Highlighting and abridging by Don

Pro Senate Bill

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April 13, 2010

Timothy Geithner
Secretary of the Treasury

How to prevent America's next financial crisis.

America is close to turning the page on this economic crisis. While far too many Americans are still out of work and face deep economic hardship, we have now reported three quarters of positive growth and the beginnings of job creation. As the economy improves, we are winding down the Troubled Assets Relief Program, and Congress is moving toward enacting the strongest financial reforms since those that followed the Great Depression.

In fact, we are repairing our financial system at much lower cost than anyone anticipated and expect to return hundreds of billions of dollars in available but unused TARP resources to the American people. That is a rare achievement in Washington.

Our latest estimate conservatively puts the cost of TARP at $117 billion, and if Congress adopts the Financial Crisis Responsibility Fee that the president proposed in January, the cost to American taxpayers will be zero. More broadly, we estimate the overall cost of this crisis will be a fraction of what was originally feared and much less than what was required to resolve the savings-and-loan crisis of the 1980s.

The true cost of this crisis, however, will always be measured by the millions of lost jobs, the trillions in lost savings and the thousands of failed businesses. No future generation should have to pay such a price.

It is simply unacceptable to walk away from this recession without fixing the system's basic flaws that helped to create it.

Thankfully, signs of bipartisan support for action seem to be emerging in Washington, including for an independent consumer financial protection agency.

That is welcome news. The best way to protect American families who take out a mortgage or a car loan or who save to put their kids through college is through an independent, accountable agency that can set and enforce clear rules of the road across the financial marketplace.

But consumer and investor protection, while critical to reform, are only one part. As the Senate bill moves to the floor, we must all fight loopholes that would weaken it and push to make sure the government has real authority to help end the problem of "too big to fail."

To prevent large financial firms from ever posing a threat to the economy, the Senate bill gives the government authority to impose stronger requirements on capital and liquidity. It limits banks from owning, investing, or sponsoring hedge funds, private equity funds or proprietary trading operations for their own profit unrelated to serving their customers. And it prevents excess concentration of liabilities in our financial system.

All of that means major global financial institutions -- whether they look like Goldman Sachs, Citigroup or AIG -- will be required to operate with less leverage and less risk-taking.

Crucially, if a major firm does mismanage itself into failure, the Senate bill gives the government the authority to wind down the firm with no exposure to the taxpayer. No more bailouts. Instead, we will have a bankruptcy-like regime where equityholders will be wiped out and the assets will be sold.

These are important steps, but they are not enough. Ending "too big to fail" also requires building stronger shock absorbers throughout the system so it can better withstand the next financial storm. To do that, the Senate bill closes loopholes and opportunities for arbitrage, and it brings key markets, such as those for derivatives, out of the shadows.
Transparency will lower costs for users of derivatives, such as industrial or agriculture companies, allowing them to more effectively manage their risk. It will enable regulators to more effectively monitor risks of all significant derivatives players and financial institutions, and prevent fraud, manipulation and abuse. And by bringing standardized derivatives into central clearing houses and trading facilities, the Senate bill would reduce the risk that the derivatives market will again threaten the entire financial system.

A clear lesson of this crisis is that any strategy that relies on market discipline to compensate for weak regulation and then leaves it to the government to clean up the mess is a strategy for disaster.

This is a defining moment for financial reform. We have to get it right. We cannot build a system that depends on the wisdom and judgment of future regulators. Even the smartest individuals armed with the sharpest tools will not be able to find every weakness and preempt every crisis. Instead, the best strategy for stability is to force the financial system to operate with clear rules that set unambiguous limits on leverage and risk.

We need that to happen here and around the world. Importantly, with the Senate bill, the United States would have a strong hand in negotiating a global agreement on new capital requirements by the end of the year. Such an agreement would establish a level playing field with minimum requirements for capital, and compliance would be open to scrutiny by regulators and the markets.

The Senate bill is strong. It would create an independent agency to better protect American families across the financial marketplace. It would protect against "too big to fail." And it would bring the derivatives market out of the dark. As the bill moves to the floor, we will fight any attempt to weaken it. The American people have suffered through too much to enact reform that does too little.

