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1 UNITED STATES OF AMERICA 2 FINANCIAL CRISIS INQUIRY COMMISSION 3 Official Transcript 4 5 6 7 Hearing on "Too Big to Fail: Government Intervention and The Role of Systemic Risk in the 8 9 Expectations and Impact of Extraordinary Financial Crisis." Thursday, September 2, 2010, 9:00a.m. 10 Dirksen Senate Office Building, Room 538 11 Washington, D.C. 12 COMMISSIONERS 13 PHIL ANGELIDES, Chairman 14 HON. BILL THOMAS, Vice Chairman 15 BROOKSLEY BORN, Commissioner 16 BYRON S. GEORGIOU, Commissioner 17 SENATOR ROBERT GRAHAM, Commissioner 18 KEITH HENNESSEY, Commissioner 19 DOUGLAS HOLTZ-EAKIN, Commissioner 20 HEATHER MURREN, COMMISSIONER 21 JOHN W. THOMPSON, COMMISSIONER 22 PETER J. WALLISON, Commissioner 1 Reported by: JANE W. BEACH, Hearing Reporter 2 PAGES 1 - 195 1 SESSION I: THE FEDERAL RESERVE: 2 BEN S. BERNANKE, Chairman 3 Board of Governors of the Federal Reserve System 4 5 SESSION II: FEDERAL DEPOSIT INSURANCE CORPORATION: 6 SHEILA C. BAIR, Chairman 7 U.S. Federal Deposit Insurance Corporation 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 2 1 P R O C E E D I N G S 2 (9:00 a.m.) 3 CHAIRMAN ANGELIDES: Good morning. Welcome to 4 the public hearing of the Financial Crisis Inquiry 5 Commission. 6 financial institutions that have become too big, too 7 important, too systemic to fail. This is our second day examining the issue of 8 Yesterday we looked at two case studies, Wachovia 9 Corporation and Lehman Brothers, and this morning we will be 10 hearing from the Chairman of the Federal Reserve, Mr. Ben 11 Bernanke, as well as the Chair of the FDIC, Ms. Sheila Bair. 12 Welcome, Mr. Chairman. Thank you for joining us 13 here today. 14 have come before this Commission, first in our offices for a 15 private session when we were first convened as we began our 16 work, I believe almost a year ago. 17 be our final hearing in Washington, D.C., although after 18 today we will head across the country to a number of 19 communities in California, in Nevada, and in Florida, to 20 hold hearings in communities that are still gripped by high 21 unemployment, high foreclosure rates, and we're going to be 22 going to those communities to see how the seeds of this 23 crisis were sown on the ground and what the consequences are 24 today. 25 I might note that this is the second time you And today, in what will Mr. Chairman, as we have done with all witnesses, 3 1 we will now ask you to do, I would now like to ask you to 2 stand so I can swear you as a witness. 3 stand and raise your right hand: 4 And if you would Do you solemnly swear or affirm under penalty of 5 perjury that the testimony you are about to provide the 6 Commission will be the truth, the whole truth, and nothing 7 but the truth, to the best of your knowledge? 8 CHAIRMAN BERNANKE: I do. 9 (Chairman Bernanke sworn.) 10 11 CHAIRMAN ANGELIDES: Thank you very much, Mr. Chairman. 12 Thank you very much for your extensive written 13 testimony. And this morning we would like to ask you to 14 speak to us orally and take up to ten minutes this morning 15 to give your opening remarks, at which point, upon 16 conclusion of your opening remarks, we will move to 17 questions from Commissioners. 18 So, Mr. Chairman, the floor is yours. 19 WITNESS BERNANKE: Thank you, Mr. Chairman. I 20 won't take a full ten minutes, and I would like to say that 21 we will be submitting additional answers to your questions 22 very shortly. 23 24 25 Chairman Angelides, Vice Chairman Thomas, and other members of the Commission: Your charge to examine the causes of the recent 4 1 financial and economic crisis are indeed important. 2 understanding the factors that led to and amplified the 3 crisis can we hope to guard against a repetition. 4 Only by So-called too big to fail financial institutions 5 were both a source--though by no means the only source--of 6 the crisis, and among the primary impediments to 7 policymakers' efforts to contain it. 8 9 In my view, the too big to fail issue can only be understood in the broader context of the financial crisis 10 itself. 11 of the factors underlying the crisis, as well as some of the 12 problems that complicated public officials' management of 13 the crisis. 14 In my full written testimony I provide an overview In understanding the causes of the crisis, it is 15 essential to distinguish between triggers: the particular 16 events or factors that touched off the crisis, and 17 vulnerabilities: the structural weaknesses in the financial 18 system and in regulation and supervision that propagated and 19 greatly amplified the initial shocks. 20 Although a number of developments helped to 21 trigger the crisis, the most prominent was the prospect of 22 significant losses on subprime mortgage loans that became 23 apparently shortly after house prices began to decline. 24 25 While potential subprime losses were large in absolute terms, judged in relation to global financial 5 1 markets they were not large enough to account for the 2 magnitude of the crisis on their own. 3 preexisting vulnerabilities, together with gaps in the 4 government's crisis response toolkit, are the primary 5 explanation of why the crisis has such devastating effects 6 on the global financial system and the broader economy. 7 Let me give an illustration of how 8 vulnerabilities in the financial system greatly increased 9 the effects of the triggers of the crisis. 10 Instead, the system's In the years before the crisis, a system of so- 11 called "shadow banks," financial entities other than 12 regulated depository institutions, had come to play a major 13 role in global finance. 14 As it grew, the shadow banking system, including 15 certain types of special-purpose vehicles such as those 16 financed by asset-backed commercial paper, and some 17 investment banks had become dependent on short-term 18 wholesale funding. 19 Such reliance on short-term uninsured funds made 20 shadow banks subject to runs, much like commercial banks had 21 been prior to the creation of Deposit Insurance. 22 When problems in the subprime mortgage market and 23 other credit markets became known, the providers of short- 24 term funding ran from the shadow banks, disrupting short- 25 term money markets. Thus, the vulnerability--in this 6 1 case, the excessive dependence of many financial 2 institutions on unstable short-term funding--greatly 3 amplified the effects of the trigger, in this case the 4 prospective losses of subprime mortgages. 5 Among the consequences of this instability were 6 sharp declines in high volatility in asset prices, 7 widespread hoarding of liquidity by financial institutions, 8 and associated reductions in the availability of credit to 9 support economic activity. 10 Many of the key vulnerabilities of the financial 11 system were the product of private sector arrangements, 12 including, as just noted, over dependence of many financial 13 institutions on an unstable short-term funding, poor risk 14 management, excessive leverage of some households and firms, 15 misuse of certain types of derivative instruments, 16 mismanagement of the mortgage securitization process, and 17 other problems. 18 But important vulnerabilities also existed in the 19 public sector, both in the United States and in other 20 countries. 21 statutory framework, and flaws in the performance of 22 regulators and supervisors. These vulnerabilities included both gaps in the 23 Important examples of statutory gaps were the 24 absence of effective authority to regulate and supervise 25 some important types of shadow banks such as special-purpose 7 1 vehicles, and broker-dealer holding companies, the lack of 2 authority or responsibility to take actions to limit 3 systemic risks, and the absence of a legal framework under 4 which failing systemically critical nonbank financial firms 5 could be resolved in an orderly way. 6 Where appropriate authorities existed, financial 7 regulators and supervisors--both in the United States and 8 abroad--did not always use them effectively. 9 bank supervisors in many cases did not do enough to force 10 financial institutions to strengthen their internal risk 11 management systems and to curtail risky practices; and bank 12 capital and liquidity standards were insufficiently 13 stringent. For example, 14 The recent financial reform legislation addresses 15 many of the statutory gaps I have mentioned, and the Federal 16 Reserve and other agencies are taking strong steps to 17 tighten the regulation of financial institutions, to give 18 regulation and supervision a more systemic and multi- 19 disciplinary orientation, and to make supervision more 20 effective. 21 Many of the vulnerabilities underlying the crisis 22 were linked to the existence of so-called too-big-to-fail 23 firms, those whose size, complexity, interconnectedness, and 24 critical functions were such that their unexpected failure 25 was likely to severely damage the financial system and the 8 1 economy. 2 Because of the grave risks presented should a 3 too-big-to-fail firm file for bankruptcy protection, in the 4 short run governments have strong incentives to prevent such 5 events from occurring; hence, too big to fail. 6 However, in the longer term, the existence of 7 too-big-to-fail firms create severe moral hazard problems 8 which can lead to the buildup of risk and future financial 9 instability, while complicating the resolution of financial 10 crises. 11 The existence of such firms also creates an 12 uneven playing field between the largest firms and their 13 smaller competitors. 14 too-big-to-fail problem be solved. 15 of the solution contained in the recent financial reform 16 bill is the development of a resolution framework that 17 allows the government to resolve a failing systemically 18 important nonbank financial firm in an orderly way, while 19 imposing appropriate losses on creditors, protecting 20 taxpayers, and limiting risks to the broader financial 21 system. 22 It is critical that the An important component Tougher regulation and supervision of 23 systemically important firms, and steps to increase the 24 resilience of the financial system, are also important if we 25 are to bring a decisive end to too-big-to-fail. 9 1 The findings of this Commission will help us 2 better understand the causes of the crisis, which in turn 3 should increase our ability to avoid future crises, and to 4 mitigate the effects of crises that should occur. 5 We should not imagine, though, that it is 6 possible to prevent all crises. A growing dynamic economy 7 requires a financial system that effectively allocates 8 credits to households and businesses. 9 credit inevitably involves risk taking. The provision of 10 To achieve both sustained growth and stability, 11 we must provide a framework which promotes the appropriate 12 mix of prudence, risk-taking, and innovation in our 13 financial system. 14 Thank you, Mr. Chairman. 15 CHAIRMAN ANGELIDES: Thank you very much, Mr. 16 Chairman. 17 the questioning, and then we will go to Vice Chairman 18 Thomas, and then to the balance of the members. 19 We will now begin with questions. I will start So I would like to talk to you for a few minutes 20 about the runup to the crisis, because I believe a lot of 21 the focus is always on did the government do the right thing 22 in the grips of the crisis; the real question for me has 23 always been how did we get to the position where we faced 24 such Draconian choices. 25 And one of the things that struck me as we 10 1 reviewed our case studies is the failure of regulator 2 supervisors to identify and contain systemic risk in 3 too-big-to-fail institutions before the crisis hit. 4 Yesterday we looked at Wachovia where assets grew 5 from about $250 billion to $782 billion by 2007, and a very 6 aggressive growth rate of 17 percent; a tangible asset to 7 tangible equity ratio of 23 to 1; the acquisition of a big 8 book of pay option ARMs from Golden West, which in and of 9 itself was three times Tier One Capital. 10 But, no recognition by the Fed or the OCC of 11 systemic risk. 12 until July of '08. 13 In fact, no downgrading of the institution A similar fact pattern at Lehman. Even though we 14 realize the Fed was not the prudential supervisor, but again 15 I'm talking in a larger sense here: 16 leverage of 39 to 1. 17 Let me just ask you: very aggressive growth, Why such a big miss? And I 18 want to put this in context, that some of your folks who 19 have spoken to us here, like Mr. Alvarez and Mr. Cole, whom 20 we interviewed, talked about the fact that, well, gee, we 21 had--and I think it was maybe Mr. Cole who used the word 22 "myopic look". 23 "We looked at safety and soundness." But shouldn't have systemic risk been part of a 24 safety and soundness regime, even in the 2000 period? 25 this a substantial miss? Was How fundamental was the failure of 11 1 2 proper supervision to the metastasizing of this problem? WITNESS BERNANKE: Mr. Chairman, first of all it 3 should be recognized that large, complex international 4 financial institutions do have an appropriate role. 5 fact that you were seeing growth and complexification of 6 these institutions in a world of financial innovation, 7 international capital flows, financial supermarkets, and a 8 whole variety of other innovations, in itself should not be 9 surprising. 10 11 12 13 And the That was happening not only in the United States but it was happening globally. So there clearly was a reason for the growth and for the more complex institutions. Now that being said, it is certainly true that 14 the system did not sufficiently anticipate the systemic 15 risks associated with these institutions. 16 frankly, partly due to the regulatory structure that was 17 given to us by Congress. 18 That was, As you had mentioned, our charge was to focus on 19 the safety and soundness of individual institutions. There 20 was no provision, no authority to address systemic risk in 21 an institution. 22 was redone and there was additional regulation put on Fannie 23 and Freddie, the Congress explicitly said that you are not 24 allowed to consider systemic risks when you are looking at 25 the safety and soundness of this institution. In fact, when the Fannie and Freddie law 12 1 Now--and furthermore, there was no-- 2 CHAIRMAN ANGELIDES: 3 Was that part of the Gramm- Leach-Bliley-- 4 WITNESS BERNANKE: No, that was part of the 5 Fannie and Freddie's, of the law that created the FHFA, the 6 new institution. 7 And furthermore, there was no--there was no 8 collective assignment, as there is under the more recent 9 reform legislation, to look for systemic risks. Many of the 10 risks that occur obviously are interactions of the size and 11 complexity of individual firms, but features of the entire 12 system. 13 overall system. 14 They are emergent properties, if you will, of the Now having said all that, I must also agree that 15 supervisors in the United States and around the world 16 underestimated the risks associated, for example, with 17 insufficient liquidity. 18 problem, or a bank run essentially. 19 Much of the crisis was a liquidity We underestimated the extent to which risks 20 remained concentrated within important financial firms. 21 so I'm not claiming that we found all those problems. 22 And But there was a combination of the structure of 23 the system, the underlying trends toward greater and more 24 complex firms, together with some mistakes and shortcomings 25 on the part of regulators. 13 1 CHAIRMAN ANGELIDES: Let me ask you [microphone 2 is off]--thank you so much. 3 long journey for this Commission. 4 It is early. It has been a And this is not a matter of political ideology, 5 but there does seem to be, within the financial markets, 6 there was--it appears to be a greater and greater reliance 7 also on self-regulation. 8 with our staff, I believe in March, talked about the 9 deregulatory environment in which policy decisions were 10 made. 11 that very squarely here. 12 Mr. Alvarez in an interview he did And again, without regard to Party--I'm going to say Mr. Cole talks about recognizing some of the 13 problems in institutions and the ride up the roller coaster, 14 but the pushback from financial institutions. 15 of this was also a function of a shift away from an 16 aggressive regulatory regime to, frankly, just a common view 17 that we should be more reliance on self-regulation, internal 18 risk management by the institutions, and replacement of 19 regulation? 20 WITNESS BERNANKE: So how much Well I think there's some 21 truth to that. It was--there was some change I think in 22 overall philosophy. 23 was a greater and greater understanding that regulators 24 could not replicate all the risk assessments that the firms 25 themselves could do, and we had to rely more on their own As firms became more complicated, there 14 1 assessments. 2 themselves, making sure that they had good systems in place, 3 and that they were taking appropriate steps to address those 4 risks. 5 And instead of looking at the risks So it was certainly a problem, and it was 6 exacerbated I think by the fact that there's always 7 implicitly an international competition. 8 one of our main concerns was London and Tokyo, were they, 9 you know, taking away the financial industry from the U.S.? 10 Before the crisis, And was excessive regulation doing that? 11 So those were some of the concerns. That being 12 said, I think that innovation in the financial system partly 13 to avoid regulation but also in part to respond to the 14 legitimate changes in the economy; I referred to the shadow 15 banking system a moment ago, the development of new types of 16 financial institutions, off-balance-sheet vehicles, nonbank 17 mortgage lenders, much bigger investment banking activities 18 and so on. 19 Our bank regulatory system was designed for a 20 bank-centric financial system, and that's where it came 21 from. 22 country, were not sufficiently proactive in establishing a 23 regulatory framework to encompass all of those aspects. 24 25 And as all these nonbank activities grew we, we the CHAIRMAN ANGELIDES: All right. Thank you. But it does seem to be, particularly if we are entering into an 15 1 era of larger and larger banks, that if we're going to have 2 banks that are too-big-to-fail it would also seem to me that 3 we need regulators who are too-tough-to-fold. 4 This is going to be a particularly challenging 5 environment with a set of even larger banks, and fewer of 6 them. 7 forward is even more dramatic? Would you agree with that? 8 9 WITNESS BERNANKE: important. That the challenge going I think it is very, very As I said before, the most important lesson of 10 this crisis is we have to end too-big-to-fail. 11 believe that we, in a much different way than we did before 12 the crisis, we now have the tools to address that. 13 And I In particular, tougher regulation and oversight 14 will reduce the risks. 15 will increase market discipline, because creditors will know 16 that they can lose money. 17 of the financial system itself will reduce the incentive of 18 the government to intervene in these situations. 19 The existence of a resolution regime And strengthening the resilience My projection is that, even without direct 20 intervention by the government, that over time we are going 21 to see some breakups and some reduction in size and 22 complexity of some of these firms as they respond to the 23 incentives created by market pressures and by regulatory 24 pressures as well. 25 CHAIRMAN ANGELIDES: So our staff prepared for us 16 1 what I thought was an excellent--all the information you 2 already know, by virtue of being Chairman of the Fed and 3 your background, but it was striking. 4 and it's posted on our website, essentially a history of 5 too-big-to-fail; also, governmental rescues, from Franklin 6 National, to Continental Illinois, through the multiple 7 rescues in 2008. 8 9 Our staff did for us, And as I look at it, you almost can take the view that, you know, Wall Street seems to believe that a 10 financial sucker is born every crisis. 11 of the biggest questions that Americans have is: 12 break this cycle? 13 And so I think one How do we What is the single most important thing that 14 should have been done, and can be done in the future, to 15 break the cycle? 16 that we can take? 17 The single most important policy action WITNESS BERNANKE: There has to be a credible way 18 to let firms fail--in fact, to require that they fail. 19 mean, I think it is striking that the new rules do not 20 permit discretion. 21 assistance, which allows the government to assist a firm to 22 continue to exist. 23 I They do not allow so-called open-bank Rather, what it does it provide a system for 24 trying to take a firm into receivership in a way that does 25 minimal damage to the system. 17 1 It's not going to be easy. I mean, let me just 2 be clear. This is not going to be easy to implement, 3 because these are large, complex firms with multi-national 4 presence. 5 CHAIRMAN ANGELIDES: 6 WITNESS BERNANKE: And significant power. And significant power. But 7 it's a very important step to take away the discretion. If 8 I might just cite the example of FDICIA, the law passed in 9 the early '90s, which created a set of well-specified 10 triggers under which the FDIC has to come in and close a 11 bank, except under extreme circumstances--the systemic risk 12 exception. 13 resolution regime in the Dodd-Frank bill. 14 There is no systemic risk exception for the That has worked very well. And the analogy to 15 using that, applying that to large firms I think is very 16 important. 17 Mr. Chairman, that this was a catastrophe, and it is bad in 18 the long run as long as in the crisis, and we must address 19 it. 20 So I could hardly agree with you more, CHAIRMAN ANGELIDES: All right. 21 a moment about failed institutions. 22 Fuld here from Lehman yesterday. 23 Federal Reserve Bank of New York. 24 25 Let me talk for As you know, we had Mr. We had Mr. Baxter from the You have stated I think on many occasions that the failure of Lehman had significant consequences. So in 18 1 our role as Commissioners trying to do our level best to 2 understand the history of his crisis, we're trying to--at 3 least I am--trying to unfurl the set of decisions, the whys, 4 the wherefors. 5 When you first testified to Congress I believe 6 after the failure of Lehman, you had essentially said in 7 your testimony--and I'm shortening this up--that Lehman was 8 not rescued essentially because the market, the 9 participants, had had time to prepare in the wake of market 10 11 developments. And I say this, as I said yesterday, it seems to 12 me the decision to allow Lehman to fail was a conscious 13 policy decision. 14 just let them go down, but that like any other policymakers 15 you were weighing a whole set of factors. 16 Now I'm not implying that people said, oh, Now since early on it seems though the Fed and 17 other officials have indicated that it was solely due to a 18 lack of legal authority, the inability to make the loan 19 under 13.3, the lack of sufficient collateral; but when I at 20 least look at the chronology, it seems to me you were trying 21 to deal with a whole set of complex factors. 22 We released yesterday a chronology of different 23 events along the way, and it seems to me, you know, there 24 was serious consideration of financial assistance, the Fed 25 stepping into the shoes of the clearing banks if that was 19 1 necessary. 2 July proposed a Maiden Lane type solution. 3 You know, Mr. Dudley, for example, I think in Mr. Geithner had told the FSA, I think as late as 4 a few days before the failure, that government assistance 5 was possible. 6 there's a Federal Reserve Board of New York document, I 7 think Mr. Parkinson circulates, that talks about an FRBNY 8 financial commitment. 9 how much we are willing to finance before the meeting And as late as I think the last few days, "We should find a maximum number of 10 starts, but not divulge our willingness to do so to the 11 Consortium. 12 long enough to guard against a fire sale, but on a short 13 enough fuse to encourage buyer of Lehman assets to come 14 forward two months to a year in duration?" 15 a note, "Lehman is bigger and more global than Bear." 16 The terms of any liquidity support should be And then there's So there seems to be a robust debate about the 17 efficacy of financial support. There certainly seemed to be 18 political considerations--and I don't necessarily mean at 19 the Fed, but among Treasury, White House, which is 20 legitimate. 21 country, how policymakers are going to view this. 22 an awareness of impacts, a larger triparty book than Bear, a 23 bigger and more complex institution to unwind. People are trying to weigh the mood of the There's 24 I don't see any documents or discussion along the 25 way about legal bars or government analysis of a shortage of 20 1 collateral. 2 in March of 2009 saying the Fed has wide latitude in terms 3 of how it defines collateral. 4 This is all by--and I see Mr. Alvarez's opinion My real question for you is: What was the mix of 5 policy considerations? 6 transactions on the private side and the public side, that 7 there will be legal barriers, obstacles that have to be 8 respected, but it doesn't look as though that cut this 9 discussion off. 10 I understand, because I've been in What were the biggest considerations? Would you 11 have saved Lehman if you had the legal authority? 12 rolling up to that decision, trying to determine were they 13 too-big-to-fail, not too-big-to-fail, you've already said 14 you thought it had significant disastrous consequences, but 15 what were the things you were trying to weigh, the decision- 16 making factors? 17 18 WITNESS BERNANKE: myself. But in So I can only speak for I don't know everybody's view on that. 19 CHAIRMAN ANGELIDES: 20 WITNESS BERNANKE: Okay. Great. So first of all there was of 21 course, we were trying to arrange a private takeover over 22 the weekend, and we wanted that to be done on the best 23 possible terms that we could. 24 25 And for that reason there was some benefit I think in the weeks prior to Lehman to keep our hands, you 21 1 know, a little bit up to the vest in terms of what we were 2 willing and able to do. 3 in the week prior to the Lehman weekend. 4 So there was some of that going on That being said, let me just state this as 5 unequivocally as I can. As you know, before I came to the 6 Fed Chairmanship I was an academic, and I studied for many 7 years the Great Depression, financial crises, and this is my 8 bread and butter. 9 allowed to fail, or did fail, that the consequences for the And I believed deeply that if Lehman was 10 U.S. financial system and the U.S. economy would be 11 catastrophic. 12 And I never, at any time, wavered in my view that 13 we should do absolutely everything possible to prevent the 14 failure of Lehman. 15 Now on Sunday night of that weekend, what was 16 told to me was that--and I have every reason to believe--was 17 that there was a run proceeding on Lehman, that is people 18 were essentially demanding liquidity from Lehman; that 19 Lehman did not have enough collateral to allow the Fed to 20 lend it enough to meet that run; therefore, if we lent the 21 money to Lehman, all that would happen would be that the run 22 would succeed, because it wouldn't be able to meet the 23 demands, the firm would fail, and not only would we be 24 unsuccessful but we would have of saddled the Taxpayer with 25 tens of billions of dollars of losses. 22 1 So it was both a legal consideration, but also a 2 practical consideration. Legally speaking, we are not 3 allowed to lend without a reasonable expectation of 4 repayment. 5 of the Reserve Bank. 6 had no ability to inject capital or to make guarantees. 7 The unanimous opinion that I was told, and I The loan has to be secured to the satisfaction Remember, this was before TARP. We 8 heard from both the lawyers and from the leadership at the 9 Federal Reserve Bank of New York, was that Lehman did not 10 have sufficient collateral to, to borrow enough to, to save 11 itself. 12 within the law would be futile and would only result in loss 13 of cash. And therefore any attempt to, to lend to Lehman 14 In some cases you can take the going-concern 15 value of the firm into consideration, but in this case 16 Lehman was under a run. 17 melting away because its customers, its counterparties, its 18 employees, and so on, were not going to be sticking with 19 this firm. It's going-concern value was 20 So I believe as of Sunday night that it wasn't 21 just a question of legality; it was a question of whether 22 there was anything we could conceivably do that would 23 prevent the failure of the firm. 24 great reluctance and sadness that I conceded that there was 25 no other option. And therefore, it was with 23 1 There was never any discussion which says here's 2 how we can save Lehman; should we do it or not? 3 had a discussion like that. 4 no way. 5 proceeded. 6 anything to save it, I would have saved it. We never The discussion was: There is And that was my belief, and that is how I Because, as I said, if I could have done 7 Now you asked, appropriately, about the-- 8 CHAIRMAN ANGELIDES: 9 Can I ask one question on that, very quickly? 10 WITNESS BERNANKE: Certainly. 11 CHAIRMAN ANGELIDES: Which is, you said you 12 represented your own views. 13 though, expressed? 14 the politics. 15 seems to be some political reluctance. 16 writing e-mails: 17 There were differential views, I've seen in the e-mails concerns about Bear's been bailed out. The GSEs. There Mr. Wilkinson's can't stomach a bailout. WITNESS BERNANKE: Well it's certainly 18 understandable that people would have those concerns, but I 19 must say that in my own case, and as far as I know in the 20 cases of the other principals, the primary consideration was 21 the knowledge that the failure of Lehman would have 22 catastrophic consequences. 23 Let me just say one word about the testimony you 24 referred to, which has gotten--which has supported this myth 25 that we did have a way of saving Lehman. This is my own 24 1 fault, in a sense, but the reason we didn't make the 2 statement in that testimony, which was only a few days after 3 the failure of Lehman, that we were unable to save it was 4 because it was a judgment at that moment, with the system in 5 tremendous stress and with other financial institutions 6 under threat of run, or panic, that making that statement 7 might have, might have even reduced confidence further and 8 led to further pressure. 9 That being said, I regret not being more 10 straightforward there, because clearly it has supported the 11 mistaken impression that in fact we could have done 12 something. 13 We could not have done anything. CHAIRMAN ANGELIDES: One last question on this 14 subject. 15 broker-dealer I believe in the amount--I mean, I guess 16 authorized, $50 billion but I think the daily amounts were 17 $29- $30 billion, and I have the numbers exactly with me, 18 that you were able to do that because? 19 WITNESS BERNANKE: 20 collateral to make--to support the loan. 21 CHAIRMAN ANGELIDES: 22 That is, a loan was made under the PDCF to the Because they had sufficient the night before at the Holding Company level? 