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CONGRESSIONAL OVERSIGHT PANEL
SPECIAL REPORT ON
REGULATORY REFORM *

MODERNIZING THE AMERICAN FINANCIAL
REGULATORY SYSTEM:
RECOMMENDATIONS FOR IMPROVING
OVERSIGHT, PROTECTING CONSUMERS,
AND ENSURING STABILITY

FEBRUARY , 2009.—Ordered to be printed

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* Submitted under Section 125(b)(2) of Title I of the Emergency Economic
Stabilization Act of 2008, Pub. L. No. 110–343

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CONGRESSIONAL OVERSIGHT PANEL SPECIAL REPORT ON REGULATORY REFORM

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CONGRESSIONAL OVERSIGHT PANEL
SPECIAL REPORT ON
REGULATORY REFORM *

MODERNIZING THE AMERICAN FINANCIAL
REGULATORY SYSTEM:
RECOMMENDATIONS FOR IMPROVING
OVERSIGHT, PROTECTING CONSUMERS,
AND ENSURING STABILITY

FEBRUARY , 2009.—Ordered to be printed

* Submitted under Section 125(b)(2) of Title I of the Emergency Economic
Stabilization Act of 2008, Pub. L. No. 110–343

WASHINGTON

:

2009

For sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov Phone: toll free (866) 512–1800; DC area (202) 512–1800
Fax: (202) 512–2104 Mail: Stop IDCC, Washington, DC 20402–0001

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U.S. GOVERNMENT PRINTING OFFICE
47–018

CONGRESSIONAL OVERSIGHT PANEL FOR ECONOMIC STABILIZATION
PANEL MEMBERS
ELIZABETH WARREN, Chair
SEN. JOHN SUNUNU
REP. JEB HENSARLING
RICHARD H. NEIMAN
DAMON SILVERS

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(II)

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CONTENTS
Page

I. Executive Summary .......................................................................................
1. Lessons From the Past .........................................................................
2. Shortcomings of the Present ................................................................
3. Recommendations for the Future ........................................................
II. Introduction ....................................................................................................
III. A Framework for Analyzing the Financial Regulatory System and Its
Effectiveness ...............................................................................................
1. The Promise and Perils of Financial Markets ....................................
2. The Current State of the Regulatory System .....................................
Failure to Effectively Manage Risk ..................................................
Failure to Require Sufficient Transparency ....................................
Failure to Ensure Fair Dealings .......................................................
3. The Central Importance of Regulatory Philosophy .............................
IV. Critical Problems and Recommendations for Improvement .......................
1. Identify and Regulate Financial Institutions That Pose Systemic
Risk .........................................................................................................
2. Limit Excessive Leverage in American Financial Institutions ..........
3. Modernize Supervision of Shadow Financial System .........................
4. Create a New System for Federal and State Regulation of Mortgages and other Consumer Credit Products ........................................
5. Create Executive Pay Structures That Discourage Excessive Risk
Taking .....................................................................................................
6. Reform the Credit Rating System ........................................................
7. Make Establishing a Global Financial Regulatory Floor a U.S.
Diplomatic Priority ................................................................................
8. Plan for the Next Crisis ........................................................................
V. Issues Requiring Further Study ...................................................................
VI. Acknowledgments ..........................................................................................
VII. About the Congressional Oversight Panel ...................................................
VIII. Additional Views ............................................................................................
Richard H. Neiman ...................................................................................
Congressman Jeb Hensarling and former Senator John E. Sununu ....
Appendix: Other Reports on Financial Regulatory Reform .................................

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SPECIAL REPORT ON REGULATORY REFORM

FEBRUARY

, 2009.—Ordered to be printed

I. EXECUTIVE SUMMARY
1. LESSONS FROM THE PAST

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Financial crises are not new. As early as 1792, during the presidency of George Washington, the nation suffered a severe panic
that froze credit and nearly brought the young economy to its
knees. Over the next 140 years, financial crises struck on a regular
basis—in 1797, 1819, 1837, 1857, 1873, 1893–96, 1907, and 1929–
33—roughly every fifteen to twenty years.
But as the United States emerged from the Great Depression,
something remarkable happened: the crises stopped. New financial
regulation—including federal deposit insurance, securities regulation, and banking supervision—effectively protected the system
from devastating outbreaks. Economic growth returned, but recurrent financial crises did not. In time, a financial crisis was seen as
a ghost of the past.
After fifty years without a financial crisis—the longest such
stretch in the nation’s history—financial firms and policy makers
began to see regulation as a barrier to efficient functioning of the
capital markets rather than a necessary precondition for success.
This change in attitude had unfortunate consequences. As financial markets grew and globalized, often with breathtaking speed,
the U.S. regulatory system could have benefited from smart
changes. But deregulation and the growth of unregulated, parallel
shadow markets were accompanied by the nearly unrestricted marketing of increasingly complex consumer financial products that
multiplied risk at every stratum of the economy, from the family
level to the global level. The result proved disastrous. The first

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warning followed deregulation of the thrifts, when the country suffered the savings and loan crisis in the 1980s. A second warning
came in 1998 when a crisis was only narrowly averted following
the failure of a large unregulated hedge fund. The near financial
panic of 2002, brought on by corporate accounting and governance
failures, sounded a third warning.
The United States now faces its worst financial crisis since the
Great Depression. It is critical that the lessons of that crisis be
studied to restore a proper balance between free markets and the
regulatory framework necessary to ensure the operation of those
markets to protect the economy, honest market participants, and
the public.

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2. SHORTCOMINGS OF THE PRESENT

The current crisis should come as no surprise. The present regulatory system has failed to effectively manage risk, require sufficient transparency, and ensure fair dealings.
Financial markets are inherently volatile and prone to extremes.
The government has a critical role to play in helping to manage
both public and private risk. Without clear and effective rules in
place, productive financial activity can degenerate into unproductive gambling, while sophisticated financial transactions, as well as
more ordinary consumer credit transactions, can give way to swindles and fraud.
A well-regulated financial system serves a key public purpose: if
it has the power and if its leaders have the will to use that power,
it channels savings and investment into productive economic activity and helps prevent financial contagion. Like the management of
any complex hazard, financial regulation should not rely on a single magic bullet, but instead should employ an array of related
measures for managing various elements of risk. The advent of the
automobile brought enormous benefits but also considerable risks
to drivers, passengers, and pedestrians. The solution was not to
prohibit driving, but rather to manage the risks through reasonable
speed limits, better road construction, safer sidewalks, required
safety devices (seatbelts, airbags, children’s car seats, antilock
breaks), mandatory automobile insurance, and so on. The same
holds true in the financial sector.
In recent years, however, the regulatory system not only failed
to manage risk, it also failed to require disclosure of risk through
sufficient transparency. American financial markets are profoundly
dependent upon transparency. After all, the fundamental risk/reward corollary depends on the ability of market participants to
have confidence in their ability to accurately judge risk.
Markets have become opaque in multiple ways. Some markets,
such as hedge funds and credit default swaps, provide virtually no
information. Even so, disclosure alone does not always provide genuine transparency. Market participants must have useful, relevant
information delivered in an appropriate, timely manner. Recent
market occurrences involving off-balance-sheet entities and complex financial instruments reveal the lack of transparency resulting
from the wrong information disclosed at the wrong time and in the
wrong manner. Mortgage documentation suffers from a similar
problem, with reams of paper thrust at borrowers at closing, far too
late for any borrower to make a well-informed decision. Just as

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markets and financial products evolve, so too must efforts to provide understanding through genuine transparency.
To compound the problem associated with uncontained and
opaque risks, the current regulatory framework has failed to ensure fair dealings. Unfair dealing can be blatant, such as outright
deception or fraud, but unfairness can also be much more subtle,
as when parties are unfairly matched. Individuals have limited
time and expertise to master complex financial dealings. If one
party to a transaction has significantly more resources, time, sophistication or experience, other parties are at a fundamental disadvantage. The regulatory system should take appropriate steps to
level the playing field.
Unfair dealings affect not only the specific transaction participants, but extend across entire markets, neighborhoods, socioeconomic groups, and whole industries. Even when only a limited
number of families in one neighborhood have been the direct victims of a predatory lender, the entire neighborhood and even the
larger community will suffer very real consequences from the resulting foreclosures. As those consequences spread, the entire financial system can be affected as well. More importantly, unfairness, or even the perception of unfairness, causes a loss of confidence in the marketplace. It becomes all the more critical for regulators to ensure fairness through meaningful disclosure, consumer
protection measures, stronger enforcement, and other measures.
Fair dealings provide credibility to businesses and satisfaction to
consumers.
In tailoring regulatory responses to these and other problems,
the goal should always be to strike a reasonable balance between
the costs of regulation and its benefits. Just as speed limits are
more stringent on busy city streets than on open highways, financial regulation should be strictest where the threats—especially the
threats to other citizens—are greatest, and it should be more moderate elsewhere.

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3. RECOMMENDATIONS FOR THE FUTURE

Modern financial regulation can provide consumers and investors
with adequate information for making sound financial decisions
and can protect them from being misled or defrauded, especially in
complex financial transactions. Better regulation can reduce conflicts of interest and help manage moral hazard, particularly by
limiting incentives for excessive risk taking stemming from often
implicit government guaranties. By limiting risk taking in key
parts of the financial sector, regulation can reduce systemic threats
to the broader financial system and the economy as a whole. Ultimately, financial regulation embodies good risk management,
transparency, and fairness.
Had regulators given adequate attention to even one of the three
key areas of risk management, transparency and fairness, we
might have averted the worst aspects of the current crisis.
1. Risk management should have been addressed through better
oversight of systemic risks. If companies that are now deemed ‘‘too
big to fail’’ had been better regulated, either to diminish their systemic impact or to curtail the risks they took, then these companies
could have been allowed to fail or to reorganize without taxpayer

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bailouts. The creation of any new implicit government guarantee of
high-risk business activities could have been avoided.
2. Transparency should have been addressed through better,
more accurate credit ratings. If companies issuing high-risk credit
instruments had not been able to obtain AAA ratings from the private credit rating agencies, then pension funds, financial institutions, state and local municipalities, and others that relied on those
ratings would not have been misled into making dangerous investments.
3. Fairness should have been addressed through better regulation of consumer financial products. If the excesses in mortgage
lending had been curbed by even the most minimal consumer protection laws, the loans that were fed into the mortgage backed securities would have been choked off at the source, and there would
have been no ‘‘toxic assets’’ to threaten the global economy.
While the current crisis had many causes, it was not unforeseeable. Correcting the mistakes that fueled this crisis is within reach.
The challenge now is to develop a new set of rules for a new financial system.
The Panel has identified eight specific areas most urgently in
need of reform:
1. Identify and regulate financial institutions that pose systemic risk.
2. Limit excessive leverage in American financial institutions.
3. Increase supervision of the shadow financial system.
4. Create a new system for federal and state regulation of
mortgages and other consumer credit products.
5. Create executive pay structures that discourage excessive
risk taking.
6. Reform the credit rating system.
7. Make establishing a global financial regulatory floor a
U.S. diplomatic priority.
8. Plan for the next crisis.
While these are the most pressing reform recommendations,
many other issues merit further study, the results of which the
Panel will present in future reports. Despite the magnitude of the
task, the central message is clear: through modernized regulation,
we can dramatically reduce the risk of crises and swindles while
preserving the key benefits of a vibrant financial system
Americans have paid dearly for this latest crisis. Lost jobs, failed
businesses, foreclosed homes, and sharply cut retirement savings
have touched people all across the county. Now every citizen—even
the most prudent—is called on to assume trillions of dollars in liabilities spent to try to repair a broken system. The costs of regulatory failure and the urgency of regulatory reform could not be
clearer.

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II. INTRODUCTION
The financial crisis that began to take hold in 2007 has exposed
significant weaknesses in the nation’s financial architecture and in
the regulatory system designed to ensure its safety, stability, and
performance. In fact, there can be no avoiding the conclusion that
our regulatory system has failed.
The bursting of the housing bubble produced the first true stress
test of modern capital markets, their instruments, and their participants. The first cracks were evident in the subprime mortgage
market and in the secondary market for mortgage-related securities. From there, the crisis spread to nearly every corner of the financial sector, both at home and abroad, taking down some of the
most venerable names in the investment banking and insurance
businesses and crippling others, wreaking havoc in the credit markets, and brutalizing equity markets worldwide.
As asset prices deflated, so too did the theory that had increasingly guided American financial regulation over the previous three
decades—namely, that private markets and private financial institutions could largely be trusted to regulate themselves. The crisis
suggested otherwise, particularly since several of the least regulated parts of the system were among the first to run into trouble.
As former Federal Reserve Chairman Alan Greenspan acknowledged in testimony before the House Committee on Oversight and
Government Reform in October 2008, ‘‘Those of us who have looked
to the self-interest of lending institutions to protect shareholders’
equity, myself included, are in a state of shocked disbelief.’’ 1
The financial meltdown necessitates a thorough review of our
regulatory infrastructure, the behavior of regulators and their
agencies, and the regulatory philosophy that informed their decisions. At the same time, we must be careful to avoid the trap of
looking solely backward—preparing to fight the last war. Although
the crisis has exposed many deficiencies, there are likely others
that have yet to be uncovered. What is more, the vast federal response to the crisis—including unprecedented rescues of crippled
businesses and a proliferation of government guaranties—threatens to distort private incentives in the future, further eroding the
caution of financial creditors and making the job of regulatory oversight all the more essential.
Realizing that far-reaching reform will be needed in the wake of
the crisis, Congress directed the Congressional Oversight Panel
(hereinafter ‘‘the Panel’’) to submit a special report on regulatory
reform,
analyzing the current state of the regulatory system and
its effectiveness at overseeing the participants in the financial system and protecting consumers, and providing
recommendations for improvement, including recommendations regarding whether any participants in the financial
markets that are currently outside the regulatory system
should become subject to the regulatory system, the ration-

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1 See Edmund L. Andrews, Greenspan Concedes Error on Regulation, New York Times (Oct.
24, 2008). See also House Committee on Oversight and Government Reform, Testimony of Alan
Greenspan, The Financial Crisis and the Role of Federal Regulators, 110th Cong., at 2 (Oct. 23,
2008) (online at oversight.house.gov/documents/20081023100438.pdf).

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ale underlying such recommendation, and whether there
are any gaps in existing consumer protections.2
Toward this end, part III of this report presents a broad framework for analyzing the effectiveness of financial regulation, focusing on three critical failures of the current system: (1) inadequate
private and public risk management, (2) insufficient transparency
and information, and (3) a lack of protection against deception and
unfair dealing. These key failures of the regulatory system have
manifested themselves in a plethora of more specific problems,
ranging from excessively leveraged financial institutions to opaque
financial instruments falling outside the scope of the jurisdiction of
any regulatory agency. While this report cannot tackle every one
of these problems, part IV focuses on eight areas of the current financial regulatory system that are in need of improvement, offering the Panel’s recommendations for each as follows:
1. Identify and regulate financial institutions that pose systemic risk.
2. Limit excessive leverage in American financial institutions.
3. Modernize supervision of the shadow financial system.
4. Create a new system for federal and state regulation of
mortgages and other consumer credit products.
5. Create executive pay structures that discourage excessive
risk taking.
6. Reform the credit rating system.
7. Make establishing a global financial regulatory floor a
U.S. diplomatic priority.
8. Plan for the next crisis.
Finally, part V of this report points to some additional challenges
in need of attention over the longer term, several of which will be
addressed in future reports of the Panel. An appendix comprising
summaries of other recent reports regarding reform of the regulatory system is found at the end of the report.
This report is motivated by the knowledge that millions of Americans suffer when the financial regulatory system and the capital
markets fail. The financial meltdown has many causes but one
overwhelming result: a great increase in unexpected hardships and
financial challenges for American citizens. The unemployment rate
is rising sharply every month, a growing number of Americans are
facing the prospect of losing their homes, retirees are worried about
how to afford even basic necessities, and families are anxious about
paying for college and securing a decent start in adult life. The goal
of the regulatory reforms presented in this report is not to endorse
a particular economic theory or merely to guide the country
through the current crisis. The goal is instead to establish a sturdy
regulatory system that will facilitate the growth of financial markets and will protect the lives of current and future generations of
Americans.

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Economic Stabilization Act of 2008, Pub. L. No. 110–343, at § 125(b)(2).

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III. A FRAMEWORK FOR ANALYZING THE FINANCIAL
REGULATORY SYSTEM AND ITS EFFECTIVENESS
1. THE PROMISE AND PERILS OF FINANCIAL MARKETS

Households, firms, and government agencies all rely on the financial system for saving and raising capital, settling payments,
and managing risk. A dynamic financial system facilitates the mobilization of resources for large projects and the transfer of resources across time and space and provides critical information in
the form of price signals that help to coordinate dispersed economic
activity. A healthy financial system, one that allows for the efficient allocation of capital and risk, is indispensable to any successful economy.
Unfortunately, financial systems are also prone to instability and
abuse. Until the dawn of modern financial regulation in the 1930s
and early 1940s, financial panics were a regular—and often debilitating—feature of American life. The United States suffered significant financial crises in 1792, 1819, 1837–39, 1857, 1873, 1893–95,
1907, and 1929–33. After the Great Depression and the introduction of federal deposit insurance and federal banking and securities
regulation, the next significant banking crisis did not strike for
more than forty years. This period of relative stability—by far the
longest in the nation’s history—persisted until the mid–1980s, with
the onset of the savings and loan crisis; dealing with that crisis
cost American taxpayers directly some $132 billion.3 The country
also suffered a group of bank failures that produced the need to recapitalize the FDIC’s initial Bank Insurance Fund in the early
1990s; suffered a stock market crash in 1987; witnessed a wave of
foreign currency crises (and associated instability) in 1994–95 and
1997–98; saw the collapse of Long Term Capital Management
(LCTM) hedge fund in 1998; and faced the collapse of the tech bubble in 2001. Financial crisis has now struck again, with the
subprime-induced financial turmoil of 2007–09.
Although every crisis is distinctive in its particulars, the commonalities across crises are often more striking than the differences. As the financial historian Robert Wright explains: ‘‘All
major panics follow the same basic outline: asset bubble, massive
leverage (borrowing to buy the rising asset), bursting bubble (asset
price declines rapidly), defaults on loans, asymmetric information
and uncertainty, reduced lending, declining economic activity, unemployment, more defaults.’’ 4
Nor are financial panics the only cause for concern. Financial
markets have also long exhibited a vulnerability to manipulation,
swindles, and fraud, including William Duer’s notorious attempt to
corner the market for United States government bonds in 1791–92,
the ‘‘wildcat’’ life insurance companies of the early nineteenth century (which took premiums from customers but disappeared before
paying any claims), the infamous pyramiding scheme of Charles

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3 On the period of relative financial stability (‘‘the great pause’’), see David Moss, An Ounce
of Prevention: The Power of Sound Risk Management in Stabilizing the American Financial System (2009). See also Federal Deposit Insurance Corporation, History of the Eighties—Lessons for
the Future, Volume I: An Examination of the Banking Crises of the 1980s and Early 1990s, at
187 (online at www.fdic.gov/bank/historical/history/167l188.pdf).
4 See Andrea Young, What Economic Historians Think About the Meltdown, History News Network (Oct. 20, 2008) (online at hnn.us/articles/55851.html).

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Ponzi in 1920, and the highly suspect practices of New York’s National City Bank and its chairman, Charles Mitchell, in the runup to the Great Crash of 1929. The apparent massive Ponzi scheme
of Bernard Madoff that has recently unraveled in 2008 is only the
latest in a long series of such financial scandals.
Even apart from the most spectacular financial crises and
crimes, the failure of any individual financial institution—all by
itself—can have devastating consequences for the investors and clients who rely on it.5 The collapse of a bank, insurance company,
or pension fund can prove particularly damaging, disrupting longstanding financial relationships and potentially destroying the safety nets that many Americans have spent years carefully building.
The good news is that many of these financial risks can be significantly attenuated through sound regulation. Well-designed regulation has the potential to enhance both financial safety and economic performance, and it has done so in the past. To be sure, the
risks of capital market crises cannot be eliminated altogether, just
as the risk of automobile accidents will never entirely disappear,
despite rigorous safety standards.
2. THE CURRENT STATE OF THE REGULATORY SYSTEM

The purpose of financial regulation is to make financial markets
work better and to ensure that they serve the interests of all Americans. There are many important (and sometimes competing) goals
of financial regulation, ranging from safety and stability to innovation and growth. In order to achieve these goals, an effective regulatory system must manage risk, facilitate transparency, and promote fair dealings among market actors. The current system has
failed on all three counts.
Failure to effectively manage risk
As the current financial meltdown makes clear, private financial
markets do not always manage risk effectively on their own. In
fact, to a large extent, the current crisis can be understood as the
product of a profound failure in private risk management, combined with an equally profound failure in public risk management,
particularly at the federal level.
Failure of private risk management. The risk-management lapses
in the private sector are by now obvious. In the subprime market,
brokers and originators often devoted relatively little attention to
risk assessment, exhibiting a willingness to issue extraordinarily
risky mortgages (for high fees) so long as the mortgages could be
sold quickly on the secondary market.6 Securitizers on Wall Street

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5 In fact, because of the salutary effects of existing regulations, not all failures of financial
institutions create the same level of damage. For instance, the government has insured consumer deposits in financial institutions since the New Deal in recognition of the dangers of a
loss of depositor confidence. Consequently, it is no longer the risk of shareholder losses that
cause fear of systemic crisis, but rather the risk of financial institutions defaulting on fixed obligations.
6 These mortgages included so-called 2–28s (which were scheduled to reset to a sharply higher
interest rate after two years) and option-arms (which allowed customers essentially to set their
own payments in an initial period, followed by ballooning payments after that). Whether or not
borrowers could reasonably be expected to repay—based on their earning capacity—was no
longer always a decisive criterion for lending, particularly against the backdrop of rising home
prices. Said one broker of an elderly client who had lost his home as a result of an unaffordable
loan, ‘‘It’s clear he was living beyond his means, and he might not be able to afford this loan.
But legally, we don’t have a responsibility to tell him this probably isn’t going to work out. It’s

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and elsewhere proved hungry for these high-interest-rate loans, because they could earn large fees for bundling them, dividing the
payments into tranches, and selling the resulting securities to investors. These securities proved attractive, even to relatively riskaverse investors, because the credit rating agencies (who were paid
by the issuers) awarded their triple-A seal of approval to the vast
majority of the securities in any given issue. The credit rating
agencies concluded—wrongly, it turns out—that virtually all of the
risk of a subprime mortgage-backed securitization was concentrated in its lowest tranches (e.g., the bottom 15 to 25 percent)
and that the remainder was exceedingly safe. Nor did the process
end there, since lower-tranche securities (e.g., those with a BBB
rating or below) could be aggregated into so-called collateralized
debt obligations (CDOs) and re-tranched, creating whole new sets
of AAA and AA securities. Only when the housing market turned
down and delinquencies and foreclosures started to rise, beginning
in 2006–07, did the issuers, investors, and rating agencies finally
recognize how severely they had underestimated the key risks involved.7
Had these excesses been limited to the subprime market, it is
unlikely that the initial turmoil could have sparked a full-blown financial crisis. Unfortunately, the broader financial system was in
no position to absorb the losses because a great many of the leading financial firms were themselves heavily leveraged (especially by
incurring a large proportion of short-term debt) and contingent liabilities (including many tied back to the housing market). Such leverage had greatly magnified returns in good times, but proved
devastating once key assets began to drop in value. Higher-leverage necessarily meant higher risk. As it became clear that not only
AAA-rated mortgage-backed securities but also AAA-rated financial
institutions were at risk, trust all but disappeared in the marketplace, leaving even potentially solvent financial institutions vulnerable to runs by their creditors, who were rattled and increasingly
operating on a hair trigger.8
In a sense, no one should have been surprised by the turmoil.
Unregulated and weakly regulated financial markets have historically shown a tendency toward excessive risk taking and instability. The reasons for this are worth reviewing.
To begin with, financial actors do not always bear the full consequences of their decisions and therefore are liable to take (or impose) more risk than would otherwise seem reasonable. For example, financial institutions generally invest other people’s money and
often enjoy asymmetric compensation incentives, which reward
them for gains without penalizing them for losses. Even more troubling, the failure of a large financial firm can have systemic consequences, potentially triggering a cascade of losses, which means
that risk taking by the firm can impose costs far beyond its own
shareholders, creditors, and counterparties. The freezing up of the

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not our obligation to tell them how they should live their lives.’’ See Charles Duhigg, When
Shielding Money Clashes with Elders’ Free Will, New York Times (Dec. 24, 2007).
7 Credit card and automobile loans are also securitized and sold in various formats. It remains
to be seen whether an increased rate of default on those loans (which can be expected as the
economic slowdown deepens) will generate a second wave of severe capital market disruptions.
8 See section III.2.

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credit markets in 2008–09, because even healthy banks are afraid
to lend, is an especially serious example of this phenomenon.
A closely related problem is that of contagion or panic, in which
fear drives a sudden surge in demand for safety and liquidity. A
traditional bank run by depositors is one expression of contagion,
but other types of creditors can also create a ‘‘run’’ on a financial
institution and potentially weaken or destroy it; for example, shortterm lenders can refuse to roll over existing loans to the institution, and market actors may refuse to continue to deal with it. In
fact, whole markets can succumb to panic selling under certain circumstances. In all of these cases, the fearful depositors, creditors,
and investors who suddenly decide to liquidate their positions may
be imposing costs on others, since the first to run will generally get
their money out whereas the last to do so typically will not. More
broadly, poorly managed financial institutions impose costs on wellmanaged ones, because of the threat of contagion.
Yet another problem endemic to financial markets is that individual borrowers and investors may not always be ideally positioned to evaluate complex risks. How can any of us be sure that
a particular financial agreement or product is safe? Ideally, we
carefully read the contract or prospectus. But given limits on time
and expertise (including the expense of expert advice), even a relatively careful consumer or investor is liable to make mistakes—
and potentially large ones—from time to time. Virtually all of us,
moreover, rely on various kinds of shortcuts in assessing risks in
daily life—intuition, seeking nonexpert outside advice, a trusting
attitude toward authority, and so on. Although such an approach
may normally work well, it sometimes fails and is particularly subject to manipulation—for example, by aggressive (or even predatory) lenders. Such problems were an important contributor to the
excesses and eventual implosion of subprime mortgage lending. In
addition, particularly in recent years, it appears that even many of
the most sophisticated investors—and perhaps even the credit rating agencies themselves—had trouble assessing the risks associated with a wide array of new and complex financial instruments.
Complexity itself may therefore have contributed to the binge of
risk taking that overtook the United States financial system in recent years.
Failure of public risk management. Ideally, state and federal regulators should have intervened to control the worst financial excesses and abuses long before the crisis took hold. Almost everyone
now recognizes that the government serves as the nation’s ultimate
risk manager—as the lender, insurer, and spender of last resort—
in times of crisis. But effective public risk management is critical
in normal times as well, both to protect consumers and investors
and to help prevent crises from developing in the first place.9
A good example involves bank regulation. Americans have faced
recurrent banking crises as well as frequent bank suspensions and
failures for much of the nation’s history. The problem appeared to
ease after the creation of the Federal Reserve in 1914 but then returned with a vengeance in 1930–33, when a spiraling panic nearly

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9 On the government’s role as a risk manager, see David Moss, When All Else Fails: Government as the Ultimate Risk Manager (2002).

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consumed the entire American banking system. All of this changed
after the introduction of federal deposit insurance in June of 1933.
Bank runs virtually disappeared, and bank failures fell sharply.
Critics worried that the existence of federal insurance would encourage excessive risk taking (moral hazard), because depositors
would no longer have to worry about the soundness of their banks
and instead would be attracted by the higher interest rates that
riskier banks offered. The authors of the 1933 legislation prepared
for this threat, authorizing not only public deposit insurance but
also intelligent bank regulation designed to ensure the safety and
soundness of insured banks. The end result was an effective system
of new consumer protections, a remarkable reduction in systemic
risk, and a notable increase in public confidence in the financial
system. By all indications, well-designed government risk management helped strengthen the market and prevent subsequent crises.10 (See figure below: Bank Failures, 1864–2000).

In our own time, appropriate regulatory measures might have
proved similarly salutary. Reasonable controls on overly risky consumer and corporate lending and effective limits on the leverage of
major (systemic) financial institutions might have been enough, by
themselves, to prevent the worst aspects of the collapse. Greater
regulatory attention in numerous other areas, from money market
funds and credit rating agencies to credit default swaps, might also
have made a positive difference. However, key policymakers, par-

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10 In fact, significant bank failures did not reappear until after the start of bank deregulation
in the early 1980s. Bank deregulation is often said to have started with the Depository Institutions Deregulation and Monetary Control Act of 1980, Pub. L. No. 96–221, and the Depository
Institutions Act of 1982, Pub. L. No. 97–320.

12
ticularly at the federal level, often chose not to expand this critical
risk-management role—to cover new and emerging risks—when
they had the chance.
Looking forward, the need for meaningful regulatory reform has
now become particularly urgent—not only to correct past mistakes,
but also to limit the likelihood and the impact of future crises and
to control the moral hazard that is likely to flow from the recent
profusion of federal bailouts and guaranties. If creditors, employees, and even shareholders of major financial institutions conclude
that the federal government is likely to step in again in case of
trouble (because of the systemic significance of their institutions),
they may become even more lax about monitoring risk, leading to
even greater excesses in the future. For this reason, the recent federal actions in support of the nation’s largest financial institutions,
involving more than $10 trillion in new federal guaranties, make
effective regulation after the crisis even more vital. The example
set in 1933—of pairing explicit public insurance with an effective
regulatory mechanism for monitoring and controlling moral hazard—must not be forgotten. In fact, the need to control the moral
hazard created by the current financial rescue may be the most important reason of all for strengthening financial regulation in the
months and years ahead.
Failure to require sufficient transparency
While allowing financial institutions to take on too much risk,
federal and state regulators at the same time have permitted these
actors to provide too little information to protect investors and enable markets to function honestly and efficiently. Because financial
information often represents a public good, it may not be adequately provided in the marketplace without government encouragement or mandate. Investors without access to basic financial reporting face serious information asymmetries, potentially raising
the cost of capital and compromising the efficient allocation of financial resources.11 Truthful disclosures are also essential to protect investors. Essential disclosure and reporting requirements may
therefore enhance efficiency by reducing these informational
asymmetries. The broad availability of financial information also
promises to boost public confidence in financial markets. As former
Securities and Exchange Commission (SEC) Chairman Arthur
Levitt has observed, ‘‘the success of capital is directly dependent on
the quality of accounting and disclosure systems. Disclosure systems that are founded on high-quality standards give investors confidence in the credibility of financial reporting—and without investor confidence, markets cannot thrive.’’ 12
From the time they were introduced at the federal level in the
early 1930s, disclosure and reporting requirements have constituted a defining feature of American securities regulation (and

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11 Modern economic research has shown that markets can only function efficiently—that Adam
Smith’s ‘‘invisible hand’’ only works to the extent that the information processed by the markets
is accurate and complete. See Joseph E. Stiglitz, Globalization and Its Discontents (2002) at ch.
3, n. 2 and accompanying text. On information asymmetry and the cost of capital, see Douglas
Diamond and Robert Verrecchia, Disclosure, Liquidity, and the Cost of Capital, Journal of Finance, at 1325–1359 (Sept. 1991). See also S. P. Kothari, The Role of Financial Reporting in
Reducing Financial Risks in the Market, in Building and Infrastructure for Financial Stability,
at 89–102 (Eric. S. Rosengren and John S. Jordan eds., June 2000).
12 See id. at 91.

