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THE ECONOMIC OUTLOOK

HEARING

BEFORE THE

JOINT ECONOMIC COMMITTEE

CONGRESS OF THE UNITED STATES

ONE HUNDRED TENTH CONGRESS

FIRST SESSION

NOVEMBER 8, 2007

Printed for the use of the Joint Economic Committee

(

(II)

JOINT ECONOMIC COMMITTEE

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

SENATE

CHARLES E. SCHUMER, New York, Chairman

EDWARD M. KENNEDY, Massachusetts

JEFF BINGAMAN, New Mexico

AMY KLOBUCHAR, Minnesota

ROBERT P. CASEY, JR., Pennsylvania

JIM WEBB, Virginia

SAM BROWNBACK, Kansas

JOHN SUNUNU, New Hampshire

JIM DEMINT, South Carolina

ROBERT F. BENNETT, Utah

HOUSE OF REPRESENTATIVES

CAROLYN B. MALONEY, New York, Vice Chair

MAURICE D. HINCHEY, New York

BARON P. HILL, Indiana

LORETTA SANCHEZ, California

ELIJAH CUMMINGS, Maryland

LLOYD DOGGETT, Texas

JIM SAXTON, New Jersey, Ranking Minority

KEVIN BRADY, Texas

PHIL ENGLISH, Pennsylvania

RON PAUL, Texas

MICHAEL LASKAWY, Executive Director

CHRISTOPHER J. FRENZE, Minority Staff Director

(III)

C O N T E N T S

MEMBERS

Hon. Charles E. Schumer, Chairman, a U.S. Senator from New York ............... 1

Hon. Jim Saxton, Ranking Minority, a U.S. Representative from New Jersey . 4

Hon. Carolyn B. Maloney, Vice Chair, a U.S. Representative from New York .. 5

Hon. Sam Brownback, a U.S. Senator from Kansas ............................................. 6

WITNESS

Statement of Hon. Ben S. Bernanke, Chairman, Board of Governors of the

Federal Reserve System, Washington, DC ........................................................ 7

SUBMISSIONS FOR THE RECORD

Prepared statement of Senator Charles E. Schumer, Chairman ......................... 40

Prepared statement of Representative Jim Saxton, Ranking Minority .............. 43

Prepared statement of Representative Carolyn B. Maloney, Vice Chair ............ 44

Prepared statement of Senator Sam Brownback .................................................. 46

Prepared statement of Representative Elijah E. Cummings ............................... 47

Prepared statement of Representative Ron Paul .................................................. 48

Prepared statement of Hon. Ben S. Bernanke, Chairman, Board of Governors

of the Federal Reserve System, Washington, DC .............................................. 49

Letter dated November 9, 2007 from Representative Loretta Sanchez to

Chairman Ben S. Bernanke with written questions for the record ................. 53

Letter dated November 26, 2007 from Chairman Ben S. Bernanke to Hon.

Loretta Sanchez re: questions for the record ..................................................... 55

Chairman Bernanke’s response to written questions submitted by Representative Sanchez ...................................................................................... 56

Chart entitled, ‘‘Projected Economic Costs of the Subprime Mortgage Crisis

State-by-State’’ ..................................................................................................... 58

Chart entitled, ‘‘The Bush Economy: Employee Compensation Has Lagged

Far Behind Productivity’’ ..................................................................................... 59

(1)

THE ECONOMIC OUTLOOK

THURSDAY, NOVEMBER 8, 2007

CONGRESS OF THE UNITED STATES, JOINT ECONOMIC COMMITTEE, Washington, DC.

The Committee met at 10 a.m. in room 216 of the Hart Senate

Office Building, The Honorable Charles E. Schumer (Chairman of

the Committee) presiding.

Senators present. Bennett, Bingaman, Brownback, Casey,

Klobuchar, Schumer, and Sununu.

Representatives present. Brady, Cummings, Doggett, English,

Hinchey, Maloney, Paul, Sanchez, and Saxton.

Staff present: Christina Baumgardner, Ted Boll, Heather

Boushey, Chris Frenze, Stephanie Dreyer, Nan Gibson, Colleen

Healy, Marc Jarsulic, Aaron Kabaker, Israel Klein, Tyler Kurtz,

Michael Laskawy, Zachary Luck, Kimberly Magee, Robert O’Quinn,

Jeff Schlagenhauf, Robert Weingart, Adam Wilson, Jeff Wrase, and

Adam Yoffie.

OPENING STATEMENT OF HON. CHARLES E. SCHUMER,

CHAIRMAN, A U.S. SENATOR FROM NEW YORK

Senator Schumer. The hearing will come to order. I want to

welcome Federal Reserve Chairman Ben Bernanke to this hearing

of the Joint Economic Committee on the Economic Outlook.

This Committee has a broad mandate to study and make recommendations about economic policy. We’re always pleased when

the Federal Reserve Chairman comes to share his views on the

state of our economy.

Chairman Bernanke, when you came before this Committee last

March, one of the major topics discussed, was the potential for fallout from the subprime lending crisis. It’s something this Committee has been very concerned with for quite some time, and I

think you’d be the first to admit that the subprime mess has not

been contained, but, instead, has proved to be a contagion that has

spread in dangerous ways throughout not just the housing market,

but our economy, and even into the global financial system.

The seizing up of credit markets this summer, was the clearest

indication of the unanticipated, potentially disastrous risks that

out-of-control subprime lending poses to the financial markets.

There is now a lack of confidence in creditworthiness throughout

the markets, and, at the core, there is a lack of confidence in the

subprime market. Until we correct that, we will not solve our

broader problems.

2

I want to applaud you and the Federal Reserve Board for your

aggressive, and, I believe, appropriate response to this summer’s liquidity crisis. It’s vital that we maintain the health of our financial

markets and ensure that they function smoothly.

You deserve credit for your prompt actions. However, while we

did weather that summer storm, I am worried that there may be

a bigger storm on the horizon.

Quite frankly, I think we are at a moment of economic crisis,

stemming from four key areas: Falling housing prices, lack of confidence in creditworthiness, the weak dollar, and high oil prices.

Each of these problems, alone, would be enough of a threat to our

economic well being, but taken together, they are essentially the

four horsemen of economic crisis.

First, as we have warned, and as you acknowledge in your testimony, we face a wave of foreclosures in the next years, that threaten millions of American homeowners and the neighbors.

The housing boom has busted, and we see trillions of dollars in

lost home values across the Nation.

Second, the credit markets remain in crisis. It’s just simply a

lack of confidence. The dollar has dropped dramatically against

most of the major currencies of the world, and it seems to hit lows

not seen in decades, nearly every day.

Finally, oil prices keep reaching near record highs, driving up energy costs in all sectors of the economy.

Even our bedrock assumptions are being put into doubt. As housing prices decline, there are real fears that we won’t be able to depend on consumers, the engine of our economy over the past few

years, to keep spending.

We now hear that foreign investors may no longer be confident

in the dollar as the global currency of choice.

I’m not surprised to hear experts such as your predecessor, Alan

Greenspan, warn about the threat of recession. I’ve begun to worry

about it, too.

In particular, as I watch bank after bank write down bad investments tied to baroque financial instruments that even sophisticated investors don’t understand, I fear for the stability and ultimate confidence in our financial system.

I’ve talked about the Wild West of subprime mortgage brokers,

and I’m beginning to wonder if we have a Wild West of unregulated

financial instruments, of SIVs and mis-rated CDOs and other complicated investments, whose values are not marked-to-market, or

even marked-to-model, but, to quote one Wall Street strategist, are

marked-to-make believe.

To quote you, Mr. Chairman, the markets want to know how

much these damn things are worth, and I want to know what all

of us—the Federal Reserve, the Congress, and this Administration

can do, if anything, to assuage those fears.

I’m very concerned, Mr. Chairman, that none of the regulators

are acting quickly or boldly enough to deal with the risks we’re facing. A laissez faire, hands-off attitude, might be appropriate, if we

had one of these crises, but confronting all of these problems at

once, should be a call to action, because the danger we face is so

much greater.

3

I know that Secretary Paulson has organized a ‘‘super conduit’’

to deal with the liquidity crunch faced by SIVs and the threat they

pose to broader financial markets.

To be direct, I’m worried that this may just be a shell game, an

attempt to move bad investments around, and keep them from

landing back on the books.

I’d be curious to hear your opinion today, Mr. Chairman, about

the Secretary’s plan, as well as your view about the risks these

complex and opaque pools of capital now present to our financial

system, and how you intend to deal with them.

If you don’t feel you have the tools at your disposal to address

these problems, then I hope you’ll share your views on what we in

Congress ought to do.

I am glad to see that much of your statement is given over to

the importance of helping distressed subprime borrowers. You mention some of the efforts my colleagues and I have made—and I

won’t spend more time on that right now, but I will say that it

would really be nice if the Administration would join us in our attempts to protect families from the fallout of the subprime lending

disaster.

The policy responses from the Administration have not come

close to matching the magnitude of the crisis. There is a lack of

confidence that anyone is in charge.

Mr. Chairman if you feel that, in your position, you cannot speak

publicly about the changes that are needed, I urge you to speak

privately to members of the Administration, use your position to

jawbone them into action.

Your predecessor was not shy about putting his prestige and

credibility to work behind the scenes. I encourage you to do the

same.

One of the great legacies of the American economy, has been its

ability to make everyone better off. Throughout most of our history,

when our economic pie has gotten bigger, everyone has shared and

the Nation has prospered and everyone got along.

But over the 7 years of this Administration, that has not been

the case. Even in the recovery of the past few years, the benefits

have gone mainly to those at the top.

Now, as we face an economic slowdown, or worse, I’m very worried that it’s those Americans who haven’t shared in our recent

growth, who will bear the brunt of economic decline, and the policies of this Administration, will only further exacerbate their difficulties.

I don’t pretend that there are easy solutions to troubling challenges facing our economy. The oil crisis, the falling dollar, they

took years in the making and will not be solved with the snap of

a finger, but we cannot shy away from those challenges.

We cannot, for another day or month, avoid these problems any

longer because the chickens seem to be coming home to roost.

We need your voice, either publicly or privately, to help move us

in that direction. I look forward to your testimony on the economic

outlook, and to an interesting discussion of how we best meet these

and other economic challenges we face.

Senator Schumer. Normally, I encourage all of our Members to

make opening statements, but because we only have a limited time

4

with Chair Bernanke, I’m going to ask your Vice Chairman and the

Senate and House Ranking Members to make opening statements.

Other Members may submit their full opening statements for the

record.

Now, I turn to the Committee’s Ranking Republican, my colleague on the House side, Mr. Saxton.

[The prepared statement of the Senator Schumer appears in the

Submissions for the Record on page 40.]

OPENING STATEMENT OF HON. JIM SAXTON, RANKING

MINORITY, A U.S. REPRESENTATIVES FROM NEW JERSEY

Representative Saxton. Mr. Chairman, thank you very much.

Chairman Bernanke, I’m pleased to join in welcoming you again

here to testify before the Joint Economic Committee.

I appreciate your testimony in the past and look forward to your

views on the economic outlook today.

According to the standard measures of performance, such as economic growth and the unemployment rate, the U.S. economy, on

the one hand, seems to be doing quite well.

Real economic growth was 3.9 percent in the third quarter, while

the unemployment rate remains relatively low at 4.7 percent in October.

Exports and consumer spending continue to advance, reflecting

the resilience of the U.S. economy. The recent pace of economic

growth is all the more remarkable, given the challenges facing the

economy.

Residential real estate investment declined at a 20–percent rate

in the third quarter, continuing a longer trend. Housing prices are

falling in many areas of the country, and housing inventory levels

are on the rise.

Oil prices, as we all know, are nearing $100 a barrel, and the

dollar is falling. In recent months, it has also become clear that a

number of large financial institutions have invested in mortgage

securities of dubious quality.

Huge writedowns of assets by Citigroup and Merrill Lynch, are

recent validations of the serious concerns about the value of mortgage-backed securities. Uncertainty about the extent of bad investments related to the subprime and other mortgages has spread, resulting in sharp declines in the valuation of bank stocks.

The financial markets have become very volatile, as we have

seen, particularly in the last several days. Even though recent economic growth appears to be strong, the combination of the decline

in homebuilding, falling housing prices, spiking oil prices, and financial turmoil risks to the continuation of healthy economic

growth.

The Fed has acted to reduce the strains on the financial sector,

to head off a slowdown in the economy. According to leadership

consensus and Federal Reserve forecasts, the economy will continue to expand through 2008.

Thank you, Mr. Chairman. I look forward to the testimony.

[The prepared statement of Representative Saxton appears in the

Submissions for the Record on page 43.]

Senator Schumer. Vice Chair Maloney.

5

OPENING STATEMENT OF HON. CAROLYN B. MALONEY, VICE

CHAIR, A U.S. REPRESENTATIVE FROM NEW YORK

Representative Maloney. Thank you very much, Mr. Chairman, for holding the hearing, and welcome to Chairman Bernanke.

We are all eager to hear your remarks on the economic outlook and

what that may mean for monetary policy during these troubling

times.

Tremendous uncertainty remains about how the subprime fallout

and the housing slowdown will infect the broader economy. Calling

it a subprime crisis is no longer adequate, as the breadth and

depth of this escalating credit crisis roils our major financial institutions, almost daily.

The seeming inability of our most sophisticated and respected institutions to measure their exposure to these assets, and more importantly, to manage the risks associated with them, poses a serious threat to our financial markets.

The chairman of General Motors’ recent admission, yesterday,

that he could not tell with any accuracy what the Company’s exposure is to subprime losses at GMAC is both stunning and frightening. Investors did not understand what they were buying when

they held CDOs and SIVs.

Now we’re seeing billions of dollars in losses on these investments. Risk is coming home to roost with a vengeance. We have

yet to see the full impact of these losses, on the economy or on the

labor market.

In the near term, forecasters expect the economy to slow, as high

energy prices and falling home values squeeze consumers, all of

which points to a gathering storm that could drag down the economy, taking American jobs with it.

The Federal Reserve has worked to prevent the economy from

derailing and has eased the credit crunch by lowering its key interest rates, but at their last meeting, the Fed signalled a wait-andsee approach for further action. With crude oil edging toward $100 a barrel and the dollar sinking like a stone, inflation is certainly a concern for the Fed. The

dollar fell sharply again yesterday, as the Chinese government signalled a shift away from the purchases of dollars in favor of Euros.

I think we would all like to hear more from Chairman Bernanke

about any contingency plans the Fed has, should economic forces

move toward a free-fall of the dollar. Our tremendous fiscal imbalances, including our record $9-trillion debt, further complicate the

Fed’s job of setting the right course for monetary policy, but for the

moment, core inflation has remained unchecked, and there is little

evidence that the labor market poses any real inflationary risks.

Wages have barely kept pace with rising prices, and they have

lagged far behind productivity.

I hope the Chairman will agree, that how American families are

faring, should not take a back seat to fighting inflation.

By all accounts, we haven’t felt the worst of the housing market

slump.

