HEARING OF THE SENATE BUDGET COMMITTEE SUBJECT: FEDERAL RESPONSE TO THE HOUSING AND FINANCIAL CRISIS CHAIRED BY: SENATOR KENT CONRAD (D-ND) WITNESS: DOUGLAS W. ELMENDORF, DIRECTOR, CONGRESSIONAL BUDGET OFFICE LOCATION: 608 DIRKSEN SENATE OFFICE BUILDING, WASHINGTON, D.C. TIME: 10:00 A.M. EST DATE: WEDNESDAY, JANUARY 28, 2009

SEN. CONRAD: The hearing will come to order. I want to welcome our witness, the new director of the Congressional Budget Office, Dr. Douglass Elmendorf. This is Dr. Elmendorf's first appearance before our committee. Congratulations on your selection. I don't think we could've done better.

I was pleased to join the House Budget Committee Chairman John Spratt in recommending Dr. Elmendorf to be the CBO director, and I am delighted that he has now taken his position at the helm of the agency. Given the extraordinary fiscal and economic challenges facing our nation, it is more important than ever that we have someone of Dr. Elmendorf's stature leading CBO. I think it is fair to say that on a bipartisan basis those of us who were interviewed, involved in the interviews, the House Republican ranking member, the Senate Republican ranking member staff, the chairman of the two committees were delighted that we had somebody of Dr. Elmendorf's quality.

Our hearing today focuses --

SEN. JUDD GREGG (R-NH): And so were the ranking members.

SEN. CONRAD: And so were the ranking members, Senator Gregg says, and I really do think that represents the feeling of all of us after the intensive interview process.

Our hearing today focuses on the federal response to the housing and financial crisis. Dr. Elmendorf has done extensive research and writing on both housing and financial market policy, so it's particularly appropriate that he is our witness.

Before I go further, I noticed that Senator Merkley has joined us, new member of the committee we want to welcome. Senator Merkley previously served five terms in the Oregon Legislative Assembly, representing House district 47 within the Portland city limits. He also served as the 67th speaker of the Oregon House of Representatives. He has a B.A. in international relations from probably the most outstanding university in the United States, Stanford University, other than North Dakota State and the UMB, (laughter) and has a Masters of public policy from the Woodrow Wilson School at Princeton.

In addition to the Budget Committee, he will serve on banking EPW and the Health Committee.

SEN. : Mr. Chairman, I would --

SEN. CONRAD: Welcome.

SEN. : -- also like to welcome Senator Merkley, and I would just note that if he wants to come over to our side, we will give him a chair that works. (Laughter)

MR. ELMENDORF: Mr. Chair, it's a delight to be here, and particularly to be here for a hearing on housing, which is so important to citizens in this country. Thank you.

SEN. CONRAD: We're delighted that you're here. With that, I want to just proceed briefly, and then turn to Senator Gregg for his opening statements.

I think we all understand that we are in the midst of the worst economic downturn our country has faced since the Great Depression. We've lost nearly two million private sector jobs in just the last four months, and we don't see that trend changing anytime soon. In response, Congress and the Administration are working on an economic recovery package.

Here are highlights of the plan that are now under consideration. It's designed to jumpstart the economy, create jobs, lay a foundation for long-term economic growth. It includes investments in infrastructure, energy, health and education. I would just say parenthetically those investments I am most interested in and most supportive of. It includes tax cuts for middle class workers, families and businesses.

Last night in the Finance Committee we considered certain additional incentives for businesses that I hope will be incorporated in the mark before it comes to the floor. We received assurances from the chairman of the Finance Committee that there will be improvements in that area before the mark comes to the floor and also that the housing credit will be substantially strengthened. I offered an amendment last night to make the $7,500 housing credit apply to not just first time purchases, but other purchases as well, although certainly not second homes or vacation homes because I think it's going to need more impetus to help us get the housing sector back on track and clear the inventory that's out there.

It also includes increases in food stamps and unemployment insurance benefits, which have -- I think we all understand -- a strong stimulative effect because those moneys flow very quickly. Unfortunately, I believe the economic recovery package as it is now structured does not adequately address the underlying housing and financial market crises that sparked the downturn in the first place. Senator Kerry and I have an op-ed that was recently published in the Wall Street Journal on this matter.

I believe the economic models that predict lower unemployment as a result of the package assume generally healthy housing and financial sectors where credit flows. That, clearly, is not the situation we now face. The housing crisis is continuing. One out of every five mortgages is under water, meaning that the home is worth less than the remaining balance on the mortgage. Some say it's as much as one in every four. And one out of every ten mortgages is delinquent or is in foreclosure. And the credit crisis continues.

News over the weekend with respect to European financial institutions, as well as our own, should serve as a warning signal to us all. I noted in the Washington Post this morning a review of the major banks all around the world and their precipitous drop in value. That has significant warning signals attached to it, and we need to pay attention. The chart I'm showing now shows about half of U.S. banks indicated they became less willing to make consumer installment loans in the final months of last year. Banks have not been that unwilling to lend in over two decades.

The weaknesses in housing and the financial sectors are creating a vicious cycle. Credit remains largely frozen. Lack of credit causes layoffs. Job losses trigger foreclosures. Foreclosures hurt bank balance sheets further, and credit tightens even more. And the bad news on all these fronts hurts confidence, causing consumers to retrench further.

So economists have told us we must address this underlying housing and financial market crisis for the stimulus package to be as effective as it might be. In this testimony before this committee earlier this month, Richard Burner, the managing director and chief U.S. economist for Morgan Stanley said this. "As you debate a new fiscal stimulus package, keep in mind that tax cuts and step-up infrastructure outlays, whatever their merits, don't get to the causes of this downturn. They mainly tackle its symptoms. In my view, two critical ingredients are still missing from the policy menu. First, cleaning up the lenders' balance sheets, and second, mitigating mortgage foreclosures. Lenders will start lending again when they feel secure about their balance sheets. Likewise, mitigating foreclosures is necessary to stem the slide in home prices, slow credit losses, and reduce the pressure on household wealth."

The final point I'd like to make is that as we consider how best to respond to our current economic downturn, we need to simultaneously prepare to pivot to address our long-term fiscal challenges. As I've said before, our nation's long-term economic security will remain in jeopardy until we address the long-term fiscal imbalances that threaten to overwhelm the federal budget in the years ahead.

Fortunately, President Obama is committed to tackling this long- term problem. In a Washington Post interview earlier this month, he announced he intends to hold a fiscal responsibility summit in February to focus on this issue. He said then what we have done is "kicked this can down the road. We are now at the end of the road, and we're not in a position to kick it any further. We have to signal seriousness in this by making certain some of the hard decisions are made under my watch, not someone else's."

With that, just before I turn to Senator Gregg, I want to indicate that Senator Warner has joined us as well. Senator Warner is also new to the committee. Want to welcome him. Senator Warner has been both a successful high-tech entrepreneur, having co-founded the cellular telephone company Nextel, and served as the 60th governor of the Commonwealth of Virginia. During that time, he chaired the National Governors Association and was named by Time Magazine as one of America's five best governors.

He's also a former Senate staffer familiar to many of us. Many of us consider him a friend, having worked for both Senators Abe Ribicoff and our colleague, Chris Dodd. Senator Warner has a law degree from Harvard Law School, which we will not hold against him, and an undergrad degree from George Washington University. Welcome, Senator Warner. Senator Gregg?

SEN. GREGG: Let me join you, Mr. Chairman, in welcoming Senator Warner. It's always nice to have former governors on the committee and in the Senate because you bring intuitive logic and thoughtfulness. It's also nice to welcome Senator Alexander back. Sort of like Haley's comet, he has returned to the committee (laughter), and we are honored.

I want to associate myself with the chairman's remarks once again. I find myself doing that a lot recently. I think his definition and analysis of the problem is right on, that we need stimulus badly, but we need it in the right places, and the place where we need it is on the problem, and the problem is to get some value in the real estate markets so that we can give people confidence again, because most people's primary asset is their home, and if they don't feel that their home has the value that they've got invested in it or that they're paying their mortgage on it, then they lose their confidence in their future.

And, of course, the price of real estate and the ability to maintain real estate prices is critical to the financial industry, which does the lending. And they have to be able to value their assets. So they need to be able to have a fixed value on their real estate portfolio, and in this economy that's been hard to get.

So like the chairman, I am disappointed that the stimulus initiatives which we're seeing so far in which the chairman mentioned were marked up in finance -- they were also marked up in Appropriations where I am a member -- did not address in a more aggressive and robust way the issue of real estate prices and how we keep people in their homes and how we reduce foreclosures.

Also, I'm concerned that so much of the stimulus package is really outside the next two years -- CBO -- as estimated. I believe that it's over 50 percent -- will be spent out -- and 2011 and beyond -- on the Appropriations side. And that's not good. I mean, we'd like to get this money out the door sooner. The Administration has said -- and I respect Mr. Orszag's representation that they're going to restructure this in a way that allows them to get 75 percent out the door in the next 18 months. I hope they can do that, but I tend to have more confidence in the CBO estimate, to be honest with you, because you're a fair arbiter on this issue.

So I believe that there's some adjustments which we can make in this stimulus package, which would hopefully make it stronger and better. We do need a stimulus package. We need it badly. But we need it to be on point, and the point is that we have to get real estate prices and the real estate portfolios stabilized.

In addition, I want to express my appreciation to the outreach that the Administration has done in this area. Yesterday the President came to our conference, which is chaired by a senator from Tennessee. He made an excellent presentation I thought and a substantive presentation and addressed his approach and what he was going -- what they're planning to do in a very comprehensive way and in a way that gave me a lot of confidence that they're on the right track, but in that context, he talked about a three-legged stool essentially, one of which is a stimulus, another which is -- initiatives in the area specifically of stabilizing real estate prices, probably using the FDIC, although he wasn't that specific.

And the third is the issue of cleaning up the balance sheets of the financial industries, again, probably through using a bad bank, although he wasn't that specific. However, we haven't seen the second two legs of this stool, and that's all we have to look at, is the stimulus package, and the stimulus package in its present structure doesn't accomplish what I think needs to be done in that area.

So we're going to be interested in your views on this. I think this is at the core of the present problems we confront. I also want a second, of course -- the end part -- ending of the chairman's statement, which reflected the need to address the long-term fiscal health of our nation by addressing the entitlement issues, which is critical, and now's a good time to do it, you know? We're in crisis. People are sober. There's a sense of community here that isn't often -- that often isn't -- doesn't exist in the Congress. There's a willingness to work across aisles. So let's move on that issue right now while the iron is hot and while we can get things done and while there's a good will to do that.