23 WITNESS BERNANKE: 24 CHAIRMAN ANGELIDES: 25 That was not available on Correct. Because the Holding Company had a capital hole, in your judgment? 25 1 WITNESS BERNANKE: I believe it had a capital 2 hole, but in any case the calculations were that the 3 liquidity demands on the Holding Company were much greater 4 than the collateral that they had available to meet those 5 demands. 6 prevent the broker-dealer from lending to its own Holding 7 Company, and it didn't seem to decide that was a smart thing 8 to do, either. 9 And moreover, by the way, we didn't do anything to CHAIRMAN ANGELIDES: Of course at that point they 10 had filed bankruptcy. 11 with yesterday's dialogue with Mr. Baxter about what I 12 referred to as the smoking letter about whether in fact the 13 Holding Company had the ability Sunday night. 14 continue to look at that matter and what transpired. 15 And I'm not going to take your time WITNESS BERNANKE: We'll I can only tell you what I 16 knew at the time. 17 was informed, and what I believed, was that there was no 18 capacity for them to borrow sufficiently, have enough 19 collateral to borrow sufficiently to meet their obligations. 20 CHAIRMAN ANGELIDES: 21 analysis? 22 analysis? 23 And what I knew at the time, and what I Was that based on an Or was that based on the private Consortium's WITNESS BERNANKE: That was based on analysis at 24 the Federal Reserve Bank of New York, primarily, which had 25 been going on through the weekend. And of course prior to 26 1 that, we had done a lot of analysis based on our presence at 2 Lehman during the summer. 3 CHAIRMAN ANGELIDES: All right. One final 4 question--I'm exhausting my time, but this is very quickly. 5 I want to ask you, as we look at the genesis of this crisis, 6 it's hard not to look at the actions of the Federal Reserve. 7 And I know Mr. Thompson is going to want to talk about this, 8 so I will just ask very quickly, when you look at the 9 opportunity to regulate subprime lending under HOPA, rules 10 were adopted in 2001 that end up covering only 1 percent of 11 the loans, when you look at the referral of unfair and 12 deceptive lending practices to Justice, only two 13 institutions, I think the Desert Community Bank in 14 Victorville, California, and the First American Bank in 15 Carpenter, Illinois, only two referrals in six years; a 16 decision not to examine nonbank subsidiaries; was this a 17 very significant failure, looking back in retrospect? 18 WITNESS BERNANKE: It was, indeed. I think it 19 was the most severe failure of the Fed in this particular 20 episode. 21 CHAIRMAN ANGELIDES: All right. Well, I think 22 Mr. Thompson will want to ask some more about that. 23 defer the rest of my questions, if I have any, to Mr. 24 Thomas. 25 I will Thank you very much, Mr. Chairman. VICE CHAIRMAN THOMAS: Thank you, Mr. Chairman. 27 1 And thank you, Mr. Chairman. 2 It's nice to see you again. Let me say first of all, for those of us who have 3 been around for awhile, some folks might move us in the 4 category of "Mr. Senator" as having been around forever, and 5 you look at the political situation just in terms of 6 coordination and ability to move quickly, which is always 7 difficult in a political body, in the fall--well, December 8 '07 through '08, fall of '08, spring of '09, and of course 9 now today, historically when you look back, that actually 10 was a Presidential election period. 11 There was a change in government. And for those 12 of us who have been actually involved in these kinds of 13 processes, I want to thank you, and I want to thank the 14 others who were involved. 15 degree of aggressiveness that, had you not been bold enough 16 to carry out, circumstances might have been significantly 17 different. Because it took, in my opinion, a 18 So thank you. 19 After the fact, you get people who may have been 20 pretty upset--some behind closed doors; some in open doors-- 21 now beginning to take a look at really where we were, and 22 situations that would have occurred. 23 Obviously you talk about gaps. The reason we 24 talk about gaps is because we now know they were gaps. 25 Before we knew they were gaps, it's always hard to find the 28 1 2 gaps. One of my worries is, now being more acquainted 3 with the complexity, the failure of transparency, what 4 people thought was adequate capital carrying out various 5 kinds of behaviors, and the complexity that's now present, 6 not just nationally but internationally, one of the concerns 7 I have is--well, your final statement about obvious needs in 8 terms of the structure that we have on a flexibility in 9 movement, that when you try to look at dealing with 10 too-big-to-fail, and so we aren't going to let that happen 11 again, and you set up a structure, is there any concern 12 about some of these structures might be too complex to 13 unravel in a time period that's meaningful, given the 14 circumstances? 15 Because at some point, what I've heard from 16 virtually everyone--and we just heard the testimony 17 yesterday on some of the derivatives products and some of 18 the synthetics built off of derivatives, they're still 19 trying to unwind them in the Lehman Bankruptcy. 20 What concerns can you share with us in terms of-- 21 I mean, I often think, you know, you've got the cartoon of 22 the child who's going to go out in the snow. 23 puts on one layer, two layers, three layers, and it finally 24 then is allowed to go outside and play and it can barely 25 move getting outside. So the mother 29 1 You can set up a structure to make sure that it 2 doesn't happen, but how do you keep the flexibility to allow 3 the system to function? 4 concerns with the Dodd-Frank legislation, providing some 5 additional tools, comfort level, and now understanding 6 better, and more importantly, if we are now not going to 7 have these crisis interventions when we do fail, unwinding 8 structures in a reasonable way? 9 Where are we in terms of your WITNESS BERNANKE: That's an absolutely central 10 question. Of course as you know, Chairman Bair has written 11 a testimony which addresses this issue in some detail. 12 VICE CHAIRMAN THOMAS: 13 WITNESS BERNANKE: As we say, she's next. She's next on the program, I 14 understand. 15 kind of firms we're talking about are much more complicated 16 than the small- and medium-sized banks which are the typical 17 companies that are unwound through the FDICIA process, for 18 example. 19 It's a very difficult problem. Certainly the So this is not at all an easy process. However, I think we will be much better off if 20 you think about--one thing I feel people don't always 21 appreciate is that we tried to do these very complex 22 operations, you know, within hours, within a weekend. 23 certainly we'd of been much better off if we'd had an 24 extended amount of time to understand, and study, and 25 prepare, and make plans, and that is an important part of And 30 1 what the FDIC's new Division on Complex Firms is about. 2 They will be aided, as will we at the Federal 3 Reserve, by living wills--that is, by a required document 4 that firms will provide which will explain how they would be 5 wound down. 6 we have the authority to require them to simplify their 7 legal and organizational structure as necessary to make it 8 feasible. 9 And if those living wills are not satisfactory, So it is going to be very difficult, but 10 certainly we will be in a much better place than we were 11 prior to this crisis. 12 I think the one area where it's going to take a 13 lot of effort is the international element, because these 14 firms--one of the banks that we supervise has offices in 109 15 countries, each one with its own bankruptcy code and its own 16 rules and so on. 17 the moral equivalent of tax treaties with other 18 jurisdictions whereby we have rough agreements on how we 19 would cooperate and work together to unwind a firm, and that 20 will be very challenging. 21 And we're going to need to develop sort of But it is something that is currently being 22 heavily investigated by international bodies like the 23 Financial Stability Board, and I think it should be a top 24 priority. 25 VICE CHAIRMAN THOMAS: And where are we in terms 31 1 of those discussions? 2 the concerns that I had. 3 if we can't get an international agreement, given the 4 complexity and multi-national nature of today's financial 5 structure. 6 cliff, the less you want to kind of make the sacrifices that 7 allow for that international stability. 8 9 Because that was definitely one of We can resolve our problems, and And of course the farther away you get from the What's your comfort level in where we're going on that? 10 WITNESS BERNANKE: Well one word on domestic, 11 which is there was just a roundtable, and the FDIC is well 12 advanced in developing some rules to explain how they will 13 invoke these powers. 14 try to develop more knowledge about how you would go about 15 unwinding U.S. firms. 16 And we are working with the FDIC to As you agreed, the international aspect is very 17 difficult. 18 mentioned, the Financial Stability Board and the Basel 19 Committee, the Bank for International Settlement, and other 20 international bodies are looking at this very seriously. 21 But there is a very concerted effort. As I I think what we will have to do is work primarily 22 with the principal countries. Although this bank is in 109 23 countries, there are 4 or 5 countries which are the most 24 important that we have to work with, which have the largest 25 banks and bank presence. 32 1 So it's going to require again some agreements, 2 some MOUs, some work together, some ideas about how you're 3 going to divide assets, how you're going to reconcile 4 different bankruptcy codes and the like. 5 of work to be done. 6 go still, but obviously we are very focused on doing that, 7 and we have a lot of cooperation and goodwill from our 8 international partners. 9 So there's a lot And, you know, I think we have a way to VICE CHAIRMAN THOMAS: And, Mr. Chairman, you 10 indicated, I think the phrase was "the regulations given to 11 us by Congress," and we always look for the ability to 12 structure legislation with the flexibility under regulations 13 to not put you into a statutory straitjacket, but I had some 14 concerns yesterday in testimony. 15 When you look at that period in late September, 16 early October, in attempting to deal with Wachovia, and in 17 the minutes of the FDIC discussions they take the very 18 extraordinary step of accepting the concept of hopefully no 19 dollar exposure but responsibility for backup on the 20 Citi/Wachovia structure. 21 That's put to bed. And then literally the very next day, IRS issues 22 2008-83, fundamentally changing a two-decade-old Tax Code 23 provision. 24 part of government being fairly sensitive because there's a 25 difference between "needed" and "desirable." And you may recall some of us from the Article I 33 1 And it concerns me very much that whoever was 2 meeting came up with an idea that could solve the problem, 3 but didn't fully appreciate the consequences of inventing 4 solutions when you're charged with not carrying out 5 activities, and the argument was "we weren't given the power 6 by Congress," but where you came up with an idea that could 7 be inventive, you go ahead and do it. 8 9 The real difficulty for me in the long run in these kinds of situations is whether the Executive Branch is 10 a demand center, or whether it's a command center. 11 clearly there are times when it has to be a command center, 12 both domestically and internationally. 13 argument that we had to be a command center is used to do 14 what you want to do, rather than not. 15 And But more often the Did you have any behind-the-scenes' knowledge of 16 IRS and Treasury deciding to create a, what we call in the 17 business, a rifle-shot in terms of picking up losses of a 18 company that they could acquire? 19 fundamentally violated a portion of the Tax Code, as I said, 20 that had been honored for a couple of decades, which 21 actually changed the result of what happened to Wachovia in 22 finding a home, in my opinion--and others may argue. Which just kind of 23 Any reaction to what I just said? 24 WITNESS BERNANKE: 25 know the facts in that. All I can say is, I just don't But I can say that I have, I have 34 1 no knowledge; I had no inside knowledge, or any other kind 2 of knowledge, of this fact before it occurred. 3 From my perspective, putting aside the very 4 important procedural and legal issues that you raise, it was 5 inconsequential because one way or the other Wachovia was 6 going to get protected. 7 concerned about. 8 9 And that was the thing I was I did not advocate or get involved in any way with the tax decision. 10 VICE CHAIRMAN THOMAS: Well our concern is that 11 in a crisis which we went through, necessity can be the 12 mother of invention, but you'd better come up with a 13 solution coming out the other end that doesn't provide you 14 or embolden you with the opportunity to do what happened 15 again. 16 I know some of my colleagues got pretty 17 frightened when they were presented with the option that you 18 must pass what's on this piece of paper before tomorrow 19 morning or the world as you know it is going to end. 20 You get away with that once, and I'm hopeful that 21 as we continue to move forward you spend a lot of time 22 consulting with those who actually believe they have some 23 role to play, not after the fact but during it. 24 25 Do you have a comfort level now in terms of your ability to communicate with the Legislative Branch that 35 1 perhaps you couldn't do in that crunch timeframe? 2 WITNESS BERNANKE: Yes, certainly with the 3 benefit of time. 4 that I wanted to do. 5 amount of heat for them, and came under a lot of pressure 6 politically and legislatively because of those actions. 7 Clearly these activities were not things The Federal Reserve took an enormous So I would much rather have not have had to do 8 them. And I am very happy to see that we're moving towards 9 a system where there is a well-designed framework for 10 addressing these problems. And I hope that we can make it 11 workable so that we will avoid any such freelancing in the 12 future. 13 VICE CHAIRMAN THOMAS: 14 Mr. Chairman, you have taken a lot of heat. 15 final legislative battle in terms of the legislative 16 product, I think you did pretty well defending your position 17 in the way the final legislation was written. 18 Well just let me say, But in the One last question in terms of comparisons, which 19 are always questions that we wind up trying to examine 20 because we don't know what happened behind closed doors. 21 How was Lehman different from AIG? 22 AIG, capital was locked up in insurance subsidiaries, no 23 buyer. If there was a run on There had to be differences, obviously. 24 What to you were the differences? 25 WITNESS BERNANKE: There was a fundamental 36 1 difference, which was--again, the issue was could we make a 2 loan that was adequately secured? 3 likely to be paid back? 4 That was reasonably Unlike Lehman, which was a financial firm whose 5 entire going-concern value was in its financial operations, 6 AIG was the largest insurance company in America. 7 Financial Products Division, which got into the trouble, was 8 just one outpost of this very large and valuable insurance 9 company. 10 And the And therefore--and in fact that's why they 11 created this, because they wanted to ride on the coattails 12 of the AAA rating of AIG. 13 So unlike Lehman, which didn't have any going- 14 concern value, or not very much, AIG had a very substantial 15 business, a huge business, more than a trillion dollars in 16 assets and a large insurance business that could be used as 17 collateral to borrow the cash needed to meet Financial 18 Products' liquidity demands. 19 20 So that's a very big difference. And indeed, the Federal Reserve will absolutely be paid back by AIG. 21 VICE CHAIRMAN THOMAS: Thank you, Mr. Chairman. 22 I just want to thank you, once again, for in political terms 23 your bravery and willingness to move in the way that you 24 did. 25 Thank you, very much. CHAIRMAN ANGELIDES: Mr. Georgiou? 37 1 COMMISSIONER GEORGIOU: Thank you for joining us 2 today, Dr. Bernanke. 3 prepared testimony, with all respect, I find a less-than- 4 thorough discussion of one area that I think is exceedingly 5 important, which is the erosion of market discipline 6 associated with the creation of the engineered financial 7 instruments that became toxic assets on the balance sheets 8 of our financial institutions. 9 After reading and re-reading your These assets became a significant cause of the 10 liquidity crisis faced by these institutions when they 11 couldn't meet their obligations, either because they 12 couldn't sell the assets without a steep discount and ever- 13 increasing discount, and couldn't borrow against the assets 14 as collateral except with a large and increasing haircut. 15 And of course when they faced collapse, these 16 institutions turned to the American Taxpayer through the 17 Federal Reserve and others to essentially rescue them from 18 their excesses. 19 You have spoken to the deterioration in mortgage- 20 origination standards which, you know, they were problematic 21 to be sure caused in many instances by differential 22 financial rewards to mortgage originators who were paid more 23 to steer borrowers to mortgage products that produced 24 greater returns to the mortgage holders and greater costs to 25 the borrower, which of course resulted in a higher 38 1 likelihood of default by the borrower, but you didn't 2 address what I regard as frequently perverse incentives of 3 the other parties to the mortgage securitization process, 4 all of whom were compensated in cash when the products were 5 created without regard to its success or failure to perform 6 as represented to the investor-owners. 7 The underwriting investment banks legally 8 responsible for the exercise of due diligence on the 9 products, the lawyers who drafted the prospectuses, the 10 accountants who created the accompanying financial 11 statements, the credit rating agencies that rated these 12 securities, all received their fees in cash when the 13 securities were sold, and only if they were sold. 14 So is it any surprise that every participant in 15 the chain opined that everything was in order when we know 16 that it was not? 17 Some 92 to 94 percent of the mortgage-backed 18 securities and their tranches that were created that were 19 rated AAA have now been downgraded, and many of them 20 exceedingly severely. 21 simple mortgage-backed securities, but collateralized debt 22 obligations in which miraculously in a process I've likened 23 to Medieval alchemy, the take the BBB tranches of mortgage- 24 backed securities, which are the first ones to suffer a loss 25 when the borrowers default, and miraculously put them all And we're not speaking here only of 39 1 together and somehow create a security that's not just rated 2 AAA, but Super Senior, and actually essentially sold as a 3 product that cannot fail, but of course fail they did. 4 And then we go to CDO-squared, CDO-cubed, and 5 synthetic CDOs which are creations that are essentially bets 6 on the success or failure of the underlying other 7 securities, when they then have other things to sell. 8 So the financial reform legislation attempts to 9 address some of these problems by prohibiting differential 10 compensation to mortgage originators for steering borrowers 11 to riskier products, and by requiring issuers to hold 5 12 percent of the products they created. 13 Since it seems to me that nothing focuses the 14 mind of Wall Street bankers more than having their own money 15 at risk and their own skin in the game, it is hoped that 16 greater discipline and diligence will be exercised when the 17 creator knows that their own financial future depends on the 18 performance of their creation. 19 So I apologize for such a long intro, 20 Dr. Bernanke, but I would ask you to comment on the 21 initiatives put in place by the Federal Reserve in 22 exercising its responsibility to be the safeguard of the 23 safety and soundness of America's financial institutions to 24 address some of these issues. 25 WITNESS BERNANKE: Sure. I did refer in my 40 1 testimony to the problems with the originate-to-distribute 2 model, which goes all the way from the initial mortgage loan 3 all the way to the securitization, and there were clearly a 4 lot of problems there. 5 We are trying to address them. Although, as I 6 said earlier, we were late in developing mortgage 7 underwriting standards under HOPA, we did in fact in 2007- 8 2008 establish some very strong standards, and I'm sure they 9 will be maintained by the new Consumer Protection Agency. 10 We also have put out--we also have banned--the 11 Federal Reserve has banned yield-spread premiums, which 12 allow lenders to be compensated on the basis of the type of 13 mortgage that they provide. 14 the front end of originate-to-distribute. And so we have tried to address 15 COMMISSIONER GEORGIOU: 16 WITNESS BERNANKE: Right. On skin-in-the-game, I think 17 we all agree that we want to create good incentives, and 18 that is one way to do it. 19 making sure that incentive compensation contracts for both 20 executives and other employees of financial firms reflect 21 appropriately the long-run returns to their activities and 22 not the short-run returns, as you were describing. And the Fed is also involved in 23 The only-- 24 COMMISSIONER GEORGIOU: 25 And how would--if I could just probe you on that, how would you propose to rejigger 41 1 those compensation incentives to reflect the long-term 2 performance? 3 WITNESS BERNANKE: Well we are asking the--since 4 the nature of the business differs across institutions-- 5 we're asking for proposals. 6 show us what they're going to do, and we work with them and 7 make sure we're satisfied. 8 We're asking for companies to But the basic principal is that returns should 9 depend--first of all, they should be risk-adjusted. 10 you take a riskier action, that should be taken into 11 account. 12 So if And secondly, there should be a longer horizon so 13 that, not just whether you made the sale, or made the deal, 14 but rather how did it work out over a number of years. 15 COMMISSIONER GEORGIOU: 16 WITNESS BERNANKE: Right. And so things like nonvested 17 stock, and things of that sort, are ways to achieve that. 18 So that is another step. 19 COMMISSIONER GEORGIOU: And some have suggested a 20 basket--an index based on a basket of the securities created 21 so that you can actually track over time the success or 22 failure of those securities, and compensate people more or 23 less depending on how they perform. 24 25 WITNESS BERNANKE: For capitalism to work, you have to have incentives tied to performance. And I think 42 1 one of the things people are very upset about is the fact 2 that it seems like a lot of people who drove their companies 3 into the ditch walked off with lots of money, and that's not 4 good capitalism, and it's not good for--it's not a good 5 ethical outcome, either. 6 The only comment I would make, though, one thing 7 which is puzzling in a way is that these firms that packaged 8 the securities, whether it was by mistake or not, ended up 9 being pretty exposed to them, and they took a lot of losses 10 in many cases. 11 though they were so exposed to these securitized products, 12 they weren't more careful. 13 And so we have to figure out why, even But that's clearly a key issue. COMMISSIONER GEORGIOU: Well thank you. And I 14 think the answer at the end there is: 15 got caught without being able to sell them all. 16 know, it is a game, to some extent, like when there's 17 musical chairs, the music stops and you're not necessarily 18 finding a seat. 19 some of these institutions. 20 Sometimes they just I mean, you And I think that to some extent happened to Let me turn--I appreciate your considerations, 21 and I encourage you, as you look at these institutions on a 22 go-forward basis, you consider that kind of--those kinds of 23 thoughts as you evaluate their soundness. 24 25 There's some data that we've seen that suggests that the sixth largest U.S. banking organizations, which are 43 1 BofA, JPMorgan Chase, Citigroup, Wells Fargo, Goldman Sachs, 2 and Morgan Stanley, now are actually larger as a result of 3 mergers and the elimination of other institutions than they 4 were even in 2007 just before the height of the crisis. 5 Apparently they are now--they were 58 percent of 6 GDP in 2007, and something like 63 percent of GDP in 2009, 7 which had gone up from 17 percent of GDP in 1995. 8 there's been a consolidation and a growth. 9 So And I guess my question to you would be: Given 10 their increasing size, do you really believe that these 11 institutions would not or would not be allowed to fail by the Fed if they 12 13 got into financial trouble today? I mean, I hope it doesn't happen, but let's just 14 say for the sake of argument that a diminution in some other 15 asset class results in serious stress to both the balance 16 sheet and the liquidity needs of these institutions. 17 really in any better shape today to avoid the bailouts that 18 have been so criticized in the last few years? 19 WITNESS BERNANKE: Are we The Federal Reserve was 20 created, but we're always well within the law, and we always 21 did what was--only exerted our legal powers. 22 changes in the bill that was just passed has, for example, 23 eliminated the ability of the Federal Reserve to lend to an 24 individual institution. 25 And the So I would say--and it also has specified of 44 1 course to the resolution regime how we must deal with a 2 failing systemically critical firm. 3 some midnight session of Congress which rewrites the law, I 4 don't see any way that it would be feasible for the 5 government to bail out a firm in the same way that happened 6 during the crisis. 7 So, you know, barring So it's very important that we make sure that our 8 methods that we do have, the resolution regime, et cetera, 9 that they work. 10 11 And that's something we're very much engaged on. I think it's also very important that we make 12 sure that firms--although we're always going to have big and 13 complicated firms, we want to make sure that they're big and 14 complicated for the right reasons, for good economic reasons 15 and not because they're simply trying to hide behind 16 too-big-to-fail. 17 combination of tougher oversight, additional capital 18 required for a systemically critical firm, tougher 19 resolution regime, and those things are going to take away 20 some of the attractiveness to firms of being too big and 21 will I think help us over time with market discipline to 22 reduce the size and complexity of some of these firms. 23 And my belief is that, again, the COMMISSIONER GEORGIOU: I noted on page 17 of 24 your prepared testimony you did speak to the size of the 25 firms and, in certain respects, the unmanageability with 45 1 2 regard to risk of some of the institutions. I wonder if--some have suggested that they've 3 simply gotten too large. I'm not sure I agree. I 4 understand the notion that we need large institutions to 5 compete in a global marketplace, and to meet the financing 6 needs of large--our own large corporations and other 7 borrowers, but it's not inconceivable and commonly utilized 8 that when a large credit facility is necessary people enter 9 into syndicates. If one bank isn't big enough, somebody, 10 one or two of them take a lead and bring others in. 11 you still end up pulling together the resources necessary. 12 And so You know, we've had some extraordinarily 13 startling testimony in the course of our eight months or so 14 of hearings. 15 Officer, and the Chief Risk Officer of AIG that they did not 16 know that the products sold by the Financial Products 17 Division had provisions in them that, if the AIG's ratings 18 went down, or the tranches that they had insured against in 19 the credit default swaps, the failure of which they'd 20 insured against, went down, that they had collateral calls 21 which were ultimately what brought AIG to the brink of 22 insolvency. We heard from the CEO, the Chief Financial 23 And the same, similar kind of astonishing 24 testimony from Citigroup's then-CEO, Chief Financial 25 Officer, and Chief Risk Officer, that they did not know that 46 1 their banking subsidiary had sold collateralized debt 2 obligations with a liquidity put associated that permitted, 3 if they were downgraded, permitted the holders to 4 essentially put them back to Citibank to the main holding 5 company and get--and they did so. 6 billion and bought this stuff back, which was a third of 7 their then-capital of $75 billion on some $3.3 trillion of 8 assets. 9 In one day they took $25 I mean, these were astonishing risk management 10 failures. 11 couldn't possibly have meant it when they testified here 12 that they didn't know. 13 And some have even speculated that really they But assuming for the sake of argument that they 14 did not know, that really can't--ought not to occur on a go- 15 forward basis. 16 diverse in their product mix that they've become too large 17 to manage? 18 address that from the Federal Reserve's perspective? 19 So are these institutions so complex and so And if that's the problem, then how do we WITNESS BERNANKE: Well it's our responsibility, 20 and the other regulators', to make sure that their 21 management is effective and that they have good risk 22 management system. 23 And if we are persuaded that they cannot manage 24 the risks of the corporation because it's too large or 25 complex, we are able--we have the authority to make them 47 1 divest, or to change their structure. 2 counting the new authority that if a firm is viewed as being 3 systemically risky, that it could be broken up on that 4 ground, as well. 5 And that is not even So we do have some authority there. And in the 6 case, for example, of Citi, which you mentioned, they are in 7 fact--they have created a very substantial portion of their 8 company, put it into a separate structure which is being 9 sold off. 10 So I agree with you that, where there is failure 11 of risk management, or business management, because of size 12 or complexity, it is very important that the firm and the 13 regulators work to address the problem, and I assure you 14 that we will. 15 16 17 COMMISSIONER GEORGIOU: Thank you, very much. If I might, could I reserve two minutes of my time? CHAIRMAN ANGELIDES: You've got one minute and 18 seventeen seconds, but we will graciously grant you the 19 forty-four seconds. 20 COMMISSIONER GEORGIOU: Thank you very much. 21 CHAIRMAN ANGELIDES: 22 COMMISSIONER HOLTZ-EAKIN: Mr. Holtz-Eakin. Thank you, 23 Mr. Chairman, and thank you, Mr. Chairman for spending this 24 time with us today. 25 I guess I would like to follow those who preceded 48 1 me in thanking you for your service during this very 2 difficult period. 3 Reserve for its cooperation with this inquiry throughout. 4 It's really been very helpful. 