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1 1 2 3 FINANCIAL CRISIS INQUIRY COMMISSION 4 5 Official Transcript 6 Hearing on "The Shadow Banking System" 7 Wednesday, May 5, 2010 8 Dirksen Senate Office Building, Room 538 9 Washington, D.C. 10 9:00 A.M. 11 12 COMMISSIONERS 13 PHIL ANGELIDES, Chairman 14 HON. BILL THOMAS, Vice Chairman 15 BROOKSLEY BORN, Commissioner 16 BYRON S. GEORGIOU, Commissioner 17 HON. BOB GRAHAM, Commissioner 18 KEITH HENNESSEY, Commissioner 19 DOUGLAS HOLTZ-EAKIN, Commissioner 20 HEATHER H. MURREN, Commissioner 21 JOHN W. THOMPSON, Commissioner 22 PETER J. WALLISON, Commissioner 23 24 Reported by: JANE W. BEACH 25 PAGES 1 - 369 2 1 Session 1: Investment Banks and the Shadow Banking System: 2 PAUL FRIEDMAN, Former Chief Operating Officer of 3 Fixed Income, Bear Stearns 4 SAMUEL MOLINARO, JR., Former Chief Financial 5 Officer and Chief Operating Officer, Bear Stearns 6 WARREN SPECTOR, former President and 7 Co-Chief Operating Officer, Bear Stearns 8 9 Session 2: Investment Banks and the Shadow Banking System: 10 JAMES E. CAYNE, Former Chairman and 11 Chief Executive Officer, Bear Stearns 12 ALAN D. SCHWARTZ, Former Chief Executive Officer, 13 Bear Stearns 14 15 16 17 18 19 20 21 22 23 24 3 1 Session 3: SEC Regulation of Investment Banks: 2 CHARLES CHRISTOPHER COX, Former Chairman 3 U.S. Securities and Exchange Commission 4 WILLIAM H. DONALDSON, Former Chairman, U.S. 5 Securities and Exchange Commission 6 H. DAVID KOTZ, Inspector General 7 U.S. Securities and Exchange Commission 8 ERIK R. SIRRI, Former Director, Division of 9 Trading & Markets, U.S. Securities and Exchange Commission. 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 4 1 P R O C E E D I N G S 2 (9:02 a.m.) 3 CHAIRMAN ANGELIDES: I would like to call the 4 meeting of the Financial Crisis Inquiry Commission to order. 5 Welcome. We have a quorum present today. I want to welcome 6 everyone to our hearing today and tomorrow on the Shadow 7 Banking System. 8 I am honored to welcome each and every one of you 9 here today. I want to again thank Vice Chairman Thomas and 10 all my fellow Commissioners for all their hard work as we 11 strive to fulfill our mission on behalf of the American 12 people. 13 I particularly want to thank Commissioners Born 14 and Holtz-Eakin for serving as the lead Commissioners on 15 this hearing. 16 Today we begin two days of public hearings. They 17 will focus on what has been called "shadow banking" and how 18 it affected the financial and economic crisis that continues 19 to grip our Nation. 20 It is largely forgotten now, but for much of 21 American history we had a banking system that was unstable 22 and prone to panics. In the 19th Century, runs on banks 23 came every few years, plunging our young Nation into 24 frequent financial crises. 25 In the first half of the 20th Century we brought 5 1 stability to the banking system. After the panic of 1907, 2 we created the Federal Reserve. After the great crash of 3 1929, we instituted reforms like Deposit Insurance, and more 4 federal oversight. 5 For decades we had a sound banking system that 6 provided capital for businesses and consumers alike. It was 7 one of the foundations of our prosperity. 8 Over the past few decades, though, a parallel or 9 "shadow banking" system has arisen that has become a 10 linchpin of our economy. However, it is largely unregulated 11 and, as we saw in the financial crisis, much more unstable 12 than anyone had thought. 13 This world of shadow banking is some $8 trillion 14 in size and almost as large as the traditional banking 15 sector. It includes investment banks, off-balance-sheet 16 entities, money market funds, and hedge funds, as well as 17 some affiliates of traditional banks. 18 During this crisis, we have seen the shadow 19 banking system upended, first by a liquidity crisis in 2007 20 as mortgages went bad at an accelerating rate, and building 21 to a crescendo in the fall of 2008 when there was a 19th 22 Century style panic, a run on the short-term, often 23 overnight loans that fund so much business financing in 24 America and around the world. 25 The market froze. Interest rates soared on the 6 1 short-term loans. Our financial system was on the verge of 2 collapse. How could this have happened? Consider Bear 3 Stearns, which we will examine today in its own right and as 4 a participant in the shadow banking system. 