Restoring American Finacial Stability Act of 2010 - Continued

Floor Speech

BREAK IN TRANSCRIPT

Mr. GRASSLEY. Mr. President, I hope we have a chance now, during the final hours of debate, to take into consideration some of the reasons we got from where we have been over the last 3 or 4 years with the bubble, and that bubble bursting a couple of years ago, and the financial crisis and the recession that has come as a result of it.

I want to start out with something that is familiar to all my colleagues, something that George Santayana said:

Those who cannot remember the past are condemned to repeat it.

As the Senate continues to debate the financial regulation bill, I think it is important to consider how we got from where we are today.

Many people believe the housing and financial crisis was the result of too much greed on Wall Street. No doubt. No doubt whatsoever; there was plenty of greed on Wall Street. But greed is like gravity--it is a constant of nature. When planes crash we don't blame gravity. If you search the Internet for the term ``decade of greed,'' you will discover that is what some people called the 1980s. There is no reason to believe people are greedier now than they were then. Greed has always existed. The Ten Commandments admonish us not to covet our neighbor's possessions. Everyone is tempted by greed. Some are more successful than others in resisting temptation. But greed alone does not explain our current crisis. We need to look further.

Many people blame the crisis on deregulation. According to this explanation, Congress repealed all the rules and let Wall Street run wild. Greedy bankers tricked innocent consumers into taking out risky mortgages and sold them to unsuspecting investors. This explanation views the crisis in terms of victims and villains. If it were only that simple.

Obviously, anyone who has committed a crime should be prosecuted to the fullest extent of the law. But this explanation overlooks several important facts: First, the United States is not alone in this crisis. Housing booms and busts are occurring all around the world resulting in government bailouts. According to the Organization for Economic Cooperation and Development--we refer to this as the OECD--nearly a dozen European countries are experiencing bigger housing bubbles than our own. These countries include Australia, Canada, Denmark, France, Ireland, Italy, New Zealand, Norway, Spain, Sweden, and the United Kingdom. The global nature of this crisis shows the problem is not ours alone.

Second, we do not have an unregulated free market. Let me underscore that point. This crisis occurred with lots of government involvement. The Federal Reserve controls the money supply. The Federal Deposit Insurance Corporation insures bank deposits. The Fannie, Freddie, Ginnie, FHA, and the Federal Home Loan Bank boards insure subsidized or guaranteed mortgages. We have an entire alphabet soup of government agencies that regulate our financial institutions--CFTC, FDIC, FHFA, FTC, NCUA, OCC, OTS, SEC, plus all the State agencies and the Federal Reserve. Finally, we have adopted a policy of too big to fail.

The essence of a free market is the opportunity to succeed and the potential to fail. As economist Milton Friedman observed: capitalism is a profit-and-loss system. The loss part is just as important as the profit part. Profits encourage risk taking and losses encourage what they should--prudence.

Unfortunately, we have privatized the profits and socialized the risks. In some cases, we have bailed out individual companies. In others, we have bailed out the financial markets. In recent years, market participants even coined a phrase for such bailouts--``the Greenspan put.'' In other words, Wall Street was betting on former Federal Reserve Chairman Alan Greenspan to protect them from their own mistakes.

Recent government bailouts, both industry-specific and market-wide, include Lockheed in 1971; Penn Central Railroad in 1974; Franklin National Bank in 1974; New York City in 1975 and 1978; Chrysler in 1980; Continental Illinois in 1984; the stock market crisis in 1987; Latin American debt crisis in the early-1980s; the Savings & Loan crisis in the late-1980s; the Mexican peso crisis in 1994; Asian financial crisis in 1997; Long-Term Capital Management in 1998; the stock market crisis in 2000; the airline industry in 2001; AIG, Bank of America, Bear Stearns; Citigroup, Chrysler, GM, Fannie and Freddie in 2008.

Reducing the cost of failure encourages reckless behavior. When people come to expect and accept government bailouts that's not capitalism--it is cronyism. Until we eliminate the perverse incentives created by these bailouts, no one can honestly say we have an unregulated free market.

I do not mean to say regulation is unnecessary. Indeed, the exact opposite is true. Free markets are not possible without laws to protect property and enforce contracts. The problem is government regulation often has unintended consequences.

The desire to control human greed through regulation is understandable. But we forget regulators are human too. They are subject to the same temptations as everyone else. History is replete with examples of regulatory capture and government corruption. The revolving door between Washington, Wall Street, and the Fed make these problems even worse. Second, regulation can provide a false sense of security. They encourage people to rely on the government instead of their own common sense. Third, regulation designed to solve one problem often create another problem. That can lead to more regulation and more problems.

But most of all, regulation cannot succeed when it is undermined by good intentions.

For most of the past century our government--under both Democrats and Republicans--has pursued an ad hoc industrial policy. We have encouraged home building to stimulate the economy, and home ownership to promote a better society. Unfortunately, we pursued these policies by undermining the safety and soundness of our financial system, which was already a house built upon sand. I will have more to say on that later.

A review of U.S. housing policy during the 20th century illustrates this point. Consider the government's first major campaign to boost homeownership as described by Steven Malanga of the Manhattan Institute.

As Secretary of Commerce, Herbert Hoover declared that nothing was worse than increased tenancy and landlordism. In 1922, Hoover launched the ``Own Your Own Home'' campaign, urging Americans to buy homes. According to Hoover, homeowners work harder, spend leisure time more profitably, live finer lives, and enjoy more comforts of civilization. He urged the lending institutions, the construction industry, and the great real estate men to counteract the growing menace of tenancy.

Hoover called for new rules that would allow nationally chartered banks to devote a greater share of their lending to residential properties. Until that time mortgage lending had primarily been conducted by savings and loans, or as they were originally known, building and loans.

