Financial Crisis Inquiry Hearing 0900-1000
TRANSCRIPT:
ANGELIDES: Good morning. Welcome to the second day of hearings by the Financial Crisis Inquiry Commission.
As the members know and as the public know who has been watching us, we have been exploring the shadow banking system in this country and its effect on the financial and economic crisis which has gripped this nation.
We have been focusing on the growth, development of this system and the risks posed by it. As we've said before, while there's significant interest, obviously, in what was done to rescue various financial institutions in the midst of a financial crisis, the charge of this commission is to examine the causes of the crisis and to explore how risks to the system developed in the first place, what could have been done, what should have been done to prevent those risks from coming into being.
We have a full day of hearing again today. We are joined, first of all, this morning by former Secretary of the Treasury Henry Paulson. And, really, with no further ado, we will begin this hearing, unless, Mr. Vice Chairman, you'd like to make an opening remark, also.
THOMAS: No, I would just like to say that yesterday was useful. Today has a real opportunity to be useful. I cannot recall -- in my four decades -- in which we have two witnesses, both of whom were former secretaries of the treasury, one who had a background on Wall Street in one of the major firms, and the other secretary having a position in the Federal Reserve in New York so that we get a full understanding, based upon our ability to ask questions, of both sides of the street from two different perspectives over a period of time which is obviously, as we now know in retrospect, very significant in the history of the United States. And so I look forward to the testimony.
Thank you, Mr. Chairman.
ANGELIDES: Thank you, Mr. Vice Chairman.
And as the vice chairman indicated, we will start today hearing from former Secretary Paulson. We will then hear from secretary of the treasury, Mr. Geithner. And then we will have a panel later in the afternoon with participants in the shadow banking system from GE Capital to PIMCO to State Street Bank.
With no further ado, Mr. Paulson, thank you for being here this morning. I'd like to ask you to stand for what is a customary oath of office that we administer to everyone who appears before us.
If you would please raise your hand as I administer the oath. Do you solemnly swear or affirm under penalty of perjury that the testimony you're about to provide the commission will be the truth, the whole truth, and nothing but the truth, to the best of your knowledge?
PAULSON: I do.
ANGELIDES: Thank you very much. Mr. Paulson, we have received your written testimony, and we appreciate it very much, and we'd like to ask you now to -- we'd like to give you the opportunity -- and we'd like to obviously hear -- an oral presentation by you. We've asked, in consideration of the time, that you keep that presentation to no more than 10 minutes.
I know you're familiar with testifying up here on the Hill, so you probably know there's a light on that box that goes to yellow with one minute, to red at -- when time is up. And if you'd make sure your mike is on, you may commence.
PAULSON: Chairman Angelides, Vice Chairman Thomas, and members of the commission, thank you for the opportunity to testify today.
I served as secretary of the treasury during the recent financial crisis. I am proud of the work we in government did to save our nation's financial system from collapse and chaos and our economy from disaster.
Even so, the crisis caused human suffering that simply cannot be measured. The American people deserve and policymakers will benefit from an understanding of the broad and diverse causes of the crisis. The job of providing that explanation falls to this commission, and it is an awesome responsibility.
Many mistakes were made by all market participants, including financial institutions, investors, regulators, and the rating agencies, as well as by policymakers. Most of these are well understood and, importantly, policymakers are currently addressing some major regulatory structure and authority issues that allowed the pre-2007 regulatory structure and authority issues that either -- excuse me, policymakers are currently addressing these regulatory structures that either allowed the pre-2007 excesses in our system or made it difficult to address the crisis.
Nevertheless, a number of the root causes are not being addressed and remain sources of danger to our country. I fully support your important mission, and I hope that my testimony today can assist it.
The roots of the financial crisis trace back to several factors, including housing policy, global capital flows, overleveraged financial institutions, poor consumer protection, and an archaic and outmoded financial regulatory system, among many other causes.
Underlying the crisis was a housing bubble, and it is clear that several policy decisions shaped the home mortgage market. Excesses in that market eventually led to a significant decline in home prices and a surge of loan defaults which caused tremendous losses in the financial system, triggered a contraction of credit, and put many Americans quite literally out on the street.
These excesses were driven in large part by housing policy. From 1994 to 2006, homeownership soared from an already spectacular 64 percent of U.S. households to a staggering 69 percent, due to the combined weight of a number of government policies and programs.
Fannie Mae and Freddie Mac, the government-sponsored enterprises, comprised a central part of the U.S. housing policy. The GSEs operated under an inherently flawed model of private profit backed by public support, which encouraged risky revenue seeking and ultimately led to significant taxpayer losses.