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of American financial regulation more generally). President Franklin Roosevelt himself explained in April 1933 that although the federal government should never be seen as endorsing or promoting
a private security, there was ‘‘an obligation upon us to insist that
every issue of new securities to be sold in interstate commerce be
accompanied by full publicity and information and that no essentially important element attending the issue shall be concealed
from the buying public.’’ 13
Historically, embedding a flexible approach to jurisdiction has
made for strong, effective regulatory agencies. When the SEC was
founded, during the Depression, Congress armed the commission
with statutory authority based upon an extremely broad view of
what constituted a security and gave it wide latitude in determining what disclosures were necessary from those who sought to
sell securities to the public. There was a similar breadth of coverage and flexibility in substantive approach in the Investment Advisors Act and the Investment Company Act, which together governed money managers. These broad grants of jurisdiction led to
the SEC’s having regulatory authority over most capital-market
transactions outside the banking and insurance systems until the
end of the 1970s.
However, the financial markets have outpaced even the broadest
grants of regulatory authority. Starting in the 1980s, skilled market operators began to exploit what had previously seemed to be
merely insignificant loopholes in this system—exceptions that had
always existed in the regulation of investment management. The
increasing importance of institutional intermediaries in the capital
markets exacerbated this tendency. By the 1990s, the growth of
over-the-counter derivative markets had created unregulated parallel capital-market products. This trend has continued in recent
years, with the SEC allowing the founding of publicly traded
hedge-fund and private-equity management firms that do not have
to register as investment companies.
Over subsequent years, the reach of the SEC and its reporting
requirements were gradually expanded. Securities traded over the
counter, for example, were brought into the fold beginning in 1964.
The SEC targeted ‘‘selective disclosure’’ in 2000 with Regulation
Fair Disclosure (Reg FD), a new weapon in the ongoing fight
against insider activities. Two years later, Congress passed the
Sarbanes-Oxley Act, which aimed to bolster the independence of
the accounting industry and required top corporate executives to
personally certify key financial statements.14
By the time the crisis struck in 2007–08, however, one of the
most common words used to describe the American financial system was ‘‘opaque.’’ Hedge funds, which squeeze into an exemption
in the Investment Company Act of 1940, face almost no registration or reporting requirements; moreover, a modest attempt by the
SEC to change this situation was struck down in federal court in
2006. Similarly, over-the-counter markets for credit default swaps

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13 See James M. Landis, The Legislative History of the Securities Act of 1933, George Washington Law Review, at 30 (1959).
14 See Chris Yenkey, Transparency, Democracy, and the SEC: 70 Years of Securities Market
Regulation, in Transparency in a New Global Order: Unveiling Organizational Visions (Christina Garsten and Monica Lindh de Montoya eds., 2007).

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and other derivative instruments remain largely unregulated and,
say critics, constitute virtually the polar opposite of open and
transparent exchange. (According to news reports, an attempt by
Brooksley Born, the former chairperson of the Commodity Futures
Trading Commission, to regulate OTC-traded derivatives in 1997–
98, was blocked by Fed Chairman Alan Greenspan, Treasury Secretary Robert Rubin, and others, allegedly on the grounds that
such regulation could precipitate a financial crisis. In any event,
Congress in 2000 prohibited regulation of most derivatives.) 15 In
addition, the proliferation of off-balance-sheet entities (conduits,
structured investment vehicles [SIVs], etc.) and the rapid growth of
highly complex financial instruments (such as CDOs) further undermined clarity and understanding in the marketplace. The financial consultant Henry Kaufman maintains that leading financial institutions actively ‘‘pushed legal structures that made many aspects of the financial markets opaque.’’ 16 Moreover, starting in
1994, with the Central Bank of Denver decision,17 the courts have
severely limited the ability of investors to police transparency failures involving financial institutions working with public companies. This failure was extended in the Supreme Court’s Stoneridge
decision,18 closing off liability to investors even in cases in which
financial institutions were participants in a fraudulent scheme.
There are of course legitimate questions about how far policymakers should go in requiring disclosure—where the line should be
drawn between public and proprietary information. But particularly given the breakdown that has now occurred, it is difficult to
escape the conclusion that America’s financial markets have veered
far from the goal of transparency, fundamentally compromising the
health and vitality of the financial sector and, ultimately, the
whole economy.
Why our regulatory system failed to expand the zone of transparency in the face of far-reaching financial innovation is a question that merits careful attention. At least part of the answer, once
again, appears to be that key regulators preferred not to expand
the regulatory system to address these challenges, or simply believed that such expansion was unnecessary. In 2002, for example,
Federal Reserve Chairman Alan Greenspan explained his view on
‘‘the issue of regulation and disclosure in the over-the-counter derivatives market’’ this way:
By design, this market, presumed to involve dealings
among sophisticated professionals, has been largely exempt from government regulation. In part, this exemption
reflects the view that professionals do not require the investor protections commonly afforded to markets in which
retail investors participate. But regulation is not only un-

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15 Peter S. Goodman, The Reckoning: Taking Hard New Look at a Greenspan Legacy, New
York Times (Oct. 8, 2008).
16 Henry Kaufman, How the Credit Crisis Will Change the Way America Does Business: Huge
Financial Companies Will Grow at the Expense of Borrowers and Investors, Wall Street Journal
(Dec. 6, 2008).
17 Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994).
18 Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 128 S. Ct. 761 (2008). See
also Congressional Oversight Panel, Testimony of Joel Seligman, Reforming America’s Financial
Regulatory Structure, at 5 (Jan. 14, 2009) (online at cop.senate.gov/documents/testimony-011409seligman.pdf).

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necessary in these markets, it is potentially damaging, because regulation presupposes disclosure and forced disclosure of proprietary information can undercut innovations
in financial markets just as it would in real estate markets.19
Subsequent developments—including the effective failure (and
rescue) of American International Group, Inc. (AIG), as a result of
massive exposure in the credit default swaps market—raise serious
questions about this hands-off view. The abuses in the mortgage
markets, and especially in the subprime mortgage market, are a
good example, but so are abuses throughout the range of consumer
credit products. The challenge now is to develop a plan not only to
bring much-needed sunlight into the most opaque corners of the financial system but to ensure appropriate regulatory adaptation to
new financial innovation in the future.
Failure to ensure fair dealings
The current regulatory system has not only allowed for excessive
risk and an insufficient degree of transparency, but it has also
failed to prevent the emergence of unfair dealings between actors.
Overt lies are dishonest, of course, and lying may trigger legal liability. But fair dealing involves more than refraining from outright lying. Deception and misdirection, are the antithesis of fair
dealing. When the legal system permits deception and misdirection
it undermines consensual agreements between parties, the very
foundation of a market economy designed to serve all individuals.
Deceptive or misleading dealings can occur in any setting, but
they are most likely to occur when the players are mismatched.
When one player is sophisticated, has ample resources, and works
regularly in the field while the other is a nonspecialist with limited
resources and little experience, the potential for deception is at its
highest. A credit card contract, for example, may be a relatively
simple, straightforward agreement from which both issuer and customer may benefit. Or it may be a thirty-plus page document that
is virtually incomprehensible to the customer. In the latter case,
the issuer who can hire a team of lawyers to draft the most favorable language may carefully measure every nuance of the transaction, while the customer who has little time or sufficient expertise to read—much less negotiate—such a contract is far less likely
to appreciate the risks associated with the deal.
Similarly, in the subprime mortgage market prospective borrowers were often led to believe that a scheduled interest-rate reset
would never affect them because they had been told that they could
‘‘always’’ refinance the property at a lower rate before the reset
took effect. Similarly, studies show that payday loan customers,
while generally aware of finance charges, are often unaware of annual percentage rates.20 In one survey, of those who took on tax

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19 The Federal Reserve Board, Remarks by Chairman Alan Greenspan before the Society of
Business Economists, London, U.K. (Sept. 25, 2002) (online at www.federalreserve.gov/
BoardDocs/Speeches/2002/200209252/default.htm).
20 See NFI, Gregory Elliehausen, Consumers’ Use of High-Price Credit Products: Do They
Know What They Are Doing?, at 29 (2006) (Working Paper No. 2006-WP-02); Credit Research
Center, Georgetown University, Gregory Elliehausen and Edward C. Lawrence, Payday Advance
Continued

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refund anticipation loans, approximately half of all respondents
were not aware of the substantial fees charged by the lender.21 One
authority on consumer credit has catalogued a long list of ‘‘tricks
and traps,’’ particularly in the credit card market, designed to
‘‘catch consumers who stumble or mistake those traps for treasure
and find themselves caught in a snare from which they cannot escape.’’ 22 While each of these contracts may meet the letter of the
law, deals that are structured so that one side repeatedly does not
understand the terms do not meet the definition of fair dealing.
The available evidence suggests that the costs of deceptive financial products are high, quickly climbing into the billions of dollars
annually.23 But the problem is not limited to monetary loss—many
people are stripped not only of their wealth, but also of their confidence in the financial marketplace. They come to regard all financial products with suspicion, including those on fair terms and
those that could be beneficial to them.
As the recent crisis has shown, the effects of deceptive contracts
can have wide ripple effects. For example, deceptive mortgages
have led to lender foreclosures on residential housing—foreclosures
that cost taxpayers money and threaten the economic stability of
already imperiled neighborhoods.24 A recent housing report observed: ‘‘Foreclosures are costly—not only to homeowners, but also
to a wide variety of stakeholders, including mortgage servicers,
local governments and neighboring homeowners . . . up to $80,000
for all stakeholders combined.’’ 25 Lenders can lose as well, forfeiting as much as $50,000 per foreclosure, which translates to
roughly $25 billion in total foreclosure-related losses in 2003.26 A
city can lose up to $19,227 per house abandoned in foreclosure in

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Credit in America: An Analysis of Customer Demand, at 2 (2001) (online at www.cfsa.net/
downloads/analysislcustomerldemand.pdf).
21 See Elliehausen, supra note 20, at 31.
22 Senate Committee on Banking, Housing and Urban Affairs of the United States Senate,
Testimony of Elizabeth Warren, Examining the Billing, Marketing, and Disclosure Practices of
the Credit Card Industry, and Their Impact on Consumers, 110th Cong., at 1 (Jan. 25, 2007)
(online at banking.senate.gov/public/lfiles/warren.pdf). The list of tricks and traps includes
‘‘universal default, default rates of interest, late fees, over-limit fees, fees for payment by telephone, repeated changes in the dates bills are due, changes in the locations to which bills should
be mailed, making it hard to find the total amount due on the bill, moving bill-reception centers
to lengthen the time it takes a bill to arrive by mail, misleading customers about grace periods,
and double cycle billing.’’ Id. at 3.
23 Oren Bar-Gill and Elizabeth Warren, Making Credit Safer, University of Pennsylvania Law
Review (Nov. 2008) (summarizing studies showing the high costs of consumer errors on checking
accounts, credit cards, payday loans and refund anticipation loans).
24 See Joint Economic Committee, Sheltering Neighborhoods from the Subprime Foreclosure
Storm,
at
15-16
(Apr.
2007)
(online
at
jec.senate.gov/index.cfm?FuseAction=
Files.View&FileStorelid=8c3884e5-2641-4228-af85-b61f8a677c28) (hereinafter ‘‘JEC Report’’).
See also Nelson D. Schwartz, Can the Mortgage Crisis Swallow a Town?, New York Times (Sept.
2, 2007) (online at www.nytimes.com/2007/09/02/business/yourmoney/02village.html); U.S. Department of the Treasury, Remarks by Secretary Henry M. Paulson, Jr. on Current Housing and
Mortgage Market Developments at Georgetown University Law Center (Oct. 16, 2007) (online at
www.treasury.gov/press/releases/hp612.htm) (‘‘Foreclosures are costly and painful for homeowners. They are also costly for mortgage servicers and investors. They can have spillover effects into property values throughout a neighborhood, creating a downward cycle we must work
to avoid.’’).
25 JEC Report, supra note 24, at 17. See also Dan Immergluck and Geoff Smith, The External
Costs of Foreclosure: The Impact of Single-Family Mortgage Foreclosures on Property Values,
Housing Policy Debate, at 69–72 (2006) (finding that a single-family home foreclosure causes
a decrease in values of homes within an eighth of a mile—or one city block—by an average of
0.9 percent, or approximately $1,870 when the average home sale price is $164,599, and 1.44
percent in low- and moderate-income communities, or about $1,600 when the average home sale
price is $111,002).
26 See, e.g., Desiree Hatcher, Foreclosure Alternatives: A Case for Preserving Homeownership,
Profitwise News and Views, at 2 (Feb. 2006) (online at www.chicagofed.org/communityldevelopment/files/02l2006lforeclosurelalt.pdf).

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lost property taxes, unpaid utility bills, property upkeep, sewage,
and maintenance.27 Many foreclosure-related costs fall on taxpayers, who ultimately must shoulder the bill for services provided
by their local governments.
The burdens of credit-market imperfections are not spread evenly
across economic, educational, or racial groups. The wealthy tend to
be insulated from many credit traps, while the vulnerability of the
working class and middle-class increases. For those closer to the
economic margins, a single economic mistake—a credit card with
an interest rate that unexpectedly escalates to 29.99 percent or
misplaced trust in a broker who recommends a high-priced mortgage—can trigger a downward economic spiral from which no recovery is possible. There is ample evidence that African Americans
and Hispanics have been targets for certain deceptive products,
much to their injury and to the injury of a country that prizes
equality of opportunity for all its citizens.28
When businesses sell deceptive products, they not only injure
their customers but also injure their competitors, who are forced to
adopt similar practices or face losing their markets. The result is
a downward spiral, a race to the bottom in which those who offer
the most slyly deceptive products enjoy the greatest profits while
entire industries and markets are corrupted and cease to provide
efficient and mutually beneficial transactions. The same phenomenon operates on a more macroeconomic level: some investment banks that may have had initial doubts about packing
subprime loans were drawn into a downward spiral, abandoning
their standards of investment quality in a race for the same profits
that other firms appeared to be making.
Assuring fair dealing is not the same as assuring that no one
makes a mistake. Buyers and sellers of financial services can miscalculate. They can fail to save, take unwise gambles, or simply
buy too much. Personal responsibility will always play a critical
role in dealing with financial products, just as personal responsibility remains essential to the responsible use of any physical product. Fair dealing assures only that deception and misdirection will
27 See

JEC Report, supra note 24, at 15.
e.g., Consumer Federation of America, Allan J. Fishbein and Patrick Woodall, Exotic
or Toxic? An Examination of the Non-Traditional Mortgage Market for Consumers and Lenders,
at
24
(May
2006)
(online
at
www.consumerfed.org/pdfs/ExoticlToxicl
MortgagelReport0506.pdf); U.S. Department of Housing and Urban Development and U.S. Department of the Treasury, Curbing Predatory Home Mortgage Lending, at 35 (2000) (online at
www.huduser.org/publications/hsgfin/curbing.html); Center for Community Change, Bradford
Calvin, Risk or Race? Racial Disparities and the Subprime Refinance Market, at 6–8 (May 2002)
(online
at
butera-andrews.com/legislative-updates/directory/Background-Reports/
Center%20for%20Community%20Change%20Report.pdf); Paul Calem, Kevin Gillen and Susan
Wachter, The Neighborhood Distribution of Subprime Mortgage Lending, Journal of Real Estate
Finance and Economics, at 401–404 (Dec. 2004). Another study, based on the Federal Reserve
data, found that ‘‘African-American and Latino borrowers are at greater risk of receiving higherrate loans than white borrowers, even after controlling for legitimate risk factors.’’ Center for
Responsible Lending, Debbie Gruenstein Bocian, Keith S. Ernst and Wei Li, Unfair Lending:
The Effect of Race and Ethnicity on the Price of Subprime Mortgages, at 3 (May 31, 2006) (online
at www.responsiblelending.org/pdfs/rr011exec-UnfairlLending-0506.pdf). A third study by the
Survey Research Center at the University of Michigan found that black homeowners are significantly more likely to have prepayment penalties or balloon payments attached to their mortgages than nonblack homeowners, even after controlling for age, income, gender, and creditworthiness. Michael S. Barr, Jane K. Dokko, and Benjamin J. Keys, Who Gets Lost in the
Subprime Mortgage Fallout? Homeowners in Low- and Moderate-Income Neighborhoods (Apr.
2008) (online at ssrn.com/abstract=1121215). And a fourth study, by Susan Woodward, found
that black borrowers pay an additional $415 in mortgage fees and Latino borrowers pay an additional $365 in mortgage fees. Urban Institute, Susan Woodward, A Study of Closing Costs for
FHA Mortgages, at ix (2008).
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28 See,

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not bring a person to ruin, while it leaves room to maximize the
opportunities for people to chart their own economic futures, free
to succeed and free to fail.
The government can play a unique role in assuring that repeat
dealings in circumstances of substantial imbalances of power and
knowledge are nonetheless fair dealings. Regulation can assure a
more level playing field, one in which the terms of an agreement,
for example, are clear and easily understood. When terms are clear,
individuals are more likely to compare options, which in turn
drives far greater market efficiency. More importantly, when terms
are clear, individuals are better able to assess investment risks and
are thus empowered to make decisions that are more beneficial for
themselves.
By limiting the opportunities for deception and allowing for the
necessary trust to develop between interconnected parties, regulation can enhance the vitality of financial markets. Historically, new
regulation has often served this role. For example, as the money
manager Martin Whitman has observed, far from stifling the markets, the new regulations of the Investment Company Act of 1940
enabled the targeted industry to flourish:
It ill behooves any successful money manager in the mutual fund industry to condemn the very strict regulation
embodied in the Investment Company Act of 1940. Without strict regulation, I doubt that our industry could have
grown as it has grown, and also be as prosperous as it is
for money managers. Because of the existence of strict regulation, the outside investor knows that money managers
can be trusted. Without that trust, the industry likely
would not have grown the way it has grown.29
Markets built on fair dealing produce benefits for all Americans
on both sides of the transactions.
3. THE CENTRAL IMPORTANCE OF REGULATORY PHILOSOPHY

The magnitude of the current financial crisis makes clear that
America’s system of financial regulation has failed. As a result,
there is now growing interest in reforming the essential structure
of financial regulation in the United States. (See the appendix for
a summary of other recent reports on regulatory reform.) Critics
highlight the inherent problems of vesting regulatory authority in
a large number of separate agencies at both the state and federal
levels, each responsible for isolated elements of a vast financial architecture. Although this complex regulatory system benefits from
competition across governmental bodies, it also suffers from the
problem of ‘‘regulatory arbitrage’’ (a situation in which regulated
firms play regulators off against one another) as well as numerous
gaps in coverage.
Structural and organizational problems are certainly important,
and are taken up in section III, below. But at root, the regulatory
failure that gave rise to the current crisis was one of philosophy
more than structure. In too many cases, regulators had the tools

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29 Letter from Third Avenue Funds Chairman of the Board Martin J. Whitman to Shareholders, at 6 (Oct. 31, 2005) (online at www.thirdavenuefunds.com/ta/documents/sl/
shareholderletters-05Q4.pdf).

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but failed to use them. And where tools were missing, regulators
too often failed to ask for the necessary authority to develop what
was needed.
Markets are powerful and robust institutions, and a healthy respect for free market activity has served this nation well since its
founding. At the same time, the best tradition in American policy
has always been pragmatic. History has consistently shown that
markets cannot be counted upon to regulate themselves or to function efficiently in the absence of regulation. While the price mechanism calibrates supply and demand, it cannot prevent bank runs,
abusive lending or Ponzi schemes without regulation. The current
financial meltdown proves these points in an especially severe way.
Excesses and abuse are all too common in a system without regulation. Government thus has a vital role to play. As President Lincoln once wrote: ‘‘The legitimate object of government, is to do for
a community of people, whatever they need to have done, but can
not do, at all, or can not, so well do, for themselves—in their separate, and individual capacities.’’ 30
Lincoln’s vision of government goes beyond correcting abuses to
improving the welfare of ‘‘a community of people.’’ Regulators must
never lose sight of the fact that the well-being of Americans is their
goal, and that the welfare of the people has never been best served
by extreme political ideologies. Franklin Roosevelt perhaps put it
best: the question, he said, is ‘‘whether individual men and women
will have to serve some system of government or economics, or
whether a system of government and economics exists to serve individual men and women.’’ 31 Not only is this pragmatic approach
democratic, asking regulation and the market to serve the American people, but it also places the American people at the foundation of the economy. If Americans are secure and flourishing, the
financial system will be secure and flourishing as well. If Americans are in crisis or face considerable risks, so too will the financial
system. Success is defined by the quality of life Americans have,
not by the impersonal metrics of any theory of government or economics.
Well-conceived financial regulation has the potential not only to
safeguard markets against excesses and abuse but also to strengthen markets as foundations of innovation and growth. Creativity
and innovation are too often channeled into circumventing regulation and exploiting loopholes. Smart financial regulations can redirect creative energy from these unproductive endeavors to innovations that increase efficiency and address the tangible risks people
face.32 As discussed above, the decades following the New Deal regulatory reforms were the longest period without a serious finanial
crisis in the nation’s history; they were also a period of unusually
high average real economic growth.

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30 Abraham Lincoln, Speeches and Writings, 1832–1858: Speeches, Letters, and Miscellaneous
Writings, at 301 (Don Edward Fehrenbacher ed., 1989).
31 Franklin Roosevelt, Remarks to the Commonwealth Club (Sept. 23, 1932) (online at
www.americanrhetoric.com/speeches/fdrcommonwealth.htm).
32 Congressional Oversight Panel, Testimony of Joseph E. Stiglitz, Reforming America’s Financial Regulatory Structure, at 3 (Jan. 14, 2009) (online at cop.senate.gov/documents/testimony011409-stiglitz.pdf).

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In April 2008, former Federal Reserve Chairman Paul Volcker
commented on these developments in a speech to the Economic
Club of New York:
[T]oday’s financial crisis is the culmination, as I count
them, of at least five serious breakdowns of systemic significance in the past twenty-five years—on the average one
every five years. Warning enough that something rather
basic is amiss.
Over that time, we have moved from a commercial bankcentered, highly regulated financial system, to an enormously more complicated and highly engineered system.
Today, much of the financial intermediation takes place in
markets beyond effective official oversight and supervision,
all enveloped in unknown trillions of derivative instruments. It has been a highly profitable business, with finance accounting recently for 35 to 40 percent of all corporate profits.
It is hard to argue that the new system has brought exceptional benefits to the economy generally. Economic
growth and productivity in the last twenty-five years has
been comparable to that of the 1950s and ’60s, but in the
earlier years the prosperity was more widely shared.
The sheer complexity, opaqueness, and systemic risks
embedded in the new markets—complexities and risks little understood even by most of those with management responsibilities—has enormously complicated both official
and private responses to this current mother of all crises. . . .
Simply stated, the bright new financial system—for all
its talented participants, for all its rich rewards—has
failed the test of the market place. . . .
In sum, it all adds up to a clarion call for an effective
response.33
As Volcker himself went on to observe, there is no going back to
the ‘‘heavily regulated, bank dominated, nationally insulated markets’’ of the past.34 At the same time, given the enormity of the
current crisis and the evident failure of financial markets to regulate themselves, it is imperative that Congress take up the challenge of fashioning appropriate regulation for the twenty-first century—to stabilize and strengthen the nation’s financial markets in
the face of extraordinary innovation and globalization. For this to
work, we must first remind ourselves that government has a vital
role to play, not in replacing financial markets or overwhelming
them with rules, but in bolstering financial markets through judicious regulation. Rooted in the principles of sound risk management, transparency, and fairness, new financial regulation can succeed, and must succeed.

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33 Paul A. Volcker, Address to the Economic Club of New York, at 1–2 (Apr. 8, 2008) (online
at econclubny.org/files/TranscriptlVolckerlAprill2008.pdf). In his address, Volcker recalled
the financial troubles of New York City in 1975—that having been the last time he addressed
the Economic Club of New York (then as President of the Federal Reserve Bank of New York).
Volcker noted in his 2008 address, ‘‘Until the New York crisis, the country had been free from
any sense of financial crisis for more than forty years.’’ Id. at 1.
34 Id. at 3.

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IV. CRITICAL PROBLEMS AND RECOMMENDATIONS FOR
IMPROVEMENT
The sweeping nature of the current financial crisis points to the
need for a thorough review of financial regulation and, ultimately,
for significant regulatory reform. As discussed in part III, financial
regulation is particularly necessary to manage risk, facilitate transparency, and ensure fair dealings. The current system has failed on
all counts, and as a result, numerous discrete problems have
emerged. This report focuses on the following most critical of these
problems:
1. Systemic risk is often not identified or regulated until crisis is imminent.
2. Many financial institutions carry dangerous amounts of leverage.
3. The unregulated ‘‘shadow financial system’’ is a source of
significant systemic risk.
4. Ineffective regulation of mortgages and other consumer
credit products produces unfair, and often abusive, treatment
of consumers, but also creates risks for lending institutions
and the financial system.
5. Executive pay packages incentivize excessive risk.
6. The credit rating system is ineffective and plagued with
conflicts of interest.
7. The globalization of financial markets encourages countries to compete to attract foreign capital by offering increasingly permissive regulatory laws that increase market risk.
8. Participants, observers, and regulators neither predicted
nor developed contingency plans to address the current crisis.
This section addresses each problem in turn, and provides recommendations for improvement.
1. IDENTIFY AND REGULATE FINANCIAL INSTITUTIONS THAT POSE
SYSTEMIC RISK

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Problem with current system: Systemic risk is often not
identified or regulated until crisis is imminent
Today, there is no regulator with the authority to determine
which financial institutions or products pose a systemic risk to the
broader economy. In 2008, Bear Stearns, Fannie Mae, Freddie Mac,
AIG, and Citigroup all appear to have been deemed too big—or,
more precisely, too deeply embedded in the financial system—to
fail. The decisions to rescue these institutions were often made in
an ad hoc fashion by regulators with no clear mandate to act nor
the proper range of financial tools with which to act.
This is the wrong approach. Systemic risk needs to be managed
before moments of crisis, by regulators who have clear authority
and the proper tools. Once a crisis has arisen, financial regulation
has already failed. The underlying problem can no longer be prevented, it can only be managed, often at the cost of extraordinary
expenditures of taxpayer dollars.

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Action item: Mandate that a new or existing agency or an
interagency task force regulate systemic risk within the financial system on an ongoing basis
A much better approach would be to identify the degree of systemic risk posed by financial institutions, products, and markets in
advance—that is, in normal times—and to regulate them accordingly. Providing proper oversight of such institutions would help to
prevent a crisis from striking in the first place, and it would put
public officials in a much better position to deal with the consequences should a crisis occur.35
To make this possible, Congress and the President should designate a body charged with identifying the degree of systemic risk
posed by financial institutions, products, and markets. This body
could be an existing agency, such as the Board of Governors of the
Federal Reserve System, a new agency, or a coordinating body of
existing regulators.36
The need for a body to identify and regulate institutions with
systemic significance is a necessary response to two clear lessons
of the current financial crisis: (1) systemic risk is caused by institutions that are not currently covered or adequately covered by the
financial services regulatory system; and (2) in a crisis the federal
government may feel compelled to stabilize systemically significant
institutions. However, no regulatory body currently has the power
to identify and regulate systemically significant nonbank institutions. Consequently, Congress should authorize legitimate, coherent governmental powers and processes for doing so.
The systemic regulator should have the authority to require reporting of relevant information from all institutions that may be
systemically significant or engaged in systemically significant activities. It should have a process for working with the regulatory
bodies charged with the day-to-day oversight of the financial system. Finally, it should have clear authority and the proper tools for
addressing a systemic crisis.
The regulator should operate according to the philosophy that
systemic risk is a product of the interaction of institutions and
products with market conditions. Thus, the regulator would oversee
structures described in the next two action items that address a
continuum of systemic risk by increasing capital and insurance requirements as financial institutions grow. This approach seeks to
maximize the incentives for private parties to manage risk while
recognizing and acting upon the fact that as financial institutions
grow they become more ‘‘systemically significant.’’
Finally, creating a systemic risk regulator is not a substitute for
ongoing regulation of our capital markets, focused on safety and
soundness, transparency, and accountability. The agencies charged
with those missions must be strengthened while we at the same
time address the problem of systemic risk.
35

See Moss, supra note 3.
that authority in an existing agency, such as the Board of Governors of the Federal
Reserve, would require attention to the issues of transparency and accountability that the Panel
will consider further when it looks at regulator structure.
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36 Vesting

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Action item: Impose heightened regulatory requirements for
systemically significant institutions to reduce the risk of financial crisis
Precisely because of the potential threat they pose to the broader
financial system, systemically significant institutions should face
enhanced prudential regulation to limit excessive risk taking and
help ensure their safety. Such regulation might include relatively
stringent capital and liquidity requirements, most likely on a countercyclical basis; an overall maximum leverage ratio (on the whole
institution and potentially also on individual subsidiaries); well-defined limits on contingent liabilities and off-balance-sheet activity;
and perhaps also caps on the proportion of short-term debt on the
institution’s balance sheet. The systemic regulator should consider
the desirability of capping any taxpayer guarantee and whether to
require systemically significant firms to purchase federal capital insurance under which the bank, in return for a premium payment,
would receive a certain amount of capital in specified situations.37
Whether such enhanced oversight for systemically significant institutions should be provided by a new systemic regulator or by existing regulatory agencies is a question that requires further study
and deliberation.
Action item: Establish a receivership and liquidation process for systemically significant nonbank institutions that is
similar to the system for banks
The current bankruptcy regime under the Bankruptcy Code does
not work well for systemically significant nonbanks institutions.
Recent experience with the failure of Bear Stearns & Co. and Lehman Brothers Inc. has indicated that there are gaps in the system
for handling the receivership or liquidation of systemically significant financial institutions that are not banks or broker-dealers and
are therefore subject to the Bankruptcy Code. Two problems are
evident: (1) Because the federal bankruptcy system was not designed for a large, systemically significant financial institution, financial regulators may feel the need to prop up the ailing institution in order to avoid a messy and potentially destructive bankruptcy process, and (2) the Bankruptcy Code’s provisions for distribution of the assets of a bankrupt financial institution do not
take into account the systemic considerations that regulators are
obligated to consider.
The Panel recommends that systemically significant nonbank financial institutions be made subject to a banklike receivership and
liquidation scheme. We note that the bankruptcy regime under the
Federal Deposit Insurance Act has generally worked well.
2. LIMIT EXCESSIVE LEVERAGE IN AMERICAN FINANCIAL INSTITUTIONS

Problem with current system: Excessive leverage carries
substantial risks for financial institutions
Leverage within prudent limits is a valuable financial tool. But
excessive leverage in the financial sector is dangerous and can pose
a significant risk to the financial system. In fact, it is now widely

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37 See

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believed that overleveraging (i.e., relying on an increasingly steep
ratio of borrowing to capital) at key financial institutions helped to
convert the initial subprime turmoil in 2007 into a full-blown financial crisis in 2008.
Recent estimates suggest that just prior to the crisis, investment
banks and securities firms, hedge funds, depository institutions,
and the government-sponsored mortgage enterprises (primarily
Fannie Mae and Freddie Mac) held assets worth nearly $23 trillion
on a base of $1.9 trillion in capital, yielding an overall average leverage ratio of approximately 12:1. We must, however, consider
this figure carefully, because average leverage varied widely for different types of financial institutions. The most heavily leveraged,
as a class, were broker-dealers and hedge funds, with an average
leverage ratio of 27:1; government sponsored enterprises were next,
with an average ratio of 23.5:1.35. Commercial banks were toward
the low end, with an average ratio of 9.8:1, and savings banks have
the lowest average ratio at 8.7:1.
Financial institutions pursue leverage for numerous reasons. All
bank lending, for example, is leveraged, because a certain amount
of capital is permitted to support a much larger volume of loans.
And the leverage of financial institutions is generally procyclical,
meaning that it tends to increase when asset prices are rising
(when leverage seems safer) and tends to decline when they are
falling (when leverage seems more dangerous).38
For an institution with high debt and a relatively small base of
capital, returns on equity are greatly magnified. Unfortunately,
high leverage can also prove destabilizing because it effectively
magnifies losses as well as gains. If a firm with $10 billion in assets is leveraged 10:1, then a loss of just 3 percent ($300 million)
on total assets translates into a 30 percent decline in capital (from
$1 billion to $700 million), raising the bank’s leverage ratio to nearly 14:1. The challenge is obviously far more extreme for a firm with
leverage of 30:1, as was typical for leading investment banks prior
to the crisis. Here, a 3 percent ($300 million) loss on total assets
translates into a 90-percent decline in capital (from $333 million to
$33 million) and a new leverage ratio of nearly 300:1. To get back
to leverage of 30:1, that firm would either have to raise $300 million in new equity (to bring capital back to its original level) or collapse its balance sheet, selling more than 95 percent ($9.37 billion)
of its assets and paying off an equivalent amount of debt.39
Although raising $300 million in new equity would seem vastly
preferable to selling $9.37 billion in assets, the problem is that fi-

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38 Tobias Adrian and Hyun Song Shin, Liquidity, Monetary Policy, and Financial Cycles, Current Issues in Economics and Finance, at 1–7 (Jan./Feb. 2008). Some have argued that high leverage—especially short-term debt—may have a positive governance impact by imposing tough
discipline on the management of financial institutions. K. Kashyap, Raghuram G. Rajan, and
Jeremy Stein, Rethinking Capital Regulation (Aug. 2008) (online at www.kc.frb.org/publicat/
sympos/2008/KashyapRajanStein.08.08.08.pdf) (paper prepared for Federal Reserve Bank of
Kansas City symposium on ‘‘Maintaining Stability in a Changing Financial System’’ in Jackson
Hole, Wyoming). Given the experiences of the last year, however, this theory requires a good
deal more research.
39 This illustration was inspired by: Brandeis University Rosenberg Institute of Global Finance and University of Chicago Initiative on Global Markets, David Greenlaw, et al., Leveraged
Losses: Lessons from the Mortgage Market Meltdown (2008) (U.S. Monetary Forum Report No.
2) (online at research.chicagogsb.edu/igm/docs/USMPFlFINALlPrint.pdf); David Scharfstein,
Why Is the Crisis a Crisis (Dec. 2, 2008) (slide presentation prepared for Colloquium on the
Global Economic Crisis, Harvard Business School).

