the Federal 

Reserve, and my Georgetown colleague, Professor Keith Ord; and 

31 

a second policy paper on impacts of TARP on commercial banks, 

with Max Gaby. 

The issue Durkin, Ord, and I analyzed is how levels of consumer 

credit have changed over the past 60 years. Surprisingly, we show 

that the aggregate real consumer credit, adjusted for price increases, and excluding mortgage credit, has increased at about the 

same annual rate as real U.S. disposable income. 

Conclusions with regard to mortgage credit are very different, 

and with subprime lending, every segment of the industry had 

abuses. 

Perhaps the greatest problem in the housing crisis was poor supervision by the Office of Thrift Supervision. The failures of 

IndyMac and Washington Mutual were holding company thrifts supervised by the OTS. I believe that if all holding companies were 

supervised by the Fed, the results would be somewhat different. 

This would be just one more example where the independence of 

the Federal Reserve is essential. 

I’m a strong proponent of merging the OTS into the Office of the 

Comptroller of the Currency, and I wish the Congress could pass 

such a separate bill to accomplish this very quickly. 

Mark Flannery has proposed requiring large banks to hold debt 

instruments he calls contingent capital certificates. They would 

automatically convert from debt to equity if the market value of a 

large bank’s equity fell below an established threshold. This eliminates regulatory delays and negotiations when a large bank might 

be in jeopardy. 

Leverage of insured depository institutions can be examined by 

a simple ratio that I have talked about in my testimony, where you 

take liabilities minus deposits as a ratio to Tier 1 capital. My research shows that risky large banks and large savings and loans 

could be identified by this ratio. 

I recommend that you not create a new government agency for 

consumer financial protection. Please consider placing the responsibility within the FDIC. 

As an independent agency, with separate budget authority, many 

necessary consumer protection systems already in place, and an existing Consumer Affairs Department, the FDIC is ideally suited, in 

my opinion, to implement the consumer financial protection that 

the Congress deems necessary. 

The aggregate fiscal debt in the United States has increased dramatically since World War II under both Republican and Democrat— 

Chairman MOORE OF KANSAS. Mr. Walker, may I interrupt you? 

And I apologize for doing this. We have 2 minutes and 15 seconds 

left before the conclusion of votes, so I think we’re going to have 

to stand in recess right now, and I would ask you if you would finish your— 

Mr. DAVID A. WALKER. Sir, I could finish in 30 seconds. 

Chairman MOORE OF KANSAS. Very good. Thank you. 

Mr. DAVID A. WALKER. The IMF establishes a 5 percent country 

target maximum of fiscal deficit ratio to GDP. The Honorable 

David Walker has already talked about this in great detail, and I 

wouldn’t attempt to repeat what he says. I just want to also urge 

32 

the subcommittee not to burden the United States with any further 

taxes that are regressive, like the VAT tax. 

That concludes my testimony, and sir, I’m sure you appreciate 

that for academics to do anything in 5 minutes is monumental. 

[The prepared statement of Professor David A. Walker can be 

found on page 308 of the appendix.] 

Chairman MOORE OF KANSAS. Same thing for Congress. And 

we’re going to stand in recess right now. I thank the witnesses. 

We’ll be back probably in about 20 or 25 minutes. If you can remain here for questions, I would appreciate it very much. 

Thank you. 

[recess] 

Chairman MOORE OF KANSAS. The committee will be back in session. 

I’m going to recognize myself for 5 minutes. 

Ms. Williams Brown, thank you for presenting this very helpful 

report by GAO on leverage. I’m interested in GAO’s observations 

with respect to leverage and international efforts, such as Basel II, 

to better supervise financial firms. 

As Congress finishes up writing financial regulatory reform, 

what steps should we take to coordinate our efforts with other 

countries to do two things: first, to better monitor and even understand leverage and risk-taking; and second, to better constrain excessive leverage? 

Ms. WILLIAMS BROWN. I think any efforts that we take in the 

United States, we have to make sure they have a strong international component. I think the crisis made it very clear that the 

focus, the national focus also had a huge global effort. 

So in terms of Basel II, I think the United States has to continue 

to be very involved in that process, in making sure that we do a 

true lookback at Basel II to determine if we need to go back and 

have a fundamental reassessment of the current approach to determining regulatory capital. 

There have been efforts in the past several months to deal with 

certain issues, such as the procyclical nature of capital, and making 

sure that institutions are building up capital levels during the good 

times, so they aren’t forced to do that in the midst of a crisis. 

