HEARING OF THE SENATE COMMITTEE ON HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS SUBJECT: WHERE WERE THE WATCHDOGS? THE FINANCIAL CRISIS AND THE BREAKDOWN OF FINANCIAL GOVERNANCE CHAIRED BY: SENATOR JOSEPH I. LIEBERMAN (ID-CT) WITNESSES: GENE L. DODARO, ACTING COMPTROLLER GENERAL, U.S. GOVERNMENT ACCOUNTABILITY OFFICE; HOWELL E. JACKSON, JAMES S. REID JR. PROFESSOR OF LAW, HARVARD LAW SCHOOL; STEVEN M. DAVIDOFF, PROFESSOR OF LAW, UNIVERSITY OF CONNECTICUT SCHOOL OF LAW; RICHARD J. HILLMAN, MANAGING DIRECTOR, FINANCIAL MARKETS AND COMMUNITY INVESTMENT, U.S. GOVERNMENT ACCOUNTABILITY OFFICE; THOMAS MCCOOL, DIRECTOR, CENTER FOR ECONOMICS, APPLIED RESEARCH AND METHODS, U.S. GOVERNMENT ACCOUNTABILITY OFFICE LOCATION: 342 DIRKSEN SENATE OFFICE BUILDING, WASHINGTON, D.C. TIME: 2:00 P.M. EST DATE: WEDNESDAY, JANUARY 21, 2009

SEN. LIEBERMAN: The hearing will come to order. Good afternoon and welcome. As our nation begins work under our brand new President to recover from the worst financial crisis since the Great Depression, we must ask how and why it happened. Is the existing U.S. financial regulatory system adequately equipped to protect consumers, investors, and our economy?

A new report by the Government Accountability Office that is focus of today's hearing lays out a very persuasive case that the answer to that question is no. Over time as the financial services sector has grown, moved in new directions, or suffered from scandals or crises, Congress has usually responded in a piecemeal fashion grafting new regulatory agencies on top of one another. As a result, responsibilities for overseeing the financial services industry are today shared by over 200 different regulatory agencies at the federal and state level, not to mention numerous self-regulatory organizations, such as the stock exchanges.

GAO's report concludes that our current regulatory structure is outdated and unable to meet today's challenges and highlights several key changes in financial markets that have exposed significant gaps and limitations in our ability to protect the public interest. Some of GAO's observations are familiar to members of this committee. We have heard over the years about the careless lending practices that led to the current subprime mortgage crisis, the increasing number of over leveraged financial institutions that need to be bailed out by the government, the failures of credit reporting agencies to provide credible ratings for increasingly complex financial products, and the inability of regulators to uncover or in some sense respond to the world's largest ever Ponzi scheme.

It gives this committee no satisfaction to note that some of these shortcomings were highlighted over six years ago in our investigation both by the full committee and the permanent Subcommittee on Investigations following the collapse of Enron. And there we noted the inadequacies of the credit rating agencies and the failure of regulators to notice failures really, to notice the red flags that warned of massive financial fraud.

Rather than contributing to the stability of financial markets, our fractured regulatory system seems to encourage financial institutions to play regulators off against one another. New and complex financial products have been created that bypass these antiquated regulatory schemes. In some derivative markets, regulation is absent altogether. All in all, these problems clearly contributed to the build up of systemic risks and the eventual breakdown in credit and financial markets in the last year that has put millions of people out of work, destroyed so much of the savings and home values of the American people, and broken our economic confidence in the future.

We've called this hearing today to take a government-wide look at our existing structure of regulation of financial services. We've asked today's witnesses, Gene Dodaro, acting controller of GAO, Professor Howell Jackson of the Harvard Law School, and Professor Steven Davidoff of the University of Connecticut Law School to tell us if the current regulatory system adequately protects consumers, preserves the integrity of our markets, and protects the safety and soundness of our financial institutions.

Given the scope of the crisis we face today, on top of the crises that we have gone through over recent years, including -- and I go back a little further here -- the savings and loan scandals, the dot com bubble, and the Enron accounting mess that I mentioned -- we think that now is the time to think not just about regulatory reform, but about regulatory reorganization.

Personally, I've not concluded whether the way to fix our current system is to establish a single overarching super regulatory agency, like that that exists in other developed countries or whether it will be wiser simply to improve the ability of the existing regulatory bodies, or whether the answer is somewhere in between. However, what I have concluded is that there is serious deficiencies in our current patchwork regulatory system. And before Congress can fix them wisely and in a way that will avoid -- will not just respond to the last economic crisis or scandal, but prevent the next one, I think we've got to step back and carefully scrutinize how the pieces would best fit together. And that, I believe, is what our committee is well suited to do.

President Obama has declared that reforming the current financial regulatory structure will be one of this top priorities in this first year of his presidency, and I think we all welcome that. Such legislation will come out of the Senate Banking Committee, although it does touch on agencies that are regulated by other committees, such as the Finance Committee or the Agriculture Committee, or the Commerce Committee.

However, I believe that this committee's unique authority concerning governmental organization and oversight, as well as the special investigative power of our Permanent Subcommittee on Investigations, requires us to get involved in this review and will enable us to help the Senate reach the right conclusions about how we restructure our system of financial governance to prevent future financial crises that can cause terrible economic pain.

You may ask how are we going to do this if the bill's not coming out of our committee? Well, we certainly can do this first with a series of hearings and investigations. Then depending on the interest and will of committee members to express our conclusions and report, which we will forward to the Banking Committee -- and perhaps, if we are so moved, to offer amendments on the floor later this year when the fiscal regulatory reform proposal reaches the floor. In any case, this is a matter of importance and urgency to our country, and I do believe that we have something to contribute to the Senate discussion and legislation.

Senator Collins.

SEN. CARL LEVIN (D-MI): Excuse me. Senator Burris is here now. I think this is his first --

SEN. LIEBERMAN: Well, yeah, Senator Levin notes that Senator Burris is here. I've got to get over a bad habit where I refer to him as General Burris because we were both attorneys general and we love that title. But Senator Burris, I really welcome you. I know of your work, and I know that though you came here, shall we say, in uncertain circumstances, I know you well enough to know that you're very well qualified to be an outstanding member of the Senate and will contribute greatly to the work of this committee, so I'm delighted that you've chosen to be on the committee, and we welcome you here today. Pleasure.

Senator Collins.

SEN. SUSAN M. COLLINS (R-ME): Thank you, Mr. Chairman. Let me also add my words of welcome to our newest committee member. I would also inform the members at this committee that we will be adding members on the Republican side. I'm very pleased that Senator McCain, Senator Ensign, and Senator Graham will be joining the committee as well. So once again, we will have a great compliment of members with which to do our work.

SEN. LIEBERMAN: And with that group, I might add -- lively hearings and deliberation.

SEN. COLLINS: This is true, Mr. Chairman. Mr. Chairman, let me start by thanking you for holding this hearing today. I spent five years in state government overseeing financial regulation, so I have a great deal of interest in this area. The spiraling financial crisis that's harmed virtually every American family -- December's job losses were the worst monthly decline since 1945 and drove the unemployment rate above seven percent. Individual retirement accounts and college savings accounts, as well as university endowments and public and private pension funds have suffered huge losses. Consumer credit and mortgage availability have become more restricted.

In the past year, more than one million homes have been foreclosed upon, and foreclosure proceedings are targeting two million more. Home prices are still falling, and at least 14 million households owe more on their mortgages than their homes are worth.

The current crisis has its roots in the financial system where a combination of low interest rates, reckless lending, complex, new instruments, securitization of assets, poor disclosure and understanding of risk, excessive leverage, and inadequate regulation poisoned the normal flows of credit and commerce. The financial system itself has not escaped this carnage. A year ago, American capital markets were dominated by five large investment firms; Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley and Goldman Sachs. Now they have either failed, been sold to banks, or have converted to bank holding companies. Tens of thousands of banking investment jobs have disappeared.

A year ago, we thought a tarp was for covering your roof after a hurricane. Now the troubled asset relief program, known as TARP, originally touted as the means for Treasury to buy troubled assets from banks, has morphed into a mechanism for buying hundreds of billions of dollars in bank preferred stock and warrants in order to inject capital into those financial institutions.

It is not sufficient for Congress to continue to infuse new money into TARP or simply to pass an economic stimulus package. We must also ask how to repair our system of financial regulation to minimize the risk that another crisis such as this might build up undetected and unchallenged.

As we consider the options for reform, the GAO's new report on financial regulation will be a valuable guidebook. It describes the structure of the current system, explains the system's inability to cope with shifting circumstances, and proposes criteria for judging reforms. GAO sums up our challenge. Quote, "As the nation finds itself in the midst of one of the worst financial crises ever, it has become apparent that the regulatory system is ill-suited to meet the nation's needs in the 21st century."

That judgment confirms what this committee has found in our hearings on commodity speculation and derivatives trading. That is, that there are too many (gaps ?) between jurisdictions, too many financial entities and instruments that can create huge risk, but are largely free from regulatory requirements, and too little attention paid to systemic risk. We now understand that everyday activities by mortgage brokers, hedge funds, over-the-counter traders, investment banks, Freddie Mac and Fannie Mae, and others dealing in mortgage- backed securities, credit default swaps, and other instruments can create a crisis that affects virtually every home and business in America.

Yet, of the dozen federal agencies and hundreds of state agencies that are involved in financial regulation, it appears that not one is cast with detecting and assessing systemic risk. We have seen the consequences of that flaw. The proliferations of unregulated and unreported credit default swaps created spider webs of commitments so that a few failures rippled into the destruction of major investment banks.

By accident or by design, there are many key players in the modern regulatory system who are unregulated or lightly regulated, including mortgage brokers, self-regulated exchanges and credit rating agencies, hedge funds, and non-bank lenders. Without additional transparency into their operations, a new systemic risk monitor would find its mission difficult to achieve.

These difficulties have become so obvious that it is now common to hear government and industry officials, as well as academic experts, calling for a new systemic risk agency or monitor and for a restructuring of regulatory agencies. In November, I introduced a bill to correct two other glaring gaps in our regulatory system; the lack of explicit regulatory authority over investment bank holding companies, and the lack of transparency for credit default swaps.

Regulatory reform is absolutely essential to restoring public confidence in our financial markets. I'm convinced we could continue to invest billions of dollars in banks, but that if we don't put in place a new, strong regulatory system, the public's confidence, which is essential to the operation of our markets, will not be restored. Americans, consumers, workers, savers, investors, deserve the protection of a new regulatory system that modernizes regulatory agencies, set safety and soundness requirements for financial institutions to prevent excessive risk taking and improves oversight, accountability, and transparency.

Mr. Chairman, I'm going to ask unanimous consent that the remainder of my statement by introduced into the record since I realize we have only limited time this afternoon and I could go on forever on what is one of my favorite issues. Thank you.

SEN. LIEBERMAN: Needless to say, I would be interested in having you go on forever.