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nancial institutions with depleted capital often find it difficult to
raise new equity, particularly in times of general financial distress.
If sufficient new capital is not available and the weakened firms
are ultimately forced to dispose of assets under firesale conditions,
this can depress asset prices further, generating additional losses
across the financial system (particularly in the context of mark-tomarket accounting). In the extreme, these sales can set off a vicious downward spiral of forced selling, falling prices, rising losses
and, in turn, more forced selling.
Action item: Adopt one or more regulatory options to
strengthen risk-based capital and curtail leverage
The goal of enhanced capital requirements is to limit excessive
risk taking during boom times and reducing the need for dangerous
‘‘fire sales’’ during downturns. Several common criteria must be
met by proposals for enhanced capital requirements. Above all, any
such proposals must operate in a way that does not restrict prudent leverage or produce other unintended consequences. Moreover,
they must recognize that proper risk adjustment can prove particularly vexing: the appropriateness of a leverage ratio depends on the
safety of the assets the leverage supports, both directly and in the
context of the business as a whole. Determining that safety level
is anything but easy, as the current crisis shows. Finally, any proposal must recognize that no one solution will fit the entire financial sector (or perhaps even all institutions of one type within the
financial sector).
A number of valuable ideas have been proposed as ways to
strengthen capital and curtail excessive leverage, including the following:
Objectives-based capital requirements. Under this approach, capital requirements should be applied not simply according to the
type of institution (commercial bank, broker-dealer, hedge fund,
etc.) but on the basis of regulatory objectives (for example, guard
against systemic risk, etc.). For example, required capital ratios
could be made to increase progressively with the size of the firm’s
balance sheet, so that larger financial institutions face a lower
limit on leverage than smaller ones (on the assumption that larger
firms have greater systemic implications and ultimately become
‘‘too big to fail’’). Required capital ratios could also be made to vary
with other variables that regulators determine to be salient, such
as the proportion of short-term debt on an institution’s balance
sheet or the identity of the holders of its liabilities.
Leverage requirements. Beyond risk-based capital requirements,
there is also a strong argument for unweighted capital requirements, to control overall leverage. Stephen Morris and Hyun Song
Shin suggest that these ‘‘leverage requirements’’ are necessary to
limit systemic risk, by reducing the need for dangerous asset fire
sales in a downturn.40 FDIC Chairperson Sheila Bair has been par-

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40 Brookings Institute, Stephen Morris and Hyun Song Shin, Financial Regulation in a System
Context, at 21–26 (2008) (online at www.brookings.edu/economics/bpea/∼/media/Files/Programs/
ES/BPEA/2008lfalllbpealpapers/2008lfalllbpealmorrislshin.pdf). See also id. at 23 (‘‘Instead of risks on the asset side of the balance sheet, the focus is on the liabilities side of balance
sheets, and the potential spillover effects that result when financial institutions withdraw funding from each other. Thus, it is raw assets, rather than risk-weighted assets that matter.’’).

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ticularly insistent on this point, declaring in 2006, for example,
that ‘‘the leverage ratio—a simple tangible capital to assets measure—is a critically important component of our regulatory capital
regime.’’ 41 It should be noted that the current crisis may be exacerbated because leverage ratios are not a common feature of banking
regulation in Europe; any approach to curtailing leverage in a
globalized financial system must implement such standards on a
global basis.
Countercyclical capital requirements. To help financial institutions prepare for the proverbial rainy day and manage effectively
in a downturn, it has been proposed that capital (and provisioning)
requirements be made countercyclical—that is, more stringent
when asset prices are rising and less stringent when they are falling. Since the procyclicality of financial institution leverage likely
intensifies the ups and downs in asset markets, countercyclical capital requirements could serve as a valuable automatic stabilizer, effectively leaning against the wind. One approach could involve a
framework that raises capital adequacy requirements by a ratio
linked to the growth of the value of bank’s assets in order to tighten lending and build up reserves when times are good. Spain’s apparently favorable experience with ‘‘dynamic provisioning’’ in its
banking regulation serves as a model for many related proposals.42
Joseph Stiglitz takes the idea one step further, suggesting that a
‘‘simple regulation would have prevented a large fraction of the crises around the world—speed limits restricting the rate at which
banks can expand, say, their portfolio of loans. Very rapid rates of
expansion are typically a sign of inadequate screening.’’ 43 Similarly, because rapid increases in leverage appear to precede periods
of financial turmoil, capital requirements could be tailored to discourage particularly quick buildups of leverage.
Liquidity requirements. To further address the problem of financial firms being forced to sell illiquid assets into a falling market,
some commentators have proposed that regulators could impose liquidity requirements in addition to capital requirements, so that financial firms would have to hold a certain proportion of liquid assets as well as a liquidity buffer that could be used in a crisis.
Armed with sufficient supply of liquid assets (such as treasury
bills), firms could safely sell these assets in a downturn without
placing downward pressure on the prices of less liquid assets,
which would contribute to systemic risk.44

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41 Federal Deposit Insurance Corporation, Remarks by Sheila C. Bair, Chairman before the
Conference on International Financial Instability: Cross-Border Banking and National Regulation, Federal Reserve Bank of Chicago and the International Association of Deposit Insurers (Oct.
5, 2006) (online at www.fdic.gov/news/news/speeches/archives/2006/chairman/spoct0606.html).
42 See, e.g., Spanish Steps: A Simple Way of Curbing Banks’ Greed, Economist (May 15, 2008)
(online at www.economist.com/specialreports/displaystory.cfm?storylid=11325484).
43 House Financial Services Committee, Testimony of Joseph Stiglitz, The Future of Financial
Services Regulation, 110th Cong. (Oct, 21, 2008) (online at financialservices.house.gov/
hearing110/stiglitz102108.pdf). Stiglitz also notes that there are ‘‘several alternatives to speed
limits imposed on the rate of expansion of assets: increased capital requirements, increased provisioning requirements, and/or increased premia on deposit insurance for banks that increase
their lending (lending in any particular category) at an excessive rate can provide incentives
to discourage such risky behavior.’’ Id.
44 Liquidity requirements can mitigate contagion, and can play a similar role to capital buffers
in curtailing systemic failure. In some cases, liquidity may be more effective than capital buffers
in forestalling systemic effects. When asset prices are extremely volatile, for example during periods of major financial distress, even a large capital buffer may be insufficient to prevent contagion, since the price impact of selling into a falling market would be very high. Liquidity requirements can mitigate the spillover to other market participants generated by the price im-

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These and other proposals will need to be thoughtfully reviewed,
bearing in mind that leverage is not a consistent phenomenon, but
rather varies across financial institutions, regulatory structures,
and different types of leveraged situations. The current crisis provides two lessons to inform this review. First, options to curtail excessive leverage must proceed as a top priority and an integral part
of the restructuring of the regulation of American financial institutions. Second, reforms in this area must reflect the primary lesson
of the crisis: that no asset types, however labeled, and no transaction patterns, however familiar, are inherently stable.
3. MODERNIZE SUPERVISION OF SHADOW FINANCIAL SYSTEM

Problem with current system: The unregulated ‘‘shadow financial system’’ is a source of significant systemic risk
Since 1990, certain large markets and market intermediary institutions have developed outside the jurisdiction of financial market
regulators. Collectively, these markets and market actors have become known as the shadow financial system.45 The key components
of the shadow financial system are unregulated financial instruments such as over-the-counter (OTC) derivatives, off-balance-sheet
entities such as conduits and SIVs,46 and nonbank institutions
such as hedge funds and private equity funds. While the shadow
financial system must be brought within any plan for systemic risk
management, that alone would be insufficient. Routine disclosurebased capital-market regulation and routine safety-and-soundness
regulation of financial institutions will not function effectively unless regulators have jurisdiction over the shadow financial system
and are able to enforce common standards of transparency, accountability, and adequate capital reserves.
As a result of the growth of the shadow financial system, it is
nearly impossible for regulators or the public to understand the
real dynamics of either bank credit markets or public capital markets. This became painfully clear during the collapse of Bear
Stearns and the subsequent bankruptcy of Lehman Brothers, and
the collapse of AIG. In the case of Bear Stearns, key regulators expressed the view that as a result of that firm’s extensive dealing
with hedge funds and in the derivatives markets, the systemic
threat posed by a disorderly bankruptcy could prove quite severe,

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pact of selling into a falling market. Moreover, because financial institutions do not recognise
the indirect benefits of adequate liquidity holdings on other network members (and more generally on system resilience), their liquidity choices will be suboptimal. As a result, liquidity and
capital requirements need to be imposed externally, in relation to a bank’s contribution to systemic risk.
Bank of England, Rodrigo Cifuentes, Gianluigi Ferrucci, and Hyun Song Shin, Liquidity Risk
and Contagion (2005) (Working Paper No. 264) (online at www.bankofengland.co.uk/publications/workingpapers/wp264.pdf).
U.S. bank regulators monitor a bank’s liquidity as part of their Uniform Financial Institutions
Ratings (CAMELS) System. See, e.g., Board of Governors of the Federal Reserve System, Commercial Bank Examination Manual, Sec. 2020.1.
45 See, e.g., Bill Gross, Beware Our Shadow Banking System, Fortune (Nov. 28, 2007) (online
at money.cnn.com/2007/11/27/news/newsmakers/grosslbanking.fortune); Nouriel Roubini, The
Shadow Banking System is Unraveling, Financial Times (Sept. 21, 2008) (online at www.ft.com/
cms/s/0/622acc9e-87fl-11dd-b114-0000779fd18c.html).
46 Off-balance sheet entities are a significant part of the shadow financial system, and are addressed in part in our earlier recommendations on leverage, and in part should be the subject
of a more extended technical inquiry into reforming Financial Accounting Standard 140.

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though difficult to predict with any certainty.47 Six months later,
Lehman Brothers was allowed to file for protection under Chapter
11, the only major financial firm to be allowed to do so in the
United States during the financial crisis. Lehman’s bankruptcy resulted in substantial systemwide disruption, particularly as a result of credit default swap obligations triggered by Lehman’s default on its debt obligations. The unregulated nature of several financial markets involved in this crisis contributed to the inability
of regulators to understand the unfolding problems and act responsively.
Action item: Ensure consistency of regulation for instruments currently operating in the shadow financial system
Extending the reach of financial regulation to cover the shadow
financial system is necessary in order to accurately measure and
manage risk across the markets. A consistent regulatory regime
will also reduce the ability of market players to escape regulation
by using complex financial instruments and to secure higher yields
by masking risk through information asymmetries.
The Panel urges Congress to consider shifting the focus of existing regulation toward a functional approach. While the details
would need to be worked out by empowered regulators, the principle is simple: hedge funds and private equity funds are money
managers and should be regulated according to the same principles
that govern the regulation of money managers generally. At a minimum, Congress must grant the SEC the clear authority to require
hedge fund advisors to register as investment advisors under the
Investment Advisors Act. If they venture into writing insurance
contracts or providing credit to others, hedge funds’ activities in
these areas need to be regulated according to the principles governing insurance or lending. An over-the-counter derivative can be
almost any kind of contract synthesizing almost any kind of economic act—such instruments need to be regulated according to
what they do, not what they are called.
While further study is needed, proposals for regulating more consistently instruments currently in the shadow financial system include: applying capital requirements to firms engaged in making
credit or insurance commitments through derivatives; requiring
transparency around derivatives contracts tied to publicly traded

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47 In a speech on August 22, 2008, Federal Reserve Chairman Ben Bernanke spoke frankly
about the potential for a Bear Stearns failure to echo throughout the financial system: ‘‘Although not an extraordinarily large company by many metrics, Bear Stearns was deeply involved in a number of critical markets, including (as I have noted) markets for short-term secured funding as well as those for over-the-counter (OTC) derivatives. One of our concerns was
that the infrastructures of those markets and the risk- and liquidity-management practices of
market participants would not be adequate to deal in an orderly way with the collapse of a
major counterparty. With financial conditions already quite fragile, the sudden, unanticipated
failure of Bear Stearns would have led to a sharp unwinding of positions in those markets that
could have severely shaken the confidence of market participants. The company’s failure could
also have cast doubt on the financial conditions of some of Bear Stearns’s many counterparties
or of companies with similar businesses and funding practices, impairing the ability of those
firms to meet their funding needs or to carry out normal transactions. As more firms lost access
to funding, the vicious circle of forced selling, increased volatility, and higher haircuts and margin calls that was already well advanced at the time would likely have intensified. The broader
economy could hardly have remained immune from such severe financial disruptions.’’
Board of Governors of the Federal Reserve System, Chairman Ben S. Bernanke Remarks on
Reducing Systemic Risk before the Federal Reserve Bank of Kansas City’s Annual Economic
Symposium
(Aug.
22,
2008)
(online
at
www.federalreserve.gov/newsevents/speech/
bernanke20080822a.htm).

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securities; and holding hedge funds and private equity funds to a
single, well-understood federal standard of fiduciary duty as other
money managers are. However, regulating the shadow markets
does not necessarily mean treating a hedge fund in the same manner as a mutual fund, or a credit default swap between institutions
in the same manner as an insurance policy sold to retail consumers. Functional regulation can mean applying the same principles and not necessarily producing identical regulatory outcomes.
Action item: Increase transparency in OTC derivatives markets
The Panel also recommends implementing new measures to improve transparency in the shadow financial system. Lack of transparency in the shadow financial system contributed to failures of
risk management and difficulty in pricing assets and assessing the
health of financial institutions. Transparency can be enhanced in
several ways; several options are presented below:
Regulated clearinghouses. A clearinghouse is an entity that provides clearance and settlement services with respect to financial
products. It acts as a central counterparty with respect to trades
that it clears. When the original parties to the trade introduce it
to the clearinghouse for clearing, the original trade is replaced by
two new trades in which the clearinghouse becomes the buyer to
the original seller and the seller to the original buyer.
Proposals for clearinghouses generally involve the clearinghouse
itself taking on credit risk. Such credit risk raises the issue of how
to provide adequate capital in case of a default. One method for
doing so involves taking the ‘‘margin’’ to secure performance of
each trade. Another method involves daily marks-to-market to reduce risk arising from price fluctuations in the value of the contract. Others have proposed guaranty funds, in which each of the
clearing members of the clearinghouse puts up a deposit to cover
its future liabilities. Most central counterparty proposals also involve ‘‘mutualization of risk,’’ in which the guaranty fund deposits
of all clearing members may be used to cover a default by one
member if the defaulting member’s margin payments and guaranty
fund contribution are insufficient to cover the loss. Finally, a clearinghouse may have the right to call for further contributions from
members to cover any losses.
In addition to regulators risk management principles, a clearinghouse structure may also involve inspection by federal officials for
the purposes of detecting and punishing fraudulent activity and
public reporting of prices, volumes and open interest.48
Exchange-traded derivatives. As an alternative to clearinghouses,
regulators can require that all standardized—and standardizable—
OTC derivatives contracts be traded on regulated derivatives markets. These markets would be governed by the same standards that
guide designated contract markets under the Commodity Exchange
Act (CEA). CEA-governed exchanges must fully disclose the terms
of the contracts traded and rules governing trading, and must also
publicly report prices, volumes and open interest. The exchange

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48 See President’s Working Group on Financial Markets, Policy Objectives for the OTC Derivatives Market (Nov. 14, 2008) (online at www.treas.gov/press/releases/reports/policyobjectives.pdf).

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would maintain detailed records to be inspected by federal regulators and would be empowered with the ability to deter, detect,
and punish fraudulent activity. Intermediaries participating in the
exchange would face registration, reporting, and capital adequacy
requirements as well. Finally, the exchanges could still make use
of clearinghouses to minimize counterparty risk.
Public reporting requirements. SEC Chairman Christopher Cox
has proposed requiring CDS market participants to adhere to a
public disclosure regime that would allow regulators to monitor
market risk and potential market abuse. Cox’s proposals include:
(1) public reports of OTC transactions to improve transparency and
pricing, and (2) reporting to the SEC derivatives positions that affect public securities.49
4. CREATE A NEW SYSTEM FOR FEDERAL AND STATE REGULATION OF
MORTGAGES AND OTHER CONSUMER CREDIT PRODUCTS

Problem with current system: Ineffective regulation of
mortgages and other consumer credit products has produced unfair, and often abusive, treatment of consumers,
which destabilizes both families and the financial institutions that trade in those products
For decades, default rates on traditional home mortgages were
low; profits to mortgage lenders were steady. Millions of Americans
used mortgages to enable them to buy homes and retain homes.
Over time, however, a number of mortgage lenders and brokers
began offering higher-priced, higher-profit—and higher risk—mortgages to millions of families.50 Unlike the low-risk ‘‘prime’’ mortgages of the 1940s through the 1990s, the new ‘‘subprime’’ offered
much bigger payouts for lenders and, ultimately, for the investors
to whom the lenders sold these mortgages, but they also created
higher costs and greater risks for consumers. For example, a family
buying a $175,000 home with a subprime loan with an effective interest rate of 15.6 percent would pay an extra $420,000 during the
30-year life of the mortgage—that is, over and above the payments
due on a prime 6.5 percent mortgage. While investors were attracted to the bigger returns associated with these subprime mortgages, many overlooked the much bigger risks of default that have
now become glaringly apparent.
The new subprime mortgages were marked by exotic, and often
predatory, new features, such as two year teaser rates that permitted marketing of mortgages to individuals who could not have
qualified for credit at the enormous required rate increase in year
three, or so-called ‘‘liars’’ or ‘‘no-doc’’ loans based on false paperwork about a borrower’s financial situation. Terms such as these
virtually guaranteed that the mortgages would default, and fami-

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49 Christopher Cox, Swapping Secrecy for Transparency, New York Times (Oct. 18, 2008) (online at www.nytimes.com/2008/10/19/opinion/19cox.html).
50 See Federal Reserve Board, Christopher J. Mayer, Karen M. Pence, and Shane M. Sherlund,
The Rise in Mortgage Defaults, at 2 (2008) (Finance and Economics Discussion Series No. 200859) (online at www.federalreserve.gov/Pubs/feds/2008/200859/200859pap.pdf) (‘‘According to data
from the Mortgage Bankers Association, the share of mortgage loans that were ‘seriously delinquent’ (90 days or more past due or in the process of foreclosure) averaged 1.7 percent from
1979 to 2006 . . . But by the second quarter of 2008, the share of seriously delinquent
mortgages had surged to 4.5 percent.’’). For detailed historical data on prime and subprime
mortgages, see Mortgage Bankers Association, National Delinquency Survey (online at
www.mbaa.org/ResearchandForecasts/productsandsurveys/nationaldelinquencysurvey.htm).

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lies would lose their homes, unless the real estate price inflation
continued. These mortgages were especially cruel for new, especially lower-income, home buyers. The data show, however, that a
substantial number of middle-income families (and even some
upper-income families) with low default risk signed up for
subprime loans that were far more expensive than the prime mortgages for which they qualified.
The complexity of subprime mortgage products made understanding the costs associated with an offered mortgage, let alone
comparing several mortgage products, almost impossible. The high
proportion of people with good credit scores who ended up with
high-cost mortgages raises the specter that some portion of these
consumers were not fully cognizant of the fact that they could have
borrowed for much less.51 This conclusion is further corroborated
by studies showing that subprime mortgage prices cannot be fully
explained by borrower-specific and loan-specific risk factors.52
These difficulties were further exacerbated by sharp selling practices and delayed disclosure of relevant documents. Buyers were
steered to overpriced mortgages by brokers or other agents who
represented themselves as acting in the borrower’s best interests,
but who were taking commissions from subprime lenders to steer
them to riskier mortgages.53 In other cases, lenders would not
make relevant documents available until the closing date. In all of
these respects, the mortgage market simply failed consumers.
Although mortgage documents include a raft of legally-required
disclosures, those disclosures are a long way from a meaningful un-

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51 In 2002, for example, researchers at Citibank concluded that at least 40 percent of those
who were sold high interest rate, subprime mortgages would have qualified for prime-rate loans.
Lew Sichelman, Community Group Claims CitiFinancial Still Predatory, Origination News, at
25 (Jan. 2002) (reporting on new claims of CitiFinancial’s predatory practices after settlements
with state and federal regulators). Freddie Mac and Fannie Mae estimate that between 35 percent and 50 percent of borrowers in the subprime market could qualify for prime market loans.
See James H. Carr & Lopa Kolluri, Predatory Lending: An Overview, in Fannie Mae Foundation,
Financial Services in Distressed Communities: Issues and Answers, at 31, 37 (2001). See also
Lauren E. Willis, Decisionmaking and the Limits of Disclosure: The Problem of Predatory Lending: Price, Maryland Law Review, at 730 (2006). A study by the Department of Housing and
Urban Development of all mortgage lenders revealed that 23.6 percent of middle-income families
(and 16.4 percent of upper-income families) who refinanced a home mortgage ended up with a
high-fee, high-interest subprime mortgage. U.S. Department of Housing and Urban Development, Randall M. Scheessele, Black and White Disparities in Subprime Mortgage Refinance
Lending, at 28 (2002) (Working Paper No. HF-014) (online at www.huduser.org/Publications/pdf/
workpapr14.pdf). A study conducted for the Wall Street Journal showed that from 2000 to 2006,
55 percent of subprime mortgages went to borrowers with credit scores that would have qualified them for lower-cost prime mortgages. Rick Brooks and Ruth Simon, Subprime Debacle
Traps Even the Very Credit Worthy; As Housing Boomed, Industry Push Loans to a Broader
Market, Wall Street Journal (Dec. 3, 2007) (study by First American Loan Performance for the
Journal). By 2006, that proportion had increased to 61 percent. Id. None of these studies is definitive on the question of overpricing because they focus exclusively on FICO scores, which are
critical to loan pricing but are not the only factor to be considered in credit risk assessment.
However, they suggest significant market problems.
52 Joint Center for Housing Studies, Harvard University, Ren S. Essene and William Apgar,
Understanding Mortgage Market Behavior: Creating Good Mortgage Options for All Americans,
at 2 (2007) (online at www.jchs.harvard.edu/publications/finance/mm07-1lmortgagelmarket
lbehavior.pdf) (quoting Fishbein and Woodall, supra note 28, at 24); Howard Lax, et al., Subprime Lending: An Investigation of Economic Efficiency, Housing Policy Debate, at 533 (2004).
53 See, e.g., Howell E. Jackson and Jeremy Berry, Kickbacks or Compensation: The Case of
Yield Spread Premiums (Jan. 2002) (online at www.law.harvard.edu/faculty/hjackson/pdfs/januaryldraft.pdf). In some neighborhoods these brokers went door-to-door, acting as ‘‘bird dogs’’
for lenders, looking for unsuspecting homeowners who might be tempted by the promise of extra
cash. Other families were broadsided by extra fees and hidden costs that didn’t show up until
it was too late to go to another lender. One industry expert described the phenomenon: ‘‘Mrs.
Jones negotiates an 8% loan and the paperwork comes in at 10%. And the loan officer or the
broker says, ‘Don’t worry, I’ll take care of that, just sign here.’ ’’ Dennis Hevesi, A Wider Loan
Pool Draws More Sharks, New York Times (Mar. 24, 2002).

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derstanding of the loan transaction—and a much longer distance
from supporting competitive markets. Many of the same points can
be made for credit cards and other consumer financial products. In
all of these cases consumers have little access to the key information they need to make responsible decisions. The result is a market in which people fail to assess risks properly, over-pay, and get
into financial trouble. As the current crisis shows, these effects are
not confined to those who buy the credit products. The high risk
that consumers could not pay back their loans was multiplied by
the bundling and re-bundling of millions of the loans into assetbacked securities. That rebundling, in turn, spread the risk further,
to the investment portfolios of other financial institutions, pension
funds, state and local governments, and other investors for whom
such risk was not appropriate. Ultimately, the widespread marketing of high-cost, high-risk consumer products has contributed to
the destabilizing of the entire economy.
If, for example, a home buyer had been required to demonstrate
an ability to pay the long-term mortgage rate rather than the teaser rate, home owners—and the country—would have been spared
the specter of millions of foreclosures when payment resets made
the monthly payment unaffordable. Moreover it would have been
impossible to offer flawed investment products based on such mortgages.
State regulators have a long history as the first-line of protection
for consumers. For example, states first sounded the alarm against
predatory lending and brought landmark enforcement actions
against some of the biggest subprime lenders, including Household,
Beneficial Finance, AmeriQuest, and Delta Funding. But states are
sometimes pressured to offer no more consumer protection than is
offered on the federal level so that financial firms do not leave their
state regulator for a more favorable regulatory environment (taking
the fee revenues they provide with them).54 Moreover, the same
competition for business that exists at the state level also exists at
the federal level. Federal regulators face the possibility of losing
business both to state regulators or to other federal regulatory
agencies. At the federal level, this problem is exacerbated by direct
financial considerations. The budgets of the OCC and OTS, for example, are derived from the number and size of the financial institutions they regulate, which means that a bank’s threat to leave
a regulator has meaningful consequences.55 As Professor Arthur
Wilmarth has testified, ‘‘Virtually the entire [Office of the Comptroller of the Currency] budget is funded by national bank fees, and
the biggest national banks pay the highest assessment rates. . . .
The OCC’s unimpressive enforcement record is, unfortunately, consistent with its strong budgetary incentive in maintaining the loyalty of leading national banks.’’ 56

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54 In any of these situations, of course, the state from which the financial institution switches
its charter is deprived of substantial revenue, and the new chartering jurisdiction gains substantial revenue.
55 Michael Schroeder, Bank Regulator Cleans House, Wall Street Journal (Aug. 19, 2005)
(‘‘Bank consolidation has created competition among regulators. The OCC has been a winner
in wooing banks to choose it as their regulator, helping to keep its coffers flush. Bank fees finance its $519 million annual budget, not taxpayer money.’’).
56 See, e.g., Senate Committee on Banking, Housing, and Urban Affairs, Testimony of Arthur
E. Wilmarth, Jr., Review of the National Bank Preemption Rules, 108th Cong. (Apr. 7, 2004)
(online at banking.senate.gov/public/lfiles/wilmarth.pdf); Christopher L. Peterson, Federalism

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This has caused much of the regulatory scheme to come unraveled. State usury laws have eroded; according to recent research,
at least 35 states have amended their usury laws to make it legal
to charge annual interest rates exceeding 300 percent in connection
with consumer credit products.57 Many states were apparently also
unwilling to deal with subprime mortgages. In 2006, fully half–52
percent—of subprime mortgages originated with companies that
were subject only to state regulation.58 And now, as the mortgage
crisis deepens, the National Association of Attorneys General has
a highly visible working group on foreclosures, but only about half
of the states participate.
In addition, the authority of the states to deal with consumer
protection for credit products has been sharply limited by interpretations in federal law. First, the Supreme Court has ruled that the
usury laws of a national bank’s state of incorporation controlled its
activities nationwide. The decision naturally produced the pressures for repeal of state usury protections noted above. Second, the
Office of the Comptroller of the Currency and federal courts have
interpreted the National Banking Act to pre-empt action by state
regulators to apply state consumer protection laws to national
banks or to operating subsidiaries of national banks; virtually all
of the nation’s large banks—and most of those receiving federal assistance under the TARP—are national banks. The OCC’s action
was prompted by the attempt of Georgia to apply its Fair Lending
Act to all banks within its jurisdiction. Yet, despite promises to
Congress and the states, federal regulators have made the problem
worse by failing to provide any significant supervision or regulation
of their own.59
Action item: Eliminate federal pre-emption of application of
state consumer protection laws to national banks
Preemption affects states’ consumer protection initiatives in
three main respects:
1. Standards: The ability of states to set consumer protection
laws and the scope of coverage for those laws.
2. Visitation: The ability of states to examine financial institutions for compliance with consumer protection laws.
3. Enforcement: The ability of states to impose penalties for violations of consumer protection laws.
Visitation and enforcement are closely connected but distinct.
Given the critical role of state consumer protection, Congress
should amend the National Banking Act to provide clearly that
state consumer protection laws can apply to national banks and to
reverse the holding that the usury laws of a national bank’s state
of incorporation govern that bank’s operation through the nation.

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and Predatory Lending: Unmasking the Deregulatory Agenda, Temple Law Review, at 70–74,
77–84 (2005).
57 Christopher L. Peterson, Usury Laws, Payday Loans and Statutory Sleight of Hand: Salience Distortion in American Credit Pricing Limits, Minnesota Law Review, at 1139 (2008).
58 Greg Ip and Damian Palleta, Regulators Scrutinized in Mortgage Meltdown, Wall Street
Journal (Mar. 27, 2007).
59 See, e.g., Watters v. Wachovia Bank, 550 U.S. 1 (2007). See also Elizabeth R. Schiltz, The
Amazing, Elastic, Ever-Expanding Exportation Doctrine and Its Effect on Predatory Lending
Regulation, Minnesota Law Review (2004); Cathy Lesser Mansfield, The Road to Subprime
‘‘HEL’’ Was Paved with Good Congressional Intentions: Usury Deregulation and the Subprime
Home Equity Market, South Carolina Law Review (2000).