Millions of Americans are worried that they can’t afford to keep

their homes, let alone to heat them this winter.

Congress is working very hard to keep people in their homes,

and to prevent another crisis like this one from happening again.

6

In the House of Representatives, we have passed reform legislation

to shore up the FHA and the GSEs.

Just this week, we passed sweeping mortgage and anti-predatory

lending legislation through the Financial Services Committee,

which will head to the floor next week.

These are important first steps. There is a great deal more to do

to help restore the American dream of many hardworking families.

Mr. Chairman, we look forward to gaining some insights into

how the Fed will balance various risks to the economy with monetary policy. Again, we welcome you to the Committee.

[The prepared statement of Representative Maloney appears in

the Submissions for the Record on page 44.]

Senator Schumer. Thank you, Vice Chair Maloney.

Ranking Member Brownback.

OPENING STATEMENT OF HON. SAM BROWNBACK, A U.S.

SENATOR FROM KANSAS

Senator Brownback. Thank you, Mr. Chairman. Mr. Chairman

we’re pleased to have you here.

The American economy has demonstrated, I believe, amazing resilience in the face of a variety of challenges. Witness 24 consecutive quarters of positive, real economic growth—24 consecutive

quarters; 50 consecutive months of payroll employment growth.

That’s the longest on record.

And there has been significant expansion in our exports, yet my

perception, and, I think, that of my colleagues up here, is that our

economy is at a crossroads. That’s why I think we’re all so interested in your testimony here today and why the markets are so interested in your testimony.

We have had a nice long run, but it looks as if there are some

really troubling signs out there. We’ve all talked about oil prices;

we’ve all talked about the subprime market. I know you’re going

to address those.

One thing that certainly seems clear to me, on our part as legislators, is that the idea of raising taxes at this point in time would

be a terrible idea and a terrible thing for the economy. If we were

either to raise them purposefully, or to allow them to be raised because we didn’t vote to extend the tax cuts that have been put in

place, that would be the exact wrong signal, the exact wrong thing

to do in an economy that is at a crossroads.

So, from our stance of fiscal policy and what we can do for economic growth on our side, I would certainly hope we would set

aside all sorts of ideas about raising taxes, and say no, we’re going

cut taxes and we’re going to keep them low to try to keep the economy going.

On your side of it, I look forward to your comments and what

your thoughts are on what we should do with subprime mortgages,

also on the impact of high oil prices on consumer spending.

I do hope the Fed is considering a further cut in rates to help

the economy, to help the American consumer, who accounts for 70

percent of the economy.

Going into the important Christmas buying season, it seems to

me now is the time—and I know you’re weighing this—but I would

certainly put my two cents worth in, that rate cuts at this point

7

in time, when the consumer is seeing so much direct pressure on

their pocketbook—those gas prices get up to $3 a gallon—it seems

to hit some sort of psychological point in the consumer’s mind.

They have less to spend, and that’s a reality for them. I’m going

to spend less in other areas. That reverberates further on through

the economy.

So, a rate cut could be something very valuable, a signal to send

into this economy—to the economy and to the consumer.

Much is at stake on our part and on your part. We look forward

to your thoughts and wisdom that you can share with us on what

we need to do to navigate through these troubled waters. I’m delighted you’re here, delighted that you’re in that job and I’m not.

[The prepared statement of Senator Brownback appears in the

Submissions for the Record on page 46.]

Senator Schumer. Mr. Chairman, proceed.

STATEMENT OF HON. BEN S. BERNANKE, CHAIRMAN, BOARD

OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM, WASHINGTON, DC

Chairman Bernanke. Thank you, Chairman Schumer, Vice

Chair Maloney, Representative Saxton and other Members of the

Committee. Thank you for inviting me here this morning to present

an update on the economic situation and outlook.

Since I last appeared before this Committee in March, the U.S.

economy has performed reasonably well. On preliminary estimates,

real gross domestic product grew at an average pace of nearly 4

percent over the second and third quarters, despite the ongoing correction in the housing market.

Core inflation has improved modestly, although recent increases

in energy prices, will likely lead overall inflation to rise for a time.

However, the economic outlook has been importantly affected by

recent developments in financial markets, which have come under

significant pressure over the past few months. The financial turmoil was triggered by investor concerns about the credit quality of

mortgages, especially subprime mortgages with adjustable interest

rates.

The continuing increase in the rate of serious delinquencies in

such mortgages, reflects, in part, a decline in underwriting standards in recent years, as well as a softening of house prices.

Delinquencies on these mortgages are likely to rise further in

coming quarters, as a sizable number of recent vintage subprime

loans experience their first interest rate resets. I will have more to

say about this problem and its implications for homeowners, later

in my testimony.

At one time, most mortgages were originated and held by depository institutions. Today, however, mortgages are commonly bundled together into mortgage-backed securities or structured credit

products, rated by credit-rating agencies, and then sold to investors.

As mortgage losses have mounted, investors have questioned the

reliability of credit ratings, especially those of structured products.

Because many investors had not developed the capacity to perform independent evaluations of these often complex instruments,

the loss of confidence in the credit ratings, together with uncerVerDate 11-MAY-2000 11:20 Apr 22, 2008 Jkt 040283 PO 00000 Frm 00011 Fmt 6633 Sfmt 6633 C:\DOCS\40283.TXT DianeA PsN: DianeA
8

tainty about developments in the housing market, led to a sharp

decline in the demand for these products. Since July, few securities

backed by subprime mortgages have been issued.

Although the problems with subprime mortgages initiated the financial turmoil, credit concerns quickly spilled over into a number

of other areas. Importantly, the secondary market for securities

backed by prime, jumbo mortgages, also contracted, and the

issuance of such securities has declined significantly.

Prime jumbo loans are still being made to prospective home purchasers, but they are at higher spreads and have more restrictive

terms.

Concerns about mortgage-backed securities and structured credit

products, even those unrelated to mortgages, also greatly reduced

investor appetite for asset-backed commercial paper, although that

market has improved somewhat recently.

In the area of business credit, investors shied away from financing leveraged buyouts and from purchasing speculative-grade corporate bonds, and some larger banks, concerned about potentially

large and difficult-to-predict draws on their liquidity and balance

sheet capacity, became less willing to provide funding to their customers and to each other.

To be sure, the recent developments may well lead to a healthier

financial system in the medium to long term. Increased investor

scrutiny of structured credit products is likely to lead, ultimately,

to greater transparency in these products and to better differentiate among assets of varying quality.

Investors have also become more cautious and are demanding

greater compensation for bearing risk. In the short term, however,

the events do imply a greater measure of financial restraint on economic growth, as credit becomes more expensive and difficult to obtain.

At the height of the recent financial turmoil, the Federal Reserve

took a number of steps to help markets return to more orderly

functioning. The Fed increased liquidity in short-term money markets in early August through larger-than-normal open market operations, and on August 17, the Federal Reserve Board cut the discount rate, the rate at which it lends directly to banks, 50 basis

points, or 1⁄2 percentage point, and, subsequently, took several additional measures.

These efforts to provide liquidity, appear to have been helpful, on

the whole, but the functioning of a number of important markets

remained impaired.

The turmoil in financial markets, significantly affected the Federal Reserve’s outlook for the broader economy. Indeed, in a statement issued simultaneously with the Board’s August 17 announcement of the cut in the discount rate, the Federal Open Market

Committee noted that the downside risk to economic growth had

increased appreciably.

The Committee took further action at its next scheduled meeting

on September 18th, when it cut its target for the Federal Funds

Rate by 50 basis points.

This action was intended as a counterbalance to the tightening

of credit conditions and to address, in a preemptive fashion, some

9

of the risks that financial developments pose to the broader economy.

The Committee met most recently on October 30 and 31. The

data reviewed at that meeting, suggested that growth in the third

quarter had been solid at a 3.9 percent rate, according to the initial

estimate by the Bureau of Economic Analysis.

Residential construction declined sharply during the quarter, as

expected, subtracting about 1 percentage point from overall growth.

However, the GDP report provided scant evidence of spillovers from

housing to other components of final demand.

Strong growth in consumer spending was supported by gains in

employment and income, and businesses increased their capital

spending at a solid pace.

A strong global economy stimulated foreign demand for U.S.-produced goods and services, as foreign trade contributed nearly 1 percentage point to the growth of real output last quarter.

Looking forward, however, the Committee did not see the recent

growth performance as likely to be sustained in the near term. Financial conditions had improved somewhat after the September

FOMC action, but the market for nonconforming mortgages remained significantly impaired and survey information suggested

that banks had tightened terms and standards for a range of credit

products over recent months.

In part because of the reduced availability of mortgage credit, the

contraction in housing-related activity seemed likely to intensify.

Indicators of overall consumer sentiment suggested that household

spending would grow more slowly, a reading consistent with the expected effects of higher energy prices, tighter credit, and continuing

weakness in housing.

Most businesses appear to enjoy relative good access to credit,

but heightened uncertainty about economic prospects could lead

business spending to decelerate, as well.

Overall, the Committee expected that the growth of economic activity would slow noticeably in the fourth quarter, from its third

quarter rate.

Growth was seen as remaining sluggish through the first part of

next year, then strengthening as the effects of tighter credit and

the housing correction began to wane.

The Committee also saw downside risks to this projection. One

such risk was that financial market conditions would fail to improve, or even worsen, causing credit conditions to become even

more restrictive than expected.

Another risk was that in light of the problems in mortgage markets and the large inventories of unsold homes, house prices might

weaken more than expected, which could further reduce consumers’

willingness to spend and increase investors’ concerns about mortgage credit.

The Committee projected overall core inflation to be in a range

consistent with price stability next year.

Supporting this view were modest improvements in core inflation

over the course of the year, inflation expectations that appeared

reasonably well anchored, and futures quotes suggesting that investors saw food and energy prices coming off their recent peaks

next year.

10

But the inflation outlook was also seen as subject to important

upside risks. In particular, prices of crude oil and other commodities had increased sharply in recent weeks and the foreign exchange value of the dollar, had weakened.

These factors were likely to increase overall inflation in the short

run and should inflation expectations become umoored, have the

potential to boost inflation in the longer run, as well.

Weighing its projections for growth and inflation, as well as the

risk to those projections, the FOMC, on October 31, reduced its target for the Federal Funds Rate an additional 25 basis points to 4.5

percent.

In the Committee’s judgment, the cumulative easing of policy

over the past 2 months, should help forestall some of the adverse

effects on the broader economy that might otherwise arise from the

disruptions in financial markets, and promote moderate growth

over time.

Nonetheless, the Committee recognized that risk remained to

both of its statutory objectives of maximum employment and price

stability. All told, it was the judgment of the FOMC that after its

action of October 31, the stance of monetary policy roughly balanced the upside risk to inflation and the downside risk to growth.

In the days since the October FOMC meeting, the few data releases that have become available have continued to suggest that

overall economic activity, the overall economy, remain resilient in

recent months; however, financial market volatility and strains

have persisted.

Incoming information on the performance of mortgage-related assets, has intensified investors’ concerns about credit market developments and the implications of the downturn in the housing market for economic growth.

In addition, further sharp increases in crude oil prices have put

renewed upward pressure on inflation, and it may impose further

restraint on economic activity.

The FOMC will continue to carefully assess the implications for

the outlook of the incoming economic data and financial market developments and will act as needed to foster price stability and sustainable economic growth.

I would like to say a few words about actions being taken to help

homeowners who have fallen behind on their mortgage payments,

or seem likely to do so.

As I mentioned, delinquencies will probably rise further for borrowers who have a subprime mortgage with an adjustable interest

rate, as many of these mortgages will soon see their rates reset at

significantly higher levels.

Indeed on average, from now until the end of next year, nearly

450,000 subprime mortgages per quarter are scheduled to undergo

their first interest rate reset. Relative to past years, avoiding the

payment shock of an interest reset by refinancing the mortgage

will be much more difficult, as home prices have flattened out or

declined, thereby reducing homeowners’ equity, and lending terms

have tightened.

Should the rate of foreclosure rise proportionately, communities,

as well as individual borrowers, would be hurt because concentraVerDate 11-MAY-2000 11:20 Apr 22, 2008 Jkt 040283 PO 00000 Frm 00014 Fmt 6633 Sfmt 6633 C:\DOCS\40283.TXT DianeA PsN: DianeA
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tions of foreclosures tend to reduce property values in surrounding

areas.

A sharp increase in foreclosed properties for sale could also

weaken the already struggling housing market, and thus potentially, the broader economy.

Home losses through foreclosure can be reduced if financial institutions work with borrowers who are having difficulty meeting

their mortgage payment obligations. In recent months, the Federal

Reserve and other banking agencies have issued statements calling

on mortgage lenders and mortgage servicers to pursue prudent

loan workouts.

Our contacts with the mortgage industry suggest that servicers

have recently stepped up their efforts to work with borrowers facing financial difficulties or an imminent rate reset.

Some servicers have been proactive about contacting borrowers

who have missed payments or face resets, as experiences shows

that addressing the problem early increases the odds of a successful outcome.

Foreclosure cannot always be avoided, but in many cases, loss

mitigation techniques that preserve home ownership are less costly

than foreclosure.

To help keep borrowers in their homes, servicers have been offering assistance through repayment plans, temporary forbearance,

and loan modifications.

Comprehensive data on the success of these efforts to avert foreclosures are not available, but my sense is that there is scope for

services to further increase their loss mitigation efforts.

The development of standardized approaches to workouts and

the sharing of best practices can help increase the scale of the effort, even if ultimately, workouts must be undertaken loan-by-loan.

Although workouts are to be encouraged, regulators must be

alert to ensure that they are done in ways that protect consumers’

interests and do not disguise lenders’ losses or impair safety and

soundness.

The Federal Reserve has been participating in efforts by community groups to homeowners avoid foreclosure. For example, Governor Kroszner of the Federal Reserve Board serves as a director

of NeighborWorks America, a nonprofit organization that has been

helping thousands of borrowers facing current or potential distress

to obtain assistance from their lenders, their servicers, or trusted

counselors through a hotline.

The Federal Reserve Board staff has been working with consumer and community affairs groups through the Federal Reserve

System, to help identify localities that are most at risk of high foreclosures, with the intent to help local groups better focus their outreach efforts to borrowers.

Other contributions include foreclosure prevention programs such

as the Home Ownership Preservation Initiative which the Federal

Reserve Bank of Chicago helped to initiate, and efforts by Reserve

Banks to convene workshops for stakeholders, to develop community-based solutions to mortgage delinquencies in their areas.

The Federal Reserve System is also engaged in research and

analysis that should involve policy responses to these issues.

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The Congress is also focused on reducing homeowners’ risks of

foreclosure. One statutory change that could help is the modernization of programs administered by the Federal Housing Administration.

The FHA has considerable experience helping low- and moderateincome households obtain home financing, but it has lost market

share in recent years, partly because borrowers have moved toward

nontraditional products with more flexible and quicker underwriting and processing, and partly because of a cap on the maximum loan value that can be insured.

In modernizing the FHA, the Congress might encourage joint efforts with the private sector that expedite the refinancing of

subprime loans held by creditworthy borrowers facing resets.

