[House Hearing, 111 Congress]
[From the U.S. Government Publishing Office]
THE END OF EXCESS (PART ONE):
REVERSING OUR ADDICTION TO
DEBT AND LEVERAGE
=======================================================================
HEARING
BEFORE THE
SUBCOMMITTEE ON
OVERSIGHT AND INVESTIGATIONS
OF THE
COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED ELEVENTH CONGRESS
SECOND SESSION
----------
MAY 6, 2010
----------
Printed for the use of the Committee on Financial Services
Serial No. 111-131
THE END OF EXCESS (PART ONE): REVERSING OUR
ADDICTION TO DEBT AND LEVERAGE
THE END OF EXCESS (PART ONE):
REVERSING OUR ADDICTION TO
DEBT AND LEVERAGE
=======================================================================
HEARING
BEFORE THE
SUBCOMMITTEE ON
OVERSIGHT AND INVESTIGATIONS
OF THE
COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED ELEVENTH CONGRESS
SECOND SESSION
__________
MAY 6, 2010
__________
Printed for the use of the Committee on Financial Services
Serial No. 111-131
U.S. GOVERNMENT PRINTING OFFICE
58-041 WASHINGTON : 2010
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HOUSE COMMITTEE ON FINANCIAL SERVICES
BARNEY FRANK, Massachusetts, Chairman
PAUL E. KANJORSKI, Pennsylvania SPENCER BACHUS, Alabama
MAXINE WATERS, California MICHAEL N. CASTLE, Delaware
CAROLYN B. MALONEY, New York PETER T. KING, New York
LUIS V. GUTIERREZ, Illinois EDWARD R. ROYCE, California
NYDIA M. VELAZQUEZ, New York FRANK D. LUCAS, Oklahoma
MELVIN L. WATT, North Carolina RON PAUL, Texas
GARY L. ACKERMAN, New York DONALD A. MANZULLO, Illinois
BRAD SHERMAN, California WALTER B. JONES, Jr., North
GREGORY W. MEEKS, New York Carolina
DENNIS MOORE, Kansas JUDY BIGGERT, Illinois
MICHAEL E. CAPUANO, Massachusetts GARY G. MILLER, California
RUBEN HINOJOSA, Texas SHELLEY MOORE CAPITO, West
WM. LACY CLAY, Missouri Virginia
CAROLYN McCARTHY, New York JEB HENSARLING, Texas
JOE BACA, California SCOTT GARRETT, New Jersey
STEPHEN F. LYNCH, Massachusetts J. GRESHAM BARRETT, South Carolina
BRAD MILLER, North Carolina JIM GERLACH, Pennsylvania
DAVID SCOTT, Georgia RANDY NEUGEBAUER, Texas
AL GREEN, Texas TOM PRICE, Georgia
EMANUEL CLEAVER, Missouri PATRICK T. McHENRY, North Carolina
MELISSA L. BEAN, Illinois JOHN CAMPBELL, California
GWEN MOORE, Wisconsin ADAM PUTNAM, Florida
PAUL W. HODES, New Hampshire MICHELE BACHMANN, Minnesota
KEITH ELLISON, Minnesota KENNY MARCHANT, Texas
RON KLEIN, Florida THADDEUS G. McCOTTER, Michigan
CHARLES WILSON, Ohio KEVIN McCARTHY, California
ED PERLMUTTER, Colorado BILL POSEY, Florida
JOE DONNELLY, Indiana LYNN JENKINS, Kansas
BILL FOSTER, Illinois CHRISTOPHER LEE, New York
ANDRE CARSON, Indiana ERIK PAULSEN, Minnesota
JACKIE SPEIER, California LEONARD LANCE, New Jersey
TRAVIS CHILDERS, Mississippi
WALT MINNICK, Idaho
JOHN ADLER, New Jersey
MARY JO KILROY, Ohio
STEVE DRIEHAUS, Ohio
SUZANNE KOSMAS, Florida
ALAN GRAYSON, Florida
JIM HIMES, Connecticut
GARY PETERS, Michigan
DAN MAFFEI, New York
Jeanne M. Roslanowick, Staff Director and Chief Counsel
Subcommittee on Oversight and Investigations
DENNIS MOORE, Kansas, Chairman
STEPHEN F. LYNCH, Massachusetts JUDY BIGGERT, Illinois
RON KLEIN, Florida PATRICK T. McHENRY, North Carolina
JACKIE SPEIER, California RON PAUL, Texas
GWEN MOORE, Wisconsin MICHELE BACHMANN, Minnesota
JOHN ADLER, New Jersey CHRISTOPHER LEE, New York
MARY JO KILROY, Ohio ERIK PAULSEN, Minnesota
STEVE DRIEHAUS, Ohio
ALAN GRAYSON, Florida
C O N T E N T S
----------
Page
Hearing held on:
May 6, 2010.................................................. 1
Appendix:
May 6, 2010.................................................. 41
WITNESSES
Thursday, May 6, 2010
Acharya, Viral V., Professor of Finance, Stern School of
Business, New York University.................................. 28
Brown, Orice Williams, Director, Financial Markets and Community
Investment, U.S. Government Accountability Office (GAO)........ 24
Geanakoplos, John, James Tobin Professor of Economics, Department
of Economics, Yale University.................................. 26
Hoenig, Thomas M., President and Chief Executive Officer, Federal
Reserve Bank of Kansas City.................................... 7
Walker, David A., John A. Largay Professor, McDonough School of
Business, Georgetown University................................ 30
Walker, Hon. David M., President and Chief Executive Officer,
Peter G. Peterson Foundation, and former Comptroller General of
the United States.............................................. 9
APPENDIX
Prepared statements:
Moore, Hon. Dennis........................................... 42
Acharya, Viral V............................................. 44
Brown, Orice Williams........................................ 214
Geanakoplos, John............................................ 232
Hoenig, Thomas M............................................. 289
Walker, David A.............................................. 308
Walker, Hon. David M......................................... 394
Additional Material Submitted for the Record
Moore, Hon. Dennis:
Federal Reserve Bank of New York Staff Report No. 328,
``Liquidity and Leverage,'' by Tobias Adrian and Hyun Song
Shin, dated May 2008, Revised January 2009................. 420
Congressional Research Service memorandum dated May 4, 2010.. 459
GAO report entitled, ``Financial Markets Regulation,'' dated
July 2009.................................................. 472
McKinsey Global Institute report entitled, ``Debt and
deleveraging: The global credit bubble and its economic
consequences,'' dated January 2010......................... 608
Paper entitled, ``Growth in a Time of Debt,'' by Carmen M.
Reinhart and Kenneth S. Rogoff, dated January 7, 2010...... 697
Biggert, Hon. Judy:
Written responses to question submitted to Orice Williams
Brown...................................................... 723
Wall Street Journal article entitled, ``A Fannie Mae
Political Reckoning,'' dated May 6, 2010................... 730
Bloomberg article entitled, ``Freddie Mac Stock Falls After
Seeking $10.6 Bln From U.S.,'' dated May 6, 2010........... 732
Article from The New York Times entitled, ``Freddie Mac Seeks
Billions More After Big Loss,'' dated May 5, 2010.......... 734
Politico article entitled, ``Frank to White House: Fight the
GOP,'' dated May 5, 2010................................... 735
Walker, David A.:
Forthcoming Journal of Economics and Business article
entitled, ``Long-Run Credit Growth in the US,'' dated March
2010....................................................... 738
THE END OF EXCESS (PART ONE):
REVERSING OUR ADDICTION
TO DEBT AND LEVERAGE
----------
Thursday, May 6, 2010
U.S. House of Representatives,
Subcommittee on Oversight
and Investigations,
Committee on Financial Services,
Washington, D.C.
The subcommittee met, pursuant to notice, at 10:05 a.m., in
room 2128, Rayburn House Office Building, Hon. Dennis Moore
[chairman of the subcommittee] presiding.
Members present: Representatives Moore of Kansas, Lynch,
Klein, Speier, Driehaus; Biggert and Lee.
Also present: Representative Royce.
Chairman Moore of Kansas. This hearing of the Subcommittee
on Oversight and Investigations of the House Financial Services
Committee will come to order.
Our hearing this morning is entitled, ``The End of Excess
(Part One): Reversing Our Addiction to Debt and Leverage,''
inspired by the April 6, 2009, Time cover story, right here,
``The End of Excess: Why This Crisis is Good for America,''
written by Curt Anderson.
This will be the first in a series of hearing where we will
look at the key issues exposed by the financial crisis, and the
next steps to continue improving financial stability in an
economic recovery.
We'll begin this hearing with members' opening statements,
up to 10 minutes per side, and then we'll hear testimony from
our witnesses.
For each witness panel, members will have up to 5 minutes
to question our witnesses.
The Chair advises our witnesses to please keep your opening
statements to 5 minutes to keep things moving so we can get to
members' questions.
Also, any unanswered question can always be followed up in
writing for the record.
Without objection, all members' opening statements will be
made a part of the record.
I now recognize myself for up to 5 minutes for an opening
statement.
The strength of our financial system and economy depends on
the responsible use of credit and debt built on trust between
the lender and borrower that payment will be made in the
future.
The word ``credit'' is derived from the Latin word
``credo,'' which simply means ``I believe.'' While the
financial industry complains about a lack of certainty as
Congress debates financial regulatory reform, there's a more
fundamental lack of trust that the American people now have in
our financial system.
To correct these two problems, this lack of certainty and
understandable lack of trust, we must enact strong rules of the
road this year, so the credibility of our financial system can
be restored.
A new law, unfortunately, can't heal our broken financial
system. The financial industry must take their own steps to
restore faith in their business. They must provide services
their customers really want, and not use hidden fees or balance
sheet tricks to cheat their way to the top again.
We need to empower consumers and investors to make better
financial decisions. Government must do its part in setting a
good example, providing efficient financial oversight with
limited resources, and getting on a path to balance the Federal
budget so we're not passing a massive debt on to our children
and grandchildren.
In 1978, our combined outstanding debt across the economy,
including financial firms, other businesses, households, and
local, State, and Federal Government was $3.6 trillion, or 157
percent of GDP. By the end of last year, that number ballooned
to $50.3 trillion, or 353 percent of GDP. This is the highest
level of combined debt of the United States on record.
Since 1978, our economy is over 6 times larger than what it
was, and we have grown, on average, $404 billion each year; but
over the same timeframe, our combined debt has grown nearly 4
times as fast, adding nearly $1.6 trillion each year on
average.
Even more troubling is the rapid growth of financial sector
debt, as it grew over 41 times larger than what it was in 1978.
As GAO noted in its leverage study that we'll hear about today,
Wall Street investment banks had leverage ratios of over 30 to
1, compared to the largest commercial banks, which averaged
leverage of 13 to 1.
In good times, this means their profits were supercharged,
but when asset prices fall, excessive leverage accelerates a
firm's failure, as we saw with Bear Stearns and Lehman
Brothers.
Are we addicted to debt and leverage? I'm afraid we might
be, and unless we take bold new steps on both financial
regulatory reform and budget reform soon, it will be very
difficult to reverse this troubling trend.
When I came to Congress in 1999--it was the last 2 years of
the Clinton Administration--we had budget surpluses those 2
years, and the first government surpluses in decades. When
President Clinton left office, the national debt stood at $5.73
trillion.
Unfortunately, over the next 8 years, our national debt
grew at a record pace, nearly doubling, and hitting $10.7
trillion. Our economy was on the verge of going off the cliff,
as we were still reeling from TARP and the financial panic in
late 2008, and our economy was losing 750,000 jobs a month in
early 2009.
Experts and economists from the left and the right,
including John McCain's economic advisor Mark Sandy, implored
Congress to act with a large stimulus to stabilize the economy,
so even though it wasn't popular, the government responded by
enacting the Recovery Act, and TARP was used to implement the
financial stability plan.
What happened next? The economy stabilized, and slowly but
surely, we are back on track with real economic growth.
A Republican witness, Professor David Walker, agrees in his
testimony, writing, ``Our economy would be rebounding much more
slowly than it has, if we had not implemented the TARP
program.''
Congress has made strong budget reforms, passing the
largest deficit-reducing legislation since 1993, in the new
health care law. We have re-implemented statutory pay-go, and
the President established a Fiscal Responsibility Commission
with a report due at year's end.
I look forward to hearing from our witnesses on these
issues today, bringing their experience and expertise on these
matters, so we can better understand how debt and leverage
impacts every single American, and what are the steps we can
take to get us back to a more stable path of economic growth.
Chairman Moore of Kansas. I now recognize for 5 minutes the
ranking member of our subcommittee, my colleague and friend
from Illinois, Ranking Member Judy Biggert.
Mrs. Biggert. Thank you, Chairman Moore, and thank you for
convening this important hearing.
Today's hearing is entitled, ``The End of Excess (Part
One): Reversing Our Addiction to Debt and Leverage.'' However,
I would like to add to that. I would add that Washington must
reverse its addiction to Big Brother government, wasteful
Washington spending, and permanent taxpayer-backed government
bailouts.
The denial in Washington must end. Washington must get on
the side of the American taxpayer, American families,
community-based financial institutions, and American small
businesses--the job creators in our economy.
