American Enterprise Institute

May 5, 2008

[Edited transcript from audio tapes]

11:45a.m.	Registration
12:00p.m.	Luncheon
12:30	Press Briefing:	George G. Kaufman (cochairman), Loyola University of Chicago
		Richard J. Herring (cochairman), University of Pennsylvania
		Marshall Blume, University of Pennsylvania
		Charles W. Calomiris, AEI and Columbia University
		Kenneth W. Dam, University of Chicago
		Robert Eisenbeis, Cumberland Advisors
		Edward J. Kane, Boston College
		Robert E. Litan, Brookings Institution and Kauffman Foundation
		Kenneth E. Scott, Stanford University
		Chester Spatt, Carnegie Mellon University
		Peter J. Wallison, AEI
1:30	Adjournment

Proceedings:

American Enterprise Institute for Public Policy Research

Shadow Financial Regulatory Committee
Transcript

May 5, 2008

George G. Kaufman:  The first order of business is some very sad news you may have heard.  One of the charter members of the committee, George Benston passed away last February shortly after our last quarterly meeting.  And he was a charter member, as I mentioned, and a great participant in the Shadow Group.  I think you are all familiar with him, and he will missed greatly by the committee. 

We have three statements today:  Statement 258 is, "If Bear Had Been a Bank," alternative title could have been, "If Bear was Bare" spelled differently; 259, "Mortgage Delinquencies and Foreclosures," and 260, "Reducing Inappropriate Political Pressures on the Federal Reserve."

As usual, we will follow the procedure where each statement will be summarized for about three or four minutes, and then we will open up the floor to Q&A.  So, the first one, "If Bear Had Been a Bank" and that will be presented by Dick Herring, Dick? 

Richard J. Herring:  Thank you, George.  As we all know, we have been cursed with the Chinese curse of living in interesting times.  And one of the most interesting things that has happened over the last few months is a distinct change in Fed bailout policy with their bailout of Bear Stearns in the second week in March.  The Fed did this in a very improvised way.  They reached back to an authority they had been given in a depression era amendment to the Federal Reserve Act that allowed them to grant loans to individuals, partnerships, corporations in emergency situations, and they deemed we were living in an emergency situation. 

This enabled them to make an overnight loan to Bear Stearns through JP Morgan Chase to avert bankruptcy, and then it was also used to fund JP Morgan Chase in a takeover of Bear Stearns.  And the transaction involved the Fed in establishing a special purpose entity, not very transparent, I would add, that would acquire $30 billion in assets from Bear Stearns.  This special purpose entity in the end was funded by a $29 billion loan from the Fed and $1 billion in subordinated debt from JP Morgan Chase.

We do not know the details of this, and this in itself is a bit of an irony since the Fed is pressing greater transparency on other institutions.  The assets will be managed over a 10-year period by BlackRock and it will be tasked with liquidating the assets; although, they can extend the period if they feel 10 years is not enough. 

Because Bear was an investment bank and not a commercial bank, the Fed really faced a very limited range of options when it was notified that Bear was experiencing financial difficulties and would likely apply for bankruptcy.  Although Bear Stearns was a prime dealer, it did not have access to the discount window to deal with its emergency liquidity problems.  After the collapse, the Fed did open the discount window to prime dealers on a temporary basis.  We do not know how long that will continue, but it did set us to thinking about how things would have been different if Bear had, in fact, been a bank.  And if Bear had been a bank, events during the second week of March should have unfolded quite differently. 

If Bear had been a bank, it would have been subject to the prompt corrective action requirements contained in fiducia, which would have had triggered interventions that would have given strong encouragement to Bear's management to recapitalize strongly and also cause them to reduce their risk exposures.  As the capital position of Bear deteriorated, it would also have been subject to an increasing number of -- an increasing amount of scrutiny by the supervisors.  So, they would have had a very broad and deep understanding of its risk exposures. 

If the prompt corrective action measures had not been sufficient, and it was going to be necessary for Bear to conclude its activities, then policymakers would have had a broader set of options.  In particular, it is likely that the policymakers would have devised a bridge bank or a bridge institution for Bear.  This would have enabled the authorities to continue all of the systemically important functions of Bear on a seamless basis.  And as you may recall, the two concerns that led people to argue that Bear was too inter-related to fail had to do with its position in the credit default swap market and in the repo market.  Both of these activities could have been maintained without interruption and, indeed, under the bridge bank authority, the Fed would have guaranteed the bridge bank for two years with possible one year extension, so that it should have calmed the market immediately. 

Despite claims to the contrary by the Treasury, and several officials at the Treasury, we think that the Federal Reserve's involvement amounted to a bailout of Bear that benefited several parties including the shareholders.  They did receive some value albeit it less than the market value that they were holding several weeks earlier, but certainly more than zero that they may well have received in bankruptcy. 

JP Morgan acquired what it regarded as a valuable franchise at a very low price with financial assistance from the government agency.  Creditors and debt holders of Bear also benefited since their claims were settled -- be settled in full and in the case of debt holders the value of the debt increased substantially in value. 

Finally, the counterparties were made whole and avoided the disposition costs and the uncertainty that would have resulted if bank -- if Bear had gone through bankruptcy.  The problem in all of this is that protecting all of the counterparties undermines incentives for them to monitor in the future in discipline bank risk taking and that can ultimately lead to larger problems and larger crises in the future.