SEN. COLLINS: (laughs)

SEN. LIEBERMAN: But without objection, we will enter the statement in the record. Senator Levin, normally we'd just have statements opening from the chair and ranking member. Senator Levin is the chair of the Permanent Subcommittee on Investigations. He has some thoughts and plans with regard to the topic of our inquiry today, and therefore, I'd like to call on him on this occasion as well for an opening statement.

SEN. LEVIN: Well, thank you, Mr. Chairman, and again, I'd be happy to have this time deducted from my --

SEN. LIEBERMAN: Not at all. (Inaudible).

SEN. LEVIN: -- question period. Mr. Chairman, I thank you and the ranking member for holding this hearing. History has proven time and again that markets are not self-policing. The Pecora hearings before a Senate Committee in the 1930s pulled back the curtain on the abuses that gave rise to the Great Depression.

Hearings since then have documented a litany of abuses by financial firms trying to take advantage of investors and markets for private gain.

In recent years, for example, congressional hearings, including by the Permanent Subcommittee on Investigations, PSI, which I chair, showed how Enron cooked its books, deliberately distorted energy prices and cheated on its taxes, becoming the seventh largest corporation in the country before its collapse. Our subcommittee hearings also show how leading U.S. financial institutions, such as CitiGroup, J.P. Morgan, Merrill Lynch, willingly participated in deceptive transactions to help Enron inflate its earnings.

Some of our other hearings at PSI have disclosed that U.S. corporations engaged in misleading accounting, offshore tax abuses, excessive stock option payments, and other disturbing practices. Our hearings in 2007 showed how a single hedge fund named Amoran (ph) made massive commodity purchases on both regulated and unregulated energy markets to profit from distorted energy prices that they helped generate, causing U.S. consumers to pay more.

Subcommittee hearings last year showed how Lehman Brothers, Morgan Stanley and others helped offshore hedge funds, dodge payment of U.S. taxes on U.S. stock dividends by facilitating complex swap agreements and stock loan transactions. Other congressional hearings have shown how countrywide and others sold abusive mortgages, over charged borrowers, and offloaded defective mortgage-based securities onto the market.

Part of the explanation for these recent abuses is the history of actions that have gradually weakened our financial regulatory system. Now, the chart, which I guess our audience can see, but we can't, so I'll quickly read what's on it -- the chart lists just a few of these actions over the last ten years.

Some of these actions are the following. Back in October of 1998 at the request of the Securities and Exchange Commission, Treasury and Federal Reserve, Congress blocked funding for CFTC regulation of over-the-counter derivatives. In 1999, the Graham- Leach-Bliley Act repealed Glass-Steagall, which separated banks, broker dealers and insurers.

In 2000, December, the Commodity Futures Modernization Act prohibited swaps regulation and opened the Enron loophole, allowing unregulated energy markets for large traders. In August of 2003, the SEC delayed requiring auditors of private broker dealers to register with Public Company Accounting Oversight Board rules. In June of '04, the SEC weakened the Net Capital Rule for securities firms. In June of '06, the Court of Appeals invalidated the SEC regulation requiring hedge fund registration. We needed the SEC to come back to us and ask for legislation. That didn't happen.

In December of '07, the SEC allowed foreign companies trading on U.S. exchanges to use international financial reporting standards without a reconciliation to U.S. generally accepted accounting principles. And this is just a few of the actions which have been taken.

It hasn't all been one way. It's mostly been one way. After the Enron scandal, we were able to enact the Sarbanes-Oxley Act that strengthened oversight of the accounting profession, required stronger financial controls, and made a number of other improvements. Last year, we successfully closed the Enron loophole, at least most of it, which borrowed government oversight of electronic energy markets for large traders. There's still more reform in that area needed.

But overall, stronger market regulation has been the exception, not the rule, and had to be one despite naysayers claiming that markets work best with minimal regulation. The current crisis shows that minimal regulation is a recipe for disaster. An overhaul of Wall Street regulation is long overdue, and Congress needs to act now to fix a broken system.

As Congress and the new Administration begin to work on the financial restructuring and our committee begins to examine these issues, I just want to briefly offer a few observations about needed financial reforms. The first is that Congress needs to put a cop on the beat in every financial market with authority to police every type of market participant and financial instrument to stop the abuses. We need to eliminate the statutory barriers, for example, that prohibit federal regulation of credit default swaps, hedge funds, and derivative traders.

We need to enact new limits on high-risk activities, including preventing banks from running their own hedge funds and requiring the end of abusive offshore activities. Congress also needs to reduce the concentration of risk to the taxpayer by preventing any one bank from holding more than ten percent of U.S. financial deposits and to institute new protections to stop financial institutions from profiting from practices that abuse investors and consumers.

Finally, Mr. Chairman, let me just add one other thought. And that is that I believe that we need to act on the substance of these abuses and to fill these gaps. The chairman and ranking member are undertaking a very important mission, which is to look at the structure of the regulation, because that is within the jurisdiction of this committee. And I don't want to in any way minimize the importance of that effort.

But we also need to make sure that this effort puts additional pressure on the committees that have the substantive jurisdiction to take the steps necessary to close the gaps that have been created in this system, the regulatory gaps so big that some of the greediest members of our society have been able to very easily walk through those gaps, making billions of dollars for themselves.

And so again, I want to commend you, Mr. Chairman. This is the more difficult part of the effort, the structuring part. And it's important to try to reach conclusions as to which agency is the proper agency to do the regulation. That's the who. But I believe the more urgent item, which I hope this effort will help support, is not so much the who, as important as that is. It's the whether, whether we're going to get a cop back on the beats.

And this effort of our chairman and ranking member is I know going to -- is aimed at supporting that goal, because both of them have expressed -- and through their actions on this committee have indicated the importance of the substantive reforms that need to be made to fill the gaps that have been created and the holes that have been gone through by too many greedy folks. And I want to commend you, Mr. Chairman, and our ranking member, Senator Collins, for your effort.

But again, I just think we've got to make sure that our effort in some way supports the critical substantive changes, which both of you have spoken about, introduced legislation on, and fully support. I thank you.

SEN. LIEBERMAN: Thanks, Senator Levin. Your statement means a lot to me. I appreciate what you've said. That's exactly what we hope to do. Your support obviously will help us to do that. And I think we can through these hearings both learn, basically educate others, and then reach conclusions which can help us to be advocates for the most effective regulation of financial sectors of our economy that we're capable of doing. And I like what Senator Levin says, and if I may again go back to our earlier days as attorneys general, Senator Burris, there is a role within the chamber for advocacy among our colleagues for the most comprehensive and toughest regulation in this particular area because so much suffering has resulted from the lack of such.

Thanks, Senator Levin. Let's go right to our witnesses now. First we're going to hear from Gene Dodaro, who, as I mentioned, is acting controller general. I'll say for the record that Mr. Dodaro is accompanied by Richard Hillman, managing director of the financial markets and community investment section of GAO, and Thomas McCool, director of the Center within GAO for Economics Applied Research and Methods.

Thanks for being here. Thanks for an excellent foundational report, which we ask you to testify on now.

MR. DODARO: Thank you very much, Mr. Chairman. Good afternoon to you, Ranking Member, Senator Collins, other members of the committee. We are very pleased to be here today to assist your deliberations on the financial regulatory system. As was mentioned, our report was intended to provide a foundation for how the system has evolved over the last 150 years, what changes have occurred in the markets that have challenged that regulatory system and caused some of the fissures that we've seen, and to put forth a framework for helping Congress crafting and evaluating proposals in order to modernize the system. Our basic conclusion is the system's outdated, it's fragmented, and it's ill suited to meet the 21st century challenges.

Now, there are many reasons why we come to that conclusion in the report, but I'll highlight three main points right now. First is that regulators have struggled and often failed to address the systemic risk of large financial conglomerates or to adequately ensure that those entities manage their own risk. Now, over the last two decades financial conglomerates have developed through mergers and acquisitions, and they've developed and gotten into banking, securities, insurance, and a wide variety of services. And while this has occurred, you know, basically our financial regulatory structure has remained relatively the same, set up in a functional basis.

This has caused tremendous coordination problems, which are documented in some of our reports, and questions about the authorities and the tools available to regulators in order to address these concerns. A vivid example is the difficulty and the ultimate failure of the SEC's consolidated, supervised program, which failed to address the holding company risk of many of the investment banks over this period of time. Our reports have also documented some of the challenges that the Office of Thrift Supervision has in managing such -- or regulating holding companies of the type that AIG had conducted.

The second major trend is the fact that the financial regulators had to deal with now some of the problems that are being created by entities that have been less regulated. These are the non-bank mortgage lenders, the hedge funds, the credit rating agencies. For example, just to give you some significance of the size of this, in 2006 for the mortgage origination loans for subprime and non-prime entities, of the 25 institutions that lent those loans that made up about 90 percent of all loans, it's about $543 billion dollars in loans. Of the 25 entities, only four were not non-bank lenders. So you had a lot of activity going on that was growing over this period of time that was not subject to the same type of regulation that commercial banks were experiencing during this period of time.

The third (main ?) trend was the emergence of a wide variety of complex financial products, as has been referenced here in the opening statements, collateralized debt obligations and billions of dollars, credit default swaps, over-the-counter derivatives, mortgage products that were innovative and did not have the type of disclosures that were needed. All this confused investors and others and complicated trying to have a picture of this.

The other conclusion that we come to is there is no one central entity that's basically charged with looking at risks across the system. And this is a major deficiency in the current structure that needs attention.

Now, our view is that reform is urgently needed. And unless it's approached and dealt with soon, the vulnerabilities that we've all talked about this morning are going to continue to remain in the system. And that just can't be, as we go forward as a country and try to stabilize the system and move forward in economic development.

Now, our framework is intended, though, to say a couple of things. One, the reform needs to be approached in a comprehensive manner so that we don't react as a country again in a fragmented approach. And our nine characteristics that we set out are intended to help in that regard to make sure that all critical elements are addressed. Now, in those nine characteristics they deal on a couple of important topics. I'll just highlight a few quickly.

First, we believe there needs to be a clear articulation of the goals of the regulatory system set in statute. That would provide consistency over time and also enable Congress to hold the regulators accountable for achieving those results. It has to be appropriately comprehensive, another characteristic. We need to close the gaps with some of these entities, the large entities that are posing risks, and many of the products. You have to move to both cover the entities as well as the complexity of these financial products.

It has to be system wide. Somebody needs to be in charge of monitoring the system and focusing on the development of risks going forward. We all know where the risks are now, but they're likely to change over a period of time. So we need to close the gaps and put a process in place to monitor this on an ongoing basis. It needs to be flexible and adaptable. We need innovation to allow for capital formation, but somebody has to make determinations on what the level of risk is that's acceptable with those innovations and make some early decisions and not wait until the consequences have become so dire over time.

You need to have an efficient system. There's a lot of overlap right now. The overlap can be dealt with as part of the reform. There needs to be strong consumer protections. It's clear from our work and the work of others, as referenced in Senator Levin's comments and the opening statements both by the chair and ranking member, disclosures have not been adequate. There also needs to be greater attention to financial literacy efforts. We've looked at the entity that's been put in place in the federal government to provide that, but it hasn't been resourced properly. Not enough attention has been given to that particular area.