5 And more generally, to the Federal I don't have a particularly systematic set of 6 questions. 7 want to go back to the trigger that you mentioned, the 8 housing bubble subprime crisis. 9 I have a couple of things I'm curious in, but I You touched on this some in your written 10 testimony, but could you just walk us through your 11 view of the causes of the housing bubble? 12 interested in the points of recognition within the Federal 13 Reserve when we had a housing bubble, and sort of what your 14 policy options were in light of that. 15 WITNESS BERNANKE: And I'm So bubbles by their very 16 nature are extremely difficult to understand, even after the 17 fact. 18 The house prices began to increase fairly rapidly 19 in the middle to late '90s. 20 accelerated to some extent in the early 2000s, and then 21 peaked in 2005-2006. 22 My own view is that there are many factors that 23 contributed to that. 24 think are important. 25 And then of course they In my testimony I discussed two that I One was the interaction of expectations and 49 1 optimism on the one hand, and innovation and mortgage 2 instruments on the other. 3 willingness on the part of lenders to make loans to people 4 who were really not qualified on the expectation that 5 appreciation in the value of their homes would allow them, 6 by giving them more equity, would allow them to refinance 7 into more standard instruments. 8 What you saw was an increased And what we saw as the crisis progressed was 9 increasingly sketchy instruments that had, if they had even 10 existed prior, had been reserved only to very limited groups 11 of customers. 12 house before using Option ARMs, and Interest Only, and other 13 complex mortgage instruments whose primary purpose was to 14 bring the monthly payment to as low a level as possible. 15 And again, that worked okay as long as prices But now you had people who had not bought a 16 were rising. 17 And once they stopped rising, the whole process unwound. 18 I think that was very important. 19 Shiller have pioneers in identifying those issues. 20 But of course prices couldn't rise forever. So And people like Bob Another factor which I have talked about since 21 2005 is the so-called "global saving glut." All that really 22 means is that, for a variety of reasons--and the timing here 23 works well--going back into the '90s the U.S. has been a 24 major recipient of global capital flows, and a lot of those 25 capital flows have gone into relatively safe fixed-income 50 1 instruments like mortgage-backed securities, or securitized 2 credit products. 3 That includes not only the excess savings from 4 Asia, emerging markets, and oil producers, but also even the 5 gross savings from Europe and other places that have been 6 looking for those kinds of instruments. 7 And so that demand both reduced mortgage rates, 8 reduced spreads, and gave investment houses in the U.S. and 9 elsewhere an incentive to create these new products, the 10 alchemy that Mr. Georgiou was talking about, taking 11 uncertain mortgages and by restructuring them creating these 12 tranches of so-called AAA Senior, Super Senior debt, et 13 cetera. 14 So I think that was probably important. 15 The controversial issue, because it matters so 16 much for the future of how monetary policy is conducted, is 17 what role did monetary policy play? 18 conventional wisdom about this. 19 answer is: 20 was. And there's a lot of And I think the only honest We really don't know exactly how big the role 21 But I have tried to give some arguments why I 22 think that the view that monetary policy was a principal 23 cause is not supported by the evidence, and I can repeat 24 that if you'd like, but very briefly there was the fact that 25 the previous relationships between monetary policy and 51 1 housing prices don't look remotely like what they would have 2 had to have been in order to account for the increase in 3 house prices in the recent episode. 4 Cross-country, we don't see any relationship 5 between monetary policy and housing prices. 6 think even if there had been some relationship, it would 7 have been very questionable that we should have, you know, 8 substantially raised interest rates in the situation in 9 2003-2004, given what was happening in the macro economy as 10 And finally, I an attempt to try and close off the housing bubble. 11 My strong preference--and I said this in my very 12 first speech as a Governor in 2002--was that we should use 13 supervision and regulation to approach bubbles. 14 do that-- 15 COMMISSIONER HOLTZ-EAKIN: 16 WITNESS BERNANKE: 17 able to do that. 18 We didn't Thank you. --going forward we need to be And that's very important. On the Fed's views, the Fed has taken criticism 19 for not, quote, "recognizing the obvious," et cetera. We 20 always of course knew the house prices were rising quickly, 21 but as of 2003-2004 there really was quite a bit of 22 disagreement among economists about whether there was a 23 bubble, how big it was, whether it was just a local or a 24 national bubble. 25 factor. So we were certainly aware of that risk 52 1 But, you know, frankly we--by the time it was 2 evident that it was a bubble and that it was going to create 3 risk to the financial system, it was rather late to address 4 it through monetary policy. 5 COMMISSIONER HOLTZ-EAKIN: So if you rolled the 6 clock forward then, and we get into the subprime mortgage 7 crisis, there's a point at which I believe you say it will 8 be contained and not spill over. 9 fingers, I'm just curious, what was the basis of that 10 judgment? 11 it obviously did. 12 And without pointing And what were the things you didn't know--because WITNESS BERNANKE: So this was related to, in 13 fact the thinking was that if house prices did come down 14 some, and that 25-30 percent was not what people were 15 contemplated, but if they did come down some, that the 16 economy could manage that okay. 17 And when I said what I said, it was based on the 18 observation that even under very bad scenarios, the total 19 losses in subprime adjustable rate mortgages, for example, 20 were unlikely to be more than say $300 or $400 billion, 21 which is a lot of money obviously, but compared to global 22 financial markets where there's $60 trillion of equity value 23 in markets around the world, it was just a very small amount 24 of money. 25 So the loss of $3- or $400 billion of equity 53 1 value would do almost nothing to the world economy. 2 But what happened here was that the financial 3 system had these vulnerabilities and weaknesses, which I 4 talked about in my longer testimony, and what was a 5 relatively small factor in the scheme of things triggered 6 these weaknesses and led to a much bigger crisis. 7 And so what I did not recognize when I thought 8 and said that this crisis was contained was that it was 9 based on my view that the losses were going to be, you know, 10 manageable. What I did not recognize was the extent to 11 which the system had flaws and weaknesses in it that were 12 going to amplify the initial shock from subprime and make it 13 into a much bigger crisis. 14 COMMISSIONER HOLTZ-EAKIN: 15 to the crisis, I want to talk a little bit about 16 too-big-to-fail institutions in both the history we have to 17 investigate, and then going forward. 18 And so if we then move So as it sort of bleeds into the broader 19 financial markets, what institutions are you watching 20 carefully? 21 that you really are worried about? And by what criteria are you selecting the ones 22 WITNESS BERNANKE: You mean today? 23 COMMISSIONER HOLTZ-EAKIN: At the time. You 24 know, as the crisis begins to unfold, what was the nature of 25 the Fed's criteria for identifying institutions that they 54 1 needed to be on watch against? 2 WITNESS BERNANKE: Well, again, to begin with 3 it's important to remember that the Fed was not a systemic 4 regulator at that time. 5 We had some very specific responsibilities for 6 bank holding companies, principally. 7 responsibilities for AIG, or for the investment banks, or 8 for Fannie and Freddie, or for mortgage bankers. 9 the areas where there were problems, we simply did not have 10 We did not have So many of an ongoing authority or supervisory presence. 11 And so we did not get heavily involved in any of 12 those situations until well into the crisis when, say, maybe 13 around the time of Bear Stearns when it was evident that 14 some important financial institutions were under a lot of 15 stress. 16 some extent the FDIC and other agencies, were then coming 17 together to try to think about how to address them. 18 And at that point, the Fed, the Treasury, and to So we came rather late to some of these firms. 19 And that was simply the nature of our responsibilities and 20 our authorities. 21 In terms of which firms to pay attention to, 22 there are multiple criteria. Certainly size is important. 23 But size is by far not the only criterion. 24 Bear Stearns was not that much larger than WaMu for example- 25 - For example, 55 1 COMMISSIONER HOLTZ-EAKIN: 2 WITNESS BERNANKE: Right. --but Bear Stearns was a much 3 more complex firm. 4 repo market--that is, in the short-term money market--and in 5 securities lending, and other short-term financing. 6 a large derivatives book. 7 It had a large presence in the triparty It had So it was very interconnected. The nature--a very important aspect of the crisis 8 was a rolling panic: the notion that as confidence was 9 lost, firms that were vulnerable from a liquidity point of 10 view came under increasing attack. 11 via the Stock Market, the declines in stock prices reduced 12 confidence, et cetera, as well. 13 And in some cases also It was our view that the failure of Bear Stearns, 14 for example, would lead to some of the same effects we saw 15 with Lehman six months later. 16 repo markets; problems in the commercial paper market, other 17 money markets; and that those short-term liquidity stresses 18 would feed over into other firms, even those firms that 19 didn't have direct counterparty relationships with Bear 20 Stearns. 21 That is, huge stresses in the So it was those criteria: 22 Interconnectedness. 23 critical functions. Complexity. Size. And also performance of 24 So, for example, banks like JPMorgan and Wachovia 25 had very important roles in various payments and settlements 56 1 and other infrastructure-type aspects of the financial 2 system, and that was an additional consideration as we 3 looked at these firms. 4 COMMISSIONER HOLTZ-EAKIN: Thank you. I don't 5 want to put words in your mouth, but when we talked 6 yesterday with former Under Secretary Steel about this, it 7 really appeared that in the crisis what mattered most was 8 not size, interconnectedness, complexity, but which markets 9 were showing signs of distress and panic. 10 And if firms were in that market, that was the criteria for intervention. 11 And the reason I wanted to push this is, in the 12 sort of new legislation there's a whole lot of ex-ante sort 13 of thinking about who is going to be the systemically 14 important institutions, which it doesn't appear that you 15 could anticipate because you don't know the markets that 16 will be distressed. 17 Do you think that's a fair concern? 18 WITNESS BERNANKE: Well it is a fair concern. 19 The legislation requires us to identify systemically 20 important institutions for the purposes of oversight, but I 21 don't believe that you have to be pre-identified as 22 systemically important for the resolution regime to apply to 23 a firm. 24 25 I think that's a decision that's made at the time. 57 1 COMMISSIONER HOLTZ-EAKIN: Okay, but how then 2 could they prepare a living will if they have not been 3 identified as someone who should be resolved? 4 WITNESS BERNANKE: Well I think that for firms 5 that are on the cusp, if you will, I think prudence might 6 have us work with them on these issues in any case. 7 that would be important for complex firms. 8 But you raise an important point. 9 COMMISSIONER HOLTZ-EAKIN: 10 11 I think I'm just trying to figure out how this works. The second question I have--this is a slight 12 tangent--but on the living will, I'm just wondering how you 13 think about this, is we relied in the past on systems of 14 internal risk assessment as a substitute for direct 15 measurement of the risk exposures of firms because they were 16 too complicated for us to do an assessment of the risk, so 17 we wanted to make sure they had good systems. 18 If firms are too difficult to resolve, can we 19 rely on their plans for resolving themselves if we don't 20 understand how to do it? 21 It sounds like the same thing. WITNESS BERNANKE: They have to come up with the 22 plan, but then we have to--so they are better placed than we 23 are to figure out the best way to unwind the firm. 24 have to take the responsibility, with their cooperation, of 25 assuring ourselves that it is a workable plan. But we And the 58 1 responsibility for that is the Fed, the FDIC, and whatever 2 other regulator is relevant. 3 together a lot of expertise and try and figure that out. 4 And so we are going to put At the Fed, one of the lessons we have taken from 5 the crisis is that we really need to take a much broader, 6 more multi-disciplinary approach. 7 finance people, more economists, more payments' people, more 8 lawyers, more accountants, to supervise--to supplement the 9 supervisory activities and make sure we really have the 10 We need to bring in more breadth of perspective that we need to get this done. 11 COMMISSIONER HOLTZ-EAKIN: Okay. So, sorry to 12 jump back and forth, but going back now to as the crisis 13 unfolded and the Fed's decisions about where to actually 14 intervene with institutions, I want to ask again about 15 Lehman versus AIG, just for thinking about the criteria for 16 intervention. 17 you said about AIG, that it was easy to make a loan in that 18 case, and I guess I just want to walk through the logic of 19 that. 20 And what I'm not sure I understand is what Because you said you didn't want to loan to 21 Lehman because you would be lending into a run, and that 22 they didn't have sufficient assets and you wouldn't get 23 repaid. 24 25 AIG had no buyer, so it looked a lot like Lehman in that regard. There was clearly a run, a liquidity run. 59 1 And you did ultimately lend into it. 2 back and lend a lot more in short order. 3 like you both lent into the run and stopped it; it looked 4 like it continued, to me. 5 And indeed, had to go So it didn't look And what I'm confused about is your assessment of 6 the ability to get repaid. 7 this could be wrong--is that a lot of the assets they had 8 were not available as collateral for loans; they would be 9 locked away in the insurance divisions in the firm. 10 11 12 13 Because my understanding--and And so what is the difference in the thinking about Lehman versus AIG and the nature of Fed intervention? VICE CHAIRMAN THOMAS: Mr. Chairman, I yield the gentleman two additional minutes to cover the answer. 14 COMMISSIONER HOLTZ-EAKIN: 15 WITNESS BERNANKE: Thank you. So first, both of them bet the 16 criterion for us trying to save them if at all possible. 17 They both were systemically critical. 18 completely separate business, an ongoing business, that had 19 a going-concern value. 20 But AIG had a It had a lot of shareholder equity. It had subsidiaries that we're seeing now that 21 they're trying to sell off that have substantial value. And 22 so it was our assessment that they had plenty of collateral 23 to repay our loan--because it was in a separate business 24 that did have a lot of going-concern value and did have a 25 lot of assets. 60 1 Now it is true that in the fourth quarter they 2 lost more money than any company in history, like $62 3 billion, and that made things much more difficult, and 4 therefore required some additional help from the Treasury in 5 terms of capital, et cetera. 6 But I think at the time that we made that 7 decision, the problems with AIG didn't relate to weaknesses 8 in their insurance businesses, it related very specifically 9 to the losses of the Financial Products Division. The rest 10 of the company was, as far as we could tell, was an 11 effective, sound company with a lot of value, and that was 12 the basis on which we made the loan. 13 COMMISSIONER HOLTZ-EAKIN: So the calculation is, 14 you can lend into the run at AIG and stop it eventually-- 15 perhaps it took longer than you thought-- 16 17 18 WITNESS BERNANKE: As long as they have enough collateral to-COMMISSIONER HOLTZ-EAKIN: --and there's no 19 capital hold on an ongoing concern, but the same is not true 20 for Lehman? 21 WITNESS BERNANKE: Lehman did not have enough 22 collateral in terms of financial assets, and its going- 23 concern value was tied up completely in its financial 24 operations. 25 or other business, that provided additional value and It didn't have a separate business, insurance 61 1 protection. 2 COMMISSIONER HOLTZ-EAKIN: Well, last question, 3 and just briefly. What would be different now--Bear, 4 Lehman, AIG--with the new authorities of the Fed? 5 that have played out if you had had the authorities you have 6 now? What would you have done in each case? 7 WITNESS BERNANKE: 8 remember Bear was acquired by JPMorgan-- 9 10 How would Well, in the case of Bear, COMMISSIONER HOLTZ-EAKIN: But it was a subsidized acquisition. 11 WITNESS BERNANKE: A subsidized acquisition. 12 Maybe the existence of this resolution regime might have 13 changed the bargaining position somehow. 14 COMMISSIONER HOLTZ-EAKIN: 15 WITNESS BERNANKE: Okay. So if we could have gotten 16 them acquired, I think that would have been the first 17 choice. 18 But without any kind of subsidy. Barring that, I think in all three cases they 19 would have been appropriate candidates for the application 20 of this regime and we would have supported that. 21 COMMISSIONER HOLTZ-EAKIN: And so in particular 22 AIG, a firm you assessed to be a healthy, ongoing concern, 23 would have been resolved? 24 25 WITNESS BERNANKE: I don't see what the alternative would have been, unless we could have somehow 62 1 stopped the run through some kind of cheery words of some 2 kind. 3 4 I don't know how to do that. COMMISSIONER HOLTZ-EAKIN: out, let me know. Thank you. 5 WITNESS BERNANKE: 6 (Laughter.) 7 CHAIRMAN ANGELIDES: 8 COMMISSIONER GRAHAM: 9 10 If you figure that I'll let you know. Senator Graham. Thank you, Mr. Chairman, and thank you, Mr. Chairman, for your excellent insights today. 11 I'll have to say it seems to me that we sort of 12 have three options in looking at this issue of what to do 13 when the too-big-to-fail institutions get in trouble, one 14 which the legislation has provided apparently as a somewhat 15 neater and cleaner funeral service as to how to bury the 16 body. 17 The others are steps that might be taken to keep 18 the institution healthy, such as the kind of more rigorous 19 oversight and regulation that you have discussed. 20 Or, the third option, might be the option of the 21 late 19th and early 20th Century with a similar situation. 22 And that is, to try to change the basic structure of the 23 too-big-to-fail institutions. 24 25 Beginning shortly after the Civil War, the growth of the commercial and industrial trust became a source of 63 1 concern. And at both the federal and the state level there 2 were a number of efforts made to try to contain their more 3 predatory policies. 4 Finally, people despaired of that, and then in 5 the early 20th Century they moved towards breaking up the 6 trust as the only way to keep them from fundamentally 7 damaging our capitalist system. 8 9 Apparently this legislation has decided that is not going to be the option that we will use, and in fact the 10 statistics are that these institutions are growing rapidly 11 as an even more dominant force within our economy. 12 You indicated some optimism about the ability to 13 supervise these institutions, and you stated that there will 14 be indicators that will indicate--that will be indicative of 15 whether this more strenuous regulation is accomplishing its 16 intended purpose. 17 I will have to say I am not that optimistic. 18 First, I'm not optimistic domestically. 19 decades, the American People have elected governments, both 20 Republican and Democratic, which have tended to support 21 looser and looser standards of regulation. 22 significant occurred during a Democratic Administration. 23 For the last three Some of the most At the international level, we see the influence 24 of these largest institutions. It's been reported currently 25 that in Basel that the Committee is under a great deal of 64 1 pressure to weaken the standards for collateral and 2 liquidity that had originally been proposed. 3 So what is your--what is the basis of your 4 optimism that domestically there is the political will for 5 sustained stronger supervision; and that there will be 6 international support for that kind of effort, so that 7 stronger supervision at home is not seen as a means of 8 neutering our ability to be an effective competitor in the 9 global financial markets? 10 WITNESS BERNANKE: Well, Senator, you've raised 11 some good issues there. 12 political will, there is probably no solution that is 13 sustainable. 14 I think if there's a lack of I think that the combination, as I said before, 15 ideally we would like to see firms restructured in a way 16 that makes economic sense, and that is consistent with 17 market forces. 18 principle, would be to combine tough oversight and 19 regulation, including such things as surcharges for--capital 20 surcharges for firms that are systemically critical, which 21 would both make them safer but also make it more onerous to 22 be a systemically critical firm. 23 resolution regime, or similar things that create more market 24 discipline. 25 this may not happen; but I think we should try to work to And the best way to do that, at least in Combine that with the And in principle--and of course I recognize 65 1 make it happen--in principle that would give firms the 2 incentives to break up, restructure, and change their form 3 in ways that will respond to the market, respond to the size 4 and complexity, which is what is really needed, and 5 eliminate the incentive to become big, just to become too 6 big to fail. 7 Now you said that the bill doesn't give us the 8 authority. In fact, it does give us the authority if we 9 despair of these other methods and we believe that a firm 10 is, its size and complexity is dangerous. 11 living will requirement, but in addition we also have the 12 authority of the regulators collectively to break up firms, 13 if necessary. 14 We have both the You may ask if there is political will to do 15 that? 16 certainly that is the charge that Congress has given the 17 regulators, and we take very seriously that charge. 18 And I don't know the answer to that question. But So I think we have put in place some reasonable 19 approaches, but I certainly appreciate your historical 20 perspective which says of course that over the long run you 21 have to take into account the political influence of these 22 large institutions. 23 I think that is an issue. COMMISSIONER GRAHAM: Well, and in terms of the 24 will of the institutions themselves, there has been quite a 25 division in American industry. Some industries have adopted 66 1 levels of self-regulation which have provided a defense-in- 2 depth against unacceptable behavior. 3 For instance, the nuclear power industry has 4 developed some very impressive processes within the 5 industry, nongovernmental, for best practices and 6 enforcement of those best practices. 7 On the other hand, the deep-water oil and gas 8 drilling industry has had almost none of that, and we have 9 just seen one of the manifestations of the failure to have 10 any kind of internal controls. 11 Is there any indication that within the financial 12 community, are they more like the nuclear power industry? 13 Or are they more like deep-water drilling in terms of their 14 indicated willingness to provide defense-in-depth by their 15 own actions? 16 WITNESS BERNANKE: Well it's an interesting 17 question. 18 analogies, there was a lot of self-regulation in the 19 financial industry. 20 Historically, again to go back to the historical There was a time when the principal regulatory 21 agency was the clearinghouse of the banks themselves within 22 a city, and they monitored the health and stability of the 23 other banks because they recognized if one bank failed that 24 they were at risk as well. 25 Clearly we have gone a long way away from that 67 1 model, and we are now primarily in a government regulatory 2 model. 3 And I think that is the dominant factor. I hope, again, though, that regulation itself is 4 not going to be adequate. We need to have market 5 discipline. 6 to manage their own risk, to take their appropriate 7 decisions based on the market signals and the incentives 8 that they are receiving. We need to have incentives in place for firms 9 And it's the combination of those two things that 10 I see as having the best chance of managing the risk in this 11 sector. 12 really at the nuclear power type of model at this point. 13 14 15 But it is, I think--you know, I don't think we're COMMISSIONER GRAHAM: Mr. Chairman, could I have two additional minutes for a question? CHAIRMAN ANGELIDES: How could I say no to you? 16 Two minutes for the Senator in the deliberative body with no 17 time limits. 18 (Laughter.) 19 COMMISSIONER GRAHAM: I was very intrigued with 20 your statement that there are going to be some indicators, 21 some markers of whether this more rigorous supervision is 22 accomplishing its objective. 23 What would you put down in the vertical column as 24 the--what are those indicators, particularly that have some 25 capacity to be quantified, that you'll be looking at to 68 1 answer the question: 2 Is the tougher regulation working? WITNESS BERNANKE: Well certainly one important 3 set of indicators relates to the cost of capital for these 4 firms. 5 source of their market advantage will be eliminated. 6 If they're not too big to fail, then an important So for example you would expect to see wider risk 7 spreads, or higher CDS spreads, reflecting the increased 8 conviction of the market that they could fail; and that 9 those spreads should be more responsive to market 10 11 developments. So that would be one set of things. And then we 12 could also look at things like return-on-equity, which 13 should not be artificially increased by too big to fail 14 characteristics of the firm. 15 COMMISSIONER GRAHAM: And do you see the Fed 16 developing this report card of indicators and periodically 17 making it available to the public so that there will be the 18 capacity for continued public monitoring of how well the 19 supervisory system is functioning? 20 WITNESS BERNANKE: Well some of the indicators I 21 just suggested are already obviously public, and anyone can 22 look at them. 23 We have developed--we are well along in 24 developing a quantitative surveillance mechanism which will 25 be looking at a whole variety of financial and other 69 1 indicators of individual firms, and using them as a 2 supplement to the on-site supervision that the supervisors 3 do. 4 I am not sure yet, you know, in what form we will 5 communicate this information to the public, but we certainly 6 want to make sure the public is confident that firms are 7 safe and sound. 8 that effectively. 9 So we will try to find ways to communicate COMMISSIONER GRAHAM: Well, just to conclude, 10 going back to the importance of the public seeing that this 11 is not only in their individual interest but also in the 12 broader societal interest to have effective regulation so we 13 reduce the likelihood of firms getting into the extremis 14 situation where you have to plan the cleaned-up funeral, I 15 believe that keeping the public informed is a critical 16 element of building that support. 17 make this as communicative and as publicly available as 18 possible. 19 WITNESS BERNANKE: 20 COMMISSIONER GRAHAM: 21 CHAIRMAN ANGELIDES: 22 25 Thank you. Thank you. Thank you, Senator. Mr. Thompson. 23 24 So I would urge you to COMMISSIONER THOMPSON: Chairman. Thank you very much, Mr. It's out of order today. CHAIRMAN ANGELIDES: I didn't realize that. It's a little switch-up, you 70 1 know, last session. 2 COMMISSIONER THOMPSON: Keep us all on our toes. 3 Thank you, Dr. Bernanke, for joining us. While 4 this hearing is about too big to fail, I would like however 5 to go back to the broader issue of the crisis, if I might. 6 So would you describe for us the role that the 7 Federal Reserve plays in monitoring or managing credit 8 standards in our country? 9 WITNESS BERNANKE: Well as I mentioned earlier, 10 the Federal Reserve has had a role in consumer protection. 11 So we have created rules, for example, on required 12 documentation; escrow accounts; and other standards of 13 underwriting that would apply to mortgages. 14 The other main area that I can think of is, like 15 other bank regulators, we want to make sure that banks-- 16 while it's their decision what kind of risk to take, and 17 what loans to make--that they are adequately capitalized in 18 order to deal with any losses that might occur. 19 And so we are pressing for, on the one hand, 20 strong risk-sensitive capital standards which will tie the 21 amount of capital that banks have to hold to the risk of the 22 loans that they make, and therefore if they make a riskier 23 loan they need to hold more capital, and they have to judge 24 for themselves whether economically it makes sense to do 25 that. 71 1 And we also want to continue to work with the 2 accountants and the SEC and others to make sure that banks 3 have adequate reserves against losses. 4 So by providing adequate capital and reserves, 5 banks have I think the right incentives to make adequate 6 loans. 7 interesting idea, some countries, the authorities actually 8 intervene in things like loan-to-value ratios, down- 9 payments, and things of that sort. We don't generally--some countries, and it's an You know, we haven't 10 done that in this country, but I think we ought to look 11 broadly at how we might ensure that we don't have a system 12 where credit gets too easy in the boom and too tough in the 13 downturn. 14 COMMISSIONER THOMPSON: In your written testimony 15 you commented about the innovation that occurred in the 16 market, primarily around originate-to-distribute model and 17 what have you, which clearly was facilitated by lax lending 18 standards. 19 Could the Federal Reserve not have stepped in as 20 it saw this model being developed in this innovation really 21 putting the economy at risk? 22 WITNESS BERNANKE: Well as I've said, I think we 23 bear some responsibility there. 24 two areas. 25 And I think primarily in The first was in the underwriting standards and 72 1 the application of the HOPA regulations. 2 again acknowledging the concern, you know one of the 3 problems there was that, although the Federal Reserve had 4 the authority to write rules, we had no enforcement 5 authority. 