And again, I congratulate the President for stepping up and saying that he intends to do that, but I think sooner rather than later is the -- watchwords on that. So we look forward to your comments, Dr. Elmendorf. Thank you.

SEN. CONRAD: Thank senator for his comments. Before we turn to Dr. Elmendorf, I'd also like to welcome back to the committee Senator Alexander, a very able and valued member of this committee in a previous iteration. And we're absolutely delighted to have him back. This is such a critical time for this committee and the Congress. We really need all hands on deck, and we need the best ideas of everyone. And we're very fortunate to have the best ideas of a new CBO director here this morning.

Dr. Elmendorf, please proceed.

DR. ELMENDORF: Thank you, Chairman Conrad and Senator Gregg and members of the committee. I'm very -- thank you, Chairman Conrad, Senator Gregg, and members of the committee. I'm very pleased to be here for my first testimony before this committee as director of CBO and welcome the opportunity to talk with you about the turmoil facing our housing and financial markets and the options that policymakers for addressing those problems.

I want to make three points today. First, turmoil in the housing and financial markets will continue for some time even with additional policies, but especially without them. Second, to generate a strong economic recovery, a wide majority of economists believe that both large-scale fiscal stimulus and focused financial monetary policies are needed at this time. Third, ensuring the availability of credit for qualified borrowers will require a multifaceted strategy that addresses the set of problems facing the financial system.

Let me elaborate on these points. First, the trauma affecting our housing and financial markets have a long way left to run. Conditions in the financial system haven improved in some important ways in recent months. For example, the intrabank market for short- term loans, which had essentially seized up in the fall, is now operating more smoothly again. Risk spreads in the market for commercial paper have decreased, and interest rates on conforming 30- year mortgages have fallen a good deal.

However, these improvements do not reflect a return to normalcy by private markets and institutions, but rather the aggressive policy actions taken by the Federal Reserve and Treasury. Moreover, despite these actions, for many borrowers credit is more expensive and more difficult to obtain than it was a few years ago. As the chairman's chart indicated, banks continue to tighten lending standards and terms for loans to both businesses and families.

And the situation is likely to get worse before it gets better. According to some analysts, U.S. banks may experience another nearly $500 billion in losses on top of the $500 billion in losses they have already recognized. Challenging conditions are likely to persist for some time in the housing and mortgage markets as well. Home sales remain weak, and construction activity continues to decline sharply. With a large glut of unsold properties, home prices will probably fall a good deal further, pushing the value of more borrowers' homes below the value of their mortgages. And as more of these underwater borrowers suffer income losses in the recession, rates of delinquency and foreclosure will rise significantly further.

The second point is that most economists think that further policy actions to restore the health of the financial system and the housing sector are needed. Broad-based fiscal stimulus will help the financial system to some extent by boosting incomes, and thereby reducing loan defaults. However, this indirect effect will not be sufficient to eliminate future losses by banks, much less to rebuild the financial system from the losses already suffered.

So policies focused directly at the housing and financial problems are a crucial compliment to stimulus, as Chairman Conrad and Senator Gregg have pointed out. Without such action, the economic recovery will almost certainly be more halting, and there would remain a larger risk of further economic decline.

Third, an effective policy to ensure the availability of credit to all qualified borrowers will require a range of tools addressing the whole collection of problems that we face. To deal with the faltering financial system, analysts have proposed several possibly complementary strategies. One is to inject additional equity into institutions, perhaps by continuing the capital purchase program under the TARP. This approach was widely supported by economists primarily on the grounds that it would give the banking system the capacity to absorb further losses and continue making loans without requiring the government to set a price for particular troubled assets.

Unfortunately, the extent of losses and the fox of uncertainty surrounding who exactly has suffered losses to what extent may mean that broad-based equity injections are not the most cost efficient way to continue to address the problems. Therefore, another strategy is to address the troubled assets directly. This can be accomplished in several ways; by the government buying assets, by the government guaranteeing assets, or by the government facilitating a division of assets into so-called good banks and bad banks.

Any of these steps could help to clarify the true condition of banks' balance sheets by removing the difficult value assets, and by removing those problems, help bank managers to focus on new loans rather than old problems. The key disadvantage of all of these set of approaches that focus on troubled assets is that it requires the government to set a price for buying the asset before a guarantee.

Yet, another complimentary strategy is for the government to increase its own lending to households and businesses. This could include new programs, or expanding existing programs, such as the Federal Reserve commitments to buy mortgage-backed securities and consumer loan-backed securities. The essential idea here is simply to provide public credit until the financial system is sufficiently healed to provide enough public -- enough private credit.

To deal with the problem of mortgage foreclosures, the government again could take different approaches. One is subsidize mortgage modifications to make mortgages more affordable for their holders. For example, the government might help pay to right down mortgage principle or to reduce mortgage interest rates. The two principle challenges here are that mortgage forbearance, modifying mortgages for people in need, will encourage additional defaults. And the second problem -- these sorts of subsidies are likely to be very expensive.

Another approach under consideration is (for foreign ?) bankruptcy law. This would lead to more modifications at little government expense. Plus, the reform of bankruptcy might also crimp the future supply of mortgage credit. Yet, a third possibility is for the government to reduce mortgage interest rates broadly. This would help both people trying to refinance unaffordable mortgages and new home buyers trying to obtain mortgages. The Federal Reserve has acted, as I said, over the last several months to buy mortgage-backed securities and has helped to bring down mortgage rates, as I mentioned, but more could be done in this area.

Let me just sum up that economists and financial experts widely agree that the financial markets are likely to remain severely stressed for some time. An additional action is desirable now to promote their recovery and hence, the economy's return to vigorous growth.

Thank you. I'm happy to take your questions.

SEN. CONRAD: Thank you very much for your excellent testimony, Dr. Elmendorf, and again, thank you for your service. Let me turn very directly to some of the possibilities you mentioned with respect to dealing with the housing crisis and the continuing troubles in the financial sector.

When the farm credit system faced a crisis in the 1980s, we were told the farm credit system was insolvent, that unless we acted, the whole system would come down. And I remember at that time the advice I had received from Carl Pollard, who was the owner of the Minnesota Twins -- but that didn't have anything to do with his expertise in banking. He was also probably the largest private banker in our region of the country headquartered in Minneapolis.

Carl Pollad asked me to his office when we were going through the S&L bailout consideration, and he had a stack of financial reports up the wall of his office. He'd done more due diligence on S&L's than probably any other person. And he said Kent, whatever you do, don't take these properties into government hands. He said inject money into the institutions, require them to rework the bad loans, and have them do the workouts. They know a lot more about these loans than any government agency will. Government can do a lot of things. It doesn't manage property well. And so he said whatever you do, don't take title. Don't take these properties into government hands.

And unfortunately, we went in a different direction with the S&L. I was one of a handful that voted against it on that basis. And in the farm credit crisis we followed that advice. We did not take title. We injected capital into the system, and we insisted that they rework the existing loans. And ultimately, it didn't cost the taxpayers a dime. In fact, we made a little bit of money, very little bit, but a little bit.

And I'm wondering if those same principles don't apply here. Maybe you can help me understand. Why wouldn't it be better -- if we form a bad bank, we're going to take ownership of those assets. If instead we provide guarantees and then insist on them doing the workouts, they've got the network across the country to do them. They know more about what's in those loan portfolios than we're ever going to know. Why shouldn't those principles guide us in this circumstance?

MR. ELMENDORF: I think, Mr. Chairman, that nearly all analysts would agree that for the government to be trying to specifically run banks on a day-to-day basis to manage those assets would not be the most efficient approach. So having a guarantee is one way, as you say, to keep those assets in the hands of the banks.

I think if we set up -- if the government were to help set up, to subsidize the creation of good banks and bad banks, that doesn't mean necessarily the government would directly run the bad banks. When the Federal Reserve took over part of the portfolio of Bear Stearns last spring, they own it, but all -- as far as I understand, all of the decisions involving are made by one private management firm with which the Federal Reserve Bank in New York has contracted to run that portfolio. So it is at least an arm's length transaction in which economists or analysts at the Federal Reserve bank in New York are not making specific decisions about how to manage individual assets.

I think another -- not to say that a good bank, bad bank -- necessarily better. I'm just saying that there are ways to keep that a little more -- a little bit of a remove. I think with a guarantee one thing, of course, to be very careful about is that that has costs to the governments as well. And as you and your colleagues make these kinds of decisions, you need to recognize -- and CBO will try to provide estimates of the cost -- the guarantees are costly in a -- certainly in a risk-adjusted sense. It's not obvious whether the government will lose money or how much, but the expectation of that, given the risks, is a real cost that should be recognized, as it has been in our budgeting regarding the TARP and the decision to put Fannie Mae and Freddie Mac into conservatorship and so on.

SEN. CONRAD: Let me just stop you on that point, because I absolutely recognize that guarantees cost money. And I am not one who's ever believed that we're going to make money on these deals. I didn't believe it at the beginning. I don't believe it now. But my experience with guarantees has been they cost less than us taking over the asset and trying to manage it. And, you know, that's just the experience that I've had, and it guarantees if there is recovery or when there is recovery -- all of us believe there will be recovery at some point -- you know, you get a bounce-back in those asset values, and those guarantees that are put in place partly to restore confidence wind up costing you a fraction of what the nominal value is.

MR. ELMENDORF: I think the confidence point is extremely important. We need to find a way to get private capital flowing back into the financial system. The government doesn't want to be responsible for providing all the resources or making all the decisions, and private capital is important, both for the funds involved and because it puts some of the decision making about which firms are viable, which firms are following successful, long-term strategies get the money.

But I think that confidence is important. One virtue that some analysts see in a good bank/bad bank approach is that it firmly separates the problems from the past, from the ongoing loans going forward. And I think a risk of guarantees is that it would not be sufficient -- the separation would not be sufficiently clear. And that would hinder banks raising you capital and focusing their energies on their future business. And I think that would be an important aspect of pursuing a guarantee strategy, is to make it sufficiently clear what the remaining bank's risks are as a way of drawing in other capital.

SEN. CONRAD: Okay.

MR. ELMENDORF: And I'll just add quickly that the experience of our country in larger crises like the S&L (knowledge ?) in this one -- but for the large -- up until now the S&L crisis -- or other countries with very large financial crises, like Japan or Sweden -- they end up being expensive for the government. There are very few examples of important financial crises that are endured without governments ending up spending a good deal of money.