You have to make sure that the regulators are independent, resourced properly to preserve that independence and give them the necessary authority to move forward. And finally we need to protect the taxpayers. Any risks that occur in the future should be borne by the entities being regulated and not by the taxpayer. That needs to be our goal, and we need to minimize taxpayer exposure so we don't go through again what we're currently going through across the country.

This is a very important initiative. GAO is pleased to assist this committee. It stands ready to help this committee and the Congress deal with these very important issues and decisions going forward. And my colleagues and I would be happy to answer any of your questions at the appropriate time this afternoon. So thank you very much.

SEN. LIEBERMAN: Thanks very much, Mr. Dodaro. That's a very good beginning for us. We're grateful that Professor Howell Jackson from Harvard Law is here; also grateful that President Obama and the new administration are not taking everybody from the Harvard Law School faculty.

(Laughter.)

In fact, if I'm correct, the president's nomination of Dean Elena Kagan to be solicitor general has moved you now to be the acting dean of the law school. Is that right?

MR. JACKSON: (Off mike.)

SEN. LIEBERMAN: Yeah. If so, I congratulate you and wish you well. Thanks for your testimony. We'll hear it now.

MR. JACKSON: Thank you very much. It's a pleasure to be here, Senator Lieberman and Senator Collins. I'm delighted to have a chance to participate in this hearing and begin the process, I hope, of a genuine and serious regulatory reform in this country, which is long overdue.

Let me begin by just commending the Government Accountability Office for their fine report. I think it does an excellent job of both pulling together its prior work on the subject and also laying out the major weaknesses in our regulatory structure. And I agree with almost everything that is in the report. The regulatory gaps that exist have created serious problems for our economy. There is a serious mismatch between our regulatory structure and the 21st century financial services industry, particularly to the extent that financial conglomerates dominate and are able to play off different regulatory agencies against each other and find this unregulated space to expand products.

I think that one of the things the report highlights in passing that's important to recognize is the world has really moved ahead of us in the area of regulatory reform. If you go around the major countries and looked at the legislation that they've been adopting over the past five to ten years, it's all been a movement towards consolidated supervision that puts us at a serious disadvantage. We have the anomalous situation in this country of having the world's most expensive regulatory structure in absolute terms and in relative terms but one that has failed to provide us the kind of protections that we need. So this committee's agenda is very much in need of setting an agenda for the whole Congress.

What I thought I'd do is comment upon five areas in which I thought it would be useful to discuss some of the ramifications of the GAO study in areas where I think the weaknesses are particularly important for this committee to note. The first has been touched upon, and I just want to talk about it a little bit more, which is the absence of a market stability regulator, something that Senator Collins mentioned. And it is certainly the case that this is a problem. The Federal Reserve Board was set up to be our market stability regulator in a time when systemic risks were thought to lie solely with depository institutions, with banks. And having a lender of last resort function, oversight of bank holding companies and member banks was thought to be -- (inaudible) -- protection. And I think in the middle of the 20th century that was the case.

Since the middle of the 20th century the role of the depository institutions has declined. Other sectors, most notably capital market sectors, have expanded dramatically. And it's not surprising today that when we move to see where the systemic risks came from, they came from other sectors of the economy. They came from the investment banking sector. They came from the OTC derivatives area. They came from innovations in mortgage lending, all things that weren't contemplated in the past. And so we need to have a regulator of market stability that can see all potential sources of regulatory risks, including insurance companies and other areas of the economy.

I think that it's appropriate to think of the Federal Reserve Board as the candidate for having that expanded power. And I know today is not the day to talk about the exact structure of regulatory reform. But I would just point out five areas of weakness with the current oversight of market stability. One is the cramped jurisdiction that the Federal Reserve Board has, now limited to a certain number of areas, not including insurance companies, not including many other areas of important systemic risks.

Another problem is the manner in which the lender of the last resort powers are structured. It's been remarked by many people that the Federal Reserve Board had to operate at the boundaries of its powers. Now, I think it acted legally, but it was constrained in how it provided liquidity in the past six months. I think that's something that needs to be clarified in regulatory reform.

I think, as was just alluded to by Mr. Dodaro, the mechanisms for ensuring that the costs of systemic risks are borne by the industry or sectors of the industry that generate those problems is an important weakness of our current structure. The FDIC's systemic intervention powers are charged back to the banking sector if they are used. The TARP has an aspirational provision for recouping some funds. But we need to have a comprehensive approach to recouping funds to make sure that the incentives are riding on the financial services industry, that they will bear the costs of systemic risks when they arise.

I think it's also important to recognize that the Federal Reserve Board needs to expand its expertise to go beyond its traditional areas of jurisdiction. The crisis with AIG and the investment banks show that it needs to have broader expertise, greater personnel skills in many areas that it's not traditionally supervised. Whether you want the Fed to be a comprehensive supervisor I think is a difficult question of regulatory design. But I think if it is going to be the market stability regulator, it's got to expand its knowledge in certain areas. There may well be things that the Fed currently does that it doesn't need to do in the future that should be reassigned to other places. But if we're going to have an effective market stability regulator, we need to think more broadly about the powers of the Fed.

Finally, it's important to recognize that many of the solutions to systemic risks and market stability need to be done on the front end. The regulation of clearing and settlement systems, limitations on investments, problems generated by the number of investments in Fannie Mae and Freddie Mac securities, these are all ordinary supervisory issues. And we need to have a mechanism where the market stability regulator can speak to the front line regulators, and in my view, have a veto or an override if it thinks those other regulators are not addressing market stability issues. So that's a weakness in the structure that the Fed comes in after the fact, not in front. And it's inevitably more costly to correct things after the fact, and that's a weakness.

Let me go on to just mention a couple of other areas of weakness that I think it's worth this committee to focus on. And the second one that I want to mention is actually Congress' role in the current difficulties, or at least the statutory structure that Congress has helped create. We have a regulatory system that has lots of legalistic divisions in regulatory authority, where the boundaries are written in very cramped ways. Every regulator has its jurisdiction, and each regulator is jealously guarding its jurisdiction against other regulators. That leads to a situation where the industry can play regulators off against each other and exploit regulatory loopholes, and the regulators are inherently at a disadvantage.

One of the items on Senator Levin's list was the failure of the SEC to oversee hedge funds. That was a decision by the Court of Appeals of the District of Columbia based on an interpretation of statute. Now, I don't agree with the interpretation of the court in that case. But it was a problem for the SEC that it had narrow jurisdictional authority. One of the things that we need to do in regulatory reform is to create broad jurisdictional mandates so that the regulators have the power to go into areas and do what needs to be done, rather than having cramped constraints.

The Division of Regulatory Authority is also totally clear in the problems of the mortgage banking industry. If you look at the regulatory structure that we have created in this country, the Department of Housing and Urban Development had a piece of consumer protection for mortgage loans. The Federal Reserve Board was responsible for sub prime loans. There were at least five federal agencies in charge of depository institutions that were making the loans. The SEC was responsible for the securitization process and the credit rating agencies. State regulators had some powers over mortgage brokerage transactions. And actually, just this last summer, we created a new licensing process for mortgage brokers. It's no surprise that in a regulatory structure that is so fragmented no one saw the home ownership problem arising and that there's no single agency to point to for responsibility after the fact.

Another area that has been alluded to already this afternoon but I would like to mention is the problem of regulatory expertise and competence. This is, I think, most apparent if one looks around the world and sees what happens when other regulatory agencies are consolidated together. And one of the things that happens is the quality of personnel that is willing to work in the regulatory agencies go up. Professionally, it's a broader mandate. There are more professional experiences. There are fewer positions that are taken by political appointees. It's a more attractive career position that attracts higher quality personnel when we have a broader mandate.

I think it's also the case to recognize that when you have a narrow regulatory function, it's hard to have expertise in every area. So the failure of Bear Stearns actually is a pretty good example of this, because when the investment bank was getting into trouble, the SEC had to look to the Federal Reserve Board of New York -- the Federal Reserve Bank of New York -- to get the personnel it needed to understand the problems. The Federal Reserve Board has a large number of economists that study banking issues in great detail. But the SEC has never had that kind of expertise, and it has lacked the bench strength to address many of the problems before. So we have a mismatch of personnel; we have an inability to move personnel from one sector to the other, which seriously constrains us in times of risk and is a weakness of our system.

Another weakness of the fragmented system is the vulnerability of specialized regulatory agencies to the problem of regulatory capture. If you're an agency and you just regulate one sector of the financial services industry or one subsector, you're much more likely to identify with the success of your constituent institutions. So I would say the comptroller of the currency and the Office of Supervision, in order to make the national charters more attractive, cavalierly preempted state law of consumer protection to the great detriment of the consumers of the regulated banks and also making the task of state regulators much more complicated if federal entities were coming in with preemption and state entities were being subject to full regulatory structure. I think there's many reasons one can explain that, but part of the reasons was the agencies much too much identified with their constituents rather than thinking about what was in the best interest of the economy and the general public.

I think in the area of consumer protection this has already been touched upon, but to the extent this committee is looking at shortcomings of consumer protection I think the fragmented regulatory structure is also a source of concern here. There are lots of functionally similar products that are regulated in different ways because different regulatory agencies have expertise over them. If you are a clever attorney, you can make an insurance product look like a securities product or a banking product look like an insurance product or an insurance product look like securities product and get a different regulatory structure. And there are many examples of repositioning to take advantage of marginal differences in regulation. And that confuses the consumer, and it creates inconsistent protections across the financial services industry.

In the area of financial education, which I think is tremendously important in the end we depend on consumers to understand the products. And we need to have those consumers be educated. There is ample academic evidence that shows that less educated consumers make poor choices, take worse mortgages, have worse credit card terms. So financial literacy is a major goal, but it can't be done on a piecemeal basis. We can't have 200 different agencies engaging in financial education. It needs to be a centralized function. It needs to be a function that attacks the problem of financial literacy in a comprehensive way. It needs to interact with the educational system. That needs to be centralized, and fragmented financial education really is no financial education.

The final point of weakness that I want to mention is also covered in the GAO's report, but it's just worth noting. We live in an increasingly globalized financial market. And a major task of financial regulators is to interact globally, to work with regulators overseas. And there are a variety of reasons for this. Amongst other things, we need to make sure the transactions are not just escaping overseas and obtaining lower regulation in other jurisdictions. But there's cooperation that needs to be done in terms of enforcement actions, memoranda of understanding, working out of consistent regulatory systems.

Our fragmented regulatory system is poorly suited for this task, having multiple entities going overseas to interact with unified regulators in other countries. When you're overseas, it's a common complaint about the United States that you can't talk to one person; you have to talk to a dozen people. There are literally -- there are monthly visitors by different regulators from the United States to London, to Tokyo, to Hong Kong, and it's an ineffective and inappropriate system. In many areas, such as in the banking area, we have multiple regulators representing the United States on the same issues that complicates negotiations, makes it more difficult to work with our allies, and it is a serious impediment to effective regulation. So I think the interactions on the international side are a separate area of concern that one should look for.