In 1927, Congress responded by passing the McFadden Act, which allowed national banks to expand their residential lending to encourage homeownership. The act also prohibited interstate branching to protect smaller local financial institutions.

Congress would later pass the Riegle-Neal Act of 1994, which repealed the ban on interstate banking, subject to certain limits. This partial repeal followed the savings and loan crisis in the 1980s. Many observers suggest the lack of diversification and concentration of risk among smaller local institutions contributed to the S&L crisis.

The housing market boomed during the 1920s right along with the stock market. When stocks crashed in 1929, so did housing. According to one study, nearly 50 percent of the mortgages in America were in default by 1934. As panicked depositors withdrew their money, banks were forced to call in loans or stop rolling them over.

Before the Great Depression, home mortgages typically required a substantial down payment--as much as 50 percent. They usually had a very short maturity--as few as 5 years. They often had a balloon payment at the end. Homeowners had to refinance their mortgage or give up their home if they could not afford to pay off the balance when their loan came due.

In response to the housing and financial crisis caused by the Great Depression, Congress enacted the Home Owners' Loan Corporation and the Reconstruction Finance Corporation. These programs were designed to bailout insolvent financial institutions; buy up troubled mortgages; and refinance them on more affordable terms. A report by HUD on the history of the era, noted that many borrowers deliberately defaulted on their mortgages to take advantage of these bailouts.

One might think of these earlier programs as the original versions of the current TARP and HAMP.

In 1934, Congress attempted to strengthen the housing and financial markets by creating the Federal Home Loan Banks--FHLB--to lend money to other banks; the Federal Housing Administration--FHA--to guarantee home loans; the Federal Deposit Insurance Corporation--FDIC--to insure bank deposits, the Federal Savings and Loan Insurance Corporation--FSLIC--to insure the deposits of S&Ls; and the Federal National Mortgage Association--Fannie Mae--to create a secondary market for government insured mortgages.

Congress would later abolish FSLIC by merging it with the FDIC following the S&L crisis in the late 1980s.

In 1944, Congress passed the GI bill, which provided low interest, zero down payment home loans for servicemen. This enabled millions of American families to move out of urban apartments and into suburban homes.

In 1945, President Truman proposed the ``Fair Deal,'' which included several housing proposals, including temporary price controls. President Truman declared:

Such measures are necessary stopgaps-but only stopgaps. This emergency action, taken alone, is good--but not enough. The housing shortage did not start with the war or with demobilization; it began years before that and has steadily accumulated. The speed with which the Congress establishes the foundation for a permanent, long-range housing program will determine how effectively we grasp the immense opportunity to achieve our goal of decent housing and to make housing a major instrument of continuing prosperity and full employment in the years ahead. It will determine whether we move forward to a stable and healthy housing enterprise and toward providing a decent home for every American family.

I ask unanimous consent to include President Truman's full statement on housing policy in the Record.

The PRESIDING OFFICER. Without objection, it is so ordered. (See Exhibit 1.)

Mr. GRASSLEY. In 1949, Congress enacted the Federal Housing Act, which provided Federal funding for slum clearance, urban renewal, and public housing. The act also expanded the FHA mortgage insurance program.

To understand the origins of our current housing and financial crisis, it is critical to recognize the role played by the FHA--the Federal Housing Administration. The FHA was created in 1934. At the time, State and Federal laws prevented lenders from reducing their down payments and lengthening the terms of their loans. As I noted earlier, the typical mortgage required a 50-percent down payment and had a maturity of 5 years. These features were considered essential to maintaining the safety and soundness of the banking system.

Lower down payments increased the risk of foreclosure because buyers had less equity in their houses. If home values declined, more borrowers might walk away from their homes instead of continuing to make payments on their mortgage. Longer terms increased the risk of insolvency among financial institutions because of an increase in interest rates or a decline in the economy.

The FHA challenged conventional wisdom. It sought to waive all of the safety and soundness regulations that applied to the mortgages it insured. According to an article by Adam Gordon published in the Yale Law Journal:

The FHA had a compelling economic case for requesting such waivers: Treating insured loans differently from uninsured loans made sense from a safety-and-soundness standpoint. From the banks' perspective, insurance balanced out the risks of lower-down-payment, longer-term loans by guaranteeing that, even if the property value went down and the buyer quit making payments, or if the buyer defaulted twenty years into a 25-year loan, the bank would be made whole by the insurance fund. These assurances and the political pressure for new ways to support homeownership led Congress and every state legislature to rapidly pass the requisite exemptions from bank safety-and-soundness laws.

By 1937, all 50 States had enacted legislation giving the FHA free rein to write its own rules with respect to the mortgages that it insured. The results were predictable. Delinquencies, defaults, and foreclosures increased dramatically.

The FHA lowered down payments from 20 percent, to 10 percent, and finally to 3 percent by the mid-1960s. As a result, the foreclosure rate increased sixfold, from less than 2 for every 1,000 mortgages to more than 12 per 1,000 mortgages.

Almost everyone seemed prepared to accept rising foreclosure rates as the price to be paid for expanding homeownership. However, the FHA soon faced a bigger scandal.

Today, we often forget just how much of the pre-civil rights era in America was marked by racial discrimination. The FHA program was a prime example. During its first 30 years in existence, the FHA maintained various policies to deny insurance to minorities. These policies effectively prevented most African Americans from obtaining FHA insured mortgages.

Being denied an FHA loan usually meant being denied any opportunity to obtain lower down payments and longer terms because such provisions were still illegal for conventional loans.

FHA's discriminatory policies did not end until Congress passed the Fair Housing Act of 1968. Unfortunately, efforts to end racial discrimination marked the beginning of what we now call predatory lending. According to Beryl Satter of Rutgers University:

After decades of refusing to insure mortgages in areas with black residents no matter what their economic status, in 1968 the FHA went to the other extreme and told mortgage companies that if they would loan in low-income minority neighborhoods, the FHA would guarantee those loans 100%.

