one other features of our legislative proposal would be to give the sec authority to require taylor payments of the kind of discomfort credit rating agencies and think it's a terrific suggestion. rating aens ratinga agency, i think, back i my tenure as governor.

there was sometimes validity in a rating agency when you're looking at state bonds and others that they did provide that independent arbiter service to kind of cut through the political clutter of both sides back and forth, that somebody could come in and assess what your state was doing, your locality was doing over a short-term or long-term basis. we did find usage of the rating agencies that they did do due diligence, something that clearly i find what the chairman said is pretty amazing as well that they did not in so many of these corporate circumstances -- although, again, the idea of legislating that requirement, i think, mr. barr, you've raised some appropriate concerns about. with that enhanced -- put that government moral hazard thing that we all don't want to extend to a whole new set of

organizations in terms of the rating agencies. i want to ask -- one is we've had mostly the issuer-paid funding model. the administration's proposal is that an investor paid funding model -- i know certain investor paid models are starting. do you really think that marketplace approach with an investor-funded rating agency, you know, i'm asking you to make a prediction now. do you think it will be successful? do you think the market will respond to that? >> i think there's an opportunity, senator, to have a structure that has both models exist and thrive if there is the appropriate regulatory backstop of a level playing field. i think that the initiative to

require an issuer to provide the basic information to all credit rating agencies when it provides it to one, so there can be true dissemation of information would help significantly in this regard if moved forward. and having a level playing field for that -- for that kind of competition on the basis of high standards and meaningful disclosure. i think there's an opportunity for that model to work. i think, frankly, we have so many challenges right now in restarting our financial markets, or securitization markets, and in laying a new foundation that it's not clear yet -- >> i didn't -- and i do understand this question of whether we should be blessing the methodologies. it's a real hard issue. let me -- with only a minute and a half left, i'll go to my other question. you know, one of the things that we -- we use these terms aaa,

aa, bb, what have you, but one of the things that i've felt that investors have not had, and i'm not sure i've had, is someone who's on the issuer's side and on the investor's side that we've ever translated that into what does that mean in terms of the actual percentage chance of default, number one, or the second category, even if there is a default, what -- what percentage of my investment could be truly in jeopardy? and should we, as we think about this -- these therm terms think putting some commonly accepted standards around for investors. what is the percentage of default risk, what percentage of your investment are you potentially going to lose? 10%, 50%, 100%? we've talked about structured products and unstructured

products. should be try to translate these letter grade ratings into actual percentage of risk of default or risk of amount of loss? >> yes, senator. i think that's absolutely critical to demystifying the process, making it more transparent. in our proposal, we fully agree with you, there should be in addition to the rating a report that describes the probability of default, the loss given default, the variance -- the reliability of the data, the underlying quality of the assets, all the information underlying the symbol so that investors in the market can make better judgments about how to evaluate the rating itself. >> we would know what an aaa rating equates to in terms of both percentage chance of default and you've got $100 invested, what percentage of that $100 you could lose if that

default takes place? >> that's right. >> all the way down to an individual -- >> correct. >> very good. thank you, mr. chairman. >> very good questions, senator. thank you very much for your thoughts on that. >> thank you, mr. chairman. secretary barr, good to see you again. >> good to see you. >> i'll say something that i think you'll find very unusual. my colleague from virginia was talking about working with the rating agencies as governor in our state, the state of nebraska, we have no debt. i never worked with a rating agency in all the six years i was governor because it wasn't relevant. we paid for everything, even highways. so that's one way of approaching this. then you don't need rating agencies. kind of an unusual phenomena to pay for things you would actually have two choices. cut spending or raise taxes.

and we could use more of that out here in washington. but i did work with rating agencies as mayor of lincoln as we would issue bonds. let me ask you a little bit maybe of a mundane question, but maybe an important question. as you know, there's been, especially recently, some articles written about first-amendment protection for rating agencies, historically it was viewed that they were issuing an opinion and therefore they had the protection of the first amendment if they were sued. as you move down this pathway of additional regulation or as senator corker points out, maybe rating agencies need to have some skin in the game, if you will. do you have any thoughts whatsoever about whether that moves the rating agency out from underneath the first amendment

protection? what would be your thoughts on that? >> senator, let me start by saying i'm not an expert in the first amendment. so my judgment, the judgment of the team when we're working on this, was that there is lots of scope for appropriate regulatory requirements on the rating agencies, including all the ones that we have in our legislation and a number of the other proposals this committee has considered that do not raise significant first amendment concerns. >> so you think they would -- and i appreciate you're not a first amendment lawyer. i'm not either. even though i am a lawyer. but you're thinking that they still will be able to defend their lawsuits by saying we're protected by the first amendment because this is an opinion? >> senator, i don't want to -- i don't want to get too deep into this here again because i'm not

an expert in the first amendment, but in our judgment, the range of proposals that we have put forth or that are in the committee drafts of -- of versions of this do not raise significant first amendment concerns in our judgment. and so i would not have put that on the top of the list of issues in the trade-offs that we've been discussing. i do not think that that is a significant issue in the trade-offs. >> okay. in your judgment, how have the rating agencies worked historically? we all know nothing was working very well over this past period of time, but historically f you were to look at how they have done, what kind of mark would you give them? >> i think in many areas, the rating agencies have performed quite important functions with respect to corporate issuance and municipal bonds in many a a

areas. they have significantly fallen down on the job in -- in those same basic areas. corporates and municipal, really straight-forward assessments that they have been significantly wrong on. and in the structured product area, i would say the evidence is really quite negative. >> here's my concern. and maybe it's a -- a question based upon what senator corker was asking you again. but it seems to me that one of the risks that we run here is that we so gum up this system with additional regulations that, number one, no one could ever enter into competition. if you don't have a head start dealing with regulations, you're just not going to get in. so we exclude competition. and the second thing is i just worry that what we end up with is -- is literally a system where the consumer pays a

heavier price for this. somebody has to pay for the regulation. there just isn't any doubt about it. have you done any cost benefit, any analysis of the impact on just the average guy out there who may be investing a bit of their retirement or whatever and the impact this will have? >> senator, i think unfortunately, the whole country is paying the price. every consumer is paying the price today of a significant failure of our financial regulatory system. so we're all paying for it now. i think we need to have a system in the future in which the level playing field and high standards are established in a way that makes it much less likely we're going to blow up our financial system and cause this amount of harm to the average american homeown homeowner, consumer, small businessperson. so the trade-off isn't even close in our judgment. the kind of approach that we're suggesting here is not a heavy regulatory burden, but it is an

essential one. >> okay. mr. chairman, thank you very much. >> thank you. i think it's valuable, by the way, to have two former governors, two former mayors on the committee. while i think there's a difference, obviously, in terms of rating agencies when it comes to municipal or public bonds as opposed to private securitizations, it's a valuable piece of information. when we talk about rating agencies, there's a tendency for us to focus on the private side of this. but we ought to keep in mind the public entity side of this question as well. i'm glad you raised that, senator warner and bob corber. >> thank you very much. thank you for your testimony. i believe that the proposal bans consulting fees by rating agencies and requirements disclosure of payments and certainly banning the consulting fees is part of the conflict of interest. we still have kind of the

fundamental notion that folks are getting paid for what they provide and the possibility of shopping between agencies, getting a heads-up of what their rating might be. is there anything we need to do that's more fundamental in terms of having a different system for structuring payments for rating, doing it through a central fund that folks pay into or some other -- is there any ideas you seriously considered that would more directly take on the conflict of interest? >> i think, senator, we think conflict of interest did play a role in this problem. we have a series of measures with respect to the banning of consulting payments, strengthening disclosure and management of conflicts, disclosing the fees paid by issuers, a look-back requirement with respect to the revolving door to make sure that revolving doors haven't influenced these

structures. designation of a compliance officer, disclosure of the preliminary rating received to get at the rating shopping question that you described. and i think fundamentally, and i -- we share senator corker's judgment that having trailer payments could play a positive role in the basic structure, having a diversity of different business structures, both investor pay and issuer pay models, together with a requirement that the information provided to one agency is provided to all the others will have a significant impact on the conflicts problem. it won't eliminate it, but it will have a significant impact. >> all of those are very good and well, but you didn't answer the question i asked, which was did you consider -- >> i'll try. >> did you consider the heart of the structural conflict of interest of having the payments go directly from the bond issuer to the -- and if you rejected such ideas, what did you consider and why did you reject

them? >> we looked at a range of models that had been proposed from a -- switching back to a full investor pay model. we looked at@@@@@@rr

we have in the structured products world very complex cdos and cdo squared that made it virtually impossible for anyone to determine the underlying foundation for what went into a cdo squared. and by that, i mean situations where you had triple b bonds that suddenly you had aaa bonds coming out of those bbb portfolios, et cetera. and yet you're so far removed from whether they were liar loans, whether they had been -- the loans had been vetted in

terms of the vinyindividual, et cetera, underwritten if you will. is there a level of complexity that should simply be banned in the interest of reducing systemic risk? is there a -- a level of slicing and dicing where -- the path is too messy from the buyer back to the foundation that essentially they don't make sense to allow in the marketplace? >> i think there are ways of getting at the basic problem of complexity in -- in alternative strategie strategies. for example, the securitization skin in the game requirement improved transparency in the securitization structure. requirements are respect to transparency at the loan level for all investors and the underlying asset with respect to, say, a borrower's fico score, what the compensation scheme was. all of those are designed to get

at that set of concerns. and better qualitative and quantitative information underlying the rating on such a structured product would permit investors to go underneath and say, well, the reason that they've assigned this rating is because their view of the cash flow distribution is this, their lost probability measurement is this, their loss severity measurement is that. >> i appreciate your response. i'm picturing what that sort of report might have looked like on some of those cdo squareds. >> i wouldn't want to write it. >> i am over my time. and so thank you very much. >> tharnnk you, senator. >> thank you, mr. chairman. secretary barr, before getting into the subject of today's hearing, i have a question on a different matter.

yesterday the "wall street journal" had a front-page article about a meeting last friday where secretary geithner attacked independent bank regulators for expressing their concern about treasury's regulatory reform proposal. were you at that meeting? >> yes. >> if you are, was the article accurate about what happened at the meeting? >> i don't have the article in front of me, senator. i'd say we have an ongoing series of conversations with a financial regulator on a regular basis. we have frank and direct conversations with them on a regular basis. >> if i give you the article, would you refresh your memory? >> i'm happy to look at the article. i'm trying to describe for you the discussion, if i could. >> all right. go right ahead. >> the conversation that we had with them, the secretary made clear the regulators are free to defend their own agency prerogati

prerogatives. he expected that they would. he asked that they keep in mind as they did that the fundamental goals that we all share to protect consumconsumers, to add systemic risk, to make sure the government had the tools they need to resolve financial firms in a crisis. as they expressed their differences that we work together in the areas where we do have agreement, we had a long conversation about the important roles of the council versus the independent regulators. we had a long discussion about microprudential versus mac macroprodential regulation. >> the same type of discussion from secretary geithner and you with the regulators that you've had in the past? >> i don't -- i don't characterize the verbiage that was used, but i'd say the frankness of the exchange -- >> we're on television. i don't think you want to do

that. >> senator, you know, you will not be surprised to learn that in treasury, there's colorful language that is sometimes used. >> i've been accused of that. i understand that completely. okay. let's get to the current thing. everybody agrees that the current rating agency model has failed. i think everybody up here does. especially for a complex structure product. there also seems to be agreement that better competition will improve ratings. how we get better competition is a more difficult question, but we must break the hold of the top two or three agencies if we're going to fix the ratings. it seems to me that there are two changes that would go a long way to fixing the competition problem. first we should eliminate any regulatory requirements to use rating agencies so that they will only be used if they add

value. second, we should require issuers to provide the same information about the securities to all investors and rating agencies, much like we do for public-traded companies with regulatory fd. that way, each agency will be able to compete based on the quality of their ratings and will break the monopoly of the issuer pay model. let me start first with the first point, that we should eliminate all requirements to use rating agencies. do you agree with that or not? >> in our adjustment, we need to go regulation by regulation. we agree with the basic goal of reducing reliance wherever possible. i think we need to go into the specific circumstances of how the sec and the bank agencies and other agencies use the ratings. in some contexts, we can go to elimination.