I should say, in this area since it's in the communities' mandate, there's a lot of expertise internationally on how to do regulatory reform. Many other jurisdictions have gone through the process, and I think particularly the British model is one to look for, for some very interesting examples of structuring the reform, which very much needs to be done.

Let me just close by saying the current financial situation is a challenge on multiple levels for this country. And for the most part, our task is regaining our economic strength and trying to restore lost value to the people of this country. The one silver lining to the current crisis is it gives us an opportunity to reform our regulatory structure. That's something that's long been overdue. It's been a difficult political task to take on, but we finally have the opportunity to address a problem of a major sort for the United States. And I hope this committee will take leadership in addressing that concern. Thank you very much.

SEN. LIEBERMAN: Very well said. Thank you. Professor Steven Davidoff is on the faculty of the University of Connecticut School of Law. I think I overheard you say you had been at Michigan before.

MR. DAVIDOFF: Wayne State Law.

SEN. LIEBERMAN: Wayne State, so you claim at least -- you don't have any connection with the State of Maine?

MR. DAVIDOFF: No. But I have been there many times, and it is a lovely place.

(Laughter.)

SEN. LEVIN: And apparently you still have a place in Ann Arbor?

MR. DAVIDOFF: Sadly, I have a house in Ann Arbor that I'm unable to sell.

(Laughter.)

SEN. LEVIN: (Crosstalk) -- raise this subject -- (crosstalk).

MR. DAVIDOFF: It's not Senator Levin's fault -- (crosstalk).

SEN. LEVIN: (Crosstalk) -- or else I wouldn't have gotten into it. But Wayne Law School, if I could say, Mr. Chairman, is the law school where my wife graduated. She's a lawyer -- (crosstalk).

SEN. LIEBERMAN: Uh-huh, that speaks for the quality of the law school.

MR. DAVIDOFF: It is the true public law school of Michigan.

SEN. LIEBERMAN: Senator Levin is known for his constituent service, and I'm sure he'll do anything he can to help you sell your house in Ann Arbor.

(Laughter.)

MR. DAVIDOFF: I like my house. Ann Arbor is a lovely place -- (crosstalk).

SEN. LIEBERMAN: (Crosstalk) -- Mr. Davidoff, I must say I'm proud that our staff search for experts in this area happily led us to somebody who is now at the University of Connecticut Law School.

MR. DAVIDOFF: Thank you.

SEN. LIEBERMAN: Please proceed.

MR. DAVIDOFF: Chairman Lieberman, Ranking Minority Member Collins, and other members of the Senate committee, I want to start by thanking you for providing me an opportunity to testify today. I'd like to start by agreeing with the uniform sentiment expressed today that today's financial regulatory architecture is fractured, archaic, and ill suited to today's modern financial world. What I'd like to do in my testimony is fill out the excellent GAO report by providing a short narrative of the deficits of the past few years, which aptly illustrates the failures of the regulatory system in its fractured nature.

I want to start with the root causes of the financial crisis. The causes of the current financial crisis are still the subject of much study and debate and will remain so long after Congress acts on any financial reform. Nonetheless, at this point, 18 months into the crisis we have a rough sketch. In summary, historically low interest rates led to excessive borrowing by both individuals and financial institutions. The consequence was the rapid rise of housing prices. These prices were increased by demands from so-called sub prime borrowers.

During the period from 2000 through 2006, the amount of outstanding sub prime mortgage debt grew an astounding 801 percent to $732 billion. These loans were often issued an underwritten under the assumption that housing prices do not fall. The assumption proved all too incorrect. And it is now all too clear that in many instances borrowers were placed into loans they cannot now afford.

Theoretically, bankers should have been more concerned with whether their loans would be repaid. However, the traditional "It's a Wonderful Life" banking model, where lenders and borrowers pass each other on the street and lenders personally assess the credit worthiness of their clients is long past. Mortgages are now securitized into asset backed facilities called collateralized debt obligations, or CDOs and sold into the market. Lenders now serve as intermediaries in this originate-to-distribute model and are more concerned with the ability to sell these loans rather than whether they are repaid.

Many of these lenders, particularly for sub prime mortgages, were non-bank lenders, subject to differing oversight and regulation than their bank counterparts.

It is now clear that this new securitization process allowed for lax lending standards. In 2005, the SEC contributed to this by liberalizing the registration process for these securities. At that time, the SEC discarded the obligation of underwriters of CDOs to perform due diligence on these CDOs to confirm adequate loan documentation. In essence, for those CDOs that were registered, the SEC relied upon private underwriters to uphold standards. Here the underwriters also procured a private ratings agency to rate the CDO tranches.

Notably though, the SEC, due to regulatory restrictions, was only responsible for regulating affirmative disclosure in the securitization process when the underwriter chose to register the securities. In no instances, as Professor Jackson highlighted, was the SEC responsible for the mortgage origination process or disclosure. In fact, financial disclosure, again as Professor Jackson highlighted, is subject to multiple regulatory agencies, none of which have the primary goal of consumer financial disclosure.

In addition, under the Credit Agency Reform Act, the SEC was affirmatively denied the ability to regulate the procedures and methodologies by which any rating agency determines credit ratings. In hindsight, the SEC and other financial regulatory agencies lack complete oversight over the mortgage securitization market, and it was a market that was, at best, subject to overlapping and conflicting regulation. This allowed market failure as lenders, rating agencies, and borrowers all contributed to lax borrowing standards and the taking of excess risks, the consequences of which we are now dealing with now.

During the period from August 2007 through March 2008, banks rushed to capitalize -- recapitalize their balance sheets from private investors. Nonetheless, the week of March 11th, 2008 Bear Stearns collapsed. In hindsight, the largely unregulated investment banking model was one over susceptible to shock. Unlike bank holding companies, investment banks historically had a leverage model ranging from 20 to 1 to 30 t0 1 and relied on short-term, highly moveable deposits for liquidity. These deposits came from hedge funds, for the most part, sophisticated financial institutions that could quickly move their assets in the case of a crisis. And this is what they did, leading Bear Stearns to lose liquidity and into a forced sale.

The fall of Lehman Brothers was due to similar factors. At the time, there was a significant outcry that the failing of Lehman and perhaps Bear Stearns was due to shorting of their stock in the market and the crisis of confidence it created. In some cases, it has led to cries for regulation of the credit default market and a prohibition on shorting. Credit default swaps, or CDSs notably, were deliberately legislated to be left unregulated by Congress in the inaptly named Commodity Futures Modernization Act. The veracity of these claims of out shorting and CDSs is unknown at this point. But in fact, due to the lack of information about trading in CDS market, I doubt anyone will ever able to definitely conclude one way or the other one this point.

The full role of derivatives generally in the financial crisis still appears uncertain. Certainly in some circumstances, derivatives increased risks, heightening the impact of the rapid decline of the CDO market. More certainly, AIG was brought down because of underwriting of credit default swaps out of a London-based subsidiary. AIG was able to leverage a regulatory gap. It was regulated by the Office of Thrift Supervision as a savings and loan holding company because of AIG's control of the thrift. But AIG was not subject, under this regulation, to the same scrutiny or heightened requirement it otherwise would have been subject to had it been a bank holding company.

Furthermore, the Inspector General of the SEC issued on September 25th, 2008 a report on the SEC's now defunct voluntary regulation program of the five investment banks, the voluntary Consolidated Supervised Entity Program. The program was doomed to fail and understaffed from the start. Three SEC employees were assigned to monitor each bank with tens of thousands of employees. The SEC never conducted appropriate, in-depth inspections as to risk measurement, capital liquidity sources, and other disclosure for these investment banks. This was true even after Bear fell. The investment banks were able to leverage a regulatory gap to avoid in-depth scrutiny of their leveraging and risk processes and be regulated to the same level as bank holding companies are.

I want to spend the next few minutes just talking about the government response to the financial crisis and again how it illustrates the fractured nature of today's regulation and regulators. Initially deprived of statutory ability to fully address the crisis, the government would engage in what Professor David Zaring and I call "regulation by deal" in order to attempt to salvage the financial system. In a series of transactions, the government nationalized Fannie Mae and Freddie Mac, bailed out AIG, arranged for the sale of Wachovia and the banking deposits of Washington Mutual.

Then with the passage of the Emergency Economic Stabilization Act and adoption of the TARP program, the Treasury Department agreed to invest -- or forced financial institutions to invest, depending upon you speak to, $125 billion in the country's nine largest financial institutions. Since that time, the government has been administering the TARP program. Along the way, the bailout of AIG has been reworked, Citi and Bank America have received a second set of TARP funds, $90 billion in total, and GM and Chrysler have also received TARP funds under the automotive component of TARP. Meanwhile, just today Treasury Secretary Nominee Geithner, part of the prior team, announced his desire to rework the entire program.

Each of these deals has been on different terms and structured, seemingly, on an ad hoc basis without organization or any systematic approach. From news reports in the Wall Street Journal and other sources, it appears that the coordination of the FDIC, Treasury, and Federal Reserve on these individual bailouts was sometimes strained by disagreement over each of their regulators role and statutory capacity. This may have contributed to the ad hoc nature of the government's response.

The statutory limitations on these agencies, as Professor Jackson alluded to, and the lack of an in-place lender of last resort also affected the regulators ability to fully respond to the financial crisis. I note that the perceived cure to a panic and general credit freeze is to restore confidence in the markets. This has, at times, been sorely lacking among the populace due to the regulators perceived ad hoc response to the financial crisis.

In conclusion, this brings us to today. I do not have time in my testimony to recommend solutions, but Congress will clearly hear much, and I offer some in my written testimony. Here, I want to conclude by answering the question posed by this hearing. Where were the watchdogs? Well in part, as you can see from my sad narrative, the regulators were hobbled by their deregulatory bent and limited, fractured and overlapping jurisdiction, which left wide parts of the financial system without oversight or regulation. Thank you.

SEN. LIEBERMAN: Thanks, Professor Davidoff. That was an excellent, really an excellent summary of how we got where we are. I must say that insofar as I expressed in my opening statement, that our intention, and hoped in these hearings we would learn so we could help to educate and then advocate effectively. I think all three of you have been excellent educators of the committee, and I thank you for it.

We'll have seven-minute rounds of questions. I'll begin now. A clear conclusion that you all share, and it begins with the excellent GAO report, is that the current system for regulating financial institutions in our country is fractured. It's out of date, and it's just not able to deal with today's complicated and immense global financial networks that do business here in the United States.

I was thinking as you were testifying that we have all become, over the last year or so, familiar with a term that I had not heard before, which is that an entity can be too big to fail, right. And so we end up extending billions of dollars either of direct aid or credit. From what you're saying, it sounds like these entities are also, it may not be that they are too big to regulate, but they are certainly too big and complicated for our current regulatory system to oversee in the public interest, and that's a big part of the problem. I take it, just to start with a baseline question, that it would be reasonable to conclude, both from the report and the testimony, that none of you think that simply fixing some of the specific authorities of existing regulatory agencies is enough to prevent the next regulatory crisis. You know what I'm saying, without a larger, comprehensive reform.