The committee is concerned about several aspects of the improvised transaction that took place.  First, the use of government resources to finance a private sector acquisition can phase a windfall profit to an individual institution.  Indeed, the increase in the market value of $12 billion of JP Morgan Chase at the initial announcement of the purchase provides a rough estimate, and I emphasize rough, of the substantial subsidy embedded in the deal. 

This increase is all the more remarkable because other leading financial institutions suffered a decline that day.  In light of this market signal, the Federal Reserve should have been in a stronger position to reduce the subsidy when the deal was renegotiated within the week.  The $1 billion in loss protection that’s extracted seems to be very little -- very small relative to the increase in the share value of JP Morgan Chase. 

Second, the structure of the financing involved the acquisition of mortgages and mortgage backed securities.  Subsequently the Fed has accepted a wide range of collateral that goes beyond the traditional limits of the credit risk in collateral traditionally honored by central banks.  Paul Volcker has made a comment on this on a number of occasions. 

Third, the perception that the Fed bailed out Bear has heightened political pressures to use the Fed's resources to support other risky assets including student loans and mortgage related securities. 

Finally, the Fed has now evidently extended its safety net protection to all investment banks that are prime dealers.  As the Bear example shows, these entities are not subject to prompt corrective action, least cost resolution, or a sufficiently wide range of resolution alternatives.  The most important reform would be to convey to the Fed the bridge bank authority for the resolution of systemically important financial institutions should such a problem arise again in the future. 

George G. Kaufman:  Thank you, Dick.  The second speaker on Statement 259 is Ken Scott.  Ken?

Kenneth E. Scott:  Well, this statement addresses the rather prominent problem of the trend that we have been experiencing toward rising mortgage delinquencies and foreclosures.  And, of course, the origin of all of this is the termination of a substantial period in which housing prices went up, up, up and never down, leaving a number of people, both borrowers and lenders, to assume that that was going to prevail in the future.  And producing borrowers that could get purchase loans with essentially no down payment and rather dubious credit history and lenders to make loans of 100 percent of the purchase price. 

And then turn them into pools and securitize the original mortgages and then tranch them into various layers of senior and junior claims.  And then continue that process, and continue that process, and continue that process.  But, at the basis of it all are losses in mortgage loans and those losses would seem most appropriately to fall on the borrowers who, in many cases, did not actually have much to lose in the transaction and the lenders who made highly risk loans. 

Well, the result is now, of course, that quite a few of those loans are going into delinquency and into foreclosure and there are, therefore, the loan losses that are generated being passed on through the pools to an array of holders whose connection to the original loans, in some cases, get rather complex and attenuated, and it is hard to trace it all through.

In response to all of these, we have had a number of proposals and actions by the administration and by various government agencies coming up with plans that in many cases -- well, the first offering in this regard was the plan advanced by Treasury Secretary Paulson that focused in particular on those category of highly leveraged, high risk loans that were (A) made to the subprime borrowers with poor credit history, and (B) were so called option arms. 

That is to say, adjustable rate mortgages that would begin at a low initial rate and after two or three years reset to higher rates.  By the time that Paulson made his particular proposal back last -- late last November, I believe, it was already clear that a substantial number of those loans had gone into delinquency and even foreclosure, in many cases, prior to their even facing a reset and going to a higher rate. 

And his proposal was not addressed to those that were already unable to meet their loan terms, but to those who were current, but facing an increased rate in the near future.  And the proposal put forth was to try to persuade lenders and borrowers to get together on a plan to freeze the initial low rate for a period of up to five years.  If they seemed to have some prospects of being able to continue to be current on that level of obligation. 

That, of course, did nothing to address, and that was recognized, all of the loans that were already delinquent or foreclosing and that was a substantial group.  At the time, I believe Sheila Bair estimated this group at about one-third of the 1.8 million total such loans are about 600,000 borrowers -- 600,000 loans and home borrowers.

Well, that is a large group, and in political terms that is quite large enough to be noticed by politicians in Congress or running for office.  And so, a number of proposals have been floated to deal with that category of borrowers as well as those not yet delinquent, and most of them involved taking the loss that was incurred by the decisions of home purchasers and lenders, and allowing the taxpayers to bear the loss or some portion of the loss instead. 

Well, we -- the committee is of the opinion that recourse to taxpayer funding ought not to be the first instinctive response.  But, there ought to be consideration of approaches to the problem, which might be able to deal with a large portion of these delinquencies without the taxpayer having to bailout either the homebuyer or the investor. 

And the particular suggestion, which we noted very briefly in a statement back in February, and are now developing a somewhat greater length is to suggest that the -- well, the Treasury, as it did in the case of its action proposal last winter in conjunction with something like a lender organization such as the American Securitization Forum, which was sort of put together for this purpose, could try to promote a program in which delinquent borrowers facing foreclosure and with little or no equity -- negative equity in the home, could give the lender a deed in lieu of foreclosure, and receive from the lender who would now get title to the property directly, a lease to rent the property for several years, coupled with an option to purchase the property. 

The point would be that people who had bought the houses with basically no down payment anyway and are now, because of falling house prices, incurring negative equity and in some cases simply walking away, really were in the position of what we are suggesting.  They were occupying the house for a low initial payment that could be regarded as rent and with the ability to actually purchase the house, if house prices went up and they acquired real equity, and could refinance the initial loan.  For example, if it were an adjustable rate arm, they would hit the reset threshold. 

