Full text of Financial Crisis Inquiry Commission : Documents Relating to the Financial Crisis of 2007-2009 : Statement of Sheila C. Bair, Chairman, Federal Deposit Insurance Corporation : On the Causes and Current State of the Financial Crisis before the Financial Crisis Inquiry Commission, January 14, 2010

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EMBARGOED UNTIL DELIVERY

STATEMENT OF

SHEILA C. BAIR
CHAIRMAN
FEDERAL DEPOSIT INSURANCE CORPORATION

on

THE CAUSES AND CURRENT STATE OF THE FINANCIAL CRISIS

before the

FINANCIAL CRISIS INQUIRY COMMISSION

January 14, 20109
Room 1100, Longworth House Office Building

Chairman Angelides, Vice Chairman Thomas and Commissioners, I appreciate
the opportunity to testify on behalf of the Federal Deposit Insurance Corporation (FDIC)
on the causes and current state of the financial crisis—the most severe financial crisis and
the longest and deepest economic recession since the Great Depression.

The last major financial crisis—the thrift and banking crisis of the 1980s—
resulted in enactment of two laws designed to improve the financial regulatory system:
The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA)
and the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA).
Combined, FIRREA and FDICIA significantly strengthened bank regulation, and
provided banks strong incentives to operate at higher capital levels with less risk, but
these regulations have also created incentives for financial services to grow outside of the
regulated sector.

In the 20 years following FIRREA and FDICIA, the shadow banking system grew
much more quickly than the traditional banking system, and at the onset of the crisis, it’s
been estimated that half of all financial services were conducted in institutions that were
not subject to prudential regulation and supervision. Products and practices that
originated within the shadow banking system have proven particularly troublesome in
this crisis. In particular, the crisis has shown that many of the institutions in this sector
grew to be too large and complex to resolve under existing bankruptcy law and currently
they cannot be wound down under the FDIC’s receivership authorities.

We are now poised to undertake far-reaching changes that will affect the
regulation of our entire financial system, including the shadow banking sector. Our
reforms must address the causes of the crisis, if we are to reduce as far as possible the
chance that it will recur. The financial crisis calls into question the fundamental
assumptions regarding financial supervision, credit availability, and market discipline
that have informed our regulatory efforts for decades. We must reassess whether
financial institutions can be properly managed and effectively supervised through
existing mechanisms and techniques.

Our approach must be holistic, giving regulators the tools to address risk
throughout the system, not just in those insured banks where we have long recognized
that heightened prudential supervision is necessary. To be sure, there can be
improvements in the oversight of insured institutions. And some banks themselves
exploited the opportunity for arbitrage by funding higher risk activity through third
parties or in more lightly regulated affiliates. As a consequence, if the thrust of reform is
to simply layer more regulation upon insured banks, we will simply provide more
incentives for financial activity to be conducted in less-regulated venues and exacerbate
the regulatory arbitrage that fed this crisis. Reform efforts will once again be
circumvented, as they were in the decades following FIRREA and FDICIA.

My testimony will focus on the failure of market discipline and regulation,
provide a detailed chronology of events that led to the crisis and suggest reforms to
prevent a recurrence.

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The Failure of Market Discipline and Regulation

Numerous problems in our financial markets and regulatory system have been
identified since the onset of the crisis. Most importantly, these include stimulative
monetary policies, significant growth of financial activities outside the traditional
banking system, the failure of market discipline to control such growth, and weak
consumer protections. Low interest rates encouraged consumer borrowing and excessive
leverage in the shadow banking sector. The limited reach of prudential supervision
allowed these activities to grow unchecked. Laws that protected consumers from abusive
lending practices were weak. Many did not extend to institutions outside of the regulated
banking sector.

Similarly, the FDIC’s authorities for the orderly wind down of a failed bank did
not apply to activity outside of the insured depository. Financial firms grew in both size
and complexity to the point that, when the weaker institutions became distressed, there
was no legal means to wind them down in an orderly manner without creating systemic
risks for the broader system. As a result of their too-big-to-fail status, these firms were
funded by the markets at rates that did not reflect the risks these firms were taking.

This growth in risk manifested itself in many ways. Overall, financial institutions
were only too eager to originate mortgage loans and securitize them using complex
structured debt securities. Investors purchased these securities without a proper risk
evaluation, as they outsourced their due diligence obligation to the credit rating agencies.

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Consumers refinanced their mortgages, drawing ever more equity out of their homes as
residential real estate prices grew beyond sustainable levels. These developments were
made possible by a set of misaligned incentives among and between all of the parties to
the securitization process—including borrowers, loan originators, credit rating agencies,
loan securitizers, and investors.

The size and complexity of the capital-market activities that fueled the credit
boom meant that only the largest financial firms could package and sell the securities. In
addition to the misaligned incentives in securitizations, differences in the regulation of
capital, leverage, and consumer protection between institutions in the shadow banking
system and the traditional banking sector, and the almost complete lack of regulation of
over-the-counter derivatives, allowed rampant regulatory arbitrage to take hold.

Many of the products and services of the non-bank financial institutions that
comprised the shadow banking system competed directly with those provided in the
traditional regulated banking system. Eventually, the largest bank and thrift holding
companies expanded into the shadow banking system by incorporating products and
services into their own more lightly regulated affiliates and subsidiaries. The migration
of essential banking activities outside of regulated financial institutions to the shadow
banking system ultimately lessened the effectiveness of regulation and made the financial
markets more vulnerable to a breakdown.

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Thus, it is not surprising that this crisis affected the largest non-bank financial
institutions first. It was at this intersection of the lightly regulated shadow banking
system and the more heavily regulated traditional banking system where the crisis was
spawned and where many of the largest losses for consumers, investors and financial
institutions were generated. Outside of the largest and most complex institutions,
traditional banks and thrifts continued to rely largely on insured deposits for their funding
and most focused on providing core banking products and services to their customers.
Eventually, these traditional institutions also suffered extensive losses as many of their
loans defaulted as a consequence of collateral damage from the deleveraging effects and
economic undertow created by the collapse of the housing bubble.

Why market discipline failed

Over the past two decades, there was a world view that markets were, by their
very nature, self-regulating and self-correcting—resulting in a period that was referred to
as the “Great Moderation.” However, we now know that this period was one of great
excess. Consumers and businesses had vast access to easy credit, and most investors
came to rely exclusively on assessments by a Nationally Recognized Statistical Rating
Agency (credit rating agency) as their due diligence. There became little reason for
sound underwriting, as the growth of private-label securitizations created an abundance
of AAA-rated securities out of poor quality collateral and allowed poorly underwritten
loans to be originated and sold into structured debt vehicles. The sale of these loans into
securitizations and other off-balance-sheet entities resulted in little or no capital being

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held to absorb losses from these loans. However, when the markets became troubled,
many of the financial institutions that structured these deals were forced to bring these
complex securities back onto their books without sufficient capital to absorb the losses.
As only the largest financial firms were positioned to engage in these activities, a large
amount of the associated risk was concentrated in these few firms.

To understand the events that triggered the crisis and necessitated unprecedented
government intervention, it is useful to consider how financial markets evolved in the
years leading to the crisis, and how failures in market discipline, regulation, supervision,
and the management of financial institutions played a contributory role.

The growth of GSEs and the originate-to-distribute model of mortgage finance

Many of the products and practices that led to the financial crisis have their roots
in the mortgage market innovations that began in the 1980s and matured in the 1990s.
Following large interest-rate losses from residential mortgage investments that
precipitated the thrift crisis in the 1980s, banks and thrifts began selling or securitizing a
major share of their mortgage loans with the housing government sponsored enterprises
(GSEs). By focusing on originating, rather than holding, mortgages, banks and thrifts
were able to reduce their interest-rate and credit risk, increase liquidity, and lower their
regulatory capital requirements under the rules that went into effect in the early 1990s. 1
Between 1985 and the third quarter of 2009, the share of mortgages (whole loans) held by
1

Under Basel I, residential mortgages held by banks had a regulatory capital requirement of 4 percent
whereas if the exposure was held in the form of a GSE mortgage-backed security, the capital requirement
was 2 percent.