Mr. Dodaro.

MR. DODARO: Certainly there are some parts of the current regulatory structure that you may want to look at, but --

SEN. LIEBERMAN: Right, sure.

MR. DODARO: But we don't think that you can adequately address this problem in a comprehensive manner without making broader changes. Now on the point that you mentioned about some of the size of the entities being to big to fail --

SEN. LIEBERMAN: Right.

MR. DODARO: Questions have to be asked about the extent of whether or not they're too big to manage effectively. One of the really important themes, I believe, that runs through a lot of this issue is the whole question of risk management approaches and models, risk management at the individual institution level, at the industry level, at our national U.S. level, and at a global level. And I think that issue really needs a lot of attention from a regulatory standpoint but also from a corporate governance standpoint.

SEN. LIEBERMAN: Uh-huh. I was wondering whether you were suggesting that there ought to be some governmental regulatory mechanism that may say to a financial entity, this next acquisition you have in mind or the next product line you're putting out is too much. In some sense, it sounds like a classic anti-trust function. It's a little bit different, of course, but what would you say to that?

MR. DORADO: Well, I would say you need some check and balance in the system. I mean ultimately the company's management, the board of directors are responsible, but there has to be a threshold of risk as to whether or not the regulators are adequately achieving the goals --

SEN. LIEBERMAN: Right.

MR. DORADO: That are to be set up with the new system and protecting investors and protecting taxpayers in particular. So this whole question of how to achieve the proper balance between regulating and allowing innovation, I think, is really going to be the tough underlying issue ---

SEN. LIEBERMAN: Yeah.

MR. DORADO: That really needs to be addressed because there's a tendency to over-regulate and have things roll back over time. Neither one of those is really the optimum solution. So, you know, our characteristics are intended to try to get to see what can happen with that balance. We also point out that there needs to be an adequate transition period in terms of whatever ---

SEN. LIEBERMAN: Sure.

MR. DORADO: -- change, but also Mr. Chairman, I would say the really other important part of this is diligent oversight on a continual basis by the Congress. The likelihood that this is going to be solved with one big --

SEN. LIEBERMAN: One big --

MR. DORADO: Drove.

SEN. LIEBERMAN: Understood.

MR. DORADO: Is really, I --

SEN. LIEBERMAN: That's always a danger here. We legislate; we reform; then we walk away.

MR. DORADO: Right, because things change. It's a fluid market.

SEN. LIEBERMAN: Agree.

MR. DORADO: Markets are going to be fluid, and there needs to be some built-in oversight on a regular basis.

SEN. LIEBERMAN: Professor Jackson, you made some interesting statements about the possibilities of expanding the authorities and powers and jurisdiction of the Federal Reserve Board. Given your druthers, would that be at the heart of your comprehensive reform, and if so, would you blend or have the fed absorb some of the existing federal financial regulatory agencies?

MR. JACKSON: Senator, that's a good question, and certainly one model that one could think about --

SEN. LIEBERMAN: Right.

MR. JACKSON: -- to say the fed is the heart of the system with the best expertise, and we will fold everything in, or a lot of things in, to make a super agency. That's not, personally, what I would favor. I think that, sort of, that amount of centralization of authority is antithetical to a lot of American traditions, and more importantly, I think what you want is a focused regulator with specific tasks. So I would prefer a model of the Federal Reserve Board having broader powers for market stability issues to, sort of, have a roving mandate throughout the system, but another counterweight federal agency with consolidated supervision --

SEN. LIEBERMAN: Uh-huh.

MR. JACKSON: -- that would be responsible for the front-line authority.

SEN. LIEBERMAN: So create a new agency that would take in some of the existing agencies?

MR. JACKSON: Yes, consolidate in the new agency. It would have front-line supervision and all of the consumer protections and day-to- day activities and have the Federal Reserve Board as an expanded oversight entity that does the market stability functions and with the lender of last resort capacity to come in should the need arise.

SEN. LIEBERMAN: Interesting.

MR. JACKSON: It's a little bit like the British model, except I would envision a more robust role for the fed than the Bank of England has.

SEN. LIEBERMAN: Got it. Professor Davidoff, I've got about a minute left in my time. Why don't you get into this discussion? What would be your druthers if you were redesigning the system?

MR. DAVIDOFF: If I were redefining the system, I'd look at it analytically as three lines, one a systemic risk regulator, second a consumer protection agency, which is the SEC and CFTC, which would have enhanced regulation over consumer financial disclosure.

SEN. LIEBERMAN: You would put them together?

MR. DAVIDOFF: I would have two separate agencies. I would put the CFTC and SEC together.

SEN. LIEBERMAN: That's what I --

MR. DAVIDOFF: There's no reason. It creates opportunities for regulatory arbitrage. There's really no good reason to have them separate any more. Some people argue they should be competitors, their models, but we have ample models and competitors abroad, globally, that can regulate them. I think there's a third type of regulator, which Professor Jackson alluded to, which is your capital regulator, which is your FDIC, OCC. And so there's really three lines, your lender of last resort, systemic regulator, bank capital regulator.

SEN. LIEBERMAN: Which would be the Fed?

MR. DAVIDOFF: Well, you can place them wherever you want.

SEN. LIEBERMAN: Yeah, okay.

MR. DAVIDOFF: And I think Professor Jackson makes a good point, which is the Fed, is naturally cited as the lender of last resort, but it's the unique independent agency, and perhaps the capital requirements should be elsewhere with Fed input because we want Congressional oversight. And this is why it's good that your committee is having the hearing because it's really a structural issue.

SEN. LIEBERMAN: Right.

MR. DAVIDOFF: Congress should not be legislating the nuances, or else you're going to get into a battle of the experts in deciding things. You should set up a regulatory apparatus and let those regulators fill it all in.

MR. DAVIDOFF: Great, thank you. Senator Collins.

SEN. COLLINS: Thank you, Mr. Chairman. Let me take up where you left off. As I look at this issue, it's clear that we have a gap that there is no one who's responsible for assessing systemic risk, what Professor Jackson called the market stability regulator. So that's a problem, and it's interesting. A few years ago, the House actually rejected regulatory authority over Freddie and Fannie that would have allowed regulation for systemic risk. And when I look back on that with the benefit of hindsight, it's just extraordinary that that amendment was defeated so handily in the House.

But then, there's also what I call the safety and soundness regulators, from my experience at the state level. We wouldn't allow a state chartered bank or credit union to have a leverage ratio of 30 to 1 that Bear Stearns did. That's just inconceivable. So you need that safety and soundness regulator to be extended so that a large investment bank has to meet the same kind of capital requirements and undergoes the same kind of audits and reviews that the local credit union, whose failure would be far less devastating for the economy.

And then the third issue, to me, is who ensures that new exotic financial instruments like credit default swaps don't fall through the regulatory gaps. To me, credit default swaps are an insurance product. And yet, they were not regulated as insurance. They also weren't regulated as securities. So help me sort through who should do what. And I'm going to start with you, Professor Jackson, because you started down that road when you said the Federal Reserve Board should have the systemic risk authority.

MR. JACKSON: Right. Well, I do think this would fall into the second heading of my discussions, I think, in terms of thinking about how you're defining jurisdiction. And this is a lawyer's task, is to write the jurisdiction of agencies, and it can be done a lot of different ways. We have tended to take a narrow focus. So the SEC has authority over securities. This is a defined term. Supreme Court has decided maybe 15 cases, at this point, about what that term means. There was litigation about whether swaps were securities in the 1980s and '90s, and they were determined to fall outside of the SEC's mandate for the most part, and Congress did not reverse it. It sort of validated that decision.

So I think that whether it's the SEC or a consolidated supervisor, one should define the jurisdiction broadly, and so, for example, you could define the jurisdiction to be over products that are financial in nature. That's a definition we use in some areas, which is an open-ended definition that gives the agency authority to say if a new product comes along that's financial and we are going to exert some sort of jurisdiction. And to pick up on a question that Senator Lieberman put forward, I do think that the agencies have to have the power, if a new product comes along, to say this is financial, and you just can't sell it willy-nilly any way you want. You can sell it, but it's got to be, for example, on an exchange with a clearing and settlement system that we can keep track of so we know the transparencies, we know counterparty risk. And that does mean saying and you can't just go to London and do it on Fleet Street any way you want because we recognize that increases risk.

So I think the regulators have got to have the self-confidence and the support to say certain products are too risky. And, you know, for too long we've said as long as it's institutional investors, we don't need to worry, they can fend for themselves, you know. The lesson of the last year is when institutional investors get into trouble, sometimes they drag the rest of us down, and we need to have a different philosophy that sometimes means saying no.

SEN. COLLINS: Professor Davidoff.

MR. DAVIDOFF: I agree with that sentiment. If you don't have regulators with broad jurisdictional authority, you will have Ph.Ds on Wall Street who will structure products to fill that black hole. And so, you need regulators with broad authority. And you need it over the entire financial system.

Credit default swaps are a perfect example. They're traded over- the-counter. We have no idea who the counter parties are.

They should be traded on an exchange, or a regulator should look at them to see if they should be traded on an exchange, but we have to regulate forward not backward. We don't know what the next crisis is going to be. So we need to have regulators that have full jurisdictional scope.

SEN. COLLINS: Should we have safety and soundness regulation for entities like the Bear Stearns of the world?

MR. DAVIDOFF: Absolutely, I mean, the investment banks -- the only reason the consolidated CFC program existed was because the investment banks needed a regulator under an EU directive.

SEN. COLLINS: That was a voluntary --

MR. DAVIDOFF: Right, it was a voluntary program that they were trying to get out of direct oversight from the EU, and they existed in this netherworld of unregulated jurisdiction. Now, the elephant in the room, which we've alluded to, is insurance. It's regulated by the state. It's a big problem about how do we capture those products because if we regulated all securities, if we have oversight of hedge funds, and here I'm talking about oversight not necessarily regulation. The regulator should have the power to regulate, but that should be done through the regulatory process. But if we leave, for example, insurance out of the mix, what do we do then?

SEN. COLLINS: Mr. Dodaro, who should be the regulator for what? Who should be the systemic risk regulator? Should safety and soundness regulation by front-line regulators be extended to all financial entities that could possibly pose hazards to the economy?

MR. DODARO: Our report at this juncture doesn't make specific recommendations, but what the points that you're probing on go to a couple of the characteristics that we have. One is the system-wide risk proponent that would look across the system and look for systemic issues. I think also, Senator Collins, that the comprehensive nature, I think you know, our suggestion and that characteristic is meant to close the gaps with entities and products.

And the third component that we point out has to do with flexible and adaptable, and I completely agree with my colleagues at the witness table here is that we need a proactive approach and not a reactive approach. And I think that's where you're headed with your question, and I quite agree with that, whoever that person is in charge. But it also goes back to our first objective here and the characteristic, which is to set clear regulatory goals and mandates and charter and give the regulators the broad authority, then hold them accountable for doing it.

SEN. COLLINS: Thank you.

