lending decisions. some of the banks would not take the capital. i think that this was helpful with lending, but this could have been much more effective. >> what you are saying is that the banks did not want to take the capital, because this would put them in the position to be more affective when they contributed because this would be under external pressure? . .

>> how much of lending and what was the right level and how was the government going to determine that. clearly, this was about lending in getting the bank's the capital they needed. >> can i have two minutes. the third question relates to a topic that you alluded to and that is the role of congress and you said that congress had barriers such as its tendency to wait until the crisis had occurred until acting and some of the jurisdictional restraints until incomprehensibly with problems. from your experience and the executive branch, trying to influence congress to be more

proactive and to be more comprehensive in its response, do you have and recommendations of what the executive branch could do to facilitate congress being a more effective partner or what congress ought to do within its own domain to enhance its contribution? >> my own experience with congress was very positive because twice i needed to go to congress with extraordinary requests and twice they reacted before disaster struck. democrats and republicans -- like a lot of people, i don't like partisanship but i saw people on both sides of the aisle come together.

i think in terms of how to solve the issue, you can get some experts the better equipped than i am to answer that question them thank-you senator graham. >> mr. secretary, it is good for you to be here. i would like to follow up a little bit on one of the questions that was passed about the rescue of bear stearns. to me, this was one of the most consequential decisions that has ever been made by our government. a kicker is a substantial argument that gave rise to moral -- there is a substantial argument that it -- that it gave rise to the collapse of lehman brothers. once bear stearns was rescued, it encouraged lehman brothers to keep its price somewhat higher

than it might otherwise have been in dealing with potential acquirers. on the other side, lehman brothers had a reasonable expectation that it might also be rescued. the chairman of lehman brothers indicated that in some of the testimony he has given to congress in the past. in addition, the creditors of lehman brothers like to reserve fund the cost so much difficulty, would probably have rid themselves of the commercial paper they were holding that would immediately have lost value if lehman brothers had actually been allowed to fail. when lehman brothers did fail, they were stuck with this commercial paper and, as you remember, the money market fund, the reserve fund actually broke the buck and there was a run on money-market funds. the consequences of rescuing lehman brothers in terms of its moral hazard was quite

significant. i would like, if i can, to follow up the reasoning a little more carefully. if i can make a couple other points. yesterday, we heard from officers and former officers of bear stearns and from german cox of the sec. -- chairman cox of the sec. i was surprised to learn that bear stearns was actually solvent at the time that it was rescued. it had not actually become insolvent according to the former officers of the company and chairman cox. the first question i would like to ask you is whether you were aware that bear stearns was a solvent company. i understand there was a liquidity problem but were you

aware that when you had bear stearns to be rescued that they were solvent? >> i think that is almost a ridiculous statement. we were told thursday night that bear stearns was going to file for bankruptcy friday morning if we did not act. how does a solvent company filed for bankruptcy? when institutions, financial institutions die, they die quickly. it is a liquidity crisis. they died because the market -- because of the market. when they die, i don't care what someone has on their books the assets were not worth more than liabilities. we were told there were filing for bankruptcy to more morning

-- tomorrow morning. we almost found out whether your hypothesis was right. if j.p. morgan had not emerged, there was nothing that was going to be done. that is your first question. >> companies can file for bankruptcy is even when they are solvent if they are illiquid. one of the definitions of bankruptcy is that you cannot pay their obligations as they come due. >> this is a financial institution? >> let's -- yes, less that not given to that. i want to make sure we are talking about the possibility that we could rescue firms that are in fact solvent. representatives of bear stearns

and chairman, both said they did not think that bear stearns was yoo big to fail and if they had failed -- they did not believe it would have caused the kind of disruption they would consider necessary to rescue an institution that was too big to fail. why did you think they were too big to fail? >> i don't take more hazard likely. -- lightly. if this had happened at a time when the credit crisis had been underway for seven months and the system was very fragile throughout the system and secondly we did not have the tools, as i said, to wind them down outside of the bankruptcy process.

what i saw in the marketplace was a market crept with fear. bear stearns was not the cause. they were a symptom of the fear and panic in the market and the broader problem of illiquidity. as i said to you, i believe that a bear stearns had failed that there were all sorts of counterparties that would have grabbed their collateral and sold and let the bigger losses and write-downs happen. your comment about the reserve fund holding and brothers paper, yes, it bear stearns had gone down, no fund would have helped lehman brothers.