Our Nation's debt is on an unsustainable track. The denial
of some lawmakers that Washington take over with bailouts and
spending that is out of control must end.
The front page of today's Washington Post reads, ``Greece's
debt-paying sparks violence.'' And as we have all seen in the
paper, this European debt crisis will seem like a drop in the
bucket when compared to our Nation's projected debt, which, by
some estimates, will reach $15 trillion by the end of 2020,
representing 67 percent of GDP.
Levels of debt that are of this nature are not sustainable
and represent a barrier to the future economic prosperity of
our Nation.
High taxes, inflation, and higher unemployment rates will
be the byproducts of the current Administration's fiscal
irresponsibility.
Linked to this irresponsibility is the Administration's
unlimited guarantee of the debt of Fannie Mae and Freddie Mac,
with trillions in obligations that are guaranteed by our
government, our taxpayers.
Freddie Mac announced yesterday that it will need an
additional $10.6 billion in government funding. That's $10.6
billion more of taxpayers' money. The latest addition brings
the GSE loss to taxpayers to $136 billion.
And with that, Mr. Chairman, I would like to ask unanimous
consent to insert in the record three newspaper articles: one
from Bloomberg, saying, ``Freddie Mac seeks $10.6 billion from
Treasury following first-quarter loss''; one from the New York
Times, ``Freddie Mac seeks billions more after big loss''; and
the third from Politico, ``Frank to White House: Fight the
GOP.''
Chairman Moore of Kansas. Without objection, they will be
made a part of the record.
Mrs. Biggert. Thank you.
The Administration has yet to even appoint an inspector
general to provide objective, independent oversight over the
Federal bureaucrats who now control the GSEs, and I know you
have had that bill to do that.
It is inconceivable that officials managing these
liabilities would be allowed to do so without proper
transparency, independent oversight, and thorough reporting to
Congress and the American people, and it's unacceptable that
the Administration continues to kick the can down the road and
still has no firm exit strategy to spare taxpayers from future
losses associated with Fannie and Freddie. Republicans are
ready to address this problem and get taxpayers out of this
mess.
Finally, the risk-takers on Wall Street need to know clear
rules of the road. The rules must say that there will be no
more bailouts and no more institutions ``too-big-to-fail.''
This message should be clear. If you run your company into the
ground, you'll be shut down. Your creditors and counterparts
won't get a bailout that's paid for by taxpayers, consumers, or
community banks and small businesses that have had no role in
your risky behavior.
I look forward to the testimony of today's witnesses. I'm
particularly interested in the findings of the GAO study from
last July, that clearly pointed to the fact that because
institutions thought that housing asset value, primarily
housing prices, would continue to rise, institutional leverage
increased.
When these institutions began to experience significant
losses due to decline in value of mortgage-related and other
assets, financial institutions attempted to deleverage and
reduce their risk by raising new equity, reducing dividend
payouts, selling assets, and reducing lending.
Raising capital, however, became increasingly difficult
after the onset of the crisis, as would-be investors began to
have doubts about the quality of these firms' assets, and
financial institutions began to deleverage by selling assets.
In the fourth quarter of 2008, broker-dealers reduced
assets by nearly $785 billion, and banks reduced bank credit by
nearly $84 billion.
This series of events significantly contributed to our
economic crisis. Today, our economy is essentially on thin ice
and susceptible to even the most moderate economic shocks,
according to GAO.
For this reason, in the reform proposal, H.R. 3310, House
Republicans proposed a market stability and capital adequacy
board to monitor these interactions.
Congress doesn't need to bestow more power on the same
Washington bureaucrats who didn't do their job at policing the
financial industry or protecting consumers in the first place.
Regulators need to get their act together. We must enact smart
financial reforms that require coordinated regulatory efforts
and bailouts, and bring certainty to the marketplace so that
investors invest, businesses expand, and more jobs are created
to put Americans back to work.
Finally, until our Federal house is in order, our children
and grandchildren will be the ones who will bear the burdens
associated with our Nation's addiction to excessive borrowing
and spending.
And with that, I yield back.
Chairman Moore of Kansas. I thank the ranking member.
I next recognize Mr. Lynch from Massachusetts for 2
minutes, sir.
Mr. Lynch. Thank you, Mr. Chairman, for holding this
hearing, and I also want to thank our distinguished panelists
for their willingness to come before this committee to help us
with our work.
Mr. Chairman, our Nation's growing addiction to debt is one
that has been largely ignored until the collapse of the
financial markets in the fall of 2007. According to the Federal
Reserve, at the end of 2009, the combined outstanding debt in
the U.S. economy was $50.3 trillion. That includes financial
industry debt, non-financial business debt, household debt, and
local, State, and Federal Government debt.
Since the boom years began in the 1980's, our debt as a
percentage of GDP has risen almost 200 percent, and while a lot
of things have happened since the early 1980's, and some of
that factor might be mitigated, I think the increase in debt
has been instructive, as to where we have been and where we're
going.
As we know all too well, no other industry was as highly
leveraged and addicted to debt as the financial system. We have
learned that Lehman Brothers, and probably other banks, used
techniques like the Repo 105 to conceal debt, masking just how
highly leveraged they actually were from regulators and
investors.
Collateralized debt obligations and other over-the-counter
derivatives were multiplying and disguising or transferring
debt off the balance sheets of companies into opaque markets,
such that regulators and market participants could only guess
at the total amounts involved in these deals.
The regulatory reform bill that the House passed last year,
the Wall Street Reform and Consumer Protection Act, would
establish a stability oversight council to give regulators
better tools to monitor and regulate excessive leverage and
risk-taking.
I know my colleague, Mr. Miller, has introduced a bill that
mirrors a number of amendments that the Senate is currently
considering to their regulatory reform bill, limiting the size
of mega-banks by setting a cap on any company's share of total
deposits and setting minimum equity levels for bank holding
companies and non-bank financial institutions.
I think these are steps in the right direction, and I'm
looking forward to hearing from our witnesses today on further
proposals to help wean ourselves from this harmful addiction to
debt.
Thank you, Mr. Chairman. I yield back.
Chairman Moore of Kansas. I thank the gentleman.
The Chair next recognizes Ms. Speier from California for 3
minutes.
Ms. Speier. Thank you, Mr. Chairman, and thank you to the
witnesses for participating in what is a very important
hearing. This hearing on the impact of leverage and increasing
debt burden is profound. I'm struck by the fact that the two
sectors that dramatically increased their debt burden leading
up to the current economic crisis were the financial sector and
consumers, and we know that it was the financial institutions
that fostered the growth in consumer debt through teaser-
interest-rate credit cards and loans, no-down auto loans, 2/28,
and no-doc pick-a-pay payments, mortgages, and home equity
loans, all so that they could be packaged into bonds and CDOs,
and synthetic CDOs, that magically received AAA ratings and
generated enormous fees and profits.
I strongly believe that excessive leverage used by the
large financial institutions was a major factor in the real
estate bubble and subsequent financial collapse in 2008. In
fact, according to Professor David Moss of Harvard Business
School, outstanding debt in the financial sector--and this
figure is truly mind-blowing--increased from $568 billion in
1980 to more than $17 trillion in 2008.
Leverage helped firms become ``too-big-to-fail.'' A firm
with $1 billion in capital can have $40 billion in liabilities,
which means that if it goes down, there are other banks and
lenders who need $40 billion in repayments if their balance
sheets are going to add up.
The banks that survived the crisis best, like JPMorgan, had
the lowest levels of leverage. The leverage ratio at Bear
Stearns reached more than 40 to 1 before it failed. By 2007,
the leverage ratios of many of the major Wall Street investment
banks reached more than 30 to 1, including Lehman Brothers and
Merrill Lynch.
But these are only their on-balance-sheet levels. These
firms also gamed their leverage numbers by using off-balance-
sheet vehicles and tricks, like Repo 105s, to make their
balance sheets look better than they really were.
The fact that most of this was short-term debt simply made
matters worse, when the real estate bubble burst, and
supposedly liquid mortgage-backed securities suddenly became
unsellable, causing a downward spiral.
I feel compelled to set the record straight. We are here
today not because of overregulation, but because of systemic
and systematic de-regulation, with the passage of the Gramm-
Leach-Bliley Act of 1999, the Commodities Future Modernization
Act in 2000, which prohibits Congress from regulating
derivatives, and the SEC's Consolidated Supervised Entities
Program in 2004 that led to a relaxation of leverage ratios for
investment banks, which then were 12 to 1. They just lifted it
altogether.
Regulators still had the power to take many actions in the
months and years leading up to the current crisis, but they
didn't believe there was a problem. Up until the bitter end,
they asserted that there was no bubble and that the market
would take care of itself. Well, it didn't.
I'm gratified that the House Wall Street Reform and
Consumer Protection Act includes my amendment that would limit
debt to equity leverage at systemically risky firms to no more
than 15 to 1. The regulators could still impose a lower limit.
I'm delighted that Thomas Hoenig, president of the Federal
Reserve Bank of Kansas City, is here. He has said publicly that
he believes that there must be a leverage ceiling. In fact, he
has said that 15 to 1 is too generous. I might add that Goldman
Sachs is presently leveraged at 15 to 1 today, and breaking its
own records for profits.
It may be impossible to devise a truly foolproof regulatory
regime to prevent the next crisis, but we should not again be
totally reliant on the wisdom and good intentions of government
regulators, or voluntary restraint by Wall Street firms.
I thank the chairman. I yield back.
Chairman Moore of Kansas. I thank the lady for her
statement, and I'm pleased to introduce our first panel of
witnesses.
First, we'll hear from Mr. Thomas Hoenig, President and CEO
of the Federal Reserve Bank of Kansas City. Welcome, Mr.
President.
And next, we'll hear from the Honorable David M. Walker,
President and CEO of the Peter G. Peterson Foundation, and
former Comptroller General of the United States. Welcome to
you, sir.
It's an honor to have such distinguished current and former
public officials before our subcommittee today.
Without objection, your written statements will be made a
part of the record.
Mr. Hoenig, sir, you're recognized for 5 minutes to provide
a brief summary of your statement.
STATEMENT OF THOMAS M. HOENIG, PRESIDENT AND CHIEF EXECUTIVE
OFFICER, FEDERAL RESERVE BANK OF KANSAS CITY
Mr. Hoenig. Chairman Moore, Ranking Member Biggert, and
members of the committee, I want to thank you for asking me to
testify here today, to give me an opportunity to share some of
my views on the issues around leverage.
Certainly, among the factors that contributed to this
financial crisis, there is no question that leverage was key,
and the unwinding of this leverage contributed to the
escalation of this crisis into the worst recession in 75 years,
hurting Americans at all economic levels.
I have spent more than 36 years at the Federal Reserve,
deeply involved in bank supervision, and it has been apparent,
to me at least, for some time that our Nation's financial
institutions must have firm and easily understood leverage
requirements.
Leverage tends to rise when the economy is strong, as
investors and lenders forget past mistakes and believe that
prosperity will always continue. If we don't institute rules
now, to contain leverage, another crisis, I can tell you, is
inevitable.
My written testimony addresses the systemic increase, or
systematic increase in debt and leverage that has occurred in
all major sectors of our economy over the past 2 decades. But
my comments today will focus specifically on what occurred at
the largest financial firms, which were the catalysts, in many
ways, for this crisis.
Leverage, of course, is the ability to use debt to build
assets as a multiple of a firm's capital base. The leverage of
banking organizations has risen steadily since the mid-1990's.
It was not immediately obvious because of the many different
ways capital and leverage can be measured.
In my judgment, the most fundamental measure of a financial
institution's capital is to exclude intangible assets and
preferred shares and focus only on tangible common equity, that
is, ownership capital actually available to absorb losses and
meet obligations.
Looking at tangible common equity, you see that leverage
for the entire banking industry rose from $16 of assets for
each $1 of capital in 1993, to $25 for each $1 of capital in
2007.
More striking, perhaps, this aggregate ratio was driven
most significantly by the 10 largest banking companies. At
these firms, assets rose from 18 times capital to 34, over the
same period, and that does not include their off-balance-sheet
activities.
These numbers, in my opinion, reflect two essential points.
First, that based on capital levels, the 10 largest banking
organizations carried fundamentally riskier balance sheets at
the start of this crisis than the industry as a whole. Second,
their greater leverage reflects a significant funding cost
advantage. Not only is debt cheaper than equity, but their debt
was cheaper than the smaller organizations, because creditors
were confident that these firms were too big to be allowed to
fail.
This was a gross distortion of the marketplace, providing
these firms an advantage in making profits, enabling them to
build size, and then, in the end, leaving others to suffer the
pain of their collapse.
This is not capitalism, but exploitation of an unearned
advantage; and the list of victims is long, including families
who lost homes, workers who lost jobs, and taxpayers who were
left to pay the tab.
This increase in leverage in the banking industry spread
broadly to other sectors of the economy, creating a general
excess of credit growth over the past 10 years, especially, as
you said, among consumers.
This economy-wide rise in leverage was based on the
assumption that asset prices would continue to rise, especially
those in housing this time. When prices fell and defaults and
losses mounted, capital ratios that had been systematically
reduced over time proved grossly inadequate.
To illustrate, suppose the 10 largest banking organizations
had been required to confine their leverage to an historically
more reasonable level of $15 of tangible assets for every $1 of
tangible common equity, rather than the 34 they had.
