>> perfect. if you could go back to moscow -- now know i'm getting. look, we have taken on, we are taking on some features that we usually prefer to say a half, look, the oil and gas sector in russia for example, and sometimes on the banks as well. has gotten too powerful. or the korean cable has taken over. and whenever we see that in other countries come in fact, when ever our treasury saw in the 1990 in other countries, they have always insisted that when you took and i crisis measures you address the underlying crisis. which is not easy to do. . .

lehman didn't have enough capital, why would anybody at that capital. we think over the counter-derivatives. i know people's eyes glaze over whenever i say that. but it's important. and it's very political. but it should be -- it should be they should be traded on exchanges and there should be more capital on the derivatives and you could see a cap on derivatives trading. there's a subsidy from the derivatives that the big broker

dealers are too big to fail they have clear up funding costs and that's a big part of the problem there. i think that's less likely to get addressed even the bank size. as for jamie diamond. all the points we make is about policy. this is not an anti-individual. i think it's helpful to put names on it. this is not a conspiracy. i mean, most of the reviews of our book have been very positive. i think two people so far have said a conspiracy theory. well, they didn't read the book. we make it very clear. this is not people conspiring. this is a system. it's a system of incentives and beliefs that develops over time. and it's a very unfortunate distorted system. and it needs to be fixed and i'm happy to talk to any banker big or small who wants to talk about this. and i do engage with them at every opportunity. and jamie diamond has not yet called me. [laughter] >> how about this lady in the middle. we'll take how many more questions. two more? this lady here and this

gentleman here have been very patient. then we can do smaller questions. >> okay. yeah, recently i've heard a lot of people the last juan was greenspan talking about paul volcker's proposal rule. that these organizations should not be trading in their own accounts with our money. but greenspan said the other day yeah i agree with him but it just isn't practical. you won't be able to separate the accounts. from the proprietary account from the bank, the personal trading to the other trading. now, i've heard others say you can't separate it. that it sounds good but in the real world it won't work. do you think it would work? >> yes. it certainly could work. i testified to the senate banking committee in february on this issue. there were a number of representatives of the banking industry who are fighting against it. and on my left was john reed the

former head of citibank who some things he regrets putting together the size of citibank. he also said in his view you could impose this kind of restriction or restrictional on proprietary trading for any large bank, for example. now, i think the other -- the deeper more troubling question is how much difference would that make. would they find other ways to get around that? would they find other ways to take excessive risk. and i'm sure they would. so while i'm supportive of the volcker rule both in general, and in this instance on the specifics i do not think it would solve much of our problems. and i really don't think it would address the problem of too big to fail. so fine, let's do it. but i think you should not regard that as a substitute for really -- [inaudible] >> yeah. look, the solution -- it's a set of solutions and you got to go over in multiple directions. you got to assume some of them are not going to work and it's good to have redundancy built into the system. but the amount and effect you

would get from that measure certainly isolation would be tiny and even as part of the measures that's not, i think, the key -- the key issue. this young gentleman is the last question. second row on that aisle. >> thank you. does what you have in mind need to be done in all of the world's financial centers in order to be effective in preventing the next crisis or is it something that can just be done here and that would be enough to avoid the subtitle of your book? >> well, it certainly can be done here. it should be done here. it would be immensely helpful for avoiding a massive meltdown. i do worry about the rest of the world. and i think we should take a leadership role. we should push for them to rein in their banks. you know, they are much deeper -- many countries are much deeper of this hole in relying on a relatively few mega banks than we are. by tradition, by history and by our established practice actually a more decentralized

system than some countries. our system is more concentrated over time but we can actually reasonably imagine the situation where we have, you know, 100 billion dollar banks competing with each other and competing globally. and that being small relative to our economy. whereas some countries even $100 billion bank would be big for that country and some countries including europe think big banks are just fine. now, i think first and foremost we deal with ourselves and we persuade people to come back with us and if they don't want to come we have to consider to what extent we regard it as safe for our nonfinancial companies to do business with massive banks that could get in trouble in other countries and to what extent we want massive banks that could really cause enormous problems to operate in the united states. we do not, for example, allow u.s. citizens to bank with financial institutions based in iran. we have very clear rules that prevent from you transacting with financial -- with banks in