it would have triggered it quicker. you would've had lehman brothers going almost immediately give bear stearns had gone and the whole process would have started earlier. >> if that's true, how could you not have rescued lehman brothers under those circumstances? what you are saying is that you have implied you're going to rescue everybody else for the same reason. >> yes, we looked at every one of these under their own circumstances but we tried hard to cope with a solution for lehman brothers, very hard. if there had been a buyer for lehman brothers like to was for bear stearns, we hope have done the same thing. -- we would have done the same thing. >> let me turn the question to another point -- you said

subprime mortgages were relatively small part of the problem although they were a trickle in element. are you aware there are views that the number of subprime and alt a mortgages is much larger than the 20% that you cited. more than half the mortgages by 2008 work subprime and alt a and were thus ready to fail and the bubble we were experiencing began to happen. if you had known that at the time, would your view about what was likely to happen or the importance of the subprime mortgages have been different? >> first of all, i don't know

that. you and i agree that housing policy is a big issue we dealt with. as i look at the market, there were excess this throughout the market. -- excesses' throughout the market. subprime was were the most egregious excesses' took place. people use the mad cow disease as an example and i think that first came from me. that is a good example because there was so much uncertainty about that.

i am not sure that would have made a big difference. >> let me tell you why i think it is significant because we have had questions here yesterday and we might have for the ones today. both regulated banks which are heavily regulated, as you know, and investment banks failed in roughly the same circumstances permit their runs on both, confidence was lost on both per the question really is, if there were circumstances that were so severe coming out of some event that was unprecedented in the last 70 years, wasn't it a significant fact that there was

no way that our regulatory system could have prevented or did prevent a loss not only among investment banks but also regulated real legs. -- real banks. >> i take your point. the fact is, this event was -- i think it is hard to go back in history and find any event that was more extraordinary in terms of the extent of the crisis, the magnitude of some of the things that were witnessed here. i think your thesis has a lot of

truth to it. >> thank you. >> thank you, mr. chairman. thank you secretary paulson for joining us today. i want to turn to a portion of your testimony with which i agree. i would like to highlight it if i could read on page 4 of your testimony on securitization, use a," because securitization separated mortgage originators and underwriters from holding the loans there is genetic, +u÷ to stop focusing on the credit worthiness of the loans they made and focus on their ability to sell those loans upstream to underwriters. they relied on their ability to sell those loans into the market. you say under writers should

keep some skin and a gay man that would probably align themselves with investors who -- skin in the game and that would properly aligned themselves with investors. that would lead to more responsible lending practices. yesterday, we heard from chairman caught in his written statement and he said were to the effect that if of lending practices have been followed, most of this crisis simply would not have occurred. this led to the creation of so much worthless mortgage paper that as of september, 2008, banks have reported over half a trillion dollars all losses in subprime mortgages. $500 billion, that was an extraordinary amount of money in

light of the capitalization of many of the institutions that had to write down his paper. yesterday, when james cayne and alan schwartz testified, i ask them what they thought of the idea of requiring investment bankers to take some of their fees and the securities they had and whether that might enhance the diligence and align the interests seven vans -- investors more closely with those of the underwriters. of course, they both said that sounded like a great idea but mr. cayen said they would not like it. , about the investment bankers. i want to hearken back to your successor at goldman sachs y s a similar question of that our first hearing in january. he said that we could take those securities but we would hedge them.

essentially, there would not have the exposure to it. they3ñr all idea it would for tm to be long on and so in your underwriting obligations when you are representing that these were sound investments, you'd be side by side with them in the long haul. all this leads me to a question which i really think there's more on your experience at goldman sachs and on the street that the treasury. -- than at the treasury. how could such a motion be implemented in light of the different responsibilities that investment banks have in at least three of their roles? one is as an underwriter in which they undertake to have a fiduciary duty to investors and represent the security that they are saddling is not just selling

a but represent that it will perform. as a market maker which is essentially what mr. lloyd blankfein was suggesting is that people last four positions and they offer their clients the opportunity to invest long or short or hedge their positions in various respects? >> and as proprietary traders investing in their own account. i would like your thoughts in this regard. if people required to hold those securities, how would you and forced them holding them and saying long on and and not hedging and is that realistic in light of the different obligations of these investment banks? >> that is a very good question. many people have recommended what i have said. the recommendation is long on policy and short on how you would implemented.