SEN. CONRAD: Well, I must say I was directly involved in the farm credit crisis, and one thing I'd like is to have you go back and have your people take a look at that because it worked, and it didn't cost taxpayers money. And we faced the insolvency in the entire farm credit system at the time.

Very quickly on another matter because my time is just about out -- the housing crisis to me screams out for more aggressive steps, including an expanded credit for people buying homes. As you know, we have -- in the House package $7,500 doesn't have to be repaid, but applies only to first time homebuyers. In your analysis, does a credit of that type affect behavior?

MR. ELMENDORF: Oh, yes. I think that a credit that reduces the cost of buying a home will lead to more homes being purchased. I don't know offhand how important quantitatively we think that sort of credit would be. I think it would be very difficult to reverse the slide in house prices overnight. As you know, we have a tremendous -- lots of unsold homes. We're entering worse economic conditions in this year than we had even last year. So I think we should not thin that we can turn that on the dime. Efforts to support housing demand, though, certainly help.

And I think the other consideration there, of course, is the duration of this additional support for the housing sector. We have as a country provided a number of important supports for housing demand through the tax deduction and mortgage interest, through Fannie Mae and Freddie Mac and a variety of features of the financial system. I think it's a fair question about how much public policy we want to be focused on increasing housing demand over the long-term. But certainly, in the short-term, more housing demand would help to turn house prices back up sooner than otherwise and help to turn housing construction back up sooner than otherwise.

SEN. CONRAD: This credit would only be through August of this year. Senator Gregg.

SEN. GREGG: Dr. Elmendorf, shouldn't any stimulus package be -- not add to the long-term baseline? Shouldn't it be basically focused on the immediate problem, be temporary, be targeted, and have a horizon which is definable rather than be a baseline builder in the out years, five, ten, fifteen years now from?

MR. ELMENDORF: Yes. CBO has enunciated several criteria for effective fiscal stimulus, that the stimulus be timely, that it occur during a period of economic weakness. I want to emphasize here that as CBO looks out into the future, and as most economists look out to the future, we see the period of economic weakness persisting for some time. We're looking for a shortfall in output relative to potential output of a trillion dollars this year and next year, and more than half of that in 2011. So the period of weakness we think will be quite long, but not five years or ten years. We're able to talk about specific criteria about cost effectiveness and about not worsening the long-run fiscal imbalance.

SEN. GREGG: Now, you mentioned about five different approaches to the housing industry. And you talked about the plusses and minuses of each one and came to sort of the conclusion that none of them are perfect. And you might want to try a variety of them and a mixture of them potentially.

But as I look at the stimulus package as it's come to us, virtually none of them are tried in the stimulus package, and we're spending almost a trillion dollars. And the number that I've heard -- I don't know this to be accurate -- is that we've got about a trillion dollars of liability out there that may not be functioning today of assets that aren't functioning, and that that's what we need to work through the system essentially.

So wouldn't it make more sense to take this stimulus package and refocus it, or at least focus a larger percentage of it on the issue of housing than is presently focused if we want to get to the underlying problems driving the economic slow-down?

MR. ELMENDORF: I think most economists would say that all of the above are needed, that both fiscal stimulus to spur demand and targeted housing and financial policies are appropriate. You're right. This stimulus package as it's been considered in the House and the Senate addresses the broader goal of boosting demanding for goods and services in the economy. It doesn't do very much -- the chairman mentioned some pieces, but doesn't do very much to address the housing and financial problems. I don't think that is the case of people not understanding the need for other policies, but simply doing one piece at a time. But that's a matter of legislative strategy that I'm not an expert on.

SEN. GREGG: Well, of course, we only have so much debt that we can issue at some time. People will start saying we've issued too much debt, and if we're going to use a trillion of it on this stimulus package, I think it would be helpful if we used a fair amount of that trillion to address the housing industry, which is what I see to be the core problem.

Another proposal that's out there to stimulate the housing industry, which I find attractive, is to develop a program, a national program, which would basically probably be run through Fannie Mae and Freddie Mac, where we would essentially create a mortgage rate of four percent for a period of -- you know, a year and a half or two years. You could get a mortgage, 30-year mortgage, four percent 30-year mortgage. So we essentially subsidize probably a percentage point from the federal government.

Have you looked at that as a way of stimulating the housing industry, and if you have, do you think it would?

MR. ELMENDORF: CBO is in the process of studying some -- a particular version of that proposal. We have not completed the analysis. I think it would certainly stimulate housing demand. As I said, Chairman Conrad, anything which brings down the cost of buying a house is going to lead to more demand for housing, and that would have salutary macroeconomic effects at the moment.

SEN. GREGG: Now --

MR. ELMENDORF: The big --

SEN. GREGG: Go ahead.

MR. ELMENDORF: I think the considerations that we will discuss when we report officially on this proposed legislation are -- number one, it would be costly for the government. Private mortgage rates are currently about five and a half percent. If the government issues mortgages essentially at four percent, that's a one and a half percentage point subsidy essentially. And the cost of that should be recognized, of course.

SEN. GREGG: Well, it would be a cost, but as a practical matter if you open the window for, say, a year and a half to clear out inventory, I think in the long run the benefit to the economy would overwhelm the cost because you would start to stabilize housing prices, which is at the essence, in my opinion, of our problem.

Another point that you made that I want to follow up on just briefly -- because there's been a lot of talk about this, not a lot, unfortunately, not a lot, but a few people who I think have been irresponsible have talked about it. You said we need to find a way to get private capital into the system. That's absolutely essential, in my opinion.

So as we addressing the fixing of this problem, we should not do anything which essentially chills the future willingness of the private markets to come in and take out the public market, should we, take out the public participation of private markets -- take out the public participation. We want the private market to come in and essentially start taking the equity position, start taking the debt, and bringing the capital into the system rather than have the federal government or the Fed, Federal Reserve, be the supplier of capital, correct?

MR. ELMENDORF: Yes. I think -- absolutely.

SEN. GREGG: So when you have people -- unfortunately, the speaker of the House -- and recently I heard an economist from Columbia, my alma mater -- some people at Columbia are a little misdirected on some issues of fiscal policy, but suggest that we should nationalize major institutions in the financial area, such as Sweden did, and such as it appears England may do with the Royal Bank of Scotland. But that is an extraordinarily counterproductive statement to make in this market and will have a massively chilling effect on the willingness of private capital to participate. We are a Capitalist system, obviously experiencing fairly significant distress, but we are at our core -- our great productivity and our great strength is that people take risks and invest. And language like that undermines that atmosphere, doesn't it?

MR. ELMENDORF: I think concern about the future actions the government might take or not take is an important factor in holding back private capital from entering the banking system now. And one of the virtues of trying to lay out a strategy, a clear plan for how to proceed is it alleviates that uncertainty.

SEN. GREGG: So I would hope people would be more tempered in their responses, even if they're economists at academic institutions. Thank you.

MR. ELMENDORF: Thank you.

SEN. CONRAD: Thank you, Senator Gregg. Senator Merkley. I did say to the new senators that we operate on a early bird rule in this committee, so senators who are here first get first recognition, even if they start at the end of the table, which is exactly where I started. Senator Merkley.

SEN. JEFF MERKLEY (D-OR): Thank you very much, Mr. Chair, and it's a delight to be here. I had the opportunity to work for the Congressional Budget Office as -- a number of years procuring briefings for Congress, and I'm delighted to be reading similarly well-prepared work here now years later.

MR. ELMENDORF: Thank you, senator. The quality of this work is a credit to the people sitting here in the first row behind me.

SEN. MERKLEY: Great. I keep telling my staff on that question, call up the CBO analyst who's working on it. We'll get some good information. I hope I don't overload them with requests.

Are you familiar with the details of the FDR strategy when we were in a similar challenge with the dropping value of houses and mortgages under water?

MR. ELMENDORF: I know a certain amount about the Homeowners Loan Corporation. Is that what you're referring to, that bought up a large amount of outstanding mortgages and then refinanced them?

SEN. MERKLEY: Yes. Are there insights there for -- as we face this challenge?

MR. ELMENDORF: I think there are. I mean, the situation, of course, was quite different, although our current outlook is as bleak as it has been in this country since the Depression. It is not at all comparable to what it was in the mid '30s when the HOLC was doing its business. I believe the delinquency rate in mortgages at the time was pushing 50 percent, as opposed, perhaps, to the ten percent that we see today.

But I think it is instructive in terms of the magnitude of the effort that a lot of mortgages were bought, a lot were refinanced, and that that -- now, many different aspects of policy worked, of course, at that time, but the HOLC seems to have been part of what turned the housing market and the economy back up again.

I think the thing one should be careful about is that the HOLC seems not to have lost the government money, and that would be a desirable outcome of interventions we might consider now, but I think would not be the best estimate of the outcome of policies that we might purpose now.

SEN. MERKLEY: Thank you. The general parallel, as I understand it, is that we had mortgages that had two problems. One is they were callable, and the second is that they were often ten-year balloons. And by reissuing 30-year mortgages -- stabilized families and stabilized the economy and stabilized the downward pressure on houses. I'm interested in learning a little bit more about some of the other details, how they dealt with the under water mortgages and so forth for insights.

In your presentation, at least in the written portion, you go into a lot of the details about the challenges of getting current lenders to renegotiate. The owner of the loan has sold the cash flows. The owners of those various cash flows might sue. You can perhaps provide immunity, but you might create constitutional property problems. It just seems to me like it's such a complicated direction that in terms of moving quickly to address the millions of mortgages that are a challenge, that we can't move fast enough and figure it out and that that's -- it's probably a sandpit.

Do you see any hope for going in that direction and really being able to incentivize lenders, or is that pretty much -- it's just too many complexities?

MR. ELMENDORF: You're certainly right that speed is of the essence, and you are certainly right that the mortgage modification process is complicated in a way that works against our being able to do anything very quickly. That is a true challenge. I think that more government subsidy, however, will encourage more action.

And yet, more government subsidy would encourage yet more action. I think the challenge that you and your colleagues face in making those choices is that it's also much more expensive the more subsidy one provides. And there's a trade-off there I think between on one hand the speed -- a number of people helped and -- but then against the budget cost of that.

SEN. MARKLEY: You know, as I've wrestled with this, I have wondered what is the -- for those who own portfolios of mortgages -- I'm assuming those are marked down in their books to some fraction of the value. Do we have a sense of what that is?

