we will see the u.s. troops appear in south china sea if that's the case? thank you. >> with respect to the first about china, i'm just go back to the point i made earlier, which is that the peace and prosperity that all have the enjoyed in the east asia pacific region, including china, which is an important economic partner of ours and so forth, the question is what is the environment within which that good thing which we have had going for 60 years will continue. one ingredient in that, really a pivotal ingredient has been the american military presence in the east asia-pacific. we want to keep that going. we think it's good for us and for everyone in the region as well. and with respect to maritime disputes in the south china sea,

i think we've been pretty clear about our outlook on that. these are things that need to be addressed peacefully. and that's the position we've taken right along. i think that's the position of principle and practice, and the secretary of defense as i left the pentagon was talking to shangri-la and i know he'll be asked about the same thing over the next couple of days. one more. >> it's a great review of the u.s. defense strategy. as secretary leaves for the region, for china and india today, what do you think he will have a message for india because, as you said earlier,

china is growing militarily. u.s. budget is going down, and china's military budget is going up, and china is in the region and this may be a special message for india. what do you think that u.s. and india will have -- do you expect any special signings between india and the secretary during his visit to india, sir? thank you. >> well, we have so much going on with india now that i'm sure there will be a number of things associated with the secretary's visit that he'll be putting in motion or concluding or whatever. we have i think the number is several tens of exercises with the indian military, and i think that's reflective of just a fact that we are destined to draw closer to a country that shares

so much in the way of its characteristics and it's values. i felt this way for a long time with india. i just met with a group of indian thinkers about security affairs a couple weeks ago that were here in washington and told them the same thing. you look around the world, and india is one of those countries that you know is a kindred soul to the united states for the future. so building that relationship and that common ground is essential. we've been at that now for ten yea years, and i know that secretary wolfowitz played an important role in that and that's been growing and growing. those of us who were enthusiastic about it, as i certainly am, and secretary panetta is and secretary clinton is, you only want to see it go faster and faster.

i'm good. i think i'm okay. one more, the gentleman in the glasses. >> thank you, sir. mike mount with cnn. you briefly did discuss sequestration, but i wanted to ask whether it happens or not, it does seem to be -- kind of a possible reality. what are the concerns you're hearing from the defense industry as a whole about sequestration and what are you talking -- >> the same things i mentioned that our managers in the government are. this is something that is both by its size and its nature -- i use the word irrational, completely irrational from a

management pointed of view. from those of us who are supposed to keep this complicated program on track, you have people working, you have a flow in your factory or whatever, you've got it all planned out, we've agreed between the two of us, we've got it in a place where we think we have a good thing going, a program that's delivering the capability we need, it's economically paced and so forth and, boom, in you come and it makes a managerial mess out of all of the things we've tried so carefully to put on a steady footing. our partners in industry and us. that's why it's so, you know, well, i use the word irrational. that's what i mean. managerial irrational. next to you. we'll make this one the last, if you don't mind. yes, ma'am.

>> my question is about biofuels. in both the house and the senate the national defense authorization act, they essentially would make it impossible for the department of defense to buy another gallon of biofuels in fiscal 2013. i wanted to get your response to that and also any word on if this would affect plans for a great green fleet or any other department of defense -- >> obviously, we asked for the freedom to do that, and we would prefer to have the freedom to do that, so that's the simple answer to your question. i'll say something more broadly about energy. we are big consumers of energy in the department, and we do play a role in natithe nation's overall energy strategy.

anything we do has to be in the interest of defense in the first instance, but the three ways we participate -- we do useful things for defense that might be useful also for the country's energy situation at large. first, we do do some r and& d. we don't try to compete with the department of energy in scope or size or quality, we can't. but there are certain areas where we have needs that are distinctive to us and where we need innovation and the only way to get that innovation is for us to sponsor it ourselves. secondly, we are frequently able to partner with the department of energy and provide installations or ranges or something else for them to try out their own r & d, and that's fine with us. if we can do that, that's fine.