various countries because we regard that as not consistent with our national interest. i think those criteria have to be reassessed. we should push our allies to come with us and to make their banks safer. but if they won't cooperate then i think we have to re-assess what we allow them to do in our country with our financial system. and remember, the driver -- the big -- what people want to participate in, in this economy, is the dynamism. and once again it will be the resilient credit-worthiness of the corporate sector and the government sector. that's us. you get to work in our financial markets if you play by our rules. not on any other basis. it's the united states. and that's the way it works and that's what you can say to the outside world. other countries by the way -- not all other countries have the ability to s and i think on that note, thank

you very much. [applause] >> simon johnson former chief economist with the international monetary fund is a professor of entrepreneurship at mit. and a senior fellow at the peterson institute for international economics. for more information, visit 13bankers.com. >> argues the 2008 eight was caused by 25 years of government interference in the stock market. she says that we need to return to a financial system in which bad businesses are allowed to fail instead of being bailed out. the manhattan institute in new york city host the hour-long event. >> good morning.

i'm amity slays. i may ask right away turn off your cell phones or beepers or check again to be sure they're turned off. we'd like to welcome you this morning to this manhattan institute event for nicole gelinas the author of the new book "after the fall." we welcome the new yorker, manhattan institute of friends and c-span viewers. i don't know how many of you have seen the new shanatural movie. chanel movie. she wasn't just the designer she was the designer. she pinpointed what was wrong with the 19th century by pinpointing what was wrong with their skirts. then with another set of markers chanel marked out the 20th what it should be, women's suits, clothes you can wear and walk in, ideas that change culture, politics, economics, not just

the rag trade all due to the utter prison of the artist. nicole gelinas is the chanel governance. in her sharp book with her -- "after the fall," she marks the spots in our past history that took us to the current financial crisis. that made it inevitable, in fact, that we would come this way with equal mastery, she pencils the pattern for the reform. you didn't know it was right until you saw it. so we want to welcome you all to hear this. nicole is the freedom trust fellow at the manhattan institute, a contributing editor to their strong magazine city journal. nicole is also a chartered financial analyst, i.e., master of her craft. two or three things i want to mention before she comes up to talk to you. one is that this book "after the

fall" is a history book. today we have our assumptions, deposit insurance is good we just need more of it maybe. another assumption that we have that the world will implode if we don't save institutions that are too big to fail. unless you go back to history, you won't know that these are new and controversial views. your irony -- your sense of irony won't work for you. and there is irony. the view about deposit insurance until just a few decades ago was that it should be limited as recently as 1989, the head of citicorp john reed warned pseudoephedri we needed to cut back or we would have a financial crisis later. people -- if you cut back deposit insurance people would know what they were risking when they put their money in an institution. they would to have evaluate the

institution and the risk. there was a time too when we didn't believe in too big to fail. the united states as nicole talks about let an important bank fail in the 1980s, penn square of oklahoma. the second achievement of "after the fall" is its solutions. nicole doesn't lay out absolute answers or call out for bailouts either. she goes for the logical middle ground, the classical solution that suits many. like making the rules of market clear. apply the same rules to everyone, no special friends. no more too big to fail special new york category. that it's wrong to have czars sitting in thrones to make the kingdom more nervous. then howard from the manhattan institute will help nicole take questions. welcome, maestro. [applause]

>> thank you, amity, for that generous introduction and limiting deposit insurance to actually insured deposits is a radical concept. now going with amity's chanel metaphor, she said in the 1920s simplicity is the keynote of elegance. she was not talking about financial markets. but she may have as well have been as hopefully if i do my job right you will see at the end of my little talk. a failure of free markets. that is what the last two years look like to many people. we've had the financial system

destroy itself so thoroughly that the government had to come along and provide it with essentially nationalization of all of its risk. so that money and credit would not disintegrate and now we have underemployment and unemployment at 17.5% but yet goldman sachs says it has to pay at least $16.5 billion worth of bonuses so that its own employees don't leave the firm. now, goldman seems to feel bad about this. it wants to donate $500 million to of small businesses. what kind of free market do we have when small businesses have to depend on rich companies treating it as a hobby in order to get capital financing? but this, in fact, has not been a failure of free markets. the past 25 years are the story of what happens when a government does not understand