Under this historic limit, they would have been forced to
hold an additional $326 billion of equity, 125 percent more
than they actually had, to absorb potential losses; or, they
would have had to cut back on their growth by nearly $5
trillion; or more likely, the combination of those two.
The point is, the institutions got away from the
fundamental principles of sound capital management, and those
institutions with the highest leverage suffered the most.
Financial panic and economic havoc quickly followed.
The process of deleveraging is still under way. Rebuilding
capital has begun. But during this rebuilding, loans are harder
to get, which is impeding the economic recovery.
With this very painful lesson fresh in our mind, now is the
time to act. I strongly support establishing hard leverage
rules that are simple, understandable, and enforceable, and
that apply equally to all banking organizations that operate
within the United States.
As we saw in the years before the crisis, leverage tends to
rise during the expansion, as past mistakes are forgotten, and
pressure for growth and higher returns on equity mount.
Straightforward leverage and underwriting rules require bankers
to match increases in assets with increases in capital, and
prevent disputes with bank examiners over interpretations of
the rules. As a result, excess is constrained and a
countercyclical force is created that moderates booms, and
forms a cushion when the next recession might occur.
I firmly believe that, had such rules been in place, we
would have been spared a good part of the tremendous hardship
the American people have gone through during the past 2 years.
Thank you.
[The prepared statement of Mr. Hoenig can be found on page
289 of the appendix.]
Chairman Moore of Kansas. Thank you, Mr. Hoenig.
The Chair next recognizes the Honorable David M. Walker.
Sir, you're recognized for 5 minutes.
STATEMENT OF THE HONORABLE DAVID M. WALKER, PRESIDENT AND CHIEF
EXECUTIVE OFFICER, PETER G. PETERSON FOUNDATION, AND FORMER
COMPTROLLER GENERAL OF THE UNITED STATES
Mr. David M. Walker. Chairman Moore, Ranking Member
Biggert, and members of the subcommittee, thank you for the
opportunity to testify today.
It's very important to state at the outset of this hearing
that not all debt and leverage is bad, however, excess debt and
leverage is. In addition, individuals, businesses, and
countries must not become accustomed to taking on debt in order
to finance their ongoing operating costs and current wants at
the expense of future needs and future generations.
Now, let me turn to the state of the U.S. Government's
finances, which is what I was asked to focus my testimony on
today.
It is clear that the United States is a great nation,
possibly the greatest in the history of all mankind. At the
same time, our country is resting on its past successes and its
sole superpower status, which is temporary, while at the same
point in time, ignoring a range of leading indicators that
clearly demonstrate that we are on an imprudent and
unsustainable path in many respects.
This includes matters such as public finance, savings
rates, educational performance, health care costs and outcomes,
and the state of our Nation's critical infrastructure.
The truth is, our country's future standing and the
standard of living for future generations of Americans is
threatened by these key sustainability challenges, and given
the subject of this hearing and series of hearings, I'll focus
my remarks on America's structural deficits, growing debt
burdens, increased reliance on foreign lenders, and low savings
rates.
During the first approximately 200 years of our republic's
existence, the Federal Government did not experience
significant and recurring deficits, unless the country was at
war, meaning a declared war, was experiencing a depression or
recession, or faced some other major national emergency.
However, within the past several decades, both America and
too many Americans became addicted to spending, deficits, and
debt. This cultural challenge is real, and it has reached
epidemic proportions in Washington, D.C.
As an example, total Federal debt levels have more than
doubled in less than 10 years, and they could double again,
within the next 10 years, on our present path.
Clearly, trillion-dollar deficits are a matter of growing
public concern. However, it's important to understand that
today's deficits do not represent the real threat to our ship
of state. The real threat is the large, known, and growing
structural deficits that will exist when the economy has
recovered, when unemployment is down, when the wars are over,
and when the crises have long passed. These literally threaten
the future standing of the United States and the future
standing of living of Americans; and as we can see, that absent
dramatic and fundamental spending and tax reforms, our Federal
debt levels are expected to skyrocket in the future. Believe
me, the markets will not allow us to get nearly very far down
this road.
Federal spending levels have grown by almost 300 percent
net of inflation over the past 40 years, and the Federal budget
is now dominated by mandatory spending programs that grow on
auto-pilot. These mandatory spending programs serve to
constrain our ability to invest in our children, in critical
infrastructure, and other areas that help to create a better
future.
As I have traveled the country and appeared to the media
promoting the need for fiscal responsibility, many have asked,
``Are we Greece?'' Their question is based on the current
challenges being experienced by that country, and the answer
that I typically give is, the United States is not in the same
situation as Greece today. However, our key public debt ratios
will be as bad as Greece's in less than 10 years. And given our
present path, we must learn the lessons of Greece and past
history, if we want to avoid a similar crisis of confidence.
Today's paper notes, ``Riots in the streets of Greece.''
This could happen in the United States in less than 10 years,
on our present path.
Today's paper notes the dominance of concern in Britain
about public debt. And as you will see, most Americans don't
realize, including most Members of Congress in all likelihood,
that our key total public debt ratios exceed Great Britain.
They exceed Spain. They exceed Ireland. They're not as bad as
Greece, but they'll be there within less than 10 years.
The truth is the debt to GDP numbers that the Federal
Government pushes on the public, tend to understate the
Nation's true leverage.
For example, current debt held by the public is about 58
percent of GDP and rising. However, if you add debt that's owed
to Social Security and Medicare and other so-called trust
funds, the debt to GDP ratio would be about 89 percent. And if
you consider the debt that's held by Fannie Mae and Freddie
Mac, which many believe should be consolidated with the U.S.
Government's financial statements, we're well over 100 percent,
and rising rapidly.
What about savings rates? Savings rates have declined
dramatically, and the net national savings rate has plunged to
the lowest level since the Great Depression.
We must recognize reality and understand that the four
factors that caused the mortgage-related subprime crisis exist
for the Federal Government's own finances: first, specifically,
a disconnect between those who benefit from prevailing
practices and those who will pay the price and bear the burden
when the bubble bursts; second, not enough transparency as to
the nature, extent, and magnitude of the real risk; third, too
much debt, not enough focus on cash flow, and overreliance on
credit ratings; and finally, a failure of existing governance,
risk management, oversight, and regulatory functions to act
until a crisis is at the doorstep.
In my view, in summary, while America is a great nation, we
are at a critical crossroads. The decisions that are made, or
that fail to be made by elected officials over the next 3 to 5
years, especially in the fiscal area, will largely determine
whether our future is better than our past, or whether our best
years are behind us.
We must move beyond delay and denial, we must start making
tough choices, and we must do so before we pass a tipping
point, which is what happened in Greece.
If you look what happens when you pass a tipping point and
you lose the confidence of your foreign lenders, interest rates
can escalate dramatically, which can set off a chain of events
that not only would have adverse economic consequences in the
United States, but dramatic adverse consequences around the
world.
The United States will not default, but we may well have to
pay much higher interest rates in the future because of not as
much concern about default, but concern about what is the
dollar worth that lenders will receive.
Thank you very much, and I'll be happy to answer your
questions.
[The prepared statement of Mr. David M. Walker can be found
on page 394 of the appendix.]
Chairman Moore of Kansas. Thank you, sir, for your
testimony.
Mr. Hoenig, thank you for testifying today, and for your
36-plus years of service with the Fed. You and your staff at
the Kansas City Fed have been leaders in our community, and an
invaluable resource as our country has slowly managed our way
through the financial crisis.
As both you and Mr. Walker have pointed out, leverage is a
double-edged sword and can be responsibly used for productive
economic outcomes. But it seems, in the last decade especially,
discipline was sacrificed for excessive risk-taking at times.
Would you elaborate on your point that, ``the greater
leverage reflects a significant funding cost advantage,'' for
larger firms? I agree with your views that this represents a
gross distortion of marketplace, and is an exploitation of an
unearned advantage.
Can you help us better understand this point, sir?
Mr. Hoenig. I hope so. The way I would start, is if you
look at my final comments, with how much additional capital it
would take to have what I think is a reasonable leverage ratio
in terms of tangible capital, you would have to raise over $300
billion equity.
Equity is more expensive, and therefore, by not having to
raise that, to be allowed to have a higher leverage ratio, your
cost of funding was, in effect, less, because smaller
institutions, who are not ``too-big-to-fail,'' of course, don't
have that advantage.
So you really have biased the outcome towards the largest
institutions. They don't have to raise as much capital;
therefore, their costs are less; plus, they're thought to be
``too-big-to-fail.'' Therefore, their credit costs, as well,
are less than you would have in a regional bank that everyone
knows could be closed if it were to fail.
So that's a huge advantage, and it perpetuates the ever-
increasing size and consolidation of the financial industry,
because, think about it. If you're on that borderline as being
thought ``too-big-to-fail,'' you have to go and get a merger
partner and get above that threshold and bring your costs down.
So it has a very perverse incentive system, that I think harms
us.
Chairman Moore of Kansas. Thank you, sir. At the end of
your testimony, Mr. Hoenig, you note that critics will oppose
more conservative capital ratios on the grounds it will
restrict growth. You admit it will, but the point that everyone
seems to miss is that runaway, excessive growth and dependence
on leverage and debt is unsustainable and dangerous, and puts
all Americans at risk.
We need to return to a more sustainable and responsive--do
we need to return to a more sustainable and responsible use of
leverage and debt; is that correct?
Mr. Hoenig. Absolutely correct, sir. I'm convinced--I have
been told many times that, if you put these leverage
constraints, you make it a rule of, say, 15 to 1, that during
the growth period, you will constrain growth.
And my answer is, yes. That's the nature of sound fiscal
management, that your capital requirements limit you. So if you
want to go out and grow your balance sheet, you have to raise
new capital to do so, which keeps it sounder, but also keeps
the growth from running away.
So, under those conditions, under having firm rules, the
capital ratios become countercyclical. When you allow them to
move, they become less restrictive during the growth period and
more restrictive during the recession. You get a procyclical
outcome. The boom is bigger, and the recession is much worse.
And that's what we want to avoid. I think this would do it.
Chairman Moore of Kansas. Thank you, sir.
Mr. Walker, thanks for your years of public service, and
what you have done to raise awareness about our long-term
budget challenges.
First, I think you make a great point in your testimony
that all debt and leverage is not bad, and with its responsible
use, it can lead to productive economic activity. But like our
addiction to foreign oil, and the dangers it poses to our
national security, you note that, ``our low savings rate and
large spending appetite, America has become unduly reliant on
foreign investors to finance our Federal deficits and debt.''
Would you explain, sir, how our dependence on excessive
debt may be a threat to our national interests in a little more
detail, if you would, sir, please?
Mr. David M. Walker. Yes, I will.
First, the fastest-growing expense in the Federal budget
today is not health care costs, although they do threaten our
future. It's interests costs. Within 12 years, without a risk
premium for interest rates, the single largest line item in the
Federal Government's budget will be interest on the Federal
debt, and we get nothing for that.
If we have to start paying a risk premium, say 200 basis
points, or 2 percent, by 2040, the only thing the Federal
Government could pay, based on historical revenue levels, is
interest on the Federal debt. We get nothing for it.
So the fact is, we have to recognize that, by having
excessive leverage, we are crowding out our ability to invest
in our future. In addition to that, we are increasing the risk
of passing a tipping point, whereas foreign investors may
decide that they want to charge us higher interest rates in
order to offset any potential risk, not as much of default, but
of a significant reduction in the value of our currency and,
therefore, their effective yield.
We are a great country, and we benefit from the fact that
we have about 62 percent of the world's global reserve
currency. That gives us more rope. It gives us more time. But
ultimately, we are not exempt from the fundamentals laws of
prudent finance; and yet we act like we are.
We're talking about our future national security, our
future international standing, and our future standard of
living.
I think we have to recognize reality. There are two kinds
of taxes: current taxes; and deferred taxes. And to the extent
that you run large deficits, those represent deferred taxes
that will have to be paid with interest.
So this is not just an economic and national security
issue; it's a moral issue.
Chairman Moore of Kansas. Very good point. Thank you for
your answer to my question, sir.
The Chair next recognizes Ranking Member Biggert for 5
minutes.
Mrs. Biggert. Thank you, Mr. Chairman.
Mr. Hoenig, the bill that is before us, the regulatory
reform bill that Democrats have proposed, isn't it, if they
have the ``too-big-to-fail'' that's a problem, isn't it likely
that the leverage problems will become even worse in the
future?
Mr. Hoenig. If we fail to address the ``too-big-to-fail''
issue, then the leverage issue and the consequence from that
will only get worse through the next cycle.
In other words, all the banks are deleveraging right now,
because of the pressure. But once the economy turns around and
we begin to expand again, the leverage, the drive for leverage
will increase as return on equity demands, return to investors
becomes of paramount focus by that CEO, and the deleveraging
will start again, and we will repeat the cycle, in my opinion.
That's why we need to have in the legislation, firm
leverage rules that the rule of law then dictates that,
inhibits that from happening, and it will, in fact, inhibit the
growth of some of these largest institutions by taking their
advantage away.
Mrs. Biggert. What, then, do we do when these--if they have
funding advantages, and the creditors, since they seem to have
a different status, the creditors will be more likely, when
they monitor, not to be as vigilant when they look at the
institution's leverage, so that it would go up.