>> you do agree that there is a definite conflict of invest presently? >> i'm sorry, in the rating agency structure? >> when i would go to a rating agency -- i'm a private corporation. i come to a rating agency. i need $200 million in bonds. they say, yes, we'll -- we'll do this. they give me a bbb rating and send me a bill for $250,000. don't you think that's a conflict? >> i do think there are serious conflicts of interest present in the existing model. that's why we require a series of steps to reduce the conflicts, disclose the conflicts, manage the conflicts. we strongly agree with your suggestion that -- that an issuer be required to provide information when it gives it to one agency to give it to all the credit rating agencies. i think that's a terrific proposal. it's part of our plan. >> now, about the second point,

and i'm a little past my time. all investors and rating agencies should have the access to the same information about a security so they can perform their own analysis of it. do you agree with that? >> i think that when -- i'm sorry. yes, when you give one rating agency the information, you should give it to all the other rating agencies as a way of enhancing competition. i do think that's an importa important -- an important part of the plan. >> do you think it's absolutely necessary for an agency to rate every security or bond that is sold to the public entities? in other words, i'm -- the city of louisville, i'm building an arena, and i -- i applied to the irs for a portion of it to be tax-free and i go to this agency and they say, well, we can't do this. and all of a sudden, someone

intervenes and all of a sudden, they found their ability to do this. and i think that's absolutely the wrong way to do business. and for -- for, you know, half a million dollars, we get $4 million worth of bonds that are 80% tax-free and 15% taxable. you think that's the right way to run a business? >> i think there are enormous inefficiencies in our revenue bond system in the united states. the rating process is one but there are many, many others. >> thank you. >> thank you very much, senator. senator schumer is next. he stepped out. mr. secretary, with that, senator shelby, do you have a question or -- >> i'll just -- do you believe, mr. secretary, that -- that eliminating the conflict of

interest, obvious to be me and a lot of other people by the rating agencies where they get paid for rating things, so to speak, and the cozy relationship there is very important in our regulatory overhaul? >> i think we have to tackle the conflict of interest head on. i'm not sure we can fully eliminate it, but i think we have to address it. >> how do we bring back what i thought we all benefited from for a long time in that -- that is securitization of mortgages. because for years and years, i wouldn't say every mortgage, you know. but there was a lot of confidence in the securitization process. and the securitization process basically worked. basically worked. now it's, for all intents and purposes, very small, if not dead. how do we do that? do we do it with stringent

ratings and trailing profits like senator corker eluded to earlier or what? how do we do this? because i don't -- i don't know if the money is ever going to flow until we bring some confidence back in securitization. maybe i'm wrong. >> senator shelby, i think it's a central question. i think in our judgment, one of the reasons why it's so critical to move on financial regulatory reform this year is precisely that. i don't think we're going to see a revitalization of our markets unless we have a new-found regulation that permits transparency in the system, restores honest and integrity to the process that was so sorely lacking in the last bit of time. so i -- i think that, you know, in our judgment we need to move quickly on financial regulatory reform, we need to have transparency in the securitization structures, we need to improve regulation of credit rating agencies, building

on the 2006 law. we need to make sure we take care of the systemic risk problem and consumer protection. we really have to move in a way that is demonstruable to the markets, that we're serious about reform. >> thank you. >> thank you very much, senator shelby. senator schumer? >> thank you, mr. chairman. thank you for holding this hearing. thank you, secretary, for coming. thank you, senator shelby, for asking that extra question. i appreciate it. i have a little statement with a little proposal in there and i'm going to ask your opinion of it. when we -- the rating agencies would be a cornerstone of credit markets. the stead, as has been said before, the credit rating agencies turned out to be one of the weakest links and those need

to be fixed, as you just said. but we found out that rating systems were filled with conflicts of interest. the worst of these conflicts were that issues went shopping for ratings like they were shopping for used cars. if they didn't like the answer they heard, they went somewhere else. because the revenues of the rating agencies grew with the massive expansion of the securitization market. the rating agencies had every incentive to help issuers structure their products to get the ratings they wanted. the result, rating agencies rubber-stamped complex products they didn't understand as investment grade using flawed analytical models and methodologies with inadequate historical data that didn't include the possibility of high mortgage defaults. we can't overestimate the imp pact this had on the financial crisis, losses in structured financial securities alone led to 1.47 trillion, trillion dollars in write-downs and losses at the largest financial institutions.

and senator reed, our chairman, has introduced a bill on credit rating agencies and the administration has proposed new rules to address the @@@@@@@ ,ár s

as a check on the first rating agency. furthermore, this check would help discourage ratings shopping and other conflicts of invest inherent in the system. we would learn who's better at rating and who's worse, and get rid of at least the conflicts o get rid of at least the conflicts of interest. i wouldn't want to do it for every issue, that's too many. we propose one out of ten. maybe it should be a little less or more. if an agency knew that there was a one in ten chance that someone else was doing an independent rating they would be more rareful. the ratings are a too much a part of the financial system to abandon. i look forward to working on the

excellent proposals and the administration to make sure we can have faith that a aaaa rating means what it says. my only question to you is what do you think of the proposals of having the sec randomly and signing a second rating agency? that would be done concurrently with the first and come out at about the same time senator schumer, i would say we share t the goal of having more than one agency rating. it's a problem in the finance area, but it exists elsewhere. in our proposal we suggest that one way to do that consistent with the sec's proposal is to require that that every issuer

provide if you have information about their issuance. there are significant incentives on the competitors to demonstrate their own rating in relation to their competitor who has been selected. i think one tradeoff that one might consider with respect to an assignment project is whether the assignment might provide a kind of sale of approval to the rating that would not be intended. it would be counter to the general thrust of what the committee has been trying to do in the area. >> two points i would make. my time is up. number one, it would be done on a random basis and secretly.

number one. and the pool would be greater than just the big three. so you have new entries with some incentive to just get it right and get it honest. second, your proposal, of course, is not mandatory. and if everyone is in the same boat and there are just a few of them doing the same practice might not prove to have the same discouraging effect. my time is up. >> happy to work with you. >> thank you, mr. chairman. >> i confer with the ranking memb

thank you gentleman. first witness is mr. steven w. joint. fitch ratings and training. our next witness is mr. james h. gellar. the president and ceo of more rapid ratings. our next witness is professor john c.coffey jr., professor that testified before the meeting on numerous occasions. there. our next witness is dr. lawrence j. white. professor of economics at new york university's school of business.

our last witness is the principal at security evaluations incorporated. he's the vice president and senior credit officer at moodys. thank you very much. mr. joint, your testimony please. could you turn the microphone on and lean in? >> thank you for the opportunity to be here today. while overall macro economic conditions remain difficult, it seems the most intense period of mashl market stress has passed. as well as a,s taken by companies individually to reduce risks. having said that, important sectors in the fixed income remain effectively closed and certain classes such as commercial mortgage-backed

securities are experiencing greater performance strain on underlying assets. during this time the focus of the ratings is implementing a broad range of our opinions and related analytics. our primary focus is vigorously reviewing our analytic approaches and changing ratings for the securities that we rate. in many cases that continues to generate downgrades in structured securities. we're releasing the updated ratings and research transparent lyparallel, we've been introducing new policies and procedures and updating existing ones to reflect the frameworks. in each of these areas we've been as transparent as possible,

broadly engaging with all market participants. happy to expand on these topics as we proceed. that said the focus of today's hearing on where we go forward from here. the house held a hearing in may. the sec had important -- considered important new rules at the round table discussion in april. we've been in discussions with the eu. actively registration and oversight system as well that applies to rating agencies. we would like to offer our perspective on several important issues. we're committed to engaging on all these matters in a thoughtful, balanced, constructive and nonself-serving manner. at the same time, some perceptions and proposals continue to circulate that could use clarification.

we are committed to being transparent in everything we do. and a good portion of the research are freely available to the market in realtime. we do not believe that everyone should agree with all our opinions. some market participants notice limits on the amount of participation has made the market overreliant on rating agencies. particularly for analysis and evaluation of structured securities. the argument followed that the market would benefit if additional information were made more broadly and readily available to all inves tors, enabling them to have the same access as mandated rating agencies in developing their own research.

should rest with issuers and underwriters. it's their transactions. they should be disclosing all the pertinent information to all investors. a related benefit is it addresses the issue of rating shopping. greater disclosure would enable nonmandated to issue ratings on structured securities if they so choose providing the market with a greater variety of opinion. discussion of additional information is a question of value without accuracy and reliability. we've taken rating agencies a number of steps to increase the assessment on the quality of information that we are provided with. we've adopted policies that we will not rate issues if we deem the quality of the information to be insufficient. the burden of due diligence in our opinion belongs with issuers and underwriters. congress should mandate that they enact rules to perform such

due diligence and make public their findings and enforce the rules that they enact. in terms of regulation more broadly, fair and balanced oversight and registration of credit rating agencies. we believe that oversight requirement should be applied consistently and equally to all nrsos. one theme is the desire to impose more accountability on rating agencies. white ultimately the market imposes accountability for our rating for the reliable and performance. so market does not have confidence in us. the value will be diminished. while we understand and agree with the notion that we should be accountable for what we two, we disagree with the idea of the position that greater reliability will achieve that. some of the discussion of

liability based on misperceptions. the rating agencies today like the accountants and officers may be held liable for securities fraud to the extent they make material stations or omissions beyond the existing laws that apply fundamentally. specifically credit ratings and opinions about future events and the likelihood he might need a credit obligation, strikes us as an unlined approach. congressman should have also considered consequences of imposing liability. mentioned extended competition might be inhibited from smaller agencies. all rating agencies also may be motivated to just try to provide the lowest security rating just to mitigate liability, which

doesn't encourage accuracy. i'm past my time. >> thanks very much, mr. joint. let me also tell you all your statements can be part of the record. if you would like to summarize them, that's certainly find. >> senators, thank you for inviting us to join you today. we're an investor page firm. pro proprietary software system. we use only financial statements, no market inputs, no analysts and no problems with issuers, bankers or advisers. our ratings far outperform the tra disal agencies in numerous cases, such as enron, delphi and others.

currently we are not an nrsro. we did not apply for the status and we don't have immediate plans to do so. there are too many mixed messages for the sec, treasury and congress for me to recommend that the designation is in their best interest. of course, the treasury's proposal, the requirement that all ratings firm must register is an unwelcomed development. we do believe that reform in the industry is necessary and must happen with a sense of urgency. we caution that if not done properly this reform may have counterproductive and unintended consequences. we also believe that disclose sure of the information is needed. rules that do not penalize small players are needed. an environment where the new innovate and the old can have behavior modified is needed. all should be primary goals of

legislation. legislation. the sec has been wrestling wit-

property detection. requiring subscriber based ratings agencies to disclose ratings actions can undermine the subscriber based business model, predicated on selling current and past ratings to investors. treasury proposal covers all types of rating agencies. that erects a major barrier for firms interfering with the rev new model. requiring registration of all companies issuing ratings is perhaps the most counterproductive initiative of all. investors will not have the inclination to look at all of these firms and will tend to remain with the providers they know best t the big three. further, registration would impose all the increased direct and incorrect costs on firms

that choose not to be an nrsro. this will stifle potential innovation and positive competition. so the treasury proposal would require firms to register, put at risk some firms intellectual property and all in all, regulatory protection is anything but a level playing field. can conflicts exist in other business models? sure, theoretically. has it distributed to any disasters? no. this red herring cannot drive new legislation. it's not the potential behavior of the describing agencies, rather the misbehaviors that

have already occurred. effective legislation must focus on the issuer-paid model and the most negative features. oversight of the nrsros that show the behavior. fostering or at least not inhibiting new players. methodology and innovation and equivalent disclosure of data used by issuer-paid agencies. for truer form to have a fighting chance these teams must be protected by the legislative frame work. we must be critically aware of how the consequences of poorly implemented regulations can leave us with a broken system that has proven it's not so deserving of protection. these should be fostered by those looking to return integrity to the issue. >> thank you very much. i take the opportunity that your

comment about registration of all rating agencies is the treasury proposal, it's not my proposal. just to clarify. >> fair enough. >> forgive me for my support. >> i'm honored, chairman reid, and fellow members of the committee to be back before the committee. i'm in the very embarrassing position of having to begin by commending and congratulating the chairman. what we're looking at in the treasury bill is 95% what was in the reid bill. the reid bill introduced in april was substantial, productive, well crafted. the problem is, there are dimensions to the whole area beyond simply administrative regulation. that's what the treasury bill particularly leaves out. thus because there is a short fall.