its proper role in the free markets. and that is to provide a level, predictable consistent system of prudent regulation so that markets can discipline themselves without causing unacceptable harm and destruction to the broader economy. now, we know how to do this. we did this for 50 years more or less well from the 1930s since until the 1980s. how did we learn how to do this? we learned lessons of the 1920s. now, the '20s were wonderful, innovative decade as amity has noted in her own work. the problem with the '20s as it relates to financial market, innovation creates optimism. optimism creates excess optimism. and when you have financial markets that don't have any meaningful regulation other than monetary policy, you have financial firms and regular

people borrowing against every last dollar of optimism projected decades into the future. you've got layer upon layer of debt upon layer upon layer of assumption going out into the future and that means when you have the slightest falter in profit expectations or some other expectation of the future, you've got -- you're pulling out one level of assumption. the whole tower of assumptions and debt collapses and then you have so much unpaid debt that the banking system is effectively bankrupt. we saw this happen in the 19 -- early 1930s. not just with borrowing against the stock market, of course, but against all kinds of asset markets. and what did we learn from this? we learned markets to have discipline themselves but not at the price of unacceptable destruction in the economy. the first elegant solution of this puzzle is how to allow market discipline without economic destruction was the fdic.

this is acceptable, moral hazard. where fdr and his policymakers decided we can eliminate the panic -- reduce panic in the financial system by protecting small depositors but we're not going to protect bad banks against their mistakes. they can still fail. it's just that these small depositors will be protected so that we will not see the destruction of money and credit again. but the most important thing that fdr realized was that you don't want to eliminate risk in the financial markets. you just want to protect the economy against the natural, inevitable excesses of optimism and pessimism. how do you do that? you limit borrowing. first of all. and you limit borrowing predictably and consistently. fdr did not set up a systemic stock regulator to figure out which stocks are safe, which are not, which ones you can borrow against unlimitedly and which ones you cannot.

instead, they said that the fed and the fcc would say you could only borrow half the price of a stock. you can speculate all you want. pick your own risk but when you are wrong, you will lose but the economy will not be bankrupt. and then they also said you've got to consistently report market activities, corporate activities so that people have a level fighting chance of understanding what risk is of out there if they choose to do so. now, this system worked well again until the 1980s. and then the financial system started to escape prudent regulation and escape market discipline and we are going through the result of that right now. so how did this happen? we go back to 1984, may of 1984, a bank called continental illinois -- this was the eighth largest bank in the country at the time. and continental illinois was a pioneer of sorts in the banks

industry. -- in the banking industry. continental was a pioneer in that it did not follow a business model of solely keeping long-term loans on its books, booking the process as people and companies repaid the loans. and having a very slow business model insulated for the most part from acute panics. instead, continental purchased loans that had been securitized. that meant that they were vulnerable to fluctuations in prices, day-to-day. and continental booked the profits from the fluctuations in those prices. that's one way that they made themselves and they made -- multiplied over many financial institutions in the future, they made the system of credit more vulnerable to financial excesses. the other way was that they

depended on short-term financing, uninsured short-term lenders provided a good deal of their money so they made themselves vulnerable in a second way because these short-term lenders could pull their money out overnight in a crisis. now the governments in 1984 -- the market started to panic into spring once they got wind that some of these securities that continental had were going bad. the government decided that continental could not fail. that the price would be too high for the national and indeed the global financial and economic system. so the reagan administration did something that was unprecedented at the time. they came out -- the fdic, treasury came out and said that none of continental illinois' bond holders, the uninsured bond holders -- they would not take any losses in the continental failure.

and this engendered quite a debate in the reagan administration. don regan who was the treasury secretary -- he wrote this in a memo to his colleagues. we believe it is bad public policy -- it would seem to be unfair and represents an unauthorized and unlegislated expansion of federal guarantees in contravention of executive branch policy. so he was against this. president reagan himself never said much publicly about the bailout. but an unnamed white house official said the president agreed with the regulator's compelling argument the other argument was a worldwide havoc. it was a sim to come. paul volcker said this bailout would not set a presidents but the markets knew it set a precedent and we got a new phrase in the financial industry if not in the public lexicon which was too big to fail.