The United States has always encouraged homeownership, and rightfully so. Homeownership builds wealth, stabilizes neighborhoods, creates jobs, and promotes economic growth, but it must be pursued responsibly. The right person must be matched to the right house, and consequently the right home loan, and in the years before the crisis, we lost that discipline.
The over-stimulation of the housing market caused by government policy was exacerbated by other problems in that market. Subprime mortgages went from accounting for 5 percent of total mortgages in 1994 to 20 percent by 2006. Consumer protection, including state regulation of mortgage origination, was spotty, inconsistent, and in some cases non-existent.
Speculation on rising home prices led to increasingly risky loans, including far too many home loans made with no money down. Securitization separated originators from the risk of the products they originated. Mortgage fraud increased, and predatory lenders and unscrupulous brokers pushed increasingly complex mortgages onto unsuspecting borrowers. The result was a housing bubble that eventually burst in a far more spectacular fashion than most previous bubbles.
Global forces also played a significant role in causing the crisis. Imbalances in the world's economies led to massive and destabilizing cross-border capital flows. While other nations save, Americans spend. Consumption in this country is a norm, spurred on by low interest rates, aided by capital flowing from countries, notably China and Japan, which have high savings and low shares of domestic consumption, and further encouraged by U.S. tax laws that discourage saving.
We are living beyond our means on borrowed money and borrowed time. Consumers, businesses, and financial institutions all overextended and overleveraged themselves with inevitably disastrous results, while our federal and state governments continue to borrow heavily, jeopardizing their long-term fiscal flexibility.
Our financial institutions, including commercial and investment banks, were notable examples of this overleveraging. In general, these institutions did not maintain sufficient high-quality capital, which left them unable to absorb the significant losses they incurred as the housing bubble burst. Many of them did not understand their liquidity positions fully.
They held insufficient cash and cash equivalents and instead relied overly on short-term funding sources that ran dry as the credit markets contracted. These leverage problems were further exacerbated by a lack of transparency, which caused problems in subprime to affect other classes of assets.
Like a tainted food scare, a relatively small batch of deadly products -- securitized subprime mortgages -- led to fear and panic in the markets for many mortgage securitizations, driving down the price of assets, which triggered huge losses and severe liquidity problems.
Derivative contracts, including excessively complex financial products, exacerbated the problems. These instruments embedded leverage in the institutions' balance sheets, along with risks which were so obscured that at times they were not fully understood by investors, creditors, rating agency regulators, or the managements themselves.
Very importantly, a number of financial institutions had woefully inadequate risk management and liquidity management practices that allowed these problems to grow and intensify, in a number of cases leading to failure of the institution.
Compounding the problems at these financial institutions was a financial regulatory system that was archaic and outmoded. Our regulatory framework was built at a different time for a different system, and it has not kept pace with the rapid changes in the financial industry.
I noted during my time at Treasury the enormous gaps in this authority, duplication of responsibility, and unhealthy jurisdictional competition. No single regulator had responsibility for overseeing the stability of the system. The result was that regulators were often unable to supervise their firms they oversaw adequately. They did not see the impending systemic problems that progressed towards the crisis. And they did not have the tools to contain all the harms that unfolded as institutions began to collapse.
In March of 2008, this led me to recommend a blueprint for the major reform of our financial regulatory system after a year-long comprehensive review.
I will turn now to the specific topics of today's hearing, the shadow banking system, a term that refers to the large capital and credit markets outside the traditional banking system that provide credit for municipal governments, corporations, and individuals for short-, intermediate-, and long-term funding needs.
Before the crisis, these markets satisfied at least half of the consumer and business credit needs and are one of the hallmarks of our advanced and highly developed capital markets. They have greatly benefited our nation, spurred growth and prosperity at all levels of our economy, and they have enabled more people to receive higher education, more people to purchase homes, more people to start new businesses, and more people to plan effectively for their children's future.
They have -- they have increased consumer choice, stimulated job creation, and allowed our system to diversify away from the large concentrated banks found in other capital markets.
PAULSON: But like all activities in the financial sector, these markers were fueled by the global excesses and regulatory flaws I've already discussed. When the crisis hit, the stress it placed on these markets exposed to many of these flaws, and these flaws in turn extended and exasperated some of the effects of the crisis.
These problems must be addressed. Our financial system cannot move forward without fortifying the weak parts of this infrastructure. In my written testimony I have addressed some specific areas of concern and my suggestions for reform. My list is not exhaustive, and there are certainly other problem areas in need of scrutiny.
In addressing these problems, however, we must make sure we retain the benefits of the underlying financial innovations. In our haste to deal with the flaws in the non-bank financial system, we should not move ourselves track to assistant of consolidated, monolithic commercial banks. I'm confident that a thoughtful process can achieve this.
Thank you, and I'd be pleased to answer any questions.