End of Geithner

Against Senate Bill


Professor of Public Policy
University of California,
Secretary of Labor under President Clinton

April 13, 2010

1 - Outlays from the federal stimulus have already passed their peak, and the Federal Reserve won’t keep interest rates near zero for very long.

2 -Most households rely on two wage earners, of whom at least one is now likely to be unemployed, underemployed or in danger of losing a job.

3 - Even households whose incomes have returned are likely to be residing in houses whose values haven’t—which means they can’t turn their homes into cash machines as they did before the recession.

4 - Secretary of the Treasury Geithner points out that:

"The true cost of this crisis, however, will always be measured by the millions of lost jobs, the trillions in lost savings and the thousands of failed businesses. No future generation should have to pay such a price."

"It is simply unacceptable to walk away from this recession without fixing the system's basic flaws that helped to create it."

"Thankfully, signs of bipartisan support for action seem to be emerging in Washington, including for an independent consumer financial protection agency. "

BUT,

This bill doesn’t rein in Wall Street.

1 - It allows so-called “specialized” derivatives to be traded without regulatory oversight.

2 - Its capital requirements are weak.

3 - It gives far too much discretion to regulators who fall asleep at the switch.

4 - It does nothing about conflicts of interest within credit rating agencies that rate the issues of the companies that put food on their plates.

5 - It puts a consumer protection agency inside the Federal Reserve whose existing consumer bureau has not protected consumers.

6 - It doesn’t do anything to control the size of banks.

7 - It delays dealing with other hard issues by assigning them to vaguely-defined “studies.”

8 - It reserves to the Federal Reserve the power to do another bank bailout.

9 - Some economic cheerleaders say rising stock prices are making consumers feel wealthier and therefore readier to spend.

10 - But most Americans’ biggest asset is their homes.

11 - The “wealth effect” is felt mainly by the richest 10%, whose net worth is largely stocks and bonds. The top 10% accounted for about half of total national income in 2007. But they were only about 40% of total spending.

12 - What’s likely to slow the jobs recovery most, however, is that many of the jobs that have been lost will never return. There is a structural shift in the economy. Companies are using the downturn to trim payrolls. And they are outsourcing.

13 - Alcoa had $1.5 billion in cash at the end of last year, double what it had on hand at the end of 2008. It cut 28,000 jobs.

End of Reich

William C. Dudley, President

Federal Reserve Bank of New York|

Excerpts from April 7, 2010 speech to the Economics Club of New York where he is a member of the Board of Trustees.

William C. Dudley became the 10th president and chief executive officer of the Federal Reserve Bank of New York on January 27, 2009. In that capacity, he serves as the vice chairman and a permanent member of the Federal Open Market Committee (FOMC), the group responsible for formulating the nation’s monetary policy.

Mr. Dudley had been executive vice president of the Markets Group at the New York Fed, where he also managed the System Open Market Account for the FOMC. The Markets Group oversees domestic open market and foreign exchange trading operations and the provisions of account services to foreign central banks.

Prior to joining the Bank in 2007, Mr. Dudley was a partner and managing director at Goldman, Sachs & Company and was the firm’s chief U.S. economist for a decade. Earlier in his career at Goldman Sachs, he had a variety of roles including a stint when he was responsible for the firm’s foreign exchange forecasts. Prior to joining Goldman Sachs in 1986, he was a vice president at the former Morgan Guaranty Trust Company. Mr. Dudley was an economist at the Federal Reserve Board from 1981 to 1983.

Mr. Dudley received his doctorate in economics from the University of California, Berkeley in 1982 and a bachelor’s degree from New College of Florida in 1974.

Mr. Dudley serves as chairman of the G-10 Committee on Payment and Settlement Systems of the Bank for International Settlements.

Excerpts from Mr. Dudley's speech:

Ucertainty is not grounds for inaction. Instead the decision whether to act depends on whether appropriate tools can be deployed to limit the size of a bubble and whether the benefits of acting and deploying such tools are likely to exceed the costs. That cost benefit calculus in turn depends crucially on the tools that we can deploy to limit the growth of bubbles, and the consequences when they burst. In this respect, I will argue that in most cases, use of the bully pulpit and macro-prudential tools such as rules limiting loan to value ratios or leverage, are likely to prove superior to monetary policy.