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Action item: Create a single federal regulator for consumer
credit products
The need for a uniform federal law to create a meaningful baseline of protections is clear. It is essential that one regulatory agency have the responsibility and accountability for drafting, implementing, and overseeing effective consumer credit product protection rules. Without a uniform set of minimum standards, regulatory arbitrage among state—and federal—regulators will continue, and no regulator or agency will have the authority and responsibility to protect consumers.
The new federal regulator must be responsible for establishing
minimum standards for disclosure and transparency, reviewing
consumer credit products (in a manner set by statute) in light of
those standards to eliminate unfair practices, and promoting practices that encourage the responsible use of credit. This regulator
should assure that consumers are not misled by the terms of the
sales pitches for credit products and that they have the information
needed to make informed and thoughtful purchasing decisions. The
statement of purposes of the legislation creating the new agency,
and the standards governing its actions, would include the need to
balance consumer protection with the legitimate need of financial
institutions to create fair products and maintain the flow of credit
to the national economy.
Creation of a single federal regulator would produce a single, national floor for consumer financial products. Some state regulators
might conclude that their citizens require better protection, and
they might put other constraints on the institutions that want to
do business in their states. This proposal leaves them free to do so.
The regulatory agency simply assures that all Americans, regardless of where they live, can count on basic protection. Regulations
that apply to all products of a certain kind—e.g., mortgages, credit
cards, payday loans—without any exceptions are far more comprehensive than those based on the kind of institution that issued
them—federally chartered, state charted, thrift, bank, etc. Because
such baselines are inescapable, the impact of regulatory arbitrage
is sharply undercut. A financial institution cannot escape the restrictions on mortgage disclosures, for example, by reincorporating
from a federal bank to a state bank. Any issuer of home mortgages
must meet the minimum federal standards.
One option is to make the new federal regulator an independent
agency within the financial regulatory community. This approach
would have several advantages. A single regulator would have the
opportunity to develop significant expertise in consumer products.
Consumer protection would be a priority rather than one issue
among many competing with a myriad of other regulatory priorities
that have consistently commanded more attention in financial institution regulatory agencies. An agency devoted to consumer protection can make it a first priority to understand the functioning
of financial products in the consumer marketplace. Expertise can
also be concentrated from around the country. A single group of
regulators can develop greater expertise to ensure that products
are comprehensible to customers and that they are protected from
unfair business practices. Such expertise can also be transferred
from one product to another. As financial products become more

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functionally intertwined—for example, home equity lines of credit
that operate like credit cards—an agency can develop the needed
cross-expertise and more nuanced rules.
Another option is to place the new regulator within the Federal
Reserve Board. The Board is the umbrella supervisor of bank holding companies, and it directly supervises state-chartered banks
that choose to become members of the Federal Reserve System. It
was given specific authority to deal with deceptive mortgages more
than forty years ago.60 Congress voted repeatedly to expand the
Board’s power to provide stronger consumer protection.61
Placing the new regulator within the Board would keep safety
and soundness and consumer protection responsibilities together,
on the ground that each responsibility, if properly implemented,
could complement and re-enforce the other. Choosing that option,
however, would require changes to the Federal Reserve Act to
make consumer protection one of the Fed’s primary responsibilities,
on a par with bank supervision. It would also depend on a new understanding and attitude by the Board toward its execution of its
consumer protection mission.
Federal Reserve Chairman Ben Bernanke has acknowledged that
although the powers of the Fed to deal with mortgage abuses were
‘‘broad,’’ 62 the Board has for years been slow to act,63 and the actions it took were inadequate.64 Its power under TILA and HOEPA
to issue regulations binding upon all mortgage lenders gave it the
capacity to halt the lending practices that inflated the housing bubble and that led millions of home owners toward eventual foreclosure, but the Fed failed to do so.
Similarly, in areas such as credit card regulation, only when
Congress threatened to take away powers, did the Fed finally act.65
Barney Frank, Chairman of the House Financial Services Committee, explained that the failure of the Fed to act was longstanding: ‘‘When Chairman Bernanke testified before us a few

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60 Truth in Lending Act (TILA), Pub. L. No. 90–321 (1968), at § 105(a) (codified as amended
at 15 U.S.C. § 1601 et seq.) (‘‘The Board shall prescribe regulations to carry out the purposes
of this title.’’). The Federal Reserve Board implements TILA through its Regulation Z. 12 C.F.R.
pt. 226. See also Home Ownership and Equity Protection Act of 1994 (HOEPA), Pub. L. No. 103–
325 (codified at 15 U.S.C. § 1639) (amending TILA).
61 Congress has amended TILA to improve consumer credit protection. See, e.g., Fair Credit
and Charge Card Disclosure Act of 1988, Pub. L. No. 100–583 (codified at 15 U.S.C. § 1637).
In 1994, Congress amended TILA again to address predatory lending in the mortgage market.
HOEPA, supra note 60.
62 In 2007, Chairman Bernanke said the Board would ‘‘consider whether other lending practices meet the legal definition of unfair and deceptive and thus should be prohibited under
HOEPA.’’ Board of Governors of the Federal Reserve System, Chairman Ben S. Bernanke Remarks on The Subprime Mortgage Market before the Federal Reserve Bank of Chicago’s 43rd Annual Conference on Bank Structure and Competition (May 17, 2007) (online at
www.federalreserve.gov/newsevents/speech/bernanke20070517a.htm). In 2008, recognizing that
its authority under HOEPA is ‘‘broad,’’ the Board strengthened Regulation Z. 73 Fed. Reg.
44,522 (July 30, 2008).
63 It was not until the end of 2001, after the volume of subprime loans had increased nearly
400 percent, that the Board restricted more abusive practices and broadened the scope of mortgages covered by HOEPA. See 66 Fed. Reg. 65,604, 65,605 (Dec. 20, 2001).
64 The Fed updated Regulation Z in response to HOEPA in March 1995. 60 Fed. Reg. 15,463.
It also amended Regulation C, ‘‘Home Mortgage Disclosure,’’ in 2002. 67 Fed. Reg. 7222. Nonetheless, neither regulation was strong enough to head off the mortgage abuses that continued
to accelerate through 2008.
65 See, e.g., Jane Birnbaum, Credit Card Overhauls Seem Likely, New York Times (July 5,
2008) (‘‘Representative Barney Frank, Democrat of Massachusetts and chairman of the House
Financial Services Committee, said the Federal Reserve acted last fall after the House approved
legislation that would have transferred some of the Fed’s regulatory power to other agencies.
‘At that point, I said use it or lose it,’ Mr. Frank recalled. ‘And subsequent to that, the Fed
began using its authority, and is now proposing rules similar to those in our credit card bill.’ ’’)

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weeks ago . . . he said something I hadn’t heard in my 28 years
in this body, a Chairman of the Federal Reserve Board uttering the
words, ‘consumer protection.’ It had not happened since 1981.’’ 66
Currently, the staffing, the budgets, the expertise and the primary responsibilities of the Fed necessarily reflect the critical functions it performs: setting monetary policy and controlling the
money supply, consolidated supervision of bank holding companies
and the financial institutions those holding companies own to assure the safety and soundness of those groups, supervision of statechartered member-banks in coordination with state regulators, and
oversight of the federal reserve banks. Under this option the Fed
would be required to accept consumer protection as a responsibility
that is the equal of its other responsibilities, staff and budget for
that function and, makes its operations in the area transparent.
These responsibilities should be subject to specific oversight by a
designated Board member.
Wherever it is placed, the success of the new regulator would depend in part on a statutory outline of the manner in which it would
be related to the various financial institution regulatory agencies,
and how those agencies would relate to one another, in dealing
with consumer credit products. The agencies that are responsible
for assuring the safety and soundness of the financial institutions
would be able to pursue those goals without interference. The point
of the single regulatory authority would be only to assure that both
financial institutions and non-financial institutions that issue consumer credit products must play on a level field, all meeting the
minimum standards established by the federal agency. No one
issuer could gain advantage by moving to a different regulator.
5. CREATE EXECUTIVE PAY STRUCTURES THAT DISCOURAGE EXCESSIVE
RISK TAKING

Problem with current system: Executive pay packages
incentivize excessive risk
Executive pay is a key issue in modernizing the financial regulatory system. However, the common focus on the themes of inequality and ‘‘pay for performance’’ misses the unnecessary risk
that many compensation schemes introduce into the financial sector. Altering the incentives that encourage this risk through the
tax code, regulation, and corporate governance reform will help
mitigate systemic risk in future crises.
Executive compensation has been one of the most controversial
issues in American business since the late 1980s. In response to
criticism that executives’ and shareholders’ interests did not sufficiently align,67 executive compensation packages began to contain
more and more stock options, to the point where options now represent the lion’s share of a high-ranking executive’s pay.68

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66 House Financial Services Committee, Subcommittee on Financial Institutions and Consumer Credit, Statement of Chairman Barney Frank, The Credit Cardholders’ Bill of Rights:
Providing New Protections for Consumers, 110th Cong. 5–6 (2008).
67 Steven Balsam, An Introduction to Executive Compensation, at 161 (2002).
68 According to academic literature, between 1992 and 2002, the inflation-adjusted value of
employee options granted by firms in the S&P 500 increased from an average of $22 million
per company to $141 million per company, rising as high as $238 million per company in 2000.
One academic study we referenced showed that, whereas in 1992 share options accounted for
only 24 percent of the average pay package for these CEOs, by 2002 options comprised approxi-

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Much criticism of executive pay has had its origins in the increase in the ratio of the pay of public company executives to average worker pay, from 42:1 in 1982 to over 400:1 in the early years
of this decade.69 Recent executive pay scandals, such as those associated with the backdating of stock options, have centered on efforts by executives to disconnect pay from performance without informing investors.70 Numerous accounts of executive pay in the
context of the financial crisis of 2007–08 have focused on large severance packages, often described as once again disconnecting pay
from performance.71
However, even before the current crises, many criticized such incentive plans for encouraging excessive focus on the short term at
the expense of consideration of the risks involved.72 This shortterm focus led to unsustainable stock buyback programs, accounting manipulations, risky trading and investment strategies, or
other unsustainable business practices that merely yield short-term
positive financial reports.
Executive pay should be designed, regulated, and taxed to
incentivize financial executives to prioritize long-term objectives,
and to avoid both undertaking excessive, unnecessary risk and socializing losses with the help of the federal taxpayer.
Action item: Create tax incentives to encourage long-termoriented pay packages
Financial firm packages typically have a number of features that
introduce short-term biases in business decision making. Most equity-linked compensation is either in the form of performance bonuses, typically awarded on an annual basis, and options on restricted stock, typically awarded in the form of grants with threeyear vesting periods, and no restrictions on sale after vesting.
These structures, together with the typical five-years-or-less tenure

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mately half of the typical CEO’s total compensation. The practice of granting option awards has
not been limited to the top echelon of company executives. The percentage of option grants to
all employees has grown steadily as well, if not at the same pace as the very top-most strata
of corporate executives.
Senate Committee on Homeland Security and Governmental Affairs, Permanent Subcommittee on Investigations, Testimony of John W. White, Concerning Tax and Accounting
Issues Related to Employee Stock Option Compensation, 110th Cong. (June 5, 2007) (online at
idea.sec.gov/news/testimony/2007/ts060507jww.htm) (internal citations omitted).
69 Jeanne Sahadi, CEO Pay: Sky High Gets Even Higher, CNNMoney.com (Aug. 30, 2005) (online at money.cnn.com/2005/08/26/news/economy/ceolpay).
70 See, e.g., U.S. Securities Exchange Commission, SEC Charges Former Apple General Counsel for Illegal Stock Option Backdating (Apr. 24, 2007) (online at www.sec.gov/news/press/2007/
2007-70.htm).
71 The most prominent example is that of Angelo Mozilo, the former Chief Executive Officer
of Countrywide Financial Corporation. Countrywide was rescued from bankruptcy by being acquired by Bank of America, which is now itself seeking additional financial assistance from the
TARP. Mozilo realized more than $400 million in compensation from 2001 to 2007, most of it
in the form of stock related compensation that he received and cashed out during the period.
Executive Incentives, Wall Street Journal (Nov. 20, 2008) (online at online.wsj.com/public/resources/documents/stlceosl20081111.html). Similarly, three of Merrill Lynch’s top executives
realized a combined $200 million in bonuses shortly before Bank of America absorbed that firm.
Andrew Clark, Banking Crisis: Merrill Lynch Top Brass Set to Share $200m, The Guardian
(Sept.
17,
2008)
(online
at
www.guardian.co.uk/business/2008/sep/17/merrilllynch.
executivesalaries).
72 CFA Centre for Financial Market Integrity and the Business Roundtable Institute for Corporate Ethics, Breaking the Short-Term Cycle: Discussion and Recommendations on How Corporate Leaders, Asset Managers, Investors, and Analysts Can Refocus on Long-Term Value, at
9–10 (2006) (online at www.darden.virginia.edu/corporate-ethics/pdf/Short-termismlReport.pdf).

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of public company CEOs, often lead to a focus on investment horizons of less than three years.73
Altering the tax treatment of executive compensation packages in
the interests of encouraging stability, lessening risks, and orienting
finance executives toward long-term goals represents a relatively
simple step toward solving the incentive problem. Such a change
could result from revising applicable tax rates, changing the treatment of compensation as income versus capital gains, or other relatively simple measures.
Action item: Encourage financial regulators to guard
against asymmetric pay packages in financial institutions,
such as options combined with large severance packages
Asymmetric links between compensation and risk create incentives for executives to pursue potentially systemically threatening
high-risk-high-reward strategies without sufficient regard for the
downside potential. Encouraging regulators to spot and discourage
compensation packages that excessively insulate executives from
losses will help resolve this asymmetry and promote stability.
Stock options create incentives that are tied to stock price, but
the overall compensation package’s asymmetric link to stock price
actually helps encourage more dramatic risk taking. As the price
of the underlying stock declines, the option holders become less
sensitive to further declines in value of the underlying stock, and
more interested in the possibility of achieving dramatic gains, regardless of the risk of further losses.74
A number of common features of executive pay practice that further protect executives against downside risk exacerbate this asymmetry problem. Among these features are the prevalence of option
repricing when the underlying company stock falls below the option
strike price for sustained periods of time and large severance packages paid to failed executives.
While asymmetries in executive compensation are potentially
harmful in the context of any company, they create particular difficulties in the context of regulated financial institutions. Most regulated financial institutions are the beneficiaries of explicit or implicit guarantees. The FDIC insurance system is an explicit guarantee to some depositors, which in the current crisis has been extended to all bank debt. The current Treasury and Federal Reserve
rescues of Fannie Mae, Freddie Mac, and AIG, and the recent
TARP actions in relation to Citigroup and Bank of America—and
perhaps all nine major TARP recipient banks—all raise issues of
implicit guarantees. These guarantees provide regulators with an
opportunity to ensure that problematically asymmetrical compensation plans do not reappear in these institutions.
Action item: Regulators should consider requiring executive
pay contracts to provide for clawbacks of bonus compensation for executives of failing institutions
Financial system regulators should consider revoking bonus compensation for executives of failing institutions that require federal
73 Id.

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74 Lucian Bebchuk and Jesse Fried, Pay Without Performance: The Unfulfilled Promise of Executive Compensation, 139 (2004).

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intervention. Whether the federal government promises to support
the institution before a crisis develops, as with Fannie Mae and
Freddie Mac, or after, as with TARP recipients, the prospect of losing bonus compensation could deter risky practices that make the
federal rescue more probable.
The cases of the Fannie Mae and Freddie Mac seem particularly
relevant. In both companies, executive pay in the course of the
1990s moved from a model focused on corporate stability to a model
focused on stock price maximization through asymmetric, shortterm incentives.75 It appears that this change fed pressures to increase margins in ways that were only possible by engaging in
riskier investment practices.76 This approach to executive pay is inconsistent with federal guarantees of solvency; inevitably, if it is
not abandoned, taxpayers will end up paying for imprudent risk
taking by improperly incentivized executives.
As the financial crisis has developed, there has been a fair
amount of discussion of clawbacks of executive pay. The SarbanesOxley Act of 2002 required clawbacks of executive pay awarded as
a result of fraudulent financial statements.77 Similar clawback provisions could help restore symmetry and a longer-term perspective
to executive compensation systems. As such, regulators should consider adding them to the tools at their disposal.
Action item: Encourage corporate governance structures
with stronger board and long-term investor oversight of pay
packages
The Associated Press recently reported that ‘‘even where banks
cut back on pay, some executives were left with seven- or eight-figure compensation that most people can only dream about. Richard
D. Fairbank, the chairman of Capital One Financial Corp., took a
$1 million hit in compensation after his company had a disappointing year, but still got $17 million in stock options. The
McLean, Va.-based company received $3.56 billion in bailout money
on Nov. 14.’’ 78
Corporate governance regulations should strengthen the role of
boards and long-term shareholders in the executive pay process
with the goal of encouraging executive pay practices that align executives’ interests with the long-term performance of the businesses they manage.
The twin problems of asymmetric and short-term-focused executive pay have been the subject of a number of reform efforts by
business groups. Such reform recommendations have come from
the Conference Board, in its report on the origins of the financial
crisis,79 and from the Aspen Institute’s Principles for Long Term

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75 Federal Reserve Bank of St. Louis, William R. Emmons and Gregory E. Sierra, Executive
Compensation at Fannie Mae and Freddie Mac (Oct. 26, 2004) (Working Paper No. 2004–06)
(online at papers.ssrn.com/sol3/papers.cfm?abstractlid=678404).
76 Id.
77 Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, at § 304.
78 Frank Bass and Rita Beamish, Study: $1.6B of Bailout Funds Given to Bank Execs, Associated Press (Dec. 21, 2008).
79 Conference Board, Linda Barrington, Ellen S. Hexter, and Charles Mitchell, CEO Challenge
2008: Top 10 Challenges—Financial Crisis Edition (Nov. 2008) (online at www.conferenceboard.org/publications/describe.cfm?id=1569).

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Value Creation,80 endorsed by the U.S. Chamber of Commerce and
the Business Roundtable, as well as by the Council of Institutional
Investors and the AFL–CIO.
Financial regulators should encourage these efforts wherever
possible and provide assistance wherever practicable.
6. REFORM THE CREDIT RATING SYSTEM

Problem with current system: The credit rating system is ineffective and plagued with conflicts of interest
The major credit rating agencies played an important—and perhaps decisive—role in enabling (and validating) much of the behavior and decision making that now appears to have put the broader
financial system at risk. In the subprime-related market specifically, high ratings for structured financial products—especially
mortgage-backed securities (MBS), collateralized debt obligations
(CDO), and CDOs that invested in other CDOs (frequently referred
to as CDO-squared, or CDO2)—were essential for ensuring broad
demand for these products. High ratings not only instilled confidence in potentially risk-averse investors, but also helped satisfy
investors’ regulatory requirements, which were often explicitly
linked to ratings from the major credit rating agencies. By 2006,
Moody’s business in rating structured financial products accounted
for 44 percent of its revenues, as compared to 32 percent from its
traditional corporate-bond rating business.81 It has also been reported that ‘‘roughly 60 percent of all global structured products
were AAA-rated, in contrast to less than 1 percent of corporate
issues.’’ 82 Financial firms, from Fannie Mae to AIG, also benefited
greatly from having high credit ratings of their own—especially
AAA—allowing them not only to borrow at low rates on the shortterm markets to finance longer-term (and higher yielding) investments but also to sell guaranties of various sorts, effectively ‘‘renting out’’ their credit rating.
Numerous explanations have been offered for credit rating agencies’ apparent mistakes, including conflicts of interest, misuse of
complex models, and their quasi-public status as nationally recognized statistical rating organizations (NRSROs).
Regarding conflicts of interests, worrisome is the rating agencies’
practice of charging issuers for their ratings, a practice that began
at Fitch and Moody’s in 1970 and at Standard & Poor’s a few years
later.83 Although the practice of collecting payments from issuers
has long provoked criticism, market observers often downplayed
these concerns, suggesting that ‘‘the agencies have an overriding
incentive to maintain a reputation for high-quality, accurate ratings.’’ 84 Others, however, claim that the ‘‘issuer pays’’ model biases
ratings upward and also encourages ‘‘ratings shopping’’ by issuers,

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80 Aspen Institute, Long-Term Value Creation: Guiding Principles for Corporations and Investors (2008).
81 Harvard Business School, Joshua D. Coval, Jakib Jurek, and Erik Stafford, The Economics
of Structured Finance, at 4 (2008) (Working Paper No. 09–060) (online at papers.ssrn.com/sol3/
papers.cfm?abstractlid=1287363).
82 Id.
83 Richard Cantor and Frank Packer, The Credit Rating Industry, FRBNY Quarterly Review,
at 4 (Summer-Fall 1994). See also Claire Hill, Regulating the Rating Agencies, Washington University Law Quarterly, at 50 (2004).
84 Cantor and Packer, supra note 81, at 4.

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which in turn provokes a race to the bottom on the part of the rating agencies, each willing to lower quality standards to drum up
more business.85
Beyond the ratings themselves, credit rating agencies also charge
issuers for advice, including pre-rating assessments (in which
issuers learn what ratings will likely be under various hypothetical
scenarios) and risk-management consulting. In some cases, credit
rating agency analysts subsequently go to work for the companies
they had been rating.86 This revolving-door practice creates not
only the potential for conflicts of interest but also for gaming of the
system, since former employees of the rating agencies presumably
know how best to exploit weaknesses in the agencies’ risk assessment models.
Many critics charge that it was the models themselves—and
overreliance on them—that got the credit rating agencies into trouble in recent years, particularly in assigning ratings to structured
financial products. ‘‘Instead of focusing on actual diligence of the
risks involved, demanding additional issuer disclosures, or scrutinizing collateral appraisers’ assessments,’’ writes one skeptic, ‘‘rating agencies primarily relied on mathematical models that estimated the loss distribution and simulated the cash flows of RMBS
[residential mortgage backed securities] and CDOs using historical
data.’’ 87
Many of the models involved excessively rosy assumptions about
the quality of the underlying mortgages, ignoring the fact that
these mortgages (especially subprime mortgages) were far riskier
than ever before and were in fact becoming steadily riskier year by
year.88 Credit rating agency modeling of mortgage-related securities may also have involved mistaken assumptions about the independence of the underlying mortgages—including the assumption
that defaults would not be highly correlated across a broad bundle
of mortgages or mortgage-related securities.89 By extension, many
of the rating agencies’ models may also have involved overly opti-

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85 House Committee on Oversight and Government Reform, Testimony of Jerome S. Fons,
Credit Rating Agencies and the Financial Crisis, 110th Cong., at 3 (Oct. 22, 2008) (online at
oversight.house.gov/documents/20081022102726.pdf).
86 John P. Hunt, Credit Rating Agencies and the ‘Worldwide Credit Crisis’: The Limits of Reputation, the Insufficiency of Reform, and a Proposal for Improvement, Columbia Business Law
Review, at 32–33 (2009) (papers.ssrn.com/sol3/papers.cfm?abstractlid=1267625).
87 Jeffrey David Manns, Rating Risk after the Subprime Mortgage Crisis: A User Fee Approach
for Rating Agency Accountability, North Carolina Law Review (forthcoming), at 32–33 (papers.ssrn.com/sol3/papers.cfm?abstractlid=1199622) (accessed Jan. 4, 2009).
88 U.S. Securities and Exchange Commission Office of Compliance Inspections and Examinations, Summary Report of Issues Identified in the Commission Staff’s Examinations of Select
Credit Rating Agencies, at 33 (July 2008) (online at www.sec.gov/news/studies/2008/
craexamination070808.pdf) (hereinafter ‘‘Summary Report’’) (‘‘In addition to the recent growth
in subprime origination, there has also been a growth in the risk factors associated with
subprime mortgages. Studies indicate that the percentage of subprime loans with less-than-full
documentation, high combined loan to total value (CLTVs), and second liens grew substantially
between 1999 and 2006. Notably, while 2/28 adjustable rate mortgages comprised just 31 percent of subprime mortgages in 1999, they comprised almost 69 percent of subprime loans in
2006. Further, 40-year mortgages were virtually non-existent prior to 2005, but they made up
almost 27 percent of the subprime loans in 2006. These data provide evidence that the majority
of subprime origination occurred within the last five years, and the loans containing very high
risk combinations are even more recent.’’). The SEC report also documented that, at one major
credit rating agency, ‘‘the average percentage of subprime RMBS in the collateral pools of CDOs
it rated grew from 43.3 percent in 2003 to 71.3 percent in 2006.’’ Id. at 7. Given these dramatic
changes in the mortgage market, basing models on historical mortgage data may have proved
particularly problematic.
89 Indeed, a significant degree of independence was essential, since ‘‘CDOs rely on the power
of diversification to achieve credit enhancement.’’ Coval, et al., supra note 81, at 10.

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mistic assumptions about the direction of housing prices (that is,
that they would not fall by much, if at all). When asked on a conference call in March 2007 about how a 1 to 2 percent decline in
home prices over an extended period of time would affect Fitch’s
modeling of certain subprime-related securities, a Fitch representative conceded, ‘‘The models would break down completely.’’ 90
Yet another problem plaguing the rating agencies’ models was
the practice of embedded structuring by issuers, according to which
CDOs would themselves become inputs into new CDOs (CDO2).
‘‘With multiple rounds of structuring,’’ three finance professors explain, ‘‘even minute errors at the level of the underlying securities,
which would be insufficient to alter the security’s rating, can dramatically alter the ratings of the structured finance securities.’’ 91
Of particular concern from a regulatory standpoint is the extent
to which state and federal (and even global) financial regulations
are linked to private credit ratings—and, in fact, to ratings issued
by just a handful of specially designated credit rating agencies, the
NRSROs). To the extent that leading credit rating agencies enjoy
a protected status and virtually guaranteed demand as a result of
their regulatory significance, they may face diminished incentives
to maintain the quality of their ratings.
The SEC has recently undertaken a number of reforms aimed at
the operations of the NRSROs pursuant to the passage of the Credit Rating Agency Reform Act of 2006 (the Rating Agency Act),92
which granted the SEC authority to implement registration, recordkeeping, financial reporting, and oversight rules with respect to
registered credit rating agencies. Before this grant of authority to
the SEC, NRSROs were essentially unregulated. Pursuant to its
new regulatory authority, the SEC has registered ten firms; 93 instituted examinations of NRSROs’ practices; 94 and proposed rules
designed to enhance accountability, transparency, and competition.95 The Rating Agency Act and the SEC’s recent regulatory activity are positive developments. However, since 2006 the financial
crisis has revealed the extent of the harmful consequences of the
deep-seated conflicts of interest and distorted incentives associated
with the credit ratings firms. With the knowledge that the contours
of reform of credit rating agency regulation must take into account
the SEC’s actions, we propose the following recommendations.
Action item: Adopt one or more regulatory options to address conflicts of interest and incentives
To address conflicts of interest, the SEC or a new regulatory
body (see below) could impose limits on the proportion of revenues
of rating agencies that are derived from issuers, though there is
disagreement about whether alternative revenue sources would
90 See

id. at 23.
at 10.
Rating Agency Reform Act of 2006, Pub. L. No. 109–291.
93 U.S. Securities Exchange Commission, Nationally Recognized Statistical Rating Organizations (online at www.sec.gov/divisions/marketreg/ratingagency.htm) (accessed Jan. 26, 2008)
(hereinafter ‘‘SEC NRSRO Web site’’). These ten include the old line firms Moody’s, Standard
& Poor’s, and Fitch. Id.
94 Senate Committee on Banking, Housing, and Urban Affairs, Testimony of Christopher Cox,
Turmoil in U.S. Credit Markets: The Role of the Credit Rating Agencies, 110th Cong. (Apr. 22,
2008) (online at www.sec.gov/news/testimony/2008/ts042208cc.htm).
95 SEC NRSRO Web site, supra note 93.
91 Id.

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92 Credit

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prove sufficient.96 Alternatively, for each rating, issuers could be
required to pay into a pool, from which a rating agency would be
chosen at random.97 Here, the challenge would be to maintain the
quality of ratings after severing the link between pay and performance. One could also imagine the introduction of grace periods in
which credit rating analysts could not take jobs with their clients.
While this too would limit conflicts of interest, it might also interfere with the recruiting of high-quality credit analysts at the rating
agencies.
To improve incentives, the SEC or some other regulatory body
should further encourage additional competition by progressively
expanding the ranks of the NRSROs.98 Other options would include
additional disclosure requirements or prohibitions on rating agencies’ use of nonpublic information.99 Since rating agencies currently
face little if any legal liability for malfeasance in the production of
ratings, a number of experts have proposed strategies for imposing
liability on credit rating agencies to ensure appropriate accountability.100 Although such reforms might well prove helpful, they
would be unlikely to solve the underlying problem by themselves.
Action item: Reform the quasi-public role of NRSROs and
consider creating a Credit Rating Review Board
Perhaps the most pressing issue of all from a regulatory standpoint is the NRSRO designation itself. Particularly given all of the
concerns that have been raised about the credit rating agencies and
their poor performance leading up to the current crisis, state and
federal policymakers will need to reassess whether they can continue to rely on these private ratings as a pillar of public financial
regulation.101 In fact, it may be time to consider the possibility of
eliminating, or at least dramatically scaling back, the NRSRO designation and replacing it with something else.102
One option would be to create a public entity—a Credit Rating
Review Board—that would have to sign off on any rating before it
took on regulatory significance. Even if an asset was rated as investment grade by a credit rating agency, it could still not be added
to a bank or pension fund portfolio, for example, unless the rating
was also approved by the review board. Ideally, the board would be
given direction by lawmakers to favor simpler (plain vanilla) instruments with relatively long track records. New and untested instruments might not make the cut. Of course, such new instruments could still be actively bought and sold in the private market-

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96 House Committee on Oversight and Government Reform, Testimony of Sean J. Egan, Credit
Rating Agencies and the Financial Crisis, 110th Cong., at 9 (Oct. 22, 2008) (online at oversight.house.gov/documents/20081022102906.pdf).
97 David G. Raboy, Concept Paper on Credit Rating Agency Incentives (Jan. 9, 2009) (unpublished working paper on file with the Panel).
98 Hill, supra note 83, at 86–87.
99 Egan, supra note 96, at 8.
100 Senate Committee on Banking, Housing, and Urban Affairs, Testimony of Frank Partnoy,
Assessing the Current Oversight and Operation of Credit Rating Agencies, 109th Cong., at 5
(Mar. 7, 2006) (online at banking.senate.gov/public/lfiles/partnoy.pdf).
101 A recent SEC report acknowledged, ‘‘The rating agencies’ performance in rating these
structured finance products raised questions about the accuracy of their credit ratings generally
as well as the integrity of the ratings process as a whole.’’ Summary Report, supra note 88, at
2).
102 Frank Partnoy has suggested linking regulation instead to market-based measures of risk,
such as credit spreads or the prices of credit default swaps. Partnoy, supra note 100, at 80–
81.

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place. Only regulated transactions that currently require ratings
would be affected. Two key advantages of this approach are that
it would permit a dramatic opening of the market for private credit
ratings and at the same time discontinue the unsuccessful outsourcing of vital regulatory monitoring.
Another, substantially different, option for the design of such a
Credit Rating Review Board would be to model the board in part
on the Public Company Accounting Oversight Board (PCAOB), a
not-for-profit corporation that was created by the Sarbanes-Oxley
Act to oversee the auditors of public companies.103 Under this
model, the Credit Rating Review Board would not rate instruments
ex ante, but instead audit ratings after the fact, perhaps on an annual basis, to ensure that rating agencies are sufficiently disclosing
their rating methodologies, the ratings agencies’ methodologies are
sound, and the rating agencies are adhering to their methodologies.
Depending on the course of the SEC’s rulemaking, the Credit Rating Review Board could coordinate with or assume some of the
SEC’s authority to regulate conflicts of interest and inspect, investigate, and discipline NRSROs.
7. MAKE ESTABLISHING A GLOBAL FINANCIAL REGULATORY FLOOR A
U.S. DIPLOMATIC PRIORITY

Problem with current system: The globalization of financial
markets encourages countries to compete to attract foreign
capital by offering increasingly permissive regulatory laws
that increase market risk
The rapid globalization of financial markets in recent decades
has created a new set of problems for national regulators and exposed market participants to an additional element of risk. Capital
is able to flow freely across international borders, while regulatory
controls are bound to domestic jurisdictions. Private actors, therefore, have the benefit of seeking out regulatory climates that best
accommodate their financial objectives. Countries, in turn, bid for
capital flows by adjusting their tax and regulatory schemes, as well
as their legal infrastructure and employment laws. While New
York and London tout their preeminence as financial capitals,
Tokyo, Hong Kong, Singapore, Bahrain, and Doha, Qatar have all
become financial hubs. At the same time, certain offshore tax havens, such as the Cayman Islands, the Bahamas, and the Channel
Islands have developed local industries catering to the financial
services needs of foreigners. Often, the sole comparative advantage
offered by these locations is the opportunity to profit from ‘‘regulatory arbitrage.’’ The consequence is a global race to the bottom
whereby deregulation is pursued to the detriment of market stability.
Meanwhile, global markets have become increasingly interconnected. From 1990 to 2000, the total dollar amount of crossborder securities holdings where non-U.S. investors held U.S. securities, or vice versa, grew from approximately $1.5 trillion to approximately $6.9 trillion.104 Today, U.S. issuers raise debt and eq103 See

Sarbanes-Oxley Act of 2002, Pub. L. No. 107–204, at §§ 101–109.
Industry Association, Securities Industry Fact Book, at 80 (2002) (online at
www.sifma.org/research/statistics/other/2002FactlBook.pdf).
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104 Securities

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uity funding in local markets all over the world. Conversely, foreign issuers who previously looked to the liquidity of the United
States capital markets now find equally liquid pools of capital in
Europe and Asia.
When financial turmoil strikes issuers or borrowers in one country, it is equally likely to have adverse consequences beyond national borders. The subprime mortgage crisis of 2008 caused widespread havoc outside the United States, beginning with a small
thrift in England and sweeping over the world. At the same time
the United States government initiated its $700 billion bailout
plan, the United Kingdom established a facility to make additional
capital available to eight of its largest banks and building societies,
the governments of France, Belgium, Luxembourg and the Netherlands made large capital infusions to bail out major banks operating in those countries, and the government of Iceland was forced
to take over the three largest banks there.105 Stock markets worldwide plunged. Investors large and small suffered.
The abiding lesson is that booms and busts can no longer be restricted to their country of origin. Nations must embark on aggressive diplomatic efforts to address the collective risks posed by today’s globalized financial markets.
Action item: Build alliances with foreign partners to create
a global financial regulatory floor
Given the ease with which money moves across international
borders, it is difficult for one country to adopt a system to provide
adequate regulation of the capital markets, as well as adequate
consumer protection, unless all major participants in the global
economy have agreed to coordinated action beforehand. Otherwise,
regulatory arbitrage and the resulting race to the bottom are inevitable. To assure the stability of the markets, it is therefore imperative for U.S. financial market regulators, as well as the State Department, to work together to encourage greater harmonization of
regulatory standards, as well as broad adoption of a floor of recognized ‘‘prudent regulatory measures.’’
Better coordination of regulation and surveillance, while difficult
to achieve, will result in better-regulated entities that are less likely to cause damages to global markets and other market participants. It is also likely to result in more efficient and less costly regulation for regulated entities.
Action item: Actively participate in international organizations that are designed to strengthen communication and
cooperation among national regulators
Financial services regulators have created a number of organizations to share ideas and information regarding financial services
entities and markets. These include the Basel Committee on Bank
Supervision (BCBS), the Senior Supervisors Group (SSG), and the
International Organization of Securities Commissions (IOSCO).