and the independent bankers association which represented small banks understood the imp cases of its president at the time warned these big bobcats have the ultimate anticompetitive government subsidy. they are too big to fail and regardless of how mismanaged they have -- when the government wants more of something it subsidizes it. if you want more corn, subsidized corn. if you want a financial crisis built up over decades based on the banks and other financial companies borrowing for the purpose of reckless speculation, then subsidize banks and other financial companies borrowing for the purpose of reckless speculation. and that is exactly what the government did with this new policy. banks and later other financial institutions could borrow at rates that they could not have otherwise borrowed at because

their lenders knew this was, in effect, lending to the government but at a higher interest rate. so this was at first limited to commercial banks. but investment banks, of course, had to compete with these commercial banks so they created their own too big to fail. this was too complicated to fail. when we hear -- [laughter] >> when we hear exotic financial instruments, credit default swaps, everything else, these are not so complicated. these are -- many of them have good innovations to be sure and are beneficial to the economy and market signals and all kinds of other things. but one of the reasons for their creation is to escape -- or was to escape these reasonable, consistent limits on borrowing. credit default swaps, speculative -- this is a way to speculate without having to put cash down. the same with securitizations, creating complex financial structures so that banks and

other investors could achieve these aaa ratings and invest in these securities without putting a consistent amount of money down to protect them in the economy from any mistakes in their assumptions. with aaa securitized mortgage loans or mortgage bonds, for example, banks could purchase these bonds with just one-eighth of the cash that would normally be set aside for any mistakes in their assumptions. so by doing this, we made the entire financial system much more vulnerable to mistakes in these assumptions just as we had done in the 1920s. now, sometimes the federal officials recognized that we were not applying the old rules to new markets. and they did -- they did just that. they applied the old rules to new markets. and one example of this is in the 1980s when paul volcker, the

fed chairman at the time, recognized that the junk bond markets were getting ahead of themselves speculatively and he simply got the fed to put the old rules regulating how much borrowing that people could do for stock speculation on this new market, which was effectively the same thing. saying the takeover companies could only borrow half of the price for a takeover. now, this provoked a tremendous outcry. but it did mean that when the junk bond market went through its turbulence and downturn in the late '80s, early '90s, the economy did not suffer the kind of catastrophe that we have suffered today. unfortunately, most of the time the governments and financial institutions did the opposite. they confused what kind of risk-taking needed clear consistent limits on borrowing and what kind of risk-taking just needed discretionary surveillance. they, in effect, thought that

the financial industry had identified and quarantined all risk. and you didn't need these old limits. and that's exactly what alan greenspan did in 2000 when he said that you don't need the old-fashioned regulations for the new fangled unregulated derivatives market including what wouldlary -- later would become the credit default system. later aig would make promises with putting negligible cash down leaving itself again no room for error if it made a mistake in these assumptions. now, enron -- before i get into enron. two examples of how these reasonable prudent regulations had eroded so thoroughly that the financial system was left without any market discipline to govern it.

by the time we got in the 2000s. 1990, drexel went bankrupt through the normal bankruptcy process. greenspan was called before congress to testify about this. he said that it would be inconceivable that we would ever apply too big to fail to an investment bank. five years later, barings investment bank in britain went bankrupt through bad derivative bank and with its lenders taking its losses because it had made these bets on regulated markets where it had put cash down and the markets understood where the risk lied. just three years later, a hedge fund, long-term capital management could not go bankrupt through the normal bankruptcy process but it had made these same derivatives bets on unregulated markets without putting any cash down. so its bankruptcy could have blown up the economy. that's what regulators worried about. they engineered a bank bailout

of this hedge fund protecting its lenders. the last mile post on our way to 2007 and 2008 was enron. enron was a very neat distillation of the entire financial industry in that its business model was borrow tremendous amounts of money, use that money to purchase its own assets from itself at ever higher prices. this allowed it to look tremendous profits which allowed it to borrow more money. why could it borrow more money because it said that it had insured its own debt and made it risk-free. now, this was a strange and fascinating business model. but by definition enron was saying if we go bankrupt, don't worry. we will pay for it. but the strangest -- [laughter] >> the strangest and most fascinating thing about enron was that the banks that enron did business with, the bear stearns, the lehmans, citigroups