6 The problem there, We would have had to rely on state and other 7 regulators to enforce those rules. And it was partly 8 because we weren't supervising these firms that we didn't 9 see what was going on quite as clearly that we didn't 10 respond as quickly as we should have. 11 important failure, as I've agreed many times. 12 But that was an The other area where both we and other bank 13 supervisors I think should have been more effective was in 14 risk management more generally. 15 enough information about what the brokers were doing on 16 their behalf, what kinds of standards they were applying. 17 The firms did not have They didn't know their own exposures to subprime 18 and other types of mortgages. 19 relied too heavily on the credit rating agencies who 20 themselves had flawed models that ignored correlated risks 21 across housing prices across parts of the country. 22 As was pointed out, they So I think those were the two areas where the Fed 23 could have--the Fed and other bank regulators--could have 24 done more. 25 second was just in the general risk management of the firms One was at the underwriting level, and the 73 1 to understand their exposures both in terms of their own 2 losses, but also their reputational and operational risks 3 that they were taking as they were packaging these 4 mortgages. 5 COMMISSIONER THOMPSON: Given my background the 6 technology business, I have an appreciation for the value of 7 innovation, and I have an even stronger appreciation for the 8 role that technology plays in the financial services sector, 9 perhaps the largest consumer in technology as a sector in 10 our economy. 11 Given that, and given the role of innovation in 12 that sector, what more should be done to manage the 13 innovation process within the financial services sector in 14 such a way that it doesn't create a systemic risk to the 15 economy? 16 WITNESS BERNANKE: I think one of the lessons of 17 the crisis is that innovation is not always a good thing. 18 There are innovations that have unpredictable consequences. 19 There are innovations whose primary purpose is to take 20 unfair advantage, rather than to create a more efficient 21 market. 22 And there are innovations that can create 23 systemic risks even if from the perspective of the 24 individual firm, you know, that risk is not evident. 25 So I'm not sure I would go so far as to say we 74 1 need to have sort of a new product-approval safety 2 commission, or something like that--although the CFPB will 3 do some of that I'm sure. 4 But the new Financial Stability Oversight 5 Council, for example, ought to pay close attention to 6 financial innovations and regulators. 7 risk management and the systemic consequences of these 8 decisions, we need to be assertive if there are developments 9 that we find either counterproductive from the perspective As we look at the 10 of consumer protection, or systemically risky. 11 ought to intervene there. 12 COMMISSIONER THOMPSON: I think we You made a comment in 13 your opening statement about your long-standing background 14 as a student of financial markets and financial crisis. 15 oftentimes in a crisis leaders are asked to do things 16 they've never had to do before. 17 asking for forgiveness, as opposed to permission. 18 And Oftentimes that means In hindsight, would you have preferred now to 19 have asked for forgiveness and done something to save Lehman 20 in such a way that this crisis would not have unfolded the 21 way it did in our economy and our country? 22 WITNESS BERNANKE: You know, it's really hard to 23 know what would have happened. I mean, one possible 24 scenario is that we would have--I mean, the only we could 25 have saved Lehman would have been by breaking the law, and 75 1 I'm not sure I'm willing to accept those consequences for 2 the Federal Reserve and for our systems of laws. 3 don't think that would be appropriate. 4 I just So I wish we had saved Lehman, but--and we tried 5 very, very hard to do so, but it was beyond our ingenuity or 6 capacity to do it. 7 creative, but I'm not willing to-- 8 9 10 And I don't think--I'm willing to be COMMISSIONER THOMPSON: But you did see it coming. WITNESS BERNANKE: We saw there were a lot of 11 risks in Lehman and other companies as well, but the actual 12 failure was not preordained. 13 hopeful, maybe too hopeful, even up to the last day, that we 14 had two potential acquirers-- 15 I mean, for example we were COMMISSIONER THOMPSON: 16 the consequences of their failure. 17 consequences. 18 My reference was more to You saw the You predicted that. WITNESS BERNANKE: I was personally convinced. 19 And I guess I would add that, you know, in our decision to 20 rescue AIG I sort of gambled--I sort of--I was sort of 21 taking a risk that, you know, it could have happened, I 22 suppose, that after a few days of market upset that the 23 market would have digested the Lehman event and people would 24 have said, well what the hell were you doing with AIG? 25 In fact, I was very, very confident that Lehman's 76 1 demise was going to be a catastrophe, and I knew AIG's 2 demise would be a catastrophe, and therefore I did whatever 3 I could to prevent that. 4 COMMISSIONER THOMPSON: So there was no way in 5 our system that someone with your perspective and insight could 6 have even influenced the White House to say, we cannot let 7 this happen? 8 9 WITNESS BERNANKE: The White House was well informed, and they were very supportive as--both the 10 previous Administration and the new Administration were very 11 supportive. 12 we could not find a way to do it. 13 We thought of all kinds of creative things, but And, you know, again, I'm not prepared to go 14 beyond my legal authorities. 15 appropriate. 16 17 18 19 20 21 I don't think that's COMMISSIONER THOMPSON: CHAIRMAN ANGELIDES: Mr. Wallison. Thank you, Mr. Thompson. I'm just full of surprises today. COMMISSIONER WALLISON: Yes. This is called Chairman's discipline. COMMISSIONER WALLISON: 23 CHAIRMAN ANGELIDES: 25 Thank you very much. 22 24 Understood. something simpler: Prerogative. It's called actually working from the outside in today. COMMISSIONER WALLISON: Like market discipline by 77 1 the Chairman. 2 (Laughter.) 3 COMMISSIONER WALLISON: 4 Okay, thank you very much, Mr. Chairman, and thank you for coming Mr. Chairman. 5 I would like to explore something called the 6 discount window a little bit. My understanding of the 7 purpose of the discount window for banks is that it is an 8 opportunity for a bank to take assets that are not liquid 9 and provide them as collateral to the Fed, and the Fed in 10 turn monetizes them in effect and the bank can then use that 11 cash to meet its obligations. 12 One of the purposes of it is to address--deal 13 with runs. 14 solvent it can present collateral, including loans, which 15 are illiquid to the Fed, and if the Fed judges that those 16 loans have some value, giving them an appropriate discount, 17 it provides cash to the bank to meet the loans--to meet the 18 obligations. 19 When a bank is facing runs, assuming that it is The fact that the Fed is doing that is very 20 influential with the market. That is to say, people say, 21 well, as long as I can make these withdrawals--that is, in a 22 run--and the cash is always there, and the Fed has been 23 lending the money, the Fed must think they're solvent, and 24 that would be the only circumstances under which you would 25 do that, then the run is supposed to sort of come to an end. 78 1 That's the theory. The market is quite satisfied 2 that the cash is always going to be there. There's no point 3 in continuing to run and take cash out of the bank. 4 Now Wachovia is an interesting case, because as 5 far as I can understand the only thing that was considered 6 for Wachovia--which again I would like your judgment on this 7 of course--the only thing that was considered for Wachovia 8 was an acquisition. 9 we understand it, was solvent but was subject to liquidity 10 problems. 11 Whereas, Wachovia, at least as far as That is to say, there were runs. Why was it, then, that as an alternative Wachovia 12 was not able to use the discount window? 13 WITNESS BERNANKE: Well they were allowed to use 14 the discount window. 15 perhaps I could come back with more information subsequent 16 to this hearing. 17 serious, and they were--it was their judgment that they were 18 not going to be able to open up within a day or two. 19 thought that the liquidity drains were such that they could 20 not meet them even with the discount window. 21 COMMISSIONER WALLISON: 22 judgment? 23 this? 24 25 And you raise a good question, and But their liquidity drains were quite They This was Wachovia's They were the ones who said we cannot survive WITNESS BERNANKE: Confirmed by the Richmond Federal Reserve Bank. 79 1 COMMISSIONER WALLISON: Okay. So it wasn't that 2 they were--anyone considered them to be insolvent? 3 simply a matter of their view, Wachovia's view, that they 4 could not survive this run even if they were able to provide 5 collateral to the Fed? 6 WITNESS BERNANKE: It was I think there was uncertainty 7 about whether they were solvent or not, because even though 8 they had regulatory capital, that capital was not very risk- 9 sensitive. And what drove--I think what initiated the run 10 on Wachovia was the failure of WaMu, which had mortgages 11 that were similar quality, similar type to those that 12 Wachovia had. 13 So part of my problem here is I don't recall 14 exactly the discussion, and I would like to get back to you 15 on that. 16 COMMISSIONER WALLISON: 17 WITNESS BERNANKE: 18 COMMISSIONER WALLISON: I'd like you to do that. But your point is well taken. All right, then let's 19 move from there to the Lehman case, because the Lehman is 20 slightly different in one sense. 21 the media had said that the Fed had given investment banks 22 access to the discount window, that was not exactly true, as 23 I understand it from a discussion I had with Mr. Baxter 24 yesterday. 25 And that is that, although What was done was that under 13.3, your special 80 1 powers to deal with serious financial consequences, it 2 enabled you to make available to investment banks funds from 3 the Fed for which you would be getting some kind of 4 collateral. 5 Now we were told by Mr. Fuld yesterday, and 6 nobody really disagreed with this, that Lehman was solvent. 7 Lehman had plenty of assets. 8 subject to a run. 9 to put words in his mouth when he responded--but my question It was solvent. It was And my question to him--and I'm hesitant 10 to him was: 11 with Lehman as it does with the discount window for banks, 12 as a matter of law? 13 illiquid assets, as long as we put a value on them, and we 14 will monetize them. 15 meet this run. 16 Well, why couldn't the Fed do the same thing And that is, we'll take all of your We will provide the cash so you can And Mr. Baxter said to me that there is a way for 17 the Fed to do that, but only if the Fed Board adopts a 18 resolution of some kind which changes the nature of what 19 they normally do under 13.3 to make it more like, if you 20 will, the discount window. 21 assets that are not liquid and use them for the purpose of 22 making a loan to an institution that is suffering a run. 23 That is to say, they can take Now you said that you were willing to do anything 24 to save Lehman. Is Mr. Baxter correct? Could the Fed Board 25 have adopted a resolution that said we will take any good 81 1 assets that Lehman has and we'll monetize them? 2 provide liquidity so that Lehman can continue to meet the 3 withdrawals, or the runs that people are referring to? 4 WITNESS BERNANKE: We'll So Lehman Brothers had a 5 holding company and it had a broker-dealer. 6 COMMISSIONER WALLISON: I'm talking about only 7 the holding company. I should have made that clear. 8 only talking about the holding company. 9 WITNESS BERNANKE: I'm All right, just for everyone's 10 information, the holding company--sorry, the broker-dealer 11 was eligible to borrow-- 12 COMMISSIONER WALLISON: 13 WITNESS BERNANKE: Right. --from an existing facility, 14 the Primary Dealer Credit Facility, and it was allowed to do 15 so. 16 COMMISSIONER WALLISON: 17 WITNESS BERNANKE: Yes. So the question was: Should 18 we create a new lending provision to allow loans to the 19 holding company? 20 COMMISSIONER WALLISON: 21 WITNESS BERNANKE: Yes. We were allowed--we are able 22 to do so under the law so far as we have sufficient 23 collateral. 24 Washington ready to call the Board together to do that, if 25 that was going to be helpful. And we were prepared to do that. And I was in 82 1 However, what I was informed by those working on 2 Lehman's finances was that it was far too little collateral 3 available to come to our window to get enough cash to meet 4 what would be the immediate liquidity runs on the company. 5 And therefore, if we were to lend, what would happen would 6 be that there would be a continued run. 7 nearly enough collateral to provide enough liquidity to meet 8 the run. 9 Reserve would be left holding this very illiquid collateral, 10 11 There was not The company would fail anyway, and the Federal a very large amount of it. So it was our view that we could not lend enough 12 to save the company under the restriction that we could only 13 lend against collateral. 14 COMMISSIONER WALLISON: And you are saying, then, 15 that even if the collateral was illiquid, you could have 16 lent against it, but you concluded--or someone in the New 17 York Fed concluded that there wasn't enough of such even 18 illiquid capital, illiquid assets for you to make this loan? 19 20 VICE CHAIRMAN THOMAS: Mr. Chairman, yield the gentleman an additional two minutes. 21 WITNESS BERNANKE: That's correct. 22 COMMISSIONER WALLISON: Did you do a study of the 23 collateral that was available? 24 study of the collateral that was available so we could-- 25 WITNESS BERNANKE: Does the New York Fed have a Well I would refer you to 83 1 them. Remember, we were working with the SEC to do these 2 liquidity stress tests that we did over the summer. 3 then over the weekend, there was 24-hour analysis going on 4 that included not only the staff of the New York Fed, but 5 also assistance from the private sector companies that were 6 gathered there. 7 And I don't have any--to my knowledge, I don't have a 8 study to hand you. But it was the judgment made by the 9 leadership of the New York Fed and the people who were 10 charged with reviewing the books of Lehman that they were 11 far short of what was needed to get the cash to meet the 12 run. And that was the judgment that was given to me. 13 So that was my understanding. 14 COMMISSIONER WALLISON: Okay, since I have a 15 minute, I'm going to ask another question on a somewhat 16 different subject-- 17 WITNESS BERNANKE: Sure. 18 COMMISSIONER WALLISON: --and that is, that 19 Wachovia failed, or didn't fail but it apparently in the 20 view of the Fed it was not viable and had to be combined 21 with some other institution. 22 One of the things you said in your testimony is 23 that there were vulnerabilities and weaknesses in the 24 system. 25 identified was the fact that the investment banks were And one of those vulnerabilities that you 84 1 lightly regulated, or not sufficiently regulated. 2 Now investment banks were in fact lightly 3 regulated, or not sufficiently regulated, but banks like 4 Wachovia and WaMu and Citi were heavily regulated by the 5 Fed, at least in the case of Wachovia and Citi by the Fed, I 6 understand WaMu was regulated separately, but what's the 7 real difference between the regulation of banks and 8 investment banks when the outcomes seem to be the same? 9 That is, the banks get into the same kinds of 10 trouble that the investment banks get into? And what does 11 that say about the idea of providing yet more regulatory 12 power to any agency, including the Fed? 13 WITNESS BERNANKE: Well, it's a good question. 14 In the case of course, just for factual information, you 15 know Wachovia was mostly a national bank, those regulated by 16 the OCC, and the Fed was the holding company supervisor. 17 I think that part of what was happening there, 18 frankly, is that--which is why some of the CEOs feel like 19 they were hit by--blindsided by a truck, is that there was a 20 systemic problem as well as an individual institutional 21 problem. 22 There was a panic that went across--that went 23 across a variety of firms. One of the sources of the panic 24 was the subprime lending, which was something that was done 25 both by banks and by nonbanks, and we all share some 85 1 2 responsibility for that. Another set of problems, though, had to do with 3 this very high reliance on unstable short-term funding-- 4 repos, et cetera, and that was much more a situation in 5 investment banks and other shadow banks. 6 you look at the chronology of the crisis, what you see is 7 that the firms that were hit first were not banks. 8 were Bear Stearns, which was under pressure during the 9 liquidity crisis in March of '08. 10 11 And that's why, if They They were Fannie and Freddie, which had separate issues. They were essentially all the investment banks, 12 Lehman, Merrill Lynch, and so on, who came under very large 13 stress early on, and then AIG. 14 conditions got very severe that banks began to face 15 liquidity problems, as well, and banks like Wachovia, which 16 had--and Citi also--which had some substantial reliance on 17 non-core deposits as a liquidity source, came particularly 18 under pressure. 19 It was only when market But your point is right. We have to improve on 20 all dimensions. 21 lending in particular was done more outside the regulated 22 bank sector than within it, certainly I don't claim that 23 there weren't problems and mistakes in the regulated bank 24 sector as well. 25 And, while I would say that the subprime CHAIRMAN ANGELIDES: All right, thank you. 86 1 COMMISSIONER WALLISON: 2 CHAIRMAN ANGELIDES: 3 4 Thank you. Mr. Bernanke--Mr. Holtz- Eakin, you have a quick follow up? COMMISSIONER HOLTZ-EAKIN: Yes, I just want to 5 make sure I understand the answer to Peter's questions about 6 Lehman and lending. 7 Here's what I don't understand. Mr. Fuld said, emphatically, that all he needed 8 was a liquidity bridge, and that he had collateral. If he 9 were to give you the collateral and you've got that, and 10 then he turns out to be wrong, you are protected. 11 replace his judgment of what he needed with the Fed's 12 judgment of how it would work out? 13 WITNESS BERNANKE: Why Because in part that when we 14 make these discount window loans, we really have two sources 15 of protection. 16 really don't want to own. 17 you will, of the firm. 18 One is the collateral itself, which we The second is the signature, if So we generally don't--for example, we don't 19 generally loan, in the banking sector we don't generally 20 make loans to failing banks even against collateral because, 21 you know, because we want to have the double protection of 22 both the firm quality and the collateral itself. 23 So it was our sense that, again based on the 24 information developed in New York, that--that Lehman was in 25 fact far short of the amount of collateral that they would 87 1 need to meet the--meet the run; that they were essentially 2 making a Hail Mary pass at the juncture. 3 going to happen was that, again, that we would lend to them 4 on illiquid collateral, the firm would almost certainly fail 5 anyway, but the other consequence would be that the Fed 6 would have a large amount of illiquid collateral which would 7 be, you know, certainly risky at least for the Taxpayer. 8 9 So that was the reason. And so what was It was our view that they did not have enough collateral, and that the runs, 10 based on a whole variety of short-term funding obligations-- 11 the fact if they got downgraded there would be more 12 collateral calls, et cetera; that there was not adequate 13 collateral to meet the run, and therefore it would be 14 needlessly exposing the Fed and the Taxpayer to, to make 15 those loans. 16 17 COMMISSIONER HOLTZ-EAKIN: was larger than your perceived catastrophe-- 18 WITNESS BERNANKE: 19 COMMISSIONER HOLTZ-EAKIN: 20 So that Taxpayer risk Well, no---when Lehman fails? Why not try the Hail Mary pass? 21 WITNESS BERNANKE: Well, because the--because the 22 view was that the failure was essentially certain in either 23 case. 24 25 CHAIRMAN ANGELIDES: Before we go to Ms. Born, Mr. Vice Chairman you had a quick-88 1 VICE CHAIRMAN THOMAS: Just 30 seconds. We may 2 be pounding this nail, but based upon yesterday and on 3 ongoing discussion, the final point that you responded to to 4 Mr. Holtz-Eakin is where I want to focus just a little bit 5 more. 6 That if there wasn't sufficient collateral, the 7 other thing I want to add to it, if you're able, is that it 8 wasn't sufficient collateral by an inch, by a mile? 9 Because you were looking at an ongoing process that you 10 essentially decided wouldn't be worth starting. So that 11 there was just no question about the shortfall? That it 12 would be an ongoing consequence? 13 WITNESS BERNANKE: My general tone and attitude 14 was, is there anything we can do? 15 goal was shared by the other principals--by president 16 Geithner, and Secretary Paulson, and Chairman Cox. 17 of those folks had been known for timidity in previous 18 episodes in terms of trying to find ways to prevent a 19 worsening of the financial crisis. 20 And I believe that that And none And what I heard from them was just the sense of 21 defeat. You know, that it's just way too big a hole. 22 my own view is it's very likely that the company was 23 insolvent, even, not just illiquid. 24 VICE CHAIRMAN THOMAS: 25 CHAIRMAN ANGELIDES: And Thank you. All right, Ms. Born. 89 1 COMMISSIONER BORN: Thank you very much, and 2 thank you, Mr. Chairman, for being willing to appear before 3 us today. 4 You previously have said that over-the-counter 5 derivatives were a mechanism that transmitted shock during 6 the financial crisis. 7 some of the ways that they did so, and their relevance to 8 systemic risk. 9 And I would like to explore with you As you've said today, the potential failure of 10 AIG was caused by AIG Financial Products Division's enormous 11 sale of credit default swaps without sufficient resources to 12 post collateral as required by their contracts. 13 Was AIG considered to be of systemic importance 14 in part because many of the world's largest and most 15 important financial firms were AIG's counterparties on these 16 credit default swaps and thus could have been impacted with 17 AIG's failure? 18 WITNESS BERNANKE: So it's a subtle point, but I 19 would distinguish just a bit from the actual financial 20 exposure and the fact that the world knew that AIG was the 21 counterparty of many of the world's leading global financial 22 firms. 23 In some cases, you know, those exposures were 24 manageable. In some cases, they would have been more--would 25 have been more substantive. But at the time we were at the 90 1 brink of a global run, a run on all financial institutions, 2 and the progenitor of runs is uncertainty. 3 When people don't know whether a bank or a 4 company is sound, then that's when they go take their money 5 out. 6 entirely sure what the net exposure of some of these 7 companies to AIG was. 8 if it had failed, investors around the world would not have 9 known, you know, what the net exposure of a given bank was 10 11 Years--I mean, two years later we are still not Certainly on the day that AIG failed, to AIG. And so my sense was, over and above the direct 12 losses and hits to capital, et cetera, that would have been 13 experienced not only through these derivative counterparty 14 agreements but also through just straight commercial paper, 15 corporate bonds, and other vehicles, that this would have 16 triggered an intensification of the general run on 17 international banking institutions. 18 significant concern. So that was a very 19 As I talked to the Commission when we met a year 20 ago, there were a number of other features of AIG that were 21 also of concern, but that was an important one. 22 COMMISSIONER BORN: So in other words, in 23 addition to the real credit exposures and financial 24 difficulties that might have been expected, there was 25 uncertainty about what the exposures were, what institutions 91 1 had them, how much they were, lack of transparency in this 2 market, that in essence fueled the panic? 3 WITNESS BERNANKE: 4 COMMISSIONER BORN: Absolutely. I think you quite 5 appropriately in your testimony distinguish between 6 derivatives transactions themselves and the infrastructure 7 for trading, clearing, settlement of those instruments. 8 exchange trading, of course, provides price discovery and 9 transparency. Counterparty, centerparty clearing, and 10 settlement allows for reduction of counterparty risk and 11 adds to the transparency of the process and the safety 12 through margins, and marking to market. 13 And So in your view, was the trading in, of 14 derivatives over the counter as opposed to exchange trading 15 in derivatives a problem that posed some risk because of the 16 lack of transparency? 17 counterparty risk in the over-the-counter arena? 18 Because of the existence of WITNESS BERNANKE: Yes, certainly. And AIG of 19 course is the poster child for that. 20 losses that their counterparties experienced on the 21 movements in the derivatives themselves, but rather the 22 counterparty risk that was the problem. 23 It was not so much the I'm sure you know that the Fed was quite 24 concerned about clearing of settlement arrangements for 25 derivatives prior to the crisis. And the Federal Reserve 92 1 Bank of New York did a lot of work to try to improve the 2 clearing arrangements for credit derivatives and also some 3 other types of derivatives. 4 the provisions in the recent financial reform legislation to 5 standardize derivatives, put them on central counterparties, 6 and the like. 7 And we were very supportive of A point that should be made, and I know you fully 8 recognize, is that if you're going to concentrate 9 counterparty risk in central counterparties, then they must 10 be safe. And for that reason we also thought it was very 11 important in Title 8 that the Fed and other agencies would 12 work together to make sure that the prudential standards 13 were imposed on those central counterparties as well. 14 But I agree with what you just said. 15 comment is that another area where the Fed has been active 16 is in trying to strengthen the so-called trading book 17 capital requirements for banks, which essentially will make 18 it more costly. 19 the-counter derivatives, the capital cost will be higher for 20 selecting the underlying risks, both counterparty and 21 fundamental risks. 22 these instruments on exchanges. 23 One final To the extent that banks still use over- So that that's another incentive to put COMMISSIONER BORN: We have heard from the 24 Federal Reserve's staff yesterday about interconnectivity of 25 large financial institutions through their counterparty 93 1 exposures in OTC derivatives contracts, and the relevance of 2 that in assessing systemic risk of those institutions. 3 And I wanted to ask you about Lehman Brothers, 4 for example. 5 before it was allowed to fail that the failure would be 6 catastrophic. 7 a significant concern at the Fed that the OTC derivatives 8 market would be severely impacted by the failure. 9 You have said that if it had been--you knew And Mr. Baxter said yesterday that there was Was this a concern of yours with respect to 10 Lehman Brothers? Did it also enter into your concerns about 11 Bear Stearns, and Wachovia, and other large institutions 12 with concentrated derivatives positions? 13 WITNESS BERNANKE: 14 of interconnectedness. 15 relationships and so on. 16 one. 17 Yes. It's not the only aspect There's a lot of funding But it certainly is an important It's very difficult to unwind these positions 18 quickly. 19 replace your protection. 20 concern. 21 of course that we took a lot of steps to try to put foam on 22 the runway, so to speak, as the expression went. 23 And when you lose a counterparty, then you have to And so it was a significant And one indication of our concern about Lehman was And one of those things we did was to work with 24 the OTC markets to try to get them to address these 25 concerns. 94 1 Another dimension of this, by the way, one of the 2 things we got to work on very quickly was the credit default 3 swaps in Lehman that others were trading and trying to 4 arrange for settlement of those as efficiently as possible. 5 And given the problems with counterparties and ambiguities 6 of clearing and so on, that itself was a fairly complex 7 process. 8 So the short answer to your question is that this 9 was an important aspect certainly for the investment banks, 10 for Lehman and Bear Stearns and to a significant extent also 11 to the other institutions that had broker-dealers in those 12 kinds of exposures. 13 14 COMMISSIONER BORN: May I just have time for one last question? 15 CHAIRMAN ANGELIDES: Would you like two minutes? 16 COMMISSIONER BORN: 17 With respect to these concerns, I assume that the Yes, that would be fine. 18 concerns went beyond credit default swaps to all over-the- 19 counter derivatives' interconnectivity. 20 default swap were a relatively small amount of the over-the- 21 counter world of derivatives at that point, and there were 22 massive connections with other kinds of over-the-counter 23 derivatives between the big dealers like the investment 24 banks and their counterparties; and that the same problems 25 of potential credit exposure, lack of transparency, As you know, credit 95 1 potential concerns about what the exposures were applied 2 generally to the whole over-the-counter derivatives market? 3 WITNESS BERNANKE: Yes. There were some types, 4 like equity derivatives, that shared some of the problems, 5 just the operational problems that credit derivatives had in 6 terms of clearing and settlement. 7 But more generally, when are bespoke derivatives, 8 for example, you had both counterparty risk and you also had 9 the complexity of trying to value the positions. And that 10 becomes serious when you're trying, in a crisis trying to 11 figure out what exposures are, and whether a company is 12 solvent or not. So, yes. 13 COMMISSIONER BORN: 14 CHAIRMAN ANGELIDES: 15 COMMISSIONER HENNESSEY: 16 17 Thank you. Great. Mr. Hennessey? Thank you. Thank you, Mr. Chairman, for coming. Yesterday Mr. Fuld argued that there was no 18 capital hole at Lehman, and that the slow six-month 19 counterparty pullback from Lehman which turned into a run in 20 mid-September was unsupported by the reality of the health 21 of his bank. 22 We heard the same thing from the heads of Bear 23 Stearns, that their firm was fundamentally healthy and that 24 they were brought down by whispers, rumors, and an 25 unsubstantiated run. 96 1 I believe I heard you just say that you thought 2 that Lehman was probably insolvent. In your view, did 3 Lehman and Bear fail only because of unjustified liquidity 4 runs? 5 firms? Or were there also genuine solvency problems at these 6 WITNESS BERNANKE: So as I said before, one of 7 the reasons that some of the CEOs felt so blindsided was 8 that there was a general panic. 