ANGELIDES: Thank you very much, Mr. Secretary.
We will now commence for questioning by members, and we will start with me and then the vice chair and then the balance of the members.
And I might say just one thing I noted yesterday, and that is Commissioner Born and Commissioner Holtz-Eakin have served as lead commissioners for this series of hearings and have done an excellent job, and I wanted to note that.
Mr. Secretary, I have a number of questions for you. What I'd like to -- and they -- they really focus on the run-up to the crisis. There's been, as I said in my opening remarks, a lot of fascination with the bailout, how the financial system was stabilized. But for me -- and, I suspect, some other commissioners -- the real question is how did we come to the point where the only options were either allow the financial system to collapse or to commit trillions of dollars of taxpayers' dollars.
What I'd like to do to start, though, this morning is ask you just a couple of questions with respect to your role at Goldman before you became treasury secretary, and then move on to your role as treasury secretary.
During that time you were the CEO of Goldman from January 1st, 2004, through June 1st, 2006, at Goldman issued 19 synthetic subprime CEOs totaling about $8.4 billion. Let me first ask you, because this goes to the shadow banking system, it goes to the system as a whole, what's your sense, if any, of the -- what's your sense of the value, if any, of synthetic CEOs in our financial system?
Do they provide any real capital or benefit to the system or are they merely a device for betting in terms of results on the system? Are they bets or are they actually devices that provide capital and liquidity of benefit to the real economy?
PAULSON: Mr. Chairman, a number of times I have said that I believe that we had access to complexity in financial products and that as I -- as I think about it, it's very hard to regulate against innovation. I think one -- one of the things that I've recommended for a number of years now is that when we look at some of these complex derivative products, some of these products, that regulators make sure that we have -- have real substantial capital charges against these products.
Now, in terms of the -- of the deals that you're talking about, I don't remember the particulars of -- of those -- of those particular products.
ANGELIDES: Do you think that they provide -- just the core issue -- do you believe they provide real benefit to the financial system and to the economy, the real economy as a whole? Or are they just side bets that...
PAULSON: I would say -- well, I would say this. To get that market making, because I think there's been a lot of -- of discussion about market making, and one -- one of the things that I saw -- and again, I haven't been in the -- I haven't been in the business for -- for four years, but one of the things I saw was that clients increasingly were asking Goldman Sachs and other banks to -- to provide capital and to help them manage risk.
And there are just many examples of -- of that. And, you know, that business, I think, is a very legitimate business, a very beneficial business. And it -- it needs to be done with very high standards, great integrity, and in a way in which you're working for your clients' interests.
And I was, you know, thinking this morning and -- about this hearing -- and thinking of all the situations where a client, you know, a major sovereign nation that was worried about the prices of oil rising would come to an investment bank and -- and look for a way of -- of protecting themselves against that -- that risk, or an airline that was worried about the -- the, you know, the -- the prices, the oil prices going up. The sovereign nation would be more concerned about oil prices going down.
So there -- there are many situations where -- where customers want their investment banks to help them manage risk, and I think that's a -- a very legitimate function.
ANGELIDES: Do you think it's -- do you think it's legitimate if there's no underlying interest? Like, you mentioned the underlying interest, obviously, airline company with oil fuel, other entities that may have a, you know, a commodity against which they may hedge, because they utilize it.
PAULSON: Well, what I would say -- I'd say this. I -- I think of all of the times when I was in the business where we employed hedges. I actually think best practice in terms of prudent risk management is -- is firms hedging securities that they have -- that they have on -- on their balance sheet.
I -- I think of underwriting of securities, where the investment bankers or bankers needed to take a short position, which is part of the offering process to make sure that there is a stable market.
You know, there are -- and there's, you know, in the housing, there's -- there's no reason why that someone, who wants to put in a hedge in terms of protecting themselves against housing prices going one way or another, shouldn't be able to do so. That's -- to me that's a very important function of a market maker.
So I think what we want to do is we want to separate the function and the market making function, which needs to be done with the very highest standards, the very highest not only in terms of compliance with the laws, but -- but doing it in a way which it inspires and keeps client trust, and separate that from -- from, you know, from activities that -- that is not done properly.
And you can -- investment banks or banks can -- can make mistakes, commit fraud in a whole variety of areas. It's -- but let's focus on the legitimate role that market making plays in the capital market.
ANGELIDES: All right. Let me ask you a very quick question, because I want to get to the meat of this in terms of your role as treasury secretary, the run-up to the crisis. But I want to ask you one quick question, since you raised the standards of conduct.
And I want to ask not so much in the role as the market maker, but obviously -- and I'm not going to refer to a specific case of that's been lodged by the SEC against Goldman -- but do you -- do you think it's appropriate when an entity is underwriting a security, that it would contemporaneously bet against that security on issuance? Is that appropriate and proper?