not all the provisions in the bill are in the treasury bill and because there needs to be a consideration of some issues beyond administrative regulation. i would have to say there's a short fall in the treasury regulation. i have to protect we will see a persistence of the status quo, dysfunctional and perverse as it is if all we do is what is in the treasury bill. in this regard i think there are two distinctive figures that have to be focused on. one, credit rating agencies do not perform due diligence. they go out and count the beans. credit rating agency give ratings based on hypothetical assumed facts unless you're getting hypothetical ratings. that has to be corrected. the credit rating agencies today do not face any meaningful risk

of liability. because as i look, i think the issuer pays model will persist and dominate. it's going to remain a built-in conflict of interest. then the other professions have found that the only thing that keeps the professional honest is the threat of litigation. the accountants have learned painfully how to steer a course between the client and integrity as one of the forces. therefore, based on that diagnosis, we have to encourage third-party due diligence. the treasury bill does this largely adopting many of your provisions. it does this by requiring disclosure when you decide to use a third party due diligence firm.

that raises the cost of a due party diligence firm. there will be many underwriters. it will simply opt not to use the third-party due diligence firm. they did in in the past. as the market grew public they dropped their use. they kept learning disquieting facts they didn't want to hear about. you can put in disclosure that says we're not using a due party diligence firm and hope that you can get away with this. how then should we deal with encouraging third-party due diligence? i would suggest we look at a different level of regulation. no one has been talking about regulating the users of the information. and the users now are closely regulated by rules that i think are over broad and ill conceived. let me give you an example.

rule 2a-7 tells money market funds they cannot by securities unless they are eligible securities. to be an eligible security you have to have a rating from an nrso rating agency. we could deregulate much of that. many of the users of information do want to rely on an nrsro. i made that clear to the sec. i think we should say to the extent you choose to rely on an nrsro rating, it has to be a rating based upon third party due diligence that verified the essential facts. that way we have something that's not a losery. it's not a hypothetical rating. because this rule already exists. i'm not proposing new rules. i'm poe poroposing making the existing rules meaningful. the point in doing this is by

focusing on the user. we are not regulating the rating agency. that allows us to sidestep arguable constitutional problems about whether we are overly regulating commercial speech. i don't think we are. we aren't doing it at if we say you only r only get the right to do this if you use one of these techniques and have good due diligence. my proposal is not to open the flood gates. it's really your proposal. i think we struck a sensible comp rromise compromise. it simply says your proposal and your bill in april paints a provision. if they give an opinion, a rating, without conducting due diligence or due diligence from the third party expert.

this does not subject them to liability, it just tells them there is uneasy safe strategy for avoiding liability, and that is to make sure the underwriter pays for and gives you a third party due diligence report that covers the critical facts in your model. this will not produce a rational litigation. this is another technique to get the critical core of due diligence back into the ratings process. thank you. i apologize for overstepping my tim time. >> thank you. >> mr. chairman, members of the committee. i'm a professor of economics at the nyu stern school of business. i was board member on federal home loan bank board. thank you for the opportunity to testify today on this important topic. i've appended to the statement for the committee a longer statement that i delivered at the securities and exchange commissions round table on the credit rating agencies on april

15, 2009, which i would like to have incorporated for the record into the statement that i'm presenting today. the three large rating agencies and their excessively optimistic ratings in the middle years of this decade clearly played a central role in the financial debacle of the past two years. given this context in history, it is understandable that there would be strong political sentiment as expressed in the obama proposals for more extensive regulations of the credit rating agencies in hopes of stalling future such debacles. the advocates want figuratively to grab the rating agencies by the lapels, to shake them, and shout, do a better job.

this urge for greater regulation is understandable. but it's quite harmful. the heightened regulation of the rating agencies is likely to discourage entry and discourage innovation in new ways of gathering and assessing information. new technologies. new methodologies. new models, including new business models. some soft which have been talked about early this morning. and it may not achieve the goal of inducing better ratings. ironically, it will also likely create a new protective barrier around the rating agencies. there is a better route. that route starts are the recognition that the centrality of the rating agencies was mandated by more than 70 years.

it goes back to the 1930s. of credential financial regulation of banks and other financial institutions. in essence, regulatory reliance on ratings. an outsourcing to the third-party credit rating agencies. for example, the prohibition. the third party judgments about the credit worthiness of bonds with the force of law. this problem was compounded when the sec created the category of nationally recognized rating organization, nrsro in 1975, and then the sec subsequently became a barrier to entry in the rating entrance. as in year of 2000 there were only three nrsros. it should thus come as no

surprise that when this literal handful of rating firms stumbled and stumbled badly in their excessively optimistic ratings of this subprime residential mortgage-backed securities, the consequences were quite serious. the recognition of the role of financial regulation enforcing the centrality of the major rating agencies then leads to an alternative prescription. eliminate the regulatory reliance on ratings. as senator bunning suggested earlier this morning. eliminate i eliminating their force of law. since the bond markets are primarily institutional markets as mentioned earlier today and not a retail securities market where retail customers do need more help, market forces can be

expected to work. in the detailed regulation proposed would be unnecessary. %b%',@ r @ @ @ @ @ rr

the bond innovation market would be open to innovation and new ideas in ways not possible since the 1930s. now, my longer statement goes into greater detail. since it was done before the obama administration's proposals were proposed, i just want to mention a few things about the proposals. i'll be very brief. >> thank you. >> it's understandable they want to do something, but i think the effort is going the wrong direction and the dangers are substantial. because they're going to raise barriers to entry, reduce the possibility of new ideas, something especially dangerous is something the that was

mentioned a few minutes ago that a requirement that all credit rating agencies, whether just an independent guy offering advice to a hedge fund or a fixed income analyst at a financial services firm must register as an nrsro strikes me as something to discourage entry, discourage the new ideas, and that can't be the direction we want to go. so let me just say again that the proposals are really wrong headed and that we really do have a superior route to go, which is a greater reliance on the market for information, which an constitutional bond market can use and use effectively. thank you for this opportunity. i'll be happy to answer any

questions. >> thank you. >> senator shelby and members of the committee. thank you for giving me this opportunity to talk about rating agency reforms. i'm a 1990 graduate of the harvard law school. barack obama was one year behind mef. what a difference a year makes. in 1997 i left in new york where i had been working in part on structured finance committees. i worked there for just over ten years. all that time in the cdo group. most of the proposals are well intentioned, but few seem likely to achieve reform. it must first present another rating financial crisis, and it must also restore investor confidence in the quality and reliability of credit ratings.

in my opinion the rating agency perform provisions of 2009 are not sufficient in themselves to accomplish either of these goals. however, the acts rule making authority could be used to expand their effectiveness. why are the reform provisions sufficient? first, they have not the product of a complete investigation into what happens at the rating agencies. without a proper investigation of what happened, not conducted on a theoretical level or in discussions with senior managers, but with the analysts who actually assigned the problem ratings in question, we cannot be sure the proposed legislation provides solutions designed to fix the problem. the best way to illustrate my second reason for questioning the sufficiency of the proposal is to ask a simple question. if the investor protection act of 2009 had been an act just as it is two years ago, do you think it would have prevented the subprime crisis? in my opinions the answer is no. it means they do not advance the

central policy goal of reform. preventing a future crisis. what reforms could achieve the goals? i have, you will not be surprised to hear, six proposals. i'm going to speak really fast or skip some. first, put a firewall around rating analysis. this is fine. but not enough. the agencies need to separate the rating business from rating analysis. investors need to believe that rating analysis generates a pure opinion about credit quality, not one even potentially influenced by business goals. even if business goals never corrupted a rating, it demands a rating analysis from bottom line analysis. investors should say they're kept safe by any agenda other than getting the answer right. and the best reform proposal will exclude business managers

from involvement in any aspect of rating analysis and also from any role in decisions about analyst pay, performance, or emotions. there's a reason why we don't want judges to have a stake in the matters before them. it's not just to make sure judges are fair. we do this so litigants have confidence in the system and trust its results. we do this even if some are all judges could decide cases fairly without such a rule. the same should be true for ratings. investors should have no cause. direct or indistrictly anyone involved. the same concerns arise with respect to annual bonus compensations and 401(k) compensations. as long as these forms of

compensation are base on how well the company performs and not limited to how well the analyst performs, there will always be doubt about how they align. third, create a remedy for unreasonably bad ratings. expand the liability of the agencies. i'm going to skip my discussion of that. change the anti-trust laws. when rating agencies compete over rating standards, everybody loses. giving them the capacity to get together to talk about rating standards may expand their ability to prevent the kind of problems that we had. imagine how different they could be today. my other proposals are to create an independence professional organization for rating analyst. yes. and also to introduce investor pay incentives into the issuer

paid frame work. neither of which i have time to discuss but are described in my statement. >> thank you. thank you all. it's been very i think informative panel. let me pose a question to all the panel members. i think i know dr. white's answer. the working group has recommended the statutes and rules to hold only securities with specific ratings should be eliminated overtime to clarify that reliance on a rating is not satisfied due diligence effort. secretary bards segtded this is an issue raised direct ly and they were going to walk through the statute. your reaction?

>> so this has come up in the hearings as well. my response there is the same today. it's held think to go back and look at the regulations individually. it would not be helpful to have a blanket dismissal of all uses of ratings and regulations. i've been around a long time. i think i can think of why the ratings were put into regulation. for positive and constructive reasons to limit risks and to use as handy benchmarks for other regulators and boards and other things. to not go back and look at them is a mistake. maybe update them. they don't necessarily all mean the same thing to all the same people. i still believe, though, that if ratings were eliminated, they will be often and frequently used by many investors, boards of directors, and investors. i believe they have value independent of whether they're forced to be used by regulation.

