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FINANCIAL CRISIS INQUIRY COMMISSION

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Official Transcript

Hearing on "The Shadow Banking System"

Thursday, May 6, 2010

Dirksen Senate Office Building, Room 538

Washington, D.C.

9:00 A.M.

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COMMISSIONERS

PHIL ANGELIDES, Chairman

HON. BILL THOMAS, Vice Chairman

BROOKSLEY BORN, Commissioner

BYRON S. GEORGIOU, Commissioner

HON. BOB GRAHAM, Commissioner

KEITH HENNESSEY, Commissioner

DOUGLAS HOLTZ-EAKIN, Commissioner

HEATHER H. MURREN, Commissioner

JOHN W. THOMPSON, Commissioner

PETER J. WALLISON, Commissioner

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Reported by:

PAGES 1 - 329

JANE W. BEACH

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Session I;

Perspective of the Shadow Banking System

HENRY M. PAULSON, JR., Former Secretary

U.S. Department of the Treasury

Session II:

Perspective on the Shadow Banking System

TIMOTHY F. GEITHNER, Secretary,

U.S. Department of the Treasury

Former President, Federal Reserve Bank

of New York

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Session 3:

Institutions Participating in the

Shadow Banking System:

MICHAEL A. NEAL, Vice Chairman, G.E. and

Chairman and CEO, G.E. Capital

MARK S. BARBER, Vice President and

Assistant Treasurer, G.E. Capital

PAUL A. McCULLEY, Managing Director

PIMCO

STEVEN R. MEIER, Chief Investment Officer

State Street

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P R O C E E D I N G S

CHAIRMAN ANGELIDES:

Good morning.

Welcome to

the second day of hearings by the Financial Crisis Inquiry

Commission.

As the members know and as the public know who

have been watching us, we have been exploring the shadow

banking system in this country and its effect on the

financial and economic crisis which has gripped this nation.

We have been focusing on the growth, development of this

system and the risks posed by it.

As we've said before, while there's significant

interest, obviously, in what was done to rescue various

financial institutions in the midst of the financial crisis,

the charge of this Commission is to examine the causes of

the crisis and to explore how risks to the system developed

in the first place, what could have been done, what should

have been done to prevent those risks from coming into

being.

We have a full day of hearing again today.

We are joined first of all this morning by former

Secretary of the Treasury, Henry Paulson.

no further ado, we will begin this hearing.

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And really, with

Unless, Mr. Chairman, you'd like to make an
opening remark also.
VICE CHAIRMAN THOMAS:

No.

I would just like to

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say that yesterday was useful.

to be useful.

Today has a real opportunity

I cannot recall in my four decades in which we

have two witnesses, both of whom were former secretaries of

the Treasury, one who had a background on Wall Street in one

of the major firms and the other secretary having a position

in the Federal Reserve in New York, so that we get a full

understanding based upon our ability to ask questions of

both sides of the street from two different perspectives

over a period of time which is obviously, as we now know in

retrospect, very significant in the history of the United

States.

And so I look forward to the testimony.

Thank you, Mr. Chairman.

CHAIRMAN ANGELIDES:

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Thank you, Mr. Vice

Chairman.
And as the Vice Chairman indicated, we will start

today hearing from former Secretary Paulson.

hear from Secretary of the Treasury Mr. Geithner.

we will have a panel later in the afternoon with

participants in the shadow banking system from GE Capital to

PIMCO to State Street Bank.

We will then
And then

With no further ado, Mr. Paulson, thank you for

being here this morning.

I'd like to ask you to stand for

what is a customary oath of office that we administer to

everyone who appears before us.

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If you would please raise your hand as I
administer the oath.

Do you solemnly swear or affirm under penalty of

perjury that the testimony you are about to provide the

Commission will be the truth, the whole truth, and nothing

but the truth to the best of your knowledge?

Mr. Paulson.

I do.

(Witness sworn.)

CHAIRMAN ANGELIDES:

Thank you very much.

Mr. Paulson, we have received your written

testimony, and we appreciate it very much.

like to ask you now to--we'd like to give you the

opportunity, and we'd like to obviously hear an oral

presentation by you.

time that you keep that presentation to no more than ten

minutes.

And we would

We've asked in consideration of the

I know you're familiar with testifying up here on

the Hill so you probably know there's a light on that box

that goes to yellow with one minute, to red when time is up.

And if you'd make sure your mike is on, you may commence.

WITNESS PAULSON:

Chairman Angelides, Vice

Chairman Thomas, and members of the Commission, thank you

for the opportunity to testify today.

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I served as Secretary of the Treasury during the
recent financial crisis.

I am proud of the work we in

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government did to save our nation's financial system from

collapse and chaos and our economy from disaster.

the crisis caused human suffering that simply cannot be

measured.

Even so,

The American people deserve, and policy makers

will benefit from, an understanding of the broad and diverse

causes of the crisis.

falls to this Commission, and it is an awesome

responsibility.

The job of providing that explanation

Many mistakes were made by all market

participants, including financial institutions, investors,

regulators and the rating agencies, as well as by policy

makers.

importantly, policy makers are currently addressing some

major regulatory structure and authority issues that allow

the pre-2007 regulatory structure and authority issues that

either--excuse me.

Most of these are well understood.

And

Policy makers are currently addressing these

regulatory structures that either allowed the pre-2007

excesses in our system or made it difficult to address the

crisis.

being addressed and remain sources of danger to our country.

I fully support your important mission and I hope

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Nevertheless, a number of the root causes are not

that my testimony today can assist it.
The roots of the financial crisis trace back to

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several factors, including housing policy, global capital

flows, over-leveraged financial institutions, poor consumer

protection, and an archaic and outmoded financial regulatory

system, among many other causes.

a housing bubble.

decisions shaped the home mortgage market.

Underlying the crisis was

And it is clear that several policy

Excesses in that market eventually led to a

significant decline in home prices and a surge of loan

defaults, which caused tremendous losses in the financial

system, triggered a contraction of credit, and put many

Americans quite literally out on the street.

were driven in large part by housing policy.

These excesses

From 1994 to 2006 home ownership soared from an

already spectacular 64 percent of U.S. households to a

staggering 69 percent, due to the combined weight of a

number of government policies and programs.

Freddie Mac, the government sponsored enterprises, comprised

a central part of the U.S. housing policy.

operated under an inherently flawed model of private profit

backed by public support, which encouraged risky revenue

seeking and ultimately led to significant taxpayer losses.

Fannie Mae and

The GSEs

The United States has always encouraged home

ownership, and rightfully so.

Home ownership builds wealth,

stabilizes neighborhoods, creates jobs, and promotes

economic growth.

But it must be pursued responsibly.

The

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right person must be matched to the right house and

consequently the right home loan.

the crisis we lost that discipline.

And in the years before

The over-stimulation of the housing market caused

by government policy was exacerbated by other problems of

that market.

five percent of total mortgages in 1994 to twenty percent by

2006.

Subprime mortgages went from accounting for

Consumer protection, including state regulation

of mortgage origination, was spotty, inconsistent, and in

some cases non-existent.

led to increasingly risky loans, including far too many home

loans made with no money down.

Speculation on rising home prices

Securitization separated originators from the

risk of the products they originated.

Mortgage fraud

increased and predatory lenders and unscrupulous brokers

pushed increasingly complex mortgages to unsuspecting

borrowers.

The result was a housing bubble that eventually

burst in a far more spectacular fashion than most previous

bubbles.

Global forces also played a significant role in

causing the crisis.

to massive and destabilizing cross-border capital flows.

Imbalances in the world's economies led

While other nations save, Americans spend.

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Consumption in this country is the norm, spurred on by low

interest rates, aided by capital flowing from

countries--notably China and Japan, which have high savings

and low shares of domestic consumption--and further

encouraged by U.S. tax laws that discourage saving.

We are living beyond our means on borrowed money

and borrowed time.

Consumers, businesses and financial

institutions all over-extended and over-leveraged themselves

with inevitably disastrous results while our federal and

state governments continued to borrow heavily, jeopardizing

their long term fiscal flexibility.

Our financial institutions, including commercial

and investment banks, were notable examples of this over-

leveraging.

sufficient high quality capital, which left them unable to

absorb the significant losses they incurred as the housing

bubble burst.

liquidity positions fully.

cash equivalents, and instead relied overly on short-term

funding sources that ran dry as the credit markets

contracted.

In general these institutions did not maintain

Many of them did not understand their
They held insufficient cash and

These leverage problems were further exacerbated

by a lack of transparency, which caused problems in subprime

to affect other classes of assets.

scare, a relatively small batch of deadly products secured

Like a tainted food

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by subprime mortgages led to fear and panic in the markets

for many mortgage securitizations, driving down the price of

assets which triggered huge losses and severe liquidity

problems.

Derivative contracts, including excessively

complex financial products, exacerbated the problems.

instruments embedded leverage in the institutions' balance

sheets, along with risk which was so obscured that at times

they were not fully understood by investors, creditors,

rating agency regulators, or the management themselves.

These

Very importantly, a number of financial

institutions had woefully inadequate risk management and

liquidity management practices that allowed these problems

to grow and intensify, in a number of cases leading to

failure of the institution.

Compounding the problems at these financial

institutions was a financial regulatory system that was

archaic and outmoded.

a different time for a different system, and it has not kept

pace with the rapid changes in the financial industry.

Our regulatory framework was built at

I noted during my time at Treasury the enormous

gaps in this authority, duplication of responsibility, and

unhealthy jurisdictional competition.

had responsibility for overseeing the stability of the

system.

No single regulator

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The result was that regulators were often unable

to supervise the firms they oversaw adequately.

not see the impending systemic problems that progressed

towards the crisis.

all the harms that unfolded as institutions began to

collapse.

They did

They did not have the tools to contain

In March of 2008 this led me to recommend a

blueprint for a major reform of our financial regulatory

system after a year-long comprehensive review.

I will turn now to the specific topics of today's

hearing, the shadow banking system, a term that refers to

the large capital and credit markets outside the traditional

banking system that provide credit for municipal

governments, corporations and individuals, for short,

intermediate and long-term funding needs.

Before the crisis these markets satisfied at

least half of the consumer and business credit needs and are

one of the hallmarks of our advanced and highly developed

capital markets.

spurred growth and prosperity at all levels of our economy.

They have greatly benefited our nation,

They have enabled more people to receive higher

education, more people to purchase homes, more people to

start new businesses, and more people to plan effectively

for their children's future.

choice, stimulated job creation, and allowed our system to

They have increased consumer

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diversify away from the large concentrated banks found in

other capital markets.

But like all activities in the financial sector,

these markets were fueled by the global excesses and

regulatory flaws I've already discussed.

hit the stress it placed on these markets exposed many of

these flaws.

exacerbated some of the effects of the crisis.

problems must be addressed.

When the crisis

And these flaws in turn extended and
These

Our financial system cannot

move forward without fortifying the weak parts of its

infrastructure.

In my written testimony I have addressed some

specific areas of concern and my suggestions for reform.

list is not exhaustive, and there are certainly other

problem areas in need of scrutiny.

problems, however, we must make sure we retain the benefits

of the underlying financial innovations.

In addressing these

In our haste to deal with the flaws in the non-

bank financial system we should not move ourselves back to a

system of consolidated monolithic commercial banks.

confident that a thoughtful process can achieve this.

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Thank you.

And I'd be pleased to answer any

questions.

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I am

CHAIRMAN ANGELIDES:
Secretary.

Thank you very much, Mr.

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We will now commence the questioning by members.

And we will start with me, and then the Vice Chair, and then

the balance of the members.

And I might say just one thing I noted yesterday.

And that is Commissioner Born and Commissioner Holtz-Eakin

have served as lead Commissioners for this series of

hearings and have done an excellent job, and I wanted to

note that.

Mr. Secretary, I have a number of questions for

you.

What I would like to--and they really focus on the

run-up to the crisis.

There has been, as I said in my opening remarks,

a lot of fascination with the bail-out, how the financial

system was stabilized.

Commissioners, the real question is how do we come to point

where the only options were either allow the financial

system to collapse or to commit trillions of dollars of

taxpayers dollars.

But for me, and I suspect some other

What I'd like to do to start, though, this

morning is ask you just a couple of questions with respect

to your role at Goldman before you became Treasury

Secretary, and then move on to your role as Treasury

Secretary.

During the time you were the CEO of Goldman from

January 1st, 2004 through June 1st, 2006, Goldman issued 19

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synthetic subprime CDOs, totaling about $8.4 billion.

Let me first ask you, because this goes to the

shadow banking system, it goes to the system as a whole,

what's your sense, if any, of the--what's your sense of the

value, if any, of synthetic CDOs in our financial system?

Do they provide any real capital or benefit to the system,

or are they merely a device for betting in terms of results

on the system?

that provide capital and liquidity of benefit to the real

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Are they bets or are they actually devices

economy?
WITNESS PAULSON:

Mr. Chairman, a number of times

I have said that I believe that we had excessive complexity

in financial products, and that as I think about it, it's

very hard to regulate against innovation.

I think one--one of the things that I've

recommended for a number of years now is that when we look

at some of these complex derivative products, some of these

products that regulators make sure that we have real

substantial capital charges against these products.

Now in terms of the deals you're talking about, I

don't remember the particulars of those particular products.

CHAIRMAN ANGELIDES:

Do you think that they

provide--just the core issue:

Do you believe they provide

real benefit to the financial system and to the economy, the

real economy as a whole, or are they just outside bets that

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WITNESS PAULSON:

Well, I would say this:

To get

at market-making--because I think there's been a lot of

discussion about market making--and one of the things I

saw--and again I haven't been in the business for four

years--but one of the things I saw was that clients

increasingly were asking Goldman Sachs and other banks to

provide capital and to help them manage risk.

just many examples of that.

And there are

And, you know that business I think is a very

legitimate business, a very beneficial business.

needs to be done with very high standards, great integrity,

and in a way in which you're working for your clients'

interests.

And it

And I was, you know, thinking this morning about

this hearing and thinking of all of the situations where a

client, you know, a major sovereign nation was worried about

the prices of oil rising and would come to an investment

bank and look for a way of protecting themselves against

that risk.

the prices--the oil prices going up.

would be more concerned about oil prices going down.

Or an airline that was worried about, you know,
The sovereign nation

So there are many situations where customers want

their investment banks to help them manage risk.

think that's a very legitimate function.

And I

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CHAIRMAN ANGELIDES:

Do you think it's legitimate

if there's no underlying interest, like you mentioned the

underlying interest:

fuel, other entities that may have, you know, a commodity

against which they may hedge because they utilize it.

obviously airline company with oil

WITNESS PAULSON:

Well, I would say this:

think of all of the times when I was in the business where

we employed hedges.

of prudent risk management is firms hedging securities that

I actually think best practice in terms

they have on their balance sheet.

CHAIRMAN ANGELIDES:

WITNESS PAULSON:

All right.

I think of underwritings of

securities where the investment bankers or bankers needed to

take a short position which was part of the offering process

to make sure that there is a stable market.

You know, there are--you know, in the housing

there's no reason why that someone who wants to put in a

hedge in terms of protecting themselves against housing

prices going one way or another shouldn't be able to do so.

To me that's a very important function of a market-maker.

So I think what we want to do is we want to

separate the function and the market making function, which

needs to be done with the very highest standards, the very

highest not only in terms of compliance with the laws but

doing it in a way which it inspires and keeps client trust,

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and separate that from, you know, from activity that is not

done properly.

And investment banks or banks can make mistakes,

commit fraud in a whole variety of areas.

on the legitimate role that market making plays in the

capital market.

CHAIRMAN ANGELIDES:

All right.

But let's focus

Let me ask you a

very quick question because I want to get to the meat of

this in terms of your role as Treasury Secretary, the run-up

to the crisis.

But let me ask you one quick question since you

raised the standards of conduct.

much in the role as a market maker.

not going to refer to a specific case that's been lodged by

the SEC against Goldman.

And I want to ask not so
But obviously--and I'm

But do you think it's appropriate when an entity

is underwriting a security that it would contemporaneously

bet against that security on issuance?

Improper?

WITNESS PAULSON:

Is that appropriate?

Well, I would just simply say

that any transaction that is done in a marketplace has got

to be done with the highest standards, fair dealing, and

making appropriate disclosures.

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Now in terms of--when you say betting against or
shorting, as I said, I can think of, you know, when I was in

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the business we managed--we sold securities in the public

market.

process.

position.

That was a legitimate function and it's done to make sure

there's a stable market.

You sold securities as part of an underwriting

The syndicate or the underwriter had a short
Okay?

Is that betting against the security?

Frankly, every one of these market making

transactions where--or many of them--the client or the

customer expects the banker to take the other side of the

trade to help them manage risk, commit capital.

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CHAIRMAN ANGELIDES:
in your mind --

WITNESS PAULSON:

CHAIRMAN ANGELIDES:

WITNESS PAULSON:

Complete disclosure is what

I said appropriate disclosure

is what I think.

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Well --

you think is elemental.

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And so complete disclosure

CHAIRMAN ANGELIDES:

All right.

Well, I don't want to put words in your mouth.

Okay.

Let's move on.

I wanted to just ask about

this.

Let me talk about Treasury Secretary.

know, but the Treasury Department, according to the website,

is responsible for--quote:

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Obviously you

"...ensuring the financial security of the United
States."

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You were head of the President's Working Group on

Financial Markets and in that regard did bring forward the

blueprint plan.

But one of the things I'm trying to get to is

what didn't we know.

future crises, we can have organizational structures, but

the real question is are we going to be able to pick up on

the warning signs.

And looking forward to the risk of

You note in your book that there was the August

17th meeting, I think, a couple of months after you get

appointed where you indicated in that meeting, August 17th

at Camp David, that--quote:

"My number one concern was the likelihood of a

financial crisis.

disruption."

I was convinced we were due for another

So here's what I want to ask you.

By the end of 2006 the leverage ratios at, you

know, Bear Stearns have hit 32 to 1, Goldman 31 to 1, Morgan

Stanley, 36 to 1, Lehman Brothers 34 to 1--not counting for

balance sheet management.

In the spring of '07, which is obviously a little

later than that date when you were at Camp David, the ratio

of level three assets, the liquid assets, assets that are

hard to price because there's no discernable market price,

at Bear Stearns are 269 percent of tangible common equity,

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at Lehman 243, at Goldman 200, at Morgan Stanley 266.

investment banks--and just as a set; they're not necessarily

unique--have been growing like weeds:

a year compounded annual growth rate, Morgan Stanley about

15 percent, Merrill Lynch 18 percent.

The

At Goldman 26 percent

And as you point out in your testimony, there are

warning signs that abound.

trying to fight, in early 2000 before you become Treasury

Secretary, deceptive and unfair lending.

preempted by the OCC.

epidemic of mortgage fraud.

States all over the country were

They were

In 2004 the FBI warns about an

I held this up yesterday.

The Economist has an

article cover called Housing Prices After the Fall, which is

in 2005.

closer at hand; it's not going to be pretty.

current housing boom ends could decide the course of the

entire world economy over the next few years.

prices are moving up in 2003 at eleven percent; 2004 fifteen

percent, 2005, fifteen percent.

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The lead of the story says the day of reckoning is
How the

Housing

You note in your testimony that subprime lending
has exploded to be 20 percent of the market.
And by 2006 mortgage debt between 2000 and 2006

has doubled in this country.

We have borrowed more in those

six years in mortgage debt than the whole 225 years in this

country's history.

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There's knowledge of the opaque natures of

derivatives.

in the market.

There's knowledge of a lot of the instruments

So here's my fundamental question:

What didn't

you and other policy makers know when you came into office--

I guess my question is:

that would have allowed both policy makers and corporate

leaders to begin to mitigate risk?

What was the missing information

WITNESS PAULSON:

Well, Mr. Chairman, I think

with all due respect I began immediately to work to mitigate

risk--that within the confines of the fact that Treasury

Secretary has no direct responsibility for regulating

entities or markets.

But as you noted, I saw immediately the huge

gaping holes in the regulatory system.

several actions immediately.

And so I took

Number one, regular quarterly meetings of the

President's Working Group so regulators could immediately

begin sharing information; figuring out how to work together

to fill in the gaps.

Now there was work done there right away on

looking at the margin requirements that--and the amount of

credit extended between the, for instance, the regulated

entities and hedge funds.

later.

I can come back to that more

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Secondly, I immediately started working with

Congress to complete regulatory reform legislation for

Fannie and Freddie, which had been stalled by politics for

years.

review.

pressing market participants to strengthen their

infrastructure in areas like OTC derivatives, areas like

that.

So I think we were on it.

And then I commenced this review, this regulatory
And out of this review came the blueprint.

And then ultimately we came out with the blueprint.

Now in terms of the excesses you talked about,

they are there.

away.

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It came

You couldn't push a button and have them go

The bad loans have been made.
CHAIRMAN ANGELIDES:

We had --

Was the toothpaste out of

the tube by the time you arrived, in your estimate --

WITNESS PAULSON:

CHAIRMAN ANGELIDES: --to coin a phrase that was

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I would say --

used thirty-some years ago by someone else?
WITNESS PAULSON:

I would say most of the

toothpaste was out of the tube.

And there really wasn't the

proper regulatory apparatus to deal with it.

CHAIRMAN ANGELIDES:

All right.

But my central question, I understand--I really

had two and you really got to the second.

But was there--by

the time you arrive is the information that you need--and

essentially financial industry leaders--it's on the table by

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2006.

hearings.

surprised; it's a tsunami.'

you have warnings ahead of time.

Because, you know, we've heard a lot in these
We've heard a lot about 'We're shocked, we're

WITNESS PAULSON:

But even when a tsunami comes

Yeah, but what was--Let me tell

you what wasn't clear to me.

And I don't think it was clear

to very many people, if any, when I arrived.

the scale and the degree of the problem.

And that was

And, for instance, if you, you know, referring to

the book, if you're going to refer there, the President said

to me, 'What will cause the crisis,' okay?

wish I knew.

is.

And I said, 'I

It will be obvious after the fact; it always

No one predicted the Russian crisis.'
Now what was--we could see some of the problems

in for instance subprime and housing.

that I was talking to--predicted this massive decline in

housing prices throughout the United States.

asked myself why--why wouldn't people have predicted that;

why wouldn't experts have predicted it.

But no one--at least

And when I've

And I think it was because we were all looking

through the paradigm that we'd had in this country since

World War II where residential housing prices have

essentially gone up, mortgages were safe investments.

so the economic models didn't project the kind of wholesale,

you know, significant decline in housing prices.

And

And so

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that was I think the--that was the thing that people didn't

predict.

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But having said that, you know, if we'd seen that
coming I'm not sure what we could have done differently.

CHAIRMAN ANGELIDES:

Even though--and this isn't

with respect to you--even though by the time all the write

downs are happening in places like Citigroup and other

institutions at the end of '07, prices have only fallen five

percent and they had fallen two percent I think in the early

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'90s.

But I see your point.
But would this be a fair characterization:

That

people knew a storm was coming.

People were concerned that

the levies were weak and hadn't been tested, and that--Is it

fair to say there wasn't a plan in place to deal with the

crisis that was inevitable?

WITNESS PAULSON:

Well, there wasn't a plan in

place when I arrived.

because I think the only plan that I know how to put in

place was to get the regulators together with a very--taking

a different approach to the President's Working Group and

with regular meetings where we started working immediately

on what we thought the issues were going to be and how to

respond to them.

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I think we put a plan in place,

And to get working on--you know, I believe to
this day that the most effective thing that anyone has done,

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either from the time I was there or since I've left, to deal

with housing has been the actions taken with Fannie and Freddie.

I think that's been the most effective to sort of stem that

decline in home prices.

right away.

And we started working on that

CHAIRMAN ANGELIDES:

All right.

I'm going to

stop right now.

leave, I have some very specific questions about Fannie and

Freddie, a couple of them.

I actually, when I close up before you

But I want to stop right now to

get to other Commissioners.

All right.

WITNESS PAULSON:

CHAIRMAN ANGELIDES:

VICE CHAIRMAN THOMAS:

That presented a whole bunch of questions that I

Thank you, Mr. Secretary.
Thank you.
Mr. Thomas.
Thank you.

hadn't planned on in terms of that discussion.

But I do want to start also with you, Mr.

Secretary, at Goldman, not for any specific recollection of

product.

One of the things I'm trying to better understand

since I don't have any familiarity with the relationships in

these institutions on Wall Street--if you asked me about

Congress I could tell you a whole lot about things that

people don't normally appreciate result in

decisions--especially small group dynamics, interpersonal

26
1

relationships, the old business of who gets what, when and

how on accommodations, which are fundamental to any

democracy in terms of quid pro quos and other structures

that are simply there that make the system work.

What I don't understand is the relationship

between institutions--especially in the so-called shadow

banking area--because to me it's remarkable that there

existed this healthy and growing structure based upon very

short term financing overnight, a number of institutions

doing that so you were sharing the grazing in the pasture.

And yet, as has been indicated in terms of Goldman with the

current CEO and others, that you would take opposite sides

in terms of market making, that was within the institution.

I'm trying to understand a relationship between

institutions, not so much in an institution, because clearly

if you're the largest you can be on both sides and play

various roles by virtue of your size.

you may have to be more dependent on others.

this business of to what extent was there a symbiotic

relationship with other firms, notwithstanding the fact

they're your competitors, or was it pretty much predatory

and that's one of the reasons the smaller ones went first.

But if you're smaller
And so it's

Because going back to the congressional example,

I could be fundamentally opposed to someone on one day on an

issue.

That issue is dispensed with.

And the next day we

27
1

wind up on the same side.

folks when they first come is you can be opposed to somebody

but if you're locked in opposition to that individual you're

going to miss a lot of opportunities to actually advance

some of the things that you're interested in.

So one of the things you tell

From your perspective, what was the culture?

Predominantly--I mean it had to be to a degree symbiotic,

didn't it?

WITNESS PAULSON:

Well, let me--I think, Mr. Vice

Chairman, what you were getting at when you talked about the

infrastructure and you talked about secured lending was the

repo market and secured lending.

little bit about that because I think it might help.

And let me just talk a

That many financial institutions--not just the

traditional investment banks--had to rely on wholesale

funding for a big part of their funding.

deposits.

market that grows up--which is a very healthy thing because

you shouldn't--you wouldn't want everyone having to rely

only on the banks for their wholesale funding.

is secured lending.

protected during bankruptcy because their collateral is

protected.

24
25

It wasn't all

And so you have this secured lending or repo

And so repo

And the lender is at least partly

I think the way you need to think about this--and
there's a market where two parties can deal with each

28
1

other--there are many sophisticated institutions--some

sophisticated, some less sophisticated--that wanted to

invest money.

money market funds, governments.

And a safer way to do it would be to enter into a secured

lending arrangement with a Wall Street firm.

You know, some of them are pension funds,
They want to invest money.

Now they could do that directly or they could do

it through a, you know, have a custodian administer it and

then handle the collateral so it would be a tri-party repo.

But that is the way it was done.

Now what happened--and here is what I think gets

to your question.

quickly with no single regulator having a purview of it, no

one looking at it and being able to get the information on

the whole thing.

a--systems didn't keep up with it; the infrastructure didn't

keep up with it, with the procedures.

got sloppy in their credit decisions.

What happened was this grew very, very

So it grew like topsy-turvy.

There was

And the participants

So it's one thing if I'm a money market fund and

I'm lending to a bank and I'm taking treasuries as

collateral.

asking for no margin, no haircut, that's a sloppy kind of

provision.

24
25

If I'm taking mortgage securities and I'm

So now what happens is this is growing up.
are excesses.

There

And I would say to the Chairman, this was

29
1

something that I was not aware of, the extent of the issue.

I had seen it through one little lens at Goldman Sachs.

so that this big market had grown up; no regulator looked at

it.

And

So now when the crisis comes and investors are

afraid, there were a number of--and so they're concerned

about Bear Stearns.

is--when you say it's predatory, these people--if someone is

afraid and they're afraid about their own institution

They lose confidence.

Then this

surviving, then they pull money out, or they don't roll over

their secured lending.

investors that don't know what to do with collateral if they

got it; they're just really looking at the underlying

credit.

Why?

Because there's certain cash

So again this was a shadow market that is a very

valuable market, should continue to be a valuable market.

It needs to be fixed.

fixed.

by a regulatory system.

Okay?

It just plain needs to be

And so there were mistakes made there by regulators,
Sloppy practices by practitioners.

And then the biggest sloppy practice of all were

the banks and investment banks if they didn't maintain

liquidity cushions.

Everybody talks about capital.

But to me the

biggest lesson I learned out of all of the crisis was the

lack of focus by so many market participants and by

30
1

regulators on the importance of liquidity.

place huge reliance on any short term overnight market if

you don't ask yourself, 'What am I going to do if that

market doesn't function as normal; how much of a cushion do

I have.'

VICE CHAIRMAN THOMAS:

And you cannot

Well, but wouldn't every

one of those institutions go to bed that night not only

worrying about themselves but others because they depend

upon this kind of short-term --

10
11

WITNESS PAULSON:
until they did.

Only--See, they didn't worry

It's hard to explain this.

VICE CHAIRMAN THOMAS:

But I had --

I don't think it's all

that hard if you use other examples.

For example, obviously

Bear Stearns and all the others thought they were liquid

until they tried to put up the assets.

felt comfortable--or other people felt comfortable with were

treasuries.

The only ones they

But the idea that an economic model in terms of

mortgages, didn't anyone look at how much--what a mortgage

was changed between the '50s, the '60s, '70s, '80 and to now

that there was significant erosion in any comfort level on

how long a mortgage could last given the rules.

Let me give you a quick example.

I represented a

big area, there's a lot of desert.

And folks would run in

the spring, when there was enough grass out in the desert,

31
1

sheep.

We began to see a fairly high loss of desert

tortoises.

wanted to put Styrofoam tortoises out in the desert when the

sheep were running on the grass to see what kind of an

interaction there was.

So the BLM wanted to run an experiment.

They

And so I told them that my sheep men would be

ready to put their Styrofoam sheep out in the desert when

the BLM was ready to put its Styrofoam tortoises because you

didn't get a decent understanding of the relationship.

When you rely on--And I want to talk about rating

agencies in a minute--someone giving a AAA rating to a

package which fundamentally was so much different than

earlier packages, and you rely on that AAA rating, at some

point doesn't somebody look at the underlying problems?

What happened, frankly, in the desert was the

crows, as population encroached on the desert the crows

followed and they'd go out and flip them over in the morning

and have a warm meal in the evening.

unless you controlled the crows, you were never going to

solve the problem.

And until and

And here the crow flipping it over, everyone

argues that we didn't have a model that could tell us what

was happening.

which people were operating, which brings me to the

question:

I just don't understand, given the level at

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1

When you became Secretary of the Treasury,

looking at it from not your narrow perspective but the

broader scope, were you shocked at the amount of weight

placed in the portfolios on these risky mortgage packages?

WITNESS PAULSON:

I was --

VICE CHAIRMAN THOMAS:

WITNESS PAULSON:

Yeah.

Were you surprised?
I'll tell you what

surprised me, which is related to your question that, as you

said, there was the rating.

But a number of the firms--you

know, I in my testimony and a number of people have talked

about its importance that those who underwrite

securitizations have some skin in the game, hold some of the

securities they underwrite.

I think that's important.

But where the big problems were, were a number of

institutions--two or three institutions that, not only did

they have skin in the game they had half their body in the

game because they had huge positions of these, out-size

positions that were over-weighted.

rated AAA.

And so --even if they're

And so I think one of the lessons of this, which

gets to your point, is that it is very hard for experts, any

experts to know anything with certainty.

been predicting this crisis for years.

predicted it, hedged themselves, and lost a lot of money.

People could have
And they could have

But it's foolhardy to tie up a lot of any

33
1

institution's balance sheet on any particular security, no

matter how high the rating is, unless it's, you know, a U.S.

government security.

VICE CHAIRMAN THOMAS:

Well, is that what

happened?

Because what I'm trying to figure out is how could the

weight of the securities that were created, supported by the

mortgage market pull down the commercial paper market, the

repo market, the auction rate securities market?

WITNESS PAULSON:

VICE CHAIRMAN THOMAS:

No, I understand.

But how

was it interconnected?

15
16

Well, that's a different--I was

just --

13
14

Was it

that big?

11
12

They tied so much up in the mortgage market?

WITNESS PAULSON:

There were several institutions

that owned too much of the paper.

But to get to your point, what happened, I think

the way to think about this is this--and I think this is

quite critical.

The subprime market by itself was a relatively

small--relative to the U.S. economy or to the U.S. capital

markets.

excesses, as we've talked about, in housing and across the

markets more broadly.

And the problem was much bigger.

There were

So one--you used an analogy of the desert.

I'll

34
1

give you an analogy that's used a lot.

dry tinder out there.

subprime.

lot of other excesses.

And there were a whole lot of things coming together to

create this crisis.

Okay?

There is a lot of

And the driest tinder was

That's where the fire started.

But there were a

And that is really what happened.

VICE CHAIRMAN THOMAS:

In terms of the rating

agencies, we have legislation now from both the House and

the Senate.

Are you familiar enough with that legislation

to have any opinion as to whether it's useful, directed,

effective in dealing with rating agencies?

WITNESS PAULSON:

I would say in terms of the

rating agency piece of this, I agree with one part of the

legislation which I think is controversial to certain

people.

regulated--and we need more regulation and we need more

disclosure and we--around the rating agencies.

I think it--no matter how the rating agencies are

I do not like the fact that we have several

rating agencies that are enshrined in our securities laws,

in regulatory manuals, and so on, and that ratings are

referred to.

dangerous crutch.

banks relied overly on a rating.

24
25

And so I think that's just a crutch and a
And I think too many investors, too many

And I'm all for the rating agencies; I think
there should be independent rating agencies.

They should

35
1

give their advice just like equity research houses do.

And

I think investors should look at those as one tool.

do not like the fact--and I support the legislation that

would take reference to credit ratings out of our securities

laws.

But I

VICE CHAIRMAN THOMAS:

All right.

The Senate would create an office within the SEC

to administer credit rating agencies' rules and practices.

Good move?

10
11

WITNESS PAULSON:
move.

12
13

VICE CHAIRMAN THOMAS:

16
17

House creates a seven-

member advisory board for credit rating agencies.

14
15

I think it's probably a good

WITNESS PAULSON:

I haven't really thought about

it.
VICE CHAIRMAN THOMAS:

But it's safe, isn't it?

I mean that's...

WITNESS PAULSON:

Yeah, it's...

VICE CHAIRMAN THOMAS:

WITNESS PAULSON:

VICE CHAIRMAN THOMAS:

You could get unanimous.

It -Both bills would require a

measure of certification that due diligence has been done by

someone, but neither one talks about who would pay for it

and its structure.

of some regulatory structure.

So again, it's going to evolve outside

36
1

WITNESS PAULSON:

Yeah.

It will--I will say

this:

oversight and regulation--no matter how you regulate them,

it will not be flawless.

No matter how you regulate this--and it needs more

It's hard to believe that anyone at a rating

agency is always going to be able to see the issues that

others don't see.

VICE CHAIRMAN THOMAS:

WITNESS PAULSON:

No.

I understand that.

And so therefore that's why I

want to get to something which is much more basic than that.

I don't want the rating agencies to be held up as the font

of all truth and be--and have the ratings be part of our

securities laws.

VICE CHAIRMAN THOMAS:

Then my only question left

is, just out of curiosity, how come you didn't put more

emphasis on the rating agencies in your testimony?

you mentioned it, but...

WITNESS PAULSON:

VICE CHAIRMAN THOMAS:

20
21
22
23
24
25

I mean

Because I -Do you think you gave it

due weight in terms of -WITNESS PAULSON:
terms of shadow banking.

No, I thought that this was in

Yeah, I have --

VICE CHAIRMAN THOMAS:

But you gave an overview

at the beginning of your testimony.
WITNESS PAULSON:

Right.

Well, I've written

37
1

about it quite a bit --

VICE CHAIRMAN THOMAS:

Right.

WITNESS PAULSON: --in my book.

And so I do think

the rating agencies made plenty of mistakes.

fell into the same paradigm that so much of the rest of the

world did.

what happened.

8
9
10

I think they

They used economic models that didn't foresee

VICE CHAIRMAN THOMAS:

But everybody has used

that as an excuse in terms of not knowing the true value of
what they held and tried to trade.

WITNESS PAULSON:

Yes.

So clearly the rating

agencies in terms of--and I made a number of strong

recommendations, actually even before Bear Stearns went

down, with the President's working group about the kind of

disclosures you need to see from the rating agencies and the

kinds of processes they need to run, and the regulatory

oversight.

What I was just trying to get to was --

VICE CHAIRMAN THOMAS:

WITNESS PAULSON: --something which was more

21
22

Right.

fundamental than that, which is:
I don't want to see a situation ever again where

a whole lot of sophisticated people can just turn and say,

'It's not my fault; it was the rating agencies.'

I want investors and big banks and regulators to

38
1

be forced to use rating as one tool, but do some of their

own work and do some thinking for themselves.

VICE CHAIRMAN THOMAS:

Thank you, Mr. Secretary.

And could I ask you--would you be willing to

respond in writing to any other questions the Commission

might have as we go forward?

learning as we go.

8
9

WITNESS PAULSON:

Of course.

Okay?

respond.

So I will--I no longer have these--but I will

VICE CHAIRMAN THOMAS:

Thank you.

CHAIRMAN ANGELIDES:

Ms. Born.

COMMISSIONER BORN:

We'll try to write

questions that can be answered by one assistant.

I just hope you

will understand that now my staff consists of one assistant.

Because, frankly, we're

Thank you.

Thank you very much, Chair

Angelides.
And I want to express my thanks to you, Mr.

Secretary, for being willing to meet with us and help us in

our investigation.

The first area that I wanted to ask you about is

over the counter derivatives.

I fully agree with you that

derivatives are extremely important instruments in managing

and hedging risk and play an invaluable role in that

39
1

respect.

Nonetheless the over the counter derivatives

market had grown to more than $680 trillion, a notional

amount by the time of the crisis in the summer of 2008.

it was virtually exempt from federal regulation and

oversight because of a statute past in 2000, the Commodity

Futures Modernization Act, which had eliminated jurisdiction

of the federal agencies over the market.

And

I wanted to ask you whether in your view this

regulatory gap played any role.

testimony derivative contracts including excessively complex

financial products exacerbated the problem during the

financial crisis.

that testimony.

You've said in your

And I wondered if you would elaborate on

WITNESS PAULSON:

Well, first of all, I think

your point is well taken.

And in the chapter that the

Chairman referred to in my book, when we had that first

conversation with the President about the potential of a

credit crisis--and the topic I talked about then was over

the counter derivatives and how quickly this had grown,

citing the same numbers you cited and just talked about them

being outside of the regulatory purview.

have at the time the right protocols for how they would

function in a crisis, and, you know, the netting agreements

and there were big back logs of really unbooked trades.

And we didn't even

40
1

So there was a lot of work being done by the Fed

at that time.

the industry.

And I was very supportive in terms of pushing

Now I think that these, first of all, these

products, they didn't create the crisis but they magnified

it and they exacerbated it.

in which it's been written about a lot in terms of the

interconnectivity, but just in terms of masking the risk.

They were so opaque and complex and difficult to understand.

And I think not only in the way

I had certain regulators when I arrived saying

that the system wasn't that leveraged because they were

looking at just the debt as opposed to what was embedded in

those products.

that is why I so strongly believe that you want to

press--standardization is in all of our interest.

Those products are hard to understand.

And

And so the way you I think get toward

simplicity--complexity just in general I think is our enemy.

You can't--it's hard to regulate against complexity and

innovation.

So I think the way you do this is you press

everything is standardized onto an exchange.

And the over

the counter you put through a central clearinghouse where

you've got great oversight.

complex there, you put big capital charges so you penalize

complexity, which will help move toward greater

And then you have, if it's

41
1

standardization.

And I think that's really the right way to deal

with it.

that as a concern. But it's not--those people that would say

it was the fundamental cause I think are wrong.

It's just something that needs to be fixed.

that it looks like some of the, you know, legislation is on

the way to fix it.

And I think you're right on in terms of seeing

COMMISSIONER BORN:

It's not.

And I'm hopeful

With respect to the remaining

over the counter market, assuming regulations are applied

that would put standardized contracts onto exchange, would

you advocate more transparency for that market?

WITNESS PAULSON:

that would solve so much.

regulators had no idea.

Yes.

That is--In this

And, you know, as you well know,
Industry participants didn't know.

You know, just taking General Motors as an

example, everyone knew how many General Motors bonds were

outstanding.

swap contracts were out there on General Motors bonds.

No one had any idea how many credit default

COMMISSIONER BORN:

WITNESS PAULSON:

COMMISSIONER BORN:

WITNESS PAULSON:

And so to me I think fortunately this is now

Or who held them.
Or who held them.
Or what the exposure was.
Absolutely.

understood by just about everyone.

42
1

COMMISSIONER BORN:

Let me ask you about the

political influence and power of the financial services

sector industry leading up to the crisis.

There are some reports that indicate that the

financial sector may have spent as much as five billion

dollars in lobbying expenses, federal lobbying expenses and

campaign contributions in the decade leading up to the

crisis, and that in 2007 there were almost 3000 registered

lobbyists in Washington who had been hired by the financial

sector.

I wonder whether some of the regulatory gaps and

weaknesses we saw may have been in part at least attributed

to this effort to influence federal policy.

WITNESS PAULSON:

You know, it's interesting.

can't comment as to how it impacted Congress.

that it is very, very difficult to get anything that's

fundamental, controversial, difficult done at Congress

without a crisis.

issues.