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banks and thrifts fell from approximately 55 percent to 25 percent. By contrast, the share
of mortgages held by the GSEs increased from approximately 28 percent to just over 51
percent, over the same time period (see Figure 1).

Figure 1
As Home Mortgage Volumes Grew,
the Share Held by Banks and Thrifts Declined.
12000

Other
Commercial Banks and Thrifts

10000

GSEs

29.3%

25.7%

23.2%

31.7%

values in $ billions

8000

29.3%

26.5%

25.4%

27.8%

6000
28.3%
29.3%
17.8%
4000
16.3%
17.8%
2000

18.3%
50.7%

0

30.9%
1985 - Q4

32.9%

39.6%
42.6%
1990 - Q4

30.6%

41.4%

40.0%

2005 - Q4

2006 - Q4

42.9%

47.8%

51.4%

2008 - Q4

2009 - Q3

51.6%
50.9%

1995 - Q4

2000 - Q4

2007 - Q4

The GSEs became highly successful in creating a market for investors to purchase
securities backed by the loans originated by banks and thrifts. The market for these
mortgage-backed securities (MBSs) grew rapidly as did the GSEs themselves, fueling
growth in the supporting financial infrastructure. The success of the GSE market created
its own issues. Over the 1990s, the GSEs increased in size as they aggressively
purchased and retained the MBSs that they issued. Many argue that the shift of mortgage

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holdings from banks and thrifts to the GSE-retained portfolios was a consequence of
capital arbitrage. GSE capital requirements for holding residential mortgage risk were
lower than the regulatory capital requirements that applied to banks and thrifts.

This growth in the infrastructure fed market liquidity and also facilitated the
growth of a liquid private-label MBS market, which began claiming market share from
the GSEs in the early 2000’s. The private-label MBS (PLMBS) market fed growth in
mortgages backed by jumbo, hybrid adjustable-rate, subprime, pay-option and Alt-A
mortgages. The PLMBS market drew from technology pioneered by the GSEs, using
desk-top underwriting, a process that allowed loan originators to rapidly determine the
credit-worthiness of a borrower applying for a conforming loan. This same technology
was ultimately adapted by mortgage bankers for Alt-A and subprime loans, speeding the
origination process for these products. These mortgage instruments, originated primarily
outside of insured depository institutions, fed the housing and credit bubble and triggered
the subsequent crisis. In addition, the GSEs – Fannie Mae, Freddie Mac, and the Federal
Home Loan banks, were major purchasers of PLMBS.

As interest rates fell throughout most of the 1990s, mortgage originators profited
from encouraging and enabling consumers to refinance their mortgage debt. Previous tax
law changes (in 1986) had eliminated deductions for non-housing-related interest
expenses, which encouraged homeowners to finance a variety of purchases through home
equity loans. The financial industry eagerly touted the advantages of housing-linked
debt. In the process, consumers became accustomed to achieving lower mortgage

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payments by refinancing or accessing homeowner equity by tapping home equity lines of
credit. Many providers of these products—mortgage brokers, mortgage bankers and
mortgage affiliates of bank and other financial holding companies—operated outside the
traditional thrift and bank regulatory system.

The well-publicized benefits associated with legitimate rate-reducing mortgage
refinancing and rising housing prices conditioned consumers to actively manage their
mortgage debt. An unfortunate consequence of this favorable environment for
refinancing was fraud. Many consumers have only a limited ability to understand details
of standard mortgage contracts let alone the complex mortgages that became common
during this period. In this environment, unscrupulous mortgage providers capitalized on
the widely advertised benefits associated with mortgage refinance, and took advantage of
uniformed consumers by refinancing them into mortgage loans with predatory terms that
were not readily transparent to many borrowers.

Consumers lacked protection from toxic mortgage products

Federal consumer protections from predatory and abusive mortgage-lending
practices are established principally under the Home Ownership and Equity Protection
Act (HOEPA), which is part of the Truth in Lending Act (TILA). TILA and HOEPA
regulations are the responsibility of the Board of Governors of the Federal Reserve
System (FRB) and apply to both bank and non-bank lenders.

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HOEPA, which was enacted in 1994, contains specific statutory protections for a
narrow category of high cost loans used for mortgage refinancings. These protections
include restrictions on prepayment penalties, balloon payments, and extensions of credit
without consideration of a borrower’s ability to repay. HOEPA defines these high cost
loans in terms of threshold levels for either interest rates or points and fees. Many of the
toxic mortgage products that were originated to fund the housing boom did not fall within
the high cost loan definition under HOEPA. However, many of these toxic products
could have been regulated and restricted under another provision of HOEPA that requires
the FRB to prohibit acts or practices in connection with any mortgage loan that it finds to
be unfair or deceptive, or acts and practices associated with refinancing of mortgage
loans that it finds abusive or not otherwise in the interest of the borrower.

Problems in the subprime mortgage market were identified well before many of
the abusive mortgage loans were made. A joint report issued in 2000 by HUD and the
Department of the Treasury entitled Curbing Predatory Home Mortgage Lending noted
that a very limited number of borrowers benefit from HOEPA’s protections because of
the high thresholds that a loan must exceed in order for the protections to apply. The
report also found that certain terms of subprime loans appear to be harmful or abusive in
practically all cases. To address these issues, the report made a number of
recommendations, including that the FRB use its HOEPA authority to prohibit certain
unfair, deceptive and abusive practices by lenders and third parties. During hearings held
in 2000, consumer groups urged the FRB to use its HOEPA rulemaking authority to
address concerns about predatory lending. Both the House and Senate held hearings on

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predatory abuses in the subprime market in May 2000 and July 2001, respectively. In
December 2001 the FRB issued a HOEPA rule that addressed a narrow range of
predatory lending issues.

It was not until 2008 that the FRB issued a more extensive regulation using its
broader HOEPA authority to restrict unfair, deceptive, or abusive practices in the
mortgage market. The new regulation, effective in 2009 and 2010, covers closed-end
mortgage loans that meet a new definition of “higher priced” mortgage loans. The
definition is designed to capture closed-end loans in the subprime mortgage market, and
is set by the FRB based on a survey of mortgage rates currently published by Freddie
Mac.

For this new category of higher priced mortgage loans, these changes address
many of the abuses which led to the current housing crisis and help assure that mortgage
borrowers have stronger, more consistent consumer protections, regardless of the lender
they are using or the state where they reside. The rule imposes an “ability to repay”
standard in connection with higher-priced mortgage loans. For these loans, the rule
underscores a fundamental rule of underwriting: that all lenders, banks and nonbanks,
should only make loans where they have documented a reasonable ability on the part of
the borrower to repay. The rule also restricts abusive prepayment penalties.

As described in our January 8, 2010 comment letter on the FRB’s pending
mortgage rulemakings, while these standards represent a positive step toward getting

11

back to basics on responsible mortgage lending for higher-priced mortgage loans and
traditional HOEPA high cost mortgages, we believe that an ability to repay standard
should be required for all mortgages, including interest-only and negative-amortization
mortgages and home equity lines of credit (HELOCs). Interest-only and negativeamortization mortgages must be underwritten to qualify the borrower to pay a fully
amortizing payment. Otherwise, the consequences we have seen during this crisis will
recur.

Similarly, the practice of making a HELOC without taking into account the
consumer's ability to repay, based on the fully drawn line, or without taking into account
the consumer's other obligations, should be prohibited. When unaffordable mortgage
loans are made, the individual borrower and broader communities are subjected to
unnecessary risks. FDIC-insured banks are already subject to this type of prudential
standard. To promote a more even playing field and prevent circumvention of this
requirement by nonbank lenders, we believe such an ability to repay standard should
apply across-the-board.