>> thank you. >> i think we're looking at moving the registration laces is a good idea. i agree they can't all be stripped out immediate by because that can be disruptive, but looked at in a methodical way expeditiously is a benefit. i think the plan calls for a 30-month review of this. that's probably a bit more time than anyone really needs to get started or at least to make a statement that this is something that -- this is a road we are marching down. i would point out that it's not just that there's a tendency for vin v investors to outsource their credit work. it presents an opportunity to arbitrage the system. a security that meets a certain standard by their regulatory oversight but has a higher yield as we saw during the crisis is something they can buy and will buy. it's beneficial to them.

it really has a handful of ways it can be complicated. but it's a good initiative. >> i was discussing this in my remarks. i gave you the example of rule 2-a7. they have to have an investment grade rating from an nrsro. i would change that. i would change that in the following way. i would not fully abolish the rule. we can't dare deregulate money market funds that came this close to failure last fall. there has to be some restriction. there you are. putting words in my mouth again. >> anyway. i would give institutional investors a choice. they could do it themselves woe will have our own prudent man to do the obligations when we do

that. or we can rely on a credit rating supported by due diligence so the critical facts have been verified by someone who is a professional. i know what will happen if given the choice. all of the smaller institutions would prefer to rely on the rating agency. when they proposed this, they nearly got assaulted with pitch forks by the community which said we don't want to take personal liability but they should have the choice. you do your own form of due diligence, which you have greater legal responsibility to do it yourself, or rely on those ratings, which are supported by legitimate verification. given that choice, i think they would be better off. it would encourage some competition. >> i think i know where you come down on the big issue.

let me pose a different question. if my time runs out we'll do a second round. i want to recognize ranking member shelby. there is an economic advantage, particularly with small entities that the treasurer of rhode island who wants to make an investment to have something shorthand. you know, aaa. and i would think that systemically and throughout the economy that the rating agencies have provided some value over time. it's not just a complete desert out there. just the issue of -- i think the approach is sequentially looking at where we can change. but a final point, even if we eliminate the requirements, the

presumption would be that issuers would still need the pay. and that given the choice most people would go to the rating agency. quick comment. >> thank you, senator. first, your larger issue. the larger question you asked. should we strip out the regulatory ratings, as my grandmother would have said from god's lip to your ear. now let me address the issue you just raise d when i advocate it can't be done overnight. you need notice, et cetera. also it would be replaced by placing the direct burden on the

bond manager at a bank, at a pension fund, at a money market@

okay. fine. but if you don't have the expertise to figure out who is a a reliable adviser and who is not, you shouldn't be running a bond fund in the first place. the regulatory powers should be used to remove somebody who is a regular adviser or not. this is an institutional market. it's not a retail market. >> thank you. i have a question. it will be the second round. thank you. thank you, gentleman. senator, shelby. >> thank you, mr. chairman rchlt mr. joint, one of the issues identified in last year's report on credit rating agencies was

that the growth in complexity of come flex products overwhelmed the rating agency. they sold in the financial markets does not out pace perhaps your firm's analytic capabilities in the way that the ceos see it. >> in today's market environment there's very little in the way of new instruments being issued. in some way we have time to reassess. some of the most complex instruments in the market. i think we took six months to analyze before deciding we could not put them in our highest ratings. that was a difficult process of analysts, modelers and

experienced people with judgment ratings have reflected the probability of the loss. some of them it's more important to think about the severity of the loss. ratings were not structured to address that. maybe they need to be. i would say we have a healthy degree of skepticism about the instruments. today we've been asked to recreate resecuritizations. we've only been willing to rate one class of security rather than trust securities. they're creating strips that if the possibility of loss is wrong you have will have great severity. so we're pausing and reassessing how we do the analysis and what the ratings mean. >> professor white, you pointed out that credit rating agencies include disclaimers telling

users not to rely on credit rating agencies in making investment decisions. the sec has directed money market funds not to rely solely, solely on ratings. by nationally recognized statistic call rating reorganizations. in making their investment decisions. does the fight that regulations require ratings send a signal to contradict the disclaimers. >> it sure sounds and looks like a contradiction to me. on one hand you have regulations to say, pay attention to the ratings. on the other hand you have the disclaimer quoted directly, s&p disclaimer. any user of the information contained herein should not rely on any credit rating or other opinion contained herein in making any investment decision. >> why do you want them, then? >> well, i don't know whether to

laugh or cry. that's why i would step away. don't rely if you want to voluntarily do so, fine. and you get to decide. you're in an institutional investor. you figure out who is the reliable provider of information, who is not. who has the business model you can trust. who, oh, i'm not so sure. that's something. >> professor, you have a comment on that? >> the way in which it is most likely to persist is if we deregulate the rules whachl will we get is most constitutional investors continuing to rely on nrsro ratings, fearing that's the safest to get sued. i think we should do simultaneously is give them more

options. let them do it themselves but to the extent they are relying on the alternative, we should upgrade by insisting on due diligence, so it's not a losery opinion. you give them more options, but they are higher quality options. >> professor white, mr. joint defends ratings as a common, independent risk benchmark that should be retained in regulations. did the failures call into question their values of benchmark? even the executives acknowledge they made mistakes. they've not been very food. quite honestly, i'm agnostic about the issue of business model. whether investor pay or issuer pay is the right model.

i think that's something that the institutional bond investor can figure out. it's important to remember the model was around for 30 years, from the early 1970s and really no major problems. >> what happened? along comes the market where there's only a handful of issuers. only a handful of nrsros they can go to. the money is very good. and they stumbled. they got careless. >> greed. >> greed was there all the time. there was concern of reputation before. somehow that got swamped. the model failed this time around. but it works for 30 years. i'm agnostic. this is something that

constitutional participants can figure out on their own to make sure at the end of the day they have safe and sound bond portfolios. >> is it possible that ratings for certain instruments such as more traditional bonds we talked about have a greater value of benchmarks than ratings provided for more complex products? >> oh, they are clearly simpler to rate. more transparent. the problems were fewer. certainly the history tells us they were better benchmarks. >> i have a question. you note the conclusion of ratings in regulations. it's given the big three a de

facto legal and statutory power over other financial institutions. you recommend that references be removed from regulation. we've been getting into this. do you leave the government's removal of ratings from the regulations would create greater due diligence? >> it absolutely will. just outside of the legal liability issue there will be the marketing issues and the investor reporting issues. the focus will come on them to understand better what types of credit work they're doing internally. disability to arbitrage the system would go away to some extent. there's no question that by imbedding the really -- the big dreams, but the nrsros in ratings in various regulations give them undue power.

over the investment decisions and risk management decisions. of the constitutional investor committee. >> how do we bring securitization back? how do we this? based on trust and maybe a period of time. it worked so well for so long. professor coffey, you have a comment? there's one rule i would suggest to you, it's that if it is too opaque to be understood, it shobt be issued. the narcotic will insist on that.

otherwise we will see the financing. >> there's no trust without it. >> there's know trust. everyone can see that no one understands this. >> senator shelby. thank you. >> thank you each of you for your testimony. i really think it's been most enlightening. each of you shed light on the issue. i really appreciate that. you probably deserve a badge of courage for showing up. thank you for that and thank you for taming time in your offices to walk through the issue with us. i know in a market economy this has affected you. a lot of employees have let the firm as a result just for less work. this is not a good time for rating agencies. i want to ask the question. if you listen, i think we were all sort of shocked that there

was no due diligence performed really. each person alluded to that in a different way. what is the value proposition that the credit agencies provide the public? the three large ones? >> so the dialogue on due jill jens, if we think about the rating agent thinks that recently started up, almost all of them are focused on corporate issuers. none are focused on structured finance. real point only. that's because disclosure of good information. able to do ratings and get investors to pay. they don't need special information. that's the process i think about as well. there should be enough public disclosure for many rating agencies and investors to use

the public information that should be reputable. so i see them as having the due diligence. the function to think forward about the risk of default and ramifications for investors and try to order that through the rating system and publish the research tells them the facts. i think the function which allows many investors that can't analyze the wide variety of financing that we can because we have a staff of 1900 people. shouldn't be the only thing investors should be looking at. one of the things we talked about in the office was the focus on the toxic asset issue. which has kind of come and gone. but how do you actually value?

that's where we spent most of our time. do you guys share with me that you could tell my zip code is what the default rates were going to be on all those kinds of things. moving away from the corporate side and looking at videos and these other instruments we're talking about. those kind of things were not done when you rated the particular securities. is that correct? >> for mortgage-backed securities that's the kind of analysis we would do. we go out and verify the individual loans in the package. looking at the history and frequency of defalls and severeties and problems we could do that as a part of the mode eling. the history is not representative of what is going to happen and subsequently happened. on these other assets it's hard

to understand what the value proposition is that you offer i@ not standing behind it like might be the case with a covered

bond. >> that's true. >> okay. but i don't think they're not -- it hasn't been my experience, although we've had quite bad experience, that some of our large and important financial institutions doing securitizations are not appreciative of the fact their name is on the securitization that they would have originated the product. so i think they are quite involved, and or be servicing the product. so i believe they have, not all firms, and some firms, have, of course, entirely disappeared. so they were doing quite a poor job and either didn't care about their reputation or just failed. >> mr. chairman, i'm going to ask one more question. >> okay. >> we're going to miss senator bunting in about a year and a half. i'm going to miss you. the whole issue, i think one of the things that we've talked about some in the past is the business model, and that is that

in the event you actually had to do due diligence and have these third party efforts take place, which, by the way, i think should have to. happen, if somebody's going to rely upon it, but in essence, it would really price you out of the market in a way, would it not. would you speak to that a little bit. if you had to really do due diligence and you had to really know what was in that package, you couldn't charge the fee that you now charge and make any money. and i think you alluded to that in our conversation, that that would be very problematic. >> well, we're not staffed in that way, to go audit or check every one of the loan packages that we've put together on every single family loan that would go into a financing, so we're not staffed that way at all. we're not staffed within the national network of auditors. or even a system of local auditors. that's certainly true. for cmbs, it's a little bit different, where we've been able to send analysts out to look at large properties, we're still

not conducting, very careful around this, due diligence around lawyers, because i'm not a lawyer, but we certainly conduct an amount of diligent investigation into what we're looking at for individual properties in commercial real estate. but for consumer assets, broadly spread, we've used a more actuarial approach assuming the facts in the files are correct. >> and everyone on the panel agrees that there should be no regulatory mandate to have to use, even a state government, city government, any type of government entity should not be mandated to have to have a rating to buy security. does everyone agree with that? everybody agrees with it. >> i think that there could be other options. >> but we should not build in having to use credit rating agencies and automatically causing people to believe that some work was actually done to due diligence wise.

>> i think we're, what some of us are saying is -- alternatives that didn't involve the use of an nrsor agency, but to the extent there already is this reputational capital, out there in the public's mind, and they're going to want you to have an nrsro rating, some of us wants to make that real and not illusory by insisting on due diligence. and that due diligence would probably be paid for by the underwriters. if the underwriters could get this market jump-started again, they would be happy to pay the cost of due diligence. >> thank you all, appreciate it. >> thank you, senator corker. senator bunting. >> thank you. five minutes turns into ten in a big hurry up here. since some of us have another meeting to go to, this is for anyone who would like to answer it. during the housing boom, the boom, rating agencies rated

mortgage-backed securities without verifying any of the information about the mortgages. if they had, maybe they would have detected some of the fraud and bad lending practices. do you think rating agencies should be required to verify the information provided to them by the issuer? and i'm going to give you a caveat. the first mortgage that i ever took, i had to take three of my federal tax returns in with me to verify that i had the income that i wrote on my application. you don't have to do any of those things right now, and i'm asking if you think we ought to have a little more verification

of what is on the list that the person who is looking for the mortgage at the time, and that's how we got into all this mischief with mortgage-backed securities being sold into the market without any verification. even though they were aaa rated. >> i would say you're right, senator. you probably wanted to hear that. you are right. and i have some charts in my statement that shows that the percentage of liar loans, no-document, low-document loans in subprime mortgages went from in the year 2001, about 28%, to the year 2006, about 51%. that's a very sharp jump and no one noticed, because no one really wanted to look. the loan originators had no interest, because they got rid of the entire loan. >> but the federal reserve was responsible for overseeing the

banks that made those loans. >> many of those loans -- >> and/or the mortgage brokers. we gave that power to the fed, and just because they didn't write any regulations, we ran into all this mischief. so the housing bubble and the bursting of it was caused by some not doing their homework. >> again, you're right, senator. >> well, i don't want to be right, because we're in a hell of a mess. if we were to require issuers to disclose information to all rating agencies, should that disclosure apply to securities that have already been rated so that we can get more opinions on the toxic securities already in the system? please. >> the short answer is yes. the percentage of new issues, particularly in the structured

