Hearing Of The Senate Committee On Banking, Housing, And Urban Affairs

Statement

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SEN. DODD: Good, we will come to order. Let me thank our witnesses for being here this morning, and colleagues as well. And just to notify the room how we will proceed -- again, there are only a handful of us here, but we have eight witnesses. And so we've got a long morning in front of us to go through these issues.

And what I'd like to do is, I'll make some opening remarks, turn to Senator Shelby. And then I'll -- as long as the room doesn't all of a sudden get crowded with a lot of members here, I'll ask Senator Reed and Senator Bennett who would like to make a couple of opening comments, and we will get right to our witnesses, who have supplied very thorough testimony. And if each read all of their testimony, we are going to be here until Friday in essence. But it's very, very good and very helpful to us. So we will proceed on those lines and hopefully have a good engaging morning here on a very, very critical issue.

So I welcome all of you to the hearing this morning entitled Enhancing Investor Protection and the Regulation of the Securities Markets. The purpose of today's hearing is to examine what went wrong in the securities markets and to discuss how we can prevent irresponsible practices that led to our financial system seizing up from ever happening again. The -- And how to protect investors, including small investors, from getting burned by the kinds of serious abuses and irresponsible behavior that we've seen in certain quarters of the markets in recent years.

We are going to hear about proposals to regulate the securities market, so that it supports economic growth and protects investors rather than threatens economic stability. As important, today, we will begin to chart a course forward. A course that acknowledges how complex products and risky practices can do enormous damage to the heart of our financial system, the American people as well, absent a strong foundation of consumer and investor protections.

Half of all U.S. households are invested in some way in securities. Meaning the path we choose for regulating this growth, and growing, segment of our financial system will determine the futures not only of traders on Wall Street, but of families across the country. A year ago this coming Saturday, the collapse of Bear Stearns underscored the important role that securities play in our financial system today.

When I was elected to the Senate in 1980, bank deposits represented 45 percent of the financial assets of the United States, and securities represented 55 percent. Today the securities sector dominates our financial system representing 80 percent of financial assets, with bank deposits a mere 20 percent.

As the securities market has expanded, so too has its influence on the lives of average citizens. Much of that expansion has been driven by deposits known as securitization, in which everyday household debt is pooled into sophisticated structures for mortgages and auto loans to credit cards and student loans.

In time, however, Wall Street not only traded that debt, it began to pressure others into making riskier and riskier loans to consumers. And lenders, brokers, and credit card companies were all too willing to comply, pushing the middleclass family in my state of Connecticut and elsewhere across the country, who would have qualified for a traditional secure product, into a riskier subprime mortgage. Or giving that 17-year-old college student, who never should have qualified in the first place, a credit card with teaser rates that were irresistible, but terms that were suffocating. As one trader said of a Detroit subprime lender, they were moving money out of the door to Wall Street so fast with so few questions asked, these loans were not merely risky, they were in fact built to self-destruct.

As we knew it, securitization did not reallocate risk; it spread risk throughout our financial system, passing it on to others, like a high-stakes games of hot potato with no incentive to make sure these risky loans paid off down the road. Each link in the securitization chain -- the loan originators, Wall Street firms and fund managers with the help of credit rating agencies, generated more risk. They piled on layers of loans into mortgage-backed securities, which were piled into collateralized debt obligations, which were in turn piled into CDOs squared and cubed, severing the relationship between the underlying consumer and their financial institutions.

Like a top-heavy structure built on shoddy foundations, it all of course came crashing down. I firmly believe that had the Fed simply regulated the mortgage lending industry as Congress directed with a law passed in 1994, much of this could have been averted. But despite the efforts of my predecessor on this committee, myself and others, many years of -- over many years, the Fed refused to act.

But the failure of regulators was not limited to mortgage-backed securities. As many constituents in Connecticut and elsewhere have told me, auction rate securities, misleadingly marketed as cash equivalents, left countless investors and city pension funds across the country with nothing when the actions failed and the securities could not be redeemed.

As this committee uncovered at a hearing about AIG last week, the unregulated credit derivatives market contributed to the largest quarterly loss in history. In recent months, we have unearthed two massive Ponzi schemes bilking consumers, investors, charities, and municipal pension funds out of tens of billions of dollars, that two separate regulators failed to detect in their examinations.

In January, I asked Dr. Henry Backe of Fairfield, Connecticut, to address this committee about the losses suffered by the employees at his medical practice in the Bernard Madoff fraud. His testimony prompted Senator Menendez and me to urge the IRS to deduct -- rather to dedicate serious resources to helping victims like Linda Alexander, a 62-year-old telephone operator from Bridgeport, Connecticut, who makes less then $480 a week and lost every penny of her retirement savings. In an instant, the $10,000 she had saved over a lifetime evaporated because regulators had no idea a massive fraud was occurring right under their noses.

This crisis is the result of many -- what many have been -- what may have been the greatest regulatory failure in human history. If you need any further evidence, consider this. At the beginning of the credit crisis in 2008, the SEC regulated five investment banks under the Consolidated Supervised Entities program -- Lehman Brothers, Bear Stearns, Merrill Lynch, Goldman Sachs, and Morgan Stanley, names synonymous with America's financial strength, having survived World Wars and the great -- the Great Depression. And through the seeds of their destruction had been planted nearly -- and though the seeds of their destruction had been planted nearly a decade ago, each was sold, converted to a bank holding company or failed outright inside of six months, every single one of them.

Our task today is to continue our examination of how to begin rebuilding a 21st-century financial structure. We do so not from the top down forcing solely -- focusing solely on the soundness of the largest institutions with the hope that it trickles down to the consumer; but rather from the bottom up, ensuring a new responsibility in financial services and a tough new set of protection for regular investors who thought these protections were already in place.

The bottom-up approach will create a new way of regulating Wall Street. For the securities market, that means examining everything, from the regulated broker-dealers and their sales practices to unregulated credit default swaps. It means ensuring that the creators of financial products have as much skin in the game when they package these products as their consumers do when they buy them. So instead of passing on risk, everyone shares responsibility.

And that means we need more transparency, from public companies, credit rating agencies, municipalities and banks. We are going to send a very clear message that these modernization efforts, the era of "don't ask" in these modernization efforts, the era of "don't ask, don't tell" on Wall Street and elsewhere is over.

For decades, vitality, innovation, and creativity have been a source of genius of our system. And I want to see that come back. It's time we recognized transparency and responsibility are every bit as paramount; that whether we are home buyers, city managers, entrepreneurs, we could only make responsible decisions if we have the accurate and proper information.

We want the American people to know that this committee will do everything in its power to get us out of this crisis by putting the needs of people first -- from constituents like Linda Alexander, who I mentioned a moment ago, to millions more whose hard-earned dollars are tied up to our secure -- tied up in our securities markets. Today's hearing will provide an opportunity to hear ideas and build a record upon which this committee can legislate a way forward for the American people to rebuild confidence in the securities markets and to put our country back on a sound economic footing.

With that, I thank our witnesses again for being here. Let me turn to my colleague, former chairman, Senator Shelby.

SEN. RICHARD C. SHELBY (R-AL): Thank you, Chairman Dodd. I think the greatest challenge -- the greatest challenge in dealing with this financial crisis is understanding its multiple, complex and interrelated causes. This hearing provides us an opportunity to examine some of the causes that relate to our securities markets and securities regulation.

Without presupposing the specific causes of the financial crisis, I think it's appropriate to conclude that a broad failure of risk management in the financial system led us to where we are today. It appears that everybody assumed that someone else was monitoring the risk.

Regulators assumed that financial institutions had properly assessed the risk of their own activities, or assumed that other regulators were watching what those entities were doing. Financial institutions failed to adequately monitor risks across business units and failed to thoroughly understand the risk associated with new financial products. They did not adequately assess either their exposures to or the health of their counterparties.

Very sophisticated investors assumed that someone else had done their due diligence. Less sophisticated investors assumed, unreasonably, that asset prices would only clam. The excessive reliance on credit ratings and the failure of the market to develop a clearinghouse for credit default swaps are just two examples of this widespread market failure.

The disastrous consequences of this nearly universal passing of the buck should serve as a guidepost for us and the SEC as we consider reforms. I think there should be clear lines of responsibility for regulators. Only then can Congress hold regulators accountable for their performance.

It's also important not to make changes to the statutory and regulatory framework that would further lull market participants into believing that regulators or other market participants are doing their work for them. We can't build a regulator big enough to be everywhere at all times.

Market participants need to do their own due diligence before and after they make an investment decision. They need to bear the cost of an unwise investment just as they reap the benefit of a wise investment.

In the end, I believe our market will best -- be best served by the combined efforts of diligent regulators and responsible market participants working under rules that are clear and consistent. Uncertainty about the rules impedes the market from working as it should. Ad hoc government actions will leave private capital to sit on the sidelines because a change in rules can radically change a market participant's expected return.

A consistent legal framework is an essential component of a competitive capital market. Investors will avoid a market if they believe the rules may change in the middle of the game. A clear example of this dynamic is the world of accounting, where many are calling for the suspensions of mark-to-market because of the adverse impact that it's presently having on the books in so many companies.

Accounting rules should be designed to ensure that a firm's disclosures reflect economic reality, however ugly that reality may be. Changing the accounting rules now will simply compound investors' awareness about investing in a market where many firms have bad or illiquid assets on their books.

I would be interested in today's hearing -- to hearing from today's witnesses on this topic, and how the SEC can improve its efforts to protect our securities markets while also facilitating continued innovation and responsible risk-taking.

Mr. Chairman Dodd, I thank you for calling this hearing. I think you're on to something here.

SEN. DODD: Well, Senator, thank you very, very much. And I've got quite a row here of witnesses to testify. Let me put it on to Jack Reed and Michael Bennet. Any opening quick comments, Jack?

SEN. JACK REED (D-RI): Mr. Chairman, I'm very interested in hearing the witnesses that we've assembled, and you have an impressive panel. Thank you.

SEN. DODD: Okay. Senator Bennet?

SEN. MICHAEL BENNET (D-CO): Mr. Chairman, thanks for holding the hearing. It is from this perspective truly a row of witnesses, so I'll wait until we are done.

SEN. DODD: And let me invite you as well, Senator, unless others show up, more than willing to have you -- I'm sorry, I didn't see -- (laughs).

If you wanted to move on up and -- at all and join us here, you -- if not, I'm fearful I may call on you as a witness here.

(Laughter.)

SEN. : Well, I have a point of view, I'd be happy to --

SEN. DODD: No. And I'm sure you do, I know you do. Senator Shelby and I just -- we've been in that chair before. In fact, I think I was the chair further back in the room a long time ago, so along the way, it's been great.

Senator Crapo?

SEN. MIKE CRAPO (R-ID): I was in that chair on this side. I know very much what it's like. Thank you very much, Mr. Chairman, I'll be very brief. I really appreciate your holding this and the other hearings that you have scheduled. As you know, I'm very interested in this issue and look forward to working with you.

SEN. DODD: Good.

SEN. CRAPO: And let's get on with the witnesses.

SEN. DODD: You bet. And I appreciate Senator Crapo has had a long-standing interest in reg reform issues and has expressed to me on numerous occasion his desire to be involved in this discussion, as has Senator Bennet and others. So -- I think we got some very interested members on the committee that will want to work together on these issues as we move forward in the coming weeks to put together a bill.

I was listening this morning to the speech by Ben Bernanke talking about his ideas. And maybe some of our witnesses -- I know you have prepared statements, but certainly feel free in your comments to react to some of his thoughts this morning. That would be welcomed as well. Since he made the speech this morning -- where was it, Brookings or -- I don't know where he --

SEN. : Foreign Relations.

SEN. DODD: Oh, Council on Foreign Relations he made it as well. With that, let me briefly -- again, I think most of our folks should know our witnesses. Very briefly, we have Professor John Coffee, who has been before us many times. He is Adolf Berle professor of law at Columbia Law School. Timothy Ryan, president and CEO of Securities Industry and Financial Markets Association; Paul Schott Stevens, president and CEO of Investment Company Institute; Professor Mercer Bullard, who is associate professor at the University of Mississippi School of Law; Robert Pickel, who is the executive director and CEO of International Swaps and Derivatives Association; Damon Silvers, is the associate general counsel at the AFL-CIO; Thomas Doe, CEO of Municipal Market Advisors; Lynn Turner, the former chief accountant at Securities and Exchange Commission.

So a good row of witnesses here to testify. And we'll begin in the order that I've introduced you. So -- Dr. Coffee, you seem to occupy that chair every time we come here.

MR. COFFEE: Well, good morning and thank you Chairman Dodd, Ranking Member Shelby, and fellow senators. I have prepared an overly long bulky 70-page memorandum for which I apologize for inflicting on you. It attempts to synthesize a good deal of recent empirical research by business school scholars, finance scholars, and even law professors about just what went wrong and what could be done about it.

I can't summarize all that, but I would add the following two sentences to what Senators Dodd and Shelby very accurately said at the outset. The current financial crisis is unlike others. This was not a bubble caused by investor mania, which is the typical cause of bubbles.

It was not a demand-driven bubble. Rather, it was more a supply- driven bubble. It was the product of a particular business model, a model known as the originate-and-distribute model, under which financial institutions including loan originators, mortgage lenders, and investment banks, all behaved similarly and went to the brink of insolvency and beyond, pursuing the model.

What's the key element of this originate-and-distribute model? You make lax loans, you make non-credit worthy loans because you do not expect to hold those loans for long enough to matter. You believe that you can transfer these loans to the next link in the transmission chain before you will bear the economic risk.

When everyone believes that, and they correctly believed that for a few years, then all standards begin to become relaxed. And we believe that as long as we can get that investment-grade rating from the credit rating agencies, we will have no problem, and weak loans can always be marketed.

There is no time for statistics here, but let me add just one. Between 2001 and 2006, a relatively short period, some of the data that I cite shows you that low-document loans in these portfolios went from being something like 28 percent in mortgage-backed securities in 2001, to 51 percent in 2006, doubling in four or five years. Investment banks, credit rating agencies are not responding to that change. That's the essential problem.

This gives rise to what I'll call, and economists call, a "moral hazard problem." And this moral hazard problem was compounded by deregulatory policies that the SEC and other institutions followed that permitted investment banks to increase their leverage dramatically between 2004 and 2006, which is only just a few years ago. This is yesterday we are talking about.

They did this pursuant to the Consolidated Supervised Entities program that you've already been discussing. And it led to the downfall of our five largest, most important investment banks, all right. Essentially the SEC deferred to self-regulation by which these five largest banks constructed their own credit risk models and the SEC deferred to them.