Low interest rates stimulate the demand for mortgage debt and housing

Early in the 2000s, two destabilizing events occurred: the technology stock bubble
burst and terrorists attacked the United States. In response, the Federal Reserve lowered
interest rates to help calm financial markets. As can be seen in Figure 2, the Fed Funds
target rate declined from 6.5 percent at the end of 2000 to 1.75 percent at the end of 2001

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and further rate cuts continued until the target rate reached 1.0 percent in June 2003. The
Federal Reserve didn’t begin to raise rates until June 2004. Many economists and
commentators have attributed a part of the housing bubble to this extraordinarily long
period of very low interest rates.

Figure 2

Target Federal Funds Rate and CPI Inflation
Percent, annual CPI inflation

7.0
6.0
Federal Funds Target Rate

5.0
4.0
3.0
2.0
1.0

CPI inflation

0.0
-1.0
-2.0
-3.0
1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Source: Federal Reserve, Haver

In 2002 and early 2003, a record boom in the volume of mortgage originations
occurred, driven primarily by the refinancing of existing mortgages. By mid-2003, longterm mortgage interest rates tested historical lows and virtually every fixed-rate mortgage
in America became a candidate for refinancing. The result was a wave of refinancing
activity that was initially dominated by prime, fixed-rate loans. During 2003, over 80

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percent of all applications were for fixed-rate loans, the majority of which were for
refinancing existing mortgages. Lenders grew their origination infrastructure to
accommodate the surge in mortgage demand.

Home-price appreciation in the United States measured 5 percent or less in every
year during the 1990s, but accelerated starting in 2000. By 2004, house prices were
rising at double-digit rates. The home-price boom was concentrated first in the
metropolitan areas of California, the Northeast, and Florida; it then spread to cities in
much of the Mountain West and further inland. While home prices were effectively
doubling in a number of boom markets, median incomes were growing much more
slowly, severely reducing the affordability of home ownership.

Home price appreciation helped set the stage for dramatic changes in the structure
and funding of U.S. mortgage loans. To the extent that prime borrowers with a
preference for fixed rates had locked in their loans by 2003, the mortgage industry began
to turn its attention—and its ample lending capacity—toward less creditworthy borrowers
and home buyers struggling to cope with the high cost of housing. Originations shifted
from refinancing to purchase financing, which rose to more than half of originations in
2004 through 2006. Another result was an increase in the origination of subprime loans,
which more than doubled in 2004 and peaked at just over 20 percent of all originations in
2005 and 2006.

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Declining affordability in high-priced housing markets contributed to a shift
toward nontraditional loan originations, such as interest-only and pay-option mortgages.
New mortgage products with artificially low initial payments were often underwritten at
the low initial payment, rather than the future higher payment that would result when the
interest rate reset. The originators and investors assumed that housing prices would
continue to increase and homeowners would refinance when the mortgage rates reset.

Mortgage refinancing was also increasingly being used to tap home valuation
gains, thus decreasing home-owner equity. Data from Freddie Mac show that in early
2003, only about 7 percent of mortgage refinancing transactions took out cash; by 2006,
over 30 percent were cash-out transactions. The Federal Reserve Board reports that by
2006, the ratio of household debt-service payments to disposable income increased
almost 30 percent from the early 1990s. Still, few homeowners defaulted on their
mortgages, as home-price appreciation, historically low interest rates, and relaxed
underwriting standards made refinancing an easy and attractive option.

Private-label MBS and structured-debt fund a housing bubble

Increasing home valuations, conforming loan limits on GSE mortgages, and
declining home affordability created incentives for financial firms to create new
mortgage products. These products required the issuance of private-label MBSs for
funding. In contrast to the MBSs issued by GSEs, which were pass-through securities
backed primarily by prime quality 30-year amortizing loans and fully guaranteed against

15

default, many private-label MBS securities were based on lower-quality mortgage pools
and left investors exposed to the risk of default.

Private-label MBSs suffer losses when the mortgages that underlie the security
default. The securities typically issued by the originators of private-label MBSs offer
investors alternative levels of protection against default risk by pooling mortgage cash
flows and paying them out to MBS investors through a tiered, or tranched, priority
structure.

A typical private-label MBS might issue six tranches or securities to fund the
mortgage pool of assets it purchases. Each tranche has an associated par value and yield
and all, except, perhaps the most junior tranches will be rated by a credit rating agency.
The cash flows from the mortgage pool owned by the MBS flow through a “waterfall”
created by the terms of the different tranches. The most senior mortgage investments
(typically AAA-rated) have the highest priority claim on the mortgage-pool cash flows
and are paid first. The remaining cash flows are then allocated to fill the terms of the
next highest priority tranche and so on through the priority structure. When all the
mortgages in the pool are performing, each tranche in the MBS structure will receive the
promised cash flows. As mortgages default, the lowest priority tranche suffers losses
first. If the mortgage pool losses are large enough, the claims of the lowest tranche could
be wiped out completely and the second-lowest priority tranche would begin to bear
losses. As losses grow, they are spread to sequentially higher priority tranches.

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During the 1990s, much of the underlying collateral for private-label MBSs was
comprised of prime jumbo mortgages—high quality mortgages with balances in excess of
the GSE loan limits. During this period, the securitizing institution would often have to
retain the risky tranches of the structure because there was no active investor market for
these securities. These tranches would be the first to suffer losses, so it was natural that
third-party investors would force the originator to hold these tranches, ensuring strong
incentives to control mortgage-pool risk. The highly rated tranches of private-label
MBSs were always in demand as they were perceived as having little credit risk and paid
relatively high yields.

However, the lack of demand for the high-risk tranches limited the growth of
private-label MBSs. In response, the financial industry developed two other investment
structures—collateralized debt obligations (CDOs) and structured investment vehicles
(SIVs). These structures were critical in creating investor demand for the high-risk
tranches of the private-label MBSs and for creating the credit-market excesses that fueled
the housing boom.

CDOs are complex structured debt securities similar in many ways to privatelabel MBSs. The primary difference between CDOs and MBSs is the collateral that is
securitized. MBSs are based on the cash flows from a pool of individual mortgage loans.
By contrast, CDOs are collateralized by pools of other debt securities which could be
(and in many cases were) MBSs. CDOs purchase debt securities, pool the cash flows
from these securities, and then sell securities created from pooling the cash flows of the

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original securities. Like a private-label MBS, a CDO might have numerous tiers and
issue corresponding tranches of securities with different claims’ priorities and credit
ratings.

SIVs are similar to CDOs in that they also purchase debt securities. They differ
from CDOs in that they purchase long-term debt securities and issue both short- and
medium-term securities to fund those securities that they purchase and subsequently pool.
The short-term securities issued by the SIVs were typically collateralized commercial
paper and many of these securities were highly rated and typically were purchased by
money market mutual funds.

CDOs and SIVs became the ready purchasers of the lower-rated tranches of
private-label MBSs. High-risk (lower-rated tranches) private-label MBS securities were
often pooled with other securities to create CDOs and SIVs. CDOs and SIVs could also
take on mortgage risk synthetically by purchasing credit default swaps (CDSs) on
securities referencing subprime and Alt-A MBSs. The pooling of cash flows from a
portfolio of debt securities, which could include CDSs, was presumed to generate
substantial diversification benefits, and rating agencies assigned high-quality credit
ratings to a large share of the securities issued by CDOs and SIVs. The end result was
that some CDOs and SIVs could issue highly rated securities and commercial paper to
fund their exceptionally low-quality asset pools of debt securities.

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The growth of the mortgage-linked CDS market allowed investors to take on
exposure to the subprime and Alt-A markets without actually owning the mortgages or
the MBSs, CDOs or SIVs obligations on entities that did own the mortgages. Through
the use of credit derivatives, investor exposure to losses in these markets was multiplied
and became many times larger than the exposures generated by the individual mortgages
alone.

As the private-label MBS market grew, issuances became increasingly driven by
interest-only, hybrid adjustable-rate, second-lien, pay-option and Alt-A mortgage
products. Many of these products had debt-service burdens that exceeded the
homeowner’s payment capacity. For example, Alt-A mortgages typically included loans
with high loan-to-value ratios or loans where borrowers provided little or no
documentation regarding the magnitude or source of their income or assets.
Unfortunately, this class of mortgage products was particularly susceptible to fraud, both
from borrowers who intentionally overstated their financial resources and from the
mortgage brokers who misrepresented borrower resources without the borrower’s
knowledge.