it. i think it is difficult to implement for the reasons you suggested. i think your question makes you think about it. the market making function is not really what we are talking about here. if a bank is in the marketplace and it has a climate that wants to sell or wants the bank to help manage risk, that is one situation. it is really as an underwriter. i don't know that i even have a problem, and i probably need to think about this more, but even as an underwriter, putting a hedge on. if the hedge is constructed properly, you could have a

hedge against the mortgage market overall. this particular security means you wanted to perform better, right? >> yes. >> because you have done such good due diligence. the only caveat i would say is that you want to have some skin in the game but you don't want to have too much. some of those firms that got into the most problems or those that kept an extraordinary amount of the paper they had underwritten which was rated aaa and were holding so much on their balance sheet that they almost fail because of that theme that is what john mack said. i asked him whether -- >> he said they choke on their own cooking. his intention was to originate

and distribute. he was not able to sell them all them up that is right. >> that is right. i am not talking about something that is different from prudent risk management. we don't want to ask financial institutions that would not involve a prudent risk management. there has to be a way that as you underwrite, separate from -- there is some piece of what you have underwritten that you could have to continue to live with. >> live with may be as long as the security is intended to produce. and maybe the bonuses that were paid to the people who did the deal and were responsible for the delegates ought to be paid in part in the securities they

created -- one thought is that many people have suggested the fact that underwriters were paid exclusively in cash. the credit rating agencies were paid exclusively in cash. the mortgage brokers were paid exclusively in cash. they did not retain any risk for the failure to perform as projected. could i have two minutes more, please? >> i would think the formulaic composition in general is a problem. and paying in cash but makes the problem much greater. >> not paying in cash. >> formulaic compensation is

another problem because again, i strongly believe that it is important to allied interests. those that underwrite the securities, an important part of their composition -- compensation should be involved in the quality of their job, not just the short-term profit. >> right, and it also has the benefit of aligning their interests with the investors who purchased it and avoiding on toward -- being on the opposite side. can i ask you to reflect a little on this question and maybe you could respond in writing if you come up with any thoughts from your long-term experience on the street as to

how this might work? this is an element that many people are looking for a solution to that could improve diligence and improve the quality of the paper sold which could avoid the problem going forward? >> this is easier to discuss at 100,000 feet into implemented. i will give more thought. >> thank you mr. secretary and thank you for your service. >> we will keep that one the system here who was very busy. >> i will give myself one minute out of my own time. there are some of us on this commission who are admitted non- economists. there is jargon that is used that we sometimes have to translate. >> i will join you on that. i am not an economist. >> i'm also not an attorney.

in trying to understand both in terms of the shadow banking system and and the point about the subprime mortgages and the packages, i think most people would understand interconnectedness. you have five men call me -- climbing a mountain and they are tied together and one falls and the rest of down with him. the terms that are being used are more difficult for me. when you use the e coli example might argument, coming from the agricultural background, if you told me that packaged spanish had a call like and you can go ahead and eat less -- eat less,

--eat lettuce, which replaced a mortgage pegasus? -- packages? did everybody have them and then the rest of them became devalued? >> i will try to explain this in simple terms. >> i can usually handle complex terms. >> you can have a very complex terms and everybody who has read the tax code knows. what had happened was that there were these very complicated securities that were hard to understand. people bought them on a rating. they knew there were problems in subprime.

once the problems occurred, then anything that looked like securitization in the mortgage area or complexity caused people to pull back. it was not a matter of pricing. it became illiquid. if there was a big concern about beef and mcdonald's reduced the price of their hamburgers, more people would not buy it they were scared. >> bear stearns kept saying that they were not big in subprime. >> people then said -- investors became concerned even if there was a low likelihood and when one asset class becomes a liquid, no one can sell it.