The 2008 experience shows, if there ever was any doubt, that in an environment of intense competition, and under the pressure of equity-based executive compensation systems that tend to be very short-term oriented, self-regulation alone simply does not work. The simplest way for a financial institution to increase profitability was to increase its leverage, and it did so to the point where they were leveraged to the eyeballs, and couldn't survive the predictable downturn in the economic weather.

So what should be done from a policy perspective? Well, here is my first and most essential point. All financial institutions that are too big to fail, which really means too entangled to fail, need to be subjected to prudential financial oversight, what I would call financial adult supervision, from a common regulator applying a basically common, although risk-adjusted standard, to all these institutions, whether they are insurance companies, banks, thrifts, hedge funds, money market funds or even pension plans or the financial subsidiaries of very large corporations like GE Capital.

In my judgment, this can only be done by the Federal Reserve Board, that's the only person in a position to serve as what's called the systematic risk regulator. I think we need in this country a systematic risk regulator, and specifically to define what this means, let me say there are five areas where their authority should be established.

The Federal Reserve Board should be authorized to do and mandate to do the following five things -- one, establish ceilings on debt-to- equity ratios and otherwise restrict leverage for all major financial institutions. Two, supervise and restrict the design and trading of new financial products, including in particular over-the-counter derivatives and including the posting of margin and collateral for such products.

Three, mandate the use of clearinghouses. The Federal Reserve is already doing this, formulating this, trying to facilitate this, but mandating it is more important. And they need the authority to supervise these clearinghouses, and also if they judge it to be wise and prudent, to require their consolidation into a single clearinghouse.

Four, the Federal Reserve needs the authority to require the writedown of risky assts by financial institutions regardless of whether accounting rules mandate it. The accountants will always be the last to demand a writedown because their clients don't want it; the regulators are going to have to be more proactive than are the accounting firms.

Lastly, the Federal Reserve should be authorized to prevent liquidity crises that come from the mismatch of assets and liabilities.

The simple truth is that financial institutions hold long-term illiquid assets which they finance through short-term paper that they have to roll over regularly and that mismatch regularly causes problems.

Now, under this "twin peaks model" that I am describing, the systematic risk regulator, presumably the Federal Reserve would have broad authority. But the power should not be given to the Federal Reserve to override the consumer protection and transparency policies of the SEC. And this is a coequal point with my first point that we need a systemic risk regulator.

Too often, bank regulators and banks have engaged in what I would term a conspiracy of silence to hide problems, lest investors find out, become alarmed, and create a run on the bank. The culture of banking regulators and the culture of securities regulators is entirely different. Bank regulators do not want to alarm investors; security regulators understand that sunlight is the best disinfectant.

And for the long run, just as Senator Shelby said, we need accounting policies that reveal the ugly truth. We couldn't be worse off now in terms of lack of public confidence. This was precisely the moment to make everyone recognize what the truth is and not to give any regulator the authority to suppress the truth under the guise of systematic risk regulation. Okay, for that reason I think SEC responsibilities for disclosure, transparency in accounting should be specially spelled out and exempted from any power that the systematic risk regulator has to overrule other policies.

Now, two last points. As a financial technology, asset-backed securitizations, at least in the real estate field, has decisively failed. I think two steps should be done by legislation to mandate the one policy that I think will restore credibility to this field.

First, to restore credibility, sponsors must abandon the originate-and-distribute business model, and instead, commit to retain at least a portion of the most subordinated tranche. The riskiest assets, some of them had to be held by the promoter because that's the one signal of commitment that tells the marketplace that someone's investigated these assets because they are holding the weakest, most likely to fail. That would be step one.

Step two, we need to reintroduce due diligence into the process, into the securitization process, both for public offerings and for Rule 144A offerings, which are private offerings. Right now, regulation may be deregulated, and it doesn't really require adequately that the sponsor verify the loans, have the loan documentation in its possession, or to have examined the creditworthiness of the individual securities. I think the SEC can be instructed by Congress that there needs to be a reintroduction of stronger due diligence into both the public and the private placement process.

Last point, credit rating agencies are obviously the gatekeeper who failed most in this current crisis. The one thing they do not do that other gatekeepers do do is verify the information they are relying on. They have their rating methodology, but they just assume what they are told, they don't verify it. I think they should be instructed that there has to be verification either by them or by responsible independent professionals, who certify their results to them.

The only way to make that system work and to give it teeth is to reframe a special standard of liability for the credit-rating agencies. I believe the Congress can do this and I believe that Senator Reed and his staff are already examining closely the need for additional legislation for credit rating agencies. And I think they are very much on the right track and I would encourage them.

What I'm saying in closing is that a very painful period of deleveraging is necessary. No one is going to like it. I think some responsibility should be given to the Federal Reserve as the overall systematic risk regulator, but they should not have authority to in any way overrule the SEC policies on transparency. Thank you.

SEN. DODD: Thank you very much.

Professor -- Mr. Ryan, welcome.

MR. RYAN: Good morning.

SEN. DODD: Good morning.

MR. RYAN: Thank you for inviting me, appreciate being here. Our current financial crisis, which has affected nearly every American family, underscores the imperative to modernize our financial regulatory system. Our regulatory structure and the plethora of regulations applicable to financial institutions are based on historical distinctions between banks, securities firms, insurance companies and other financial institutions; distinctions that no longer conform to the way business is conducted.

The negative consequences to the investing public of this patchwork of regulatory oversight are real and pervasive. Investors do not have comparable protections across the same or similar financial products. Rather, the disclosures, standards of care and other key investor protections vary based on the legal status of the intermediary or the product or service being offered.

In light of these concerns, SIFMA advocates simplifying and reforming the financial regulatory structure to maximize and enhance investor protection and market integrity and efficiency. Systemic risk, as Professor Coffee noted, has been at the heart of the current financial crisis.

As I previously testified, we at SIFMA believe that a single, accountable financial markets stability regulator, a systemic regulator, will improve upon the current system. While our position on the mission of the financial markets stability regulator is still evolving, we currently believe that its mission should consist of mitigating systemic risk, maintaining financial stability, and addressing any financial crisis, all of which will benefit the investing public.

It should have the authority over all markets and market participants, regardless of charter, functional regulator or unregulated status. It should have the authority to gather information from all financial institutions and markets, adopt uniform regulations related to systemic risk, and act as a lender of last resort. It should probably have a more direct role in supervising systemically important financial organizations, including the power to conduct examinations, take prompt corrective action, and appoint or act as the receiver or conservator of all or part of the systemically important organizations.

We also believe, as a second step, that we must work to rationalize the broader regulatory framework to eliminate regulatory gaps and imbalances that contribute to systemic risk by regulating similar activities and firms in a similar manner and by consolidating certain financial regulators.

SIFMA has long advocated the modernization and harmonization of the disparate regulatory regimes of investment advisory, brokerage, and other financial services in order to promote investor protection. SIFMA recommends the adoption of a "universal standard of care" that avoids the use of labels that tend to confuse the investing public, and expresses, in plain English, the fundamental principles of fair dealing that individual investors can expect from all of their financial service providers.

Such a standard could perform a uniform -- could provide a uniform code of conduct applicable to all financial professionals. It would make clear to all individual investors that their financial professionals are obligated to treat them fairly by employing the same core standards whether the firm is a financial planner, an investment adviser, a securities dealer, a bank, an insurance agency or another type of financial service provider.

The U.S. is the only jurisdiction that splits the oversight of securities and futures activities between two separate regulatory bodies. We support the merger of the SEC and the CFTC.

We believe that the development of a clearinghouse for credit derivatives is an effective way to reduce counterparty credit risk, facilitate regulatory oversight and thus promote market stability. In particular, we strongly support our members' initiative to establish a clearinghouse of CDS. We are pleased to note that ICE US Trust opened its doors for clearing CDS transactions yesterday.

Finally, the current financial crisis reminds us that markets are global in nature and so are the risks of contagion. To promote investor protection through effective regulation and the elimination of disparate regulatory treatment, we believe that common regulatory standard should be applied consistently across markets. Accordingly, we urge that steps be taken to foster greater cooperation and coordination among regulators in all major markets. Thank you.

SEN. DODD: Thank you very much for that.

Paul, welcome; it's nice to see you now before the committee.

MR. STEVENS: Thank you very much, Mr. Chairman. I got that right? On now?

SEN. DODD: Yeah.

MR. STEVENS: On behalf of the institute and our member funds, I thank you Chairman Dodd, Senator Shelby, and all the members of the committee for making it possible for me to appear today. We serve 93 million American investors as you know, and we strongly commend the committee for the attention you're devoting to improving our system of financial regulation.

I believe the current financial crisis provides a very strong public mandate for Congress and for regulators to take bold steps to strengthen and modernize regulatory oversight. Like other stakeholders, and there many of course, we've been thinking hard about how to revamp the current system. Last week, we published a white paper detailing a variety of forms and in it we recommend changes to create a regulatory framework that provides strong consumer and investor protection while also enhancing regulatory efficiencies, eliminating duplication, closing conspicuous regulatory gaps, and frankly, emphasizing the national character of our financial services markets.

I'd like briefly to summarize the proposals. First, we believe it is crucial to improve the government's capability to monitor and mitigate risks across the financial system. So ICI supports creation of a system risk regulator. This could be a new or an existing agency or interagency body, and in our judgment should be responsible for monitoring the financial markets broadly, analyzing changing conditions here and overseas, evaluating and identifying risks that are so significant that they implicate the health of the financial system, and acting in coordination with other responsible regulators to mitigate these risks.

In our paper, we stress the need to carefully define the responsibilities of a systemic risk regulator as well as its relationship with other regulators. And I would say, Mr. Chairman, that's one of the points that Chairman Bernanke made in his speech today to leverage the expertise and to work closely with other responsible regulators in accomplishing that mission.

In our judgment, addressing systemic risk effectively, however, need not and should not mean stifling innovation, retarding competition, or compromising market efficiency. You can achieve all of these purposes, it seems to us, at the same time.

Second, we urge the creation of a new capital markets regulator that would combine the functions of the SEC and the CFTC. This capital market regulator's statutory mission should focus sharply on investor protection and law enforcement. It should also have a mandate, as the SEC does currently, to consider whether its proposed regulations promote efficiency, competition, and capital formation.

We suggest several ways to maximize the effectiveness of the new capital markets regulator. In particular, we would suggest a need for a very high level focus on management of the agency, its resources, and its responsibilities, and also the establishment of mechanisms to allow it to stay much more effectively abreast of market and industry developments.

Third, as we discuss more fully in our white paper, effective oversight of the financial system and mitigation of systemic risk will require effective coordination and information sharing among the systemic risk regulator and the regulators responsible for other financial sectors. Fourth, we've identified areas in which the capital markets regulator needs more specific legislative authority to protect investors and the markets by closing regulatory gaps and responding to changes in the marketplace. In my written statement I identify four such areas -- hedge funds, derivatives, municipal securities, particularly to improve disclosure standards and the inconsistent regulatory regimes that exist today for investment advisors and broker-dealers.

Now, as for mutual funds, they've not been immune from the effects of the financial crisis, nor for that matter, have any other investors. But our regulatory structure, and this bears emphasizing, which grew out of the New Deal, as a result of the last great financial crisis, has proven to be remarkably resilient even through the current one.

Under the Investment Company Act of 1940 and other securities laws, fund investors enjoy a range of vital protections. Daily pricing of fund shares with mark-to-market valuation every business day, separate custody of all fund assets, minimal or no use of leverage in our funds, restrictions on affiliated transactions and other forms of self-dealing require diversification, and the most extensive disclosure requirements faced by any financial products.

Funds have embraced this regulatory regime and they have prospered under it. Indeed, I think recent experience suggest that policymakers should consider extending some of these very same disciplines that have worked so well for us since 1940 to other marketplace participants in reaction to the crisis that we're experiencing today.

Finally, let me comment, Mr. Chairman, briefly on money market funds. Last September, immediately following the bankruptcy of Lehman Brothers, a single money market fund was unable to sustain its $1 per share net asset value. Coming hard on the heels of a series of other extraordinary developments that roiled global financial markets, these events worsened an already severe credit squeeze. Investors wondered what other major financial institution might fail next and how other money market funds might be affected.

Concerned that the short-term fixed income market was all but frozen solid, the Federal Reserve and the Treasury Department took a variety of initiatives, including the establishment of a temporary guarantee program for money market funds. These steps have proved highly successful. Over time, investors have regained confidence. As of February, assets and money market funds were in an all-time high, almost $3.9 trillion.

The Treasury Department's temporary guarantee program will end no later than September 18th. Funds have paid more than $800 million in premiums, yet no claims have been made, and we do not expect any claims to be made. We do not envision any future role for federal insurance of money market fund assets, and we look forward to an orderly transition out of the temporary guaranteed program.

The events of last fall were unprecedented, but it's only responsible that we the fund industry look for lessons learned. So in November 2008, ICI formed a working group of senior fund industry leaders to study ways to minimize the risk to money market funds of even the most extreme market conditions.

That group will issue a strong and comprehensive set of recommendations designed, among other things, to enhance the way money funds operate. We expect that report by the end of the month. We hope to place the executive summary in the record of this hearing, and Mr. Chairman, I would be delighted to return to the committee if it's of interest to you to present those recommendations at a future date. Thank you very much.

SEN. DODD: Very much -- thank you very much for that, and so we'll welcome that addition to the committee record as well.

Professor Bullard, thank you very much for joining us.

MR. BULLARD: Thank you, Chairman Dodd, Ranking Member Shelby, members of the committee, for the opportunity to appear here today. I congratulate the committee for its thorough and deliberate investigation into the causes of the current financial crisis. Recent events have provided useful lessons on the management of systemic risk, prudential regulation, and investor protection in the investment management industry.

The performance of stock and mutual fund -- stock and bond and mutual funds, for example, has demonstrated the remarkable resiliency of the investment company structure in times of stress. As equity values have plummeted, most shareholders and stock funds have stood their ground notwithstanding that they have the right to redeem their shares at short notice at their NABs (ph).

There is no scientific explanation for the stability of mutual funds during this crisis, but I believe it is related to this redemption right as Paul was describing a moment ago. Mutual fund investors are confident that they will receive the net asset value of their holdings upon redemption, and they appear to believe that the net asset value of those shares -- that net asset value will be fair and accurate. This confidence in the valuation and redeem-ability of mutual fund shares reduces the likelihood of the kind of panicked selling that cause -- that creates systemic risk and may provide a useful lesson for the regulation of other financial intermediaries.