These new classes of mortgage products were especially profitable to originate
since virtually all of them carried high fees and high implicit rates of interest.
Homeowners found them appealing because many included an initial period of artificially
low payments and, for some, the underwriting standards allowed them to qualify for a
mortgage when traditional products and underwriting criterion would deny them credit.

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By late 2006, the attractive yields offered by private-label MBSs were readily
attracting investors. Such securities represented more than 55 percent of all MBSs
issued. Consumers became comfortable with the idea of frequent mortgage refinancing
and many eagerly adopted these new mortgage products to benefit from the low initial
payment period. In many respects, the “refinance often” model mistakenly became, for
many consumers, a vision of “smart money management.”

The role of rating agencies

It seems unlikely that a very liquid private-label MBS market would have existed
without market-accepted credit agency ratings. In many cases, relatively little specific
detail was made available to investors about the actual loans that were included in
private-label MBS pools, and even if available, it would have been very expensive for
individual investors to analyze the underlying pool risk characteristics.

Once a rating was accepted, and as long as the securities performed well, few
investors found cause to question the accuracy of the rating or to raise questions about
rating agencies’ opaque proprietary risk-assessment methodologies. As we can now fully
appreciate, the outsourcing of the risk assessment of private-label MBSs and the
securities issued by CDOs and SIVs to rating agencies turned out to be particularly
problematic. Important flaws in agency ratings methodologies did not become apparent
until housing prices stopped appreciating.

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With these high ratings, MBS, CDO, and SIV securities were readily purchased
by institutional investors because they paid higher yields compared to similarly rated
securities. In some cases, securities issued by CDOs were included in the collateral pools
of new CDOs leading to instruments called CDOs-squared. The end result was that a
chain of private-label MBS, CDO and SIV securitizations allowed the origination of large
pools of low-quality individual mortgages that, in turn, allowed over-leveraged
consumers and investors to purchase over-valued housing. This chain turned toxic loans
into highly rated debt securities that were purchased by institutional investors.
Ultimately, investors took on exposure to losses in the underlying mortgages that was
many times larger than the underlying loan balances. For regulated institutions, the
regulatory capital requirements for holding these rated instruments were far lower than
for directly holding these toxic loans.

The crisis revealed two fatal problems for CDOs and SIVs. First, the assumptions
that generated the presumed diversification benefits in these structures proved to be
incorrect. As long as housing prices continued to post healthy gains, the flaws in the risk
models used to structure and rate these instruments were not apparent to investors.
Second, the use of short-term asset-backed commercial paper funding by SIVs proved to
be highly unstable. When it became apparent that subprime mortgage losses would
emerge, investors stopped rolling-over SIVs commercial paper. Many SIVs were
suddenly unable to meet their short-term funding needs. In turn, the institutions that had
sponsored SIVs were forced to support them to avoid catastrophic losses. A fire sale of

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these assets could have cascaded and caused mark-to-market losses on CDOs and other
mortgage-related securities.

Employee compensation

Our discussion of market failure in this crisis can not be complete without
examining the role of employee compensation and its contribution to the risk undertaken
by financial institutions. The crisis has shown that most financial-institution
compensation systems were not properly linked to risk management. Formula-driven
compensation allows high short-term profits to be translated into generous bonus
payments, without regard to any longer-term risks. Many derivative products are longdated, while employees’ compensation was weighted toward near-term results. These
short-term incentives magnified risk-taking.

A similar dynamic was at work in the mortgage markets. Mortgage brokers and
bankers went into the subprime and other risky markets because these markets generated
high returns not just for investors but also for the originators themselves. The standard
compensation practice of mortgage brokers and bankers was based on the volume of
loans originated rather than the performance and quality of the loans made. From the
underwriters’ perspective, it was not important that consumers be able to pay their
mortgages when interest rates reset, because it was assumed the loans would be
refinanced, generating more profit by ensuring a steady stream of customers. The longtail risk posed by these products did not affect mortgage brokers and bankers incentives

22

because these mortgages were sold and securitized. The lack of a downside in these
compensation schemes ultimately hurt both those who could not pay their risky
mortgages and the economy.

Lessons learned

As the crisis has demonstrated, the market, abetted by the alchemy of ratingagency assisted securitization, did not prevent the growth of excessively easy access to
credit and the resultant massive economic loss. Because markets are not always selfregulating and self-correcting, we need to find ways to strengthen market discipline.
Central to this task, incentives need to be realigned so that consumers, investors and
financial institutions accurately assess the risks they undertake. For instance, loan
originators and firms that securitize these loans should have to retain some measure of
recourse to ensure sound underwriting.

Consumers should be given financial products that are easy to understand and
accurately reflect their ability to repay the loans. Investors and creditors should face
some amount of loss, in the event of default; this should cause them to perform due
diligence and not simply rely on third-party assessments of the quality of the investment.
And finally, we must impose market discipline by ending too big to fail. This is best
accomplished by establishing a credible resolution regime for large interconnected firms.

23

Failure of regulation

Not only did market discipline fail to prevent the excesses of the last few years,
but the regulatory system also failed in its responsibilities. There were critical
shortcomings in our approach that permitted excessive risks to build in the system.
Existing authorities were not always used, regulatory gaps within the financial system
provided an environment in which regulatory arbitrage became rampant, and the failure
to adequately protect consumers created safety-and-soundness problems. Moreover, the
lack of an effective resolution process for the large, complex financial institutions limited
regulators’ ability to manage the crisis. Looking back, it is clear that the regulatory
community did not appreciate the magnitude and scope of the potential risks that were
building in the financial system.

For instance, private-label MBSs were originated through mortgage companies
and brokers as well as portions of the banking industry. The MBSs were subject to
minimum securities disclosure rules that are not designed to evaluate loan underwriting
quality. Moreover, those rules did not allow sufficient time or require sufficient
information for investors and creditors to perform their own due diligence either initially
or during the term of the securitization. For banks, once these loans were securitized,
they were off the balance sheet and no longer on the radar of many banks and bank
regulators.

24

With hindsight, the financial innovations that led to the crisis, while complex in
many respects, can be understood. At the time the bubble was building, few saw all the
risks and linkages that we can now better identify. The traditional tools used by safetyand-soundness regulators, like peer institution analysis, did not detect individual
institution excesses because many of the peer institutions also analyzed engaged in the
same risky activities. These activities were profitable, until the risky activities
undertaken by all became unsustainable.

Many of the structured finance activities that generated the largest losses were
complex and opaque transactions, and they were only undertaken by a relatively few
large institutions. Access to detailed information on these activities—the structuring of
the transactions, the investors who purchased the securities and other details—was not
widely available on a timely basis even within the banking regulatory community.

Record profitability within the financial services industry also served to shield it
from some forms of regulatory second-guessing. The bank and thrift industry reported
six consecutive years of record earnings from 2001 through 2006. High earnings can
represent the outcome of successful business strategies, but they can also be a potential
red flag for high-risk activities. Often, the potential risks associated with strategies that
give rise to outsized profits are not obvious especially when supervisors are examining
new bank products or activities.

25

The financial regulatory system collectively did not rein in many of the risky
financial activities that helped create the conditions for the crisis. Where law or
regulation does not expressly restrict activities, supervisors rely on judgment to identify
risk and the exercise of formal or informal corrective action to affect behavior. For
supervisors to compel a change in behavior, however, requires a strong case for remedial
action. When banks post many quarters or even years of repeated high earnings,
preventative actions can be difficult. For example, underwriting standards were clearly
deteriorating during the credit boom, yet the industry reported a record low non-current
loan ratio of 0.70 percent in the second quarter of 2006. It proved difficult for regulators
to rein in profitable legal financial activities without hard evidence that the activities were
creating unwarranted risk. In retrospect, it is clear that supervisors were not sufficiently
forward looking in identifying and correcting imprudent risks. This needs to be
addressed, by strengthening regulatory standards, requiring credit quality analysis to be
more forward looking, and establishing better supervisory benchmarks for identifying
excessive risk taking. Current profitability alone is not a sufficient measure of safety and
soundness.