I do know

But there are a lot of jurisdictional

This is complex stuff.
And what I saw in terms of regulators, I just saw

regulators seriously working to try to gather the

information.

arrived if I'd had to explain to a man from Mars as to how

this--and I see you laughing because you know--how this was

regulated and why OTS regulated these institutions and OCC

And it was just--if a man from Mars--when I

43
1

these, and why there wasn't any regulator that had access to

all of the information in the shadow banking market and so

on, I could never have explained it.

And so I have no doubt that lobbying has an

impact.

But there you would have to talk to some other

members of the panel that are closer to the political

process than I am.

8
9
10

COMMISSIONER BORN:

Well, clearly there were

regulatory gaps or weaknesses in terms of the oversight of
the shadow banking areas.

Don't you agree?

WITNESS PAULSON:

COMMISSIONER BORN:

Yes.
And did you think that the

effort by the SEC to create a consolidated supervised entity

program for the investment bank holding companies was a step

in the right direction?

WITNESS PAULSON:

You know, it's--I'll tell you,

at the time when I was on Wall Street I did.

that the people we worked with at the SEC were of the

highest quality.

with them I thought that there were just some very, very

strong professionals there, and working very hard and very

diligently.

And I thought

And when I was in government and working

So it was--so I look at it from that perspective,

and then I just simply say if I get up to 100,000 feet and

look at it I just say, 'We all made mistakes.'

You know,

44
1

when you look at, you know, there were regulatory mistakes

over periods of time and clearly from the bankers and the

investors and all the different participants.

But I never doubted for a minute the competence

and the professionalism of the regulators at the SEC who had

just in a very short time--remember, this program for the

Consolidated Regulatory Program had just recently evolved

and then we had the tsunami.

COMMISSIONER BORN:

Do you think that going

forward it's important to try to eliminate regulatory gaps -

WITNESS PAULSON:

Yes.

COMMISSIONER BORN:

WITNESS PAULSON:

COMMISSIONER BORN: --shadow banking system?

WITNESS PAULSON:

--like those for the -Oh, yes.

Well, I think--Here's what I

think going forward:

institutions, they need to have sort of a uniformity of

approach, and in having tough, consistent regulation without

some being able to find nooks and crannies.

I think these big complex financial

And then in terms of the shadow banking there

needs to be--that's a big reason why I recommended the

systemic risk regulator concept was someone needs the

authority and the ability to gather all of the information

necessary so you can look at these big systemic issues.

And

45
1

I do think that if a systemic risk regulator had been in

place they would have had more authority to deal with, you

know, the over the counter derivatives much earlier or would

have had the purview and the authority to deal with the repo

market.

6
7

COMMISSIONER BORN:

Or with institutions like AIG

WITNESS PAULSON:

COMMISSIONER BORN: --which was not really

10
11

Oh, absolutely.

overseen effectively.
WITNESS PAULSON:

Absolutely.

company level.

institution that was able to arbitrage and sort of build

itself up by playing the gaps in the system.

That's right.

At the holding

COMMISSIONER BORN:

That was an example of an

Well, one of the questions

that I have is--and would be interested in your observations

on this--you know, obviously there were problems in

supervision, even with bank holding companies in terms of

the biggest institutions.

companies are even bigger than they were in 2008 because of

consolidations, because businesses have gone --

And today some of those holding

WITNESS PAULSON:

COMMISSIONER BORN: --out of business, and for

24
25

Right.

other reasons.
Are these institutions really capable of

46
1

effective supervision by government regulators?

Indeed, are

they capable of effective internal management?

your experience at Goldman Sachs could inform that issue.

Probably

WITNESS PAULSON:

Well, I would say this to you:

That I think that the level of concentration

where we have ten big institutions with sixty percent of the

financial assets, you know, this is a dangerous risk.

8
9
10

Now I believe these institutions are necessary;
they perform a valuable role.

So the way I get at your

question is this:

I say first of all, I know we can have better

regulation.

capital requirements, bigger liquidity requirements.

then I come to the conclusion that regulation will never be

perfect.

wanted to blow themselves up, it's hard to believe that the

regulators are always going to be able to find the problems

that they can't find themselves.

Absolutely know better, more consistent, bigger
But

Unless you hypothesize that these institutions

And so there will be--there will continue to be

failures.

Since the time we've had capital markets institutions have

failed.

There have been since the beginning of time.

We've had financial crises.
That is why I believe in addition to

strengthening the regulatory system you need these

resolution authorities so that the government has the

47
1

authority that when a big institution fails to step in

outside of the bankruptcy process and wind it down and wind

it down in a way in which you're not saving and propping it

up in their current form.

that they're liquidated.

But you can train regulators to do that.

The expectation has got to be
And I know that's complicated.

And that's why I'm such a big proponent of this

will concept, you know, that these big institutions work

with the regulators to create a roadmap for their

liquidation if they do fail because I--so again, you'll

never get perfect regulation.

American people are ever going to again want to see the

taxpayer come in and bail out or save these institutions.

So when they fail we need a way of liquidating

But I just don't think the

them and liquidating them in a way in which they don't hurt

the American people and take the system down.

me--so you're right, we can never--regulation, we should

strive to make it as good and as effective as we can and to

give the regulators the tools they need and the information

they need so they'll be right more often.

will be failures and we have to figure out how to deal with

them so it doesn't hurt everyone else.

And that to

But then there

COMMISSIONER BORN:

May I have --

CHAIRMAN ANGELIDES:

COMMISSIONER BORN: --another two minutes?

Yes.

48
1

I just wanted to follow up with you on a specific

example.

with that Goldman Sachs is like, what running it involved.

For example, Goldman Sachs.

You are very familiar

Do you think from your experience as the head of

a big institution like Goldman Sachs that it is capable of

an orderly wind-down in case it gets into financial

problems?

8
9

WITNESS PAULSON:

Yeah.

I think that any

institution can be wound down--It's complicated--over a

period of time.

You can't--No institution, no matter what

their capital says, if you have to liquidate it right away

there's no institution I think that the assets will be worth

more than the liabilities.

And again, my view is that with any institution

there has got to be a way that if they fail that you know,

and the expectation is, that they're not going to be propped

up in their current form; that they'll be broken up, they'll

be changed in some way, they'll be liquidated in a way.

so I believe that can be done.

COMMISSIONER BORN:

CHAIRMAN ANGELIDES:

COMMISSIONER HOLTZ-EAKIN:

23
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25

And

Thank you.
Mr. Holtz-Eakin.
Thank you, Mr.

Chairman.
Mr. Secretary, thank you for joining us today.
appreciate your testimony.

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I want to go back to this observation in your

book that a crisis was inevitable and ask you:

Does that

mean if there had not been a housing market crisis to

trigger it, something else would have?

WITNESS PAULSON:

Well, when I said 'inevitable,'

what I said in the book was that our history in this country

has been--and certainly in modern times--is every six,

eight, ten years there's been some crisis.

starting with the S&L crisis.

We could go

And I could just take you

through the various, you know, the '94, '98 with long term

capital, what we had with Russia and Asia.

what I saw was excesses building in the system.

So we've had these.

Now I could have said the same thing in 2004 or

'05, and, you know, I would have been wrong in terms of the

timing.

But ultimately you were going to have these.

And what I saw--and I didn't realize how true it

was--was I said to people the difficulty or the interesting

thing about the next crisis is we're going to be seeing how

these complex instruments and some of these private pools of

capital, and markets away from the traditional financial

institutions perform for the first time under stress because

there had been a lot of change.

this performed under stress.

24
25

And so we saw how a lot of

So, yeah, I think it's inevitable.

And I think

as sure as we're sitting here today that the next crisis is

And so

50
1

inevitable.

but there will be stresses and problems in the capital

markets, you know, some time in the future, probably in our

lifetimes again.

be relatively small manageable events.

I don't think it's going to happen right away,

And so the key thing is how to have those

They'll never be small events to those right in

the middle of the markets dealing with them, but so that

they're small manageable events to the rest of us in the

broader economy.

COMMISSIONER HOLTZ-EAKIN:

But the signature of

this particular crisis that we sadly have to report on is

the housing market?

WITNESS PAULSON:

COMMISSIONER HOLTZ-EAKIN:

Yeah.
You would agree with

that?

WITNESS PAULSON:

Yes.

COMMISSIONER HOLTZ-EAKIN:

In your testimony you

said that there were several policy decisions that shaped

the home mortgage market.

decisions?

WITNESS PAULSON:

What would be the list of policy

Well, I think what you would

need to look at, you just need to look at the weight of the

whole series of decisions we made, you know, the various

programs for housing.

it's the FHA, their various HUD programs, state programs.

It's not just Fannie and Freddie but

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1

I'd say even just take something like the

mortgage interest rate deduction.

You know, a million

dollar mortgage, it's deductible.

Is that fair relative to

renters or--forgetting about fairness, I think you have the

sum total of so many things pushed housing way up.

I would travel around the world when I was in the

capital markets and other nations would look at us in awe

that we had home ownership above 60 percent.

weren't satisfied with that; we got it up to 69 percent.

You know, we

I just think you need to look at those policies as

fundamental root causes of the crisis.

12
13

COMMISSIONER HOLTZ-EAKIN:

And on that list would

be the GSEs, Fannie Mae and Freddie Mac?

WITNESS PAULSON:

Yeah.

COMMISSIONER HOLTZ-EAKIN:

Right.

Yeah.

In your book you also

said that shortly after you arrived as Secretary of Treasury

you received a briefing about the GSEs and the quote is that

they were a disaster waiting to happen.

interviewed you, you said that the business model is

fundamentally flawed.

And when our staff

And could you just tell us exactly what the flaws

were in the GSE business model and why you thought they were

a disaster waiting to happen?

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25

WITNESS PAULSON:

Yeah.

Well, I sure didn't

predict this disaster happening the way it did.

So I'll

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tell you that.

without, you know, that turned out to be prophetic.

didn't see it quite as clearly as it came about.

That was a phrase, you know, that I used
But I

But in terms of the structure that, first of all,

there were the ambiguities.

government support, the Congressional charter.

private capital and private profit.

and the compensation model.

there.

Okay.

There was the implicit
And then

And the shareholders

So there was a contradiction

Then secondly, this was a situation where

Congress presumed to be the regulator.

capital, you know, legislatively defined capital.

the level of capital but what could count as capital.

some things that I considered DS capital, you know,

intangibles and so on were defined as capital.

regulator was set up to be weak.

negative about the people that held that job, but they were

not given the authorities that a normal regulator is given,

a safety and soundness regulator to make judgments about

capital.

They defined
Not only
And

And so the

I'm not saying anything

You had a--and then the elephant had clearly

gotten too big for the tent.

Right?

These things just grew

and grew and grew.

of the--it's just hard for people when we throw around these

numbers to even comprehend.

And so you had--when you looked at all

But you have $5.4 trillion when

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you look at the securities they had insured, the debt they

had issued.

So the danger, you know, if one of these--when

you look at the capital markets, you know, the danger they

posed was sort of unimaginable.

about the failure of any one institution.

posed by a lack of confidence in the ability of these

entities to repay their debt was much greater than that.

these were big.

You know, we could talk
But the danger

And then I think the part in the book you alluded

to really had to do with their portfolios.

topic of debate because they would not only guarantee--or

insure mortgage pools, they then would take their low

funding and buy in these mortgages and hold them.

said that this was necessary for their mission to support

their market.

their earnings were coming from that.

a fiduciary duty to their shareholders.

This was a big

And they

But as people explained to me, two-thirds of
And their boards had

We could talk about the public mission, they

could talk about, you know, they could testify up on the

Hill about meeting their housing goals.

shareholders and that's where their duty was, was to grow

their profits.

But they had public

So as I look at that I never so much blamed the

people that ran those organizations as those that designed

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the plane we asked them to fly before they flew it into the

side of the mountain, you know.

wrong structure.

So it was not--it was the

COMMISSIONER HOLTZ-EAKIN:

So one of the things

we heard yesterday was that during the early part of March

as Bear-Stearns came under duress agency securities were no

longer accepted as collateral in the overnight repo market.

And indeed if you look back on spreads at Fannie and Freddie

during that period they're spiking up and showing clear

signs of market distrust.

So I want you to walk me through the thinking

then during that period when Fannie and Freddie were

actually permitted to drop the limits on their portfolios

and lose a capital surcharge at a time when the market is

saying, even with the capital surcharge and limits on the

portfolios they aren't very safe.

WITNESS PAULSON:

Yeah.

It was exactly the

opposite of what you said.

them to get them to raise capital, to increase their

capital.

and raised seven billion dollars of capital.

net increase in capital.

capital; it turns out they didn't.

commitment.

I had had my staff work with

And so as a result of what we did Fannie went out
So there was a

Freddie committed to increase
They didn't meet their

But to step back--but that's sort of the specific

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1

question you asked.

happened was this:

But to get back more broadly, what had

They had--the credit crisis came in mid-2007.

And then most of the damage had been done by that point

because, you know, after that time mortgage lending

virtually ground to a stop away from Fannie and Freddie.

And there was all kinds of evidence of really very

responsible borrowers that wanted to buy homes and had the

economic wherewithal that were having trouble getting

10
11

mortgage funding.
And so now Fannie and Freddie are essentially the

only game in town.

believe the problem was already baked.

the securities in their portfolios.

what they'd guaranteed before the housing bubble had

broken--or burst.

And they needed--and so the, you know, I
I mean they owned

They had guaranteed

And so what we were doing in March of 2008 at the

time when we took the action we took with Bear Stearns, we

also were trying to increase confidence in these

organizations and get them to increase their capital.

So again I was pressing many institutions to

raise capital.

I was talking to many CEOs of institutions

and saying I've never see the CEO of a financial institution

lose his job by having too much capital, you know; raise

capital when you can raise capital.

We pressed them.

As I

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1

said, Fannie raised--lived up to their commitment; Freddie

didn't.

3
4
5

COMMISSIONER HOLTZ-EAKIN:

They got it from the

Treasury yesterday.
If you run the clock forward, then, knowing what

you know about their financial condition, I believe you said

something to the effect that the Fannie Mae-Freddie Mac

reform legislation gave you a bazooka that you would never

have to use.

And then shortly thereafter you used it.

WITNESS PAULSON:

I never said never.

Okay?

COMMISSIONER HOLTZ-EAKIN:

WITNESS PAULSON:

What I said was, when I got this authority I said

No, so --

I didn't say never.

that I was asking for unlimited authority.

politically to say 'unlimited' so I said 'unspecified.'

wanted to have the maximum amount of authority.

to the extent we have--the more authority we have the more

confidence the markets will have, and that's the

greatest--and that will increase--reduce the likelihood

we'll have to use it.

It sounded bad

And I said

And what happened was with Fannie and Freddie we

weren't the regulator.

people to get in and look at it.

we actually got in--okay?--and got the authority.

We didn't have the authority or the
Okay?

So it wasn't until

And so I was working very hard to get the

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1

emergency legislation from Congress--or get legislation from

Congress, reform legislation.

these entities.

unimaginable risk.

And then confidence went in

And as I said, it was sort of an

So we went and got this emergency authority.

And

then once we got it we were able to--we had Morgan Stanley

working with Treasury as our advisor.

had the Fed working with FHA go in and look at these

entities.

We had the OCC.

And it was only then we were able to get our arms

around sort of the scope and the magnitude of the capital

problem.

And then the fact that we had these authorities,

for the first time we could address the problem.

do something about it.

capital and to put them into conservatorship.

sort of the story there.

We could

We had the authority to put in

COMMISSIONER HOLTZ-EAKIN:

So that's

I want to--I don't

have much time, but I also wanted to go back and talk about

the Bear Stearns episode itself.

on whether Bear could have been allowed to fail.

What we heard yesterday --

WITNESS PAULSON:

COMMISSIONER HOLTZ-EAKIN:

WITNESS PAULSON:

COMMISSIONER HOLTZ-EAKIN:

I wanted to get your views

Whether Bear could what?
Be allowed to fail.

Yeah.
And we heard yesterday

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1

fairly convincing testimony that the purchase of Bear set

the expectation that other institutions would get help.

that when Lehman went down and did not get help that was a

great shock and surprise to the market.

And

So I was wondering if you would give us your

views, particularly about setting the precedent, having, you

know, seen intervention with Fannie and Freddie set

expectations, how you thought about doing that with Bear.

9
10

VICE CHAIRMAN THOMAS:

Mr. Chairman, if we could

give the Commission five extra minutes.

WITNESS PAULSON:

Okay.

I would like to answer

that question because in terms of convincing testimony, you

will never hear convincing testimony from anybody on this

who was close to the markets, in my judgment.

15
16

COMMISSIONER HOLTZ-EAKIN:
time to answer, so go.

17
18
19

And we're getting you

WITNESS PAULSON:

Because--Here's what I would

say.
First of all, let's look at the timing on this

because Bear was rescued in March and we got the emergency

legislation on Fannie and Freddie in July, and they were put

in conservatorship in September.

I believe that if Bear had not been rescued and

it had failed the meltdown that we began to see after Lehman

had gone would have started months earlier, and we would

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1

have really been in the soup because it would have

started--now that I look at it, with hindsight--before

Fannie and Freddie were stabilized.

the mess we would have had?

Could you just imagine

If Bear had gone there were hundreds, maybe

thousands of counter parties that all would have grabbed

their collateral, would have started trying to sell their

collateral, drove down prices, create even bigger losses.

There was huge fear about the investment banking model at

that time, and--because of the lack of Fed oversight and

access to the discount window and so on.

would have seen other investment banks go very quickly.

So I think you

Now those that make that argument are missing, to

me, one fundamental fact:

the expression once, toothpaste out of the tube.

That as the Chairman said--used

Once the--the crisis had been going on for seven

months when Bear went.

You didn't see excessive risk-taking.

speculation.

prudent loans that weren't being made.

afraid to buy student loan securitizations where the

government was behind it.

The system was very, very fragile.
You didn't see

As a matter of fact, there were a lot of
Investors were even

Sovereign wealth funds and other foreign buyers

that had come in to Morgan Stanley, CitiGroup, Merrill

Lynch, and all lost a lot of money.

People were scared.

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1

it wasn't like people said, 'Gee, they bailed out Bear.

we can go and let Lehman be profligate.'

Now

You know, the losses that Lehman had and that

others had were in positions that were already on their

balance sheet that were illiquid positions that just had to

be marked down as the economy turned down and as the--and as

home prices dropped.

have had a hard time finding any buyer for any institution

if the government had--again, if Bear had failed.

So again, you know, I think you would

COMMISSIONER HOLTZ-EAKIN:

One last question.

Thank you.

You talked about the

investment bank model sort of being in trouble.

heard yesterday from the SEC is that investment banks had

voluntarily brought themselves to a Basel II capital

standard, had liquidity requirements in excess of those

required of commercial bank holding companies, that by the

standards of regulation they were fine.

And so my question specifically is:

What we

Is there a

real difference in the performance of commercial versus

other entities during the crisis?

the board.

22
23
24
25

WITNESS PAULSON:
given where I came from.

We saw failures across

Now I may have a bit of a bias

But I will tell you this:

Analytically that I think--people throw around
the leverage ratios.

And if you had adjusted for accounting

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1

differences, the fact that investment banks had the

discipline of marking securities to market--that I think

that they were at least as well capitalized as the

commercial banks--I believe that the issues--I

think this was a confidence issue.

I think that it started--I think you had a couple

of investment banks in Bear and in Lehman Brothers that had

big exposure to the housing market--and Bear in particular

probably wasn't as diversified as some of the others.

think it really comes down to liquidity management and

liquidity cushions.

liquidity management.

with banks and investment banks.

And I

And I think I saw the same lack of
You know, I saw it across the board

But--so my comment didn't get to the relative

strength or weakness; it really got to a concern and a lack

of confidence.

entity in the middle of a crisis it's very hard for that

company to continue to exist.

19
20

And when the market loses confidence in an

COMMISSIONER HOLTZ-EAKIN:

Thank you, Mr.

Secretary

CHAIRMAN ANGELIDES:

Thank you.

I'm going to take a couple of minutes of my time.

I just want to follow up on something that Mr. Holtz-Eakin

raised.

At our last hearing when we had Fannie Mae in

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1

front of us the Vice Chairman and I described a timeline

which we've now verified.

record as well as the underlying documents.

And I'd like to enter it into the

COMMISSIONER HOLTZ-EAKIN:

And it gets to what's

happening in that late February-early March time frame and

culminates around what you might call the Bear weekend.

WITNESS PAULSON:

CHAIRMAN ANGELIDES:

Right.
And let me see if I can

describe this very quickly.

There's obviously concerns about the meltdown of

the private side of the mortgage market.

some pretty darn big concerns about Fannie.

said both publicly and in the interview with our staff--what

you said to our staff is 'they'--meaning Fannie and

Freddie--were the game in town; they were the only game in

town.

You've also

But it looks like what's happening here is the

portfolio caps are going to be lifted.

February 28th.

now into a market with big headwinds.

You had expressed

I think that happens

So that Fannie and Freddie will keep lending

And the deal I think that you and your team are

trying to broker--and I don't know if that's an accurate

characterization, but certainly involved in--involves them

continuing to lend in, having their capital surcharge

reduced some--in fact instantly, I think, reducing their

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1

capital by ten percent on the promise to raise more capital.

Is that a fair assessment?

WITNESS PAULSON:

It was a--they made a commitment to raise more

capital.

6
7

And Fannie raised seven billion dollars -CHAIRMAN ANGELIDES:

didn't.

8
9

Well, I would say this:

Fannie did and Freddie

Right.
WITNESS PAULSON:

And Freddie didn't live up to

the commitment.

And so there was net more capital raised.

And

there was the deal which the regulator and the GSEs working

with my staff brokered was a lifting the capital surcharge

to raise capital and it was to--and I just can't say

strongly enough--it was to raise capital.

The other thing I will say, when you're saying

lending into headwinds, I object.

opposite.

had declined dramatically in housing prices and they were

continuing to decline.

I think just the

I think what you will find is that the markets

So everyone was aware of the issue.

And so the losses they had didn't stem from--I

think you're going to find didn't stem from going ahead and

doing risky things in here.

going on in the housing market, and what had gone on in all

of the loans that they'd guaranteed before that and put on

their balance sheet.

It had to do with what was

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CHAIRMAN ANGELIDES:

going to have to look at this.

get to the nub of, which is:

concerns.

which Mr. Steele writes to Mr. Mud--quote:

Well, see, and I think we're
But here's what I wanted to
It's clear there's deep

Lockhart--in fact there's an email March 16th in

"Lockhart needs to eliminate the negative

rhetoric because it looks like the regulator is not really

wild about this."

But interesting also, he says, 'I was leaned on

very hard by Bill Dudley, who worked for Mr. Geithner, to

harden substantially the guarantee.

it has not been part of my conversation with anyone else.

view it as a very significant move, way above my pay grade

to double the size of the U.S. debt in one fell swoop.'

the day or two before the transaction gets done Lockhart

objects by saying, 'This idea strikes me as perverse as I

assume it would seem perverse to the markets that a

regulator would agree to allow a regulatee to increase its

very high mortgage credit risk leverage without any new

capital.'

21
22
23

I do not like that and
I

And

Now I understand that part of this was to raise
more capital.

But here's my essential question.

You had deep doubts.

And I'm just trying to get

a sense of how you saw the markets in March.

Bear had just

been--quote, unquote--well, acquired, but there was a rescue

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1

involved because the Fed's involved.

At this point in a sense you're striking a deal

that allows them to stay in the market.

concerns about solvency.

that, look, we're now in the business of a bailout.

6
7

Is there a view at that point

Does the bailout start in March or do you
genuinely believe things are going to right themselves?

8
9

You have deep

WITNESS PAULSON:

Neither one.

I didn't believe

things were necessarily going to right themselves, and the
bailout didn't start in March.

This--I just cannot say it clearer and more

definitively.

That's what this was about.

This was about getting them to raise capital.
And guess what--it did.

Okay?

Fannie raised seven billion dollars in capital.

Freddie committed to raise capital and then later their

lawyer said, 'Well, we need to wait until the second quarter

numbers are out.'

numbers are out we had gone and gotten the emergency

legislation.

And by the time the second quarter

But this was solely about raising capital.

Because what we were dealing with, we were dealing with a

situation where the markets were on edge.

only game in town.

to them.

capital.

They were the

And I was pressing--this was not unique

We were pressing financial institutions to raise

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And to me it was an unimaginable risk that these

things posed.

that time to Congress and get these authorities.

no idea that we could have got those authorities.

remember, I had seen Congress, Fannie and Freddie were a

political football like you wouldn't believe.

reform stymied for years.

the kinds of authorities we needed.

I had no idea that we would need to go at
And I had
Because

I had seen

And we were working to try to get

And so I had no idea that we were going to need

to get the authorities, get the authorities we got, which

let us get in with the real experts to get their arms around

the problem, and then get the tools we needed to address the

problem.

So working with the limited tools we had without

being the regulator for Fannie or Freddie we pressed them to

raise capital.

think that was a sign of confidence when they announced it

and then when they went and Fannie raised capital.

And I think that was the right thing.

CHAIRMAN ANGELIDES:

All right.

You know, at some point I think--given your one

staff person--I'd like to follow up a little on this.

But I

think there's a bigger objective here, which is also trying

to understand as markets are wobbling --

WITNESS PAULSON:

Right.

CHAIRMAN ANGELIDES: --this kind of dichotomy I

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1

think you faced.

And maybe--and I'm going to really move on to

other members.

written question.

versus also acknowledging publicly the state in which

they're in.

7
8
9

I'll just state it and we'll ask in a
Between trying to stabilize the markets

But I'll--let me do this.
WITNESS PAULSON:

Let me --

Well, obviously we--I would

just simply say this:
What you need to recognize--and I'll say this and

I'll answer it in writing and answer it the same way--is

that Treasury is not the regulator.

authority, we didn't have the people, we didn't have the

capacity to really get in there.

doing was pressing them to raise capital.

We didn't have the

Okay?

So what we were

It was only when the markets lost confidence and

we needed to get these authorities that we had the tools to

get in there and get our arms around the problem.

CHAIRMAN ANGELIDES:

Senator Graham.

COMMISSIONER GRAHAM:

21
22

All right.

Thank you.

Thank you, Mr. Chairman.

And thank you, Mr. Secretary.
I would like to ask three questions that relate

to lessons learned.

final financial crisis that this country is going to have.

As you say, this is not going to be the

One of those relates to a continuation of the

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Bear Stearns story, and that is when you faced the issue of

Lehman Brothers you were, in addition to dealing with

Lehman, you were establishing a principle, which was that

Bear was not a precedent for all future similar

circumstances; that you were not going to rally the Federal

Government to the salvation of every institution.

What were the factors that caused you to make the

case by case decision that Lehman was not worthy of a

federal-assisted transition?

WITNESS PAULSON:

Thank you for asking that

question because, despite the fact I've written a book and

answered this hundreds of times, people tend still not--and

despite the fact that we've had Ben Bernanke and Tim

Geithner say the same things--people still question us on

this a lot because it's hard to understand.

But the fact is that Bear faced a liquidity and a

capital problem.

in J.P. Morgan to come in and solve the capital problem and

be able to guarantee Bear's trading books during the

pendency of the shareholder vote.

learned there that the government--how limited our

authorities were.

guarantee an investment bank's liabilities or to put in

capital.

And we were very fortunate to have a buyer

And so we were--and we

We couldn't--no one had the authority to

And so--and we didn't have resolution authority.
After that I made a number of speeches where I

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1

talked about the need for this.

unfortunately were unable to get any bank to play the role

on Lehman that JPMorgan played on Bear.

very hard to do that and we were left, frankly, powerless.

And so we prepared for the, you know, for the bankruptcy.

Lehman came along.

And so we tried

So this was not something we did intentionally.

And it was just a--we just had a flawed regulatory system

and powers.

COMMISSIONER GRAHAM:

The second area is

conditionality of funds to financial institutions through

RARP or other bail-out practices.

to be the perception of the U.S. where there were relatively

few requirements, in the United Kingdom--for instance, the

Royal Bank of Scotland was required to accept certain

conditions as to what its lending practices would be,

limitations on dividends and compensations.

17
18
19

In contract to what seems

Why were there not similar conditions attached to
the bail-out of U.S. financial institutions?
WITNESS PAULSON:

Well, this was a totally

different program.

institutions as they serially failed, as they did in the UK.

We did not want to be dealing with

We diagnosed the problem as being a big capital

shortfall in the banking sector.

And so we designed a

program that would be attractive to healthy banks so that

they would want to come in and voluntarily participate.

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1

And we put in preferred, which was passive--we

didn't want it to look or be like a nationalization--and

designed so that the government would get the money back

because it was senior to the common.

whole purpose of the program.

And so that was the

And, you know, interestingly enough, you know, I

was hopeful when we announced it that we'd get a couple

thousand banks that would participate, two or three

thousand.

But right after we announced it we had critics

start saying, 'You've got to force them to lend.'

didn't say how much or how you were going to make them lend

or what the government would do.

their compensation,' understandably.

understandably, a number of the banks said, 'Wow, I'm not

sure we like this deal.'

They

'You've got to control
And then

And so we had a good number of banks apply for

TARP, get accepted, and then pull back.

And we had about

700 not quite take the money.

because it prevented their collapse and the government's

going to get the money back with a profit.

And it was a big success

But I think if it hadn't been stigmatized by all

those that wanted to put the various controls on it that we

would have had two or three thousand banks; they would have

had the money for three to five years.

done far more than any stimulus program to get the economy

And that would have

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going again.

But you know, again, I think some of those who

say the program didn't work because there wasn't enough

lending were those people that stigmatized it.

were trying to deal with healthy banks and make it

voluntarily come in.

banks like the British government had done.

tired of dealing with them serially when they failed.

So again, we

So we weren't trying to nationalize

COMMISSIONER GRAHAM:

And we were

Well, there was a public

perception that one of the justifications for this was to

stimulate the economy by making credit available.

WITNESS PAULSON:

Yes.

COMMISSIONER GRAHAM:

And there was

disappointment when there were perceptions that that wasn't

happening.

WITNESS PAULSON:

You're right.

You're

absolutely right.

for--and I didn't make this point and I should have--the

whole reason for designing the program was so many banks

would take it, would have the capital, and that would lead

to lending.

And, of course, that was our whole reason

That was the whole purpose.
But in a funny way, as soon as we announced it

before the first banks ever got the capital people were

saying, 'Make them lend; why aren't they lending more.'

course, now if you're a bank do you really want this deal.

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And how is Big Brother going to help you step in and tell

you how to make these lending decisions.

3
4

And so I think what happened was then some banks
were reticent to take the capital.

5
6

Now I think it did help.
lending.

And it did help with

But it could have been much more effective.
COMMISSIONER GRAHAM:

Is what you're saying that

banks didn't want to take the capital which would put them

in a position to be a more effective contributants to the

economy because they felt that they would be under external

pressure to do that very thing?

WITNESS PAULSON:

That's right.

I think a number

of banks did.

I think even those banks rushed to pay it

back--okay?--because of the extent to which they were

stigmatized.

And so we had almost 700 banks take it.

But

And so I think banks were understandably

concerned.

So you had this paradox.

People wanted them to

lend more.

But by clamoring for somehow or other there to

be strings attached.

those--you know how people--you know, how much people wanted

the banks to lend; more than they'd lent in the middle of

the crisis during the excesses?

lending was--what was the right level and how was the

government going to determine that.

And I was never quite sure what

Or, you know, how much

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Clearly this was about lending and getting the
banks the capital they needed so that they could lend.

COMMISSIONER GRAHAM:

Could I have two minutes?

The third question relates to a topic that you

have alluded to, and that is the role of Congress.

you've said that Congress had barriers such as its tendency

to wait until the crisis had occurred before acting and then

some of the jurisdictional restraints on dealing

comprehensively with problems.

And

From your experience in the executive branch

trying to influence Congress to be more proactive and to be

more comprehensive in its response, do you have any

recommendations of what the executive branch could to do

facilitate Congress being a more effective partner or what

Congress ought to do within its own domain to enhance its

contribution?

WITNESS PAULSON:

I could say my own experience

with Congress was very positive because twice I needed to go

to Congress with extraordinary requests and twice they

reacted before disaster struck--okay?--the crisis.

And Democrats and Republicans--I don't have

any--Like a lot of people, I don't like partisanship.

I--but I saw people on both sides of the aisle come

together.

got to--you can get some experts up here that are more

And

I think in terms of how to solve the issue you've

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equipped than I am to deal with that question.

COMMISSIONER GRAHAM:

CHAIRMAN ANGELIDES:

Mr. Wallison.

COMMISSIONER WALLISON:

Mr. Secretary, it's good of you to be here.

appreciate it very much.

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9

Thank you, Mr. Chairman.
Thank you, Senator Graham.

Thank you, Mr. Chairman.
I

We all do.

I'd like to follow up a little bit on some of the
questions that my colleague, Douglas Holtz-Eakin, had asked

about:

one of the most consequential decisions that has ever been

made by our government.

substantial argument that it gave rise to moral hazard that

made the Lehman collapse much more significant than it

otherwise would have been if it would have occurred at all.

And I want to point out, for example, that once Bear Stearns

was rescued it certainly encouraged Lehman to keep its price

somewhat higher than it might otherwise have been in dealing

with potential acquirers because, on the other side, Lehman

had a reasonable expectation that it might also be rescued.

And I think the chairman of Lehman indicated that in some of

the testimony he's given to Congress in the past.

the rescue of Bear Stearns, because to me this was

I think there's a

In addition, creditors of Lehman, such as the

Reserve Fund that caused so much difficulty, would probably

have rid themselves of the commercial paper that they were

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holding that would immediately have lost value if Lehman had

actually been allowed to fail.

they were stuck with this commercial paper.

as you remember, that particular money market fund, reserve

fund actually broke the buck and there was a run on money

market funds.

And so when Lehman did fail
And, of course,

So the consequences of rescuing Lehman in terms

of its moral hazard were quite significant.

if I can just to follow up your reasoning a little bit more

So I would like

carefully.

If I may make just a couple of other points.

Yesterday we heard from officers of--and former

officers of Bear Stearns--and from Chairman Cox of the SEC.

And we learned--I was surprised to learn that Bear Stearns

was actually solvent at the time that it was rescued.

had not actually become insolvent, at least according to

Chairman Cox and according to those former officers of the

company.

And so the first question I'd like to ask you is

whether you were aware that Bear was in fact a solvent

company.

But were you aware you were dealing when you got Bear to be

rescued that you were dealing with a solvent company?

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Now I understand there was a liquidity problem.

WITNESS PAULSON:
ridiculous statement.

I think that is almost a

We were told on Thursday night that

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Bear was going to file for bankruptcy Friday morning if we

didn't act.

bankruptcy?

So how does a solvent company file for

You know, it is--When institutions, financial

institutions die they die quickly.

They die because the market loses confidence.

It's a liquidity crisis.

When they die I don't care what someone has got

on their books--okay?

Assets, if you had to sell them, are

not worth, you know, more than liabilities.

mistake about it:

for bankruptcy tomorrow morning.'

So make no

We were told, 'The jig's up; we're filing

And you know what?

If--And at the time, you

know, we almost found out whether your hypothesis was right

because if J.P. Morgan hadn't emerged there was nothing that

was going to be done here.

But so, okay.

That's your first question.

COMMISSIONER WALLISON:

Now I would say that

companies can file for bankruptcy even when they're solvent

if they are illiquid because one of the definitions of

bankruptcy is you cannot pay your obligations as they come

due.

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It's not simply being legally insolvent.
WITNESS PAULSON:

This is a financial

institution.
COMMISSIONER WALLISON:
into that point.

Yes.

But the point is--

But let's not get

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WITNESS PAULSON:

Well, I think that's a huge

point.

COMMISSIONER WALLISON:

The point is I just want

to be sure that we are talking about a possibility that we

could rescue firms that are in fact insolvent.

Now the officials of--the officers of Bear

Stearns we talked to, and Chairman Cox--although Chairman

Cox was not speaking as chairman of the SEC--both said they

did not think that Bear Stearns was too big to fail, and

that if it had failed it would have caused--they did not

believe it would have caused the kind of disruption that we

normally consider as necessary to rescue an institution that

is too big to fail.

Why did you think that Bear was too big to fail?

WITNESS PAULSON:

First of all, I don't take moral hazard lightly.

Okay.

If Bear Stearns, if this had happened at a time--this

occurred at a time when the credit crisis had been underway

for seven months and the system was very fragile, throughout

the system.

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Secondly, we didn't have the tools, as I said, to
wind them down outside of a bankruptcy process.
So what I saw in the marketplace was a market

gripped with fear, and that Bear was not the cause.

Bear

was a symptom of fear and panic in the market and of this

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broader problem of illiquidity.

And so, as I said to you, I

believed that if Bear had failed that there were all sort of

counter parties which would have grabbed their collateral,

sold it.

write downs, you know.

It would have led to bigger losses and bigger

And, for instance, your comment about the reserve

fund holding Lehman paper, yeah, darn right.

If Bear had

gone down the reserve fund wouldn't have held Lehman paper

and neither would any other fund.

And, you know--or many of

them.

And so you would have--it just would have triggered

it quicker.

immediately if Bear had gone, and just the whole process

would have just started earlier.

You would have had Lehman going I think almost

COMMISSIONER WALLISON:

All right.

Well, if that's true then how could you not have

rescued Lehman under those circumstances?

you're saying is that--you had implied that you were going

to rescue everybody else for the same reason:

fear in the market.

WITNESS PAULSON:

Yeah.

Because what

There was

We looked at every one

of these, you know, on their own circumstances.

tried hard to come up with a solution for Lehman, very hard.

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25

But we

Again, if there had been a buyer for Lehman like
there was for Bear we would have done the same thing.
COMMISSIONER WALLISON:

Let me just turn the

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questioning to one other point, if I can ask you a question

on a different subject.

You said that subprime mortgages were a

relatively small part of the problem, although they were a

triggering element --

WITNESS PAULSON:

Commissioner Wallison. --I think, in your view of

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9

Right.

this.
Are you aware that there are views that the

number of subprime and Alt A mortgages in the market is much

larger than the 20 percent you cited?

all mortgages by 2008, as much as half of all mortgages were

subprime and Alt A, and thus were ready to fail when the

bubble that we were experiencing began to flatten out.

As much as half of

If you had known that at the time --

Vice Chairman Thomas:

Mr. Chairman, yield the

Commissioner additional three minutes.

COMMISSIONER WALLISON:

Thank you.

If you had known that at the time would your view

about what was likely to happen or the importance of

subprime mortgages have been different?

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WITNESS PAULSON:

I'm not sure.

First of all, I

don't know that.
But I don't--I think the big question--and I
think where you and I agree is that housing policy and

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housing was the big issue here that we dealt with.

look at the problem, there were excesses throughout the

market but that it was housing policy and montages more

generally, okay?

And as I

So I'm not as focused on, you know, I think

subprime was, you know, was obviously where the most

egregious excesses took place.

know, people use this e. coli example or mad cow disease.

That I think first came from me and Treasury and we use it

And I have no doubt--You

in the book.

because there was so much uncertainty about that it

infected, you know, so many of the others in securitizations

in terms of the way investors concern.

concern.

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16
17

And I do think that it's a good example

So it was a big

But I'm not sure that if I had--that that would
have made a big difference.
COMMISSIONER WALLISON:

Let me tell you why I

think it's significant to think about it in these terms.

And that is--we've had questions here yesterday, and we

might have some further ones today--and that is that both

regulated banks, which are heavily regulated, as you know,

and investment banks failed in roughly the same

circumstances.

Confidence was lost in both.

There were runs in effect on both.

And so the question really is if there were

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circumstances that were so severe coming out of some event

which seems unprecedented in at least the last 70 years,

wasn't it a significant fact that there was no way that our

regulatory system could have prevented or did prevent the

loss of--not only among investment banks, as we've been

talking about, but also among regulated real banks.

WITNESS PAULSON:

You know, I take your point.

mean the fact is this was a--this event was--it's hard I

think to go back in history and find any event that was more

extraordinary in terms of the extent of the crisis, the

magnitude of some of the things that were witnessed here.

And so I think your thesis is, you know, has got a lot of

truth to it in terms of the housing.

COMMISSIONER WALLISON:

CHAIRMAN ANGELIDES:

COMMISSIONER GEORGIOU:

And thank you, Secretary Paulson, for joining us

with which I agree.

could.

Thank you, Mr. Chairman.

I want to turn to a portion of your testimony

Mr. Georgiou.

here today.

Thank you.

And I'd like to highlight it if I

On page four of your testimony on securitization
you say:
"Because securitization separated mortgage
originators and underwriters from holding the risk of the

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loans they originated it enabled subprime lenders to stop

focusing on the creditworthiness of the loans they made and

instead focus solely on their ability to sell those loans

upstream to underwriters.

their underwriting criteria, relying on their ability to

sell the securities into a booming market."

Underwriters in turn relaxed

You go on to say:

"Reforms are unquestionably required.

disclosure is necessary.

Better

Underwriters and originators

should be required to retain some portion of what they sell.

Requiring underwriters to keep some "skin in the game" will

properly align their incentives with those of investors who

end up holding the bulk of the risk."

And then you go on to say:

"These changes will provide the securitization

market with powerful incentives to focus on creditworthiness

and will lead to more responsible lending practices."

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19

And then yesterday we heard from Chairman Cox.
And in this written statement he said words to the effect:

"If honest lending practices had been followed

much of this crisis quite simply would not have occurred.

The nearly complete collapse of lending standards by banks

and other mortgage originators led to the creation of so

much worthless or near-worthless mortgage paper that as of

September 2008 banks had reported over one-half trillion

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1

dollars in losses on U.S. subprime mortgages and related

exposure."

3
4

One-half trillion dollars, 500 billion dollars, 500,000
million,

which was, you know, an extraordinary amount of money in

light of the capitalization of a lot of the institutions

that had to write down this paper.