The current crisis has exposed certain investor protection issues, however, and investors and target date and short-term bond funds have experienced investment returns that are not consistent with returns typical of that asset class. If a fund uses the name Target Date 2010, for example, its equity allocation should fall within the generally expected range for someone on the brink of retirement. Similarly, a 529 Plan option that is touted as appropriate for a 16- year-old should not lose 40 percent of its value two years before the money will be needed for college.

Investors should be free to choose more aggressive asset allocations than those normally considered most appropriate for the situation. But funds that use a name that most investors will assume reflects a particular strategy should be required to invest consistent with that strategy.

In contrast with other types of mutual funds, the performance of money market funds has raised systemic and prudential regulation concerns. Money market funds constitute a major linchpin in our payment system and therefore a run on these funds pose a significant systemic risk.

The management of this risk has been inadequate as demonstrated by the recent run on money market funds following the failure of the reserved primary fund. There are important lessons to be learned from this experience, but not the lessons that some commentators have found.

The Group of Thirty, for example, has recommended that the money- market franchisee be eliminated. Former Fed Chairman Volcker explained that if money market funds are going to talk like a bank and squawk like a bank, they ought to be regulated like a bank.

The problem with this argument is that money market funds don't fail like banks. Since 1980, more than 3,000 U.S. banks have failed, costing taxpayers hundreds of billions of dollars. During the same period, two money market funds have failed costing taxpayers zero dollars.

I agree that a regulatory rearrangement is in order but it is banks that should be regulated more like money market funds. Banks routinely fail because they invest in risky long-term assets while money market funds invest in safe short-term assets. Insuring bank accounts may be necessary to protect against the systemic risk that a run on banks poses to the payment system, but there is no good reason why banks should be permitted to invest in sure deposits in anything other than the safest assets. And there is no good reason why money market funds that pose the same systemic risk to our payment system should be left uninsured.

I know, Senator Dodd -- Chairman Dodd, you may have picked up this morning on Chairman Bernanke's comments that some kind of interim insurance program may be appropriate response to the crisis. And I have to disagree with Paul that the September -- the program will necessarily end in September. I posted an article on SSRN that deals with one thesis to how to approach money market fund insurance, and I hope the committee and staff will take a look at that.

The current crisis has also exposed significant weaknesses in hedge fund and investor and advisor regulation. For example, hedge funds are permitted to sell investments to any person with a net worth of at least $1 million, a minimum that has not been adjusted since 1982.

This means that a hedge fund is free to sell interest to a recently retired couple that owns a $250,000 house and has $750,000 investments, notwithstanding that their retirement income is likely to be around $35,000 a year before Social Security.

Finally, the Madoff scandal has again reminded us of the risks of the SEC's expansive interpretation of the broker exclusion from the definition of investment advisor. It appears that Madoff did not register as an investment advisor in reliance on the SEC's position that managing discretionary accounts could somehow be viewed as solely incidental to related brokerage services.

This overbroad exclusion left Madoff subject only to broker regulation, which failed to uncover this fraud. The SEC has since rescinded its ill-advised position on discretionary accounts but it continues to read the solely incidental exception, so broadly as to the thousands of brokers who provide individualized investment advice, subject only to a broker's suitability obligation.

These brokers should be subject to the same fiduciary duties that other investment advisors are subject to, including the duty to exclude -- to disclose revenue-sharing payments and other compensation that create a potential conflict with their client's interests.

And finally, I would just add to the comments on the question of systemic or prudential regulator. I agree with Professor Coffee's comments that there is something simply fundamentally inconsistent with the SEC's investor protection role and the prudential role that it has not served particularly well in recent times and that those roles should be separated.

I agree that there should be a federal prudential regulator, which is what I would call it, that oversees all of those similar characteristics such as net capital rules, money market fund rules, banking regulations that share those prudential or systemic risk concerns. It's not clear to me, however, the particular types of liabilities that insurance companies hold would be suitable for one common prudential regulator, that that's something we don't necessarily need to consider unless the federalizing of insurance regulation begins to make additional progress.

And I would also add that we need to keep in mind that there is a significant difference between customer protection and investor protection. I think when Paul was talking about a capital markets regulator, the way I would think of capital markets is being a way of talking about a regular -- as an investor protection regulator, which would serve fundamentally different functions.

Especially in that it embraces risk and looks to the full disclosure of that risk as its principal objective as opposed to what might be viewed as customer protection, which is really to ensure the promised services are what are delivered in a fully disclosed and honest way. These and other issues are addressed in greater detail in my written submission. Thank you very much.

SEN. DODD: Thank you very, very much.

Mr. Pickel, I thank you for joining the committee.

MR. PICKEL: Thank you, Mr. Chairman, and Ranking Member Shelby, and members of the committee, thank you for inviting ISDA to testify here today. We're grateful for the opportunity to discuss the privately negotiated derivatives business, and more specifically, the credit default swaps market.

I've submitted written testimony, and as you've noted Mr. Chairman, that is a lengthy submission and so I would like to summarize some of the key remarks that I included in that testimony. I think first and foremost we need to understand that the benefits of the OTC derivatives business are significant for the American economy and for American -- and American companies.

They manage a broad range of risks using these instruments that are not essential to their businesses, allowing them to manage these financial risks typically so that they can focus on the business that they run. So a borrower, borrowing on a floating basis, can use an interest rate swap to manage its exposure to exchange fixed for floating obligations.

Currency exposure; many companies have significant operations around the world and have significant currency exposure and use currency swaps, OTC currency swaps to manage that risk. ISDA itself uses currency swaps to manage its overseas exposure.

Commodity exposure; airlines have significant exposure to fuel cost and they typically look to utilize OTC derivatives to manage that exposure. And finally, credit exposure using credit derivatives, credit default swaps, exposure to suppliers or to customers where credit is a significant concern. Companies can use these products to help manage that risk.

These products also create efficiencies in pricing and wider availability of credit, particularly credit default swaps. They facilitate lending at lower rates and they are critical to have available and have them widely available as we come out of this recession. I think they would be an important part of the ability of firms to manage credit risk as they look at these important credit issues that we face in this financial crisis.

As far as the role of the credit default swaps and OTC derivatives generally in the financial crisis, first of all, I think -- and this committee certainly heard testimony -- the fundamental source of the crisis is imprudent lending, particularly in the U.S. housing sector, but extending to other markets as well, credit cards and commercial lending as an example. We must distinguish between the credit default swap business and the collateralized debt obligations business. There has been reference to the originate-to-distribute model. That certainly applies to the securitization process and to the CDO process.

In the credit default swap business, a company, a bank that has lent money may use a credit default swap to hedge its exposure on that credit. It will -- in that process it will be maintaining its lending relationship with the borrower and it will also be taking on credit risk in paying a fee to the company that's selling protection. So it's distinctly different from the originate-to-distribute model.

We certainly have heard testimony and this committee heard testimony last week on the AIG situation. I think we need to spend some time, and this organization needs to spend some time talking about that. AIG obviously was significantly involved in credit default swaps. It was the means by which it took risk, but we must understand the poor choices, the adverse policies, and the misunderstood risks that were involved there. And this committee heard a lot about that in the testimony last week, particularly from Mr. Polakoff from the Office of Thrift Supervision.

These were the source of their problems, these misunderstood risks and poor decisions. They were contrary to the best practices in the industry and to the experiences of swap market participants for the past 20 years.

The fundamental decision that AIG made was to take on exposure to the housing market. They did that, yes, via credit default swaps. They also did that, as this committee heard last week, in other means as well, through their securities lending business in which they actually continued to lend and take exposure to those markets into 2006-2007, when the worst of these securities were generated through the lending process.

They also had a very myopic view of loss. They were only looking at the payout potential, the possibility they would actually have to pay out on these transactions. There was no consideration of the implications of the mark-to-market losses that they could face and to the effects on their capital and their liquidity. They seem to have completely ignored the possible effects of that.

They relied on their AAA rating and refused to provide collateral from the start of their trading relationships. It takes away the discipline that collateral provides in that trading relationship. Collateral is extensively used in the OTC derivatives business to help manage risk and also introduce discipline to the trading relationship.

They agreed on the other hand to provide collateral on the downgrade of their credit rating. That led to a falling off of a cliff effectively leading to substantial liquidity problems which eventually lead to the decision to intervene.

So yes, these decisions and policies are important to understand and we need to take steps to make sure that this does not happen again. But those relate to the decisions they made and not to the products themselves. The products, in fact, have performed as the parties intended. In fact, just yesterday the Senior Supervisors Group, which is a group of senior supervisors from the G-7 countries, talked about how the CDS product had performed multiple times over the course of last fall and into this year in helping to settle transactions of credit default swaps that parties had engaged in.

And they acknowledge that this process has been extremely effective. And then finally, this is a very important week in the credit default swap market. I believe Mr. Ryan referred earlier to the fact that one of the clearinghouses that has been talked about for many, many months has now actually begun to clear transactions and that is a very significant development.

And later this week, ISDA itself will introduce some changes to the standard contract that will facilitate the settlement of these trades in the future and will also facilitate moving more transactions on to a clearinghouse. So that's a very important development.

There is much to be done by ISDA, by the industry, in close consultation with this committee and other committees in Congress as well as the regulators here in the United States and globally, and we are committed to be engaged in that process. We look forward to working with you as you analyze the causes of this financial crisis, and based on that analysis, consider changes to our regulatory structure with a goal to obtaining greater transparency, greater disclosure, and greater coordination among regulators. Thank you again for your time and I look forward to your questions.

SEN. DODD: Thank you very, very much.

Damon Silvers. Damon, good to have you with us.

MR. SILVERS: Good morning, Chairman Dodd and Ranking Member Shelby. Thank you for inviting me here today. Before I begin, I would like to note that in addition to my role as associate general counsel of the AFL-CIO, I am the deputy chair of the Congressional Oversight Panel created by the Emergency Economics Stabilization Act of 2008 to oversee the TARP. While I will describe in my testimony aspects of the Congressional Oversight Panel's report on regulatory reform, my testimony reflects my views alone and the views of AFL-CIO unless otherwise noted, and is not on behalf of the panel, its staff, or its chair.

The vast majority of American investors participate in the markets as a means to secure a comfortable retirement and to send their children to college, as you noted, Mr. Chairman, in your opening remarks. While the spectacular frauds like the Madoff Ponzi scheme have generated a great deal of publicity, the bigger question is what changes must be made to make our financial system a more reasonable place to invest the hard-earned savings of America's working families.

Today, I will address this larger question at three levels, regulatory architecture, regulating the shadow markets, and the challenge of jurisdiction, and certain specific steps Congress and regulators should take to address holes in the investor protection scheme. First, with respect to regulatory architecture. The Congressional Oversight Panel, in its special report on regulatory reform, observed that addressing issues of systemic risk cannot be a substitute for a robust, comprehensive system of routine financial regulation.

Investor protection within the system should be the focus of a single agency within the broader regulatory framework. That agency needs to have the stature and independence to protect the principles of full disclosure by market participants and compliance with fiduciary duties among market intermediaries. This has been noted by several -- of -- several of the panelists prior to me.

This mission is a natural tension with bank regulators' mission of safeguarding the safety and soundness of the banks they regulate and that natural tension would apply to a systemic risk regulator that was looking more broadly at safety and soundness issues.

Because of these dynamics, effective investor protection which -- requires that any solution to the problem of systemic risk prevention should involve the agency charged with investor protection and not supersede it.

The -- I have a bit more detailed document on issues associated with creating a systemic risk regulator that I will provide the committee following the hearing. I should just note that in relation to this it is my belief that a more of a group approach to systemic risk regulation, rather than designating the Fed as the sole regulator, would be preferable.

Among the reasons for this are the issues of information sharing and coordination that other panelists raised, but most importantly, the fact that the Federal Reserve in its regulatory role fundamentally works through the regional Fed banks which are fundamentally self- regulatory in nature.

Several of the prior witnesses have mentioned some of the problems with self-regulation on critical issues. Furthermore, a systemic risk regulator, as we have learned through the TARP experience, is likely to have to expend public dollars in extreme circumstances. It's completely inappropriate for that function to be vested in a body that is at all self-regulatory. While the Fed could be changed -- its governance could be changed to make it fully a public agency, that would have implications, I believe, for the Fed's independence in its monetary policy role.

Now, we have already in the Securities and Exchange Commission a regulator focused on investor protection. And although the Commission has suffered in recent years from diminished jurisdiction and leadership failure, the Commission remains an extraordinary government agency whose human capital and market expertise needs to be built upon as part of a comprehensive strategy for effective re-regulation of the capital markets.

This flows -- this point flows right into the issue of jurisdiction in the shadow markets. The financial crisis we are currently experiencing is directly connected to the degeneration of the New Deal system of comprehensive financial regulation into a Swiss cheese regulatory system, where the holes, the shadow markets, grew to dominate the regulated markets.

The Congressional Oversight Panel specifically observed that we needed to regulate financial products and institutions, in the words of President Obama, "for what they do, and not what they are." The Congressional Oversight Panel report further stated that shadow institutions should be regulated by the same regulators that currently have jurisdiction over their regulated counterparts.

So for example, the SEC should have jurisdiction over derivatives that are written using public debt or equity securities as their underlying asset. At a minimum, the panel stated, hedge funds should also be regulated by the SEC in their role as money managers. There is a larger point here though; financial re-regulation will be utterly ineffective if it turns into a series of rifle shots at the particular mechanisms used to evade regulatory structures in earlier boom-and- bust cycles.

What is needed is a return to the jurisdictional philosophy that was embodied in the founding statutes of federal securities regulation -- very broad, flexible jurisdiction that allowed the Commission to follow changing financial market practices. To follow this principle, the SEC should have jurisdiction over anyone over a certain size who manages public securities, and over any contract written that references publicly traded securities. Applying this principle would require at least shifting the CFTC's jurisdiction over financial futures to the SEC, if not merging the two agencies under the SEC's leadership, as I gather some of my fellow panelists believe is necessary.

Moving on to substantive reforms. Beyond regulating the shadow markets, the Congress and the Securities and Exchange Commission need to act to shape a corporate governance and investor protection regime that is favorable to long-term investors and to the channeling of capital to productive purposes. First, strong boards of publicly traded companies that the public invests in; having strong boards requires meaningful accountability to long-term investors. The AFL- CIO urges Congress to work with the SEC to ensure that long-term investors can nominate and elect psychologically independent directors to company boards through access to the corporate proxy.