Similarly, the recent housing boom has been driven by two innovations. One in housing finance where subprime lending made mortgage credit available to households that were of lower income and less credit worthy. And two, in structured finance instruments such as collateralized debt obligations or CDO’s. The first innovation significantly broadened the availability of mortgage credit to households. The second innovation reduced the cost of this credit. Cash flows from the underlying mortgage assets were apportioned among senior and junior tranches. These tranches which had been rated by the rating agencies were then distributed to a wide range of investors. This structured finance innovation in turn was supported by innovations in the shadow banking system. Security lenders, structured investment vehicles and conduits bought the highly rated tranches of the structured finance products, and financed these assets in the wholesale short term funding markets.

In the subprime structured finance boom, there were several important positive feedback mechanisms. In particular the surge in credit availability drove up the demand for housing and pushed up housing prices. This increase in demand caused the default experience associated with such lending to be very low. And this reinforced the notion that subprime lending was not very risky. It also reinforced the demand for complex CDO’s secured by such assets. During the boom structured finance models appeared to be sound because losses on the underlying subprime mortgage loans were low, and because the correlation rates in performance across different assets in the pools were low, just as the models had predicted.

In the housing boom the end came about for several reasons. One limiting factor was the rise in home prices outstripped income growth. Thus, for the boom to persist underwriting standards had to be continually relaxed. Only in this way could a new cohort of first time buyers that qualify for big enough mortgages to be able to afford to buy their homes. The difficulty in replenishing the pool of new buyers limited how fast demand could keep rising. In addition, the rise in home prices led to an explosion of supply. Especially in areas like Arizona, Florida, Nevada and inland California where buildable land was plentiful. As supply caught up to demand, this led to a downturn in prices. Once this occurred, the poor underwriting standards associated with subprime mortgage lending became apparent. Subprime borrowers could no longer easily refinance or sell the house at a higher price and repay the original mortgage. As Warren Buffet reportedly once quipped, “only when the tide goes out do you discover who has been swimming naked.”

The policy maker needs to develop a perspective about whether these demand and supply changes are realistically sustainable to the extent implied by market prices. In particular, carefully analyzing the assumptions that underpin the sustained increases in asset prices which might be symptoms of a bubble, and considering the risks that these assumptions might be wrong, is very important. Also, looking carefully at the dynamics of the system on which the beliefs are based may be useful. In particular, are the dynamics of the system reinforcing or dampening. If the dynamics are reinforcing, then there is a greater likelihood of an asset bubble.

The next step is for the policy maker to evaluate what tools might be available to curve the imbalances that have been identified. The idiosyncratic nature of the innovations and belief systems associated with particular bubbles, implies that the tools used to respond to each bubble will likely have to be different and tailored to the features of the particular bubble in question.

Credit bubbles that burst threaten the stability of the financial system much more directly than equity bubbles.

That is because much of the debt is held by banks and security dealers that are highly leveraged. As a result, when the bubble deflates, it can take the financial system with it. In contrast, because most equities are held on an unleveraged basis by investors, such as pensions and mutual funds, the sharp decline in equity prices will not typically threaten the entire financial system. A comparison of the consequences of the technology stock market crash in equities versus the mortgage debt market crash, strongly supports this thesis. Although the wealth loss was roughly comparable, the bursting of the housing bubble had a much greater negative affect on the financial system and on the macro economy.

So what are the tools of which the policy maker should respond? As I see it, there are three broad sets of tools available. One, the bully pulpit, two, macro-prudential tools, and three, monetary policy. Let me now discuss each of these in turn. The first tool available is to simply lean against the wind of conventional wisdom by speaking out about the dangers associated with the incipient bubble. The policy maker could point out the assumptions embedded in the rapid rise in asset prices and question the accuracy of the assumptions. Obviously, the policy maker might be ridiculed by true believers about the lack of understanding about the important nature of the innovation. But I suspect that over time a proactive central bank that laid out the risk clearly would gradually gain credibility with market participants. Use of the bully pulpit would allow the central bank to signal its concerns. This might be useful in shifting the risk/reward tradeoff by raising the risk that the talk might foreshadow more forceful action. That by itself could temper behavior. Announcement affects can be very powerful, especially when they can be followed by changes in policy.