did not think this business model was very strange at all. and when people say when could we have averted this crisis by doing something different with bear stearns in 2007 by bailing out lehman, the last time to do anything about this was enron. after that, these regulations had solely eroded the financial markets which were not subject to any reasonable rate -- discipline because they knew that market discipline meant economic catastrophe. and that is how we get from there to 2007/2008 when the markets finally did correct their excesses just as they had into the late '20s but they could not do so without creating a great depression and that's how we got the nationalization of all risk in the financial industry. the opposite of prudent regulation and discipline is not freer markets as we've seen. it is nationalization of one of

the most important elements of the economy, who decides which businesses get investment capital and on what terms? now, it's fashionable to see that the crisis has been a black swan. something that we could not have anticipated once in a 100-year event. the real black swan would be if we had gotten rid of every pursued regulation and all market discipline of finance and we hadn't had historic financial crisis. now, what does it mean? its good news in a way. we know exactly what we have to do. we have to go back and apply the old principles to new markets. we don't need huge bureaucracies, micromanagement of finance by the government, consumer financial protection agencies, systemic risk regulator. we don't need any of that to do that. if we had had a systemic risk regulator five years ago, the

regulator would have said these aaa mortgages are just fine. these are perfectly safe. there's no crisis. nothing to see here. a regular cannot do more from preventing and predicting financial crises. in fact, it hurts the market's ability to do that because it does not operate under failure. the lesson we learned 50 years ago consistent, predictable borrowing limits across financial instruments that are similar to one another regardless of what the financial industry thinks of their risk. the government should not be assessing risk from the top down, which is effectively what they have been doing. the financial industry should be assessing risk from the bottom-up with the government setting consistent limits on borrowing. so when they are wrong these firms can go bankrupt and the economy does not explode.

if we had had these limits in place five years ago, aig -- we can look at this from the supply side and the demand side. from the supply side of providing financing, aig could not have insured $500 billion worth of mortgage-related securities and other securities while putting very little cash down. if they had to put 10, 20% down they would have thought twice -- if they didn't think twice they could have gone under and the economy would have had some protection just as with berings 15 years ago. if you had new speculative markets, the housing market became a speculative market. you had to put 10, 20% down payment down. this market would not have gotten away from itself the way that it ended up doing. because as prices rose, people would not have had the cash to keep up with these rising prices. dampening demand across all price levels.

with these simple rules in place, we can go back to a consistent predictable system where financial firms and global investors know that everyone is playing on the same level playing field with a fair chance. and with the most important regulation of all, market discipline once again governing the financial industry. you can't just say you're ending too big to fail. the markets will know that you haven't done it as long as failure means politically and socially unacceptable economic catastrophe. now, what if -- what does failure protect that is important economically? two things. one, bad businesses and bad ideas should not survive into the future with government money. you have a company like aig who has a very good divisions. the corporate structure failed

and using these good divisions to make these tremendous bets that ended up going bad, sell these divisions off to someone who can manage them better, don't have a insurance backed insurance company competing with the rest of the insurance business. and the second thing is fairness. the public can see this is an unfair system. the public has been at bailouts every step of the way. even bailouts meant to help out their own neighbors. this is not mindless, heartless populism. the public can see that this is not free markets. and the public is angry at goldman sachs not because they don't like rich people. it's just because they can see this is unfair. and the public is right. that goldman is operating with an implicit government's guarantee. and it does not end the problem for these banks to pay back their t.a.r.p. money. in fact, in some ways it makes it worse because at least with t.a.r.p., people know there's government money there.

now we have again an unseen government presence distorting this economy. however, this is not something that the public can do by itself. we do need political leadership here for washington to realize that reasonable regulation with the end being fair, consistent financial market discipline -- that this is not a barrier to free market capitalism. that this is in the end a necessary prerequisite to free market capitalism. so with that, i'm very happy to take questions. thank you very much. [applause] >> i'm howard hughes, vice president for research at the manhattan institute. and my job really here today is to point out questioners for nicole. if i might start, nicole on your

point about extending simple rules to new markets, do you have some feeling -- there's a lot of legislation now being considered in washington, both from the house and the senate side. is any of it consistent with the proscription you've offered this morning? >> no. [laughter] >> the one thing that is consistent was the bill -- one of the first bills that came out which was put unregulated derivatives on the regulated market. however, that seems to have disappeared somewhere. and now we have chris dodd -- senator dodd and representative barney frank going with this idea from president obama to create this systemic risk regulator. dodd's spokesperson said just the other day, we need a system that predicts and prevents future crises. that is an impossible goal. all they can do is protect against the effects of future crises.