Second, effective investor protection requires comprehensive executive pay reform involving both disclosure, governance, and tax policy around two concepts. Equity-linked pay should be held significantly beyond retirement; and two, pay packages as a whole should reflect a rough equality of exposure to downside risk as well as to upside gain. Part of this agenda must be a mechanism for long- term shareholders to advise companies on their executive pay packages in the form of an advisory vote.

Finally, Congress needs to address the glaring hole in the fabric of investor protection created by the Central Bank of Denver and Stoneridge cases. These cases effectively granted immunity from civil liability to investors for parties such as investment banks and law firms that are co-conspirators in securities frauds.

Now, to address very briefly the international context. The Bush administration fundamentally saw the internationalization of financial markets as a pretext for weakening U.S. investor protections. That needs to be replaced by a commitment on the part of the Obama administration, the Congress and the regulators to building a strong global regulatory floor in coordination with the world's other major economies.

However, Congress should not allow the need for global coordination to be an impediment or a prerequisite to vigorous action to re-regulate U.S. financial markets and institutions. Obviously, this testimony simply sketches the outline of an approach and notes some key substantive steps for Congress and the administration to take.

While I do not speak for the oversight panel, I think I am safe in saying that the panel is honored to have been asked to assist Congress in this effort, and is prepared to assist this Committee in any manner the Committee finds useful. I can certainly make that offer on behalf of the AFL-CIO. Thank you.

SEN. DODD: Thank you very much.

Mr. Doe, we thank you for joining us, the Municipal Market Advisors.

MR. DOE: Chairman Dodd, Senator Shelby, and Committee members, it is a distinct pleasure that I come before you today to share my perspective on the municipal bond market.

My firm, Municipal Market Advisors, has served for the 15 years as a leading independent research and data provider to the industry.

In addition, from 2003 to 2005, I served as a public member of the Municipal Securities Rulemaking Board, the self-regulatory organization of the industry established by Congress in 1975.

There are nearly 65,000 borrowers in the municipal market that are predominantly states and local governments. Recent figures identify an estimated $2.7 trillion in outstanding municipal debt.

This is debt that aids our communities -- excuse me -- in meeting budgets and financing society's essential needs, whether it is building a hospital, constructing a school, ensuring clean drinking water, or sustaining the safety of America's infrastructure.

A distinctive characteristic of the municipal market is that many of those who borrow funds, rural counties and small towns, are only frequently -- infrequently engaged in the capital markets.

As a result, there are many issuers of debt who are inexperienced when entering a transaction, and are unable to monitor deals that may involve movement of interest rates or the value of derivative products.

According to The Bond Buyer, the industry's trade newspaper, annual municipal bond issuance was ($)29 billion in 1975, whereas in 2007, issuance peaked at ($)430 billion.

In the past 10 years, derivatives have proliferated as a standard liability management tool for many local governments.

However, because derivatives are not regulated, it's exceptionally difficult, if not impossible, to identify the degree of systemic, as well as specific risk for small towns and counties who have engaged in complex swaps and derivative transactions.

Municipal issuers themselves sought to reduce borrowing costs in recent years by selling bonds with a floating rate of interest, such as auction rate securities.

Because states and local governments do not themselves have revenues that vary greatly with interest rates, these issuers employed interest rate swaps to hedge their risk. Issuers use the instruments to transform their floating risk for a fixed-rate obligation.

A key factor in the growth of the leverage and derivative structures was the prolific use of bond insurance.

Municipal issuers are rated along a conservative ratings scale, resulting in much lower ratings for school, districts, and states than for private sector, financial, and insurance companies.

So although most states and local governments represent very little default risk to the investor, the penal ratings scale encourage the use of insurance for both cash and derivatives in order to distribute products to investors and facilitate issuer borrowing.

So instead of requiring more accurate ratings, the municipal industry chose to use bond insurance to enhance the issuer's lower credit rating to that of the higher insurance company's rating.

The last 18 months have exposed the risk of this choice when insurance company downgrades, and auction-rate security failures, forced numerous leveraged investors to unwind massive amounts of debt into an illiquid secondary market.

The consequence was that issuers of new debt were forced to pay extremely high interest rates and investors were confused by volatile evaluations of their investments.

The 34-year era of the municipal industry's self regulation must come to an end. Today, the market would be in a much better place if, first, the regulator were independent of the financial institutions that create the products and facilitate issuers' borrower -- borrowing.

Municipal departments represent a relatively small contribution to a firm's revenue and this inhibits MSRB board members from seeking regulatory innovation.

Second, if the regulator were integrated into the national regime of regulation. Since the crisis began we discovered a limited market knowledge here in DC, in the Federal Reserve, Treasury, Congress, and the SEC.

I might add that when the crisis began and emerged in August of 2007 that we were immediately contacted by the New York Federal Reserve and the Federal Reserve itself and been quite impressed in the last 18 months with their vigilance and interest in this sector. So integration, we believe, would speed market recovery by the shared information.

Third, the regulator's reach and authority needs to be extended to all financial tools and participants of the municipal transaction. This means rating agencies, insurers, evaluators, and investment and legal advisors both -- for both the cash and swap transactions.

This need has become more apparent as we uncover the damage issuers in states such as Alabama, Tennessee, and Pennsylvania are suffering relative to interest rate swaps.

Fourth, the regulator -- if the regulator were charged with more aggressively monitoring market data with consumers' interests in mind -- when I think of consumers I think of both investors and the issuers. In 2008, there were specific instances of meaningful transactions and price irregularities that should have prompted regulatory investigation to protect consumers.

The good news is that this new era of regulatory oversight could be funded by the MSRB's annual revenue in 2008 of $20 plus million collected from the bond transactions themselves and can be staffed by the current MSRB policy and administrative infrastructure.

I should be clear. The innovations of derivatives and swaps have useful application and have been beneficial to those who -- for which they are appropriate. However, it is also important that these instruments become transparent and regulated with the same care as the corresponding municipal cash market. It is critical to get this right. There is simply too much at stake.

Thank you for having me here today. And I look forward to participate in the questions of this session.

SEN. DODD: Thank you very much, Mr. Doe.

Lynn Turner, the chief accountant -- former chief accountant of the Securities and Exchange Commission. And Mr. Turner, we thank you.

MR. TURNER: Thank you, Chairman Dodd, Ranking Member Shelby. It's always good to be here. In this particular case, I must commend both of you for holding this hearing on an issue that's not only impacted millions of investors, but just literally everyone that's been devastated for this economy. I would ask that my written testimony be included in --

SEN. DODD: Yeah, let me make that clear. I know there is a lot of additional documentation, and some of you may want to add as well, and so all of that will be included as part of the record. And we thank you for that.

MR. TURNER: It's only 17 pages, so it's a little bit quick to read than Professor Coffee's.

(Laughter)

Senator Dodd, I think you're right, there is really three root causes of this problem; people made bad loans, gatekeepers sold out, and a lack of regulation or regulators missing in action, quite frankly.

And it's not the first time. As an auditor in the Southwest in Denver, I lived through this with the S&Ls had to do restructurings, workouts at that point in time. And those issues were all existent then and we're back to a repeat.

So, as Mr. Doe and Mr. Silvers indicated, I think it's especially important that this go around the committee get it right. I know there is some push to try to get something done by an August recess. I would say it's more important to hit this target.

We've seen the markets serve as trustee of two large institutional investors. We've seen legislation come out that hasn't instilled that confidence to date. And we need to get it right this time, so we instill that confidence and don't see a market of 5000, quite frankly.

So I would ask you to take your time, whatever is necessary sooner better than late, but I'm not sure this is one that can be both fast and right.

Senator Shelby, you asked someone to comment on the mark-to- market accounting, being the one accountant on Green Ice (ph) -- (inaudible) -- on this, let me say, I couldn't agree more with you.

The mark-to-market accounting that we're debating now is the same issue we debated two decades ago during the S&L crisis. And as the 1991 GAO report stated, the failure of the banks and the S&Ls during that travesty to turn around and take their marks down in a timely manner resulted in a lax regulator action, people not getting on top of managing their assets and problems quick enough, contributed to a significant increase in the cost to the taxpayers of that bailout.

And so I would again urge you to push for transparency here, not step on those accounting standards, and let's get the real numbers. When you look at banks like Citigroup who are trading at a stock price for less than what you can buy a Happy Meal these days at McDonald's.

We know that the market clearly aren't -- isn't viewing those financials as credible and we need to get that credibility back into the system.

Certainly, as my fellow panelists mentioned, there is also gaps in regulation.

Without a doubt the credit derivative market we all know about that. You certainly have all heard about that as recent as last week.

But it was not so much the failure of a regulatory system, although, things need to be fixed this was a failure of regulators to act. The Office of the Comptroller of the Currency, the SEC, both had risk management offices.

The Federal Reserve had examiners day in day out at Citigroup. And this is not the first time Citigroup became, for all practical purposes, insolvent, in need of a bailout.

When I was at the commission two decades ago, the exact same thing happened. And you ask, how can the Fed turn around and allow that to happen. I remember being in a meeting with banking regulators and the chairman of the Fed sometime ago.

And I was asked along with the chairman of the SEC at the time, what's wrong if the banks are allowed to fudge the numbers a little bit. Now, I think we know. If you turn around and ask me, is that who you're going to make our systemic regulator, I would turn around and say, I would hope not.

Rather I think, a notion that Professor Goldsmith, the former SEC commissioner advocated, that the council or commission -- I think, Damon talked on it as well -- is a much better approach. You've got to give us as investors, someone regulating that we can trust in.

The notion of prudential supervision needs to be a notion that dies. What we want is actual regulators doing their job, that's what we are turning around and paying them for. And while there certainly the SEC has fallen off the track here -- I must say that over the years, it's been very successful in its mission to protect investors and gain their confidence.

I think investors will -- would be ill-served and very concerned if some other regulator with a mission other than investor and consumer protection first and foremost was giving -- given that leading role to protect them.

As the committee crafts a solution, I simply believe and focus on systemic regulator in and of itself in doing regulation around just a systemic regulator doesn't get the job done.

I think a more comprehensive single bill is the right way to go after that. And in doing so, I think you should focus on a few key principles that you need to ensure or establish; independence in the system, transparency, accountability, enforcement of the law, and making sure those responsible for doing the job have adequate resources.

Following these key principles -- it's more specifically spelled out in the written statement -- I think there needs to be a closure of the regulatory gaps such with credit derivatives, SEC oversight over in the investment banks, certainly the mortgage brokers who brought this problem upon us, greater accountability established through governance and investor rights including private right to actions, as Damon has mentioned for credit rating agencies, assisting others in the commission of fraud.

Regulators simply can't do it all. And we'll never have enough resources, so we have to give institutional investors a chance to get justice and recover money when there has been fraud involved.

We need to enhance transparency and disclosure not only by the issuers, but also by the regulators. The testimony last week, where the Fed wouldn't give us the names and the details behind the credit derivatives and who was really getting bailed out at AIG was most concerning and disappointing.

There needs to be improvements in self-regulation. And there obviously needs to be a better enforcement of the laws and regulation. But in the end, no agency here neither the (CFT ?), SEC, the banking regulators can do it without adequate resources.

For example, the Office of Compliance and Inspections of the SEC, you're asking them to inspect 16,000 mutual funds; 11,000 plus investment advisors with 440 people. It simply can't be done. At a minimum, the SEC needs $100 million to get the type of technology that just brings them up to what we use down the street in the market.

If they don't even have those tools there is no way they can supervise and stay on top of it. ($)100 million in technology and then they need about another ($)85, ($)90 million just to bring staffing up to the levels they were four to five years ago. And they need it now. They don't need it in October 1 of 2010. That needs to go into the budget now, not a year-and-a-half from now.

So I'd certainly urge -- and I know this isn't the appropriations committee, but I'd certainly urge the Senate to find a way to get them the resources. Without that you're asking them to go into a gunfight with an empty gun and we all know what happens then.

So with that I'll close and be happy to answer any question.

SEN. DODD: Thank you very much, Mr. Turner.

And now what I'll do in terms of time and I will rigidly hold people to it obviously, but try and do five or six minutes and it will give us a chance at least to get around and go over that. Don't worry about it so much we will just try to move along because again we want to get our witnesses involved.

The temptation here, is to focus on sort of one aspect of this. And there are a lot of issues, obviously, across the spectrum, from obviously, credit default swaps, transparency, corporate governance issues, conflicts of interests, credit rating agencies, I mean just a lot of matters to pick out.

So I'm going to try and ask a broader question and then ask each one of you to comment on the broader question. And I think I know the answer to this having listened to all of you, but -- and looked at your testimony.

But I'd like to ask -- and beginning with you, Dr. Coffee, and I think you identified this. But if you can make one recommendation as we're looking at this. And obviously, we got our hands full here in the coming weeks.

And I, by the way, I take the point that was raised either by Mr. Doe or Mr. Turner, I guess, this -- of getting this right. And obviously, there is a sense of urgency. But I think the committee would agree that we want to get it done, we want to work at this very hard, but we do want to get it right.

And so striking that balance between moving with some haste, but not to such a degree that that becomes the goal rather than producing a product here that has been well thought out.

But if you can make one recommendation that you feel is the most important legislative or regulatory action that the committee could take to improve investor protection or the quality of securities regulation in the light of the financial crisis that we're experiencing, what would it be? What's your one recommendation for us? And just go down the line.

MR. COFFEE: (Off mike).

SEN. DODD: You need the microphone on to --

MR. COFFEE: I would tell you that it is the twin peaks model for securities regulation than just having separate peaks. One, the systematic risk regulator, the prudential supervisor, I don't think the SEC is the best agency there for that, by training a culture it's a lawyer-dominated agency focused on enforcement and disclosure, which it does well.

It is not able to deal with financial institutions at least in terms of its first line responsibilities. Some one else can do that better presumably the Federal Reserve.

SEN. DODD: Yeah.

MR. COFFEE: But as was said by other people today, I think there is always the danger that the cultures of securities and banking regulation are so different and if you put them all in one agency, the centralized regulator much like the British model, the FSA, you're going to have tensions and tradeoffs --

SEN. DODD: Yeah.

MR. COFFEE: -- between investor protection and the protection to bank solvency. Thus I think you have to have a separate investor protection agency. You could merge the SEC and the CFTC, or you could transfer financial futures to the SEC.

That's going to be costly in terms of the political process. I don't know whether it's feasible. But the first step I would say is to try to have a systematic risk regulator and to not give it the authority to override the disclosure regulators on questions of accounting or on investor protection. So that's the structural issue from 40,000 feet above --

SEN. DODD: Yes.