people then go to sell another asset class. they sell a mortgage is that they can and pretty soon those become illiquid because everybody is trying to sell them. everybody is sitting around the risk control table trying to sell the same thing. >> it is contagion rather than common stock? >> you try to sell something that becomes a liquid -- illiquid and they become correlated because they are what everybody else try to sell. >> barristers said the only thing they could deal with was treasury. -- bear stearns said the only thing they could deal with was treasury. >> counterparties in the repo market lost confidence in bear stearns.

they were unable to borrow against certain securities. >> is that the same? >> this was a loss of confidence that others were experiencing. it was not nearly to the senate stand. this was focused on their restaurants. lending practices were very sloppily. if i wanted to repel a treasury. it by repro a mortgage security and you give me wonder% of the value of london, that is sloppy. there is an assumption you could keep borrowing at full value on these securities when they were dropping in value. >> i will have to ask my colleague if sloppy is an

economist's term. >> mr. hennessy. >> thank you. i would like to ask you to focus on a specific firm failures. we were talking about what those firms failed. i would like to askñi for you to explain your thinking about some areas you feared might happen if they were not bailed out a rescued. bear stearns, fannie mae and freddie mac, and a ied. as i understand it, the seven --aig. as i understand it, the results were completely different. with bear stearns, you described that if they were the slowest deer and the lion got that the next slowest dear might fall.

there were other scenarios. could you compare and contrast? >> i have to be very careful here because with what i know today in terms of what i knew then. with bear stearns, what i knew then, i knew enough to know that the system was very fragile and that there were so many unknowns in terms of the counterparties that this was a very dangerous risk to take. to have them go down. from what i know today, what was waiting for us in terms of

fannie mae and freddie mac, which it did none of them, and how much more severe the overall situation was. there is no doubt that -- bear stearns was the kind of firm i believe would have gone down like drexel burnham. it would have been a more normal market as opposed to one their wares huge stress and fragility. this caused me concern. fannie mae and freddie mac are a different order of magnitude. that is an unimaginable rest to me. if there had been -- that is an unimaginable risk to me.

there was $3.70 trillion in the u.s. and it flowed through the financial markets like water. if there was a big disruption there, no one in the world without any confidence in our ability to deal with this. >> which you are describing are two different things. it bear stearns failed, it was not that other people believe their securities and that would put them under it was the same problem that the same problem they had what affected other firms. >> it would started a chain reaction. >> with fannie mae and freddie mac, there were other firms that held their debt and the balance sheets and their collapse would have caused problems. >> yes, but it is more than that.

to is the whole thought that something of this magnitude -- it is ball thought that something of this magnitude happening in the united states of america that we've were not going to stand behind that. why would any institution be safe? when you talk about lehman brothers, >> it was about a id. >> --aig. >> of the word order of magnitude bigger than lehman brothers or bear stearns. -- they were an order of magnitude bigger than lehman brothers or bear stearns. there was no one regulator that had a clear line of sight. we knew the least about it.

we knew it was huge in terms of the size and interconnectedness and credit defaults what some call the counterparties. it was a real example of rating. it was also liquidity. many people entered into contracts with them without getting normal margin because they were triple-a. they entered into contracts where they would have to post collateral if there was a downgrade. you touch so many individuals because they guaranteed through their contracts and retirement plans for teachers and care workers and others.

you get tens of millions of americans there. it's like lehman brothers squared. >> different topic -- yesterday, from the bear stearns executives, we consistently heard non-specific hypotheses that there was someone strategically in setting the çópanic -- in citing the panic, that there were actors trying to bring them down. you hear this crop allot but you never hear anyone to name names and say here who was be a big strategically. do you think there were participants out there who were trying to bring down their

restaurants or any of these other firms? >> i do. first of all, i don't think this was the fundamental cause. where there is smoke, there is fire, number one. it was a loss of confidence. i believe short-selling is essential for the price discovery process in the u.s.. i do not use the word collusive because that has a legal connotation. i would say that when you see serial attacks, not just industry overall but serial attacks and it was the easiest trade to short the stock and allow the credit defaults what to widen and see it go like "wolf pack trying to pull down the deer.