That was the economic reality of a lot of these home financings to begin with, and our suggestion that it be recognized such in legal terms as well with the lender taking a deed in lieu, suffering a loss, renting the property at a current market rental value to the borrower/occupant of the house.  And with the borrower having, which is what the borrower had originally, basically an option to purchase the house if equity developed because market prices instead of going down stabilized or went up. 

The advantages of that kind of a proposal would be that from the standpoint of the lender, the mortgage pool, you would avoid foreclosure costs.  You would avoid eviction costs if those -- if that was necessary after foreclosure.  You would avoid maintenance cost of maintaining empty properties from the kind of vandalism and deterioration, which is often experienced.  And they avoid, at least at that time, for the time, resale costs.  In the aggregate, that would be rather substantial and, although, it would not accrue to the lender, it would also avoid some of the spillover costs that people have been concerned with about the creation of large numbers of vacant houses in a particular neighborhood depressing other properties and their value in that same neighborhood. 

So, this kind of a proposal where it would fit the circumstances of the home borrower and the lender would not throw losses onto the federal taxpayer.  It would not involve somewhat large and indeterminable amounts of federal funding.  There are some issues as to the practicality of this proposal and we note them at -- some of them in the statement.  There is the question of the ability of the administrator of the mortgage pool, mortgages having gone, in many cases, not all, from the original lender into a pool for collateralization of mortgage backed securities. 

The administrator of the pool then is basically in the position of the original lender and then as the claims on the mortgage cash flow are tranched and sliced and moved on, and tranched and sliced again, and so on, it is the administrator of the original pool who is in charge of the servicing of the loans in that beginning -- in that beginning pool. 

And so, there would be a question as to whether the administrator of the pool or the servicing agent would have the authority to accept the kind of transaction that we are referring to of exchanging a deed in lieu of foreclosure and giving out a rental contract and an option.  That is not wholly free from doubt.  It depends upon the terms of the pooling and service agreement.  There is not complete standardization in those agreements, but many, probably most of them, afford a certain amount of discretion to the servicing agent to not merely to foreclose, but to obtain title to property and to hold the property for a period of time before disposing of it. 

This, in other words, does not require a constitutionally questionable override of the contract by law, nor does it necessarily involve the servicing agent from trying to execute transactions that under the contract he would not have the authority to do. 

But, again, it does depend upon the terms of the particular agreement and the language is not, as is often the case, totally specific.  And so, there is some possibility of argumentation over that. 

The basic limitation on the exercise of discretion by the servicing agent is the decision of the sort I am talking about.  It must not be contrary to the best interests of investors.  Well, that is a judgment call and it seems to me that in view of all of the costs that I referred to earlier that would be avoided by this procedure, there would be very strong grounds for viewing that as a reasonable exercise of discretion in the interest of investors, who are admittedly going to be suffering losses under this kind of a procedure, but on the ground that the losses would be greater if it were not followed and you went into foreclosure.  Unless, of course, Congress rides to the rescue and pumps federal money into the picture, and we are trying to say that there are alternatives to that that certainly ought to be considered and explored.

Another complication is that in some cases, the number is maybe 20-25 percent of all these adjustable rates subprime arms.  The buyer in the process of getting 100 percent financing, took out a second mortgage on the property, so that a deed in lieu of foreclosure given to the holder of the first lien would still leave the second lien there.  If all you did was wipe out the first lien in this transaction, then that would turn the second lien into basically a first lien.  And the -- so you would have the situation that a second lien, second mortgage, highly risky and under circumstances where the equity in the house has fallen below the amount of the loans, economically in many cases worthless. 

Still, there would be some holdup potential in having that second lien and, therefore, you might be in situations where there would have to be a bargain struck by the first lien holder to make some kind of a payment to, "Go away and not bother me" to the second lien holder to get rid of it.  That opens up the possibility for strategic behavior, "I will hold it up unless you pay me more than the value of my claim," which is in many cases probably very close to zero, "but why should not I try and get something out of it?" 

So, you have an issue here and to the extent that a modest payment would not suffice the first lien holder would, in fact, have to proceed to foreclosure and wipe out the second.  Presumably an indication of willingness to do that if necessary would lead second lien holders to behave perhaps a bit more reasonably. 

There are other possible complications, which we do not try to go into in the statement, for the most part, because I think they have been adequately addressed.  For example, debt forgiveness under the Internal Revenue Code was treated as income to the debtor, so that you would in a process like this, which would -- in a process like this potentially be faced with income tax on the amount of forgiven debt.  Congress addressed that issue last December in some legislation, which for a temporary period said that -- I will not go into the details, but if it’s a mortgage on a residential property not above a certain amount for the next couple of years, that kind of forgiveness will not be treated as income under the Internal Revenue Code.

There are also technical issues.  These mortgage pools are organized as REITs, real estate investment trusts, and that is so that you get passed through tax treatment.  And to be treated as a REIT, you cannot be -- you cannot be highly actively managing the pool.  It has to be basically sort of a passive pool.  So, would this exceed the requirements for passivity and the Treasury Department -- the Internal Revenue Service issued some rulings, I think, back in December to indicate the parameters within which the status of a REIT would not be questioned by the service. 