MR. COFFEE: -- start there.

SEN. DODD: Is that -- so Eugene Ludwig I've talked to, and he's talked about a similar twin peaks structure that you just described. That's a -- are you familiar with his thoughts on this?

MR. COFFEE: Well, this term "twin peaks" has been used by a number of people --

SEN. DODD: I understand.

MR. COFFEE: -- around the world.

SEN. DODD: Yes.

MR. COFFEE: -- which is two models, the centralized regulator, which is what the U.K. has, and it's not worked that well there either. And we have the twin peaks model, which Australia and the Netherlands and other countries have. We, in the U.S., have a unique fragmented system that is virtually balkanized --

SEN. DODD: Yeah.

MR. COFFEE: -- with a different regulator for every class of institution. We got to move to one of those two, and I'm telling you that the twin peaks model, I think, is vastly superior.

SEN. DODD: Okay, I agree.

Tim Ryan?

MR. RYAN: This is unique. We basically agree with the professor. I mean, we've not worked out most of the details on both aspects of the twin peak, but we know that the number one recommendation we have today -- and actually the country needs it.

We need confidence in the system, there is no confidence today. We need a systemic risk regulator for the major institutions. And we would urge you to do that in a timely fashion. And we would define timely, by the end of this year, and to do it right. Thank you.

SEN. DODD: Stevens.

MR. STEVENS: We, as you know, endorse with some cautions, the idea of a systemic risk regulator, but if you push me to say what one thing, Mr. Chairman, I would say that we need a capital markets regulator that's really at the top of its game.

This problem would not have grown unless the securities markets made available, through packaging and reselling and all the rest of it, a vast opportunity to take these mortgages and distribute them to financial institutions globally.

I, in 30 years, have been a close observer of the SEC. And I think it's a remarkable agency, but it is -- it's seen challenges in keeping up with the growth, and the complexity, and the linkages, the internationalization of our capital markets.

What we need to do is give it the right tools, give it the right range of authority, and make sure there is a very strong management focus there that keeps it on its mission.

And I agree with you, investor protection is mission one, but also has a very important regulatory role. And so it needs to understand and be able to keep pace with these market changes in the way that's, I think, proven to be very, very difficult.

SEN. DODD: Yes.

MR. STEVENS: So that would be my recommendation.

SEN. DODD: Okay.

Professor Bullard.

MR. BULLARD: Mine would be to -- probably to expand what Professor Coffee was saying. I think that from an investor protection point of view, what's important to understand is that investor protection actually assumes that we want investors to take risk.

And therefore investor protection is about making sure that the risks that they take are consistent with their expectations. That is fundamentally inconsistent with a prudential oversight role.

Prudential oversight is what you want when somebody buys a life insurance and expects the money to be there if their spouse dies, they invest in a banking account and they expect those assets to be there, they buy a money market fund and they expect that to be a safe investment.

That is antithetical to investment -- investor protection risk because they are sometimes the disclosure of the truth undermines the confidence that you need that those people rely on to keep their investments in -- to keep their assets in banks and money market funds.

So I would say those have to be separated. And investor protection needs to be, again, as I mentioned earlier, kept distinct from customer protection, which again is not something that needs to be regulated with an eye to promoting risk taking. That is risk taking based on high expected value investments.

And then finally, I would say that I'm a little concerned about mixing the systemic issue and the prudential issue. The way I've always thought about prudential oversight is that you are making sure that the promises made with respect to generally liabilities on the one side are matched by the kind of assets that are created to support those liabilities.

Systemic oversight is where you assume that prudential regulation being necessarily imperfect will sometimes lead to a breakdown. And the question is when is -- what is the role of the government going to be to prevent that breakdown in a prudential system, which will happen sometimes, and what will you do when it steps in.

I think that that is a fundamentally separate function from prudential regulation. And that's why -- I'm not sure what a systemic regulator is as apart from a prudential regulator, but that's something I think that -- it would help to have more clarity on.

SEN. DODD: Yes.

MR. : I think the requirement for greater coordination among the regulators is very important. I think that one of the things we're looking at here in the financial crisis is the ability to connect the dots across different products and across different markets both nationally and globally.

I think that's the root of some of those suggestions for the systemic risk regulator, but I think it can also be achieved as I think Mr. Silvers and Mr. Turner suggested through greater coordination or some collections of supervisors who would look at these issues and connect those dots.

SEN. DODD: Mr. Silvers.

MR. SILVERS: I find myself in the unusual position of having really nothing to disagree with in what I've heard so far at the table.

(Laughter)

I would say though that the single item that I would put to you -- I would put differently than my other -- than my co-panelists have done so far.

I think that conceptually, the thing you want to be most focused on is in showing that we no longer have a Swiss cheese system, right. That we no longer have a system where you can do something like insure a bond either in a completely regulated fashion, right, in which there are capital requirements, and disclosures requirements, and preclearance, or in a completely unregulated fashion through, essentially a derivative, and where you have none of these things.

That the content of what a financial market actor does should determine the extent and type of that regulation. Closing regulatory loopholes, ending the notion that we have shadow markets, I think, is the most important conceptual item for Congress to take up because otherwise if it continues to be possible to essentially undertake the same types of activity with the same types of risk, but to do so in an unregulated fashion, we will replay these events with a fair degree of certainty.

And I believe that much of what the discussion about structure here has been is actually about how we do that ending of shadow markets and regulatory gaps. I think in certain respects, some of the how is less important than actually getting it done.

I would say though that I really strongly endorse what Mercer said about the different functions of regulation that there are -- that there is investor protection, disclosure and fiduciary duty oriented.

There is consumer protection, where I think, Mercer, you had a different phrase for it, but protection around the public buying financial services which doesn't want to take risk and then there is safety and soundness regulation. Those things are different and it's dangerous to blend them.

SEN. DODD: Yeah.

Mr. Doe?

MR. DOE: As I've listened to my fellow panelists, a remind of a book called, "Why Most Things Fail" -- excuse me -- by a U.K. economist name Paul Ormerod where he draws comparisons between species extinction models and those of corporate and market failures.

And in it he cites two conditions, where we have failure and -- of a species. And one is when it gets soft and isn't challenged. The second is when there is not incremental learning that's constantly being done.

And I think what we -- what I've gathered in the last 18 months, and again in our small niche in the municipal bond industry, which is smaller than others, but in -- that had been addressed here today. But is it the idea of a regulator that has an inspired inquisitiveness and a sense of purpose so that they are eager to pursue an understanding of the markets that they regulate.

If there has been one -- and I -- this is where I hope that if we have a consolidated or a sharing of information across the different asset classes or the different products, whether they be cash, whether they be swaps, whether they are equity, whether they are fixed income that this provides an opportunity of being able to identify the first hints of failure that might occur in a system. In that way we might be faster to act.

I think what is very interesting about again the industry that I've been involved with, in the municipal bond sector, is that when innovation -- products finally makes its way into the public sector, there is -- it's almost the last place, again, because the revenue relatively is small compared to the other asset classes in the taxable markets.

But I think it becomes magnified because you're starting to deal now with the public trust in a most intimate form. And I think so that when we start looking at regulation, it's again how do you inspire that trust, but how you inspire that inquisitiveness of the regulator. And maybe it's the pride associated with doing the job that they feel that they're really able to accomplish something and make a difference. And I think that's what we're all trying to do here. Thank you.

SEN. DODD: And lastly, Mr. Turner.

MR. TURNER: I actually think if I could just pick up a magic wand and do one single thing here, it would make sure that inside the agencies, the regulators we had confident people who were in the right mindset to go do their jobs.

Bad loans, Fed had the law that you'll passed in 1994 giving them clear cut authority to go eliminate those, they didn't do it, enforcement agencies haven't done enforcement.

The bottom line here is much of this could have been prevented without a single additional piece of legislation being done if people had just done their jobs back here.

And I'd urge you, go back, let's make sure we get the right people in, and then let's make sure, quite frankly, there is more active -- proactive oversight by the appropriate committees for those responsible.

Aside from that, I'd turn around and say the number one thing in the system has to be independence. These agencies have to clearly understand they're independent and free to go do what they need to do to protect the investors and consumers.

There should have been the independence in the credit rating agencies. They clearly sold out, and the e-mails and all show it, that wasn't there. There need to be independence in the compliance officers, in these businesses, in these banks.

Clearly, that wasn't there. So aside from making sure you got people doing the job, we can have one peak, we can have two peaks, we can have 50 to 14,000 peaks that we got in Colorado. But if you got that, people sitting on the top of each of those peaks, it isn't going to matter what you legislate here.

SEN. DODD: On that encouraging note, let me turn to Senator Shelby.

(Laughter)

SEN. SHELBY: Mr. Chairman, we're glad you're here. Thank you, thank you very much.

Professor Coffee, I'd like to direct this to you if I could. Thank you. Welcome to the committee again. You spend a lot of time here. And we welcome you and you've added a lot to us.

You recommend giving the Federal Reserve Board authority to regulate capital adequacy, safety and soundness, and risk management of all financial institutions that are quote "too big to fail."

Is this suggestion based on a careful examination of the Federal Reserve's track record? As a prudential supervisor up to this point, which I think is lacking. And did you take into consideration the fact that the Fed already has responsibility for monetary policy, bank supervision, and lender of last resort functions.

And are you concerned about the implications of the fact that, as you noted, the Fed is not politically accountable in the way other agencies are. I know that is a lot of question, but you're the distinguished professor, you can handle it all.

(Laughter)

MR. COFFEE: (Off mike).

SEN. SHELBY: Can you bring your mike up a little bit.

MR. COFFEE: (Off mike).

SEN. SHELBY: It's not on, yet.

MR. COFFEE: (Off mike) -- it is far from perfect. I think it's better-positioned than agencies like the SEC. The SEC is focused on transparency and enforcement, not on prudential supervision. And the second-tier functions of an agency are the functions that are most likely to be captured by the industry.

Also frankly, there no longer are any investment banks. They've all moved some place else. There is nothing left for the SEC to exercise prudential supervision over. Therefore, I got to think we have to start, once and all, with the Federal Reserve as the only body that has this capacity, that has the orientation and has the competence; it may not always have performed well.

Your point about political accountability is very important, and that's why I keep insisting that investor protection should not be subordinated, and should be given to a very independent agency -- the SEC or the SEC/CFTC, because I don't think you can count on the Fed with its orientation to ever be a champion of the investors' rights.

Their culture is one of secrecy, and you saw this all in the AIG. I think AIG is representative of the problems you will have if you depend upon the Fed for transparency. But I don't think the SEC is going to do much better than it did in the Consolidated Supervised Entities Program.

SEN. SHELBY: Okay. Professor Coffee, are you concerned that when you identify institutions as too big to fail, that will dull the market discipline of those firms which will -- in which the market will view as having a federal guarantee? Is that a concern always in the marketplace?

MR. COFFEE: I'm not testifying that every organization should be bailed out. I think the ones that most merit this are the ones that are so entangled, that you get the true problem of systemic risk.

Systemic risk is the danger of interconnected failures, the chain of falling dominoes. I'm not telling you whether or not AIG should get more money. I'm telling you only that where we have companies that are too entangled to fail, that's where we most need prudential supervision and a systemic risk regulator.

SEN. SHELBY: Mark-to-market accounting -- Mr. Turner brought this up, and I think he's right. Do you believe the current attacks on mark-to-market accounting, Mr. Turner, are motivated by similar understandable desire to award taking painful write-downs?

MR. TURNER: I think, without a doubt, Senator Shelby, they are. Our problem here is, you know, if you make a loan at $100, you know you are only going to get $70 back -- that's okay once or twice, but we did it millions and millions of times. And the bottom line is they just aren't worth what they were.

And to report to the public, to investors, regulators, that you got a balance sheet that's substantially different than what it's really worth is just flat-out misleading, if not straightforward fraudulent.

SEN. SHELBY: Mr. Ryan, your testimony recommends that financial market stability regulator that, among other things, would have a direct role in supervising, quote your words, "systemically important financial organizations." What are the criteria, Mr. Ryan, that you would recommend for identifying systemically important entities? And do you believe that there would be any competitive implications for firms that are not so designated?

MR. RYAN: Thank you for your question. We've given a lot of thought to a number of issues, and on some of these issues we do not have final decisions. I'm talking now within the industry. For instance, we spent a lot of time talking about should we recommend the Fed immediately as the systemic regulator. And we've not come to that conclusion yet.

If we had to do it right away, they're probably the best qualified to do it. But we think that the industry and the Congress, the American people, deserve a really comprehensive view. The same is true of who is systemically important. It's pretty easy to identify the early entrance, because they meet the test that Professor Coffee has enunciated.

They're too interconnected, they're very large, they're providing consolidated services to the citizens of this country. And we need a better understanding of their interconnected aggregated risks. So the first group will be easy. The second group will be more difficult, because they may not be so interconnected. They may not even be that large. But they may be engaged in practices which could have a very dramatic impact on our health.

So our hope would be that we anoint a systemic regulator -- maybe it's a new entity, maybe it's within Treasury, maybe it's the Fed -- that we orient them in legislation towards pre-selection of the people who are very obvious, and that we give them the flexibility to include -- and actually, they have people move out of systemically important status going forward.

So once you're in it doesn't necessarily mean that you'll stay in it. I think it's pretty clear that we all know the basic early entrance and there are larger financial institutions. We, by the way, would not limit this by charter at all. So there'll be banks, there'll be insurance companies, there'll be hedge funds that could be private equity players. It's people who could have a dramatic effect on our lives.

SEN. SHELBY: Professor Coffee, why should we continue to prop up banks that are basically insolvent -- some of our large banks that are walking dead, so to speak? Give them a transfusion, and there is no end in sight. Why should we do that rather than take over some of their guarantee, some of their assets and whatever we have to do, and run them down?

MR. COFFEE: Again it's a perfectly fair question. And I'm not telling you that every bank should be bailed out, not even every large bank. But if we are going to get the financial system working again, we have to move credit through banks.

SEN. SHELBY: Sure.

MR. COFFEE: You can nationalize them. There is supposed to be a management --

SEN. SHELBY: I've never advocated that. No.

MR. COFFEE: The government can't run a bank, it might be this -- if you want to name institutions that may not -- (inaudible) -- for your bailouts, AIG is an example. It is not a bank. And basically, the government is spending $160 billion there to pay off the counterparties, most of whom are foreign banks.

SEN. SHELBY: Obviously poorly regulated.