It might also consider granting the Agency the flexibility to design products that improve affordability through such features as

variable maturities or shared appreciation.

Also, the FHA could provide more refinancing options for riskier

households, if it could tailor the premiums it charges for mortgage

insurance to the risk profile of the borrower.

As I have discussed in earlier testimony, the Federal Reserve is

taking steps to avoid subprime lending problems from recurring,

while preserving responsible subprime lending. In coordination

with other Federal supervisory agencies and the Conference of

State Banking Supervisors, we have issued principles-based underwriting guidelines on subprime mortgages to help ensure that borrowers obtain loans that they can afford to repay and have the opportunity to refinance, without prepayment penalty for a reasonable period before the first interest rate reset.

In addition, together with the Office of Thrift Supervision, the

Federal Trade Commission, the CSBS, and the American Association of Residential Mortgage Regulators, we have launched a pilot

program aimed at strengthening reviews of consumer protection

compliance at selected non-depository lenders with significant

subprime mortgage operations.

Finally, using the authority granted to us by the Congress under

the Home Ownership and Equity Protection Act, we are on schedule to propose rules by the end of this year to address unfair or

deceptive mortgage lending practices. These rules would apply to

subprime loans offered by any mortgage lender.

We are looking closely at practices such as prepayment penalties,

failure to escrow for taxes and insurance, stated income and lowdocumentation lending, and failure to give adequate consideration

to a borrower’s ability to repay.

Using our authority under the Truth in Lending Act, or TILA,

we expect that we will soon propose rules to curtail abuses in mortgage advertising and to ensure that consumers receive mortgage

disclosures at a time when the information is likely to be the most

useful to them.

We are also engaged in a rigorous broader review of the TILA

rules for mortgage loans which will make use of extensive consumer testing of disclosures. Thank you. I’d be pleased to answer

your questions.

[The prepared statement of Chairman Bernanke appears in the

Submissions for the Record on page 49.]

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Senator Schumer. Thank you, Mr. Chairman. We very much

appreciate your comprehensive testimony.

You noted in your statement, that you thought there would be

slow growth in the next few quarters, but not a recession. You also

noted that there are downsides that one would have to take into

account, and they would be, again, what I call the four horsemen

of our economic problems: Lower housing prices, higher oil prices,

dropping dollar, and lack of confidence in the credit markets.

So, let me ask you a question: Is a recession out of the question?

What is the likelihood that we might go into a recession? If I could

make it simple, on a scale of 1 to 10, 10 being most likely, how likely is a recession?

Chairman Bernanke. Mr. Chairman, as you noted, our forecast

is for moderate, but positive growth going forward through the next

few quarters. Economists are extremely bad at predicting turning

points, and we don’t pretend to be any better.

We have not calculated a probability of recession, and I wouldn’t

want to offer that today. Again, our assessment is for slower

growth, but positive growth going into next year. We think that by

the spring or early next year, that as these credit problems resolve

and as we hope the housing market begins to find a bottom, that

the broader resiliency of the economy, which we are seeing in other

areas outside of housing will take control and will help the economy recover to a more reasonable growth pace.

Senator Schumer. Thank you. Next, yesterday, there was mention by a Chinese official—and some gave it more credence than

others—that the Chinese might start investing more of their assets, even switching over some of their assets to those in stronger

currencies than the dollar.

How worried are you about that? How likely is it to occur? How

much credibility do you give this statement that was made yesterday?

Chairman Bernanke. There is no official Government statement in this regard, and I’m not particularly concerned about any

major change in the holdings of China or any other country.

There is, on the margin, sovereign wealth funds and portions of

reserve accumulations that are being devoted to higher returns

which means spreading across instruments, as well as across currencies.

But, again, I don’t see any significant change in the broad holdings of dollars around the world. dollars remain the dominant reserve asset, and I expect that to continue to be the case.

We would like to add, though, that the strength of the dollar, in

the medium term, will ultimately depend not on those portfolio

choices, so much as on the strength of the U.S. economy, our trade

situation, and on the openness of our financial markets to foreign

capital. I’m optimistic on those fronts, and I do believe that that

will lead to a sound dollar in the medium term.

Senator Schumer. Wouldn’t it be in the interest of some of

these foreign countries, in the longer term, not in the immediate

term, if the dollar continues to show the weakness that it has

shown so far, to diversify?

Chairman Bernanke. Well, if they’re pegging their exchange

rate to the dollar, then there’s a certain need, but to hold dollars,

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of course. But I think, more broadly, that the financial markets in

the United States are still the deepest, the most liquid, and offer

the most range of investment opportunities; and in that respect,

you often see, for example, trade between third countries, still

being invoiced in dollars, because it remains a standard of value

around the world, and I expect that to continue.

Senator Schumer. One of the engines of our economic growth,

the main engine, has been consumer spending. It’s been estimated

that a significantly high percentage of that consumer spending was

fueled by refinancings of homes which gave the consumer more

money to spend for other things.

The decline in housing prices, both because refinancings would

decline and because people felt they had less in terms of assets,

present a problem for consumer spending. How much do you expect

the decline in housing prices to affect consumer spending? And

again, if home prices decline further than you expect, would that

create a real danger for our economy?

Chairman Bernanke. Certainly, as homeowners see their

wealth declining in terms of their house value, that will affect their

thinking about long-term spending opportunities and affect their

spending.

We do not take an alarmist view of this, however. There are

some who feel that consumers react extremely strongly, for example, to changes in home equity line availability.

Our sense is that the relationship between home wealth and consumer spending is governed primarily by what’s called the wealth

effect, which suggests that for each dollar that a house value falls,

there’s a net effect on consumer spending of somewhere between 4

and 9 cents, something like that.

That may be an effect that’s maybe spread over a period of time,

so there will be an effect, but we see it as relatively moderate. But

as you point out correctly, there are a number of factors at play

right now, including high oil prices, for example, that would be

negatives for consumer spending.

On the other hand, to the extent the labor market has remained

reasonably strong and employment income has continued to grow,

that is a positive to help sustain consumers.

Senator Schumer. One final question: Federal Reserve Governor Kroszner recently suggested that mortgage investors and

servicers modify subprime mortgages en masse rather than on a

case by case basis because it’s just so hard. There are so few people

on the ground. These are complicated instruments these days.

What is your view of doing that? I know the Federal Reserve has

said you were going to issue some guidance to lenders on these

standardized loan modifications. Could you comment on how seriously the Fed would take Governor Kroszner’s idea and what you’re

doing about it?

Chairman Bernanke. We take it seriously. I mentioned in my

testimony the need to scale up these efforts as resets become eminent. We are looking, for example, we are already talking with

servicers who are developing either computer programs or templates or procedures that allow them, at least as a first cut, to categorize mortgages in terms of how they are to be treated.

15

That, on the one hand, will help them scale up their efforts. We

believe that is beginning to happen. We encourage that to happen.

In addition, by providing a systematic approach to addressing

these mortgages they actually protect themselves against claims by

investors or others who feel that they are arbitrarily changing or

modifying the loans.

We do support scaling up these efforts. And the best way to do

that is to create some more systematic approaches to doing so.

Senator Schumer. Thank you.

Congressman Saxton.

Representative Saxton. Thank you, Mr. Chairman.

Let me ask: I sat here this morning observing the information

flow back and forth. We talked about a number of issues, some of

which are positive and some of which are not so positive.

For example, on the positive side, it is good news that core inflation—the numbers that we look at to study core inflation—lead us

to think that inflation, at least core inflation, seems to be pretty

much in check.

On the other hand, we have talked about construction, particularly housing construction, being in not such good shape.

You just mentioned that the house price decline has a wealth effect which has implications going forward. The financial condition

of large banks has been discussed here at some length this morning, and that is cause for some concern relative to economic growth.

And of course, the potential effect of hundred-dollar-a-barrel oil

has implications going forward as well.

I noted from the FOMC statement last week, it suggested at

least to some that some in the markets said the Fed monetary policy stance was becoming, quote, ‘‘more neutral.’’

Given that core inflation seems to be in check, and given that

there are concerns going forward with the economy, could you give

us your view of what perhaps ‘‘more neutral monetary policy’’

means?

Chairman Bernanke. Yes, Congressman.

As we said in our statement, we feel that the risks in terms of

what could go wrong in both directions have become more balanced

since we have taken 75 basis points of cuts in the last two meetings to try to offset the tightening of credit that we see.

On the inflation side, it is true that there are some positives.

Core inflation has been lower. We believe that inflation expectations remain reasonably stabilized.

That being said, Congresswoman Maloney mentioned oil prices

and the declining dollar which may have some effects on import

prices. Those are effects we cannot ignore.

Should inflation expectations begin to move up and inflation

begin to rise, it would be very costly for us to have to bring that

back down. And so that is a concern we have, and we need to pay

attention to inflation. It is very important that we do so.

On the output side, again, we do expect some slowing relating to

a variety of factors including tightening credit conditions and the

slowing in the housing market. But as you mentioned yourself, the

broader economy outside of housing has been remarkably resilient

over the last couple of years.

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We had 4 percent growth in the third quarter even with the percentage point subtracted for housing, and the numbers we have

seen in the last week or two have not really changed the view that,

so far at least, the spillovers from housing to the broader economy

have been limited.

Having said all that, there are a lot of uncertainties. The financial market turmoil creates a good deal of uncertainty on how that

is going to evolve. The housing market creates uncertainty. The

dollar and oil prices are sources of uncertainty.

So our view is that we have a mandate to fulfill. That mandate

is to ensure price stability and maximum employment, and we will

be very dependent on the data. We will be observing what data

comes in. We will be looking at conditions of the financial markets,

and we will be trying to continuously update our views on how the

economy is likely to evolve and respond as we see those risks

change in one direction or another.

We certainly want to be able to respond as needed to meet our

mandate.

Representative Saxton. Thank you. On the housing spillover,

I have been curious about this because I have been watching the

same, or many of the same numbers that you have.

You would think that with construction being down, other sectors

of the economy would be directly affected: major appliances, hardware of various kinds, the lumber industry obviously, and other

sectors of the economy that provide products that are used in the

home construction business, as well as other related sectors of the

economy.

Do you have any idea why it is that the spillover effect does not

seem to be more evident?

Chairman Bernanke. Congressman, we do see the spillover in

the areas that you mentioned. For example, the Detroit auto makers are showing declines in their sales of pickup trucks because of

the declines in construction activity.

And certainly companies making appliances and home furnishings and so on have seen activities decline, and in general

manufacturing activity has slowed and looks at this point to be

growing very, very slowly. That in part reflects the relationship between manufacturing and housing, which is only partly offset by

exports.

But in general I think there are two factors that have kept the

economy growing. One is that the labor market has remained reasonably strong, and with reasonably good availability of jobs and

income growth consumers have money to spend.

The second factor which is going to support the economy going

forward is that the global economy is also very strong, and demand

for U.S. production and exports has helped buoy our economy.

For the first time in this last year, in a year-and-a-half or so, for

the first time in many years the trade sector has been a positive

contribution to the U.S. growth as opposed to a negative contribution. And I think going forward we will see additional strength

coming from foreign trade.

Representative Saxton. Thank you, Mr. Chairman.

Senator Schumer. Vice Chair Maloney.

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Representative Maloney. Thank you very much for your testimony today. I am really stunned by the lack of understanding by

investors in major sophisticated institutions in SIVs and CDOs.

They seem not to have understood the risk.

We are seeing major losses at major institutions. My question is:

Does the Fed—I certainly hope the Fed has a better understanding,

or sense of what is in these CDOs and SIVs than the investors.

Chairman Bernanke. The problems emerged some time ago

when the subprime losses began to appear. Some of these mortgage-backed securities and other types of instruments that had

mortgages, even though they were technically rated AAA began to

show losses.

Suddenly the confidence was lost, and investors became unwilling to buy these instruments. In retrospect, it is surprising and disappointing that, as you say, sophisticated investors essentially

looked at the credit rating and that is all they did. They did not

do due diligence. They did not investigate what was in the CDOs,

for example, in any detail.

Representative Maloney. Has the Fed investigated?

Chairman Bernanke. The Fed of course is working with the

other regulators: the SEC, the Accounting Board, and so on, to

make sure that these off-balance-sheet instruments and the bank

balance sheets themselves are being written down appropriately so

they reflect the actual values.

We are working with the banks and the ones who sponsor these

off-balance-sheet instruments to make sure they are getting true

valuations.

It is a little bit of a moving target, because as time passes, we

see ratings downgrades, for example, and some of the assets have

to be re-valued again.

But it is very much in the interest of the banks to disclose as

much as possible and to write down their losses. We, along with

the other regulators, are paying close attention to that marking

process.

Representative Maloney. It seems that the CDOs are so

opaque in their risk and composition that trade in them only works

in a rising market.

I have seen your actions in this area and I wonder why hasn’t

the Fed been more insistent on a major improvement in transparency as a condition of the Government’s willingness to participate in basically propping up these markets.

As you know, when Government came in and worked with longterm capital markets in 1998, we demanded risk management.

Best practices came out of it. Treasury demanded basic improvement in the bailout in Mexico.

Why isn’t the Fed coming out with specific, really best practices

or goals to force the transparency in this area that everyone seems

to not understand basically what they’re buying or the value?

Chairman Bernanke. First, Congresswoman, we are not bailing

out anybody. We did not put a penny of our money or Federal

money into the banks, or into the CDOs. What we are doing is exercising our responsibility to make sure that the banks disclose the

information, and that they value these things properly.

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It is not our practice in the broad financial world to protect investors, particularly sophisticated investors who should be able to

make their own evaluations, from buying individual instruments.

Our responsibility is to make sure that the banks are safe and

sound, and they are appropriately valuing their balance sheets and

their exposures to these off-balance-sheet instruments are appropriately measured and accounted for, particularly with respect to

capital. That is what we are focused on.

We have been focused on it for some time. As we move forward

into Basel II and other changes we are making, it is certainly going

to be something we are looking at very closely.

Representative Maloney. Last week former Secretary Rubin

said that a weak dollar is bad for the U.S. economy. Do you agree

with him that a strong dollar increases Americans’ standard of living and keeps inflation low?

Or do you think, as some economists argue, that we can devalue

our way to prosperity, allow the dollar to weaken to boost exports,

help close the trade deficit, and create better jobs?

Chairman Bernanke. Again, the Secretary of the Treasury is

the spokesperson for official policy. We are looking at the dollar

primarily as it affects the U.S. economy.

Representative Maloney. Let me say this a different way. Do

you think that the dollar, the decline of the dollar, will lead to inflation and higher long-term interest rates?

Chairman Bernanke. The decline of the dollar has the potential to raise import prices and contribute to inflation. Therefore, we

are very attentive to that risk.

In all but the shortest of terms, the Federal Reserve’s policy determines how much inflation there is, and we are going to make

sure that the inflationary impact that may come from the weakening dollar is not passed into broader prices and becomes part of

the underlying inflation rate.

Representative Maloney. Thank you. My time is up.

Senator Schumer. Senator Brownback.