>> okay. the house rules are keep it short, keep it in the form of a question. tell us who you are. and wait for the microphone. and i'll start with the gentleman on the far right there. wait for the microphone, please. >> thank you. my name is roger moke. i would like to ask about three specific remedies to see if you're for any of them. bringing back glass steagall, breaking up the big banks and imposing leverage requirements. >> okay. i'll do the first two first, roger because those two go together. imposing leverage requirements and breaking up the big banks. another part of one of these bills coming out of congress is an amendment to allow regulators to identify too big to fail financial institutions and force them to break up. but we can't tell which of these institutions are too big to fail.

few people would have said bear stearns was too big to fail seven years ago. which is how far in advance you need to do these things. if we credibly end too big to fail by protecting the economy from failure, leverage -- and if we put consistent borrowing limits across financial instruments in financial institutions, no matter what they call themselves, leverage will take care of itself through reasonable regulations and through market forces. because lenders will know they no longer have an implicit government guarantee. they will care more what they're doing with their money. the same thing with too big to fail financial institutions. lenders will do their own surveillance here if they know these institutions can fail without taking the economy hostage. glass-steagall we are used to

living in a mark to market world. we're not going back to holding loans for books on 30 years and booking the process slowly. investors want to know what's going on -- a better solution than going back to glass-steagall is to better protect the economy from prices -- fluctuating prices in securization markets because that is what kills credit or makes credit too excessive. one way of doing that is varying capital requirements with liabilities. one of the most acute dangers is financial firms relying on short-term overnight lending. make them hold more capital proportionate to the amount of short-term lending that they have as you better protected the economy. and i can -- you know, this idea comes from alan greenspan. in 1984, before he was fed chairman, he was on an economist panel after the continental illinois rescue, and he said that banks should hold against

losses depending on the type of liabilities that they have. >> do any of the regulators currently have the power to implement the kinds of solutions that you're advocating? >> well, in the '80s paul volcker had the power and the convincing clout to convince the feds to put the old borrowing limits on the junk markets. in the '90s alan greenspan had so much clout in congress that they took his word for whether unregulated derivatives needed to be regulated or not. so in effect, the fed has been a systemic risk regulator for two decades. where they had the discretion sometimes they used it properly and sometimes they didn't. where they didn't, they had

plenty of gravitas to go to congress and ask for it. so it's not a matter of not enough power. it's a matter of failing to recognize that we need these consistent rules. [inaudible] >> i'm ken silber with research magazine. what do you think about ron paul's effort to audit the fed and then more importantly abolish the fed? >> well, he sold more books than me so far. [laughter] >> i think this is an example of why -- if reasonable politicians on both sides of the aisle don't come up with reasonable solutions, people are going to gravitate toward these unreasonable solutions. we don't need to get rid of the fed. what we can't depend on monetary policy is our only regulatory tool which is effectively what we've done for 20 years. i mean, people -- monetary policy is wrong.

it's the human condition for monetary policy to be wrong. but we need limits on borrowing so that mistakes in monetary policy don't create any asset bubble in one particular asset class that becomes so big that it can't fix itself without destroying the economy. and we need to do more with monetary policy and focusing on the fed what it did right and wrong is a drack on my view. -- distraction on my view, thank you. >> hi, this is ray niles. what about getting rid of some of the regulations that i would view as sort of part of the root cause of the problem. and really in the '30s, the guarantees of mortgage loans and the creation of fannie mae and freddie mac -- securitization was invented by the federal government. and, you know, why not get rid of that. that, i think, led to overborrowing. i'm curious on your thoughts on that. >> right.

i agree with you wholeheartedly. the government should have create the consistent environment for these financial firms to do their business. not force certain classes of lending at the expense of free and fair and prudent markets, which is what they've done sometimes with worse effect than at other times you have the idea of mortgages with no down payments, borrowing 120% of the value of the home. you know, there's this sort of myth that fannie and freddie made the banks do this. but fannie and freddie didn't help. and they allowed this to look respectable. the government said it was okay, therefore, it must be okay. fannie and freddie were too big to fail. this is a whole other area that goes along with inappropriate government distortion. thanks, ray.