But there are a number of other efforts that we need to continue 

to focus on from a global perspective, and Basel II is one place definitely to take a look. 

Chairman MOORE OF KANSAS. Thank you. 

Professor Acharya, I had one thing that was troubling for our 

committee and Americans to learn at our recent hearing on the 

failure of Lehman Brothers, was how they used Repo 105 and other 

means to hide their excessive leverage. 

How concerned are you about debt masking, especially since the 

SEC depends on quarter-end reporting requirements? Is there a 

better way to monitor debt and leverage? 

Mr. ACHARYA. I think this ought to be one of the most significant 

concerns, especially if we are talking about regulating leverage, not 

just the use of Repo 105 by Lehman Brothers. Especially from 2004 

until the middle of 2007, there was over $1 trillion of assets parked 

in what were apparently not balance sheet entities, which had direct connections back to bank balance sheets, but that were never 

33 

consolidated, either for accounting purposes or for purposes of calculating regulatory capital. 

So one of the big messages, I think, from this crisis is that it’s 

not just important to put in place a law with the right intention. 

I think the enforcement of the law, good enforcement of the law is 

equally important. And we really have to legislate the shadow 

banking world, because one of the reasons why the shadow banking 

world has developed is precisely to get around some of the important leverage and capital regulations. 

So I would say two things. Any leverage regulation that does not 

address the shadow banking world will simply push more leverage 

into the shadow banking world. And two, the right way to proceed 

is to legislate transparency so that regulators, on a high-frequency 

basis, can actually observe the leverage of these institutions, and 

provide timely aggregated reports to themselves, as well as to market participants. 

Chairman MOORE OF KANSAS. Thank you, sir. 

Professor Walker, you say in your testimony, ‘‘I believe that the 

TARP commitment was essential,’’ and later say, ‘‘Our economy 

would be rebounding much more slowly than it has if we had not 

implemented the TARP program.’’ 

Of course, a lot of Americans were very upset about TARP, and 

most of us who voted for it didn’t feel good about it when we did 

it, but we felt we had to. And all the experts who looked at this 

said we didn’t have an option. 

Will you elaborate, sir, on how, if TARP was not enacted into 

law, the situation might have been worse, not just for Wall Street, 

but for Americans and our constituents back home, if you agree 

with that? 

Mr. DAVID A. WALKER. Yes, I do, Congressman. 

And I think that, without TARP, we could easily have had unemployment double the current rates. There have been a few policy 

pieces written on that, maybe not as analytical as we would all 

like, but I think there was a real risk. 

The other thing was that—and this was sort of my perspective 

at the time—it was clear that Congress was standing up and tackling this vigorously, and I think that inspired some confidence. I 

think it may have inspired some confidence in international markets. Yes, we had this crisis, but we weren’t going to ignore it, and 

the Congress was taking the lead. 

Chairman MOORE OF KANSAS. Thank you, sir. 

My time has expired. 

Ms. Biggert, you’re recognized for 5 minutes. 

Mrs. BIGGERT. Thank you, Mr. Chairman. 

In the Wall Street Journal today, there is a Fannie Mae political 

reckoning article, and I just want to read something from there. 

It says: ‘‘The Financial Crisis Inquiry Commission spent yesterday focusing on financial leverage, using Bear Stearns as an example, but Fannie and Freddie were twice as leveraged as Bear and 

much larger as a share of the mortgage market. Fannie and 

Freddie owned, or guaranteed, $5 trillion in mortgages and mortgage-backed securities when they collapsed in September 2008. Reforming the financial system without fixing Fannie and Freddie is 

like declaring a war on terror and ignoring Al Qaeda.’’ 

34 

And then in the former panel, I asked the other Mr. Walker 

about how you would—that there were some alarming numbers regarding the Federal debt, especially when you account for the debt 

owed to Social Security, Medicare, and the total GSE liabilities. 

What should be done regarding GSE debt? Can the Federal Government afford to continue writing a blank check to Fannie and 

Freddie? 

Who would like to answer that? 

Mr. Geanakoplos? 

Mr. GEANAKOPLOS. ‘‘Geanakoplos.’’ 

Mrs. BIGGERT. ‘‘Geanakoplos.’’ 

Mr. GEANAKOPLOS. It means ‘‘Johnson,’’ in Greek. 

Mrs. BIGGERT. Oh, good. You must be Swedish, then. Just kidding. 