Speculators immediately exploited the new policy by buying slum properties, and then bribing someone to appraise the properties at, say, quadruple their real value. Speculators might buy a house for $5000 but get a corrupt FHA appraiser to say it was worth $20,000. Once they had that appraisal, they could easily sell that property for $20,000. So what if the price seemed high? The mortgage lender couldn't lose--after all, $20,000 was the property's appraised value, and more importantly, the FHA insured the loan 100%. [Speculators] enticed buyers by emphasizing the low down payment rather than the high final cost. People eager to buy on such terms were easy to find. They were usually black or Latino, and often low income. Given the desperate housing shortage facing low income families during that decade of massive inflation, an offer of a home of one's own for $200 down was often irresistible.

The speculators made the procedure quick and easy. They did all the paperwork, routinely falsifying the buyers' income to make it look like they could carry the overpriced loan. The lenders didn't ask any questions about these loan applications because the mortgages were fully insured; the creditworthiness of the borrower was therefore of no relevance. Since mortgage companies also made profits through the exorbitant service fees they charged for FHA loans, they made money on every sale, with no risk whatsoever.

By 1972, similar abuses of FHA programs were being reported in Boston, New York, Newark, Philadelphia, Wilmington, Miami, Detroit, St. Louis, Seattle, Los Angeles, and Lubbock, Texas. The New York Times noted that FHA-guaranteed loans were being given on ``substandard'' buildings that lacked ``such essentials as adequate heating and plumbing.'' The confluence of inflated mortgage payments and high repair costs meant that the low-income buyer never had a chance. The repossessed buildings sometimes ended up back in the hands of the speculators, who started the cycle anew.

While the scandal meant ruin for low and moderate-income home buyers, it meant huge profits for those in the game. .....

The companies exploiting FHA policies were not marginal. In New York top officials of three of the largest mortgage lenders in the region were convicted of housing fraud in 1975. In Brooklyn alone, the U.S. Attorney's office produced a five hundred-count indictment demonstrating that ``real estate speculators, brokers, lawyers, appraisers and bribed FHA employees conspired in the scheme'' to get FHA insurance on slums sold at inflated prices.

The FHA planted many of the seeds that ultimately grew into the current housing crisis.

The goal of making homes affordable was used to justify the weakening of traditional standards of safety and soundness. The goal of eliminating discrimination was used to justify extending both FHA and conventional loans to borrowers with poor credit and low income. These changes led to rising foreclosures. Lenders responded by charging higher rates and fees to cover their losses. Higher rates and fees increased the cost of buying a home and led to new charges of discrimination on the basis of predatory lending. That led to renewed calls for innovative ways to reduce the cost of housing. That led to a further weakening of safety and soundness standards. All of that brings us to where we are today.

Before discussing our current crisis, however, let me conclude my brief review of the history of U.S. housing policy.

In the midst of the FHA scandal, Congress created more programs to promote the American dream of home ownership.

In 1968, Congress enacted the Truth in Lending Act to require clear disclosure of lending arrangements and costs associated with a loan.

Also in 1968, Congress split Fannie Mae into two parts creating the Government National Mortgage Association, Ginnie Mae, which now deals with government guaranteed mortgages, primarily those insured by the Department of Veterans and the FHA.

In 1970, Congress created the Federal Home Loan Mortgage Corporation, Freddie Mac, to compete with Fannie Mae.

In 1974, Congress passed the Real Estate Settlement Procedures Act to prohibit kickbacks between lenders and settlement agents and require a good faith estimate of all closing costs.

In 1977, Congress enacted the Community Reinvestment Act, CRA, to encourage banks to meet the needs of their local communities in a manner consistent with safe and sound lending practices. According to Peter Wallison of the American Enterprise Institute, the CRA had a vague mandate to prevent banks from refusing to lend to qualified borrowers, which was enforced by denying mergers and acquisitions among banks. Initially, enforcement actions were rare. But over time, Congress shifted its emphasis from ``encouraging'' to ``requiring'' and from ``safe and sound'' to ``innovative and flexible.'' Ultimately, the CRA helped undermine the banking system by encouraging more risky loans.

As Stan Liebowitz of the University of Texas at Dallas observed: ``From the current hand-wringing, you'd think that the banks came up with the idea of looser underwriting standards on their own, with regulators just asleep on the job. In fact, it was the regulators who relaxed these standards--at the behest of community groups and `progressive' political forces .....''

But before faulty underwriting helped create the current housing crisis, there was the S&L crisis.

The late 1970s and early 1980s saw a dramatic rise in inflation due to the steady erosion of sound monetary policy in previous decades. Rising inflation led to higher interest rates, which threatened to destroy the Savings and Loan industry.

S&Ls relied on short-term deposits to fund long-term, fixed-rate mortgages. Rising inflation forced them to pay higher rates to attract new deposits. But they continued to earn the same rate on their existing mortgages. Rising costs relative to a fixed income undermined profits and threatened insolvency.

The S&Ls were further hampered by Regulation Q, which limited the interest rate they could pay to attract new deposits. The origin of Regulation Q dates back to the 1930s when Congress authorized the Federal Reserve to set interest rate ceilings.

According to proponents, the ceiling on interest rates would encourage smaller rural banks to lend in their own communities rather than send their money to larger urban banks where they might earn more. The ceiling was also seen as a way to increase bank profits by limiting the competition for deposits; in other words, it would prevent banks from engaging in a bidding war for new customers. Regulation Q was extended to S&Ls in 1966.

State usury laws also placed limits on the interest rate paid to depositors as well as the interest rate charged to borrowers further undermining the S&Ls' financial viability.

Congress took numerous steps throughout the 1980s to forestall the S&L crisis. These steps ultimately failed as more than 1,600 banks and S&Ls were either closed or bailed out by the government. The S&L crisis ultimately cost taxpayers more than $120 billion.