MR. ELMENDORF: So, so far world financial institutions have taken about a trillion dollars, have recognized officially about a trillion dollars of losses. Much of that is on mortgages or mortgage- related securities. I don't know the exact number offhand, but we can give you an estimate. And of that trillion dollars, about half has been borne by U.S. institutions, which is the $500 billion that I referred to.

Looking ahead at prospective losses, analysts are looking for a fairer number of -- a fair amount of further mortgage losses, but also much more loss on commercial real estate and on consumer loans due partly because of the -- importantly due to the weakening economic conditions and the affect of the recession.

SEN. MARKLEY: I was thinking more in percentage terms, but let me just tell you what -- the thought I was playing with, is if a portfolio mortgage is marked down to 80 percent of its value, could you have a situation where the government buys those mortgages at 80 percent, that they proceed to them guarantee private loans that refinance those mortgages, and so the government -- since it gets paid back every penny, and yet the family ends up stabilized with a fixed rate 30-year mortgage, and yet we don't experience, if you will, the massive sort of expenditure requirement that I know that many members of the Senate are concerned about.

MR. ELMENDORF: I think the problem here is that a pool of mortgages will be marked down in value based on some expectation of how many families will end up defaulting and what the losses on those defaults and foreclosures will be. But then when it comes to dealing with individual families, whoever controls the mortgage -- private lenders now or the government at some point -- needs to decide whether to renegotiate that mortgage or not.

For a family that would otherwise go into foreclosure, modifying the mortgage to mark down the principle amount is going to be advantageous to the lender. On the other hand, for the families that will keep paying interest on the mortgage anyway, marking down the principle and thus the mortgage payment is disadvantageous to the lender. So the lenders could isolate the families that would end up defaulting, then renegotiating, modifying those mortgages, would be useful.

But the only alternative is to modify all of the mortgages, all the ones that will go into foreclosure and all the ones that would not otherwise. Then it gets very expensive per foreclosure. So as you noted, ten percent of mortgages now -- I think a little under ten percent -- are seriously delinquent or in foreclosure. Anything which is done for those ten percent of the mortgage holders, which is very helpful to them, will look helpful to some of the 45 -- let's say less than five million households -- will look helpful to the other 50 or so million households.

That's a fundamental problem in this sort of modification. And it's a problem that private lenders face, and it's a problem the government would face as well. And that's why it's hard to limit the losses that are realized, because you're in a sense helping other families that would like to be helped and might deserve to be helped, but would otherwise keep paying.

SEN. MARKLEY: And that's exactly the reason I was asking what the average percentage markdown is on the pool, which takes into account the entire extend of mortgages from those that are healthy to those that are not.

Another approach would be to basically buy out existing mortgages for those who are going under to have the new loan, the new first mortgage, be equal to the value of the house, to have the homeowner then also carry a (silent ?) second mortgage for the difference between the value of the first mortgage and, if you will, what they owed previously, perhaps with a shared appreciation model.

In this case, the family still owes the same amount, but it's structured in such a fashion that they're much more likely to succeed and stabilize the family. Is that an approach you all have worked through your models as to how that might be implemented?

SEN. MARKLEY: I'm not sure whether we've analyzed that particularly. I think that how that changes the incentives of the families involved depends a lot on how the second mortgage is structured, so I understand your point about being a shared appreciation mortgage. I think those sorts of modifications certainly have potential, but we would need to work through the specifics. Obviously, in this sort of situation the details matter a lot, and we would need to work that out specifically.

SEN. MARKLEY: Well, I'll just close by saying I look forward to working with CBO, that I think that there are many challenges to figuring out a pathway to move quickly that is fair to our taxpayers and yet addresses the significant impact on failing mortgages on this downward cycle, and figuring out the right path will be critical, not only to stabilizing millions of families, but to reversing the downward collapse of the economy. And thank you very much.

MR. ELMENDORF: Thank you, senator.

SEN. CONRAD: Thank you, senator. Senator Bunning.

SEN. JIM BUNNING (R-KY): Thank you, Mr. Chairman.

SEN. CONRAD: Can I just say, Senator Bunning --

SEN. BUNNING: Thank you, Mr. Chairman.

SEN. CONRAD: You know, I think you would be a $20 million man in today's baseball market. (Laughter)

SEN. BUNNING: Well, since I can't throw, it doesn't make any difference. Welcome, Dr. Elmendorf. I thank you for --

MR. ELMENDORF: Thank you, senator.

SEN. BUNNING: -- being here. Can I ask you about Fannie and Freddie specifically? At what point do bailed out liabilities like Freddie and Fannie need to be brought -- when do they need to be brought on to the federal books of the government, and in other words, how should we treat the new taxpayer liability from recent investments in financial firms?

MR. ELMENDORF: What CBO has done regarding Fannie and Freddie is to estimate the expected cost of the difference between Fannie and Freddie's assets and liabilities at the time they were placed in conservatorship, and that estimated cost has been incorporated into our estimate of the budget deficit. And we put that -- so we've already accounted for that. It's around $200 billion. And if our estimates turn out to be right, then they'll be no further reckoning in the budget. Of course, to the extent that we have under estimated or over estimated the amount of --

SEN. BUNNING: (Inaudible)?

MR. ELMENDORF: -- yeah, then we'll make an adjustment down the road.

SEN. BUNNING: Does that go with the same -- other -- different entities that -- let's put it this way rather than bailouts, since nobody likes to use those words around here, that they -- we have invested -- the federal government has invested in, like CitiCorp, like AIG, like -- I mean, we have equity. We have a piece of paper. But there is no assurance that that piece of paper is going to be worth anything, particularly -- I look at some of the continuing liabilities that seem to accumulate with bailed out entities, or reinvest entities, and instead of shrinking, they seem to be growing. We started at $85 billion at AIG, went to $150 billion. Now we're at $200 billion. And the same thing happened at CitiCorp.

And so I ask the same about that.

MR. ELMENDORF: So we've made the same sort of calculation for the moneys expended through the TARP program. We've looked at the -- as you know, the government has taken preferred shares in a number of companies.

SEN. BUNNING: Yes.

MR. ELMENDORF: We have looked at the yields on the preferred shares of those companies trading in the private market as a measure -- as a private market measure of the risk involved, and we've used that risky interest rate essentially to discount the flows that we expect to get if all goes well. But, of course, the risk adjustment means that it might not go well. And it is out of that risk adjusted present value calculation that we determined that for the entire -- and looking ahead to what might done with the rest of the TARP, but for the entire $700 billion that was authorized last fall, we estimate that the total cost of that to the federal government in this risk- adjusted present value sense is about $200 billion. That was also in our estimate of the budget deficit for this fiscal year. So part of the reason why our estimate of this year's budget deficit was so high -- $1.2 trillion -- and higher than some analysts had predicted we would announce -- is because of incorporating the -- our estimate on a one-time basis of expected costs for both Fannie Mae, Freddie Mac, and for the capital injections under the TARP.

SEN. BUNNING: Let me switch gears on you just a little bit. Your predecessor, Peter Orszag, took a great deal of interest in the danger of unchecked entitlement spending. Do you share his views on this? If not, could you elaborate the differences?

MR. ELMENDORF: I most absolutely share his views, and I think all of our views, about the dangers of the fiscal path the country is on. And we understand -- I think all of us -- that the rising costs of the health entitlements and of Social Security are -- have put the government budget on an unsustainable course.

SEN. BUNNING: Okay. Current CBO practices assumes that any law that increased spending will be permanent. On the other hand, current CBO practices assume that any tax decrease will not be permanent. Do you have any plans to address this inconsistency?

MR. ELMENDORF: I am not yet an expert, senator, on the logic underlying all of scoring practices that CBO has followed over the years, so I'm aware of the statements that you make, but I cannot offer at the moment a full justification of them. I think we are always interested -- our goal is to be as transparent as possible about what is happening in the federal budget and to offer as -- and when we offer budget forecasts -- to make those forecasts as revealing as possible. And that means both -- perhaps our judgments about what is going to be useful to this committee, to members of the Congress, to members of the public.

So I am happy to talk with you about those issues in the future, but I do not have any plans to make changes at this time.

SEN. BUNNING: I would like to get back to something that the prior senator brought up, the new senator from Oregon. There occurs when you make an adjustment in mortgages -- and you adjust from 100 percent, say, to 75 percent. There occurs a capital gain to the unfortunate person that gets that. Yesterday (laughs) we tried in finance to erase or to mitigate some of the circumstances of that unsuccessfully. We are still working on it with the help of Senator Conrad, obviously, who brought the bill -- or the amendment to the bill that we're working on, the stimulus package.

But there is nothing unless we change the tax policy that can eliminate -- if you adjust those mortgages from 100 percent o 80 or 75 percent from that capital gain that now has to be paid on the forgiveness, unless we adjust, as Senator Conrad had suggested yesterday, a tax holiday, or allowance for that capital gain to be taken out. And you realize when we passed the Freddie and Fannie unlimited federal government assistance and the $300 billion in FHA assistance, we thought we were actually solving a problem, but we put too many restrictions on the FHA money, and we've only had 111 people -- can you believe that -- out of five million that are in trouble with their mortgages apply for that FHA assistance. We've got $300 billion sitting there to help them with their mortgages. We've only had 111 ask for assistance.

Do you have some suggestions -- I'm almost finished with my time -- suggestions on how we could adjust that?

MR. ELMENDORF: I think the changes are already underway to try to improve the deal, if you will, from the perspective of private lenders. But it is another reflection of the intrinsic problem here, which is that if a set of homeowners bought houses for $200,000 apiece and they put ten percent down, so they borrowed $180,000, and now the price of the house has fallen below the $180,000 -- that nobody wants to admit to the loss in that.

And if we think the crucial way to keep people in their homes is to get the value of the mortgage they owe down below the new value of the house, which evidence suggests is important in keeping people in their homes, then either the private lenders have to agree to write down the amount that they're going to receive -- and again, that makes sense for them for people who would otherwise, in fact, default, but not for all those who would otherwise keep paying -- and it's hard to distinguish them -- or the government needs to come up with that money to help subsidize the write-down. That's a very expensive business.

What happened in Hope for Homeowners Program was that the effective government subsidy -- when all the different provisions were sliced and diced -- was pretty small, a couple of percent. And that's partly why CBO, in fact, estimated that the take-up would not use nearly the $300 billion, although in the event the take-up has been even lower than CBO and other analysts expected.

SEN. BUNNING: Way lower.

MR. ELMENDORF: Yes.