Senator Brownback. Thank you, Mr. Chairman.

Mr. Bernanke, on page 6 of your testimony you indicated you

were going to continue to talk about the need to foster price stability and sustainable economic growth.

I want to make sure I am clear with you on this. Do you consider

either of these as the greater threat at this point in time? Or that

these are roughly kind of equal threats, price stability, or inflation

and economic growth?

Chairman Bernanke. We assess the risk to those objectives as

being roughly balanced at this time. There are risks on both sides

of the mandate.

As we go forward, however, we are not dogmatic. As we go forward we are going to follow the data. We are going to see what

happens in the financial markets, and we are going to try to make

judgments over time as we get the information.

Senator Brownback. Even as oil prices go to $100 a barrel, $3

at the gas pump? You look at those as particularly equal?

I look at gas prices and that is directly out of the consumers’

pocketbooks. That is a direct hit. Then as we are going into the

Christmas season, I am having to pay a lot more at the pump. I

19

think you really begin to affect the mentality when you get to that

$3-a-gallon gas or above, as it is in many places around the country.

Chairman Bernanke. Senator, you are absolutely right. This is

a big burden for the U.S. economy. Although we have been pretty

resilient so far in dealing with higher oil prices, I would point out

that while it has its effects on consumer spending it is also obviously an inflation risk both because of oil prices and gasoline prices

are part of the consumer’s basket and therefore part of inflation,

and even more concerning would be if those gas prices were to feed

through into other costs and lead to a broader rise in prices.

So we have to be very vigilant to make sure that higher oil prices

do not translate into broader inflation in the economy.

Senator Brownback. Not as the Fed Chairman, but as an economist, raising taxes at this point in time, not dealing with the Alternative Minimum Tax problem that is grabbing more people, or

allowing a raising of taxes on dividends or capital, what sort of impact would that have on the economy at this point in time?

Chairman Bernanke. Senator, I am not going to comment on

specific individual proposals. I do think that a net gain, a net increase in taxes that was substantial would probably not be advisable because of its effect on aggregate demand.

But it is a complex issue, each of these tax areas that you are

mentioning, to talk about the pros and the cons. We can pursue

that if you like, but I prefer not to take a position on one side or

the other of these individual tax proposals.

Senator Brownback. Still, as an overall item in the economy

at this point in time where you have an economy that is concerning, to raise taxes now would not be advisable for its impact

on the long-term economic growth in the economy.

Chairman Bernanke. A large increase in net taxes would tend

to be a drag on consumer spending and on the economy through

a number of different channels, I should say. That would be an

issue, I think, if that were to be the case, given what we expect

to be a slower growth economy for the next couple of quarters.

Senator Brownback. I want to look at the impact of China on

the U.S. economy. You must be watching that very closely. Their

purchasing, or their use of dollar denominations, inflationary impact coming from consumer products coming out of China into the

U.S. economy, or the concern we have of consumer products coming

from China, what are the lead factors you are watching in the Chinese economy as far as its impact in the United States?

Chairman Bernanke. The main thing we would like to see in

China is a rebalancing of the economy away from this very strong

dependence on exports which contributes to global imbalances and

to the U.S. external deficit toward a more domestically driven economy.

So, particularly, in China this is a rather remarkable statistic.

But the average national savings rate in China is close to 50 percent, as poor a country as it is. Which means that in order—even

though they have very high capital investment—in order to sustain

growth they have to export. They have a current account surplus

now on the order of 9 to 10 percent of GDP.

20

They need to re-orient their growth toward domestic needs. They

do need to do that by strengthening consumer spending and by reducing the emphasis on exports.

I gave a speech some time ago talking about some of the ways

they could do that, by strengthening the social safety net so people

did not have to save so much in anticipation of being sick or retiring.

In addition, as we have talked often—and Senator Schumer has

often emphasized—they need to increase the flexibility of their exchange rate in order to allow for the natural process of demand to

shift away from a totally export-oriented economy and more toward

a balanced domestically oriented economy.

Senator Brownback. Thank you, Mr. Chairman.

Senator Schumer. Senator Bingaman.

Senator Bingaman. Thank you very much, Mr. Chairman, for

being here.

Let me ask about the secondary market for mortgages. My impression is that the ability of an individual to borrow from a bank

ultimately depends upon the ability of that bank to turn around

and sell that mortgage into a secondary market of some kind.

That seems to me to be the place where the system is breaking

down or has broken down; and over the next 6 months or so, that’s

the place where the greatest danger lies.

If banks are not able to sell into a secondary market, credit continues to get restricted and limited. Would you have any thoughts

as to how to fix that problem?

Chairman Bernanke. I agree with you that one of the largest

factors that leads us to think the economy is going to slow somewhat, is precisely that issue. Mortgage availability has declined

significantly. That’s affecting demand for housing and the housing

sector and seeping over to the broader economy.

Some of this is probably inevitable, in the sense that we’ve seen

a significant tightening of lending standards in the subprime area,

which is understandable given the problems in that area. But we’re

also seeing, for example, problems of banks securitizing prime

jumbo mortgage loans, that is, mortgage loans that are greater

than $417,000.

That doesn’t mean those loans aren’t being made. Many banks

are making them and keeping them on their balance sheets, and

there is some securitization going on that’s limited.

The result is that those mortgages are still available, but at

somewhat tighter terms and higher prices than otherwise.

I think, over time, that market is going to improve. I’m not sure

what an immediate fix would be. There’s been some discussion of

raising the conforming loan limit on GSEs.

If we do that, I think it ought to be a very temporary measure

and be done in a way that assures us that doing so doesn’t risk the

underlying safety and soundness of those institutions.

Senator Bingaman. Would you think a temporary increase of

that $417,000 limit would make some sense?

Chairman Bernanke. One suggestion I would have—again, it’s

very important that we not override the regulators’ view that the

safety and soundness of these institutions must be protected.

21

So, one possibility would be if the Federal Government were willing to act as guarantor. For example, suppose the GSEs were to

pay their usual mortgage insurance credit fee to the Federal Government which then acted as guarantor, so to take away the credit

risk from the GSEs.

They could then process these jumbo loans and sell them in the

secondary market, and that would, I think, be of some assistance

to the mortgage market.

From the Federal Government’s point of view, that would be taking on some credit risk which you may or may not be willing to do.

I think that if you did that, it would be a good idea to make the

GSEs ultimately responsible for any excess losses, or some part of

excess losses relative to the premiums that are paid, and leave it

to the regulator to determine when the safety and soundness was

adequate that the GSEs could make that repayment.

So I think there might be some mechanisms that involve Federal

interaction, but I think it’s extremely important, as we look at

these options, that we don’t take actions that will endanger the

safety and soundness of the underlying institutions.

Senator Bingaman. Just to follow up on that suggestion that

you made there about the Federal Government taking on this risk,

would we have to legislate to do that?

Chairman Bernanke. Yes.

Senator Bingaman. Is the legislation that is pending in the

House—have you reviewed that as to whether that accomplishes

what you’re suggesting?

Chairman Bernanke. I’m not aware that it does. The legislation in the House, is mostly about dealing with those who are in

trouble, borrowers already in trouble, and, prospectively, the rules

for avoiding future abuses.

There is not, to my knowledge—perhaps Senator Schumer can

correct me—there has not been, to my knowledge, a lot of effort devoted toward the secondary market.

Senator Bingaman. Thank you.

Senator Schumer. Senator Sununu.

Senator Sununu. Thank you, Mr. Chairman. I think I’ll begin

my questioning with an issue related to the one Senator Bingaman

was talking about, but it is, frankly, a little bit more negative in

its perspective.

Yesterday, the Dow dropped 360 points, and a number of analysts in the financial press blamed a lot of that drop on the New

York Attorney General and his press release that alleged, in his

words, quote, ‘‘systemic fraud,’’ and, quote, ‘‘a pattern of collusion

in the mortgage industry.’’

The Attorney General made those allegations with specific reference to transactions between Fannie Mae, Freddie Mac, and

Washington Mutual for which he issued subpoenas. My question to

you, is, in this environment where we see big problems with credit

in the mortgage industry, is this kind of a press release really helpful to solving the problems in front of us.

Chairman Bernanke. Senator, I don’t want to intervene in the

Attorney General’s decisions about what cases to pursue, and I

would add that the Federal Reserve has, obviously, no regulatory

authority over any of those institutions.

22

I think what’s upsetting the stock market is that it’s primarily

financial stocks that have been falling, and the concern is that financial firms have not, in the view of the stock market, perhaps

completely written down the losses that they’ve suffered.

Senator Sununu. I will be happy to address transparency, and

I’m not asking you to comment on whether or not someone is guilty

or not guilty, but I’m trying to identify whether or not this will

help us address the problems that exist in the industry.

Chairman Bernanke. I don’t want to intervene in the Attorney

General’s decisions.

Senator Sununu. If you don’t want to comment on it, that’s

fine. Obviously, again, I want to understand what is helpful and

what isn’t.

You mentioned transparency in the marking-to-market. This is

something else that I’d like to talk about, and apparently, you’d

like to talk about it more than my first question, so I’ll be happy

to move there.

The Treasury announced a super SIV, a large, enhanced liquidity

vehicle to try to deal with liquidity issues in structured investment

vehicles. There are 30 of them, mostly held by very large institutions.

You point out that transparency is essential. The process of price

discovery is essential to working through these problems.

What, in your opinion, is the purpose of this enhanced liquidity

vehicle, and what will its impact on price discovery be?

There is a Federal official quoted in the Wall Street Journal, that

said that this proposal, quote, ‘‘has the potential to contribute,

rather than to impair these markets in the process of price discovery.’’

I would maintain that it’s just as true to say this vehicle has the

potential to impair, rather than to contribute to the markets in the

process of price discovery. What’s the purpose of the vehicle and

what impact do you think it will have on price discovery?

Chairman Bernanke. Senator, it all depends on the execution,

as I’m sure you would agree. My understanding of the idea behind

it is that a consortium of banks, together with investors—major investors—would oversee the process of purchasing high-quality assets from these unwinding SIVs and create a new vehicle which

would then be financed by commercial paper purchased by, for example, large mutual funds.

My understanding of the process is that because investors, as

well as a number of banks would be involved, essentially as gatekeepers in bringing assets into this new vehicle, that the valuations—there will be an incentive, particularly on the part of the

investors, but also on the part of banks who didn’t have direct disclosures.

There would be an incentive to create accurate market pricing if

that is the way it works. Again, it depends on the execution, but

if that’s the way it works, it would remove some overhang from the

market; it would create a stable financing source for those assets,

and it ought not to be inconsistent with the price discovery process.

Senator Sununu. I would only observe the operative phrase you

used regarding participation of investment firms that don’t have

exposure in these areas. If you look at the list of firms that were

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most excited about participating, they all have significant exposure

in these investment areas.

When you were here last, which was 7 months ago, I explained

if you looked at the aggregate down payment available in our economy from consumers on homes and looked at changes in credit underwriting standards, it was very likely that this year, home inventories, inventories of unsold homes, would increase from the level

back in March of—approximately 6 months, to 8 to 10 months. I

asked you, what do you think the impact on demand or the economic level of activity would be, if housing inventories were at 8

to 10 months, as opposed to today’s 6 months?

And you responded, if they were at that level—and I do not expect that they will be, construction will fall further. I’m sure we’ll

never have the opportunity to say at any other time, that I was

right and you were wrong, and granted, maybe it was just a lucky

guess, but I think we’ve looked at changes in credit and we’ve

looked at what was available for down payment. It’s highly likely

that inventories would go at least to those levels.

I think, without going into detailed explanation, that there’s a

very good chance, over the next 12 months, that inventories will go

to at least 12 months and probably to 14 months. What would be

the impact on the economy and, in specific terms, of an increase

in housing inventories to 14 months, and what is the best estimate

or the best forecast of those at the Fed looking at the housing industry today?

Chairman Bernanke. Senator, you were right and I was wrong.

Senator Sununu. I didn’t ask you to say that by any means.

Chairman Bernanke. Inventories have risen, and they’ve produced a great deal of downward pressure on construction. And to

get to where you’re describing would require further declines in demand, slower responses by homebuilders, and it would suggest

even a greater disequilibrium and a longer period of workout that

would subtract directly from economic growth, and increase the

hazard of spillovers into other parts of the economy. That’s a concern.

Again, our anticipation—and it depends very much on both the

homebuilders’ response and the buyers’ response—is that those inventories are not going to go much further from here, but in 6

months, you can tell me, you know, that I was wrong again.

Senator Sununu. I will not look forward to that.

Chairman Bernanke. We believe that this process, although

we’re now under a million single-family homes, from a peak of 1.7

million—we’ve really greatly reduced the rate of home construction,

so, in some sense, we think there’s a minimum because there is a

certain amount of family formation and so on that’s going to support a certain amount of building.

So we don’t expect it to get to the point you suggest, but perhaps

you’re a better forecaster.

Senator Schumer. Congressman Cummings.

Representative Cummings. Thank you very much, Mr. Chairman. Mr. Chairman, thank you for meeting with us.

Many Members of Congress are now holding forums in their districts, as I will be doing very shortly to help people who are coming

to our doors, literally with tears in their eyes, trying to figure out

24

how they’re going to manage a foreclosure that’s right around the

corner. Unfortunately, they have been harmed by what they

thought was going to be a dream, now turning into a nightmare.

You know, as I sat here and I listened to you, it seems like you

have painted a very rosy picture of the foreclosure situation, but

if you came and walked through my district, Mr. Chairman, I think

people would be surprised that you seem so calm.

Let me ask you a broad question on how we make economic decisions. Why did anyone think that the housing market would not

suffer tremendous losses, particularly given the extent of subprime

lending extending to those with poor credit, and also given the obvious risks associated with the increases, which could certainly be

expected due to adjustable-rate mortgages and certain nontraditional loan packages?

Given the extent of the declines that have occurred, do you think

that our markets are adequately regulated?

Chairman Bernanke. Congressman, first, I don’t know how you

got the impression that I was unconcerned about foreclosures.

Representative Cummings. I didn’t say you were not concerned. I just said you seem to be pretty calm about it, and I guess

what I’m trying to make sure of is that there’s a connection. I note

so often that what happens is that when we make a decision in the

suites, we forget about the people who actually have to go through

this, but I will not forget those indivuduals, especially as a Member

that lives in the inner city of Baltimore.

I look at my constituents who are losing their homes, who are

seeing their values go down. Baltimore appreciated, I think, something like 1200 foreclosures in January, now 7,000 just recently, in

a month. I mean, things—they’re becoming alarming, and I guess

I’m just trying to figure out exactly how. You talked a little bit earlier about efforts on the part of the companies to fix mortgages in

order to help people get fixed rates.

I just want to know, I want from you every single thing that you

can possibly do to help us help our constituents.

I was just telling Representative Hinchey on the way over, when

a person loses their home, it’s not just their loss; it’s the family’s

loss and their dream. The dream that they thought they had captured suddenly disappears out of their hands. Children look at

them and they say, well, gee, I don’t know whether I’m going to

try to buy a house. That’s the problem.