The S&L crisis shows the failure of many small banks can be just as costly as the failure of a few large banks. That is a lesson we must not forget as we consider ways to address the problem of too big to fail.

In 1980, Congress enacted the Depository Institutions Deregulation and Monetary Control Act to abolish caps on both the interest paid and the interest received.

The Alternative Mortgage Transactions Parity Act of 1982 preempted State laws to enable the nationwide use of adjustable rate mortgages, balloon payments, and negative amortization.

These flexible features proved useful during the inflationary 1970s and 1980s. But they also set the stage for the emergence of the housing crisis of today.

The Secondary Mortgage Market Enhancement Act of 1984 made it easier to issue mortgage backed securities and enabled financial institutions, pension funds, and insurance companies to invest in the top rated tranches of these securities.

The Tax Reform Act of 1986 eliminated the double taxation of dividends paid to those who invest in real estate mortgage investment conduits, REMICs. The act also eliminated the tax deduction for interest paid on consumer loans, except for those secured by a home mortgage.

These two acts established the path toward the creation of collateralize debt obligations, CDO, and the off-balance sheet entities known as special investment vehicles, SIVs, which featured prominently in the latest crisis. The tax deduction for home equity loans contributed to the overleveraging of housing.

The Financial Institutions Reform and Recovery and Enforcement Act of 1989 abolished the Federal Savings and Loan Insurance Corporation; it transferred the regulation of thrift institutions from the Federal Home Loan Bank board to the Office of Thrift Supervision; it allowed bank holding companies to acquire thrifts; it established new regulations for real estate appraisals; it established new capital reserve requirements; it required the publication of CRA evaluations.

This act also included reforms of the real estate appraisal system, which had broken down during the FHA scandal in the 1970s, and contributed to the S&L crisis. Despite these reforms, faulty or fraudulent appraisals contributed to the most recent crisis as well.

Federal Deposit Insurance Corporation Improvement Act of 1991 allowed the FDIC to borrow from the Treasury and created new capital requirements and risk-based deposit insurance premiums. Moreover, it granted the Federal Reserve authority to lend directly to nonbank firms during times of emergency.

This authority increased the moral hazard problem by expanding the scope of potential Federal bailout recipients. This authority played a critical role in bailing out AIG.

The Federal Housing Enterprises Financial Safety and Soundness Act of 1992 was enacted, in part, to encourage Fannie Mae and Freddie Mac to increase their service to low- and moderate-income families and neighborhoods. These changes, along with others that followed, served to undermine standards of safety and soundness by allowing Fannie and Freddie to receive credit toward its affordable housing goals by purchasing subprime loans from other lenders. This increased the demand for such loans as well as the amount of funds available to finance them.

The 1992 act coincided with a Boston Federal Reserve Bank study on discrimination in mortgage lending. In theory, lenders evaluated the collateral and creditworthiness of those seeking to borrow money. Those applicants who qualify get credit, and those who do not are denied. The Boston Fed study suggested qualified minority applicants were being denied.

In response to growing concerns that traditional underwriting standards had a discriminatory impact on low-income and minority families, many housing advocates began to urge the widespread adoption of risk-based pricing. Unlike traditional underwriting, risk-based pricing assumes everyone can qualify as long as they pay an interest rate, or other fee, that reflects their individual risk. Thus, risk-based pricing was viewed as a way to safely implement the flexible underwriting standards needed to eliminate discrimination and expand homeownership.

In 1993, the Federal Reserve Bank of Boston published a report entitled ``Closing the Gap.'' This report included recommendations on ``best practice'' from lending institutions and consumer groups. It offered lenders a ``comprehensive program'' to ensure all loan applicants are treated fairly and to reach a more diverse customer base.

The report stated:

While the banking industry is not expected to cure the nation's social and racial ills, lenders do have a specific legal responsibility to ensure that negative perceptions, attitudes, and prejudices do not systematically affect the fair and even-handed distribution of credit in our society. Fair lending must be an integral part of a financial institution's business plan ..... Even the most determined lending institution will have difficulty cultivating business from minority customers if its underwriting standards contain arbitrary or unreasonable measures of creditworthiness. ..... Institutions that sell loans to the secondary market should be fully aware of the efforts of Fannie Mae and Freddie Mac to modify their guidelines to address the needs of borrowers who are lower-income, live in urban areas, or do not have extensive credit histories.

In 1995, the Department of Housing and Urban Development announced a National Homeownership Strategy which stated:

The inability (either real or perceived) of many younger families to qualify for a mortgage is widely recognized as a very serious barrier to homeownership. [The Strategy] commits both government and the mortgage industry to a number of initiatives designed to: (1) Cut transaction costs through streamlined regulations and technological and procedural efficiencies; (2) Reduce down-payment requirements and interest costs by making terms more flexible, providing subsidies to low- and moderate-income families, and creating incentives to save for homeownership; (3) Increase the availability of alternative financing products in housing markets throughout the country.

Efforts to expand the use of flexible underwriting standards raised obvious concerns about the potential for increased defaults and foreclosures. To address these concerns, numerous groups, both inside and outside government, conducted studies, and proposed new laws and regulations.

In 1996, Freddie Mac issued a report to Congress based on its effort to develop an automated underwriting system. The report concluded that it was possible to replace ``subjective human judgment'' with computers that could accurately assess ``multiple risk factors'' and ``identify which loans would wind up in foreclosure and which would not.'' By fairly and objectively accessing individual credit risk, an automated system could eliminate discrimination and strengthen the underwriting process.

This study was primarily focused on improving the prime mortgage market by identifying applicants who received prime loans, but shouldn't have, and applicants who did not receive prime loans, but should have. However, the ability to identify risk within the prime market led to the conclusion that it was possible to do the same thing in the subprime market as well. In relatively short order, Fannie, Freddie, and almost every other participant in the home mortgage market adopted computerized systems to analyze and securitize home loans. These new procedures were applied to subprime loans.