And yesterday when James Cayne and Allen

Schwartz, the last two CEOs of Bear Stearns testified, I

asked them what they thought of the idea of requiring

investment bankers to hold--take some of their fees in the

actual securities that they create, whether that might

enhance the diligence and, you know, align the interests of

investors more closely with those of the underwriters.

And of course they both said that sounded like a

great idea, but Mr. Cayne said, you know, they're not going

to like it, he said about the investment bankers.

And I just want to harken back to your successor

at Goldman, whom I asked a similar question of back at our

first hearing in January.

those securities but then what we would do would hedge

them,' and essentially not, you know, not effectively have

the exposure to it.

idea would be for you to be long on it so that in your

underwriting obligations when you were representing to

investors that these would be sound investments you would

And he said, 'Well, we could take

And of course I said, 'Well, the whole

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actually be side by side with them in the long haul.'

All of which is to lead me to a question which I

really think bears more on your experience at Goldman Sachs

and on the street generally than at the Treasury of, the

Secretary:

How could such a notion be implemented in light

of the different responsibilities that investment banks have

in at least three of their roles:

One is as an underwriter in which they undertake

to have a fiduciary duty to investors and represent that a

security is--that they're selling is not just the right to

sell it but to actually represent that it will perform as

represented;

Two, as a market maker, which is essentially what

Mr. Blankfein was suggesting, which is that people ask for

positions and they offer their clients the opportunity to

invest long or short or hedge their positions in various

respects;

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20
21

And really third, as proprietary traders
investing for their own account.
And the reason I say that--and I'd just like your

thoughts in this regard--is if people were required to hold

those securities, one, how would you enforce them holding

them and staying long on them, not hedging them; and is that

realistic in light of the differential obligations of these

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investment banks?

WITNESS PAULSON:

That's a very good question.

And a lot of people have recommended what I've recommended.

And this recommendation is short on--long on policy and

short on how you would implement it.

think it is difficult to implement for the reasons you

suggested.

And I'll tell you:

But I would--And I think your question has got

the nub of the way you need to think about it because I

think a market making function is not really what we're

talking about here, you know.

marketplace and it's got a client that wants to sell or

wants a bank to commit capital or help manage risk, that's

one situation.

If a bank is in the

So it's really as an underwriter.

And I don't know that I even have a problem--and

I probably need to think about this some more--but even as

an underwriter putting a hedge on, again the hedge if it's

constructed properly you could have a hedge against, for

instance, the mortgage market overall.

security you're going to want to perform better, right?

COMMISSIONER GEORGIOU:

WITNESS PAULSON:

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24
25

But this particular

Correct.

Because you have done such good

due diligence.
And so I think the only caveat I would say is you
want to have some skin in the game--and I made this comment

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1

earlier.

actually those firms, some of them that got into the most

problem were those that kept an extraordinary amount of the

paper they had underwritten, which was rated AAA, and were

holding so much on their balance sheet that they almost

failed because of it.

But you don't want to have too much because

COMMISSIONER GEORGIOU:

said.

own cooking.

He said--I asked him whether they ought to eat their
He said, 'Well, we choked on our own cooking,'

is what he said.

their books.

And he got stuck with those securities on

But that wasn't his intention.

to originate and distribute them.

sell them all.

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16

Oh, that's what John Mack

WITNESS PAULSON:

His intention was

But he wasn't able to

That's right.

That institution

and two others choked on their own cooking.

COMMISSIONER GEORGIOU:

WITNESS PAULSON:

Right.

And so what we're talking about

here, I'm not talking about something that's different from

prudent risk management.

financial institutions to do things that's not going to

involve prudent risk management.

way that as you underwrite that there's some piece of what

you've underwritten that you continue to have to live with

and own.

I don't think we ever wants to ask

But there's got to be a

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COMMISSIONER GEORGIOU:

Right.

Live with really

maybe even as long as the security is intended to produce.

WITNESS PAULSON:

Right.

COMMISSIONER GEORGIOU:

And maybe the bonuses

that were paid to the people who did the deal and were

responsible for the diligence ought to be paid in part in

the securities that they created.

8
9

I mean one of the thoughts is--that many people
have suggested here is that the fact that underwriters were

paid exclusively in cash, you know, the credit rating

agencies were paid exclusively in cash.

brokers were paid exclusively in cash when the issue was

sold and didn't have any--didn't retain any risk for the

failure to perform as projected was a problem.

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16

The mortgage

I'm sorry, could I have a couple of minutes?

Two

minutes more, please?

CHAIRMAN ANGELIDES:

Absolutely.

COMMISSIONER GEORGIOU:

Yes, sir.

WITNESS PAULSON:

Thank you.

I would think that formulaic

compensation just in general is a problem.

particularly--and then paying it in cash makes the problem

much greater.

COMMISSIONER GEORGIOU:

WITNESS PAULSON:

Giving--and

Not paying in cash?

I'm saying paying it

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in--formulaic compensation is a problem.

COMMISSIONER GEORGIOU:

WITNESS PAULSON:

Right.

And then paying in cash is

another problem because again I strongly believe that when

looking at compensation it's very important to align

interest and for there to be a long tail on that

compensation.

the securities, however it is done, an important part of

their compensation should be how well they do their job.

So, as you say, that those that underwrite

But how well they do their job has got to be the quality of

their job, not just the short-term profit.

COMMISSIONER GEORGIOU:

Right.

And I think that it also has the beneficial

impact of aligning their interests with the investors who

purchase it.

WITNESS PAULSON:

COMMISSIONER GEORGIOU:

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19

Yeah.
And avoiding

untoward--being on the opposite side.
I wondered if I could ask you in just the last

few seconds I have here to reflect a little upon this

question and maybe you could respond in writing if you come

up with any thoughts from your long-time experience on the

street as to how this might work.

element, I think, that many people are looking for a

solution to that could improve diligence and improve the

Because this is an

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quality of the paper sold, which could avoid the problem

going forward in the future.

WITNESS PAULSON:

Like so many things, it's

easier to discuss this at 100,000 feet than it is to figure

out how to implement it.

COMMISSIONER GEORGIOU:

WITNESS PAULSON:

COMMISSIONER GEORGIOU:
Secretary.

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12

15
16
17
18
19

Thank you so much, Mr.

And thank you for your service.
CHAIRMAN ANGELIDES:

And we're going to keep that

one assistant of yours real busy between now and December.

13
14

I will give it some more

thought.

9
10

Right.

VICE CHAIRMAN THOMAS:

Could I have just a

minute.
CHAIRMAN ANGELIDES:

Absolutely.

just a minute; absolutely.
VICE CHAIRMAN THOMAS:

I'll give myself a minute

out of my own time.
There are some of us on this Commission who are

admitted non-economists.

which we sometimes have to translate.

22
23
24
25

You can have

And so there's a jargon that's used

WITNESS PAULSON:

I will join you in that.

I'm

an admitted non-economist.
VICE CHAIRMAN THOMAS:
admitted non-attorney.

Yeah.

I'm also an

So there's a whole lot of things I'm

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admitted 'non' on.

But in trying to understand both in terms of the

shadow banking system and the point that Mr. Wallison makes

so clearly about the subprime Alt A mortgages, the flawed

mortgage packages, I think most people would understand

interconnectedness, i.e., you've got five men climbing a

mountain, they're all roped together.

the other four with him.

One falls, he pulls

But contagion and common shock that are terms

that are being used are for me a little more difficult to

parse.

When you use the e. coli example, my argument is,

coming from the ag background and the other stuff, that if

you told me that spinach, packaged spinach--which was an

actual case--had e. coli, you could go ahead and eat

lettuce.

because it isn't the spinach.

be that everybody had it.

You don't have to worry about getting e. coli
And then common shock would

So where do you place the mortgage packages?

Did

everybody have them and that pulled everyone down and then

all the other assets became devaluated?

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25

WITNESS PAULSON:

You see, here's what happened.

And I'll try to explain this in simple terms.
VICE CHAIRMAN THOMAS:
complex terms if they're defined.

I can usually handle

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WITNESS PAULSON:

But this will be--you can

handle very complex terms --

VICE CHAIRMAN THOMAS:

WITNESS PAULSON: --as anybody who's read the tax

Okay.

code knows.

But what had happened was there were these very

complicated securities that were hard to understand.

bought them on a rating.

in subprime.

People

And they knew there were problems

And so once the problems occurred then there

were--anything that even looked like securitization in the

mortgage area or complexity caused people to pull back

because they said--and it wasn't a matter of pricing.

became illiquid.

McDonald's reduced the--if there was a big concern about

beef somewhere and McDonald's reduced the price of their

hamburgers more people wouldn't buy it if they were scared.

People --

19
20

That's why the e. coli thing, you know, if

VICE CHAIRMAN THOMAS:

But what about the plague,

for example?

WITNESS PAULSON:

VICE CHAIRMAN THOMAS:

Yeah.
See, Bear Stearns kept

saying, 'We weren't very big in subprime.'

big in Alt A.

WITNESS PAULSON:

Well, they were

But what happens is that was

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it.

So people then said--investors became concerned, even

if there was a very low likelihood.

when one asset class becomes illiquid--okay?--no one can

sell it, then what happens, people all run to sell another

asset class.

salable.

everybody's trying to sell them.

around the same risk control table trying to sell the same

thing, and all the buyers are in the hospital.

And so they go to sell the mortgages that are

And pretty soon those become illiquid because

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11

And so what happened is

VICE CHAIRMAN THOMAS:

And everyone's sitting

So it's contagion rather

than common shock?

WITNESS PAULSON:

It's contagious because

illiquid, you try to sell something that becomes illiquid

because of fear it can't be sold.

shouldn't be related, you know, that they're not supposed to

be correlated do become correlated because they're what

everyone else tries to sell.

VICE CHAIRMAN THOMAS:

So then securities that

And Bear Stearns at the

end said the only thing they could really deal with were

Treasuries.

WITNESS PAULSON:

Well, I would just simply say

that counter parties in the repo market lost confidence in

Bear Stearns.

certain securities.

And they were unable to borrow against

VICE CHAIRMAN THOMAS:

Notwithstanding the fact

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others had the same?

WITNESS PAULSON:

Yeah, there were others--No,

others had--this was a loss of confidence.

Others were

experiencing similar problems, but not nearly to the same

extent.

This was focused on Bear Stearns.

VICE CHAIRMAN THOMAS:

WITNESS PAULSON:

So it was degree.

But let me also say to you that

lending practices were very sloppy, and borrowing practices.

It's one thing if I want to repo a Treasury.

Okay?

If I'm

redoing a mortgage security and you're giving me 100 percent

of the value lending on that, not asking for a haircut,

that's sloppy.

And so what happened was there was an assumption

you could keep borrowing at--quote--full value on these

securities when they were dropping in value.

VICE CHAIRMAN THOMAS:

Okay.

I'll have to ask my

colleague, Doug Eakin--an admitted economist--if sloppy is a

term of art.

CHAIRMAN ANGELIDES:

Mr. Hennessey.

COMMISSIONER HENNESSEY:

What I'd like to ask you to do is to focus on

three specific firm failures--I guess four if we package

Fannie and Freddie together.

why those firms failed.

for you to explain your thinking about scenarios that you

Thank you, Mr. Chairman.

And we were just talking about

But instead what I'd like to ask is

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feared might happen if they were not bailed out or

rescued--whatever your favorite term is.

So Bear, Fannie and Freddie, and AIG; because as

I understand it, the scenarios, the really bad scenarios

that might have happened if those firms had failed were

somewhat different, in particular thinking about counter

parties.

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9

With bear it sounded like what you were
describing was if Bear was the slowest deer and the lions

got it that the next slowest deer might fall prey to the

lions, whereas there were other scenarios, as I understood

it, for what would happen, you know, to the system if Fannie

and Freddie failed or what would happen if AIG failed.

So could you compare and contrast?

WITNESS PAULSON:

COMMISSIONER HENNESSEY:

WITNESS PAULSON:

Well -What concern --

I would say it's one thing--I

have to really be very careful here because doing it with

what I know today in terms of what I knew then.

Okay?

So with Bear Stearns, what I knew then, I

wasn't--I knew enough to know that the system was very

fragile and that there were so many unknowns in terms of the

counter parties that this was a very dangerous risk to take

and an imprudent risk to take to have them go down.

What I know today is that what was waiting for us

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in terms of Fannie and Freddie, which I didn't know then,

and what was--you know, and how severe the overall situation

was.

firm that I believe if it had gone down like a Drexel or

whatever during a more normal market, as opposed to one

where there was huge stress and fragility.

beneath the surface, you know, throughout the institutions

in Europe and the U.S., it caused me concern.

But there's no doubt that--and Bear was the kind of

And what I saw

Now you mentioned Fannie and Freddie.

just a different order of magnitude.

posed sort of an unimaginable risk to me.

That's

As I said, that just

It's just the whole--if there had been a loss of

confidence that they didn't have the ability to pay back

their securities--I mean there was 3.7 trillion held in the

U.S., 1.7 trillion outside of the U.S., they just sort of

flowed through the financial markets almost like water.

They were liquid securities, they were considered to be.

So that would have--if there had been a big

disruption there no one in the world would have had any

confidence in our ability to deal with this.

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COMMISSIONER HENNESSEY:

Can I interrupt you for

a second?

What you're describing I think are two different

things.

With Bear it's that if Bear fails, it's not that

other people would be holding Bear securities and that would

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push them under.

Bear might then affect another firm.

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It's that the same problem that affected

WITNESS PAULSON:

It would start a chain

reaction.

COMMISSIONER HENNESSEY:

Right.

Whereas with

Fannie and Freddie what you're describing is that there were

actual firms that held Fannie and Freddie debt on their

balance sheet and Fannie and Freddie's collapse would have

caused problems on their balance sheet.

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WITNESS PAULSON:

Yeah.

But, Keith, it's more

than that.

It's just the whole thought--okay--that something

of this magnitude, you know, that was chartered by the

United States of America, with our housing bubble that we

were going to stand behind that.

would any institution be safe.

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And then, you know, when you talk about Lehman, I
will say to you that --

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There would be--well, why

COMMISSIONER HENNESSEY:

Actually it was about

AIG.

WITNESS PAULSON:

Oh.

AIG.

Okay.

Well, AIG is an order of magnitude bigger than

obviously Lehman or Bear.

It was one that we knew the least

about because there was no one regulator that had, you know,

a clear line of sight.

So we knew the least about it.

But

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we knew that it was huge in terms of the size and the

interconnectedness and the credit default swaps with all the

counter parties.

It's a real example of rating.

You know, I have a--you know, the danger of a AAA

rating where--and again liquidity.

contracts with them without getting normal margin because

they were AAA.

have to post collateral if there was a downgrade, you know,

without saying, well, how do we make sure we have the

Many people entered into

They entered into contracts where they would

liquidity to deal with a downgrade.

And then, of course, you touch so many

individuals because they had these--they guaranteed through

their--get contracts and other retirement plans for teachers

and health care workers and others.

millions of Americans there.

insurance.

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So you get tens of

You get, you know, the

So it again was, you know, it's like Lehman
squared or whatever.

COMMISSIONER HENNESSEY:

Okay.

Yesterday--a different topic.

Yesterday

consistently from the Bear executives we heard non-specific

hypotheses that there was someone who was strategically

inciting the panic; that there were actors out there who

were actively trying to bring Bear down to make money.

hear this crop up a lot, but you never hear anyone actually

You

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name names and say, 'Here's who I think was behaving

strategically.'

I'm not going to ask you to name names.

But do

you think that there were participants out there who were

trying to bring down Bear or any of these other firms?

WITNESS PAULSON:

I do.

First of all, I don't

ever mean that this is the fundamental cause.

I think that

there was--where there's smoke there's fire, number one.

And it was about a loss of confidence.

I believe short-

selling is essential for the price discovery process in the

U.S.

got a legal connotation.

But I don't use the word 'collusive' because that's

But I would say that when you see serial

attacks--okay?--not just sort of an industry overall but

serial attacks.

stock and then bet on the credit default swaps to widen and

do that.

wolf pack trying to pull down the weak deer.

And it was the easiest trade to short the

And to see it go sort of like from, you know, the

So I'm not saying there was behavior that was

illegal.

they were--the SEC to investigate.

found something that was illegal like collusive or

manipulative they would have acted--or they will act.

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That was something that I'd want--and I'm sure
And I'm sure if they

But I do think that, like so many things, we had
rules that were there to serve us well in normal times.

But

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when we had extraordinary times like this we needed to take

some extraordinary actions with regard to short-selling.

And I still think those that are thinking about circuit

breakers or ways of addressing, you know, short-selling

during times of crisis or when a stock moves too far, you

know, are important things to do.

7
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And I do think--it sure looked to me like some
kind of coordinated action.
COMMISSIONER HENNESSEY:

Thank you.

CHAIRMAN ANGELIDES:

Ms. Murren.

COMMISSIONER MURREN:

And thank you, Mr. Secretary, for spending so

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Thank you, Mr. Hennessey.

Thank you.

much time with us talking about these important issues.
I'd like to talk to you actually about a

fundamental assumption that people seem to have.

would like to challenge it and get your response to it.

People often say that financial innovation is a

great thing.

an important purpose.

think about cancer research, technology.

And I

It's important.

It's necessary and it serves

But when I think about innovation I

And it seems to me that when you look at

financial innovation over the last let's say decade, you've

got MBS, CDS, CDOs, that all of these really seem to have

led to a common lack of understanding about the instruments

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themselves, both on the selling side of it and on the buying

side of it.

products that have become increasingly complex.

It could extend all the way down into mortgage

And yet they don't seem to protect the people

that would use these kinds of innovations to protect

themselves against a natural business exposure.

seem to have strengthened the U.S. economy and helped the

real economy to evolve.

is to enrich all of the intermediaries throughout this

They do not

But really what it has served to do

process and to create a lot of unpredictability and a lot of

volatility, which leads us to where we are today.

So I guess with that, do you really believe that

financial innovation beyond a certain point is a positive

thing?

WITNESS PAULSON:

No, I don't.

But here is a

problem.

And we really get to the problem we were talking

about earlier, is how to deal with this.

doubt in my mind that a lot of innovation has been good.

mean the fact that we have strong markets, efficient markets

away from, you know, the banks, that I think the concept of

securitization is a good one, and, used properly, it's

great.

Because there's no

I think the repo markets are.

But we have had excessive innovation and

complexity.

And I think particularly--I think excessive

complexity is a problem in a lot of places, even with tech

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companies bringing out new products.

can only--you're just bound to have mistakes the more

difficult, the more complex something is.

And you just learn you

And, of course, with the kinds of complexity we

have with these financial products, it is a real problem.

And so again the only way I can think to practically deal

with it, because I think it is very difficult to write a

rule that said you can do this and you can't do that on

behalf of the government, so I just think that regulators

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should be pushing towards standardization.
And I think the right way to deal with it is with

capital charges, and big capital charges.

If something

is--and, you know, transparency.

toward--fighting toward transparency, disclosure, and

penalize complexity with capital charges.

Just pushing

COMMISSIONER MURREN:

Thank you.

I'd like to follow up on that issue of

transparency, in particular looking at the conversation we

were just having about--indirectly about hedge funds and

their behaviors within the market.

moments for Bear Stearns was when their hedge fund

operations declared that they were insolvent, I guess.

And one of the salient

When you think about the activities of hedge

funds surrounding the crisis there was a fair degree of lack

of transparency in that regard.

Do you think that these are

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entities that should be included in what you just described,

which is a regime that more adequately discloses not only

the positions but also perhaps the motivations of the

various players within the markets?

WITNESS PAULSON:

Yeah, it's very interesting

because we focused on hedge funds early on with the

President's Working Group.

did was to audit the relationships between the prime brokers

and the big banks, you know, and the hedge funds and make

And one of the first things we

sure that the regulated institutions had plenty of capital

and plenty of margin.

where the problem occurred.

And as it turns out, this wasn't

And I think that work was good because it didn't

have a problem.

the regulated entities.

on the citizen conduits, you know, we were focused on the

hedge funds.

But the problem was right under our nose in
And, you know, we weren't focused

But having said that, I recommended that in the

blueprint we put out that hedge funds that were big and

complex enough to be systemically important be

chartered--Okay?--and have that regulation.

for that.

And so I do think that's important.

COMMISSIONER MURREN:

One final question.

And I am all

Thank you.
One of the things that's

striking to me in talking to everyone that we've talked to

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so far is there really hasn't been anyone yet who has

admitted that they've made mistakes in this whole thing,

that they would do differently.

that from 10,000, or is it at 100,000 feet that everybody

makes mistakes?

to tell us what mistakes you might have made in the course

of the crisis.

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I know that you've said

I'm wondering if you'd like to be the first

WITNESS PAULSON:

Well, I would say there's a

good number of mistakes because the--you know, and I think

my mistakes were primarily communications mistakes.

hardly know where to begin there because, you know, let's

start with the TARP.

And I

When we sent the outline we sent a three-page

outline up to Congress.

conference and should have said, 'This is not take-it-or-

leave-it; this is not complete; this is a starting point for

negotiations.'

We should have had a press

I was never able to explain to the American

people in a way in which they understood it why these

rescues were for them and for their benefit, not for Wall

Street--never, ever to make that connection.

rescues today remain very, very, very unpopular.

And the

I think that the things that are generally

pointed out as mistakes that we made are in most cases

situations like Lehman Brothers where we didn't have the

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authorities.

Okay?

And, you know, again looking at it for

100,000 feet, I think the major decisions we made--and I

think with 20/20 hindsight it's easier to say this--working

with imperfect tools and authorities were the right ones.

Okay?

right ones.

And I look back on those and I think they were the

But along the way there were plenty of mistakes

made by everyone.

better a lot of the time.

And, you know, I sure wish I communicated

COMMISSIONER MURREN:

When you look around at the

other people that were involved in this could you give us

maybe just the top two or three mistakes that you saw made

that might have made a difference in all this?

WITNESS PAULSON:

liquidity.

to look at capital.

Well, I think understanding of

I just can't say that over enough.

It's so easy

But capital is a number and it is, you know,

whether it's eight percent or ten percent--and you've got to

look at that in relation to the overall balance sheet.

so when you find a bank taking a prime brokerage account and

taking those securities and using them to finance itself

overnight, but then making a 30-day or 60-day loan to the

prime broker so the prime broker now takes the securities

out, you can't finance yourself overnight but you've still

got that 30-day loan to them.

And

I wonder how people do those

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things.

And so I think those--I think liquidity and

understanding liquidity.

believe despite--you know, we could just talk about all the

mistakes the bankers made, all the mistakes the rating

agencies made.

And then other than that I really

But I think this Committee, if you don't get to

the root causes of these we'll be sitting down with another

Committee in a number of years and it will be worse because

there will be still those mistakes all those different

market participants make but we'll still have the root

cause, which is we'd better change our housing policy, we'd

better restructure and really scale back and shrink the

mission of Fannie and Freddie at a minimum; we'd better do

some things with our tax policy and do some things to

encourage savings in the United States and discourage over-

borrowing.

So again that would be my two cents worth.

COMMISSIONER MURREN:

CHAIRMAN ANGELIDES:

Just one technical matter.

Thank you.
Mr. Secretary, thank you.
When I started

today--

Oh, I'm sorry, Mr. Wallison.

COMMISSIONER WALLISON:

CHAIRMAN ANGELIDES:

Two minutes?

Right.

All right.

And then I have

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a very quick close and...

COMMISSIONER WALLISON:

Yeah.

I just wanted to

follow up on something I thought was very important that

Vice Chairman Thomas talked about, the issue of common shock

and liquidity.

It seems to me the significant fact is that

because of the big losses on subprime and Alt A loans, as

you probably know, the mortgage-backed securities market

came to a halt basically in 2007--that is, couldn't buy or

sell mortgage-backed securities and CDOs and so forth, but

basically mortgage-backed securities.

seems to me, that financial institutions couldn't sell a

substantial portion of their assets and they became largely

illiquid.

assets because of the rules for accounting at the time.

And this meant, it

And in fact they had to write down some of their

So for that reason these institutions looked like

they were unstable or perhaps insolvent.

certainly illiquid and that is very important, as you

pointed out.

banks simply couldn't cope with that.

disappearance of a major asset class; it just was no longer

there.

They were

So the regulation of banks and investment
This is the

There was no market for it any more.
And I would like to have your reaction to that as

a person who is familiar with markets.

WITNESS PAULSON:

Yeah.

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There is no doubt there was real liquidity

problems, huge liquidity problems.

to value assets.

accounting.

thoughtful people that blame mark-to-market accounting, fair

value accounting.

And that makes it hard

And I know your view on mark-to-market

And I know there are a number of very

I'm not one of them.

In other words, I believe the problems would have

been worse without it.

institutions had mark-to-market accounting the excesses

wouldn't have built up to the point that they built up.

would have been more apparent.

you run an institution if you don't have the discipline of

having to mark these assets and put a real value on them

rather than a historical value on them continually.

I believe if more financial

And I frankly don't know how

So again, I'm a proponent--and I think--and I had

people during the crisis say, 'I've got an idea.

stop mark-to-market accounting and the problem will go

away.'

investors.

transparency.

Let's just

And of course that really would have scared
And investors wanted more visibility and

But again, I understand your view.

And I've

spent a lot of time talking about this with thoughtful

people.

to-market accounting accentuated some of the issues.

And there's no doubt that during the crisis mark-

COMMISSIONER WALLISON:

I shouldn't have

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mentioned mark-to-market accounting.

that I was talking simply about the lack of liquidity that

came from the fact that people couldn't value their assets

any more.

WITNESS PAULSON:

COMMISSIONER WALLISON:

WITNESS PAULSON:

There was no market for

There was not a market, or at

least a market they wanted to accept.

10
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Absolutely.

their assets.

8
9

I want to just clarify

CHAIRMAN ANGELIDES:

Mr. Holtz-Eakin.

Very

quickly.

COMMISSIONER HOLTZ-EAKIN:

Thank you.

I just wanted to dig down in the weeds on two

failures and get your opinion on what happened.

know, the overnight repo market failed pretty dramatically.

And we've talked about that.

One is, you

But something that also failed was the sort of

traditional role of the commercial banks as a conduit to the

investment banks.

billion to J.P. Morgan, who knew them, knew their

collateral, and was unable in the crisis to have that loan

take place.

by the officers of Bear Stearns, who said that, you know,

one of the things that went in the past is when things got

bad the investment banks could go to the commercial banks

In particular Bear Stearns went for $30

And this is related to remarks made yesterday

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who had a lender of last resort and that that mechanism was

available to ameliorate difficulties.

3
4

What went wrong in this crisis that that didn't
happen?

WITNESS PAULSON:

Well, I think you need to

expect in any crisis if it's severe enough that an

institution is going to do what it takes to preserve itself

and not overexpose themselves to credit risk.

think that, you know, Tim Geithner, who you'll be talking

And the--I

about later probably can tell you a lot more than I can

about the tri-party repo market.

works:

But remember how that

You've got the custodian banks, and then

after--there's a big time during the day when they, for

almost for administrative convenience were the ones that had

the collateral.

the ones that had all of the--you know, they owned the risk.

And that was an uncomfortable spot for them to be in, and it

was an uncomfortable spot for any particular institution

that was on the other side to be in to be so dependent on

one or another institution.

But during the crisis of course they were

But I don't--I can't comment beyond that, just

simply saying that it is very difficult at a time when

everyone is worried about markets and--to ask institutions

to extend a lot of credit when the confident goes and a run

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has started.

COMMISSIONER HOLTZ-EAKIN:

All right.

CHAIRMAN ANGELIDES:

Early on I referenced when I began the

Thank you.

Just one technical matter.

questioning some documents provided to us by Goldman with

respect to CDOs.

Sachs, one from the Senate Permanent Subcommittee on

Investigations and a page compiled by our own staff from

other Goldman documents, just for clarity.

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11
12
13
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16
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18
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20
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23
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I'd like to enter two pages from Goldman

(INSERT.)

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Just as a closer at least for me very quickly,

Mr. Secretary, because it's been gnawing at me.

So when

Paul Reverse saw the lantern, one if by land, two of by sea,

he jumped on his horse and said, 'The British are coming.'

And I referred earlier to this kind of dilemma you may have

faced.

Here's my question:

Why is it in 2007 that no one from the public and

9
10

financial industry leadership saddled up like Paul Reverse
and warned about the coming crisis?

WITNESS PAULSON:

In 2007 why no one...

I think a lot of people saw excesses.

But

remember, we'd had the nine markets for some time.

is it that, you know, almost any bubble becomes obvious

after the fact.

when you look at them. They all have, you know, they're

usually benign markets.

risk-taking, too much debt, and not a lot of transparency.

And why

And they all have certain things in common

There is almost always excessive

But here I think that many people knew there were

excesses.

And I think there were very few of us--I

certainly didn't--that saw something of the magnitude we

saw.

It's pretty hard to predict a 100 year storm.

CHAIRMAN ANGELIDES:

WITNESS PAULSON:

CHAIRMAN ANGELIDES:

Even as late as late 2007?

Well -Because late 2007 you were

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worried --

WITNESS PAULSON:

CHAIRMAN ANGELIDES:

No, no.

In late 2007 --

Were you worried about

shaking the markets?

WITNESS PAULSON:

Yeah.

I would say in late 2007

I think we knew the markets were fragile.

I think that I--and I've said this a number of times

before--I think I was as concerned as anyone around me.

But in late 2007

And I underestimated in late 2007 and in early

2008, I underestimated--I knew there was a problem.

underestimated the magnitude and the scale of what we were

dealing with--It was just so big--really, almost every step

of the way.

Now I look back and say if I'd been omniscient

I'm not sure what I would have done differently with the

powers.

hard to imagine what we were going through.

don't like to think about it.

But this was--as I think back on it today it's even
It keeps me--I

CHAIRMAN ANGELIDES:

I know the Vice Chair would like to make a

21
22

comment.

All right.

But I'm going to let him close this.
I just want to thank you for coming today.

probably could ask you many more hours of questions.

But

we're going to take 15 minutes for lunch after the Vice

Chair makes his closing remark.

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Thank you, Mr. Secretary.

VICE CHAIRMAN THOMAS:

Mr. Secretary, I think

some of the problem might have been that you were flying at

100,000 feet.

Edwards Air Force Base was in my district for the

entire time I was in Congress.

X15 and flew above 60,000 feet they got astronaut wings.

I'd suggest if you were at about 50,000 then you could have

had a little better picture of what was going on.

WITNESS PAULSON:

VICE CHAIRMAN THOMAS:

And when pilots got into the

Good point.
Thank you very much for

coming.

We really, really appreciate the ability to cross

sections with one person in trying to get a better

understanding of what happened, in both government and the

private sector.

WITNESS PAULSON:

CHAIRMAN ANGELIDES:

We will take a 15-minute recess, Commission

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23
24
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Members.

Thank you.
Thank you.

So we've got to move fast.
(Whereupon, a brief recess was taken.)

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2

CHAIRMAN ANGELIDES:

The meeting of the Financial

Crisis Inquiry Commission will come back into order.

Welcome, Mr. Secretary.

Thank you for joining us

today, and we appreciate you joining us midway in two days

of hearings about the shadow banking system.

Let us start, as we do with all witnesses, and

I'm going to ask if you would stand to be sworn for the

oath.

If you would please stand and raise your right hand.

Do you solemnly swear or affirm under penalty of

perjury that the testimony you are about to provide the

Commission will be the truth, the whole truth, and nothing

but the truth, to the best of your knowledge?

SECRETARY GEITHNER:

I do.

(Witness sworn.)

CHAIRMAN ANGELIDES:

Good.

I know you've been to

the Hill a few times, and you know what those microphones

and lights mean, but in this instance we appreciate having

received your written testimony and we would like to afford

you the opportunity, and we would like the benefit of an

oral presentation by you this morning.

yellow light will go on, and when time is up the red light.

We would like to ask you to give us a presentation of up to

ten minutes, and then we will move to Commissioner

questions.

Thank you, so much.

At one minute the

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WITNESS GEITHNER:

Thank you, Mr. Chairman.

Mr.

Vice Chairman, and Members of the Commission:

Thanks for the chance to have me up here today.

You are engaged in a very important job of sifting through

the wreckage of this crisis so that we can better understand

what caused it and how to prevent a recurrence, and I

welcome a chance to be a part of that effort.

8
9

The Senate took a very important step yesterday
in passing, with overwhelming bipartisan support, reforms to

prevent future financial bailouts.

not sufficient step to make our financial system more

stable.

This is a necessary but

As the debate now shifts to the design of

consumer protection, oversight of derivatives markets, and

other issues, the votes ahead are very important.

And within the context of this hearing, I want to

emphasize a central tragic lesson of this crisis.

create a more stable financial system by carving out certain

types of financial institutions or activities from these

reforms.

We cannot

If we do, we will only make the system less

stable.

If we do, we will only allow once again firms in

the business of providing credit to escape the necessary

protections we need for consumers and businesses against

predation, abuse, and excessive risk.

We have to create a

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strong set of rules that no institution can escape.

In the aftermath of the Great Depression, the

United States put in place broad protections over the

financial system that laid the foundation for a more stable

banking industry for several decades.

But over time, this financial system outgrew

those protections.

banking regulation encouraged activity to move away from the

banking sector in search of weaker regulation and the

Over time, the constraints imposed by

promise of higher returns.

And over time, a large parallel banking system

took root outside of the regulatory framework established

for banks.

financial institutions were allowed to engage in the

business of banking, providing financial services to

individuals and companies without being regulated as banks.

In this parallel system, a diverse group of

At its peak, this financial system financed about

$8 trillion in assets, becoming almost as large as the

traditional banking system.

substantial leverage with relatively thin cushions against

the possibility of loss.

And much of that system used

This parallel financial system, operating with

much weaker protections, proved exceptionally vulnerable to

a loss of confidence.

began to pull back and demand more collateral, forcing

As the crisis intensified, investors

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institutions in this parallel system to sell assets to meet

those demands for cash, pushing the price of financial

assets down, leading to a vicious cycle of panic.

That run--it was a classic run--on our financial

system brought us to the brink of collapse and our economy

faced the risk, a credible risk, of entering a second Great

Depression.

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9

Now many people called this parallel system a
shadow banking system, but it was not hidden away.

operated in broad daylight, financed by institutional

investors with no history--a system with no history, or

reasonable expectation of government support in a crisis.

Instead, in many ways this parallel system was a pure

failure of market discipline.

So why did the protections put in place following

the Great Depression not protect us against the growth of

risk in this parallel system?

First, what helped make the growth in this system

possible was we entered a long period of relative economic

and financial stability during which borrowers and investors

took on more and more risk.

Trillions of dollars of financial decisions were

made in the U.S. and around the world on the expectation

that house prices would never fall; that future recessions

would be short and shallow; that systemic financial crises

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in developed markets were a thing of the past; and that the

world economy would continue to grow unabated.

Those judgments proved tragically optimistic, and

ultimately the protections put in place around the

traditional banking system did not provide sufficient shock

absorbers to withstand a deep recession and a substantial

fall in real estate values.

But part of the cause lies in our balkanized,

fragmented regulatory system designed in a different era

that lagged far behind changes in the financial markets.

The government system of financial oversight was

simply not designed to constrain risk taking in this

parallel financial system.

limited to banks.

authority to set and enforce capital requirements on major

institutions that operated essentially banking businesses

outside of bank holding companies.

Prudential regulations were

The Federal Reserve had no legal

The Fed also had no legal authority over

investment banks, diversified institutions like AIG, or

hundreds of nonbank financial finance companies.

you know had no legal authority to set and enforce capital

requirements on a consolidated basis across the full range

of activities of investment banks.

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The SEC as

And more broadly, and this is critical, no
regulator or supervisor had the core mission of looking

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across the financial system and taking action to prevent the

diversion of activity away from the protections regulations

were designed to provide.

The result was a system that applied safety and

soundness regulation only to banks was unable to protect the

safety and stability of the broader financial system.

Now addressing these failures is an essential

part of the comprehensive reforms now being considered by

Congress.

These reforms would require the enforcement of

tough constraints on leverage and risk taking across the

major institutions that played a critical part in causing

this crisis.

Financial institutions will no longer be able to

escape these limits.

institutions will be forced to operate with higher capital

and more stable funding, reflecting the greater risk they

pose to the economy as a whole.

Large and complex global financial

These reforms will bring derivatives markets out

of the dark.

and comprehensive oversight over all derivatives markets and

all participants in those markets.

They will provide transparency and disclosure

And we will bring standardized derivatives into

central clearinghouses and trading facilities, reducing the

risk that the derivatives markets could again threaten the

system.

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These reforms will provide more stability in

funding markets through reform of money market funds to make

them less vulnerable to runs, and to make repo markets more

resilient.

These reforms will help improve disclosure and

accounting requirements, reducing opportunities for evasion

and giving investors better tools for assessing risks.

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They will address conflicts in rating agencies
and reduce the vulnerability of the system to future
mistakes in credit ratings.

And they will provide a carefully designed type

of bankruptcy process for large financial institutions so

that we can break them up with no risk of loss to the

taxpayer and less risk of damage to the economy as a whole.

Now I know when people look back at this crisis,

when they look at the excessive risks that were taken by

large institutions, there is a natural inclination to want

to move those risky activities elsewhere.

stability, some argue, we should simply separate banks from

risk.

To create

But, in important ways, driving risk-taking into

areas with less regulation—that’s exactly what caused this

crisis.

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The fundamental lesson of the parallel financial
system is that we cannot make the economy safe by taking

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functions that are central to the business of banking,

functions that are necessary to help raise capital for

businesses, help businesses hedge risks, and move them

outside of the banks, outside the reach of strong

regulation.

Mr. Chairman, let me just close by thanking the

Commission for your important work in drawing public

attention to what I think was one of the key factors in this

crisis, and one of the most important objectives of

financial reform.

Thank you, very much.

CHAIRMAN ANGELIDES:

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Geithner.

Thank you, Secretary

We will now begin the questioning.
Let me start with just a few questions.

And as I

said to Former Secretary Paulson today, at least in my

instance, while there's been a lot of fascination generally

with the bailout and how the financial system was

stabilized, I think the questions I want to focus on today

is how do we come to the point where it seemed like the only

two options were either to allow a collapse of the financial

system, or to commit very, very substantial, trillions of

dollars of taxpayer money, to save it.

And I do want to talk to you in your role as

President of the Federal Reserve Board of New York,

recognizing that you had direct supervisorial

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responsibilities over bank holding companies, but beyond

that in many respects you were the eyes and ears of the

Federal Reserve on Wall Street.

You were in constant contact with primary

dealers.

financial community.

in monitoring systemic risk, and in fact had undertaken some

efforts with respect to cleaning up the backlog in trade

confirmations in the OTC derivatives market.

You had a board that did have linkages to the
And that you had played a special role

So one of the things I noted in preparing over

the last month for our look at the shadow banking system is

that in the period of 2004, 2005, 2006 you actually made a

number of speeches about risks that were extant on

derivatives, and contagion, shadow banking--I will note you

made two different speeches on the same day, May 19th, it

must have been a busy day, talking about risk, about

concentration of risk posed by CDOs and credit derivatives;

and about leverage in the system.

And it seems to me you were in a place where you

had an extraordinary access to information, not just market

data, but what primary dealers were telling you, info on the

repo markets.

I have, particularly as we look forward trying to assess the

impact.

So this is a pretty fundamental question that

What didn't you know?

And this doesn't need to

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be just ad hominem, but what did you and other key policy

makers not know and not have before you to understand the

magnitude of what might hit us?

WITNESS GEITHNER:

CHAIRMAN ANGELIDES:

WITNESS GEITHNER:

Well, Mr. Chairman-Microphone on.
Sure.

Let me just start by

saying I had spent the previous 15 years in public service

dealing with a series of incredibly damaging emerging market

financial crises, and the financial crisis in Japan.

So when I went to the New York Fed, I had been

blessed or scarred by the experience of watching countries

manage and mismanage the development of risk in systems, and

how to clean up and contain the damage in the aftermath.

And when I went to the New York Fed, early in that process

beginning in 2004 we began a series of very important

initiatives to try to contain, dial back, reduce the growing

risk we saw in the system and improve the odds that if

conditions changed, if we faced a shock, a recession, that

the system was going to be stronger, in a stronger position

to withstand that shock.

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Let me just briefly mention the three most
important things we did in that context.
The first was to bring a series of experts in

markets and risk management, led by Jerry Corrigan, together

to do a comprehensive examination of the state of risk

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management practice in managing exactly the kind of things

that have been the subject of this crisis:

derivatives, exposure to hedge funds, complex financial

products, how liquidity is managed, how stress testing is

conducted.

risk in

And using a model of a process very much like

what you are doing, which is a sort of a post-mortem process

after the failure of long-term capital management, we

brought that group together at my initiative and asked them

to do a comprehensive evaluation and to provide

recommendations.

Then we took those recommendations and we asked

the major firms in the world to undertake an assessment of

how they were doing against those recommendations.

Second, a very important thing we did is to bring

financial supervisors of all the major global firms--the

SEC, the British FSA, their counterparts in France and

Germany and Switzerland in particular, together to conduct a

series of what we called horizontal reviews to try to assess

limitations and risk management and try to encourage people

to fix those problems in risk management early.

And those were targeted on very much like the

thing I began with, risks in derivatives, in lending to

hedge funds, in management of liquidity, in conducting

stress testing.

And those efforts were designed to assess

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what was best practice, where there were gaps, and try to

bring all the supervisors together around the world to

encourage, beginning at that point in the period of '05-'06-

'07, to try to get firms to dial back the risks they were

taking.

And the, finally, just to mention the one thing

you mentioned, we began a similar effort to start to clean

up the derivatives markets for more standardization,

automation.

Those were fundamental changes that have paved

the way now to what we hope to achieve in these reforms to

bring this stuff out of the dark onto clearing houses so we

can manage the risk better.