Many of them, I’m sure, will go a lifetime and never be able to

buy a house. Again, we’re talking about this economy that we want

to keep strong, but what we’re failing to examine, are the people

who are literally being taken out of the market due to a foreclosure.

Chairman Bernanke. Congressman, I spent about half my testimony talking about this problem. It’s a very serious problem. I

think it hurts people; I think it hurts communities.

I discussed a number of the actions that companies are taking,

and I would urge, first of all, that people in trouble get in contact

very early with their servicer or their lender because the earlier

you get in touch, the better chance there is to work something out.

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I urge the lenders and the servicers to expand their efforts to try

to restructure mortgages and help people stay in their homes. I

think it’s very important.

I talked about the Federal Reserve’s efforts to try to work with

community groups to try to assist that process, and I also talked

about regulatory actions that we’re taking to try to ensure that it

doesn’t happen again.

So, it is a very important problem, and we spend a lot of time—

we’ve been meeting with people. I met a few days ago with Reverend Jesse Jackson to talk about some of these issues.

We have been spending a lot of time on this issue, and we think

it’s a very, very important issue for which we’re going to do everything we can.

Representative Cummings. Those companies that are participating are pretty much voluntary?

Chairman Bernanke. We have to try to give them guidance, to

show them how best to approach this problem. We think it’s in

their interest. It’s in nobody’s interest if a creditworthy borrower

loses their home. It’s not in anybody’s interests.

We want to try to make sure that they have the flexibility and

the leeway needed to restructure loans for people who should be in

the home, have the credit to be in the home.

Representative Cummings. A little earlier, you said that the

patchwork nature of enforcement authority and subprime lending

poses a special challenge. Can you discuss what should be done to

improve enforcement of provisions intended to protect consumers in

the subprime markets?

Chairman Bernanke. Enforcement is an issue. We are working,

as I mentioned, on a set of regulations that would apply to all lenders, so that would be a new set of rules that would apply to all

lenders, including those outside of the Federal safety net.

The question is enforcement. The States are typically in charge

of overseeing the non-federally regulated lenders. Some of them are

very, very good at doing that, but we think there’s probably more

that we can do at the Federal Reserve to work with them, to coordinate with them.

We have right now going on, a pilot program where we are working with other agencies and with the States to try to compare our

approaches to supervision and oversight for mortgage lenders, to

see what we can learn from each other, and to try to increase our

coordination with them, to try to make them as effective as possible, and try to get as close a relationship with them as possible.

Representative Cummings. Thank you, Mr. Chairman.

Senator Schumer. Congressman Paul.

Representative Paul. Thank you, Mr. Chairman. The best way

I could describe the problems that we face here in this country, as

well as the problem the Federal Reserve faces, is that we are, indeed, between a rock and a hard place.

We have a serious problem that we don’t talk about much, how

we got here. We talk about how we’re going to patch it up.

The bubble has been burst. We saw what happened after the

NASDAQ bubble burst. We don’t ask how it was created, and now

we have a housing bubble that’s deflating and spreading. Nobody

says, where does it come from?

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What is the advice that you generally get? That is, inflate the

currency. They don’t say inflate the currency; they don’t say debase

the currency; they don’t say devalue the currency; they don’t say

cheat the people who are safe; they say, lower the interest rates,

but they never ask you—and I don’t hear you say too often—the

only way I can lower interest rates is, I have to create more money.

I have to lower the discount rate; I have to make it generous; I

have to increase reserves; I have to lower the interest rate, fix the

interest rate, the overnight rate.

The only way you can do this is by increasing the money supply.

I see this as the problem that we don’t want to talk about.

Currently, of course, we can’t follow the money supply with M3,

but we can follow one of your statistics, the MZM, the rating caps

available, and we see that inflation is alive and well.

That money supply figure is going up at about 20 percent,

annualized. This just means the dollar gets weaker. Everybody

says, well, that’s great, the dollar is weaker and we’re going to

have exports. And that is a fallacy. It may be for a month or 2, but

it just invites inflation.

Unless we get down to the bottom of it and define what inflation

is, and not look only at prices—this was taught by the free market

economists all through the 20th century. They said, beware, they

will increase the money supply, but they will make you concentrate

on prices, and we’ll give you CPIs and PPIs and they’ll fudge those

figures, and they’ll talk about wage and price controls to solve our

problems.

And we ignore the fundamental flaw which is, not only have we

had a subprime market in housing, but the whole economic system

is subprime, and we have artificially low interest rates.

It was not under your tenure in office. It has been going on for

10 years or longer. Now we are bearing the fruits of that policy of

1 percent interest rates, overnight rates, and that is not a distortion? Instead of looking at the prices, the consumer prices which

nobody in this country really believes, we need to talk about the

distortion, the malinvestment, the misdirection, the bad information that has been gotten from artificially low interest rates.

In many ways some people refer to you as a price fixer, you

know, because you fix interest rates. The market is powerful, and

usually overwhelms and does come into play, but when the Fed

fixes an interest rate at 1 percent, that is price fixing.

At the end of your testimony you suggested that we should address this housing crisis and we should have rules that would address deceptive lending practices.

I just think that is not the answer at all. The real deception is

when we distort the value of money when we create money out of

thin air. We have no savings. Yet there is so-called ‘‘capital.’’ There

is money available, but it comes from what you have to do when

the pressure is put on you.

So I think we have to get back to the very fundamentals of where

this problem comes from. The bubbles occur when we have this

malinvestment and the creation of new money.

So my question boils down to this: How in the world can we expect to solve the problems of inflation—that is, the increase in the

supply of money—with more inflation?

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Chairman Bernanke. Congressman, first as a small technical

point on the growth in money, money growth has been pretty moderate over the last 2 years.

The decrease in MZM is probably related to the financial turmoil.

People have been taking their savings out of risky assets and putting them into the bank, and that makes the money data show

faster growth.

I am not sure that is indicative of a policy necessarily. What we

tried to do is follow the mandate that Congress gave us. The mandate that Congress gave us is to look at employment and inflation

as measured by domestic price growth, as I talked about today, and

I think you would agree we do see risks to inflation and we are

taking those into account and want to make sure that prices remain as stable as possible in the United States.

Representative Paul. How can you do this and pursue this policy you have without further weakening the dollar? There is a dollar crisis out there, and people’s money is being stolen. People who

have saved are being robbed.

If you have devaluation of the dollar by 10 percent, people are

being robbed of 10 percent. But how can you pursue this policy

without addressing the subject that somebody is losing their wealth

because of a weaker dollar? And it is going to lead to higher interest rates and a weaker economy.

Chairman Bernanke. If somebody has their wealth in dollars

and they are going to buy consumer goods in dollars who is a typical American, then the decline in the dollar, the only effect it has

on their buying power is it makes imported goods more expensive.

Representative Paul. But not if you’re retired and elderly and

you have CDs; their cost of living is going up no matter what your

CPI says. Their cost of living is going up. They are hurting. That

is why the people in this country are very upset.

Thank you.

Representative Hinchey [presiding]. We have a certain level of

anxiety up here, Mr. Chairman, because there are votes pending

shortly in both Houses. I am going to go briefly, and then we will

try to keep it as fast as possible.

First of all, let me express my appreciation to you for all the good

work you do, and of course for being here with us today.

The Federal Reserve has a dual mandate from the Congress. One

is to hold down inflation and make sure it doesn’t impede upon the

economy, and the other is to promote economic growth and to

maintain and sustain strong employment figures—good jobs for

people as much as possible.

It seems to me that right now you are facing a very complex set

of conflicting circumstances on both ends. It is going to be a real

challenge to deal with this not just from your point of view, but

from our point of view.

I think in a variety of ways obviously we are all limited in what

we can do, and I think that the mandate of the Federal Reserve

is specific.

I think that you have done just about all you can do. There will

probably be some pressure to lower interest rates again, but the

fact is, if those interest rates continue to go down, then the inflation issue is going to continue to be jacked up.

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We are right now facing an inflationary situation which is increasing. Estimates are that it could go up as high as 2 percent

over the course of the next year, maybe even higher than that.

And in that context, I think we have to realize that in that core

inflation we are not including the two most inflationary aspects of

this economy: the cost of energy, particularly oil, and the price of

food, both of which are rising dramatically. If that continues, then

the pressure on inflation obviously is going to be much, much higher.

We are also confronting a situation of a declining economy. This

economy is not doing well. The example of the mortgage foreclosures on 2 million people—and it may be a lot more than that

as time goes on—is really not the cause of the problem we are facing, but just a factor of it. It is a factor of the weakness of this

economy.

The question we are facing is: How are we going to deal with

this?

You have got a dollar which is now depressed to record lows.

There is every indication that that is likely to continue unless

something is done to try to address it. The major problem with the

dollar being driven to record lows, the major factor of that is the

deep debt that this economy is in both, from the Federal point of

view and from people’s personal points of view.

Federal debt now is up above $9 trillion. It has risen by more

than $4 trillion over the course of this Administration. And all

across the country people are spending nearly 10 percent more,

month by month by month, more than what they are making.

So the increase in personal debt is going up rapidly. Obviously,

that cannot be sustained. And that is in fact what is sustaining

whatever growth we are experiencing in this economy.

Then people talk about the job rate is good. But as a matter of

fact, the job rate is not good. One of the things that is not being

considered, in the context of the unemployment rate, is the number

of people who have dropped out of the economy altogether, dropped

out of the job market. They are not seeking jobs. The unemployment rate is not 4.7 if you bring those people in. It brings it up

well above 5 percent and maybe as high as 5.5 percent.

All of these factors are crunching in on us. It reminds me of a

period that we faced a couple of decades ago which was phrased

‘‘stagflation’’ when you had increasing inflation and a downturn in

the economy, which is essentially what we are confronting today.

We have low job growth rate in America today over the course

of the last 6 years, the lowest job growth that we have seen since

the Depression. I think that we deeply depend upon you to give us

some advice.

What is Congress going to do to try to deal with this economy

when we look at the Federal Reserve struggling with it and we see

that there is a limitation on what you can do with regard to interest rates, which is your primary factor in trying to drive the economy?

Chairman Bernanke. You are certainly correct that there is a

delicate balance on both sides of the mandate, which is difficult to

assess.

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I think the area where the Congress has the most influence is

fiscal policy, obviously, and making wise decisions about spending

that will promote growth, that will support and structure education

and those sorts of things. That is as important as is having a rational, sensible tax policy.

I would like to be more specific than that, but I think that is

really the area where Congress can be most effective.

In addition, I suggested today that there might be steps Congress

could take to try to ameliorate the disclosure issue you mentioned.

The Federal Housing Administration is one potential vehicle, but

there may be others.

I do think there are things that can be done. I guess I should

also say that while we do expect slower growth, fortunately, we do

not see anything approaching a period of the 1970s. We think

growth will be more moderate, and inflation has some risks to it,

but we do think that the performance should be much better than

that, period.

Representative Hinchey. I hope your optimism on that has

some validity. I would hate to see it go in the opposite direction.

We are teetering right now in a very, very difficult set of circumstances.

I am very pleased to hear you talk about how this Congress

should be focusing more and more attention and resources on

things like education and health care and building up the basic infrastructure.

We are now spending $2 billion a month in Iraq on a war which

was justified under completely falsified premises. So this Congress—you are right, Mr. Chairman—has got to refocus its attention and begin to deal with the basic aspects of this economy and

deal with the situation in the Middle East much more constructively than we have.

Because I think what you have done with the interest rate situation has sustained things for a longer period of time than it would

have, but I think that that time is just about on the edge of running out.

I am really concerned about what is going to happen now over

the course of the next few years.

Thank you very much.

Representative Maloney [presiding]. Mr. Bennett.

Senator Bennett. Thank you very much, Madam Chair.

First, just a personal observation. When I first came to the Senate 15 years ago and attended these meetings, the drum beat that

I heard over and over again was: We are not making enough credit

available to the poor.

We were coming out of the savings and loan crisis. And in response to that crisis, financial institutions were bringing down the

basis on which they would make loans in order to keep themselves

from the bankruptcies that occurred with the savings and loan crisis.

The argument from Congress was: You were far too restrictive in

your requirements as to who can get money, and you should loosen

up; you should make credit available to the poor; you are failing

your social responsibility for not making credit available to the

poor.

30

Now I find it interesting that we find that the new cry is: You

have made too much credit available to the poor. It is your responsibility, you financial institutions.

I do not in any way condone those financial institutions that

have played fast and loose with the rules. They are the ones that

are paying the biggest price with this meltdown, and they should.

But we should remember that in the circumstance, many people

have acquired homes that would not otherwise have homes, and

the better off they will be. Many of those borrowers who were getting hurt falsified their income statements. Others were speculators who were flipping properties and had not intention of living

in them.

They were participating in the bubble and betting on tulip time,

betting that some greater fool would come buy the house at a higher price than they paid, and they lost their bet, and they deserve

what they got.

The fundamental question, picking up a little bit on what Senator Sununu was saying, we have heard forecasts as to how long

it will take for this to work itself out, and it will work itself out.

Markets make better decisions than governments do. And the

market will punish; the market will reward, and the market will

ultimately stabilize.

I remember forecasts that it would work itself out in about 6 to

8 months. Give me your forecast now. That clearly is not right, and

I do not know whether you made it, or whether I made it, or whatever; and that does not matter. Look into your crystal ball. Is it

going to take a year? Is it going to be the end of 2008 before the

market has sorted this all out?

Do you think that is too pessimistic, or too optimistic? What is

your sense?

Chairman Bernanke. Senator, first the reason that many forecasters, including the Federal Reserve, have understated the

amount of time it would take for this to resolve has been because

we have continued to get bad news on subprime lending and the

implications of that for housing demand.

We saw that in the spring. We have seen it now more recently.

And these things have led us to extend the period of adjustment.

From our perspective, what we are asking ourselves is: When

will housing construction stabilize, even at a low level, so that it

no longer subtracts from growth percentage point as it has been?

That does not mean that it is going to be recovered to where it

was or anything like that. At the risk of being proved wrong again

and having a new credit crunch and other factors delaying it even

further, our current calculation is that things will begin to flatten

out in the second quarter of next year. So it is still I guess 6

months, but that is of course very provisional.

One of the things we look at very carefully, as the data come, in

are what is happening to permits and starts and mortgage applications and the like. We continue to adjust our forecasts according to

that.

Senator Bennett. You are more optimistic than some of the

other economists I have talked to. That is helpful.

Let me switch topics entirely now that we have you here with

your background and address a question that I think is long term—

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very serious for the American economy. The short-term label on it

is called ‘‘Sovereign Wealth Funds.’’

As we see countries by virtue of the oil prices become very, very

wealthy, we think of the Middle East countries, but we also have

to include Russia in this category. We see a change in the underlying economic structure. Instead of wealth being held in the hands

of shareholders who have an agenda to increase the wealth, we see

wealth held in the hands of governments who have political agendas as to how they will use the wealth.