Of course, risk based pricing also raised concerns that lenders might charge borrowers more than their risk profile would justify. Such overcharges raised the specter of predatory lending.

In response, Congress enacted the Home Ownership and Equity Protection Act of 1994 which required disclosures and imposed restrictions on high-cost loans. This act served to highlight once again the difficulty of promoting flexible underwriting to expand homeownership while at the same time trying to protect consumers from discriminatory lending.

The Taxpayer Relief Act of 1997 exempted from taxation profits on the sale of a personal residence of up to $500,000, couples, or $250,000, singles. This change provided a boost to home prices by increasing the after-tax rate of return on housing.

The Interstate Banking and Branching Efficiency Act of 1994 repealed restrictions on interstate banking. This act was designed to address the lack of diversification and the concentration of risk among smaller local financial institutions that contributed to the S&L crisis.

The Financial Services Modernization Act of 1999--also known as Gramm-Leach-Bliley--repealed part of the Glass-Steagall Act of 1933. The extent to which this repeal contributed to the current crisis is the subject of much debate.

Glass-Steagall prohibited commercial banks from underwriting or dealing in securities. It also prohibited them from having affiliates that were principally or primarily engaged in underwriting or dealing in securities. It is important to understand exactly what this means.

As Peter Wallison of the American Enterprise Institute has explained:

Underwriting refers to the business of assuming the risk that an issue of securities will be fully sold to investors, while ``dealing'' refers to the business of holding an inventory of securities for trading purposes. Nevertheless, banks are in the business of making investments, and Glass-Steagall did not attempt to interfere with that activity. Thus, although Glass-Steagall prohibited underwriting and dealing, it did not interfere with the ability of banks to ``purchase and sell'' securities they acquired for investment. The difference between ``purchasing and selling'' and ``underwriting and dealing'' is crucially important. A bank may purchase a security--say, a bond--and then decide to sell it when the bank needs cash or believes that the bond is no longer a good investment. This activity is different from buying an inventory of bonds for the purpose of selling them, which would be considered dealing.

The Gramm-Leach-Bliley Act did not repeal the restriction on underwriting or dealing by commercial banks. It only repealed the restriction on affiliates. There is no evidence the activities of any affiliates were large enough to cause the current crisis.

On the other hand, as Mr. Wallison noted, there was a critical exception to the Glass-Steagall prohibition on underwriting or dealing by commercial banks. It did not apply to securities issued by Fannie Mae and Freddie Mac.

The major commercial banks--such as Citibank, Wachovia, Bank of America, JP Morgan Chase, and Wells Fargo--that got into trouble did so by engaging in activities that were never prohibited by Glass-Steagall. These banks suffered heavy losses because they invested in poorly underwritten, overvalued mortgage-backed securities, including those of Fannie and Freddie.

Likewise, the major investment banks--such as Lehman Brothers, Bear Stearns, Merrill Lynch, Morgan Stanley and Goldman Sachs--that got into trouble have always been exempt from Glass-Steagall. As I will discuss later, the demise of these investment banks was due to a new variation on the classic bank run.

The Commodity Futures Modernization Act of 2000 authorized over-the-counter financial derivatives. Although over-the-counter derivatives, like credit default swaps, CDS, are exempt from most regulation, those who buy and sell them are not. For example, the acting director of the Office of Thrift Supervision, OTS, recently testified about the American International Group, AIG, one of the major participants in the CDS market. According to his testimony, ``..... in hindsight, OTS should have directed the company to stop originating CDS products ..... [and] OTS should also have directed AIG try to divest a portion of this portfolio.''

Although AIG was comprised of more than 220 companies operating in more than 130 countries, its primary line of business was insurance. According to a Government Accountability Office report:

State insurance regulators are responsible for monitoring the solvency of insurance companies generally, as well as for approving transactions regarding those companies, such as changes in control or significant transactions with the parent company or other subsidiaries .....

In other words, Federal and State regulators had the authority to monitor the financial institutions which were among the largest buyers and sellers of CDS contracts, and take appropriate action to protect their safety and soundness. Unfortunately, the regulators failed to recognize the inherent dangers created by the bubble in the housing market.

The Federal Deposit Insurance Reform Act of 2005 raised the limit on deposit insurance; merged the various deposit insurance funds; provided credits for banks for prior contributions; and required rebates when the deposit fund goes above 1.5 percent of deposits.

The Credit Agency Reform Act of 2006 required rating agencies to register with the SEC. Despite these requirements, the ratings agency contributed to the most recent crisis as well.

Credit ratings agencies--such as Fitch, Moody's, and Standard & Poor's--have been given privileged status as Nationally Recognized Statistical Rating Organizations, NRSROs, since 1975.

These agencies played a significant role in the recent financial crisis in two different ways. First, they placed their AAA seal of approval on subprime mortgages that were converted into traunches--or tiers--of securitized loans. Second, they contributed to excessive borrowing because of flawed capital standards. According to government regulations, banks needed $1 in capital for every $25 of single-family home loans. But, if those mortgages were converted into AAA securities, the banks could hold $60 in loans for every $1 in capital. Higher leverage entails greater risk to the financial system.

This brief legislative history produces an unmistakable feeling of Deja Vu as one considers where we are today. The current crisis has been summarized along the following lines:

In response to the high-tech, dot-com bust in 2000, the Federal Reserve began a series of interest rate cuts reducing the Fed Funds rate from 6.5 percent to 1.0 percent. As cheap credit flooded the markets, financial institutions adopted reckless lending practices under the political banner of increasing homeownership. These practices included liar loans, no verification of income or assets; no-money down, including seller-financed and other third-party contributions, and wrap-around loans; interest-only loans; negative amortization, missed payments are added to the principal; adjustable-rates; and balloon payments.