9 general financial crisis that put companies under 10 There was obviously a extraordinary strain. 11 That being said, there was certainly a hierarchy 12 and the weaker companies were certainly the first to feel 13 pressure. 14 weakest of the investment banks, and Lehman was widely 15 viewed to be the second weakest, and so on. 16 clearly losses and liquidity issues at those companies. 17 So Bear Stearns was widely viewed to be the And there were In particular, in the case of Lehman they had 18 raised some capital in the spring, but they had not 19 succeeded in spinning off a substantial position that had a 20 lot of embedded losses in it, and they had not succeeded in 21 raising additional capital, which suggested that they were 22 not able to persuade new investors to come in. 23 So it was a combination of general fear 24 certainly, but also some legitimate concerns about both the 25 asset position of the company--you know, its balance sheet-97 1 but also I think some concerns about the longer term 2 viability of the firm, the business model, and other issues 3 that were concerning folks as well. 4 And it's just the nature of financial 5 institutions that they live on confidence. 6 counterparties and customers and creditors don't believe 7 that they were sustainable, then the pressure mounts very 8 quickly. 9 COMMISSIONER HENNESSEY: Good. When their I hear a lot more 10 discussion about how to prevent failure of these firms than 11 about what will happen if or when the next failure occurs. 12 Now the government has the new resolution 13 authority, and at some point these large nonbank financial 14 firms will have living wills. 15 yet in place. But those mechanisms are not It takes time to implement them. 16 We were discussing before some of the 17 international aspects of the resolution authority, which I 18 imagine are nightmarishly complex. 19 your 13.3 authority has been curtailed, and there won't be 20 the TARP around. And at the same time, 21 Are you confident that the government, including 22 the Fed, has the tools it needs to deal with a failure of a 23 too-big-to-fail firm if and when it should next occur? 24 25 WITNESS BERNANKE: Well I'd prefer not to be tested in the next few days, if you wouldn't mind. 98 1 (Laughter.) 2 WITNESS BERNANKE: 3 COMMISSIONER HENNESSEY: 4 That being said-We all hope that won't be the case. 5 WITNESS BERNANKE: That being said, the FDIC has 6 embarked on this with admirable urgency, as Chairman Bair 7 will tell you in a little while, and they are moving very 8 quickly to try to set up the rules which will be needed to 9 implement this. 10 It's not only a question of implementation, but I 11 think the benefit of this--and I'm sure Mr. Wallison would 12 agree--would be having some certainty in advance about how 13 the process will be run and, you know, what the effects will 14 be on particular creditors, and so on, of the firm. 15 So it is a work in progress right now for sure, 16 but we are working very quickly to try to put it into 17 operation. 18 COMMISSIONER HENNESSEY: Is it, if I could, is it 19 just a timing thing in terms of getting these mechanisms up 20 and running? 21 firm-specific loan anymore, and the TARP isn't there to 22 provide capital injections, is there a scenario on which you 23 might need to put money into a firm where there is or is not 24 a tool to actually do that? 25 If you don't have the ability to provide a WITNESS BERNANKE: Well remember that Treasury 99 1 can provide a loan, as long as it's repaid, either from the 2 company in receivership or, if necessary, from an assessment 3 of the financial industry. 4 So if money is needed to prevent a disorderly 5 failure, or to facilitate the bridging process, et cetera, 6 then--then the government can provide that. 7 And the Fed, meanwhile, is of course very limited 8 in our ability to go beyond just our normal lending to a 9 sound company. 10 But that was a change we were comfortable with as long as these alternative authorities were provided. 11 COMMISSIONER HENNESSEY: Good. Systemic risk. 12 You hear a lot of people talk about it. 13 precise definition, other than people usually say it means 14 risk to the system, which-- 15 (Laughter.) 16 COMMISSIONER HENNESSEY: I haven't heard a --doesn't--and I 17 understand that there's always going to be discretion 18 involved, and that it's been much more of an art than a 19 science. 20 good work in trying to turn this from an art to science to 21 eventually some sort of engineering where you can measure 22 this and analyze systemic risk? 23 Are there efforts underway, or has anyone done any WITNESS BERNANKE: Yes. There's right now an 24 active academic research literature looking at some of these 25 things, trying to identify, for example, what some of the 100 1 criteria are; how big; how interconnected, those sorts of 2 things. 3 There is some criteria involving things like 4 correlation. 5 company X with other shares of other companies, and what 6 does that say about its systemic importance, and things of 7 that sort. 8 You know, how correlated is the stock of So there is an academic literature underway. The 9 Federal Reserve has to set up a set of rules that will 10 govern how we recommend to the oversight council which 11 companies are to be treated as systemically critical for the 12 purposes of special oversight. 13 And so we're going to have to write a rule which 14 puts down on paper in a way that is legally sensible what 15 are the criteria we're looking at. 16 So to some extent it is going to ultimately 17 remain subjective, and I think the systemic criticality of 18 any individual firm depends on the environment. 19 decisions vis-a-vis some of the firms we addressed might 20 have been different in a more calm environment. 21 So our So the overall economic and financial environment 22 also matters, not just the characteristics of the firm. But 23 we are cognizant that we need to be more specific. 24 said, there is a literature to draw on, and we have a 25 project at the Fed right now trying to write this rule that And as I 101 1 will govern our recommendations. 2 COMMISSIONER HENNESSEY: Good. I'll end with an 3 easy one. Other than your own speeches, what do you think 4 are the most important writings on the crisis as a whole? 5 If you could recommend that people read two or three really 6 good speeches, books, papers, whatever they happen to be, 7 what are the most important or under-appreciated works out 8 there? 9 CHAIRMAN ANGELIDES: 10 December 15th when our report comes out. 11 (Laughter.) 12 WITNESS BERNANKE: And by the way, that is pre- Well, I think there's a lot of 13 interesting work. 14 narrative histories and so on, and I won't bother to go over 15 those. 16 there is some interesting academic work already looking at 17 these issues, and I even made reference in my testimony to 18 Gary Gorton's work where he is pretty clear to identify the 19 analogies between what happened to the shadow banking system 20 and classic bank runs, 19th Century style bank runs. 21 think that work is very interesting. 22 I know you're familiar with sort of the But I think, again not to sound too professorial, I There's also quite a bit of interesting work by 23 people like Markus Brunnermeier at Princeton, which looks at 24 the dynamics of a panic in the repo market and how that 25 cycle of increasing haircuts in margin worked. And he and 102 1 others have also done some of the work I referred to a 2 moment ago on trying to identify systemically critical firms 3 by looking at their financial characteristics. 4 Maybe I can come up with a few other things, 5 given a little bit of time, but there is some interesting 6 work underway in this area. 7 CHAIRMAN ANGELIDES: 8 "Chairman Bernanke's Fall Reading List"? 9 Could you provide us (Laughter.) 10 CHAIRMAN ANGELIDES: 11 WITNESS BERNANKE: 12 (Laughter.) 13 CHAIRMAN ANGELIDES: 14 WITNESS BERNANKE: 15 CHAIRMAN ANGELIDES: If you would give us-- Only if you take a test on it. Well, we're taking a test. I'll do that. And we may just post it on 16 the web, too, as our featured event of the day. 17 all kidding aside, it would be great if there are a few 18 pieces you think-- 19 WITNESS BERNANKE: But, no, If you would like to 20 understand that this is not the first time through, read The 21 Lords of Finance book, which won the Pulitzer Price for its 22 history of the Great Depression, and you will feel 23 sometimes, doesn't this seem awfully familiar. 24 CHAIRMAN ANGELIDES: 25 COMMISSIONER MURREN: Right. Ms. Murren. Thank you. And thank you, 103 1 Mr. Chairman, for your comments and for your time today. 2 My question begins actually in your written 3 testimony where you reference the Gramm-Leach-Bliley Act as 4 having limited the regulators' ability to really get a whole 5 picture of any one enterprise's risks and financial position 6 and activities. 7 And I was wondering if, when you think back to 8 how the crisis unfolded--part of our charge is to determine 9 what caused it--in your mind does this act rise to the level 10 of causation? 11 part of the whole unfolding of the crisis? 12 Or is it simply one of many factors that were WITNESS BERNANKE: 13 factors. 14 caused problems. 15 I think it was one of many And you could point to specific examples where it For example, the Fed was somewhat reluctant to 16 examine nonbank subsidiaries of bank holding companies 17 feeling that the sense of the law was we needed to defer to 18 whoever was nominally the regulator. 19 And so for that reason we were probably not as 20 aggressive as we should have been in terms of identifying 21 some of the consumer protection issues that arose from 22 mortgage companies and other nonbank lenders. 23 be one example. 24 25 So that would Another example, which is more complex, has to do with the role of off-balance sheet vehicles. This turned 104 1 out to be a big problem in that under the existing 2 accounting--under the existing accounting rules at the time, 3 if a bank did not have a majority ownership of an off- 4 balance sheet vehicle, it didn't have to consolidate that 5 vehicle with its own balance sheet, and its capital charges 6 were limited only to explicit commitments of liquidity or 7 capital to the vehicle. 8 9 And so in actuality it turned out that the exposures via these vehicles were much greater than 10 understood, in part because the banks themselves didn't have 11 good monitoring systems, and also because in the event, for 12 reputational reasons, they often came to rescue these 13 vehicles when they got into trouble, even though they were 14 contractually obliged to, and that cost them money as well. 15 And so there was some, I think a little bit of 16 uncertainty about, given that these off-balance sheet 17 vehicles might have been sponsored by the bank which 18 therefore would make them responsible in some sense of the 19 direct bank supervisor, like the OCC, but they were also 20 obviously a part of the overall holding company. 21 there was a little bit of uncertainty about whose 22 responsibility these were, and maybe there was not 23 sufficiently aggressive attention paid to those off-balance 24 sheet--I'm sure there was not sufficiently aggressive 25 attention paid to those off-balance sheet vehicles. I think 105 1 So I do think that there were some problems 2 there, and some things fell between the cracks. 3 want to elevate it to a principal cause of the crisis, but 4 it was one of the reasons that some of the risks that faced 5 the overall companies on an enterprise-wide basis were not 6 adequately appreciated. 7 COMMISSIONER MURREN: I wouldn't And with that in mind, with 8 the new legislation that's recently passed, had that been in 9 place at the time what actions would have been taken that 10 might have been different? 11 different about the body of knowledge that you and other 12 regulators might have had about those enterprises that would 13 have allowed you to act perhaps more preemptively? 14 Or what would have been WITNESS BERNANKE: Well, I think the clearest 15 case was the nonbank subsidiaries where we, for example, did 16 not--we only began a pilot program to look at nonbank 17 lending subs in 2007 or so, working with the other 18 regulators of those subs trying to identify consumer 19 protection issues. 20 In the absence of GLB, I think we would have been 21 earlier looking at some of those problem areas and been less 22 reticent in going into those. 23 Again, the issue of off-balance sheet vehicles is 24 more complicated, but I think that the situation in the 25 legislation now, which rather than letting these issues fall 106 1 between the cracks essentially gives multiple responsibility 2 and says you have to both look at this, is more likely to 3 identify those problems in the future. 4 COMMISSIONER MURREN: Thank you. Another 5 question, just to touch back on something that came up 6 earlier which is the housing bubble, can you talk about your 7 feeling as to the relationship between securitization and 8 the housing bubble? 9 WITNESS BERNANKE: I think there was a 10 relationship. 11 originate-to-distribute model. 12 for securitized products, which came in part from foreign 13 investors, but not entirely of course. 14 So securitization was the other end of the And there was a big demand To create the raw material for securitized 15 products, you had to have lots of mortgages being made. 16 as a result, to expand the number of potential home buyers 17 you had to lower the standards. 18 weak underwriting, and more and more exotic mortgage 19 instruments being used to expand the number of people who 20 could get mortgages, and therefore buy houses. 21 And And so you got increasingly And what this did was, I don't remember the exact 22 number, but some very substantial fraction of the mortgages 23 issued in '05-'06 were subprime or at least nonprime 24 mortgages. 25 for houses. And that obviously increased the overall demand 107 1 So you see a chain going from demand for 2 securitized products, the demand for raw material, to 3 pressure to weaken underwriting standards to expand the 4 number of people borrowing, to increase house prices. 5 then it was a circle, because again as house prices rose 6 lenders became even more comfortable making more risky 7 loans, and that just was a self-fulfilling prophesy, at 8 least until prices got to the point where they couldn't be 9 sustained any further. 10 So there was indeed a connection there. 11 COMMISSIONER MURREN: And And so your feeling is it 12 was really more the demand that was driving the process, as 13 opposed to the push from the originators who stood obviously 14 to do rather well in an environment where they could 15 continue to create and originate mortgages? 16 it's both? 17 WITNESS BERNANKE: Or do you think So I think if there was a 18 push, it may have come not so much from the ultimate 19 mortgage-makers who themselves are agents of the banks, or 20 investment banks. 21 the folks who were creating those securitized products--the 22 salesmen going out and saying, here's an attractive 23 investment vehicle, look, it's rated AAA. 24 25 There was probably some push coming from So there certainly was some pressure coming from that side. But clearly there was an awfully strong demand, 108 1 both domestically and abroad, for, given how low--in 2 particular, you know, given that Treasury yields were pretty 3 low, and given the demand for longer term safe, fixed-income 4 assets, that demand partly from abroad drove Wall Street to, 5 you know, to create these products to satisfy that demand. 6 COMMISSIONER MURREN: 7 WITNESS BERNANKE: 8 CHAIRMAN ANGELIDES: 9 Terrific. Thank you. You're welcome. just a couple of quick wrapups. All right, Mr. Chairman, I have a couple of quick 10 items and, I know, very quickly, that Member Georgiou and 11 also Senator Graham have a couple of quick questions. 12 I want to ask you about something we talked about 13 both historically and going forward. 14 challenge of the fact that we have too-big-to-fail 15 institutions, and going forward we have institutions that 16 may be not only too big but too few to fail, fewer 17 institutions, larger scale, and how there will be a 18 challenge of political will for regulators to be as tough as 19 they need to be. 20 We've talked about the But it seems to me there was and is an 21 accompanying question. And that is one of resources. 22 don't just mean resources in shear numbers. 23 be blunt about it. 24 greased pigs. 25 they're inventing new products. And I I mean, let's A lot of the Wall Street guys are like They're hard to catch. And, you know, Sometimes you can call it 109 1 "innovation," and as you noted that may be a kind word in 2 many respects. 3 And I guess my question is: To what extent was 4 the kind of mismatch here a problem? And what will it be in 5 the future? 6 diminution of the ethos of public service, there's been 7 growing compensation gaps. 8 all know, is no picnic. 9 your confidence level that we can attract the resources? 10 You know, I saw almost no debate during Dodd- And I don't just mean, look, there's been a Being in the public arena, as we And I guess my question is: What's 11 Frank about the resource level, the talent level, that you'd 12 need to be able to have effective oversight. 13 extent was that a problem, and will it be a problem? 14 WITNESS BERNANKE: And to what No, it's a very good question, 15 and you're right that we can't outspend Wall Street in terms 16 of hiring people, obviously. 17 incentives to evade regulation in certain circumstances. 18 And they have very strong Just a couple of comments. One is that this is 19 one of the reasons why having some market discipline will be 20 very helpful. 21 that comes form investors. 22 up, or stock prices going down, that's a signal we should 23 pay attention to because clearly you have very talented 24 people who are in the markets and are assessing these firms, 25 and their information, you know, is transmitted to prices. We need to have the additional set of eyes And when we see spreads opening 110 1 We should pay close attention to that. 2 The other comment--and I think one of the things 3 we learned, and we learned this from our stress testing and 4 some other areas, is that we really need to use all our 5 resources. 6 So it's one thing to have experienced 7 supervisors, and collectively among us, and the FDIC, and 8 the OCC, we have a cadre of very experienced supervisors, 9 but given the innovations in finance, and global capital 10 flows and the like, we need to bring in other expertise as 11 well. 12 And so at the Fed we have, as I said we've taken 13 a much more multi-disciplinary approach to bring in 14 economists, financial specialists, and other types of 15 experts to support the supervisory work. 16 So I think that will be helpful. And, you know, 17 Mr. Thomas mentioned how the Fed had retained a lot of the 18 supervisory authority. 19 was because we have a lot of those skills which are going to 20 be necessary to make this work. 21 I think one of the reasons for that All that being said, you know, it's just simply 22 never going to be the case that the government can pay what 23 Wall Street can pay. 24 hard and watch very carefully to make sure that we, you 25 know, that we are successful in oversight. And we're going to have to work very 111 1 Again, we don't have to replicate every business 2 decision, or evaluate every asset. 3 what we can try to do is make them convince us that they 4 have systems and risk management in place that will 5 plausibly deliver the right answers and give us confidence 6 that they're doing the right thing. 7 We can't do that. But But you're absolutely right, that this is an 8 important issue as a practical matter as we try to implement 9 this law. 10 CHAIRMAN ANGELIDES: All right. Final question 11 from me, and it's something you talked about and we've 12 talked about internally. 13 I have wrestled with this a little. 14 magnitude of subprime lending. 15 order of a trillion dollars. 16 I know my friend John Thompson and You talked about the I think you talked about the You talked about the magnitude of this asset 17 class. I think you talked in your testimony about some days 18 we have fluctuations in the market that are as great. 19 WITNESS BERNANKE: Right. 20 CHAIRMAN ANGELIDES: And so, again, not to speak 21 for my colleagues here, I clearly see that these toxic 22 assets entered the pipeline and were pushed through it; that 23 these toxic mortgages flowed through this pipeline. 24 25 But what I'm trying to get a sense of as we do our work is, as you know a healthy patient or a healthy 112 1 person can get pneumonia and survive it easily. 2 elderly patient gets pneumonia and it's the death knell. 3 To what extent--in this instance it appears this 4 was the infection. 5 if?s" but I'm going to ask it. 6 A frail, I don't necessarily want to do "what What was the dominant phenomenon here? 7 toxicity, or the fragility of the system? 8 infection or the weakness of the body? 9 WITNESS BERNANKE: The You know, the The theme of my longer 10 testimony was triggers versus vulnerabilities, exactly what 11 you're talking about. 12 Part of the reason--well, if we had had a 13 healthy, strong, stable financial system, it could have 14 accepted this problem without creating such a major crisis. 15 So I believe very strongly that it wasn't subprime lending, 16 per se--although obviously that was a bad thing and caused 17 significant problems--but rather it was the fact that the 18 system as a whole had structural weaknesses. 19 like, the e. coli got into the food supply and that created 20 a much bigger problem. 21 CHAIRMAN ANGELIDES: And so, if you But the fact that it was the 22 housing asset, which was so broadly held by 67, 69--65 to 69 23 percent of the population, the middle class, it was the 24 biggest asset, the fact that the e. coli got into the most 25 widely eaten food product, was that--did that exacerbate it? 113 1 Or was it the nature of the securitization that exacerbated 2 it? 3 I mean, what would have been--could it have 4 happened with other asset classes? 5 that we want to game it, but what were the unique features 6 that allowed this to metastasize? 7 WITNESS BERNANKE: And again I don't know So if you were just to do a 8 macro economic model and looked at the effects of the house 9 price up and down, and ignored all the financial crisis 10 effects, just looked at the effects on consumer wealth and 11 the like, you would not find anything like the crisis that 12 we've seen. 13 The magnitude would not be big enough. What caused the crisis was essentially, as--well, 14 there are many things that caused the crisis, but it's the 15 e. coli effect; that there was an awful lot of dependence on 16 short-term, unstable funding, which is analogous to the 17 deposits in banks before the period of Deposit Insurance. 18 Since these deposits were not insured, they were 19 prone to run. 20 with the assets they're lending against, even if it's only 21 one percent, or two percent, they say, well, what the hell, 22 I'm going to take my money out, and why should I lend 23 against this potentially risky product? 24 25 And when people think there's something wrong And that panic, which in turn forced people to sell assets into illiquid markets, brought down asset 114 1 prices, created more problems for other firms, it was that 2 dynamic that was a very important part of this. 3 And so I still think of this as more of the 4 trigger, the e. coli, than of the factor that itself would 5 have caused the system to seize up. 6 7 CHAIRMAN ANGELIDES: your remaining-- 8 9 Commissioner Georgiou, for COMMISSIONER GEORGIOU: Thank you. And to follow up on that, Dr, Bernanke, another problem we heard a great 10 deal about during our hearings was this notion of regulatory 11 arbitrage and capital arbitrage, where institutions held 12 assets off-balance sheet to avoid capital requirements, and 13 in some cases mischaracterized assets to put them into 14 categories that required them to hold less capital under the 15 rules. 16 You know, we talked about Citi at its peak. 17 you brought in all the dispersed assets, had some $3.3 18 trillion in assets with roughly $75 billion in capital, 19 which was only a little over 2 percent. 20 third of that got used in one liquidity put on one set of 21 CDOs. 22 If And, you know, a Obviously in hindsight almost everyone agrees, 23 including your predecessor as Fed Chair, that more capital, 24 less leverage would have ameliorated the financial crisis. 25 It may be facile to say that the system would 115 1 have been safer had the financial institutions been required 2 to raise and hold more capital, but the mere fact that it's 3 facile does not necessarily make it untrue. 4 I wondered if you could tell us what the Fed's 5 views are going forward regarding capital requirements, and 6 what particular provisions you put in place to ensure that 7 the financial institutions that have grown so large and are 8 prone to be rescued are well capitalized on a go-forward 9 basis? 10 WITNESS BERNANKE: Thank you. I think it's 11 important, when you think about the situation going forward, 12 to recognize that there are two big things happening. 13 One is the financial reform legislation recently 14 passed in the U.S. Congress and signed by the President. 15 The other is a substantial reform of international capital 16 standards, which is currently going on, and I'll be 17 attending the Basel meeting next weekend in Switzerland. 18 So the United States agrees--Secretary Geithner 19 has talked about this--we agree, Chairman Bair, that 20 stronger capital standards are absolutely essential as one 21 of the key components going forward to assure the safety of 22 the system. 23 And so what we are talking about with our 24 international colleagues in Basel now is, first, having more 25 capital; having higher quality capital that is not using 116 1 intangible assets and other things that are not loss 2 absorbing as capital; making capital more risk-sensitive so 3 that it responds more to losses and absorbs losses more 4 effectively; creating some counter-cyclicality in capital so 5 that capital be built up in good times and run down in bad 6 times; and finally, we're working with the accountants and 7 others to--you know, we've gone beyond the situation you 8 talked about where Citi had all these off-balance sheet 9 assets which were not consolidated and has been very largely 10 changed now by new accounting rules which will require 11 consolidation where there is substantial ownership of those 12 assets. 13 And on top of that, we are looking for 14 international leverage standards, and international 15 liquidity standards. 16 substantial improvements in those regulations 17 internationally, to create a level playing field, and I do 18 believe that as we go forward that those rules and their 19 implementation will be of the same order of magnitude of 20 importance in assuring a safe financial system going forward 21 as the changes, very important changes being made in the 22 recent legislation. So we expect to have some very 23 COMMISSIONER GEORGIOU: 24 CHAIRMAN ANGELIDES: 25 Thank you, Dr. Bernanke. Senator Graham, you had a quick closing question? 117 1 COMMISSIONER GRAHAM: Yes. Chairman-- 2 CHAIRMAN ANGELIDES: One each, but very quickly. 3 COMMISSIONER GRAHAM: The Chairman answered the 4 question that I was going to ask which related to what is 5 the status of off-balance sheet items, but I cited earlier a 6 report that there seems to be a weakening of resolve by the 7 Basel Group in terms of liquidity and capital standards. 8 Does that coincide with what you're hearing? And 9 if so, do you think that we can anticipate adequate resolve 10 at the international level to get these standards where they 11 need to be? 12 WITNESS BERNANKE: So when you're developing a 13 complex set of capital standards, it is important to consult 14 with the banks to understand, make sure you understand what 15 the implications are for how much capital they'll hold, and 16 how it will affect their business, and so on. 17 It is important to understand that. You're not 18 making good policy if you don't understand the implications 19 of your decisions. 20 That being said, that is not the same thing as 21 weakening standards. We want to make sure the standards are 22 rational and effective. 23 standards. 24 that they will be a substantial improvement over the 25 standards that we've had in the last few years. And we are committed to very strong And I think you will see, when they come out, 118 1 COMMISSIONER GRAHAM: Thank you. 2 CHAIRMAN ANGELIDES: Mr. Wallison? 3 COMMISSIONER WALLISON: 4 Thank you. Just one question. 5 Bank regulators have, for many years, been 6 concerned about fair-value accounting, mark-to-market 7 accounting, and some have said that that had something 8 significant to do with what happened in the financial 9 crisis. 10 What's your view of that? 11 WITNESS BERNANKE: Well I think that mark-to- 12 market accounting at times increased the procyclicality of 13 the system. 14 illiquid and it was very hard to value assets. 15 There were times when markets were highly That being said, I think we should do our best to 16 get appropriate market values of assets that do have market 17 prices. 18 Now there is a somewhat different issue when 19 you're dealing with long-term credit in the banking book 20 where there is no secondary market, and appropriate 21 valuation requires, you know, a model or some assumptions. 22 So I'm in favor of accurate accounting. I think 23 there are sometimes problems when markets are very illiquid 24 and the FASB tried to move in the direction of clarifying 25 how to deal with so-called Level 3 assets in illiquid 119 1 markets, but I'm also very cautious about applying mark-to- 2 market accounting to the long-term loans, the bank loans in 3 the banking book of the banks. 4 If I could say one quick thing about the Wachovia 5 question you asked me before, I would just point out that 6 the decisions there, the interventions there, were FDIC 7 decisions. 8 They must have made--I'm sure they made 9 independent judgments about the best way forward, and with 10 their concern about protecting the Deposit Insurance Fund 11 I'm sure they were trying to find the least-cost solution 12 for that. 13 COMMISSIONER WALLISON: My question--thank you 14 for that, but my question really was what importance do you 15 think mark-to-market accounting might have had in the 16 financial crisis as we understand it? 17 decline in asset values. 18 WITNESS BERNANKE: That is, this huge I think it exacerbated it 19 somewhat, but it's the nature of financial markets that 20 asset prices move up in booms and down in crashes, and that 21 is an exacerbating factor, but, you know, we don't want to 22 sacrifice accurate valuations to eliminate that issue. 23 mean, I don't think you could. 24 25 I So it was an issue, but I don't think we should conclude from that that we should abandon mark-to-market 120 1 accounting. 2 CHAIRMAN ANGELIDES: Mr. Chairman, thank you very 3 much for this second appearance before us during our 4 deliberations. 