Is that a potential problem, too?
Mr. Hoenig. As long as we do not address ``too-big-to-
fail,'' that is not a potential, but an immediate, real
problem.
The creditors have to be under--that's why I prefer a rule
of law that takes away discretion from the bureaucrat or from
the policy person, so that in the crisis, you don't have that
option to bail out, so that you have to take certain steps,
controlled, to prevent a financial meltdown as such, but we can
do that, and then the creditor knows that they will be in line,
and they will get--
Mrs. Biggert. So it would be like an enhanced bankruptcy?
Mr. Hoenig. That's correct. An enhanced bankruptcy for a
failure process that assures everyone that the largest
institution will be dismantled if it fails.
Mrs. Biggert. Okay. How has recent Fed policy encouraged
the use of debt financing?
Mr. Hoenig. In the sense of the last of this past cycle,
I'm on the record as saying that when you keep interest rates
exceptionally low for an extended period, you are encouraging
credit, because of course, it's cheaper to borrow than to raise
equity, it's more convenient, and therefore, you encourage
credit. So you add to the incentives by keeping interest rates
lower than they would otherwise be under normal market supply
and demand conditions. So that's one of the issues we have to
confront.
Mrs. Biggert. Thank you.
Mr. Walker, then, you point out some alarming numbers, and
alarming other things, too. And thank you for your testimony. I
hope you don't scare everybody to death.
Regarding the Federal debt, when you account for the debt
owed to Social Security, Medicare, and the total GSE
liabilities, what should be done regarding the GSE debt?
In other words, you talk about mandatory spending, and we
have to reduce that? Really, discretionary spending is not near
the amount of the mandatory. But how does the GSE liability fit
in there, and what should be done with their debt, and can we
continue to really continue to fund Fannie and Freddie as we're
doing now?
Mr. David M. Walker. First, in my personal view, the debt
that's owed to the Social Security and Medicare trust funds
should be deemed to be a liability.
On one hand, we hold it out as an asset of the trust funds.
We tell the beneficiaries of those programs that you can count
on it, it's guaranteed by the full faith and credit of the
United States Government, both as to principal and interest. We
won't default on it. But yet, right now, it's not considered a
liability.
And so, therefore, if it was, and by the way, it is part of
the total debt subject to the debt ceiling limit, our current
debt to GDP ratio would be 89 percent, and rising rapidly.
The issue of Fannie Mae and Freddie Mac is a little
different. We do account for transactions, such as the $100
billion plus that we have already provided to them. The
Treasury has now effectively guaranteed trillions of dollars of
Fannie Mae and Freddie Mac debt. That's a contingent liability.
But now, the Federal Government essentially controls Fannie Mae
and Freddie Mac, and one of the questions that's going to have
to be answered for this year's financial statements is, should
they be consolidated into the financial statements of the
United States Government.
Current accounting allows for that not to happen if it's
temporary. It's not so clear to me how temporary this situation
is, and so it's something that's very serious and we need to
focus on it.
Bottom line, we're in worse shape than we tell people, and
we need to recognize reality, that we're not exempt from the
fundamentals of prudent finance. We also need to do what it
takes to avoid what's happening in Europe right now.
Mrs. Biggert. Thank you. My time is up. I yield back.
Chairman Moore of Kansas. Thank you.
The Chair next recognizes, Mr. Lynch, from Massachusetts.
Sir, you have 5 minutes.
Mr. Lynch. Thank you, Mr. Chairman.
I want to thank you both for your willingness to come
before the committee here today, and I also thank you for the
frankness of your testimony; and I share a lot of the same
sentiments about where we're heading.
One of the particular areas I think that--let's go to the
``too-big-to-fail'' discussion. We talked about the 10 banks
that really exceeded, by everyone's estimate, the existing
capital structure regulation, and they accomplished that. We
had regulations in place about how much leverage there could be
for these banks.
What they did is, they used derivatives, they used these
special purpose vehicles, used them by several names, but
basically, in many cases, they contained these collateralized
debt obligations, or collateralized loan obligations, and they
moved that debt off their balance sheet.
And that way, they were able to stay within the regulatory
framework, at least nominally, until it hit the fan, and these
folks had to take all that stuff back on their balance sheets
because there were no buyers, and those investments basically
deteriorated.
That practice allowed these banks to become ``too-big-to-
fail,'' in my opinion.
I'm just wondering what you think about the Senate version
of financial services reform, and also the House version, where
we put some limits on these derivatives, we have established
exchanges, which provides for transparency, we have provided
for clearinghouses, and I'm a little bit nervous, because it
still allows these clearinghouses to be owned by these 10
banks. As a matter of fact, 5 of the banks own 97 percent of
all the clearinghouses, and that troubles me greatly.
But there's also a dark market that is maintained, for
unilateral trading of these complex derivatives that go on
between individuals. And so, I'm nervous about the perpetuation
of this practice of moving stuff off the balance sheet, and
that has allowed this leverage to go on.
I would just like to hear from each of you whether or not
you think my fears are unfounded, or perhaps you might suggest
a way of getting at that.
Thank you.
Mr. Hoenig. I think your fears are well-founded. I think
the amount of off-balance-sheet activities with certain kinds
of derivatives and synthetic derivatives have contributed to
this crisis. I think that would be hard to refute, actually.
I do believe that the legislation should provide, number
one, for better disclosure and for requiring these institutions
to keep a portion of that on their balance sheet, whether it's
5 percent or 10 percent, so that you can monitor, and they have
some skin in the game, if you will, to monitor that off-
balance-sheet activity. That's number one.
Number two, on your exchanges, I'm very strongly supportive
of a clearinghouse, but even exchanges, where you bring it to
the light of day. A market discovery price is more available,
people can, not behind the scenes this dark market manipulate
to, say, push something so they can gain in a short position,
and so forth.
I know there's a lot of discussion right now in the Senate
on those particular industry players, but I think that can be
dealt with, and the main objective should be to get
transactions in the open, that is, a clearly regulated exchange
or clearinghouse--it has rules that it abides by--would be the
best outcome for the American people, and for the financial
industry, actually.
Mr. David M. Walker. I think, clearly, with regard to the
private sector, there's no question that there need to be
tougher capital requirements, that also give appropriate
consideration to derivatives.
In addition, there needs to be more transparency, no
question, and better oversight than historically has been the
case.
But let me remind you that you're correct, Congressman
Lynch, that these special purpose entities and the use of
derivatives didn't serve to mitigate risk but to enhance risk,
which was part of the problem.
The Federal Government has special purpose entities, too.
They're called trust funds. And one could argue that GSEs might
be deemed to be special purpose entities, too.
So we need to practice what we preach. We need to do what
we need to do with regard to institutions and instruments that
represent systemic risk, but we also need to put our own
financial house in order, and make sure that we're leading by
example, and practicing what we preach.
Mr. Lynch. Thank you. I yield back.
Chairman Moore of Kansas. Thank you, sir.
The Chair next recognizes Mr. Driehaus for 5 minutes.
Mr. Driehaus. Thank you very much, Mr. Chairman. Thank you
for holding this hearing.
And I appreciate the testimony of the two witnesses. I
think it's an issue that, while we talk about it from time to
time on the surface, very rarely do people dig down and try to
get toward solutions when it comes to our indebtedness.
I was very interested, Mr. Walker, specifically, in some of
the solutions that you had focused on in your testimony, one of
those being the issue of tax expenditures, which I think the
vast majority of Americans pay very little attention to. This
idea that we, as the Federal Government, forego over $1
trillion in tax revenue is very serious.
I describe it as a revenue stream that looks like Swiss
cheese, because of all of the carveouts that exist, not just--
and it happens in the States as well as in the Federal
Government.
But what ends up happening is the rates that are then
applied don't really bring in the revenue that it's suggested
that they otherwise might. Instead, you have a situation where
government is picking winners and losers in the economy, which
only leads to a declining revenue stream.
The challenge, though, is that anytime you try to close one
of those loopholes, anytime you try to close one of those
intentional carveouts, you're accused of raising taxes.
As you look at The President's Commission to Address the
Deficit and the Debt, how do we treat the Tax Code, especially
tax expenditures, so that they're no longer being viewed as
political football, but that we have a long-term, sustainable
tax policy that businesses in the United States can actually
count on, while actually lowering the rates, in my opinion,
because I think you can close a lot of loopholes, and
dramatically lower the rates.
But I would be very interested in your comments.
Mr. David M. Walker. First, there are two kinds of
spending. There's front-door spending, which is about $3.8
trillion for this year. And there's back-door spending, which
is the revenue that we lose because of tax preferences,
deductions, exemptions, exclusions, credits, etc., over $1
trillion a year.
They're not in the budget. They're not in the financial
statements. They're not part of appropriations. And they're not
systematically reviewed for reauthorization. That has to
change.
We have to take a hard look at them to understand whether
or not their future focused, results oriented, to try to
understand who is benefitting from them. And, in many cases,
quite frankly, they fuel problems.
For example, the largest tax preference is the exclusion
from individual income and payroll taxes of employer provided
and paid health care. That fuels health care cost increases. It
creates great inequities between the haves and the have-nots.
So I think it's important that be on the table. It has to
be part of comprehensive tax reform.
And, quite frankly, I think ultimately the Federal
Government is going to have to employ a special process,
possibly with outside experts, to go through a disciplined,
independent review of major spending programs, both front-door
and back-door, and to make recommendations on what the Congress
should consider doing to put us on a more prudent and
sustainable path.
There's no question that we need comprehensive tax reform,
and that if we broaden the base, we can keep rates low and, in
fact, potentially even lower, especially on the corporate side,
for competitiveness reasons.
At the same point in time, I can also tell you that,
because of a very simple principle, math, taxes are going up.
There's no way that we can solve our structural fiscal
imbalance solely on the spending side--although my personal
view is we have to do more on the spending side of
reprioritization and constraint than on the revenue side--but
we're going to have to have more revenues.
And the longer we wait to come to the realization that we
have to make tough choices on both sides, the bigger the change
is going to have to be, the less transition time, and the more
risk of passing a tipping point.
Mr. Driehaus. Would you support a systemic process within
the Congress, a litmus test, if you will, so that any Member,
coming before the Ways and Means Committee or any other
committee, with a tax expenditure, would have to meet a set of
criteria in order for the tax expenditure to even be
considered?
Mr. David M. Walker. Absolutely. I think we need a set of
criteria for direct spending and indirect spending.
Believe it or not, this country has been in existence since
1789, and it has never had a strategic plan.
Believe it or not, this country doesn't have a set of
outcome-based indicators--economic, safety, security, social,
environmental--to assess what's working and what's not, and how
do we compare to others.
Believe it or not, we have never gone through a systematic
review of major tax preferences or spending programs to find
out whether they're future-focused, delivering results,
affordable, and sustainable.
It's about time.
Mr. Driehaus. Mr. Hoenig, I don't know if you have any
comments on tax--
Mr. Hoenig. I would answer one thing, though, that plays on
this, that I think is important.
If we don't address the issues, front-door, back-door, the
issues you're bringing up, I'm absolutely confident that there
will be mounting pressure on the Federal Reserve system to help
finance this through monetization of debt, and the outcome for
that for this country is inflation at some point in the future.
And of course, that is a tax.
Mr. Driehaus. Yes.
Mr. Hoenig. And it's the most regressive tax we can put on
the American people.
So it's important, I agree so much with Mr. Walker, that we
address this starting now in some systematic fashion, or we
will pay dearly a generation, or a lot sooner than that, ahead
of us.
Mr. Driehaus. Thank you, Mr. Chairman.
Chairman Moore of Kansas. We have a little bit of time
left. If it's okay with the witnesses, if you're okay with
this, we're going to each ask one more question, if that's all
right, if people have the questions.
Mr. Hoenig, when considering a leverage ratio cap of 15 to
1, would you include off-balance-sheet assets in that number,
and how do those get considered in monitoring leverage?
Mr. Hoenig. What I would tend to do is require a portion of
the off-balance-sheet to be counted on the balance sheet.
If you originate it and push it out, you keep a portion of
it, and then your leverage against that.
Because I think the fact that you constrain the leverage to
that very hard number, and keep a fair amount of the off-
balance-sheet then in your calculation, you will constrain the
use of off-balance-sheet activities. Otherwise, it becomes very
complex.
One of the issues in our past crisis around capital is,
frankly, the Basel capital standards, which were so complex
that they were gamed almost immediately by the institution that
wanted to leverage out.
So the simpler, the more direct, the better.
Mr. David M. Walker. If I may, Mr. Chairman--
Chairman Moore of Kansas. Mr. Walker, yes, sir.
Mr. David M. Walker. --on that.
First, to me there's a difference between how do you treat
them for capital requirements and for regulatory purposes, and
what do you do with them from an accounting standpoint.
I don't think that Congress should set accounting
standards. We could be in real trouble if that happens. But I
do think that you have to give consideration, as has been
mentioned, about what do you do for purposes of capital
requirements and regulatory heft.
Chairman Moore of Kansas. Thank you, sir.
The Chair next recognizes the ranking member, Ms. Biggert,
if you have a question.
Mrs. Biggert. Thank you, Mr. Chairman.