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105 Steven Erlanger and Katrin Bennhold, Governments on Both Sides of the Atlantic Push to
Get Banks to Lend, New York Times (Nov. 6, 2008).

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The SSG, for one, meets regularly to discuss supervisory matters
and to issue recommendations for better supervision.106
The SSG also periodically sponsor ‘‘colleges of supervisors,’’ in
which supervisors from several countries that have jurisdiction
over part of the operations of a globally active financial services
firm will convene to discuss issues regarding regulation of the firm.
Established linkages between regulators with different perspectives
on a particular entity facilitate information-sharing that enables all
supervisors to better understand the risks facing the entity. These
relationships also ensure better coordination during times of stress.
These efforts should be expanded to include consideration of systemically important financial institutions, in order to develop a better understanding of the risk profiles of such institutions and to
improve their ability to intervene where the risk profile increases
to potentially destabilizing levels.
8. PLAN FOR THE NEXT CRISIS

Problem with current system: Participants, observers, and
regulators neither predicted nor developed contingency
plans to address the current crisis
Despite calls for caution from some quarters, very few observers
predicted the severity of the current collapse in the housing, debt,
and equity markets, or the massive decline in economic activity.
Those commentators who most vocally raised doubts about the sustainability of housing prices, the pace of derivatives growth, or lax
regulation were largely dismissed as fearmongers, or as simply ‘‘not
getting it.’’ 107
Traditional measures of financial and economic exposure, such as
bank capitalization, troubled loans, stock prices, and money supply
growth, indicated only moderate exposure to a sharp asset price
collapse and a severe recession.108 Yet there was a compelling case
for concern based on a closer examination of the multiple layers of
leverage invested in housing assets and their derivatives.109 More
broadly, stagnant household productivity, the pace of financial
product innovation and the increased leverage on Wall Street
might all have set off alarm bells.110
Indeed, some analysts see systemic collapses as inherently more
likely in complex, interdependent systems such as our modern financial environment.111 While most destructive outcomes are
deemed to be so unlikely, based on historical comparisons, that
they are not worth considering, recent analysis indicates on the

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106 Senior Supervisors Group, Observations on Risk Management Practices in the Recent Market Turbulence (Mar. 6, 2008) (online at www.newyorkfed.org/newsevents/news/banking/2008/
ssglrisklmgtldoclfinal.pdf).
107 See, e.g., Meet Dr. Doom, IMF Survey, at 308 (Oct. 16, 2006) (online at www.imf.org/EXTERNAL/PUBS/FT/SURVEY/2006/101606.pdf).
108 See, e.g., id.
109 Government Accountability Office, Financial Regulation: A Framework for Crafting and
Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System, at 16–23
(2009) (online at www.gao.gov/new.items/d09216.pdf) (discussing overleveraging and financial
interconnectedness as contributing to a risky financial environment immediately preceding the
current crisis).
110 Id.
111 Id. at 18–19.

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contrary that complex systems produce these ‘‘outlier’’ results on a
counterintuitively regular basis.112
Current institutions are not likely to fare better in the future.
Governments, industry, Wall Street, and academia typically employ
economists with similar training and backgrounds to create their
forecasts, leading to procyclical optimism and convergence of economic forecasts. In particular, economists have a truly dismal
record in predicting the onset of recessions and asset crashes.113
Given the risk of a similar collapse in the future and the lack of
formal processes in business or government requiring that the truly
dismal scenarios be assessed, the current system will likely face
similar risks not long after the present crisis is resolved.
Action item: Create Financial Risk Council of outside experts to report to Congress and regulators on possible looming challenges
To promote better planning, financial experts should be aiming
to identify the problems of the future, much as the military does.
To this end, the Panel recommends establishing a Financial Risk
Council featuring a truly diverse group of opinions, a formal mechanism whereby the concerns, both individual and collective, of this
group will be regularly brought to the attention of Congress and financial regulators, with a focus on precisely those low-likelihood,
huge-magnitude developments that consensus opinion will dismiss.
The council should consider all potential domestic and foreign
threats to the stability of the U.S. financial systems. These sources
of threat should include, but not be limited to: (1) Economic shocks
and recessions; (2) asset booms and busts; (3) fiscal, trade, foreign
exchange, and monetary imbalances; (4) infrastructure failures,
natural disaster, and epidemics; (5) institutional mismanagement;
(6) crime, fraud; and terrorism; (7) legislative and regulatory failure; and (8) failed product and process innovation.
Strong, independent thinking among the membership of the
Council will be critical: Every effort should be made to avoid an optimistic consensus that there are no major threats looming. To that
end, Council members should represent a diverse array of stakeholders, with a record of speaking their minds.
The council would be required to publish regular reports to Congress and to select among various techniques for identifying
threats. These approaches might include:
1. Wargaming: Teams represent various market, government,
regulatory, and subversive constituents. A control team sets up the
initial environment and introduces destabilizing changes. The
teams respond in real time and the control group feeds the impacts

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112 See, e.g., Nassim Nicholas Taleb, The Black Swan: The Impact of the Highly Improbable
(2007); Daniel G. Goldstein and Nassim Nicholas Taleb, We Don’t Quite Know What We Are
Talking About When We Talk About Volatility (Mar. 28, 2007) (online at ssrn.com/
abstract=970480).
113 Even where outside advisory groups have been set up to counsel the Government regularly
´
on economic issues, as the Conseil d’Analyse Economique (CAE) does in France, there is a
´
marked similarity of backgrounds among their membership. Conseil d’Analyse Economique,
Membres du Conseil (online at www.cae.premier-ministre.gouv.fr) (accessed Jan. 26, 2009). This
may help explain why these bodies did not produce even minority viewpoints warning of the
current financial crash; CAE did not produce a report on the subprime mortgage crisis until Sep´
´
tember, 2008. Conseil d’Analyse Economique, Rapports du Conseil d’analyse economique (online
at www.cae.premier-ministre.gouv.fr) (accessed Jan. 26, 2009).

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of their decisions into the environment. Subsequent to the
wargame, there is an examination of outcomes, the level of constituent preparedness, and the quality of the risk management
processes.
2. Strategic scenario analysis: An analytic team works backward
from worst-case financial crisis outcomes to identify the potential
triggering factors and preventative or mitigating solutions. This approach prevents the ‘‘it couldn’t happen’’ mindset.
3. Nonlinear modeling/‘‘black swan’’ sensitivity analysis: An analytic team assumes previously unseen levels for key variables in
order to destabilize financial models and observes break points and
systemic failures.
A Financial Risk Council composed of strong, divergent voices
should avoid overly optimistic consensus and conventional wisdom,
keeping Congress appropriately concerned and energized about
known and unknown risks in a complex, highly interactive environment.

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V. ISSUES REQUIRING FURTHER STUDY

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There are several important questions regarding financial regulatory reform that are beyond the scope of this Report, and will require further attention.
First, the Panel has identified three highly technical issues relating to the financial regulatory system, and recommends that the
relevant regulatory agencies take up specialized review of these
questions. These are:
1. Accounting rules: Further study is required to identify needed
reforms of the current accounting rules, particularly with connection to systemic risk. Among the issues that should be considered
are mark-to-market accounting, mark-to-model accounting, fairvalue accounting, issues of procyclicality, accounting for contingent
liabilities, and off-balance-sheet items.
2. Securitization: Further study is required to consider the logic
and limits of securitization, and reform options such as requiring
issuers to retain a portion of offering, phased compensation based
on loan or pool performance, and other requirements.
3. Short-selling: In light of recent imposed limits, regulation of
short-selling should be further studied and long-term policies
should be developed.
Second, the Panel plans to address regulatory architecture more
thoroughly in a subsequent report, including the issues of co-regulation, universal banking, regulatory capture, the revolving door
problem, bankruptcy and receivership issues involving financial institutions, and the division of regulatory responsibilities.

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VI. ACKNOWLEDGMENTS

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The Panel owes a debt of gratitude to many people who helped
produce this report. Our deepest thanks go to Professor David Moss
of Harvard Business School, who played a key role in conceptualizing and drafting the report. He was ably assisted by Melanie
Wachtell, who worked long hours both to direct the underlying research efforts and to help pull the final draft together. The Panel
is also grateful to Christopher Caines for his meticulous and
thoughtful editing of this report. We express our thanks to Professor Arthur Wilmarth, Professor Patricia McCoy, Professor Ronald Mann, Professor Julio Rotemberg, Professor David Scharfstein,
and Dr. Robert Litan, all of whom read portions of the draft and
made helpful comments. Ganesh Sitaraman and Jonathan Lackow
offered important drafting assistance. Thanks are also due to
Abbye Atkinson, Brett Arnold, Cole Bolton, Marc Farris, Arthur
Kimball-Stanley, Gregory Lablanc, Eric Nguyen, Adam Pollet, Walter Rahmey, Chris Theodoridis, Patrick Tierney, and Chieh-Ting
Yeh, who contributed careful and detailed research to this undertaking.
The Panel also gratefully acknowledges the assistance of Christine Sgarlata Chung, assistant clinical professor of law and director
of the Securities Arbitration Clinic at Albany Law School, and
David P. McCaffrey, distinguished teaching professor at Albany–
SUNY, the co-directors of the Center for Financial Market Regulation, in preparing the summaries of prior reports on regulatory reform contained in the appendix and the longer summaries of those
reports that may be found on the Panel’s Web site, cop.senate.gov.
The Panel is also grateful to the following individuals who generously provided their time and expertise to the preparation of this
report: Tobias Adrian, Professor Edward Balleisen, Dean Baker,
Brandon Becker, Pervenche Beres, Professor Bruce Carruthers,
Professor Lord Eatwell, Douglas Engmann, former Senator Phil
Gramm, Professor Michael Greenberger, Professor Joseph
Grundfest, Michael Jamroz, Robert Kelly, Professor Naomi
Lamoreaux, Professor Stan Liebowitz, Professor Andrew Lo, David
Raboy, Professor Hal Scott, L.W. Seidman, Professor Jay
Westbrook, Professor Luigi Zingales, Professor Todd Zywicki, and
the Squam Lake Working Group on Financial Regulation (including Martin Baily, Andrew Bernard, John Campbell, John Cochrane,
Doug Diamond, Darrell Duffie, Ken French, Anil Kashyap, Rick
Mishkin, Raghu Rajan, David Scharfstein, Matt Slaughter, Bob
Shiller, Hyun Song Shin, Jeremy Stein, and Rene Stulz). The Panel
thanks the following institutions and organizations for their contributions: Business Roundtable (including John Castellani and
Tom Lehner), the Chicago Board Options Exchange, the Financial
Industry Regulatory Authority, the Council of Institutional Investors (including Anne Yerger, Amy Borrus, and Jeff Mahoney), the
Consumer Federation of America (and Barbara Roper), the International Swaps and Derivatives Association (and Robert Pickel),
and the National Consumer Law Center (including Lauren Saunders and Margot Saunders). The Panel also benefited from the
guidance of David Einhorn, Sarah Kelsey, Arthur Levitt, Alex Pollock, Professor Robert Merton, and Lawrence Uhlick.

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VII. ABOUT THE CONGRESSIONAL OVERSIGHT PANEL

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In response to the escalating crisis, on October 3, 2008, Congress
provided the U.S. Department of the Treasury with the authority
to spend $700 billion to stabilize the U.S. economy, preserve home
ownership, and promote economic growth. Congress created the Office of Financial Stabilization (OFS) within Treasury to implement
a Troubled Asset Relief Program (TARP). At the same time, Congress created the Congressional Oversight Panel to ‘‘review the current state of financial markets and the regulatory system.’’ The
Panel is empowered to hold hearings, review official data, and
write reports on actions taken by Treasury and financial institutions and their effect on the economy. Through regular reports, the
Panel must oversee Treasury’s actions, assess the impact of spending to stabilize the economy, evaluate market transparency, ensure
effective foreclosure mitigation efforts, and guarantee that Treasury’s actions are in the best interests of the American people. In
addition, Congress has instructed the Panel to produce a special report on regulatory reform that will analyze ‘‘the current state of the
regulatory system and its effectiveness at overseeing the participants in the financial system and protecting consumers.’’
On November 14, 2008, Senate Majority Leader Harry Reid and
the Speaker of the House Nancy Pelosi appointed Richard H.
Neiman, Superintendent of Banks for the State of New York,
Damon Silvers, Associate General Counsel of the American Federation of Labor and Congress of Industrial Organizations (AFL-CIO),
and Elizabeth Warren, Leo Gottlieb Professor of Law at Harvard
Law School to the Panel. With the appointment on November 19
of Congressman Jeb Hensarling to the Panel by House Minority
Leader John Boehner, the Panel had a quorum and met for the
first time on November 26, 2008, electing Professor Warren as its
chair. On December 16, 2008, Senate Minority Leader Mitch
McConnell named Senator John E. Sununu to the Panel, completing the Panel’s membership.
Congressman Hensarling and former Senator Sununu did not approve this report. Their alternative view is included in the following section.

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VIII. ADDITIONAL VIEWS
RICHARD H. NEIMAN
I am pleased to support the Panel’s special report on regulatory
reform, which begins to address some of the most critical issues
facing our nation, such as improving consumer protection, reducing
systemic risk, eliminating regulatory gaps, and enhancing global
co-ordination of supervision. These are precisely the issues we need
to address in these unprecedented times, when Americans are losing their homes, and the financial system and our economy are at
greater risk than at any time since the Depression.
Addressing any one of these issues individually would be a challenge; compiling a report that addresses them all within nine short
weeks was a herculean task. Given the diversity of backgrounds
and ideological views of the Panel members, the fact that we have
reached agreement on the critical issues and on many action items
to address those issues is truly remarkable.
As the only regulator on the panel, I find it appropriate to highlight certain issues of particular importance and to which I bring
a unique perspective.
STATES MUST BE ALLOWED TO INCREASE THEIR ROLE IN PROTECTING
CONSUMERS

States have long strived to protect their citizens from harmful financial products and should continue to carry out this vital role.
States, like New York, sounded an early alarm on subprime lending by adopting anti-predatory lending legislation and reaching
landmark settlements with the nation’s top mortgage bankers, providing hundreds of millions of dollars in consumer restitution and
improving industry practices.
Rather than join with the states, however, the OCC and the OTS
thwarted state efforts, by claiming broad field preemption and then
failing to adopt measures that protected consumers. This federal
overreach caused gaps in consumer protection standards, as more
protective state laws were set aside without being replaced by appropriate national standards or equivalent enforcement efforts.
I want to underscore the Panel’s recommendation to eliminate
federal preemption of state consumer laws and confirm the ability
of states to examine and enforce compliance with federal and state
consumer protection laws. The recommendations will restore the
appropriate balance between federal and state regulators and provide the basis for a ‘‘New Federalism.’’ It will draw on what is best
about our current dual banking system, close gaps in consumer
protection, and maximize the effectiveness of the joint resources of
state and federal regulators.
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THE FEDERAL RESERVE BOARD SHOULD SET MINIMUM FEDERAL
STANDARDS FOR CONSUMER PROTECTION

The Panel’s report calls for the establishment of a single federal
regulator that would have overarching consumer protection responsibilities, such as setting national minimum standards. We need to
establish adequate baseline consumer protections for all Americans. Under this proposal, states could adopt more stringent requirements than the federal body, as local conditions warranted,
and could regulate consumer protection standards in the absence
of federal action. This would allow states to serve as incubators to
develop innovative regulatory solutions. Laws that are tried first at
the state level and found successful often serve as the model for
laws at the national level.
The national minimum standards should go beyond required disclosures and extend to substantive regulation of consumer financial
products. Disclosure alone does not address the issues that gave
rise to the current crisis. We need to address key issues, including
affordability, suitability, and the duty of care owed by financial
services providers to consumers.
While I wholeheartedly support a heightened emphasis on consumer issues, I believe the functions of consumer protection should
not be separated from the role of safety and soundness. Loans that
take unfair advantage of consumers adversely affect the safety and
soundness of financial institutions. Regulators must consider an institution’s activities holistically, to detect emerging problems and
have adequate tools to respond. Too narrow a mission could lead
to myopic, impractical regulations, increasing the likelihood of negative unintended consequences and threatening to undermine the
safety and soundness of financial institutions. Assigning the consumer protection function to a new stand-alone agency with a limited mandate would create yet another federal bureaucracy, at a
time when I believe we need to be streamlining and avoiding
counter-productive regulatory turf wars.
I recognize that the Federal Reserve Board may have been slow
to take up consumer protection responsibilities placed on it by Congress. However, I believe that the current crisis has demonstrated
to the Fed the importance of consumer protection to the health of
our financial institutions and the economy as a whole.
THE FEDERAL RESERVE BOARD SHOULD BE THE SYSTEMIC REGULATOR

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The Panel’s report correctly identifies the need for a federal systemic risk regulator, and I concur with proposals, such as those by
the Group of Thirty, that this role be performed by a country’s central bank.
The current crisis has demonstrated that the Federal Reserve
Board, our nation’s central bank, is ideally suited to harness the
tools available to it to address systemic risk. The Fed has played
a pivotal role in designing and implementing solutions to the current financial crisis and has gained unparalleled insight into risks
presented by non-banking as well as banking institutions. However, the Fed still has no explicit authority over many non-banking
organizations that meet the definition for being ‘‘systemically significant.’’ The Fed’s function in setting monetary policy, as well as

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supervising banking organizations and providing discount window
facilities, strategically places it at the heart of the nation’s regulatory nerve center. Creating new agencies to perform these broader systemic tasks would needlessly duplicate existing functions, dilute current levels of expertise and fail to take advantage of the
wealth of experience accumulated by the Fed. The Federal Reserve’s mission could easily be updated to formally incorporate
these tasks into a broader mandate. I am confident that result
would be a healthier, more vibrant financial system.
WE NEED TO RESTORE THE CONFIDENCE OF THE AMERICAN PUBLIC

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As the Panel’s report states, we need to restore a proper balance
between free markets and the regulatory framework, in order to
ensure that those markets operate to protect the economy, honest
market participants and the public. I look forward to working with
Congress to address the issues the report identifies, so that we can
restore the confidence of the American public in the financial services system.

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CONGRESSMAN JEB HENSARLING AND FORMER
SENATOR JOHN E. SUNUNU
PREFACE

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As part of the Economic Emergency Stabilization Act of 2008
(Pub. L. No. 110–343), Congress required that the newly established Congressional Oversight Panel (the Panel) prepare a report
‘‘analyzing the current state of the regulatory system and its effectiveness at overseeing the participants in the financial system and
protecting consumers, and providing recommendations for improvement, including recommendations regarding whether any participants in the financial markets that are currently outside the regulatory system should become subject to the regulatory system, the
rationale underlying such recommendation, and whether there are
any gaps in existing consumer protections.’’ Even in an environment where dozens of organizations have already offered their own
perspective on the economic crisis and regulatory reform, assembling such a document in the short time the Panel has been in operation would be a daunting task. Adding to the challenge, the
Panel is a diverse group which possessed a dedicated, but minimal
staff well into the middle of January. As a result, much of the work
drafting the Panel Report was given to individuals outside its operation.
Building consensus over such a broad range of economic questions would be difficult in any event. The timing and process for
preparing this document, unfortunately, made it more so. Given
the differences that remain regarding our views of the systemic
weaknesses that led to the crisis, and, more important, policy recommendations for reform, we have chosen not to support the Panel
Report as presented. Instead, we provide here a more concise statement of the underlying causes of the current financial crisis and a
series of recommendations for regulatory modernization. While
there are several points in the Panel Report with which we agree,
we also provide a summary of several areas where our disagreement led us to oppose the final product.
This statement is organized into several sections:
1. Introduction
2. Observations on Current State of Financial Regulation
3. Underlying Causes of the Credit Crisis
4. Recommendations for Financial Service Regulatory Modernization and Reform
5. Differences with Congressional Oversight Panel Recommendations
In preparing this summary, we drew heavily from several
sources, which presented a range of views, but in which we also
shared many common themes and recommendations. These include
the Group of 30’s Financial Reform: A Framework for Financial
Stability, the Committee on Capital Markets Regulation’s Recommendations for Reorganizing the U.S. Financial Regulatory
Structure, the GAO’s A Framework for Crafting and Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System, and the Department of the Treasury’s Blueprint for a Modernized Financial Regulatory Structure. Others playing an influential

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role in helping frame the often complicated policy questions engendered by this work include the scholars at the American Enterprise
Institute (AEI), particularly Peter Wallison and Alex Pollock, as
well as those at George Mason University’s Mercatus Center, including Professor Todd Zywicki, Houman B. Shadab, and Satya
Thallam.
If one theme emerged among others in these differing perspectives on the challenges ahead, it is that our pursuit should not be
simply to identify new rules or areas in which to regulate, but to
build a structure and system that is modern and appropriate to the
institutions and technologies being used every day. A well-designed
system should enhance market discipline, minimize risks to taxpayers, and avoid the pitfalls of unintended consequences. We hope
our recommendations are true to these objectives.
INTRODUCTION

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Since the collapse and rescue of Bear Stearns in March 2008, legislators, regulators, and financial market participants have found
themselves enmeshed in a discussion of whether the financial system needs to be saved, and, if so, how best to save it. In October
2008, Congress passed the Emergency Economic Stabilization Act
(EESA), which made available $700 billion for the purpose of purchasing mortgage-backed securities from financial institutions in
hope of stabilizing the financial system. Shortly after Congress
voted to make these funds available, the Treasury Department
changed course and instead decided to purchase capital in the nation’s financial institutions to free up credit markets.
Recent events—including additional losses by the nation’s financial institutions, new Treasury programs to support two of the
country’s largest financial firms, and reports that the sums spent
thus far on recapitalizing financial institutions have had only modest impact—demonstrate that while identifying problems in a marketplace might be easy, the task of isolating those problems, diagnosing their cause, and discerning how best to address them remains challenging. The conversation over how best to revive the financial system continues, and despite its urgency, it is essential
that the participants in that conversation not rush to act in pursuit
of a plan that fails to solve the problems we face, or makes them
worse.
Beyond the pressing challenges to stabilize our economic system,
however, is the broader question of how best to oversee our financial system. If reorganization is to be done responsibly, it will demand an extraordinary amount of study, research, thought, and
discussion, beginning with a careful, unbiased consideration of
what exactly led to the crisis that now threatens our financial system. The observations and recommendations contained in these
views should therefore be viewed as a preliminary contribution to
the debate, not the final word. If not for reasons of modesty, then
for reasons of prudence and responsibility, readers should be cautioned that this represents the opening round of a longer conversation regarding the future of our financial system.
While the rapid escalation of the credit crisis last fall forced Congress to forgo a more deliberative process in considering policy options to respond, it is widely acknowledged now by both proponents

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and opponents of congressional action that properly addressing this
crisis will involve a more carefully crafted response than the broadly defined powers given to Treasury under the $700 billion EESA.
The stakes are no less important in regulating our financial system, for the consequences of mistakes made in rushing to fix a
problem not fully understood will sow the seeds of even greater
problems in the future.
As a precursor for constructive reform, policy makers must first
avoid a reflexive urge to simply write new rules. In the wake of the
largest financial crisis since the Great Depression, some have
called immediately to ‘‘reregulate’’ the financial system to prevent
calamities like this from occurring again. Those that believe that
regulation is the only answer, however, ignore the significant ways
in which government intervention magnified our existing problems.
In fact, there are few, if any, segments of the economy in which
government regulates, intervenes, and legislates as heavily as it
does in the financial and housing sectors. Before embracing more
government regulation as the only answer, such advocates should
consider the many ways in which government regulation itself can
be part of the problem. The history of financial regulation is replete
with such examples as either regulators or regulation have simply
failed or made matters worse.
In fact, the hallmark of past efforts to regulate the financial system has been that government regulation frequently fails. History
has also repeatedly shown us that adding rigid new government
regulations in the midst of a crisis to solve existing problems may
be like the old military adage of armies being prepared to fight the
last war. For example:
1. For decades, banking regulators tried to fix deposit prices
nationally through ‘‘Regulation Q,’’ which effectively denied
savers significant amounts of interest and, in turn, imperiled
thrifts and banks as deposits fled when interest rates were
high. As with all government regulation, Reg Q was grounded
in the belief that government mandates could manage market
forces and keep banks safer.
2. Twenty years ago, in response to the failure of 1,600 commercial banks in the savings and loan crisis, the federal government enacted the Federal Deposit Insurance Corporation
Improvement Act of 1991 (Pub. L. No. 102–242) (FDICIA),
which significantly tightened bank and S&L regulation in an
attempt to generate stability. However, the tougher restrictions
of FDICIA did not fix the problem, and the savings and loan
crisis ended up costing American taxpayers over $120 billion.114
3. More recently, state and federal legislation mandated the
use of credit ratings from a few rating agencies, which effectively transformed these agencies into a government-sponsored
cartel. What began as an impulse to bring safety and objectivity to the regulation of broker-dealers ended by creating a

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114 Timothy Curry and Lynn Shibut, The Cost of the Savings and Loan Crisis: Truth and Consequences, FDIC Banking Review (December 2000) (online at www.fdic.gov/bank/analytical/banking/2000dec/brv13n2l2.pdf).

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concentrated point of failure, jeopardizing the entire financial
system.
4. Finally, there is the example of the Federal Reserve’s effort to use monetary policy to avoid the recessionary effects of
the tech bubble’s bursting, only to find that in doing so, it had
helped create the housing bubble.
In addition to its demonstrated failure in preventing financial
collapse, regulation imposes significant costs on the financial system in several ways. For example, rather than increasing stability
and enhancing safety, regulation can invite chaos and encourage
otherwise irrational risk taking among market participants who
falsely believe that government will act as a guardian angel to protect them. Market participants thus underprice risk because they
conjecture government has managed the risks that market participants would otherwise have had to assess. However, in reality, any
government—from our current one to the most heavy-handed of all
totalitarian central planners—can never completely regulate a market given its resource constraints and the ingenuity of individual
entrepreneurs with a proper profit motive.
Regulation can also reduce competition because its costs are
more easily borne by large companies than by small ones. Large
companies also have the ability to influence regulators to adopt
regulations that favor their operations over those of smaller competitors. This is particularly true when regulations add costs that
smaller companies cannot bear. Take, for example, the continuing
decline in the number of community banks, the locally owned and
operated institutions at the heart of many small towns and cities
across the county. In 2004, the Federal Deposit Insurance Corporation (FDIC) released a report on the future of banking that found
that although community banks still make up a majority of the
banking industry, the number of community banks had been cut almost in half since 1985. The report also found that their deposit
share has also declined significantly in that time frame as large
banks extended their geographic reach.115 Regulation also may
keep low cost producers or international competitors out of regulated markets.
Regulation can also harm consumers in the form of higher costs,
less innovation, and fewer choices. Regulatory costs are passed
along to consumers through higher prices for services or products.
For an example, one need only look at their monthly telephone bill
to see firsthand how the cost of various government regulations imposed on phone services are directly passed on to consumers in the
form of new fees. Since the application of regulations over a population is generally universal but the direct benefits are often only
individually realized, many regulations end up imposing costs on
all consumers for the benefit of a limited few. Additionally, the associated cost of some regulations end up exceeding their value by
adding costs to the process of developing new products or new services. There are countless examples of this phenomenon in the insurance industry, where it can take years to achieve the regulatory

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115 Tim Critchfield with Tyler Davis, Lee Davison, Heather Gratton, George Hanc, and Katherine Samolyk, Community Banks: Their Recent Past, Current Performance, and Future Prospects (2004) (online at www.fdic.gov/bank/analytical/future/fobl03.pdf) (hereinafter ‘‘FDIC Future of Banking Study’’).

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approval needed to roll out a new product offering or, in some bewildering cases, to enact rate reductions for the benefit of consumers if the reduction is approved at all.116
Instead of creating new regulatory hurdles, a superior approach
to better protect consumers and preserve wealth-creating opportunities is to enhance and reinforce wise regulation while bolstering
private sector market discipline. This belief was well articulated in
March 2000, when Gary Gensler, then Under Secretary for Domestic Finance in President Clinton’s Treasury Department and currently President Obama’s nominee to chair the Commodity Futures
Trading Commission (CFTC), testified before the House Financial
Services Committee regarding systemic risk in our capital markets.
Over the course of his remarks, Gensler explained that instead of
advocating for new or increased regulations, the approach supported by Treasury emphasized the formative role of the private
sector in protecting market participants:
The public sector has three roles. . . . Promoting market discipline means crafting government policy so that
creditors do not rely on governmental intervention to safeguard them against loss.
Transparency is the necessary corollary to market discipline. The government cannot impose market discipline,
but it can enhance its effectiveness by promoting transparency. Transparency lessens uncertainty and thereby
promotes market stability.
Promoting competition in financial markets lessens systemic risk. The task of public policy must be to ensure the
stability and integrity of the market system. In any sector
of the financial market, the dominance of one or two firms
can lessen competition and the efficiency of the market
pricing mechanism. In addition, the entry of a subsidized
financial institution into a market may motivate other
firms to take on greater risks and weaken their operating
results.117
Under Secretary Gensler had the right idea then, and his words
should help provide the framework for the structural changes to
our regulatory regime that we are now considering.
OBSERVATIONS ON CURRENT STATE OF FINANCIAL REGULATION

The United States has the most robust, accessible, and sound financial structure of any country in the world. That structure has
provided unparalleled opportunities for millions, from seasoned
market participants to casual investors to hardworking teachers
and nurses hoping to live out the American dream. The success of
our structure has been based on market discipline coupled with an
appropriate level of regulation that fosters competition, transparency, and accountability.

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116 John Kennedy, Gov. Crist, State Regulators Reject State Farm’s 7 Percent Rate Reduction,
Chicago Tribune (July 31, 2007) (online at www.chicagotribune.com/business/sfl0731statefarm,0,3467689.story).
117 House Financial Services Committee, Subcommittee on Capital Markets, Securities, and
Government Sponsored Enterprises, Testimony of Gary Gensler, Securities and Government
Sponsored Enterprises, 106th Cong. (Mar. 22, 2000) (online at financialservices.house.gov/banking/32200gen.htm).