So, the bottom line in all of this is, we think that there really ought to be considerations of approaches that do not involve extraction from taxpayers if other avenues would work for some, not all, borrowers in this situation of being delinquent and facing foreclosure.  And it would not create incentives that would distort mortgage financing and induce even greater risk taking by borrowers in the future.  And that is an important point to keep in mind when you are talking about any kind of federal subsidy program.

George G. Kaufman:  Thank you, Ken.  Our final statement revisits something that we have talked about in the past and Kane will summarize it.

Edward J. Kane:  Thank you, George.  Mission creep [sounds like] is a feature of most bureaucratic organizations, and it is a particular danger in the wake of improvisational action to work through a crisis.  So, this statement calls for a reassessment of just what responsibility should lie within and also outside of the Fed's mission statement.  The current turmoil is brought into greater focus, the political danger to the Federal Reserve of being responsible on the one hand for economic and financial stability.  And on the other hand, for day-to-day regulation and supervision of financial markets and institutions including especially consumer protection. 

As we have stressed in a number of past statements that we cite one from 1998, there are great disadvantages to saddling the Fed with these day-to-day supervisory and regulatory responsibilities.  Doing so tends to introduce tradeoffs that politicize the regulatory process and limit the Fed's ability to pursue the more important stability objectives. 

So, because of its regulatory responsibilities, the Fed is actually less accountable for its monetary policy actions and stability protections, and it finds itself being drawn into politically charged battles. 

And there are two such battles raging now, appropriate measures for protecting consumers against lender abuse in the future.  We know there has been a lot of attention paid to that; in December issued a plan, which drew 5,000 comments telling you just how politically charged it is.  And whether how taxpayer dollars might be channeled to assist distressed homeowners to avoid foreclosure, something that Ken was discussing. 

So, members of Congress and presumably the administration have urged the Fed to be more aggressive in using its regulatory powers and have openly pressured Chairman Bernanke to support particular foreclosure avoidance initiatives.  Neither consumer protection nor foreclosure relief lie within the special purview of a central bank. 

Our main point is really twofold, that not only is what should be the accountable ambit of a central bank unrelated to these two issues, but combining the central banking responsibilities with these other concerns opens avenues of political pressure that can poison outcomes for monetary policy and regulatory policy alike.  So, what we are really saying, and we have said it for years, the more goals the Fed is asked to pursue, the more the Fed becomes enmeshed in politics.  The Fed -- and the whole idea of having an independent central bank is to let them stay out of politics. 

So, the Fed may in the future hesitate to provide appropriate assistance to a troubled financial institution if it is also called upon, out of political calculation of fairness, to provide compassionate aid to homeowners or credit card borrowers.  In the face of political stress, the Fed might decide to give into political pressures and concerns other than monetary policy and stability in order to preserve its political capital to fight the battles necessary to have a free hand in its central fields of responsibility.

So, at a minimum, consumer protection responsibilities in banking should be removed from the Federal Reserve.  We do not say this, but divided perhaps between the FDIC and the FDIC.  Thank you.

George G. Kaufman:  Thank you, Ed.  And now it is time to take questions from the floor, from the audience.  I think we have a microphone.  If you raise your hand, I will recognize you and if you do get the microphone, tell us who you are, and then if you wish to direct your question to a particular member of the audience -- of the panel, please do so.  I also urge you, the panel gives speeches.  You ask questions.  Over there.

Charles Balogh:  This is for Ken.  All for your proposal about renting out the properties, but are these pool managers really up to being landlords?  That is the only problem I really see with the whole thing.

Kenneth E. Scott:  I am sorry.  I did not catch that.

George G. Kaufman:  Who are you please?

Charles Balogh:  Charles Balogh.  I do not represent anybody, but I guess this is the first time I have ever asked one --

Kenneth E. Scott:  Uh-huh.

Charles Balogh:  -- for this panel, but like that is the only thing I have against your proposals.

Kenneth E. Scott:  I did not understand the question.  Would you repeat it?

Charles Balogh:  Are these pool lenders prepared to be landlords?  I mean it seems to me if you are in a pool, you just put your money and you have somebody manage it.  Are they ready to -- you know, the mundane things like fixing the plumbing and everything, are they prepared for that?

[Cross-talking]

Kenneth E. Scott:  Well, they are certainly not looking forward to it. 

[Laughter]

Kenneth E. Scott:  But, no, any mortgage pool has to contemplate the possibility that some of the mortgages that are in the pool -- this is true even if they are junk, will go into delinquency and foreclosure.  And then you will have the problem that your loan has turned into real estate, and you are going to have to try to get as much as you can out of owning the real estate.  And that is going to mean that you are going to be facing things like the plumbing and so on, if you are the owner of the property and having to maintain it while you try to prepare and seek a resale.  And, of course, at the moment, a resale would not all be an altogether attractive possibility either because we are in a period of declining house prices. 

But, the basic question, "Are servicers prepared to do this?"  Historically, they have not had to do a lot of it.  Now they are going to find they are going to have to do a lot more of it.  They are having to expand capacity in areas that, to an extent, exceeds what they have done in the past.  But, it is something that real estate management has always had to cope with.