and then, third, there are a few areas and very carefully selected areas in which we by following our own need, defense needs, act as a first adopter of a technology that might later prove of wider use, might. i can give you an example. high energy density batteries. everybody has talked to the troops and how they complain about carrying around all these electronics that they carry around. the heavy part isn't the electronics. it's all the batteries. if we could get a higher energy density battery, we would pay a lot for it, more than you would pay to put it in your flashlight and that would be a perfectly legitimate investment for our troops, and it may be that if we made an investment of that kind, over time that technology would mature, the price would come

down, and it would become competitive in the commercial marketplace in which case we would have fostered an innovation of greater use. good thing, defense has done that in many, many fields or many, many decades and absolutely fine. but we start with the first principle is anything we do has to make sense from a defense point of view. we are the department of defense and that's how we justify our investments. >> the secretary has been very generous with his time. i want to thank you, sir, for joining us. i hope you feel like you've got away without suffering too many casualties. please come back again. >> wonderful group of people. thank you so much for the opportunity. [ applause ]

coming up here on c-span3, a look at the causes behind the 2008 financial crisis with former freddie mac chief economist kevin villani. that's followed by girl scouts ceo anna marie chavez on the future of the organization which celebrates its centennial this year. then a hearing on railroad and highway security with tsa officials testifying. on the other c-span networks, the atlanta council holds a discussion on europe's financial crisis. the ceo of deutsche bank discusses european action so far and gives his thought on the future economic outlook in europe. that's at 5:00 eastern on c-span. president barack obama is getting a little help from former president bill clinton at a trio of campaign fund-raisers

in new york tonight. they'll speak at a high dollar fund-raiser at a private home, then headline a gala at the waldorf-astoria hotel. you can watch live coverage of that at 8:25 eastern on c-span. and they will end the night at an event dubbed barack on broadway. and ben bernanke gives his annual report this week. we'll have live coverage on c-span3. over the past four years pulitzer prize winning author david maraniss has been researching and writing his tenth book "barack obama the story." the research included speaking with his relatives in kenya and discovering his ancestry on the shores of lake victoria. he also toured the jofer gins of his mother's family. the book comes out on june 19th

but book tv will give you an early look with exclusive pictures and video including our trip to kenya as we traveled with the author in january of 2010. join us sunday, june 17th, at 6:00 p.m. eastern time and later at 7:30 that same night your phone calls, e-mails, and tweets for david maraniss on c-span2's book tv. >> this is c-span3 with politics and public affairs programming throughout the week and every weekend 48 hours of people and events telling the american story on american history tv. get our schedules and see past programs at our websites. and you can join in the conversation on social media sites. now, a look back at the causes of the 2008 financial crisis and housing bubble. kevin villani, a former chief economist for both the department of housing and urban development and for freddie mac says housing policy initiated the financial crisis.

mr. villain na co-authored the paper, "what made the financial crisis systemic." this was hosted by the cato institute. >> good afternoon. i want to welcome everyone to today's luncheon. i am mark calabria. i will be serving as a moderator. the recent multibillion dollar losses at jpmorgan have renewed the unsettled debates surrounding the need for the dodd/frank act as well as its effectiveness. defenders argue that jpmorgan's losses prove the value of dodd/frank while its detractors argue that the act is either grossly insufficient or even misguided. last week one of the architects of dodd/frank, former treasury official michael aybar wrote in politico that jpmorgan's losses

prove that opponents of financial reform are wrong. what professor aybar and other dodd/frank apologists ignore is that the substance that is the quality of reform is far more important than its quantity. today's speaker, kevin villani, will argue for reform of our financial and mortgage systems, contradodd rank, however, the reforms covered this afternoon will be deririf derived by an a of the weaknesses. any reform of our financial system will only be as good as the assumptions from which it begins. today we will examine the assumptions both behind dodd/frank and behind the financial crisis inquiry question. after finding those assumptions wanting, our speaker will offer his own observations of what caused the failures. kevin villani is uniquely qualified. in the early 1980s he served as the first chief economist at

freddie mac as well serving as the chief financial officer. prior to his work at freddie mac, he was chief economist for hud. kevin has held a variety of teaching positions including positions at the university of southern california. he's also helded adjunct positis at purdue and george mason university. certainly gets around the academic circle quite a bit. dr. villani has been instrumental in the development and an introduction of many of the innovative financial instruments currently in use. he has written or co-authored approximately 100 books and articles and has edited several academic journals. he has a b.s. in mathematics from the university of massachusetts at amherst and a ph.d. from purdue. perhaps more importantly than any of those accomplishments, at least in my view, kevin is also