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Yet recently, this approach has been attacked by a small but
vocal chorus claiming that two decades of financial deregulation
has initiated the crisis that our financial system is now facing.
These advocates of expanded government power contend that for
years, government has been hard at work repealing all aspects of
regulation in our financial sector. However, while such rhetoric
might elicit some populist appeal, such claims do not bear scrutiny
because the facts simply do not exist to support them.
One frequent argument heard from many critics is that the
Gramm-Leach-Bliley Act (P.L. 106–102), which repealed the Depression-era Glass-Steagall Act’s separation of investment and commercial banking, was somehow responsible for the current credit
crisis. To the contrary, a wide variety of experts across the political
spectrum have dismissed that claim as ‘‘a handy scapegoat’’118 at
best. When asked in October 2008 if Gramm-Leach-Bliley was a
mistake, Alice M. Rivlin, the former director of both the Congressional Budget Office and the Office of Management and Budget,
testified: ‘‘I don’t think so, I don’t think we can go back to a world
in which we separate different kinds of financial services and say
these lines cannot be crossed. That wasn’t working very well. . . .
We can’t go back to those days, we have got to figure out how to
go forward.’’ 119 Even former President Bill Clinton remarked in a
2008 interview that ‘‘I don’t see that signing that bill had anything
to do with the current crisis.’’ 120 If anything, Gramm-Leach-Bliley
has played a significant role in attenuating the severity of this crisis by allowing commercial banks to merge with floundering investment banks—like JPMorgan Chase and Bear Stearns, Bank of
America and Merrill Lynch, and Goldman Sachs and Morgan Stanley—actions that would have been explicitly prohibited had the
Glass-Steagall Act still been in effect.
Although the advocates for expanded government power would
have you believe otherwise, a careful examination of the historical
record points toward the conclusion that regulation of the financial
services sector has at least held constant if not substantially increased in recent years. One need only think about the sprawling
regulatory mandate that the Sarbanes-Oxley Act (P.L. 107–204)
imposed upon our financial system. Intended to toughen financial
reporting requirements in the wake of the Enron scandal, Sarbanes-Oxley has created many needed reforms but its burden has
also resulted in many companies taking their business—and their
money—overseas. The result has been a flow of capital away from
the U.S., capital which could have helped to shore-up American
banks. In addition to Sarbanes-Oxley, over the last twenty years
the federal government has implemented a wide array of new regulations on banks, mortgage lenders, and other financial services
companies. These new regulations include:
118 David

Leonhardt, Washington’s Invisible Hand, New York Times (Sept. 26, 2008).
Financial Services Committee, Oral Remarks of Alice Rivlin, The Future of Financial Services Regulation, 110th Cong. (Oct. 21, 2008) (online at financialservices.house.gov/
hearing110/hr102108.shtml).
120 Bill v. Barack on Banks, Wall Street Journal (Oct. 1, 2008) (online at online.wsj.com/article/SB122282635048992995.html).
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119 House

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1. The Federal Deposit Insurance Corporation Improvement Act
of 1991 (P.L. 102–242), which was designed to improve bank supervision, examinations, and capital requirements.
2. The Home Ownership and Equity Protection Act (HOEPA) of
1994 (P.L. 103–325), which mandates enhanced disclosures by
lenders who make certain high-cost refinancing loans to borrowers.
3. The 1989 and 2002 expansions of the mandated data furnished
by lenders under the Home Mortgage Disclosure Act (HMDA).
4. The 2001 Bank Secrecy Act amendments made by the USA
PATRIOT Act (P.L. 107–56), which enhanced anti-terrorist and
money laundering record-keeping requirements for banks.
5. The Fair and Accurate Credit Transactions Act of 2003 (P.L.
108–159), which created new information sharing, indentify theft
protection, and consumer disclosure mandates.
6. The Bankruptcy Abuse Prevention and Consumer Protection
Act of 2005 (P.L. 109–8), which required lenders to provide new
disclosures regarding credit offers and interest rates.
7. Various other Truth in Lending Act (TILA)/Regulation Z regulations and other federal banking agency guidance regarding lending, offers of credit, and consumer protections.
In fact, instead of wholesale deregulation, the case can be made
that government has made concerted efforts to strengthen the very
regulations that helped set the stage for the current financial crisis. To take one obvious example, there has been a strengthening
of the Community Reinvestment Act, which has encouraged banks
to make mortgage loans to borrowers who previously would have
been rejected as non-creditworthy. Also, the Department of Housing and Urban Development’s (HUD) affordable housing mandates
for the government-sponsored enterprises (GSEs) were steadily increased from the 1990s through 2008, adding new targets and rules
that compelled Fannie and Freddie to take certain loan purchasing
actions to stay in compliance. Additionally, U.S. bank regulators
are moving to quickly implement new capital requirements through
the Basel II capital accord, which was less than two years old when
plans for its adoption were announced on September 30, 2005.
These untested rules will replace the Basel I rules that generally
assigned lower capital charges for housing assets, which tended to
increase the leveraging of housing-related assets, making our financial system less stable.121
Furthermore, proponents of the ‘‘regulation is the cure’’ argument must bear in mind that the most egregious financial failures
have occurred not in the unregulated financial markets of hedge
funds and over-the-counter derivatives, but in the highly regulated
world of commercial and investment banking, where regulation has
been the most burdensome. The former U.S. investment banks—
which bought the so-called toxic assets that have been identified as
one of the root causes of the financial crisis—were regulated by the
Securities and Exchange Commission (SEC). Yet that supervision
was insufficient to prevent the collapse of Bear Stearns or Lehman
Brothers, two of this nation’s largest investment banks, or the

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121 Risk-based Capital Standards: Advanced Capital Adequacy Framework—Basel II, 72 Fed.
Reg. 69,288 (Dec. 7, 2007) (to be codified at 12 C.F.R. pts. 3, 208, 225, 325, 559, 560, 563, 567)
(online at www.setonresourcecenter.com/register/2007/Dec/07/69288A.pdf).

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charter transformation of two other large investment banks, Goldman Sachs and Morgan Stanley, into bank holding companies. The
credit rating agencies that blessed these products with AAA ratings
were also regulated by the SEC, yet that supervision was not
enough to prevent the inaccurate evaluations and gross errors in
judgment of those agencies.
This nation’s highly regulated commercial banks, subject to regulation by several agencies similarly snapped up large quantities of
these assets, all while supposedly under the oversight and supervision of their regulators. Yet the results of this country’s heavy
regulation of commercial banks have also been abysmal. Wachovia,
formerly the nation’s fourth largest bank, was regulated by the
Comptroller of the Currency (OCC). Countrywide Financial was a
national bank under OCC supervision until mid-2007, and then it
became a federal thrift regulated by the Office of Thrift Supervision (OTS). Washington Mutual, IndyMac and Downey Savings
and Loan Association were all also federal thrifts regulated by the
OTS. All five were well regulated. And the housing market collapse
caused all five to fail.122
By contrast, many of the less stringently regulated actors in the
financial system, such as hedge funds and other private pools of
capital, and less stringently regulated products, such as derivatives
and swaps traded over the counter, seem to have weathered the
crisis better than their highly regulated counterparts. While investors in some of those products have lost money, and some of the
companies engaged in those lines of business have closed their
doors, these failures did not produce massive systemic risk concerns that required federal intervention placing taxpayer dollars at
risk.
These observations lead to the clear point that heavy regulation,
despite the outsized claims made for its effectiveness in avoiding
crisis, will not solve our problems. As financial historian Bernard
Shull stated in a 1993 paper on the matter:
Comprehensive banking reform, traditionally including
augmented and improved supervision, has typically evoked
a transcendent, and in retrospect, unwarranted optimism.
The Comptroller of the Currency announced in 1914 that,
with the new Federal Reserve Act, ‘‘financial and commercial crises or panics . . . Seem to be mathematically impossible.’’ Seventy-five years later, confronting the S&L
disaster with yet another comprehensive reform . . . The
Secretary of the Treasury proclaimed ‘‘two watchwords
guided us as we undertook to solve this problem: Never
Again.’’ 123
More than fifteen years after Shull’s paper, many stand ready to
march down the same well-worn path, clinging to the belief that
heavy-handed regulation holds the answer. Those claims should be
rejected. There is a better and more effective path to choose.

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122 Binyamin Appelbaum and Ellen Nakashima, Banking Regulator Played Advocate Over Enforcer, Washington Post (Nov. 23, 2008.) (online at www.washingtonpost.com/wp-dyn/content/article/2008/11/22/AR2008112202213lpf.html).
123 Bernard Shull, The Limits of Prudential Supervision: Economic Problems, Institutional
Failure and Competence (1993) (online at www.levy.org/download.aspx?file=wp88.pdf&
pubid=378).

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A BRIEF HISTORY OF THE SUBPRIME CRISIS

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To some observers, the turmoil in the U.S. financial markets,
caused by severe dislocations in the country’s housing markets, has
heralded the end of the free-market system. But with all due respect to the critics of capitalism, the economic crisis in which the
country now finds itself reflects not the failure of the free-market
system, but more so the result of decades of misguided government
policies that interfered with the functioning of that system. While
recent events demonstrate a need for regulatory reform, modernization, and improvement, the larger lesson is that a number of wellmeaning but clearly misguided government policies distorted America’s housing markets, which in turn produced grave consequences
for the financial system and the underlying economy.
In a rush to be seen as doing ‘‘something’’ in response, the advocates of expanded government power have brought forward a range
of old proposals to regulate, reregulate, and overregulate any and
every aspect of our economy. We believe a more practical approach
would be to identify and correct the government policies that inflated the housing bubble underlying this crisis and then decide
what change is necessary. Thus, the essential debate is not between deregulation and re-regulation, but instead between wise
regulation and counterproductive regulation. Wise regulation helps
make markets more competitive and transparent, empowers consumers with effective disclosure to make rational decisions, effectively polices markets for force and fraud, and reduces systemic
risk. Counterproductive regulation hampers competitive markets,
creates moral hazard, stifles innovation, and diminishes the role of
personal responsibility in our economy. It is also procyclical, passes
on greater costs than benefits to consumers, and needlessly restricts personal freedom.
Those who simply advocate for reregulation because they claim
that the free markets have failed ignore the various ways that government itself helped set the stage for the current financial crisis.
The housing sector—where the difficulties confronting our markets
started—is not a deregulated, free-market in any sense of the word.
This country’s housing market is overloaded with substantial government components, including the regulatory roles of large government agencies; implicit and explicit government guarantees
supporting the underwriting, issuance, and securitization of mortgages; and a cluster of mandates aimed at achieving universal
home ownership. Indeed, the crisis this country finds itself facing
does not stem from deregulation (since little has taken place over
the last couple of decades) or even the mistakes of participants in
the free market (although many harmful mistakes were committed), but instead from the myriad ways in which government
initiatives interfered with the functioning of private markets.
Our observations have led us to conclude that there are at least
five key factors that led to the current crisis:
1. A highly accommodative monetary policy that lowered interest rates dramatically, kept them low, and inflated the
housing bubble.

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2. Broad federal policies designed to expand home ownership
in an ‘‘off-budget’’ fashion, which encouraged lending to those
who could not afford home ownership.
3. The moral hazard inherent in Fannie Mae and Freddie
Mac, the two failed GSEs, which exploited their congressionally granted duopoly status to benefit from privatized profits
earned against socialized risks taken.
4. An anticompetitive government sanctioned credit rating
oligopoly that misled investors and failed in its responsibility
to provide accurate, transparent assessments of risk.
5. Failures throughout the mortgage securitization process
that resulted in the abandonment of sound underwriting practices.
Monetary Policy. The Federal Reserve set the stage for a wave
of mortgage borrowing by keeping credit conditions too loose for too
long earlier this decade. In response to the bursting of the hightech bubble in 2000, the Federal Reserve began lowering interest
rates in early 2001 to cushion the economic fallout. These highly
accommodative policies were maintained in response to the 2001
recession and the economic shock of the 9–11 terrorist attacks. The
target for the federal funds rate—the benchmark interbank lending
rate in the U.S.—was lowered to just 1 percent by mid-2003, and
maintained at that level until mid-2004.124 The real funds rate—
which is the difference between the funds rate set by the Federal
Reserve and expected inflation—demonstrates just how aggressively the Federal Reserve was in conducting monetary policy during this period. The real funds rate dropped from 4 percent in late
2000 to ¥1.5 percent by early 2003.125
The Federal Reserve’s decision to cushion the economic blow
from the dramatic collapse in equity prices unleashed a wave of
cheap credit on a housing market that was already experiencing a
boom cycle. By mid-2003, the interest rate on a conventional thirtyyear mortgage dipped to an all-time low of just 5.25 percent, fueling demand in the housing market thanks to mortgage credit that
had become cheap and plentiful in light of the Federal Reserve’s
rate cuts.126 As a result of demand and cheap credit, new home
construction rose to a twenty-five-year high in late 2003, and remained at historic levels for two years.127
It has been widely reported that over the last fifty years, there
has not been a single year in which the national average home
value had fallen despite some regional declines and various economic troubles and recessions. The allure of this statistic was so
appealing that even former Federal Reserve Chairman Alan Greenspan and current Chairman Ben Bernanke at various points attested to it in defense of our housing markets. In fact, a 2004 report by top economists from Fannie Mae, Freddie Mac, the Na-

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124 Federal Reserve Board, Open Market Operations (online at www.federalreserve.gov/fomc/
fundsrate.htm) (accessed Jan. 26, 2009).
125 Mark Zandi, Financial Shock: A 360° Look at the Subprime Mortgage Implosion, and How
to Avoid the Next Financial Crisis (2009).
126 Federal Reserve Bank of St. Louis, Economic Research (online at research.stlouisfed.org/
fred2/series/MORTG/).
127 Remarks of John B. Taylor at the Symposium of Housing, Housing Finance, and Monetary
Policy sponsored by the Federal Reserve Bank of Kansas City in Jackson Hole, Wyoming (Sept.
2007) (online at www.kc.frb.org/PUBLICAT/SYMPOS/2007/PDF/Taylorl0415.pdf).

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tional Association of Realtors, the National Association of Home
Builders, and the Independent Community Bankers of America entitled America’s Home Forecast: The Next Decade for Housing and
Mortgage Finance even concluded that ‘‘there is little possibility of
a widespread national decline since there is no national housing
market.’’ 128 This widely held belief augmented Federal Reserve
monetary policy and further inflated the housing bubble.
Even with the brisk pace of home construction, demand still outstripped supply, pushing home prices even higher. Between 1995
and 2002, in the midst of the housing boom, home prices appreciated between 2 percent and 5 percent a year. By 2004 and 2005,
at the height of the bubble, home prices were appreciating at nearly 15 percent per year. Between 1997 and 2006, real home prices
for the U.S. as a whole increased 85 percent. Another measure of
the unsustainable inflation that took place in housing prices is the
relationship between house prices and rents. Over the past twentyfive years, the price-to-rent ratio was roughly 16.5. In 2003, at the
start of the bubble, the price-to-rent ratio was 18.5. It then quickly
grew to an all-time peak of 25 by the end of 2005.129
The bubble grew as cheap credit and sharply increasing home
prices fueled the frenzy of first-time homeowners eager to buy into
a market before prices got out of reach. It also encouraged current
homeowners to purchase bigger homes or to buy additional properties for investment purposes. Federal Reserve economists have
estimated that the share of investment real estate purchases
jumped to roughly 17 percent in 2005 and 2006 at the height of the
housing boom, up from just more than 6 percent a decade earlier.130
These double digit increases in housing prices not only stimulated demand among home buyers who wanted to get into the
housing market before they were priced out or were eager to invest
on rising home prices, they also created an environment in which
lenders, securitizers, and investors believed that it was impossible
to make a bad loan. The consequences should have been foreseeable. Borrowers bought bigger, more expensive homes, betting that
perpetually rising housing prices would allow them to refinance
their mortgages at a later date while benefiting from ongoing appreciation in housing values. Lenders assumed that even if buyers
defaulted, rising house prices would allow them to sell the home for
more than the amount owed by the borrower.
Economists have consistently identified the Federal Reserve’s accommodative monetary policy as one cause of the current financial
crisis. For example, John B. Taylor, a professor of economics at
Stanford and the creator of the ‘‘Taylor rule’’ guideline for monetary policy, has said the Federal Reserve made a mistake by keeping interest rates so low. According to Taylor’s formula, the Federal
Reserve should have raised interest rates much sooner than it did

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128 David Leonhardt and Vikas Bajaj, Drop Foreseen in Median Price of U.S. Homes, New
York
Times
(Aug.
26,
2007)
(online
at
www.nytimes.com/2007/08/26/business/
26housing.html?ei=5090&en=9bd44f2f8b0ef4f4&ex=1345780800&partner=rssuserland&emc=rss&pagewanted=all).
129 Zandi, supra note 125; Robert J. Shiller, The Subprime Solution: How Today’s Global Financial Crisis Happened, and What to Do About It (2008).
130 Robert B. Avery, Kenneth P. Brevoort, and Glenn B. Canner, The 2006 HMDA Data, Federal Reserve Bulletin (Dec. 2007).

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given the economic conditions at the time. Taylor himself has said
that ‘‘a higher funds path would have avoided much of the housing
boom. . . . The reversal of the boom and thereby the resulting
market turmoil would not have been as sharp.’’131 Given the key
role that the Federal Reserve’s monetary policy has played in contributing to the credit crisis we now face, it must be acknowledged
that those decisions had a major impact on market conditions and
helped to influence how investors chose to allocate their capital in
our economy.
Federal Policy to Expand Home Ownership. For well over twenty
years, federal policy has promoted lending and borrowing to expand
homeownership, through incentives such as the home mortgage interest tax exclusion, the Federal Housing Administration (FHA),
and discretionary spending programs such as HUD’s HOME block
grant program. But perhaps the most damaging initiative undertaken by the federal government was the effort to pressure private
financial institutions to subsidize home ownership through the
Community Reinvestment Act (CRA). Undertaken with the best of
intentions—expanding home ownership among poor and underserved communities—the unintended consequences of the CRA
clearly demonstrate that government’s attempts to manipulate
market behavior to achieve social goals often lead to harmful results.
Enacted in 1977, the CRA encouraged banks to extend credit to
‘‘underserved’’ populations by requiring that banks insured by the
federal government ‘‘help meet the credit needs of its entire community.’’ To ensure that banks are meeting this mandate, each federally insured bank is periodically examined by its federal regulator. As a result of its enactment, bank lending to low- and moderate-income families has increased by 80 percent.132
In 1997, Wall Street firms, the GSEs, and the CRA converged in
a landmark event: the first securitization of CRA loans, a $384-million offering guaranteed by Freddie Mac.133 Over the next 10
months, Bear Stearns issued $1.9 billion of CRA mortgages, backed
by Fannie or Freddie, and between 2000 and 2002 this business accelerated in dramatic fashion as Fannie Mae issued $20 billion in
securities backed by CRA mortgages.134 By encouraging lenders
and underwriters to relax their traditional underwriting practices,
the CRA, investment firms and the GSEs saddled American taxpayers with the consequences of mortgages that borrowers cannot
repay.
Equally problematic are reports that some of these CRA-inspired
loans are mortgages that borrowers can repay, but choose not to,
given that the property that secures these loans is now worth less
than the amount outstanding. Whether borrowers cannot or will
not repay, the irony is that these lower-income home buyers—those
who were supposed to benefit from the government’s actions—are
now defaulting at a rate three times that of other borrowers. With
131 Taylor,

supra note 127.
Department of the Treasury, The Community Reinvestment Act after Financial Modernization: A Baseline Report (Apr. 2000).
133 First Union Capital Markets Corp., Bear, Stearns & Co. Price Securities Offering Backed
By Affordable Mortgages Unique Transaction to Benefit Underserved Housing Market (Oct. 20,
1997).
134 Fannie Mae Increase CRA Options, ABA Banking Journal (Nov. 1, 2000).
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132 U.S.

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these defaults, the damage to homeowners, neighborhoods, state
and local governments as the tax base shrinks, and now to all
American taxpayers, is enormous.
In the course of this crisis, there has been some heated discussion over the role CRA loans have played in contributing to our
current woes. Proponents of CRA-like mandates have maintained
that only a small portion of subprime mortgage originations are related to the CRA, and those CRA loans that have been written are
performing in a manner similar to other types of subprime loans.
Such claims, however, miss the fundamental point that critics of
the CRA have made: though they may be small in volume, CRA
loan mandates remain large in precedent because they inherently
required lending institutions to abandon their traditional underwriting standards in favor of more subjective models to meet their
government mandated CRA obligations.
For example, in April of 1993, the Boston Federal Reserve Bank,
under the leadership of future Freddie Mac Chairman Dick Syron,
published an influential best practices guide called Closing the
Gap: A Guide To Equal Opportunity Lending. The guide made several recommendations to lending institutions on various ways they
could increase their low-income lending practices. Some of these
recommendations, which encouraged institutions to abandon the
traditional lending and underwriting policies used to ensure the
quality of loans made, included:
1. ‘‘Special care should be taken to ensure that standards are
appropriate to the economic culture of urban, lower-income,
and nontraditional consumers.’’
2. ‘‘Policies regarding applicants with no credit history or
problem credit history should be reviewed. Lack of credit history should not be seen as a negative factor. . . . In reviewing
past credit problems, lenders should be willing to consider extenuating circumstances.’’
3. Institutions can ‘‘work with the public sector to develop
products that assist lower-income borrowers by using public
money to reduce interest rates, provide down payment assistance, or otherwise reduce the cost of the mortgage.’’
4. ‘‘A prompt and impartial second review of all rejected applications can help ensure fairness in the lending decision and
prevent the loss of business opportunities. . . . This process
may lead to changes in the institution’s underwriting policies.
. . . In addition, loan production staff may find that their experience with minority applicants indicates that the institution’s stated loan policy should be modified to incorporate some
of the allowable compensating factors.’’ 135
Taken in isolation, the good intentions of these recommendations
is plain; taken together, however, it is also clear that lenders were
being urged to abandon proven safety and soundness underwriting
standards in favor of new outcome-based underwriting standards.
Again, the salient point is not to debate the notion of could or
should more be done to make affordable loans available to underserved communities. The question is what damage is done to the

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135 Boston Federal Reserve, Closing the Gap: A Guide to Equal Opportunity Lending (Apr.
1993) (online at www.bos.frb.org/commdev/commaff/closingt.pdf).

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overall stability of an institution when it alters its lending guidelines to comply with a government mandate to advance a social policy.
Similarly, banks were urged by other private sector parties to ignore traditional lending guidelines, this time in the pursuit of
greater and faster profit. In May of 1998, Bear Stearns published
an article with guidance on why and how lenders should package
CRA loans into mortgage backed securities.136 That document advised lenders that: ‘‘Traditionally rating agencies view LTV (loanto-value ratios) as the single most important determinant of default. It is most important at the time of origination and less so
after the third year.’’ Bear Stearns also encouraged lower lending
standards by arguing that when ‘‘explaining the credit quality of a
portfolio to a rating agency or GSE, it is essential to go beyond
credit scores,’’ and that ‘‘the use of default models traditionally
used for conforming loans have to be adjusted for CRA affordable
loans.’’ While such advice might have been important to maximizing profitability, Bear Stearns’ guidance is yet one more example of how the conflict between a social policy mandate like the
CRA and the fiscal requirements of basic safety and soundness operations led to a dangerous diminution in lenders’ traditional underwriting standards.
The GSEs. Standing at the center of the American system of
mortgage finance are the two now-failed government-chartered behemoths created to expand homeownership opportunities: the Federal National Mortgage Association (Fannie Mae) and the Federal
Home Loan Mortgage Corporation (Freddie Mac). Market participants have long understood that this government created duopoly
was implicitly, though not explicitly, backed by the federal government. This ‘‘implied guarantee’’ flowed from several factors, including the very existence of a government charter that effectively
sanctioned this duopoly, access to a Treasury line of credit, and exemption from payment of state and local taxes. Although Fannie
and Freddie were nominally designed to be competitors, in practice
this implied guarantee allowed the two largely to work in unison
as a cartel to set and maintain prices in the market.
The dangers inherent in such an implied guarantee were twofold.
First, their unique status allowed Fannie and Freddie to borrow
funds in the marketplace at subsidized rates. Ostensibly, these
funds would be used to purchase mortgages from lenders, fulfilling
their mission to provide liquidity in the secondary mortgage markets. For over a decade, however, the GSEs continued to build
enormous investment portfolios, earning profits by arbitraging the
difference between their low, subsidized borrowing costs and the
higher yields in their portfolio’s ever riskier assets. Beginning in
1990, their investment portfolios grew tenfold, from $135 billion to
$1.5 trillion,137 allowing many of their shareholders and executives
to become personally wealthy thanks to the GSEs’ subsidized bor-

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136 Dale Westhoff, Packaging CRA Loans into Securities, Mortgage Banking (May 1, 1998) (online at www.allbusiness.com/personal-finance/real-estate-mortgage-loans/677967-1.html).
137 U.S. Department of the Treasury, Remarks of Assistant Secretary for Financial Institutions
Emil W. Henry Jr., before the Housing Policy Council of the Financial Services Roundtable (June
26, 2006) (online at www.ustreas.gov/press/releases/js4338.htm).

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rowing costs while the American taxpayer assumed most of the
risk.
Second, their implied guarantee created a false sense of security
and standards for the products they purchased and securitized.
This perception played a major role in the proliferation of GSEbacked subprime and Alt-A securities, providing a de facto government seal of approval for even the riskiest loans as market participants believed these securities were appropriately priced and represented minimal risk. Their predominance in the mortgage market meant that Fannie and Freddie’s business practices—credit rating, underwriting, risk modeling—were seen as the ‘‘gold standard’’
in the industry, despite flaws that later became apparent.
For its part, Congress substantially magnified these potential
risks by charging the GSEs with a mission to promote homeownership and thus inflating the supply of credit available to fund residential mortgages. The GSEs’ congressional mandate and their access to cheap funding allowed the government to pressure Fannie
and Freddie to expand homeownership to historically credit-risky
individuals without the burden of an explicit on-budget line item
at taxpayer expense, a budget goal long sought by housing advocates. For instance, in 1996, the HUD required that 42 percent of
Fannie’s and Freddie’s mortgage financing should go to borrowers
with income levels below the median for a given area.138 HUD revised those goals again in 2004, increasing them to 56 percent of
their overall mortgage purchases by 2008.139 In addition, HUD required that 12 percent of all mortgage purchases by Fannie and
Freddie be ‘‘special affordable’’ loans made to borrowers with incomes less than 60 percent of an area’s median income, and ultimately increased that target to 28 percent for 2008.140
These ‘‘affordable housing’’ goals and other federal policies succeeded at increasing the homeownership rate from 64 percent in
1994 to an all-time high of 69 percent in 2005.141 However, they
did so at a great cost. To meet these increasingly large government
mandates, Fannie and Freddie began to buy riskier loans and encouraged those who might not be ready to buy homes to take out
mortgages. This GSE-manufactured demand boosted home prices to
an artificially high level and fostered enthusiasm for the wave of
exotic mortgage products that began to flood the market.
For example, in 1999, under pressure from the Clinton Administration to expand home loans among low- and moderate-income
groups, Fannie Mae introduced a pilot program in fifteen major
markets encouraging banks to extend mortgage credit to persons
who lacked the proper credit histories to qualify for conventional
loans. The risks of such a program should have been apparent to
all. The New York Times, in a prescient comment on the program
at the time, remarked: ‘‘In moving, even tentatively, into this new
area of lending, Fannie Mae is taking on significantly more risk,
which may not pose any difficulties during flush economic times.
138 Russell

Roberts, How Government Stoked the Mania, Wall Street Journal (Oct. 3, 2008).

139 Id.
140 Id.

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141 Id.

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But the government-subsidized corporation may run into trouble in
an economic downturn, prompting an economic rescue.’’ 142
During this period, the government also began to push Fannie
and Freddie into the subprime market. In 1995, HUD authorized
Fannie and Freddie to purchase subprime securities that included
loans to low-income borrowers and allowed the GSEs to receive
credit for those loans toward their mandatory affordable housing
goals. Subprime lending, it was thought, would benefit many borrowers who did not qualify for conventional loans. Fannie and
Freddie readily complied, and as a result, subprime and near-prime
loans jumped from 9 percent of securitized mortgages in 2001 to 40
percent in 2006.143
Fannie’s and Freddie’s heavy involvement in subprime and AltA mortgages increased following their accounting scandals in 2003
and 2004 in an attempt to curry favor with Congress and avoid
stricter regulation. Data from these critical years before the housing crisis hit show Fannie and Freddie had a large direct and indirect role in the market for risky mortgage loans. In 2004 alone,
Fannie and Freddie purchased $175 billion in subprime mortgage
securities, which accounted for 44 percent of the market that year.
Then, from 2005 through 2007, the two GSEs purchased approximately $1 trillion in subprime and Alt-A loans, and Fannie’s acquisitions of mortgages with less than 10-percent down payments almost tripled.144
Without question, the purchase and securitization of such loans
by Fannie and Freddie was a clear signal and incentive to all loan
originators to write more subprime and Alt-A loans regardless of
their quality. As a result, the market share of conventional mortgages dropped from 78.8 percent in 2003 to 50.1 percent by 2007
with a corresponding increase in subprime and Alt-A loans from
10.1 percent to 32.7 percent over the same period.145 The message,
as The New York Times noted, was clear: ‘‘[T]he ripple effect of
Fannie’s plunge into riskier lending was profound. Fannie’s stamp
of approval made shunned borrowers and complex loans more acceptable to other lenders, particularly small and less sophisticated
banks.’’146 Soon, Fannie and Freddie became the largest purchasers
of the higher-rated (AAA) tranches of the subprime pools that were
securitized by the market. This support was essential both to form
these investment pools and market them around the world. Fannie
and Freddie thus played a pivotal role in the growth and diffusion
of the mortgage securities that are now crippling our financial system.
Fannie and Freddie also played a leading role in weakening the
underwriting standards that had previously helped ensure that
borrowers would repay their mortgages. For instance, in May 2008,
Fannie and Freddie relaxed the down payment criteria on the
mortgages they buy, accepting loans with down payments as low as

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142 Steven A. Holmes, Fannie Mae Eases Credit to Aid Mortgage Lending, New York Times
(Sept. 30, 1999).
143 Roberts, supra note 138.
144 American Enterprise Institute, Peter Wallison and Charles Calomiris, The Last TrillionDollar Commitment: The Destruction of Fannie Mae and Freddie Mac (Sept. 30, 2008).
145 Joint Center for Housing Studies, The State of the Nation’s Housing (2008) (online at
www.jchs.harvard.edu/publications/markets/son2008/index.htm).
146 Charles Duhigg, Pressured to Take More Risk, Fannie Reached Tipping Point, New York
Times (Oct. 5, 2008).

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3 percent.147 And in recent years both companies markedly stepped
up their guarantees on Alt-A loans, which often did not require the
verification of income, savings, or assets for potential borrowers.
Between 2005 and the first half of 2008, Fannie guaranteed at
least $230 billion worth of these risky loans, more than three times
the amount it had guaranteed on all past years combined. However, these poorly underwritten loans are now increasingly turning
sour amid the housing downturn, especially those concentrated in
California, Florida, Nevada, and Arizona, where the housing bubble
was particularly large and real estate speculation was rampant.148
To preserve their government-granted duopoly powers and maintain unfettered access to cheap funds, Fannie and Freddie spent
enormous sums on lobbying and public relations. According to the
Associated Press, they ‘‘tenaciously worked to nurture, and then
protect, their financial empires by invoking the political sacred cow
of homeownership and fielding an army of lobbyists, power brokers
and political contributors.’’ 149 Fannie and Freddie’s lobbyists
fought off legislation that might shrink their investment portfolios
or erode their ties to the federal government, raising their borrowing costs. In fact, Franklin D. Raines, Fannie Mae’s former
chairman, once told an investor conference that ‘‘we manage our
political risk with the same intensity that we manage our credit
and interest rate risk.’’ 150 Raines’s statement was undoubtedly
true: over the past ten years, Fannie and Freddie spent more than
$174 million on lobbying.151
As long as times were good, the GSEs were able to point to their
affordable housing goals to distract attention from the inherent
risk their business model posed. But, for more than a decade,
alarms have been sounded about the precarious position of the
GSEs. For example, in Congress, as far back as 1998, GSE reform
advocates like former Rep. Richard Baker were voicing their concerns over ‘‘the risks and potential liabilities that GSEs represent.’’ 152 In 2000, Rep. Baker demonstrated he was far ahead of
the curve when he observed that by ‘‘improving the existing regulatory structure of the housing GSEs in today’s good economic climate, we can reduce future risk to the taxpayer and the economy.’’ 153 That year, the House Financial Services Committee held
no fewer than six hearings on the subject of GSE reform, with at
least five more over the following two years.154 Yet from 2000 to
2005, although at least eight major GSE reform bills were introduced in Congress, Fannie and Freddie exerted enough influence

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147 Fannie Mae Relaxes Loan Down Payment Requirements, Reuters News Service (May 19,
2008).
148 James R. Hagerty, Fannie, Freddie Share Spotlight in Mortgage Mess, Wall Street Journal
(Oct. 16, 2008).
149 Tom Raum and Jim Drinkard, Fannie Mae, Freddie Mac Spent Millions on Lobbying, Associated Press (July 17, 2008).
150 Wallison and Calomiris, supra note 144.
151 Fannie Mae, Freddie Mac Spent Millions on Lobbying, Associated Press (July 17, 2008).
152 House Financial Services Committee, Statement of Rep. Richard Baker, Joint Hearing on
Government
Sponsored
Enterprises,
105th
Cong.
(July
16,
1997)
(online
at
financialservices.house.gov/banking/71697bak.htm).
153 House Financial Services Committee, Subcommittee on Capital Markets, Securities, and
Government Sponsored Enterprises, Statement of Rep. Richard Baker, Housing GSE Regulatory
Reform Hearing, 106th Cong. (March 22, 2000) (online at financialservices.house.gov/banking/
32200bak.htm).
154 House
Financial Services Committee, Archived Hearings (online at http://
financialservices.house.gov/archivelhearings.html).