PAULSON: I -- I would just simply say that any -- any transaction that is done and the marketplace has got to be done with the highest standards, fair dealing, and making appropriate disclosures.
Now, in -- in terms of when you say betting against or shorting, as -- as I said, I -- I can think of -- of, you know, when I was in the business and we managed, we sold securities in the public market. You sold securities as part of an underwriting process. The syndicate or the underwriter had a short position, OK? Is that betting against a security? That was a legitimate function, and it's done to make sure there's a stable market.
Frankly, every one of these market making transactions, where many of them, the client or the customer expects the banker to take the other side of the trade, help them manage risk, commit capital.
ANGELIDES: And so complete disclosure in your mind, complete disclosure is what you think is elemental.
PAULSON: I -- I said appropriate disclosure is what I...
ANGELIDES: All right. Well, I don't want to put words in your mouth.
OK. Let's move on. I wanted to just ask you about this. Let me talk about treasury secretary. Obviously, you know, but the Treasury Department, according to the Web site, is responsible for, quote, "ensuring the financial security of the United States." You were ahead of the president's working group on financial markets and in that regard to bring forward the blueprint plan.
But one of the things I'm trying to get to is what didn't we know. And looking forward to the risk of future crises, we can have organizational structures, but the real question is are -- are we going to be able to pick up on the warning signs?
You -- you note in your book that there is the August 17th meeting, I think, a couple of months after you get appointed, where you indicated in that meeting, August 17th at Camp David, that, quote, "my number one concern was the likelihood of a financial crisis. I was convinced we were due for another disruption."
So here's what I want to ask you. Sitting in that position, having come from Wall Street, by the end of 2006, the leverage ratios at, you know, Bear Stearns have hit 32 to 1; Goldman, 31 to 1; Morgan Stanley, 36 to 1; Lehman Brothers, 34 to 1, not counting for balance sheet management.
In the spring of '07, which is, obviously, a little later than that date when you were at Camp David, the ratio of Level 3 assets, in liquid assets, assets that are hard to price because there is no discernible market price, at Bear Stearns are 269 percent of tangible common equity; at Lehman, 243; at Goldman, 200; at Morgan Stanley, 266.
The investment banks -- and just as a set; they're not necessarily unique -- have been growing like weeds -- at Goldman, 26 percent a year compounded annual growth rate; Morgan Stanley, about 15 percent; Merrill Lynch, 18 percent.
And as you point out in your testimony, there are warning signs that abound -- states all over the country trying to fight, in early 2000 before you become treasury secretary, deceptive and unfair lending. They were preempted by the OCC.
In 2004 the FBI warns about an epidemic of mortgage fraud. I held this up yesterday. "The Economist" has an article cover called "Housing Prices after the Fall," which is in 2005. The lead of the story says the day of reckoning is closer at hand. It's not going to be pretty. How the current housing boom ends could decide the course of the entire world economy over the next few years.
Housing prices are moving up in 2003 at 11 percent; 2004, 15 percent; 2005, 15 percent. You note in your testimony that subprime lending has exploded to be 20 percent of the market. And by 2006 mortgage debt between 2000 and 2006 has doubled in this country. We've borrowed more in those six years in mortgage debt than the whole 225 years in this country's history.
There is knowledge of the opaque natures of derivatives. There is knowledge of a lot of instruments in the market. So here's my fundamental question. What do you and other policymakers know? When you came in to office, I guess my question is, what was the missing information that would have allowed both policymakers and corporate leaders to begin to mitigate risk?
PAULSON: Well, Mr. Chairman, I think with all due respect I began immediately to work to mitigate risk, that the -- and within the confines of the fact that treasury secretary has no direct responsibility for regulating entities or markets. But what -- as -- as you noted, I saw immediately huge, gaping holes in the regulatory system, and so I took several actions immediately.
Number one, regularly quarterly meetings of the president's working group so regulators could immediately begin sharing information, figuring out how to work together to fill in the gaps. Now, there was work done there right away on looking at the margin requirements that -- and -- and the amount of -- of credit between -- extended between, for instance, the regulated entities and hedge funds. I can come back to that more later.
Secondly, I immediately started working with Congress to complete regulatory reform legislation for Fannie and Freddie, which had -- which had been stalled -- stalled by politics for years.
And then I commenced this review, this regulatory review, and out of this review came -- came the blueprint. It came pressing institutions, pressing market participants to strengthen their infrastructure in areas like OTC derivatives, areas like that. And -- and then, ultimately, we came out with the blueprint. So I think we were -- we were on it.
Now, the -- in terms of the excesses you talked about, they're there. You couldn't push a button and -- and have them go away. The bad loans had been made. The -- the -- we -- we had...