MR. COFFEE: But I'm saying that the key bank institutions are the only way we can get a corporate capital system moving again. The money has to flow through the system. And if they are part of the basic transmission belt, then there is a strong argument for ensuring their survival.

SEN. SHELBY: Mr. Ryan, you and your organization, the Securities Industry and Financial Markets Association, have advocated a merger of the SEC and the CFTC. You're not by yourself there.

If a merger was to go, should it go forward, should it occur simultaneously with whatever broader regulatory restructuring we undertake in this committee, should it be part of the overall comprehensive structure -- restructure?

MR. RYAN: I would sort your -- because I think the biggest issue Congress has right now -- you obviously have many, many issues on your plate, and sorting them by priority is an essential component of your work right now, I'm sure. So our recommendation is that you sort them with the systemic regulator being first and immediately come behind that with cleaning up the many regulatory agencies that have overlapping authority.

If I was the new regulator, I may actually ask you to do those simultaneously so I'd know my job. May I also --

SEN. SHELBY: It would send certainly to the market, would it not?

MR. RYAN: Yes, sir. I think that's possible. May I also just provide one comment based on your last question to the professor to my right?

SEN. SHELBY: Go ahead.

MR. RYAN: Because I'm probably -- because I spent an awful lot of time in this committee when I was the OTS regulator --

SEN. SHELBY: You did?

MR. RYAN: -- dealing with the RTC. And what I learned through those three years brings me to a very firm view on opposition totally to nationalization of financial institutions.

We have a process in this country through the FDIC where we in a sense nationalize -- we call them "bridge banks." We know that if you put very large institutions into bridge banks and they stay there for a very long period of time, the cost escalates enormously. You can look back to the RTC experiences.

SEN. SHELBY: Absolutely.

MR. RYAN: If we ask the government to take control of large financial institutions and run them, the cost of resolution is going to dramatically increase. The way we're doing it right now is much better. Thank you.

SEN. SHELBY: One last question, Mr. Chairman, if I can, to Mr. Silvers.

Silvers, you advocate a greater role for long-term investors in the election, and I would use your term "psychologically independent directors" on corporate boards. What measures would you take to ensure, sir, that these directors, whose responsibilities would flow to all shareholders of the corporation, are independent not only of management which is important, but also the shareholder group responsible for their election?

MR. SILVERS: Now, Senator Shelby, I think that there are several specific ways of doing that. The first is that those mechanisms, as my testimony indicated, need to be titled to a certain amount of tenure as a shareholder. I think that is a way of ensuring that it's not captive to individuals who are looking for liquidity --

SEN. SHELBY: What do you mean by "tenure" of a shareholder?

MR. SILVERS: Holding -- holding period, right, that anyone who could use such a mechanism would have to be a fairly long-term holder so that you ensure that it's not used by people who are seeking a liquidity event, it's people who are seeking long-term help and cooperation.

Secondly, I think obviously that there needs to be -- depending on exactly what mechanism one uses, all right, that all discussions in this area have required that anyone who use such a mechanism would be either by themselves or as part of a group, a significant set of holders. Certainly in large corporations, more than 1 percent of the shares -- very large public corporation, that's a very large collection of money or at least it used to be until recent market events.

And then thirdly, the most important protection here is a very simple one, which is that we are talking about a nomination mechanism, not an election mechanism, all right, that the majority of stockholders would have to vote for such a person. And the corporation, the management, at least under Delaware law, has the right to use fairly much limitless resources to campaign against them. I think that's the fundamental barrier.

Senator Shelby, if you'd allow me, I want to say a word or two to you about the Federal Reserve in response to your questions to Professor Coffee and say I believe that the concerns you raised are profound and important ones, and that they are profound in relationship to the question of whether we want a full -- the task we are asking a systemic risk regulator to take on, fundamentally public task.

And the oversight panel that I serve on, in its regulatory reform recommendations, specifically stated if we're going to ask the Fed to take that, those obligations on the Fed must be governed differently. I would be comfortable personally with that arrangement with a greater degree of accountability and get -- doing away with the self- regulatory aspects of some of what the Fed does.

But I'm convinced that that's probably not the best way to do this. And the reason why I'm convinced about that is because a) I think that the Fed -- that you're then -- there are tradeoffs with the Fed and the other things we ask the Fed to do.

And the second reason is because -- well, I agree with Professor Coffee that the SEC is not suited to be the systemic risk regulator, that that job is going to -- as long as we have a twin peaks type model where information about our market is flowing from different directions within the regulatory system, that the -- that that coordination of information and openness to information is critical.

If we ask one body to take it on, that's going to have an impact on the flows from the other bodies. The best answer, I think in light of that, is an agency with staff, right, that is governed by the heads of our twin peaks or our three peaks -- I hope we don't get the 14 -- how many 100 peaks were you talking about, Lynn? -- but an agency that is governed by the independent regulators, but has its own staff and mission in this area. And I think the Fed would play a very large role there because they are --

SEN. SHELBY: And they can't be overridden by the Fed.

MR. SILVERS: Yes, I -- no, that's --

SEN. SHELBY: That's -- (cross talk).

MR. SILVERS: I don't think we can give the power to override fully-public bodies charged with issues like investor protection to the Fed.

And thank you, Senator. I appreciate your indulgence.

SEN. SHELBY: Thank you.

SEN. DODD: Thank you, Senator, very much.

And that is a question that many of us have raised given the already full plate that the Fed has, an additional role they've taken on. The obvious problem is that, well, if you move away from the Fed as a model, creating a whole new entity raises another whole set of issues.

And that's the quandary I find myself and I -- I don't disagree with Richard Shelby's point. We've all talked about it here at various other times. And then I quickly say to myself, so what's your alternative. And when I come to my alternative, I find myself almost in as much of a quandary.

And so we find ourselves in this position in trying to make a choice between an existing structure in which I can see how this could fit -- I think you point as well -- but we'd have to make some changes in this thing. We're trying to create something altogether new which is also that it's just difficult. But it's a very critical point, obviously, and one that we're talking about obviously at this point. Anyway -- that point.

Senator Bennet, I thank you for your patience.

SEN. : Mr. Chairman, I want to start broadly and then ask a couple of narrow questions.

Professor Coffee talked about the difference between the culture of the banking regulator and the culture of the securities regulator, which has been a theme that we've heard about in this committee. And in thinking about the new structure, we want to make sure that that culture shifts, I think, so that we get the kind of oversight that all of us would feel comfortable with.

And in addition to that, there is the issue of no matter what structure you have, the constant innovation that goes on in the market and having some assurance that the regulators keeping up with that innovations. Well, we want the innovations, but we also want to make sure we understand it. And then Mr. Turner's observation that what's really critical as it is with all human institutions is that you get the right people in the job.

And unfortunately, neither he nor we have the magic wand that he called for. But I guess the question I have is are there thoughts from you, Professor Coffee, or others on the panel, about what we could do with this legislation to assure that we have the kind of attention to the changes in the market, knowledge about approach and the right people, so that we can really get the job done?

MR. : First of all, you and Senator Shelby are definitely focused on the proper issue. The Federal Reserve may have to change. You may have to give it a very different staff, a very different accountability structure. You are certainly going to want it to monitor, but I don't think you can ever make the Fed into a strong enforcement agency. I don't think you'd ever make the SEC into a strong prudential supervisor.

What I think you can -- have to recognize is in terms of new market developments, the Fed has a more universal view. The SEC, at least as it stands today, doesn't have jurisdiction over swaps, over the kind of derivatives, or futures. It's not going to know inherently what's going on in those areas.

Yes, you could merge the SEC and the CFTC, but that compounds the political difficulties of achieving our solution by, I think, several orders of magnitude. And I would agree with the prioritization model that Mr. Ryan just discussed. First create the optimal kind of systematic risk regulator which may require changing the Fed, changing its accountability structure, giving it a permanent staff that would do the kind of monitoring we wouldn't mind. But I think that's the smaller change than designing something totally from scratch.

MR. : Senator Dodd, could I comment on that?

SEN. DODD: (Off mike.)

MR. : You know, I know that many have not had a chance to absorb it, but I'm very struck by what Chairman Bernanke had said today, because everyone is talking about his agency, of course. And he says, and I'm quoting now, "Any new systemic risk authority should rely on the information, assessments, and supervisory and regulatory programs of existing financial supervisors and regulators whenever possible."

What that means to me is they don't want to take all these functions aboard themselves. They want a very strong capital markets regulator, they want a very strong bank regulator, they probably want a very strong federal insurance regulator that they can work with. And the notion that they can pull all of that inside the Fed, and at the same time accomplish their traditional missions, is something I think -- as I read the speech, and this is more subtext than text -- is unsettling to the chairman of the Fed and with good reason, I believe.

I would say also in commenting on Chairman Dodd's quandary -- and I don't know if this is useful or not. But I spent a considerable period of time as Chief of Staff for the National Security Council. And I've reflected a lot on that innovation in our government. It came online after World War II in our experience as a nation of the inability to coordinate and integrate the efforts of our diplomatic service, our armed forces, and the like, at a time when we had burgeoning global responsibilities as the superpower in the aftermath of World War II.

It is a cabinet-level council that's chaired by the president. It has a staff that's -- professionalism and abilities have been built up over time, and its function is there to collect information, to monitor developments, to integrate and coordinate the efforts of government. I think it is not out of the question that you could create a similar coordinating mechanism.

And I think this is part of what Damon is pointing toward. At a very high level with the regulatory agencies that would pull all their expertise together, give the chairmanship over to someone -- and maybe that's the chairman of the Fed -- give it a permanent staff, and allow it to be monitoring and collecting data and doing the analysis, but in conjunction with those who are the frontline regulators, and whose expertise has got to be leveraged. At least that's, I think, a reasonable concept in which to reflect.

SEN. : Completely unrelated question, and didn't come here to ask you, but the ranking member asked about mark-to-market and your answer was very clear. This is the place where I've gone back and forth. If our markets were -- if we had -- if our markets were lubricated and we're doing what we're supposed to be doing, we wouldn't be sitting here talking about investing taxpayers' money the way we're talking about investing to create stability in the market.

And I wonder whether there are others here that have a different point of view on mark-to-market. Is it in this sense -- it seems to me that there is a legitimate distinction between assets that are held by these banks that have no collateral behind them or very little collateral, and assets that are held by our banks that have collateral, but simply have no market right now, and therefore aren't trading at all.

I know there's a peer review that says that should tell you that the assets don't have value. But the thing I keep stumbling over is that some have collateral and some don't have collateral, and shouldn't we be taking notice of that.

MR. : I do not, in general, share Lynn's complete enthusiasm for mark-to-market accounting. I think that there are a wide range of areas in financial accounting where historical cost accounting is actually more indicative of the life of the business than mark-to-market. However, the financial institutions, particularly those with demand deposits, where in theory the funds can walk out the door, are ones that seem uniquely kind of attuned to mark-to-market principles.

And in the course of the work of the congressional oversight panel, we have done two hearings, two field hearings in relationship to our mortgage crisis which I believe -- and I think most economists believe -- is at the heart of what has gone wrong here in our economy that underlies the financial crisis.

And it is clear from those field hearings -- in PG County not 10 miles from here and in Nevada, that even at this late day, we do not seem to be able to get rational outcomes at a private ordering in terms of non-performing mortgages. We can't get the mortgage providers and the services to negotiate rational outcomes to the homeowners.

Now, I believe that this is related to the remnants of non-mark- to-market accounting and banking that effectively loans that are never going to be worth -- the banks' accounting loans that are never going to be worth full value even though they are collateralized, all right, at high values. And that -- maybe not at full, maybe not at par but at close to par.

And that the one thing that we force them to mark them down would be a rational settlement with the homeowner, but then you'd have to admit what you actually had. Now the -- you ask about collateral. You walk through the subdivisions, and not all of them are new. In PG County, you've got a lot of people who've been effectively exploited and stripped of their homes. That's Prince George's County for those who've not -- the Washingtonians, here in Maryland.

You look at those properties -- there may be collateral, but it will never support par value, never. It may return -- it may recover value, right. It may -- 10 years from now -- if the last very serious real estate collapse is indicative -- and I'm afraid this is clearly worse -- in many areas it took 10 years to recover from the bust of the late '80s and early '90s.

But returning to par in 10 years means you're never really worth par; present value basis -- you're not going to be there.

And so I'm in favor of sort of -- I'm kind of in the middle of the road on these issues, but I think we need to recognize that there could be very, very serious broad economic consequences of indulging in the fantasy, right, that subprime loans backed up by collapsed residential property are ever going to be worth par. They're just not. And if we put -- and the pretence is actually throwing people out of their homes.

SEN. : Mr. Chairman, can I -- one more quick question for --

SEN. DODD: You may.

SEN. : -- Mr. Doe. I just read this in your testimony we've been -- there's a line of conversation that Senator Warner and I have been having. I assume that your view is that there is federal authority now to be able to intercede either through the Treasury or the Fed with the VRDO market in some way that may give hospitals, public hospitals, schools, and other municipal credit some relief from the lack of market that exists for a variable rate debt.

MR. DOE: Well, I think one of the key issues associated with that is that many of the assurance that have -- that are confronted now with challenges of restructuring their debt in the variable rate market. As I point out in my testimony, that these variable securities are -- have links to interest rate swaps and which create all sorts of issues.

And one of the things that these -- the cost of termination of the swap transaction has become overly penal, and in some of these small towns and counties where it's arguably -- that there was a mismatch in terms of appropriateness. And again, remember that the regulatory bodies with municipal industry doesn't have purview -- you know, is limited purview only on dealers and only on cash securities.

So there you have these cash transactions going to swaps -- makes a little bit of a conundrum. But one of the things that we think is as where the Treasury could step in and make a big impact is to provide subsidized loans to municipal issuers that would help and terminate those swap transactions. And then over time, the cost of those loans could be recouped in future transactions -- (inaudible).

And I think that would be a really important step. And it goes to the people there and the institutions that have been most adversely impacted.

SEN. : I'd like to thank the witnesses for their testimony.

Thank you, Mr. Chairman.

SEN. DODD: Thank you very much.

Senator Reed.

SEN. REED: Well, thank you very much, Mr. Chairman.

And thank you, gentlemen, for your excellent testimony. And just there is two preliminary points. First, I want to thank Professor Coffee for his kind words about our credit relating legislation. Thank you very much and thanks for your help.

And then to Mr. Turner's point about the need for resources regardless of what we do. This Omnibus debating contains an additional $38 million for the Securities and Exchange Commission. And the proposed budget of the president is -- got a 13 percent increase over the '08 marks going forward.