As these risky loans were extended to marginal borrowers who could not afford their overpriced homes, the financial wizards on Wall Street devised schemes to theoretically insure themselves against default. These so called credit default swaps allowed investors who purchased mortgage-backed securities to pay fees to underwriters, like AIG, in exchange for a promise to cover any losses. Because regulators and other market participants did not seriously consider the possibility of falling home prices and rising default rates, these CDS contracts were not backed by adequate collateral to cover potential losses.

By allowing those who bought and sold mortgage-backed securities to transfer risk to other market participants, it became more difficult to determine who would suffer the actual losses as home prices began to fall and default rates began to rise. The house of cards collapsed as financial institutions became less willing to lend to each other under the growing cloud of uncertainty.

While there is plenty of blame to go around for getting us into this mess, and there were lots of contributing factors, ultimately this crisis was triggered by a new variation on the classic bank run. Here's how Gary Gordon of Yale University describes what happened:

In a banking panic, depositors rush en masse to their banks and demand their money back. The banking system cannot possibly honor these demands because they have lent the money out or they are holding long-term bonds [which can only be sold at fire sale prices] ..... the panic in 2007 was not like the previous panics in American history ..... it was not a mass run on banks by individual depositors, but instead was a run by firms and institutional investors on financial firms.

According to Mr. Gordon, this run was caused by the collapse of the repurchase agreement--or repo--market. Before the crisis, trillions of dollars were traded in the repo market. No one knows the exact amount because there are no data on the total size of this market or the identity of all its participants. Estimates suggest it could be as much as $10 trillion, which is roughly equal to the total assets of the entire U.S. banking system.

As tempting as it may be to blame our current crisis on Wall Street greed
and irresponsible deregulation, the truth is a bit more complicated, as I think I have tried to show. To understand how we got to where we are today, it is necessary to review some history and some economics.

There have been financial booms and busts throughout recorded history--from tulip mania, the South-Sea bubble, and the Mississippi scheme, to the Mexican peso crisis, the Asian crisis, and the dot-com boom.

Economist Hyman Minsky argued there are five stages of a financial bubble: stage 1, investors get excited about some asset or commodity; stage 2, prices rise as more investors enter the market; stage 3, euphoria occurs as financial markets devise new ways to inflate the bubble; stage 4, investors begin to cash-out of the market; and, stage 5, panic sets in as the bubble pops and everyone tries to get out before it is too late.

There have been alternating cycles of financial fear and euphoria throughout history. While greed and speculation played an important role, there is another essential element that is all too often overlooked. That critical ingredient is money.

The nature of money, the source of its value, and the determination of its supply are topics of extreme importance. Historically, money is believed to have developed from the concept of barter or exchange. Individuals wished to trade one good for another. The most desirable, divisible, and nonperishable goods were designated as money. Cows, wheat, rice, rocks, sea shells, silver, and gold have all served as money throughout history.

The development of money soon led to the introduction of banking. Banks served not only as a place to store money, but also as a means to facilitate commerce by granting various types of loans.

The deposit of money involves two different concepts. First, a demand, or checking, deposit implies a custody arrangement. The bank maintains 100 percent reserves. Thus, the funds are available at all times to meet the needs of the depositor. Second, a loan, or time, deposit implies a temporary transfer of ownership. The bank is authorized to make loans. Thus, the funds are transferred to someone else who is obligated to repay them at some future date.

Initially, most banks recognized and accepted the distinction between these two different kinds of deposits. Moreover, they confined their lending activities within the limits of their total deposits. But they quickly discovered that not everyone sought to withdraw their money at the same time. Thus, they decided they could safely issue as much credit as they desired, as long they retained enough money to meet expected withdrawals. So began the practice of fractional reserve banking.

According to economist Jesus Huerta de Soto, early European bankers often sought to conceal their use of fractional reserves while claiming to maintain 100 percent reserves. Only later upon receiving official government sanction did they openly admit to and defend the practice of fractional reserves.

The most common defense of fractional reserve banking is that it is highly unlikely that most depositors will seek to withdraw their funds simultaneously. Thus, it is said the law of large numbers permits a bank to safely lend out most of its funds. But as Huerta de Soto observes:

..... in the field of human action the future is always uncertain, ..... The open, permanent nature of the uncertainty ..... differs radically from the notion of risk applicable within the sphere of physics and natural science.

History shows beyond a doubt that we cannot predict when a bank run will occur. The creation of deposit insurance and the establishment of a central bank as a lender of last resort would not be necessary if we could predict such events with any degree of certainty.

The dangers created by misguided efforts to treat uncertainty of human action as some form of statistical risk is evident in the current crisis. The use of computer models to convert subprime loans into AAA securities ignored the human action of declining underwriting standards and the growing bubble in the housing market.

Some observers may be tempted to conclude this crisis is simply the latest in the cycle of booms and busts that inevitably plague mankind. Others may be tempted to conclude we need a brand new systemic risk regulator--in other words, we need someone to oversee the safety and soundness of our entire financial system. The logic behind this approach is that our current hodgepodge of Federal and State regulatory agencies was too busy looking at the individual institutions within their jurisdiction. No one saw the big picture.

However, the problem is not that we lack a systemic risk regulator. The problem is we already have a system risk creator, namely the Federal Reserve.

Mark Thornton of the Ludwig von Mises Institute describes central banking as a confidence game:

The Federal Reserve plays a confidence game with us. A confidence game ..... is described as an attempt to defraud a person or group by gaining their confidence. ..... [The] Fed's basic confidence game [is] trying to gain and maintain our confidence in its system and getting us not to take proper precaution against the negative effects of its policies. ..... [The] Fed's mission [is] to instill confidence in us about the economy while simultaneously instilling confidence in us about the abilities of the Fed itself. The first mission is easy to see because Fed officials are almost always publicly bullish and hardly ever publicly bearish about the economy. The economy always looks good, if not great. If there are some problems, don't worry, the Fed will come to the rescue with truckloads of money, lower interest rates, and easy credit. If things were to get worse, which they won't, the Fed would be able to respond with monetary weapons of mass stimulation. All this is consistent with the viewpoint of mainstream economists who see the business cycle as caused by psychological problems and random shocks. In their view, it is your fault for becoming overly speculative and risky and then lapsing into risk aversion and depression. It is your fault!