This testimony has been really, really good. Thank you.
Could you just, each of you, say what would be the first
three things that you would do right now, that we can do
immediately, to stop the bleeding, to stop the debt increase?
We'll start with you, Mr. Walker.
Mr. David M. Walker. First, tell the American people the
truth, which is what we're trying to do, about where we are,
where we're headed, how do we compare to other nations, the
benefits of acting sooner rather than later, the dramatic kind
of changes we're going to have to make, and the potential
adverse consequences to our country and their families if we
don't.
That means engaging the American people outside the Beltway
in ways that haven't been done, representative groups. And
frankly, we're going to fund, along with the MacArthur
Foundation and the Kellogg Foundation, an effort to do so in 19
cities around the country on June 26th of this year, but that's
just a beginning.
We also are publishing this Citizens' Guide and
distributing it, and each of you have a copy.
Secondly, I think next year, we should reform Social
Security to make it solvent, sustainable, secure, and more
savings-oriented. It's a lay-up. You can miss a lay-up. But
it's a high-percentage shot.
I think there's pretty much a parameter of what needs to be
done there. Social Security is not our biggest problem, but it
would be a credibility enhancer and a confidence builder.
Secondly, next year, I think we should enact statutory
budget controls--spending constraints, etc.--that will take
effect once we hit certain triggers relating to economic growth
and unemployment.
And then, beyond that, I think that we need to set the
table for what will be very tough choices for health care cost
reduction, which the last bill really didn't do much on, and
for comprehensive tax reform that will improve the economic
growth, enhance our competitive posture, and generate more
revenues.
Those things, I think, are going to have to be done
together, because they're going to involve very tough choices
and you're going to have to do tradeoffs and probably deal with
it as a package.
Mrs. Biggert. Thank you.
Mr. Hoenig?
Mr. Hoenig. I would add--I think those are great
suggestions--I think there needs to be brought forward to the
American people a realization that we have to engage in a
shared sacrifice, if you will, that we're all going to have to
take a hit, because I find that we all want to do this, but not
for our particular area, our particular project. And there has
to be this education, communication that would take that
forward.
I think that has to also be incorporated into the
congressional process. In other words, we are going to take
this forward as a Congress, not as a party, and so we can deal
with this.
And then I do agree, we need to put budget constraints on
ourselves that force us then to then face up to these shared
sacrifices and these cuts and these taxes that are ours to
face.
Mrs. Biggert. Thank you.
Chairman Moore of Kansas. Shared sacrifice. What a radical
notion. That's really something I agree with.
You're recognized, Mr. Lynch, for up to 5 minutes.
Mr. Lynch. Thank you. Thank you, Mr. Chairman.
Mr. Walker, you're passing comment regarding the recently
passed health care bill, and I cannot ignore that.
I'm one person who voted against that for precisely the
reason that you raised, that the idea at the beginning of the
health care debate was that, since we were paying 3 times as
much as any other nation on health care, that we would squeeze
down the costs and use the savings to pay for some health care
for the people who weren't covered.
And I know I disagree with a lot of my colleagues on this,
but, it's sort of like throwing an anchor to a drowning man,
from a budgetary standpoint, committing $1 trillion when we
have all these problems on our plate.
Mr. Hoenig, I read your comment on that, and I think both
of you have said that we have to realize that the rules of
finance apply to us, and that goes for the Fed, that goes for
Treasury, and that goes for the people in Congress, and to the
President, that the rules of finance apply to us.
And sometimes around here, we act like there's no
connection at all to what we do and what we pass and someone
who's going to have to pay the bill somewhere down the road.
I read recently, in my clips here, I can't track it down,
but Moody's--and this was regarding the discussion with Greece
and Spain and Portugal and Ireland, and Moody's--someone at
Moody's made a statement that the United States ought to be
careful, because based on the amount of debt that we're
acquiring here, and the track that we're on, that we could lose
our AAA bond rating, and that would be devastating, to increase
greatly the cost of our borrowing, and the loss in confidence
in the United States.
And I was wondering if you could comment on that, and what
the repercussions might be if the financial markets, given how
we're running our business here, called the United States of
America, if there were loss of confidence and we were to lose
that AAA bond rating.
Mr. Hoenig. I think your concern is very legitimate. And
I--whether it's a financial institution or a company or the
U.S. Government, I have a saying that, based on my experience,
once there is a shred of doubt, it's too late.
Mr. Lynch. Right.
And so, we're now in a position where we see this wave
coming at us, and we can do something about it. But once it
gets to our shores, if you will, and this doubt enters, then we
will see it reflected in our interest rates, in our value of
our currency, and in our future wealth.
So we need to do it now. Doubt is going to be the outcome,
and that will be a very expensive proposition for us all.
Mr. David M. Walker. About a year ago, the major rating
agencies downgraded the outlook for Great Britain to maintain
its AAA credit rating. It didn't downgrade their rating. It
downgraded the outlook.
Our ratios on total public debt are worse than Great
Britain. If we fully accounted for the trust fund obligations
and other activities, even with regard to the Federal level,
they're worse.
And so I think the fact of the matter is, we benefit from
having 62 percent of the world's global reserve currency, and
secondly, home team bias. Most rating agencies are based here.
And in my view, there's absolutely no question, on the path
that we're on, one would have to seriously question how long we
will retain a AAA credit rating under our current path. We
shouldn't get to that point.
And that's why, last month, we surveyed about 100 top
former leaders, from Congress, the Executive Branch, and the
Federal Reserve. Chairs and ranking members of Finance, Ways
and Means, the Budget Committees, Treasury Secretaries, Fed
Reserve Board members, Treasury Secretaries, OMB directors, CBO
directors.
There was 100 percent agreement, with a 60 percent response
rate roughly, that we're on an unsustainable path. Super-
majority agreement that we must take concrete actions within 1
to 2 years to avoid the risk of passing a tipping point.
Numbers like that are clear and compelling.
So we have to move past denial. We have to move past delay.
We need a plan, and we have to start acting.
Mr. Lynch. Thank you both.
I yield back.
Chairman Moore of Kansas. Thank you, sir.
Mrs. Biggert. Mr. Chairman, could I ask unanimous consent
to allow Mr. Royce from California to--he's a member of the
general committee, but--
Chairman Moore of Kansas. Certainly. Without objection, it
is so ordered.
Mr. Royce, you're recognized for 5 minutes.
Mr. Royce. I appreciate it, Mr. Chairman.
I had a question for Mr. Hoenig.
In a recent book co-authored by two economists, Rogarth and
Reinhart, they note the painful consequences of the rising
government debt load that often follows financial implosion, or
a financial crisis. And despite vocal warnings from economists,
the United States is following the pattern that they set out,
rather blindly.
We were overleveraged prior to the financial crisis, but
the Federal Reserve and the U.S. Government have lent or spent
or guaranteed about $8.2 trillion to prop up the economy in the
last 2 years.
And a quarter--you also throw into the mix here that
Chairman Bernanke has said our budget deficits and the budget
proposal put forward by the Administration, going forward, is
unsustainable. So we don't see things getting better with these
trillion dollar deficits that we are budgeting for now.
The IMF and the OECD are projecting that the stock of
public debt in advanced economies is going to double and reach
an average level of 100 percent of GDP in the coming years.
So I would ask you, we have been through a financial crisis
where much of the private sector debt was simply transferred to
the Federal Government. In essence, that's the bottom line. And
that's contributed, then, to these unsustainable Federal
deficits.
So where does this road lead; and do you foresee a
financial crisis that now morphs instead into a sovereign debt
crisis here in the United States?
Mr. Hoenig. I think that the steps that were taken in the
crisis to staunch it, to end it, were taken aggressively. I
think now we have to be prepared to reverse that, and we need
to do it carefully and systematically, but we need to reverse
it.
These debt levels that we have been talking about here this
morning, whether it's the financial institutions, the Federal
Government, and even the Federal Reserve's balance sheet, need
to be addressed and reduced. And I think that's paramount.
Or, as Rogarth and Reinhart have shown, we will compromise
our future and, as we have been talking here this morning, it
will as well, and I think, as I said earlier, there will be
increasing pressure.
If this isn't addressed sooner and systematically, and
people don't have confidence that we're going to address it,
then we will see pressure for the Federal Reserve to monetize
more of this debt, inflationary pressures will rise, and there
will be a strong impact on the dollar, long-term, and on our
Nation's wealth.
So it's--
Mr. Royce. That is the concern of a number of economists,
that the path of least resistance here might be runaway fiscal
deficits which will then be monetized by the Federal Reserve.
I think you recently gave a speech highlighting the
possibility that Congress could soon be knocking on the Fed's
door to monetize the debt.
Mr. Hoenig. Right.
Mr. Royce. Are you concerned with the precedent that has
been set by the Fed in this regard, because last year, the Fed
bought $1.8 trillion of Treasury securities and agency debt?
And the other issue that I just asked about, which comes
out of that same book by Rogarth and Reinhart, is that the
buildup of excessive debt, they say, inevitably leads to
stagnant economic growth going forward, which you alluded to.
Clearly, there is the need for deleveraging that lies ahead for
our economy, both in government and privately held debt, and
instead, we seem to be piling on, especially if you look at the
increases in all of the agency spending, the appropriations,
the separate appropriations bills, which go up by double
digits.
Do you foresee a stagnant economy, as long as this level of
debt remains? What's your forecast here?
Mr. Hoenig. First of all, yes, I am concerned by the
precedent set, and I think we need to, that's why I say we need
to reverse that quickly to bring our balance sheet back down.
We need to do it systematically and carefully, but we need to
do it.
If we don't, and we get ourselves into an environment of
growing debt, unsustainable, as Mr. Walker had pointed out, and
we then put pressure to monetize it, which would cause us to
have inflation, we will endanger our economy and stagnation is
a possibility. It's unavoidable, if we don't take action now.
Mr. Royce. Thank you, Mr. Hoenig.
Mr. David M. Walker. Congressman, if I can respond quickly?
Mr. Royce. Absolutely.
Mr. David M. Walker. First, on my testimony, I talked about
the four parallels between the factors that caused the
mortgage-related subprime crisis and the Federal Government's
own finances. We need to learn lessons from that.
Secondly, with regard to the book you're referring to, I
think it refers to the fact that once you have debt equal to
about 90 percent of the economy, then it has an adverse effect
on economic growth; and once you get to 100, it's very
troubling.
If you count the Social Security and Medicare debt, we're
at 89 percent, and growing rapidly. That doesn't count the GSEs
and things of that nature.
And then lastly, you can't monetize your way out of this
problem, and let me tell you why: because, while monetizing
your way out, which creates an inflation risk, might help deal
with the current debt, and lessen the burden of the current
debt, the real threat to the future of this country is the $45
trillion in off-balance-sheet obligations, $38 trillion for
Medicare alone, that grows faster than inflation and faster
than the economy.
You have to make tough choices. You need to do it within 2
years, at least to start, or else we could be facing something
that we don't want to see in this country.
Mr. Royce. Thank you.
Chairman Moore of Kansas. I thank the gentleman.
And I would, at this time, like to thank our panel members
here, Mr. Hoenig and Mr. Walker, for your testimony, and for
answering our questions. It has been a very, very good
exchange, and I very much appreciate that.
I'm advised that votes will be called in the very near
future, probably in the next 5 to 10 minutes, and I would like
to excuse the first panel, and again thank you for your
testimony and your service, and ask the second panel members to
be seated so we can maybe just get at least preliminarily
started here, and then move on.
Thank you again.
I'm pleased to introduce our second panel of witnesses, and
please work with me and forgive me if I mispronounce any names
here.
First, we will hear from Ms. Orice Williams Brown,
Director, Financial Markets and Community Investment at GAO.
Next, will be Professor John Geanakoplos, James Tobin
Professor of Economics at Yale University.
Then, we'll hear from Professor Viral Acharya--excuse me.
Will you pronounce it, sir? Okay--Professor of Finance, Stern
School of Business at New York University.
And finally, we'll hear from another David Walker, a
different David Walker, Professor David A. Walker, who is the
John Largay Professor at the McDonough School of Business at
Georgetown University.
Without objection, your written statements will be made a
part of the record.
Ms. Williams Brown, you're recognized, ma'am, for 5
minutes.
STATEMENT OF ORICE WILLIAMS BROWN, DIRECTOR, FINANCIAL MARKETS
AND COMMUNITY INVESTMENT, U.S. GOVERNMENT ACCOUNTABILITY OFFICE
(GAO)
Ms. Williams Brown. Thank you.
Chairman Moore, Ranking Member Biggert, and members of the
subcommittee, I appreciate the opportunity to testify before
you this morning on the role of leverage in the recent
financial crisis.
As you know, the Emergency Economic Stabilization Act of
2008 mandated that GAO study the role of leverage in the
crisis. My statement today is based on that report.
While the report covers a wide range of issues, I would
like to highlight a few key points concerning how leverage is
defined, its cyclical nature, how it's constrained, and
regulatory limitations.
The buildup of leverage during the market expansion, and
the rush to reduce leverage or deleverage when market
conditions deteriorated, was common with this and past
financial crises.