The second set of tools include those that are macro-prudential in nature. I would define macro-prudential tools as regulatory and supervisory actions that are not applied on a firm specific basis. These include tools designed to temper demand or increase supply in the asset subject to the bubble. Or to increase the ability of skeptics to take the other side of the market in which the bubble may be occurring. For example, to counteract the housing bubble, tools available might include limiting loan to value ratios, limiting debt service to income ratios or increasing the taxes on housing transactions. Several Asian and some European countries have used such tools to limit speculative real estate activity. Apparently with some success, although, the counterfactual cannot be known by definition. To limit a subprime lending boom the authorities might wish to enforce strict underwriting practices. Including verifying purchasers incomes and enforcing rigorous appraisal valuations. Increasing the ability of investors to short the assets in question may also be helpful. In terms of macro-prudential tools I would also include tools that influence how the financial system operates and functions. Such tools might include supervisory measures that set liquidity and capital requirements for financial institutions and other intermediators. They might also include tools that try to limit the overall buildup of leverage in the financial system. For the equity market, macro-prudential tools might include margin rules for cash, options, futures, and equity over-the-counter derivatives. For the fixed income market, such tools might include raising haircuts charged to dealers on their repo financing. Raising the hair cuts that securities dealers assess against the collateralized borrowings of their customers as part of their prime brokerage businesses or raising initial margin requirements and OTC derivatives transactions. Macro-prudential tools are undoubtedly difficult to use effectively in practice. For example, it is difficult to judge their impact. If loan to value ratios for single family mortgages are lowered by five percentage points, how big of an impact will that have on housing demand. There is also a risk that the rules or regulations will simply be circumvented. For example, investors might move to instruments or to off-shore regimes with less stringent margin and leverage restrictions. Thus, it is important that the authorities have the ability to apply the macro-prudential tools broadly throughout the financial sector. None of this is going to be easing, a lot more work will be required to develop a portfolio of tools that could be used that would be effective and that would not be subject to significant evasion or unintended consequences. In terms of the use of macro-prudential tools, let me briefly take note of another issue that I think requires significant consideration. The issue of governance. Who controls all of these tools? Who decides when the tools will be deployed and how extensively or intensively? Having a sufficient tool kit seems like a good idea, but lodging all of this authority within a single entity or institution might not be practical or desirable.

Question from Roger Altman: Bill, the Consensus Economic Forecast and I just looked it up again this morning, and I looked at the Bloomberg Survey of 50 economists as most recently reported, envisions quite modest growth and a relatively high unemployment over the three year period covered by this particular forecast. Approximately three percent real growth over the period and unemployment rate reaching or descending only to 8 percent at the end of 2012. The question is, do you think it is possible for meaningful inflationary pressures, not a slight uptick, but meaningful inflationary pressures, to arise in this country in the face of such weak growth and employment markets?

William Dudley: I think the answer is, it is possible, because inflation is not just a consequence of how much slack there is in the economy but also it is a function of inflation expectations. So you could be perfectly comfortable in terms of the fact that you have plenty of excess slack in the economy but if inflation expectations became unmoored, then you could still have an inflation problem. That is one reason why the Federal Reserve has been trying to do a lot to communicate to market participants about our exit from our enlarged balance sheet. To reassure people that we have the tools in place to exit smoothly when the time comes. We do have those tools and the ability to pay interest on excess reserves. We do have the tools in terms of the ability to drain reserves through reverse repurchase operations, in turn with the positive accounts. And the reason why we are telling people that now is not because the exit is near at hand, but because we want people not to be worried about our ability to do so because we want to keep inflation expectations well anchored. Inflation expectations are well anchored. So that is a very good thing, but it is very important that we continue to work on that.

I think that there is no question that the decline in loans outstanding, at least to a degree, is a function of the tightening of credit standards that we have seen over the last year. And it is also a symptom of the fact that some banks, especially small and medium sized banks are still under a lot of duress, in part because they have large commercial real estate exposures and those exposures are going to take many, many years to work out. So I would view the decline in credit outstanding, as a symptom of the underlying tightness and credit availability. Now what I would expect will happen is that if the banking system gradually heals itself, we will start to see credit availability improve. And in fact the survey of Senior Loan Officers suggests that people are no longer tightening credit conditions, so we may be about to see a beginning of a loosening. Certainly the large banks are in much better shape than they were a year ago. Last year, the large banks that were subject to the supervisory capital assessment program raised almost $200 billion of equity, $100 billion in the market and nearly $100 billion by converting preferred stock and asset sales. So they are in pretty good shape now. It is really the small and medium sized banks that have to get healthier. And I think that is just going to take time for that to take place. I think this is one reason why, if I come back to your first question, why people are seeing moderate growth over the next couple of years, as opposed to strong growth over the next couple of years, is the fact that the banking system is still not fully back to health.