>> janet norman, bedford street ventures. how do you say citibank's future? [laughter] >> i used to work at citibank. citibank's future -- they cannot succeed without market discipline. and right now they operate without market discipline. and just as importantly, they are distorting what other firms do. because they have got to compete against effectively a government subsidized bank. so again this is a place just like aig where you've got great business lines, great people in some places but you've got to unlock these people and put them in the hands of managers who know how to manage the company.

and you've got to do that at the expense of bond holders who freely lent money to the company and should take a loss when their prospects turn out to be not what the lenders had thought. there is -- there's no justification for not having bond holders to the financial system take losses, then you're just back to the problem of too much debt. no regulation in the world can overcome this subsidy. >> hi, i'm mark green. what do you think -- how do you think the too big to fail issue can be resolved with the concentration of assets? seven largest financial institutions in the country control over 70% of all the total assets and have a very big competitive advantage over the other 10,000. >> uh-huh. the first thing is not to make the problem worse, which is exactly what we've been doing

over the past two years with failed banks largely being bought by these too big to fail financial institutions. and beyond that, this is a place where it will be a very slow evolution. we did not build up too big to fail overnight. we won't end it overnight. but once the government puts in place a credible system for failure, lenders will provide market discipline here. and push these firms to break themselves up. otherwise, they'll have to pay much more for their financing commensurate with the prospects for failure and for mismanagement as well. lenders will forgive mismanagement when they know they're being subsidized by the government, they lend to the government directly and put up with plenty of mismanagement there. [laughter] >> marshall with henry armstrong associates.

when one considers that not only do the debt holders of larger investment banks but the equity holders were essentially made whole, one can -- one can surmise that it wasn't just the threat of systemic failure that induced the government to support those institutions. do you think that eliminating the risk of systemic failure through limits on leverage will eliminate the temptation to bail out those institutions for other perhaps more parochial reasons? >> well, they wouldn't have the excuse of -- and not that it's an excuse. there was real, obviously, risk and reality of systemic failure. but they could not go to the public or to congress and credibly say we've got to pay everyone 100% on the dollar on aig's credit default swaps or

the whole system will collapse. so that's -- when you've got a predictable consistent system of bankruptcy or some other resolution as the fdic does, you eliminate the cover for doing anything for any other reasons or for their perception that you've done it for other reasons which is just as important. and geithner could learn a lesson about dubai. dubai say why should we bail out dubai world which is essentially a bailout of sophisticated banks. we did the same thing with aig because -- or partly because we were under this immediate systemic pressure. >> ira stole, future of capital.com. would your limits on borrowing apply just to financial firms with insured depositors or to

the whole economy? and if so, what's the philosophical justification for the interference in the right of contract of a willing lender to loan as much money as he wants to, to a borrower? >> thanks. the justification is that your right to lend or borrow on an unlimited basis ends where your ability to hold the entire economy hostage begins. but multiplied across the economy borrowing without any room for error just results in nationalization. we saw this in the 30s. we saw it again over the past two years. and we can't -- one of thelñw lessons of the modern way of creating credit through securities is you can't protect credit from the excesses of speculation just through the uninsured deposits.

we have to have some consistent limits across these financial instruments because these are the instruments of credit. now, you still have fluctuation optimism, pessimism and you should but you can't hold the economy hostage. and we've always had limits on borrowing even outside of insured deposits. you can't -- requirements for stocks and regulated derivatives hold whether these are held by firms with insured deposits or not. >> robert george, "new york post" forgive me if i didn't hear this -- if you answered this in the previous question. but you said that you didn't like the idea of, you know, getting rid of the fed. what about the idea, though, of auditing it which again somebody pointed out, you know, it started out as a fringe thing from ron paul and now it's got,

i think, a majority of signatures in the house. >> one of the problems with all of the bailouts that we've done over the past 18 months is we have this secrecy where you had -- the fed and the treasury pressuring bank of america possibly not to talk about the losses that it could incur with the purchase of merrill lynch. so all of this back room secrecy, this idea that big government and big banks are colluding to hide information from investors has led to these proposals to audit the fed, all kinds of other things. i think if we get out of the bailout business, people will feel more comfortable that there is transparency, consistent release of information. that the government isn't using its powers to favor certain institutions over others. so some of this pressure will go away.