Now as you know, those efforts were, in the end,

fundamentally inadequate.

enough.

There are a lot of complicated reasons for that that I would

be happy to discuss, in part because we were operating

within a set of existing capital requirements that did not

adequately capture the risk that the system had to the

possibility of a deep recession.

They did not do enough soon

They did not come with enough force and traction.

So I think the simplest way to answer your

question about what did we not know, what we did not know

was the degree to which the system was reliant on ratings,

ratings that did not capture what falling house prices would

do to losses across the system.

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We did not know the extent to which this parallel

financial system had built up leverage and exposure to

liquidity risk in a level that would, when it came crashing

down, would threaten the stability of the rest of the

system.

We did not know how vulnerable money markets were

to runs, how unstable that basic funding structure was.

I could go on.

CHAIRMAN ANGELIDES:

So overrun by events,

inadequate political infrastructure to make the changes

necessary, under calibrating the size of the wave?

WITNESS GEITHNER:

And

Absolutely.

I think that the-

-you know, since we were coming out of a period where, as I

said in my remarks, we had these two fundamental

characteristics of the system.

seemed relatively calm.

shocks from LTCM since, the system had got through them

without catastrophic damage.

One is, a long period that

So even with all the financial

That created a sense, a false sense of

complacency about how resilient the system was.

And you had

this enormous growth in leverage and run risk, liquidity

risk, in a large parallel financial system.

related.

had no experience, with what a shock this large would do,

what would happen when you had a run on that system.

Those were

And it was--people could not assess, because they

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Now, but you're exactly right, so the oversight

system, as I said in my remarks, did not give--did not

establish a set of classic constraints on leverage that all

financial systems require on what came to be a large part of

the American financial system.

And people tried, with duct tape and string, like

the SEC did in their CSE regime, to take the authority they

had and make the best of it, and try to get to a point where

they were trying to put in place better constraints, but

that effort came too late.

grounded in law.

It was too weak.

It was not

And it was fundamentally inadequate.

CHAIRMAN ANGELIDES:

So let me ask this.

That

is, given you had spoken on this, and you had actually

identified what you saw were levels of risk, and some might

say levels of irresponsibility, so you saw those two trains

of risk and irresponsibility, you know, going towards each

other, towards collision.

in leadership sounded the alarm early enough and loud

enough?

Do you believe that you or others

WITNESS GEITHNER:

Oh, Mr. Chairman, I will say

this always, and I would say it again, absolutely we could

have done more.

CHAIRMAN ANGELIDES:

WITNESS GEITHNER:

people ask is this inevitable?

Okay.
Absolutely.

And, you know,

Were we really fundamentally

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powerless as a country to prevent this from building up?
And I do not agree with that.

I do not believe

we were powerless.

just from the benefit of hindsight--but I would say that if

the Government of the United States had moved more quickly

to put in place better design constraints on risk taking

that captured where there was risk in the system, then this

would have been less severe.

I think that--it's unfair to say this

And if the Government had moved more quickly to

contain the damage, I think the crisis would have been less

severe, as well.

CHAIRMAN ANGELIDES:

So let me talk about that.

In the last two days, I've cited a number of market warnings

that I won't repeat today from the dramatic expansion of

mortgage debt in this country, to the explosion of subprime

lending, the efforts of states that were preempted by the

OCC to fight unfair and deceptive lending.

a person in real estate investment, just on the ground

seeing 11, and 12, and 13, and 15 percent annual increases

in home prices.

And, look, I was

So a lot of warning signs out there.

So clearly one of the things you've identified is

the lack of the structural ability to move on these

problems, but do you also think--I want to ask this, and

I've really thought about it as we've gone through a set of

hearings--do you also think that the system doesn't have

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enough iconoclasts in it?

That the decision making process

is unduly controlled, essentially, by people who are of the

financial system and close to it and unable to step away

from it in a way you need for true risk assessment?

WITNESS GEITHNER:

CHAIRMAN ANGELIDES:

I think-And of course I think there

are variations of this, all the way from people maybe on

Wall Street who can't see what's happening in Bakersfield,

and Sacramento, on the ground to families, to people who

just don't have enough distance to make a critical analysis

that you would want and expect?

WITNESS GEITHNER:

I think that is a very good

question.

jobs, and I definitely tried in the New York Fed to make

sure that we brought together people in advisory committees

we established that represented a great diversity of views

in these things, from the academic community, from the

broader business community.

And I try always--I've always done this in my

And we put in place a series of advisory

committees that tried to capture that diversity of interests

and perspectives.

important.

makers to make sure that they force themselves to be exposed

to a wide diversity of views.

Because I think what you said is so

And I think that it's very important for policy

Fundamentally I don't think that was the problem.

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I think the problem was that you did not have a centralized

accountability matched with authority anywhere in the

government to look across the system, try to identify where

we had a problem, and have the capacity to go in and act

preemptively to try to put in place measures that might

mitigate those risks.

Our system was fundamentally solid and

balkanized.

You had people trawling over parts of the

system, and parts of the system that are very risky with

nobody looking at it, and nobody responsible, nobody in

charge, and that was a tragic failure for the country as a

whole.

It was an avoidable failure, I believe.

It's

easy to say that in hindsight, but it was true, as you said,

at the time that anybody who was operating in that world

could see that you were seeing classic signs of a asset

price credit bubble that could prove very catastrophic.

And the way I used to say it, Mr. Chairman, was

that we had this huge wave of changes in finance, capacity

to hedge, other things that helped disperse risk, that

looked like that produced a more stable system.

like they would reduce the probability of a major financial

crisis.

happened--they also meant that if we were to face a major

financial crisis, it could be much more damaging and much

They looked

But they also--and this was essential to what

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harder to manage.

start, as it did, in this parallel system where there was

much more leverage and liquidity risk.

complicated it dramatically.

tools there to try to contain the damage earlier.

is really the story of the crisis.

Because it was likely to take place and

CHAIRMAN ANGELIDES:

Derivatives markets

And you did not have in place
And that

And many of those,

quote/unquote, "signals" I was talking about were not just

market data, but looking at leverage ratios, liquidity risk

in those firms that were evident.

Now two very quick, specific questions, because I

want to move on to other Commissioners, about points in

time.

is also try to measure what people saw at different points.

Because one of the things I think we are trying to do

So very quickly--and I raised this with Secretary

Paulson today--on March 16th there was some engagement, as

you know, between the Secretary and Fannie, Freddie, OFAO, I

think fairly stated, to life the portfolio caps, keep them

in the marketplace as the private market has totally

withdrawn.

The only reason I mention it is there's a

reference--and I don't expect you to know this email, but

I'm looking for the bigger picture here--Bob Steele, who's

involved in these negotiations essentially to keep Freddie

in the game.

I think that's how Secretary Paulson would

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phrase it.

It says:

I was leaned on very hard by Bill

Dudley to harden substantially the guarantee.

I do not like

that.

It's not been part of my conversation with anyone

else.

I view that as a very significant move, way above my

pay grade, to double the size of the U.S. debt in one fell

swoop.

I think what I'm really driving to is, in March,

that Bear weekend, were you worried about what something of

the magnitude that ultimately happened in September

happening in March?

WITNESS GEITHNER:

Absolutely.

were.

Bear Stearns fell off the cliff, we were deeply worried

about what that would do to the broader stability of the

financial system.

Freddie, like many other parts of the financial system,

faced very substantial losses on their, particularly their

retained mortgage portfolio.

encourage the relevant authorities to encourage those firms

to go out and raise a lot of capital.

I'm sure Secretary Paulson was.

I think we all

At that time, as

And we knew at that point that Fannie and

And we worked very hard to

As we were doing in other parts of the system, it

seemed the straightforward, sensible thing.

And that was

important because, as we saw, fundamentally, short capital

going into a storm like this is catastrophic, and they were

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short capital.

And the problem with these crises is, people tend

to wait.

is expensive, they don't want--their shareholders.

the basic classic pattern that was magnified dramatically in

the untenable corporate structure Fannie and Freddie had,

and we worked, as many people did, very hard to try to

encourage people, to encourage them to raise capital early

for exactly the reasons that the email reported.

If they wait too long, it looks weak, the pricing

CHAIRMAN ANGELIDES:

Just kind of yes or no, were

you for hardening the guarantee at that point?

share Mr. Dudley's view?

WITNESS GEITHNER:

So it's

Did you

I often used the argument that

you need to make it more credible to the world.

going to have the financial resources to meet their

commitments.

is by making sure they raise more capital.

strengthen what was an implicit commitment at that point for

the government to stand behind them.

They're

You can do that lots of different ways.

One

The other is to

And ultimately of course that was--both were

necessary, and I was fully supportive of the judgment, of

the need to take that step.

CHAIRMAN ANGELIDES:

All right.

And this again goes to depth.

Final question

for you.

Later today we will

have a panel of GE Capital, Pimco, State Street,

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participants in the, quote/unquote "shadow banking system,"

but also the repo market.

Now it appears from documents that we have that

GE was able to keep going with its issuance of commercial

paper throughout this crisis, even though of course the

general spread over LIBOR increased for all participants.

But, you know, at some level the disruption of the credit

capacity of GE speaks volumes about the depth of what we

were seeing.

So on September 29th and 30th, you had six

telephone conversations with Mr. Immelt.

that in context, you probably lived--you know, you probably

didn't get any sleep these days, but the 27th and 28th was

the day that Goldman and Morgan Stanley became bank holding

companies, that weekend.

And just to put

On Monday, the 29th, that's the day the Dow

dropped 777 points after the House voted down the financial

bailout bill.

Was Mr. Immelt speaking to you about concerns

about disruption and their ability to issue commercial

paper?

WITNESS GEITHNER:

What you've seen, you've

described exactly well.

At that point, after that famous

mutual fund, money market fund broke the buck in the wake of

Lehman's failure, you had a broad-based run on money market

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funds, or the risk of that.

on commercial paper markets.

And you had a broad-based run

And so you faced the prospect of some of the

largest companies in the world and the United States, losing

the capacity to fund and access those commercial paper

markets.

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So we were involved at that time in designing
what ultimately became the Commercial Paper-CHAIRMAN ANGELIDES:
WITNESS GEITHNER:

CPF.
--Financing Facility, which is

a backstop for the commercial paper markets, to complement

the temporary guarantee for money market funds.

So I was involved in a whole range of efforts to

help design that facility.

conversations with people across the financial markets who

depended on commercial paper markets, who were trying to

make sure we were aware of what was happening and how

perilous it was.

And I was exposed to and had

You didn't need a phone call to tell you that.

All you needed to do was look at what was happening in the

price of that stuff and how hard it was.

development that was self-evident and obvious to all of us

at the time.

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CHAIRMAN ANGELIDES:

And it was a

But was Mr. Immelt concerned

specifically about that and talk to you about that?

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WITNESS GEITHNER:

I could go back and try to

refresh my memory on those specific conversations, but what

I'm sure they were about is trying to make sure we were

aware of how perilous they thought even a company that

strong, how perilous those markets were at that time.

But as I said, that was self-evident.

It was

obvious, conspicuous, and you could see it just looking at

your screen.

CHAIRMAN ANGELIDES:

Right.

And I don't expect

you to carry our daily planner with you, but if you would

check on that, because I think we're trying to get a measure

of the intensity and direct concerns by different market

participants.

30th, and there are six conversations.

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16

If you would check, it's September 29th and

Thank you.
point.

That's all my questions at this

Mr. Vice Chairman?

VICE CHAIRMAN THOMAS:

Thank you, Mr. Chairman.

Mr. Secretary, I do really appreciate, one, your

willingness to come before us, but, two, the manner in which

you have done so.

protocol, having been around a long time, but our ability to

talk to Secretary Paulson, and the value of his having been

on Wall Street in the private sector, and then becoming

Secretary of the Treasury, followed by your presence which

had you at the Federal Reserve just prior to coming to the

I am very sensitive to structure and

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Secretary of the Treasury--I noted both of you also went to

Dartmouth; I don't know what that means to all these Harvard

guys around, but I appreciate that.

(Laughter.)

VICE CHAIRMAN THOMAS:

It gives us an opportunity

to ask questions which bridge that 2002-2003 to 2009 window

in a way I don't think we've ever been able to do that.

So when I ask you this question, especially based

upon your comments about what you did at the New York Fed in

bringing together experts for the state of risk management,

then running a global confab with those same subject matter,

and most people can't see this, and this is the only thing I

have available right now, but basically it's the assets of

selected financial sectors.

And it shows, the blue, obviously are the

deposits of the old-fashioned banks, and then this is the

shadow banking above it (indicating).

Reserve Board of Funds Flow Release.

And it is a Federal

So it was around, and people were aware of that.

And when you run the numbers, and this is all 2008, you have

this commercial banks at about $7.3 trillion, the so-called

shadow banks somewhere between $7.1, $7.3, so I mean a 50-50

split right there.

mortgage-backed securities, 2008, about $6.7 trillion.

then you've got over-the-counter derivatives, same time

When you look at the residential
And

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frame, about 2008, gross market value of $20 trillion,

nominally $684 trillion.

And we all knew about the runs on the bank in the

'30s and the liquidity problem.

Didn't anybody talk about

the top-heavy aspect, that somehow what worked to keep

conventional banks--and because of those restraints then

they developed other approaches, but clearly it was the same

thing almost all over again, except much more difficult to

perceive because of the muddiness, the ratings, and the

rest.

That never came up as a subject matter, either when

the experts sat around and talked about we're kind of

concerned about the weight shift into an area that could

have liquidity problems and could be subjected to a run like

we had in the '30s?

And the global folk didn't talk about it, either?

I just don't get it.

And I need to understand.

Now what we've heard from a lot of other people, players in

the market, was that nobody had a model that in the

pejorative sense people have said that never thought housing

prices were going go down--I think the corrector answer is,

no one thought they were going to go down that far.

And even given that, you have areas in the

government that talk about disasters that no one likes to

think about because somebody's got to think about disasters

that no one thinks about.

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I would think that the New York Fed might be

involved in that.

Looking at those markets, the monitoring

job may not have a direct power position, but you're the

best person in my opinion to ask in that '03 to '08 period.

What happened?

WITNESS GEITHNER:

Absolutely.

Let me just begin

by saying financial crises are caused by unwillingness of

people to think the unthinkable, and say, well, that seems

kind of unlikely so we're not going to worry about that.

That is the fundamental mistake that underpins

most financial crises.

And our system was--that mistake was

pervasive across the system.

VICE CHAIRMAN THOMAS:

WITNESS GEITHNER:

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Basic, or total?

Well, complete, whichever

phrase you want to use.
VICE CHAIRMAN THOMAS:

Yeah, because even the

people, the watchers watching the action apparently thought

the same thing.

WITNESS GEITHNER:

No, I wouldn't say that.

VICE CHAIRMAN THOMAS:

WITNESS GEITHNER:

Okay.

The initiatives that I

described that the Chairman began with, that we at the New

York Fed were engaged in, we didn't call it, we didn't

really talk it back in '04-'05 about the shadow banking

system, but we were deeply focused on exactly this risk.

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You know, when I explained to people when I first

came into that job, I said, well, let's just look at the

system today.

about the investment banks?

It's true we have these major banks, but what

What about AIG?

Who is watching them?
What about the GSEs?

What about

the hundreds of finance companies that built up, not as

banks but doing basic banking?

So that basic concern about the vulnerability of

the financial system to systemic risk in those institutions

was central to the efforts that I described that we

initiated.

Now you are right to say that those were outside

of our--in many ways outside of our formal legal authority,

and outside of our mandate in some sense, but we knew they

made the core of the system we were responsible for more

risky.

effect we were the only fire station in town you could turn

to when things fell apart for liquidity.

And we knew we were in the classic position where in

But we had no capacity to constrain risks outside

that regulated core.

But what none of us anticipated I

think was--and I certainly did not understand fully--was

what produced that parallel finance system, how vulnerable it was to

runs.

were--again, they were operating in public markets, issuing

publicly rated debt under the disclosure laws of the United

How you could have had a system where these people

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States, funded by institutional investors, that market

discipline and all the checks and balances we rely on in

that area would have proved so inadequate to contain

leverage earlier.

Fannie and Freddie you could understand because

it was centrally moral hazard, but in the other part it's

hard to make that argument in that case.

So I guess I would say that set of concerns was

central to the efforts we began, but fundamentally what we

learned, what we discovered is, and this is an important

lesson for us that underpins our reform efforts, is that you

can't run a stable system with one part under constraints

and leverage and one part without.

And these constraints on leverage, capital

requirements, were not conservative enough, where they

existed, and they were not designed in a way, given the

accounting disclosure regime, that allowed us to fully

capture the risk in the extreme event.

And partly because of the reliance on ratings,

partly because we have this long history before relative

stability, so it wasn't in the memory, and that left the

whole system more vulnerable to the collapse when it came.

VICE CHAIRMAN THOMAS:

So given those areas that

you did have responsibility over, the old-fashioned

commercial banks, Bank of America, Morgan Chase, Citibank,

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the one thing that strikes most people when they talk about

it, they're really, really upset about what happened in the

residential mortgage area because it affects them directly.

What scares them more was the fact that there

were no firewalls anywhere.

And that what started in an

area that you could say wasn't regulated, by definition

shadow banking and the rest of it, but it also affected the

structure that was designed after the initial failure not to

fail again.

WITNESS GEITHNER:

VICE CHAIRMAN THOMAS:

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13

Exactly.
Okay, so I got it right,

but how come we didn't get it right?
WITNESS GEITHNER:

Well, again, we came in--

another tragic failure of the crisis was that we designed a

system with deposit insurance around banks, access to a

lender of last resort, basic protections designed to prevent

a fire caused by the failure of a single bank to infect and

jeopardize the stability of banks.

That system, long tested over time, comes with

moral hazard risk.

Not perfect.

crisis being a good example.

of those protections.

Lots of failures, the S&L

But this other system had none

No fire breaks.

No firewalls.

And the Executive Branch of the United States,

the largest financial system in the planet, came into the

crisis with the President having only emergency authority

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limited to the act of closing financial markets, or

declaring a bank holiday.

largely panic-increasing, not panic-containing.

Actions in a crisis which are

So you're exactly right.

We didn't have the

tools to prevent the fire from jumping the firebreak and

infecting the system, and these reform proposals Congress is

debating--I know that's not the subject of your hearing--are

designed to provide exactly those tools, to make sure that

large, complex institutions like AIG manages itself to the

edge of failure, you can put them out of their misery safely

and prevent the fire from breaking--from jumping the fire

break.

VICE CHAIRMAN THOMAS:

One last question, which

again amazes me in terms of how many people have used it as

an answer, in terms of the assets that they held and the

potential liquidity, especially in the shadow banking area,

they were AAA rated.

I mean, at what point, when you look at the kind

of residential mortgage product that was bundled, everybody

knew, people that you never thought could get in a house,

had gotten in a house.

20-percent-down and all the other arguments that gave you

some comfort.

So something had happened to the old

Why would anyone think a package of the '08 stuff

would have the same AAA rating as the package of the 2000 or

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1990 rating?

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3

Was it because they wanted to believe it did?

I mean, how could anybody think that?

And

especially this group of experts and others?

WITNESS GEITHNER:

Well when things are going

well, people are making money and they tend to think they're

smart, not lucky, and they think that it just validates

wisdom.

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9

VICE CHAIRMAN THOMAS:

Mr. Secretary, I just have

to tell you that when things are going well and people are

making money, no one thinks about making the amount of money

that was being made--

WITNESS GEITHNER:

VICE CHAIRMAN THOMAS:

I agree.

I completely agree.

--on Wall Street.

That's

not money.

WITNESS GEITHNER:

I completely agree.

And it

reinforced again this basic collective sentiment that we had

somehow produced a perfectly stable system immune to shocks,

things couldn't go bad.

happened to compensation, a whole range of other incentive

structures, fed that illusion.

And you're right in many ways, what

VICE CHAIRMAN THOMAS:

Somewhere I remember reading something about

pride going before a fall.

Secretary.

Thank you.

Thank you, very much, Mr.

CHAIRMAN ANGELIDES:

Ms. Born.

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COMMISSIONER BORN:

Thank you very much, and

thank you, Mr. Secretary, for being willing to join us and

help us in our investigation.

Your testimony I think demonstrates how there

were regulatory weaknesses, regulatory gaps, that tied the

hands of the regulators and financial supervisors during the

crisis.

8
9
10

And I take it that you feel that lack of
regulatory powers in some areas was an important aspect of
the problem.

WITNESS GEITHNER:

Oh, absolutely.

As I said in

my written testimony, this crisis is littered with examples

of authority that was not used early enough and forcefully

enough.

But in the subject of your hearing, and this is

true for shadow banking, parallel banking, derivatives

markets generally, I would say the oversight failure was a

gap, a vast gulf in accountability and legal authority that

prevented people, even people who had perfect foresight,

from acting preemptively to contain those risks.

COMMISSIONER BORN:

Let me just ask you briefly

first about the over-the-counter derivatives market, an

enormous and unregulated market, as of the time of the

crisis, where there were tens of thousands of contracts out

there creating counterparty credit risk, and virtually no

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transparency.

You said in your testimony:

These markets have

proved to be a major force of uncertainty and risk during

periods of financial disruption.

Do you feel that the lack of regulation, the lack

of transparency, the enormous size of the market, played a

role in exacerbating the financial crisis?

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9

WITNESS GEITHNER:

I do.

I would emphasize two

things, though.

The first is that--and this is I think

fundamental.

You had very large institutions writing

hundreds and hundreds of billions of dollars of commitments

in derivatives without capital to back them up.

obviously true for AIG, but it was true for a whole industry

of monoline insurance companies, and of course it was true

for many other financial institutions.

This was

So fundamentally what happened is, when they had

to meet those commitments they didn't have enough resources

to do it.

collapse.

And of course that brought them to the edge of

But I think the other problem was that in this

world of millions of bilateral contracts it was like

spaghetti, cooked spaghetti together.

hit and you had to untangle those and try to figure out what

was my exposure to default risk across the system, it was

And when the crisis

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very hard for people to know.

And, they reacted as people do in facing fear.

They decided, I am going to withdraw and pull back from risk

wherever I can.

like margin spirals do, and that tends to amplify the

crisis.

And that in a crisis tends to feed a panic

So the inability that those tens of thousands or

millions of contracts provided for people to assess quickly

what my exposure was to a risk of default by a major

institution was a substantial factor exacerbating the panic

and made the crisis harder to manage.

And of course the paradox is that those were

markets designed to help people hedge risk.

people the capacity to hedge risks, but it also gave them

much more risk of exposure to panics when things fell apart.

COMMISSIONER BORN:

And that gave

So not only--I mean, I

believe they are very useful instruments and essential to

managing risk, but they also magnified risk greatly in this

disruption.

WITNESS GEITHNER:

COMMISSIONER BORN:

I agree with that.
Is this why the

Administration is proposing regulatory oversight over the

market?

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25

WITNESS GEITHNER:

Yes, absolutely.

Again, these

markets grew up--grew dramatically in the decade that

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preceded this crisis.

You know this of course very well.

The risks were apparent to many earlier, but they

grew dramatically over that period of time.

fundamentally--I mean, people were doing this thing by

spreadsheet and fax.

accessible records of what their exposure was.

And it was a

People did not have electronically

There were huge backlogs of transactions not

captured by risk management systems.

So when we came--when

I came to the New York Fed and we started an effort to clean

that up and produce it, it put us in the position where we

could finally propose reforms that would bring the

standardized part of the market onto clearinghouses and make

sure that centrally cleared stuff would be traded on

exchanges, or on electronic trading platforms, and the reforms

also of course as I said give people the authority to make

sure that major institutions writing these commitments are

forced to hold capital against it; that margins are

conservative enough; and that the SEC and the CFTC have the

tools they need to better police fraud and manipulation to

deter fraud and manipulation earlier.

Those are the reforms now working their way

through the Congress, and they are a very strong package of

reforms.

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25

COMMISSIONER BORN:

You have essentially

indicated that the lack of regulation, or the lower level of

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regulation in shadow banking made the shadow banking sector

more vulnerable to the financial problems that we

experienced in 2007 and 2008.

And I wanted to ask about kind of the flip side

of the coin, which is:

of the shadow banking system impacted subtlety or at all on

banking regulation?

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9

Whether the growth and competition

Because this was a less-regulated system.

think the banks did suffer competitively with various

aspects of the shadow banking system.

deposits to the money market funds.

commercial loans to commercial paper, and repo.

imagine that commercial banks, having felt this competitive

pressure, would have wanted to be able to engage in broader

activities and with less constraints from banking

regulators.

You know, they lost
They lost potential
And I can

We have been told during our investigations that

by the time Glass-Steagall was altered by Gramm-Leach-

Bliley, there was not a great deal of separation in fact

between the activities commercial banks could engage in and

investment banks.

So I wanted to ask you whether, as a banking

regulator, you saw pressures to soften constraints on the

commercial banking sector because of the growth of shadow

banking?

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1

WITNESS GEITHNER:

constraints.

everything that was happening.

examples.

I did not feel those

But what you described was central to
And you gave all the right

But let me provide a couple, a few more.
We created a system that allowed institutions to

in effect choose the regulator.

were banks that chose to become thrifts, Countrywide being

the best example.

The best examples of that

A lot of people thought regulatory competition

was a virtue.

you allow people to move risk to where the regulations are

weakest and they operate with leverage and risk to the

system, that's just a catastrophic choice.

It would produce better regulation.

But if

So you saw it definitely across banking

regulators.

example where Countrywide was able to evade the tougher

restrictions of a Fed regime and choose the softer regime,

restrictions of an OTS regime.

And in fact, you know, Countrywide is an

That's a good example.

And overwhelmingly you saw people pressured,

banks and--pressure to follow the market down.

happened in mortgage underwriting is another great example.

What

I think it's true in the early part of that

decade, really probably up to 2004, most mortgages were

still underwritten by banks and by thrifts.

But over time of course most of the mortgages

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1

migrated to other parts of the system outside the banking--

remote to the banking system for the same basic reason.

So again, the mistake is to permit that on a

scale that can threaten the system.

reforms do, which is very important, is recognize the basic

principle that if you're doing banking we regulate you as

banks so we can better protect the system.

8
9

And again what these

It doesn't mean everybody has to be exactly the
same in their financial structure, but the leverage

requirements they operate with, the requirements on funding,

should be economically similar so we produce a level of

stability that's more tolerable for the country.

COMMISSIONER BORN:

When you were at the Federal

Reserve Bank of New York, you and your staff had the role of

overseeing some of the biggest bank holding companies in the

world.

adversely during the financial crisis that we've

experienced.

And those were also institutions that suffered

I wonder if you would comment on the ability of

supervisors to effectively oversee institutions that are

that large and that complex?

and your staff really had the capabilities to do the kind of

job you would have wanted to do?

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25

WITNESS GEITHNER:

And, whether you felt that you

I believe we did.

And I think

that we have examples where it worked quite well, and

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1

examples where it was just fundamentally inadequate.

It was absolutely made more difficult by the fact

that we were operating in a system where the checks and

balances that we all rely on, which are internal controls,

good audit control regimes in these firms, risk management

systems that look across the entire entity and capture those

risks and bring them together so you can look at them, those

things were fundamentally weak and inadequate, and we were

very vulnerable to that.

We were somewhat vulnerable to the fact that

under Gramm-Leach-Bliley we rely on functional supervisors

to supervise for safety and soundness the underlying bank,

or in the case of the SEC in this case it was the broker-

dealer.

able to push risk into other jurisdictions like in many

cases in the UK in ways that make it harder to capture it.

And we were vulnerable to those limitations of that system

as a whole.

And these firms operated across the world and were

And of course as we've learned, the capital

requirements, and the accounting requirements, and the

disclosure requirements did not do a good enough job of

giving us a good picture of what capital really was relative

to risk.

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25

And that is why the big lesson I take from this,
among the many lessons, are to make sure that we force the

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system to run with more conservative requirements on

leverage.

that depends on a community of regulators always being wise,

and tough, and smart, and have foresight, and perfect

foresight to come and preemptively and preempt pockets of

risk, and bubbles, and leverage.

Because I do not believe you can design a system

I think it's unlikely.

We will do our best. Our successors will do their

best.

But they will be imperfect.

And the best defense

against that potential problem is to force the system to run

with stronger shock absorbers:

available to absorb losses across the system; and again

that's the lesson we're trying to bring about with these

reforms, so that not just the institutions run with less

leverage, but that markets like repo, or secured funding

markets, securities lending markets, et cetera, derivatives

markets, where firms come together, also run with much more

conservative cushions against the unknowable, against the

uncertain, against the likelihood, the possibility that the

next shock could be beyond our imagination, beyond our

experience, and could be very damaging.

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22
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reserves, in terms of cash

I think that's the central lesson we try to take-I try to take from the crisis.
COMMISSIONER BORN:

What about the need for a

systemic view which is very hard for any of our existing

regulators to have because of their siloed jurisdiction?

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1
2
3

WITNESS GEITHNER:
important.

I think that is very

There are two ways to do it, just conceptually.
One is to take all the regulatory

responsibilities that are relevant to systemic risk, put

them in one place, like maybe the British did in some ways,

and have a single point of accountability for measuring and

managing all those basic risks.

8
9

I don't think that system works.
it's feasible.

I don't think

We're proposing a different model, which is

to create a council, which brings those firms, those

entities together with their functional specialization for

market integrity, for resolution like the FDIC for safety

and soundness, for the payment system, et cetera, and put

them in a place where they have to sit around the table with

the Secretary of the Treasury, who because we're the

custodians of the taxpayers' money, and fundamentally

responsible for the financial security of the country, have

to be in a position to be accountable to the Congress for

making sure that complement of regulators is running the

system sufficiently conservatively, that there are not big

gaps, the system is not lagging way behind the growth in

these markets.

Now that is not going to force perfect foresight,

but I think it offers a better chance of at least forcing

somebody to be accountable for looking across the system to

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1

make sure that we don't recreate again huge gaps,

opportunities for evasion, arbitrage, where the rules lag

way behind risk in the way they did in this case.

COMMISSIONER BORN:

CHAIRMAN ANGELIDES:

COMMISSIONER BORN:

Could I have two minutes?
Two minutes.
Let me ask you one last

thing.

There became prevalent a view among economists, a

view among some regulators during the last 10 or 20 years,

that financial markets were essentially self-regulatory, and

government supervision, government regulation of markets,

was either unnecessary or actually counterproductive.

Do you think that played a role in the regulatory

weaknesses and the regulatory gaps that you have described

in your testimony?

WITNESS GEITHNER:

It's hard to know.

I find it

hard to imagine that anybody who lives in financial systems

believes fundamentally they are self-regulating, just

because the history of financial systems is a history of

recurrent crises, some devastating like this one, and some

more mild, but always consequential.

And we learn those lessons painfully, of course,

but I think the lesson of behavior and experience in history

is that if you allow institutions to take deposits that can

be withdrawn on demand and make loans that can't be called

on demand, then you create a risk of runs.

And if you allow

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1

them to run with big leverage, that's consequential to the

economy as a whole.

And so we built up a set of protections, not just

to counteract the moral hazard caused by the perception that

these firms are important--failure would be consequential--

but to make sure that you protect the economy from things

getting out of whack.

Now our system, like any country, has among its

strength, it has a lot of people with diverse perspectives

making these decisions in the Congress and in the regulatory

community.

I think the real problem was that that long

period of stability allowed all views to prevail.

people could say that proves that all these innovations

reduce risk; that they prove that the market is working

well; that capital requirements are strong.

period where risks seemed permanently reduced allowed people

to not confront I think what were fundamental

vulnerabilities.

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21

And that long

So that is the way I would try to answer that
question.

COMMISSIONER BORN:

CHAIRMAN ANGELIDES:

COMMISSIONER HOLTZ-EAKIN:

Some

Mr. Chairman.

Thank you.
Mr. Holtz-Eakin.
Thank you,

Thank you, Mr. Secretary, for coming today.

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One of the things that is delightful about your

testimony is you actually are clear about what you think and

don't think of what went on, and that is not in the typical

performance by someone at the table.

So thank you.

Let me ask you a few questions about that.

One

thing you said is that a root cause of the crisis is uneven

regulation, or absence of regulation.

8
9

Yesterday we learned that under the CSE Program
the SEC felt that all of the five major investment banks had

adequate capital.

had the 10 percent capital that the Fed would have required.

They had more than adequate liquidity because they had gone

above the Standards the Fed imposed on bank holding

companies.

They met the Basel II Standards.

They

What difference would having it be a legal

requirement make, given that they were in compliance with

the standards?

WITNESS GEITHNER:

I want to answer that question

carefully because I was not--as you know, I was not their

supervisor--

COMMISSIONER HOLTZ-EAKIN:

WITNESS GEITHNER:

I know.

-- and I have no underlying

knowledge of their financial condition, but I think it is

very--

COMMISSIONER HOLTZ-EAKIN:

But you're saying that

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it's necessary to have legal regulatory authority, and since

they were in compliance with the regulations, what does

making it legal do?

WITNESS GEITHNER:

I think it would be actually

very hard to justify a judgment that those firms were

operating with a level of leverage and a sufficiently

conservative funding structure that made them equivalent,

certainly three of them, equivalent in terms of stability to

those firms that were operating under the constraints of the

leverage ratio and the broader bank supervisory regime.

I don't think--I would not agree with that

judgment.

don't even know what happened after, after the storm

enveloped many of them and had no direct knowledge before

that.

appropriate way, which is economically, they were allowed to

run with more leverage, much more exposure to run risk than

was true for a classic bank subject to a leverage ratio and

the other requirements that came.

And of course I'm limited by the fact that I

But I think it is fair to say, looked at in the

COMMISSIONER HOLTZ-EAKIN:

Well I guess that

leads to my second question, which is the assertion that

this was a fundamentally more fragile structure.

aftermath it appears that regulated banks, commercial banks,

and the shadow, whatever you want to call them, failed at

comparable rates.

In the

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WITNESS GEITHNER:

COMMISSIONER HOLTZ-EAKIN:

3
4

I think-So where's the

fragility-WITNESS GEITHNER:

--I think you're right to

point out, we know the banking systems are fundamentally

fragile, and most financial crises are classic failures of

traditional banking.

without--too cheaply, without being compensated for risks,

et cetera--so you're exactly right, and this crisis shows

10
11

Banks lending too much for too long

you both examples.
But it began and was much more severe, in my

view, in this parallel banking system.

crisis would have been much easier to manage if it was

simply a classic banking crisis, which are slower moving by

design because liquidity risk is more contained.

think you're right to say on both divides, traditional

banking and in parts of the shadow system, you saw people

taking too much risk against the possibility, the remote

possibility, they thought, of a deep recession, a deep fall

in real estate values.

I think you're right.

And I think the

But I

And as I said in my

remarks, I absolutely believe that the leverage constraints,

the capital requirements that were put in place in the

traditional banking system were not conservative enough.

And I think they were not conservative enough in two

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respects.

One is they didn't give enough weight to the

possibility you'd have a huge shock like this.

also didn't capture the exposures banks had to the pressures

that would come when that parallel banking system--didn't

collapse, but parts of it collapsed with enormous stress.

7
8

And they

So I think those were a failure in design of
capital requirements around traditional banks as well.

COMMISSIONER HOLTZ-EAKIN:

Just as a point of

clarification, would you agree that you don't really want to

call it "shadow" versus "traditional banking" in terms of

institutions?

in traditional banking and seen by the regulators that were

simply the activities that were the same as in the shadow

banking system, right?

There's a set of activities that were located

WITNESS GEITHNER:

COMMISSIONER HOLTZ-EAKIN:

18
19

There were, yes.
The banks owned hedge

funds.
WITNESS GEITHNER:

I think that's fair to say.

And if you want to try to say what's the one cause that was

common to everything--

COMMISSIONER HOLTZ-EAKIN:

Well I would love to

hear that, because you haven't disagreed with any of the

causes that have been put up so far.

believe started the crisis?

And which

So what don't you
causes are the most

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important?

WITNESS GEITHNER:

Well I was going to say I

think if you look at a single factor that underpinned the

risk management failures, the failures of the capital

regime, the ratings failures, et cetera, was the failure to

anticipate the possibility that houses prices would fall as

much as they did and what effects that would have on

stability as a whole.

And, you know, that failure is the same failure

that caused millions of families to borrow more than the

value of their home was likely to be worth, as well as

people lending more against the value of their home than was

probably prudent in general.

I think that would be one.

What was not a cause of the crisis?

COMMISSIONER HOLTZ-EAKIN:

Yes.

that people have put forward do you think

crossed off our list?

report, so--

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20

ought to be

We don't have forever to write this

WITNESS GEITHNER:

Well why don't you give me

your candidates, and I'll respond.

(Laughter.)

WITNESS GEITHNER:

COMMISSIONER HOLTZ-EAKIN:

WITNESS GEITHNER:

Which things

flows?

I mean, I do think-Global capital flows.

I'll give--global capital

I believe that a long period of very low real

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1

interest rates around the world absolutely contributed to

the crisis.

money looking for a return.

I think that created this enormous force of
I would say it was a factor.

I mean, this is a deeper conversation of course

but there are people who believe that at the root of

everything was a unifying moral hazard risk, which as I said

I think is more complicated than that.

8
9
10

I don't believe that the existence of the fire
station causes financial crises.

So I wouldn't put that

high on the list.

COMMISSIONER HOLTZ-EAKIN:

WITNESS GEITHNER:

13
14

Okay.

But you probably should test

me on the others.
COMMISSIONER HOLTZ-EAKIN:

come back to this.

but I don't want to lose all my time.

Let me go to--I'll

I don't know what order to do this in,

Another thing you said in your sort of diagnosis

of the problem was the absence of a systemic regulator, and

I was instantly going to point out the FSA and the fact that

England had a financial crisis, and you've already dismissed

them as not your preferred model.

But to what extent did we not already have a

President's Working Group on Financial Markets that had the

capacity to do exactly what you're suggesting:

look at risks, and we got a financial crisis anyway?

sit down,

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WITNESS GEITHNER:

An excellent question, I

agree, and I think that that body did not provide this

important function.

just establishing in statute that it's now a Council with a

more formal mandate won't necessarily make sure that people

use that with that effect.

And you're also right to say that it's

But I think it is an important difference in the

sense that the way the reforms are designed now, there

really is an explicit mandate with the ability to in effect

deter weakening of, let's say, prudential safety and

soundness requirements, and to recommend they be higher.

And the existing, much more informal structure

that is the President's Working Group doesn't come with that

mandate or that responsibility.

So I think this would help.

But again, as you know, I think from what I said,

I don't think committees prevent financial crisis.

committees solve financial crises.

you do need to invest people with the direct responsibility.

You want people to wake up every day with a sense of

obligation, not just to look across the system where risks

are, but to give them some authority to act in that case.

I don't

But on the other hand,

And we did not establish in the Executive Branch

of the United States that set of, that obligation or quite

that capacity for leverage.

COMMISSIONER HOLTZ-EAKIN:

I want to go back now

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to your time as president of the New York Fed.

period, the Board of Governors came to the conclusion that

the risks in subprime housing could be contained, and indeed

made a statement to that effect.

Did you agree with that?

WITNESS GEITHNER:

During that

I never made that statement,

was not part of making it--

COMMISSIONER HOLTZ-EAKIN:

WITNESS GEITHNER:

Did you agree with it?

--and I would not have said it

that way.

was that I think we faced growing risks across this

financial system of exposure to a very dramatic crisis.

What I said, and I believe I tried to say this,

And part of it of course was what was happening

in real estate markets.

what was happening in subprime.

phenomenon that produced this mix of leverage across the

system.

facing significant risk but risk from a much broader and I

think more dangerous constellation of forces than simply

what was happening in subprime.

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22
23

It was not principally because of
It was a much broader

So I tried to cast it, when I talked about it, as

COMMISSIONER HOLTZ-EAKIN:

And what would be on

that list in that constellation?
WITNESS GEITHNER:

Well again, to oversimplify,

you had people taking huge leverage bets on the possibility

on a world which did not envision house prices falling

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1

sharply, or growth falling off the cliff.

That was the unifying mistake that so many people

in risk management, investors, borrowers, made.

COMMISSIONER HOLTZ-EAKIN:

Were you surprised by

the concentration of mortgage exposures on the balance

sheets of, for example, the regulated banks?

WITNESS GEITHNER:

No.

Citi--

I think that, you know,

banks lend money.

Banks always hold exposure to real estate

risk, as you've seen across the country.

You know, the

story of community bank failures across the country is deep,

concentrated exposure to commercial real estate relative to

capital.

So no surprise in that.
What was surprising was that a huge part of that

risk was held in these financing vehicles that came with

very high ratings, in these structures that came with very

high ratings.

capital requirements, that they were not designed--they were

designed in a way that made the system much more vulnerable

to those failures and did not protect against those

failures.

And as I said, this is a fatal flaw in the

So people everywhere took false comfort from the

fact that a huge amount of these exposures to real estate

risk were in securities that were rated AAA.

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25

COMMISSIONER HOLTZ-EAKIN:

Were you surprised by

the large amount of hedging that was done through AIG and

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other monoline insurers through the CDs?

WITNESS GEITHNER:

Of course I was like up to my

eyeballs in the growth in the CDS market and what that meant

for the system, but we had no window in, no capacity to

assess who had actually written huge commitments relative to

their capital.

Because, as you know, the things we could see

were only in those institutions we could regulate, and as I

said even those metrics we used were flawed.

But we were

not able to see where you had those huge pockets of risk in

institutions outside the banking system that wrote those

huge commitments in derivatives.

COMMISSIONER HOLTZ-EAKIN:

When you tasked Mr.

Corrigan to assess risk management practices and develop

best practice and sent them off to the financial community,

how did they do?

You never said.