ANGELIDES: Was the toothpaste out of the tube by the time you arrived, in your estimation...
PAULSON: I would say...
ANGELIDES: ... to coin a phrase that was used 30-some years ago by someone else?
PAULSON: I would say most of the -- most of the toothpaste was out of the tube. And the -- and there was -- there really wasn't the proper regulatory apparatus to deal with it.
ANGELIDES: All right, so -- but my essential question -- I understand -- I really had two, and you really got to the second, but was there -- by the time you arrive, is the information that you need and essentially financial industry leaders, it's on the table by 2006? Because, you know, we've heard a lot...
PAULSON: Well, I...
ANGELIDES: ... in these hearings. Can I say -- we've heard a lot about, "We're shocked. We're surprised. It's a tsunami." But even you -- even when a tsunami comes, you have warnings ahead of time.
PAULSON: Yes, but what was -- let me tell you what wasn't clear to me, and I don't think it was clear to very many people, if any, when I arrived, and that was the scale and the degree of the problem.
And, for instance, if you -- you know, referring to the book, if you go a little bit further, the president said to me, "What will cause the crisis?" OK? And I said, "I wish I knew. It'll be obvious after the fact that all it is -- no one predicted the Russian crisis." Now, what -- was we -- we could see some of the problems in the -- in, for instance, subprime and -- and housing, but no one -- at least that I was talking to -- predicted this massive decline in housing prices throughout the United States.
And when I've asked myself why, why wouldn't people have predicted that, why wouldn't -- why wouldn't experts have predicted that, and I think it was because we were all looking through the paradigm that we'd had in this country since World War II, where residential housing prices had essentially gone up, mortgages were safe investments, and so the economic models didn't project the kind of -- kind of wholesale, you know, significant decline in housing prices.
And so that was, I think, the -- that was -- that was the thing that people didn't predict. But having said that, you know, if -- if -- if we'd seen that coming, I'm not sure what we could have done differently.
ANGELIDES: Even though -- and this isn't with respect to you -- even though by the time all the write-downs are happening at places like Citigroup and other institutions, at the end of '07, prices had only fallen 5 percent, and they had fallen 2 percent, I think, in the early '90s, but I see your point.
But it -- but would this be a fair characterization, that people knew a storm was coming, people were concerned that the levees were weak and hadn't been tested, and that -- is it fair to say there wasn't a plan in place to deal with the crisis that was inevitable?
PAULSON: Well, there wasn't a plan in place when I arrived. I think we -- we put a plan in place, because I think -- the only plan that I know how to put in place was to -- to get the regulators together with a very -- taking a different approach to the president's working group, and with regular meetings, where we started working immediately on what we thought the issues were going to be and how to respond to them.
And so -- and to get working on, you know, I believe to this day that the most effective thing that anyone has done, either from the time I was there or since I've left, to deal with housing has been the actions taken with Fannie and Freddie. I think that's been the most effective to sort of stem that decline in home prices. And we started working on that right away.
ANGELIDES: All right. I'm going to stop right now. I actually -- when I close up, before you leave, I have some very specific questions about Fannie and Freddie, a couple of them, but I want to stop right now to get to other commissioners, all right? Thank you, Mr. Secretary.
PAULSON: Thank you.
ANGELIDES: Mr. Thomas?
THOMAS: Thank you. That presented a whole bunch of questions that I hadn't planned on, in terms of that -- that discussion.
But I do want to start, also, with you, Mr. Secretary, at Goldman, not for any specific recollection of product. One of the things I'm trying to better understand, since I don't have any familiarity with the relationships in these institutions on Wall Street -- if you ask me about Congress, I could tell you a whole lot about things that people don't normally appreciate result in decisions, especially small-group dynamics, interpersonal relationships, the old business of who gets what, when and how on accommodations, which are fundamental to any democracy, in terms of quid pro quos and other structures that are simply there that make the system work.
What I don't understand is the relationship between institutions, especially in the so-called shadow banking area, because to me it's remarkable that there existed this healthy and growing structure based upon very short-term financing, overnight, a number of institutions doing that, so you were sharing the grazing in the pasture.
And yet, as has been indicated in terms of Goldman, with the current CEO and others, that you would take opposite sides in terms of market-making. That was within the institution. I'm trying to understand a relationship between institutions, not so much in an institution, because clearly if you're the largest, you can be on both sides and play various roles by virtue of your size, but if you're smaller, you may have to be more dependent on others.
And so it's this business of, to what extent was there a symbiotic relationship with other firms, notwithstanding the fact they're your competitor, or was it pretty much predatory and that's one of the reasons the smaller ones went first?