Leverage traditionally has referred to the use of debt
instead of equity to fund an asset, and has been measured by
the ratio of total assets to equity on the balance sheet. But
the recent crisis revealed that leverage can also be used to
increase an exposure to a financial asset without using debt,
such as by using derivatives.
Given the variety of strategies to achieve leverage, no
single measure can capture all aspects of leverage.
Our findings concerning the role of leveraging and
deleveraging in the recent crisis reveal that leverage steadily
increased within the financial sector before the crisis began
in mid-2007, and banks, securities firms, and others sought to
deleverage and reduce their risk during the crisis.
While this work, which builds upon the work of others,
suggests that efforts taken to deleverage by selling assets and
restricting new lending could have contributed to the crisis,
others noted that the crisis was the result of prices reverting
to their fundamental values after a period of overvaluation.
These varying perspectives illustrate the complexity of the
crisis, and, given the range of assets involved, are not
necessarily contradictory.
Moreover, some argue that leverage created vulnerabilities
in the market that increased the severity of the crisis.
In addition, subsequent disorderly deleveraging by
financial institutions may have compounded the crisis.
For example, some studies suggest the efforts taken by
financial institutions to deleverage by selling financial
assets could cause prices to spiral downward during times of
market stress, and exacerbate a financial crisis.
Second, the studies suggest that the deleveraging by
restricting new lending could slow economic growth. However,
other theories also provide possible explanations for the sharp
price declines observed in certain assets.
The issues raise questions about how leverage is
constrained, which varies by type of institution.
For example, for federally regulated institutions,
regulators can limit leverage through minimum-risk-based
capital, leverage ratios, and liquidity requirements. However,
for other institutions such as hedge funds, market discipline
supplemented by regulatory oversight of institutions that
transact with them, conserve to constrain their use of
leverage.
The crisis revealed limitations in the regulatory
approaches used to restrict leverage.
For example, regulatory capital measures did not always
fully capture certain risks, which resulted in some
institutions not holding capital commensurate with their risk
and facing capital shortfalls when the crisis began. Moreover,
regulators faced challenges in countering cyclical leverage
trends.
The crisis also revealed that, with multiple regulators
responsible for individual markets or institutions, none has
clear responsibility to assess the potential effect of the
buildup of system-wide leverage or the collective effect of
institutions' deleveraging activities.
Finally, a lesson of the crisis is that an approach to
supervision that focuses narrowly on individual institutions
can miss broader problems that are accumulating in the
financial system. In that regard, regulators need to focus on
system-wide risks to and weaknesses in the financial system,
not just individual institutions.
In closing, I would like to note that, since the onset of
the crisis, regulators have continued to re-evaluate capital
standards, namely, Basel II, and the countercyclical nature of
leverage and capital.
However, efforts to monitor leverage must include a
mechanism to evaluate the amount of leverage in the system, in
order to better identify and mitigate potential systemic risk.
Mr. Chairman, Ranking Member Biggert, this concludes my
oral statement, and I would be happy to answer any questions at
the appropriate time.
[The prepared statement of Ms. Williams Brown can be found
on page 214 of the appendix.]
Chairman Moore of Kansas. Thank you for your testimony.
The Chair next recognizes Professor Geanakoplos.
You're recognized, sir, for 5 minutes.
STATEMENT OF JOHN GEANAKOPLOS, JAMES TOBIN PROFESSOR OF
ECONOMICS, DEPARTMENT OF ECONOMICS, YALE UNIVERSITY
Mr. Geanakoplos. Thank you for inviting me to talk today
about managing leverage, managing the leverage cycle.
For a long time, we have recognized the need to manage
interest rates. That's what the Federal Reserve does. But we
don't have a regulator to manage leverage. And I have written
about this for 10 or 15 years.
I wasn't the first one to think of this idea. Shakespeare,
400 years ago, in The Merchant of Venice, explained, in a
negotiation over a loan, you had to figure out not only the
interest rate but also the collateral. And if we ask, which did
Shakespeare think was the more important, nobody can remember
the rate of interest that Shylock charged, but everybody
remembers the collateral, the pound of flesh.
The play ends, by the way, with the regulatory authority of
the court deciding not to change the interest, not to change
the principal, but to change the collateral. It should have
been a pound of flesh, but not a drop of blood. And that's what
I'm advocating today, that we manage leverage, and not manage--
pay so much attention to interest rates.
I'm talking about securities leverage. When you have a
house at 20 percent downpayment, that means a 5 to 1 leverage,
the cash divided into the amount of assets. That's what I'm
talking about.
The reason I wrote about this is, there's a puzzle in
economics: how could it be that one supply-equals-demand
equation determines two things, the interest rate and the
leverage, or the amount of collateral? In my theory, it does. I
resolved that problem.
So leverage is important for three reasons, two of which
people know: The more leveraged you are, the riskier your
situation. If the asset changes by 1 percent, your profits go
up by 5 percent, if you leverage 5 to 1. Also, there's no
recourse aspect of collateral. You can walk away from your
house, and if the house goes to zero, you lose the $20 you put
down.
But there's a third aspect of leverage that didn't get so
much attention, which is the main thing I have called attention
to, which is that, with a lot of leverage, a very few people
can own all the assets, and the implication of that is, the
more leverage in the economy, the higher the asset prices; the
less leverage, the lower the assets prices.
The reason for that is, if you think of people, the buyers,
on a continuum for the most enthusiastic at the top to the
least enthusiastic, wherever the price is, the people above who
are going to think that it's a good deal, and they'll be
buyers; the people who are less optimistic will think that it's
a bad price, and they'll be sellers.
If you allow leverage in the system, the marginal guy, the
guy on the threshold of buying or selling, his opinion is
determining the price. If leverage goes up, you need fewer
people at the top to buy all the assets. The marginal guy, on
the threshold, is higher, and so the price now reflects his
opinion, which is a higher opinion, because he's a more
optimistic person. That's why prices go up when there's more
leverage.
The reason for this heterogeneity between people more if
some people are more risk-tolerant, some people like to live in
the houses more, many reasons, some people are more optimistic.
So the leverage cycle is that there's too much equilibrium
leverage in normal times, and therefore, too high asset prices,
and then suddenly there's too little leverage in a crisis, and
therefore, too low asset prices. And this bouncing up and down
of asset prices is very harmful to the economy.
The crisis always begins the same way. There's bad news,
but it's not just bad, it's scary. For example, they tell you
your plane is 10 minutes late. Well, 10 minutes isn't so bad.
It's that you start to worry maybe it's going to be an hour or
two late.
A bank announces it's going to lose $5 billion. That's not
the end of the world. But if it's going to lose $5 billion,
maybe it will lose $10 billion. And that's what you're worried
about.
Or delinquencies in the home--homeowner delinquencies go
from 1 percent to 5 percent. The real problem is people now
think they might go to 30 percent.
So the next stage is, the lenders get nervous, and they cut
lending, and they increase margins, and leverage starts to
collapse, and then the optimistic buyers, when the prices are
going down, they lose all their money.
So a price might go down from 95 to 69, not because anybody
thinks their own information justified--the bad news isn't
enough for anyone to think it should go down that far.
But the optimists who bought at the beginning, the top 13
percent, say, when the price starts to go down, they get wiped
out.
Then the next group, who's going to buy after the crash,
the next group are not only not as optimistic, but they can't
borrow the money to buy it. So it takes a lot more of them to
buy it.
And so the marginal buyer goes way down, way below where he
was before, and the price is lower, not because of the bad news
alone, but because of these, the bankruptcy of the optimists
and also because leverage is so far down.
So that's my theory. And this has recurred over and over
again, in 1994, 1998, 2007.
So just to show you some data, there's a famous graph. That
green curve, which is Schiller's home price data, it went from
2000 at 100, 90 percent up, to 190, and then dropped to 130.
And he called it irrational exuberance.
But if you look at the downpayments, the purple, it went
from, measured from the top, 14 percent down to 2.7 percent
down, and then to 20 percent down. It reached the peak at
exactly the same time.
If you look at toxic mortgage security prices, they
collapsed, went from 100 to 60, and now they're going back up
to 80.
If you look at the blue line, that measures downpayment
again, in reverse direction, you see that leverage suddenly
collapsed, and leverage went back up, and that's why prices are
going back up.
So, the leverage cycle was worse this time than all the
previous times--I'm just going to go 20 more seconds--worse
this time than all the previous times because the leverage
wasn't just a few financial institutions, but millions upon
millions of homeowners, and so we had a double leverage cycle,
millions of people plus our financial institutions, and also we
introduced CDS, which is another way to leverage.
So, what should we do about the leverage cycle? The most
important thing to do is monitor leverage, securities leverage.
Go to all the big financial institutions and ask, ``What is
the downpayment you're requiring for housing, for securities
that people are buying,'' and publish that data every month,
and also measure people's leverage. Put CDFs on exchange and
regulate leverage in normal times. Don't let banks make 2
percent downpayment loans on houses and banks lending on
mortgage securities.
The last thing is, people keep--this is my last slide--
people talk about monitoring leverage with the 15 percent rule
that has been advocated by the previous panelists. In my
opinion, that's a mistake. We should be looking at leverage at
the securities level, not at the investor leverage. What's the
downpayment on securities?
Leverage can move from one institution to another. If you
require 15 percent for some institutions, it will move to some
other place. People can lie about their leverage. You can't lie
about what the downpayment is, because there are two people you
can check what the downpayment was.
Thirdly, and most importantly maybe, leverage at the
investor level goes in the wrong direction. When there's a
crisis, and it's hard to get a loan, and the downpayments go
way up, the bank, the investor leverage looks like it's going
up, because their equity is disappearing, so debt to equity is
going up, just when the leverage is actually collapsing in the
system. And also, there's less pressure on a regulator to
monitor security leverage.
So I went over. Thank you.
[The prepared statement of Professor Geanakoplos can be
found on page 232 of the appendix.]
Chairman Moore of Kansas. Thank you, sir, for your
testimony.
The Chair will next recognize Mr. Acharya--is that correct,
sir--for up to 5 minutes.
And I would advise the people in the room here that votes
have been called. We have about 10 to 12 minutes, I think, for
votes. So if we can get both of these last remaining witnesses
for 5 minutes each, we would appreciate that.
Sir, you're recognized.
STATEMENT OF VIRAL V. ACHARYA, PROFESSOR OF FINANCE, STERN
SCHOOL OF BUSINESS, NEW YORK UNIVERSITY
Mr. Acharya. Thank you, Mr. Chairman, and members of the
subcommittee.
Along with my colleagues at the Stern School of Business,
New York University, I have co-edited two books on the
financial crisis and co-authored research papers that help
understand how the financial sector escalated its leverage
before the crisis, and what can be done about it in future.
Much of what I say today is based on this research.
We seem to witness, on a somewhat regular basis, episodes
in which financial intermediaries are all overextending credit,
and are themselves funded with excess leverage. When the
economic cycle turns downward, they fail in a wholesale manner
requiring massive government interventions.
While leverage has its bright side in expanding finance for
households and the real economy, its dark side is precisely
this boom-and-bust cycle. Unfortunately, this dark side has
become enduring.
With each cycle comes in place, more government
intervention and guarantees of financial sectors debt, some
explicit, such as deposit insurance, and others implicit, such
as ``too-big-to-fail,'' or ``too-systemic-to-fail.''
The result is that financial firms find it cheap to borrow
and post their returns without sufficient regard for risks.
One of the most salient such episodes was the period since
2004, during which the financial sector in the United States,
and in many parts of the Western world, grew its balance sheet
at an unprecedented speed, and did so mainly through leverage.
There were three primary failures, in my view, that led to
this escalation of leverage: one, access to government
guarantees that were not paid for, especially for the
commercial banks and Government-Sponsored Enterprises; two,
ineffective enforcement that allowed bank regulation to be
arbitraged--that is, circumvented by a sophisticated financial
sector; and three, in case of investment banks and the
insurance sector, simply poor design of regulation.
The end effect of these failures was that large and complex
financial institutions, 10 of which owned over 50 percent of
the financial sector's assets, operated at historically high
leverage, in some cases exceeding 25 to 1, or, in other words,
$24 of leverage on a $25 balance sheet.
Much of this leverage was undertaken in the shadow banking
world, the less-regulated, or unregulated part of the financial
sector.
This part of the financial sector consists of off-balance-
sheet entities that are connected to, but do not appear on bank
balance sheets, borrowing and lending between financial firms,
including through repos, or repurchase agreements, and the
over-the-counter derivatives.
Much of this leverage was also short-term in nature, to be
rolled over each night or week, and yet it funded long-term and
illiquid assets, such as subprime loans.
This exposed the financial system to great risk from a
secular economic downturn, and because the leverage was highly
opaque, when financial firms failed, uncertainty about how
losses would transmit to others paralyzed the system. In the
end, the government and the Federal Reserve ended up bearing
much of the losses.
What can be done to deal better with this boom-and-bust
cycle of leverage in the financial sector?
In the interest of time, I'll focus only on those
regulatory options that directly deal with leverage in good
times.
First, current capital regulation does not take into
account the leverage structure of a financial firm's balance
sheet. This major shortcoming should be addressed, for
instance, by imposing a tax on leverage, or better, by
introducing upper limits on leverage, such as 15 to 1, as has
been employed successfully in other countries such as Canada;
or better still, by embedding leverage information in
supervisory tests to assess whether banks can withstand extreme
losses in economic downturns.