5 Like many other institutions, Bear took 6 extraordinary risks, invested heavily in mortgages and 7 mortgage securities, was thin on available capital, and 8 dependent on the good graces of its creditors for overnight 9 loans. 10 By one measure, its ratio of assets to tangible 11 equity was 38 to 1, a precarious position to say the least. 12 When their funding dried up, the company stood on the verge 13 of collapse and finally had to be purchased by JPMorgan 14 Chase & Company with more than $29 billion in government 15 assistance. 16 We will also be examining the Securities and 17 Exchange Commission which had oversight over much of the 18 shadow banking world under a 2004 program that ended in 2008 19 when the five financial giants under its purview either 20 failed, were acquired, or turned into bank holding 21 companies. 22 We will have questions of Treasury Secretary 23 Geithner who used to head the Federal Reserve Bank of New 24 York, which was charged with serving as the Federal 25 Reserve's eyes and ears on Wall Street. 7 1 We will also have former Treasury Secretary 2 Paulson here, and we will ask him how and why the shadow 3 banking system grew and came to pose a risk to our financial 4 system and our economy. 5 While considerable attention by journalists and 6 historians has, with good reason, focused on the rescue of 7 various financial institutions and our financial system, we 8 want to explore why these kinds of risks developed in the 9 first place; what could have been done and what should have 10 been done to prevent them. 11 To use a metaphor, yes, there is a general 12 interest in how the fire was brought under control, but our 13 job is to find out why the fire started; what warning signs 14 were ignored; what building codes, if you will, could have 15 prevented the fire in the first place; where were the 16 firefighters; who was playing with matches. 17 On behalf of the American people, we have been 18 charged with getting the answers to these questions, and we 19 will. 20 If you go to our website at fcic.gov, you will 21 find more information on the shadow banking system where our 22 research staff has prepared an excellent preliminary report. 23 I would urge everyone to go look at that report to get an 24 overview of the shadow banking system as it developed. 25 So thank you all for being here today, and now I 8 1 would like to turn the microphone over to Vice Chairman 2 Thomas. 3 VICE CHAIRMAN THOMAS: Thank you, Mr. Chairman. 4 That was a good, broad explanation of where we are today. 5 This hearing obviously is only a small part of 6 the Commission work, and the broader themes that we have to 7 look at are shifting constantly. This world of finance, 8 which has changed so dramatically, is an area that frankly 9 most Americans are not aware of, and if they are they are 10 not aware of it in any level of detail that we are beginning 11 to investigate. 12 So when I try to explain what we are doing to 13 some of my friends, I fall back on some of the analogies 14 that allow us to communicate. And one of them that I am 15 very familiar with is the automobile. 16 Up until the 1950s, it was pretty easy to be a 17 shade tree mechanic. You basically looked at the 18 automobile, and if it wouldn't run you looked at whether or 19 not you got spark; you looked at whether or not the fuel/air 20 mixture was okay; and if it was, then you went through a 21 series of checks that were not all that difficult, not 22 withstanding the confusing nature of an automobile to a lot 23 of people. 24 When I was in grade school, we went to a bank. I 25 took some money with me to put it in my savings account. I 9 1 got a passbook, and over the years I began to realize that 2 was where you went to get a loan if they thought you could 3 pay it back. 4 And what happened to the automobile in the '60s, 5 '70s, '80s, and into the 21st Century, in part happened to 6 the financial structure. That is, cars got very 7 complicated. It was still the old spark and fuel, who got 8 what, when, and how, and so the banking system was the same, 9 but we began to use computers to measure more precisely. 10 It became much more of a unique relationship.
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