Edward J. Kane:  Could I just add to this?  I think that is a great question, and it is a question that has to be asked of everyone of the proposals that is going through Congress and the administration, "Will the party who is being assigned these new tasks, like the FHA in some cases, or the appraisal industry in others, are they up to the task?  What kind of incentives do they face?"  At least the financial institutions have the right incentives, which is a plus, but there is a lot of staffing and training that has to happen simply because we are experiencing -- we have got a great expansion in certain tasks that have not historically been located anywhere.

Chester Spatt:  And if I could just elaborate further, the real estate -- well, the servicers have not traditionally performed lots of -- lots of activity as managers of real estate property.  This is, of course, part of the servicers' responsibility is to deal with property in the event of delinquency, default, foreclosure, to the extent that the servicers need to have different types of staff then simply to accept the receipt of payments.  I am sure that they are up to the task of, to some extent, altering the composition of their staff. 

And, indeed, folks with sort of specialization with respect to real estate property right now are finding other aspects of their activities more limited than traditionally.  And so, I think there is likely to be many folks in a natural labor market who could perform such services.

Tom Cargill:  Yes.  Tom Cargill.  Question for Richard.  Does the committee believe that Bear Stearns was a mistake?  That the Federal Reserve should not have bailed it out?  Or does the committee believe that it was the proper thing for a central bank to do, but they just did it poorly?  And what does the committee think about the commitment to bail out or deal with other investment companies that are not banks?

Richard Herring:  We did not actually take a position as a committee as to whether they should have done.  I think some of us would have been interested to play the counterfactual experiment of seeing if they had dealt with Bear as they did with Drexel Burnham, which is to say, stand aside, but step in to make sure that all the clearing and settlement goes through smoothly.  And that is a way of limiting the spillover disruptions, but the committee did not really take a view. 

What we did take a view on was that if such interventions were going to take place, it is highly undesirable to improvise them in a way in which the Fed was forced to do.  The Fed should have at its disposal, a broader set of policy options that would allow us to stabilize markets to prevent the spillovers that were obviously very much of concern at that time yet still get the maximum value out of the failed firm. 

What you essentially need in the case of a bankruptcy is time.  Time to figure out how much the institution is worth.  Time to identify the seller to whom it is worth most.  When your are presented with a crash on a Friday and a Monday deadline, there is not enough time to make those judgments.  Nobody can do deep enough due diligence. 

The merit of the bridge bank kind of plan is that it does give people sufficient time to decide whether Bear would have been worth most as a freestanding bank that somebody might have purchased, or merged, or it might have been worth more in pieces.  It could have been dealt off piecemeal.  It would not have been necessary to essentially bribe one of what we believe is one of the best capitalized, strongest banks to take it on simply as a matter of regulatory necessity rather than thoughtful plan. 

And I think looking at the world ahead, we cannot be sure that we are not going to be in this situation again.  And so, the Fed really should think through very carefully how they would intervene with regard to any of the institutions they regard as systemically important.

Essentially, unless we have a way of taking out and winding down the affairs of every large bank and financial institution in a way that does not create systemic spillovers, there is really not much teeth in market discipline.  Because when confronted with the fact of market discipline in a large systemically important institution, the authorities will essentially cave.

George G. Kaufman:  Let me add a couple of things.  As we have mentioned before when we talk about prompt corrective action, two things.  One, the whole purpose of prompt corrective action is not to punish institutions.  Not to fail them -- it is to turn them around before failure, and you do this buying time, by getting the regulators in there before capital is depleted totally.  And this gives the regulators then the time to do all the things that Richard talked about.  And people tend to forget that prompt corrective action has implications other than how we fail institutions. 

I might also mention that if you are unaware of it, the Insolvency Resolution Code for banks, not for bank holding companies, for banks, is very different than the General Corporate Bankruptcy Code.  There are no stays.  It is administrative.  There is no appeal process.  It is overnight and, it is something that people may want to take a look at to see if what want to generalize this to the investment banking industry, Ed.

Edward J. Kane:  This, again, is a great question that we do not have the data to say whether Bear Stearns is a mistake, and had it been a bank, the Inspector General of the Federal Reserve would be responsible for conducting a material loss review.  And if you have read any of these material loss reviews, you understand that they really surface all the information as to what was done and not done in terms of insolvency prevention and resolution, what the alternatives were, and we would be able to answer that question. 

So, I find it very unfortunate that we do not -- that the Fed is not defending itself.  I think there is sort of an ethical duty if you are agent for taxpayers to convince them with data that you are doing the right thing.  That is again my opinion.  The Federal Reserve is just waving a flag of saying that, "Things might have gotten terrible if we did not do this, and we will not tell you in detail what these are or what we projected these to be, but just rely on us.  Just trust us."  And this is something that I think increasingly citizens around the world are uncomfortable with.  Whether it was done -- I think it was done poorly in that -- and we say in the statement that the Fed did not get enough of an upside of the rescue for taxpayers. 

Richard J. Herring:  I would add one more point just to perhaps belabor the obvious, but we have known since -- surely Barings' failure and certainly with the near failure --

[Cross-talking]

Richard J. Herring:  -- second Baring, and the near collapse of Long-Term Capital Management that normal bankruptcy procedures just do not work for these large institutions that trade intensively. 