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that only one, the Federal Housing Finance Reform Act of 2005,
ever gained enough support to be passed by either body, but it ultimately did not become law.155
Others in government shared similar concerns. In 1997, the General Accountability Office cautioned in its testimony before the
House Financial Services Committee that ‘‘the outstanding volume
of federally assisted GSE credit is large and rapidly increasing.’’ 156
As referenced above, then-Treasury Under Secretary Gensler testified in March 2000 that ‘‘the willingness of a GSE to purchase a
mortgage has become a far more significant factor in deciding
whether to originate that mortgage.’’ Gensler went on to state that
as the GSEs continue to grow, ‘‘issues of potential systemic risk
and market competition become more relevant,’’ and concluded that
the current moment was ‘‘an ideal time to review the supervision
and regulation of the GSEs.’’ 157 In 2004, then-Federal Reserve
Chairman Alan Greenspan warned in his testimony before the Senate Banking, Housing, and Urban Affairs Committee that ‘‘the current system depends on the risk managers at Fannie and Freddie
to do everything just right. . . . But to fend off possible future systemic difficulties, which we assess as likely if GSE expansion continues unabated, preventive actions are required sooner rather
than later.’’ 158
Outside of Congress, more red flags were flown over the obvious
weaknesses of the GSE model. At another House Financial Services
Committee hearing on GSEs in 2000, low-income housing advocate
John Taylor of the National Community Reinvestment Coalition
warned that the lack of a strong regulatory agency for Fannie and
Freddie ‘‘threatens the safety and soundness of the GSEs.’’ 159 At
the same hearing, community activist Bruce Marks of the Neighborhood Assistance Corporation of America expressed his fears that
without enhanced regulatory control over Fannie and Freddie, the
GSEs might participate ‘‘in potentially profitable but also potentially risky investments [sic] schemes [that] pose potential risks for
the housing and banking industry and for the economy in general.’’ 160
Unfortunately, despite all the evidence of systemic risk and repeated efforts to consolidate, strengthen, and increase regulatory
oversight of Fannie and Freddie, calls for reform mostly fell on deaf
ears. One reason why reform efforts failed was that the GSEs and
their ardent defenders in Congress have spent the better part of
the last decade first ignoring, then rejecting, then attempting to
155 H.R.

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1461, 109th Cong. (2005)
156 House Financial Services Committee, Subcommittee on Capital Markets, Securities, and
Government Sponsored Enterprises, Testimony of Jim Bothwell of the Government Accountability Office, Joint Hearing on Government Sponsored Enterprises, 105th Cong. (July 16, 1997)
(online at financialservices.house.gov/banking/71697gao.htm).
157 Gensler, supra note 117.
158 Senate Committee on Banking, Housing, and Urban Affairs, Testimony of Alan Greenspan,
Proposals for Improving the Regulation of the Housing Government Sponsored Enterprises, 108th
Cong. (Feb. 24, 2004) (online at www.access.gpo.gov/congress/senate/pdf/108hrg/21980.pdf).
159 House Financial Services Committee, Subcommittee on Capital Markets, Securities, and
Government Sponsored Enterprises, Testimony of John Taylor, Hearing on Improving Regulation of Housing GSEs, 106th Cong. (June 15, 2000) (online at financialservices.house.gov/banking/61500tay.htm).
160 House Financial Services Committee, Subcommittee on Capital Markets, Securities, and
Government Sponsored Enterprises, Testimony of Bruce Marks, Hearing on Improving Regulation of Housing GSEs, 106th Cong. (June 21, 2000) (online at financialservices.house.gov/banking/62100mar.htm).

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contradict the mounting evidence that the whole system was in
danger. In 2001, Fannie Mae itself attempted to dispel the need for
any change, declaring before Congress that ‘‘we operate successfully under the most rigorous of safety and soundness regimes; we
are subject to a high level of market discipline and provide the
marketplace with world-class disclosures.’’ 161 Freddie Mac, for its
part, used the same hearing to proclaim that their ‘‘superior risk
management capabilities, strong capital position and state-of-theart information disclosure make Freddie Mac unquestionably a safe
and sound financial institution.’’ 162
After their credibility eroded from their accounting scandals,
Fannie and Freddie increasingly relied on elected officials to fight
attempts at reform. In 2003, Rep. Barney Frank famously remarked at a hearing on a pending GSE reform bill: ‘‘I believe there
has been more alarm raised about potential [GSE] un-safety and
unsoundness than, in fact, exists. . . . I do not want the same kind
of focus on safety and soundness that we have in OCC and OTS.
I want to roll the dice a little bit more in this situation towards
subsidized housing.’’ 163 In 2004, Senator Chris Dodd called Fannie
and Freddie ‘‘one of the great success stories of all time,’’ 164 while
in 2005 Senator Chuck Schumer confessed that perhaps ‘‘Fannie
and Freddie need some changes, but I don’t think they need dramatic restructuring in terms of their mission.’’ 165 The scope of this
head-in-the-sand mentality was perhaps most completely embodied
by Rep. Maxine Waters who, in 2002, categorically rejected the
need for any GSE reform bill, proclaiming at a House Financial
Services Committee hearing on the matter ‘‘If it is not broken, why
fix it?’’ 166
Although it is fair to say that no one ought to be blamed for lacking the ability to predict the future, the fact remains that for more
than a decade there were clear, discernable, and announced warnings that Fannie and Freddie were growing too big and that if left
unchecked would eventually collapse beneath their own weight. Too
many public policy makers failed to heed those warnings, or knowingly disregarded them, and as a result taxpayers have now been
left to pick up the pieces by taking on hundreds of billions of dollars worth of risk. Ironically, when the housing bubble finally
burst, the resulting wave of foreclosures stemming from loans the
GSEs forced into the market will likely end up reducing homeownership rates across the country, a direct contradiction to the stated
purpose of Fannie and Freddie that their supporters for so long
sought to advance.

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161 House Financial Services Committee, Subcommittee on Capital Markets, Securities, and
Government Sponsored Enterprises, Testimony of J. Timothy Howard of Fannie Mae, Hearing
on Reforming Fannie Mae and Freddie Mac, 107th Cong. (July 11, 2001) (online at
financialservices.house.gov/media/pdf/071101th.pdf).
162 House Financial Services Committee, Subcommittee on Capital Markets, Securities, and
Government Sponsored Enterprises, Testimony of Mitchell Delk of Freddie Mac, Hearing on Reforming Fannie Mae and Freddie Mac, 107th Cong. (July 11, 2001) (online at
financialservices.house.gov/media/pdf/071101md.pdf).
163 House Financial Services Committee, Oral remarks of Rep. Barney Frank, Hearing on H.R.
2575, The Secondary Mortgage Market Enterprises Regulatory Improvement Act, 108th Cong.
(Sept. 25, 2003) (online at financialservices.house.gov/media/pdf/108-54.pdf).
164 What They Said About Fan and Fred, Wall Street Journal (Oct. 2, 2008).
165 Id.
166 House Financial Services Committee, Statement of Rep. Maxine Waters, Hearing on Housing Government Sponsored Enterprises, 107th Cong. (July 16, 2002) (online at
financialservices.house.gov/media/pdf/071602wa.pdf).

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Credit Rating Agencies. In order to sell subprime securities to investors, those securities first had to be rated by the credit rating
agencies. Like so many other players, the credit rating agencies
were caught up in the pursuit of fees generated from the real estate boom. This overwhelming desire to maximize their profits from
the housing bubble is perhaps best captured by an e-mail message
from a Standard & Poor’s official who wrote that ‘‘We rate every
deal. It could be structured by cows and we would rate it.’’ 167 To
perform their work, these agencies made extensive use of sophisticated modeling in an attempt to predict risk and the likelihood of
default on loans. However, much like everyone else, the credit rating agencies falsely assumed that housing prices would never go
down nationwide, which meant that their elaborate mathematical
models were defective from the start. When mortgage defaults accelerated and home prices began to plummet, securities based on
those loans that were once highly rated were downgraded to junk
causing a wave of financial turmoil for scores of market participants at every level.
But the failure of the credit rating agencies would not have generated the disastrous consequences that it did had that failure not
been compounded by further misguided government policies, which
had effectively allowed the credit rating agencies to operate as a
cartel. For decades, federal financial regulators have required that
regulated entities heed the ratings of a select few rating agencies.
For example, since the 1930s regulators have not allowed banks to
invest in bonds that are below ‘‘investment grade,’’ as determined
by the select few rating agencies as recognized by the government.
Although the goal of having safe bonds in the portfolios of banks
may be a worthy one, bank regulators essentially delegated a major
portion of their safety assessments to the opinions of these rating
agencies.
This delegation of authority by bank regulators was further compounded in 1975, when the SEC also delegated its safety judgments regarding broker-dealers to the credit rating agencies. As an
attempted safeguard against unqualified agencies from participating in the process, the SEC created a new Nationally Recognized Statistical Rating Organization (NRSRO) designation for
qualified entities, and immediately grandfathered the three large
rating agencies into this category. Following the SEC, other financial regulators soon adopted the NRSRO category for their delegations, assuming this government stamp of approval would ensure
the continued quality of the ratings produced by those agencies.
Over the next 25 years, the SEC allowed only four more rating
firms to achieve the NRSRO designation, but mergers among the
NRSROs eligible to issue ratings recognized by the regulators
shrunk the number of NRSROs back to three by year-end 2000. In
2006, Congress passed legislation (Pub. L. No. 109–291) to address
part of this situation which required that the SEC cease being a
barrier to entry for legitimate rating agencies, and gave it limited
regulatory powers over the NRSROs. Although the SEC has des-

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167 House Committee on Oversight and Government Reform, Hearing on Credit Rating Agencies and the Financial Crisis, 110th Cong. (Oct. 22, 2008) (online at oversight.house.gov/documents/20081023162631.pdf).

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ignated six additional NRSROs since 2000,168 competition and
transparency in the ratings agency system remains inadequate.
The SEC has never developed criteria for the designation and, once
designated, NRSROs have for too long been allowed to operate
without further scrutiny by the SEC for competence or accuracy.
By adopting this NRSRO system, the SEC thus established an
insurmountable barrier to entry into the rating business, eliminating market competition among the rating agencies. No one could
be surprised that once they were spared the market discipline, the
quality of the work by protected rating agencies would diminish.
Market Behavior. Government policies that dominated and distorted the nation’s housing market clearly set the stage for the
housing crisis. But there were also significant mistakes made by
private-sector participants at each step of the originate-to-distribute model of mortgage financing which compounded the government’s failure. The benefits of this system—such as lower financing
costs and the efficient distribution of risk—were significant. Over
time, however, the belief that home prices would continue their relentless, upward path distorted began to distort decision making at
every step along the path.
The belief that real estate prices would only go up led borrowers,
originators, lenders, securitizers, and investors to conclude that
these investments were risk free. As a result, the traditional underwriting standards, based on the borrower’s character, capacity to
repay, and the quality of collateral were abandoned. What many
failed to realize was that those standards were designed not only
to protect the participants in the system from the consequences of
a bubble, but also to protect the underlying financial system itself.
Borrowers. Building on that belief that housing prices could
never go down, borrowers were encouraged to borrow as much as
possible and buy as much house as they possibly could, or else invest in other properties that could always later be resold for a profit. The result was that borrowers often ended up with mortgage
products that they failed to understand, that they could not afford,
or that ended up exceeding the value of the property securing the
mortgage. Those concerns were less important as property values
continued to rise, since borrowers could always refinance or sell to
benefit from the continued appreciation of the property. However,
when property values began to fall, in many cases borrowers soon
realized that the economically rational course of action for them
was to mail in their keys to the mortgage servicer and simply walk
away. Since mortgages are non-recourse loans, doing so meant that
someone else was bearing the downside risk. While the vast majority of borrowers continue to honor their commitments and pay their
mortgages, for many of those who put little or no money down their
mortgages became a ‘‘heads I win, tails you lose’’ proposition.
Mortgage Originators. Because mortgage originators were compensated on the quantity rather than the quality of loans they
originated, there was little incentive to care if the loans they originated would perform. The compensation of mortgage brokers was
also tied to the interest rates and fees paid by customers, which

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168 AEI Center for Regulatory and Market Studies, Lawrence J. White, Lessons from the Debacle of ’07–’08 for Financial Regulation and Its Overhaul (Jan. 2009) (Working Paper No. 09-01).

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created a financial incentive for some brokers to direct borrowers
to loans that may not have otherwise been in their best interest.
For example, some originators who advocated for certain subprime
loans received commissions that were more than twice as high as
the commissions they would have received for higher-quality loans.
This incentives model put a much higher premium on quantity over
quality, which only diminished the safety and soundness of the entire system as even more risks were externalized while profits were
internalized.
Mortgage Fraud. Integral to understanding the root causes of our
current credit crisis is an acknowledgement of the rampant mortgage fraud that took place in the mortgage industry during the
boom years. Fueled by low interest rates and soaring home values,
the mortgage industry soon attracted both unscrupulous originators as well as disingenuous borrowers, resulting in billions of dollars in losses. As early as 2004, FBI officials in charge of criminal
investigations foresaw that mortgage fraud had the potential to
mushroom into an epidemic. In 2008, the Department of Treasury’s
Financial Crimes Enforcement Network (FinCEN) announced a 44
percent increase in Suspicious Activity Reports from financial institutions reporting mortgage fraud, with some 37,313 mortgage fraud
reports filed in 2006, and 52,868 mortgage fraud reports filed in
2007. According to FinCEN, mortgage loan fraud was the third
most prevalent type of suspicious activity reported, lagging behind
only money laundering and check fraud. From 2000 to 2007,
FinCEN found that the reporting of suspected mortgage loan fraud
had increased an astounding 1400 percent from 3,515 cases in 2000
to 52,868 cases in 2007.169
Unfortunately, law enforcement officials failed to stop the epidemic that they had accurately diagnosed because they did not devote adequate resources to the problem. Even though the FBI and
the Justice Department are charged with the responsibility of investigating and prosecuting illegal activities by originators, lenders,
and borrowers, the focus of those agencies was trained on national
security and other priorities. As a result, inadequate attention was
paid to many of the white-collar crimes that contributed to the financial crisis. For example, by 2007, the number of agents pursuing mortgage fraud shrank to around 100.170 By comparison, the
FBI had about a thousand agents deployed on banking fraud during the S&L bust of the 1980s and 1990s. Although the FBI later
increased the number of agents working on mortgage fraud to 200,
others have pointed out that the agency might have averted much
of the problem had it heeded its own warning about widespread
mortgage fraud.171
Lenders. The belief that housing prices would rise forever, coupled with the ability to package loans for sale to investors, profoundly changed the way in which lenders underwrote loans. While
underwriting had traditionally been based on the borrower’s ability
to repay a loan, as measured by criteria such as employment history, income, down payment, credit rating, and loan-to-value ratios,

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169 Financial Crimes Enforcement Network, FinCEN Assessment Reveals Suspected Mortgage
Loan Fraud Continues to Rise (Nov. 3, 2007).
170 Richard B. Schmitt, FBI Saw Threat of Loan Crisis, Los Angeles Times (Aug. 25, 2008).
171 Id.

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rising home prices pushed lenders to abandon these criteria. Little
concern was paid to the risks of this change, given that in a worstcase scenario, servicers could always foreclose upon a property to
satisfy the mortgage in full. As a result, lenders pioneered new
mortgage products, such as no-doc and low-doc loans, low- and nodown-payment loans, and innovations that took rising home prices
for granted. That is not to say that these exotic products are illegitimate; each may have its own appropriate use for borrowers in specific circumstances. But the broad application of these tailored
products to any person in any circumstance invariably led to some
borrowers receiving loans that were wholly inappropriate for their
needs and capacity to repay. The ability to securitize these loans
further degraded lending standards by allowing lenders to shift the
risk of nonperforming mortgages onto the investors that purchased
securities built around these products. In a world in which lenders
could securitize even the most poorly underwritten of mortgages,
what mattered most to lenders was that the loan did not default
within an agreed-upon period—typically 90 or 180 days. Whatever
happened after that time was someone else’s problem.
Securitizers. Securitizers pooled mortgages of all types and quality together to create complex and often opaque structured products
from these loans, such as mortgage-backed securities (MBS) and
collateralized debt obligations (CDO). Securitizers knew that some
portion of the mortgages they securitized would fail, but they believed that by structuring these mortgages into securities with different levels of risk, they could effectively eliminate any risk from
those defaults with the guarantee of safer, performing loans. This
belief grew from the assumption that others along the chain—the
mortgage brokers and lenders—had adequately underwritten the
loans so that any defaults would be manageable, and that housing
prices would never go down. Those false assumptions belied the
fact remains that in any finance model, you can never eliminate
risk from a system of lending; at best, you can hope to control it
by offsetting smaller sections of riskier loans with larger sections
of safer loans. But that risk, while controlled, is always there, a
lesson which the entire financial system is currently experiencing
firsthand.
Investors. Like so many others, private investors in pursuit of
risk-free investments failed to appreciate that if housing prices
could go up, they could also go down. Rather than performing their
due diligence on these mortgage-backed securities, many investors
put their faith in the rating agencies and other proxies, and did not
fully appreciate the risks they faced. Some large institutions further compounded their mistakes by holding their mortgage investments off-balance-sheet, using a loophole set forth in the regulatory
capital requirements that permitted them to hold low-risk investments in special investment vehicles or conduits. And other large
institutions—such as the former investment banks—availed themselves of an exemption granted by the SEC that permitted them to
ignore traditional debt-to-net capital ratios—traditionally 12:1—
and lever up as much as 40:1.172 It was in this way that the once

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172 Stephen Labaton, Agency’s ’04 Rule Let Banks Pile on New Debt, New York Times (Oct.
2, 2008).

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highly sought but ultimately poorly underwritten mortgages came
to be the ‘‘troubled assets’’ that have now caused the collapse of so
many in our financial system. Using first the assumption, and by
2008 the proof, that the government would deem certain institutions that had gambled on these assets to be too big or too interconnected to fail, these institutions and their creditors succeeded in
making the taxpayer the ultimate bag holder for the risks they
took, demonstrating yet again that the standard governing the
housing boom and bust was ‘‘heads I win, tails you lose.’’
Mark-to-Market Accounting. The boom and bust nature of the
housing and financial markets in recent years was amplified by the
application of financial accounting standards that required financial institutions to write down their MBS assets to ‘‘market value’’
even if no market existed. As a result, institutions that held mortgage-backed securities found themselves facing the withdrawal of
financing, often forcing them to sell these assets at distressed or
liquidation prices, even though the underlying cash flows of these
portfolios might not have been seriously diminished. In a liquiditystarved market, more and more distressed sales took place, further
pulling down asset prices. These declining prices in turn created
more lender demands for additional collateral to secure their loans,
which in turn resulted in more distressed sales and further declines in asset values as measured on a mark-to-market basis. The
result was a procyclical engine which magnified every downward
price change in a recursive spiral, all of which might have otherwise been avoided had the mark-to-market standard provided better guidance on how to value assets in non-functioning markets.
Summary. The financial crisis which has unfolded over the past
two years has numerous causes, and decisions made in the private
sector were, in many cases, unwise. But the failure of government
policy and the market distortions it caused stand at the center of
the crisis. Whether by the Federal Reserve’s engineering an artificially low interest rate, Congress’s well-intentioned but misguided
efforts to expand home ownership among less creditworthy borrowers, or the GSEs’ securitization and purchase of risky mortgagebacked securities, the federal government bears a significant share
of the responsibility for the challenges that confront us today.
To address these challenges, what is needed most is not simply
reregulation or expanded regulation, but a modernized regulatory
system that is appropriate to the size, global reach, and technology
used by today’s most sophisticated financial service firms. At a
time when our nation’s economy desperately needs to attract new
investment and restore the flow of credit to where it can be used
most productively, we must at all costs avoid regulatory changes
under the label ‘‘reform’’ that have the unintended consequence of
further destabilizing or constricting our economy. We should carefully consider the so-called lessons of the subprime crisis to be sure
that whatever changes we adopt actually address the specific underlying causes of the crisis. These reforms should require the participants in the financial system to bear the full costs of their decisions, just as they enjoy the benefits. They should also enhance
market forces, add increased transparency, and strip away counterproductive government mandates.

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Perhaps above all, we should avoid creating a system in which
market participants rely upon an implicit or explicit government
guarantee to bear the risk for economic transactions gone wrong.
If the events of the past two years have demonstrated anything, it
is that whenever government attempts to subsidize risk—from efforts to stabilize home prices to the latest government-engineered
rescues of financial institutions deemed too big to fail—those efforts are usually costly, typically ineffectual, and often counterproductive. We should all know by now that whenever government
subsidizes risk, either by immunizing parties from the consequences of their behavior or allowing them to shift risk to others
at no cost, we produce a clear moral hazard that furthers risky behavior, usually with disastrous consequences.
Any regulatory reform program must recognize the ways in
which government is part of the problem, and should guard against
an overreaction that is certain to have unintended consequences.
Perhaps Harvard economist Edward L. Glaeser put it best: ‘‘We do
need new and better regulations, but the current public mood
seems to be guided more by a taste for vengeance than by a rational desire to weigh costs and benefits. Before imposing new rules,
we need to think clearly about what those rules are meant to
achieve and impose only those regulations that will lead our financial markets to function better.’’ 173
RECOMMENDATIONS FOR FEDERAL REGULATORY REFORM

Developing an agenda for reform is an inherently controversial
enterprise. As with any suggested change, some will stand to benefit while others might be forced to adjust to the new realities of
a different regulatory scheme. The recommendations contained
here are not immune from this charge, and there will invariably be
disagreement over the advantages and disadvantages of some of
these proposals. However, we believe that the following recommendations remain true to our objectives of helping to make
markets more competitive and transparent, empowering consumers
with effective disclosure to make rational decisions, effectively policing markets for force and fraud, and reducing systemic risk.
In considering the appropriateness of each item, the devil will always be in the details regarding how any of these recommendations might be enacted. Even the best idea, if poorly implemented,
would lose many of the potential benefits it might otherwise yield.
Thus, these recommendations are best understood as conceptual
proposals rather than specific instructions for how to improve our
regulatory system.
Given the limited time and resources available to the Panel to
conduct this review, in many cases there are still unanswered questions about certain aspects of these reforms and in some cases even
a few qualified reservations between the authors. Nevertheless, we
believe that each proposal contains clear benefits for our economy,
and has been structured to avoid the potential for unintended consequences. They deserve open consideration and debate in the public arena, and the opportunity to stand or fall on their own mer-

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173 Edward L. Glaeser, Better, Not Just More, Regulation, Economix (Oct. 28, 2008) (available
at economix.blogs.nytimes.com).

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its—a fitting tribute to the competitive free-market system that we
are dedicated to strengthening and preserving.
1. REFORM THE MORTGAGE FINANCE SYSTEM

The current financial crisis originated in the mortgage finance
system, and much of the resulting turmoil can be traced to government interventions in the housing sector which helped fuel a classic asset bubble. Reform must begin with Fannie Mae and Freddie
Mac, the GSEs whose influence drove the deterioration of underwriting standards, growth in subprime mortgage backed securities,
and whose subsidized structure will result in hundreds of billions
of dollars in taxpayer losses. The mortgage origination market
itself should also be improved by establishing clearer standards,
transparency, and enforcement.
1.1

Re-charter the housing GSEs as mortgage guarantors, removing them from the investment business
At the center of the need for reform are Fannie Mae and Freddie
Mac. As Charles Calomiris and Peter Wallison of AEI recently
wrote: ‘‘Many monumental errors and misjudgments contributed to
the acute financial turmoil in which we now find ourselves. Nevertheless, the vast accumulation of toxic mortgage debt that poisoned
the global financial system was driven by the aggressive buying of
subprime and Alt-A mortgages, and mortgage-backed securities, by
Fannie Mae and Freddie Mac. The poor choices of these two
GSEs—and their sponsors in Washington—are largely to blame for
our current mess.’’ 174
The GSEs fueled the housing bubble through their ever expanding appetite for increasingly risky investments that they held in
their massive portfolios. They financed these investments by borrowing at low, subsidized rates, and over time the firms became
ever more dependent on their high yields to meet their earning targets. At one time, Fannie and Freddie accounted for more default
risk than all other U.S. corporations combined—default risk implicitly backed by the federal government.175 These risks to the taxpayer and the financial system were obvious, and should have been
dealt with long ago.
Now that the GSEs have been taken into conservatorship, Congress has the opportunity to ensure that the damage they inflicted
will never be repeated. This can be accomplished in one of two
ways. One option is for Congress to phase out the GSEs’ government charter and privatize them over a reasonable period of time
following a model similar to that of the successful Sallie Mae privatization a decade ago. Legislation to that effect was introduced
in the 110th Congress and will likely be re-introduced in the current Congress. These firms can and should compete effectively in
the financial service marketplace on a level playing field without
implicit or explicit taxpayer guarantees.
Alternatively, Congress could opt to recharter the GSEs as government entities whose only mandate is to guarantee and help
securitize mortgages. Such a structure would remove them entirely
174 Blame

Fannie Mae and Congress for the Credit Mess, Wall Street Journal (Sept. 23, 2008).
Wallison, Regulating Fannie Mae and Freddie Mac (May 13, 2005) (online at
www.aei.org/publications/pubID.22514/publdetail.asp).
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175 Peter

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from the investment business by prohibiting them from maintaining massive investment portfolios which have proven to be a tremendous source of systemic risk. In either alternative, Congress
must avoid a return to the flawed public purpose/private ownership
model that permitted the GSEs’ shareholders to profit at taxpayer
expense.
1.2 Simplify mortgage disclosure
The events of the past year have made painfully clear that the
vitality of our financial system depends on a well-functioning housing market in which borrowers are able and willing to abide by the
terms of the mortgage contracts into which they have entered. Unfortunately, the needless complexity involved in obtaining a mortgage appears designed to keep borrowers from fully understanding
these important agreements. One way to minimize this complexity
is to place essential information for borrowers in a simple, one-page
document that makes clear what borrowers need to know before
they enter into what will be for many the biggest financial transaction they will ever undertake. This information will permit borrowers to make an appropriate decision regarding the costs and affordability of borrowing to buy a house. This one-page document
would include such items as monthly payments, interest rate, fees,
and possible changes in the amount of payments for adjustable rate
mortgages including the maximum possible interest rate on the
loan and the maximum monthly payment in dollars. The one-page
document should also include the warning that home values can go
down as well as up, and that the consumer is responsible for making the mortgage payments even when the price goes down.
1.3

Establish minimum equity requirements for government guaranteed mortgages
Because federally guaranteed mortgages put the taxpayer on the
hook for any potential associated losses, the taxpayer needs to be
protected from opportunistic borrowers that might otherwise walk
away from a mortgage if housing prices fall. One way to protect the
taxpayer is require the borrower to provide a bigger downpayment.
If the taxpayer is going to take on risk, it is only fair that the borrower share in that risk as well.
FHA loans currently require at least a 3.5 percent downpayment,
which is clearly too low. The minimum downpayment for all government-insured or securitized mortgages should be raised immediately to at least 5 percent, and to as much as 10 percent or higher, over the next several years as market conditions improve. Lest
the advocates of government-subsidized mortgages in which taxpayers bear the risk complain that 5 percent is too high, it bears
pointing out that would still be four times as lenient as the 20 percent standard that was in place two decades ago.
Allow Federal Reserve mortgage lending rules to take effect
and clarify the enforcement authority for mortgage origination
standards
In July 2008, the Federal Reserve approved a comprehensive
final rule for home mortgage loans that was designed to improve
lending and disclosure practices. The new Federal Reserve rule was
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1.4

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designed to prohibit unfair, abusive or deceptive home mortgage
lending practices, and it applies to all mortgage lenders, not just
those supervised and examined by the Federal Reserve.
The final Federal Reserve rule adds four protections for ‘‘higher
priced mortgage loans,’’ which encompasses virtually all subprime
loans. The final rule:
1. Prohibits lenders from making loans without regard to a
borrower’s ability to repay the loan.
2. Requires creditors to verify borrowers’ income and assets.
3. Bans prepayment penalties for loans in which the payment can change during the first four years of the loan (for
other higher-priced loans, a prepayment penalty period cannot
last for more than two years).
4. Requires creditors to establish escrow accounts for property taxes and homeowner’s insurance for all first-lien mortgage loans.
In addition, the Federal Reserve issued the following protections
for all loans secured by a consumer’s principal dwelling:
1. Creditors and mortgage brokers are prohibited from coercing a real estate appraiser to misstate a home’s value.
2. Companies that service mortgage loans are prohibited
from engaging in certain practices, such as pyramiding late
fees.
3. Servicers are required to credit consumers’ loan payments
as of the date of receipt and provide a payoff statement within
a reasonable time of request.
4. Creditors must provide a good faith estimate of the loan
costs, including a schedule of payments, within three days of
a consumer applying for a mortgage loan.
Finally, the rule sets new advertising standards, which require
additional information about rates, monthly payments, and other
loan features. It also bans seven advertising practices it considers
deceptive or misleading, including representing that a rate or payment is ‘‘fixed’’ when it can change.
These new rules represent a change in federal regulation that,
regardless of whether or not one agrees with the degree to which
consumers might benefit from all of these rules, will significantly
alter the way in which the mortgage lending industry operates.
Thus, before policymakers succumb to the desire to write additional
rules and regulations, they should allow the Federal Reserve’s new
guidelines to take effect, monitor their impact upon mortgage origination, and clarify the authority for enforcing these new federal
standards. Additionally, for these new rules to work effectively,
they must be appropriately enforced. In particular, Congress
should ensure that federal and state authorities have the appropriate powers to enforce these laws, both in terms of resources and
actual manpower, for all mortgage originators.

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1.5 Enhance securitization accountability standards
The advent of securitization has been a tremendous boon to the
mortgage industry, and countless millions of Americans have directly or indirectly benefited from the liquidity it has created. Nev-

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ertheless, the communicative nature of loans in the securitization
process has helped diminish accountability among market participants, eroding the quality of many loans. Thus, to restore accountability, minimum standards should be set for all loans that are to
be securitized so that securitizers retain some risk for nonperforming loans.
One proposal would be to link the compensation securitizers receive for packaging loans into mortgage-backed securities to the
performance of those loans over a five year period, rather than the
six-month put-back period that is the current standard. This
change in compensation would thus give the securitizer an economic stake in the loan’s long-term performance, aligning the
securitizer’s incentives with those of borrowers, investors, and the
broader economy. Further, consideration should be given to applying additional limitations on the ability to securitize loans that
carry with them an explicit government guarantee.
2. MODERNIZE THE REGULATORY STRUCTURE FOR FINANCIAL
INSTITUTIONS

´
It has become a cliche to observe that if one were designing a
regulatory system from scratch, one would not come up with the
patchwork system of agencies with overlapping jurisdictions and
conflicting mandates. The U.S. financial regulatory system is fractured among eleven federal primary regulatory agencies in addition
to scores of state regulatory agencies. The system developed over
a 200-year period, during which institutions largely lacked the ability to transact business nationwide, let alone globally. Insurance,
securities, and bank products were sold by different institutions,
and little cross-market competition existed.
During the past thirty years, changes in size and technology
have opened financial markets to buyers and sellers around the
globe, transaction times are now measured in fractions of a second,
and consumers have been given access to a broad range of valuable
products from a single provider. Innovations in products and technology, and the global nature of financial markets are here to stay.
An unnecessarily fragmented and outdated regulatory system imposes costs in several ways: inefficiencies in operation, limitations
on innovation, and competition restraints that are difficult to justify.
2.1 Consolidate federal financial services regulation
The benefits of a more unified federal approach to financial services regulation have been a constant theme in proposals for regulatory reform, some of which were under consideration and announced before the onset of the current financial crisis. For example, the Group of 30, in its very first recommendation, called for
‘‘government-insured deposit taking institutions’’ to be subject to
‘‘prudential regulation and supervision by a single regulator.’’ 176
The Committee on Capital Markets Regulation has similarly called
for a consolidated U.S. Financial Services Authority (USFSA) that
‘‘would regulate all aspects of the financial system including mar-

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176 The Group of 30, Financial Reform: A Framework for Financial Stability (Jan. 15, 2009)
(online at www.group30.org/pubs/recommendations.pdf).