5 I also want to reiterate something that the Vice 6 Chairman and others have said. Douglas Holtz-Eakin I know 7 mentioned it specifically. 8 Federal Reserve have been very forthcoming and very 9 cooperative in terms of providing documents, information, You and your staff at the 10 making folks available for interviews, and we appreciate the 11 way in which you have helped us conduct our investigation 12 and our inquiry for the benefit of the American People and 13 for history. 14 You have been very good in this regard, and we 15 look forward to continuing to do work together as we do our 16 final report. 17 morning. Thank you very much for being here this 18 WITNESS BERNANKE: Thank you, Mr. Chairman. 19 CHAIRMAN ANGELIDES: We will now take a ten- 20 minute break, members, and then Chairman Bair will be before 21 us. 22 23 (Whereupon, at 11:41 a.m., the meeting was recessed, to reconvene at 11:55 a.m., this same day. 24 25 121 1 AFTERNOON SESSION 2 (11:55 a.m.) 3 CHAIRMAN ANGELIDES: The public hearing of the 4 Financial Crisis Inquiry Commission on the subject of 5 financial institutions that have become too big to fail, too 6 important to fail, too systemic to fail, will recommence. 7 Thank you, Chairman Bair, for being with us 8 today. 9 you as a witness. 10 We are going to start, as we always do, by swearing So if you would please stand and raise your right hand, I will read the oath to you: 11 Do you solemnly swear or affirm under penalty of 12 perjury that the testimony you are about to provide the 13 Commission will be the truth, the whole truth, and nothing 14 but the truth, to the best of your knowledge? 15 CHAIRMAN BAIR: I do. 16 (Witness Bair sworn.) 17 CHAIRMAN ANGELIDES: Thank you. Chairman Bair, 18 thank you for your extensive written testimony. 19 would like to ask you for now is obviously to present to us 20 orally. 21 You know how the lights work, and the mikes work, you're a 22 pro at this, so if you would start your testimony that would 23 be terrific. 24 25 What we We will provide you up to ten minutes to do that. WITNESS BAIR: Chairman Angelides, Vice Chairman Thomas, and Commissioners: 122 1 I appreciate the opportunity to testify today on 2 systemic risk and ending too big to fail. 3 September 2008 dramatically illustrated the flaws of our 4 former regulatory and bankruptcy framework for responding to 5 distressed large and complex financial institutions. 6 The events of My testimony discusses two cases, Washington 7 Mutual and Wachovia, that demonstrate the dilemma we faced 8 between the risk of a wider financial crisis and the 9 prospect of bailing out bank owners and creditors. 10 While the FDIC was able to resolve WaMu under our 11 normal procedures without creating further disruption to the 12 financial system, an accelerated time frame, a lack of 13 information, and a complex organizational structure made the 14 dilemma worse at Wachovia. 15 Because the risks and uncertainties of creating 16 wider market instability were just too great, we invoked the 17 Systemic Risk Exception for the first time, and were 18 prepared to implement a resolution on that basis. 19 As events unfolded, however, that resolution plan 20 was not carried out because Wachovia was sold in an 21 intervening private transaction. 22 or even more pronounced for other large nonbank 23 organizations that faced collapse at about the same time. 24 Most notably, the critical shortcomings of the bankruptcy 25 process as applied to large financial institutions was But the problem was equal 123 1 demonstrated by the market reaction to the September 15, 2 2008, collapse of Lehman Brothers. 3 The provisions of the Dodd-Frank Act provide new 4 regulatory tools to preserve financial stability and protect 5 Taxpayers from losses sustained by large financial firms. 6 Resolution plans mandated by regulators and 7 created by the institutions themselves will specify how a 8 systemically important institution could be resolved and 9 will help to ensure that the complex structure of an 10 institution does not prevent its orderly resolution. 11 Backup examination and enforcement authority will 12 give the FDIC better information in advance about 13 systemically important institutions, making it more likely 14 that an orderly resolution can be achieved. 15 The FDIC has already updated its supervisory 16 memorandum of understanding with the other federal banking 17 regulators to enhance our existing backup authorities. 18 Finally, the new resolution authority will make 19 the FDIC's liquidation process available for bank holding 20 companies and nonbank financial companies to provide a means 21 to unwind them without disruption, delay, and uncertainty 22 usually associated with bankruptcy. 23 Had these authorities been in place in 2008, the 24 FDIC would have already had a detailed resolution plan for 25 Wachovia. We would have had better information about its 124 1 structure and risk profile, and we would have faced fewer 2 impediments to effecting its orderly resolution. 3 In short, Wachovia, or Lehman for that matter, 4 could have been resolved without a bailout and without 5 disrupting financial markets. 6 More importantly, had the current law been in 7 place in 2008, investors and institutions like Wachovia or 8 Lehman would have had every reason to expect losses in the 9 event of failure and would have exerted more effective 10 market discipline over their activities. 11 Finally, I would like to highlight what I see as 12 three main areas of priority for implementation under the 13 new law. 14 Under the new Orderly Liquidation Authority, the 15 largest financial firms must develop credible resolution 16 plans, working with the FDIC and Federal Reserve, so that we 17 have the information and planning needed for an orderly 18 resolution. 19 It is critical that Living Wills are not simply a 20 paper exercise. 21 business decisions so that the companies operate more 22 efficiently and reduce the possibility of any future 23 collapse. 24 25 This planning process should affect Under the law, they can be required to make changes if necessary to avoid creating undue systemic risk. 125 1 We are working with our international partners to achieve 2 legal reform for a more cooperative international insolvency 3 process. 4 These are all key steps in truly ending too big 5 to fail. I view the Financial Stability Oversight Council 6 as a forward-looking forum for members with diverse 7 expertise to share their specialized knowledge, and to make 8 recommendations on addressing emerging risks to the 9 financial system. But regulators must have the courage to 10 act on the Council's recommendations if we are to address 11 systemic risks before they resolve any damage to our 12 economy. 13 Reforms to bank capital requirements under 14 consideration by the Basel Committee will serve to weed out 15 hybrid instruments that weaken the capital structure, add 16 new capital buffers so de-leveraging need not crush lending 17 in a crisis, and place higher capital charges on the riskier 18 derivatives and trading activities. 19 I urge a prompt finalization and implementation 20 of new Uniform Global Capital Standards so that regulatory 21 uncertainty can be reduced and investors can regain 22 confidence in the long-term stability of our global 23 financial system. 24 25 If financial reform is about anything, it should be about stabilizing the financial system so that it can 126 1 meet the credit needs of the real economy and support long- 2 term sustainable growth. 3 To be sure, as I've previously testified before 4 this Commission, regulatory policy is but one component of 5 restoring a more vibrant economic future. 6 that promotes the efficient allocation of resources is also 7 essential. 8 9 A fiscal policy In this regard, we hope the Congress will review the large level of government support provided to home 10 ownership to determine whether it has resulted in the most 11 productive allocation of resources. 12 For our part, we are working with our regulatory 13 counterparts to promptly implement regulations in the areas 14 of liquidation authority and the Financial Stability 15 Oversight Council. 16 on the Basel Committee with regard to international capital 17 standards. 18 And we are working with our counterparts We are approaching these tasks with both the 19 sense of urgency and a considered view toward the long-run 20 effectiveness. 21 exercising our authorities under the Dodd-Frank Act can we 22 succeed in putting our financial system on a sounder and 23 safer path for the long term. Only if we create strong frameworks now for 24 Thank you very much. 25 CHAIRMAN ANGELIDES: Thank you, Chairman Bair. 127 1 We will now move to questioning. 2 So let me start the questioning, per usual. One 3 thing that struck me in the runup to the System Risk 4 Exception for Wachovia is the extent to which there was 5 really no look at the systemic implications or risk. 6 know that folks say, well, that wasn't the role, but it does 7 seem to me that in the context of safety and soundness that 8 people can also look, or regulators could have looked at the 9 larger risk to the system. 10 The Fed seeks risks as early as '07. And I The 11 downgrades by the Fed and the OCC don't come until '08. 12 know you're not the primary supervisor--I think you've got 13 one on-site examiner. 14 I You yourself say, I believe in your interview 15 with our staff, that you really didn't, I don't think you 16 got notice of the run until Friday, which is when it 17 occurred. 18 condition until Saturday. And you don't really have real knowledge of their Is that an accurate statement? 19 WITNESS BAIR: Yes. 20 CHAIRMAN ANGELIDES: To what extent was this just 21 a glaring hole in the system? 22 whole, have taken the larger view? 23 Isn't it too simple to just say, well, that wasn't in our 24 job description? 25 WITNESS BAIR: Should regulators, as a And could they have? Well, we won't say that. I do 128 1 think there were earlier warning signs. 2 in fairness to the other regulators, we were earlier in the 3 week, we did see some escalating distress, liquidity 4 distress with Wachovia. 5 was under control, and it wasn't until Friday night when we 6 were told there a liquidity crisis that could actually--that 7 necessitated some weekend action. 8 9 You're right. And We were told Friday morning that it So it was a very short timeframe to deal with this. And I do think, in retrospect, we were operating with 10 imperfect information. 11 primary regulators, as we needed to. 12 We were relying heavily on the As you know, we only had one of our own 13 examiners, as a backup examiner, in Wachovia. And that is 14 not to criticize the primary regulators. 15 working very hard and doing their job, but we have a 16 distinct role. 17 deposits. 18 if the institution could not maintain its obligations. Everybody was They had $265 billion of exposure in insured They had responsibility for an orderly resolution 19 We needed more information to make a decision, 20 direct information and an ability for us to independently 21 assess the situation, and make decisions that we were 22 comfortable with. 23 So that is a lesson that I learned going forward, 24 and this is one of the reasons why we renegotiated our 25 Memorandum of Understanding with the primary regulators. We 129 1 will now have five examiners full time at these very large 2 institutions, with others on an as-needed basis. 3 will be for any institution, regardless of its CAMELS rating 4 or how healthy it is, given the size of the institutions and 5 how quickly they can deteriorate and this will be an ongoing 6 presence. 7 And that And we also have the additional authority now for 8 holding companies, as well. This is Wachovia, and like WaMu 9 Wachovia had a significant amount of securities activities 10 that occurred outside of the insured depository institution, 11 which we had no information about at all because prior to 12 Dodd-Frank our backup authorities only extended to what was 13 going on inside the insured depository. 14 CHAIRMAN ANGELIDES: All right. You clearly had- 15 -we, as you know, put on the record yesterday the transcript 16 of the FDIC Board meeting in which you considered the System 17 Risk Exception for Wachovia. 18 significant reservations. 19 You've said: And you clearly had Well, I think this is one option of 20 a lot of not-very-good options. 21 that both Treasury and the Federal Reserve Board weighed in 22 early for us to provide a System Risk Exception. 23 I've acquiesced in that decision. 24 comfortable with it. 25 I would note for the record You say: I'm not completely I'm looking for my notes, but I think you also in 130 1 interviews with the staff indicated that this was something 2 that the White House and the Federal Reserve wanted to move 3 on. 4 5 Were the reservations just ones of you're trying to absorb it Saturday and you've got to make a decision-- 6 WITNESS BAIR: Right. 7 CHAIRMAN ANGELIDES: --early Monday morning? Or 8 were there some fundamental reservations about, for example, 9 apparently--not getting into the gossip of who was mad at 10 who--but there did seem to be, according to your interview, 11 a philosophical difference when then New York Reserve--Mr. 12 Geithner, how's that, it's been a long series--Federal 13 Reserve Board of New York president, Mr. Geithner, a 14 disagreement about whether creditors, bondholders, should be 15 fully protected. 16 What were the reservations? 17 WITNESS BAIR: Well, I think--I don't think there 18 was any question in my mind we had to do something that 19 weekend. 20 had a very successful, I felt, resolution of WaMu. 21 And we had--the system was highly unstable. But other things were going on. We The TARP bill 22 was in flux. Lehman I think served as a catalyst for all of 23 this. 24 where we'd had a bank run before and after the bank closing. 25 So we had redoubled our efforts to assure insured depositors We had had a stabilizing event with Indy Mac earlier, 131 1 that their money was safe. 2 But my worst--we were guaranteeing about $5 3 trillion of insured deposits, and my worst nightmare was 4 that bank depositors would start losing confidence in the 5 system and pull their money out. 6 We had already lost wholesale funding. The 7 shadow sector had completely seized up. 8 were staying, but if that changed we would have truly had a 9 cataclysmic situation. 10 Insured deposits So I didn't feel that we could afford on Monday 11 morning any risk that Wachovia would open and run out of 12 money, or have a disruptive situation. 13 risk that we could tolerate. 14 That was just not a So it was clear to me over the weekend we needed 15 to do something. 16 System Risk Exception and provide what we call Open Bank 17 Assistance to them, or whether we tried to put it through a 18 normal resolution process. 19 Really the issue was whether we did the That was the discussion I wanted to have more of, 20 but the time just did not permit it. And at the end of the 21 day, I don't second-guess what I did. The statute clearly 22 says that this needs to be a collaborative decision with the 23 FDIC, the Fed, and the Treasury, in concurrence with the 24 President. 25 felt strongly that a Systemic Risk determination with Open And the other parties had spoken on this and 132 1 Bank Assistance would provide the greatest amount of 2 stability. 3 So there was a philosophical disagreement over, 4 you know, bondholders. 5 that equity shareholders and term bondholders know their 6 money is at risk, and should understand they take losses, 7 especially with insured banks where the process has been 8 around for a long time and should be, and I think is, 9 clearly understood by the market. 10 We don't feel--I felt and still feel So there was a philosophical disagreement. That 11 isn't to say I'm right, or anyone is wrong, it's just that 12 it was, and it was a factor in these discussions. 13 don't look back. 14 We moved on. 15 we took over the weekend did stabilize the situation for 16 Wachovia. 17 We had a discussion. But I We made a decision. And the good news was, on Monday the decision CHAIRMAN ANGELIDES: And I guess on reflection, 18 and this isn't second-guess, but with respect to WaMu you 19 did not fully protect bondholders, right? 20 WITNESS BAIR: 21 CHAIRMAN ANGELIDES: 22 23 24 25 We did not. We did not. And you think that was the right decision? WITNESS BAIR: I absolutely do think that was the right decision. CHAIRMAN ANGELIDES: For market discipline 133 1 purposes? 2 WITNESS BAIR: Yes. Absolutely. WaMu was not a 3 well run institution. I think that was clear from our 4 supervisory perspective. 5 6 CHAIRMAN ANGELIDES: When the OTS let you in, right? 7 WITNESS BAIR: That's right. And Permanent 8 Subcommittee investigations in the Senate did a very good 9 review, as well. And there were a lot of troubling things 10 going on at that bank. 11 regulators should have been more on top of it, but, you 12 know, it shouldn't be just regulators; it should be 13 shareholders, and creditors putting pressure on those 14 institutions, too, for better risk management. 15 not done. 16 And we can debate about whether And that was And so that's where the losses should have been, 17 and I think it was a very appropriate resolution. 18 was consistent with our statutory process. 19 process Congress told us to use. 20 CHAIRMAN ANGELIDES: Right. And it That is the I'm going to 21 surprise my fellow members by saying this is my last 22 question to you, at least for now. 23 And that is, as I have read the materials 24 prepared for this hearing, this portion of our 25 investigation, not only interviews with all the principals, 134 1 but also historical materials. Our staff prepared an 2 excellent staff report for us, which has now been posted on 3 the Web, in which they traced the history of bailouts over 4 time. 5 And there's this pattern of institutions growing 6 like a weed, using high leverage, taking on enormous risks. 7 I think we've seen it all along the path. 8 I've said, it's almost like financial groundhog day again 9 and again. 10 I mean it is, as You look at this, and it's hard not to come away 11 with a view that what Wall Street has needed is not a series 12 of bailouts but a financial intervention. 13 (Laughter.) 14 CHAIRMAN ANGELIDES: But what I'm concerned about 15 at this point is, how do you break this repeat pattern? 16 it is something we asked Chairman Bernanke. 17 have fewer, bigger banks now. 18 test of will of the regulators to be able to constrain--you 19 know, it's always hard. 20 The fact is, we It is going to be an enormous I think you said in your interview the job is to 21 take the punch bowl away. 22 regulators. 23 challenge of that. 24 challenge in the run-up to this crisis? 25 And And that is the job of prudential But tell me the risks you see here and the And to what extent was that a failed Everything was good. People were booking 135 1 profits-- 2 WITNESS BAIR: 3 CHAIRMAN ANGELIDES: 4 to say: 5 Yes. --very hard to be the ones This is spiraling out of control. WITNESS BAIR: Right. Well, that's right. 6 the job of regulators to take away the bunch bowl. 7 to do it when times are still good. 8 once things start turning bad. 9 late. 10 It is You need You don't want to wait, It's just going to be too But that requires political support, as well. 11 And I think in the early 2000s there were efforts to try to 12 rein in some of these really questionable mortgage lending 13 practices that we were seeing when I was at Treasury, and 14 there was just no political will to do that. 15 So I think that has to be--I think the new 16 Financial Stability Oversight Council is the vehicle where 17 Congress has placed accountability for making those 18 decisions with that Council. 19 need to have the courage to exercise the decisions, and do 20 so even if we get pushback from it. 21 when things are still profitable. 22 And it will be our job, and we Because you need to act If you wait until the losses start occurring, it 23 is going to be too late. I think I do not under-estimate 24 the importance for increased capital standards. 25 leverage--the combination of excess leverage with too big to Excess 136 1 fail was a toxic combination in feeding this crisis. 2 And, you know, the private sector held the up- 3 side, with the assumption being that the government was 4 going to take the down-side. 5 risk-taking. 6 That in and of itself fed So getting rid of too big to fail, restoring 7 market discipline through effective resolution authority, 8 and increasing capital requirements to de-leverage, making 9 sure that there are bigger cushions there so when the next 10 cycle comes--there will be another cycle. 11 with cycles. 12 We can't do away But when it comes, there is more of a capital 13 cushion to absorb the losses so you won't have a situation 14 where you've got to do a government bailout or confront a 15 failure situation. 16 So I think the tools are there. The regulators 17 have to use them. 18 leadership need to support the regulators when they need to 19 make unpopular decisions. 20 But the Congress and the political CHAIRMAN ANGELIDES: I'm going to break my own 21 rule, because you just said something that I've got to 22 follow up on. 23 market believes that the too big to fail doctrine has been 24 broken? 25 Do you really believe at this point that the WITNESS BAIR: Well, I think it's up to us to 137 1 effectively inform the new authorities that Congress has 2 given us. 3 they should read the statute itself. 4 pushed for this language--the statute very specifically 5 prohibits any kind of open-institution assistance. 6 I think if they think it is still around, I think The statute--and we So what happens, it's going to have to be 7 Congress doing it. 8 authority to do bailouts anymore, and we think that is a 9 good thing. 10 We don't think we need it, if we have resolution tools, which Congress also gave us. 11 12 Because the regulators simply have no CHAIRMAN ANGELIDES: Thank you very much, Chairman. 13 Mr. Vice Chairman? 14 VICE CHAIRMAN THOMAS: Thank you. I am tempted, 15 but I guess I won't ask you if the scope of the legislation 16 extends to Kabul, Afghanistan, based upon this morning's-- 17 WITNESS BAIR: Well, no it doesn't, but we have 18 made a high priority of--we have a lot of education and 19 training that we do with developing countries. 20 think Afghanistan has been one of them, but I think this is 21 a key issue of having deposit insurance systems, and 22 credible deposit insurance systems, in developing countries 23 as well. 24 25 VICE CHAIRMAN THOMAS: I don't I do want to thank you for your written testimony, especially because--I don't know if 138 1 I've been reading as widely as I normally do, but I have not 2 really seen--let me say, I thought your testimony, the 3 written testimony, was very good in a succinct way on where 4 we were, where we are, but more importantly where we can go. 5 Now I don't know whether we will go, but that we can go. 6 WITNESS BAIR: Right. 7 VICE CHAIRMAN THOMAS: One of the difficulties, 8 especially in these very complex areas today, we used to 9 just go ahead and bite the bullet and make law. And then of 10 course you have a statute that you have to deal with, and 11 then you get to promulgate regulations from a narrow 12 opportunity. 13 I think it does make sense, once we come out the 14 other side of these, to pass law with significant regulatory 15 capability in fleshing it out, because it makes it not only 16 timely and appropriate but I think the better value is that 17 there can be adjustments over time without having to go back 18 through. 19 The problem with that course is, you have this 20 big splash about having passed the law, and then you've got 21 to roll all the regulations out. 22 What was your reaction, and how should we read 23 the--it's in the SEC's jurisdiction, not yours, but it was 24 the first one out of the chute in terms of the rating 25 agencies. 139 1 WITNESS BAIR: Right. 2 VICE CHAIRMAN THOMAS: It's kind of like Bear 3 Stearns and then Lehman. 4 hopefully the next few that role out will be well done, done 5 in a way they don't get flipped or put on the spot like we 6 did with the rating agency adjustment attempt. 7 8 That was an aberration, and What was your take on that event? You had preferred something else rolling out first? 9 WITNESS BAIR: Well I think actually the 10 legislation itself really eliminates the ability of 11 regulators to use ratings in any way. 12 VICE CHAIRMAN THOMAS: 13 WITNESS BAIR: Right. And so certainly with structured 14 financial products the ratings were a terrible failure, and 15 definitely fed the crisis. 16 the hook. 17 diligence, too. 18 That's not to let investors off Investors should have been doing their own due But the ratings were not good. I think--and for corporate debt, there's a better 19 record, frankly. And to eliminate our ability to use them 20 at all, especially in more traditional areas, for the 21 ratings to perform better is going to create some unique 22 challenges for us. 23 rely on ratings of certain types of investments that they 24 hold, in terms of the risk weighting, how much capital they 25 have to hold against those exposures. Especially for the smaller banks, we 140 1 And so if we can't use ratings at all, we have to 2 find something else. 3 alternatives out there that are going to be any better, or 4 cost effective, especially for smaller banks. 5 And I'm not sure that there are So that said, Congress has told us they don't 6 want us to use ratings as all. 7 best to make that work. 8 Notice of Proposed Rulemaking out, asking for comments on 9 what kind of alternatives we can use for banks in setting 10 So we are going to do our We have an ANPR out, an Advanced capital standards, where we do rely on ratings a lot. 11 And so I'm hoping we can get some good thinking 12 on that and move forward in a way that's consistent with 13 Congressional intent. 14 elimination of the use of ratings. 15 But it was quite sweeping in its VICE CHAIRMAN THOMAS: And it was pretty reactive 16 in terms of the Street's reaction to that, at least on an 17 initial basis in terms of the rating agencies. 18 WITNESS BAIR: 19 VICE CHAIRMAN THOMAS: 20 21 22 23 Right-I mean, they weren't going to rate. WITNESS BAIR: There was, but I think the SEC acted very quickly to provide the relief that's necessary. VICE CHAIRMAN THOMAS: But if you don't want to 24 have that repeated 232 times, or it's going to be a long 25 time getting where we need to go. 141 1 WITNESS BAIR: That's right. And I think we are 2 all committed to being very careful, deliberative, and 3 transparent about this, as well. 4 VICE CHAIRMAN THOMAS: And then a specific point, 5 because you have a--you're in front of us, and you had a 6 unique role on the Wachovia weekend. 7 On page 10, as you run through what happened and 8 the choices, I was struck--and I've mentioned this over the 9 two days of the hearings--that when you look at September 10 28, 29, and then 30, and as the chairman indicated the 11 minutes, it was clear that you had to take an extraordinary 12 position--i.e., an extraordinary measure--which it was 13 assumed would not put you at risk, but there was a potential 14 for risk. 15 I imagine it was fairly animated in terms of 16 behind-the-scenes discussions with all the players to reach 17 that point, not withstanding you came out with a unanimous 18 decision--that's what happens when you break a huddle; WITNESS BAIR: That’s right (laughter) VICE CHAIRMAN THOMAS: 19 -- everybody's now on the same page, and that was an indication 20 that you decided that was where you were going to go--and it 21 isn't so much the decision you made on the 29th, given the 22 options available to you. 23 one day later the Internal Revenue Service decides to put 24 out the 83 Notice, which changes two decades of IRS Code tax 25 behavior. What kind of floored me was that 142 1 And then, three day I guess--two days after that, 2 the deal which apparently was very difficult to come to a 3 conclusion that would be offered to save Wachovia, is gone 4 and Wells Fargo offers a no-strings-attached arrangement. 5 And what I have heard from some folk is that, not 6 withstanding that very interesting timing, that the Tax Code 7 change which was made by IRS, which was repudiated almost as 8 quickly as Congress could get itself focused on removing 9 that because it was a rifle shot for banks only, had no 10 consequence in the decision between your difficult motion to 11 take extraordinary action and Wells Fargo wrapping up a deal 12 that had no involvement by the FDIC, or frankly virtually 13 anyone else on a financial commitment. 14 15 16 Was that all coincidence, circumstance, interesting string of events that had no relationship? WITNESS BAIR: Yes, sir. We had no--we had no 17 knowledge of anything going on over at the IRS. 18 a factor on decisionmaking at all. 19 surprise to us. 20 21 VICE CHAIRMAN THOMAS: It was not It came as a complete But it was fortuitous, right, because-- 22 WITNESS BAIR: It was. 23 VICE CHAIRMAN THOMAS: --it relieved the FDIC of 24 any responsibility. And of course the Fed had no stake in 25 the game, so the only folk that potentially were at risk now 143 1 was, once again, a loss of revenue if in fact it was as big 2 as some people say, ten times the amount that otherwise 3 would have been available. 4 WITNESS BAIR: 5 VICE CHAIRMAN THOMAS: 6 Right. So it is just all coincidental. 7 WITNESS BAIR: 8 VICE CHAIRMAN THOMAS: 9 WITNESS BAIR: 10 know anything about it. 11 had no say in this. 12 transaction. It was--yes-From your perspective. From my perspective, we didn't We were surprised by it. And we So once Wells came in, it was a private 13 So, no, it was not a factor at all. 14 VICE CHAIRMAN THOMAS: But it was a public change 15 in the law by an Executive agency which, even in their IG's 16 statement, probably wasn't lawful, and in most of the tax 17 expert academia was clearly an over-reach. 18 WITNESS BAIR: Right. 19 VICE CHAIRMAN THOMAS: And there was no 20 discussion at Treasury in looking at options, or provide 21 alternatives in which they decided to go ahead and go 22 forward? 23 Why in the world--and I know you-- 24 WITNESS BAIR: 25 VICE CHAIRMAN THOMAS: I don't know. --to answer, but I'm 144 1 looking--why in the world would they pull the trigger on the 2 30th based on the difficult decision you reached in your 3 minutes? 4 WITNESS BAIR: I don't know if the IRS was aware 5 of what we did. 6 on. 7 of you obviously are very expert in tax matters, given your 8 former chairmanship of House Ways and Means. 9 VICE CHAIRMAN THOMAS: 10 They were completely different things going And I'm not a tax lawyer. I will defer to you in terms follow, but-- 11 (Laughter.) 12 VICE CHAIRMAN THOMAS: 13 14 Those don't necessarily --but I appreciate the comment. WITNESS BAIR: I can't speak to it. I don't know 15 what was going on at the IRS, and I assume they were 16 completely devoid of what we were doing. 17 I don't think there was any knowledge on their 18 part, not that I'm aware of--I don't know. 19 surprised by it. 20 21 Again, we were It just happened. VICE CHAIRMAN THOMAS: I just wanted to ask you that so we could put that on the record. 