If I may draw a comparison to two competing examples:

ExxonMobil when it makes money off of oil, uses that money to try

to find more oil; Hugo Chavez, when he makes money off that oil,

uses it to try to destabilize South America and become the next

Fidel Castro.

We are seeing foreign governments making purchases that have

political implications. This is not the Japanese buying Rockefeller

Center. I remember everybody being all upset in the 1980s: The

Japanese have bought Rockefeller Center. And I said, yes, and

what are they going to do about it.

Are they going to jackhammer it up and take it to Tokyo? They

are stuck with it. It is in New York. And as it turned out, they sustained a fairly significant loss on the value of Rockefeller Center

after they bought it.

But in today’s world, you can buy a company. You can dominate

an industry that is worldwide. Then, inject into that the geopolitical agenda rather than an investor’s agenda and that could

make your job significantly more difficult.

I am sure you had some thoughts on this down at the Fed. I

would appreciate it if you would share some of those with us.

Chairman Bernanke. Certainly, Senator, this is a topic of discussion at the G7 recent meetings, Sovereign Wealth Funds. There

are quite a variety of them. Norway has one, for example. But of

course, many of them are based on oil revenues or foreign exchange

currency revenues.

The view of the G7—collectively we asked the IMF and other institutions to work with us on this—that Sovereign Wealth Funds

need to have a code of conduct that describes how they go about

investing in other countries.

The code of conduct includes transparency, so we know what

they are doing; governance, so we know how they are controlled

and to what purpose; and importantly, to the issue you are referring to, that their investments be economically oriented and economically motivated in order to make a profit or a return, as opposed to gaining control of an important company or industry.

So I believe it is very important that Sovereign Wealth Funds

follow that type of behavior. In return for that, I think we need to

keep our markets open. And when they are investing as good investors and good citizens, that we should allow them access to Rockefeller Center, if that happens to be what they want to buy next.

But it is an important issue because they are now larger than

hedge funds collectively, and the way they conduct their investments will be very important as we go forward.

But again, I understand your issue. The reform of CFIUS that

recently took place tries to address the national security aspects of

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this. So I think the combination of the code of conduct by the Sovereign Wealth Funds, national security protections along the lines

of CFIUS, but open financial and capital markets of the United

States that will attract foreign investment I think are the elements

that will allow this to work.

Senator Bennett. Thank you. My time is up. I will just make

this one quick comment:

Of the oil companies that dominate the world now, those that are

owned by shareholders like ExxonMobil represent a small percentage. The dominant oil companies are Gazprom, Pemex, and companies of that kind. And as we beat up on American oil companies

as if they really control the market, we should understand that the

market is being controlled by foreign governments.

Senator Casey [presiding]. Congresswoman Sanchez.

Representative Sanchez. Thank you, Mr. Chairman. To some

extent I would like to associate myself with the remarks of Congressman Paul earlier about some of the things that have been

going on structurally. I think that is really where the problem is.

I represent Orange County, which is headquarters to probably all

of the major builders, even in the United States. We export construction of new homes, in particular, from Orange County.

I am also the home of four mortgage originators: Ameriquest,

21st Century, and so many others. And I represent Anaheim and

Santa Ana, California, which 1 out of every 3 homes up for sale

right now in those two cities, or 33 percent, are from foreclosure.

This is really, really hitting home.

By the way, I was just out to purchase a home in the last 10

days. I have an 800+ credit score. I have no debt, basically. I have

a lot of assets. And I went to the one institution where I carry a

small loan with them, a home loan, and they quoted me a price of

100 basis points over what is quoted in what we are talking about

as far as rates in the paper, in the newspapers.

If there is a credit crunch on for somebody like me, there is really a credit crunch on for people trying to work out of their homes

and trying to save their credit, or trying to save their home.

I think it is a very, very big problem for us. And of course Bill

Gross, a big Republican and CEO of PIMCO, on Monday, basically

told us that he thought he would foresee this for another 2 or 3

years. We are really not anywhere close to the bad part of this.

As well as some of the homebuilders, the new builders who told

me, ‘‘I was selling product at a million dollars, new product at a

million dollars. And today, Loretta, you can go down and the same

product I am selling for $700,000 5 miles out of your District in Orange County near the Coast,’’ not one of those places where you are

out in the middle of nowhere. They are really having problems.

So I think we have really got a problem on our hands. But this

generates, I think, from really bad policy, fiscal policy coming out

of Washington, DC, in particular over the last 6 years. I really

have to say that.

And Mr. Chairman, you are at the Federal Reserve, but you were

the advisor to the President on this. I think we have some real

problems here, structural problems.

I think the decline of the dollar is only beginning. And I would

ask you, I have lots of questions, but I don’t have time because we

33

have a vote on the floor, but I would ask you that in your private

meetings you get this Administration to understand they need to

invest in their people’s health. They need to invest in their people’s

education. We need to invest in transportation, in communication,

and things that make our people more productive. And we need to

stop wasting our money.

Mr. Hinchey said $2 billion a month in Iraq. It is $3 billion a

week of operating expenses in Iraq. That is not even going to my

defense contractors for future systems weapons in California. No.

That is operating, and it does not come back to the United States.

Please, in your private meetings, you have a different role now,

but in your private meetings, we need to get this Administration

to understand we cannot continue to spend and not invest in our

people and in our country.

That is what I would like to tell you this morning.

Senator Casey. In the interest of getting everyone to vote, the

House is now having a vote, I would ask that we take a brief recess. I know the Senate has one vote. I think I can get back here

rather quickly, as can other Members.

Mr. Chairman, I know you have other engagements. You are able

to stay here until 12:20? That is my understanding.

We will take a brief recess and resume.

[Recess.]

Representative Maloney [presiding]. I apologize for having

these votes and running back and forth.

Mr. Brady.

Representative Brady. Thank you, Madam Chairwoman.

Mr. Chairman, thank you for being here. So far about $50 billion

of losses have been identified in the subprime loans at this point.

Some estimates say the final amount may be equal to the savings

and loan default with a total of about $150 billion.

Is that in the ballpark of what you estimate to be eventually declared?

Chairman Bernanke. Yes, that is in the ballpark. Although I

would emphasize that there is no reason to think that would all be

in financial institutions. It would be spread around to a lot of investors of different types.

Representative Brady. Do you see that impact working

through our economy until the second quarter of next year?

Chairman Bernanke. It is not the financial losses, per se, but

rather the weakness in the housing market that will keep construction on the downtrend probably through at least early next year.

Representative Brady. Do you see there being a maturing

market for these mortgage assets that are basically illiquid at this

point? I know Secretary Paulson is working to work with the master liquidity enhancement conduit. Does the Fed see a way to accelerate the mature market where we will see the true value of assets

that are being held?

Chairman Bernanke. First I should say the markets are working hard to achieve that. The commercial paper market, for example, has stabilized and a lot of the bad paper, or weaker conduits,

have unraveled and the stronger of the conduits are now stabilizing

and are being funded.

34

With respect to Federal Reserve’s role, we along with other bank

regulators—the SEC and so on—whose job it is essentially to look

at it from the perspective of the banks and the other financial institutions to make sure that they both have their own balance sheets,

and through the conduits in which they have interests, or which

they sponsor are appropriately marking down assets according to

the best available prices or measures of value.

Representative Brady. How long do you think it will be before

we see the true value of those assets? Do you expect that to be occurring within the next quarter? Obviously they have appreciated

significantly.

Chairman Bernanke. Again, speaking from the point of view of

financial institutions, I think they are being aggressive in marking

down their assets. Based on what they can see, they have in most

cases disclosed the losses that they have.

The possibility remains that assets, individual assets, will continue to be marked down as they get downgraded for example,

which requires rethinking.

I do believe financial institutions are being aggressive, and it is

certainly very much in their interests to get that information out

as fast as possible.

Representative Brady. Like a Master Liquidity Enhancement

Conduit (MLEC), I am trying to understand the creation of it. Do

you think that accelerates the true value of these assets, or delays

them a bit?

Chairman Bernanke. As I discussed earlier, I think it depends

on the execution. If it does involve the oversight of investors and

a range of financial institutions, then ideally the assets go into the

MLEC at a fair value at a market value.

So if it works properly, I think it would speed up the recognition

of values in part because it would remove some of the risks of fire

sales and a rapid drawing down of assets in some of these vehicles

and allow the market to stabilize and begin to make a better longterm valuation of what is in these assets.

Representative Brady. A final thought on the subprime. I

know that you have given it both thought and action. I, like most

Members of this body, am a big believer in home ownership for all

the many benefits of it.

It seems to me Congress’s policy is encouraging regulation and

tax incentives. We have encouraged home loans and business loans

to borrowers who do not have a strong credit history, all with the

worthy goal of increasing lending to those constituencies.

But given the weakness that this crisis has revealed from income

verification to lax underwriting, to suspect credit ratings, to what

extent have congressional policies such as the Community Reinvestment Act—or truthfully any other policy—to what extent have

Congressional policies played a role in the subprime crisis?

Chairman Bernanke. That would be very difficult for me to

judge. I think what I would like to say is that lending to people

without long, well-established credit histories can be both profitable and socially beneficial, and we have seen that.

We have seen responsible subprime lending, and we have seen

subprime credit extended in other areas as well. We have also seen

35

at least the reduction of red lining and those similar issues that

were a problem in the past.

I think, again, it depends on execution. Banks can lend to underserved populations, but the rules of credit worthiness and underwriting still obviously apply. We have learned that lesson in the

last couple of years.

Representative Brady. I asked that only because when we

have taken the approach of sort of going after the market on this,

and there is substantial merit to that, but I just wonder if it is time

for Congress to reassess our policies. Is it time to require a down

payment?

Do we have more substantial asset tests when you take out a

variable rate mortgage? Because there you are, not only open to the

economy, but you risk the interest rate fluctuations as well.

Is it time for Congress to take a look at back to basics, as to how

we can both encourage home ownership but lessen the risk of bad

loans?

Chairman Bernanke. Two comments. One goes back to the

CRA issue. A lot of the subprime lending was done by nonbank

lenders who have no CRA obligations. In that case, obviously there

was no CRA effect.

As far as underwriting is concerned, you cannot really legislate

good underwriting. But you can require, for example, that lenders

take appropriate account of ability to repay and so on. That is in

some of the bills that are there, but it is also something we are

looking at in the Federal Reserve in our regulatory process that we

expect to have next month to release some rules.

Representative Brady. Thank you. Will there be any recommendation for Congress, Mr. Chairman?

Chairman Bernanke. No, just a rules change.

Representative Brady. Thank you, Mr. Chairman.

Senator Schumer [presiding]. Senator Casey.

Senator Casey. Thank you, Mr. Chairman.

I appreciate the opportunity to participate in this hearing. Chairman Bernanke, we appreciate your patience with us voting and

having a brief recess.

I just have two areas to cover. One of course is on the subprime

crisis. And I have a second area to cover. I wanted to first of all

highlight some of your testimony.

On page 6 of your testimony, in the section that deals with

subprime borrowers, you say at the end of that first full paragraph

and I quote:

Should the rate of foreclosure rise proportionately, communities as well as individual borrowers would be hurt because concentrations of foreclosures tend to reduce property values in surrounding areas. A sharp increase in foreclosed properties

for sale could weaken the already struggling housing market and thus potentially

the broader economy.

Unquote.

Which is what your testimony was. I thought that was a good

summation of what this crisis means for individual families and

their communities, but also a larger impact on the economy.

I just wanted to direct your attention to two charts. The first is

a map developed by this Committee: ‘‘Projected Economic Costs of

the Subprime Mortgage Crisis State by State.’’

36

[The chart referenced above appears in the Submissions for the

Record on page 58.] I note that Pennsylvania is around $2.5 billion. Other States are

higher than that. The overall numbers—for those who cannot see

it—for the third quarter of 2007 to the third quarter of 2009, loss

of home value, loss in neighboring property value, loss in property

tax value,the overall number based upon this research can be summarized this way: Seventy-one billion dollars in housing wealth directly destroyed because of the foreclosures reducing the value of

the home. Thirty-two billion dollars in housing wealth indirectly

destroyed. We know these numbers. I thought this was a graphic

presentation of what it means State by State and nationally, and

you know that as well, Mr. Chairman.

I do note in your testimony, and I was grateful that you highlighted a lot of the strategies that are being employed now, on

pages 7, 8, and 9, loan workouts, loss mitigation techniques, repayment plans, temporary forbearance, loan applications, work with

community groups.

I note that Senator Schumer, Senator Brown, and I have worked

on legislation. But in addition to that, we pushed to have $100 million—we actually wanted $300 million in the budget, but we came

out with $100 million—to help fund these community groups that

are trusted by home owners and people within that community, but

also have some certifiable expertise.

So you highlight a lot of the strategies that banks and financial

institutions are employing, the work the Fed has done, the work

the Congress could do, especially with the Federal Housing Administration, and I say all that just as a preliminary backdrop to the

question:

If someone in Pennsylvania or any other State is watching your

testimony today, even though you have covered this broadly and

specifically, I would ask you just to restate what you can tell them

that you are trying to do, the Fed is trying to do, to deal with the

immediate impact. A lot of what we talked about here will prevent

this from happening again, we hope. We are working on that. But

what can you tell them now that the Fed is doing in the immediate

or near term to help those who have already been the victims of

not just the crisis, but the impact of the reset on their bottom line

families?

Chairman Bernanke. If I were speaking to someone in that situation, the first thing I would say to them is, ‘‘Get in touch with

your lender.’’

Experience shows that the earlier you get in touch, the more

quickly and more likely it is that you can resolve the issue. Indeed,

the banks tell us that one of their big problems is that nobody will

respond to their calls, and they find it very difficult.

So I would give that piece of advice to your constituents.

With respect to what the Fed is doing, obviously our first responsibility is to try to maintain a healthy economy, which will help reduce the costs that you allude to. But in addition, as I have discussed in my testimony, we are quite active.

As you know, we have Reserve Banks around the country, in the

different regions of the country, and we have been quite active in

working with those community groups that you mentioned, trying

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to help them identify strategies, help them identify communities

where the problems are most severe and where their efforts should

be concentrated trying to help with their training.

We have convened groups at the Fed and other places—I’ve spoken myself to many, many different people—about the barriers to

refinancing, for example, the accounting and other barriers.

The Fed was one of the first to bring forward this issue of FAS–

140 which is an accounting provision that can impede refinancing.

So in all these dimensions, we are doing what we can as a central

bank to assist in resolving this problem.

Your characterization—I read the JEC report and it properly

characterizes this as a very, very important problem that has implications not just for individuals, but for the broader economy as

well.

Senator Casey. Do you see any further interventions that the

Fed is planning or at least contemplated or seriously considered?

Chairman Bernanke. We hope that our actions to stabilize financial markets and the economy, will help the credit crunch situation we see now.

We still have to see that improve over time. It will be very nice

to see the secondary markets for prime jumbo loans, for example,

jump up again. We get to see more activity.

One of the problems right now is that creditworthy borrowers

who would like to refinance out of the subprime ARM are finding

it very difficult to do so, because of tightened credit terms.