i'm not saying there is behavior that was illegal. if the sec investigated and found something illegal, collusive, or criminal, they would have acted. i think we have rules that would serve as well in normal times but when we had extraordinary times like this, we needed to see take some extraordinary actions with regard to short- selling is. i think those thinking about circuit breakers or ways of addressing short selling in times of crisis or when a stock moves too far are important things to do. it looked to me like some kind

of coordinated action. >> thank you. >> thank you, mr. secretary for spending so much time with us talking about these important issues. i would like to talk to you about the fundamental assumption that people seem to have an outlet to challenge it and get your reaction to it. people say financial innovation is a great thing. they say is necessary and serves an important purpose. what i think of innovation, i about cancer research, technology, and it seems to me that when you look at financial innovation over last decade, you have mbs and cdo's and these seem to have led to a common lack of understanding on the selling and buying side of it. it could extend into mortgage products that have become increasingly complex. they don't seem to protect the people that would use these kind

of innovations to protect themselves against natural business exposure. they do not strengthen the u.s. economy or of the real economy , too. they created a lot of unpredictability and a lot of volatility which leads us to where we are today. with that, do you really believe that financial innovation is a positive thing? >>no, i don't. we get to the problem we're talking about earlier which is how to deal with this. there is no doubt in my mind that a lot of innovation has been good. the fact that we have strong markets, efficient markets away from the bank's cas, the concept

of secured as a nation is a good one and i think it's great. the repo markets are. we have had excess of innovation and complexity. i think excess of complexity is a problem and a lot of places. you are bound to have mistakes the more complex something is. with the kind of complexity we have been financial products, it is a problem the only way i can think to practically deal with it because i think it is very difficult to find a role the says you could do this or you can't do that -- i think that regulators should be pushing toward standardization and i

think the right way to deal with that is with capital charges. if something is transparent -- pushing toward transparency, disclosure, and penalize complexity with capital charges. >> thank you. i would like to follow up on the issue of transparency and look at the conversation we were having indirectly about hedge funds and their behavior is within the market. one of the salient moments for bear stearns's when their hedge fund operation declared that they were insolvent, i guess. when you think about the activities rejected his of hedge funds from the crisis, there was a fair degree of lack of transparency. do you think these are entities in what you just described?

>> we focused on hedge funds early on. this was the president's working group and one of the first things we did was all that the relationship between the prime brokers and the big bags. banks and the hedge funds. we want to make sure that the institutions had plenty of capital and margin. as it turns out, this was not where the problem occurred. i think that work was good but the problem was right under our nose in the regulated entities. we were not focused on the conduit, we were focused on hedge funds brett having said that, i recommended in the blueprint we put out that hedge funds that were big and complex enough to be systemically

importance be charted. they need to have that regulation. i am all for that. i think that is important. >> thank you. one final question -- one thing that strikes me is that there really has been no one yet who has made mistakes in this that they would do differently. you said that everybody makes mistakes. i wonder if you would like to be the first to tell us what mistakes you might have made in the course of the crisis? >> there are a good number of mistakes. my mistakes were primarily communication mistakes. let's start with the tarp. when we sent a three-page outline to congress, we should

of had a press conference and said this is not take it or leave it. we should of said this was a starting point for negotiations. i was never able to explain to the american people in a way in which they understood it was these rescues were for their benefit, not for wall street. the rescues today remains very unpopular. the things that are generally the were appointed as mistakes that we've made, in most cases, are situations like lehman brothers where we did not have the authority. i think the major decisions we made with 20/20 hindsight,

working with the imperfect tools and authorities were the right ones. i look back and think they were the right ones. olongapo way, there were -- along the way, there were plenty of mistakes made. i sure wish i communicated better. >> when you look around at the other people involved in this, could you give us the top two or three mistakes made that might have made a difference in all this? >> i think it was the understanding of liquidity. it is easy to look at capital. that is a number. whether it is 8% or 10%, you could look at that in relation to the overall balance sheet. when you find a bag taking -- a bank taking a prime brokerage

account and taking those securities and using them to finance themselves overnight but the making a 30-day or 60-day loan to the prime brokers so they take the security oup, i wonder how people do those things. i think liquidity and understanding liquidity and other than that, i really believe that despite this, we could talk about all the mistakes the bags and rating agencies made but i think if you do not get to the root causes of these, we will be sitting down with another committee and in a number of years and it will be worse because we will still have the root cause which is we