And the problem is that normal bankruptcy procedures inevitably involve a stay and if there is a stay on positions that are being dynamically hedged, other market participants do not know what their exposures ultimately will be or how to hedge them.  It often happens at a time when markets are moving quickly.  And so, it is a sure recipe for spillovers and broader financial disorder. 

That is all foreseeable.  That means that it would have been useful for our regulatory officials to be thinking about ways they might handle that when it next arises.  We know it will happen again, but if they have tools that are no better than when they approached Bear with, I do not think we can expect a better outcome.  And in fact, I think over time will get more frequent and bigger crises. 

It is important to understand what the sources of spillover concerns were.  A lot of them had to do with over the counter derivatives and there are some, I think, careful studies these days about thinking about moving more of those onto exchanges where the counterparty risks that surfaced are really not an issue.  Sorry, I have gone into [indiscernible].

Hee Seok Chae:  My name is Hee Seok Chae.  I am broker consultant.  I have question in overall, the strength of the economy, I -- let me pose it this way, when the real estate price goes up based on the market theory, it should come down.  Maybe there should be a cycle ups and downs, up and downs, but this time I think the price appreciation has quite lengthened with the supply of either ammunition or just "ammunition" the liquidity by the financial sector.

And on the other hand, another episode just in the real -- in the stock market, investors who are financial institution or even invest -- financial analyst, investment analyst, all the time evaluate it based on the performance and in a sense they got pressure of immediate performance of the stock market. 

So, usually, I feel that they do not like the market coming down or even have a correction or are pulled down.  And I think this kind of mood will, in a sense, in collaboration with the whole financial market raise the bubble or subprime mortgage just crisis or instant which we are talking about. 

And then now, the Congress want to support those speculate who are -- you know those entities or -- yes, I am just raising question, and support those side.  Also, we are coming up with the solutions to tailor the side effects, but in a sense that there is all the time groups which got benefit from these measures. 

Also there are a number grassroots people who suffers all into the price wise of the real estate, and I wonder whether this kind of liquidity measure by the Fed or either insolvency rescue or liquidity solution, just on the part of institution way or governmental side, measure could contribute the overall strength of the United States, because in a sense when we ease the liquidity it will help dollar depreciated. 

And also we have seen the oil price coming up and also the asset prices, commodity prices, all coming up and now we are easing giving more liquidity to political [sounds like] ammunition for the financial institutions to make money anywhere, which could have a spillover or side effects in other parts of the world. 

And I wonder if this is healthy policy measure on the part of the United States government or the Federal Reserve or the industry?  Or let the market correct itself and just see what is going on and maybe -- I will stop.

Robert Eisenbeis:  I think you have asked a lot of complex questions and issues, but in the bottom line is, what should policy be?  Should policy essentially have been targeted to keep interest rates as low as they were for as long as they were?  I think it is fairly clear that when that happened there was a major engine that drove a lot of the ups and downs, and particularly the ups that we saw in the housing market.  And so, I think from a monetary policy perspective, the focus should be on the intermediate and the longer term and targeting rates that are consistent with equilibrium. 

The minute you start to get into policies that essentially try to prevent every bad thing from happening by pricking bubbles and the like, you actually can add to instability because you put too much liquidity into the market or you take too much out and you can cause instability.  So, I think that if that is the question, I think the risk management policies are probably a mistake. 

Radcliffe Lewis:  Hello.  Radcliffe Lewis.  Intellect say -- I am trying to frame a question here.  My understanding is that the committee has found itself in a situation where there is a lack of transparency to solve the matters that you would like to have analyzed with respect to the Bear Stearns bailout.

On the other side of the coin, one of the things that I have come across with regard to investment banks and other firms that provide either financial -- that provide the financial packaging necessary for prospective investors to close mortgage deals, are the appearance of various nonprofit agencies that are -- they call themselves development coalitions, development associations, economic partnerships and so on.  And what they do is they essentially a bounty of information to prospective investors so that they then tap into their recommendations and become clients of the investment banks purchasing properties sometimes in cities where they do not dwell.

 And the question that I have here is, if you are looking at the market that seems to be out of control, it is not engaging proper auto regulation, is it appropriate in the committee's viewpoint that these various nonprofit agencies that seem to have such a deep hand in real estate prospecting, is it appropriate for them to be granted 501(c)(3) status?  Or is that something that the group and others like us who are concerned about this matter should begin to look into and begin to audit just exactly what is the mission that causes the IRS to grant nonprofit standing to these organizations, and to what degree do you think that is relevant to your deliberations here?  Thank you.

Edward J. Kane:  I will take it just to make the point that it is the Treasury's job, the IRS's job to assess about any 503(c)(1) firm whether it is doing a sufficient amount of public good and whether it meets various other tests.  We did not discuss that this weekend, so as a committee we do not like to give an answer other than what I just said, I think.

Satya Thallam:  Satya Thallam, George Mason University.  Richard, if you could address this.  You mentioned in the statement that one of the beneficiaries of the Bear Sterns deal were counterparties that were -- that benefited by not having to deal with certain disruptions in their business.  And it seemed like the sense of the committee is that this undermines a certain amount of market discipline, but by your own admission in a dynamically adjusting market, especially where some of these assets are quite complicated, perhaps the market does not know how to price some of these assets. 