Mr. GEANAKOPLOS. Yes. We should never have allowed Fannie 

and Freddie to get so big and so leveraged. The only reason they 

were able to get so big is, the government implicitly guaranteed 

their debt, so they would borrow tremendous amounts of money, 

and investors wouldn’t think twice about it, when giving them 

money, because they figured that the money was good because the 

government was backing it. 

And many people called for regulation of Fannie and Freddie, 

and called for them to be—for their debt levels to be held lower, 

and called for them to be smaller, and we ignored those calls. And 

then, in fact, they did fail, and we are now put in the position of 

having to honor what was only an implicit guarantee. 

So we could, at one point, have—at that point, we could have defaulted on the debt. And a lot of it is held by China, a lot of it is 

held by American investors. We made a choice not to default, and 

now we hold the debt. 

And as you said, if you put Fannie and Freddie’s portfolios together with all the loans they insured and so on, it comes—plus if 

you put together the other government purchases, like through 

FHA, you’re talking about $6- $8 trillion worth of mortgages that 

our government—debt offset by mortgages that our government 

owes. 

And the fact is, we’re going to—there are going to be a lot of defaults. We might lose almost $1 trillion. There are estimates at 

$400 billion. It might come to almost a trillion. 

I don’t know what we can do about it now. We have committed 

ourselves to back it. Unless we default on it, we’re going to lose 

that money. We just have to prevent ourselves from ever getting 

in that position again. 

Mrs. BIGGERT. Would you agree, then, that the government has 

to get out of the business of financing or providing guarantees 

across the entire economy? 

Mr. GEANAKOPLOS. The government can never be on the hook for 

such a tremendous amount of money. 

Right now, almost all the mortgage lending is being done by the 

government. There are hardly any other loans being done by the 

private sector. 

The government has to find a plan of not—the FHA plan is to 

loan at 3 percent down now. That’s again, that out-competes any 

35 

private lender. So instead of encouraging private lending, they’re 

discouraging private lending. 

So I think that we need a different kind of initiative that will foster more private lending instead of government lending. 

Mrs. BIGGERT. Thank you. 

Then, Mr. Walker, you—given the data that you provided on government debt, which is alarming, would you agree that the government has to get out of the business of financing or providing guarantees across the entire economy? 

Mr. DAVID A. WALKER. I don’t think we can have the U.S. Government get out of that activity, but I think what we really need 

to do is to make sure that the public understands, and the markets 

understand, the various aspects of the debt. 

I am guessing, if we did a survey, and let’s say we took a survey 

just of people who have business education degrees, undergraduate 

and Master’s, just that limited group, and we asked them about the 

role of Fannie and Freddie in terms of the U.S. Government, that 

most would say they are government agencies. 

We have a tremendous job to do in terms of financial literacy in 

the United States, and it’s not just people who have had no training, in terms of understanding risk and leverage and things that 

this committee is dealing with in these hearings. 

Mrs. BIGGERT. So you would call for greater transparency? 

Mr. DAVID A. WALKER. Absolutely. 

Mrs. BIGGERT. We really have, what, two choices. One is that we 

would put them on a budget, as a government agency, and be 

under the controls of salaries and everything else; or, we would just 

turn them into a private, just a private company, and they would 

fend for themselves. 

Mr. DAVID A. WALKER. Either one of those would be a big improvement from the current environment, and the—I would put it 

on budget as soon as possible, and then think about gradually 

privatizing. 

I have done a little bit of work in some of Central European 

countries in terms of privatization, and actually have a paper linking privatization and fiscal deficits. And it turns out that, for the 

most part, rising privatization needs to accompany larger Federal 

deficits. 

So I’m not sure that would be translatable to industrialized countries, but it is something to be alerted to. 

Mrs. BIGGERT. Thank you. My time has expired. 

Chairman MOORE OF KANSAS. Mr. Lee, you’re recognized for 5 

minutes, sir, if you have questions. 

Mr. LEE. Thank you very much. 

I apologize for my lateness, but I’m glad to have a chance to hear 

from some of you. 

And it’s ironic we’re talking about deleveraging of the banking 

institutions, but one of my bigger concerns is the deleveraging of 

the U.S. Government. Among the lessons that we learned from the 

financial crisis was certainly the dangers of financial concentrations. 