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ket structure and activities and safety and soundness.’’ 177 Treasury’s Blueprint for a Modernized Financial Regulatory Structure
recommends a Prudential Financial Regulatory Agency (PFRA)
with oversight over ‘‘financial institutions with some type of explicit government guarantee associated with their business operations.’’ 178
The current regulatory structure for oversight of federally chartered depository institutions is highly fragmented, with supervision
spread among at least five agencies including the OCC, OTS,
FDIC, National Credit Union Administration (NCUA), and the Federal Reserve. Thus, Congress should streamline oversight of these
federally chartered and insured institutions.
2.2

Modernize the federal charter for insured depository institutions
There are many kinds of insured depositories operating under
unique charters including national banks, thrifts, state chartered
members of the Federal Reserve system, state chartered nonmembers, credit card banks, federal and state credit unions, and state
charted industrial loan corporations. While this vast array of institution type may have had a sound historical basis, changes in the
national economy and regulatory landscape have made many of
these differences functionally obsolete. Although regulatory competition can prove beneficial, the current state of duplicative banking regulation has several negative consequences as well, including
unnecessary consumption of federal regulatory resources, consumer
transparency, and differences in charters for largely similar institutions, which can lead to unfair competitive advantages for institutions governed by certain charters over others.
In particular, the OCC and the OTS play a very similar role for
two classes of depository institutions which were once were quite
different in nature, but now compete for the same customers, offering similar services. The thrift charter was originally instituted to
foster the creation of financial services organizations to encourage
home ownership by ensuring a wide availability of home mortgage
loans. Due to a number of national policy changes that have been
instituted over the last several decades to encourage homeownership and the decreasing share thrifts have of the residential mortgage market in relation to commercial banks, a unique thrift charter is no longer necessary to meet this goal. Moreover, the constraints of the thrift charter limit the diversification of thrifts’ loan
portfolios, which only exacerbates their ability to remain financially
healthy in a weak real estate market.
Many individuals and organizations reviewing the current regulatory landscape have come to the conclusion that these agencies,
and their corresponding federal thrift, and federal bank charters
should be unified. In fact, back in 1994, former Federal Reserve
Governor, John P. LaWare recommended combining the OCC with

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177 The Committee on Capital Markets Regulation, Recommendations for Reorganizing the
U.S. Financial Regulatory Structure (Jan. 14, 2009) (online at www.capmktsreg.org/pdfs/
CCMR%20-%20Recommendations%20for%20Reorganizing%20the%20US%20Regulatory%20
Structure.pdf).
178 U.S. Department of Treasury, Blueprint for a Modernized Financial Regulatory Structure
(Mar. 31, 2008) (online at www.ustreas.gov/press/releases/reports/Blueprint.pdf) (hereinafter
‘‘Blueprint’’).

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the OTS.179 Similarly, in 1996, the GAO recommended that primary supervisory responsibilities of the OTS, OCC, and the FDIC
be consolidated into a new, independent Federal Banking Commission.180
Congress should consider other steps to modernize and rationalize the federal charter system. Each class of charter should be reviewed for purpose, structure, cost and distinct characteristics. Unnecessary differences are potential sources of confusion, conflict, or
taxpayer risk, and should be eliminated wherever possible.
2.3 Consolidate the SEC and CFTC
Similar to the rationalization that is needed in banking regulation, consolidation of securities regulation in the U.S. through the
merger of the SEC and the CFTC should also be undertaken. Most
countries have vested the power to oversee all securities markets
in one agency, and for good reason—more efficient, consistent regulation that protects consumers in a more uniform manner. As the
Treasury Blueprint states: ‘‘Product and market participant convergence, market linkages, and globalization have rendered regulatory
bifurcation of the futures and securities markets untenable, potentially harmful, and inefficient. The realities of the current marketplace have significantly diminished, if not entirely eliminated, the
original rationale for the regulatory bifurcation between futures
and securities markets.’’ 181
It further notes that: ‘‘Jurisdictional disputes have ensued as the
increasing complexity and hybridization of financial products have
made ‘definitional’ determination of agency jurisdiction (i.e., whether a product is appropriately regulated as a security under the federal securities laws or as a futures contract under the CEA) increasingly problematic. This ambiguity has spawned a history of jurisdictional disputes, which critics claim have hindered innovation,
limited investor choice, harmed investor protection, and encouraged
product innovators and their consumers to seek out other, more integrated international markets, engage in regulatory arbitrage, or
evade regulatory oversight altogether.’’ 182
In testimony before this panel, Joel Seligman, President of the
University of Rochester and a leading authority on securities law,
agreed, stating, a ‘‘pivotal criterion to addressing the right balance
in designing a regulatory system is one that reduces as much as
is feasible regulatory arbitrage. Whatever the historical reasons for
the existence of a separate SEC and CFTC, the costs of having a
system where in borderline cases those subject to regulation may
choose their regulator is difficult to justify.’’ 183
The most significant obstacle to this proposal is a political one.
Congressional oversight of the two agencies is split between two
committees in both the House and Senate. Consolidation would
most likely mean that one committee would lose out, leading to a
classic turf war. Since the nature of futures trading has evolved

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179 Walter W. Eubanks , U.S. Congressional Research Service, RL33036, Federal Financial
Services Regulatory Consolidation: An Overview (July 10, 2008), at 14.
180 Government Accountability Office, U.S. and Foreign Experience May Offer Lessons for Modernizing U.S. Structure (Nov. 1996) (online at www.gao.gov/archive/1997/gg97023.pdf).
181 Blueprint, supra note 178.
182 Id.
183 Seligman, supra note 18.

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significantly over the years, and is now dominated by non-agricultural products, the Senate Banking and House Financial Services
Committees would be the appropriate venue for all congressional
securities oversight.
2.4

Establish an optional federal charter for national insurance
firms
The U.S. federal financial service regulatory infrastructure contains no agency or organization responsible for oversight of national insurance firms. As far back as 1871, regulators saw the
need for uniform national standards for insurance. That year,
former New York Insurance Commissioner, George W. Miller, who
founded the National Association of Insurance Commissioners
(NAIC), made the following statement: ‘‘The Commissioners are
now fully prepared to go before their various legislative committees
with recommendations for a system of insurance law which shall
be the same in all States, not reciprocal but identical, not retaliatory, but uniform.’’ 184 That need for uniform standards has grown
quite considerably during the past 138 years.
Congress should institute a federal charter that may be utilized
by insurance firms to underwrite, market, and sell products on a
national basis. While individual state insurance regulators have effectively managed state guarantee pools, as well as safety and
soundness within their jurisdiction, they simply are not equipped
to effectively oversee a global firm such as AIG, which had 209 subsidiaries at the time the federal government acted to prevent its
collapse in the fall of 2008. Of the 209 subsidiaries, only twelve fell
under the jurisdiction of the New York insurance commissioner,
which was effectively AIG’s primary regulator.185
By allowing insurance firms to choose between a unified national
charter or maintaining operations under existing state regulation,
Congress can build upon the success of state guarantee pools and
maintain state jurisdiction over premium taxes. A national charter
would also allow regulators to take a comprehensive view of the
safety and soundness of large insurance companies and to better
understand the potential risks they may pose to the strength of the
broader U.S. economy. Lastly, a federal insurance regulator would
be able to implement effective consumer protection, provide a clear
federal voice to coordinate global insurance regulation with foreign
counterparts, and ensure appropriate access for U.S. insurance
companies in overseas markets.
3. STRENGTHENING CAPITAL REQUIREMENTS AND IMPROVING RISK
MANAGEMENT

The experience of the past two years demonstrates that our financial system was far more susceptible to shocks from the housing sector than it should have been, as a result of capital requirements that were insufficient to sustain financial institutions in

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184 House Financial Services Committee, Subcommittee on Capital Markets, Securities, and
Government Sponsored Enterprises, Testimony of Rep. Sue Kelly, NARAB & Beyond: Achieving
Nationwide Uniformity in Agent Licensing, 107th Cong. (May 16, 2001) (online at
financialservices.house.gov/media/pdf/051601ke.pdf).
185 John Sununu, et al., Insurance Companies Need a Federal Regulator, Wall Street Journal
(Sept. 23, 2008) (online at online.wsj.com/article/SB122212967854565511.html).

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time of stress. Those weaknesses were in turn further exacerbated
by certain standards and practices, such as a heavy reliance on
credit rating agencies and the application of mark-to-market accounting standards. To ensure that our financial system can better
withstand these kinds of shocks, capital requirements should be
strengthened and risk management should be enhanced.
3.1 Strengthen capital requirements for financial institutions
One of the key lessons that has emerged from this crisis is that
our financial institutions did not have adequate capital reserves to
weather the turmoil in the housing market due in large part to the
fact that many of the assets they held were inextricably linked to
this market. One way to address this problem would be to ensure
that regulators can demand that financial institutions increase
their capital during flush times. Those reserves could then serve as
a cushion during bad times when capital is much harder to raise.
The provisioning requirements would be based on the health of the
economy as a whole, thus building upon systemic strength and
buffering against systemic weakness.
These countercyclical requirements would be quite different from
those governing the regulatory capital that financial institutions
are required to hold today. The current capital rules for lending are
out of date, subject to manipulation, and do not accurately reflect
the risks associated with lending activities. That said, there are
also significant flaws and risks associated with the new capital
rules called for by the Basel II regime.
Much of the initial modeling now available suggests that average
capital requirements for banks subject to Basel II methodologies
would decrease. The determination to allow the largest and most
complex banks to use internally developed, historical models for the
purpose of determining capital risk charges merits further and closer scrutiny. Given the current financial crisis and the federal guaranty on deposits that banks enjoy, weak capital requirements
called for by Basel II could leave taxpayers on the hook yet again.

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3.2 End conduits and off-balance-sheet accounting for bank assets
Apart from its procyclicality, Basel II permitted banks and other
financial institutions to keep assets such as mortgage-backed securities off their books in conduits or structured investment vehicles
on the grounds that these assets were high-quality and low-risk.
Even if such an assessment were accurate—and the past two years
have demonstrated that it was not—off-balance-sheet arrangements such as this permit financial institutions to game the regulatory requirements in place. These off-balance-sheet arrangements
were made even more dangerous by the perception that their liabilities were implicitly guaranteed by the institutions that sponsored
them, which permitted even greater leverage to build before the
credit crisis hit. Thus, all assets and liabilities of a financial institution should be held on the balance sheet. If nothing else, one of
the lessons of this credit crisis is the necessary steps should be
taken to eliminate the notion of an ‘‘implicit guarantee’’ of anything
in our markets.

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3.3 Adjust the application of mark-to-market accounting rules
Fair value accounting should be revised and reformed. As things
stand now, the accounting rules magnify economic stress and can
have serious procyclical effects. When markets turn sour or panic,
assets in a mark-to-market accounting system must be repeatedly
written down, causing financial institutions to appear weaker than
they might otherwise be. A superior accounting system would not
require financial institutions to write down their assets at a time
when prices have fallen precipitously during a rapid downturn as
in the collapse of a bubble. Thus, alternative asset valuation procedures—such as discounted cash flow—should be used, and it should
be made easier for financial institutions to declare assets as heldto-maturity during these periods. In normal markets, prices will
fluctuate within a limited range, and will rise slowly if at all. But
in times of crisis—such as the one we are facing—write-downs
beget fire sales, which beget further write-downs.
In late September 2008, the SEC released guidelines that allowed companies greater flexibility in valuing assets in a nonfunctioning market. Such changes are encouraging. Moving forward, accounting rules have to provide transparency and the most accurate
depiction of economic reality as possible. It is for the best that the
development of accounting rules should not be conducted in the political arena. However, it is clear that the rules need to be improved, taking into account the lessons learned from recent events.
Ultimately, greater transparency and accuracy in accounting standards are necessary to restore investor confidence.
3.4 Eliminate the credit rating agencies’ cartel
The failure of the credit rating agencies in the financial crisis
could not be more apparent. Much like the GSEs, the credit rating
agencies benefited from a unique status conferred upon them by
the government. They operated as an effective oligopoly to earn
above-market returns while being spared market discipline in instances where their ratings turned out to be inaccurate. The special
status of the rating agencies should be ended so as to open the ratings field to competition from new entrants and to encourage investors and other users of ratings not to rely upon a ratings label as
a substitute for due diligence.

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3.5 Establishing a clearinghouse for credit default swaps
Despite recent criticism heaped upon them, the thriving credit
default swaps (CDS) market demonstrates the valuable role that
innovation plays in improving the functioning of our financial markets. Through the use of CDS, investors and lenders can hedge
their credit exposures more efficiently, thereby freeing up additional credit capacity, which has in turn enabled banks to expand
credit facilities and reduce costs of funds for borrowers. CDS have
enabled asset managers and other institutional investors to adjust
their credit exposures quickly and at a lower cost than alternative
investment instruments, and have enabled market participants to
better assess and manage their credit. CDS have also enabled market participants to value illiquid assets for which market
quotations might not be readily available.

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Despite their many benefits and the crucial role that CDS have
come to play in the financial system in managing risk, legitimate
concerns have arisen regarding the transparency of the system and
the management of counterparty risk. To address these concerns,
the Federal Reserve, the CFTC, and the SEC have recently agreed
on general principles to provide consistent oversight of one or more
clearinghouses for CDS trades. The proposed guidelines will result
in more public information on potential risks being provided to
counterparties and investors, as well as the mitigation of any systemic losses caused by potential fallout from the CDS market.
These principles constitute a valuable first step in creating a
CDS clearinghouse and will further improve a product that has
thus far proven invaluable in managing risk when prudently used.
A properly structured clearinghouse, capitalized by its members,
spreads the risk of default and fosters market stability by acting
as the sole counterparty to each buyer and seller. A clearinghouse
will allow performance risk to be isolated to net exposure, rather
than related to the much larger gross positions in the market.
A number of reforms have already reduced risk in the CDS market. The CDS market has already dramatically increased margin,
mark-to-market and collateral requirements for hedge funds and
other investment institutions on the other side of any trade. And
at the behest of the New York Federal Reserve and other regulators, record keeping has improved; trade confirmations, for example, now must be tendered quickly. Buyers of CDS protection now
also must formally approve any switch of their coverage from one
insurer to another. Previously, the insured might not know who
was its latest counterparty.
A clearinghouse, however, may not be appropriate for the most
complex and unique over-the-counter derivatives. Moreover, because a clearinghouse arrangement spreads risk to other market
participants, it could encourage excessive risk taking by some, especially if risks associated with more exotic products are not priced
properly due to information asymmetry. Policy makers and regulators should continue to work with the private sector to facilitate
a CDS clearinghouse that provides greater transparency and reduces systemic risk in the broader financial markets.
4. ADDRESS SYSTEMIC RISK

Consolidate the work of the President’s Working Group and the
Financial Stability Oversight Board to create a cross-agency
panel for identifying and monitoring systemic risk
Systemic risk can materialize in a broad range of areas within
our financial system: at both depository and nondepository institutions, within either consumer or commercial markets, as a result
of poor fiscal or monetary policy, or initiated by domestic or global
activity. Thus, it is impractical, and perhaps a dangerous concentration of power, to give one single regulator the power to set
or modify any and all standards relating to such risk. Systemic risk
oversight and management must be a collaborative effort, bringing
together the leading authorities for addressing safety and soundness, managing economic policy, and ensuring consumer protection.
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One alternative to a single systemic risk regulator would be to
develop a panel of federal agencies to consider jointly these important questions. The Presidential Working Group (PWG) was established after the stock market crash of 1987 to make recommendations for enhancing market integrity and investor confidence. Similarly, the Financial Stability Oversight Board (FSOB) was established under the EESA in 2008 as a cross-agency group to oversee
the Troubled Assets Relief Program (TARP) and evaluate the ways
in which funds might be used to enhance market stability. Both
groups include the Treasury, the Federal Reserve, and the SEC.
The PWG adds the CFTC, while the FSOB includes the Housing
Secretary and the Director of the Federal Housing Finance Agency
(FHFA), which oversees the housing GSEs.
While the quarterly evaluation of TARP operations provided by
the FSOB will continue through the life of the program, the broad
mission and structure of these two organizations are, in many respects, redundant. Moreover, they represent the collaborative,
cross-agency structure that would best provide insight in to the
practices, policies, and trends that might contribute to systemic
risk within the financial system.
By combining and refocusing the efforts of these two organizations, Congress can establish a body with the requisite tools to
identify, monitor, and evaluate systemic risk. The panel can make
specific legislative recommendations, as well as encourage immediate action consistent with the significant regulatory powers already vested in its members.
A Panel comprised of the Federal Reserve, the Treasury, the primary regulator of federally insured depository institutions, and the
combined SEC/CFTC, would have authority to access detailed financial information from regulated financial institutions, require
disclosure of information necessary to evaluate risk, and require
that financial institutions to undertake corrective actions to address systemic weakness.
DISAGREEMENT WITH PANEL REGULATORY RECOMMENDATIONS

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In far too many areas, the Panel Report offers recommendations
or policy options that are rife with moral hazard and the potential
for unintended consequences. Given that some of the principal
causes of this financial crisis include the moral hazard embedded
in the charter of Fannie Mae and Freddie Mac, market-distorting
housing mandates like the CRA, and the unintended consequences
of a credit rating agency certification process which restricted competition, we must be particularly mindful of these risks. In some
cases, a highlighted action may appear benign, but the more detailed summary includes proposals or policy ‘‘options’’ that cannot
be supported.
Other sections, such as those dealing with systemic risk and leverage, include highly proscriptive proposals that would be difficult, if not impossible to implement outside the walls of academia.
Finally, the Panel Report all but ignores the critical role played by
the Federal Reserve’s highly accommodative monetary policy, and
the host of troubles created by the government charter and implicit
backing of the GSEs. Avoiding discussion of such important components of the crisis will inevitably lead one to set the wrong prior-

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ities for reform. While not exhaustive, the following represents a
list of the more significant disagreements held with the Panel Recommendations for Improvement:
1. The Panel Report calls for a ‘‘body to identify and regulate institutions with systemic significance’’ and ‘‘[i]mpose heightened regulatory requirements for systemically significant institutions.’’ The
recommendations suggest that firms designated as such are to be
subjected to unique capital and liquidity requirements, as well as
special fees for insurance. Although it is important that regulators
work to identify, monitor, and address systemic risk, such explicit
actions are more likely to have unintended and severe negative
consequences.
Publicly identifying ‘‘systemically significant institutions’’ will
create significant moral hazard, the cost of which will far outweigh
any potential regulatory benefits. Consider the two possible effects
of being identified as such. First, in one case, the cost and burdens
of additional capital and regulatory requirements (as recommended) place a firm at a competitive disadvantage relative to
its peers. Thus, the competitive strength of a systemically significant firm is impaired, raising the probability of a business failure—
an undesirable outcome.
In the alternative case, the market may view designation as a de
facto guarantee of public support during times of financial stress.
The firm attains a beneficial market status, and enjoys advantages
such as a lower cost of capital in the public markets. The costs of
failure are thus socialized, while profits remain in private hands
(much as was the case for the GSEs, Fannie Mae and Freddie
Mac). Recent events make clear that this scenario is perhaps an
even more undesirable outcome than the former.
Unfortunately, these are the only two practical outcomes of any
designation—either markets will view it as a competitive burden or
as a competitive advantage. It is unrealistic to argue that such a
‘‘significant’’ designation would be viewed as competitively neutral.
Moreover, it is unreasonable to assume that government will manage the potential moral hazard more effectively than was done in
the case of the GSEs.
2. The Panel Report recommends the formation of ‘‘a single federal regulator for consumer credit products.’’ Such an action would
isolate the activity of creating and enforcing consumer protection
standards from oversight of safety and soundness in financial institutions.
The regulation of any federal financial firm requires the balancing of multiple policy choices and should be done by one institution. Experience has shown us with the GSE model that having
two stated goals, one for safety and soundness and one for social
policy, inherently will lead to conflict. Since the new consumer
product regulator would be able to affect all financial institutions,
eventually those rules will conflict with a bank’s profitability, capital levels, and ultimately, solvency. Under this Panel proposal, an
independent agency would have power to impose regulations that
could well undermine the health of banks, but would not be responsible for the safety and soundness of those banks.

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This balance is of particular significance within institutions that
have been provided with explicit taxpayer funded guarantees, such
as FDIC insurance. By placing both responsibilities with the same
regulator, greater assurance is provided that taxpayer interests
will not be placed in jeopardy by regulations that unnecessarily
weaken capital or competitive position.
3. The Panel Report broadly calls for the adoption of new regulations ‘‘to curtail leverage.’’ While the recommendation implies that
regulators across the spectrum of financial institutions set inappropriate standards for leverage, this simply is not the case.
Few, if any, observers of the current crisis have argued that capital standards set by the FDIC and other federal and state banking
regulators overseeing depository institutions were set at dangerously low levels. To the extent that FDIC insured institutions
have become troubled, it has been largely the result of deteriorating loan quality. Thousands of such institutions across the country remain strong and healthy. Raising their capital standards now
in an effort to ‘‘curtail leverage’’ would be highly procyclical and
would sharply limit the availability of credit for consumers and
businesses.
Without question, there were some financial firms, notably nondepository institutions such as broker-dealers, that were allowed to
raise their leverage ratios substantially in recent years. The SEC
ruling issued in 2004, which allowed alternative net capital requirements for broker-dealers, contributed significantly to the failures of both Bear Sterns and Lehman Brothers. The regulatory decision to rely on internal models for risk weighting assets appears,
in retrospect, to have been a major miscalculation.
Moreover, prudent regulators may wish to consider adopting capital policies that are more counter-cyclical as well, to encourage the
building of stronger reserves during good times and ensure greater
stability in periods of financial stress. Blanket mandates to ‘‘curtail
leverage,’’ however, will only restrict access to credit and limit successful lending models where they are needed most.
4. The Panel Report argues that: ‘‘Hedge funds and private equity funds are money managers and should be regulated according
to the same principles that govern the regulation of money managers generally.’’ The recommendation fails to recognize the important distinctions between investment firms and fails to explain why
these distinctions should be ignored.
There exist clear and dramatic differences between managing
capital allocation on behalf of a $5 billion pension fund, and investing funds placed in a personal IRA or 401k. Under current law, private equity, venture capital, and hedge funds may not be marketed
to retail investors. While they remain subject to all regulations regarding trading and exchange rules and regulations, they are not
subject to the marketing and registration requirements designed to
protect smaller, unsophisticated investors, because they do not
serve that market.
Suggesting that more regulation should be imposed on these entities in light of the current crisis ignores the fact that even under
the tremendous financial upheaval of the past year, no major hedge
funds have declared bankruptcy, and taxpayers have been exposed

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to no losses resulting from failed hedge fund or private equity investment activity.
Finally, it may be worth noting that several high-profile hedge
fund management firms were among the first to publicly and accurately assess the dangers inherent in the housing finance system,
mortgage backed securities, and Fannie Mae and Freddie Mac.
5. The Panel Report call for Congress to ‘‘[e]liminate federal preemption of application of state consumer protection laws to national banks.’’ Such a change would effectively defeat the purpose
of a uniform federal charter for insured depository institutions.
As previously mentioned, the regulation of any federal financial
firm requires the balancing of multiple policy choices and should be
done by one institution. By giving state regulators the power to affect bank profitability, capital levels, and solvency standards, this
proposal would greatly enhance risk and curtail innovation in our
system. Under the Panel proposal, states would not be responsible
for the safety and soundness of federally chartered banks, but
would have authority to impose regulations that could well undermine the health of those banks.
Allowing states to impose their own consumer protection laws
also undermines the fundamental purpose of a federal banking
charter. Congress established federal financial charters to enable
firms to offer products and services on a uniform national basis.
Standardization of products and services lowers costs, and acts as
an incentive for innovation by enabling new products to be brought
to market sooner. Allowing every state to impose its own set of
product or business standards on national banks would represent
a step backwards, away from strong well-balanced federal regulation that allows national firms to compete effectively with global
peers.
6. The Panel Report calls for new ‘‘tax incentives to encourage
long-term-oriented pay packages,’’ which would represent an unprecedented intervention in the operation of private employment
markets.
The Federal Government should not structure the tax code to reward, penalize or manipulate compensation. Congress attempted to
do this in the Omnibus Reconciliation Act of 1993, Pub. L. No. 103–
66, which contained the so-called ‘‘Million-Dollar Pay Cap.’’ 186 It
not only failed to achieve the stated goals of its authors, it had unintended consequences: by raising taxes on cash compensation,
more firms chose to compensate executives with large packages of
stock options, resulting in numerous high-profile multimillion-dollar ‘‘pay days’’ when the options were exercised.
Compensation committees should establish executive pay policies
that are fair, encourage sound long-term decisions, and are fully
disclosed to shareholders and the public. Using the tax code to design an ideal pay structure will certainly have unintended negative
consequences, as has been demonstrated by past action, nor will it
be successful in deterring companies from paying their employees
what they wish to attract and retain the best available talent.

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Reconciliation Act of 1993, Pub. L. No. 103–66, at § 13211.

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7. The Panel Report calls upon Congress to ‘‘consider creating a
Credit Rating Review Board’’ which would be given the sole power
to approve ratings required by pension fund managers and others
to purchase investment securities.
The credit rating system is badly in need of reform, but the main
weakness in the current system has been the existence and operation of, effectively, a duopoly—a status created by the restraints
of the government certification process. Giving a government operated Credit Review Board the power to sign off on all credit ratings
brings the system to a single point of failure, and becomes a significant source of systemic risk. Improving the credit rating system
will require more competition, an elimination of conflicts, and accountability. Regulators can facilitate this accountability by tracking the default levels of rated securities over time, and publicly disclosing the best and worst rating agency performance.

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APPENDIX: OTHER REPORTS ON FINANCIAL
REGULATORY REFORM

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Other reports on financial regulatory reform that are comparable
to this report in various respects are itemized in the following list
and then briefly summarized in the table below. Reports in both
list and table appear in reverse chronological order by the name of
the issuing organization. In the list, each item is followed by a
short-form reference in brackets.
Group of 30 (G–30). Financial Reform: A Framework for Financial Stability. January 15, 2009. http://www.group30.org/pubs/
publ1460.htm. [G–30 January 2009]
Committee on Capital Markets Regulation. Recommendations for
Reorganizing the U.S. Financial Regulatory Structure. January 14,
2009. http://www.capmktsreg.org/. [CCMR January 2009]
¯
Robert Kuttner, Prepared for Demos. Financial Regulation After
the Fall. January, 2009. http://www.demos.org/pubs/reglfalll
¯
1l8l09%20(2).pdf). [Kuttner/Demos January 2009]
United States Government Accountability Office (GAO). Financial Regulation: A Framework for Crafting and Assessing Proposals
to Modernize the Outdated U.S. Financial Regulatory System.
(GAO–09–216). January, 2009. http://www.gao.gov/new.items/
d09216.pdf. [GAO January 2009]
North American Securities Administrators Association. Proceedings of the NASAA Financial Services Regulatory Reform
Roundtable. December 11, 2008. http://www.nasaa.org/content/
Files/ProceedingslNASAAlRegulatorylReformlRoundtable.pdf.
[NASAA December 2008]
President’s Working Group on Financial Markets (PWG).
Progress Update on March Policy Statement on Financial Market
Developments. October, 2008. http://www.ustreas.gov/press/releases/
reports/q4progress%20update.pdf. [PWG October 2008]
Group of 30 (G–30). The Structure of Financial Supervision: Approaches and Challenges in a Global Marketplace. October, 2008.
http://www.group30.org/pubs/publ1428.htm. [G–30 October 2008]
Financial Stability Forum (FSF). Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience and
the Follow-Up on Implementation. April 7, 2008 and October 10,
2008. http://www.fsforum.org/about/overview.htm. [FSF April 2008
and October 2008]
Basel Committee on Banking Supervision. Principles for Sound
Liquidity Risk Management and Supervision. September, 2008.
http://www.bis.org/publ/bcbs144.htm. [Basel Liquidity Risk Management September 2008]
Professor Lawrence A. Cunningham, for Council of Institutional
Investors. Some Investor Perspectives on Financial Regulation Proposals. September, 2008. http://www.cii.org/UserFiles/file/Sept2008
MarketRegulation.pdf. [Cunningham/CII September 2008]
The Counterparty Risk Management Policy Group (CRMPG) III.
Containing Systemic Risk: The Road to Reform. August 6, 2008.
http://www.crmpolicygroup.org/docs/CRMPG-III.pdf. [CRMPG III
August 2008]
Institute of International Finance (IIF). Final Report of the IIF
Committee on Market Best Practices: Principles of Conduct and Best

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Practice Recommendations—Financial Services Industry Response
to the Market Turmoil of 2007–2008. July, 2008. http://
www.ieco.clarin.com/2008/07/17/iff.pdf. [IIF July 2008]
Securities Industry and Financial Markets Association (SIFMA).
Recommendations of the Securities Industry and Financial Markets
Association Credit Rating Agency Task Force. July, 2008. http://
www.sifma.org/capitallmarkets/docs/SIFMA-CRA-Recommendations.pdf. [SIFMA July 2008]
United States Securities and Exchange Commission Staff. Summary Report of Issues Identified in the Commission Staff’s Examination of Select Credit Rating Agencies. July, 2008. http://
www.sec.gov/news/studies/2008/craexamination070808.pdf.
[SEC
Staff July 2008]
International Organization of Securities Commissions Technical
Committee (IOSCO). Report on the Subprime Crisis. May, 2008.
http://www.iosco.org/library/pubdocs/pdf/IOSCOPD273.pdf. [IOSCO
Subprime Crisis May 2008]
International Organization of Securities Commissions Technical
Committee (IOSCO). The Role of Credit Rating Agencies in Structured Finance Markets. May, 2008. http://www.iosco.org/library/
pubdocs/pdf/IOSCOPD270.pdf. [IOSCO CRA May 2008]
President’s Working Group on Financial Markets (PWG). Policy
Statement on Financial Market Developments. March, 2008.
http://www.ustreas.gov/press/releases/hp871.htm.
[PWG
March
2008]
Senior Supervisors Group (SSG). Observations on Risk Management Practices in the Recent Market Turbulence. March 6, 2008.
http://www.newyorkfed.org/newsevents/news/banking/2008/ssgl
risklmgtldoclfinal.pdf. [SSG March 2008]
United States Department of the Treasury. Blueprint for a Modernized Financial Regulatory Structure. March, 2008. http://
www.treas.gov/press/releases/reports/Blueprint.pdf.
[Treasury
March 2008]
Financial Services Roundtable (FSR). The Blueprint for U.S. Financial Competitiveness. November, 2007. http://www.fsround.org/
cec/blueprint.htm. [FSF April 2007 and October 2007]
United States Chamber of Commerce Commission on the Regulation of U.S. Capital Markets in the 21st Century. Report and Recommendations of the Commission on the Regulation of U.S. Capital
Markets
in
the
21st
Century.
March
2007.
http://
www.uschamber.com/publications/reports/0703capmarkets
comm.htm. [Chamber of Commerce March 2007]
Mayor Michael Bloomberg and Senator Charles Schumer, with
McKinsey & Company and New York City Economic Development
Corporation. Sustaining New York’s and the U.S.’ Global Financial
Services Leadership. January, 2007. http://schumer.senate.gov/
SchumerWebsite/pressroom/speciallreports/2007/NYlREPORT
%20lFINAL.pdf. [Bloomberg/Schumer January 2007]
Committee on Capital Markets Regulation (CCMR). Interim Report of the Committee on Capital Markets Regulation. November,
2006. http://www.capmktsreg.org/.[CCMR November 2006]

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00:49 Mar 13, 2009

Jkt 047018

PO 00000

Frm 00118

Fmt 6602

Sfmt 6602

E:\HR\OC\E018A.XXX

E018A

Insert offset folio 115/150 here 47018A.017

jbell on PROD1PC69 with HEARING

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