Because going back to the congressional example, I could be fundamentally opposed to someone on one day on an issue, that issue is dispensed with, and the next day, we wind up on the same side. So one of the things you tell folks when they first come is, you can be opposed to somebody, but if you're locked in opposition to that individual, you're going to miss a lot of opportunities to actually advance some of the things that you're interested in.
From your perspective, what was the culture predominantly? I mean, it had to be to a degree symbiotic, didn't it?
PAULSON: Well, let me -- I think, Mr. Vice Chairman, what you were getting at when you talked about the infrastructure and you talked about secured lending was the repo market and secured lending. And let me just talk a little bit about that, because I think it would -- it might help -- help, that many financial institutions, not just the traditional investment banks, had to rely on wholesale funding for a big part of their funding. It wasn't all -- it wasn't all deposits.
And so you have this secured lending or repo market that grows up, which is -- it's a very healthy thing, because you shouldn't -- you wouldn't want everyone having to rely only on the banks for their wholesale funding, and so repo is secured lending, and the lender is at least partly protected during bankruptcy, because their collateral is protected.
I think the way you need to think about this -- and then -- and there's a market where two parties could deal with each other. There are many sophisticated institutions -- some sophisticated, some less sophisticated -- that wanted to invest money. You know, these are -- some of them are pension funds, money market funds, governments. They want to invest money.
And a safer way to do it would be to do -- enter into a secured lending arrangement with -- with -- with a Wall Street firm. Now, they could do that directly or they could do that through a -- you know, have a custodian administer it and then handle the collateral, sort of be a tri-party repo, but that was the way it was done.
Now, what happened -- and here's what I think gets to your question -- what happened was this grew very, very quickly, with no single regulator having a purview of it, no one looking at it and being able to get the information on the whole thing.
So it grew like topsy-turvy. There was a -- systems didn't keep up with it. Infrastructure didn't keep up with the procedures. And the participants got sloppy in their credit decisions.
So it's one thing if I'm a money market fund and I'm lending to a bank and I'm taking Treasuries as collateral. If I'm taking mortgage securities and I'm -- and I'm asking for no margin, no haircut, I'm -- that's a sloppy kind of provision.
So now what happens is this has grown up, there are excesses, and I would say to the chairman, this was something that I was not aware of the extent of the issue. I had seen it through one little lens at Goldman Sachs. And so that this big market had grown up, no regulator looked at it.
So now when the crisis comes and investors are afraid, there are -- there were a number of -- and so they're concerned about Bear Stearns. They're -- they lose confidence. Then this is -- when you say it's predatory, these people -- if someone is afraid and they're afraid about their own institutions surviving, then they pull money out and -- or they don't roll over their secured lending.
Why? Because there are certain cash investors that don't know what to do with collateral if they got it. They're just really looking at the -- at the underlying credit.
So, again, this was a shadow market that is a very valuable market, should continue to be a valuable market, and it needs to be fixed, OK? It just plain needs to be fixed.
And so there were mistakes made there by regulators, by a regulatory system, slopping practices by practitioners. And then the biggest sloppy practice of all were the banks and investment banks if they didn't maintain liquidity cushions.
Everybody talks about capital, but to me, the biggest lesson I learned out of all of the crisis was the lack of focus by so many market participants and by regulators on the importance of liquidity. And you cannot place huge reliance on any short-term overnight market if you don't ask yourself, "What am I going to do if that market doesn't function as normal? How much of a cushion do I have?"
THOMAS: Well, but wouldn't every one of those institutions go to bed that night not only worrying about themselves, but others, because they depend upon this kind of short-term...
PAULSON: Only -- see, they didn't worry until they did. It's hard to explain this, but I had...
THOMAS: I don't think it's all that hard if you use other examples. For example, obviously, Bear Stearns and all the others thought they were liquid until they tried to put up the assets. The only ones that they felt comfortable, or other people felt comfortable with were Treasuries.
But the idea that an economic model, in terms of mortgages, didn't anyone look at how much -- what a mortgage was changed between the '50s, the '60s, '70s, '80s and to now, that there was significant erosion in any comfort level on how long a mortgage could last, given the rules?
Let me give you a quick example. I represented a big area -- there was a lot of desert -- and folks would run in the spring, when there was enough grass, out in the desert sheep. We began to see a fairly high loss of desert tortoises. So the BLM wanted to run an experiment. They wanted to put Styrofoam tortoises out in the desert when the sheep were running on the grass to see what kind of an interaction there was.
And so I told them that my sheep men would be ready to put their Styrofoam sheep out in the desert when the BLM was ready to put its Styrofoam tortoises, because you didn't get a decent understanding or relationship. When you rely on -- and I'm going to talk about rating agencies in a minute -- someone giving a AAA rating to a package which fundamentally was so much different than earlier packages, and you rely on that AAA rating, at some point, doesn't somebody look at the underlying problems?