SEN. LIEBERMAN: Thanks very much, Senator Collins. Senator Levin.

SEN. LEVIN: Thank you, Mr. Chairman. Let me do something, which really isn't the direct purpose of the hearing, but something that I want to take advantage of your expertise while you're here. And it's obvious from your answers that you do have some opinions on not just who should do the regulation but whether certain activities ought to be regulated.

I don't know whether, Mr. Dodaro, you're going to want to or be able to comment, but let me start with our other two witnesses. First, should hedge funds be regulated, Professor Jackson?

MR. JACKSON: Yes.

SEN. LEVIN: Professor Davidoff?

MR. DAVIDOFF: Yes.

SEN. LEVIN: Are they currently regulated?

MR. JACKSON: I would say inadequately. I think this is a good example that the SEC had an initiative to bring the advisers under their jurisdiction, whether that's strong enough for all aspects of their activities, I'm not sure, but that was certainly an important first step. I think beyond thinking about the hedge funds as entities, it's the products, the credit default swaps, the OTC products that need to be brought into what, I think, would look more like a futures regulation standard. And I would say here, I think this is just an excellent area to rethink how we got into the current situation of the CFTC and the SEC being in competition for business and trying to attract entities by giving exemptions that play to our disadvantage over the long run. So I think --

SEN. LEVIN: I'll get to the specifics of the hedge funds later.

MR. DAVIDOFF: Can I just add something on the hedge funds?

SEN. LEVIN: Yeah.

MR. DAVIDOFF: I think if you ask someone, if you ask a regulator, what role did hedge funds play in the current financial crisis, I think they would look at you like a deer in the headlights because we just don't know. And one of the things that we need to do is have, and even the hedge fund managers who testified about a month ago agree, we need an oversight process of hedge funds. And we need an ability, a disclosure process. It may need to be confidential, but there's also systemic risks of unregulated capital pools that any systemic risk regulator will have to look at. Even the Harvard Endowment is in some terms a hedge fund and we need to bring those capital pools under some oversight, or else the next systemic risk will arise there. And it happened in long-term capital management. It could happen again.

SEN. LEVIN: Okay, let me move to the credit default swaps. We've had a lot of discussion about that. The SEC chairman, back in October, asked for jurisdiction over those credit default swaps. Professor Jackson, should they be regulated?

MR. JACKSON: Yes, I think that Chairman Cox's proposal was a good one, albeit a piecemeal response. But that would be an incremental improvement, his recommendation.

SEN. LEVIN: Mr. Davidoff?

MR. DAVIDOFF: Yes, I think they should be moved to an open exchange. The purpose of a --

SEN. LEVIN: Where they would be regulated?

MR. DAVIDOFF: Yes, where they would be regulated. That way we can see the pricing, and the price discovery mechanism can work, and if credit default swaps are going up on an entity, we can see it instead of --

SEN. LEVIN: Senator --

MR. DAVIDOFF: -- process.

SEN. LEVIN: Senator Collins, I believe, her last session at least, introduced a bill on this, and I fully support that effort, but bottom line is the two of you believe that Congress should eliminate the barriers to the regulation of credit default swaps?

MR. DAVIDOFF: Yes.

SEN. LEVIN: Right. By the way, just Mr. Dodaro, if you have a feeling on any of this if this is within you ambit just jump in at any time.

MR. DODARO: Okay, well I'll get caught up quickly.

SEN. LEVIN: Okay.

MR. DODARO: First, on all these areas our belief is you definitely need more transparency. I agree with my other witnesses that whoever the systemic risk regulator is should have some jurisdiction over these issues, and Senator, I'd point and to some of these derivative products as dating back as far as 1994, you know, JAO is encouraged that some of the regulators have oversight over these derivative products.

SEN. LEVIN: All right, I want to keep going down kind of a rat- a-tat-tat list here if I can because I think this is important while we have your expertise here. Now we were talking about credit default swaps there. Now what about federal regulation of all types of swaps, including interest rate, equity, and foreign currency swaps, same answer or different answer? Professor Jackson?

MR. JACKSON: Well, I think that you need to look at some of these products on a case-by-case basis, but I think that you need to have a single financial authority who is making a decision about the best way to approach these instruments, and in some cases, it may not be necessary to go to exchange-based regulation. One may want to do it by regulating the entities that engage in the transactions. But I don't think we should have an artificial boundary or a competition between agencies around these instruments. I think they should be fully within the financial sector and an expert agency should have the jurisdiction.

SEN. LEVIN: The jurisdiction to regulate?

MR. JACKSON: Yeah.

SEN. LEVIN: There ought to be jurisdiction in an agency to regulate.

MR. JACKSON: To regulate.

SEN. LEVIN: Fair enough. Professor Davidoff?

MR. DAVIDOFF: Absolutely.

SEN. LEVIN: All right.

MR. DAVIDOFF: You need the ability.

SEN. LEVIN: And the authority in an agency to regulate.

MR. DAVIDOFF: Yes.

SEN. LEVIN: Now what about over-the-counter market derivatives?

MR. JACKSON: I would give the same answer to that.

SEN. LEVIN: Same answer Mr. Davidoff or different?

MR. DAVIDOFF: Same answer. You need jurisdiction over everything.

SEN. LEVIN: Okay. Capital reserve requirements on banks and security firms, should Congress require regulators to impose stronger capital reserve requirements?

MR. JACKSON: Well, I --

SEN. LEVIN: I mean just simply authorize them to do it.

MR. JACKSON: I think that Congress needs to be careful not to be too specific in its dictates, if only that -- if you are too specific, the industry will work around it. I think that comprehensive capital requirements are important, and it needs to be done not just at banks and insurance companies, but it needs to be done for conglomerates as well including the entities that we don't have traditional names for. So I think, one, we need to be careful about specifying sector regulations as opposed to saying we need to have a comprehensive oversight of solvency and liquidity.

SEN. LEVIN: Authorize an agency to do that.

MR. JACKSON: Authorize an agency.

SEN. LEVIN: And then in keeping with your previous answer essentially.

MR. JACKSON: Yeah.

SEN. LEVIN: Professor Davidoff?

MR. DAVIDOFF: Again, I --

SEN. LEVIN: I know this may sound obvious to you, but let me tell you, we've got to build up a record if we're going to move quickly on this thing. I mean, I think all of us want to get to the structural issues. And again, I commend our Chair and ranking members. It is a tough job to do that. It's a harder job in a lot of ways, more technical; it doesn't have the glamour of some of these other issues, so called sex appeal, but it's essential that that be done, but we can't let that effort stop us from doing some of the things we've got to move very, very quickly on. So that's why I want this record to be --

MR. DAVIDOFF: Can I just add one thing to your very good point?

SEN. LEVIN: Of course.

MR. DAVIDOFF: Which is Congress should use its political capital to set up a structure, and they shouldn't get bogged down in the details. I mean, sometimes they should, but bank capital requirements is a fight that Congress doesn't need to pick. They can have the regulator have the authority and give them the authority to set it.

SEN. LEVIN: It's clear that we ought to act to give the regulators those kind of authorities.

MR. DAVIDOFF: Yes.

SEN. LEVIN: My time is up. I have some additional questions, Mr. Chairman, for the record along the same line, and I very much appreciate the patience of our witnesses here because this is really slightly different than what they were called to testify and which is very valuable testimony, but I want to thank you for your testimony.

SEN. LIEBERMAN: Thanks, Senator Levin. I agree with you. And to go back to a metaphor you used in your opening statement, which is used a lot, but is very relevant here and your particular last series of questions made the point, which is there are a lot of financial beats in America today that don't have a cop on them, and that's part of the reason why we're in the mess we're in now. The second thing is that the public gets this, and they are really infuriated, and it does create a political moment in which we can achieve the kind of comprehensive pro-active reform and regulation of financial entities that you've all, in one way or another, called for. So obviously, at some political moments you can overreact. This happens to be a political moment, I think, where the public wants us to do, in fact, what we should do. And you're testifying from a very non-political point of view that that's exactly the case.

SEN. LEVIN: If I could just interrupt for one second, we had the SEC months ago asking us for authority to regulate credit default swaps.

SEN. LIEBERMAN: Yeah.

SEN. LEVIN: Now, it shouldn't take us more, as far as I'm concerned, to do that little piece as quickly as we can. If we're talking, I don't know a trillion dollars.

SEN. LIEBERMAN: You know, I happen to have that --

MR. DAVIDOFF: Twenty trillion.

SEN. LEVIN: Twenty trillion dollars --

SEN. LIEBERMAN: Here's an --

SEN. LEVIN: Of exposure.

SEN. LIEBERMAN: Here's an interesting number from June 2006 until June 2008, the market value of outstanding credit default swaps increased from $294 billion to $3.1 trillion, so in just two years it went up tenfold.

SEN. LEVIN: Wow.

SEN. LIEBERMAN: That's a lot of money even around here. (Laughter.) I do agree.

MR. DAVIDOFF: Thank you.

SEN. LIEBERMAN: Senator Tester is next. For Senator Burris' information, we have a rule on this committee that we call on the senators in the order of arrival. So you'll be next after Senator Tester.

SEN. JOHN TESTER (D-MT): Yeah, thank you, Mr. Chairman, and I too appreciate the hearing that you and the raking member have lined up here. I don't know how many members on this committed are also on banking. I am one. Senator Carper was; I don't think he's on it any more, but I don't mean to speak for the chairman. You know him better than I do, off of banking, but I would say that any sort of suggestions that this committee could give to the banking committee would be well accepted. This is a very complex issue, and as you pointed out, is an issue that I think, the public wants something done here to reestablish faith in the marketplace.

SEN. LIEBERMAN: Thanks, Senator Tester. I forgot that you're on the Banking Committee. I did talk to Senator Dodd about the hearing, and he was encouraging, and obviously, we defer to you in terms of legislation, but maybe this committee can offer some suggestions about what form that should take.

SEN. TESTER: We'd be more than happy to take them forward, and we'd be more than happy to hear suggestions with you on a personal basis because, like I said, it's complex. I guess the question I would have for all three of you. You understand how complex the markets are, and you already talked about the holes and the overlaps and the fact that it doesn't work very well right now. How much time do you think, if we really got after it, would it take to develop a structure that would be comprehensive enough to add consumer confidence to the marketplace but yet not so detailed that we would have to fight fights we didn't have to fight and not so regulatory that it would take away flexibility in the system and deter growth? Just give me an idea on how long you guys think that would take to do something that would be thorough.

MR. JACKSON: Well, I think that's a good question, and the way I think about it is on two levels. For Congress and the new administration to come to a consensus about the direction that we should go in, whether it should be the two-peak model that I was sort of outlining or a three-peak model that Professor Davidoff was suggesting or a more narrow set of consolidations with a different agenda, I think that's something that could be decided in this session, sort of relatively quickly.

I think that the task of implementing is one that you need to give a lot of thought to. Just as an example, in the United Kingdom there was a four-year process, three to four-year process from when the Blair government decided it was going to consolidate supervision. It created a shell entity that sort of carried the baggage, but the legislation took three years to enact, and actually, they created the agency first, and it had the task of helping draft its own legislation. I think the more you go to a really comprehensive solution, the more you're going to need to draw on expertise, but it's a very technical task.