22 WITNESS BAIR: Yes, absolutely. 23 VICE CHAIRMAN THOMAS: It was an amazing series 24 of events, as far as I'm concerned, that led to a completely 25 different resolution. 145 1 2 Were you surprised by the Wells stepping up to the plate-- 3 WITNESS BAIR: Yes, I was. 4 VICE CHAIRMAN THOMAS: 5 WITNESS BAIR: 6 VICE CHAIRMAN THOMAS: --and making that move? Yes, I was. Okay, that's good. That's 7 a nice niche I can put that in. Thank you, very--well, I 8 think a lot of us were surprised. 9 really appreciate, once again, the help that you have given 10 us early on and your continued willingness, obviously, if we 11 want to ask you some questions after this I know you will 12 respond-- 13 WITNESS BAIR: 14 VICE CHAIRMAN THOMAS: 15 Thank you, very much. Yes. --and provide us with that additional information. 16 WITNESS BAIR: 17 VICE CHAIRMAN THOMAS: 18 CHAIRMAN ANGELIDES: 19 COMMISSIONER HOLTZ-EAKIN: 20 I Absolutely. Thank you. Thank you. Mr. Holtz-Eakin. Thank you. And thank you for spending this time with us. 21 First, just for the record, we ask everybody all 22 the time, and in particular Mr. Bernanke, if he could rerun 23 history would monetary policy look different? 24 regulation of mortgage origination look different? 25 Would Looking back, what should the FDIC have done 146 1 differently in the runup to, and the crisis itself? 2 WITNESS BAIR: Well that's a good question. I 3 think we should have been more attentive to our backup 4 authority, and our resolution functions. 5 came to the FDIC in June of 2006 we were heavily focused on 6 the supervisory side. 7 primary regulator of. 8 9 I think, when I Primarily smaller banks we were the We had just gotten authority to risk-adjust our own insurance premiums from Congress, which was very helpful 10 because there had been an extended period of time where 11 under the law we basically couldn't charge banks anything 12 for their deposit insurance. So we weren't building up the 13 Fund as we should have been. And we weren't adjusting those 14 premiums on the basis of risk. 15 So we implemented those authorities very quickly. 16 And I think we also eliminated--there was something called 17 the "Merit System" that had been put into place before I 18 came. 19 That basically was a very streamlined examination 20 process, which I didn't think was prudent. 21 bank, even if it's a perfect CAML picket one, picket fence 22 rated one institution, should have its loan files looked at. 23 And so we got rid of that. 24 25 I think any So we did try to turn course a bit and start providing more supervisory vigor. And in retrospect, 147 1 though, I think we should have focused more on our backup 2 authority and getting better up-to-speed on the large 3 institutions. 4 5 So I think in terms of the FDIC's role, I wish we had moved on all those issues earlier. 6 COMMISSIONER HOLTZ-EAKIN: I want to now talk a 7 little bit about the WaMu episode. 8 testified, and if I remember how he said it correctly, he 9 said the failure of WaMu caused Wachovia's liquidity runs. 10 11 Chairman Bernanke just You just said the WaMu resolution was very successful--I think those were your terms? 12 WITNESS BAIR: Yes. 13 COMMISSIONER HOLTZ-EAKIN: 14 regrets about the way it was done? 15 options that you felt were inferior? 16 WITNESS BAIR: Do you have any And what were the other Well I think there was a 17 culmination of events that led to Wachovia's liquidity 18 problems. 19 Wachovia, it was now how the resolution of WaMu was handled; 20 it was the fact that WaMu had failed for reasons related to 21 a very large Option ARM portfolio on the West Coast, which 22 Wachovia also had because of its Golden West acquisition. 23 24 25 And if there was a connection between WaMu and COMMISSIONER HOLTZ-EAKIN: And he said that, just to be clear. WITNESS BAIR: So that would be--no, I don't 148 1 think that the way that, you know--with WaMu we put that out 2 for competitive bidding. 3 all the uninsured depositors were protected, and most of the 4 general creditors, the services providers, et cetera. 5 was really term debtholders that will have some recovery, 6 and equity shareholders that took the losses. 7 We were able to get a bid where So it But Wachovia was losing uninsured deposits; they 8 were losing transaction accounts; they were losing 9 derivatives counterparties. It was part of a larger 10 escalating--I would use the word "panic," but it was a near- 11 panic situation from a whole series of events--Lehman, AIG, 12 the uncertainty of the TARP legislation. 13 confused. 14 And the market was The market was absolutely confused. And even though Lehman--excuse me, the WaMu 15 process shouldn't have surprised anybody, because for banks 16 we did have a statutory process in place that's been around 17 for a long time and should have been well understood by the 18 market. 19 It was a financial institution, and that was 20 different from what had happened with Lehman, with what had 21 happened with AIG, with what had happened with Bear Stearns, 22 and I think the market was confused. 23 So that's why I think it gets very important to 24 have this resolution authority, so the market will now 25 understand: it will be bankruptcy, or it will be this 149 1 resolution. 2 is pretty much the same. 3 But under both processes, the claims priority COMMISSIONER HOLTZ-EAKIN: Let me ask a little 4 bit about that. When they conducted the stress tests, it 5 was announced that the 19 large banks would not be subject 6 to prompt corrective action-- 7 WITNESS BAIR: 8 COMMISSIONER HOLTZ-EAKIN: 9 Um-hmm. --based on the discovery in the stress test, despite the fact that in 10 FDICIA prompt corrective action is not discretionary; it's 11 nondiscretionary. 12 How do you feel about that? WITNESS BAIR: Well, I think--I'm not sure--I 13 don't recall that we specifically said we would not follow 14 prompt corrective action. 15 I think what was said was that the Treasury would 16 stand behind--to the extent these banks' capital 17 deficiencies were identified at these banks, they would be 18 given time to raise private capital, if they could, and the 19 Treasury would come in with the TARP capital investment. 20 So either through TARP or through private 21 capitalizations they would stay above their PCA levels. The 22 government was not going to let those 19 banks become 23 insolvent. 24 is really inconsistent with PCA, because it really involved 25 a commitment to keep them above PCA through TARP So I think that was--so I don't know that that 150 1 2 investments, if necessary. COMMISSIONER HOLTZ-EAKIN: I guess the reason I 3 asked was, looking forward, you know, the new resolution 4 regime and, you know, the Dodd-Frank legislation, is 5 described as nondiscretionary. 6 WITNESS BAIR: 7 COMMISSIONER HOLTZ-EAKIN: 8 9 Um-hmm. Will market participants really believe that, in light of this episode? WITNESS BAIR: Right. Well, again I think the--I 10 don't think it was inconsistent with PCA. 11 should also--we should focus also on the fact that PCA only 12 applies to insured depository institutions. 13 institutions were not just banks with holding company 14 structures, major investment banks. 15 commitment was through the TARP to keep them above--so they 16 didn't go below PCA. 17 that 2 percent trigger. 18 I also--you Those 19 But again, I think the The government would not let them hit So I don't know if that's inconsistent with what 19 the PCA constrains. 20 And we pushed very hard for very explicit statutory language 21 that says we can't provide, and the Fed can't provide, open 22 institution assistance anymore. 23 resolution process. 24 25 You know, the law is what the law is. They have to go through a The only time the government can step in is where a system-wide support--and perhaps that type of situation 151 1 can be viewed as system-wide support, I don't know, but we 2 would not want individual institutions to ever be bailed 3 out, and I think the statute is very clear on that point. 4 5 COMMISSIONER HOLTZ-EAKIN: So I'm fundamentally evil, so I-- 6 WITNESS BAIR: Okay, that's fine. 7 COMMISSIONER HOLTZ-EAKIN: --I think of things 8 all the time, so imagine the Fed--we won't use the FDIC--but 9 the Fed in principle can open up facilities eligible to 10 everybody under the law, and then an individual bank could 11 show up, and they could assess their collateral and say we 12 can help you, and everyone else they could decide their 13 collateral is not good enough. 14 Does the law really restrict actions to open, 15 individual institutions? 16 WITNESS BAIR: Well, I think the 13.3 17 restrictions are not as stringent as they are on us, and 18 frankly we push. 19 should be just as stringent as they are for us. 20 have to--well actually now we have to go to Congress, as 21 well, for any kind of debt-guaranty program. 22 We thought that the 13.3 restrictions And we will Congress did not restrict the Federal Reserve 23 Board so significantly. 24 open to everybody. 25 solvent institutions. But it does have to be generally I believe it's supposed to only be to I believe there's an express 152 1 provision that says if the government takes losses on those 2 facilities, that immediately triggers either a bankruptcy or 3 a resolution. 4 shareholders and creditors will have to take the losses, 5 with the government having the first-priority claim. 6 So they will have to be closed, and the COMMISSIONER HOLTZ-EAKIN: Okay. To switch 7 subjects just a little bit, I've always wondered, the role 8 of this in the financial crisis. 9 of Fannie Mae and Freddie Mac, among many others, is the One of the unique features 10 fact that there are no restrictions on the amount of their 11 securities that banks can hold in their portfolios. 12 WITNESS BAIR: Yes. 13 COMMISSIONER HOLTZ-EAKIN: And so question number 14 one is, in terms of transmission of the crisis how 15 significant do you think that was? 16 And question number two: The decision to wipe 17 out the preferred holders, many of which I believe were your 18 insured banks, how much did that impact the FDIC directly 19 and the transmission of this crisis? 20 WITNESS BAIR: Right. Well, I think the 21 internalization of risk in the financial sector is a huge 22 problem. 23 focus on in our resolution plan, is requiring all of these 24 large bank holding companies and other nonbank systemic 25 entities to give us in detail who are their counterparties, And this is one of the things that we want to 153 1 who does hold their debt, who does hold their debt equity. 2 Because nobody has a big picture now. 3 difficult for us to try to project who was going to take-- 4 who could potentially be put over the cliff with Fannie and 5 Freddie and the preferred being wiped out. And it was 6 It turns out, we did on an inter-agency basis, 7 obviously this was not a result that the Treasury wanted, 8 and I on the margin did increase our losses, too. 9 think for the most part the failures occurred with banks 10 that were pretty weak and probably wouldn't have made it 11 anyway. 12 But I And we did provide additional time, which we are 13 allowed to under statute in prompt corrective action to give 14 them an additional time to have capital restoration plans, 15 and a lot of them did. 16 Some of them were not able to do so. But I think it does--you're right. It 17 underscores a broader problem: there's too much 18 internalization. 19 will also eliminate the ability to count as capital equity 20 held by another financial institution. 21 important. 22 faced with the situation where, by closing one entity and 23 imposing market discipline, you may precipitate the closing 24 of five others because they all have such tremendous 25 exposure, then you've got a real problem. I mean, one of the Basel Accord provisions That is extremely Because if you have the--you know, if you're 154 1 So I think this is something we've been very 2 focused on. 3 Basel Capital rules are addressing it in part, and we will 4 work through our resolution plans that we require these 5 large satellite institutions to have more more transparency 6 across the board for all of them. 7 8 And again, we will want to have--I think the COMMISSIONER HOLTZ-EAKIN: Thank you very much. Thank you, Mr. Chairman. 9 CHAIRMAN ANGELIDES: Can I ask for just a quick 10 clarification? 11 the GSEs were put in the conservatorship, was there a 12 consultation with you with respect to how it was done such 13 that it wiped out the preferreds? 14 And maybe I missed it when you spoke. WITNESS BAIR: We were asked by Treasury to try 15 to give them an analysis of how many banks would fail. 16 we did that analysis. 17 information. 18 19 And we were operating under imperfect We thought the number was fairly small. affected--but it did turn out to be fairly small. CHAIRMAN ANGELIDES: analysis? WITNESS BAIR: 23 CHAIRMAN ANGELIDES: 25 And do we have that I would just ask that we get that analysis. 22 24 And It did turn out--there were some that were 20 21 When Okay. Okay, thank you. All right, Mr. Georgiou. COMMISSIONER GEORGIOU: Thank you, Mr. Chairman, 155 1 2 and thank you Chairperson Bair. A problem that we've heard a great deal about 3 during our hearings was this notion of regulatory arbitrage 4 and capital arbitrage when institutions held assets off- 5 balance sheet to avoid capital requirements, and in some 6 cases purposefully characterized assets in particular ways 7 to put them into categories that required less capital to be 8 held under the rules. 9 And now, with your authority extended I suppose 10 to really all these institutions that include a depository 11 function, even at Citi we found at its peak that if you'd 12 brought everything on balance sheet they had something like 13 $3.3 trillion of assets, and about $75 billion of capital, 14 which was just a little over 2 percent net/net. 15 You know, obviously we've heard from other people 16 in hindsight that everyone agrees that if there were more 17 capital and less leverage that the prices might have been 18 ameliorated. 19 20 21 I wonder if you have a view as to what the--how to address this issue on a go-forward basis? WITNESS BAIR: Well I think both the accountants, 22 as well as the Dodd-Frank help with this. FAS 166 and 167 23 requires a lot of assets that were off-balance sheet to now 24 be counted on balance sheet. 25 and capital standards that were generally higher inside the We also in terms of arbitrage 156 1 bank and outside the bank, we supported very strongly 2 Senator Collins' amendment to require that the capital 3 levers for bank holding companies, as well as nonbank 4 systemic financial entities, has to be at least as high, the 5 capital has to be at least as high as what we require 6 generally applicable to any bank, large or small. 7 So this will help--I think this will help a lot 8 in terms of ending the regulatory arbitrage that exists 9 between doing things in the bank or doing things outside the 10 bank where you could have greater leverage. 11 be uniform. 12 will come before for bank holding companies as well as for 13 other nonbank systemic entities. 14 tremendous help to us. 15 It now has to So the generally applicable standard for banks COMMISSIONER GEORGIOU: I think this will be a Can you give us an 16 example of how that might impact a particular institution? 17 I mean, how much additional capital, either as a percentage- 18 -as a percentage would that customarily require? 19 WITNESS BAIR: Well, we have actually run some 20 aggregate analysis. I'd be happy to get the aggregate 21 numbers to you. 22 but it will increase capital levels at holding companies. 23 We've done it for bank holding companies. 24 the Council has not designated any particular nonbank 25 financial entities yet as systemic that would be subject to I don't know them off the top of our head, We haven't--since 157 1 this, we wouldn't have that. 2 holding companies, we could share some information with you 3 on that. 4 5 6 But for the impact on bank COMMISSIONER GEORGIOU: I'd appreciate that, if you would provide that. We have heard, pardon some people's skepticism, 7 that we've ended the too-big-to-fail problem. 8 have, but it's not entirely clear. 9 WITNESS BAIR: 10 I hope we Right. COMMISSIONER GEORGIOU: A lot of institutions 11 have grown enormously. 12 been brought to our attention by our staff that the top six 13 banking institutions held roughly--their assets were roughly 14 17 percent of US GDP in 1995, gone up to 38 percent in '02, 15 58 percent in 2007, and given the disappearance of some 16 entities and the merger of some entities into the larger 17 ones, they've actually gone up from 58 percent to 63 percent 18 of GDP in 2009. 19 We have these statistics that have So these six institutions at least--Bank of 20 American, JPMorgan Chase, Citigroup, Wells, Goldman Sachs, 21 and Morgan Stanley--all appear even today to be institutions 22 which, if they were stressed as they were two years ago, 23 would be candidates for assistance of some sort from the 24 government, not withstanding the prohibition on particular 25 assistance to single institutions that's in the Dodd-Frank 158 1 bill. 2 I wonder if you could speak to that: 3 really believe, if push comes to shove, these institutions 4 will be allowed, with the new resolution authority, to 5 dissolve themselves? 6 WITNESS BAIR: We do. If you I think over time there 7 will be market pressures to downsize. 8 capital requirements will create some pressure to downsize. 9 I think increasing I think increased market discipline through new 10 resolution authority will also create pressure to downsize. 11 But I do think that with the tools we have available we can 12 do an orderly resolution. 13 once we have their own living will plans. 14 largest entities that have dominant depository institutions, 15 there's a lot of information about them already. 16 We can do it more effectively But for the So I think, yes, we can use this resolution 17 mechanism if we need to for institutions even of that size. 18 And we have the capacity to move the key functions of the 19 entity into a bridge bank and fund it temporarily to keep 20 the franchise available as we market and sell it off. 21 this is a tool that we have used for many years, and it 22 works quite successfully. 23 And So we do think it will be a system that will work 24 better than bankruptcy, and it certainly is a much better 25 alternative to bailouts. 159 1 COMMISSIONER GEORGIOU: Okay. I think really, if 2 I could, Mr. Chairman, I would like to reserve time and 3 perhaps I will come back afterwards. 4 Chairwoman Bair. 5 CHAIRMAN ANGELIDES: 6 COMMISSIONER GRAHAM: 7 Thank you very much, Thank you. Senator Graham. Thank you, Mr. Chairman. Thank you, Madam Chairman. 8 I am concerned with the statistics that 9 Commissioner Georgiou just stated about the increasing level 10 of concentration in our largest financial institutions. 11 Why do you think this is happening? 12 the argument that it's in the public interest? 13 WITNESS BAIR: And what's I think it happened because of 14 too-big-to-fail. 15 had an implied government backstop. 16 were willing to pump money into you to get highly leveraged 17 returns. 18 government backstops for very large financial institutions, 19 combined with capital standards that were not high enough. 20 I think the bigger you got, the more you And the more investors I think it's a combination of the implicit So I do think over time--I will also say under 21 Dodd-Frank that the new Financial Stability Oversight 22 Council has the ability, at the Fed's initiative I believe, 23 to start requiring divestitures if it's determined that this 24 institution poses a systemic risk currently. 25 We also, the Fed and the FDIC jointly, if these 160 1 institutions do not submit a living will--i.e., resolution 2 plan--that we think is sufficient to show they can be 3 resolved in an orderly way, we also have the power to start 4 ordering divestiture. 5 6 7 So those are pretty extraordinary tools, but those are tools that are available to us in the new law. COMMISSIONER GRAHAM: Do you believe there is the 8 political support, both in the Executive Branch and in the 9 Congress to implement these available powers to begin the 10 process of restraining the growth of these large 11 institutions? 12 WITNESS BAIR: Well we'll find out soon. I think 13 we certainly are forging ahead, and I think everybody else 14 is just as committed. 15 I think you heard Chairman Bernanke is highly 16 supportive of resolution authority, and working with us in 17 the areas where we have joint rulemaking authority. 18 So I think it needs to be done. 19 done in a measured, and transparent way, but also in a 20 timely way. 21 It needs to be Our plan is to have a general framework out for 22 resolution authority in the very near future, and we will 23 use that as an interim final rule to solicit more detailed 24 comment, and have a more detailed plan finalized over the 25 next several months. 161 1 On the living will piece, the statute gives us an 2 outside marker of 18 months. 3 much earlier than that, if possible. 4 the markets in the United States are resilient, and I think 5 if they understand what the rules are they'll be able to 6 live with the rules. 7 get the rules out and have clarity. 8 9 I'd like to get the rule out So I think--you know, But I think the important thing is to COMMISSIONER GRAHAM: Chairman Bernanke talked some about the possibility of coming up with a report card 10 indicating whether these large institutions were in fact 11 responding to some of the new incentives. 12 13 14 Do you see the utility of something like that through your agency? WITNESS BAIR: Yes, I do. I think I--that's the 15 first I've heard of that, so I don't know exactly what the 16 proposal is, but I think it's a good idea. 17 something we'd want to do jointly with the Fed, as opposed 18 to having--we wouldn't want dueling report cards, probably. 19 It might be But the Fed though is--we have resolution 20 authority over nonbank systemic entities. 21 the lead supervisor obviously for bank holding companies, as 22 they are now for the nonbank systemic entities. 23 assume, in terms of developing that type of institution- 24 specific report card, the Fed would have the lead. 25 COMMISSIONER GRAHAM: The Fed will be So I I also asked the chairman 162 1 about the difference in some other areas of the economy in 2 terms of whether the private entities have come together to 3 provide some effective voluntary oversight and enforcement 4 of their best practices, using the nuclear industry as the 5 good example, and maybe the not-so-good example being the 6 deep-water drilling industry. 7 From your perspective, are the institutions that 8 you supervise in terms of their willingness to come together 9 to provide a voluntary early line of defense against 10 inappropriate activities, are they more like the nuclear 11 industry, or the deep-water drilling? 12 WITNESS BAIR: Right. Well I think most are 13 trying to do the right thing, I really do. 14 roundtable discussion on resolution authority, and wanted to 15 start the dialogue on living wills, too, and I was 16 impressed. 17 We just had a We had many very large institutions present, and 18 they had all, it was clear to me, already given this some 19 serious thought. 20 they do understand the mandate. 21 So I think they are taking it seriously; They do understand that if they don't adhere to 22 the statutory requirements there will be other, more adverse 23 consequences in terms of the potential for forced 24 divestiture. 25 but it is there and could be used if it needed to be used. And that wouldn't be in anybody's interest, 163 1 2 So I was encouraged by that roundtable. Again, there is still a lot of work ahead, but I was encouraged. 3 COMMISSIONER GRAHAM: I would suggest that that 4 movement towards a greater degree of acceptance of 5 independent responsibility might be an appropriate item on 6 your report card. 7 WITNESS BAIR: I think that's right. 8 Accountability--you know, we can't do this all, and if we 9 don't have responsible management taking ownership and 10 accountability for the changes that need to be made, it is 11 not going to work. I couldn't agree more. 12 COMMISSIONER GRAHAM: 13 CHAIRMAN ANGELIDES: 14 COMMISSIONER HENNESSEY: 15 Mr. Hennessey. You really are mixing things up. 16 (Laughter.) 17 CHAIRMAN ANGELIDES: 18 Thank you, Mr. Chairman. doctrine. No, that's the fairness Outside in/inside out. 19 COMMISSIONER HENNESSEY: 20 I want to follow up actually on two of Doug's 21 22 Thank you, Mr. Chairman. questions and just ask you to drill down a little bit more. One is on banks holding GSE. In particular, I'm 23 interested in debt. And I just want to review kind of for 24 the record and make sure I understand it. 25 FDIC-insured bank, I can't hold more than a certain portion So if I'm an 164 1 of my assets in the debt of General Motors, or IBM, but I 2 can hold 100 percent of my assets in the debt of Fannie or 3 Freddie? 4 Is that basically right? WITNESS BAIR: I think that's right. 5 have our capital expert--that is right, yes. 6 COMMISSIONER HENNESSEY: 7 rules? 8 9 10 I don't And who sets those Are those FDIC rules? WITNESS BAIR: Well, those were rules--no. would be set on an interagency basis. Those And I think it's a point well taken. 11 COMMISSIONER HENNESSEY: So is it sort of a 12 common set of rules that FDIC and OCC and the Fed all agree 13 and say here are the rules? 14 WITNESS BAIR: That's right. 15 COMMISSIONER HENNESSEY: And is that an area that 16 should be looked at going forward to say, you know what, 17 we're going to treat these guys the same as others, given-- 18 WITNESS BAIR: Absolutely. Absolutely. I think, 19 you know, while we're on the subject, we'll just go a little 20 further and, you know, there's a lower risk waiting for GSE 21 debt, too, than there was for corporate debt. 22 right? 23 24 25 And was that No, I don't think it was, either. So, yes, I'm not going to disagree with you on any of that. COMMISSIONER HENNESSEY: And looking back, I mean 165 1 my recollection during the crisis is, once you got to the 2 point where Fannie and Freddie were failing, sort of the 3 risk waiting is a long-term problem, but the real systemic 4 transmission risk was the fact that, if we broke the line 5 into GSE debt, there were banks that would fail because they 6 had bet too heavily on GSE. It was that concentration-- 7 WITNESS BAIR: 8 COMMISSIONER HENNESSEY: 9 10 Right. --of firm-specific risk. Is that right? WITNESS BAIR: This is a two-year-old 11 conversation, but I don't frankly recall when Treasury 12 started engaging us on this. 13 the decision that they weren't going to go above preferred. I think they had already made 14 COMMISSIONER HENNESSEY: 15 WITNESS BAIR: Right. I'll go back and check that, but I 16 don't think--there were others. 17 held a lot of GSE debt. 18 Treasury, too, but I don't recall that they had ever 19 considered going-- 20 So you should probably ask COMMISSIONER HENNESSEY: 21 transition, then, into Basel. 22 discussion for Basel, as well? 23 are held all over the world. 24 25 It wasn't just banks that WITNESS BAIR: Let me try a smooth Should that be a topic of Because agency securities That's true. That's very true. And I would have to--there are limitations on the ability of 166 1 financial institutions to hold equity in other financial 2 institutions. 3 weighting, I don't--I will check. 4 considered, it hasn't risen up to the principal level, but I 5 can check on that for you. 6 On the debt holdings in terms of the risk COMMISSIONER HENNESSEY: If it has been Related to that, I've 7 seen some of the same press reports about pushback within 8 the Basel discussions that the capital levels are too 9 stringent. 10 Who is pushing back? WITNESS BAIR: 11 confidential. 12 those are the rules-- 13 14 Well, those conversations are So I know that's an issue with some, but COMMISSIONER HENNESSEY: Can you tell us what Continent it is? 15 (Laughter.) 16 WITNESS BAIR: Well, I wouldn't disagree with any 17 of the public reports, I'll put it that way. I mean, I am 18 just really hoping we can all go with a consensus. 19 it troubles me if individual countries, you know, want to 20 adhere to too-big-to-fail as a basic tenet of their banking 21 system. 22 allow excessive leverage with your banking sector, knowing 23 those capital levels will not be sufficient to cover losses 24 if you get into a downturn, you're really just saying you're 25 going to be bailing them out. Because that's really the alternative. I think If you 167 1 And so that's not good for anybody. And so we do 2 need to all do this together. 3 competitive disadvantage, it's more of an issue among 4 countries in Europe than it would be the U.S. versus Europe. 5 I think in terms of a But I do hope that we can all come to agreement 6 on that. 7 too-big-to-fail, and an important component of that is 8 making them have capital high enough to absorb their losses 9 so they can stand on their own two feet. 10 It's in everybody's interest to get rid of COMMISSIONER HENNESSEY: Good. Nonbank financial 11 institutions and FDIC-insured banks, and the FDIC model of 12 course is since the deposits are insured, or at least up to 13 a certain level depositors don't have to worry about it. 14 And one thing we heard from Chairman Bernanke and others is 15 that you had liquidity runs which were parallel to the old 16 pre-FDIC bank depositor runs. 17 WITNESS BAIR: Right. 18 COMMISSIONER HENNESSEY: Reading your testimony, 19 it sounds like the same sort of liquidity runs were 20 occurring with at least Wachovia and WaMu. 21 22 23 WITNESS BAIR: Uninsured depositors, they were, absolutely. COMMISSIONER HENNESSEY: Uninsured depositors. 24 But were Wachovia and WaMu experiencing the same sorts of 25 liquidity runs that we hear about-168 1 WITNESS BAIR: 2 COMMISSIONER HENNESSEY: 3 WITNESS BAIR: Wachovia was--yes, Wachovia COMMISSIONER HENNESSEY: So the nondepositor liquidity problems were-- 8 9 Yes. was, yes. 6 7 --the nonbank financial institutions? 4 5 Yes. WITNESS BAIR: That's right. 10 Also impacted in some banks. That's exactly right, yes. COMMISSIONER HENNESSEY: Okay. And then could 11 you take a minute just to drill a little more maybe into 12 explaining--because I hear so much about the way FDIC did 13 the Washington Mutual resolution--can you just simply 14 explain kind of-- 15 16 VICE CHAIRMAN THOMAS: Would the gentleman like an extra minute for her to explain it? 17 COMMISSIONER HENNESSEY: Thirty seconds for the 18 response--for my question, and whatever time she needs to 19 respond. 20 VICE CHAIRMAN THOMAS: 21 COMMISSIONER HENNESSEY: 22 Okay. Can you just explain-- 23 CHAIRMAN ANGELIDES: 24 COMMISSIONER HENNESSEY: 25 Thank you. He says 'yes.' --where you drew the line, why, and what that complaint is of what your response 169 1 is to it? 2 Because I'm not sure I understand. WITNESS BAIR: Well, you know, I think--I'm sure 3 everybody would of liked to have gotten bailed out. 4 that's, you know, if you're holding debt or equity you're 5 going to want to prefer that you'd gotten bailed out. 6 think-- 7 COMMISSIONER HENNESSEY: I mean So I Actually--actually, if I 8 could, the concern I'm hearing is that the way FDIC did it 9 was in some way upending the traditional capital structure, 10 or it sent signals to others who held bank debt. 11 WITNESS BAIR: 12 COMMISSIONER HENNESSEY: 13 No, no. And I'm sorry, because I'm confused in what I'm hearing. 