What happened, frankly, in the desert was the crows, as population encroached on the desert, the crows followed, and they'd go out and flip them over in the morning and have a warm meal in the evening. And until and unless you controlled the crows, you were never going to solve the problem.
And here the crow, flipping it over -- everyone argues that we didn't have a model that could tell us what was happening. I just don't understand, given the level at which people were operating.
THOMAS: Which brings me to the question, when you became secretary of the treasury, looking at it from not your narrow perspective, but a broader scope, were you shocked at the -- at the amount of weight placed in the portfolios on these risky mortgage packages?
PAULSON: I was...
THOMAS: Were you surprised?
PAULSON: Yes, I'll tell you what surprised me, which is related to your question, that (inaudible) there was the rating, but a number of the firms, you know, I in my testimony -- a number of people have talked about it -- it's important that those who underwrite securitizations have some skin in the game, hold some of the securities they underwrite. I think that's important.
But where the big problems were, were a number of institutions, two or three institutions that not only did they have skin in the game, they had half their body in the game, because they had huge positions of these outsized positions that were overweighted, just -- and so even if they were rated AAA.
And so I think one of the lessons of this, which gets to your point, is that it is -- it's very hard for experts -- any experts to know anything with certainty. People could have been predicting this -- you know, this crisis for years, and they could have predicted it, hedged themselves, lost a lot of money.
But you -- it's just -- it's foolhardy to put -- tie up a lot of any institution's balance sheet on any particular security no matter how high the rating is, unless it's, you know, a U.S. government security.
THOMAS: Well, is that what happened, they tied so much up in the mortgage market? Because what I'm trying to figure out is, how could the weight of the securities that were created, supported by the mortgage market, pull down the commercial paper market, the repo market, the auction-rate securities market? Was it that big?
PAULSON: Well, that's a different -- I was -- I was just...
THOMAS: No, I understand. But how is the...
PAULSON: There were several institutions that owned too much of the paper. But to get to your point, what happened, I think the way to think about this is this. And I think this is quite critical.
The subprime market by itself was a relatively small, relative to the U.S. economy or to the U.S. capital markets. And the problem was much bigger. There were excesses, as we've talked about, in housing and across the markets more broadly.
So one -- you used an analogy of the desert. I'll give you an analogy that's used a lot. There was a lot of dry tinder out there, OK? And the driest tinder was subprime. That's where the fire started.
But there is a lot of other excesses. And that's -- that is really what happened. And there are a whole lot of things coming together to -- to create this crisis.
THOMAS: In terms of the rating agencies, we have legislation now from both the House and the Senate. Are you familiar enough with that legislation to have any opinion as to whether it's useful directed, effective in dealing with rating agencies?
PAULSON: I would say, in terms of the rating agency piece of this, I agree with -- with one part of the legislation, which I think is controversial to certain people. I think it -- no matter how the rating agencies are regulated -- and we need more regulation and we need more disclosure and we -- around the -- the rating agencies -- I do not like the fact that we have several rating agencies that are enshrined in our securities laws, in regulatory manuals, and so on, and that -- and that ratings are referred to.
And so I think that's just a crutch and a dangerous crutch, and I think too many investors, too many banks relied overly on a rating. And I'm all for the rating agencies. I think they should be independent rating agencies. They should give their advice, just like -- like equity research houses do, and I think investors should look at those as one tool.
But I do not like the fact -- and I support the legislation that would -- would take reference to credit ratings out of our securities laws.
THOMAS: All right. The Senate would create an office within the SEC to administer credit rating agencies' rules and practices. Good move?
PAULSON: I think it's probably a good move.
THOMAS: House creates a seven-member advisory board for credit rating agencies.
PAULSON: I haven't -- I haven't really thought about it.
THOMAS: Fairly safe (ph), isn't it? I mean...
PAULSON: Yes, it's...
THOMAS: You could get unanimous.
PAULSON: I...
THOMAS: Both bills would require a measure of certification that due diligence has been done by someone, but neither one talks about who would pay for it and a structure. So, again, it's going to evolve outside of some regulatory structure.
PAULSON: Yes, it will -- I will say this. No matter how you regulate this, and it needs more oversight and regulation, no matter how you regulate, it will not be flawless. It's hard to believe that a -- that anyone at a rating agency is always going to be able to see the issues that others don't see...
THOMAS: No, I understand that.
PAULSON: And so, therefore, that's what -- I want to get to something which is much more basic than that. I don't want the rating agencies to be held up as the font of all truth and the -- and have the ratings be part of our securities laws.
THOMAS: Then my only question left is, just out of curiosity, how come you didn't put more emphasis on the rating agencies in your testimony? I mean, you mentioned it, but...