Credit terms should be tight and underwriting should be good,

but to the extent that there’s an artificial reduction in supply of

credit associated with the financial market situation, we hope that

our policies would lead, over time, to a more normal, better functioning financial system.

Senator Casey. I have one more question. I want to turn to a

second chart. The staff of this Committee makes great charts, and

I want to make sure we use them.

[The chart referenced above appears in the Submissions for the

Record on page 59.]

This one is very simple, but profound in its impact. The gap—

and anyone who can differentiate between red and blue on this

chart, can see it—the gap between productivity, which has been

rising, as we see, since the late 1990s, compensation per hour rising, but not nearly as significantly.

That gap between the blue, the higher line, the blue line, and the

red line, I think, is an academic way of expressing profound frustration and anxiety that a lot of families feel. They feel that they

are working harder than ever before and the data supports that,

the productivity and output numbers support that, but their bottom

line is not growing.

And on top of the wage stagnation or failure to grow, they have

higher healthcare costs, even though they’ve leveled off; higher

costs in tuition and stories about an increase in fuel for the average

family, paying maybe 11 percent more this year that I saw in a report yesterday.

I ask you—and this is a tough question to answer briefly, but I’d

ask you to choose one of two options, because I know you have

some limitations on what you can say, but in the context of what

38

either Congress can and should be doing to reduce that gap between productivity and wage growth, or if you cannot make such

a recommendation, or don’t feel comfortable with doing that, just

a general philosophical statement about what can we do as a society and as a government, to try to bring those two lines together,

to have higher wage growth in the context of higher output.

Chairman Bernanke. I was asked a little earlier about what

Congress could do to address these problems. You pointed to some

of the issues that are hurting middle class living standards.

One, of course, is energy. That has been a big problem throughout this period. Certainly, I know that Congress is working on energy policies and trying to find ways to provide alternative sources

of energy that would be more economical in the long run.

You mentioned healthcare, where the costs continue to rise.

That’s part of our inflation issue, and we measure those costs in

our inflation index.

Certainly, there are numerous reforms that can be undertaken.

It is far too much to try to address in 15 seconds, to address that

very important problem. I’ve spoken on a number of occasions, and

this doesn’t directly address your issue, but certainly there’s a lot

of concern about the rise in inequality in our society, and part of

that, at least, is the result of the increasing return to high education and skills that we see in our modern technological, mobilized

economy.

And although it’s a medium- to long-term solution, I do think

that education and training and skill creation is critical for creating a broad base for prosperity in this country.

Senator Casey. Thank you very much, Mr. Chairman.

Senator Schumer. We want to thank you. I know you have to

leave at 12:20 p.m., but I just have a quick, quick question here.

In your testimony, you suggested that GSEs might be allowed to

securitize jumbo loans with the Federal Government acting as

guarantor. I think that’s a very good idea.

In fact, legislatively, it is something that I would try to introduce

and get passed. Do you have any idea of how high that ought to

go? For all loans, even two- or three-million-dollar loans?

Chairman Bernanke. That’s up to Congress, but, certainly——

Senator Schumer. What would be your thought?

Chairman Bernanke [continuing]. A million dollars.

Senator Schumer. Thank you, Mr. Chairman, for your patience. We had a series of votes. We very much appreciate your

being here.

[Whereupon, at 12:20 p.m., the hearing was adjourned.]

(39)

Submissions for the Record

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41

42

43

44

45

46

47

PREPARED STATEMENT OF REPRESENTATIVE ELIJAH E. CUMMINGS

Welcome Federal Reserve Chairman Ben Bernanke to this important hearing on

the U.S. Economic Outlook. As you know, this Committee has a broad mandate that

includes the duty to make recommendations about economic policy that affects each

and every American. It is with great anticipation that I welcome your testimony and

look forward to hearing your views about the state of our economy and how to prevent what tentatively looks like a forthcoming recession.

As you know, Mr. Chairman, you testified in our last hearing on the U.S. economy

in March of 2007 that you foresaw an upward swing in the U.S. market and you

believed that the potential fall out from subprime lending—or rather ‘‘predatory’’

lending—could be ‘‘contained’’ instead of spilling over to other industries, such as

the financial services and construction industries, amongst others.

However, despite your high hopes, the exact opposite has happened. The housing

and mortgage crisis has only worsened—with housing prices falling nationally for

the first time since the Great Depression. Making matters worse, the American people continue to suffer under a market where loosing ones home has become the

nightmare of 1 out of 5 homeowners with subprime loans, costing 2.2 million families their homes.

The stark reality is that we as Members of Congress see the results in the devastating experiences of our constituents. Anyone who walks through my district will

see family after hard-working family losing their homes because they were victimized by predatory subprime lenders. In fact, Maryland is currently ranked 22nd nationally in home foreclosures—compared to last year’s ranking of 40th adding to this

crisis the city of Baltimore has experienced a loss of $1.8 billion over the past 2

years in reduced property value.

The effects of the subprime lending crisis are rippling throughout the economy,

reflected in everything from the accelerating slump in housing markets across the

country to the summer’s global financial crises driven almost entirely by fears about

the collapsing subprime mortgage market. While continuing to jeopardize the overall

economy, the subprime crisis also continues to drive tens of thousands of families

out of their homes, constricting the flow of credit to millions of Americans and directly and indirectly affecting our financial services sector.

Investors in the financial sector have suffered from extreme losses that appear to

only be worsening. Morgan Stanley recently declared a $3.7 billion loss on subprime

mortgage-linked investments resulting in an expected $2.5 billion hit to its overall

net income. Even financial stocks have declined due in part to the effect of the

subprime lending crisis.

Although I applaud the Federal Reserve for their efforts to alleviate the negative

effects of the subprime crisis by issuing guidelines to be followed by lenders and

participating in programs like NeighborWorks America, a nonprofit organization

that helps thousands of borrowers who are facing current or potential distress in

obtaining assistance from their lenders, more needs to be done.

Therefore, I have a difficult time buying the picture of potential economic growth

being painted when I see people who may have lost their only chance in a lifetime

at home ownership.

All the while, Mr. Chairman, this Administration and President have continued

to spend U.S. taxpayer dollars unwisely. As you are aware, on Monday, October 22,

2007, President Bush requested an additional $46 billion for U.S. military operations in Iraq and Afghanistan. This is on top of the original $150.5 billion requested at the beginning of Fiscal Year 2008, bringing the total amount requested

to $196.4 billion—more than 10 times the original $50 to $60 billion cost estimated

by the White House in 2002. Meanwhile, the Administration is satisfied with continuing our military operations in Iraq—functioning on borrowed time and largely

borrowed money, costing an astounding 70 percent of an estimated 2.4 trillion in

taxpayer dollars over the course of the next decade according to the Congressional

Budgetary Office. The result is a limited budget to advance our priorities at home—

like aiding the increasingly unstable real estate market, advancing U.S. trade and

safeguarding a continued decline in the value of the U.S. dollar.

In fact, Mr. Chairman the dollar has declined 6 percent against the Euro since

August. However, the Euro is not the only currency rising against a falling U.S. dollar: the Australian dollar, the Japanese Yen, and the Canadian dollar are following

the same trend. Even in an address by the President of France, Nicolas Sarkozy in

a joint session to Members of Congress and the Senate made a striking warning

that ‘‘the dollar cannot remain solely the problem of others’’ and that if ‘‘we are not

careful, monetary disarray could indeed morph into economic war, and we would

all—all of us—be its victims.’’ And sadly—it appears that President Sarkozy’s warning has increasingly becoming our reality. Countries that hold large amounts of U.S.

48

dollars are already changing their currency reserves in favor of the Euro: Russia,

Switzerland, the United Arab Emirates and Venezuela are just few examples.

It is time that we focus on individuals—and on those who are being left behind

in our economy. According to data recently released by the Internal Revenue Service, Americans’ average income in 2005 was less than in 2000, the fifth consecutive

year in which this was the case—and the first period since World War II during

which incomes have not grown. We also see that income and wealth are becoming

increasingly concentrated in the hands of a very few. Thus, those making more than

$1 million received just under 50 percent of all the income gain that occurred in

2005. We need to focus on ensuring that we do not leave increasing numbers of our

fellow citizens behind as we work to move ahead.

Chairman Bernanke, I appreciate you appearing before us today. I look forward

to your testimony and learning what steps we can take to improve our dire economic

situation.

PREPARED STATEMENT OF REPRESENTATIVE RON PAUL

Our economy finds itself in a precarious state. Oil prices are rising, gold is nearing all-time highs, and the dollar is nearing all-time lows. The root of this crisis,

as with past financial and economic crises, results from Federal Government intervention into the economy, not to anything endemic to the market, nor to the actions

of market participants.

The collapse of the housing market has served as a catalyst for the economy’s latest bust. For years the Federal Government has made it one of its prime aims to

encourage homeownership among people who otherwise would not be able to afford

homes. Various Federal mortgage programs through the FHA, Fannie Mae, and

Freddie Mac have distorted the normal workings of the housing market.

The implicit government backing of Fannie Mae and Freddie Mac provides investors an incentive to provide funds to Fannie and Freddie that otherwise would have

been put to use in other, more productive sectors of the economy. It was this flood

of investor capital that helped to fuel the housing bubble.

Legislation such as the Zero Downpayment Act and the misnamed American

Dream Downpayment Act made it possible for people who could not afford down

payments on houses to receive assistance from the Federal Government, or even to

pay no down payment at all, courtesy of the taxpayers. The requirement of a down

payment has always helped to ascertain the ability of a buyer to pay off a mortgage.

It requires the buyer to show hard work and thrift, the ability to delay present consumption in order to make a larger acquisition in the future.

When this requirement is minimized or eliminated, you introduce a new class of

homebuyers, people who are unable to budget and save for the purchase of a home,

or who should wait for a few years until they have saved enough to purchase a

home. Federal policies have encouraged investors, lenders, and brokers to cater to

these people, so it is no surprise that market actors came up with ever more sophisticated means of bringing these people into the real estate market.

Finally, the Federal Reserve’s loose monetary policy and lowering of interest rates

were a major spur to the housing boom. Low interest rates influence marginal buyers, those who are sitting on the fence, and encourage them to take on a mortgage

that they otherwise would not. Even when interest rates are raised, no one expects

them to stay high for long, as there is always pressure from politicians and investors to keep rates low, as no one wants the cheap credit to end.

Thinking that interest rates will cycle from low to higher, back to low, lenders

begin to offer adjustable rate mortgages, 2/28’s, 3/27’s, and other sophisticated mortgages that may trap many unsavvy buyers. Buyers go short, lenders go long, and

many people have been burned as a result.

It is time that the Federal Government get out of the housing business. Through

our interventionist legislation we have caused the boom and bust, and any attempts

at reform that fail to address the causes of our current problem will only sow the

seeds for the next bubble.

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PREPARED STATEMENT OF HON. BEN S. BERNANKE, CHAIRMAN, BOARD OF

GOVERNORS OF THE FEDERAL RESERVE SYSTEM, WASHINGTON, DC

Chairman Schumer, Vice Chairman Maloney, Representative Saxton, and other

members of the Committee, thank you for inviting me here this morning to present

an update on the economic situation and outlook.

DEVELOPMENTS IN FINANCIAL MARKETS

Since I last appeared before this Committee in March, the U.S. economy has performed reasonably well. On preliminary estimates, real gross domestic product

(GDP) grew at an average pace of nearly 4 percent over the second and third quarters despite the ongoing correction in the housing market. Core inflation has improved modestly, although recent increases in energy prices will likely lead overall

inflation to rise for a time.

However, the economic outlook has been importantly affected by recent developments in financial markets, which have come under significant pressure in the past

few months. The financial turmoil was triggered by investor concerns about the

credit quality of mortgages, especially subprime mortgages with adjustable interest

rates. The continuing increase in the rate of serious delinquencies for such mortgages reflects in part a decline in underwriting standards in recent years as well

as softening house prices. Delinquencies on these mortgages are likely to rise further in coming quarters as a sizable number of recent-vintage subprime loans experience their first interest rate resets. I will have more to say about this problem and

its implications for homeowners later in my testimony.

At one time, most mortgages were originated and held by depository institutions.

Today, however, mortgages are commonly bundled together into mortgage-backed

securities or structured credit products, rated by credit-rating agencies, and then

sold to investors. As mortgage losses have mounted, investors have questioned the

reliability of credit ratings, especially those of structured products. Because many

investors had not developed the capacity to perform independent evaluations of

these often-complex instruments, the loss of confidence in the credit ratings, together with uncertainty about developments in the housing market, led to a sharp

decline in demand for these products. Since July, few securities backed by subprime

mortgages have been issued.

Although the problems with subprime mortgages initiated the financial turmoil,

credit concerns quickly spilled over into a number of other areas. Importantly, the

secondary market for securities backed by prime jumbo mortgages also contracted,

and the issuance of such securities has declined significantly. Prime jumbo loans are

still being made to prospective home purchasers, but they are at higher spreads and

have more-restrictive terms. Concerns about mortgage-backed securities and structured credit products (even those unrelated to mortgages) also greatly reduced investor appetite for asset-backed commercial paper, although that market has improved somewhat recently. In the area of business credit, investors shied away from

financing leveraged buyouts and from purchasing speculative-grade corporate bonds.

And some larger banks, concerned about potentially large and difficult-to-predict

draws on their liquidity and balance sheet capacity, became less willing to provide

funding to their customers or to each other.

To be sure, the recent developments may well lead to a healthier financial system

in the medium to long term: Increased investor scrutiny of structured credit products is likely to lead ultimately to greater transparency in these products and to better differentiation among assets of varying quality. Investors have also become more

cautious and are demanding greater compensation for bearing risk. In the short

term, however, these events do imply a greater measure of financial restraint on

economic growth as credit becomes more expensive and difficult to obtain.

FEDERAL RESERVE POLICY ACTIONS

At the height of the recent financial turmoil, the Federal Reserve took a number

of steps to help markets return to more orderly functioning. The Fed increased liquidity in short-term money markets in early August through larger-than-normal

open market operations. And on August 17, the Federal Reserve Board cut the discount rate—the rate at which it lends directly to banks—50 basis points, or 1⁄2 percentage point, and subsequently took several additional measures. These efforts to

provide liquidity appear to have been helpful on the whole, but the functioning of

a number of important markets remained impaired.

The turmoil in financial markets significantly affected the Federal Reserve’s outlook for the broader economy. Indeed, in a statement issued simultaneously with the

50

Board’s August 17 announcement of the cut in the discount rate, the Federal Open

Market Committee (FOMC) noted that the downside risks to economic growth had

increased appreciably.

The Committee took further action at its next scheduled meeting, on September

18, when it cut its target for the Federal funds rate 50 basis points. This action was

intended as a counterbalance to the tightening of credit conditions and to address

in a preemptive fashion some of the risks that financial developments posed to the

broader economy.