14 WITNESS BAIR: No, that is not. And if you would 15 like a walk-through from our Receivership staff, I would be 16 happy to provide that. 17 COMMISSIONER HENNESSEY: 18 WITNESS BAIR: But, no, we had been on top of 19 that for several months. We did have time there working 20 with OTS and the bank. 21 more capital into it. 22 Yes. There were a lot of efforts to get They went through two different bank runs and 23 were hemorrhaging deposits badly. 24 were being pulled. 25 portfolio. Their lines of credits They had a very, very bad Option ARM Their immediate failure was triggered by 170 1 liquidity, but I think all of our examiners think there 2 would have been a capital insolvency. 3 already knew that. 4 The market just So we gave the bank as much time as we could to 5 get their recapitalization. 6 fortunately as part of that recapitalization, they had 7 talked to other investors. 8 investors that had already been into the bank, the thrift, 9 doing due diligence. 10 It couldn't come through. But There were a number of other So that when we had to start our own process, we 11 had folks who were familiar with the institution and were 12 prepared to bid. And that is the same process we use for 13 small banks now. That's the same process we use every 14 Friday. 15 COMMISSIONER HENNESSEY: Thank you. 16 WITNESS BAIR: 17 CHAIRMAN ANGELIDES: 18 COMMISSIONER MURREN: 19 Thank you, Chairman Bair. You're welcome. Heather? Ms. Murren. Thank you. I would like to 20 actually focus on the traditional bank examination process 21 for a couple of minutes. 22 WITNESS BAIR: 23 COMMISSIONER MURREN: Okay. It's been told to me that 24 that process has actually changed post-crisis; that after 25 the crisis it's gotten much more intense; that the examiners 171 1 are at the banks longer, and perhaps are a little tougher in 2 their judgments than they had been previously. 3 And I'm curious as to whether you think that's 4 fair, or whether you think that that's simply by virtue of 5 the environment that we're in? 6 WITNESS BAIR: Well I think our examiners overall 7 have tried very hard to take a balanced approach, and we've 8 encouraged them in Washington to take a balanced approach. 9 It is a more distressed environment. We do have 10 a lot of banks out there--it's a minority, but still a 11 significant number that have some very troubled loans still 12 on their books that they're still working through. 13 And those types of banks take more time for 14 examiners to go in and to work with them. 15 clear that we want banks to lend. 16 prudent loans. 17 banks or the examiners over-reacting and battening down the 18 hatches and just not extending credit. 19 possible thing that we could have for the economy or for the 20 banking system. 21 But we've made it We want them to make We want them to lend. We don't want the That's the worst So I think overall our examiners have set the 22 right tone. We have issued multiple pieces of guidance 23 encouraging them and banks to lend, to work with borrowers 24 when they do get into trouble whether it's a mortgage 25 holder, whether it's a commercial real estate borrower, if 172 1 they get into trouble to try to work out the loan, if that's 2 going to present better value and typically it will in a 3 distressed environment like this to try to do some type of 4 loan modification. 5 And so I think that's overall been as successful 6 as it can be, given the current environment. But I know 7 there are still particular cases where we hear complaints, 8 and we have an ombudsman here, and banks can engage the-- 9 that's what the ombudsman is for. If they feel like the 10 examiner is not following articulated policies, they have 11 recourse. 12 COMMISSIONER MURREN: Thank you. To follow on 13 this, in your written testimony you talked about the fact 14 that sometimes it is difficult to see, particularly in the 15 larger, more complex institutions, things that may not be 16 apparent prior to failure, such as exposures and systemic 17 linkages. 18 And I'm curious as to whether, when you think 19 about the ability going forward to evaluate that, has the 20 fundamental bank examination process also evolved to include 21 those things as the portfolio of things they look at? 22 that more the-- 23 WITNESS BAIR: Or is That's a really good question. So 24 I think the answer is, I would like to see that. We are 25 pushing--I'm chairman of the Federal Financial Institutions 173 1 Examination Council, otherwise known as FFIEC, which is an 2 interagency group focused on bank examination practices. 3 And we would very much like to update our 4 CAMELS rating process and expand the types of questions that 5 examiners traditionally ask to get more focused. 6 Right now the examination process is very, very 7 focused on credit quality on the asset side. 8 are those loans performing, not so much on the liability 9 side. 10 11 So how well You know, where's your liquidity coming from? is stable? What What's not? So getting more information along those lines I 12 think would be extremely helpful for all banks. 13 would like to see that as part of our examination process. 14 And so I For the larger institutions we've also been 15 working with the New York Fed on more detailed information 16 on liquidity for the very largest institutions. 17 very much an area of focus right now. 18 COMMISSIONER MURREN: Great. That is I have one question 19 that's a little bit off of this topic, but has anyone done, 20 to your knowledge, an analysis of what the capital ratios-- 21 what would they have had to have been post-mortgage crisis 22 to allow some of these firms to have actually survived? 23 it possible? 24 25 WITNESS BAIR: Was We do have those numbers, and they're part of the aggregate analysis that we were doing of 174 1 how much additional capital would come in under the new 2 capital standards. 3 you. 4 And I would be happy to provide it to COMMISSIONER MURREN: Do you happen to recall 5 what the general numbers look like? 6 WITNESS BAIR: I think economists, different 7 people, agree, I think for Tier One Common Equity, which is 8 true loss-absorbing capital, the range is from 8 to 13 9 percent. 10 COMMISSIONER MURREN: 11 CHAIRMAN ANGELIDES: 12 very quickly, 8 to 13 percent on Tier One? 13 WITNESS BAIR: 14 CHAIRMAN ANGELIDES: 15 WITNESS BAIR: 16 CHAIRMAN ANGELIDES: 17 WITNESS BAIR: 18 CHAIRMAN ANGELIDES: 19 Great. Thank you. Just to follow up on that Um-hmm. How does that compare to-- Tier One Common. Tier One Common? Yes. How does that compare to pre-crisis? 20 WITNESS BAIR: Well, there was not a Tier One 21 Capital in the U.S., especially for holding companies, that 22 included a lot of things that-- 23 24 25 CHAIRMAN ANGELIDES: Excuse me? For what kind of companies? WITNESS BAIR: For holding companies. 175 1 2 CHAIRMAN ANGELIDES: For holding companies. I just didn't hear you. 3 WITNESS BAIR: It involved a lot of things that 4 were not true losses through capital, a lot of hybrid debt. 5 So when I'm talking about Tier One Common Equity, true loss- 6 absorbing capital. 7 the current requirement for risk-based capital is 8 percent, 8 for Tier One for adequate, like 10 percent for well, but 9 there was just a predominance of that had to be Common 10 We did not have a requirement for the-- Equity. 11 So the actual amount of true losses that were in 12 Common Equity was significantly lower. 13 Basel right now is to get the Tier One Common Equity levels 14 up. 15 16 CHAIRMAN ANGELIDES: WITNESS BAIR: 18 CHAIRMAN ANGELIDES: Functionally? True loss-absorbing capital was at what level? 20 WITNESS BAIR: 21 my head. 22 could. The--I don't know off the top of I'd like to get the written analysis for you, if I 23 CHAIRMAN ANGELIDES: 24 WITNESS BAIR: 25 But do you know where it was functionally? 17 19 So that the focus of percent. Okay, if you would, please. But it would probably be around 4 Between 4 to 6 percent would be my guess. 176 1 2 CHAIRMAN ANGELIDES: range. Thank you. So you're talking about 4 to 6, now up to 8 to 13. 3 WITNESS BAIR: Well, again, this is being debated 4 right now. 5 international community. 6 seen have been 8 to 13 percent, yes. 7 8 9 That was the And it's not just my decision. It's part of an But the ranges of estimates I've CHAIRMAN ANGELIDES: Terrific. COMMISSIONER BORN: Thank you. Thank you. Ms. Born. And thank you 10 very much, Chairman Bair, for appearing before us. 11 you are the only witness to have appeared publicly before us 12 twice, so I think our thanks are particularly necessary. 13 WITNESS BAIR: 14 COMMISSIONER BORN: I think My pleasure. I would like to explore with 15 you a little bit how over-the-counter derivatives played a 16 role in creating financial institutions that are too big to 17 fail, the topic of our hearing today. 18 And more specifically, whether the 19 interconnections between large financial institutions 20 through counterparty relationships in over-the-counter 21 derivatives, and whether the concentration of over-the- 22 counter derivatives' positions in the largest institutions 23 played a role and were significant factors in rendering 24 those institutions too-big-to-fail. 25 WITNESS BAIR: Well I think with AIG clearly that 177 1 was the problem. 2 crisis in a number of ways. 3 problem. 4 a problem. 5 I think derivatives played a role in this Concentrations was clearly a The lack of transparency in the market was clearly So nobody knew where the risks were. 6 where the exposures were. 7 nobody knew where the losses would fall next. 8 9 Nobody knew So everybody seized up because I think CDS in particular created an illusion of risk-free transaction, when it just simply wasn't the case 10 because of the concentration of who was holding--who was 11 going to have to pay if there was a credit default. 12 So I think all those factors played in and were 13 major contributors to this crisis. And I am very glad, 14 thanks to your leadership, early leadership on this, that 15 Dodd-Frank has got a number of key provisions to move so 16 much of this on to exchanges and through central clearing 17 now. It will be a big help. 18 COMMISSIONER BORN: Do you think those provisions 19 will reduce the systemic risk from the over-the-counter 20 derivatives market? 21 WITNESS BAIR: I think it will certainly reduce 22 the risk. 23 for end users, as you know, and we'll see how that plays 24 out. 25 I think there's still a fairly large flexibility I think in terms of, we were disappointed in 178 1 terms of our own resolution process. 2 timeframe to decide whether to accept or repudiate 3 derivatives contracts if a bank, or now a systemic financial 4 entity fails. 5 a weak bank, we can require that they have systems in place 6 so that they can tell us on basically a moment's notice what 7 their net exposures are per counterparty. 8 9 We have a very short We were hoping--right now, for banks, if it's But for a healthy bank, we can't require that. And we were really hoping to get that. That's probably 10 something we'll keep pushing for. 11 holding companies we, with the other regulators, can 12 institute a rule to require that they know, on a real-time 13 basis, what their net exposures are by counterparty, which I 14 think will be extremely helpful as well in terms of managing 15 risk and risk concentrations. 16 17 18 Ironically, for nonbank But for banks, we still have this gap that we'll try to get fixed. COMMISSIONER BORN: Let me just go back to one 19 factor in the financial crisis and the panics that were 20 created by--or that you were concerned would be created by a 21 failure of Wachovia, the panic that was created by the 22 failure of Lehman Brothers. 23 I know that you've said you were concerned as 24 part of the systemic risk analysis for Wachovia about the 25 counterparty relationships, including the over-the-counter 179 1 derivatives relationships. 2 WITNESS BAIR: Right. 3 COMMISSIONER BORN: Was your concern limited to 4 the credit default swap positions? 5 to the overall positions, which of course were much larger? 6 WITNESS BAIR: Or was it--did it relate They had a lot of structured 7 products in their trading book that we, again, just did not 8 have enough information to get up to speed on. 9 don't think it was just CDS. So, no, I John Corston, who's our lead 10 examiner, here--it wasn't just CDS, yes. 11 COMMISSIONER BORN: And do you think that, as of 12 that time, the over-the-counter derivatives market as a 13 whole was playing a role in market uncertainty and panic? 14 WITNESS BAIR: I do. Because, again, because of 15 the opacity of the market nobody knew where the risks were, 16 who was going to take the losses, and that just--you know 17 the wholesale sources of funding just completely dried up, 18 just because nobody knew where the exposures were and who 19 was going to take the losses. 20 COMMISSIONER BORN: Well let me just say, as a 21 final thing, that I think that a lot of the steps that were 22 taken on systemic risk in the Dodd-Frank bill and that are 23 being taken administratively are in the right direction. 24 I certainly hope--I think one issue has been the 25 institutional supervisor's focus on individual institutions 180 1 and thereby-- 2 WITNESS BAIR: Yes. 3 COMMISSIONER BORN: --the ignorance, or the lack 4 of attention, lack of focus, to market-wide issues like the 5 securitization process, like the over-the-counter 6 derivatives market, and I very much hope that the Financial 7 Stability Council will look not only at the systemically 8 significant institutions, but keep an eye out for 9 systemically relevant markets and problems in those markets. 10 WITNESS BAIR: I agree with you. I agree with 11 you. The products and practices can be just as devastating 12 as individual risk institutions, perhaps more so. 13 COMMISSIONER BORN: 14 CHAIRMAN ANGELIDES: 15 COMMISSIONER WALLISON: 16 And thank you for being here, Madam Chairman. 17 Thank you. Mr. Wallison. Thank you, Mr. Chairman. I have been trying to explore a little issues 18 associated with the discount window, which I know you don't 19 manage or have any control over. 20 WITNESS BAIR: Right. 21 COMMISSIONER WALLISON: But some of the issues 22 that have come up is, what was the significance of the 23 discount window at the time that Wachovia ran into 24 difficulties? 25 What we have heard is that the plan for Wachovia 181 1 was to combine it with some other institution. 2 to have been the only plan. 3 the discount window is available specifically for runs for 4 solvent banks. 5 That seems Now my understanding is that Was it the view of the FDIC, or any of the other 6 regulators as far as you know, that Wachovia was in fact 7 insolvent? 8 9 WITNESS BAIR: Again, I don't think we had the-- no, at that point in time it was not. It was a liquidity 10 crisis. 11 closed if it becomes insolvent or if it cannot meet its 12 obligations. 13 Though I will say, under the FDI Act a bank can be So the Fed has no affirmative obligation to fund 14 an entity just because it's got a liquidity crisis. 15 actually the Fed is specifically prohibited from lending 16 into a failing institution. 17 So I don't speak for the Fed. And I don't know what 18 the Fed's decision making was on that, but I will say this 19 is a sensitive area for us. 20 lending, and that is government assistance going into that 21 troubled institution, and that facilitates a lot of other 22 counterparties, right, pulling their money out, the Fed is 23 the secured lending and the Fed takes the highest quality 24 collateral when it lends into an institution. 25 Because if the Fed does start If that institution then subsequently fails, it 182 1 will cost the FDIC a lot of money. 2 specifically says that the Fed should not be lending into a 3 failing institution. 4 we agree to that. 5 That is why the statute And actually I think can only do so if So I don't know the specific situation about the 6 Wachovia's use or not use of the discount window. 7 defer to the Fed on that. 8 policy matter, this is a sensitive area for us. 9 certainly support the Fed being very careful about when they 10 11 12 13 I would But I would say as a general And we use that. Because if the institution ends up failing, it will definitely increase our costs. COMMISSIONER WALLISON: Well when I raised this 14 question with Chairman Bernanke this morning, he said that 15 you--that is, the FDIC, not "you" specifically but the FDIC- 16 -had said, at least as I heard him, the FDIC had said that 17 Wachovia was a failing institution and therefore the Fed 18 could not make that loan to them because they would not 19 normally lend into a failing institution. 20 asked the question about the solvency. 21 WITNESS BAIR: That's why I Well it was--well, I guess we were 22 acting on information from the OCC, which is not here, and 23 the Fed were providing us, and the bank's own information 24 suggesting they could not meet their liquidity needs. 25 could not meet legal demands and obligations that they had They 183 1 come Monday morning. 2 in paper that they had not been able to raise on Friday. 3 And I think there was about a billion COMMISSIONER WALLISON: Well just to be clear, 4 the whole purpose of the discount window is to solve 5 liquidity problems. 6 WITNESS BAIR: Right. 7 COMMISSIONER WALLISON: And so it's not a 8 question of whether they could meet their liquidity needs; 9 the question is whether people thought they were insolvent. 10 WITNESS BAIR: Right. But I think, again I--at 11 that point in time, it was not insolvent. 12 maintain capital solvency was an open question, depending on 13 a lot of factors like what's going to happen to the housing 14 market. 15 Whether it would But there were certainly a lot of credit quality 16 issues with Wachovia. 17 it wasn't a perfectly healthy institution; it just fell 18 victim to broader market events. 19 reacting to some very bad decisions the management had made. 20 I don't think anyone can suggest that COMMISSIONER WALLISON: Clearly the market was Okay, well then 21 unfortunately that leads to the next question. And that is, 22 if you approved--that is, the FDIC--approved a combination 23 between Citibank that was already a very weak institution, 24 and an institution that apparently you thought was on its 25 way to failure, and in that combination, as you said in your 184 1 prepared testimony, Citi had to assume $42 billion of risk 2 on Wachovia as part of that transaction, how does any of 3 that make any sense? 4 I mean, we have Citi that's already weak and in 5 trouble. 6 organization that I think you thought might be insolvent, or 7 on its way to insolvency-- 8 9 They are being asked now to merge with an WITNESS BAIR: Well it was clearly failing. I mean, the FDI Act specifically recognizes liquidity failures 10 are capital insolvencies. 11 was clearly failing. 12 based on the information we had, we thought that Citi was 13 the stronger institution. 14 From a liquidity standpoint, it And so, you know, I think at the time, And obviously later they ran into their own set 15 of problems. 16 collective decision of everyone that this would stabilize 17 the situation; that this would stabilize the situation that 18 Citi was, even though it perhaps its own problems, was the 19 stronger institution than Wachovia and that would stabilize 20 the situation. 21 But at that point, I think it was the We had to do something. I mean, I think we had-- 22 we had to do something. And I think, you know, saying, 23 well, the Fed should just lend, that, that also is a form of 24 government assistance. 25 government bailout. Some may also view it as a form of 185 1 And if all of the counterparties started pulling 2 out of Wachovia, with the Fed left, with a huge exposure to 3 Wachovia, and then it had failed later, I would be having a 4 very different hearing with you right now. 5 it a perfect decision, Peter? 6 the information we had and the options we had available, I 7 think it was the only course of action at that point. 8 9 No, it wasn't. COMMISSIONER WALLISON: CHAIRMAN ANGELIDES: 11 COMMISSIONER THOMPSON: 13 14 15 All right. But based on Thank you, Madam Chair. 10 12 So I think, was Mr. Thompson. It's nice to bat clean- up, for a change. CHAIRMAN ANGELIDES: I was going to say, the clean-up batter, for a whole nine months of hearings. COMMISSIONER THOMPSON: I won't take you back 16 through the past. I'd like to look forward, if we might, 17 and focus on the new regulations. 18 hallelujah day when the Dodd-Frank bill passed and you now 19 have more things to help you control this environment. 20 WITNESS BAIR: 21 COMMISSIONER THOMPSON: It must have been a Right. But I was struck by the 22 comment you made that says there's little discretion now in 23 the hands of any of the regulators, particularly in an 24 environment where innovation occurs so fast. 25 financial system, not just a U.S. financial system. It's a global 186 1 And crises, as they erupt or emerge can't be 2 anticipated in legislation and regulation. 3 think it is reasonable that the Congress would give you no 4 discretion whatsoever in the way they have outlined the 5 current legislation? 6 WITNESS BAIR: So do you really Well, there is discretion in terms 7 of providing system-wide support. 8 13.3 facility. 9 to approve their use of that. The Fed has it through a I believe the Secretary of the Treasury has And we would have it with a 10 Congressional approval process for providing system-wide 11 guarantees of financial liabilities. 12 So if it is truly a system-wide crisis impacting 13 all institutions, healthy and not, we do have the ability to 14 provide some system-wide support. 15 resolution piece for the ones that are failing because they 16 were mismanaged which will be put into resolution process. 17 So I think that the combination of--well, first But we also have the 18 of all, it's my fervent hope that, through greater market 19 discipline and higher capital standards we will certainly 20 have another cycle. 21 facing, I hope we do not see that again. 22 extraordinary event. 23 But the kind of cataclysm we were This was truly an We will have cycles, but I do think these 24 combination of tools will be sufficient. And I think, you 25 know, again, of the different options that are available, 187 1 bailouts are just not acceptable going forward. And the 2 bankruptcy, I think frequently will be the course used for 3 the weaker institutions. 4 Where they have systemic functions, the 5 government setting up a bridge and operating it as it's sold 6 off for a period of time, I think that is an important tool 7 for us to have as well. 8 9 10 COMMISSIONER THOMPSON: So there is room for some judgment to be applied? WITNESS BAIR: Yes, in terms--if it's a true 11 system-wide crisis, that's right; yes. 12 generally available assistance on a system-wide basis. 13 Then, even if the government took a loss on those types of 14 facilities, as we were discussing earlier, that would 15 trigger either a bankruptcy or a resolution. 16 shareholders and creditors would be taking the losses, not 17 the government. 18 COMMISSIONER THOMPSON: But again, only for So the I was also struck by the 19 fact that you highlighted the Financial Stability Oversight 20 Council as one of the three key important attributes as we 21 move forward. 22 Quite frankly, my experience in the private 23 sector has been that councils are places where people go to 24 opine and pontificate, and nothing ever gets done. 25 WITNESS BAIR: Right. 188 1 COMMISSIONER THOMPSON: And with the limited 2 experience, candidly, I've had in government, it's very true 3 there. 4 5 So what would lead us to believe-CHAIRMAN ANGELIDES: "commissions"? 6 (Laughter.) 7 CHAIRMAN ANGELIDES: 8 You said "councils," not "commissions." 9 He said "councils" not There's a very fine distinction. (Laughter.) 10 WITNESS BAIR: 11 COMMISSIONER THOMPSON: 12 VICE CHAIRMAN THOMAS: 13 Okay. So why should-Reserving the right to object. 14 (Laughter.) 15 WITNESS BAIR: 16 COMMISSIONER THOMPSON: That's right. --why should we believe 17 that this Council is going to be uniquely different and keep 18 us out of trouble? 19 WITNESS BAIR: Well, you know, I think--I'm glad 20 you're skeptical because that will put pressure on all of us 21 to make sure that we don't just, you know, meet every 22 quarter and look at each other. 23 I think one thing that's been helpful, though, is 24 Congress has clearly given this new Council accountability. 25 And if there's another systemic crisis, we can't go and say, 189 1 well, the Fed had holding companies and, you know, the OCC 2 had national banks, and the SEC had the investment banks. 3 We're all put together in the same room, and it's our job to 4 manage systemic risk and make sure there are no regulatory 5 gaps. 6 So we have accountability. We have ownership. 7 If we don't do our job, then we should be held strongly 8 accountable. 9 think people keeping our feet to the fire will help us get 10 So I'm hoping that kind of pressure--plus, I the job done. 11 I think Congress also has prescribed specific 12 statutory roles for the Council with time frames, so we have 13 to move ahead if we're to comply with the statute, and we 14 should comply with the law and we have to move ahead. 15 So I have high hopes for it. I do. It's not 16 structured exactly the way we thought. 17 more of an independent council with an independent chairman 18 with writing authority and more of a robust entity. 19 think the structure that Congress approved can work, and we 20 will do everything we can from our perspective to make it 21 work. 22 COMMISSIONER THOMPSON: We were thinking But I So final question. If 23 you look back over the last three years, four years, and if 24 you had one bullet that you could fire as a regulator that 25 would have mitigated or, quite frankly, prevented this 190 1 financial calamity, what would that have been? 2 WITNESS BAIR: I absolutely would have been over 3 at the Fed writing rules, prescribing mortgage lending 4 standards across the board for everybody, bank and nonbank, 5 that you cannot make a mortgage unless you have documented 6 income that the borrower can repay the loan. 7 COMMISSIONER THOMPSON: 8 CHAIRMAN ANGELIDES: 9 Here, here. All right. Thank you. Thank you. more questions from Commissioners, compelling--yes. Any It 10 doesn't have to be compelling, it just has to be a question. 11 Go ahead, Mr. Holtz-Eakin. 12 COMMISSIONER HOLTZ-EAKIN: Following up on Mr. 13 Thompson's question, why isn't the new Stability Council 14 just the President's Working Group on Financial Markets with 15 a coat of paint? 16 WITNESS BAIR: Well, I hope--you know, the 17 President's Working Group has done some good work. 18 been behind the scenes, and I think that's been an area of 19 criticism, so perhaps it's not been--its contributions have 20 not been as appreciated as much, but I think it has specific 21 statutory responsibilities, unlike the President's Working 22 Group. 23 It's It has specific jobs, and timetables to fulfill 24 those jobs, and has specific accountability, too, whereas 25 the President's Working Group is more of an ad hoc 191 1 enterprise after the '87 market break. 2 So I think it will be--I think the President's 3 Working Group has done a lot of good work. 4 will be a more robust, more comprehensive effort. 5 VICE CHAIRMAN THOMAS: I think this On that point, I think 6 it's also that you're out on point; that you're seen as a 7 functioning structure. 8 WITNESS BAIR: Yes. 9 VICE CHAIRMAN THOMAS: Any of the ad hoc 10 structures are inside change and you've got to cover over 11 them. 12 supposed to be a team, and it will be apparent if you are or 13 you aren't. 14 15 I like the exposure idea and the fact that you're WITNESS BAIR: Right. I think that's right. I agree with that. 16 COMMISSIONER HOLTZ-EAKIN: Thank you. You know, 17 the Working Group has been around a long time, but I don't 18 think it has a terribly illustrious history of success. 19 WITNESS BAIR: Well the FDIC was not a member of 20 the President's Working Group, and actually until 2008 I 21 think. But anyway-- 22 COMMISSIONER HOLTZ-EAKIN: 23 WITNESS BAIR: 24 25 You must explain. I think it did. It has made some good contributions. CHAIRMAN ANGELIDES: And we really don't need an 192 1 empirical study of its effectiveness, do we? 2 COMMISSIONER HOLTZ-EAKIN: 3 (Laughter.) 4 CHAIRMAN ANGELIDES: Can we request that? Anyway, thank you very much, 5 Commission members. 6 being here not only twice before, but I might add I noticed 7 in the work up here for being interviewed by our staff 8 twice. 9 Thank you very much, Chairman Bair, for WITNESS BAIR: Yes. 10 CHAIRMAN ANGELIDES: 11 WITNESS BAIR: 12 contribute to your success, as well. 13 14 So at the end of the day-- Well, we want to help and CHAIRMAN ANGELIDES: And we'll sign a copy of the book for you. 15 WITNESS BAIR: Okay, great. 16 CHAIRMAN ANGELIDES: Or we'll present you with an 17 enhanced e-version of the book that maybe links to some of 18 your testimony. 19 VICE CHAIRMAN THOMAS: Mr. Chairman, I'm 20 wondering if she's been so attached to us from an offensive 21 or a defensive point of view? 22 (Laughter.) 23 VICE CHAIRMAN THOMAS: 24 25 But thank you very much for your help. CHAIRMAN ANGELIDES: And I want-193 1 2 VICE CHAIRMAN THOMAS: helpful. 3 WITNESS BAIR: 4 CHAIRMAN ANGELIDES: 5 And early on it was very Good. I want to make just a few thank-you here. 6 I want to thank, first of all, all the people 7 around the country who did tune in to watch us on C-Span. 8 have been quite struck by the number of people who have 9 walked up to me who have said they have watched these 10 hearings, not because of us so much but because of this 11 tremendous hunger to understand what's happened to our 12 country. 13 I want to thank all our witnesses who came before 14 us. 15 let me start with the Commission Members for their 16 preparation, for their seriousness, and I really think for 17 the way in which we've gone about this set of hearings to 18 try to learn information, and gather it not only for 19 ourselves but the public. 20 I want to thank the Commission Members and the staff-- I want to thank the staff, who has put in a 21 tremendous number of hours and effort, a real testament to 22 public service. 23 I I want to thank Chairman Dodd for, once again, 24 making this room available to us. And I want to remind 25 everyone that, while this is our last hearing in the 194 1 Nation's Capital, we are going to be in four cities across 2 the country: 3 communities that are struggling with double-digit 4 unemployment, and that are in the grips of some of the most 5 severe foreclosure crises in this country. 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Bakersfield, Las Vegas, Miami, Sacramento, So thank you all very much. This public hearing of the Financial Crisis Inquiry Commission is adjourned. (Whereupon, at 1:20 p.m., Thursday, September 2, 2010, the hearing was adjourned.)
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