SEN. BUNNING: Oh, well, we have to adjust that so that more people can be available for that.

MR. ELMENDORF: But there are a number of ways to change the parameters in that program that could induce more take-up, and I think most people would think that would be a constructive direction.

SEN. BUNNING: Thank you very much, doctor.

MR. ELMENDORF: Thank you, senator.

SEN. CONRAD: Thank you, Senator Bunning. And thank you for your reference to what we attempted to do last night. We did a get commitment from the chairman to work with us. I think it is very, very important what Senator Bunning was talking about, if I could just give briefly an example. If you have a million dollar issue, you've got a million dollar commitment, and you renegotiate the $800,000 -- and this can happen in a mortgage. It can happen in a business loan. That creates a $200,000 taxable event. And that is one of the problems that is locking up business activity right now.

So we are hopeful that we're going to be able to make some progress on this before we get to the floor. It's very costly. The amendment that I offered last night costs $14-16 billion was the estimate. I personally think it's one of the things that's going to have to be done. And we'll go next to Senator Warner.

SEN. JOHN WARNER (R-VA): Thank you, Mr. Chairman, and I look forward to working with you and Ranking Member Gregg on this committee. I'd also quickly add that you gave me a kind introduction. And I also, when I was governor, lugged charts and graphs, so I hope I can participate in those activities as well.

Dr. Elmendorf, thank you. I know we've got to vote, so I've got three separate sets of -- areas of questions, one around transparency; second around the housing market; and third around the credit markets, and I know we may be short on time. First, on transparency, really happy to see your presentation, because one of the things that's driven me crazy on particularly the already existing actions is the lack of transparency to the American people about how these dollars have been spent or invested. And at least folks in Virginia think we've -- first round of the talk -- that we've totally flushed it down the toilet. When, in reality, hopefully we may have some discount, but there may be some return.

I see you've got 214 institutions we've invested in. You've laid out some of the terms and conditions of the major institutions. Why couldn't we have a website that will portray, by institution, what we've invested, what the terms and conditions are, and how we're doing based upon other like kind preferred shares, for example, in the major institutions that we've invested in so that we could track -- American people could track it on a daily basis? You've obviously been able to do that. Could that not be done by the administration or by someone to get this information out?

MR. ELMENDORF: Yes, I certainly think it could be.

REP. WARNER: I know we trust the new economic team of the president to do that, but I -- this is the first time I've actually seen this kind of data out there, so it's very helpful.

Second, and following up on both Senator Bunning and Senator Merkley's comments, on the question of the housing area, as we think about mortgage write-downs, whether it is through the cram down process, the bankruptcy, or renegotiation, how much of a challenge and how much of this is kind of new area? Because we've had not only a dramatic increase in securitization, but as we've taken these loans and sliced them and diced them in so many ways and added so many new instruments, trying to adjust that last 2-5 to 10 percent of debt with some of the CDOs and other things off to the side, that even if you don't have one single party to negotiate with across the table; and two, even if you then do have an ability to renegotiate down, how that differential between the -- using the chairman's example -- of the 100 down to 75, how that loss is spread so we don't end up with years of lawsuits. Has anyone been looking more closely at the mechanics of that process?

MR. ELMENDORF: A lot of people have been working on it. I think the basic problem is that when all the securitization and further complications took off, people didn't anticipate needing to renegotiate the mortgages.

SEN. WARNER: Right.

MR. ELMENDORF: So the servicing agreements don't deal with it very effectively. They're not always clear about what rights the servicer has. They provide no mechanism for the servicer to be paid for the extra costs that they incur in trying to modify mortgages. And that's a mistake that's hard to remedy now.

But I think beyond that, as I said, is even if it were just Jimmy Stewart, the banker across the desk from an individual, there's still the problem that whether that individual is going to -- many of those individuals who are underwater will keep paying, even without modifications. Some will not. And I think all the mortgage plans that are being discussed try to find some way to identify the ones who will not be able to pay and help only them. But it is difficult to target it that well. And that's probably why the costs get large.

SEN. WARNER: One of the things that was talked about, earlier we heard a lot of conversation about; you hear less now, but it is about the question of mark to market accounting rules and whether there ought to be some kind of holiday on that, so that as these financial institutions don't have to continually remark down their portfolio and perhaps even below what the actual asset value is, which ends up meaning that if we do recapitalize those dollars can't be used to lend out. They have to be kept on reserve. You got a feeling on any of that mark to market debate?

MR. ELMENDORF: I think there's a diversity of views among experts on that. But I think the majority of experts actually lean toward maintaining mark to market rules. One of the key problems now is the lack of clarity about what institutions' financial condition really is. And the more we move away from mark to market accounting, for all of the flaws of whatever the current marks would be, the less clarity that we get. And one of the virtues, for example, people see in the Swedish plan was that they enforced mark to market strictly and through that mechanism seemed to reveal which institutions were viable and which were not. And they closed the ones that weren't, and they supported the ones that were. So I think on balance, most analysts actually favor the mark to market rules, despite all the various problems, as the most effective way to gain clarity about what's going on now as a way to then move forward.

SEN. WARNER: And I know our time is short, but one last question on the credit markets. It seems to me that one part of the debate that has been missing, at least in terms of in the legislative standpoint, has been as we think about this -- the president's reinvestment plan, that one of the areas that has stymied this job growth and reinvestment opportunities is the freezing of the municipal and any other kind of public bond markets, whether your housing authority markets, your local school division, your state transportation bonds. And I, for one, think these are projects ready to go, that these are projects that, with the appropriate risk assessment, that the Fed or the TARP could -- funds could be used to either be purchasers or to be insurers of last resort. And jump starting that public market -- we've done a lot in the commercial paper area -- but jump starting those public financing markets could have job benefits, would have community benefits. And if we put the right type of insurance on this, would not have great exposure in terms of public funds. Have you all looked at that -- those public bond markets?

MR. ELMENDORF: I think you're just right, that those markets are suffering from some of the same problems that are afflicting other parts of the financial system have received less policy attention. I believe that the Federal Reserve is more restricted in what it can do regarding those securities. The clause of the Federal Reserve Act that refers to their extra powers under unusual and exigent circumstances does not refer to loans to other governments. It refers to loans to private borrowers. So I'm not a lawyer, and I don't exactly, but I think that there are limitations on what they can do. And that may be part of why they had not pushed ahead in that direction -- (crosstalk).

SEN. WARNER: (Crosstalk) -- Federal Reserve -- (crosstalk).

MR. ELMENDORF: But TARP could take action.

SEN. WARNER: The only last point is that the irony is that these are projects that are most ready to go, that are -- have a readily identifiable ability to be repaid, because in the normal course -- and yet, they're not being put to bed and being conducts (ph).

SEN. ELMENDORF: Yes. I think that's right, sir.

SEN. WARNER: Thank you, Mr. Chairman.

SEN. CONRAD: (Off mike) -- say to colleagues about five minutes left in the vote. So I think we better take a recess. I think that's the most appropriate thing, because I don't know if Senator Murray may have additional questions. I do.

MR. ELMENDORF: Okay.

SEN. CONRAD: And so if you don't mind we take a 15-minute recess.

MR. ELMENDORF: I'll be right here. Thank you, Mr. Chairman.

(Recess.)

SEN. CONRAD: Hearing will come back to order. I apologize to Dr. Elmendorf. As you know, the Senate, when a vote is called, we respond. And it's always somewhat unpredictable when a major bill is on the floor when votes might occur. They're telling me that we may face another vote at 12:10. So I think, in fairness to my colleagues, I will not go to my second round until everybody's finished their first round. Senator Nelson has joined us. Are you ready to go, or would you prefer -- you'd defer to Senator Warner. Senator Warner, if you'd like to go to your second round.

SEN. WARNER: Mr. Chairman, I'll let you go -- (laughing.) You can see I'm getting used to this when I said, "Mr. Chairman, I'll let you first." I'd be happy to follow in any order you'd ask.

(Laughter.

)

SEN. CONRAD: Okay. I'll go to my second round and try to be brief about it. Dr. Elmendorf, the great concern I have, as I look at where we are with respect to the second half of TARP and the economic recovery package, that we in effect, have been silo-ed in these two pots of money without sufficient coordination between the two. And when I review what I believe are the needs for the financial sector and housing, and I'm repeatedly told, well don't worry about those being addressed in the economy recovery pot, because they will be addressed in the second half of TARP.

And I look at what remains in the second half of TARP, less than $350 billion, which is an extraordinary sum of money. But when I look at losses in the financial sector that I'm told may be approaching $1.9 trillion, and we've put out $350 billion so far, that's a yawning gap. Can you help us understand your sense of how big and how deep the hole is? And how much of it may have to be covered by federal, by taxpayer resources?

MR. ELMENDORF: (Off mike) -- happy to offer a qualitative sense of that. Estimates of the total losses to be suffered by financial institutions very widely, the numbers that I've seen -- not that we've generated at CBO but from an outside analyst whom I respect -- talked about perhaps $2 trillion, as you said, of losses by worldwide financial institutions, about half of that by U.S. institutions, and about half of that already recognized by them. That leaves us $500 billion of losses yet to be recognized, by this estimate, in addition to the fact that even without further losses, institutions are already obviously suffering from losses of capital and the ability to do new lending.

So I think the gap that remains in terms of the recapitalization needed by the banking system exceeds the amount of money left in the TARP. I think by a good margin, not even counting the fact that part of the TARP will probably go to mortgage foreclosure relief, as I understand it, and perhaps to other targeted issues. So the remaining gap is wide. Certainly, hundreds of billions of dollars of additional capital will be needed that is not available through the TARP.

I think a crucial question is how much of that can come from the private sector and how much will need to be government funds. That depends on how the program is structured and it is, I think, very difficult to judge. For all the discussion that's in my testimony and other places about the need for a strategy now -- in fact -- and we need one In fact, it will still be very uncertain just how this play out and what will happen. But I think the odds are that more money will be needed than has been authorized so far in the TARP, probably to the tune of hundreds of billions of dollars.

SEN. CONRAD: (Crosstalk) --

MR. ELMENDORF: Your colleagues will, of course, get to decide. But I think that's what will be presented to you.

SEN. CONRAD: Let me just say, that is very much in line with my own kind of back of the envelope calculation here, from what I've been able to ascertain. And the problem is, it seems to me, the number is growing on us, because things continue to fall away. They continue to fall away in housing and the way the shower (ph) index shows that. They continue to fall away from us in terms of the financial sector. Senator Warner and I were just talking about the story in today's paper about the dramatic loss of valuation in the major banks around the world. And there is a really a stunning --

MR. ELMENDORF: Stunning picture, wasn't it?