as for the specific proposal of auditing the fed, i don't think it's helpful because it looks like congress has -- the fed has always politicized the congress obviously votes on the fed chairman. but we don't need more day to day political interference. if they're auditing monetary policy it confuse the markets as to what the fed -- is it making decisions based on the merits or based on its congressional audit. thank you. >> henry stern, new york civic. what you say seems eminently sensible to me and i think to a lot of people in this room. is there anyone in washington who believes the way you do? [laughter] >> and is there anyone advising president obama who thinks that

way? >> the problem with the president's advisors is they've -- they've lived for too big to fail for so long that some of them just can't conceive of another system. they just think how it should be. and the answer is to figure out how to make a better too big to fail rather than end it. and they've lived in this system where you don't have any consistent limits to protect you from your inevitable mistakes. they just think they are not going to make mistakes and when they do they think they are so smart that they will extricate their mistakes and there is no reason to protect themselves from their future mistakes. what is the lesson that we're learning from this crisis? it's the same lesson, unfortunately, from washington's perspective that we learned from long-term capital management. boy, we're so smart we figured out how to get out of this. now they're saying, look at us.

we figured out how to prevent a depression. so they're not humbled by this. >> i quite agree with henry. it sounds very plausible what you're saying. but i'm wondering where do you actually set these reasonable limits to borrowing? i heard you say in the beginning 50% margin for stocks. later on you said 10% would have been fine for aig to put down on the cds. most people think 80% is a reasonable margin for mortgages. 20% down. is there methods for actually setting these in a sensible way without too much protection? >> it should be consistent across any one asset class or investment class or anything that mimics that investment class.

so 50% margin requirement on stocks -- i don't think the number -- you know, could they have done it 50 years ago, 40%, 60%? the consistency that matters so that you don't game the system. and the lower requirements on the futures markets -- these have been been in place for a long time. seem to have worked reasonably well for decades. so i would submit that derivatives that act like these derivatives with the lower margin requirements should also have those requirements as long as they're consistent across the asset class. and for houses, this -- anything that is above 20%, you're just making the problems that ray mentioned worse. where too many people won't be able to afford a house. there's pressure for other ways of making them able to afford it. we had 20% down payment requirement for the housing market for a long time. worked reasonably well and i think we could go back to that.

as long as this holds across the housing market, no one can say there's no risk here. therefore, we can lower it and eliminate it. >> sherry seigel. it sounds to me like a lot of what you're suggesting on too big to fail is actually application of classical antitrust analysis to some of our financial institutions. if that's the case, do we have a regulator or regulators who you would trust to apply that analysis in a relatively efficient way so thatcould achieve the goal of breaking up too big to fail? >> i think if we have market discipline of these firms, it actually lessens the need for antitrust.

you know, we see more so in britain right now than here. where the public is very concerned that these banks have too much consumer power where you've got two or three banks that set the whole market. and looking at it from an antitrust is another example of a government solution to a government problem where there's a much easier solution, allow for market discipline and let the markets force some of these firms to break up. and if that doesn't work, we've certainly got antitrust and everything else. but let's try the obvious. market discipline solution before we go to the secondary command and control government solutions. >> bill honeycut nicole, you've recently about dubai and new york state.

would you expand on that a little bit. >> sure. this is not -- this is actually quite on-topic because we have dubai and abu dhabi saying we're not going to bail out our investment arm. and, of course, this investment arm does not have sovereign guarantees. and the government is effectively saying we've decided we want you to read the fine print after everyone has invested. why are people surprised at this? only in a world in which the financial industry considers bailouts to be an entitlement is this a surprising announcement. what dubai world is saying is very reasonable. you lent us money based on valuations that don't hold anymore, we borrowed money on these valuations. this is not a recourse lending. we've got to go and adjust the price of these assets and adjust the prices of debt. this happens and should happen all the time in the financial industry dealing with the

consequences of you're actions is part of doing business. as it relates to new york, we have these off-balance sheets, quasi state entities not officially guaranteed by the governments all over the place. and people are depending on this too big to fail guarantee with state and local finances as well. nobody would invest in a lot of new york's boondoggle products if they did not think there's a bailout from the state in a crisis. and for that matter people would not invest in new york and california debt if they did not think that washington considers these to be too big to fail. so we've got these government distortions preventing states and cities from getting their spending in order. this same guarantee that comes from washington -- it makes these -- distorts these market signals so that they're unrecognizable.