Paul Calello: Bill, you have spoken about the importance of regulatory reform, and I will stick on that for another question. Including a wide range of financial intermediaries. And the question I have for you is do you believe that the current legislation before Congress today addresses that or does something more need to be done there?

William Dudley: Well first of all we don’t know exactly what the legislation that is going to come forth from Congress, so I think it is a little premature to decide whether it is broad enough. But I certainly take the point of your question. It is very important that we don’t just jack up the requirements a lot on commercial banks and then let all of their activity flow into the nonregulated sector. So it is very important that the regulation be applied broadly across the financial system. And I think people recognize that. But it is hard to do in practice. You know, I think the fact that the Congress is talking about systemic risk regulation is helpful in that regard.

Because that implies that you are looking at risk horizontally across the financial system, not vertically in little silos, with each regulator worried about their particular set of financial institutions. So, I think that discussion makes me feel more comfortable. But I think you are raising a very, very important issue and it really is important that the regulation be broad because we don’t want to just drive activity from the now very tightly regulated sector into the unregulated sector.

Roger Altman: Well let’s move on to some tougher ones. Bill, everybody knows that one aspect of the crisis that we just came though was a series of regulatory failures or enforcement failures. And the Federal Reserve wasn’t exempted from that. The Federal Reserve, of course, did regulate bank holding companies, and we saw gigantic losses and government rescues and so forth in that sector which the Federal Reserve was responsible for supervising. So the question is, what steps has the Federal Reserve taken to ensure that the mistakes it made won’t recur?

William Dudley: I think there is no question that the Federal Reserve and a lot of the other regulators could have done much better and so I stipulate that. And as a consequence of that, we recognize that. We have been doing a lot of work to try to figure out how we can do supervision better. We have done some studies at the Federal Reserve Bank of New York. The Board of Governors is involved in a very big effort system wide to revamp how we do supervision. And I think the changes that we are putting in place are designed to do a couple of different things. One, much more multidisciplinary. Not just bank examiners, but bank examiners, market people, researchers, economists, to get a sense of the whole landscape. I think one of the problems going into the crisis was everything was looked at on an individual, institution by institution basis, and you looked at the institution and you look at their capital and you looked at their earnings, and their capital was pretty good and their earnings was pretty high, so it looked pretty good. But, you weren’t really capturing all of the linkages across the financial system. So the second thing we are doing is horizontal reviews. So best practices. Who is doing things well, who is doing things that are not that well, and basically bringing the people who aren’t doing well up to snuff. So I think that is another important change that we are doing. And the third thing that I think we are doing is we are trying to develop a more challenging culture about supervision, in terms of thinking about the bank as a business. How does the bank make money. How does it generate revenue. What risk does it take to generate that revenue. Rather than, checking the boxes in terms of is the bank conforming to every little piece of rule and regulation. If you don’t get that big picture right, you are not going to do a very good job at supervision. So this is very important to us and we are definitely working on it.

Glenn Hubbard: I have one member question before we close that draws on a recent op-ed from Chuck Schwab in the Wall Street Journal on the subject of interest rates. That persistently low interest rates discourage savings in general and are seriously damaging to seniors living on a fixed income. Your thoughts?

William Dudley: I think Chuck Schwab’s observation is correct that low interest rates are not attractive to savers and there is a consequence of that. But, at the end of the day the Federal Reserve had to set monetary policy for what is best to achieve its twin objective of full employment and price stability. And our view right now is that the Federal Funds rate needs to be exceptionally low for an extended period to contribute to easier financial conditions to support economic activity. The reality is, in the current environment, we are not getting the job gains that we would like to get. We would like to see employment gains much more substantial than what we have gotten. So what that tells us is that monetary policy needs to be on a very easy setting right now to stimulate the economy, to stimulate employment growth. That has to be our first priority.

 

End of Dudley