WITNESS GEITHNER:

They did--well, the

institutions did not do well, but the recommendations I

think, even if you look back in retrospect at them, were

quite good.

lesson I take from this is that we did not have sufficient

traction to use those recommendations to induce enough

changes in behaviors earlier largely because we were still

operating within the existing capital requirements.

And what we did not--and as I said, I think the

And I don't think--I think the only way I can

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think of preventing that from happening in the future again

is to make the simple capital requirements and the leverage

ratio and the other ones conservative enough so you can rely

on them, not rely on all these other things we tried to do.

Remember, all these firms, when you looked at

their stated ratios. they gave you some comfort that they

held a fair amount of capital against their risks.

false comfort.

you've got to run the system with more conservative shock

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11

That was

The simple lesson I think is just to say

absorbers.
COMMISSIONER HOLTZ-EAKIN:

I am in complete

concurrence that in the end you need more capital.

want it to look like I'm contesting that.

to get a sense for, given what the perceived best practice

might be, what your assessment of their actual practice was,

and whether they improved it in response to this.

WITNESS GEITHNER:

I don't

I was just trying

I think some did improve.

There's a nice way to do this comparison exactly the way

you're doing it.

Counterparty Risk Management Policy Group II Report,

excellent title, and you compare it against this thing we

organized called the Senior Supervisors Group Report, which

is a report on actual practice across those firms that I

think was published in the Fall of '08?

And you can see in there a pretty stark comparison and

If you look at the Corrigan Report,

'07?

I'm not sure.

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criticism of what was the state of actual practice.

And I think we had significant effect in changing

practice, but obviously not enough.

inadequate.

5
6

COMMISSIONER HOLTZ-EAKIN:

Those efforts were

So, before I run out

of time, two more questions.

Number one, you said in your opening statement

that among the things that caused the crisis was the

government not moving quickly enough to do things.

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11

When should it have moved?
have done?

And what should it

And what did you mean by that?
WITNESS GEITHNER:

Well again, I'm making things

more simple than they obviously could be.

historically, I would say that it did move early enough,

effectively enough, to contain the emerging risks across the

system.

COMMISSIONER HOLTZ-EAKIN:

WITNESS GEITHNER:

But to say that

Preemptively.

Preemptively, and when things

started to fall apart--and I think this is true for

governments around the world--did not move quickly enough

and forcefully enough to try to contain the damage.

I think that the Federal Reserve was

exceptionally aggressive, took a huge amount of criticism,

did things we hadn't contemplated ever before with the

authority Congress gave us, but in the end you can't solve

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2

these financial crises with tools that are about liquidity.
They require ultimately, as we saw, the full

financial force of the government in terms of fiscal policy

to support demand, and ultimately capital in the system and

broad-based guarantees to contain panics.

that if that had been deployed more quickly--and many of us

of course were strong advocates of early action--I think

this would have been a less damaging crisis.

9
10
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VICE CHAIRMAN THOMAS:

And I believe

I yield the gentleman two

additional minutes.
COMMISSIONER HOLTZ-EAKIN:

In particular, one of

the things that you pointed out is that investment banks

don't have access to a lender of last resort--indeed, many

of these nonbank.

A question that immediately comes up then is:

Should the Fed have moved more quickly to provide Discount

Window access to people outside bank holding companies?

as you know, there's lots of interest in the decision making

that went into that, and I'd love to hear your views.

WITNESS GEITHNER:

And

We were extraordinarily

reluctant, I think appropriately reluctant to take that

exceptional step.

Depression, again, to provide our traditional lending

facilities, against collateral, to institutions we were not

supervising and regulating--because we knew in doing that

It had not been taken since the Great

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you would be creating enormous moral hazard risk for the

future.

And I think we were appropriately reluctant to

take that step until we believed, and we came to believe of

course that fateful week in March, that the system was at

the edge of collapse.

Now those facilities of course are not designed

to protect individual firms from their failures.

They are

designed to protect the system from broad-based runs to

prevent solvent institutions from becoming illiquid.

they can only achieve so much, as you've seen.

And

But we were very reluctant until we were at the

point where we thought there was a substantial possibility

of systemic collapse.

necessary, and in my judgment essential, that we do it.

I fundamentally believe we did it at the right time.

And at that point, it was absolutely

COMMISSIONER HOLTZ-EAKIN:

Thank you, Mr. Chairman.

VICE CHAIRMAN THOMAS:

And

Thank you.

The former Chairman of

Bear Stearns yesterday said that you did it 45 minutes too

late.

end result would have been significantly different?

Different?

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25

If you could do it an hour earlier, do you think the

Or ultimately no difference?
WITNESS GEITHNER:

I don't.

chance to testify on this before.

And I've had the

Again, these--and I think

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the history of what happened after this proves this basic

point.

Again, these facilities allow us to lend against

collateral to mitigate--not completely prevent--but to limit

the severity of the liquidity run crisis.

prevent--they can't protect a firm that can't convince its

investors it has a franchise that can earn enough money to

cover their risk, has enough capital to cover their risks.

9
10
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VICE CHAIRMAN THOMAS:

But they cannot

Unless your pockets are

deep enough.
WITNESS GEITHNER:

And we were not prepared--we

were not prepared to lend into a run on an institution that

had lost the capacity to convince people it was viable.

That would have been irresponsible as an act.

VICE CHAIRMAN THOMAS:

CHAIRMAN ANGELIDES:

COMMISSIONER GRAHAM:

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19

Thank you.
Senator Graham.
Thank you, Mr. Chairman.

Thank you, Mr. Secretary, for excellent testimony.
I would like to put our crisis into a broader

perspective.

and others who have been at least subtlety critical that we

may be moving too rapidly and therefore not properly

integrating our reforms with what will happen on a broader

multinational basis.

I have seen some foreign ministers of finance

Could you comment as to where do we--is this

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crisis--if you do a diagnosis, would that result in a

sufficiently similar determination of causation to then lead

to essentially similar prescriptions being written for a

variety of countries?

5
6

WITNESS GEITHNER:

Senator, let me just say two

things in response.

There are a lot of people--and we debated this--

who made the argument a year ago that we should wait until

this crisis was definitively passed.

We should undertake a

much longer reflection of how best to fix it before we began

the process of broader reform.

And we made the different choice.

We decided--

and we did this with countries around the world--that we

were better able to get consensus quickly on a stronger set

of reforms if we were acting when people were deeply aware

of the scars of the crisis and the damage; the memory hadn't

faded.

And, you know, I think we know what we need to

know about the core choices involved in reforming the

system.

parallel with other major economies.

of last year when we were laying out our initial set of

proposals, we also negotiated with G-20 and with the new

Financial Stability Board, a complementary set of proposals

that we hoped would be enacted globally.

And we've done this in close cooperation and in
So as early as April

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And there are core elements of our reforms that,

to be effective have to be done multilaterally.

example of that is capital requirements globally.

are in the process of negotiating a new international

capital accord to limit leverage and risk taking.

The best
And we

But there are some things that are problems that

are unique to our market that are going to have to be done a

little differently.

make sure we are fixing those things, too.

And our responsibility of course is to

The world I believe generally would very much

like to see the United States act to fix the things we got

wrong in our country, and are depending on us to do it.

I've never heard any of them suggest to us that we should

slow the pace of reform down.

And

They want to make sure that we are doing this in

ways that globally would be not too punitive on them.

there's a lot of concern outside of the United States that

some of the proposals we've been promoting on capital, for

example, are going to be a big burden for other countries.

And that is the source of some tension, as it is inevitable

it should be, but it's a sign of, I think you should view it

as a sign of health that we're trying to--we're being

ambitious in what we're trying to achieve.

COMMISSIONER GRAHAM:

And

If I could pick up on that

issue of capital, I was surprised to learn that under the

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Basel, I believe it's Basel II, that the value of

securitized mortgages is higher for purposes of capital

purposes than the underlying mortgages themselves?

a correct statement?

WITNESS GEITHNER:

Is that

I do not know whether that

exact point is correct.

the things that's important to note.

effect for U.S. banks--it's still not in effect for U.S.

banks--and it was essentially irrelevant to the cause of the

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11

But I would say it this way--one of
Basel II was not in

crisis.
All U.S. firms were operating under Basel I

design back in 1990 with a set of leverage requirements.

And those set of risk weights did not do a good job of

capturing a broad set of risks firms were running, and we're

involved in a very important process in the United States to

try to change those to make them better reflect risk.

COMMISSIONER GRAHAM:

Well you've sort of

anticipated my question.

If that statement that I made--and

maybe I had the wrong Basel--is correct, and my colleague

thinks it is correct, did this indicate that the

international financial community was falling victim to the

same mistake that we made, which was to put unwarranted

value behind a certain set of instruments largely because

they had a high credit rating without any requirement that

there be some greater due diligence as to just what was the

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composition of those structured instruments?

WITNESS GEITHNER:

Absolutely.

And

the system was riddled with that basic vulnerability.

is, it was too dependent on ratings that were too vulnerable

to mistakes.

they should have.

Which

And firms, as a result, held less capital than

COMMISSIONER GRAHAM:

And do you believe that the

international financial community is moving to correct those

errors?

WITNESS GEITHNER:

Absolutely.

You know, the way

our system works is, we don't turn this over to the

international community to solve for us.

figure out what makes sense to the United States, and then

we try to build consensus internationally to pull other

firms to that level.

be more conservative to differ if we think we need to do it

differently.

What we do is we

But we preserve the authority here to

You pointed out one example of a set of basic

vulnerabilities in that system, but we were fortunate in

many ways because we did have a crude leverage ratio in

place for banks and bank holding companies.

did not.

forced to run with more capital--they had less leverage,

less vulnerable to crisis than was true for many other

countries.

Many countries

And as a result, our firms had--and they were

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1

And as many people have pointed out, our banks,

although they look large because we're a large country,

we're much smaller as a share of our economy than was true

for all the other major countries.

the peak, even with investment banks now called banks, are

about 1 times GDP.

the peak were almost 8 times GDP.

GDP.

So our banks were, at

The comparable numbers in Switzerland at
In the UK, almost 5 times

In Continental Europe, 2 to 3 times GDP.

So our banks were less leveraged and the whole

system as a whole was much smaller as a share of our

economy.

very severe, but we were in a much better position to

withstand the shock than was true for many other countries.

It's hard to imagine it because our crisis was

COMMISSIONER GRAHAM:

Those leverage ratios that

you just cited, they're so extreme.

a higher proportion of the financial business in a place

like Switzerland is run through traditional banks, as

opposed to what we're studying these two days, the shadow

system?

WITNESS GEITHNER:

Does that indicate that

You're exactly right.

Those

systems are what we called "universal banking models."

And

they combine in one entity, legal entity, the whole span of

financial activities.

securities markets, are a less important source of credit

than it is in our country.

And their capital markets, their

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In our country, still roughly half of credit

comes through institutions we call banks, and roughly half

of credit comes through the securities markets, both simple

bond markets as well as the asset-backed securities markets.

COMMISSIONER GRAHAM:

CHAIRMAN ANGELIDES:

Would you like a couple of

minutes?

8
9

I am almost out of time.

COMMISSIONER GRAHAM:

If I could get a couple of

additional minutes to ask a different question.

And that

is, you've talked a lot about your efforts in New York, and

now here, to look over the horizon and try to have a better

idea of what's coming at us.

To what degree will the reforms that you are

advocating increase our capability to be more anticipatory

and therefore proactive rather than just reactive?

WITNESS GEITHNER:

I think they will help.

They

will help a lot.

And of course ideally what you want is a

system that is able to move more preemptively, that is more

agile, that can stay closer to the frontier of innovation,

and we hope to produce that.

can.

saying that you need to do your best to design a system that

creates that possibility, but you need to prepare for the

possibility it won't be perfect and so therefore you want

the system to have better cushions against the inevitable

But there's no guarantee we

And that's why fundamentally I keep coming back and

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uncertainty we all live with.

Because we won't know with confidence where the

next shock is going to come from.

it's going to be less damaging when it happens.

COMMISSIONER GRAHAM:

CHAIRMAN ANGELIDES:

COMMISSIONER WALLISON:

We just need to make sure

Thank you.
Thank you.

Mr. Wallison.

Thank you, Mr. Chairman.

And thank you, Mr. Secretary, for coming to spend some time

with us today.

This has been very informative.

I would like to follow up on what my colleague,

Douglas Holtz-Eakin was talking about before because I think

these are very important questions.

question of whether you in what you are proposing for a

reform is really attempting to solve the right problem.

Because I think you would agree that you don't want to solve

the wrong problem.

trying to figure out what the problem really was.

And particularly the

And one of the things we are in is
Okay?

Now in the hearings that we have held so far, it

seems fairly clear that it did not really matter whether you

were a regulated bank, or you were a less regulated

investment bank, in terms of what happened to that

institution in the financial crisis.

that?

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25

WITNESS GEITHNER:
that.

Would you agree with

No, I wouldn't agree with

I would say that in a--let's think of it this way.

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1

Say you had a world where you only had two institutions.

You had classic banks that take deposits and make loans, and

you had banks that, let's call them "banks" for the minute,

for the moment, but they're funded very short, no deposit

insurance, money can leave in an instant, and they're able

to take on more leverage than banks.

7
8

COMMISSIONER WALLISON:

But their assets are

different than banks?

WITNESS GEITHNER:

Well, in many--

COMMISSIONER WALLISON:

Banks assets tend to be

long term, right?

short-term assets, easily sold, in theory?

And investment banks tend to have very

WITNESS GEITHNER:

A little less short than many

people thought.

A very substantial portion of their assets

were quite illiquid in the crisis and they could not sell

them, actually, that quickly.

COMMISSIONER WALLISON:

WITNESS GEITHNER:

Right.

Which is a fundamental

difference.

the level of maturity transformation, that risk to run, in

many of those other institutions was very, very large, I

think in many ways as large as banks.

And so the level of--I'm not an economist--but

But the difference is that when liquidity dries

up in that parallel system, the assets were not liquid

enough in a panic to be able to sell them and meet your

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1

demand for margin, et cetera, meet your demand for

withdrawals.

And that put enormous pressure on the rest.

And so that stuff came really crashing down.

It was only--if we were dealing only with

mistakes banks have always made over centuries, it would

have been a much more slow moving crisis, because liquidity

would have been more stable, because most of it was deposit-

funded, and it would have been a much easier crisis to

manage.

It would have been a serious recession still,

because of everything else, but it would have been an easier

crisis to manage.

So I think it was different consequences.

COMMISSIONER WALLISON:

Okay.

Now I think you

raised exactly the point that I was trying to get to, and

thank you very much.

And the point is:

In 2007, as you recall--you were at the Fed at

the time--the mortgage-backed securities market simply came

to a halt.

meant that these investment banks that you're talking about

here turned out to have in effect long-term assets when they

were intended to be short-term assets.

A completely unprecedented event.

So the question really is:

And that

Is the right question

the investment banks?

Or is it what caused the short-term

assets they thought they had to become the long-term assets

that made them look a little bit like regulated commercial

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1

banks?

And so I am going to posit to you the possibility

that because of this crash in the mortgage-backed securities

market that turned short-term assets into long-term assets,

no regulatory system could have survived this.

Because we took about $2 trillion in assets that

were on the banks of financial institutions--on the balance

sheets of financial institutions all over the world--also

particularly in the United States, but all over the world--

and we made them illiquid.

They couldn't be sold.

Isn't that a major effect that no regulatory

system could have anticipated?

about what caused that to happen?

imposing more regulation?

WITNESS GEITHNER:

And shouldn't we be thinking
Rather than simply

Well I'm not quite sure where

you're going with that, but I think that's an interesting

question.

I guess, I guess I would try still to look at it

this way.

If you're going to take on a lot of risk, whether

it looks short-term or long-term, whatever it is, whatever

you think about your assets, but you know there's risk in

those assets, and you're going to fund them with money that

can leave in a heartbeat, and you don't hold much capital

against the risk of losses in that case, then you're going

to have a problem.

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And that I believe is a problem that is mitigated

if you get capital regulation right over institutions that

are in the business of making our markets work and helping

companies borrow.

But I completely agree that there are a whole

other set of things that happened in our financial markets

that made us more vulnerable to the abrupt loss of

confidence in anybody holding a security backed by real

estate in the United States.

Lots of things contributed to

that, too, and that made it worse, but--anyway, I'm not sure

where you were going.

COMMISSIONER WALLISON:

Well all I'm saying is

simply this:

that is, that we had an abrupt, common shock

to the entire system coming from the fact that a very large

number, size of assets simply disappeared as saleable assets

on the balance sheets of banks, and on the balance sheets of

investment banks--

WITNESS GEITHNER:

Then maybe--

COMMISSIONER WALLISON:

--and that changed the

condition of those institutions very materially from a

capital and from a liquidity standpoint, and I'd like your

reaction to that.

WITNESS GEITHNER:

I guess I think that's right,

but again that's sort of what happens in any crisis.

happens in any crisis is two propositions are tested.

What

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One is the proposition that your funding is

stable.

And, you know, a lot of people made a lot of

judgments on the expectation that liquidity would be

seamless, permanent, uninterrupted, never disappear, it

would all be there, and cheap, and available.

assumption is tested in a crisis.

That

The other assumption tested is you hold a bunch

of assets.

And you think you know what you might lose in

those assets if you have to sell them, or hold them over

time and you lost losses.

And it usually takes both those

mistakes to cause a crisis.

at the same time, and they were somewhat related, as you

said--

And I think we had both of them

COMMISSIONER WALLISON:

WITNESS GEITHNER:

Yes.

--because people ran because

they saw the--or at least they couldn't assess what the risk

was in the assets.

COMMISSIONER WALLISON:

But what I'm saying is,

this wasn't "any crisis."

This was a much larger crisis than

anything we've experienced before.

is that we're talking about an asset size larger than

anything we've ever experienced before--about $2 trillion in

mortgage-backed securities, and related securities scattered

throughout the financial world, and suddenly becoming

almost, not worthless, but very difficult to sell except

And I think the reason

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into the most distressful circumstances.

2
3

So isn't that a problem?

Rather than whether we

had sufficient regulation?

WITNESS GEITHNER:

No, I don't think so, because

again in any--like almost every financial crisis sort of has

real estate at the scene of the crime.

matter how fancy the products are, what you've called them,

CDOs, or asset-backed securities, whatever, the usually have

real estate central to the crime.

It doesn't really

So nothing unique in

that.

And again, what we do is we protect ourselves

from that risk by making sure that the institutions that are

necessary to make markets function, to make economies work,

hold enough capital to cover their losses and aren't

vulnerable to runs.

And again, I don't think regulation can solve all

problems.

Regulation can cause lots of damage.

poorly, it's damaging.

evasion.

center of any diagnosis of the problem in the reforms.

Regulation creates incentives for

But capital limit leverage I think has to be the

COMMISSIONER WALLISON:

additional time, so I will go on.

23
24
25

Done

CHAIRMAN ANGELIDES:

I have a little bit of
That is--

Three minutes from the Vice

Chairman.
COMMISSIONER WALLISON:

Three minutes.

Here's

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the issue.

solution to this problem.

year flood--that is, we haven't had anything like this since

the Depression--are you talking about imposing so much in

the way of capital requirements on our banking system, on

our investment banking system that they will no longer be

able to offer reasonably priced credit to those who need it?

8
9

You suggest that capital regulation would be a
But if we are talking about a 70-

WITNESS GEITHNER:

No.

But you're asking exactly

the right question I believe.

Just a short story.

When I first came to the New

York Fed and I was understanding the system in which banks

were operating, I asked my colleagues, I said how do we know

what's enough capital?

capital?

How do we choose what's enough

And my colleagues used the same example you said,

which is to say that we think it's enough to cover a 30-year

flood, but not a 100-year flood.

about what level of insurance you force firms to run with

against what is the probability of a flood.

Governments make a choice

And I agree that we cannot and should not try to

design a system that makes failure impossible, that would

cover any--because that would impose excessive costs on

businesses and would not be efficient for the country as a

whole.

But I can say with a lot of confidence that our

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1

requirements were too thin, too modest, and it would be

better for credit generally, better for the economy, better

for the allocation of capital across time, if those

requirements were more conservative.

with you, you can't design them and should not try to design

them to protect against all sorts of shocks, and we have to

have a system that allows for failure.

8
9
10

But I completely agree

We just don't want the failure to be as damaging
as it was in this crisis.
COMMISSIONER WALLISON:

One last question, then.

You say in your prepared testimony that the financial

system--I think I'm quoting here--"outgrew the protections

that were created in the Depression."

Now wouldn't it be fair to say that the system

grew outside the banking system not to avoid regulation so

to speak, but because banks were in fact unable to

participate in the securities market which was a very

efficient market for financing business, and financing

consumers--this is the securitization market.

really effectively prevented from participating in that, in

part because of Glass-Steagall, and I'm not advocating

Glass-Steagall certainly, but isn't that why we developed

this shadow banking system, if we want to call it that?

24
25

WITNESS GEITHNER:
this paradoxical feature.

Banks were

The capital requirements had

They were strong enough to

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1

encourage a lot of that funding to shift outside to where

there was no capital regulation, but they were not strong

enough to protect the system when that system came crashing

down.

But I don't think the premise is quite right in

the sense, Mr. Wallison, that banks were allowed to help

companies raise debt and equity.

participate actively in these other secured funding markets-

-for credit card receivables, for automobile receivables--

And they were allowed to

not just real-estate backed, asset-backed.

able to fully participate in that system, and a lot of them

did of course in ways that left them in the panic you

referred to, exposed to loss.

14
15
16

So they were

So I don't think I quite agree with that part of
your question.
COMMISSIONER WALLISON:

have, but thank you very much.

CHAIRMAN ANGELIDES:

COMMISSIONER GEORGIOU:

That's all the time I

Mr. Georgiou.
Mr. Secretary, you said

something to the effect that all this stuff started to crash

down, and crash down pretty quickly.

to explore whether the stuff really deserved to crash down,

and was really created in such a way that anybody who was

other than right in the center of it and not looking at it

ought to have known that it had the strong possibility of

I guess I would like

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2

crashing down.
Yesterday we had testimony from former SEC

Chairman Cox who said something to the effect that if honest

lending practices had been followed, much of this crisis

quite simply would not have occurred; the nearly complete

collapse of lending standards by banks and other mortgage

originators led to the creation of so much worthless, or

near worthless mortgage paper that as of September 2008

banks had reported over one-half trillion dollars in losses

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on U.S. subprime mortgages and related exposure.
And the creation of those mortgages was

exacerbated by then turning those residential mortgage-

backed securities into collateralized debt obligations in a

process that at the last hearing I likened to something like

medieval alchemy where you took this low-rated tranche, the

BBB-rated tranches of the residential mortgage-backed

securities--93 percent of the tranches were higher rated.

This was the bottom 5 percent of the 7 percent.

percent of equity below.

There was 2

Then you took that tranche, low-rated, from a

whole bunch of mortgage-backed securities and created

something called the collateralized debt obligation, somehow

slicing and dicing that and ending up with a security that

had not only AAA, but some 50 percent of it was AAA+ rated,

which was super-senior tranches, ostensibly.

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But of course we now know that all that was

essentially fictitious, really, and that when you lost a

very modest amount, when these mortgages began not to

perform in some modest amount, 3, 5 percent, you impacted

all that BBB tranche, and then you essentially rendered the

CDOs worthless.

And it was exacerbated--I think it's important to

note it was exacerbated by the shadow banking system in a

couple of ways.

We had another $120 billion of those CDOs

that were essentially insured by AIG by selling credit

default insurance against it, which they weren't capitalized

for, and they were essentially spreading their AAA rating

like holy water over these CDOs that didn't deserve to be

rated in that way, and another $60 billion was sold to

commercial paper conduits.

So you took these fundamentally flawed

securitized products and concentrated risk in a number of

institutions which ultimately we as taxpayers had to bail

out--AIG, Citi, which took a $25 billion liquidity put on

these CDOs off their balance sheet, which is essentially a

third of their capital, which nobody seemed to have noticed

anything about.

And I guess all of this goes to say that we

needed to, it seems to me, have people prepared to recognize

that the emperor had no clothes; that there needed to have

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been people who saw that the possibility of this collapse of

the securities was much, much higher than anybody gave them

credit for.

general problem.

And I wondered if you could speak to that

WITNESS GEITHNER:

I think I agree with much of

what you said.

And I think you're right that you had a

dramatic erosion in underwriting standards.

money against a very large fraction of the value of a house

inherently exposed to substantial risk of loss if you had

So people lent

the combination of prices falling a lot and a lot of people

losing their jobs.

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And that risk was pervasive across the system.
It was in--

COMMISSIONER GEORGIOU:

fall that much.

They can just fall a little bit.

They don't even have to

I mean, they don't have to fall a lot.

WITNESS GEITHNER:

Right.

So relatively modest

losses would have eaten deeply into those particular

tranches of CDOs.

you described.

I think you're absolutely right in what

But I guess what I would emphasize is that it

wasn't just in those complex structures.

It was across the

system.

an example, banks across the country that did lend too much

against real estate as a whole.

It was in--I mean, you know, Countrywide would be

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And it was--it was--

COMMISSIONER GEORGIOU:

mortgages themselves.

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And they just held the

WITNESS GEITHNER:

They held some of them, and

they--

COMMISSIONER GEORGIOU:

Right.

But, I agree with

you, it wasn't exclusively that, but it was significantly

that.

discussing for the last few days is that a number of the

And I guess, you know, part of what we've been

parties who originated these mortgages held--essentially had

no consequence if they failed.

the securities themselves.

Not just the mortgages, but

And I don't know that in this regulatory reform

that's going on how much there will be remedial--how many

remedial measures will be made to address that question.

And would the systemic risk council that you propose, or

that people have proposed, be able to identify this kind of

problem in the future?

WITNESS GEITHNER:

And you are right to say that

these reforms won't solve all these problems definitively.

We won't know for sure which ones they do an adequate job of

solving, but they do do some very important things.

They do get fundamentally at some of the

conflicts in rating agencies that helped contribute to the

mistakes in ratings.

They will force much more disclosure,

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not just about ratings and their methodologies, but into

these basic complex asset-backed securities structures so

investors have a better chance of looking deep into them and

understanding the risks they're exposed to.

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They will force firms that write these
commitments to hold more capital against those commitments.

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COMMISSIONER GEORGIOU:

And to hold some of the

securities themselves, if I understand it.

WITNESS GEITHNER:

Yes, and to retain an economic

interest in those securities.

we are confident these things would be helpful.

So again, these things are--

I think you could say they're necessary.

But of

course over time people will find their way around them.

And if you have another period where you create great

incentives for people to take great risks, they will do it

again.

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Our job is to make sure that those mistakes when
they happen are not as damaging to the system.
COMMISSIONER GEORGIOU:

I guess the other thing

that we looked at at the last hearing that I'd just like

your comment on was this capital arbitrage where

institutions like Citi were putting things either off

balance sheet or into different elements, putting it in

their trading book, that avoided people recognizing,

different regulatory entities recognizing that there was

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ultimately a risk in this particular instance of liquidity

puts to $25 billion, almost a third of their capital, if

this one set of CDOs failed.

WITNESS GEITHNER:

Well again you're exactly

right.

The system did not capture the economic exposure

many firms had to the funding vehicles they used.

I mean, the crisis began in July 2007 when a

French bank that owned a money market fund closed the gates

on withdrawals because that fund had funded a bunch of risk

in structured investment vehicles, these off balance sheet

fancy vehicles, of German banks that had bought a huge

amount of U.S. subprime mortgage risk.

So--and without, frankly, the knowledge of the

fund or the bank in some basic sense.

happened across the system.

regime, the disclosure regime, the rating regime, the

capital regime, did an adequate job of capturing those risks

of exposure.

So, but, you know, it

And neither the accounting

And that is a fixable problem.

It won't get fixed perfectly, and you want to

make sure it adapts over time better, but that is a--I think

that is a problem that we can do a much better job of

preventing in the future by again making sure the accounting

conventions capture these exposures.

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Disclosure is better.
conflict.

Ratings less vulnerable to

Capital provides bigger cushions against

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uncertainty and loss.

a good place to start.

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It won't solve all problems, but it's

COMMISSIONER GEORGIOU:

Very good.

Thank you,

very much, Mr. Secretary.
CHAIRMAN ANGELIDES:

Right.

Mr. Secretary, very

quickly I just want to make an observation, picking up

really on the comments of Mr. Wallison and Mr. Georgiou

about the regulatory framework.

One of the things that struck me when I heard

that discussion is so many people who have come before us

have talked about how nothing could have been done to avert

the crisis, but what's at least clear to me as I read more

and more and hear more and more is

should never have been done at the outset.

there's a lot that

And when you were talking about in this

discussion what kind of regulation on securitized products

or on capital, is it fair to say that we can't also forget

to look at the point of origin of problems?

In other words, there was a situation here, and

I'm not saying it was the whole of the problem, but the fact

was the poisonous subprime loans were permitted to enter the

system in the first place.

instruments were created that helped carry that poison

throughout the system.

And then exotic financial

And so any look back and look forward has to look

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at the point of entry of the contamination, doesn't it?

WITNESS GEITHNER:

I agree.

But again I would

just underscore this is in the character of saying it's

worse than you think.

look at losses on prime mortgage loans, on conforming

mortgages in this crisis they are very high, too, well

outside the expectations of most people in this case because

again house prices fell so far, and unemployment rose so

much more than people had expected.

I would just emphasize that if you

So it was pervasive.

And I do not believe you

can prevent all financial crises.

can try to run a system that tries to prevent failures.

the job of government is to make sure that you make those

failures less damaging; that they don't cause so much

collateral damage to the innocent, they don't have such

catastrophic consequences for the economy, and I believe we

can do a better job.

very good framework for fixing not just the direct cause of

this crisis, but making us much less vulnerable in the

future.

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I do not believe that you
But

And I think these reforms provide a

But crises will happen.

Again, what policy

should do is make them less damaging.
CHAIRMAN ANGELIDES:

I mean the only other

observation I would have is, would you agree that the

problem in prime mortgages may have been exacerbated by the

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price run-up, which in part may have been fueled by the

availability of no down payment, negative amortization, a

whole slew of loan products to a whole set of consumers who

otherwise wouldn't have been able to enter that market?

WITNESS GEITHNER:

CHAIRMAN ANGELIDES:

item so I don't forget today.

of cleanup.

with Mr. Immelt.

I do agree with that.
Okay.

One other just small

And this is just in the way

I had earlier asked you about conversations
I want to expand just for a minute.

We had talked briefly about the CPFF.

And by the

way, I assume you've had a lot of conversations with him

because he was on your board.

7th of 2008 you announced the commercial paper program,

October 27th you began buying commercial paper.

originally there was some talk about that being only asset-

backed and not unsecured?

but--

But I know that on October

I believe

I don't know if it was shifted,

WITNESS GEITHNER:

We started a facility called I

think the Asset-Backed--it had some acronym, but it was

about asset-backed commercial paper.

place a broader commercial paper-backed facility.

CHAIRMAN ANGELIDES:

And then we put in

But when I asked you about

the conversations, I asked about September 29th and 30th,

and whether there was concern about being able to issue

commercial paper by GE.

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I would like to expand that to just ask you, did

conversations occur about being able to enter those programs

because of a necessity of those programs to support their

issuance, or the market as a whole?

WITNESS GEITHNER:

Again, to the best of my

recollection, Mr. Chairman, those conversations, like I had

with a variety of people in the markets both money market

funds, institutional investors, and people who were relying

on CP markets, they were about making sure we understand how

broad the problems were.

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And people had lots of ideas about how we should-as they always do--about how we should solve them.

CHAIRMAN ANGELIDES:

check.

carry your daily planner--

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Well you were going to

Why don't you--I don't expect you, like I said, to

WITNESS GEITHNER:

But your question was, were

they about both the asset-backed-CHAIRMAN ANGELIDES:

GE's ability to (a) issue in

that time period, you know, fear of their own issuance; and

(b) their participation in those programs.

WITNESS GEITHNER:

Okay.

I'm happy to go back

and check. But again, my recollection is that absolutely,

almost certainly they were about making sure we understood

how broad the potential financing stress was.

heard from across the system, across the economy,

And like we

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encouragements for us to do something about it.
CHAIRMAN ANGELIDES:

All right.

and if you can swing back.
(Information to be provided.)

Double-check,

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CHAIRMAN ANGELIDES:

COMMISSIONER HENNESSEY:

Mr. Hennessey?
Thank you.

And thank

you for coming today.

I am a little concerned about one of the biggest

challenges we have here, two of the biggest challenges, are

the advantage of hindsight, and the danger of selection

bias.

supervisors did not know what was going to happen.

We now know what happened when policymakers and

And as you well know, at any point in time you

can find someone who is predicting almost any outcome.

so we have had, you know, people point to specific

predictors from the past and say, why weren't those paid

attention to.

And

And with respect to Senator Graham, I want to use

an analogy from his home state:

certainty that devastating hurricanes will hit Florida.

that is different than suggesting that I should know when a

specific hurricane is going to hit Miami.

know that houses are being built that are too big on the

shores of Florida, that's different than saying I should

have known about this hurricane.

suggesting, that I knew that a particular situation was

going to occur, and that someone did nothing about it.

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I can tell you with
But

And even if I

Or, as some have been

And since you were running the New York Fed, that
argument would apply to you.

And I don't buy the argument,

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but I want to ask you about it, with respect to housing, and

then with respect to how the housing problems translated

into the financial sector.

I think it was generally known for years, if not

decades, that U.S. policy subsidizes housing.

of my economist friends would say "over-subsidizes" housing

relative to other forms of capital investment.

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I know a lot

I know that I did not know until the Fall of 2007
that there were specific severe problems in an element of
the housing finance market.

Can you comment on the argument that policymakers

should have seen well before the Summer or Fall of 2007

those housing problems?

argument?

Do you believe that is a valid

WITNESS GEITHNER:

I basically agree with where

you begin.

to you, which is be wary of the benefits of hindsight.

and be skeptical of the capacity for foresight.

completely agree with that.

And I say--I usually say exactly the same thing
And,

So I can only tell you what I thought at the

time.

Which is, that I was very worried about the

possibility that this whole set of forces you saw in the

long period of rising house prices, huge increases in

leverage, the growth in these risky funding structures

outside the banks, I was very worried that those risks would

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be substantial for the system.

what the possibility was of a big shock, where it would come

from, how it would happen, how damaging it would be.

thought--I thought there was a risk it would be quite

damaging and harder to manage than previous financial crises

for the reasons I said before.

And, that we did not know

But we

But I would not claim, in having said that, that

I thought at the time, or I spent time--I went a lot of time

with people in these markets of course, and I did not find

people at the time who were particularly compelling about

exactly putting these things together and seeing how exactly

what was happening in no-doc loans, NINJA loans, et cetera,

was actually producing huge exposures that looked AAA or

super-senior.

So that's a complicated answer to your question.

But in general I agree with you that, be wary of the

benefits of hindsight.

reason I think it's important to come back to the simple

risks and leverage is that leverage is hard to capture.

you could observe at that time that there was leverage in

the system that made us vulnerable to a shock when it was

going to happen.

timing, nature, magnitude of that shock.

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But I think on these basic--the

But

But nobody had the capacity to predict the

And again, the lesson I would take from that is
to say that design a system that recognizes that limitation.

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Don't design a system that tries to depend on people sitting

in these jobs, like you had, or everybody else had, and

saying we're going to hope those people in Washington step

in preemptively with perfect wisdom in the future and

deprive people of taking, borrowing too much.

I think that would not be a good way to run a

system.

skepticism in it about the capacity of individuals to act

preemptively.

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Run a system that rests on--that has some more

And I think that is what these reforms try to

do.
COMMISSIONER HENNESSEY:

Thank you.

The second

part of that same sort of question, and I could characterize

it as were you generally surprised by the Bear event?

then subsequent events?

And

And what I mean, more specifically, is by the

Fall of 2007 everyone knew that there were severe problems

in subprime financing, but then taking that to specific

failures of specific institutions, some have been suggesting

that you and others should have seen that was going to

happen, or some are even implying that people did see that

that was going to happen and didn't do something about it.

WITNESS GEITHNER:

Well as I tried to explain, we

did a lot of things, starting in 2004, which were designed

to make the system more resilient and reduce the risk that,

whatever happened, it would be less damaging.

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And as I said, I think those steps--I think they

were--had the right objectives.

many areas.

They were very effective in

Think, for example, of what happened to how

little effect hedge fund failures had on the system as a

whole.

were helpful for the system.

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A lot of examples of things that those results that

But absolutely did not do enough soon enough to
make the system strong enough to withstand that.

But our--

for us, in my view, this crisis started in the middle of

2007.

doing things we had never done before.

ahead of other countries, to help to put some foam on the

runway and to sort of contain the risks that would escalate

and contaminate other institutions.

And as you know, the Fed moved very aggressively,
Way

But ultimately of course you don't solve these

problems by simply using liquidity.

with more force.

No road map.

COMMISSIONER HENNESSEY:

You have to solve them

Good.

I want to praise

you for the work that you did, and have been doing, on

dealing with the resolution issues, having to do with credit

derivatives.

making about in effect hardening the system so that, even if

all of the oversight, and all of the supervision fails, that

the system is more robust to withstand that shock.

And I strongly support the arguments you're

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We heard from Bear.

profitable.

occurred.

We were solvent.

They said, look, we were
Just an irrational run

After Bear there was the Emergency Liquidity

Facility at the Fed which, as I understand it, has since

expired.

firm faces an irrational run.

Isn't the system not hard enough in that particular area

where the same thing could happen?

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So let's imagine that another profitable, solvent
Isn't there the same risk?

VICE CHAIRMAN THOMAS:

Mr. Chairman, I yield the

gentleman two additional minutes.

COMMISSIONER HENNESSEY:

WITNESS GEITHNER:

Thank you.

I would not characterize what

happened in that case as a run on a solvent institution.

But if we don't reform the system, absolutely we're still

living with that vulnerability today.

You know, we're still living with the same system

that produced this crisis.

protections, preventative and better tools for crises, we'll

be living with a more vulnerable system.

And without the full set of

Because the actions we were forced to take do add

to moral hazard.

here and did nothing, did not pass reforms, the system would

be less--more vulnerable, less stable than in the past.

And again, if you did nothing, you sat

But absolutely, even solvent firms are vulnerable

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to runs.

very strong financially come under extraordinary pressure

because the world went into panic.

And you saw a lot of institutions that were very,

And again, I think the best defense against that

is to make sure that the entire system, firms and these

funding markets, derivative markets, et cetera, are run with

thicker cushions against loss.

less fragile when somebody makes huge mistakes.

That will make everything

But also make sure that when things fall apart,

when people make mistakes, you can put them out of their

misery without the taxpayer being exposed to loss, and you

can draw a firebreak around them so that the fire doesn't

jump to the rest of the system.

That is the basic, simple theory that underpins

these reforms.

They won't be designed to prevent people from making

mistakes.

And I think those are achievable reforms.

We just want the mistakes to be less damaging.
COMMISSIONER HENNESSEY:

So that's the resolution

authority, and then a whole set of requirements to reduce

the probability that any one particular firm gets itself

into a situation where investors will lose confidence.

WITNESS GEITHNER:

Yes.

COMMISSIONER HENNESSEY:

But as we saw with

Wachovia, and WaMu, even insured institutions can face runs.

I presume that even if say the pending legislation becomes

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law, even if you have the resolution authority and those

other strengthening things, you are still at a greater risk

for one of these non-insured firms of an irrational

liquidity run just because that facility doesn't exist.

You could still have a firm that claims, or

believes that it's solvent and profitable saying, look,

there's an irrational run; I'm running out of liquidity.

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WITNESS GEITHNER:

I think that's right.

the question you have to ask is:

Is that desirable?

I think
And

will that induce more conservative behavior?

You know, in the absence of expectation there's a

safety net that should induce caution.

Of course it didn't

work that way for large parts of the system coming into the

crisis.

So again, I think the lesson we try to take is to

say there's a function called banking which is about helping

companies raise capital, helping people borrow to finance

things they need.

crises.

requires this mix of constraints on risk-taking, and better

fire fighting capacities when things fall apart.

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You want that system to be stable in

Otherwise, economies can't function well.

And that

And you can't make the system stable if that set
of protections only exists on fundamentally half the system.

COMMISSIONER HENNESSEY:

CHAIRMAN ANGELIDES:

Thank you.

Ms. Murren.

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COMMISSIONER MURREN:

Thank you.

Thank you, Mr. Secretary, for being here to talk

to us about this.

bolts question that actually came up in our last hearings,

which were on Citi.

question former Chairman Greenspan, and in this instance we

were able to take a look at the 2005 Operations Review of

the Bank Supervisor Group at the Federal Reserve Bank of New

York.

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I would like to follow up on a nuts-and-

And we had had the opportunity to

And this one is dated May 9th to May 27th of
2005.

I would like to enter that into the record.
This is an internal peer review report, and it is

conducted by examiners from other Federal Reserve Banks.

And it is my understanding that each Reserve Bank is

reviewed every four years.

And, that in this particular report there was

commentary made that related to the Citigroup team, that was

that the team's time and energy is absorbed by hot topic

supervisory issues which include compliance, governance,

information requests, and that that keeps the team from

fully completing its continuous supervision objectives.

The result is that there are insufficient

resources to conduct continuous supervision activities in a

consistent manner.

the sufficiency of staff across the LCVO portfolio.

And we recommend that management review

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And then there's also another report, which is

the same year I think on the same topic, which is titled "A

Draft Closeout Report," which also mentions not having

sufficient staff to sustain continuous supervision

activities which may result in late reaction to address

emerging risk areas.

I am curious about, when you look back on this

and, you know, recognizing the benefits of hindsight, do you

agree with the findings of this report that there were

insufficient resources allocated specifically to Citigroup,

and also perhaps to other large, complex banking

organizations?