Second, the regulation of the shadow banking world needs to
be brought in line with the on-balance-sheet regulation of
financial firms. Any attempt to regulate leverage that ignores
the shadow banking world would only lead to further growth of
off-balance-sheet forms of leverage.
In addition, greater transparency of the shadow banking
world needs to be legislated so that regulators and market
participants have timely and accurate information to understand
and, if needed, restrict and discipline the leverage of
financial firms.
And last, but not least, the government should plan for a
graceful exit from the large number of guarantees provided to
the financial sector, not just as part of the rescue package in
2008, but from well before. In particular, reform of the
financial sector should also include reform of the Government-
Sponsored Enterprises.
I'll be happy to provide more detailed proposals on these
during the question-and-answer period. Thank you, Mr. Chairman.
[The prepared statement of Professor Acharya can be found
on page 44 of the appendix.]
Chairman Moore of Kansas. Thank you, sir. Mr. Walker, you
are recognized for 5 minutes. And votes again have been called,
but I think we have time for your testimony.
We're going to hear your testimony, then we're going to
take a break for votes, and we'll be back for questions.
STATEMENT OF DAVID A. WALKER, JOHN A. LARGAY PROFESSOR,
McDONOUGH SCHOOL OF BUSINESS, GEORGETOWN UNIVERSITY
Mr. David A. Walker. Thank you.
Chairman Moore, Ranking Member Biggert, and subcommittee
members, thank you for this opportunity to testify in front of
the House Financial Services Oversight and Investigations
Subcommittee.
I'm David A. Walker, the John A. Largay Professor in the
McDonough School of Business at Georgetown University.
Large firms that are managing their risk effectively are
not necessarily too big, and our economy needs their services.
Some mismanaged firms needed greater regulation. Some
aggravated the financial crisis, and many of those have already
failed. Breaking up a large firm that shows unreasonable risk
would be much preferred to future bailouts.
There are three recommendations I would like to offer to
the committee: one, merge the Office of Thrift Supervision into
the Office of the Comptroller of the Currency, as soon as
possible; two, do not subject small insured depository
institutions to unnecessary additional capital restrictions--
Basel I and Basel II are more than sufficient; and three,
assign consumer financial protection responsibility to the
FDIC, without creating a new agency and an additional
bureaucracy.
For the record, I submitted copies of two papers: a peer-
reviewed study on long-run credit growth in the United States,
co-authored with Dr. Thomas Durkin, former senior economist
with the Federal Reserve, and my Georgetown colleague,
Professor Keith Ord; and a second policy paper on impacts of
TARP on commercial banks, with Max Gaby.
The issue Durkin, Ord, and I analyzed is how levels of
consumer credit have changed over the past 60 years.
Surprisingly, we show that the aggregate real consumer credit,
adjusted for price increases, and excluding mortgage credit,
has increased at about the same annual rate as real U.S.
disposable income.
Conclusions with regard to mortgage credit are very
different, and with subprime lending, every segment of the
industry had abuses.
Perhaps the greatest problem in the housing crisis was poor
supervision by the Office of Thrift Supervision. The failures
of IndyMac and Washington Mutual were holding company thrifts
supervised by the OTS. I believe that if all holding companies
were supervised by the Fed, the results would be somewhat
different. This would be just one more example where the
independence of the Federal Reserve is essential.
I'm a strong proponent of merging the OTS into the Office
of the Comptroller of the Currency, and I wish the Congress
could pass such a separate bill to accomplish this very
quickly.
Mark Flannery has proposed requiring large banks to hold
debt instruments he calls contingent capital certificates. They
would automatically convert from debt to equity if the market
value of a large bank's equity fell below an established
threshold. This eliminates regulatory delays and negotiations
when a large bank might be in jeopardy.
Leverage of insured depository institutions can be examined
by a simple ratio that I have talked about in my testimony,
where you take liabilities minus deposits as a ratio to Tier 1
capital. My research shows that risky large banks and large
savings and loans could be identified by this ratio.
I recommend that you not create a new government agency for
consumer financial protection. Please consider placing the
responsibility within the FDIC.
As an independent agency, with separate budget authority,
many necessary consumer protection systems already in place,
and an existing Consumer Affairs Department, the FDIC is
ideally suited, in my opinion, to implement the consumer
financial protection that the Congress deems necessary.
The aggregate fiscal debt in the United States has
increased dramatically since World War II under both Republican
and Democrat--
Chairman Moore of Kansas. Mr. Walker, may I interrupt you?
And I apologize for doing this. We have 2 minutes and 15
seconds left before the conclusion of votes, so I think we're
going to have to stand in recess right now, and I would ask you
if you would finish your--
Mr. David A. Walker. Sir, I could finish in 30 seconds.
Chairman Moore of Kansas. Very good. Thank you.
Mr. David A. Walker. The IMF establishes a 5 percent
country target maximum of fiscal deficit ratio to GDP. The
Honorable David Walker has already talked about this in great
detail, and I wouldn't attempt to repeat what he says. I just
want to also urge the subcommittee not to burden the United
States with any further taxes that are regressive, like the VAT
tax.
That concludes my testimony, and sir, I'm sure you
appreciate that for academics to do anything in 5 minutes is
monumental.
[The prepared statement of Professor David A. Walker can be
found on page 308 of the appendix.]
Chairman Moore of Kansas. Same thing for Congress. And
we're going to stand in recess right now. I thank the
witnesses. We'll be back probably in about 20 or 25 minutes. If
you can remain here for questions, I would appreciate it very
much.
Thank you.
[recess]
Chairman Moore of Kansas. The committee will be back in
session.
I'm going to recognize myself for 5 minutes.
Ms. Williams Brown, thank you for presenting this very
helpful report by GAO on leverage. I'm interested in GAO's
observations with respect to leverage and international
efforts, such as Basel II, to better supervise financial firms.
As Congress finishes up writing financial regulatory
reform, what steps should we take to coordinate our efforts
with other countries to do two things: first, to better monitor
and even understand leverage and risk-taking; and second, to
better constrain excessive leverage?
Ms. Williams Brown. I think any efforts that we take in the
United States, we have to make sure they have a strong
international component. I think the crisis made it very clear
that the focus, the national focus also had a huge global
effort.
So in terms of Basel II, I think the United States has to
continue to be very involved in that process, in making sure
that we do a true lookback at Basel II to determine if we need
to go back and have a fundamental reassessment of the current
approach to determining regulatory capital.
There have been efforts in the past several months to deal
with certain issues, such as the procyclical nature of capital,
and making sure that institutions are building up capital
levels during the good times, so they aren't forced to do that
in the midst of a crisis.
But there are a number of other efforts that we need to
continue to focus on from a global perspective, and Basel II is
one place definitely to take a look.
Chairman Moore of Kansas. Thank you.
Professor Acharya, I had one thing that was troubling for
our committee and Americans to learn at our recent hearing on
the failure of Lehman Brothers, was how they used Repo 105 and
other means to hide their excessive leverage.
How concerned are you about debt masking, especially since
the SEC depends on quarter-end reporting requirements? Is there
a better way to monitor debt and leverage?
Mr. Acharya. I think this ought to be one of the most
significant concerns, especially if we are talking about
regulating leverage, not just the use of Repo 105 by Lehman
Brothers. Especially from 2004 until the middle of 2007, there
was over $1 trillion of assets parked in what were apparently
not balance sheet entities, which had direct connections back
to bank balance sheets, but that were never consolidated,
either for accounting purposes or for purposes of calculating
regulatory capital.
So one of the big messages, I think, from this crisis is
that it's not just important to put in place a law with the
right intention. I think the enforcement of the law, good
enforcement of the law is equally important. And we really have
to legislate the shadow banking world, because one of the
reasons why the shadow banking world has developed is precisely
to get around some of the important leverage and capital
regulations.
So I would say two things. Any leverage regulation that
does not address the shadow banking world will simply push more
leverage into the shadow banking world. And two, the right way
to proceed is to legislate transparency so that regulators, on
a high-frequency basis, can actually observe the leverage of
these institutions, and provide timely aggregated reports to
themselves, as well as to market participants.
Chairman Moore of Kansas. Thank you, sir.
Professor Walker, you say in your testimony, ``I believe
that the TARP commitment was essential,'' and later say, ``Our
economy would be rebounding much more slowly than it has if we
had not implemented the TARP program.''
Of course, a lot of Americans were very upset about TARP,
and most of us who voted for it didn't feel good about it when
we did it, but we felt we had to. And all the experts who
looked at this said we didn't have an option.
Will you elaborate, sir, on how, if TARP was not enacted
into law, the situation might have been worse, not just for
Wall Street, but for Americans and our constituents back home,
if you agree with that?
Mr. David A. Walker. Yes, I do, Congressman.
And I think that, without TARP, we could easily have had
unemployment double the current rates. There have been a few
policy pieces written on that, maybe not as analytical as we
would all like, but I think there was a real risk.
The other thing was that--and this was sort of my
perspective at the time--it was clear that Congress was
standing up and tackling this vigorously, and I think that
inspired some confidence. I think it may have inspired some
confidence in international markets. Yes, we had this crisis,
but we weren't going to ignore it, and the Congress was taking
the lead.
Chairman Moore of Kansas. Thank you, sir.
My time has expired.
Ms. Biggert, you're recognized for 5 minutes.
Mrs. Biggert. Thank you, Mr. Chairman.
In the Wall Street Journal today, there is a Fannie Mae
political reckoning article, and I just want to read something
from there.
It says: ``The Financial Crisis Inquiry Commission spent
yesterday focusing on financial leverage, using Bear Stearns as
an example, but Fannie and Freddie were twice as leveraged as
Bear and much larger as a share of the mortgage market. Fannie
and Freddie owned, or guaranteed, $5 trillion in mortgages and
mortgage-backed securities when they collapsed in September
2008. Reforming the financial system without fixing Fannie and
Freddie is like declaring a war on terror and ignoring Al
Qaeda.''
And then in the former panel, I asked the other Mr. Walker
about how you would--that there were some alarming numbers
regarding the Federal debt, especially when you account for the
debt owed to Social Security, Medicare, and the total GSE
liabilities.
What should be done regarding GSE debt? Can the Federal
Government afford to continue writing a blank check to Fannie
and Freddie?
Who would like to answer that?
Mr. Geanakoplos?
Mr. Geanakoplos. ``Geanakoplos.''
Mrs. Biggert. ``Geanakoplos.''
Mr. Geanakoplos. It means ``Johnson,'' in Greek.
Mrs. Biggert. Oh, good. You must be Swedish, then. Just
kidding.
Mr. Geanakoplos. Yes. We should never have allowed Fannie
and Freddie to get so big and so leveraged. The only reason
they were able to get so big is, the government implicitly
guaranteed their debt, so they would borrow tremendous amounts
of money, and investors wouldn't think twice about it, when
giving them money, because they figured that the money was good
because the government was backing it.
And many people called for regulation of Fannie and
Freddie, and called for them to be--for their debt levels to be
held lower, and called for them to be smaller, and we ignored
those calls. And then, in fact, they did fail, and we are now
put in the position of having to honor what was only an
implicit guarantee.
So we could, at one point, have--at that point, we could
have defaulted on the debt. And a lot of it is held by China, a
lot of it is held by American investors. We made a choice not
to default, and now we hold the debt.
And as you said, if you put Fannie and Freddie's portfolios
together with all the loans they insured and so on, it comes--
plus if you put together the other government purchases, like
through FHA, you're talking about $6- $8 trillion worth of
mortgages that our government--debt offset by mortgages that
our government owes.
And the fact is, we're going to--there are going to be a
lot of defaults. We might lose almost $1 trillion. There are
estimates at $400 billion. It might come to almost a trillion.
I don't know what we can do about it now. We have committed
ourselves to back it. Unless we default on it, we're going to
lose that money. We just have to prevent ourselves from ever
getting in that position again.
Mrs. Biggert. Would you agree, then, that the government
has to get out of the business of financing or providing
guarantees across the entire economy?
Mr. Geanakoplos. The government can never be on the hook
for such a tremendous amount of money.
Right now, almost all the mortgage lending is being done by
the government. There are hardly any other loans being done by
the private sector.
The government has to find a plan of not--the FHA plan is
to loan at 3 percent down now. That's again, that out-competes
any private lender. So instead of encouraging private lending,
they're discouraging private lending.
So I think that we need a different kind of initiative that
will foster more private lending instead of government lending.
Mrs. Biggert. Thank you.
Then, Mr. Walker, you--given the data that you provided on
government debt, which is alarming, would you agree that the
government has to get out of the business of financing or
providing guarantees across the entire economy?
Mr. David A. Walker. I don't think we can have the U.S.
Government get out of that activity, but I think what we really
need to do is to make sure that the public understands, and the
markets understand, the various aspects of the debt.
I am guessing, if we did a survey, and let's say we took a
survey just of people who have business education degrees,
undergraduate and Master's, just that limited group, and we
asked them about the role of Fannie and Freddie in terms of the
U.S. Government, that most would say they are government
agencies.
We have a tremendous job to do in terms of financial
literacy in the United States, and it's not just people who
have had no training, in terms of understanding risk and
leverage and things that this committee is dealing with in
these hearings.