SEN. CONRAD: -- stunning, stunning picture of what we face around the world. And so I write a letter to the administration to Mr. Summers and Mr. Geithner, and I told them I worry very much that there aren't enough resources in this package to deal with the housing crisis, continuing housing crisis; the financial sector; and the need to give lift to the economy. And that I'm very concerned that they're going to come back here in several months and say we need this additional several hundred billion dollars. To me, we'd be much better off, if that is the case, to reconfiguring part of the economic recovery package to better address these other needs and/or to add resources to TARP and to do it now, because I think the mood around here for additional, substantial packages in diminishing.

We've been through the rebate, which I don't think worked well at all. The best estimates we have is 30 -- or 40 percent of that money got injected. Then TARP basically -- the first two phases of TARP, which frankly I don't think worked particularly well, although I think they averted a total collapse. Maybe you could give us your estimates on that. What would have happened absent the injection of capital provided for in TARP I?

MR. ELMENDORF: I think that absent that injection of capital, the financial system would really have broken apart in a way that we have not seen at least since The Great Depression in this country. It's very hard to know; we don't have historical experience here to compare it to really. But I thought the period between the collapse of Lehman Brothers and the move towards the TARP was a frightening one in terms of the financial system. And a strong financial system is a key foundation stone of a strong economy. So I think it is very worrisome. I think it's hard to know what the TARP money did, because we don't observe the world without it.

Moreover, it's hard to track, impossible to track any actual dollar that is injected into a large, complex institution and see exactly what that dollar accomplished. But I think the sense on the part of some people is that TARP didn't work because we haven't fixed all of the problems in the financial system I think is misleading. And there are, certainly, particular aspects like inter-bank lending where conditions have markedly improved. And that is the thing closest to the institutions that TARP is designed to help.

SEN. CONRAD: And I think -- are you referencing there the TED spread?

MR. ELMENDORF: Yes.

SEN. CONRAD: Yeah. That improved quite dramatically. It was nine times what was typical at the height of the crisis. It's improved substantially from there, but it's still nowhere near normal.

MR. ELMENDORF: Right.

SEN. CONRAD: And yes, my own belief is absent the first TARP, the system would have collapsed. And I believe the Dow would be probably in the 4,000 range today if we had not done it. I believe that the point that many make, and I have made, that we didn't get the expansion of credit that we would have hoped for also perhaps doesn't take account of how serious the impairment of capital was to these major institutions. And absent those injections, they would have been calling good loans right, left, and sideways to rebuild capital. Is that your --

MR. ELMENDORF: I think it's exactly right. They've lost a lot of capital, and on top of that they're trying to reduce their leverage in response to the greater risks in the world. A combination of those things would lead, without public policy, to a very sharp decline in total loans outstanding in the order of trillions of dollars. And it is to offset that; that is the basic reason for trying to intervene in the financial system now. So I think the judgment of most economists is the TARP money did as much as a few hundred billion dollars would do. And that's a stunning statement given the amount of money, but it reflects the scale of the problem.

SEN. CONRAD: Well, I do think that is part of the problem here is yes, $350 billion is a staggering amount of money, staggering. But you put it up against the losses in the banking sector in this country alone, approaching a trillion dollars, and that's a mighty deep hole to fill. Senator Sessions.

SEN. JEFF SESSIONS (R-AL): Would the chairman yield and let me do a follow-up to that question right there? A variation of your question is what if the first tranche of $350 billion had been used just to go to mortgages? Where would we be?

MR. ELMENDORF: I think we'd be in a better place in the mortgage market but a much worse place for the financial system and the economy as a whole.

SEN. SESSIONS: Why is that?

MR. ELMENDORF: Because bank lending is important for all of the pieces of economic activity. It is important for mortgages but also very important for consumer loans of other sorts and extremely important for business activity, and not just investment as what we might think of needing a loan for but even for regular business operations. I think all of that was endangered by the breakdown in the banking system that we were witnessing last fall. And I think the TARP money, in the judgment of most analysts, avoided a real calamity in the financial system as a whole and thus in the economy as a whole. But as you were pointing out, Senator, it did not do much directly about the mortgage problem.

SEN. CONRAD: Senator Sessions.

SEN. SESSIONS: Well, I was home with my 90-year-old aunt this weekend. She has macular degeneration and can't read the paper but listens to the news. And she said, "You all don't know what you're doing up there, do you?" And you say this, Mr. Elmendorf, but I just got to tell you. A lot of people think the first $350 billion did very little. And in fact, we were told one thing and within a week we're doing another. And so if anybody suggests that this has been a very, very carefully constructed expenditure is -- I don't see how they can make that case. Would you agree it's been a hit and miss?

MR. ELMENDORF: My 75-year-old mother has a similar reaction to your 90-year-old aunt, senator. (Laughing.) I didn't say that it was well constructed or carefully considered. I think it was an emergency response to an emergency.

SEN. SESSIONS: Well, I know the excuse is well, it was an emergency, so we don't care; we did something. And that's politically of value, and nobody can prove it wouldn't have been a lot worse if we hadn't. So I'll leave that issue aside.

You've worked in the CBO, and you've worked in the Treasury, and you've worked, I believe, in administrations before. I think -- and at Brookings, which is a well respected institution. So I would just ask you, you fully understand that republicans and democrats, liberals and conservatives, free market and government interventionists have to depend on CBO's numbers and that integrity, and honesty, and consistency is expected of you; do you not?

MR. ELMENDORF: Yes, I understand that. We take that responsibility very seriously at CBO.

SEN. SESSIONS: And I appreciate that. And I'd just ask you -- and you're committed to that service to America.

MR. ELMENDORF: Yes, absolutely. I'm honored to have the opportunity, and I would not have been interested in this job if that was not the role that I wanted to play, senator.

SEN. SESSIONS: Thank you. And I'm sure you're committed to that and all, but we're a little nervous around here about the way money has been thrown around. And the chairman is asking some very serious questions. Looking at CBO's budget outlook, they're showing by 2014, which I guess is four or five years from now, that the net interest on the debt -- that's on page 16 of this chart book that you've got out I'm looking at -- you know is $392 billion, almost $400 billion. And the next year it's $418 billion in interest on the debt alone.

Now, Mr. Chairman, I know the Bush administration was savaged for the money that it spent on the war in Iraq. That's about $500 billion over the whole time of the Iraq war. So we're going to be at an interest rate, annual interest payment of around $400 billion in five years. And that does not include the stimulus package, $900 billion stimulus package, which we've gotten some recent numbers from CBO on that. I guess it shows $38 -- $37 billion more by 2014. So we're really about $440 -- $430 billion by 2014. Can you share any thoughts with us on the impact of that and I guess in the financial markets what kind of uncertainties that creates. And I know you projected an interest rate for this, and you do your best job you can; you project. And we don't know for certain. But what are the factors that impact the interest rate we might be paying on our debt four or five years from now?

MR. ELMENDORF: At the moment, senator, our country is experiencing a bit of reprieve in terms of the financial markets' scrutiny of our long-term budget imbalance. And the reprieve is coming because investors around the world are scared of risks in many private financial assets. And U.S. Treasury securities are still viewed as the gold standard, so people are moving money into Treasury securities from other U.S. assets and from other assets around the world. That's actually helped to hold down our interest rates for the moment.

It is, undoubtedly, a temporary reprieve. And no one can be sure when the reprieve will be lifted.

SEN. SESSIONS: These are about as low as we've ever had historically in modern times?

MR. ELMENDORF: They are very low. And most analysts expect that as the economy in this country and around the world emerges from the recession that the fiscal imbalance will start to register more prominently in the minds of investors and that they will become more leery of investments in this country and won't want to hold so much Treasury debt. And at that point, interest rates will rise. There's a risk of that happening at any point. We -- it's a matter of confidence, in many ways, and of all the things economists model badly, confidence is one of the worst.

So there's a risk, at any point, that people could get concerned, more concerned than they are. I think people understand these numbers in an intellectual sense. But I don't think it's operating on their investment decisions at the moment because they're more worried about something else. But at some point, they will become more worried about this, and at that point the consequences for the U.S. economy will become more apparent. And I think that's why CBO said one of the criteria for effective fiscal stimulus is to not worsen the long run imbalance in the budget. And that's partly because of the long run costs but also because of the risk that if the long run imbalance is viewed as drifting even further out of control that we could be sparking some concern and thus sparking some more immediate reaction that would cut off part of the recovery.

SEN. SESSIONS: It seems to me that it's pretty much a temporary thing that people would loan money to the government, buy bonds and treasuries at an interest rate of less than 1 percent, because they would just want more return. And also the capital surge around the world, like from oil going to the Middle East is way down, so their ability to buy even if they wanted to buy would be down. And the chairman had a New York Times article showing that China's surplus dropped from $50 billion a month to $20 billion. So even if they wanted to buy, they don't have as much money to buy. So are those factors that might cause a spike in interest rates?

MR. ELMENDORF: Those factors are certainly relevant. I think the thing which is providing the funds is that consumers and businesses around the world are doing less spending. So think about our consumers who suffered big losses perhaps in the value of their homes, big losses on any stocks that they hold. That's trimming consumption considerably. That's part of what's leading us deeper into this recession. It also does raise saving a bit at the moment. The personal saving rate is rising a little in this country. So it's the move toward less spending and more saving around the world that's provided the funds to buy our debt. But you're absolutely right that the decline in incomes people are experiencing is working the other direction.

SEN. SESSIONS: Thank you, Mr. Chairman. I appreciate our new director. And like Mr. Sunshine, I can understand his answers. Thank you for that. Sometimes around here our experts are awfully obtuse.

SEN. CONRAD: I would say to the senator that in the interview process, which is, as you know, conducted by the chairman and ranking members of the committee and our staffs -- I think you would have been very, very pleased with Dr. Elmendorf. He is a straight shooter. He tells people when he doesn't know the answer. As you know, his job is not to give us policy advice.

SEN. SESSIONS: Right.

SEN. CONRAD: But to give us analytical advice. And I tell you, I think I can speak for all four of us, it was an impressive set of interviews. Senator Nelson.

MR. ELMENDORF: Thank you, Mr. Chairman. Thank you, senator.

SEN. BILL NELSON (D-FL): For this next tranche of $350 billion, what would you prefer it to go into, a federal guarantee protecting the banks against the losses on assets that are backed by the failing mortgages? Or would you want to set up some kind of government institution to buy the toxic assets?