In concert with mortgage-market innovations over the past two decades, financial
institutions became much bigger and more complex. Much of the growth in banking
organizations resulted from consolidations and acquisitions. Outside of depository
institutions, growth was organic, but much of it was driven by credit securitization and
credit risk transfer activities. For example, CDSs began only in the late 1990s, and have

26

grown at a geometric pace since they began trading. CDOs and SIVs were more recent
examples of credit risk transfer activities.

Only the largest financial firms are prominent dealers in any of these opaque
activities and many of these institutions are subject to some regulatory oversight. The
securities themselves, CDOs and SIVs, are subject to securities disclosure laws, but
CDSs and other derivatives are specifically exempted from regulation. The crisis amply
demonstrates the need for regulatory oversight and improved transparency of the
derivative and structured-debt markets.

Similarly, large institutions are the ones most likely to be involved in all types of
complex financial “innovations.” In the current system, the risks generated by offbalance-sheet activities were exceptionally hard to assess. Yet, as the crisis has
demonstrated, these off-balance-sheet activities can seriously harm the finances of the
consolidated organization and the economy more widely. The increasing size, span, and
complexity of financial institutions have not only undermined market discipline, but have
also made regulation and supervision remarkably difficult.

Another barrier to collecting accurate and comprehensible information on the
state of the financial system was the growing importance of the shadow banking sector.
Credits that were once held on bank and thrift balance sheets as loans became
intermediated into private-label securities and distributed by a host of capital market
intermediaries. As the credit bubble was building, regulatory authorities came to believe

27

that credit risks were being dispersed to institutional investors who were capable of
managing the risks. It is now obvious that these beliefs were unwarranted. In hindsight,
it is fair to say that regulators either did not have sufficient information to fully
understand how concentrated risk was becoming, or if regulators had access to the
information, they were unable to understand and identify the risks.

In addition to the advantageous capital treatment of off-balance-sheet assets, other
types of regulatory arbitrage were rampant. In the mid-1990s, bank regulators working
with the Basel Committee on Banking Supervision (Basel Committee) introduced a new
set of capital requirements for trading activities. The new requirements were generally
much lower than the requirements for traditional lending under the theory that banks’
trading-book exposures were liquid, marked-to-market, mostly hedged, and could be
liquidated at close to their market values within a short interval—for example 10 days.

The market risk rule presented a ripe opportunity for capital arbitrage, as
institutions began to hold growing amounts of assets in trading accounts that were not
marked-to-market but “marked-to-model.” These assets benefitted from the low capital
requirements of the market risk rule, even though they were in some cases so highly
complex, opaque and illiquid that they could not be sold quickly without loss. Indeed, in
late 2007 and through 2008, large write-downs of assets held in trading accounts
weakened the capital positions of some large commercial and investment banks and
fueled market fears.

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Capital regulation permits financial institutions to use derivatives and collateral to
reduce their capital requirements by hedging risk. This can present opportunities for
institutions to exploit gaps or loopholes in regulation and encourage risk-taking that is
unsupportable for the financial system as a whole. For example, an unsustainable volume
of CDSs underwritten by a largely unregulated London-based affiliate of AIG, an AAArated insurance company, enabled a number of institutions to reduce their capital
requirements using the regulatory benefits of hedging. 2 Despite the fact that it
underwrote an unsustainable volume of CDSs—many guaranteeing protection on
subprime backed MBS, CDO and SIV securities—the rating agencies continued to affirm
AIG’s AAA rating. In retrospect, it is clear that market participants used ratings to
arbitrage differences in regulations and capital requirements across sectors in a way that
both concentrated and obscured underlying risks and made the financial system more
fragile.

In 2001, regulators reduced capital requirements for highly rated securities.
Specifically, capital requirements for securities rated AA or AAA (or equivalent) by a
credit rating agency were reduced by 80 percent for securities backed by most types of
collateral and by 60 percent for privately issued securities backed by residential
mortgages. For these highly rated securities, capital requirements were $1.60 per $100 of
exposure, compared to $8 for most loan types and $4 for most residential mortgages.

2

New York State expressly exempted CDSs from insurance regulation. AIG owns a small thrift and the
EU recognized the Office of Thrift Supervision as AIG’s consolidated supervisor.

29

Like the market risk rule, this rule change also created important economic
incentives that altered financial institution behavior by rewarding the creation of highly
rated securities from assets that previously would have been held on balance sheet. For
example, as discussed earlier, the production of large volumes of AAA-rated securities
backed by subprime and Alt-A mortgages was almost certainly encouraged by the ability
of financial institutions holding these securities to receive preferential low capital
requirements solely by virtue of their assigned ratings from the credit rating agencies.

Capital requirements were lowered for securities borrowing and lending
operations both through rule makings and through interpretive letters. Reducing the
capital required for these activities allowed banking organizations and securities broker
dealers to increase the leverage and / or reduce the costs associated with these activities.
While these activities traditionally had very low loss levels, due in large part to the highly
liquid and marketable nature of the collateral (U.S. Treasury securities, GSE issued debt
and securities, and U.S. listed equities) additional forms of collateral such as structured
finance products were being financed using repo and securities lending. Excess leverage
using tri-party repo arrangements was a contributing factor in the failure of Lehman
Brothers Inc. Going forward, regulators should increase the capital and margin required
for these activities, and determine whether certain collateral should be ineligible for repo
or securities borrowing and lending activities.

There are differences in regulatory capital between banks and holding companies.
Capital requirements for bank holding companies are less stringent, qualitatively and

30

quantitatively, than those applicable to insured banks. Specifically, leverage ratio
requirements are lower for bank holding companies and, unlike insured banks, bank
holding companies are permitted to include, within limits, certain types of hybrid capital
instruments and subordinated debt as regulatory tier 1 capital.

The capital differences have created a situation where certain large bank holding
companies became significantly more leveraged on a consolidated basis. The policy
rationale for lower capital requirements at the holding company was presumably that
these entities did not enjoy an explicit federal safety net. As it transpired during the
crisis, however, a number of nonbanking affiliates sought either the support of their
affiliated federally insured banks or other forms of federal support. There is reason for
concern, therefore, that a lower capital requirement for holding companies is one of the
factors that may contribute to an unwarranted expansion of the federal safety net.

For example, in 2005, the Securities and Exchange Commission allowed large
broker dealers to adopt lower capital standards in their Consolidated Supervised Entity
(CSE) capital rules without the leverage requirement applicable to U.S. banks.
Subsequent to the adoption of the CSE capital rules, the large broker dealers markedly
increased their use of financial leverage. In 2008, two of the five institutions using the
CSE capital rules collapsed, one was acquired, and the other two experienced liquidity
issues. The issues facing the large broker dealers are attributable to multiple factors, but
we do believe differences in capital requirements between these institutions and

31

commercial banks may have encouraged the use of financial leverage at these five
institutions, making them more fragile and less resilient to the effects of the crisis.

The federal housing GSEs operated with considerably lower capital requirements
than those that applied to banks. Low capital requirements encouraged an ongoing
migration of residential mortgage credit to these entities and spurred a growing reliance
on the originate-to-distribute business models that proved so fragile during the crisis. Not
only did the GSEs originate MBSs, they purchased private-label securities for their own
portfolio, which helped support the growth in the Alt-A and subprime markets. In 2002,
private-label MBSs only represented about 10 percent of their portfolio. This amount
grew dramatically and peaked at just over 32 percent in 2005.

In 2004, the Basel Committee published a new international capital standard, the
Basel II advanced internal ratings-based approach (as implemented in the United States,
the Advanced Approaches), that allows banks to use their own internal risk assessments
to compute their risk-based capital requirements. The overwhelming preponderance of
evidence is that the Advanced Approaches will lower capital requirements significantly,
to levels well below current requirements that are widely regarded as too low.