business now is small to compared to what was -- >> what was. >> so back to your question of how do we get the market moving again, we have to provide to the market greater insight to what's already out there. and to just provide the detailed due diligence information and supporting information of structured products that come to market today is insufficient. and i would just add that one of the areas that gets short thrift when we discuss structured products is the collateralized loan obligation asset class. it is equally, if not more important than the cdos and other securitized structured products and the information availability is much smaller. and it is much more tightly controlled by the rating agencies that currently do rate those -- >> i only have five minutes, so i'm not trying to cut you off, but i want to ask, because do you think this is a question for anybody. do you think the rating agencies

should be able to be sued for errors in their ratings? >> because i'm probably the one most associated with saying there has to be some litigation remedy, let me say, i don't think it should go that far. i don't think there should be a cause of action for negligence. i don't think misjudgments should produce litigation. i think it should be for being reckless. and when you give a rating without knowing any facts at all, then it's reckless. >> well, then, that is a cause of -- >> but i think you went beyond that and said, should you just be sued because -- >> no, no. if you find negligence, then there is a cause of action. >> not under the federal securities laws, and i don't think we should try to increase anything in federal law that would cause a negative-based cause of action against the rating agencies. >> okay. how about this question? do you think issuers that relied on flawed ratings to sell their product should be able to be sued for using those flawed

ratings? >> i think they're going to be sued directly, because they made fraudulent misstatements. and that's how they are being sued. i don't think -- i think the plaintiffs barred with regard to the ratings agencies as a additional part to throw in, but they have very modest expectations of what they can get from them, and they haven't gotten any significant settlements. >> the question -- i'm over time. thank. >> if you want to take some more time? >> the only thing that i wanted to ask is that here we have a situation where they weren't given enough information or they didn't investigate far enough with the mortgage backed securities, and they accepted the fact that these were legitimate mortgage-backed securities by the banks, then i see where they wouldn't be held responsible. but if they didn't go into the details of what kind of mortgages they were selling or

were being sold, then i think they should be held responsible. >> and i think that's the line between negligence and recklessness. >> thank you. thank you very much. >> thank you, senator bunning. mr. froeby, again, thank you for your testimony, but also for your insights, because you actually were sort of there in the middle of this while at an opportune level, not at the top, not at the bottom, but right where the work was being done. you mention of your six proposals, you suggested the test and it's an interesting test that would it have hurt the problems we soar, and you suggested the proposals before us would not accomplish that. of those six, what's the most critical thing from your view we would have to or one or two that we would have to incorporate in our reforms? >> in some ways, the most important would be the hardest to implement. that is the idea that you separate analytical function from the management function. just as in the court system or at any university, you want your

professors, your judges to be independent of people who are sort of managing the process. at the rating agency, you want the analysis to be independent of the business decision. and i think that's probably the key. also, the most difficult. another really important one is affecting the way analysts are paid. i think analysts should not be -- their pay, their compensation, their reward should not have anything to do with how the company does. because the best answer from the analyst may impact company revenue negatively. that you may want -- you want to encourage them to give that negative answer, despite the impact it may have to their own financial situation. so those two are important. i think expanding liability is key. and finally, the one that is probably -- forgive me for saying it so informally -- the weirdest proposal is that the rating agencies be allowed to cooperate. if the rating agencies had gotten together five years ago

and said, we're not going to allow for the securitization of wire loans, if they had been able to get together and agree that they were all going to do that and they wouldn't feel undercut by their competitors, i think we would have seen much of this subprime crisis averted. so. >> thank you. professor, i just want to follow up and senator bunning's line of questioning about liability. as you pointed out, the standard for liability under the securities laws is essentially recklessness. it's a very high -- extreme recklessness. >> it's a very high threshold, as it should be. the proposal i've made is not to change that liability standard, but to change explicitly the pleading standard. and i wanted you to -- if that's your understanding, since you've looked at the legislation, since that's the case, and also the rationale is that until you get to discovery, it's awful hard to

understand what was done on a factual basis, and just your comments on that. >> i agree with what you're saying and i think it's a sound proposal. i also think that it will produce very few litigated losses for the credit rating agencies, because you give them, in your statute, a kind of safe harbor. if they get independent due diligence done by a professional, they are going to be safe. so it tells them, they can avoid litigation if they do what we want them to do, which is bring in due diligence. but everything you said is correct. >> let me, another point too. and i think it's important, because we specifically point out that their ratings would not be considered a forward-looking statement for purposes of section 21-e of the securities act. which is the same protection we give to accountants and et cetera. and that is, evening, important, because without that, they're a liability for projecting the

future. forecasting, would be,@@@@@ @ å i would think that the

accountants who have to certify would have a responsibility to, at this juncture, to do exactly what the rating agencies might be able to do, which is to go in there and say, my god, none of these loans are paying and we have to mark down this item. so two comments to that. >> well, let me say on the first point, which is the litigation question about the corporate issuer. i know a lot about this kind of litigation. those suits were originally brought as defamation suits, and they all lost. and that's where court started talking about the first amendment, because defamation triggers the first amendment. none of those suits have won at all. in the securities law area, there are other problems. the issuer didn't purchase or sell. it doesn't have 10b-5 standing, and the issuer didn't rely on this. it can't say it was misled by the rating. that is a phantom fear that issuers will be able to sue rating agencies.

but if you're concerned about it, you can expressly deal with that. >> mr. jones, a quick point about the accountant. maybe i'm imprecise in my analysis, but shouldn't they have the responsibility now, if it's a publicly traded, is the bank holding this mortgage-backed security and it's under water, don't they have to write it down or -- >> responsibilities of accountants are well beyond my expertise -- >> that's fair. >> and certainly have been well covered over the past years. i certainly understand the point and i certainly believe that the more information that's available, the more parties can be involved in opining. and that may extend and possibly should extend beyond those who are in, you know, these intermediary role and should extend all the way to the institutional investors who are making these decisions and buying these instruments. >> thank you. thank you, all. senator corker, you have a

question? >> yes, thank you all for your testimony. mr. joynt, back to you again. there's been some discussion about changing the compensation. by the way, i want you to know, i'm one of those that's slow to sort of mandate how we do those kind of things, but just going to the business model side of it, is that something that's farfetched, or do you think any of the credit rating agencies have thought, well, we'll take a bigger fee, but we'll take it over time based on performance. has any of that had any kind of serious discussion at all, at your company level, or to your knowledge, standard & poor's or others? >> so the best discussion about that, i think, was at the s.e.c. hearing and maybe in subsequent conversations where they're trying to think about a better or different payment model. it's very difficult for me and my firm to think about how we would adopt a second kind of payment or fee structure without having it coordinated with

others. so it would be quite problematic. you might not realize, but today when we rate structured finances, we don't take all the income in immediately, we defer a portion of the fee for the future to pay for surveillance, continuing surveillance. because if we're not rating any new issuances, we have analysts to follow the outstanding tractions. that could be changed into some kind of success fee or something. there are alternatives. i think that the s.e.c. continues to progress and try to think about what could be workable. >> so then, in answering the question that way, you actually would not be opposed to that being mandated by the government or the s.e.c., as long as everyone was doing it? >> i'm open to the dialogue about it. each time we've had a dialogue, there's been weaknesses in each one of the ideas. and of course, it could be quite a dramatic change in kind of profile for agency like fitch. so, for example, in the roulette

wheel alternative, if ten rating agencies decide they would like to rate structured financing, i guess each one would only get chosen one-tenth of the time. that's quite difference from today's business dynamic for our firm. so i think while we're open to the dialogue, i would have to at least consider how it would impact our business fortunes. >> professor coffee, when professor white and i have enjoyed your all's dialogue a great deal, but when he was talking about the particular bond manager assuming the liability, you were shaking your head in the opposite direction. his was shaking. and i just wondered if you wanted to respond to that? >> the change -- to an issuers pay model was the early 1970s. asset-backed securitizations don't really become significant before about 1990.

what was happening was that the big two back then, fitch really wasn't one of the big three at that point, really were break even marginal companies. and as the costs became more expensive. once we get the structure of finance, the cost could be as high as $750,000 to raid a very complicated structured finance offering, or at least that's the fee charged in a slightly competitive market. that's such a high cost that i don't think that could easily be dealt with under a user pay system. you can't put all that work in, hoping you'll get paid. that's why they've focused on structured bonds rather than this complex structured finance deal. but what i was disagreeing with is why the system broke down. it broke down well before structured finance. and quite frankly, every other gatekeeper you can think of, accountants, investment bankers, lawyers, they're paid by their client also.

it's got certain efficient qualities. >> so it was obviously magnified and multiplied with all of these complex securities, but when you say it broke down well before, expand on that a little bit. >> around 1972 or '3, moodies and standard & poor's started insisting that issuers, you pay them for the rating process. in the old days, moody's put out a book, moody's bible. and in the world we get into by the '70s, that's a very slow process of publishing a book and there's what the economists would call a public goods problem here or a free rider problem. if you sell just one copy of the book, 10,000 people can read it and they gain the same information. so you had to find some way that you could force people to subscribe to you and the marketplace didn't react well to insisting upon you pay a subscription fee. >> yet, you've said you know that's not going to change. >> i think the issuer pays model, which is the model we

move to in the 1970s will be the predominant model, as far forward as i can see. i certainly wish to encourage user pays. i think they are a very important check and balance on the system. but i think they'll primarily be a check and balance on the system and most of the business will be done under an issuer pays business model. >> yes, sir? >> i would just like to point out that if you look at the newer agencies or firms, be they nrsos or not, they are almost entirely subscription-based or user-based businesses. no one else is coming into the market and saying, let's start up a new issuer pay. and the reason for that is that the market share is so unbelievably tightly held by three players. so for competitive reasons, for all of the regulatory reasons that we've already discussed, breaking into that business as a new player is a relatively futile effort. but i would just add to professor coffee's comments that

one of the reasons that we start out as a firm like us, like rapid ratings starts out rating individual corporations is, yes, they are simpler than trying to rate structured products, but the availability of information is completely different. we rate entirely based on disclosed publicly available financial information for public companies and private companies, they are the -- the data that is provided to us by our customers under contract and confidentiality agreement with full understanding on a bilateral basis that we are not conducting due diligence for them, but if they are a bank that has a lending relationship, they supply that information. if it's a corporation that has a counterparty risk relationship, they're receiving that information. they supply it to us. it's about availability of information. so new competitors, regardless of the revenue model, are not going to break into with a couple of very small exceptions, the real point happens to be one of them, going so break into the

structured business when the payment, as professor coffee just mentioned, needs to be a front-loaded payment and the information is simply not being shared. >> i appreciate your comments earlier about the unintended consequences of making everyone register. i think that was a valuable contribution. but let's move down that path just a little bit, the one you're on. and we visited the offices of second market and i know that they're setting up sort of a public option process for securities and they're doing a great job and being very successful, and i hope they are, because they've come up with a brilliant idea. at the same time, as i looked at what they were disclosing on some of these, as you just mentioned, there's not as much information as one would like. i've read op-eds recently where disclosure on these ought to be broadly given. if that was the case, are you saying that an entity like yours

actually would rate many of these more complex securities. i find that's a lot of work for, you know, the millions of these securities being offered. is that something you would pursue? >> i'm saying we would have the choice. that would be a business choice we would have and we would make it as we make any other business choice. there are other independent, non-nrso research firms that are staffed, not in an analytical, quantitative way that we are, but staffed with enough people to be able to execute that type of analysis. not on all structured products, of course, but on individual asset class by asset class and clos being one of them and being able to provide an extremely good alternative, despite the fact that not all of us would be staffed and certainly would be able to say, day one, we'll go ahead and get into the market to do all of -- to wholesale, get into the structured product rating business.