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WITNESS GEITHNER:

Here's how I think about this.

Again, colored a little bit by hindsight.
I was very concerned in looking at our mix of

responsibilities in those bank holding companies about the

burden imposed by a range of what you might call compliance

obligations--consumer protection, CRA, Bank Secrecy Act--

very important policy instruments, policy requirements that

we were charged with enforcing through regulation, and the

burden those imposed relative to the resources we had to

also do what you might call a much more difficult task, also

an important task, of judging whether a firm had a risk

management capacity to manage his risk adequately, whether

the safety and soundness obligations we faced were

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adequately met, whether liquidity was managed carefully

enough, et cetera; whether the firm had, for example

adequate stress testing regimes to capture what might happen

if all those securities it held turned to mud.

And I felt--and again, this lesson helped shape

what we've proposed on financial reform, because we've

proposed to take the Fed out of the business of consumer

protection and have it focus in its supervisory

responsibilities on a narrower range of safety and soundness

requirements.

appropriate, in part because again it helps make sure that

these people are focused on a more single mission, which is

safety and soundness, which as we've discovered is so

important to the system as a whole.

And I still believe that is right and

COMMISSIONER MURREN:

I guess the question then

would also be, have we had an opportunity to be able to

address that?

Or have you?

If you look, also a similar Operations Review,

and this one is dated December of '09, there are still

references here to the timeliness of supervisory products

being a concern, and that it is in fact a repeat finding

from the 2005 Operations Review.

And there are further citations that relate to

supervisory ratings not being updated on an ongoing basis to

reflect the evolving risk profile and financial condition of

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the organization.
Do you feel like the responsiveness of the

supervisors at the Federal Reserve Bank in New York was

swift enough to the circumstances?

have been more aggressive in their ratings and their

supervision and reporting of this condition of Citigroup?

WITNESS GEITHNER:

Do you think they should

I believe that these are the

most capable, most talented public servants I have ever

worked with.

But I absolutely agree--and I've said this,

and I'll say it many times--that I do not think we did

enough as an institution with the authority we had to help

contain the risks that ultimately emerged in that

institution.

And I think a lot about what we could have done

differently in that context.

And maybe part of it is about

resources, but I think it's a more fundamental problem,

which is I think that the system, again we were operating

with a set of rules that did not compel firms to hold enough

capital against the risks they were taking.

capture them.

in this reform processes that we rely not so much on the

discretion of supervisors to force more than the framework

forces, try to get the rules better.

live with a set of measurable objective rules and you're not

forced with the risk that these very capable people, because

They did not

And that is why I believe it is so important

And so that firms can

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of other preoccupations, other burdens, were insufficient

leverage and traction--you don't want the system to rely on

their ability to force firms to be more conservative than

the rules require.

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6

You've got to make sure the rules adapt and force
more conservatism themselves.

COMMISSIONER MURREN:

Do you think that there

should have been more examination of the off balance sheet

entities of Citigroup, specifically the underlying assets?

Is that something you think that would be beneficial as we

go forward?

WITNESS GEITHNER:

Absolutely.

And again, a

fundamental lesson of these reforms--and a lot of this has

happened with the evolution of accounting already in

capital--is that you need to make sure that these either

come on balance sheet, or if they're going to stay off

balance sheet that you force people to hold capital against

the risk in those exposures.

has been made in that area.

Absolutely.

A lot of progress

I would give just one cautionary note, though.

Those particular sets of risks themselves did not in the end

prove that large, in that particular case.

was a problem across the system, and it made it much harder

for people to really understand what fundamentally might be

the ultimate measure of losses in a lot of institutions that

It was--but it

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took too much risk to the real estate losses they had.

COMMISSIONER MURREN:

Thank you.

And I think I

need to enter these two reports that I cited into the

record.

Do you need information on that?

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CHAIRMAN ANGELIDES:

Operations Report and the 2009 Operations Report.

COMMISSIONER MURREN:

CHAIRMAN ANGELIDES:

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I noted it was the 2005

Yes.
Can I just very quickly,

though, we're going to keep you on schedule here.
remarkable.

Correct?

This is

But I just want to press one last point.
In our interviews with Federal Reserve Bank of

New York staff, we were told that they did not look at the

credit quality of assets held by any of Citi's off balance

sheet entities.

it, what happened at Citi is they had been reporting a $13

billion subprime exposure.

I'm sure you're quite aware, in a matter of weeks leading up

to Mr. Prince's resignation, that was revised upward to $55

billion.

And actually in the end, as we understand

And as you know, in kind of a,

And they actually took that twenty-five back onto

their balance sheet, even though they weren't legally

required to as a liquidity put.

least say it was material.

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So I think we could at

The other thing that was pointed out to us is the
Examiners at the OCC complained about the provisions of

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Gramm-Leach-Bliley, saying that it prevented them from

obtaining the information about nonbank affiliates and kept

them blind to some of the asset quality problems that

eventually came back on the balance sheet.

It sounds to me like there was a little hole

here.

and no one is really looking at them.

a risk, or at least certainly a potential risk.

You had these off balance sheet entities, vehicles,

WITNESS GEITHNER:

And so they did pose

Absolutely they presented a

risk, and I didn't mean to claim otherwise.

they were material in the sense of--and, you know, this

system, this system of a whole bunch of different regulators

looking at pieces of the entity.

looking at the whole thing.

And I agree

The Fed is supposed to be

Accounting regime, rating dependence, capital

that didn't capture the risk, internal checks and balances

that failed to capture those risks, that system absolutely

did not work.

CHAIRMAN ANGELIDES:

Right.

And by the way, I

should add, the SEC told us they were aware of those.

really fell, it seems to us, at least my reading of it, into

a black hole of sorts.

WITNESS GEITHNER:

CHAIRMAN ANGELIDES:

WITNESS GEITHNER:

Right.

They

And I think--

Or a gray hole.
In many ways, the problem with

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the hole, or the shadow was that it looked like it was

called AAA, or Super Senior, and people didn't say, well,

how big a cushion of loss absorption is underpinning that?

And so that's why all of a sudden stuff that looked like it

was risk free had a lot of embedded losses.

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CHAIRMAN ANGELIDES:

And of course then there

were CDOs composed out of BBB tranches.
With that, I want to thank you--I'll let you
close us up--thank you very much, on behalf of all the

Commissioners, for coming here today, for your time, for

your answers to our questions.

Mr. Vice Chairman?

VICE CHAIRMAN THOMAS:

Mr. Secretary, we are

going to be sending you a list of causes, those that had

been mentioned and those that weren't, and we really

appreciate you helping us.

than that, as one of the major architects of the financial

regulatory reform that's currently being examined by

Congress, would you provide a 30-second, or a one-minute pep

talk to the Commission as we're going forward attempting to

find the causes of the financial crisis, while you and

others have already decided what it was?

But probably more fundamental

(Laughter.)

VICE CHAIRMAN THOMAS:

WITNESS GEITHNER:

And you can take a minute.

You are doing such a terrific

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job--

(Laughter.)

WITNESS GEITHNER:

--of exposing the full range

of fundamental causes, that you are helping the cause of

reform.

exposed with the core of the reforms that the Senate is now

considering, and you are giving great energy and urgency to

the task.

Because we can match very closely the causes you've

But don't stop now.

Even if the Senate enacts

this stuff in the next two weeks, don't stop your exercise,

because that's just the first stage.

have to not just deal with the GSEs and the housing finance

markets, we are still going to have to design these set of

constraints on capital liquidity, disclosure, et cetera.

We are still going to

We have a huge amount of work ahead of us in that

process, and the process that you are undertaking, as well

as the other bodies in the Hill and internationally, will be

central to that process.

So when Congress, as we hope they will, enacts

these reforms, it will be the beginning of the process of

reform, not the end.

will be so important to exercise, but--I'm not quite sure

you wanted this, Mr. Thomas--but please encourage our

leaders in the Senate to act on reform so we can get on with

the business--

And the work you have ahead of you

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VICE CHAIRMAN THOMAS:

I'm trying to explain to

them the institution, and the fact that the committees have

jurisdictions which don't necessarily cover everything that

needs to be done.

deadlines that are created by the leadership in Congress,

but the follow-ship sometimes doesn't get there.

And I hope people notice there are

WITNESS GEITHNER:

too.

quickly.

I am learning that myself,

But I think we're close now, and I hope they move

VICE CHAIRMAN THOMAS:

WITNESS GEITHNER:

I think we are.

And remember, there will still

be an enormous amount of work that we have to shape, and the

process of inquiry you've laid out will be enormously

important to that work.

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VICE CHAIRMAN THOMAS:

And final word, we've got

to quit talking about it as history.

WITNESS GEITHNER:

It's here still.

The vulnerability, absolutely.

We are living with the system today that caused the worst

financial crisis since the Great Depression, and it is worse

than that.

have to do that create the risk of moral hazard.

don't act to fix those problems, we will be more vulnerable.

Because we had to do things no one should ever
And if we

So my compliments to what you are trying to do,

and keep at it.

the bill done.

Don't stop just because we're going to get

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VICE CHAIRMAN THOMAS:

CHAIRMAN ANGELIDES:

That was pretty good.
Thank you, very much.

got out of that question and answer unscathed, and we will

take, Commissioners, a 15-minute break.

at 2:35, or actually we'll do it at 2:30.

12-minute break.

We will recommence
We will take a

Thank you very much, Mr. Secretary.

(Whereupon, at 2:18 p.m., the hearing was

recessed, to reconvene at 2:30 p.m., this same day.)

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AFTERNOON SESSION

(2:33 p.m.)

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CHAIRMAN ANGELIDES:

The meeting of the Financial

Crisis Inquiry Commission will come back into order.

We are on our final session of day two on our

hearing on the shadow banking system.

witnesses who are with us today.

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I want to welcome our

Gentlemen, as you know, we have been undertaking
an examination of the growth and development of what has

been termed the "shadow banking system," looking at how that

system developed, the risks it posed, what happened to that

system in 2007-08, and the consequences for our financial

system and our economy.

I would like to start off today by asking you all

to stand so we can do what we customarily do for every

witness who comes before us, and that is to stand and raise

your right hand, and I will administer the oath to you as

witnesses.

Do you solemnly swear or affirm under the penalty

of perjury that the testimony you are about to provide the

Commission will be the truth, the whole truth, and nothing

but the truth, to the best of your knowledge?

MR. McCULLEY:

MR. NEAL:

MR. BARBER:

I do.

I do.
I do.

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MR. MEIER:

I do.

(Witnesses sworn.)

CHAIRMAN ANGELIDES:

Terrific.

We are grateful

for the written testimony that you have provided to us, and

we are going to ask each of you to give an opening statement

of no more than five minutes--both an opportunity for you to

speak to us, and for us to hear your views.

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And so we will go, without political prejudice,
from left to right here, and we will start with you, Mr.
McCulley.

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If you would, start off.
WITNESS McCULLEY:

Thank you, Chairman Angelides-

CHAIRMAN ANGELIDES:

Okay, and I should add one

other things, gentlemen.

yellow light that comes on with one minute to go, and the

red light is when time is up.

You will see that there will be a

WITNESS McCULLEY:

Thank you, Mr. McCulley.
Chairman Angelides, Vice

Chairman Thomas, and the Honorable Members of the

Commission:

My name is Paul McCulley, and I am a managing

director and portfolio manager with PIMCO.

colleagues at PIMCO, I thank you for the invitation to

appear before this distinguished Commission.

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On behalf of my

PIMCO is an investment management firm founded in
1971 based in Newport Beach, California.

As an investment

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manager, PIMCO is hired to invest money on behalf of clients

in accordance with contractual guidelines they establish

with us.

Our objective is to protect and enhance our

client's assets, their pensions, savings, and investments,

and thereby help them achieve their investment goals over

time.

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We do not conduct investment banking or
proprietary trading activities, and we are not a brokerdealer.

Let me turn now to the substantive issue that

you've asked me to speak about today, which is the role of

the shadow banking system in the financial crisis of 2007

and 2009.

Let me give you a definition.

Shadow banks are

levered financial intermediaries engaged in liquidity,

maturity, and credit quality transformation but operating

without public safety nets.

access to the Fed's Discount Window.

Notably, FDIC insurance and

Shadow banking, that phrase, is not a pejorative

phrase, but merely a descriptive phrase of how the shadow

banking system works.

Let me turn now to the fundamental role of banks.

Banking is fundamentally defined as the business of

transforming savings into investment in our economy while

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simultaneously acting as the Nation's payment system.

Traditionally we think in terms of this activity

in the context of conventional banks, which issue deposits

and then turn them into loans.

necessarily requires faith on the part of depositors that

their money is safe.

The system therefore

In the wake of repeated bank runs in the early

20th Century, Congress enacted legislation creating the

Federal Reserve in 1913, and the FDIC in 1933.

As Professor

Gordon observed earlier before this Commission, FDIC insured

deposits issued by banks with access to the Fed's Discount

Window are informationally insensitive.

That is, holders of such deposits do not have to

do any due diligence or gathering of information to feel

comfortable holding such deposits because they are viewed by

the public as being backed by the full faith and credit of

our government.

Since the creation of the Federal Reserve and the

FDIC, conventional banking has inherently been a joint

venture between the private sector and the public sector.

Deposits are made informationally insensitive to

the public by the safety nets from the government, allowing

conventional bankers to redeploy those deposits into longer

dated, riskier loans and securities earning a net interest

profit.

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Given the fact that the conventional banking

system is indeed a joint venture between the private sector

and the public sector, conventional banking has been

regulated.

In recent decades, the shadow banking system

developed to provide many of the same lending and

intermediary functions of conventional banks, also sharing

their same profit motive.

Today, many Americans have financed their homes,

car loans, and student loans via institutions that are part

of the shadow banking system.

One of the distinctions between conventional

banks and shadow banks is that, while conventional banks are

subject to extensive regulatory framework, shadow banks

typically are not.

In order to serve a similar function as

conventional banks, shadow banks needed to create an asset

that was perceived by the public as just as good as a bank

deposit.

insensitive asset.

This in turn meant creating a informationally

The shadow banking system effectively did that.

But, unlike the conventional banking system, the shadow

banking system was and is inherently vulnerable to runs if

their liabilities suddenly become informationally sensitive.

CHAIRMAN ANGELIDES:

How much time do you need to

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wrap up?

WITNESS McCULLEY:

CHAIRMAN ANGELIDES:

One minute, sir?
Okay.

I will grant one

minute, yes.

WITNESS McCULLEY:

Indeed, a run on the shadow

banking system was, as was discussed throughout these

hearings, one of the defining characteristics of the most

recent financial crisis.

Short-dated liability holders of the shadow banks

discovered that actually the assets they were holding were

not just as good as deposits, but were informationally

sensitive.

And when they became informationally sensitive,

you had a run.

actions by government, and governments around the world were

required to stop it, as Secretary Geithner explained.

Call it the Great Run.

Let me conclude.

Extraordinary

There are many lessons to be

learned from the crisis.

the shadow banking system is indeed a banking system engaged

in the same type of activity as banks.

For me, the most important is that

Thus, I believe that the key guidepost for reform

of our financial structure is simple.

does, not what it is called, should determine how it is

regulated.

What an institution

I look forward to your questions, and I thank

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you.

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CHAIRMAN ANGELIDES:

Thank you, Mr. McCulley.

Mr. Neal?

WITNESS NEAL:

Chairman Angelides, Vice Chairman Thomas, and

Thank you.

Members of the Commission:

I appreciate the opportunity to appear before you

here today.

CEO of G.E. Capital and a Vice Chairman of General Electric

My name is Mike Neal.

I am the Chairman and

Company.

We at G.E. and G.E. Capital hope that our

participation on this panel today is helpful as you pursue

your important mission of analyzing the causes of the

financial crisis.

I grew up in Georgia.

I graduated from Georgia

Tech and started with G.E. 31 years ago.

out on the industrial side of the company.

financial services back in the mid-1980s, and I've had a

series of operating roles since that time.

President and Chief Operating Officer of G.E. Capital back

in the 1990s.

in the early 2000s, and then the CEO of G.E. Capital a few

years ago.

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I actually started
I moved into

I became

I became the CEO of G.E. Commercial Finance

I am proud to lead a company that has focused on
lending to Main Street businesses and consumers.

Our

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lending supports more than 170,000 small businesses in their

daily operations.

Our business relationships include household

names like Lowe's, GAP, EBay, JC Penny's, Rooms To Go, and

Wal-Mart.

commercial lending, equipment lending, leasing, middle-

market corporate finance, aircraft financing, health care

financing, franchise financing, fleet leasing, dealer

financing, energy financing.

G.E. Capital is a market leader in mid-market

If you flew in here today on

U.S. Air, you probably flew in on one of our aircraft.

We concentrate on extending straightforward

commercial loans and capital to largely middle-market

customers.

We match-fund our debt, a policy that allows us to manage

risk associated with the funding for specific assets.

We underwrite these loans to hold, not to sell.

Our leverage is quite low.

We did not and do not

originate CDOs or SIVs.

default insurance.

And what we do use with derivatives, what some people might

call the old-fashioned way, we hedge responsibly against

interest rate, exchange rate, and other fluctuations in our

liabilities.

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We did not and do not sell credit

We did not and do not trade derivatives.

Our business is focused on Main Street.

And when

small business and their customers succeed, so do we.
The turmoil in the markets over the past two-and-

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a-half years has been unlike anything I have ever

experienced during my 30 years at G.E.

lost their savings, their jobs, their homes, and confidence

in our financial system and its institutions has been

shaken.

Many Americans have

We think it is good for policymakers to think

about regulatory reforms.

of the past two-and-a-half years, we have continued to lend

to Main Street throughout this period.

Yet, even with the market turmoil

We will continue to

do so.

We extended $96 billion of new credit in the

fourth quarter of 2008.

maintained our focus on lending to Main Street, while

strengthening

balance sheet.

As the crisis unfolded, we

our credit risk management and shrinking our

G.E. Capital was able to meet its short and long

term funding needs throughout the financial crisis.

raised more than $15 billion of capital through an equity

offering, and managed through the challenges of the past

three years without seeking extraordinary assistance through

the Federal Government's TARP Capital Purchase Program.

G.E.

Of course G.E. Capital did participate in CPFF

and TLGP Programs, which were very important and meaningful

for us.

programs in just a minute.

My colleague, Mike Barber, will speak to those

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G.E. is, first and foremost, an industrial

company.

G.E. Capital's focus on middle-market commercial

lending is consistent with our parent's company focus.

will continue to maintain a straightforward and focused

portfolio and emphasize risk management, capital allocation,

and cost.

Before, during, and after the crisis, G.E.

Capital has avoided riskier structured finance businesses,

reduced balance sheet and risk, and strengthened capital

ratios, while enhancing its liquidity.

These actions have made us a much stronger

company.

We have fully appreciated that our middle-market

customers are critical to turning around the economy and

stand ready to continue working with them in the years

ahead.

I hope you will find Mark Barber's discussion of

our commercial operations helpful, and I welcome your

questions.

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CHAIRMAN ANGELIDES:

Mr.

Barber?

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Thank you, Mr. Neal.

WITNESS BARBER:

Chairman Angelides, Vice

Chairman Thomas, and Members of the Commission:

Thank you for the opportunity to appear here

today.

My name is Mark Barber, and I am Deputy Treasurer of

General Electric Company, and G.E. Capital, with

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responsibility for short-term funding and investment.

I joined G.E. Capital in 1989 as Assistant

Treasurer for Short-Term Funding, after 10 years with Ford

Motor Company's Financial Services Unit.

than 20 years at G.E., my work has related to the company's

short-term funding and investment activities.

And during my more

I manage G.E. Capital's commercial paper program.

It is one of the company's overall funding and liquidity--it

is part of the company's overall funding and liquidity

operation.

I will provide a brief overview of G.E. Capital's

commercial paper funding program and government programs

established during the financial crisis.

Unlike many of the structured financial products

that have come under scrutiny in the wake of the crisis,

unsecured commercial paper is not a new or complicated

product.

1952.

paper to meet its liquidity and funding needs.

market that is long known for its depth, efficient pricing,

informed investors, and transparency.

G.E. Capital has issued commercial paper since

Today, G.E. Capital continues to issue commercial
This is a

G.E. Capital, unlike most other commercial paper

issuers, prices and sells commercial paper directly to

investors without going through dealers.

day how much cash we want to raise based on a number of

We determine each

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factors, including the amount of the company's maturing

commercial paper, and its current and projected liquidity

profile.

We set pricing daily based on our borrowing needs

and market factors, and then present to potential investors

our pricing scale for newly issued commercial paper.

Our primary commercial paper purchasers are

institutional investors, including investment managers,

money market mutual funds, state and local governments,

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corporations, and a variety of other institutions.
G.E. Capital maintains strong relationships with

commercial paper investors, many of which have been

purchasing commercial paper directly from us for years.

As the credit markets began to experience stress

in 2007, G.E. monitored changing market conditions to ensure

stable and prudent short-term funding.

periodically reviewed its key drivers of liquidity, debt

issuance and maturities, backup credit lines, asset

origination and income, access to securitization and

syndication platforms, and other liquidity sources.

To this end, G.E.

In 2008, many financial institutions faced a

stagnating debt market, a weakening secondary market, and

growing investor concerns over safety and security.

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The bankruptcy filing of Lehman Brothers on
September 15th placed significant pressure on money market

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funds, a number of which held Lehman-issued commercial

paper.

In particular, the reserve primary fund was

forced to write down $785 million in holdings of Lehman-

issued commercial paper, and subsequently announced that it

had, quote/unquote, "broken the buck" on September 16th.

The fund experienced massive demands for investor

liquidations that it could not fully honor.

Investors began

to question the vulnerability of other prime funds, and as a

result began a more widespread withdrawal from prime

institutional money market funds.

In October of 2008, the government took steps to

restore investor confidence in the short-term funding

market.

Reserve's Commercial Paper Funding Facility, or the CPFF,

and the FDIC's Temporary Liquidity Guarantee Program, or

TLGP.

These steps included the creation of the Federal

G.E. Capital participated in both the CPFF and

the TLGP.

business through this crisis.

secure and, with the support of our investors, continued to

fund our operations every day, despite volatile and stressed

markets.

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G.E. is proud of the way we've managed our
We kept the company safe and

We also respect the important role federal
officials played to reassure investors and navigate the

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market uncertainty.

maintain its conservative business model.

to experience anything like the events of the Fall of 2008

again.

Going forward, G.E. Capital will
We all hope never

Our continued aim is to maintain and improve

shareholder value through smart, safe, and secure lending

and funding practices.

I hope my testimony today has been useful to the

Commission, and I look forward to answering your questions.

Thank you.

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CHAIRMAN ANGELIDES:
Barber.

Mr. Meier?

Thank you very much, Mr.

MAI-ER or MAY-ER?

WITNESS MEIER:

CHAIRMAN ANGELIDES:

WITNESS MEIER:

Chairman Angelides, Vice Chairman Thomas, and

It's "My-er" actually.
Mr. Meier.

Thank you.

Members of the Commission:

Thank you for the opportunity to appear before

you today.

Investment Officer for Global Cash Management at

Street Global Advisors, which is the investment management

arm of State Street Corporation.

My name is Steven Meier.

I am the Chief
State

I have more than 26 years experience in financial

services, with a focus on traditional money markets, fixed

income, global cash, and financing.

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The events of 2007 and 2008 were unprecedented,

and their consequences were devastating.

saw the values of their homes and savings decline, business

fail, and our economy entered into a severe recession.

Millions of people

On behalf of State Street, I would like to

express our gratitude to the American people and our leaders

for their resolve and determination throughout this

difficult period in our Nation's history.

Although many are still suffering, the commitment

of America's people and institutions has put us on a path to

recovery.

My understanding is that the Commission is

primarily interested in three short-term lending activities:

repurchase agreements, commercial paper, and securities

lending.

these topics as appropriate.

I would be happy to answer questions on each of

It is important with respect to all these

instruments that institutions properly assess and manage

risk.

credit team tasked with evaluating counterparty and issuer

risk.

At State Street Global Advisors we have a dedicated

This group considers a range of factors in

assessing potential client counterparties, and thoroughly

investigates the quality of the underlying collateral.

In the commercial paper market, particular

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emphasis is placed on vetting issuers and examining the

liquidity support providers.

This rigorous credit analysis helps protect our

clients and allowed State Street Global Advisors to focus on

solid investments during difficult market conditions.

None of the money market funds advised by State

Street Global Advisors risked breaking the buck, and the

other cash products underlying our securities lending

program have not experienced material credit losses.

The credit and asset-backed markets, however,

have experienced extreme illiquidity and credit spread

widening, and the market price for those products have not

always reflected the quality of the underlying assets.

Neither State Street nor our cash funds had

material exposure to Bear Stearns immediately prior to its

sale, and while some of our clients did have collateralized

securities lending and repurchase agreement exposure to

Lehman Brothers and its affiliates, our clients did not

incur any investment losses as a result of such exposure.

I have thought long and hard about the lessons

learned from the financial crisis.

highlight three points in particular.

I would like to

First, credit quality alone may not be sufficient

to protect against price degradation when there is limited

market liquidity.

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Second, the secondary market liquidity mechanism

has proven less reliable in a severely distressed market,

which has implications for portfolio construction.

And third, I believe the industry has

increasingly recognized the need for substantial additional

committed resources and infrastructure to manage money

market assets.

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Let me also say that I do not believe the blame
for this crisis can be attributed to any single event,

entity, product, or decision.

crisis flowed from a confluence of factors, many of which

the Commission is investigating.

In my view, the financial

In particular, I would point to excessive

leverage and inadequate capital requirements which

ultimately contributed to a lack of liquidity and frozen

credit markets.

Thank you again for the opportunity to be here

today.

I will be pleased to answer any of the Commission's

questions.

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CHAIRMAN ANGELIDES:

Thank you very much,

gentlemen.
So we will now start our questioning.

Let me

just start with a very few before we go to the Vice Chair,

and let me start with you, Mr. McCulley.

I was struck by something in your testimony, both

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written and verbal, about the vulnerability to the system

still today.

because you really end on the note that institutions ought

to be treated and regulated for what they do, not how

they're legally defined.

Let me ask you just the fundamental question,

And so does that argue for more sweeping deposit

insurance?

mitigated historically, or today, the possibility of a run?

Or how do you really, truly--how could you have

WITNESS McCULLEY:

As Secretary Geithner was

testifying earlier, there were large nonbank levered

institutions that were systemically important but weren't

regulated at the consolidated level with respect to capital,

or liquidity buffers, or activities that they could engage

in.

They escaped, if you will, the regulatory

umbrella of the conventional banking system.

crisis, the run, originated in the shadow banking system and

moved over into the conventional banking system.

And the

And as the case with Lehman's failure, we could

not have a orderly bankruptcy because we did not have a

resolution authority to unwind that firm in a orderly way.

And we found out that a disorderly bankruptcy created huge

collateral damage, not just for the financial system, but

for the real economy.

And, quite frankly, we still don't have such a

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resolution authority.

respect to your question is that we need the ability in our

country to have orderly failure, because disorderly failure

of a systemically important institution is simply too

painful for our economy.

So my most important message with

CHAIRMAN ANGELIDES:

Would the presence of a

resolution authority in and of itself have mitigated the

possibilities of runs on Bear and on Lehman and on other

nonbank institutions?

WITNESS McCULLEY:

By itself I don't think that

resolution authority is the solution.

whole mosaic of regulatory arrangements to make our system

less vulnerable to runs.

I think we need a

And I would point out that runs happen on

institutions, and then spread throughout the system, because

you have important institutions that have inadequate

capital, and perhaps dodgy assets, and when that is

recognized by the investment public they naturally withdraw.

So actually having bigger buffers of capital in

Systemically important institutions, regardless of what their legal

structure is, I think is an important safeguard.

not initiate a run on a bank that is sound.

People do

Now after you get a run, you can see a cascading

effect.

But the original run involves fundamental problems

with an institution.

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CHAIRMAN ANGELIDES:

All right.

In March of

2008, in one of Mr. Thomas's and my home state papers,

actually the hometown paper of Ms. Born, the San Francisco

Chronicle, you said, quote, "People had levered half the

distance to the moon in dodgy assets."

So I guess this is a way of saying you thought

they were over-levered and in very risky assets.

ask you a question.

repo lenders, at what point did that become relevant to repo

But let me

At what point was there knowledge by

lenders?

Take me through late 2007-2008 and the

recognition by repo lenders, other short-term lenders, as to

this fundamental problem.

that time?

Why wasn't that evident before

WITNESS McCULLEY:

I think it was evident.

And

it became quite evident in the summer of 2007 when you saw

the funding for the shadow banking system become more dear

and less available.

backed commercial paper market before it was demonstrated in

the repo market.

And actually it was in

the

asset-

And if you had to pick a day when I think the

recognition really hit, was August 9th of 2007 when Bank

Paribas froze redemption in three of its off-balance sheet

vehicles.

the short-term funding markets that the assets that they

And that was the ringing of the bell I think to

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were owning, whether it's asset-backed commercial paper or

repo, had become informationally sensitive.

comes informationally sensitive, you will have a pulling

back.

And when it

So actually for us involved in the market, and I

think for the market at large, you really have to go back to

the summer of 2007.

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9

CHAIRMAN ANGELIDES:

But it was event driven, but

up until that time you relied on--the information you relied

on was, what, credit ratings, an assumption that the

collateral was sufficient, that there weren't underlying

problems in the collateral itself?

WITNESS McCULLEY:

CHAIRMAN ANGELIDES:

Really, kind of going to

your, the lender's level of due diligence?

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17

I think as a general--

WITNESS McCULLEY:

I think that's a very

important point.

CHAIRMAN ANGELIDES:

Because actually, let me

just add something else you said because I think it's

important.

the bubble were driven by mortgage originators:

originate to distribute outfits who were turning

underwriting standards into a very, very sad joke.

the marginal source of finance for the marginal buyer-

speculator.

You actually spoke about how the later stages of
They

That was

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You then go on to say:

Getting a handle on this

phenomenon, which clearly the Fed did not, required more

than macro data.

shoe leather research.

It required good, old-fashioned

So I would ask, of the funders as they saw what

was entering the system, the collateral that was backing the

asset-backed commercial paper, the nature of the assets in

the institutions who were doing the loan, kind of what level

of due diligence, what level of recognition did you have

before August 9, 2007?

WITNESS McCULLEY:

Clearly the industry at large

was not doing adequate due diligence, and was outsourcing

it, if you will, way too much to the rating agencies, and

also to the conventions of the tri-party repo system where

your lesser quality assets were repoed.

From the standpoint of what we were doing at

PIMCO, and this was long before 2007, we have never used

asset-backed commercial paper in our routine liquidity

management.

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We simply haven't used the product.
We were unique I think in the industry of not

using asset-backed commercial paper--

CHAIRMAN ANGELIDES:

couldn't understand it?

behind it?

Because you felt you

You didn't really know what was

WITNESS McCULLEY:

The key reason is that asset-

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backed commercial paper was issued by off--in the main, by

off-balance sheet vehicles, conduits, and SIVs.

couldn't do the due diligence on what the SIV was holding on

the asset side, then I did not want on behalf of our clients

to own the liabilities.

And if I

I did not want to own the liability of what I did

not know on the other side, so we didn't.

that we at PIMCO were not participants in the tri-party repo

market where the lesser quality assets were funded by the

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11

I would also note

shadow banking system.
We were engaged in the bilateral repo market on

Treasury and agency collateral.

So when I look back at how

we ran our business for our clients, we simply were not

involved in those two arenas.

CHAIRMAN ANGELIDES:

Mr. Neal, just as a follow up, did you hear the

All right.

prior session with Mr. Geithner at all?

WITNESS NEAL:

Just small pieces of it.

VICE CHAIRMAN THOMAS:

CHAIRMAN ANGELIDES:

WITNESS NEAL:

CHAIRMAN ANGELIDES:

Microphone on.
Yes, microphone.

Sorry.
Well I had asked him, and

you might shed light on this, I had asked him--because one

of the things I know that our staff talked to the G.E. folks

about is your continued ability to issue commercial paper

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even during the depths and the difficulty of the crisis, and

apparently we've received information that shows you

continued to do it all the way through as, I believe, with

fairly consistent spreads below LIBOR.

Director, who did not knowledge me--

(Laughter.)

CHAIRMAN ANGELIDES:

8
9
10

I was looking at our

But is that an accurate

statement?
STAFF DIRECTOR:

Yes.

CHAIRMAN ANGELIDES:

Yes.

Even though she didn't

acknowledge me, she did hear me.

couple of things.

some critical days:

that's in the wake of the official announcement by AIG that

it had signed a definitive agreement to obtain an $85

billion line of credit. It's over the weekend when Goldman

and Morgan Stanley become bank holding companies.

But I was curious about a

I asked Mr. Geithner about, you know,
September 29th, September 30th, when

On Monday, September 29th, the Dow dropped 777

points after the House of Representatives voted down the

financial bailout bill.

So this is a pretty critical time.

And what I

was trying to get a handle on is, in those conversations, or

other conversations, was G.E. expressing a deep concern

about your ability to continue to issue commercial paper?

So that was one set of questions.

Mr. Neal?

Mr.

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Barber?

Either one of you?

WITNESS NEAL:

I'll start with that, if that's

okay.

In the early days--well, early days, late summer--you

know, we actually benefitted I think from a flight to

quality in some cases in our CP program.

Now we're not naive to what was going on in the

market, particularly as you moved more into September, but

we were able to sell our quota every day, what we were

trying to raise.

I think you've seen the data on that.

The markets were choppy.

We were concerned about

the markets and the direction of the markets and where they

might ultimately end up.

doing okay.

But having said that, we were

I would say it got more difficult after the

reserve fund, after Lehman.

issuing, and issuing successfully, through that period.

Having said that, we were still

I think a lot is to the strength of G.E., a AAA-

rated player, at least at that time.

the first quarter, but I would answer your question that

way.

CHAIRMAN ANGELIDES:

We were downgraded in

Yes, but to get to the

extent of the crisis, did G.E., Mr. Immelt, yourself, other

representatives, urge for example the Federal Reserve to

initiate the CPFF program and other support programs because

you were concerned about the ability to continue to issue?

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WITNESS NEAL:

We had a number of people--and

Mark might be better to talk to that than me--that were in

contact with different members of government.

conversation with Mr. Geithner, or Secretary Paulson, about

something like that.

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7
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WITNESS BARBER:

I never had a

Mr. Chairman, just to echo Mr.

Neal's comments, in the period up to Lehman Brothers we were
funding normally in the markets and benefitting from,
through in fact the asset-backed commercial paper challenges

that Mr. McCulley has described, a bit of a flight to

quality, as investors pulled back from some of those

structures and came to recognize names like G.E.

And after Lehman Brothers and the Reserve Fund,

it is true that we had regular dialogue with the Federal

Reserve Bank of New York, their team there, that had I think

a meaningful outreach process to many members of the market,

many issuers and investors on both sides.

find out what was going on and how the markets were

performing.

them as we went through that crisis.

dialogue.

Their job was to

And we of course shared our experience with
So there was regular

And through there, they were aware of the

withdrawal of liquidity from some of the funds and the

challenges it would have created across the whole market.

And we simply shared with them our experience in issuing

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every day.

CHAIRMAN ANGELIDES:

One more question on this

line, and then I want to stop and move on.

You were pretty

big participants in both the TLGB program, which was the

FDIC backstop long term debt.

at one point about eighty?

$80 billion?

I think you borrowed I think

Does that sound about right?

WITNESS BARBER:

Yes.

CHAIRMAN ANGELIDES:

I think you've paid it down,

though.

billion has been repaid.

CPFF program, even though I believe you are no longer in

that program?

You still have about $59 billion outstanding.

$21

You were a big participant in the

Is that accurate, or not?

WITNESS BARBER:

That is correct, sir.

The

program is shut down, and you may know that the program took

in three-month commercial paper, issued into it, and

whatever we put into the program we paid down on our first

roll, as the market began to heal and to improve.

CHAIRMAN ANGELIDES:

So I guess my only question

is:

Did you participate in those programs because you

needed to, or because they offered favorable pricing that

allowed you to be competitive with others in the market?

WITNESS BARBER:

Sure.

I'm glad you asked the

question.

What I would say to you is that in the period

after the reserve fund, G.E. Capital honored requests for

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liquidity from many of our investors who needed to move to

cash.

And in the two or three week period following

that, those requests were significant and we did our best to

provide that liquidity to the market.

basis for our communication to our investors, and publicly,

when we announced that we were going to apply for the CPFF,

that we would use this as a process to provide liquidity.

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10

CHAIRMAN ANGELIDES:

In fact, that was the

To meet your own liquidity

needs, which were a function of--

WITNESS BARBER:

--investors liquidity, very much

like what the asset-backed commercial paper program was

doing for the Fed.

helpful to investors in providing liquidity to them, and it

was very useful that way.

So funding ourselves through, and

But after the first issuance into it, we matured

out everything and ended in probably February I think it

was.

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20
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CHAIRMAN ANGELIDES:
much.

All right.

Thank you, very

Mr. Thomas?
VICE CHAIRMAN THOMAS:

I am interested in a

couple of different directions, and I am pleased to have you

in front of us.

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25

One, because although it's partially useful,
pathology isn't all that much fun in talking to folks that

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used to be there.

you're still here.

3
4
5

You have come out the other end and

So you might have a slightly different look at
tomorrow than you had yesterday, based upon having survived.
I am trying to understand--let me ask it this

way, and I am really just asking any of you who want to

respond, to respond.

8
9

You're sitting at the table.

You are in some

kind of a general category like shadow banking, or non-

traditional banking, however you want to phrase it.

folks look at each other as competitors?

business relationship that you feel toward each other?

that make sense?

involvement that none of you are in direct competition?

you seek out a niche that doesn't put you in direct

competition with others, not withstanding the fact you're

supplying a service and you're using a similar financing

mechanism which isn't in the traditional system?

Do you

What's the
Does

Are you in such discrete areas of

WITNESS MEIER:

Mr. Vice Chairman, if I can

address that, I would say that we are also a fiduciary and

an investment manager.

in that respect, we are a competitor of PIMCO.

We don't take proprietary risks.

We also have significant business dealings with

PIMCO at the State Street Corporation level, as providing

clearing and custody operations for them.

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I should also mention that we are a significant--

2
3
4

VICE CHAIRMAN THOMAS:

Are you trying to put them

out of business by being better at what you do?

WITNESS MEIER:

They're very good at what they

do, but I think we're very formidable as well.

it's more of a friendly competitive rivalry.

So I think

In terms of our relationship with G.E. and G.E.

Capital Corp. in particular, we are a significant investor

of their assets, both commercial paper and medium-term

notes.

VICE CHAIRMAN THOMAS:

One of the things that

amazes me is that this particular niche isn't a niche

anymore.

side in volume, living off of finding your daily bread every

day, versus the more traditional model.

And that you grew to equal the commercial banking

I'm trying to determine whether you feel in the

way in which you get your assets a certain camaraderie,

commonness of function, that you now look at the person next

to you slightly differently than you did a couple of years

ago in terms of whether or not you can sustain the model

that you have, what you've been through?

I really do--and I'll make it specific to you,

Mr. McCulley--I really do believe there can be runs on banks

that are sound.

Because it would be based on inaccuracies,

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1

rumors that have no truth to them, but that doesn't mean

that you can't produce a run.

reasons they created that backstop of FDIC and the rest to

give a comfort level, and obviously that isn't available to

you.

6
7

Do you believe that you can do a better job on
the margins on return on capital than the commercial banks?

8
9

And that was one of the

WITNESS McCULLEY:

First and foremost, PIMCO is

not a shadow bank.

VICE CHAIRMAN THOMAS:

WITNESS McCULLEY:

No, I understand.

PIMCO is an investment

manager.

VICE CHAIRMAN THOMAS:

None of you are the "bank"

part of the "shadow banking."

the specificity of the definition.

group of people who stay alive in a particular type of

market.

WITNESS McCULLEY:

And I don't want to dwell on
I'm trying to take a

I think all of us as

participants in the money markets have deeper appreciation

than we had a few years ago at just how vulnerable the

system can be to a loss of confidence.

And I think collectively in our industry that we

recognize the need for levered institutions that don't have

access to our lender of last resort, or deposit insurance,

to have robust capital buffers, as well as liquidity buffers

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such as backup lines of credit with conventional banks.

From the standpoint--

VICE CHAIRMAN THOMAS:

dodgy assets.

WITNESS McCULLEY:

VICE CHAIRMAN THOMAS:

Well, and-So would you define for me

how you avoid dodgy assets?

8
9

And we also don't want any

WITNESS McCULLEY:

First and foremost is, as an

investment manager you do your homework.

You have a

fiduciary duty to your clients to invest in quality assets.

VICE CHAIRMAN THOMAS:

WITNESS McCULLEY:

So I have nothing but AAA.

No, that's not necessarily the

case.

research to the rating agencies, but actually doing it

yourself.

industries, and actually, if I might, I will tell you

something that we did at PIMCO back in 2005 and 2006.

Doing your homework is not outsourcing your credit

It's due diligence on companies, due diligence on

We started in '05 when we believed that there

were serious signs of bubbles in the property market.

sent out credit analyst to 20 different cities to do some

old-fashioned shoe leather research.

around the country, getting on the ground, speaking with

real estate brokers, mortgage brokers, and players in the

real estate market in each local area in order to determine

just what was going on in the markets, including this

Literally, 20 cities

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degradation, the outright degradation of underwriting

standards.

So we literally got on the ground and observed

it.

And when our group came back, they reported what they

saw and we adjusted our risk accordingly.

6
7

VICE CHAIRMAN THOMAS:
mortgage--

8
9

So you got out of the

WITNESS McCULLEY:

We severely limited our

participation in the private-label mortgage securitization.