Thus, despite widespread discussion of strengthening capital requirements,
including recent proposals by the Basel Committee, banks around the world continue to
implement Advanced Approaches designed to lower those requirements. The basic
engine of capital calculation in the Advanced Approaches, its so-called “supervisory

32

formulas,” and the use of banks’ own risk estimates as inputs to those formulas, remain in
place even though there is growing evidence that these formulas are seriously flawed.

These critical elements of the Advanced Approach will produce capital
requirements that are both too low and too subjective. Large reductions in risk-based
capital requirements under the Advanced Approach could effectively swamp the
beneficial effects of other reforms the Basel Committee has proposed. Unrestricted use
of the Advanced Approach risks a situation in which these capital reforms ultimately are
little more than mitigating factors that turn a large drop in capital requirements into a
somewhat smaller drop, resulting in a failure to address the excessive leverage that
preceded the crisis.

These considerations strongly support the use of a simple and straightforward
international leverage constraint as a complement to the risk-based capital rules. The
FDIC has advocated a minimum leverage requirement for many years and we are
gratified that this proposal is included in the recent Basel Committee consultative
package.

Even with a simple leverage constraint, however, we believe that allowing the
Advanced Approach to be used to effect an ongoing reduction in risk-based capital
requirements during a multi-year project to strengthen requirements is unwise. I am and
continue to be, a strong advocate of the view that the Advanced Approaches should not
be used to reduce capital requirements.

33

The Need for Regulatory Reform

The financial crisis revealed that risks grew across the financial system,
unimpeded by a stove-piped financial regulatory framework. Non-banks originated
subprime loans. Insurance companies wrote credit default swaps. Bank underwriting
practices deteriorated. Consumer protections were deficient across the system.
Regulators were slow to identify risks before the industry experienced widespread losses
and even slower to identify the systemic nature of the underlying problems. The
activities of unsupervised financial entities outside the traditional banking system made it
more difficult for regulators and market participants to understand the real dynamics of
bank credit markets and public capital markets. The existence of one regulatory
framework for insured institutions and a much less stringent regulatory scheme for nonbank entities created the conditions for arbitrage that permitted the development of more
risky and harmful products and services outside regulated entities.

By 2007, banking regulators had come to understand that they did not have the
proper tools to wind down a large complex non-depository institution without causing
disruptions to the broader financial markets. As a result, the government was forced to
rely on ad hoc measures involving government support to stabilize the situation. An
exception was the Fall 2008 resolution of the $300 billion savings bank Washington
Mutual (WAMU), which the FDIC was able to resolve without disruption and without
cost to the government. We were able to use existing regulatory authorities because the
vast majority of WAMU’s operations resided within the insured depository

34

The WAMU resolution—with a private sector acquirer—reflected an effective
bidding process and regulatory action that facilitated a closing while the institution still
had value that exceeded its insured deposit liabilities. While creditors and bondholders
were treated as mandated by statute, it was a seamless transition for depositors and other
bank customers. As evidenced by the orderly resolution, WAMU could be resolved
without posing systemic risk. The process worked as Congress intended and imposed
losses on shareholders and uninsured creditors. The WAMU resolution process mirrors
the way in which a large interconnected financial institution would be treated under
proposals currently before Congress.

Leading into the crisis, most of the largest financial firms were viewed as having
sufficient capital and earnings to weather an economic downturn, even if one or more of
them failed. There was little recognition of how interconnected and fragile these large
firms had become through their origination and purchases of highly leveraged, structured
debt (MBSs, CDOs, SIVs) and closely related derivatives. Regulators were wholly
unprepared and ill-equipped for a systemic event that initially destroyed liquidity in the
shadow banking system and subsequently spread to the largest firms throughout the
financial system.

In effect, the management of these large, complex financial firms and the markets
in which they operated acted as if these firms were too big to fail. Prior to the crisis these
firms had virtually unlimited access to artificially cheap financing that only encouraged
them to grow and take additional risks. Unfortunately the notion that they were too big to

35

fail has proven to be true, as massive amounts of taxpayer funds have been injected into
these firms to prevent their failure and thus maintain financial stability during the crisis.

Why are these firms too big to fail? These firms have become highly leveraged
and massively complex with multiple financial subsidiaries, extensive off-balance-sheet
activities and opaque financial statements. These expansive inter-connected structures
were managed as if they were a single entity, ignoring the corporate legal separateness of
their many subsidiaries. In addition, these firms were highly interconnected through their
capital markets activities, such as derivatives, private-label MBSs and structured-debt
issuance.

This increased complexity was not accompanied by changes in our resolution
regime. The FDIC only has authority to take over the insured institutions in the holding
company, not the holding company itself. Where banks are just one part of these
interconnected structures, it is not possible to take over and resolve the bank separately
from other parts of the holding company. As a result, it is extremely difficult to take over
and rapidly unwind these institutions under our current rules.

The Reform Agenda

The massive expenditure of public funds and the near collapse of the financial
system have demonstrated that we need major financial reforms. We must make

36

fundamental changes to reduce moral hazard and improve the system’s resiliency in the
face of a financial crisis.

Resolution Authority

Foremost among needed reforms is a new legal and regulatory framework for
large interconnected firms to ensure their orderly wind-down while avoiding financial
disruptions that could devastate our financial markets and economy. A resolution
mechanism that makes it possible to break-up and sell a large failed interconnected firm
offers the best option. It should be designed to protect the public interest, prevent the use
of taxpayer funds, and provide continuity for the failed firm's critical financial functions.
The FDIC's authority to resolve failing banks and thrifts is a good model.

This is the same model that has allowed the FDIC to seamlessly resolve thousands
of institutions over the years. We protect insured depositors while preserving vital
banking functions. The FDIC has the authority to move key functions of the failed bank
to a newly chartered bridge bank. Losses are imposed on market players who reap the
profits in good times, but who also should bear the losses in the case of failure.
Shareholders of the failed bank typically lose all of their investment. Creditors generally
lose some or all of the amounts owed them. Top management is replaced, as are other
employees who contributed to the institution’s failure. In addition, the assets of the failed
institution are sold to a stronger, better managed buyer.

37

If this process were applied to large interconnected financial institutions—
whether banks or non-banks—it would prevent instability and contagion, and enforce
market discipline while promoting fairness. Financial markets would continue to
function smoothly, while the firm's operations are transferred or unwound in an orderly
fashion. The government would step in temporarily to provide working capital (liquidity)
for an orderly wind down, including providing necessary funds to complete transactions
that are in process at the time of failure.

We propose that working capital for such resolutions come from a reserve that the
industry would fund in advance. This would provide better protection for taxpayers than
borrowing funds when needed and repaying the borrowings through industry
assessments. Resolution activities require working capital up front since the failed firm
would immediately need liquidity to support the firm’s vital operations, maintain the
firm’s value, and help preserve system-wide liquidity.

Building a fund up front would also help prevent the need to assess institutions
during an economic crisis—on a procyclical basis, and would assure that failed firms
have paid something into the fund. Paying regular premiums would help covered
financial institutions better manage their expenses. To avoid double charging banks that
already pay deposit insurance premiums, the assessments should be based on assets held
outside of insured depositories. Any costs associated with the resolution not covered by
the fund would be recouped through additional industry assessments.

38

A pre-funded reserve is superior to an ex-post funding system. In an ex-post
system, firms that fail never pay and the costs are borne by the surviving firms.
Regardless of how well-designed, an ex-post funding system necessitates borrowing
(from the taxpayers) to fund the resolution. Even if the funds were fully repaid by the
industry, the use of government funds would undoubtedly be viewed by the public as a
government bailout. A pre-funded system reduces the likelihood of borrowing. In the
midst of a crisis, the resolution authority should not feel constrained to delay or forego
the optimal resolution by a reluctance to borrow funds from the Treasury in order to
avoid the appearance of a bailout.