Many institutions relied on particular investors to roll over the 

loans, and when those investors would not oblige, over the concerns 

of the leverage of the institutions, as we all know, failures began 

36 

to result. These institutions were not able to finance through other 

investors, and began defaulting on their own obligations. 

When I see the Administration implementing a policy of borrowand-spend, I believe there are very scary parallels to this situation. 

My background prior to coming here last year was running a 

manufacturing business, and I know a little bit about leveraging 

and being able to read a balance sheet. And if you look at our balance sheet, it’s a frightening set of circumstances. 

Under the President’s current budget, we are on plan to borrow 

42 cents for every dollar we spend in this country. It is—if this was 

done in the private sector, I hate to tell you, the company would 

be out of business. 

In just 2 years from now, our national debt will be bigger than 

the size of our entire U.S. economy. We’re talking about close to a 

$15 trillion deficit. Our debt to GDP ratio would be at over 100 percent. And what people forget is, Greece is at 125 percent. We’re not 

far behind. 

Getting to my point here, the Chinese hold a huge amount of our 

government debt, I believe in total, in aggregate, of roughly 7 percent. My concern is, when they decide to stop financing our spending, what ultimately could happen is the same thing that we’re seeing in some of our financial institutions. The United States is going 

to have to search out for other investors. 

Ultimately, what we will see are higher interest rates, and we’re 

looking at—when you’re looking at a deficit this high, the interest 

payment alone will typically exceed what we’re paying out, for example, in Social Security, or what we’re doing with our national— 

with our defense. 

We have a policy here that the Administration is really, in my 

opinion, shying away from, and we have to get our fiscal house in 

order. 

Maybe I can start with Mr. Walker. Your concerns—do you agree 

that this is a real possibility with how leveraged the U.S. Government is? 

Mr. DAVID A. WALKER. Everything I know about—the numbers 

that you have posed are very accurate. 

I was surprised to hear you say the 7 percent. I thought the 

number was larger than that, but it may depend on calculations, 

for China. 

I am very concerned about the rise in interest rates, and I cite 

in my testimony, in the submitted testimony, work of the budget 

director previously writing about fiscal deficits causing rising interest rates. So I agree with you. 

But I don’t think we had a choice. I think— 

Mr. LEE. If you were an auditor on safety and soundness, and 

you were auditing our books, would you shut us down? 

Mr. DAVID A. WALKER. No, I wouldn’t shut us down. I would say, 

as the Comptroller General, former Comptroller General David 

Walker, has written extensively, that we need to make some dramatic changes. 

One of the things I have heard him say in other presentations 

was that we need to index the age at which people collect Social 

Security. When we started Social Security originally, we said peoVerDate Nov 24 2008 12:04 Oct 25, 2010 Jkt 058041 PO 00000 Frm 00044 Fmt 6633 Sfmt 6633 K:\DOCS\58041.TXT TERRIE
37 

ple can collect at age 65, and the expectation was that you would 

live 7 years, maybe 9 years. 

Now, the expectation is, you begin collecting Social Security, at 

age 65, and you could well be collecting it for 25 years. 

So I think, if I were the auditor—and I don’t have that training 

in accounting—I would say, ‘‘Look, we need to go back and make 

a lot of changes in how we’re committing.’’ 

Mr. LEE. Does anybody else want to comment? 

Mr. ACHARYA. Yes. I just wanted to note something that President Hoenig actually mentioned earlier in the day, which is that 

the real danger we face is that the pattern of capital flows, in this 

case, money coming from China, is such that it remains very stable 

for long periods of time, and, boom, one day it will just start reversing itself. 

So— 

Mr. LEE. If that were to occur, what impact would you expect if 

that happened? 

Mr. ACHARYA. My sense is that it’s kind of too late to do much 

at that point. I think— 

Mr. LEE. If China stopped buying our debt, what would you 

think the short-term impact would be? 

Mr. ACHARYA. I think the short-term impact would be a substantial rise in the borrowing costs, compared to what we have. 

There’s a sense in which the flood of Chinese money coming in 

is a mixed blessing, which is that it’s sort of masking, actually, the 

‘‘true’’ cost of our borrowing. 

Mr. LEE. It’s much like the housing market. When we had the 

bubble, nobody wanted to end the parade, and now we have China 

coming in buying our debt, and again, it’s giving us an excuse not 

to make some hard decisions in this country. 

Mr. ACHARYA. Absolutely. 

Mr. LEE. With that, I appreciate your comments, and I’ll yield 

back. 