Mrs. Biggert. So you would call for greater transparency?
Mr. David A. Walker. Absolutely.
Mrs. Biggert. We really have, what, two choices. One is
that we would put them on a budget, as a government agency, and
be under the controls of salaries and everything else; or, we
would just turn them into a private, just a private company,
and they would fend for themselves.
Mr. David A. Walker. Either one of those would be a big
improvement from the current environment, and the--I would put
it on budget as soon as possible, and then think about
gradually privatizing.
I have done a little bit of work in some of Central
European countries in terms of privatization, and actually have
a paper linking privatization and fiscal deficits. And it turns
out that, for the most part, rising privatization needs to
accompany larger Federal deficits.
So I'm not sure that would be translatable to
industrialized countries, but it is something to be alerted to.
Mrs. Biggert. Thank you. My time has expired.
Chairman Moore of Kansas. Mr. Lee, you're recognized for 5
minutes, sir, if you have questions.
Mr. Lee. Thank you very much.
I apologize for my lateness, but I'm glad to have a chance
to hear from some of you.
And it's ironic we're talking about deleveraging of the
banking institutions, but one of my bigger concerns is the
deleveraging of the U.S. Government. Among the lessons that we
learned from the financial crisis was certainly the dangers of
financial concentrations.
Many institutions relied on particular investors to roll
over the loans, and when those investors would not oblige, over
the concerns of the leverage of the institutions, as we all
know, failures began to result. These institutions were not
able to finance through other investors, and began defaulting
on their own obligations.
When I see the Administration implementing a policy of
borrow-and-spend, I believe there are very scary parallels to
this situation.
My background prior to coming here last year was running a
manufacturing business, and I know a little bit about
leveraging and being able to read a balance sheet. And if you
look at our balance sheet, it's a frightening set of
circumstances.
Under the President's current budget, we are on plan to
borrow 42 cents for every dollar we spend in this country. It
is--if this was done in the private sector, I hate to tell you,
the company would be out of business.
In just 2 years from now, our national debt will be bigger
than the size of our entire U.S. economy. We're talking about
close to a $15 trillion deficit. Our debt to GDP ratio would be
at over 100 percent. And what people forget is, Greece is at
125 percent. We're not far behind.
Getting to my point here, the Chinese hold a huge amount of
our government debt, I believe in total, in aggregate, of
roughly 7 percent. My concern is, when they decide to stop
financing our spending, what ultimately could happen is the
same thing that we're seeing in some of our financial
institutions. The United States is going to have to search out
for other investors.
Ultimately, what we will see are higher interest rates, and
we're looking at--when you're looking at a deficit this high,
the interest payment alone will typically exceed what we're
paying out, for example, in Social Security, or what we're
doing with our national--with our defense.
We have a policy here that the Administration is really, in
my opinion, shying away from, and we have to get our fiscal
house in order.
Maybe I can start with Mr. Walker. Your concerns--do you
agree that this is a real possibility with how leveraged the
U.S. Government is?
Mr. David A. Walker. Everything I know about--the numbers
that you have posed are very accurate.
I was surprised to hear you say the 7 percent. I thought
the number was larger than that, but it may depend on
calculations, for China.
I am very concerned about the rise in interest rates, and I
cite in my testimony, in the submitted testimony, work of the
budget director previously writing about fiscal deficits
causing rising interest rates. So I agree with you.
But I don't think we had a choice. I think--
Mr. Lee. If you were an auditor on safety and soundness,
and you were auditing our books, would you shut us down?
Mr. David A. Walker. No, I wouldn't shut us down. I would
say, as the Comptroller General, former Comptroller General
David Walker, has written extensively, that we need to make
some dramatic changes.
One of the things I have heard him say in other
presentations was that we need to index the age at which people
collect Social Security. When we started Social Security
originally, we said people can collect at age 65, and the
expectation was that you would live 7 years, maybe 9 years.
Now, the expectation is, you begin collecting Social
Security, at age 65, and you could well be collecting it for 25
years.
So I think, if I were the auditor--and I don't have that
training in accounting--I would say, ``Look, we need to go back
and make a lot of changes in how we're committing.''
Mr. Lee. Does anybody else want to comment?
Mr. Acharya. Yes. I just wanted to note something that
President Hoenig actually mentioned earlier in the day, which
is that the real danger we face is that the pattern of capital
flows, in this case, money coming from China, is such that it
remains very stable for long periods of time, and, boom, one
day it will just start reversing itself.
So--
Mr. Lee. If that were to occur, what impact would you
expect if that happened?
Mr. Acharya. My sense is that it's kind of too late to do
much at that point. I think--
Mr. Lee. If China stopped buying our debt, what would you
think the short-term impact would be?
Mr. Acharya. I think the short-term impact would be a
substantial rise in the borrowing costs, compared to what we
have.
There's a sense in which the flood of Chinese money coming
in is a mixed blessing, which is that it's sort of masking,
actually, the ``true'' cost of our borrowing.
Mr. Lee. It's much like the housing market. When we had the
bubble, nobody wanted to end the parade, and now we have China
coming in buying our debt, and again, it's giving us an excuse
not to make some hard decisions in this country.
Mr. Acharya. Absolutely.
Mr. Lee. With that, I appreciate your comments, and I'll
yield back.
Chairman Moore of Kansas. Thank you, sir.
We're going to do a second round of questions, if that's
all right.
Professor Geanakoplos, you make some suggestions that,
instead of monitoring leverage on a firm-by-firm basis,
especially if those firms have an incentive to use off-balance-
sheet instruments to hide their true leverage and risk-taking,
that we should monitor leverage on a transaction-by-transaction
basis, looking at how much downpayment was used to purchase a
security.
Would you please, sir, explain how this might help us
better constrain excessive leverage?
Mr. Geanakoplos. Thank you for the question. You have put
it exactly the way I intended it.
Everybody who borrows money, practically, has to put up
collateral, so if you monitor things transaction-by-
transaction, you get all the transactions. So you'll find out
not just about a few banks, how leveraged they are. You'll find
out something about the entire system. That's number one.
Number two, the transaction's, I call it security leverage,
the downpayment, is an accurate indicator of where the economy
is going.
If you do investor leverage, you often get the opposite
number. So take a problem where the--like we had recently. The
market is going down, nobody is able to borrow, precisely
because they have to put up too much collateral.
So the actual leverage is going down in the system, but if
you look at one of our big banks, their leverage is going up,
most of those institutions, because they're Lehman or Bear
Stearns, just before they go out of business, they're running
out of equity, and it looks like their leverage is
skyrocketing.
If you measure investor leverage, you're often going to get
precisely the wrong number, so just at the moment when there's
a crisis, and if anything you should be loosening leverage,
their leverage looks like it's getting tighter, and the
regulator might be led to do the exact wrong thing.
Third, as you said, you can hide your leverage, if you're
an institution. You put things off-balance-sheet, you can do
all kinds of tricks. But if you're talking about an actual
transaction, the lender is going to want protection, so there's
going to be real collateral there, and you'll know how much it
is. You also have two people telling you what the leverage is.
So for all those reasons--oh, and then lastly, if you try
to set a 15 percent rule, I think this could be quite
dangerous. If you set a 15 percent rule for a select few
institutions, the leverage will move. You'll have a huge
incentive to move the leverage somewhere else, and you'll never
be able to catch up to it. But if you're looking at it,
security-by-security, it has to be there. It's something
measurable.
So I think everyone would agree that transparency is
tremendously important. The numbers that should be published
every month are averages of the security leverage numbers, so
the average downpayment on a house, the average downpayment on
a mortgage security if you buy it.
And those numbers, if they appeared in newspapers, and
generally speaking, people would have a much more accurate
picture of what was going on in the economy, and the regulator
would have pressure from the public, actually, to do the right
thing, because everybody would know where we are.
But if you just measure a few institutions, that leverage
is going up and down in the wrong direction part of the time,
depending on their profitability, and not on what the borrowing
conditions really are.
Chairman Moore of Kansas. Thank you.
Does anybody else have a comment on this? Ms. Williams
Brown?
Ms. Williams Brown. I would like to comment on this.
The Systemic Risk Council concept continues to be very much
individual institution focused, but if the council is really to
function effectively, it needs to be able to look for risk
throughout the system, and this offers an interesting way to
begin to try to peel that onion of looking at and identifying
risk that may be building up in the system, that poses a
systemic risk. So I think it's an interesting idea.
Chairman Moore of Kansas. Mr. Acharya?
Mr. Acharya. I would just like to add one institution that
is being discussed, which could serve a very big role here--the
Office of Financial Research. I think its goal should be
exactly what John has described, which is to record the
financial transactions which are taking place, be it issuing a
new debt out there, doing a derivatives transaction.
And the most important thing is that some of this
information is being recorded right now, but no one is actually
recording how much up-front payment or collateral is actually
being put up when the transaction is being done.
Even in our derivative contract records, we don't have this
information right now, so we are relying on markets' ability to
discipline each other, but that's leaving a lot to the market.
Mr. Geanakoplos. Could I add one more thought on that?
Chairman Moore of Kansas. Yes, sir.
Mr. Geanakoplos. I would just re-emphasize that point.
So one of the ways of leveraging the system is using
derivatives, but this--and people say it's very hard, how to
keep track of leverage, when there are all these derivatives
and things.
But actually, this transaction-by-transaction approach
works there, too, because if you write a CDS insurance contract
saying you'll pay if the bond defaults, you have to put up
collateral for that, too. So we know how much collateral is
being put up for that, as well. So you'll cover the derivatives
case, as well as leverage moving around, and many--it's a
principled way of getting at the problem.
Chairman Moore of Kansas. Thank you.
My time has expired.
Ms. Biggert, do you have questions?
Mrs. Biggert. Thank you, Mr. Chairman.
Ms. Williams Brown, thank you for talking about the risk,
as such. I hope that you would take a look at H.R. 3310, the
Republican bill, which really addresses that issue.
In your study of leverage, did the GAO review the current
status of the balance sheets of the GSEs, Fannie and Freddie?
Ms. Williams Brown. We did not include them.
Mrs. Biggert. Can you do that?
Ms. Williams Brown. Yes.
Mrs. Biggert. Yes. Since Fannie and Freddie were leveraged
twice as much as Bear Stearns, does the GAO plan to examine why
the GSEs were leveraged to such extremes?
Ms. Williams Brown. We currently don't have plans, and we
haven't been asked to do that, but if we were asked to do that,
we would.
Mrs. Biggert. Okay. Is that because it's--there's no
reason, it's just you haven't been asked?
Ms. Williams Brown. Correct.
Mrs. Biggert. Okay. Would this fall within the mandate to
examine leverage in ESA?
Ms. Williams Brown. It's something that we could have
expanded the scope to do, but on this particular mandate, we
were given a fairly short window to do the work, so we did not
specifically include Freddie and Fannie in our study at the
time.
Mrs. Biggert. Could I ask you to do that?
Ms. Williams Brown. Yes.
Mrs. Biggert. Or, I ask you to do that.
Ms. Williams Brown. Okay.
Mrs. Biggert. Professor Walker, you mentioned that larger
institutions are riskier than smaller institutions based on a
non-deposit liability to Tier 1 capital ratio.
Is that higher risk, level of risk due to the ``too-big-to-
fail'' status, or is there another issue there?
Mr. David A. Walker. I didn't do calculations that I guess
would direct me immediately to ``too-big-to-fail,'' and I think
that, when we go through and look at individual institutions,
of the large ones, we see some that, where this would surely be
a problem, and others not. So I think we would have to take it
one at a time.
The ratio that I used struck me as a way of getting at the
pieces of the leverage and liabilities of institutions that
were not deposits, and I'm not assuming all those deposits are
insured, but they are different from the other aspects of the
liabilities, and I wanted to get a handle on that.
I should also mention, and there's a table in my testimony
showing this, that I broke large and small at $1 billion in
assets, and with more time, I would take that apart and do
considerably finer lines, to try to narrow down sort of where
the break point would be.
I'm guessing that it would be $10 billion or maybe even $25
billion, where you would see the higher risk.
Mrs. Biggert. With that, I yield back.
Chairman Moore of Kansas. Thank you, Ms. Biggert, and thank
you to our witnesses.
I want to thank all of the witnesses for your testimony
today. Today's hearing was helpful to further explore these
important issues of debt and leverage, giving us a better sense
of how we need to use them for responsible purposes, and not
get carried away, putting our financial system and economy at
risk.
At future hearings in this series this summer, we'll be
exploring the importance of risk management, better
understanding short-term markets like the repo market,
financial literacy, and other key issues.
I ask unanimous consent that the following items be entered
into the record: the McKenzie Global Institute's Report on Debt
and Deleveraging; GAO and CIS reports on leverage; a paper on
growth and debt by Professors Reinhart and Rogarth; and a paper
on liquidity and leverage by Adrian and Chen.
The Chair notes that some members may have additional
questions for our witnesses, which they may wish to submit in
writing. Without objection, the hearing record will remain open
for 30 days for members to submit written questions to our
witnesses and to place their responses in the record.
This hearing is adjourned, and again, I thank our witnesses
for appearing and testifying today.
[Whereupon, at 12:47 p.m., the hearing was adjourned.]
A P P E N D I X
May 6, 2010
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