>>ed up to mention something? >> i just wanted to say, you can combine investor pay and issue pay. and you would do it by giving the investors the opportunity to pick which agency an issuer uses. it's the power of the issuer to decide who would rate that became the source of, i think, the big problems in the last few years. they could pit the agencies against each other. and if you just take that power away from them, much of the problem is solved. combine the two. it can be done. i don't think it would be insurmountable. >> mr. chairman, thank you, and each of you, one of the great privileges we have here is to hear from intelligent people like you often and we thank you very much. >> appreciate it. >> thank you, senator corker. gentleman, thank you for your excellent testimony. my colleagues may have additional questions and i would ask them to submit them by august 12th and ask you to respond as quickly as you can. all statements of my colleagues will be made part of the record and your statements will be made fully part of the record. thank you very much and the hearing is adjourned.

market's instrument, as long as it is a debt instrument they want to be paid and they know that if a financial institutions gets in trouble, that debt will be converted into equity, a buffer against loss and they would be subject to loss. so i think that market discipline has a number of different and -- avenues we should pursue. and market discipline itself should be pursued along side of some of the regulatory mechanisms. if i could, you know, i was not at the federal reserve up until a few months ago. and as i have said repeatedly, i do believe there is plenty of blame to go around everywhere. but i don't honestly think all

roads lead to the feds. >> which don't leave it to the fed? >> i would say, senator, bear stearns, aig, lehman brothers, fannie and freddie. there were a lot of problems in this system, and as i said earlier, i think before this crisis is over we will have seen a lot of failures in a lot of kinds of institutions. i don't say that to try to reflect -- reflect responsibility. i think part of what i was trying to say and my prepared remarks and my introduction remarks was that i, and i think everybody on the board, take seriously where things did not get regulated as well as they should have and where the structure needs work. that is why we started to make the changes we are already making. the images for the record, and we all know this, but who is -- >> just for the record, and we all know this, who is the regulator? in know it is the federal

reserve. you are now a member of the board of governors. let's be honest. >> absolutely true, senator. in some cases the bank is regulated by of the regulatory agencies, -- >> but the primary regulator -- >> of the holding company -- >> is the federal reserve. i don't have much time. i want to pick up on a couple of things. today's "the wall street journal" had a tough article dealing with secretary geithner when he met a bunch of you where he told the financial regulators that they should stop -- could you imagine the gall here -- that they should stop criticizing the obama administration is a redwood to reform plan. my gosh. i hope you won't quit. i think your honesty and your candor here is very important. and we recognize the role of the treasury to set policy for financial regulation, but ultimately it is going to be the congress.

this committee, both sides of the aisle, and the house, it's going to set the tone and create the laws. i appreciate you bringing this independent perspective with all kinds of pressure placed on you. does the testimony that you have given here today, that you provided, is that your own views, such as it was, not any way influenced by secretary geithner's tirade against the other day? serious question. >> who are you asking the question of? >> asking all of you. >> congress requires and prohibits the treasury department from intervening in any legislative -- expressed to this committee. we did not clear our statements to the treasury department and we take that independent function very, very seriously. >> sheila? >> yes, i don't think anybody thinks we are not independent.

>> we hope -- >> at some of the, senator. the only people i discuss this with our my fellow members of the board and staff at the federal reserve. >> senator shall become i think our testimony speaks for self -- yes, we are independent. >> thank you very much. >> a little surprised by senator richard shelby's question considering the positions you have all taken. let me look at this and kind of a different way. the public has a general understanding that the investing public and the victims of this financial disaster -- as a general understanding of the regulation of financial institutions, putting it mildly, fell far short. somehow the belief that the most egregious institutions found an agency that was too easy on them, and washington, we call it regulators shopping.

they just think that the government for whatever reason is too easy on wall street agreed. @@@@@@%rr are financial institutions, rigor-matory system, and an administration that i think has equally smart people that understand this, why is there not -- how do you explain in understandable terms if you are talking directly to the american people now and not to this

committee, what we should do to fill those gaps so that these kinds of egregious and awful things don't happen again? starting with you. then i think there was arbitrage -- >> i think there was arbitrage, but between the bank and non- bank sectors, other vehicles vs. higher leverage the misplaced capital requirements for commercial banks. on consumer protection it was third-party mortgagor regulate -- originators, not affiliated -- original loans being funded by wall street funding vehicles. pretty much outside any type of prudential or consumer protection standards that are within the purview of the banking regulators. so i think it is unfortunate the word bank is used for just about everybody. my role -- bank as an fdic- insured institution, and, listen, we all make mistakes but the insured bonds apart institution, that sector has held up pretty well. this is why you saw in december so many fleeing to become bank

holding companies and trying to grow their insured institutions because that was the sector that was left standing. which is hard for us, because our exposure has increased significantly, we have tried to do the things we need to do to stabilize the system, but in this increased our exposure significantly. so i think that testified before, the arbitrage between the banks and non-banks and have a consumer agency with a focus especially on examination of non-banks sector and system risk council that we have the authority to define system issues or systemic institutions whether or not a voluntary one to come in under the more stringent regulatory regimes we have four banks and bank holding companies, that they should be told they need to do that. so i do think of are the charts between the banks and nonbanks sector, not between individual different types of bank charters and certainly not between the choice of state of the federal charter, of 8000 community banks of the country, most do have a state charter, we regulate about 5000 of them.

i don't think they really contributed to this but -- you have seen additional assistance community banks -- to read what rick and television for fear of franklin, which right here come inevitably there would be a regulatory the point that would be dominated by the large institutions, london together. there is a valid reason for state charters. community banks from a state charter community banks tended be more local and their interest in how they conduct their lending. so i think to try to draw that issue in to the much larger problems we have with arbitrage between banks and non-banks and a lack of regulation of derivatives i think is misguided and it is not where we should be focusing efforts on what the american public should focus effort. >> your thoughts? >> i agree with everything shall bear just said and to point out we also regulate about a quarter of the nation's community banks, all different sizes of institutions. most of the problems did not take place inside of the

insurance depository institutions that we supervise, which are the most extensively regulated parts of the system. and, of course, we did make some mistakes and the were some problems. we are not discounting that. that is not where most of the more. the second thing i would say, i think there are a number of very sound and strong proposal in the administration's reform proposals which i do support, as i testified, just some places where we think it should be shaped differently. and carrying out our duty to provide our views independently, that is what we are trying to suggest. with cfts, we agreed to have a strong federal consumer protection rules writer to set a single set of rules that applies to everybody. a very powerful change. but we think taking that same step and applying it to enforcement and examination of financial and depository institutions to do that should stay with the bank regulators where it works well and it is that all of that effort should go, on examination, enforcement

and implementation side, to the non-banking sector where there really were very substantial problems that have way disproportionately higher levels of foreclosures, for example, in your state and many of the stage for prevented in this room. >> thank you. >> thank you, senator. i think, if you are asking what the public should be focused on, my suggestion would be, too big to fail. that is not the only problem, by a long shot, but to me it continues to be the central problem, the ability to avoid the moral hazard that comes with too big to fail institutions. as i said a moment ago, i think we need a variety of supervisor and regulatory tools to contain that problem, whether it is resolution, bringing systemically important institutions into the perimeter of regulation, making sure the kinds of capital and liquidity requirements that systemically important institutions have will truly contain on toward risk-

taking. i think we are going to need a broad set of activities, but too big to fail was at the center, not the only cause, but what at the center of the crisis, and that is what i think we all need to focus on. the only other thing i would say quickly, it harks back to a colloquy you and i had a couple of weeks ago when i was testifying, when you and i were talking but attitudes and orientation and how people in the congress and regulatory agencies and the administration think about issues and problems. it is not easy to insure against people losing interest in issues. but i think that is a role that in a system of government that has a lot of checks and balances, we have to think about. how do we try to institutionalize skepticism, institutionalize critical thinking, to look at developments in the financial world so that we don't just say that is just a market development, it must be benign,

but instead being able to distinguish it intelligently between the nine, useful innovation and one hand and building problems on the other. >> thank you. >> thank you, sir. one of the advantages of a panel on this, you get to agree and dispel the notion that we disagree on some anythings. i agree with my colleagues. but i would also like to focus on our veterans position between banks and nonbanks. the cftc provision goes along ways toward dealing with it -- cfta. you don't get to sell a product at a non-regulated entity under different terms of conditions from a different regulatory structure that you would and depository institutions or otherwise related entity. i think that is one of the critical components of the administration's proposal, to fix that gap. >> thank you. to recommend mr. chairman. >> senator corker. >> thank you for your testimony. i also, like most people did, read the story this morning in

"the wall street journal" regarding the meeting on friday, and generally speaking, did it captured the essence of the attitude? >> you take that one. [laughter] >> very briefly, i just -- want to move on. >> it was a candid conversation about the institutions, our agencies different views on the subjects. >> generally fair article? >> a lot of it was true. >> ok -- [laughter] i guess what i would like to get at is it is my understanding that the original draft had the national banking supervisor not being actually a part of treasury. i think we have seen today -- and we have known for some time -- treasury can exercise -- tried to exercise influence over

organizations and my understanding is in the beginning, the banking supervisor was not a part of treasury. at the last minute it was put back in. i just wonder if one of the things we ought to be looking at is absolutely ensuring that this banking supervisor -- even more independent than has been laid out. very briefly. >> may i respond to that? >> adulate this may surprise you, but i was a strong advocate of keeping it within the treasury but subject to the same fire walls we have now, which dose -- does give the agency is strong ability to operate independently. i believe creating a new board, if you have three other regulators still in existence and everyone has forced them i'd think it will confuse things. it is critical, however, you do have the statutory fire walls. that is a position that i actually advocated for.

>> any different opinions in the panel? >> as an independent agency, i think the types of supervisory functions that occ and ots perform, and will look at them in terms of the front line prevent -- prudential supervision of the banks we ensure. i think there are some merits making it independent. i think you do want to make sure it is as and solid as possible for an nea -- from any type of influences -- as insulated as possible for any influences. >> i think i have actually been very supportive of our chairman of the federal reserve. yet at the same time there is no doubt the federal reserve had some failing in this last go around. i read your 2005 federal reserve

system purposes and function document. it actually does, for what it's worth a mistake that one of your responsibilities as maintaining the stability of the financial system and containing systemic risk that may arise in financial markets and providing financial services to depository institutions. so i think it is fair to say that in essence you sort of did have responsibility there, and i am wondering how harboring all of that at the federal reserve would not alter, if you will, be a bit. i think all of us understand today that we need to be more concerned about systemic risk. i am sure the fed does, too. and i say this with respect to the organization. but obviously with concerns. i am just wondering what would be different if in fact the fed was a system of regulator, the system of regulator? >> first off, senator, i don't

think there are any proposals on the table that would really make the fed a systemic risk regulator in a sense to be able to swoop in anywhere and anytime saying we need to do something about this. the proposal that we endorsed was making the federal reserve the consolidated supervisor of systemically important institutions. i would say in direct response to your question, there is certainly a responsibility there. and i would certainly be the first to say that responsibilities at all the financial regulators, including the fed had, were not exercise as effectively as they ought to have been. but i would also say that when you give an entity responsibility, you do have to make sure you give it authority to achieve that responsibility to fulfil it and you have the mechanisms that would allow it to do the job. and when you have a circumstance in which large institutions

which turned out to be systemically important, i think, in some cases come to the surprise of many, were not within the perimeter of regulation, it was obviously not going to be an easy matter to contain the activities of those institutions, including a lot of the wholesale funding and a lot of the very tightly wound approach to securitization, that was a major contributor to these problems. so, i guess i would say, first, need to make sure that the appropriate authorities are present. second, as i have often said, there needs to be a real orientation of our regulatory approach more generally -- and i mean the system. and, third, the federal reserve i think needs to take more advantage of the comparative abilities that it has. that is why we wanted to move forward, to make use of the economic and financial expertise to provide a monitoring of and a

check upon the on-the-ground supervisors. that is where the advantages lie and that is where you bring together. >> one last question. i know there is differing thoughts on too big to fail, but each of you feels that it is a big issue. i know i would like to see a resolution mechanism in place, much like chairman bair proposes. mr. dugan, i don't understand how, if you continue to give treasury the ability to solve the problem with taxpayer money, if they deem it an important thing to do, i don't understand how it creates any market discipline. it seems to me leaving that they got line in place defeats all market discipline. i don't understand how you can cause those to measure up or how