Chairman MOORE OF KANSAS. Thank you, sir. 

We’re going to do a second round of questions, if that’s all right. 

Professor Geanakoplos, you make some suggestions that, instead 

of monitoring leverage on a firm-by-firm basis, especially if those 

firms have an incentive to use off-balance-sheet instruments to 

hide their true leverage and risk-taking, that we should monitor leverage on a transaction-by-transaction basis, looking at how much 

downpayment was used to purchase a security. 

Would you please, sir, explain how this might help us better constrain excessive leverage? 

Mr. GEANAKOPLOS. Thank you for the question. You have put it 

exactly the way I intended it. 

Everybody who borrows money, practically, has to put up collateral, so if you monitor things transaction-by-transaction, you get all 

the transactions. So you’ll find out not just about a few banks, how 

leveraged they are. You’ll find out something about the entire system. That’s number one. 

Number two, the transaction’s, I call it security leverage, the 

downpayment, is an accurate indicator of where the economy is 

going. 

38 

If you do investor leverage, you often get the opposite number. 

So take a problem where the—like we had recently. The market is 

going down, nobody is able to borrow, precisely because they have 

to put up too much collateral. 

So the actual leverage is going down in the system, but if you 

look at one of our big banks, their leverage is going up, most of 

those institutions, because they’re Lehman or Bear Stearns, just 

before they go out of business, they’re running out of equity, and 

it looks like their leverage is skyrocketing. 

If you measure investor leverage, you’re often going to get precisely the wrong number, so just at the moment when there’s a crisis, and if anything you should be loosening leverage, their leverage looks like it’s getting tighter, and the regulator might be led 

to do the exact wrong thing. 

Third, as you said, you can hide your leverage, if you’re an institution. You put things off-balance-sheet, you can do all kinds of 

tricks. But if you’re talking about an actual transaction, the lender 

is going to want protection, so there’s going to be real collateral 

there, and you’ll know how much it is. You also have two people 

telling you what the leverage is. 

So for all those reasons—oh, and then lastly, if you try to set a 

15 percent rule, I think this could be quite dangerous. If you set 

a 15 percent rule for a select few institutions, the leverage will 

move. You’ll have a huge incentive to move the leverage somewhere 

else, and you’ll never be able to catch up to it. But if you’re looking 

at it, security-by-security, it has to be there. It’s something measurable. 

So I think everyone would agree that transparency is tremendously important. The numbers that should be published every 

month are averages of the security leverage numbers, so the average downpayment on a house, the average downpayment on a 

mortgage security if you buy it. 

And those numbers, if they appeared in newspapers, and generally speaking, people would have a much more accurate picture 

of what was going on in the economy, and the regulator would have 

pressure from the public, actually, to do the right thing, because 

everybody would know where we are. 

But if you just measure a few institutions, that leverage is going 

up and down in the wrong direction part of the time, depending on 

their profitability, and not on what the borrowing conditions really 

are. 

Chairman MOORE OF KANSAS. Thank you. 

Does anybody else have a comment on this? Ms. Williams 

Brown? 

Ms. WILLIAMS BROWN. I would like to comment on this. 

The Systemic Risk Council concept continues to be very much individual institution focused, but if the council is really to function 

effectively, it needs to be able to look for risk throughout the system, and this offers an interesting way to begin to try to peel that 

onion of looking at and identifying risk that may be building up in 

the system, that poses a systemic risk. So I think it’s an interesting 

idea. 

Chairman MOORE OF KANSAS. Mr. Acharya? 

39 

Mr. ACHARYA. I would just like to add one institution that is 

being discussed, which could serve a very big role here—the Office 

of Financial Research. I think its goal should be exactly what John 

has described, which is to record the financial transactions which 

are taking place, be it issuing a new debt out there, doing a derivatives transaction. 

And the most important thing is that some of this information 

is being recorded right now, but no one is actually recording how 

much up-front payment or collateral is actually being put up when 

the transaction is being done. 

Even in our derivative contract records, we don’t have this information right now, so we are relying on markets’ ability to discipline 

each other, but that’s leaving a lot to the market. 

Mr. GEANAKOPLOS. Could I add one more thought on that? 

Chairman MOORE OF KANSAS. Yes, sir. 

Mr. GEANAKOPLOS. I would just re-emphasize that point. 

So one of the ways of leveraging the system is using derivatives, 

but this—and people say it’s very hard, how to keep track of leverage, when there are all these derivatives and things. 