better change our housing policy and restructure and scale back and shrink the mission of freddie mae and freddie mac. we better do some things with their tax policy and o some things to encourage savings in the united states. we want to discourage overbore way. q:kn-- over borrowing. >> two minutes and then i have a quick close them off a lot to fall on something i think was important. the issue of common stock and liquidity. it seems to me that because of the big losses on subprime, as you probably know, the mortgage- backed securities market came to a halt in 2007. they could not buy or sell

mortgage-backed securities, cdo's and so forth. this meant that financial institutions could not sell a substantial portion of their assets and they became largely illiquid. in fact, they had to write down some of their assets because of the roles for accounting at the time these institutions look like they're unstable or perhaps illiquid and it was important, as you pointed out. the regulation of banks and investment banks simply could not cope with that. this is the disappearance of a major asset class. it was no longer there. there was no market for it anymore. i would like to have your reaction to that as a person who is familiar with market. >> there is no doubt there was real liquidity problems. that makes it hard to evaluate

assets. i know your view on mark to market accounting. i know there are a number of powerful people that blatant mark to market accounting. , fair value accounting. i am not one of them. i believe it would have been worse without it. i believe it more financial institutions had marked to market accounting, the excess is would not have built up to the point they had. i do not know how you run an institution if you do not have the discipline of having putting real value on these assets rather than historical value. i am a proponent. i had people during the crisis say they have an idea to stop marked to market accounting and the problem will go away. that would have really scared investors.

i understand your view. i spent a lot of time talking about this with thoughtful people. there is no doubt that during the crisis, mark to market accounting accentuated some of the issues. >> i did not mention mark to market accounting. the lack of liquidity that came from this, people could not value their assets in more. >> exactly, there was not a market they want to accept. >> i just want to talk about two failures. the up one was the overnight repo market. something that also failed was the traditional role of commercial banks as a conduit to investment banks.

bear stearns went to j.p. morgan who knew their collateral. [no audio] [no audio] >> an institution will do what it takes to preserve itself and not overexpose themselves to credit risk.

tim geithner can probably tell you more than i can about the tri-party repo market. remember how that works. you have the custodian banks. there's a big time during the day for administrative convenience have the collateral. during the crisis, they were the ones that had -- they own the rest. -- they own the rest. that was uncomfortable spot for them to be an or any particular institution. i cannot comment beyond that. it is very difficult at a time when everyone is worried about markets to ask institutions to

extend a lot of credit when conference goes at a run has started. >> 1 technical matter -- early on, i referenced some documents provided from goldman sachs regarding cdo's. i would like to enter two more. very quickly, mr. secretary -- when paul revere solar lantern, jumped on this course and said the british were coming -- i referred to the dilemma you may have faced. why is it in 2007 that no one from the public and financial

industry leadership saddled up like paul revere and warned about the coming crisis? >> in 2007, i think many people saw excesses but remember we had the nine markets for some time. in almost any bubble, it becomes obvious after the fact. they all have certain things in common when you look at them. they used the nine markets. there is almost always excess of risk-taking and not a lot of

transparency. many people knew there excesses'. . there were very few of us that saw something of the magnitude we saw. it is hard to predict a 100-year storm. >> even as late as 2007? >> no -- >> you were worried about shaking the markets. >> in late 2007, i think we knew the markets were fragile. in late 2007, i have said this a number of times before, i think that i was as concerned as anyone around me and i

underestimated in 2007 and in early 2008 -- at new there was a problem and i underestimated the magnitude of the scale of what we were dealing with. it was just so big. i look back and say if i had been on missions, i don't know what i would have done differently. it is hard to imagine what we were going through, even thinking about it today. >> i know the vice chair of like to make a comment and i will let him close this. thank you for coming today. we could probably as good many more hours of questions but we will take 50 minutes for lunch after the vice chair backs is closing remarks. >> some of the problem might have been that you were flying at 100,000 feet. andrews air force base was in my

district while i was in congress. when they flew above 50,000 feet, they got as not wings. thank you for coming. we really, really appreciate the ability to cross sections with one person in trying to get a better understanding of what happened. thank you. >> thank you. >> we will take a 15 minute recess. we have to move fast. [captioning performed by national captioning institute] [captions copyright national cable satellite corp. 2010] >> in a few moments, more about the world economy with bob davis of "the washington journal." of "the washington journal."