VICE CHAIRMAN THOMAS:

Well especially if you're

in Orange County and you could observe not only your

neighbors but yourself in terms of what happened in the real

estate market.

In terms of G.E.'s role, size, perspective, did

you ever think what happened could happen?

was always a possibility, wasn't there, that what you

thought were assets that you had to rely on for your daily

bread in turning them over that somebody might just say no?

And of course if they never had, you don't anticipate that,

right?

WITNESS NEAL:

I mean, there

I think, you know, from my

perspective I never anticipated that things could be as bad-

-it hadn't happened in my lifetime--as we saw in the Fall

and Winter of 2008, principally from a funding standpoint.

Our assets have actually held up pretty well

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through the recession.

G.E. Capital is different than State Street and PIMCO.

we do is we have 8000 sales people that call on CFOs, and we

originate, we finance, we lease, it's what we do.

Just under--just to make a point,
What

People like PIMCO and State Street support us by,

you know, working with us on the debt side.

VICE CHAIRMAN THOMAS:

And you have a foot

through the door because of the first two letters of your

name.

WITNESS NEAL:

We are highly rated.

And we are

highly profitable.

We have run what we think is a pretty

wonderful business for a long period of time, and so we are

attractive.

I think, as I mentioned earlier, there was a

flight to quality, at least for awhile, with us through

that.

17
18
19
20

But the-VICE CHAIRMAN THOMAS:

So you had no worries at

all during this period?
WITNESS NEAL:

Oh, tons of worries.

Every, you

know, our customers--

VICE CHAIRMAN THOMAS:

WITNESS NEAL:

What was number one?

Just where were things going.

know, for me, I start with Bear, go through the GSEs, Ed,

Lehman, watch the buck doesn't get broken.

happened twice, very often.

It's only

The investment banks become

You

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1

bank holding companies.

2
3

WaMu, the run on Wachovia.

VICE CHAIRMAN THOMAS:

You used to know what

quality was and you couldn't quite define it anymore?

WITNESS NEAL:

It was just a remarkable time,

from that standpoint.

everything, just like I'm sure all of you did during that

period of time.

And, you know, what's the ultimate impact

on the economy?

What's the ultimate impact on our business?

So you wonder.

You worry about

So we became I think both prudent and

conservative as we worked to manage our way through that

successfully.

we were successful as we went through that in funding

ourselves.

But we were concerned.

VICE CHAIRMAN THOMAS:

I was concerned.

But

Do you still think there's

a clear separation between the two financial structures?

mean, as people talked about moving toward the Gramm-Leach-

Bliley removal of Glass-Steagall, that commercial banks were

moving more in the direction of your profile, it sounds to

me like you want to move more in the direction of some kind

of a support window that would allow you in difficult times,

if you followed certain rules.

side, from your perspective, that either advantages you or

disadvantages you in terms of your current business model?

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25

WITNESS NEAL:

What comes out the other

I would say that what we do,

commercial banks typically don't do a lot of.

We just have

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a different business model.

and smaller businesses.

lender, in many ways.

We tend to be in middle market,

We finance--we're a collateral

When you think of commercial banks and Glass-

Steagall, that was more of a move into investment banking,

trading, proprietary trading.

don't do.

8
9

These are things that we

I think the way to think about G.E. Capital is
just as an old-fashioned finance company.

We happen to be a

big one.

global at it, and the business has been a strong contributor

to G.E.'s profits for quite a long period of time.

And we happen to be pretty successful.

But that's the niche that we're in.

We're

We've become

what we think are experts on collateral classes, on customer

groups; whether that's franchise financing.

through D.C., a lot of the franchises you see, we may be the

finance company in that; aircraft, we're the biggest in

that; trucking.

of.

20
21

If you drove

It's just things that banks don't do a lot

VICE CHAIRMAN THOMAS:

Yes, diesel engines on

railroads, and that sort of thing?

WITNESS NEAL:

That sort of thing, yes.

VICE CHAIRMAN THOMAS:

Mr. Meier, looking at what

the legislation is and where it looks like it's going, what

do you see that you'll have to change in terms of your

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2

business model?
WITNESS MEIER:

In terms of our business model

I'm concerned about the impact of legislation on the

availability of credit to consumers.

about the impact on our growth potential as a Nation, in

terms of slowing down that ability to lend.

Also I'm concerned

I think when you look at our business--

VICE CHAIRMAN THOMAS:

9
10
11

Well, but if you saw what

happened when we didn't slow down the lending, that ought to
at least temper you a little bit, shouldn't it?
WITNESS MEIER:

Perhaps, Mr. Vice Chairman, but--

12
13
14
15

VICE CHAIRMAN THOMAS:

It's tough to get out of

the hole we're in.
WITNESS MEIER:

Yes.

I think when you look at

our business and our assets and our management and the types

of assets we buy, potentially it may temper your view in

terms of the nature of the problem.

For example, as this point we've got about $575

billion in assets under our management at our peak, well

over $700 billion in cash.

those assets were invested in regulated banks.

At our peak, over 80 percent of

We are a big buyer of time deposits, certificates

of deposit, commercial paper holdings; ninety percent plus

are dominated by bank holding company issuance.

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Our repurchase agreement counterparties, now if

you include Goldman Sachs and Morgan Stanley, is 100 percent

financing for banks.

conduits that we purchase are typically issued by banks.

The asset-backed commercial paper

We don't simply look at the assets, although we

do do due diligence.

we also look through to the liquidity support providers.

And we wouldn't buy any asset-backed commercial paper

conduit unless we're 100 percent sure that they are fully

We know the sponsors, the entity.

But

supported by a bank institution.

So the shadow banking system has got various

definitions, but from our perspective, Mr. Vice Chairman, we

agree that we prefer, given the risk tolerance of our

clients, to invest in highly regulated entities such as

banks.

VICE CHAIRMAN THOMAS:

Thank you, Mr. Chairman,

my time is up and I want to hear from others, but I just

want to reference the discussion about where we are.

Today the Dow went down 998 and a half points earlier.

has recovered up to about -465.

And that's the world we are

still in, obviously with worry about Greece.

Thank you, Mr. Chairman.

CHAIRMAN ANGELIDES:

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25

Just before we go to Ms.

Born, a very quick question for Mr. Neal and Mr. Barber.
Just a quick reaction.

You are in the old-

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1

fashioned finance business.

You actually lend to businesses

that are creating products, employment.

reaction to--I assume you don't have on your books, you

don't carry as assets subprime CDOs, CDO-squared, other

structure products?

WITNESS NEAL:

No.

CHAIRMAN ANGELIDES:

Just any visceral

No, we don't.
Any judgment on their

utility to the financial system and larger economy,

synthetic CDOs, CDO-squared?

10
11

WITNESS NEAL:
think, Mr. Chairman.

12
13

"Synthetic" is a bad word, I

But, no, we don't do that.

CHAIRMAN ANGELIDES:

Synthetic is a bad word, or

the devices are not particularly good?

WITNESS NEAL:

I think, you know, I run a finance

company.

We are just not in those businesses.

I think

there certainly are products like that that I think weren't

understood well in some cases, maybe not rated well in some

cases.

We've been quite disciplined about that.

But it's not a line of business that we're in.

We do a number of things, but in most cases it's

financing, leasing, lending, and middle to small--now we do

it in 50 countries around the world, but we stayed to that.

We don't have a broker-dealer.

originate to sell.

And that's a business that we've grown quite a bit over the

We're not a--we don't

We originate for our own balance sheet.

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2

last 30 years, and it's attractive.
Now we went through a tough cycle, as did

everybody else, in the last two years.

But we are coming

out of it now.

better, at least in terms of our operations.

better about it.

I would say the good news is things are
So we do feel

But I'm not an expert on those products.

CHAIRMAN ANGELIDES:

Ms. Born.

COMMISSIONER BORN:

And thank you all for being willing to appear

Thank you, very much.

before us and help us with our investigation.

first questions I want to direct to Mr. Neal and Mr. Barber

about G.E. Capital, which I do consider to be part of the

shadow banking system, although not part of the investment

banking system.

lend it the way banks do, but you're on a different model

than the investment banks.

commercial bank, although I understand you do have a thrift

subsidiary in your affiliates.

19
20
21

I think my

Because I think you do borrow money, and

You're not regulated as a

I understand that you are the biggest, the
world's biggest issuer of commercial paper?
WITNESS BARBER:

Is that right?

We, worldwide, are the largest

issuer of commercial paper.

probably in the top five, but I don't believe we're the

largest issuer now.

In the United States we are

But we are a large issuer, yes, ma'am.

COMMISSIONER BORN:

Well let me ask you about

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what kind of problems were experienced in the commercial

paper market during 2008, for example, as first of all Bear

Stearns failed and was acquired by JPMorgan, and then later

in September we had Lehman Brothers and the GSEs and AIG get

into trouble.

I noticed, I'm sure there was a lot of turmoil in

the markets during that period of time.

you like to respond to that?

WITNESS BARBER:

Sure.

Mr. Barber, would

Commissioner, you've

referenced an extended period of time.

when I think the marketplace, particularly asset-backed

commercial paper began to experience some challenges, as I

mentioned earlier we, as we have at different points, stress

in the money market in past years actually benefitted a

little bit as our investor base for G.E. and G.E. Capital

Paper, we had a little bit of a flight to quality back to

us; investors that may not have worked with us for awhile

came back.

The period of 2007

So we saw continued good demand.

And I would

also quickly add that we're an issuer of commercial paper in

the U.S., and also in other markets around the world.

similar experience there.

And one of the advantages that we had, which I

mentioned in my opening remarks, is that we deal directly

with end investors.

So we don't work through an

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1

intermediary.

managers and the credit teams, and the leadership teams at

organizations like State Street Global Advisors, and PIMCO,

and many others, really helps us better understand the

portfolio strategies and plans that they have.

The relationship we have with the portfolio

They have their views on G.E. and G.E. Capital,

and it's our opportunity to express to them our company's

performance, our funding plans, our liquidity models.

that direct relationship is very important to us.

It's part

of our DNA, and it is one of the things that really helped

us through the entire period that you're talking about.

I think that in the period following--in the

commercial paper market--following the events that we've

talked about, Lehman, and Reserve, and so forth, you began

to see some conditions that we had never seen before.

And in the range of 45 percent of our funding

would have come at that point in time from the money market

fund industry, which tells you that we also had 55 percent

or so of our funding that came from sources different from

those.

So well diversified investor base.

But when you

began to see withdrawals of liquidity from some of the

portfolios, their natural reaction would have been to

protect their cash, to hold cash, and therefore reduce

demand for longer dated paper.

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One of the important metrics that we have around

G.E. Capital's program is that we keep what we think is a

fairly long and modest average remaining term on the

program.

in the longer maturity ranges.

and other invest--

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It means it's well extended.

COMMISSIONER BORN:
maturity ranges be?

It's well placed out

And the money market funds

What would the longer

What's your average range?

WITNESS BARBER:

You may know that commercial

paper can be issued, a 3A paper at least can be issued all

the way out to nine months.

COMMISSIONER BORN:

WITNESS BARBER:

Right.

And our average remaining term

at that period of time was somewhere in the 55 to 60 day

range, maybe a little bit more, which I think, I don't know

for sure, is generally on the longer end of how paper

programs are managed.

So we had what we thought was a long and

conservative goal in the reality with our program.

when we went into that period, we saw less demand for long-

term paper, but we still found many buyers.

not just money funds that we'd sell to.

And so

Again, this was

And as I mentioned also, we saw requests for

redemption of our paper early to meet liquidity demands,

which we did our best to honor.

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So communication with our investors about their

plans and what they were seeing, opportunity to talk with

them about our own funding and liquidity plans and the

success we were having in marketing our own debt, and just

understanding where the liquidity pressures were coming.

All that helped us really navigate through the period.

It was very important, we thought, that some of

the actions that the government was taking to support

liquidity in not just our market but others, that those

steps were helpful in terms of bringing liquidity and

stability back to markets that had never seen anything like

this.

So I think the steps that they took--"they"

meaning the Fed and the CPFF, the asset-backed support

program which of course we weren't a part of but

accomplished pretty much the same thing, then ultimately the

TLGP were very, very useful.

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COMMISSIONER BORN:

And I suppose the support to

the money market funds had an impact, as well?
WITNESS BARBER:

I forgot that.

I think probably

my colleagues to the left and right can speak more to that

than I can, but I think you're correct.

COMMISSIONER BORN:

Right.

So since you weren't

in the asset-backed commercial paper market, you did not

feel that contraction that occurred in 2007 with respect to

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that market?

WITNESS BARBER:

We didn't feel that contraction

there.

I would quickly add that we do have a small asset-

backed commercial paper program called Edison Asset

Securitization, which we're no longer originating assets in

there, so it's in a declining mode.

program.

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It's a very small

So we didn't see any pressure there.
COMMISSIONER BORN:

You did reduce I think your

issuance of commercial paper by 2009, compared to 2007, for

example.

their accuracy, was you had about $106 billion of commercial

paper outstanding in 2007.

billion in 2009.

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The statistics I have, and I'm not vouching for

And it was down to about $50

Is that right?

WITNESS BARBER:

Your numbers are very close,

yes.

COMMISSIONER BORN:

So you brought it down during

that period by about half.

happened?

didn't have the need for that much funding because you were

contracting your operations?

And I wondered why that

Was it because of market conditions?

WITNESS BARBER:

Because you

Why was that?
Sure.

As a member of the

corporate treasury team supporting the assets that are

underwritten that Mike has described to you, we are always

evaluating conditions in the marketplace to know how we can

support those assets, the pricing of our debt, the strengths

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of the market.

So in that evaluation, as we were going through

the September and October period, a decision was made that

it would be prudent for us to reduce our reliance on the

commercial paper market, and we did.

We communicated that to the marketplace.

We took

action to produce the numbers along the lines that you're

speaking of.

our total debt is a little less than 10 percent, about 9.1

percent of total debt, which we think is very conservative

and well managed, manageable.

billion today, worldwide; 80 percent of it in the United

States, the other 20 percent in markets outside the U.S.

significantly less reliance on commercial paper.

And today, commercial paper as a percentage of

COMMISSIONER BORN:

And that number is about $46

I assume that you both feel

that you have survived this crisis rather better than, for

example, the big investment bank holding companies did,

which either had to become bank holding companies or were

acquired or went bankrupt.

What do you attribute that to, Mr. Neal?

WITNESS NEAL:

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Well I would say some of it is

just our model.
COMMISSIONER BORN:

What aspects of your model

have protected you from this turmoil?
WITNESS NEAL:

I would say we originate assets to

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hold.

We only originate assets to hold.

that is, if we did a transaction that was for 10 years, we

look at the risk in it as a 10-year risk.

And what I mean by

Others, particularly in this period of time when

originate-to-sell or distribute became such a popular line

of business, your risk, the way you think about it is very

different.

And so the underwriting becomes:

hold it to maturity.

You may have it in your warehouse for 60 days.
Can I sell it?

Not will I

And because of that, our portfolio, our losses,

which we're not immune to this cycle, but our losses have

performed well below the Fed cases.

itself is less impacted because of that.

And so the business

I would say another thing is that we, again we

match-fund everything.

transaction in Australia and we can't raise Aussi dollar, we

might raise that here and then swap into that

five-year transaction and five-year money is not the right

way to raise capital that day, we may raise something else,

but we swap into that.

And when we borrow, if we have a

We do not--we do everything we can to only take

credit risk in these transactions that we have.

that's a piece of it.

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If we have a

We were AAA.
stable.

So I think

We were downgraded to AA, but

Everybody--there's no one left.

I mean, the whole

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industry was in the first quarter of last year, but we were

able to get through this.

I think G.E. is an enormous source of strength

for us.

with these markets, we cut our dividend.

dividend from G.E. Capital back to G.E.

We brought it down to 10.

zero just to keep capital in the company.

When things got difficult, when we got concerned
This is the
It was 40 percent.

We eventually brought it down to

We adopted a program which we called "Safe and

Secure" at that moment in time.

equity into G.E. Capital--not the government, G.E. did that.

So a huge source of strength for our company in that regard.

G.E. raised equity and put

We became very conservative at that period of

time.

40.

cash.

sheet.

we have 2-1/2 times coverage on the CP program.

expensive, but it is very safe, from that standpoint.

We took our commercial paper down.

Today in the mid-

It's less than 10 percent of our stack.

We raised

Today we have over $60 billion in cash on the balance
We have $52 billion in backup bank lines.

So today
It's

So when we saw what was coming--and of course the

company itself, the stock took a beating during this period

of time, although it's coming back nicely now; but we

adopted, we thought, the right strategy with our investors

to make the company very safe, and we have.

COMMISSIONER BORN:

So part of it was a different

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business model than the investment banks.

terms of both the kind of assets you had, the fact that you

were lending to hold and not to sell; your ability to call

on your parent and its rating for equity suffusions, or

other kinds of support.

For example, in

I wanted to ask you about the thrift and the kind

of supervision that is being given by the Office of Thrift

Supervision, which I understand became G.E.'s consolidated

supervisor under the requirements, so that you would meet

the requirements of the EU which requires that in order to

do business in the EU any financial institution has to have

a consolidated supervision in its home country, or become

subject to EU regulation.

WITNESS NEAL:

Um-hmm.

COMMISSIONER BORN:

Does the Office of Thrift

Supervision

requirements on G.E. as a whole, the entire holding company?

Or is it just imposing those on the thrift?

between?

impose capital requirements, and liquidity

Or something in

Some of the affiliated companies and not others?
WITNESS NEAL:

To answer your question, the

Office of Thrift Supervision, you're very accurate in terms

of how--we had them as a result of the thrift, and then the

FSA gave them equivalency and they became our consolidated--

our regulator at that time.

They live with us.

They are in the building.

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They have offices.

at risk.

out.

regularly.

in that regard.

They talk to us on a regular basis.

So we are regulated.

CHAIRMAN ANGELIDES:

COMMISSIONER BORN:

CHAIRMAN ANGELIDES:

COMMISSIONER BORN:

WITNESS NEAL:

COMMISSIONER BORN:

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Maybe two minutes?
Sure.

Absolutely.

So they regulate all of G.E.

Um-hmm.
But do they go up to the

parent, G.E., or not?

Would you like additional

Capital?

So they regulate all--

time?

Not the same as a bank

holding company, but we are regulated by the OTS.
COMMISSIONER BORN:

I meet with them

My CFO meets with them sometimes twice quarterly

They do look

And from a G.E. Capital perspective, they report

6
7

They do look at capital.

WITNESS NEAL:

They do, but most of their focus

is on the-COMMISSIONER BORN:

Financial operations, which

are clearly in G.E. Capital.
WITNESS NEAL:

But you should also know,

Commissioner, that we are regulated all over the world.

are regulated--we own banks.

country we're in.

We're regulated in every

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I read sometimes that we're not regulated.

are.

the Banque de France.

The first person I see when I travel to Japan is the Bank

Governor in Japan, because we're a large Japanese company,

as well.

was the only avenue available to us when that happened, and

they are with us, and they do regulate us.

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10

We feel regulated in that regard.

We're regulated by

We're regulated in Central Europe.

But we do have the OTS.

COMMISSIONER BORN:
stationed at G.E. Capital?

And quite frankly that

How many people do they have

How many examiners?

WITNESS NEAL:

Eight to ten.

COMMISSIONER BORN:

Before this program, the

Consolidated Supervisory Entity Program of OTS was adopted

for you, did you have any regulation other than direct

regulation of the thrift affiliate?

WITNESS NEAL:

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19

We had that, and we had the Bank

of New York.
COMMISSIONER BORN:
Bank of New York you mean?

WITNESS NEAL:

COMMISSIONER BORN:

You had the Federal Reserve

New York State Bank.
New York State Bank was your

banking regulator, state banking regulator?

WITNESS NEAL:

That's right.

COMMISSIONER BORN:

CHAIRMAN ANGELIDES:

Thank you.
Mr. Holtz-Eakin.

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COMMISSIONER HOLTZ-EAKIN:

Thank you,

Mr. Chairman, and thank you gentlemen for spending this time

with us.

Let me just pick up there on one last little

detail, which is sort of whether you view your supervision

by OTS in particular a stress test of the type that the Fed

would run under its Supervisory Capital Program, whether you

feel this is a comparable supervisory regime or not?

WITNESS NEAL:

We think so.

We spent a lot of

time in 2009 trying to--we stressed ourselves, and then had

an all-day investor meeting, 184 pages, on March 19th where

we took our whole business through our best--we had a lot of

help with this--the Fed stress cases.

with us.

The OTS is involved

We think that we have stressed the business, and

the business has been stressed with the help of the OTS in a

way that is comparable.

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19

COMMISSIONER HOLTZ-EAKIN:

So you actually used

the Fed's stress--

WITNESS NEAL:

As best we could.

We got a lot of

advice on--obviously we weren't one

our investors were asking for that so we did.

lot as we tried to make G.E. Capital one of the more

transparent companies out there.

for us, largely.

of the 19 banks, but
It helped a

And I think that worked

And, frankly, we have performed below

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2

base case since that time, and the business is better.
COMMISSIONER HOLTZ-EAKIN:

Can I ask you one more

question about just sort of the business model, which is:

Do you have loans into commercial real estate, residential

real estate?

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7
8
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WITNESS NEAL:

We do.

We have--we have both

commercial and residential.
COMMISSIONER HOLTZ-EAKIN:

Residential real

estate mortgages?
WITNESS NEAL:

Yes.

We owned a company.

bought it in 2004, a company called WMC, which was in the

residential--it was in Burbank, California.

We were in the business for about three years.

very comfortable with it, and in about 2006 became

uncomfortable with the business model and exited the

business in early 2007.

estate in other parts of the world.

We bought it.
We never got

But we do have residential real

We have a pretty good mortgage company in the UK.

We have a large residential mortgage company in France.

we also have a residential mortgage company in Australia.

Our banks that we--not in this country.

COMMISSIONER HOLTZ-EAKIN:

WITNESS NEAL:

And

But you own abroad.

--own abroad, Bank of Budapest in

Hungry, Czech Agribanca in the Czech Republic, they all have

mortgages as part of their normal product suite.

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COMMISSIONER HOLTZ-EAKIN:

So has your mortgage

losses looked like the industry as a whole, like the great

losses in the U.S.?

else?

Or have you done better than everyone

WITNESS NEAL:

We have done pretty well around

the world.

The UK business was loss-making last year, but

not big, and turning the corner.

right, $40 million roughly profit in the first quarter.

The French platform is largely prime and has

performed well.

distribute.

have--

It was a forty, is that

The UK business is not originate to

It's originate for our own balance sheet, so we

COMMISSIONER HOLTZ-EAKIN:

to distribute entities?

originate to hold for balance sheet?

WITNESS NEAL:

Do you have originate

I thought you were exclusively

In terms of the mortgage business,

I would say for the most part.

originate to distribute in the Australian platform, but

we're winding that down.

There is probably some

Honestly, we are less interested in mortgages

globally and are not trying to grow those businesses at this

point.

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COMMISSIONER HOLTZ-EAKIN:

How about commercial

real estate?
WITNESS NEAL:

Commercial real estate we have--

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we're a large commercial real estate player.

about 28 countries around the world.

billion book of commercial real estate.

We operate in

We have about an $80

Of that book, about 60 percent of it is a debt

book.

And about 40 percent of it--these are rough numbers--

is an equity book.

holding.

And again, originated for our own

COMMISSIONER HOLTZ-EAKIN:

performing, that book in particular?

WITNESS NEAL:

And how is that book

It's been hard.

The values of

commercial real estate--and I would say that was maybe one

of our misses, that the book is too big, particularly the

owned book.

When we used to think about a cycle in real

estate, we would think of it being down 20, 25 percent.

These assets in many cases have fallen 40, in that regard,

and as a result of that we've had to put a lot of reserves

into that business.

The business was quite profitable back in 2007,

and last year, I don't know the exact number, but over a

billion dollars in losses in that regard, much of it

accounting in terms of reserves, but we are a large player

around the world.

COMMISSIONER HOLTZ-EAKIN:

Thank you.

I wanted to pick up just a couple of details on

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some of the other business models here.

of the asset-backed commercial paper, you said.

give up some yield in the process?

touched that?

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6

WITNESS McCULLEY:

Right.

You don't hold any
Don't you

You said you never

And in fact that was a

conscious decision that we made on behalf of our clients.

COMMISSIONER HOLTZ-EAKIN:

How do you hold onto

your clients if you're giving up yield?

WITNESS McCULLEY:

Our investment portfolios away

from our money market products have cushions of cash, but

the value added in the overall portfolio tends to come from

other holdings in the portfolio besides cash, and in

investing the cash buffers in the portfolios, you give up

historically some incremental yield, a handful of basis

points, to being in conventional commercial paper versus

asset commercial paper.

that that was the prudent thing to do for our clients, to

give up that handful of basis points, because we could not

get comfortable looking through the balance sheet of the

conduits and get comfortable with the assets they were

holding.

And we made the judgment as a firm

So it was a conscious decision to give up a few

basis points in the interest of preservation of capital for

our clients.

COMMISSIONER HOLTZ-EAKIN:

Thank you.

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Mr. Meier, you said that you invest in commercial

banks, regulated banks.

investment banks?

4
5

WITNESS MEIER:

Do you have any exposure to

We have exposure to what were

investment banks back in the day.

I guess if you consider--

6
7

COMMISSIONER HOLTZ-EAKIN:

WITNESS MEIER:

Not any more, yes.

--Goldman Sachs banks, but, yes,

we do.

COMMISSIONER HOLTZ-EAKIN:

So one of the things

I'm curious about is I think it's true that both of you were

involved in repo agreements with Bear Stearns, is that

correct?

WITNESS MEIER:

COMMISSIONER HOLTZ-EAKIN:

WITNESS McCULLEY:

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18

Yes.
Mr. McCulley?

Historically, yes, we were

involved in repo.
COMMISSIONER HOLTZ-EAKIN:

So when you looked at

the collateral--and I gather you would have used only their

Treasuries and agency securities?

WITNESS McCULLEY:

COMMISSIONER HOLTZ-EAKIN:

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Right, and bilateral.
And bilateral repo.

What collateral would you use?
WITNESS MEIER:

It was dominated by traditional

collateral, Treasuries, bills, bonds, notes, agency

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1

debentures, and agency NBS.

alternative collateral.

3
4
5

But we did have some

We also settled 100 percent of those transactions
on a tri-party basis.
COMMISSIONER HOLTZ-EAKIN:

Okay.

So what I'm

interested in is, as we move to the Fall of 2007 and start

to move toward March of 2008, obviously the crucial period,

how were you evaluating the collateral?

We heard testimony yesterday that in repo you

evaluated it on the basis of the counterparty, not the

collateral; and that Bear's problem was as a counterparty.

I was curious how you, first Mr. McCulley, viewed

what you were holding from Bear, and whether you were

evaluating the collateral, which you looked through and

understand; or whether you were looking at Bear itself?

WITNESS McCULLEY:

I think you do both.

First,

you want to know that you are adequately over-collateralized

so that you're really lending against the collateral with

the haircut.

But also you look to the counterparty.

Because

if the counterparty fails to deliver on the repo, you by law

have the collateral.

amount of money that you lent, and you can go sell the

collateral outside of the bankruptcy process.

of the legal structure for repo.

The collateral is greater than the

That's part

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But actually, that is not something that you

normally want to do.

the collateral, but that quite frankly is a very serious

headache.

with counterparties where you think there is a significant

possibility that you may actually be forced to liquidate the

collateral in order to be made whole.

at both.

You secure yourself, and you can sell

And so therefore you would prefer not to deal

COMMISSIONER HOLTZ-EAKIN:

WITNESS MEIER:

So you actually look

Mr. Meier?

I would agree with Mr. McCulley.

We certainly look at both.

are a first line of defense, and we don't want to go through

that uncomfortable process of having to liquidate

collateral, irrespective of whether it's over-collateralized

or not.

I would say the counterparties

It is something that creates concern among our

investors.

considerable.

terms of Bear Stearns as a counterparty, we would opt not to

roll transactions with them, even though it's traditional

collateral that typically benefit from a flight to quality,

and it was over-collateralized.

The headline risk associated with that would be
So again, when there was a deterioration in

COMMISSIONER HOLTZ-EAKIN:

I want to ask a

further question about both the collateral and the

counterparty, which is:

We have heard conflicting reports

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on Bear Stearns's problems.

they were always solvent, and that they were in the end

victims of a run founded on rumors that were not true.

we have had other officials, notably former Secretary

Paulson, say that they were insolvent.

Their officials told us that

So in your evaluation of them as a counterparty,

what did you see when you get to March of 2008?

McCulley?

WITNESS McCULLEY:

Mr.

For a levered financial

institution, if the marketplace comes to the conclusion,

rightly or wrongly--

12
13
14
15

And

COMMISSIONER HOLTZ-EAKIN:
the marketplace conclusion.

I'm not interested in

I want--

WITNESS McCULLEY:

--that they're insolvent, then

they are insolvent.

COMMISSIONER HOLTZ-EAKIN:

WITNESS McCULLEY:

So your conclusion?

If Bear was liquidated, it

would have been insolvent.

going concern, and it was only a going concern because it

was merged into JPMorgan.

the game in financial services.

22
23

It was solvent only if it was a

That's the essence of the name of

If you have to prove your solvency, then in fact
you're not solvent.

COMMISSIONER HOLTZ-EAKIN:

WITNESS MEIER:

Mr. Meier?

I would suggest when we looked at

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Bear Stearns, our analysis was as follows:

think that the senior management from Bear Stearns have a

much better determination of whether they were solvent or

not.

First of all, I

From our perspective, though, their problems

really began in the early part of 2007.

They had well

documented, well covered in the financial press, problems

with some of their hedge funds.

concentrated business model.

They had a very

And they were a significant

participant in the mortgage market, in the subprime mortgage

market, and private label securitization as well.

They had a significant fixed-income business, not

much diversification beyond that.

focus had really been in the U.S., so they didn't really

have global diversification.

Their assets and their

They were a leveraged entity, and we knew what

our behavior was; that over the course of time, other

investors would start to certainly roll down their exposure

to Bear Stearns, which meant that the potential for a quick

run was significant.

They also had issues, problems with their

management team and leadership that were covered in the

markets as well, and in the press.

increasingly concerned about them as a counterparty and

ultimately reached the determination that, given the risk

So we became

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aversion, the risk appetite of our clients, it was more

prudent to simply no longer roll over purchase agreements

with Bear Stearns.

4
5
6

COMMISSIONER HOLTZ-EAKIN:
you pull back from, and when?
WITNESS McCULLEY:

Lehman?

And so who else did
Mr. McCulley?

During that period after the

Summer of 2007 when you got the run on the asset-backed

commercial paper market, we as an industry, and we as PIMCO

on behalf of our clients became ever more circumspect with

respect to counterparty exposure.

where we did have concerns we reduced exposure, yes.

COMMISSIONER HOLTZ-EAKIN:

Lehman when they went under?

WITNESS McCULLEY:

And we had concerns, and

Were you exposed to

Our clients owned Lehman

Brothers bonds in their portfolios at the time, yes.

COMMISSIONER HOLTZ-EAKIN:

WITNESS McCULLEY:

Under your advice?

We collectively made the

decision to invest in Lehman Brothers bonds, their unsecured

debentures, and in retrospect that was a decision we wish we

hadn't of made.

COMMISSIONER HOLTZ-EAKIN:

And what was different

about them versus Bear Stearns that gave you the confidence

to make those investments?

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25

WITNESS McCULLEY:

As a practical matter, they

were both operating in a similar business model.

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COMMISSIONER HOLTZ-EAKIN:

WITNESS McCULLEY:

Yep.

Bear was smaller and, as Mr.

Meier noted, had a more concentrated business in the

mortgage arena, and also was not globally diversified.

conceptually Lehman had a better business than Bear did, but

as a practical matter we found out that diversification

globally did not matter and that their concentration in

mortgage risk was very, very large.

So actually the big difference between those two

firms is that one the Federal Reserve could find sufficient

collateral in order to facilitate a loan to do the merger

with JPMorgan, and in the case of Lehman Brothers they

couldn't find sufficient collateral to lend against.

COMMISSIONER HOLTZ-EAKIN:

CHAIRMAN ANGELIDES:

COMMISSIONER HOLTZ-EAKIN:

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18
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20
21
22

Could I get--

Three minutes.
Did you expect them to

find a partner and get assistance?
WITNESS McCULLEY:

That was the general market

expectation.
COMMISSIONER HOLTZ-EAKIN:

Mr. Meier, same

question, in the interest of completeness.
WITNESS MEIER:

When I think of our exposure to

Lehman Brothers--and we did have exposure on a fully

collateralized basis for repurchase agreements with Lehman

Brothers--when we looked at them as a counterparty, it was a

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1

different analysis.

Lehman Brothers as a business had been very

focused on the short end of the curve.

recognized leader in providing services and products to the

money market area.

out to say five years.

They were a

And when I say that, it would include

They had a more diversified revenue source.

had significant growth in their equity business, for

example.

They were a global firm with growing operations

outside the States.

They

So a more diversified business model.

I think also we had a relatively high degree of

confidence in their management because they had been through

liquidity crises in the past, and that they had--they were

able to survive in difficult markets.

I would also say our analysis shifted pretty

dramatically post-Bear Stearns, and that the Bear Stearns

sale to JPMorgan was orchestrated by the Fed.

thereafter, the Fed announced the Primary Dealer Credit

Facility, which I think was a tremendous benefit to Lehman

Brothers.

at the time was that would provide them with time to

recapitalize themselves, seek other partnerships, and

potentially sell the firm.

would occur over the course of time.

COMMISSIONER HOLTZ-EAKIN:

Immediately

And our expectation at the time, our assessment

And our expectation is that

I want to go back to

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the haircuts on collateral.

agency securities in your repo with Bear?

WITNESS McCULLEY:

What haircuts did you apply to

Well convention on Treasury

and agency collateral is 102 percent.

alternative collateral, haircuts go up but we were not

engaged in repo with Bear in alternative assets.

would be conventional 102.

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9
10
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COMMISSIONER HOLTZ-EAKIN:

And then for

So it

And that didn't change

even right up to the very last transactions you did with
them?
WITNESS McCULLEY:

For Treasury and agency

collateral, and agencies were implicitly and then explicitly

backed by Uncle Sam, that was convention.

conventional haircuts if we chose to do business with them.

Because, remember, you never want--you really don't want to

get in the situation where you have to liquidate the

collateral so--

COMMISSIONER HOLTZ-EAKIN:

WITNESS McCULLEY:

COMMISSIONER HOLTZ-EAKIN:

And we applied

I understand, but--

--it's that two-pronged issue.
--you've told us that

you did great due diligence on looking at what was actually

inside things.

decided there wasn't a decent mortgage in America, and you

applied no haircuts to agency securities?

So you sent people to 20 cities.

WITNESS McCULLEY:

No, 102 percent.

You

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COMMISSIONER HOLTZ-EAKIN:

But you didn't

increase them in light of the growing evidence of bad

mortgage origination, which in the end was going to be on

the books of Fannie Mae and Freddie Mac?

WITNESS McCULLEY:

We fully expected that our

government, if push comes to shove, would wrap its arms

around Freddie and Fannie, and that's precisely what

happened.

COMMISSIONER HOLTZ-EAKIN:

CHAIRMAN ANGELIDES:

Thank you.

Just one little follow-up

from me before I go to you, Senator, because, before I

forget it, which is, I think it was you, Mr. Meier, and

maybe you, Mr. McCulley, or maybe both of you cited media

reports.

When the folks from Bear were here yesterday they

cited the extent to which rumors helped drive the liquidity

squeeze.

staff, folks indicated that sometimes folks in your position

may just decide not to have an institution as a counterparty

to avoid the heartburn of explaining to clients why you have

that institution that has negative media around it as a

counterparty.

I believe in the course of interviews with our

To what extent--I assume you do more thorough due

diligence than picking up the newspaper, but to what extent

does it factor in?

Just stories that may or may not have

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full veracity?

WITNESS MEIER:

If I can address that,

Mr. Chairman, of course we don't make credit decisions based

on what's covered in the popular press.

own head work around our counterparties and the issuers with

whom we buy paper from, but it is a source of information

out there and it does affect perception in the marketplace,

and it does, candidly, expose certain investment vehicles to

headline risk and flight risk.

CHAIRMAN ANGELIDES:

We do all of our

I think what I'm really

asking, sometimes you just decide in the range of vehicles

available to you, you know, why screw around with this one

and have to explain it to your clients when there's other

good choices.

Reasonable?

WITNESS McCULLEY:

Rational?

Or no?

Prudent risk management means

that you're on top of all of your counterparty relationships

all the time.

shoe leather work.

deteriorating, then logically you should pare your

exposures, ask for additional collateral, et cetera.

you also do read the newspapers, because in highly levered

financial institutions sometimes perception can become

reality.

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25

And that means doing your head work and your
And if you see that your counterparty is

In fact, that's what a run is about.

But

So you do

have to be attuned to the perception of the market while

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you're also focused like a laser beam in your own credit

work.

CHAIRMAN ANGELIDES:

All right.

COMMISSIONER GRAHAM:

Senator Graham?

Thank you, Mr. Chairman,

and thanks to each of the gentlemen for their very

insightful testimony.

Our Commission was established to answer the

question what went wrong, what was the cause of the financial

crisis we're in.

Do you consider that the segment of the

financial industry that you occupy was responsible for any of

the crisis that we are now living through?

WITNESS McCULLEY:

The underlying culprit in the

crisis you have to trace back to the systemic degradation of

underwriting standards in mortgages.

COMMISSIONER GRAHAM:

WITNESS McCULLEY:

That is where the--

In residential mortgages?

Residential, and also on the

commercial side, but in an immediate sense the residential

came first.

today, there are a number of vectors you have to look at

from the standpoint of the crime, but systemic degradation

of underwriting standards for mortgages is where the smoking

gun is.

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24
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So as Secretary Geithner was discussing earlier

COMMISSIONER GRAHAM:

And you don't have any of

those bullets in your pocket?
WITNESS McCULLEY:

I didn't underwrite any loans

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where the borrower didn't put any money down, and didn't

have to show his W-2, and didn't have to pay the full

interest rate.

business.

We're not in the mortgage underwriting

WITNESS NEAL:

Senator, I would just add, I don't

know if the so-called shadow banking system versus the

banking system was the major--I think what happened is we

had for awhile more liquidity in the marketplace than

anything I've ever seen.

And that created a lot--you know, it was pretty

remarkable.

you go back to 2007, as crazy as it seems now, that that

liquidity was going to be here for awhile.

were talking about it, new forms of capital from around the

world, China, India, sovereign wealth.

was a general view, and it was wrong, that the world was

going to be very liquid for at least awhile.

And also, Senator, there was a general view, if

The consultants

And so I think there

So I think that's a piece of it.

I think that

allowed people to maybe get over-levered in some of these

spaces.

have the potential for volatile assets, you are on very thin

ice in that regard.

And, you know, if you have high leverage and you

I would agree with Paul that, you know, this

originate-to-sell changed things.

It happened in leveraged loans.

It's not just mortgages.
It happened in other

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markets.

operates.

But I think that it changes the way the business

If you are putting an asset, whether it's a

mortgage or an LBO, if you're originating that to have it on

your balance sheet for the term, then you will look at it

for the term.

with the consequences of that decision.

8
9

You have to live with it.

You have to live

If you're originating that transaction only to
put it into a security and sell it, particularly if you're

not going to stay in the security, it becomes a fee-based

business.

because you get paid monthly based on what you sell.

goes out, you take what they call in the industry a skim--

another bad word I think--but that's how it works.

It's really just how much can I originate,
It

And I think a lot of the underwriting problems

really happened from the standpoint that this underwrite-to-

distribute model became very large.

And I think that

created--so you have high leverage.

You have high

liquidity.

The liquidity didn't last.
You have the issue I think where people were a

little bit lulled to sleep just from the standpoint that

they thought it was--you know, when you see 2 percent cap

rates, things are expensive.

be that way for 10 years, you know, maybe not so expensive.

But if you think it's going to

So I think that's why people maybe didn't make

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some of the bold actions that they might have made

otherwise.

a lot--but the underwriting standards of some firms, some

institutions, depending on what they were doing, wasn't that

good.

And then I think the underwriting--and it varied

That's how you get into these no-doc--I mean,

why--Senator, if you owned your own bank, you wouldn't let

anybody bring in a transaction to you where you don't know

if they have a job or not, or there's no documents.

You

just wouldn't do it.

But maybe if you think you're just going to sell

it and take a fee, and then people sort of say, well,

there's so much liquidity, asset values will continue to

rise so it really doesn't matter.

wrong, you're very wrong on this.

16
17
18

And of course when you're

So I think--I mean, that's how I would think
about it.
COMMISSIONER GRAHAM:

Any other comments on the

possible contributions of this aspect of the industry

towards the crisis?

WITNESS MEIER:

Well, Senator, if I can address

that, please.

hindsight, things are a lot clearer than they were back in

say 2006 and 2007.

I would suggest, with the benefit of

Clearly there was an excessive amount of leverage

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and too much liquidity in the marketplace.

McCulley and Mr. Neal are correct in that there was a

thinking on the part of some market participants, the

philosophy of originate-to-securitize and get the risks off

your book.

I think Mr.

There also was just a significant flow of asset-

backed securitizations coming down the pike, and I think

many investors didn't do their homework.

their analysis.

They didn't do

And I think that's where they got into

trouble.

In terms of, you know--

COMMISSIONER GRAHAM:

Excuse me.

Is that

because, was there a lower level of due diligence during

this period than had been the norm let's say over the

preceding 5 or 10 years?

WITNESS MEIER:

Senator, I really can't say

whether there was or there wasn't.

perspective that we never let down our guard in terms of the

due diligence and the analysis we did.