The Committee met most recently on October 30–31. The data reviewed at that

meeting suggested that growth in the third quarter had been solid—at a 3.9 percent

rate, according to the initial estimate by the Bureau of Economic Analysis. Residential construction declined sharply during the quarter, as expected, subtracting about

1 percentage point from overall growth. However, the GDP report provided scant

evidence of spillovers from housing to other components of final demand: Strong

growth in consumer spending was supported by gains in employment and income,

and businesses increased their capital spending at a solid pace. A strong global

economy stimulated foreign demand for U.S.-produced goods and services, as foreign

trade contributed nearly 1 percentage point to the growth of real output last quarter.

Looking forward, however, the Committee did not see the recent growth performance as likely to be sustained in the near term. Financial conditions had improved

somewhat after the September FOMC action, but the market for nonconforming

mortgages remained significantly impaired, and survey information suggested that

banks had tightened terms and standards for a range of credit products over recent

months. In part because of the reduced availability of mortgage credit, the contraction in housing-related activity seemed likely to intensify. Indicators of overall consumer sentiment suggested that household spending would grow more slowly, a

reading consistent with the expected effects of higher energy prices, tighter credit,

and continuing weakness in housing. Most businesses appeared to enjoy relatively

good access to credit, but heightened uncertainty about economic prospects could

lead business spending to decelerate as well. Overall, the Committee expected that

the growth of economic activity would slow noticeably in the fourth quarter from its

third-quarter rate. Growth was seen as remaining sluggish during the first part of

next year, then strengthening as the effects of tighter credit and the housing correction began to wane.

The Committee also saw downside risks to this projection: One such risk was that

financial market conditions would fail to improve or even worsen, causing credit

conditions to become even more restrictive than expected. Another risk was that, in

light of the problems in mortgage markets and the large inventories of unsold

homes, house prices might weaken more than expected, which could further reduce

consumers’ willingness to spend and increase investors’ concerns about mortgage

credit.

The Committee projected overall and core inflation to be in a range consistent

with price stability next year. Supporting this view were modest improvements in

core inflation over the course of the year, inflation expectations that appeared reasonably well anchored, and futures quotes suggesting that investors saw food and

energy prices coming off their recent peaks next year. But the inflation outlook was

also seen as subject to important upside risks. In particular, prices of crude oil and

other commodities had increased sharply in recent weeks, and the foreign exchange

value of the dollar had weakened. These factors were likely to increase overall inflation in the short run and, should inflation expectations become unmoored, had the

potential to boost inflation in the longer run as well.

Weighing its projections for growth and inflation, as well as the risks to those projections, the FOMC on October 31 reduced its target for the Federal funds rate an

additional 25 basis points, to 41⁄2 percent. In the Committee’s judgment, the cumulative easing of policy over the past 2 months should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time. Nonetheless, the

Committee recognized that risks remained to both of its statutory objectives of maximum employment and price stability. All told, it was the judgment of the FOMC

that, after its action on October 31, the stance of monetary policy roughly balanced

the upside risks to inflation and the downside risks to growth.

In the days since the October FOMC meeting, the few data releases that have become available have continued to suggest that the overall economy remained resilient in recent months. However, financial market volatility and strains have persisted. Incoming information on the performance of mortgage-related assets has intensified investors’ concerns about credit market developments and the implications

of the downturn in the housing market for economic growth. In addition, further

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1 Board of Governors of the Federal Reserve System (2007), ‘‘Working with Mortgage Borrowers,’’ Division of Banking Supervision and Regulation, Supervision and Regulation Letter SR

07–6 (April 17); and ‘‘Statement on Loss Mitigation Strategies for Servicers of Residential Mortgages,’’ Supervision and Regulation Letter SR 07–16 (September 5).

sharp increases in crude oil prices have put renewed upward pressure on inflation

and may impose further restraint on economic activity. The FOMC will continue to

carefully assess the implications for the outlook of the incoming economic data and

financial market developments and will act as needed to foster price stability and

sustainable economic growth.

HELPING DISTRESSED SUBPRIME BORROWERS

I would like to say a few words about actions being taken to help homeowners

who have fallen behind on their mortgage payments or seem likely to do so. As I

mentioned, delinquencies will probably rise further for borrowers who have a

subprime mortgage with an adjustable interest rate, as many of these mortgages

will soon see their rates reset at significantly higher levels. Indeed, on average from

now until the end of next year, nearly 450,000 subprime mortgages per quarter are

scheduled to undergo their first interest rate reset. Relative to past years, avoiding

the payment shock of an interest rate reset by refinancing the mortgage will be

much more difficult, as home prices have flattened out or declined, thereby reducing

homeowners’ equity, and lending terms have tightened. Should the rate of foreclosure rise proportionately, communities as well as individual borrowers would be

hurt because concentrations of foreclosures tend to reduce property values in surrounding areas. A sharp increase in foreclosed properties for sale could also weaken

the already struggling housing market and thus, potentially, the broader economy.

Home losses through foreclosure can be reduced if financial institutions work with

borrowers who are having difficulty meeting their mortgage payment obligations. In

recent months, the Federal Reserve and other banking agencies have issued statements calling on mortgage lenders and mortgage servicers to pursue prudent loan

workouts.1 Our contacts with the mortgage industry suggest that servicers recently

have stepped up their efforts to work with borrowers facing financial difficulties or

an imminent rate reset. Some servicers have been proactive about contacting borrowers who have missed payments or face resets, as experience shows that addressing the problem early increases the odds of a successful outcome. Foreclosure cannot

always be avoided, but in many cases loss-mitigation techniques that preserve

homeownership are less costly than foreclosure. To help keep borrowers in their

homes, servicers have been offering assistance with repayment plans, temporary forbearance, and loan modifications. Comprehensive data on the success of these efforts to avert foreclosures are not available, but my sense is that there is scope for

servicers to further increase their loss-mitigation efforts. The development of standardized approaches to workouts and the sharing of best practices can help increase

the scale of the effort, even if, ultimately, workouts must be undertaken loan by

loan. Although workouts are to be encouraged, regulators must be alert to ensure

that they are done in ways that protect consumers’ interests and do not disguise

lenders’ losses or impair safety and soundness.

The Federal Reserve has been participating in efforts by community groups to

help homeowners avoid foreclosure. For example, Governor Kroszner of the Federal

Reserve Board serves as a director of NeighborWorks America, a nonprofit organization that has been helping thousands of borrowers facing current or potential distress to obtain assistance from their lenders, their servicers, or trusted counselors

through a hotline. The Federal Reserve Board’s staff has been working with consumer and community affairs groups throughout the Federal Reserve System to

help identify localities that are most at risk of high foreclosures, with the intent to

help local groups better focus their outreach efforts to borrowers. Other contributions include foreclosure prevention programs, such as the Home Ownership Preservation Initiative, which the Federal Reserve Bank of Chicago helped to initiate, and

efforts by Reserve Banks to convene workshops for stakeholders to develop community-based solutions to mortgage delinquencies in their areas. The Federal Reserve

System is also engaged in research and analysis that should help inform policy responses to these issues.

The Congress is also focused on reducing homeowners’ risk of foreclosure. One

statutory change that could help is the modernization of programs administered by

the Federal Housing Administration (FHA). The FHA has considerable experience

helping low- and moderate-income households obtain home financing, but it has lost

market share in recent years, partly because borrowers have moved toward nontraditional products with more-flexible and quicker underwriting and processing and

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partly because of a cap on the maximum loan value that can be insured. In modernizing the FHA, the Congress might encourage joint efforts with the private sector

that expedite the refinancing of subprime loans held by creditworthy borrowers facing resets. It might also consider granting the agency the flexibility to design products that improve affordability through such features as variable maturities or

shared appreciation. Also, the FHA could provide more refinancing options for

riskier households if it could tailor the premiums it charges for mortgage insurance

to the risk profile of the borrower.

As I have discussed in earlier testimony, the Federal Reserve is taking steps to

avoid subprime lending problems from recurring while preserving responsible

subprime lending. In coordination with other Federal supervisory agencies and the

Conference of State Banking Supervisors (CSBS), we have issued principles-based

underwriting guidance on subprime mortgages to help ensure that borrowers obtain

loans that they can afford to repay and have the opportunity to refinance without

prepayment penalty for a reasonable period before the first interest rate reset. In

addition, together with the Office of Thrift Supervision, the Federal Trade Commission, the CSBS, and the American Association of Residential Mortgage Regulators,

we have launched a pilot program aimed at strengthening reviews of consumer protection compliance at selected nondepository lenders with significant subprime mortgage operations.

Finally, using the authority granted us by the Congress under the Home Ownership and Equity Protection Act, we are on schedule to propose rules by the end of

this year to address unfair or deceptive mortgage lending practices. These rules

would apply to subprime loans offered by any mortgage lender. We are looking

closely at practices such as prepayment penalties, failure to escrow for taxes and

insurance, stated-income and low-documentation lending, and failure to give adequate consideration to a borrower’s ability to repay. Using our authority under the

Truth in Lending Act (TILA), we expect that we will soon propose rules to curtail

abuses in mortgage advertising and to ensure that consumers receive mortgage disclosures at a time when the information is likely to be the most useful to them. We

are also engaged in a rigorous, broader review of the TILA rules for mortgage loans,

which will make use of extensive consumer testing of disclosures.

Thank you. I would be pleased to answer your questions.

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RESPONSE FROM CHAIRMAIN BEN BERNANKE TO WRITTEN QUESTIONS SUBMITTED BY

CONGRESSWOMAN LORETTA SANCHEZ

Q.1. Mr. Chairman, in your testimony you discussed specific Federal Reserve policy actions due to the recent financial turmoil. You mention increasing liquidity through larger-than-normal open market operations, cutting the discount rate by 50 basis points, and several additional measures.

What were the additional measures taken?

A.1. The chronology below shows the principal monetary policy actions and other

measures in financial markets that the Federal Reserve has taken over the past

several months.

August 10: Federal Reserve issued a statement reaffirming its commitment to pro- vide liquidity to facilitate financial market functioning and added $38 billion in reserves through three open-market operations largely collateralized by agency-issued

or agency-guaranteed mortgage-backed securities.

August 17: The Federal Open Market Committee (FOMC) issued a statement observing that the downside risks to growth have increased appreciably; the Federal

Reserve Board approved a 50 basis point reduction in the primary credit rate and

announced that term financing will be provided for up to 30 days renewable by the

borrower.

August 20: The Federal Reserve announced that it will redeem $5 billion in Treasury bill holdings from its System’s Open Market Account (SOMA) portfolio.

August 21: The Federal Reserve reduced the minimum fee rate for the SOMA Securities Lending Program.

August 23: The Federal Reserve clarified the eligibility and haircuts for collateral

that can be used to back discount window loans.

August 20 to October 23: The Federal Reserve approved the requests of several

large commercial banks for exemptions from Section 23A of the Federal Reserve Act

in order to enable the banks to lend to their securities affiliates to fund loans to

customers that hold substantial mortgage-related assets. The exemptions are available for the duration of the period that the special discount window term lending

arrangements announced on August 17 remains available.

September 18: FOMC reduced the target Federal funds rate by 50 basis points

to 4.75 percent. The Board approved a further 50 basis point reduction in the primary credit rate.

October 31: The FOMC lowered the Federal funds rate by 25 basis points to 4.5

percent. The Board approved a further 25 basis point reduction in the primary credit rate.

Q.2. You mentioned that you hope that policy responses to the credit crisis will not lead to an artificial tightening of credit. However, how concerned are you about artificially low interest rates?

A.2. The Federal Reserve recognizes that costs and risks can arise both from a

stance of monetary policy that is too tight and one that is too easy. Interest rates

that are too high given anticipated economic and financial conditions can lead to

subpar expansion in output and employment; interest rates that are too low can add

to inflationary pressures. The objective of the Federal Reserve in conducting monetary policy is to foster achievement of our statutory dual mandate of maximum employment and stable prices.

Q.3. Mr. Chairman, you declared that the Fed had not calculated the

chances of the economy moving in a recession. If you had to, what would

you say the odds are? We all know that the economy is going to slow as

the housing situation will continue for 2 years or more. What probable

event or events could take the economy over the edge into a recession?

A.3. Over the years, economists and statisticians have made a number of formal

efforts to predict recessions, and, hence, to assign odds to the likelihood of a recession occurring over a given time period. Unfortunately, these efforts have fared

poorly. In part, the difficulty arises from the fact that all recessions are different.

Although all recessions are characterized by declines in economic activity across a

broad set of indicators, each individual recession seems to stem from different

causes. Because economic conditions are different prior to and during each recession, it is difficult to find reliable indicators that help predict the next recession.

Moreover, the structure of the economy continually evolves, which adds to the challenge of predicting recessions. In particular, changes in technology, domestic and

international market structures, demographics, and economic policy over time result

in shifts in the relationships between economic indicators and economic outcomes.

Even though one cannot predict with reasonable confidence the probability of a

recession occurring over, say, the next twelve months, it is possible to identify some

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of the possible events that could pose downside risks to the performance of the economy. In that regard, I would point to the potential for a more severe contraction

in the housing sector as an important risk. In addition, it is possible that financial

market conditions could deteriorate significantly or that current tighter credit conditions could exert unexpectedly large restraint on household and business spending.

Nevertheless, it is important to keep in mind that during recent decades, the U.S.

economy had proved quite resilient to episodes of economic and financial distress.

Accordingly, although a good deal of uncertainty surrounds the economic outlook,

the pace of economic expansion seems likely slow in the near term and then should

return to a moderate rate over the course of the next year.

Q.4. With the markets reacting with so much volatility when only one, albeit large, sector of the economy takes a downturn, it appears that you are

exhibiting a confidence in the overall economy that is not entirely justified.

How long do you envision the housing sector to remain in recession? In

your calculations, what percentage of the overall economy is made up by

the housing sector?

A.4. Conditions in the housing sector are likely to be weak into 2008. This assessment reflects a number of factors. On the demand side, tightened terms and reduced

availability of sub-prime and jumbo mortgages has impaired the ability of some prospective buyers to obtain financing. In addition, some prospective purchasers apparently are reluctant to buy when they think that house prices will be weak or falling

for a while. On the supply side, the inventory of unsold homes is quite high relative

to sales. The overhang is likely to weigh heavily on construction activity as well as

the prices of both newly built and existing homes.

Moreover, as I mentioned in my prepared statement, on average from now until

the end of next year, nearly 450,000 subprime mortgages per quarter are scheduled

to undergo their first interest rate reset. Relative to past years, avoiding the payment shock of an interest rate reset by refinancing the mortgage will be much more

difficult, as home prices have flattened out or declined, thereby reducing homeowners’ equity, and lending terms have tightened. Should the rate of foreclosure rise

proportionately, communities as well as individual borrowers would be hurt because

concentrations of foreclosures tend to reduce property values in surrounding areas.

A sharp increase in foreclosed properties for sale could also weaken the already

struggling housing market and thus, potentially, the broader economy.

Finally, the housing sector typically is more cyclical than many other parts of the

economy; its share of overall activity tends fluctuate a fair amount over time. Over

the past quarter century, the nominal value of spending for residential investment

has varied between 31⁄4 and 61⁄4 percent of GDP, with an average of 41⁄2 percent.

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