MR. ELMENDORF: Well, as the chairman just said, I don't offer policy advice. But I can tell you, I think, some of the consequences of choosing different courses of action here. Without significant injection of government funds to subsidize mortgage modifications, the pace of modifications will remain small relative to the number of people heading into foreclosure. At the same time, without substantial injection of government funds into the banking system, the banks will remain preoccupied with their past losses. Private capital will stay on the sidelines, fearing both the unknown in the banking system and the unknown of possible future government action. And with the banking managers trying to keep their heads above water and private capital not coming in, bank lending will be significantly restricted, and that will raise the cost of credit and lead to less government -- lead to less private spending.

SEN. NELSON: So your answer is basically we're going to have to do both.

MR. ELMENDORF: I think that's the experience we've seen in other countries. The savings and loan crisis cost us basically 2 percent of GDP. But that's -- as large as that seemed at the time, that is not as significant as the problem that we face now. And other countries that have faced serious financial crises have spent very large amounts of money to get out. And those that have waited to do it have spent more and spent longer in a period of recession or severe economic weakness.

SEN. NELSON: Look backward and tell me. With the problem having been to begin with the bad mortgages that were securitized and sold throughout the financial system, if our first response had been let's send this money in there to buy up these toxic assets, when would that have worked without having to go and start bailing out banks in the continuum of time as the problems unfolded last year?

MR. ELMENDORF: At the time, when I was a private agent making recommendations, I was one of, I think, a chorus of economists who supported the idea of equity injections into banks instead of asset purchases. The logic was essentially that setting the price for the assets was a very difficult business. Much of the toxic securities are not widely traded, so market prices are not available. And deciding how much to pay would matter very consequentially for the cost to taxpayers, the benefits to bank owners, and might matter differentially across banking institutions.

SEN. NELSON: Okay --

MR. ELMENDORF: So we --

SEN. NELSON: Wouldn't that then necessitate having the savings and loan approach that we had, go in and buy up those bad assets and set -- and hold them then until the price came back up?

MR. ELMENDORF: So one important difference in the savings and loan situation is that at the time the assets came to the government automatically in the sense that we had a FDIC guarantee of deposits. When institutions failed, to honor the guarantee, the FDIC put the money up -- well, and the savings and loans, of course, the FDIC at the time -- put the money up, and the assets came to the government. And they were managed in a way that I -- there were debates, in fact, about how quickly the assets should be sold but managed in a way to try to maximize taxpayer return.

The harder issue now, I think is, at the moment, is at what price one brings those assets into the government. One can wait for the banks to fail and then in a sense we get them all automatically. But I think the concern among most observers is that we don't want to wait, because that pulls the economy down faster.

So it's deciding the price to go out and get them, or another way to put that would be how much to charge for the guarantee. And I think that's a tough trade-off. We don't want to benefit the managers and owners who made bad decisions. On the other hand, if we let them sort of stew in their mess, then we run the risk of driving the economy further into the ground. And that's what makes that decision of what to pay hard. The virtue of equity investments was that you could do a lot of money very quickly by making those choices. I think in retrospect that did work to stave off immediate collapse. But it doesn't solve all the problems. That's why we're back here today.

SEN. NELSON: If you had a federal guarantee protecting banks against those losses that are backed by the bad mortgages, would that then not require the federal government to put capital into banks and therefore the nationalization of banks?

MR. ELMENDORF: I think it could avoid putting in capital now. Of course, the essence of the guarantee is that we might have to put money in later. And CBO is in the process of developing techniques for estimating the cost of guarantees. So that cost could be -- I mean, very uncertain but potentially expensive down the road.

I think the issue on ownership, the economists who have advocated equity injections did it not because they wanted the government to be the owner of the banks in the terms of running the banks. Most of the proposals were very explicitly not for majority stakes or direct control. It was viewed as a way of putting money in that would be roughly even-handed across institutions and could be done quickly.

But you're absolutely right, the more of that that is done, the larger the stake that the government takes, the more the government becomes the de facto owner. And one implication of this picture that the chairman referred to that showed how much the market value of banks has shrunk over time is that, in fact, the sorts of money that we are talking about them needing would buy a very significant share of the equity of some institutions. So that is, I think, an increasing challenge. As more money goes in and the share that the government owns goes up then the issues you raise become even more acute.

SEN. NELSON: So if you buy up the toxic assets or, in the alternative, you guarantee the toxic assets, you're still saying that we're probably going to need to put money into banks anyway, which means we're going to get preferred shares and so forth for the federal government.

MR. ELMENDORF: Eventually, I think that's right. The essence of the problem is that they've lost. And to make the system move on, money needs to be added.

SEN. NELSON: So it's bad news, Mr. Chairman. And I just want to say -- (laughing) -- so the newly confirmed Secretary of the Treasury is basically -- it looks like he's going to have to take this course.

MR. ELMENDORF: I think that's the expectation of most observers, yes, sir.

SEN. NELSON: Either guarantees or buying them up and injection of capital into the banks.

MR. ELMENDORF: Yes. I would just say I think the third possibility related to guarantees and buying the assets would be what's described as a good bank/bad bank approach --

SEN. NELSON: Right.

MR. ELMENDORF: -- in which the bad assets are separated out. But then at that point, the government needs to provide some financing for that.

SEN. NELSON: And how much is this going to add to our national debt, Mr. Chairman?

SEN. CONRAD: My own belief is hundreds of billions beyond the commitments that have already been made, hundred of billions. I tell you, I don't perhaps want to talk about it in this setting, but other conversations I've had over the weekend with respect to the financial sector -- very sobering stuff. Yes, Senator Sanders.

SEN. BERNIE SANDERS (D-VT): Thank you very much, Mr. Chairman. And welcome, Dr. Elmendorf.

MR. ELMENDORF: Thank you, senator.

SEN. BERNIE SANDERS: And I apologize for not being here earlier. I want to ask you mostly questions about the financial crisis and then I want to ask you another question about how CBO makes their accounting assessments. Question number one, between 2001 and 2007 commercial banks alone, not investment houses, just commercial banks alone made some $700 billion in profit. That's a lot of money. Now as a result of the greed, recklessness perhaps, and illegal behavior on the part of the relatively -- of Wall Street, they are coming to the taxpayers for huge bailouts, and we have no idea how much that's going to end of costing.

A very simple question, the average guy goes out and has a lot of luck. He wins the lottery. He makes a lot of money and puts the money in the bank. Bad times come, he says, well good news. I won the lottery. I have a lot of money. I'll pay off my debts. These guys have made unbelievable sums of money. Then through their greed and recklessness, they created a terrible crisis and now we have to bail them out. Where did all their profits go?

MR. ELMENDORF: As you know, senator, the banks have paid out profits in the form of dividend payments to shareholders.

SEN. SANDERS: Yeah.

MR. ELMENDORF: They've paid salaries to managers.

SEN. SANDERS: Yeah.

MR. ELMENDORF: That money is not directly recoverable legally. But I certainly understand the frustration that the American people feel --

SEN. SANDERS: Yeah.

MR. ELMENDORF: -- at this situation.

SEN. SANDERS: Yeah, they sure do. In other words, some people became incredibly rich and then when things got bad it's the average Joe who has to bail them out. And somehow or another we have to deal with that. And that is why, by the way, in terms of the first bailout I proposed -- I voted against it. I proposed a surtax on people whose families had at least a million dollars in income because they are the people who benefitted from Bush's economic policies in general.

All right, the second question is taxpayers provide all of these, I guess, quote/unquote "capital injections" into these banks. We're talking $350 billion plus more in the next tranche. And people go to these banks -- news reporters go. Tell us what you're doing with this money. And the banks say, oh, well frankly we thank the public very much for bailing us out, but we don't want to tell you what we're doing with the money. Are you using this money to lend it out to small businesses to create jobs? None of your business; we will do with it as we want to do with it. All right, so my question to you is why is there not -- why haven't we forced transparency and demanded that these banks lend out the money as they were supposed to do, rather than perhaps use it for bonuses, for mergers, acquisitions, et cetera?

MR. ELMENDORF: I think as an analytic matter, senator, it's very difficult to track what happens to a dollar that goes into a very large and complicated institution. A lot of money goes in, and a lot of money goes out of these banks. Knowing what was done with a particular dollar is really, I think, an almost unanswerable question. There's also a broader problem, which is that we don't know what would have happened otherwise. So economists talk a lot about the counterfactual situation.

SEN. SANDERS: Right.

MR. ELMENDORF: Without the money, what would have happened?

SEN. SANDERS: But don't you think -- if I give you. You come to me and you say, look, I need a lot of help. And I'm saying, okay, I'm a nice guy. We're going to bail you out. Don't I have a right to have -- understanding what you said -- you telling me well look, in general, this is what I'm doing. I know you wanted us to make loans to loosen up capital. Don't you think we have a right to know a little bit more than these banks are telling us?

MR. ELMENDORF: I think certainly the government can set the conditions that it wants on these injections. And it did set some, of course, as part of the legislation authorizing the TARP. The will, in some cases, be a tradeoff between the speed with which actions can be taken and the care with which they are taken. And I think one of the -- when the TARP was being debated, of course there was a great sense of urgency, I think, in the minds of most people watching the financial system. And that may be one reason why more discussion was not made at that time of these issues.

SEN. SANDERS: With the exception of our friend from -- Bernie Madoff who pulled off a remarkable -- I mean, it's again incomprehensible how you could pull off a $50 billion Ponzi scheme in this day in age without being detected by the SEC. Do you believe that Wall Street leaders engaged in illegal behavior and that some of them should end up behind bars in the coming years?

MR. ELMENDORF: I think it's very appropriate to prosecute people who have broken laws. I'm not a lawyer. I don't really know securities laws, so I'm not a good judge of what's happened. I think where there was lawbreaking it should be addressed. I --

SEN. SANDERS: Well, that goes without saying. But when people break the law, we generally try to prosecute them. I think there is an outrage on the part of the people, Mr. Chairman, that is not necessarily perceived here in Congress. The recklessness, the greed, I suspect the illegal behavior of maybe a few hundred, few thousand people has impacted and destroyed the lives of millions of people in this country. And in my view, they have got to be held accountable. And I am concerned that because they are rich and powerful they don't get the same treatment as the average criminal. But I think we have got to address that issue.