But actually, this transaction-by-transaction approach works 

there, too, because if you write a CDS insurance contract saying 

you’ll pay if the bond defaults, you have to put up collateral for 

that, too. So we know how much collateral is being put up for that, 

as well. So you’ll cover the derivatives case, as well as leverage 

moving around, and many—it’s a principled way of getting at the 

problem. 

Chairman MOORE OF KANSAS. Thank you. 

My time has expired. 

Ms. Biggert, do you have questions? 

Mrs. BIGGERT. Thank you, Mr. Chairman. 

Ms. Williams Brown, thank you for talking about the risk, as 

such. I hope that you would take a look at H.R. 3310, the Republican bill, which really addresses that issue. 

In your study of leverage, did the GAO review the current status 

of the balance sheets of the GSEs, Fannie and Freddie? 

Ms. WILLIAMS BROWN. We did not include them. 

Mrs. BIGGERT. Can you do that? 

Ms. WILLIAMS BROWN. Yes. 

Mrs. BIGGERT. Yes. Since Fannie and Freddie were leveraged 

twice as much as Bear Stearns, does the GAO plan to examine why 

the GSEs were leveraged to such extremes? 

Ms. WILLIAMS BROWN. We currently don’t have plans, and we 

haven’t been asked to do that, but if we were asked to do that, we 

would. 

Mrs. BIGGERT. Okay. Is that because it’s—there’s no reason, it’s 

just you haven’t been asked? 

Ms. WILLIAMS BROWN. Correct. 

Mrs. BIGGERT. Okay. Would this fall within the mandate to examine leverage in ESA? 

Ms. WILLIAMS BROWN. It’s something that we could have expanded the scope to do, but on this particular mandate, we were 

given a fairly short window to do the work, so we did not specifically include Freddie and Fannie in our study at the time. 

Mrs. BIGGERT. Could I ask you to do that? 

40 

Ms. WILLIAMS BROWN. Yes. 

Mrs. BIGGERT. Or, I ask you to do that. 

Ms. WILLIAMS BROWN. Okay. 

Mrs. BIGGERT. Professor Walker, you mentioned that larger institutions are riskier than smaller institutions based on a non-deposit 

liability to Tier 1 capital ratio. 

Is that higher risk, level of risk due to the ‘‘too-big-to-fail’’ status, 

or is there another issue there? 

Mr. DAVID A. WALKER. I didn’t do calculations that I guess would 

direct me immediately to ‘‘too-big-to-fail,’’ and I think that, when 

we go through and look at individual institutions, of the large ones, 

we see some that, where this would surely be a problem, and others not. So I think we would have to take it one at a time. 

The ratio that I used struck me as a way of getting at the pieces 

of the leverage and liabilities of institutions that were not deposits, 

and I’m not assuming all those deposits are insured, but they are 

different from the other aspects of the liabilities, and I wanted to 

get a handle on that. 

I should also mention, and there’s a table in my testimony showing this, that I broke large and small at $1 billion in assets, and 

with more time, I would take that apart and do considerably finer 

lines, to try to narrow down sort of where the break point would 

be. 

I’m guessing that it would be $10 billion or maybe even $25 billion, where you would see the higher risk. 

Mrs. BIGGERT. With that, I yield back. 

Chairman MOORE OF KANSAS. Thank you, Ms. Biggert, and 

thank you to our witnesses. 

I want to thank all of the witnesses for your testimony today. Today’s hearing was helpful to further explore these important issues 

of debt and leverage, giving us a better sense of how we need to 

use them for responsible purposes, and not get carried away, putting our financial system and economy at risk. 

At future hearings in this series this summer, we’ll be exploring 

the importance of risk management, better understanding shortterm markets like the repo market, financial literacy, and other 

key issues. 

I ask unanimous consent that the following items be entered into 

the record: the McKenzie Global Institute’s Report on Debt and 

Deleveraging; GAO and CIS reports on leverage; a paper on growth 

and debt by Professors Reinhart and Rogarth; and a paper on liquidity and leverage by Adrian and Chen. 

The Chair notes that some members may have additional questions for our witnesses, which they may wish to submit in writing. 

Without objection, the hearing record will remain open for 30 days 

for members to submit written questions to our witnesses and to 

place their responses in the record. 

This hearing is adjourned, and again, I thank our witnesses for 

appearing and testifying today. 

[Whereupon, at 12:47 p.m., the hearing was adjourned.] 

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