I know from our

We had concerns about the subprime mortgage

market, the Alt-A market for the same reasons as have been

articulated here through other committee discussions.

You know, we saw a decline in average FICO

scores, the average credit quality of the borrowers, higher

loan-to-value ratios.

We saw all sorts of unusual mortgages

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1

coming down the pike such as IOs, and Option Arms.

We saw concentrations of paper being distributed

or sold into the marketplace in real estate markets that had

significant appreciation.

COMMISSIONER GRAHAM:

Yesterday we had people

with very impressive resumes who said that they could not

see this storm coming over the horizon.

half-dozen data points that you were monitoring which caused

you to see something was coming over the horizon.

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11

You just listed a

What is that caused you to be as sensitive to
what was happening when other people were not?

WITNESS MEIER:

That's a great question, Senator.

I think it had probably more to do with the types of assets

we manage.

The fact that we manage most of the assets in our cash

business to a book value construct.

margin of error.

The risk tolerance of our underlying clients.

So there's a very small

So for us it came down to the question of

suitability, and exposing our clients into assets that could

potentially have a lot of either ratings volatility, spread

volatility, and price volatility which just seemed

inappropriate and unsuitable.

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24
25

COMMISSIONER GRAHAM:

Well, in fact I have no

time-CHAIRMAN ANGELIDES:

Would you like some,

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Senator?

COMMISSIONER GRAHAM:

CHAIRMAN ANGELIDES:

COMMISSIONER GRAHAM:

Two minutes?
You can have two minutes.
From the conversation that

I had before this session started, I gathered that some of

the reasons that people are here in the audience is because

of what's happening a few hundred yards away from here in

the Senate.

[Cell phone rings.]

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11

COMMISSIONER GRAHAM:

Excuse me, let me turn this

off.

How would your industry be affected by the

financial reform legislation that's currently being

considered?

WITNESS McCULLEY:

Well we're actually in

different industries.

The bookends of the table are in the

same industry, and in the middle is in a different industry.

COMMISSIONER GRAHAM:

WITNESS McCULLEY:

I used--

But for all of us at the

table--and I'm hesitant to speak for all of us; people will

speak for themselves--I think we all have a interest in a

financial system that has built in safeguards against a

repeat of what happened during the crisis.

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25

I think we all--not just as members of the
financial services arena, but as citizens--have a tremendous

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1

interest in Washington putting in the appropriate regulatory

structures--and that includes such things as capital

requirements, resolution authority, lots of things that go

under that mosaic--but I think that we as an industry

benefit if our industry is properly regulated and policed.

So I think we will end up, I trust we end up in a

better place for the financial services industry because I

want, and my firm wants, and our clients want us to be

participating in a sound industry that doesn't have fringe

elements that are disrupting the normal functioning of the

market, or tainting the integrity of the market.

WITNESS NEAL:

Senator, I would say, first of all

I would say that we applaud what you are doing here and the

good work that you are doing, because we think this work

needs to be done.

From my perspective, the whole idea of regulatory

reform is much needed.

regulation to me makes sense.

company.

doesn't threaten the system I think makes a lot of sense.

I think the concept of systemic
It makes sense to our

The ability to resolve companies in a way that

We think the idea of having more and better

capital inside of financial institutions will make them

safer, will make the industry safer.

liquidity at hand to deal with unforeseen issues that might

come up from time to time we think makes a lot of sense.

Having enough

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Having cash to really give you the extended time

you need as you may need to make choices about reducing a

balance sheet, or generating cash in some other way I think

makes sense.

The whole idea I think of match-funding your

assets and liabilities, something some people do, some

people don't, you know, borrowing short, lend long works

until it doesn't.

funding, matching that from a duration standpoint, makes a

10
11

But I think the idea of having match-

lot of sense.
To me the whole idea of having different types of

underwriting, the idea that you have underwriting--I would

tell you that I think many people that underwrite to hold on

their own balance sheet have done better in this process

than the securities have done where that didn't happen.

So the idea that this work that you're doing ends

up in a different way of thinking about this from a

regulatory standpoint, from a resolution standpoint, I think

we think it's a good thing.

WITNESS MEIER:

CHAIRMAN ANGELIDES:

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23

I would add to that-Go ahead and just answer,

one minute to answer, and then we'll move on.
WITNESS MEIER:

Sure.

I would concur with

everything that's been said.

I would also add to that, I

think it's certainly in the best interests of the American

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1

people--and Secretary Geithner referred to this earlier as a

100-year storm; we want to make sure this isn't an every 10-

year storm.

So I do think that regulatory reform will be

important in terms of protecting the American people, our

interests and our position in the world.

COMMISSIONER GRAHAM:

CHAIRMAN ANGELIDES:

Mr. Wallison?

Thank you.
Thank you.

COMMISSIONER WALLISON:

Thank you, Mr. Chairman.

Let me start with you, Mr. McCulley.

You said

that we should have a regulatory system in which

systemically important firms are regulated.

was sort of the point you were making at the outset.

I'm wondering how we can tell whether a firm is systemically

important.

systemically important?

I think that
And

How would you tell whether a firm is

WITNESS McCULLEY:

There's not a precise--

COMMISSIONER WALLISON:

WITNESS McCULLEY:

COMMISSIONER WALLISON:

I know.

--definition.
I'm not asking for a

definition.

I'd like to just know how you, if you were say

the chairman of the Federal Reserve and had an opportunity

to say which firms you are going to regulate, which may come

out of the current regulatory bill that's before Congress,

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how would you decide whether to regulate a firm as

systemically important?

WITNESS McCULLEY:

I think this question has been

grappled with repeatedly.

tests involved 19 firms, so obviously those 19 were deemed

systemically important.

legislative process now is to deem anybody who has greater

than $50 billion worth of footings to be systemically

important.

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11

You think in terms of the stress

And in one of the proposals in the

So it's not an easy thing to do.
thing to do.

CHAIRMAN ANGELIDES:

WITNESS McCULLEY:

sorry.

Did you say "footings"?
Size of balance sheet, I'm

I'm using jargon.

CHAIRMAN ANGELIDES:

WITNESS McCULLEY:

CHAIRMAN ANGELIDES:

It’s an important

Thank you.
Um-I've heard more complex

jargon.

(Laughter.)

WITNESS McCULLEY:

The important thing is that

you have a resolution mechanism for these institutions so as

that if they fail they can fail in a orderly fashion.

That's more important than defining whether it's 46 or 73

firms.

orderly funeral for them if they die, as opposed to a

debacle like we had post-Lehman.

Whatever you define it is that you can have a

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COMMISSIONER WALLISON:

Okay.

Now you said that

PIMCO is not a member of the shadow banking system.

you think it's not?

4
5

WITNESS McCULLEY:

Why do

PIMCO is an investment

manager.

COMMISSIONER WALLISON:

funds.

banking system.

hedge fund?

Yes, and so are hedge

Hedge funds are thought to be members of the shadow

So in what way is PIMCO different from a

WITNESS McCULLEY:

PIMCO does not manage money

for PIMCO.

clients--it's a small portion of our business--run levered

mandates.

they explicitly in their investment management contract

request that we lever their portfolio.

PIMCO manages money for clients.

Some of our

When they hire us to be the investment manager,

So some of our clients would be--could be

characterized as shadow banks, because they're levered

without access to a lender of last resort.

as the investment manager is not a shadow bank.

But PIMCO itself

COMMISSIONER WALLISON:

simply a fund manager, is it not?

managing their own money, but they are making investments

with their own money.

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25

WITNESS McCULLEY:
deemed a shadow bank.

But a hedge fund is
I mean, yes, they're

The hedge fund itself could be

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COMMISSIONER WALLISON:

WITNESS McCULLEY:

That's right.

The manager of the hedge fund-

COMMISSIONER WALLISON:

WITNESS McCULLEY:

COMMISSIONER WALLISON:

WITNESS McCULLEY:

--is not.

--is not.
Right.

Now frequently it's the case

with hedge funds that the manager is investing his own

money--

COMMISSIONER WALLISON:

WITNESS McCULLEY:

--whereas, we are a third-

party manager.

COMMISSIONER WALLISON:

you are investing, is that right?

15
16
17

Um-hmm.

WITNESS McCULLEY:

But you have a fund that

I'm not sure I'm following the

question.
COMMISSIONER WALLISON:

When your customers give

you money to invest for them, do they not give you the

opportunity to take this money, put it into an account of

some kind, and manage it for them?

WITNESS McCULLEY:

Yes, they do.

And some of

those clients indeed want that account to be managed on a

levered basis.

characteristics of a shadow bank; that's correct.

So that account would have the

COMMISSIONER WALLISON:

Now you said before--I'm

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obviously going to run out of time with all the things I'd

like to ask about--but you said before that financing

sources like Bear would be better off if they were

implicitly backed by the government.

to give them access for example to, not a financing source

but a financing user like Bear, would that be helpful in

making sure that we didn't have the kind of crisis that we

had before?

use of financing sources be regulated or have access to the

Would that be helpful,

Would you suggest that anyone that is making

Discount Window, the Fed's Discount Window?

WITNESS McCULLEY:

Unambiguously, if you are

going to have access to the Fed's Discount Window, you

should be regulated.

COMMISSIONER WALLISON:

WITNESS McCULLEY:

Yes.

It is simply not tenable for

the Fed to be lending to someone that they have no

regulatory control on.

seems to me.

That's a self-evident truth, it

After the merger of Bear into JPMorgan, the

Federal Reserve created the Primary Dealer Credit Facility,

which they did under Section 13.3 of the Federal Reserve

Act, opening effectively the Discount Window to the primary

dealers.

24
25

That was not an easy decision for the Federal
Reserve to make.

Because essentially they opened a facility

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1

to lend to people they weren't regulating.

that's an appropriate approach.

access to the Federal Reserve's balance sheet, then it seems

to me it's axiomatic that you should be regulated.

So I don't think

If you're going to have

And that was an emergency thing, and actually

they had to evoke 13.3 to do it.

Again, going forward, the

key issue it seems to me is we need to have a mechanism so

as that a systemically important institution can fail in a

orderly fashion.

Orderly bankruptcies should not be the

tender for a large fire.

However, if they're disorderly,

they become the tender for a fire that almost engulfed our

financial system and gave us a nasty recession.

So I put the most emphasis on orderly unwinding.

COMMISSIONER WALLISON:

And what is the

difference between a disorderly and an orderly unwinding, in

your view?

WITNESS McCULLEY:

Actually I think Secretary

Geithner did a excellent job of articulating that this

afternoon.

a house can burn down but doesn't in the process burn down

the neighborhood.

A orderly unwinding, to use his analogy, is when

COMMISSIONER WALLISON:

But that means, does it

not, that creditors of that institution, or I don't know how

we analogize it to a house, but the creditors of that

institution are paid off?

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WITNESS McCULLEY:

CHAIRMAN ANGELIDES:

3
4
5

That's correct.
Would you like additional,

what, two minutes?
COMMISSIONER WALLISON:

WITNESS McCULLEY:

COMMISSIONER WALLISON:

Just to get this

question in.

Yes.

That's correct.
Creditors would have to

be paid off?
WITNESS McCULLEY:

No, no.

An orderly resolution

could involve, and should involve haircuts for creditors.

And in fact one proposal that's being discussed for an

orderly resolution is actually another section of the

Bankruptcy Code specifically so as that you can have an

orderly resolution, in which case unsecured creditors simply

take a haircut and take the loss, as opposed to unsecured

creditors in a bailout getting par on the dollar and the

taxpayer being on the hook.

I don't want that to happen.

COMMISSIONER WALLISON:

I don't think anyone

wants it to happen.

But the thing I'm trying to get at is,

if you tell creditors that they are going to take a loss,

say we decide that they're going to take a 20 percent loss,

wouldn't that signal to other creditors in the market that

they have to run from whatever their investments are because

they are not going to be paid out fully?

definition of a disorderly workout, or bailout, or whatever

Isn't that the

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you want to call it?

WITNESS McCULLEY:

Commissioner, we're talking

about changing the regime so as that you know ahead of time

that you're not going to be bailed out; that if the

institution gets into trouble, it will go into an orderly

unwinding process and you will lose money.

the regime which allows you to return to market discipline.

8
9

So it's changing

If I know as an investor that I'm not going to be
bailed out and that I am going to take a haircut in the

event that the financial institution goes under, then I will

either charge a higher interest rate or not lend to them at

all.

13
14

So returning market discipline to the system is a
key part of regulatory reform.

15
16

COMMISSIONER WALLISON:

Why wouldn't bankruptcy

do the same thing?

WITNESS McCULLEY:

In fact I'm suggesting that it

would.

Bankruptcy Code to make a special case so as that you have

an orderly unwinding.

But you would need to have a new section of the

Remember, Lehman Brothers went through bankruptcy

and that was disorderly.

So therefore if you want to go the

Bankruptcy Code, you would need legislation that created a

separate section for systemically important financial

institutions.

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COMMISSIONER WALLISON:
Thanks very much.

3
4
5

I've run out of time.

CHAIRMAN ANGELIDES:

All right.

Mr. Georgiou, go

ahead.
COMMISSIONER GEORGIOU:

Mr. Neal and Mr. Barber,

I wondered if you could tell me, you've shrunk the size of

your borrowings, and I take it comparably your assets,

considerably over the last two years.

whether you did it to de-lever your borrowings, or because

Was that--can you say

the demand for your services and your loans were, your

financings, were less?

I mean, which?

WITNESS NEAL:

complicated, the answer.

two thousand--we go through a strategic plan just like all

of G.E. does each year, and we went through a fairly

rigorous capital allocation approach in terms of, you know,

what businesses were strategic, what product lines, what

geographies, what areas had we performed well over time, and

really what was the best part of the company.

each year, because even in the year where we may be growing

we still have businesses that we want to grow faster,

businesses that we might want to exit.

It's a great question, and it's
We actually started back in early

We do that

I would say, as we rolled into this very

difficult environment in 2009 and part of 2008, a number of

things happened.

One is, we accelerated that plan in order

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1

to generate cash, or have the balance sheet be stronger.

I would say, secondly, because of the recession--

a big piece of what we do is finance capital equipment--

there was less being sold.

on our new volumes, even in businesses that we find highly

attractive from that perspective.

So that put some pressure just

But the view is, our view is, my view is, from a

G.E. Capital perspective, we were probably a little too big

from just a good portfolio management inside of a company

like G.E.

now and the end of 2012 by about 25 percent.

COMMISSIONER GEORGIOU:

So we're reducing the size of the company between

From your height?

from your current--

WITNESS NEAL:

From the height, in terms of our

size.

about $440 billion by the end of 2012, largely exiting

businesses not in the U.S., but in other parts of the world.

We'll have the business down to a balance sheet of

COMMISSIONER GEORGIOU:

But of that, you finance,

what was it, 20 percent through commercial paper?

right, or no?

WITNESS NEAL:

Is that

Well today the debt stack in the

company, we have about--and Mark may correct me here--but we

have about $500 billion of total debt.

of that is long-term debt.

COMMISSIONER GEORGIOU:

About $350 billion

Right.

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WITNESS NEAL:

Less than fifty, about forty-six I

think today is commercial paper, of different tenors.

not all short.

It's

Then we have about $100 billion of other types of

financing.

banks--

We do have deposits both in this country in the

COMMISSIONER GEORGIOU:

I understand, yes.

So I

guess, Mr. Barber, when you said you shrunk the commercial

paper by half, that's really--that wasn't,

wasn't going down by half?

means of funding?

your business

It was just that particular

Is that correct?

WITNESS BARBER:

Yes, sir.

COMMISSIONER GEORGIOU:

WITNESS BARBER:

Okay.

There's a shift that would have

occurred in our funding mix, and Mike is absolutely right

about his numbers and how the debt stack shapes up right

now.

increased cash portfolio that we have.

commercial paper that we are rationing and turning over in

the market.

other forms of funding, whether it's long-term debt, or

deposits that we take around the world, and so forth.

So there's less reliance on commercial paper, an
So there's less

That's balanced out by increases in some of our

COMMISSIONER GEORGIOU:

Mr. McCulley, I guess I understand you don't like

tri-party repo?

Is that right?

Thanks.

You prefer bi-party?

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2

WITNESS McCULLEY:

Historically that is correct,

that we have not been comfortable with the tri-party.

COMMISSIONER GEORGIOU:

WITNESS McCULLEY:

And why is that?

Because there was not full

transparency to us on the marking of collateral in the

tri-party system.

instruments in it.

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9

And the tri-party system has lower quality

The tri-party system is being seriously evaluated
and strengthened in efforts led by the New York Fed, and it

is quite possible that going forward we may be involved in

the tri-party repo arrangements because we think the

architecture is going to be made much more robust.

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14

But historically we did not think the
architecture was sufficiently robust.

COMMISSIONER GEORGIOU:

So you only engaged in

transactions where you actually knew exactly what the

collateral was and you were dealing with the party that held

it?

WITNESS McCULLEY:

Yes.

We were engaged in

bilateral, where actually the counterparty to repo actually

wired the collateral to the custodian bank of our client.

It would not be held by a third-party bank.

COMMISSIONER GEORGIOU:

Right.

And I take it,

Mr. Meier, you did engage more in tri-party repo?

right?

Is that

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WITNESS MEIER:

Yes, Commissioner.

I would say

at our peak, with about $175 billion worth of repurchase

agreements outstanding, about 98 percent settled on a

tri-party basis.

COMMISSIONER GEORGIOU:

WITNESS MEIER:

Um-hmm.

And I would also have to say

that, you know, 50 percent of those assets and our current

assets are what would be considered traditional collateral.

So Treasuries, agency, agency mortgage-backed securities.

The tri-party settlement system is really just a

mechanism for obtaining possession and control of the

collateral.

counterparty's clearing bank for operational efficiencies.

It happens to occur at our dealer or bank

COMMISSIONER GEORGIOU:

Okay.

And, Mr. Meier, to

stick with you for just a sec, you said something to the

effect that asset prices--you discussed asset prices getting

below fundamentals.

mortgages, outside of mortgages?

Was this an asset class other than

WITNESS MEIER:

Pretty much everything,

Commissioner.

widened on everything, including say General Electric Credit

Corp paper, which we certainly had a very high degree of

confidence in them as an issuer as a counterparty.

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25

In the height of the panic, credit spreads

COMMISSIONER GEORGIOU:
contagion, in your view?

And how did that cause

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WITNESS MEIER:

Wow.

I think it added to a

downward spiral in terms of the capital commitment and the

unwillingness on the part of banks and dealers to make

markets in the secondary market.

When I think back to how this crisis really

began, it was a slow and steady deterioration in the

subprime market.

recognition, I'd say an acute recognition, that potentially

some of the asset-backed commercial paper conduits could

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11

Come August of 2007, there was a

have exposure to those areas.
As a result, investors in general--without even

looking into the underlying assets--decided I don't want to

be in any asset-backed commercial paper, I don't want to

invest in a fund that may have those positions.

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17

COMMISSIONER GEORGIOU:

Regardless of whether

they were--what the asset was backed by?
WITNESS MEIER:

That's exactly right,

Commissioner.

that informed transparency is critical.

what we owned, but they didn't actually have the information

that we had in terms of doing our due diligence in looking

at everything.

So I think the lesson I learned from that was
Our clients knew

So the problem was, when we buy asset-backed

commercial paper, we actually look through to the underlying

bank that supports that.

We only buy fully supported

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conduits, which means they have 102 percent of bank lines

behind them.

So the issue is, when investors en mass pulled

out of a $1.2 trillion market, the asset-backed commercial

paper conduit market, those liquidity providers that were

supposed to provide liquidity contingent upon an inability

to roll commercial paper realized that they may be called to

provide funding.

So they started hoarding cash.

And a lot of

those institutions were banks.

hoarding cash and derisking their portfolio, they stopped

making normal secondary markets.

And in the process of

So what started out as a liquidity crisis quickly

moved into a credit crisis, and then ultimately an economic

crisis on a global scale.

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17

COMMISSIONER GEORGIOU:

Could I have one more

minute for follow-up?

CHAIRMAN ANGELIDES:

Absolutely.

COMMISSIONER GEORGIOU:

If I understand that, you

had 102 percent fully backed with, what, lines of credit

from banking institutions?

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WITNESS MEIER:

Liquidity lines from banking

institutions.
COMMISSIONER GEORGIOU:

But of course they didn't

have the liquidity to honor those obligations, so they had

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to delever.

that.

They had to start selling their assets to do

WITNESS MEIER:

That's exactly right.

And I

should also state, Commissioner, that we didn't approve all

asset-backed commercial paper conduits for purchase in our

funds.

probably had about 25 percent of the universe of available

conduits approved, and we had relatively small positions in

them.

Again, we did a detailed credit analysis.

COMMISSIONER GEORGIOU:

Mr. McCulley, did you--

could you comment on that process of contagion?

you see the same thing going on with regard to all this

asset-backed paper?

WITNESS McCULLEY:

Yes.

I mean, did

It was very obvious in

the Summer of 2007 that a run on the asset-backed commercial

paper was underway.

some $400 billion was not rolled.

I think in the last four months of 2007

So it was very evident that the users of asset-

backed commercial paper, the buyers went on a buyer strike

and simply weren't rolling.

chain of reaction that you and Mr. Meier were detailing.

And then it kicked off a whole

COMMISSIONER GEORGIOU:

WITNESS McCULLEY:

particularly August of 2007.

And that started when?

In the Summer of 2007,

COMMISSIONER GEORGIOU:

Thank you very much.

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CHAIRMAN ANGELIDES:
BMP?

Post?

Or pre?

Can I say, post-BMP?

Pre-

Do you remember which came first?

WITNESS MEIER:

Post.

WITNESS McCULLEY:

WITNESS MEIER:

WITNESS McCULLEY:

Post, I think.

It was right afterwards.
It was in and around that

time.

asked to define what was the single day that was the Minsky

moment, it was that day, August 9th.

That would be August 9th of 2007, which is, when I'm

CHAIRMAN ANGELIDES:

I was wondering when you

were going to get that phrase in.

(Laughter.)

CHAIRMAN ANGELIDES:

COMMISSIONER HENNESSEY:

All right.

Mr. Hennessey.
Thank you, Mr. Chairman.

I am going to direct this to Mr. McCulley, but I hope the

rest of you will jump in as well.

One of my takeaways from both Secretary Paulson

and Secretary Geithner was, don't spend all your time

thinking about solvency; spend more time thinking about

liquidity and the liquidity problems that occurred.

I am going to present some somewhat jumbled

thoughts and I want to ask if you can help me sort them out.

And it's sort of a similar line to what Peter was getting

at.

First of all, I have a similar question to him,

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which is:

was having a disorderly resolution regime, and have said and

believe that we need an orderly resolution regime.

I have believed that a big part of the problem

And then someone asked me:

that?

be orderly.

What do you mean by

And I kind of wave my hands and say, well, it has to

So to the extent that any of you have seen good

explanations or good analyses--you were referring to some

that might be out there--I would love to be better educated

on smart people who have actually thought about the details

of what a new section of the Bankruptcy Code means, or what

was actually missing.

the mechanics of that well enough.

Because I don't actually understand

Okay, now on to my area of confusion.

I sort of

think of this as on the solvency side we were dealing with

it--sorry, on solvency issues we were dealing with this on

the asset side.

money in.

We used TARP to put a bunch of taxpayer

I kind of get that.
On the liquidity issues we were basically dealing

with it by guaranteeing liabilities.

So the Fed was doing

it by opening up their Discount Window to institutions

they'd never done it before.

mutual funds for awhile.

FDIC, right, increasing the limit from $100,000 to $250,000

for individuals, and then if you've got, what, a transaction

We guaranteed money market

And then made some changes in the

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account and a small business you're guaranteed for good.

I understand why those made sense during the

crisis.

I understand why I think they worked, basically, to

at least slow down the liquidity runs.

saying they're going to continue their policies at least

through the end of the year, and quite possibly longer.

The FDIC is now

And what scares me is that we are then

substituting regulatory discipline for market discipline, at

least in those areas.

And so, Mr. McCulley, coming back to

your original concept of parity between traditional

commercial banking and shadow banking, commercial banks have

deposits.

else.

The shadow banks don't.

They have something

Setting aside the supervision aspects, how do you

deal with the guarantees of liability issue?

create the parallel, or do you create the parallel to

deposit insurance?

discipline versus regulatory discipline with liquidity runs

and shadow banking?

How do you

And how do you think about market

Does my question--I think you can see the area

I'm sort of circling around.

WITNESS McCULLEY:

Yes, I do.

And I think all of

us in the industry and here in Washington are grappling with

that question.

comments.

And I come back to what I said in my opening

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The essence of banking is to create an asset for

the public, which is the liability of the bank, that is

informationally insensitive.

it, it is informationally insensitive because it has the

full faith

6
7

and credit.
And the shadow banking system actually with

commercial paper and repo became informationally sensitive.

8
9

If you have the FDIC label on

COMMISSIONER HENNESSEY:

at least before-WITNESS McCULLEY:

COMMISSIONER HENNESSEY:

WITNESS McCULLEY:
term deposits.

16
17
18

Right.
--we did guarantees, it

was only partially guaranteed.

14
15

But even in the

commercial banking world, it is partially sensitive because,

Right.

And that remains the case on

Obviously on transaction deposits--

COMMISSIONER HENNESSEY:

So it's not all or

nothing.
WITNESS McCULLEY:

It's not all or nothing.

It's

a two-tiered structure.

And the bottom line is, if you

require a nonbank intermediary to have sufficient capital,

then the theory is that the senior lenders to that

institution, including in the commercial paper market, or

more importantly in the repo market, will look at that

balance sheet and say it's a fortress balance sheet,

therefore I am comfortable being a senior lender; that the

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1

fortress balance sheet makes the senior short-dated

liability of that institution informationally insensitive.

3
4

So that is the objective through capital
requirements.

COMMISSIONER HENNESSEY:

So the functional

parallelism can be addressed on the capital side rather than

by having the government guarantee liabilities for shadow

banks?

Is that the concept?
WITNESS McCULLEY:

That is the concept, as well

as having strong liquidity buffers for shadow banks, as well

as conventional banks.

if you tell a shadow bank by regulatory powers that you

will--

So it's a belt-and-suspenders, that

COMMISSIONER HENNESSEY:

WITNESS McCULLEY:

--on liquidity--

--be robust on capital, and

you will be robust on liquidity, then you dramatically

reduce the odds of a run.

And the problem for a run is that, once one

institution is run upon, then you get effectively a

contagion effect.

COMMISSIONER HENNESSEY:

Okay.

But then your

functional parallel does not require the government to

necessarily guarantee any of the--explicitly guarantee the

liabilities of a shadow bank if they are sufficiently strong

from a regulatory standpoint on both capital and liquidity

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1

requirements?

2
3

WITNESS McCULLEY:

That is my interpretation,

yes.

COMMISSIONER HENNESSEY:

CHAIRMAN ANGELIDES:

Okay.

Mr. Hennessey, can I just

ask a quick question on your time that related to what

you're talking about?

liquidity on one side must also be combined with some

prudence on the asset side?

Should I also--the capital and

WITNESS McCULLEY:

Certainly I think part of

regulation, whether it's a conventional bank or a shadow

bank, is having guidelines on what is a permitted and not a

permitted asset.

So I said belt-and-suspenders.

a third one in this trio.

about how much capital, how much liquidity, and what type of

activities that you can engage in so as to ensure safety and

soundness.

19
20

So, yes, that.

There needs to be

CHAIRMAN ANGELIDES:

All right.

Regulation is

I apologize.

just wanted--

COMMISSIONER HENNESSEY:

Not a problem.

So, and I agree with what you were saying before

with Peter, which is obviously if your shadow bank has

access to the Discount Window, or something else, then you

have to have the strong supervision of it.

But the converse

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2

isn't necessarily the case?
What I hear you saying is, you do not have to

provide shadow banks with access to the Discount Window, or

an FDIC-like guarantee of liabilities, as long as you've

covered your belt and suspenders and buckles?

WITNESS McCULLEY:

Is that--

Yes, I think that's right.

It's important that you don't have to have mirror treatment

from the standpoint of their liabilities.

to have essentially a similar framework for capital,

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11

But you do have

liquidity, and activities.
And then I come back to something that I know is

important to you and everybody else, is that if a

systemically important institution gets into trouble, that

you can orderly unwind it so that if one house in the

neighborhood goes down, you don't have a spreading of the

fire through the entire neighborhood.

COMMISSIONER HENNESSEY:

Okay.

Good.

Now let me

take that, and let me zoom all the way out.

legislation is moving through the House and Senate, lots of

elected officials like to say how the action they're taking

is going to make sure this never happens again.

And what I always come back to is:

Because as

What do you

mean by "this"?

And what it sounds like is, in this piecing

together what I'm hearing from you, and what I've heard from

the two Secretaries, is that we are not necessarily ending

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1

up in a situation where a large financial institution won't

fail.

authority.

institutions, if all of the regulatory protections and

oversight you're talking about happen; it just won't spread

to the rest of the system if what you've designed is robust?

Is that the way to think about it?

8
9
10

Right?

They may fail.

You may have the resolution

You can still have runs on large financial

WITNESS McCULLEY:
think about it.

I think that's a good way to

We have seen a disorderly unwind of a

systemically important institution, and that was ugly.

So that we want to avoid.

And the architecture

that's evolving should include, critically, a means to avoid

that.

As Secretary Geithner was testifying, we can't

outlaw failure in our system.

you don't want to outlaw failure.

winners and losers.

have a proper funeral.

become a systemic event.

20
21

24
25

Capitalism is about

And when you lose, you go broke and
But you don't want to have that

COMMISSIONER HENNESSEY:

Let me get you--my time

is running out--30 seconds?

22
23

In fact, in a capital system

CHAIRMAN ANGELIDES:
two.

Absolutely.

You can take

We're almost to the finish line.
COMMISSIONER HENNESSEY:

On this point, I grimace

every time I hear one of these elected officials say "never

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1

again."

actual goal should be to try and change this from a 1 in 30

year occurrence, to a 1 in 100 or 200, or 300, just because

the efficiency costs of going to "never" are far too high.

Because the way I think about this is that the

Is that--I see some nodding here from Mr. Meier.

Is that a better way to--understanding that they're all

communicating for other purposes, is that a better way to

think about it?

of this happening again; we're trying to reduce it

That we're not trying to eliminate the risk

significantly without having the efficiency costs be too

high?

Mr. Neal?
WITNESS NEAL:

It seems to me, if I think about

this simply, to me the bright line is around resolution.

Can a firm be successfully resolved, or not?

firm can be successfully resolved--because I think what the

Commission should not want to do is make financial services

not a--you know, not a lubricant for the economy.

I think if a

I think you want a vibrant financial services

industry that competes in that regard.

I think if a firm,

for whatever reason, however it ultimately gets looked at,

cannot be resolved because it's too interconnected, it's too

global, it's too, something, maybe it's too damaging for its

customers, I mean I think those are all things you might

consider from that regard, then you would hold it to a

standard that wouldn't allow it to need to be resolved in

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that regard.

I think regulation of financial services to where

you don't have some of the excesses that took place maybe in

some of these exotic products, maybe in some of these

enormously high leverages that happened in some places,

makes sense for everybody.

next step, to me again it's just--I'm just telling you my

view--it really gets down to where a company, a firm can be

resolved successfully, in which case I think they ought to

But then when you get to that

be regulated, but regulated with a spirit of letting them

compete.

12
13

COMMISSIONER HENNESSEY:

Could we just here Mr.

Meier?

CHAIRMAN ANGELIDES:

WITNESS MEIER:

Yes.

Thank you.

Commissioner, I think

if we manage to a perfection standard of "never again," of

never having defaults, or the ability for even a

systemically important institution to become insolvent, I

think we've probably, to your point, reached the line of

governance efficiency.

So I do think that it should be more along the

lines of institutions can fail.

those failures?

What's the resolution of

And I think to a point made earlier, as well, in

terms of the responsibility on the asset side, I said in my

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1

oral remarks that I do think there's a recognition that

there needs to be more, I'm paraphrasing, but there needs to

be more due diligence done on the part of investors, more

risk analysis.

rating agency.

And you can't outsource that to a credit

I believe that that analysis and assessment needs

to be done in-house.

credit quality; it speaks to suitability.

Because it doesn't speak just to the

COMMISSIONER HENNESSEY:

Thanks.

I think of this

as what elements made the system so that it was not

sufficiently hardened and insufficiently robust to withstand

the shock; whereas, most of the rest of the focus has been

about how do we make sure future shocks don't occur, and

what elements caused the shocks to be damaging?

I think we need to focus on all of the above, but

a system that's robust and hardened, so that when bad things

happen because regulators are not going to be perfect in the

future either, I think is one that is more survivable,

basically.

Thanks.
CHAIRMAN ANGELIDES:

Thank you.

Ms. Murren.

And

after Ms. Murren is done, I just have one thing to add into

this little discuss, or a question.

Go ahead.

COMMISSIONER MURREN:

Along this thread, but maybe getting down to the

Thank you.

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microscopic level and adding some color to it, if you reel

back the tape to the fall of '08, from my recollection it

was probably one of the more overwhelming and potentially

frightening periods of time for corporate America.

So we have G.E., who has got a sterling

reputation for management, good quality assets, a company

that's in a diversified line of businesses.

comment on, at that particular moment in time, not with the

benefit of hindsight, were you worried about the viability

Could you

of G.E. Capital?

level about your ability to finance the company going

forward with long-term debt?

believe that the government ultimately, coming in to support

the markets, helped you as a company with a great reputation

to be able to weather this?

And were you worried at the parent company

WITNESS NEAL:

And to what extent did you

I would like to take that, if I

can.

Everybody was worried.

September with the number of failures, we did a lot of

contingency planning inside of G.E.

As we progressed through

We had a lot of levers:

a very strong company,

the ability to raise capital, the cash position of the

parent.

terms of just our survivability should the debt markets go

away period--you know, it's hard to get your head there--but

should it happen, we are a finance company.

The lever we haven't talked about a lot is the, in

So, you know,

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we collect a lot of cash.

some.

We're a different model than

We collect about $100 billion a quarter of cash.

So we would of had to lean into new origination, new

business, if things had gotten bad enough.

less new credit as we collect obligations that are owed to

us to build cash.

8
9

You know, extend

But we were never concerned about the viability
of the company.

The company is strong.

The company had a

very strong balance sheet through a very difficult time,

particularly in terms of the stock price, just in terms of

what happened.

situation that we couldn't handle.

But we never, you know, foresaw a liquidity

The way you handle it might not be that

attractive in some cases.

prudent.

We raised equity.

company.

We cut the dividend back to the parent.

Ultimately the parent reduced the dividend.

painful actions in many ways.

We did what we thought was
We put it in the financial

These were

And I think the never lever we would have--if

again the markets were just gone, totally frozen, we would

of had to extend less credit.

we participated in, while not designed for us, they were

designed to stabilize the markets, and I think they did in a

way that was enormously beneficial, and it benefitted us as

The government programs that

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well, as it did many others in that time, because this was a

market phenomenon unlike any that I had imagined in that

regard.

But we would have gotten through it.

The G.E. Capital would probably be a smaller

business in the future because of it, but I think what the

government did was appropriate.

CPFF, these were money makers.

8
9

I think in terms of TLGP,

Now at the day one you might not know if it will
be or not, but it turned out to be, in that regard.

I think

they did stabilize things.

about a game we didn't have to play in that regard.

were ready.

Some of it would have been difficult, but just to answer

your question, Commissioner, I think we would have come

through it.

successful business model.

So you're asking a question

We thought about it.

But we

We had scenario planning.

We're a very strong company with a very

COMMISSIONER MURREN:

A number of witnesses have

made commentary about the feeling that they felt that they

had been the subject of market manipulation, rumors in the

market, those types of things.

though your company, your equities or debt, were ever the

target of any kind of issues that might surround rumors in

particular relating to G.E. Capital?

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25

WITNESS NEAL:

Did you at any point feel as

You know, just my view, and I've

heard some of the previous testimony, again this is my

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1

personal view, you know, it's pack hunting when you're in

the sights of some of these large hedge funds, and I think

things do happen.

You know, sometimes it's real information.

Sometimes it may be a rumor.

financial services during that period of time that actually

came under fire in that regard--we certainly did.

survived it.

I think anybody that was in

Some didn't, in that regard.

But I do think it’s those kinds of activities, we

call it--I call it, you know, pack hunting.

that that does happen.

our share.

had almost $50 billion of unmarked CMBS.

less than $100 million, and it had been marked.

tough to undo it.

There are rumors.

Because I think
We certainly had

We had one where it was reported on TV that we
We actually had
But it was

I don't know where it came from, but it was

there.

But things like that happen.

You know, and if you

get in a very difficult market, a very scary market for

people, if you can get put into a position where there's no

buyers of your stock, then the stock value can drop very

quickly in that regard.

So I think things like that do happen.

And, you

know, I don't know if it's, you know--you know, I don't know

how you could prove it in some cases, but I think we felt

some of that, too.

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COMMISSIONER MURREN:
of you for coming here.

Thank you.

Thanks to all

I appreciate it.

CHAIRMAN ANGELIDES:

I know the Commissioners are

probably anxious to go.

two days in this room with a lot of different people, but I

do want to ask one--oh, go ahead, Mr. Hennessey.

7
8

We've had 16 hours over the last

COMMISSIONER HENNESSEY:

Can I just report on two

current events?

CHAIRMAN ANGELIDES:

Absolutely.

COMMISSIONER HENNESSEY:

One, a Senator on the

Floor within about the past hour was asking why the

Financial Crisis Inquiry Commission exists if the Senate is

about to pass legislation, and suggested that maybe we

should be disbanded.

discussion.

So I just add that into the

And then, would note that while the Dow closed

down 3.1 percent today, at about 2:30 p.m. it was down

nearly 1000 points, which as I remember it is a larger drop

than on any single day in September of 2008.

point about needing to be robust and able to withstand

shocks, there are other shocks out there besides real

estate.

CHAIRMAN ANGELIDES:

So back to my

And I assume you're assuming

to the latter event, not the former event?

drop, not the one Senator on the Floor?

The 1000-point

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(Laughter.)

COMMISSIONER HENNESSEY:

CHAIRMAN ANGELIDES:

I just had one, and it relates really to what you

Yes.

Okay, just to be clear.

talked about shocks, because you talked about belts

and suspenders, and what was the third thing, Keith?

was that phrase?

COMMISSIONER HENNESSEY:

CHAIRMAN ANGELIDES:

What

Buckles.

But I heard you

also say the fourth element of that.

period of shock, but to keep liquidity in the market was the

resolution authority.

something.

Not so much for the

I just want to understand

It's important because you as a creditor want to

be able to keep lending, and you want to have some certainty

as to result, both in terms of priority and timing for

disposition of your position.

WITNESS McCULLEY:

Correct?
Resolution authority, a robust

one, is important because it provides assurance to the

marketplace that a firm can be unwound in an orderly fashion

with creditors taking losses but it doesn't create a

contagion effect.

CHAIRMAN ANGELIDES:

Right.

But the difference

between that and Chapter 11 would be certainty as to

priority?

Or would it also be, for example, some kind of

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assured DIP financing, Debtor In Possession, financing to

carry it through so there's an orderly liquidation of the

assets to retain as much value as possible?

You know, I'm just trying to get a simple answer,

why that and not Chapter 11?

WITNESS McCULLEY:

Brothers and it didn't work.

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CHAIRMAN ANGELIDES:

We tried that with Lehman

I can't remember the

corporate section for liquidation, 13?

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Or Chapter 7?

WITNESS McCULLEY:

And there have been a number

of proposals by scholarly, thoughtful people on this area.

CHAIRMAN ANGELIDES:

But in simple terms, is it

order priority, the time frame for resolution, as well as

some funding mechanism so you don't have to dump assets

quickly?

WITNESS McCULLEY:

That is essentially the

framework, including a mechanism through essentially the DIP

financing to provide comfort to counterparties.

CHAIRMAN ANGELIDES:

Right.

comfort to counterparties, correct?

lend in reasonably.

financing?

This is all about

So you'll continue to

And who would provide the DIP

WITNESS MEIER:

Mr. Chairman, if I could answer

your earlier question, I do think the resolution process, in

terms of leveraged institutions with securities holdings

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that rely on say repurchase agreements, that that resolution

would entail an orderly liquidation of those assets, as

opposed to each fully secured counterparty grabbing their

collateral and rushing to the market and dumping them at any

price.

CHAIRMAN ANGELIDES:

Right.

Okay, I understand.

So it's not necessarily DIP financing, because it's not an

ongoing concern.

Correct?

WITNESS MEIER:

Yes.

CHAIRMAN ANGELIDES:

WITNESS McCULLEY:

All right.
There could be some type of

temporary DIP financing, but it's simply temporary to bridge

you to the day where the funeral is conducted.

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CHAIRMAN ANGELIDES:

And presumably it would be

priced to attract whoever would provide it.

WITNESS McCULLEY:

CHAIRMAN ANGELIDES:

Thank you very, very much, for your time.

Commissioners, for your hard work.

Yes.
All right.

We could go on.
To the

And I want to, before we adjourn, I want to thank

Chairman Chris Dodd and the staff of the Senate Banking,

Housing and Urban Affairs Committee for giving us this room,

and giving us the support necessary to hold these two days

of hearings on the shadow banking system.

Thank you very much.

The meeting of the

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Financial Crisis Inquiry Commission is adjourned.
(Whereupon, at 5:05 p.m., Thursday, May 6, 2010,
the meeting was adjourned.)

Full text of Financial Crisis Inquiry Commission : Documents Relating to the Financial Crisis of 2007-2009 : Official Transcript : Hearing on "The Shadow Banking System", Thursday, May 6, 2010, Dirksen Senate Office Building, Room 538, Washington, D.C.

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