One example of something that came up here that we didn't mention in our testimony, dealing with financial institution failures. Right now, one of the problems, one of the reasons, things are too big to fail is that we don't have a mechanism for wrapping up big institutions because we have the banks, the securities companies, the insurance companies, and the Federal Bankruptcy Code all interacting. Well, we should have a consolidated disposition process so when Lehman goes bankrupt, we can actually deal with it and then we actually could make it fail because we would have a mechanism.

SEN. TESTER: So you're saying several years?

MR. JACKSON: Several years.

SEN. TESTER: Mr. Davidoff?

MR. DAVIDOFF: I think I agree with that assessment but I think that Congress can pass a bill that does it this session.

SEN. TESTER: Mr. Dodaro?

MR. DODARO: I think part of it depends on a couple of factors. One, the Congress requires that a congressional oversight panel under TARP to submit a regulatory reform proposal and also requires the Secretary of the Treasury to have a proposal. There have been a couple that have come forward from other sources and the extent to which there is a consensus gathering on some of those issues, I think is important. But I think it's going to take time to do it right and to do it comprehensively.

SEN. TESTER: Well, let me ask you this then. If it takes that kind of time, do you think that there's any threat -- and I mean that just as it sounds -- any threat that a regulatory system from outside this country could actually become the standard by which we live by? Do you or Mr. Davidoff?

MR. DAVIDOFF: I think the answer to that is no. I mean, they are equally as troubled and capital flows, although they can shift rapidly, are staying concentrated in the U.S. due to our --

SEN. TESTER: Do you feel the same way, all of you? How about you, Mr. Jackson? What I'm concerned--do you understand the question?

MR. JACKSON: No. No. I don't. Can you just repeat the question?

SEN. TESTER: What I'm concerned about is ours is just -- it is screwed up right now, to be kind. The financial is a worldwide situation that we would be, if it's not done in a reasonable amount of time and maybe that is a reasonable amount of time, would we be actually having to live under the rules of another -- the EU's financial system or the Pacific Rim's or however you want to put it? That's the question. You see what I'm saying? If ours is inadequate, does that mean we have to take theirs? Does that mean the companies, the investors, all of the above?

MR. JACKSON: Well, I think, as Professor Davidoff says, the companies will stay in the United States because there is so much business in the United States. They're going to be here and they'll live with our rules. I think that we can learn from other jurisdictions and I think we can have a more effective and cost effective regulatory system if we move toward consolidation which is what's done around the world, but we control our regulatory fate.

SEN. TESTER: Okay. Good. That's all I needed to know. Mr. Dodaro, do you see it the same way?

MR. DODARO: Yeah, basically.

SEN. TESTER: Good. Perfect. I've got a question because it's been brought up a few times. My mother brought it up to me a while back. It's something that we bounce off and around once in a while. We're 10 years after Gramm-Leach-Bliley which means we're also 10 years after the undoing of Glass-Steagle. If Glass-Steagle would've been still in effect, do you see this same problem would've happened?

MR. JACKSON: I'm fairly confident the same problem would've happened. The securitization process was already underway and we didn't need Gramm-Leach-Bliley to facilitate that.

MR. DAVIDOFF: I think it exacerbated -- the banks and the investment banks, again, competing with each other and the investment banks were not built to take on, to compete --

SEN. TESTER: So you're saying Gramm-Leach-Bliley exacerbated it?

MR. DAVIDOFF: Yes.

SEN. TESTER: Okay.

MR. DODARO: I think the question is more what wasn't done rather than what was done, and I think the necessary adjustments weren't made to the regulatory structure to follow the policy decisions and what was going to occur in the market.

SEN. TESTER: Okay. Thank you, Mr. Chairman. I wish to welcome Senator Burris to the committee and I'm sure that his opinions and perspectives will be much valued.

REP. LIEBERMAN: Thanks, Senator Tester. Again, I'm really happy that you're on the Banking Committee. That gives us a good link to the work of that committee. Senator Burris, it's really a great honor, having met you before, you're coming to the Senate knowing of your service in Illinois, particularly the time as Attorney General, but obviously, you've done a lot beyond that. To call on you for the first time to question the witnesses. Senator Burris of Illinois.

SEN. BURRIS: Thank you, Mr. Chairman. By the way, Mr. Chairman, I am also an old banker, so now, my career as the first black in this nation to be a bank examiner for the Comptroller of the Currency and I'm sitting here just taking all this in.

REP. LIEBERMAN: That's great.

SEN. BURRIS: I have a couple questions I would like to ask. Number one, have we really listed the various agencies? We've got the FDIC. We've got the SEC. How many agencies are involved that would be impacted by any type of regulation? And would we have to then seek to come up with some type of blanket overall package that would impact each one of these agencies that has these piecemeal jurisdictions over all of these various entities? How many are there? Comptroller, you're also trying to get the Comptroller over the --

MR. JACKSON: In the GAO report, they have nine, I believe --

SEN. BURRIS: There are nine?

MR. JACKSON: -- primary agencies, if you don't include Treasury, but it would be 10, if you included Treasury. But I would ask that they confirm that.

MR. DODARO: Yes, there would be 10 with Treasury and I think your question is appropriate both in designing the reform that would be put in place, but also making the transition as --

SEN. BURRIS: As to try to tie all those together and get all those different interests that, you know, the turf they got to protect and all the other parts of the situation that could cause a problem.

MR. DODARO: Yes.

SEN. BURRIS: Mr. Jackson?

MR. JACKSON: I think there actually are some that the GAO report may not have included. I would include the Department of Labor with respect to ERISA issues. I'd include HUD with respect to mortgage lending. You could say that the most important financial agency for most people is the Social Security Administration with its retirement savings program. So there are a host of little pockets around the government in addition to the primary agencies that one should think about collectively, but it's a large number.

MR. DAVIDOFF: I would add that I don't expect that everything will be cleaned up into a neat package. I would recommend you build dominant regulators, whether you adopt a "Twin Peaks" model, the "Three Peaks" model and have them, over time, have their primary goal so they can absorb these functions.

SEN. BURRIS: And one other point that may seem a little bit farfetched, but I have to take my mind to the ultimate of all this and that is the consumer.

How would that consumer get impacted by this over all change in regulations? Because if the consumer ended up getting all caught up in these various different piecemeal approaches as we got the subprime lending and then, not only subprime, but all of our above prime got caught up in doing these equity loans and house values dropping so that also impacted what happened in our financial markets because there are a lot of individuals who are not subprime who are just underwater. I mean, their mortgages exceed their overall value of the property that they're living in and that constant pressure of you know, taking out the equity, taking out the equity, because it's not going to go down, and we found ourselves in serious trouble. You know, the consumer has to be taken into consideration of how these regulations can impact them and I just hope that we would give some thought to just how that ultimate person would be impacted by that.

MR. JACKSON: Senator, one of the problems as I see it is that each of our agencies has a Consumer Protection Division or a Division of Consumer Affairs, but it takes a second seat to other functions at the Fed or at the OCC or at the other agencies. What we need to do is increase the salience and importance of the consumer protection function and that can be done with an accountability standard.

It can be done in a consolidated agency by having a Division of Consumer Affairs, perhaps with a political appointee and Senate confirmation to elevate the status, or it could be done with a specialized market conduct regulator that has consumer protection as a mandate. But I think it starts with Congress saying that this is a major goal and setting up a structure that someone has that as their main mission, not as a secondary or tertiary mission which sort of tends to be what's going on nowadays.

SEN. BURRIS: Thank you very much.

MR. DODARO: Senator, I completely agree with that and that's one of the main characteristics that we point out that should be in the framework of crafting and evaluating proposals to reform the structure. Also, the states play a very important role here as I'm sure you are aware based on your past position.

SEN. BURRIS: State comptroller, too.

MR. DODARO: And I do think that whatever is done ought to be to preserve and to build upon also that check and balance at the state level.

MR. DAVIDOFF: Again, I would just add a small point which is it should have broad jurisdiction, so it's not just mortgage disclosure, it's credit card disclosure, financial protection for consumer financial products.

SEN. BURRIS: Absolutely. Thank you, Mr. Chairman.

SEN. LIEBERMAN: Thank you very much, Senator Burris. I appreciate that, you know, your question was an interesting one and, if you add on the state agencies that really do get involved, you could get pretty rapidly up to about two hundred separate oversight. Now, we have some ability, but we don't want to overdo it to deal with the state agencies as well and allocate authority, but it really is a fragmented system and it does leave a lot of gaps and give people room to play games in between.

SEN. BURRIS: Mr. Chairman, you mentioned one industry that we really need to look at and that is the insurance industry.

SEN. LIEBERMAN: Yes, sir.

SEN. BURRIS: We really have to check out the insurance industry.

SEN. LIEBERMAN: Thank you. We look forward to working with you on the committee. We'll do a second round for any of the Senators who want to ask additional questions.

Professor Davidoff, I wanted to ask you one thing briefly which is, in your testimony, interestingly, you mentioned that the lack of coordination between some of the existing regulatory agencies -- in the case you particularly mentioned the FDIC, Treasury, and the Fed -- may actually have contributed to the ad hoc and, ultimately, inadequate nature of the government's response to the current fiscal crisis.

So the fragmentation in the system may not only create gaps that allow for the problems, but it also creates a problem in responding to a crisis or a scandal, correct?

MR. DAVIDOFF: Correct. I mean, obviously, I was not in the discussions, but from news reports, it is clear that the regulators conflicted over what to do at certain times and they lacked the full authority to address the crisis and these bailouts, the reason why they're so haphazard, one reason at least is because they were structured within the narrow limits of the law that they were subject to.

SEN. LIEBERMAN: I believe Mr. Dodaro first and then others mentioned the ideal here or goal that we may, as part of our reform, want to create a system in which the financial entities are asked to bear the cost of the risk.

Just conceptually, I mean, the canvas is empty now and we're thinking about how to paint on it, what kind of system would that involve and would it be fees up front?

MR. DODARO: It would basically have to have some kind of fee structure. It would, basically, take the bank insurance fund concept that's in place and replicate that or expand it or adapt it -- is probably a better word -- to the other types of services and products so that there is a -- and this goes through to how the regulators should be funded to preserve their independence. So I think it's both a system that needs to be put in place modeled after the bank insurance fund, conceptually, that would require some fees into a centralized fund that could then provide for the industry that was in need of it, but also, have it be funded in a way where the regulators have clear independence. Right now, they're funded in different schemes which contribute to some of this difficulty in deciding how to hold people accountable.

SEN. LIEBERMAN: We've been reminded in the Madoff case that there is a fund there that can be drawn on, to a limited degree, to try to compensate people who were cheated by Madoff, but I presume that there are large areas of financial transactions where there is no such fund and, therefore, there is no coverage for loss, correct? Professor Jackson?