So, insofar as this kind of compensatory making whole of the counterparties may undermine market discipline, but how much is the market just unable to price these kind of assets and are they just sort of being made whole for a negative externality in a tertiary market?  If that makes sense. 

It seems like the effect of making -- I guess another way of saying it is, it seems like the effect of making these counterparties whole is twofold, one which is negative and one may be positive or compensating for a risk that just may not be properly priced.

Richard J. Herring:  It is an interesting point if we are dealing with just stupid counterparties, is there any real surface served by inducing them to be smarter the next time?  I think there is actually.  If you think about a system that relies heavily on market discipline, those that are best positioned to actually impose that market discipline are the sophisticated counterparties that are dealing in these sophisticated instruments.  And to protect them entirely from loss when things go badly, I think, is only an incentive for them to have still more complicated larger positions next time around.  And that, I think, can be very damaging for the whole system. 

I would be much happier if I saw our system moving more toward a system where discipline was applied primarily by market counterparties and less by federal edict and bright line rules from Basel.  And I am afraid that the kind of precedent we set in Bear, it was sort of crossing a regulatory rubicund and going in the wrong direction.

George G. Kaufman:  Over here.

Edward J. Kane:  Let me just say, my grandmother used to say that "Expense is a dear school, but fools will have no other."  So, if we are worried about people that go into deals they do not understand, you have to burn them to teach them.

Sue Simon:  I am Sue Simon at Capital Insights Group.  Several months back, I think Treasury Secretary Paulson talked about the response to the housing crisis is a work in progress something that is evolving.  And it seems to me it is still evolving, and I am wondering if you have opinions about the fact that we have different signals from regulators and policymakers still in Washington about what is the appropriate solution.  I guess the Office of Thrift Supervision has a negative equity idea of some way of getting loans recharacterized.  Now Sheila Bair apparently is talking about the Treasury buying loans and apparently the Treasury though still defends the initiatives that it has taken. 

Do you have an opinion about this in general and as particularly about the new FDIC idea where that fits in?

Kenneth E. Scott:  Well, there are a lot of ideas out there and they are still in process of taking form and compromises being negotiated.  And we did not try to do a dissection of either Sheila Bair's most recent proposal or the things in the House or the things in the Senate.  It is a moving target, and it did not seem like it would necessarily be a productive undertaking. 

I think we do believe there are some first principles that ought to be followed in this process, not that they are likely to be, but ought to be.  And one of them is that tapping the taxpayer is not the first resort, but ought to be the last resort.  So, if there are other approaches that do not involve throwing losses onto taxpayers those certainly ought to be examined and tried for all that they are worth.

If the conclusion is that they are not a complete solution to the problem -- well, actually nothing is -- and you are going to go off into various forms of federal largess whether it is directed directly to borrowers who were, in many cases as I said, economically renters with an option if things went their way.  Or it ought to go somehow to investors who were buying securities that if the housing trend kept going for another four years would have a wonderful payoffs.  But, when they did not prove to be the case have losses that now they think somebody else ought to step in and take off their hands.  That in -- and the government will end up doing something that creates bad incentives, bad incentives for borrowers, bad incentives for lenders. 

The question is it ought to be minimized to the extent that it is feasible in a political system, which responds to non-economic incentives more strongly than it does to economic incentives.  And in doing that, one of the things that ought to get attention much more than it is likely to, is how are you structuring incentives for future behavior and what are you doing that will diminish the problem that you saw this time or will increase the problem next time?

And a large part of the problem this time was leverage.  These loans were highly leveraged.  Borrowers had little or no equity in the house.  Now, there is a difference between investments in the capital markets and investment in-houses.  Investments in the capital markets people are accustomed to think of as they are making it for a return and they regard it as something that under normal circumstances will be quite liquid.  And over here in the investment in Wall Street community they are shocked to find that they are now in a period where a lot of those assumptions are not being borne out.

In the home purchase market, most of those -- you know that is a consumption as much as it is an investment and people do not think that they are going to have to hit it for -- or they ought not be encouraged to think that it is something that they are going to trade in the short term or pull cash out of and treat as a liquid asset in the short term.  That is not a terribly productive way to structure your housing finance.

So, that the principle that ought to be followed is one, I think, very carefully as you design some form of government payments to various parties whose claim on the proposition that they deserve them is questionable.  What are you doing for the future behavior of these parties?  And what chickens are you hatching that will come home to roost?  If I have not destroyed that metaphor.

[Laughter]

Paul Merrion:  Hi, Paul Merrion from Crain’s Chicago Business Magazine.  In the Treasury's blueprint for regulatory reform, there was a little noticed recommendation that said the Fed should have access to data on the futures trading markets and positions in case there is ever some crisis it has to deal with.  Do you see that as a reasonable idea or does that stake out new ground for the Fed as the ultimate back stop of the future?

Richard J. Herring:  This is actually not an aspect that we addressed specifically at all.  In fact, we had only a very cursory review of the Treasury proposal, which is very far ranging.  The logic of it, as I understand it, was the Fed is going to be given enormously broad responsibilities for financial stability, which would give them in some sense the right to get whatever information they need from whatever corner of the economy might generate systemic instability.

As posed, it seemed so broad and so lacking in detail that it was really hard to comment.  It is very hard to see how that could be a workable system, especially since the Fed would -- it did not appear the Fed would have any particular prudential power to do more than just observe.  And so, it gave them enormous responsibility without much actual power.