So I completely concur that we can make all the structural and legislative changes in the world, but if they don't have the resources and the will to do the job, it won't get done. One of the impressions I had speaking -- listening to your comments is that, you know, I think we are in this sort of false logic where regulators of all ilk were looking at the capitals institutions saying we don't have to be too sensitive to the risk evaluation assessments, because they've got capital. Of course, the capital is risk-based.

So you're in this circle around where if don't do a good job, the value in capital based on risk, then you don't have the capital, et cetera. And part of this goes to Basel, the efficacy or the effectiveness of Basel. I think that has to be looked at. And the other issue I think it has to be looked at too is just the managerial capacity to run these organizations.

And in one of the issues of sizes you really have that wherewithal, the computer systems, the structural managerial skills to run them. This is a long sort of preface to be saying that it appears that this -- my view, twin peaks model we'll probably adopt in some form, that by default, perhaps the Federal Reserve would become regulated.

And unless we make some significant changes in the culture and the operating standards of the Federal Reserve, we might be exactly where we were before, that this sort of -- this looking at risk -- not looking at risk, not looking really good well at management. So I look to your comments, Professor Coffee, and gentlemen.

MR. COFFEE: I think that -- I do think that we're now in the world where the price of all bank stocks has fallen so low with Citi trading at $1.50. This is the time to pursue mark-to-market, because the market doesn't believe these banks have any value. You might as well bring the accounting in accord with reality as the market reflects it -- changes in the Federal Reserve is a sound concern.

And I can't tell you, because I'm not a Federal Reserve expert, of what the five things I would do first to the Federal Reserve are.

SEN. REED: Anyone has any comments? Mr. Ryan?

MR. RYAN: We've been talking about resources, and many of the panelists have talked about whatever changes we make here, let's make sure that we have the right people doing the job, that they have adequate resources.

One specific topic, I think, deserves the committee's attention and Congress' attention is whoever is going to do this job has to have the technology resources to get the job done, because when we ask someone to be the systemic regulator for our most important financial institutions, we're also, I think, asking them to do a job that regulators have not really done well at all, which is to look over the horizon.

They're pretty good at looking back and looking at what went wrong and let's see if we can fix it. But we're going to ask this new entity or the Fed to do a job that was not really done before, and they need to have the tools to do it.

They really need to think about the technology demands, because right now we do not have a full understanding of the aggregated or collective risks of all of these interconnected entities. We have the capacity to do it from the technology -- hardware, software standpoint, but we don't really have that done. It's going to be very expensive. It's very important that you spend some time on that.

SEN. REED: One of the points that I would notice that when Chairman Donaldson became chairman of the SEC, he tried to establish a risk-assessment operation. That initiative was undone by his successor. But I think we should consider along those lines, Mr. Ryan, requiring the system that's regulated to have a rather independent risk assessment group that, on a periodic basis, will publish to the Congress and to the people what they consider to be the most significant pending risk in the likelihood. And that might force discussion, and maybe even sometimes action.

Mr. Bullard, and then -- first of all excuse me, Mr. Silvers and then Ms. Turner, and then I -- last point.

MR. : I just wanted to add that again, to me the systemic risk question is one that someone who has oversight over a range of prudential regulatory regime. And the Fed already is our systemic regulator. You may not have that aggregated information as Paul was talking about. But it has the discount window, it has the open market transactions, it has the ability essentially to create money, although the Treasury has shown remarkable ingenuity in trading money recently as well.

So it already serves in that role. But I think it's a separate question as it sits back and decides where it needs to take action to affect credit markets. It sees some hotspots over here with respect to the support for some area that also should not necessarily be expected to be the prudential regulator that's in charge of monitoring what stands behind that particular area of our financial services, because those really are separate functions.

The systemic regulators, one who can go in and fix it with ultimately taxpayer dollars, and then tries to find situations where it can mitigate that risk and reduce that. The prudential regulators, the one who writes the rule that says to back these kinds of liabilities, these are the kinds of assets we expected you to have. And I'm not sure that those are necessarily ones that should be or have to be housed in the same agency.

SEN. REED: Mr. Steven and Mr. Lynn (ph), I have one final --

MR. : Sure.

SEN. REED: -- unrelated question.

MR. SILVERS: Senator Reed, first of all I share your concerns about Basel II. I think that's clearly part of the causal fabric here that -- for our crisis. Three points about the sort of managerial and past challenges associated with systemic risk regulation.

First, congressional oversight panel and its regulatory reform report suggested that the notion of intelligence are looking over the horizon in relation to financial market systemic risk. It should perhaps be delegated not to a regulatory body, but to a panel of outside experts. Some of my fellow panelists might make good members of such a panel, whose sole job was to look ahead, and they were not intertwined in the politics of the regulatory landscape.

Secondly -- and this is a concern that Senator Shelby raised -- our view was that it would be a very bad idea to name who was systemically significant. And this, in fact, is not only a bad idea in terms of more hazard, but it's actually impossible to do. That in a crisis, people -- institutions will turn out to be systematically significant that you had no idea were.

An exhibit one for that is Bear Stearns. And so -- and there are other times, calm times, when very large institutions may be allowed to fail and probably should be. And that rather than naming institutions, we ought to have the capacity -- and this comes to your point -- the capacity for the systemic risk regulator to work with other regulators to set ratchets around capital requirements and around insurance cost, to discourage people getting essentially too big to fail, and to set up the financial basis to rescue them if we do.

And finally, there is I think some -- I'm not a Fed expert, but I think there is some confusion about where the money comes from for bailouts and rescues and so forth. The Fed doesn't have the authority, as far as I know -- although you all maybe can educate me -- the Fed doesn't have the authority to simply expend taxpayer dollars, right?

The Fed lends money. It's the lender of last resort. In a true systemic crisis, as we've just learned, we get beyond the ability of liquidity to solve the problem. And in that circumstance, we start expending taxpayer dollars. It's hard not to look at the top experience and what preceded it and not conclude that this -- that the ad hoc quality of those experiences did not build public confidence or political support for what had to be done.

Given all of that, when -- I think that we need to understand that when we ask a body to take on the role of systemic risk regulator, that's also meaning we're asking him to take on the role of rescuer and potentially to expend taxpayer dollars.

And that, I think, requires a set of governance mechanisms and capacities to your question, Senator, that we have yet really to build. And it also requires, I think, a careful balance between genuine public accountability and transparency on the one hand, and genuine independence from the all too eager desire of everyone around to bail out their friends.

SEN. REED: Mr. Turner, you have comments?

MR. TURNER: Just like Damon, I would say Basel II needs to be reexamined. I expressed concern almost eight years to the Fed that it would not work. And I think if it stays where it is, it will contribute to further problems. I think Sheila Bair has been very insightful on that in that regard.

As far as managing the risk, I've actually had to run a large international semiconductor company. And in the technology area we had a lot of risk, and it changed very dramatically, much faster than what it even does in the banking industry.

And what we found was if we were going to be successful in managing the risk, we could not do it with the same people that we had necessarily running the operational, the manufacturing side of the company. You needed a group of people that were much more focused on the future and where things were going. They needed to be looking not just ahead, but much further ahead, and have a focus not only on what was going on, but where that turned around and took you.

And after Donaldson formed the Risk Management Office, I went and visited with him for a while. Certainly, that type of mentality plus the tools were not in that group at that point in time. I've not seen that at the Fed in my dealings with the Fed for the last couple of decades either.

I'm not sure you can get that without a major wholesale change. And so I come back to -- having gone through this and having to manage risk myself -- I come back to probably what Damon said. And probably the best way to put this together across the broad spectrum would be to create the separate organization shared with the board of the major -- chairman of the major agencies, but with real staff and real resources.

And focused on that aspect of the business, I just don't think we're going to get it if you put it inside one of these agents. And in fact think about -- we've had risk management -- Risk Management Office in the Fed, in the OCC, in the SEC, and it hasn't worked. And why would we turn around -- given what this devastation and travesty has caused us all, why would we go back and say let's try it again? You know, this is not one where I give people the nerve to swing at the back.

SEN. REED: Mr. Chairman, I've really been very -- kind of have one question from me. And this is --I'll address it first to Professor Coffee, because it's -- might be way off the beaten track, and in fact it sounds like a extra-credit question in law exams. So here it goes.

(Laughter)

What has happened to Rule 10b-5? And then I've been listening to discussions of potential fraud in the marketplace, securities that had no underlying underwriting. And I grew up thinking that material omissions as well material commissions gives the SEC in every capacity as long as it's a security to go in and vigorously to investigate a private right of action.

And yet I've been before this -- the committee announced that two and three years, and I don't think anyone has brought up, you know, Rule 10b-5 actions or -- can you just sort of --

MR. COFFEE: I'm glad you asked that question, because it's a good question. But there are two major limitations on Rule 10b-5. As you've heard from others on this panel, it does not apply to aiders and abettors, even those who are conscious co-conspirators in a fraud. That's one limitation that Congress can address.

And two, when you require to apply Rule 10b-5 to the gatekeepers, whether it's the accountants or the credit rating agencies, you run up against the need to prove c. emptor (ph). It's possible to have been stupid and dumb rather than stupid and fraudulent, and that's basically the defense of accountants and credit rating agencies.

I think you need to look to a standard of c. emptor that will at least create some thread of liability when you write an incredibly dumb AAA credit report on securities that you have not even investigated, because you're don't do investigations as a credit rating agency, he has to assume that the facts that you're given by management. So I do think there is some need for updating the antifraud rules for --

SEN. REED: Thank you.

SEN. DODD: Senator Warner.

SEN. MARK WARNER (D-VA): Thank you, Mr. Chairman, and fascinating panel.

First of all, I commend you for asking that just the one takeaway question from me to these gentlemen. And well, I think there was this consensus that we need to get rid of this shadow market. We need to make sure we get rid of the Swiss-cheese approach to regulation.

I think we may be challenged taking some of these specific -- some of these broad overviews and taking them into specific legislation. And I appreciate you asking that question.

And I want to follow up before I get to my quick question on Senator Shelby's comments along the notion of the institutions that have posed the systemic risk, the too-big-to-fail excuse, and then comments about perhaps not publishing those systemic risks.

But this problem we're in the middle of the crisis now of too big to fail, and I would be curious perhaps in a written question to the members. I know Senator Shelby has, I think, provocatively raised a number of times the issue of how much more on Citi, and should we go ahead and let it go through some kind of process. And the quick response would be, well no, that's too big to fail.

I'd love to hear from the panel perhaps in written testimony, if you notice the transition, dramatic transition -- and I know we're sometimes afraid of the terminology whether it's receivership, nationalization, some other way to get it a lot of its -- the current ditch that it's in, you know. How you will take one of these institutions that fall into this too-big-to-fail category that appears to have real solvency issues and get it to a transition. I'd perhaps work with the senator on submitting that type of written question.

So we've seen, you know, the big takeaway from -- on how we regulate and then where we picked this prudential or systemic risk oversight. We've seen the question of how do we deal with the current rule by challenging the institution. I'm going to come with my question, and I know my time is about up, but I'll start with Mr. Pickel, but would love to hear others' comments on this.

And actually we connect this from the other range. Even if we get the risk right, we had great people that Mr. Turner (ph) has advocated, where and how should we look at the products? I would argue that intellectually I understand that the value of derivatives and the better pricing of risk.

I can't agree with -- want somebody to say how much societal value have we gained from this additional pricing of this risk when we've seen all of the -- the downside that the whole system is now absorbing, because -- to use your terms, you know, actions by AIGs and others of -- misunderstanding of their products and not taking appropriate hedging. And I guess I've got a series of questions in how do we prevent the current products or future products from being abused.

How do we -- should we have standards whereby if an AIG or future AIG either misunderstood or went beyond protocols, that that would send off more than an alarm bell and would it require some kind of warning? Is it simply enough to say we're going to move toward some level of a clearing house that is clearing alone on our security?

Is there a -- some of the European regulators have talked about for those products and contracts that don't go to a clearing house, should there be needs of additional capital requirements? You know, I'm all for innovation. But in some case, I think under the guise of financial innovation and financial engineering, we've ended up with a lot of customers, including customers that Mr. Doe represents in terms of some of the new market getting in way over their head. And I just fear on a going-forward basis that regulation and transparency alone may not solve the problem.

So rather than coming at the macro level on regulation or on the specific issues that I think Senator Shelby has wonderfully raised about how do we unwind one of the too-big-to-fail institutions, I'd like to look at it from the bottom up on the products line. And starting with Mr. Pickel and then anybody else' comments.

MR. PICKEL: Yes, I think as far as the products themselves -- if you look, for instance, at the credit-default swap market, there's information that's been published by the Depository Trust & Clearing Corporation through their trade information warehouse which encompasses 80 to 90 percent of credit default swaps engaged in around the world.

And the information there is that of the virtually all the trades in that warehouse, essentially all, 100 percent are done involving at least one dealer party who is in fact a regulator institution, and actually 86 percent of them were between two dealer institutions.

So you've got that structure of the institutional regulation there that -- of the oversight of those individual firms looking at the activities of those firms. And I think the committee again heard testimony from the OTS last week admitting some shortcomings in their enforcement and their execution of their authority.

But perhaps we should look at making sure that they've the ability to understand and get more detail on the products that those individual entities are --

SEN. WARNER: A quick question to Mr. Pickel. Did those 86 percent of institutions, their involvement using these products, are you assuming the market knows all the terms and conditions and we've got a transparent market there?

MR. PICKEL: You've got -- the parties who are engaged in those transactions have access to information and have the transparency to engage in those transactions. I think you also have regulators who have the authority whether they've exercised it -- what they've done with that we should discuss further.

But they have the authority to understand what those institutions are doing. I think the other thing is -- and we've got a very good example of this in the credit default swap market, an effort that goes back to September 2005 started by now Treasury Secretary Geithner to pull in the regulators in a global initiative -- regulators from around the world as well as at the -- at that time 18 major credit default swap players, dealers to -- and it also by-side entities as well to talk about issues that were serious and needed to be addressed in the credit default swap market at that time.

And significant progress was made very quickly with the implicit threat -- or actually explicit threat I think -- from the regulators that if you don't get your act in order on these backlogs and assignment issues, that they will actually stop people from trading. So the regulators indicated that they would take that action, and the industry responded.

The experience that we've gone through in settling credit default swaps over the past six to eight months has been significantly facilitated by the foresight of Secretary Geithner at that time to anticipate these problems.