PAULSON: Because I...
THOMAS: Do you think you gave it due weight, in terms of...
PAULSON: No, I thought that this was -- I -- in terms of shadow banking, yes, I -- I -- I have -- have...
THOMAS: Well, but you gave an overview at the beginning of your testimony.
PAULSON: Well, I've written about it quite a bit in my book. And so I do think the rating agencies made -- made plenty of mistakes. I think they -- it fell into the same paradigm that -- that so much of the rest of the world did. They used economic models that didn't foresee what -- what -- what happened.
THOMAS: But everybody has used that as an excuse in terms of not knowing the true value of what they held and tried -- tried to trade.
PAULSON: So clearly the rating agencies, in terms of -- and I made a number of -- of strong recommendations actually even before Bear Stearns went down with the president's working group about the -- the kind of disclosures you need to see from the rating agencies and the kinds of processes they need to run and the regulatory oversight.
What I was just trying to get to was something which was more fundamental than that, which is, I don't want to see a situation ever again where a whole lot of sophisticated people can just turn and say, "It's not -- not my fault. It was the rating agencies'."
I want -- I want investors and big banks and regulators to be forced to use rating as one tool, but do some of their own work and do some thinking for themselves.
THOMAS: Thank you, Mr. Secretary. And could I ask you -- would you be willing to respond in writing to any other questions the commission might have as we go forward? Because, frankly, we're learning as we go.
PAULSON: Of course. I just hope you will understand that now my staff consists of one assistant, OK? So I will -- I no longer have these -- but I will respond.
THOMAS: We'll try to write questions that can -- that can be answered by one assistant. Thank you.
ANGELIDES: Thank you.
Ms. Born?
BORN: Thank you very much, Chair Angelides.
And I want to express my thanks to you, Mr. Secretary, for being willing to meet with us and help us in our investigation.
The first area that I wanted to ask you about is over-the-counter derivatives. I fully agree with you that derivatives are extremely important instruments in managing and hedging risk and play an invaluable role in that respect.
Nonetheless, the over-the-counter derivatives market had grown to more than $680 trillion in notional amount by the time of the crisis in the summer of 2008, and it was virtually exempt from federal regulation and oversight because of a statute passed in 2000, the Commodities Futures Modernization Act, which had eliminated jurisdiction of the federal agencies over the market.
I wanted to ask you whether, in your view, this regulatory gap played any role. You've said in your testimony, "Derivative contracts, including excessively complex financial products, exacerbated the problem during the financial crisis." And I wondered if you would elaborate on that testimony.
PAULSON: Well, first of all, I think your point is well taken. And in the chapter that the chairman referred to in my book, when the -- when we had that first conversation with the president about the -- about the potential for credit crisis, and the topic I talked about then was over-the-counter derivatives and how quickly this had grown, citing the same numbers you cited, and just talked about them being outside of the regulatory purview, and it just -- we didn't even have at the time the -- the right protocols for how they would function in a crisis and, you know, the netting agreements, and there were big backlogs of really unbooked trades.
So there was a lot of work being done by the -- by -- by the Fed at that time. And I was very supportive in terms of pushing the industry.
Now, I think -- I think that these -- first of all, these products, they didn't create the crisis, but they magnified it, and they exacerbated it, and I think not only in the way which has been written about a lot, in terms of -- of the interconnectivity, but just in terms of masking the risk, that just were so opaque and complex and difficult to understand.
I had certain regulators when I arrived saying that the -- that the system wasn't that leveraged, because they were looking at just the debt, as opposed to what was embedded in those products. Those products are hard to understand.
And so I -- that is why I so strongly believe that you want to press -- standardization is in all of our interests. And so the way you, I think, get towards simplicity -- complexity just in general I think is our enemy. You can't -- it's hard to regulate against complexity and innovation, so I think the way you do this is you press everything that's standardized onto an exchange, and the over-the- counter you put through a central clearinghouse, where you've got great oversight, and then you have -- if it's complex there, you put big capital charges, so you penalize complexity, which will help move toward greater standardization.
And I think that's really the right way to deal with it, and I think you're right on in terms of seeing that as a concern, but it's not -- those people that would say it's a fundamental cause, I think, are wrong. It's not. It's just something that needs to be fixed, and I'm hopeful that it looks like some of the -- you know, the legislation is on the way to fixing.
BORN: With respect to the remaining over-the-counter market, assuming regulations are applied that would put standardized contracts onto exchange, would you advocate more transparency for that market?
PAULSON: Yes. Yes, that is -- in this -- that would solve so much. And, you know, as you well know, regulators had no idea. Industry participants didn't know. You know, just taking General Motors as an example, everyone knew how many General Motors bonds are outstanding. No one had any idea how many