we can craft something that actually worked and calls people like the senator of ohio posset constituents and mine, which i think are different in thinking about some things, i@@r government was involved. people can second-best some of the judgments, but i really do not think it is a good idea to

completely forbid the ability to address system and situations and crises of we have to. -- systemic situations and crises. >> thank you all for your testimony. i gather from the panel that, in fact, there is a sense that the un may be what the administration is promoting, which is merging ots into the occ, there isn't a view that there should be further regulatory consolidation. my question is, if we don't do that, then there still seems to be the opportunity for regulatory arbitrage. weather regulated companies would choose what they believe to be the most -- regulator. so what mechanisms can we put in place to prevent that, to prevent the shopping? for example, the administration's restrictions that are proposed on the ability of a troubled bank to

switch charters -- is that enough by themselves to prevent regulatory arbitrage that we want? i would like to hear some of your ideas. >> senator, i will start, if it's ok. i think first of congress has provided some mechanisms to contain regulatory arbitrage. a lot of restrictions that apply to national banks are made by congress to apply to state banks if they are going to get federal deposit insurance. that is an important backdrop, number one. number two, the provision you referred to i think is an important one, it is one in which the agencies have already tried to act. actually i was going to tell the chairman this, there was a break in the hearing in march where chairman bair turned to me and said we have to figure out a way to do something about entities

trying to get different charters when they see enforcement action coming. launched -- to have agencies all reaffirm this charter converting ought not to happen unless it is a signed institution and unless you don't have the enforcement kind of actions pending and you ought not to be will to use it to avoid supervisory ratings. a couple of instances of institutions shifting charters over the last few years has become reasonably well known, and engaged sort of flight from enforcement. so i think this was a very important gap to plug. >> anything else? >> i think it is very important. we have seen over the years a number of institutions come in number of situations in which people have switched charters to avoid supervisory actions. anatoly support the action we have taken. if we wanted to go forward and put some things in legislative

language, i think that might be very good idea. just make sure we don't change in the future. >> i would agree. and we indicated and are written testimony. we are the insurer -- so once the insurance is granted if the entity decides to leadership we really don't have a role in that. we particularly feel it is in our interest to make sure we want good strong -- prudential supervision and we don't want charter convergence to undermine the process. we would also have to work with you, and the center and i had a conversation about that, putting some of like that in the statute. >> i joined senator reid and that effort. >> senator addendas -- senator menendez, could i address the question? from one of the charter's acting being used as an example as an arbor try opportunity -- arbitrage opportunity is countrywide moving from the fed to regulation by ots did this

was march of 2007. in doing so, countrywide brought approximately $92 billion of assets to the ots. we undertook extensive investigation by the fed, including fed bank of san francisco and others as well as state regulators within the fed's holding company jurisdiction. granted the charter to countrywide. one of the things that seemed to be lost in the discussion is that the three months or four months before countrywide came before ots, citibank took two historic thrift charters totaling $322 billion of assets to the national bank charter from the federal thrift charter shortly after countrywide came, capital one took approximately $17 billion in assets from a thrift charter to the occ. i would suggest that the mere action of an entity, a business entity, choosing to chains -- change its charter on its business plan in and of itself

does not necessarily suggest they are fleeing. i just wanted to make -- >> i appreciate that. let me ask a question. several big banks have come here and argue before the committee that we shouldn't have a consumer financial protection agency because it is dead to separate safety and soundness regulations from consumer protection regulations. but that argument, at least to me, doesn't make much sense because safety and soundness regulations and consumer protection regulations are currently together in the same agencies. and that very system failed miserably to protect middleclass american consumers. .

>> the fdic and the acc have no power to write consumer rules. we examine and enforce, so that has been separated already. i think the bank regulators -- i don't want to speak for others, but the bank regulators are generally supportive of this. the choice was between being a bank or a non-bank, and being a mortgage broker with little regulation, you could original laws without anybody looking over your shoulder. aggressively marketing these teaser rate to 28's and 327's. the agency, this new agency, is providing rules across the board for banks and non-banks, and i think, as we have all testified, that keeping the examination enforcement function with the

bank regulators for the banks and having this new agency focus its examination enforcement resources on the non-bank sector, where there is not much oversight at this point, i think would give the consumers across the board, whether they are dealing with the bank or non-banks, some base level of protection, and the right to the making sure that those rules are enforced and adhered to. does that answer your question? >> to you want to get in? >> i agree completely with everything sheila just said. we have examples of a number of ways in which integrated safety and soundness and consumer protection supervision of supervisors has brought together problem -- race and found issues for both safety and soundness purposes and consumer protection purposes that otherwise would not have been found under the current system. we believe -- that the believe

the examination and supervision function in place -- examiners are good looking and rules that are written, and to the extent that a new agency writes strong rules, they will be complied with by banks with this function better than any other alternative model. >> my understanding from the panel is that you are all in support of the consumer financial protection agency? >>, senator, that is not true. the federal reserve has not taken a position one way or the other. >> are you going to take a position? >> i would not anticipate it. we were specifically asked, i guess we would at least discuss it among ourselves. i think our effort at this point has been to point out the virtues of integrated supervision and regulation of consumer products, along side of the obvious virtues of a separate agency. >> thank you, senator menendez. as senator bunning.

>> thank you, mr. chairman. i am happy to see all of you today. after you kiss the ring of the secretary of the treasury, you finally got out of the room, and you are tear in person to testify -- you are here in person to testify, independently. that is nice to see that. mr. tarlow c-span.or-- tarull.oi want go back to something you said earlier. he said the fed wants the authority and power to enforce. we gave you that 14 years ago, more than 14 years ago, actually. it is 15 or 16 years ago. and you did not write a regulation for 14 years to govern the banks that were under your control. or the mortgage brokers that were under your control. i know you're not at the fed. that is not a problem.

the problem is that the fed had the ability to act and did not. so you might understand some of us not being agreeable to giving you more power when you failed in enforcing the power we gave you. for your information, you can take it back to a chairman bernanke and the rest of the board and say, "it took you, mr. bernanke, two years after you became chairmen to write a regulation on mortgages, and it took chairman greenspan 12 years not to write in, so we are a little reluctant to give at the fed knew additional authority." i just happen to agree with chairman bair on when the rubber hits the road, they are there to

make something happen. now, our panel is trying to figure out how to stop the robber hitting the road -- in other words, to prevent systemic risk from becoming too big to fail. that seems to be the major problem. senator worker brought it up earlier today -- senator corker brought up earlier today, about we really need ideas, because we seem to have failed by not giving the authority to the right person, or the right person not in forcing the authority we gave them. my question to you is what additional authority to you think we should give the fed? >> senators, as you know, i agree, personally, not a board position, with you that the fed

to too long to use its existing authority to enact the consumer protection associated with mortgages. i was referring a few moments ago, and i will allow the rate on and now -- i will elaborate on now, to provide the authority to any systemic institution. as you know, a year and a half ago, that statement would have, in practical terms, it meant that a whole set of institutions -- the five freestanding investment banks -- would likely have been brought in by law to the consolidated supervisory situation. because of the financial crisis, and the fact that a couple of those institutions are no longer with us, and that others have become a bank holding companies, the immediate practical importance of the authority would not be as great

as it would have been a year and half or two years ago. there is the possibility that an institution that has become a bank holding company in the middle of a crisis, in order to get the interim writer -- impr imatur, would decide it is not like being a supervised entity and would -- >> we could prevent that. >> absolutely. and secondly, in the future, if other institutions grow or activities migrate from the regulated sector to other institutions, we would want and make sure that any institution which itself becomes systemically important would also be subject to consolidated supervision. that is what i've is referring to earlier. >> sheila, could you expand on the ability of the fdic to

preempt -- in other words, to get in front of the foreclosure or the shutting down of -- in other words, looking prior to with your regulatory regime into banks that you have under the fdic jurisdiction? in other words, preventing. >> preventing, exactly, and we all have things we wish we had done differently but i think congress did the fdic helpful new tools that were finalized in early 2006 to make risk-based adjustments to our premiums every charged for deposit insurance, because at least for insured depository institutions, this helps us provide economic disincentives to high-risk behavior, and this is a tool we have been learning and use it and will continue to refine, but it has been helpful, i think. the big problem -- the

shortcoming we have found is that when these larger entities get into trouble, sorr)rr$ securities and exchange commission -- into the securities and exchange commission have some kind of ability to examine all of the aspects of that institution?

i'm looking at aig, for instance. >> i think that generally it is the holding company -- >> correct, it is the holding company. >> i think the sec's regime is not on prudential supervision but investor protection, and it is a transparency regime. they do not do safety and soundness overside -- oversight of listed companies. >> thank you. >> senator tester. >> thank you, mr. chairman, and thank you, panelists for being here today. i think we all agree that the gaps exist. i think we all agree that we still have not sealed those gaps up. and so, i guess, referring to the testimony from a gentleman on the second battle -- panel,

he writes and recommends creating a world-class financial insufficient specific regulator at the federal level -- financial institution and specific read a letter at the federal level. quite close to what i have in mind. you guys have someone addressed this in some of your other questions, but going back to what senator menendez asked in that he wanted to know if it could be laid out to seal these gaps by rulemaking or some other method, i am not sure i got an answer to that question i want you to share your thoughts as concisely as possible, because each one of you could burn for minutes at 50 seconds with one answer if you wanted, as to why this significant reform in this direction is not the direction to go.

taking off your hat, as individual department leaders, because turf does not play a role -- if someone says i will disarm your farm, i would be upset about it -- but how would we get these gaps closed without something like this? go ahead, sheila, and we will go down the line. >> i think the charter choice, if you will, was between being a bank are not being a bank, and being much less regulated in the non-banking this year. that is the arbitrage that need to be addressed. >> and what you're saying is that that cannot be addressed with one? >> no, it could not, because you'd be consolidating what we do with the depository institutions, but it would not expand beyond the heavily regulated -- -- >> could it? >> for things systemic in

nature, you could do it with this risk council, some ability to look across systems and a dubose credential requirements regarding capital and leveraged to mitigate systemic risk. that would be across all sectors, not just for banks. >> senator, i do believe you could do more streamlining, move more down in the direction you are talking about. we do not have an ideal system. but as you move down, there are issues you have to confront. if you want to have an effective deposit insurance corp., if you go for a long time without having any bank failures, they will not have a lot to do, and will know the system very well if they do not supervise banks. likewise, the federal reserve has some things to offer to the supervision, particularly the very largest institutions at the holding company level that are engaged in a lot of nonbanking activities, and to think that a banking supervisor would do all

that as well without having a benefit raises questions. >> senator, i would say, trying to be succinct, that the most important gaps to fill it is making sure that every systemically important institution comes under the barometer of regulation, and secondly, what we were discussing earlier, which is to say that the assurance that there be charter convergence motivated by efforts to escape enforcement and bad ratings, and just be clear, it would be a perfectly good idea for the congress to legislate on that matter so that in the unlikely event that our successors did not share the same view, that they could not go in the opposite direction back to any situation which charter conversions could be done for the wrong route reasons. >> i understand that, but what you're saying that is that a world class institution, a specific regulator, could work?