So that was an important step at that time. So I think looking at those kind of public-private interactions where regulators and the industry work together to identify these issues is very important going forward as well.

SEN. WARNER: Professor Steven, and why don't you go from there, Mr. Ryan, Mr. Silvers.

MR. : Thank you, Senator. I think it's really an excellent question, and I've asked myself this. And it's not intended as a competitive observation. If Franklin Roosevelt would have come back today and he would find we had these enormous pooled funds that were outside, virtually outside of any form of regulation, I think he would say I thought we saw that problem in 1940.

We need to make sure that the evident developments -- and these are not secrets -- the evident development, major developments in our capital markets are addressed as they arise. Hedge fund investing is no doubt a tremendous innovation that can be of great value. But there were trillions of dollars in hedge funds that had no form of regulation. I think that's something that Congress was aware of; certainly the SEC was aware of.

You could say the same about the major pooled funds in the money markets that will be part of the subject of our report when it's issued.

Money market mutual funds are about $4 trillion intermediary, but we're only about a third of the money market which has many other pooled funds. So I think it's a problem, and this is how I envision it, of making sure that the capital markets regulator is staying even with market developments.

And that's going to require not only nimbleness at a regulatory level, but frankly, Mr. Chairman, it requires -- it puts a burden on committees like yours, because in many instances it's going to require the tough work of closing regulatory gaps, providing new authority, and even providing the resources.

I don't think, however, that the answer, Senator, is creating a new agency that only looks at products, because those product survive and exist in the context of a larger marketplace, and they need to be understood in that context.

SEN. WARNER: Mr. Ryan?

MR. RYAN: Bob Pickel and I have basically overlapping membership. He is very domain-oriented, very specific to derivatives, and we are basically -- almost all of the other products and oversight. We've spent a lot of time I would say over the last six months, trying to figure out which we would be recommending for new regulatory structure.

And I would say it's a uniform view among the core members of our group and of his group that we feel comfortable recommending a systemic risk regulator that would have no real limits on their authority so they'd have all markets, they'd have all market participants who are significant, wouldn't make any difference of their charter. So it could be a bank, could be an insurance company, could be a hedge fund, and included therein would be their authority to deal with, for instance, derivative products.

So we see -- we can see that there is a lack of confidence in the system, there's a lack of confidence among members of this committee, members of Congress, members of other statutory developing entities around the globe, and we need to address that. So our first attempt at this is to say let's do it through the systemic regulator.

Through the systemic regulator we will also expand the activity, expand the breadth and depths of what is done from a regulatory standpoint to cover areas that have been discussed during this panel, some of the stuff that Paul has raised. But that's the best way to do. We're also going to, in a very early phase, be able to address most of the key issues and do it in a thoughtful manner.

SEN. WARNER: (Inaudible) -- Mr. Doe?

MR. DOE: Senator, I mean these are very acute observations made about this set of questions. First, I'm pleased to see that a moment of disagreement has emerged. My colleagues on the panel who wish to put the burden of regulating unregulated markets like hedge funds and derivatives on the systemic risk regulator are, in my opinion, making a grave mistake. That what we need is routine regulation in those areas.

That is what closing the Swiss cheese system is about is routine regulation, not emergency regulation, not, you know, looking at will they kick off a systemic crisis -- just an observation about that.

I think that the Fed's refusal to regulate mortgages was rooted somehow in the sense that consumer protection was a kind of something that wasn't really a serious subject for serious people. It turned out to be, of course, the thread that unraveled the system. I think that we should learn something from that.

When we talk about routine regulation in these areas, I think to your question, we've got to understand that it's more than one thing, right? That for example, a credit default swap contract is effectively a kind of insurance, right. And if someone is writing that insurance, they need -- they should probably have some capital behind the promise they're making.

That is what we learn not just in the new deal, but long before it, about the insurance itself which was once a exotic innovation. But we're going to be -- we have to have capital behind it. But that's not the extent of what we need to do. If, for example, there are transparency issues, there are disclosure issues associated with these kinds of contracts, in full contracts in which this -- in which public securities are the underlying asset, it's clear that we need to have those kinds of disclosures, because if we don't, then we've essentially taken away the transparency from our securities markets.

And now finally, this comes -- two final points. One is derivatives and hedge funds have something profound in common. They don't have any substantive content as terms. They are legal vehicles for undertaking anything imaginable, right? You can write a derivative contract against anything, right?

You can get -- write it against the weather, against credit risk, against currency risk, against securities, against bond, against equity, against debt. It's just a legal vehicle for doing things in an unregulated fashion. A hedge fund is the same thing. The hedge fund is not an investment strategy.

It's just a legal vehicle, and it's a legal vehicle for managing money any way you can imagine -- there -- in a way that essentially evades the limits that have historically been placed on bank trusts and mutual funds and so on and so forth. The -- what smart regulation here isn't specific to those terms, it's specific to those activities, it's specific to money management, it's specific to insurance, it's specific to securities.

And that's why it's so important that when we talk about filling these regulatory gaps, we do so in a manner that is routine, right, not extraordinary.

SEN. WARNER: Thank you.

MR. : Senator Warner, if I could just offer a example. I like Mr. Silvers' comment about this type of regulation being key to try to get -- bring vigilance. Let me give you just a quick example of why -- when I hear you ask the question about products, why I think that's so important.

After the Lehman bankruptcy in September, on the Wednesday following, there was a liquidation -- unannounced liquidation by money market funds of a substantial holdings of cash equivalent securities which had been created in the municipal market through leverage programs, and which were used -- essentially synthetic securities, some derivatives.

The liquidation unannounced to get a trying time in the market in mid-September resulted in the following day of there being no liquidity in the municipal secondary market, where one transaction that occurred in a distressed situation resulted in the replacing of the entire holdings of investors that were in mutual funds, that were in individual holdings.

We estimated that in a back-of-the-envelope kind of way, but about $5.5 billion were lost on that September 18th, solely because a new liquid market -- because liquidation of a cash security that came from -- that was synthetic in order to fulfill the needs of having short-term investments for these money market funds.

You see, that created a crisis in confidence that -- and a confusion among investors as to what was the security of the credits of the states, of the towns, that were, you know, that were issuing municipal debt. And that type of concern -- and that lasted through September and October, and municipal issuers who were trying to come to market and raise important funds for capital projects and for operations, were really inhibited by extraordinarily penal rates.

And so here we had this, you know, a single event and that's cascaded touching upon cash securities, derivative securities, and then also tied to the most secure cash equivalents in these money market funds. The other thing, I think, is really important and not to be lost here as we're talking about cash securities, we're talking about derivatives; a lot has been talked about credit default swaps in the municipal market, predominantly its interest rate swaps.

Here there isn't -- again there isn't transparency, and yet these are linked incidentally with cash transactions. And when we talk about, gee, the taxpayers coming in and helping to bail out the various transgressions that have occurred in the banking system or in the financial system is that here we have taxpayers -- and I think Senator Shelby, you have some instance with some derivatives in your state there that are getting a lot of headlines.

And taxpayers are on the hook most directly right there. And I would argue and suggest to you the notion of really examining this opportunity we have in our U.S. municipal bond market where all of these products have come to roost, and the credit default swap market is emerging. It's in its nascent stage in the municipal bond market, yet it's there.

And it's creating, perhaps in a thinness or a new liquid market in that -- those derivative products is maybe creating misconceptions about the soundness of our states and our towns and our counties. And so I think that when we started looking at how do we gain transparency on these securities that are now part of the risk management of our municipalities, and how do we help so we can understand them, so we can see them.

So investors that are putting there, are facilitating the borrowing by buying these securities, how that they can see what is going on, and we can also help to protect these issuers who, as Mr. Turner was saying, that -- whereas we're talking about broadly in this financial regulation of the separation of risk management and operation is that here we have these -- our states and our -- again towns counties that are serving -- having -- wearing both hats in using complex securities that they may not have fully understood.

So I guess right here you talk about products. I applaud that, because I think that it just can't be the people involved. We have to look at what's being used by also being -- the words when you use "nimble," so that we can be -- adapt regulation and be flexible so there is new innovations come in that can be very positive, but also could be seen and understood.

SEN. WARNER: And I know -- I think our time has expired. And my only last comment would just be that I think we will get to some stance where we have some level of regulatory oversight. My hope is that we will adhere to Mr. Connors' suggestion that it is a nimble and well-funded regulator.

But I would say from the industry, we're going to need your help on setting standards not just retrospectively, but prospectively being with the complexity in financial engineering that goes on. You know, I just don't want to be here five years later looking at what the next round of new products would be and say why didn't we see that ahead of time and -- helping us see what those standards so that you don't end up with having to pre-clear every new product at some regulator. You know, you're going to have to really step up on this and then give us some assistance.

Thank you, Mr. Chairman.

SEN. DODD: Thank you as well, Senator Warner. Very good questions.

And before I turn to Senator Shelby for any closing comments or questions he has. I'm struck by a couple of things. It is exactly the point that Senator Warner was concluding with that this debate about whether or not we have a principle-based system or rule-based system in the country.

And I've always felt that that was sort of in a small tiny minority that has attracted the principle-based system for the simple reason that seems to me almost in a way that didn't intimidating in a rule-based system for the very reason Senator Warner suggested that you end up setting standards or rules, and within a matter of only hours in some cases, a very creative imaginative people can come up and figure out some way just to get around that rule, legally and ethically and every other reason. And so we are back at it again because someone is going to -- now I think that the clearing house makes a lot of sense by the way of new product lines. And I know senator Shelby feels as strongly as I do about that.

But that in itself sort of is an indication of a problem we have with a rule-based system. And I wonder if just quickly any of you have any quick comments on a rule-based versus a principle-based system that you care to share at this point. Professor Coffee.

MR. COFFEE: Well, I've written a good -- a long article on this. It's currently posted on SSRN. I don't take any workable system can exist without being a combination of both.

SEN. DODD: Yeah.

MR. COFFEE: We need the principles to backstop the rules, but you can really only enforce rules. And particularly in our litigation-oriented system, we want rules that let you know you're within the safe harbor, and you have done what you're supposed to do. So I think there has to be a combination of both with principles backstopping the rules.

SEN. DODD: Yeah, anyone else want to comment on that?

MR. : I -- Senator Dodd --

SEN. DODD: Yeah.

MR. : I agree with Jack on this one. First of all, you know, you look at the Ten Commandments, half of the people tell you the principles, half of them tell you the rules.

(Laughter)

So I'm not sure anyone knows really what a principle is or rule is. I think it does take a combination. Principles get so broad and they just never get enforcement. Rules get so detailed that people just skirt around them. So it takes some commonsense and a combination.

SEN. DODD: Mr. Silvers, you got a comment on that?

MR. SILVERS: Only that one of the reasons why this discussion has become sort of hard to follow, hard to understand is because the concept of a principles-based system became a code word for a weak regulatory.

SEN. DODD: Yeah.

MR. SILVERS: And in reality, a true principles-based system would be the strongest possible regulatory system. But it would one no one could live in, right, for the reasons that my two colleagues in the panel have had.

SEN. DODD: Yes.

MR. : I would agree, in general, that we prefer a principles-based approach. There may be certain circumstances such as what retail investors were having more, you know, clear rules for those who engage in those markets that would be appropriate.

But for the, you know, the markets that I think people are engaged in, in derivatives, you know, fixed-fee (ph) derivatives, I think the principles approach is the best one.

SEN. DODD: Yeah.

MR. : I would just add putting on a private-practice hat for a moment that principles-based regulation is intimidating as you described, because what it means is that regulators have enormous enforcement discretion. And we typically have at least, the SEC is -- it means that they play "got you," and bring cases that are based on specific rules that are made up under those principles as opposed to having known ahead of time exactly how the SEC might interpret sub- positions.

SEN. DODD: Senator Shelby.

SEN. SHELBY: I'll be brief. Mr. Chairman, thank you for assembling this panel.

We could be here all day and probably learn a heck of a lot. Principles matter, but rules matter too. I like the idea of what Professor Coffee said. We might need a hybrid some way.

If you just have principle, no rules, you know, gosh, you know, who's going to define them to a certain extent. But just rules and people say, well, we got a rule, how can we get around it. You know, how can we evade it in some way.

So maybe it's a combination. Who knows? But thank you for your input, and you know, we have an awesome task ahead of us here. We've got to do this right. We can't rush to it. We both met with the president on this and meet in meetings and it's got to be comprehensive. It can't cover every contingency, but I think we can do better than we've been doing.

But I wish my friend Senator Warner was still here, because we agree on a lot of things. But some of the product approvals, some of these products have got to be approved before they do irreparable damage to, I think, the marketplace myself.

Thank you, Mr. Chairman.

SEN. DODD: Thank you, Senator Shelby.

And again, you've been a terrific panel and offered some wonderful advice. And I will probably submit some additional questions for you over the coming days. And we look forward to your continuing involvement with this kind of formal setting here, but my intention is to also have some informal settings with interested members here and other members who are not on the committee necessarily who would like to be a part of the discussion as we move forward.

Because this is a growing interest, obviously, not just on the part of this committee, but others who care about this issue, and are interested in how we proceed. So I am very, very grateful to all of you for your knowledge, your background, your experience, and the thoughtfulness with which you prepared your testimony today and contributing to this very, very difficult task.

And I'm going to just say as well how much I appreciate Senator Shelby and the other members of the committee. There are always from time to time when we have our differences, but Senator Shelby has made the point and I'm making as well, this is one where the barriers that we traditionally see along political lines have to really evaporate and disappear.

I personally said -- I'm agnostic on the question of -- I don't bring any ideological friend or whatever to this. I want to do something that works, that closes gaps, that doesn't have that Swiss- cheese look to it, where people don't fall on shop in a sense in order to avoid a regulatory process. That means we have good people who are being adequately compensated for the jobs that they are doing.

And then doing what has to be done is engaging on a consistent basis. These things are never done forever. There are always new products, new ideas, new -- which is the genius of this in many ways. I mean, that's not a liability, that's an asset in a sense.

I've often said our goal here is to, one, make sure that we have a solid sound system that reflects the times we're in, but not so rigid that it in any way strangles the kind of creativity and imagination that has drawn the world and others to come here to make their investments, because we are creative and imaginative.

But at the same time, we don't want to be at such creativity and imagination that we lose the kind of protections. Striking that balance is never perfect. It's never perfect. It's always choosing one way or the other. And our job is to constantly try and keep that balance if we can as we go forward.

And that's the challenge we have in front of us. And so we welcome your involvement. Thank you immensely for your participation. The committee will stand adjourned.

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