MR. JACKSON: There is a complicated system of guarantee, specific guarantees. It is limited given the involvement in the Madoff case because that only was for fraud that he engaged in, apparently.

SEN. LIEBERMAN: Right. That's right.

MR. JACKSON: And there is the FDIC fund for banks. There are state guarantee funds operated at the state level for insurance companies to protect individuals when institutions fail. I think the model for systemic recovery would be the FDIC Improvements Act of 1991 which, basically, says that if the FDIC saves a bank that is too big to fail and takes on extra costs, those extra costs are then charged back to the whole banking sector over some period of time.

And TARP has that characteristic, too. There is a provision that says if TARP loses money, which it seems like it will, then in five years, the Treasury has to make a recommendation for a chargeback. That's the kind of mechanism on the systemic risk side.

I think for ordinary failures, the pre-funding model, which Mr. Dodaro referred to, is the sensible one. The FDIC fund is kept at a certain percentage of deposit, so that handles routine failures. But then when there is a special failure, you need to have some special mechanism and it should be consistent throughout the financial services industry and it's not right now. If the Federal Reserve Board loses money on some of its interventions, there is no mechanism to get recovery and there is no general system for charge backs that I think would be important to put into place.

SEN. LIEBERMAN: Would you like to add anything to this discussion?

MR. DAVIDOFF: No, sir. I think it's been aptly addressed.

SEN. LIEBERMAN: Good enough.

Since we're painting on a big canvas that is not, at least I'd like to think not filled now as we reconsider where we are, we're dealing here in so many cases with an extraordinarily different international financial system where enormous sums of money travel with incredible rapidity. One of you mentioned, using it, for another point, how frustrated European regulators, the Brits, are sometimes when they come here because they have to shop around and figure out who to talk to.

This may be reaching a bit beyond, but in response to the current crisis, you know, one of the things we've learned, for instance, last year, I remember reading that there was a town in Norway that was going under financially because it had put its money in mortgage- backed securities that were failing. Pardon? In Iceland. Exactly. Exactly.

Should the U.S. be initiating some round of international discussions now to create either new international entities for financial regulation or institutionalizing or regularizing some kind of interaction between national regulators?

MR. JACKSON: Well, I mentioned the international connection and I do think it's increasingly important for us to have coordination and cooperation particularly with our leading economic allies. I think that having a kind of discussion of having more regulation, tightening the regulation, is entirely appropriate, but it means that the pressure to move offshore is going to be strong. And there are sort of two places people can move offshore.

There are to the developed countries -- Europe, Asia, and Asian markets --where we can and should have good coordination. I think the task of absolute harmonization is not an appropriate aspiration because their systems are different, their traditions are different, but we need to have convergence and coordination with these major entities. And then we need to collectively deal with the second group of entities which are the offshore centers that we can only deal with collectively.

We've had some good experience internationally cooperating on that, but we need to be working with our allies to protect all of us against the offshore centers, though. That's a priority.

SEN. LIEBERMAN: Mr. Dodaro, Mr. Davidoff, any response to our international responsibilities?

MR. DODARO: I think there are two things at a minimum.

One is there had been some international bodies of individuals from the different countries that have had some dialogues. I know this was mentioned to me when I was in the U.K. talking to one of their Treasury officials, and so, there are proposals both to perhaps more institutionalize this and expand this type of regular discussion and dialogue on issues. Secondly, there should be some discussions looking at international organizations like International Monetary Fund and others that could perhaps play an enhanced role in this. I'm not positing any particular outcomes, but I do think international dialogue is very important as part of the equation in this particular issue.

MR. DAVIDOFF: I would just add, I think there is an extraordinary, already, amount of dialogue between regulators. The Fed, in fact, entered into a dollar loan program with the other banks in Europe because of their difficulties. I think that the issue is (a) that dialogue is good, but (b) we have to take a stand on some regulation and say, "This is where we'll go." And because someone else does it differently, doesn't mean that we have to set it there. Now, that should be done with the regulatory process and we need to keep the preeminence of the U.S. capital markets. And the best way to do that is (a) through treaties and cooperation, but also, by saying, "You're not going to be able to come into our system," which is the largest system, "if you don't play by our rules."

SEN. LIEBERMAN: Excellent. Thanks. Senator Collins?

SEN. COLLINS: Thank you, Mr. Chairman. Professor Davidoff, I want to talk further with you about the "too big to fail" issue which the Chairman raised at one point.

It concerns me that we are creating a classic moral hazard. If we send the signal and, indeed, we are sending the signal that, if you're big enough so that there are consequences to the economy in terms of job losses or other cascading effects, that we're not going to allow you to fail, that we take away any incentive to carefully manage risk. In addition, we encourage companies to become bigger and bigger or to enter into financial arrangements where there are more complex and interlocking transactions to make these institutions failure too consequential for our economy. How do we prevent that?

I know that's not an easy question, but I'm really concerned that we're sending a message to just become bigger and bigger, riskier and riskier, and don't worry, Uncle Sam will bail you out.

MR. DAVIDOFF: This is a hard one. Let me give you just a quick anecdote. When Lehman failed, it defaulted on its commercial paper which was held by the money market funds, including prime reserve which broke the buck. In the space of 48 hours, over $200 billion dollars was taken out of money market funds. Money market funds, if they don't have money, can't buy commercial paper. Most of industrial America finances its operations through commercial paper. Literally, the cash machine almost shut down because Lehman defaulted on its commercial paper, the money market funds were losing all their funds and couldn't fund the commercial paper market, companies couldn't get their commercial paper, and they were unable in that market to get their financing. And that just shows how tightly interconnected the world is today.

I think what you do, and I look forward to a vigorous debate and the other experts offering their opinion, is you do two things. One, ironically, we've been building big institutions through this process. You need to manage those institutions. And, second, I think, this has been such an extreme event that the moral hazard effects may be reduced, but we need to put in incentives for the people who are trading and running these institutions; that they will be penalized. I hate to jump into the executive compensation arena and we, certainly, shouldn't in doing regulatory reform, but you need incentives that people will be punished. They can't leave with $100 million dollar exit package. If their institutions fail, they should leave with nothing, including without their country club membership.

SEN. COLLINS: Professor Jackson, I'd like you to address this as well, but I also want you to address a related issue.

When I look at the financial markets and its related to the problem I've just outlined, a related issue is risk is divorced from responsibility at every step along the way. It used to be that your community bank made the loan, kept the loan, so if the loan went bad, that institution bore the consequences.

Now, the mortgage broker may make the loan, take his fee, he doesn't care what happens to the loan after that. Then it goes on to the financial institution which takes its fee. Then it's sold on the secondary market. Everybody is getting a cut along the way. Then, when the mortgage is sliced and diced and securitized, it means that nobody is really bearing the risk of the decisions that were made. And yet everybody is taking a cut and getting paid along the way. And I don't know what we do about this.

MR. JACKSON: This has definitely been a problem and you've described the nature of the huge moral hazard agency problem that the mortgage financing system has generated. One thing that I will say going forward is, if we look at the system backwards and we think of that pension fund up in Norway that ended up holding mortgaged paper, it's going to be a lot more careful the next time it buys American securities, if it ever does. So I think we can expect some pretty severe market corrections. You know, one of the ironies is, we're living in an over market reaction. No one wants to finance mortgages anymore, which is part of our problem that we're currently in.

Some of the correction is going to come from people who have been burned who are going to be more careful. We clearly need to look at these relationships and decide when there's not enough skin in the game. Whether we want to have a mortgage brokerage industry operating the way it has in the past, I'm quite dubious. I'm quite dubious anyone will ever buy mortgages from the old mortgage broker system, but we need to look at those conflicts very carefully.

On "too big to fail," one thing I'd just like to say is, it's important for groups like the GAO to think hard about why institutions are too big to fail. Sometimes the reason is we've allowed them to enter into such complicated transactions and complicated networks that we can't unwind them. I think AIG and Lehman and Bear Stearns had this characteristic.

The solution is make a better swap system with clearinghouses, and then, if we had a good clearing system, we can let them fail. So, you can prevent "too big to fail" by not having complex payment systems or complex clearing systems, so that's a prospective solution. Something like Fannie Mae and Freddie Mac, they're too big to fail because they had too large a share of the mortgage business and we also let every bank in the country buy as much stock or bonds of Fannie and Freddie as they wanted. Now, that's a recipe for "too big to fail."

If we're going to have GSEs in the future, which is an open question, we should make them smaller. We should not let their financial significance be so big so that if one of them needs to shut down, we can't just shut it down.

We can correct some aspects of "too big to fail" going forward. If we have a disposition mechanism that can handle liquidation in a sensible way, that will also give us more latitude. So smart regulation can allow us to enforce market discipline and I think that's an important lesson going forward.

SEN. COLLINS: Thank you. Mr. Chairman, I am going to have to leave and I apologize that I won't hear the Senator's final round of questions to be asked, but he's done well. Could I just read for the record from Warren Buffet in 2002. He's not called "The Oracle" for nothing. He wrote to his shareholders and he said, "We, at Berkshire Hathaway try to be alert to any sort of mega-catastrophe risk and that posture makes us unduly appreciative about the burgeoning quantities of long term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside."

Listen to this statement. "In our view, however, derivatives are financial weapons of mass destruction carrying dangers that, while now latent, are potentially lethal."

How sad it is that when Warren Buffet said this in 2002 that the regulators apparently weren't listening.

SEN. LIEBERMAN: Amen! Thanks, Senator Collins. Senator Burris, no further questions? Thanks so much. We appreciate it. The three of you have been excellent witnesses and, again, I thank you, Mr. Dodaro for the GAO report. You've really gotten us off to a good start here. We're quite serious about this. Actually, I think, in talking to the members, you've engaged our interest.

I wonder if I could presume on your service to the committee, this is the pleasure this Senator gets in getting two law professors a homework assignment, so to speak.

I'm really intrigued by the "Two Peak" and "Three Peak" models. I'm not asking for a large article because I know you're very busy, but if you would, for the benefit of the committee, in writing, over the next couple of weeks, just outline, if you were starting again, or acknowledging that we're not starting again, but with what we have now, how would you bring agencies together? How would you change things? I think it would be very helpful to us and to the Congress overall.

Mr. Dodaro, to the extent that you're able to do that within your mandate, we would, of course, really welcome the same from you and we're glad to talk to you more about the best way we can do that.

MR. DODARO: Yes. I'd like to give that some thought.

SEN. LIEBERMAN: Good.

MR. DODARO: We could have some follow up dialogue. I'd also like to recognize the fine efforts of the GAO team that put the report together and I'd like to submit their names for the record.

SEN. LIEBERMAN: Please do. It's another excellent piece of work to assist Congress and in the public interest by GAO. I appreciate it. We will keep the record of this hearing open for fifteen days in case any of you want to submit additional testimony or any of the members want to submit testimony or questions to you, but I can't thank you enough for bringing forth your expertise to help us prevent another crisis such as the one we're going through now.

With that, the hearing is adjourned.

MR. DODARO: Thank you.

Copyright 2009 Federal News Service, Inc. All Rights Reserved