This may seem like an unfair characterization of the Fed, but consider the following quotes from 2007. Remember, by early 2007 housing prices were falling in many areas.

In January of 2007, Chairman Bernanke described the Fed's superhero-like ability to access information, identify risk, anticipate crisis, and respond to any challenge.

Mr. Barnanke said:

Many large banking organizations are sophisticated participants in financial markets, including the markets for derivatives and securitized assets. In monitoring and analyzing the activities of these banks, the Fed obtains valuable information about trends and current developments in these markets. Together with the knowledge obtained through its monetary-policy and payments activities, information gained through its supervisory activities gives the Fed an exceptionally broad and deep understanding of developments in financial markets and financial institutions. .....

In its capacity as a bank supervisor, the Fed can obtain detailed information from these institutions about their operations and risk-management practices and can take action as needed to address risks and deficiencies. The Fed is also either the direct or umbrella supervisor of several large commercial banks that are critical to the payments system through their clearing and settlement activities. .....

In my view, however, the greatest external benefits of the Fed's supervisory activities are those related to the institution's role in preventing and managing financial crises.

Finally, the wide scope of the Fed's activities in financial markets--including not only bank supervision and its roles in the payments system but also the interaction with primary dealers and the monitoring of capital markets associated with the making of monetary policy--has given the Fed a uniquely broad expertise in evaluating and responding to emerging financial strains.

I could go on at length reading similar quotes from various Fed officials. But to save on time and embarrassment, I will simply put Mr. Thornton's article in the Record, and skip to his conclusion. Mr. Thornton says:

We can see that the Fed is a confidence game. Their public pronouncements, while heavily nuanced and hedged, uniformly present the American people with a rosy scenario of the economy, the future, and the ability of the Fed to manage the market. Ben Bernanke told Congress [in March of 2010] that we are in the early stages of an economic recovery. Of course, he has been saying that since the spring of 2009 (if not earlier). ..... These are the people who said that there was no housing bubble, that there was no danger of financial crisis, and then that a financial crisis would not impact the real economy. These are the same people who said they needed a multi-trillion dollar bailout of the financial industry, or we would get severe trouble in the economy. They got their bailout, and we got the severe trouble anyways. It is time to bring this confidence game to an end.

Mr. President, I ask unanimous consent that Mr. Thornton's article be printed in the RECORD.

The PRESIDING OFFICER. Without objection, it is so ordered.

(See exhibit 2.)

Mr. GRASSLEY. The current financial reform bill will not end the cycle of financial booms and busts. This cycle is not the result of green, or capitalism, or animal spirits, or irrational exuberance. Ultimately, it is caused by our failure to recognize and enforce traditional legal principles, namely, the protection of private property.

According to Huerta de Soto: It is a remarkable fact that three of the most noted monetary theorists of the eighteenth and early nineteenth centuries were bankers: John Law, Richard Cantillon, and Henry Thornton. Their banks all failed.

Law was involved in the infamous Mississippi scheme, and Cantillon was involved in a fraudulent stock trading scheme. Only Thornton escaped controversy because his bank did not fail until after his death. All of these bankers were actively involved in convincing their colleagues and customers of the safety, soundness, and wisdom of violating traditional legal principles.

Once upon a time, common sense as well as the law recognized the difference between a demand deposit and a loan deposit.

According to Huerta de Soto, ancient Roman law made it clear that bankers carried out two different types of operations. On one hand, they accepted demand deposits, which involved no right to interest and obligated the bank to maintain the continuous availability of the money; and the depositor had absolute privilege in the case of bankruptcy. On the other hand, bankers also received loan deposits, which obligated the banker to pay interest on the money; and the depositor lacked all privileges in the case of bankruptcy.

The clear distinction between these two types of deposits began to break down with the unfortunate choice of a penalty for the failure to return a demand deposit. A banker who accepted a demand deposit and later failed to return the money upon demand was obligated to pay a penalty in the form of interest.

According to Huerta de Soto, the ban on usury by the three major monotheistic religions--Judaism, Islam, and Christianity--did much to complicate and obscure medieval financial practices. Historically, usury meant charging any interest on a loan. Today, it means charging excessive interest on a loan.

Since it was forbidden to pay interest on loans, it is easy to understand how convenient it was in the Middle Ages to disguise a loan as a deposit in order to make the payment of interest legal, legitimate and socially acceptable. For this reason, bankers started to systematically engage in operations in which the parties openly declared they were entering into a deposit contract and not a loan contract.

The method of concealment ..... was a simulated [demand] deposit which ..... was not a true [demand] deposit at all, but rather a loan [deposit]. At the end of the agreed-upon term, the supposed depositor claimed his money. When the [bank] failed to return [the money], [the bank] was forced to pay a ``penalty'' in the [form] of interest on [its] presumed ``delay.''

Disguising loans as deposits became an effective way to get around the canonical ban on interest and escape severe sanctions, both secular and spiritual.

It would appear the history of banking consists of a continuous effort to eliminate the distinction between these two types of deposits. I do not mean to criticize modern day bankers. I suspect they are largely unaware of this history. They simply operate under the rules as they exist today. Anyone who studies money and banking in college is taught about fractional reserves, deposit insurance, and the need for a central bank to serve as lender of last resort. This is standard fare that passes for higher education around the world.

As economist John Maynard Keynes once observed, ``even the most practical man of affairs is usually in the thrall of the ideas of some long-dead economist.''