This proposed resolution mechanism, with a pre-funded reserve, would address
systemic risk without a taxpayer bailout and without the near panic we saw a year ago. It
would provide clear rules and signals to the market. Most importantly, over the long run,
it would provide the market discipline that is so clearly lacking today

Incentives to Reduce Size and Complexity

A reserve fund, built from industry assessments, would also provide economic
incentives to reduce the size and complexity that makes closing these firms so difficult.
One way to address large interconnected institutions is to make it expensive to be one.
Industry assessments could be risk-based. Firms engaging in higher risk activities, such
as proprietary trading, complex structured finance, and other high-risk activities would
pay more.

39

Large interconnected firms should also be required to develop their own
liquidation plan—a living will so to speak—which would demonstrate that they could be
broken apart and sold in an orderly manner. An approved liquidation plan would result in
greater legal and, in particular, functional separation of affiliates within these large
financial holding companies and greater autonomy and firewalls surrounding insured
banks.

The largest firms that impose the most potential for systemic risk should also be
subject to greater oversight, higher capital and liquidity requirements, and other
prudential safeguards. Off-balance-sheet assets and conduits, which turned out to be notso-remote from their parent organizations in the crisis, should be counted and capitalized
on the balance sheet. We fully support the changes that the Financial Accounting
Standards Board (FASB) has implemented in FAS 166 and 167, which would accomplish
the goals of bringing the off-balance-sheet assets and conduits back on institutions’
balance sheets.

Taken together, these measures would help ensure that our largest and most
complex firms can either withstand a significant crisis, or be wound-down without resort
to a government backstop. Only by instituting a credible resolution process and
penalizing high-risk activity will we be able to limit systemic risk, and the long-term
competitive advantages and public subsidy it provides to the largest institutions under the
current system.

40

Systemic Risk Council

The significant size and growth the shadow banking system has made it all the
more difficult for regulators or market participants to understand the real dynamics of
either bank credit markets or public capital markets. The existence of one regulatory
framework for insured institutions and a much less stringent regulatory scheme for nonbank entities created the conditions for arbitrage that permitted the development of risky
and harmful products and services outside regulated entities.

A distinction should be drawn between the direct supervision of large
interconnected financial firms and the macro-prudential oversight and regulation of
developing risks that may pose systemic risks to the U.S. financial system. The former
appropriately calls for the identification of a prudential supervisor for large
interconnected firms. Entities that are already subject to a prudential supervisor, such as
insured depository institutions and financial holding companies, should retain those
supervisory relationships.

The macro-prudential oversight of system-wide risks requires the integration of
insights from a number of different regulatory perspectives—banks, securities firms,
holding companies, and perhaps others. Only through these differing perspectives can
there be a holistic view of developing risks to our system. As a result, for this latter role,
the FDIC supports the creation of a Systemic Risk Council to oversee systemic risk
issues, develop needed prudential policies and mitigate developing systemic risks. In

41

addition, for systemic entities not already subject to a federal prudential supervisor, this
Council should be empowered to require that they submit to such oversight, presumably
as a financial holding company under the Federal Reserve, without subjecting them to the
activities restrictions applicable to these companies.

Supervisors across the financial system failed to identify the systemic nature of
the risks before they were realized as widespread industry losses. The performance of the
regulatory system in the current crisis underscores the weakness of monitoring systemic
risk through the lens of individual financial institutions and argues for the need to assess
emerging risks using a system-wide perspective.

In designing the role of the Council, it will be important to preserve the
longstanding principle that bank regulation and supervision are best conducted by
independent agencies. Careful attention should be given to the establishment of
appropriate safeguards to preserve the independence of financial regulation from political
influence. To ensure the independence and authority of the Council, consideration should
be given to a configuration that would establish the Chairman of the Council as a
Presidential appointee, subject to Senate confirmation. This would provide additional
independence for the Chairman and enable the Chairman to focus full time on attending
to the affairs of the Council and supervising Council staff. Other members on the
Council could include, among others, the federal financial institution, securities and
commodities regulators. In addition, we would suggest that the Council include an odd
number of members in order to avoid deadlocks.

42

The Council should complement existing regulatory authorities by bringing a
macro-prudential perspective to regulation and being able to set or harmonize prudential
standards to address systemic risk. Drawing on the expertise of the federal regulators, the
Council should have broad authority and responsibility for identifying institutions,
products, practices, services and markets that create potential systemic risks,
implementing actions to address those risks, ensuring effective information flow, and
completing analyses and making recommendations. In order to do its job, the Council
needs the authority to obtain any information requested from large interconnected
entities.

The crisis has clearly revealed that regulatory gaps, or significant differences in
regulation across financial services firms, can encourage regulatory arbitrage.
Accordingly, a primary responsibility of the Council should be to harmonize prudential
regulatory standards for financial institutions, products and practices to assure that market
participants cannot arbitrage regulatory standards in ways that pose systemic risk. The
Council should evaluate differing capital standards which apply to commercial banks,
investment banks, and investment funds to determine the extent to which differing
standards circumvent regulatory efforts to contain excess leverage in the system. The
Council could also undertake the harmonization of capital and margin requirements
applicable to all OTC derivatives activities, and facilitate interagency efforts to encourage
greater standardization and transparency of derivatives activities and the migration of
these activities onto exchanges or Central Counterparties.

43

The Council should have rule-writing authority to harmonize capital, leverage and
liquidity standards. Primary regulators would be charged with enforcement, but if they
fail to act, the Council should have back-up enforcement authority. The standards set by
the Council should be designed to provide incentives to reduce or eliminate potential
systemic risks created by the size or complexity of individual entities, concentrations of
risk or market practices, and other interconnections between entities and markets. Any
standards set by the Council should be construed as a minimum floor for regulation that
can be exceeded, as appropriate, by the primary prudential regulator.

The Council should have the authority to consult with financial regulators from
other countries in developing reporting requirements and in identifying potential systemic
risk in the global financial market. The Council also should report to Congress annually
about its efforts, identify emerging systemic risk issues and recommend any legislative
authority needed to mitigate systemic risk.

Some might fear that a council would have too much vested authority. We
disagree. In our view, a deliberative council would provide adequate checks and
balances to address any dissenting view. A Council with regulatory agency participation
would ensure that decisions reflect the best interests of public and private stakeholders.

44

Derivatives Markets

Concentration, complexity and the opacity of the derivatives markets were further
sources of risk in the current crisis. While these markets can perform important riskmitigation functions, they have also proven to be a major source of contagion during the
crisis.

Losses on poorly underwritten mortgages products were magnified by trillions of
dollars in derivative contracts whose values were derived from the performance of those
mortgages. Exposure concentrations among derivatives dealers certainly helped to
catalyze systemic breakdown. Derivative exposures can create collateral runs similar in
many respects to the depositor runs that occurred during banking panics prior to the
establishment of the FDIC.

For instance, when a derivatives dealer’s credit quality deteriorates, other market
participants can demand collateral to protect their claims. As the situation deteriorates,
collateral demands intensify and, at some point, the firm cannot meet additional collateral
demands and it collapses. The resulting fire sale of collateral can depress prices, freeze
market liquidity, and create risks of collapse for other firms. Derivative counterparties
have every interest to demand more collateral and sell it as quickly as possible before
market prices decline.

45

One way to reduce these risks while retaining market discipline is to make
derivative counterparties and others that collateralized credit exposures keep some “skin
in the game” throughout the cycle. The policy argument for such an approach is even
stronger if the firm’s failure would expose the taxpayer or a resolution fund to losses.
One approach to addressing these risks would be to haircut up to 10 percent of the
secured claim for companies with derivatives or other secured claims against the failed
firm if the taxpayer or a resolution fund is expected to suffer losses. To prevent market
disruptions, Treasury and U.S. government-sponsored debt as collateral would be exempt
from the haircut. Such a policy would limit the ability of institutions to fund themselves
with potentially risky collateral and ensure that market participants always have an
interest in monitoring the financial health of their counterparties. It also would limit the
sudden demand for more collateral because the protection could be capped and also help
to protect the taxpayer and the resolution fund from losses.