George G. Kaufman:  Question over here.

Male Voice:  The lease proposal replacing all those mortgage -- [audio break] -- have you sort of written up a statement -- [audio break 01:02:45-01:03:18]

Kenneth E. Scott:  Thus far I have not been retained for that purpose. 

[Laughter]

Kenneth E. Scott:  But, I do not see why it would be particularly challenging.  You are coupling two fairly familiar legal instruments, a lease, a rental contract, and an option to buy.  And you are getting in exchange, a deed in lieu of foreclosure, so that you avoid the whole foreclosure chain.  And the thing that -- and all three of those are fairly standard kinds of and familiar kinds of legal documents and procedures.

The thing that would be variable and would not lend itself to standardization would be that, well, what are the particular circumstances of the particular situation?  Does the homeowner have negative equity?  If so, how much?  That is to say, what is the relationship between the loan debt first and second and the current market value of the house as best you can guess at it?  What is the current rental value of properties in that area?  These are obviously things that are going to vary, are going to be the subject of some negotiation between the involved parties, and I do not think could be standardized. 

So that all that it seems to me Treasury could do with a suggestion like this would be to try to draw attention, publicize, and push the concept for the parties then to work out in their own circumstances.  That is exactly I think what they tried to do with Help Now and the American Securitization Forum and so on. 

I might add that Secretary Paulson was out in Stanford a couple of weeks ago and in the question period after his talk, I asked this in the form of a question and, you know, the exchange idea.  And the answer made it clear that I had not -- well, to put it I guess diplomatically, that I had not made clear my idea.  And it took me a little while here to explain it, and it -- I did not take that amount of time in putting the question to Secretary Paulson. 

But, it seems to me that it is something that Treasury ought to take a hard look at and they do have already in place through what they created in connection with the freeze concept, it seems to me, some of the necessary institutions and contacts to implement this kind of a concept if they think it has merit. 

George G. Kaufman:  We have time for one more question.

John Berlau:  Yes.  John Berlau, Competitive Enterprise Institute.  From what we know of the details of the Bear Sterns collapse and bailout, what does the -- do panelists think the role was of mandatory marked-to-market accounting?

They had a panel about marked-to-market accounting in the economy in general.  The idea that even if you are not trading the security and even if the loans are still performing, you still have to mark it down, you know, if the market collapses as if you are selling it tomorrow.

But, I was wondering specifically in the Bear -- and it is enshrined for standards like Basel II and FASB 157, but I was wondering specifically in the Bear Stearns collapse, were there things where banks had to mark their loans to Bear Stearns to market it and that is why they were so anxious to get the collateral?  Or just what details are known if anyone has any thoughts on mark-to-market accounting or potential solutions, I would be interested as well.

George G. Kaufman:  The person who would have answered that, of course, would have been George Benston, but since George is not with us, Richard?  Chester?

Edward J. Kane:  Just let him.

Chester Spatt:  You know, I think a lot of the context of that the -- that from the Fed's statements it felt it was facing was that folks did not want to invest on a short term basis in Bear securities and investors such as money market funds were reluctant because of concerns about whether they were going to be able to get their money back and my sense is that those investors would be interested in the confidence they felt that other investors had rather than the -- I think rather potentially than just the precise marking of the securities.  That is sort of -- that would be my personal opinion.

I think that the crisis was not kind of a mechanical one about the finance -- the regulators say that Bear was solvent and that there was this confidence of crisis.  Now, presumably the confidence of crisis I think reflected the underlying economics and fair value accounting at some level is sort of linked to that -- is linked to that.

Richard J. Herring:  There was an earlier episode involving Bear that I think does reflect some of the issues you raised.  You may recall that in late June, Bear had two hedge funds that were focused on mortgage related paper.  They had high faluting [sounds like] titles like very high quality.  And so, anyhow, one was leveraged, one was not.  There was a question about whether Bear would let them go and initially Bear put in a billion plus to keep them going to avoid selling the assets into the market because a number of counterparties thought that they would be harmed if the market values of these assets were revealed.  Subsequent time has proven those prices were probably right on the mark and that simply suppressing them would certainly have not helped things and perhaps made them worse.

Edward J. Kane:  If I could just add to this.  There is an assumption in your question that the revelation of this weakness is what is important and as Dick said, the accounting had enough options that the -- and delays that Bear Stearns appeared from an accounting point of view to be solvent.  But, if it were solvent, it should be able to convince sophisticated counterparties of this.

So, you know, their problem is the losses that were imbedded in their positions and that this -- whether these surface in the accounting or not, the people that are doing business with them are concerned. 

[audio break]

Robert Eisenbeis:  This was not a sudden event as far as Bear Stearns was concerned.  It was well publicized that it was making and having problems in its mortgage loan portfolio in 2006.  That continued into 2007.  There was problems in the hedge fund.  There were losses at the end of the year.  It was a very highly leveraged institution.  It was an accident waiting to happen and I think it is wrong to say that this was something that happened overnight.  The event was an overnight event, but this was a long time coming, and this is part of why we emphasize this importance of prompt corrective action. If Bear had been a bank, they would have started to have been under pressure instead of having the chairman out playing bridge.

George G. Kaufman: I want to thank you all for coming, and I want to wish you a happy summer, and we’ll see you all in September.