Having said all this, the question remains: Where do we go from here?

To answer that question let me return to the topic of money. In a world of paper currency--without the backing of any tangible commodity--the supply of money is ultimately determined by the government.

In most countries, the power to create money has been delegated by the government to a central bank. The central bank in turn controls the money supply in a number of ways: buying and selling financial assets--so-called discount window or open-market operations--and requiring banks to keep deposits at the central bank--so-called reserve requirements.

As our Nation's central bank, it is often suggested that the Federal Reserve controls both interest rates and the money supply. However, the only interest rate the Fed controls is the discount rate. That is the rate the Fed charges other banks when they borrow money from the Fed. The Fed generally prefers that banks borrow from each other. So, it usually sets the discount rate higher than the rate banks charge each other. That rate is called the Federal funds rate.

U.S. banks are required to hold reserves as a percentage of their demand deposits, but not their loan deposits. These reserves are designed to cover daily withdrawals. On any given day, some banks may have a reserve shortfall, while others may have excess reserves. Thus, banks borrow from each other on an overnight basis. The Fed sets a target for the interest rate banks charge each other--the Federal funds rate--and then it attempts to achieve its target.

According to the textbook explanation, when the Fed wants to lower the Federal funds rate, it buys financial assets, such as government bonds, from other banks and pays for them by creating additional reserves. This is sometimes referred to as creating money out of thin air. Since the banks now have more reserves, they are generally willing to lend at a lower rate. When the Fed wants to raise the Federal funds rate, it sells financial assets back to the banks and withdraws the additional reserves. Since the banks now have fewer reserves, they will usually require borrowers to pay a higher interest rate.

The Fed can also change the supply of money by changing the reserve requirement. By raising or lowering the reserve requirement, the Fed can control how much money banks must hold in reserve. Higher reserves mean less money is available for banks to lend, and lower reserves mean more money to lend.

Although central banks control the money supply in the long run, in the short run individual banks are largely in control.

As the Federal Reserve Bank of Chicago explained in its publication Modern Money Mechanics:

In the real world, a bank's lending is not normally constrained by the amount of reserves it has at any given moment. Rather, loans are made, or not made, depending on the bank's credit policies and its expectations about its ability to obtain the funds necessary to pay its customers' checks and maintain required reserves in a timely fashion.

In other words, when banks make loans, they create new deposits, thereby increasing the money supply. In the short run, banks are free to make as many loans as they want based solely on their expectation of future repayment and their ability to meet required reserves and expected withdrawals, plus their capital requirements.

In the long run, central banks control reserve requirements and the cost of borrowing excess reserves. Thus, they can eventually prevent individual banks from endlessly expanding the money supply.

Money can be defined as the thing that all other goods and services are traded for, or as the means to achieve final settlement of all transactions. As the means of final payment, money is uniquely valued above all other assets. It is considered to be the most liquid because it is accepted by everyone and it trades at face value. That is, $1 is always equal to $1.

Because banks have the power to create money--within limits set by the central bank--they are viewed with a high degree of suspicion. But banks are ultimately at the mercy of their customers because they are obligated to convert deposits into cash. When banks lose the confidence of their customers, they are subject to bankruptcy if too many customers try to withdraw their money. Banking panics in the past led to the creation of central banking and deposit insurance. These government safety nets were designed to prevent the collapse of the banking system.

To further limit the risk of a banking failure, the government imposed various standards of safety and soundness. These standards range from underwriting loans to maintaining adequate levels of capital and reserves. While these standards make banking safer, they also make it more expensive. It takes time and effort to evaluate the creditworthiness of borrowers. Likewise, money that is set aside in reserves cannot be used to make a loan and earn a rate of return.

As I have outlined earlier, Congress undermined both underwriting standards and capital requirements in an effort to expand home ownership. However, these actions alone would not have likely caused the crisis.

Another major contributing factor was the fact that all of the limits placed on traditional deposit-based commercial banking led to the expansion of the alternative securities-based investment banking system. This system is sometimes referred to as the ``shadow'' banking system. While both types of banks are arguably clouded by a fog of confusion, the differences are very clear.

Investment banks do not accept or create deposits. Instead, they help businesses and governments raise money by selling their stocks and bonds to investors. To accomplish this goal, they also perform two other important functions. They transform stocks, bonds, or mortgages into securities. This securitization process is designed to diversify the investments and reduce market risk. Many investment banks also serve as market-makers.

Just as a commercial bank must meet a depositor's demand for cash, a market-maker must buy securities for cash. However, there are two important differences. Unlike deposits that must be redeemed $1-for-$1, securities are redeemable at the market-price, which could be more or less than the amount originally paid. The other important difference is that investment banks do not have an established government safety net.

They do not have access to deposit insurance because they do not have deposits. They do not typically have the ability to borrow from the central bank as the lender of last resort, again because they do not have deposits. Nevertheless, when they lose the confidence of their customers, they are subject to the equivalent of a bank run.

That is basically what happened. Investment banks borrowed short term, primarily through repos, and invested long term, primarily in mortgage-backed securities. When it finally became apparent to everyone that mortgage default rates were going up and home prices were going down, the short-term lending came to an end. Without the ability to borrow more short-term money or sell long-term securities at their original price, the investment banks faced insolvency.

This was not our first crisis, and it won't be our last. Increased transparency and accountability are necessary, but they are not sufficient. A sound financial system requires a sound monetary policy. That means a strong and stable dollar.

The history of U.S. monetary policy, indeed the history of monetary policy around the world, reveals an ongoing effort to devalue money through endless inflation.

The reform we need most is to overcome the temptation to purchase prosperity with inflated dollars. Until that goal is achieved, I am afraid the current reform effort will amount to little more than rearranging the deckchairs on the Titanic.

Mr. President, I yield the floor.

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