It is important that we improve the resiliency of the financial markets and reduce
the likelihood that the failure of any individual financial firm will create a destabilizing
“run” in the markets. We should require that all standardized OTC derivatives clear
through appropriately designed and central counterparty systems (CCPs) and, where
possible, trade on regulated exchanges. To ensure necessary risk management, these
CCPs and exchanges must be subject to comprehensive settlement systems supervision
and oversight by federal regulators.

46

We recognize that not all OTC contracts are standardized. In those limited
circumstances where non-standardized OTC derivatives are necessary, those contracts
must be reported to trade repositories and be subject to robust standards for
documentation and confirmation of trades, netting, collateral and margin practices, and
close-out practices. This is an essential reform to reduce the opacity in the OTC market
that contributed to market uncertainty and greatly increased the difficulties of crisis
management during this crisis. Today, trade repository information is not yet complete
or available to all regulators who need it. For example, the FDIC as deposit insurer and
receiver, does not currently have access to end-user data from the CDS trade repository.
This gap must be closed.

Improved transparency is vital for a more efficient market and for more effective
regulation. The clearance of standardized trades through CCPs and the reporting of
information about non-standardized derivatives will greatly improve transparency. To
achieve greater transparency it is essential that CCPs and trade repositories be required to
make aggregate data on trading volumes and positions available to the public and to make
individual counterparty trade and position data available on a confidential basis to federal
regulators, including those with responsibilities for market integrity.

Consumer Protection

Many of the current problems affecting the safety and soundness of the financial
system were caused by a lack of strong, comprehensive rules against abusive lending

47

practices applying to both banks and non-banks, and lack of a meaningful examination
and enforcement presence in the non-bank sector. Products and practices that strip
individual and family wealth undermine the foundation of the economy. As the current
crisis demonstrates, increasingly complex financial products combined with frequently
opaque marketing and disclosure practices result in problems, not just for consumers, but
for institutions and investors as well. As the ultimate insurer of over $6 trillion in
deposits, the FDIC has both the responsibility and vital need to ensure that consumer
compliance and safety and soundness are appropriately integrated.

The FDIC supports the establishment of a single primary federal consumerproducts regulator along the lines of the proposed Consumer Financial Protection
Agency. In the FDIC’s view, a consumer products regulator should regulate providers of
consumer credit, savings, payment and other financial products and services. It should be
the sole rule-making authority for consumer financial protection statutes and should have
supervisory and enforcement authority over all non-bank providers of consumer credit
and back-up supervisory authority over insured-depository institutions.

The agency should eliminate regulatory gaps between insured depository
institutions and non-bank providers of financial products and services by establishing
strong, consistent consumer protection standards across the board. It should eliminate the
potential for regulatory arbitrage that exists because of federal preemption of certain State
laws. While Federal preemption is framed as a way to affect cost efficiencies for
financial firms, it has now become clear that abrogating sound state laws, particularly
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regarding consumer protection, created opportunity for regulatory arbitrage that resulted
in a regulatory “race-to-the-bottom.” Supporters of preemption have emphasized the cost
efficiency argument. However, many commercial firms have been able to survive and
profit throughout the years without the benefits of federal preemption. The FDIC’s view
is that creating a “floor” for consumer protection, based on either appropriate state or
federal law, rather than the current system that establishes a ceiling on protections would
significantly improve consumer protection.

Also, since most of the problem products and practices that contributed to the
current crisis began outside the banking industry, focusing examination and enforcement
on the non-bank sector is key to addressing most of the abusive lending practices faced
by consumers. A consumer protection regulator should have sole rule-writing authority
over consumer financial products and services and the federal banking regulators should
be required to examine for and enforce those standards. If the bank regulators are not
performing this role properly, the consumer regulator should retain backup examination
and enforcement authority to address any situation where it determines that a banking
agency is providing insufficient supervision. By freeing the consumer regulator from
direct supervision and enforcement of depository institutions, the agency would be able
to focus its examination and enforcement resources on the non-bank financial providers
that provide financial products and services that have not previously been subject to
federal examination and clear supervisory standards.

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Improved consumer protections are in everyone's best interest. It is important to
understand that many of the current problems affecting the safety and soundness of the
financial system were caused by a lack of strong, comprehensive rules against abusive
practices in mortgage lending. If HOEPA regulations had been amended in 2001, instead
of in 2008, a large number of the toxic mortgage loans could not have been originated
and much of the crisis may have been prevented. The FDIC strongly supported the
FRB’s promulgation of an “ability to repay” standard for high priced loans in 2008, and
continues to urge the FRB to apply common sense, “ability to repay” requirements to all
mortgages, including interest-only and option-ARM loans.

Conclusion

In my testimony today, I have discussed some of the financial sector
developments that fueled a speculative boom in housing that ended badly—for
consumers, savers, financial institutions, and our entire economy. As the committee
examines the causes of the financial crisis, it should also consider long-standing features
of the broader economy that may have contributed to the excesses that led to the crisis.

This crisis represents the culmination of a decades-long process by which our
national policies have distorted economic activity away from savings and toward
consumption, away from investment in our industrial base and public infrastructure and
toward housing, away from the real sectors of our economy and toward the financial
sector. No single policy is responsible for these distortions, and no one reform can

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restore balance to our economy. We need to examine national policies from a long-term
view and ask whether they will create the incentives that will lead to improved and
sustainable standards of living for our citizens over time.

For example, federal tax policy has long favored investment in owner-occupied
housing and the consumption of housing services. The government-sponsored housing
enterprises have also used the implicit backing of the government to lower the cost of
mortgage credit and stimulate demand for housing and housing-linked debt. In political
terms, these policies have proven to be highly popular. Who will stand up to say they are
against homeownership? Yet, we have failed to recognize that there are both opportunity
costs and downside risks associated with these policies. Policies that channel capital
towards housing necessarily divert capital from other investments, such as plant and
equipment, technology, and education—investments that are also necessary for long-term
economic growth and improved standards of living.

As the housing boom gathered steam in this decade, there is little doubt that largescale government housing subsidies only encouraged more residential investment. These
policies amplified the boom as well as the resulting bust. In the end, government housing
policy failed to deliver on its promise to promote homeownership and long-term
prosperity. Where homeownership was once regarded as a tool for building household
wealth, it has instead consumed the wealth of many households. At present, foreclosures
are nearing 3 million per year and the rise of housing-linked debt has resulted in more
than 15 million households owing more than their home is worth.

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But this is not the only example of well-intentioned policies that have distorted
economic activity in potentially harmful ways. For example, the preferential tax rate on
capital gains, which is designed to promote long-term capital investment, has been
exploited by private equity and hedge fund managers to reduce the effective tax rate on
the outsized incomes earned by the relatively few who work in these industries. And
while the establishment of emergency backstops to contain financial crises can help to
limit damage to the wider economy in the short-run, without needed reforms these
policies will promote financial activity and risk-taking at the expense of other sectors of
the economy.

Corporate sector practices also had the effect of distorting of decision-making
away from long-term profitability and stability and toward short-term gains with
insufficient regard for risk. For example, performance bonuses and equity-based
compensation should have aligned the financial interests of shareholders and managers.
Instead, we now see—especially in the financial sector—that they frequently had the
effect of promoting short-term thinking and excessive risk-taking that bred instability in
our financial system. Meaningful reform of these practices will be essential to promote
better long-term decision-making in the U.S. corporate sector.

Whatever the reasons, our financial sector has grown disproportionately in
relation to the rest of our economy over time. Whereas the financial sector claimed less
than 15 percent of total U.S. corporate profits in the 1950s and 1960s, its share grew to 25
percent in the 1990s and 34 percent in the most recent decade through 2008. The

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financial services industry produces intermediate products that are not directly
consumed—transactions services and products that channel savings into investment
capital. While these services are essential to our modern economy, the excesses of the
last decade represented a costly diversion of resources from other sectors of the economy.
We must avoid policies that encourage such distortions in economic activity. Fixing
regulation will only accomplish so much. Longer term, we must develop a more strategic
approach that utilizes all available policy tools—fiscal, monetary, and regulatory—to
lead us toward a longer-term, more stable, and more widely-shared prosperity.

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