>> i actually think that, as sheila suggested earlier in the hearing, that what we have learned in this crisis is that there were a lot of different models of supervision and regulation around the world. none of them performed particularly well. that seems to me more of a lesson in than anything about a particular structure or anything else. none of them performed particularly well. >> i would pick up on the point that your concept is a world- class financial institutions a regulator. one of the lessons that we have learned, and sheila has mentioned it a couple of times, is that we have banks and non- banks, providing the same kinds of services in a different structure. if you are a financial institution, you have world class regulators, currently. if you don't, you are operating in a less than regulated or unregulated requirement for it if you wanted to close that gap, there is a process by which you can do that, starting with the cfpa, the administration's

proposal. the difficulty is how that is carried out. we suggest as bank regulators that we can do it more effectively. but that is the start. you have to start looking at things like capital requirements, capital structure, for those who are not financial institutions. >> ok, currently, have made any progress -- have we made any progress, and not necessarily -- we as a general group -- toward regulation of derivatives and credit default swaps and those sorts of things? are we in the same boat as a year ago? >> i would say that we are. >> everybody agree with that? >> yes, and that requires legislation to fix. >> are we concerned about that? >> yes. i think it's huge. >> mr. chairman, have you gotten

recommendations from these folks are anyone else on how to deal with these? >> we are working on legislation that comprehensively deals with this, and hopefully we can do that and come back in the fall but that is the purpose of these hearings, to bring these ideas together. >> as anybody given concrete ideas -- >> written -- there have been all sorts of recommendations made. i will say, jon, that senator reed and senator bunning are working and an idea -- and number of our colleagues are working on various ideas to be part of a larger bill. >> i think it is someone could read it is somewhat distressing that, quite frankly, from my perspective, and i'm not an expert in this field at all, we have a lot of people trying to do good work, but there are still gaps, obvious gaps, and then at the banking level we have a myriad regulators out

there and if i were a banker, i would be going crazy. i really would not know which person to be knowing who i have to deal with -- let's just put it that way. and then if you take into consideration -- sheila, i think he said that community banks were not really a problem, but they are getting pressed as hard as anybody, as far as regulation goes. i think this is an opportune time, in the middle of a potential -- not a potential -- middle of a crisis to take a look at our regulation system and say let's simplify it. let's make it lean and mean and simplify it. i don't think that can happen unless we are willing to think outside the box and do things differently than we've done in the past. thank you all for being here. >> thank you very much. senator vitter. >> ms. bair, i wanted to ask you

a few things that are a little off topic, but are important, and that has to do with the recent actions of the financial accounting standards board with regard to bringing certain things up at an off balance sheet, on balance sheet, and what impact the will have on institutions. how will fdic to the consolidation of previously off balance sheets entities, and in particular, will the agency require additional capital for assets brought on balance sheet? >> well, yes, banks must follow u.s. gap, so if those of the accounting rules, the capital -- more assets are coming on balance sheet, then capital levels will be impacted accordingly. we still have concerns about the timing of all of this. we support the general direction of bringing this all back on balance sheet. but the timing still dismiss some heartburn, whether they

need to be on this accelerated -- still gives me some heartburn, whether they need to be on this accelerated from work. the rules written now, as i understand, even if he retains some portion of interest, the whole securitization might have to come back on balance sheet, and keeping people having some skin in the game. i think there are a lot of issues and questions about the timing, but we cannot control that. we cannot file letters and that is about it. but banks must follow u.s. gap. >> of the capital ratios set in law -- >> yes, they are set by statute. there is not a lot of flexibility there. >> not flexibility for phasing? >> not very much at all, no. >> senator, i think that traditionally, the leverage ratio follows gap completely.

there can be variations, and at times, it has been more restrictive than cap. there is some flexibility to look at this and phase it in at some time. that is an issue that i think all the regulators are looking at now to address, try to address some of the issues the chairman just raised. but i think that the bottom line is that this stuff is going back on the balance sheet and banks will have to hold capital against it. it is a matter of timing and how it gets things done. >> i don't think anybody is arguing about the fundamental issue, but i am concerned with timing and facing, because it could have negative consequences if we are here tomorrow overnight. what is the current thinking about how that should be handled? >> i think the regulators are still discussing how this affects regulatory capital. at the accounting rule becomes effective at the end of this year. beginning of next year. and how the regulatory capital rules respond to that is

something that we are discussing and providing some notice to the public shortly. >> when do you think there will be fairly clear guidance for institutions about what to expect and what time table and what facing, if you will? >> if i had to guess, and this is an interagency process, i would say weeks, not months. >> and i assume all the agencies and regulators involved are in discussions about this? >> it is an interagency role as cap requirements like this always are. it is a discussion among the agencies. >> does anybody else have comments about that? ok, that is all i have. >> senator reed. >> since countrywide was brought up, i want to make sure i have some facts right. it started off with the national

bank subsidiary. you regulated the bank, mr. dugan, and the fed regulated the holding company? under your policy in case law, the subsidiary of the affiliated mortgage company was not subject to california law? >> so we regulated the bank, and it did a portion of its business inside the bank. it did all of the subprime lending outside the bank, not in the subsidiary bank. >> it was subject to california law? >> but the bank itself was not subject to california law, and it is also where they did not do their subprime lending that caused them a number of problems. >> prime lending it was an entity that was subject to california -- a prime lending was an entity that was subject to california law, attorney general review, all that? >> at that time, before they

switch charters, yes. >> did they do that, to your knowledge? what completed the use? @@@@@@@ e bank, i presume. and the company that the bulk of the subprime was a california-regulated market and it -- california-regulated

mortgage entity? >> i don't remember the percentage of california as opposed to new york or other states. >> when you, your organization, reviewed and inspected these holding companies, did you notice anything? did you inspect them, or just the fsb? >> we spent a lot of time with the fed and the occ earlier in previewing for what it was that was coming our way. we also convened shortly after granting the charter. the charter was granted in march 2007. we convened what i call a regulators conference, where we invited at had a regulators from many states come in and discuss with us some of their particular concerns, if any related to the operation of the if it's within a holding company structure, including new york, california, others. >> did that alert you to potential problems? >> yes, it did.

it started to, sir. >> we had come a few hearings ago, mr. meltzer and doctor rivlin, who had a longtime association with the federal reserve. their recommendation was that the federal reserve should get out of supervising entities and concentrate on the issue of the monetary policy, and perhaps other issues. my question -- i will let you answer last, the governor could i think you have an opinion on this. but to the other panelists, if the federal reserve, following this advice by two very knowledgeable and experienced people, does not perform as the supervisor for a large holding companies, who would or should? do we have to create another entity? what is a general knowledge

about that? >> that is right. the fed is the holding company supervisor for the vast majority, not all, but the very largest institutions. i think he would decree a new agency to do it. -- i think you would have to create a new agency to do it. >> you can put the holding company supervisor and bank supervisor in the same entity. i think, frankly, for smaller institutions, a lot of institutions, were the only subsidiary of the company is the bank, there is logic to that. but where u.s. companies with a lot of different businesses engaged in nonbanking activities, that is where the particular expertise of the fed, because of its clauses of the capital markets -- its closeness to the capital markets, all that comes into play, and replicating that would be the most difficult challenge for any agency to recreate either separately or inside the credential supervisor.

>> very cook it, because i have to give the governor -- >> i think you could replicate that. the difficulty would be in dealing with the state-chartered organizations, where you do not already have a right to little like the occ or to yes. -- do not already have a right to a little like the occ or ots. >> if the fed is the regulator, you have to be able to work with what is now the deference to functional regulators, which we have identified as a problem. you might want to put that into your answer, too, governor. >> thank you, senator. you know, people are attracted, particularly once people get out of government or who have never been in government, to need solutions that look great on paper. i think that anybody who has

dealt with this crisis and financial supervision on an ongoing basis will tell you that the whole point about the financial sector of our economy is that it reaches everywhere and it affects everything. and if one is looking to a central bank to perform the dual mandate given to it by the congress of trying to maximize employment and achieve price stability, i don't think there's any way that without having an awful lot of attention to financial stability. to achieve financial stability, one has to have an influence upon the major kinds of financial activities which are going on in that -- performed by the larger institutions. i think the interrelationships

between monetary policy aims and goals of financial stability really undergird the case for our central bank and central banks around the world of being involved in supervision. point two, a graphic illustration of what can happen when the central bank is not closely involved in supervision was observed a couple of years ago in the united kingdom, where, following the decision to have a single financial services at the ready with all supervisory responsibilities for all kinds of financial institutions, the bank of england, the central bank, was not involved in supervision at all, and when a significant financial institution, northern rock, failed, the bank of england was not in a position to be able to make judgments about the failure of the iraq --

failure of northern rock and within the system. you have a robust debate within the uk now as to whether they need to return authority to the bank of england in order to coexist, i assume, with the financial-services authority. there have been some proposals to put everything back into the bank of england. i personally would not think that would be a good idea. you raise the question, the issue of the ability to get information and enforce where necessary. it is important, if you are going to ask an entity to perform a role consolidated supervision, you have to make sure that they have the tools to do so. now, as it happens, right now there is, and i have no reason to expect there will be, quite a good relationship between the fed and the controller with respect to banks within holding companies, but we need to make sure that sometimes kinds of

information that are not gathered in bank supervision or, for that matter, supervision of other kinds of regulated entities, insurance entities or other entities, can, if necessary, be obtained in order to provide the kind of supervisory oversight of the whole institution that you are asking about, or looking for. i don't personally anticipate that there is going to be lots of utilization of such a thing, but i think you do have to have that kind of backup authority. >> i have gone way over my time. i'm abusing -- >> just if i could very quickly responded on the functional by the latter point, it may go to for the way it is now, but the way the administration has proposed it has pushed it too far in the other direction. >> point noted. thank you, my colleagues.

>> senator martinez. >> i want to ask about the proposal of the in administration regarding the elimination of restrictions to interstate banking for in state banks. communities in florida would be greatly concerned about that. i wonder if aggressive ranching did that contributed to excessive risk-taking, which, i desire to increase market share, may have had a lot to do with the problems we have seen lately. eliminating branch banking -- how would that change the competitive landscape? >> senator, the fdic has not taken a position on a particular provision. we don't have a corporate position on it. >> i do not think it would be a good idea to reimpose limits on interstate branching. right now there are some limits left for doing your first branch

into a state. but basically, the decades-long restriction on them gradually evolved over the year to prevent interstate branching, i think it did permit more diversification geographically, which is helpful in some circumstances. i would personally not be in favor of for the limits. -- of further limits. >> i would just say that you alluded to certain the circumstances in which interstate operations became a problem. i think that can be the case. but that is where it is important to focus on business model of the entity in question, and it ought not to be allowed to engage in unsafe and unsound practices, whether they involve excessive branching that is unsupported by sound business plans or other practices. >> let me point out that thrifts enjoyed the ability to branch interstate without

restriction. with community banks, my impression is that that privilege has had some impact, but i am not certain how great. >> my colleague from montana brought up the testimony from mr. ludwig, i want to go into another area of his testimony that i found very interesting. he makes the point, and i'm sure he could make it much better than i, which he may get a chance to do later, but he would suggest avoiding a two-tier system that allows the largest too big to fail institutions over smaller institutions. he makes the point that perhaps it would be also two-tier regulators, the best light it is in one system and others in another. the--- to regulators in once -- the best regulators in one system and the others in another. and not treating a bias and the

system that would be in favor of those institutions to develop over those that were not too big to fail. >> there are a couple of questions, one being weather should be tier one entities designated as to begin fail, regardless of the occ and oversight. and weather as part of regulatory consolidation that you have a regulator based on size. we have concerns about designating institutions formally as tier one. i think you could probably say he was not, based on asset size, be -- you could say who was not, based on asset size, be systemic. if you don't have a right -- if you don't have a resolution system, it could be problematic.

in terms of bank regulation, and like consolidated holding company supervision, -- are like consolidated holding company supervision, you should have a federal charter and state- chartered we have a fairly large state chartered entities. the charter choice, i think, is a good one to have. you do want to have not given regulatory policies, but perhaps ones with -- more immediacy of it dealing with the state level banking supervisor is helpful. i would maintain that along the state federal charter as opposed to size limitations. >> i know we have a vote, and i don't know how much time have left, so i will leave at that. >> thank you. senator merkley. >> i wanted to start by asking the governor -- it is my understanding that some problems at citigroup a