the author of two recent cato policy papers. the most recent paper is "what made the financial crisis systemic" while his early paper is "the subprime lending debacle." both of these can be found online at www.cato.org. i want to welcome kevin to the podium. [ applause ] >> thank you very much, mark. i want to thank you all for coming and i want to thank mark for setting this up. as a third generation milton friedman student i was taught to believe there's no such thing as a free lunch but i can see here in washington the rules don't apply. the topic today, what made the financial crisis systemic, is quite ambitious for a lunchtime seminar. there's been hundreds of books and thousands of academic papers, and there's hundreds of stories out there, but we're going to try to keep it fairly

simple, discuss two stories. one is the financial crisis inquiry commission report that was published in january of last year, and then the one single dissent by commissioner peter wallaces wallaceson. now, the financial crisis inquiry commission spent tens of millions of dollars. they had 100 staff. they took testimony from 700 people. they had millions of pages of testimony, and they produced a report on what caused it, and basically it was -- they were charged to study 22 specific causes. they found evidence of all sorts of causes, a confluence of failures, mostly related to private label securitization, and the one thing they exonerated was the political housing goals and, of course, they exonerated or they found that fannie mae and freddie mac

were led into this market by the private label market. the diagnosis is diametrically opposed to that of the financial crisis inquiry commission. that is nothing else counted. it was the entire crisis related to the existence of housing policy and since fannie and freddie were the implementers of that policy they led the way and hud as the mission regulator also extended those housing goals to others in the market, including the private label, and so everything else would be a symptom of what happened when that happened. so in some sense the financial crisis inquiry commission was set up to emulate the pa cora commission. the pecora commission was established during the great

depression and purportedly the idea was it would investigate the causes of the financial crisis in the great depression, but, in fact, it was a report to implement a long-standing agenda which related the implementtation of glass stie l stiegal. even though the evidence suggested that that had nothing to do with the depression at that time. and i will argue that that sowed the seeds of the current crisis. if you understand how the housing goals work, then nothing else matters. and i just re-read that report. my discussion today is basically going to agree with the dissent. i agree with one point in the financial crisis inquiry commission report, and that is that the prudential regulation failed pervasively. there's a new book out "the

guardians of finance" it's failed chronically in doing that. so the one thing we have to understand if those two things alone could cause the financial crisis to be systemic, then that's all we need to explain it, and everything else will be a symptom of what happens when you get a crisis that bad. now, it all starts then with the housing goals. what are the housing goals? the housing goals were in the original '68 act. they were implemented first in the 1970s but fannie mae wanted no part of those housing goals and i can remember the arguments we had with them at that time to try to convince them they weren't binding anyway, that whatever they did, they already met the housing goals. but they were looking ahead, and in 1992 we passed the ironically named federal housing enterprise safety and soundness act which was more about implementing housing goals than it was about making these organizations more safe and sound, and the whole idea was that these goals would

eventually become more binding with lending quotas to lower income households that would eventually reach 50% to 70%. the second thing that we did in 1994 was we put a formal requirement that they target an increase in the home ownership rate from 65% to 70%. that seems very modest, but the u.s. at this time already had the most liberal lending requirements among any of the market economies. so the question was how are they going to be able to get there? this i stole from mark when he was in italy. but just a basic graph. even though fran indiaannie and said their goal was to promote home ownership, they never really did. they were stuck at 65% when fan fri and freddie were down to zero. it wasn't at all clear how the home ownership rate was going to get to 70%.

so the question is how does fan indiana and freddie subsa dies borrowers so we can increase the home ownership rate to 70% and to make loans more affordable? there's the irrelevance ther rum that came out in the 1950s. it says for any firm, for any bank, for any finance company, for any pool of mortgages, your total funding cost is the same regardless of how you decide to fund it. makes perfect sense. and the more the risk, the higher the funding cost will be to fund that risk. the well-known exception to that which turns out to be fundamental for understanding the mortgage markets was tax. that is debt is deductible and equity returns aren't deductible. there's a big difference in costs. the second biggest exception is

that with agency status, no matter how little equity you have or how much loan risk you have, your debt costs aren't going to go up. so the key to their funding is they can fund an unlimited amount at basically the government's cost of funds no matter how risky they get or how little capital they have and this is what's supposed to generate the money to fund the subsidies. this gives rise to what "the wall street journal" called the public risk for private profit model. and essentially you're providing subsidies through finance. now, politicians love this because there's nothing on the budget they have to justify. and private firms are exempt from political contributions so it works both ways. one of the commission staffers, tom stanton, wrote papers on this 20 years ago that said this is not uncommon. this is basically what a monopoly charter of the king did for the previous 1,000 years. you give a monopoly charter and they're going to favor certain entities.