SEN. CONRAD: Senator, if I could just interrupt, and it won't come out of your time -- just on this issue. I think you're right. I think we will find lawbreaking. I think we will find criminal wrongdoing. I think people should go to jail. I have written the attorney general, and I have asked that in every one of these cases where government funds are infused that there be an investigation and that people be held to account. There have got to be prosecutions of criminal wrongdoing. And it's breathtaking.

SEN. SANDERS: (Crosstalk) --

SEN. CONRAD: I think we're going to find a lot.

SEN. SANDERS: Do you know what the problem is, Mr. Chairman, is the amount of money is so huge that nobody can get their hands around it. Somebody robs $50,000, $30 -- we understand the problem. What are we talking about, trillions of dollars? What is a trillion dollars? Nobody in America understands what that is. So the problem is so big that I think we have not focused, as the chairman said, on potential illegal behavior and what we're going to do to these people.

All right, let me ask you another question. We've talked primarily about TARP funds, but there's another huge source of funding from the Fed, which I think you estimated to be about over $2 trillion -- $2 trillion, a few bucks here or there. It adds up, which is going out to whom? I mean, I don't quite understand how over $2 trillion can be lent out -- Mr. Chairman, I'm not quite sure that we know who is receiving this money. We don't know what the terms are. How do you lend out $2 trillion of federal funds through the Fed and nobody knows anything about this? Dr. Elmendorf.

MR. ELMENDORF: Well, the way you do it is that you try to save a financial system in which -- that consists of tens of trillions of dollars, hundred of trillions of dollars of derivatives outstanding. I mean, the numbers are very large. We have a very large economy with a very, very large financial system. I agree with you that making clear to members of Congress and to the public what the money is doing is important. I am not -- don't, of course, want to speak for the Federal Reserve.

I think in many cases the terms are disclosed when they have announced new facilities, as they call them, to lend to particular institutions with particular types of collateral -- (crosstalk) --

SEN. SANDERS: Let's not get too complicated here. Does anybody know? Has it been made public who has received this $2.3 trillion and under what terms? Is that public information?

MR. ELMENDORF: I think some of that is public and some is not. So some of these institutions that have received help are disclosed -- (crosstalk) -- are not.

SEN. SANDERS: But don't you think it's a little bit weird and a little bit undemocratic that the taxpayers of this country are providing help -- maybe it's good, maybe it's bad, maybe it's right. How do you know there aren't huge conflicts of interest? How do you know you're not giving money to your friends if we don't know anything about it? We argue here. We have two-hour debates on a $50 million appropriation. They have trillions of dollars. I don't know; maybe the chairman does. I don't know if you have information. You don't have information either. I mean, I think it's incomprehensible, but tell me why -- (crosstalk).

MR. ELMENDORF: Well again, obviously you could ask members of the Federal Reserve Board to come testify to you and to explain what they've been doing. I think one argument that is worth keeping in mind for not disclosing everything is concern about the stability of institutions.

SEN. SANDERS: Well --

MR. ELMENDORF: One of the reasons why the Federal Reserve's discount window, which stands ready to lend to institutions at an announced rate, does not have a lot of institutions that turn up is because those institutions are concerned that revealing their borrowing will cause a run of sorts on the institution.

SEN. SANDERS: Well, I do understand that --

MR. ELMENDORF: One advantage of the Federal Reserve's facility that didn't reveal who was getting those kinds of loans -- it was one of the first things they did -- was the institutions would feel free to come without risking that kind of -- (crosstalk).

SEN. SANDERS: I really do understand that, but on the other hand, I think the average person would think it's incomprehensible again. Of course, that's the word we keep using about this whole financial disaster, that trillions of dollars are being lent out without transparency or accountability.

All right, let me switch gears, take you to a more mundane subject, as we're off of this huge financial disaster. There has been a criticism of the CBO for a number of years -- and I know you have a tough job. You have to assess how much -- if I introduce legislation, how much is it going to cost the taxpayer? That's fair enough. The problem that you have is sometimes legislation is introduced which will cost a certain amount of money, but it actually will save money. I'll give you an example.

We're going to introduce, very shortly, a legislation to build a number of -- to great expand the number of community health centers around this country, focus on primary health care, preventative health care. A lot of studies out there suggest that by keeping people from going into an emergency room, keeping people from going into a hospital, it cuts back on Medicaid; it cuts back on Medicare expenditures, not to mention expenditures in the whole health care system. That really you save substantial sums of money. So if I introduce this and the cost goes -- what it will cost us is going from $2 billion to $8 billion over a five-year period, how do you assess -- I think we can make the case that we're saving taxpayers' money. How do you put that into your equation in analyzing how much that legislation costs or saves?

MR. ELMENDORF: Our objective is very clearly to include all of the ramifications of legislation in our reports to you. I was just meeting, for the first time the day before yesterday, with the people at CBO who estimate costs for SCHIP, heading towards, I guess, being just CHIP. And one of the very important factors they keep track of is how people move between Medicaid and SCHIP depending on the rules and what the states -- how the states respond, how private individuals respond. We keep track of people moving from private insurance, looking at how employers respond --

SEN. SANDERS: But if we do something --

MR. ELMENDORF: We try to incorporate all of that.

SEN. SANDERS: Do you do things like saying, oh, if a person can go to a doctor early and not end up with a terrible illness that we have to spend $100,000 in the hospital for, that's a savings?

MR. ELMENDORF: Yes.

SEN. SANDERS: Do you guys throw that into the equation?

MR. ELMENDORF: Yes. That's certainly one of the ramifications that we're trying to capture.

SEN. SANDERS: Okay.

MR. ELMENDORF: Now, we don't always have evidence --

SEN. SANDERS: Right.

MR. ELMENDORF: -- consistent with the intuition that we or others -- (crosstalk).

SEN. SANDERS: No. I --

MR. ELMENDORF: But where we can find evidence, we work very hard to incorporate as many different effects in the interconnected world as we can.

SEN. SANDERS: But the criticism, Mr. Chairman, has been is that it's pretty easy. If my bill goes from $2 billion to $8 billion, we're spending $6 billion. That's pretty clear. But we're also saving substantial sums of money, and I understand that part of it is a little bit harder to determine. But I hope you give serious thought and build into your analysis the savings as well as the expenditures.

MR. ELMENDORF: We absolutely do everything in that direct that we can.

SEN. SANDERS: Okay, good.

SEN. CONRAD: (Off mike) -- but the vote is on. For some reason, the lights on the clock are not functioning properly. And my timer is not functioning properly, so we have some electronic problem going on here. So we'll draw to a close. I think --

SEN. SANDERS: Well, I'm finished. Thank you very much, Mr. Chairman.

SEN. CONRAD: I understand. I thank very much the senator for his able questioning. Let me just say my own belief here is not only was Madoff engaged in a giant confidence game and giant Ponzi scheme. I believe part of the derivatives market will prove to have been the same thing. These very exotic insurance instruments used to try to guard against downside risks in overly leveraged financial institutions -- and where did all these losses come from? They come from companies not having the capital to back financial guarantees that they made. That is, in part, what has occurred here, and that's over in the question of derivatives and debt swaps. I think we have a Ponzi scheme of staggering proportion going on.

I have questioned people who are in the business. I asked them a year ago, some of them in these firms, did anybody have any concept of how much risk was out there. And they asserted to me they did not. People who are in the top management of these instruments in global firms, I asked them if any of them could understand -- the top executives understand the formulas that were being used to assess risk. They hired a bunch of Ph.D. economists who I have regard for, who wrote formulas. I asked my staff about a year ago to bring me some examples of these formulas. And I must say, I could not make head nor tail out of them. I have a masters in business administration.

I have always been very good in math. I couldn't make head nor tail out of them. And I said to the -- some of the executives I was with, do the executives in these firms really understand these formulas? Because I would guess most of them have the same business training I do.

No. They didn't know. They didn't understand these formulas. And these formulas clearly did not assess risk properly. And yet, they are making hundreds of billions of dollars of debts around the world. And now, these chickens come home to roost, and I am extremely concerned about what I am hearing about the financial system. And that's why I think we've got to refocus on the need to effectively deal with that and the housing crisis. If we don't, I don't see how recovery occurs. And I personally don't believe we've -- we've yet grappled with this in the most effective way. And I give you the chance to respond to these observations.

MR. ELMENDORF: I agree with everything you've just said, senator. I think at least two important points you've raised. One is that -- and not to minimize the illegal actions that were taken by people -- but that most of the problem, in the judgments of analysts, is not what was illegal and done anyway. It's what was legal and not understand and was done. And it is an immensely complicated business, and lots of people took a lot of risks they didn't understand.

And the second point -- yes.

SEN. CONRAD: (Off mike) -- have you looked at any of these formulas that were written to assess risks with respect to debt swaps and derivative instruments?

MR. ELMENDORF: I have seen some of them. Senator --

SEN. CONRAD: Do you understand them?

MR. ELMENDORF: -- I don't understand them either, despite my training. To be clear, when we tell you that we estimate the costs of the TARP injections to be about $200 million, that answer comes partly out of those sorts of complicated financial formulas. We have people at CBO who are real experts at financial economics, which I am not. But one appropriate caution about our numbers is that they are based on models drawing on historical data that can be wrong in just the way we've watched the private investors be wrong.

SEN. CONRAD: (Off mike) -- that point if I could. I personally believe the CBO forecast is overly optimistic. I used to have the responsibility of forecasting revenue for my state, and I had that responsibility for six years. And I have seen repeatedly forecasters are wrong at the turns. It's just human nature. We all -- I'm not being accusatory here. This is human nature, and I've experienced this myself as a forecaster. At the turns, you always underestimate the up side and underestimate the down side. And I think the CBO forecast suffers from that flaw, which I think all forecasters are suffering from. My own belief is the down turn is going to be more prolonged and sharper than most of these forecasts capture. And I won't ask you to defend the forecast, because that was made before you were in this position. But I make that observation as my own belief.

And we've got -- we really have a very substantial responsibility to the American people on our collective shoulders. And we have got to do a much better job than we've done thus far in fashioning answers. That's my belief. Thank you very, very much for your testimony here today, and thank you very much for taking on this responsibility. We all recognize around this table that you could make a great deal more money in the private sector and that you bring to this work real distinction and great credibility. And we are delighted, and I can speak for republicans and democrats who were involved in the selection process, you really shined through. Thank you very much.

MR. ELMENDORF: Thank you, Mr. Chairman. I, with CBO, look forward to working with you and the rest of the committee.

SEN. CONRAD: We look forward to it as well. The committee will stand adjourned.

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