so what fannie mae and freddie mac mac did was leverage a lot lot. that generated about $10 billion a year in tax savings and $10 billion a year in financing cost savings, and that money was sort of split. the borrowers got a better deal, 25 to 50 basis point, they probably got half the subsidy and the other half went to shareholders and management and back to congress. now, the key thing about all of this is it worked well, but you can only leverage to infinity, you can only drive capital to zero, so the magnitude of subsidies you can derive by giving them a capital advantage is going to be limited. and the 70% home ownership rate implied a fairly big expansion of the market from where it had been at 65% and because they had loan limits and because they had affordable housing requirements, it meant that they were going to have to expand the market going

down market to subsidize lower income households. so basically by the year 2000, we had the financial institutions leveraged 100 to 1. we had the borrowers putting very little down so they were leveraged a lot. and it turns out the only ones with capital in the mortgage system were the private mortgage insurers and you can see none of this had had much impact on the home ownership rate. it still wasn't clear how we were going to get this home ownership rate up. so there's a lot of papers, and i see peter is here and thank you very much for coming. he's written most of these papers. there's a ton of data about the quality of the mortgages when we get to the year 2000. the previous decade this all worked pretty well. fannie mae's stock price quadrupled from 1990 to the year 2000. by the year 2000 we had already been in a housing boom for about three years and the pool of potential borrowers was a lot

weaker. i want to point out two elements of the characteristics. one, the down payment requirements had basically been replaced because these purchase money second mortgages could be -- could bypass the private mortgage insurers and they could be funded in the capital markets or fannie mae was buying purchase money seconds. we no longer had the borrower with any stake in the game. the second thing is a lot of these loans had teaser rates which means they didn't even have to pay the full monthly payment and they didn't have to have enough income to qualify and they could refinance after the teaser rate was supposed to go to the fully indexed rate. so the borrowers worked only so long as house prices continued to rise. and they didn't care what they paid for the house price because they were putting no equity into it. so what that essentially leads to is a go for broke model. that is, these were loans that people should have known to be risky on the front end just looking at the characteristics of the borrowers with high

leverage and we know at the back end that they lost money. this was a period, the first five years of the last decade, of relatively low profits and the losses they took subsequently offset all those profits. so it was a losing proposition right from day one, january 1, 2000, in my view, and for reasons i think were predictable. and that's because they were funding high-risk, low-return mortgages which is something that was very much different than their success story for the previous three decades. so what was on their mind is not -- we can't clearly know. they were either excessively optimistic, some say they were, or they were pushed by their housing goals, or they didn't care if they took a lot of losses later because that came later. but the private label securitization system did the same thing. they were making loans, and these loans didn't have enough yield to compensate for the risk, and when we look back in retrospect, we know that the bbb

securities they issued during this five-year period lost about 30% of their value due to default. so this was a bad bet as well. so you have to ask yourself why were so-called private label security advertisers also willing and able to make a bad bet for five years? i actually found this graph on the internet and then realized it was in the dissent. they say a picture is worth a thousand words. this one could be worth 10,000 words, and this is just the plot of house prices against a scale of 100. and you can see that the biggest peaks had been at about 125 from 110. so, for example, in the 1990s, i had a real estate development business building ocean front homes in la jolla. didn't go very well but i had the same attorney as mitt romney. and i closed it down. in 1999 my contractor came back to me and said, let's get

started up again. and i said, look, i said it's 1999 it take twos years to get a permit. by the time we have a house built it will be three years. by the year 2002 we'll already be on the downside of this market, which we would have been if we had followed historical trends. there had never been a bubble bigger than that. of course, i was wrong, but the question is why did the bubble grow first to five times and then to ten times the size of the biggest bubble in history? if you can understand this, then you know everything you need to know about the subprime crisis. and so what happened was in 2005 they continued to go. now, the losses that the ensued were much deeper. that is by 2007 we know that that cohort of loans or the net loss on the entire pool is 60% and it's still growing. you can't tell me that people thought they were good loans when they made them