You probably haven't heard about the Financial Crisis Inquiry Commission. It was established by Congress in May of last year. Ten members, including (full disclosure) me. It is kind of a 9/11 Commission for the financial crisis. We are supposed to report to Congress, to the American people, and to the President about what caused the financial crisis. We are not supposed to make recommendations about what should be done. We have barely have enough time to come up with a comprehensive discussion of the causes. We are supposed to report on December 15, 2010 -- nine months from now -- not quite seven months from now to finish our report. We are still in the process of researching and investigating.

I began looking at Fannie Mae and Freddie Mac eleven years ago. I had retired from a law practice at that point, and gone to work at the American Enterprise Institute with one idea in mind: that there was something wrong with the setup in profit-making institutions owned by shareholders but backed by the U.S. government. That cannot work. It is a prescription for disaster, and it has turned out to be one.

In the course of studying the two institutions, Fannie May and Freddie Mac, I learned quite a lot about the housing business, housing policies and so forth -- and I have concluded at this point that the financial crisis was caused by the housing policies of the U.S. government. It was not caused by the lack of regulation, which is the underlying theory of what the Obama Administration has proposed. It was not caused by predatory lending. It was not caused by greed on Wall Street.

God knows there was greed on Wall Street, but that did not cause our financial crisis.

What caused the financial crisis are 26 million subprime and Alt-A loans, mortgages, that are in our financial system. Now, that is a number you probably have not heard.

Let me just define terms. A subprime loan is a loan to a borrower who has weak credit, blemished credit. Technically it is below a 660 FICO score. That is the way credit is measured. A 660 FICO score is not very high, and if you are below a 660 FICO score, you are a subprime borrower. An Alt-A loan is a loan that is deficient. It is not the borrower who is deficient, it is the loan that is deficient. For example, no down payment. No documentation. A reset after two years with a teaser rate, with a reset to a possibly higher rate; all kinds of other deficiencies. Those are Alt-A loans. There are about as many Alt-A loans in this 26 million as there are subprime loans, and both of them are failing at absolutely unprecedented rates. No one has ever seen rates like this.

Now, what does this mean in terms of 26 million loans? There are about 54 million mortgages in the United States, so almost half of all mortgages in the United States were weak, deficient and ready to fail as soon as the housing bubble flattened out -- and that is exactly what happened at the end of 2006. The housing bubble, which was already of unprecedented proportions, by 2006 had begun to top out, and by early 2007, delinquencies had begun to show up and mortgage defaults were occurring. These were much, much larger than anyone who was an observer of the market imagined they would be. No one had ever seen rates of delinquency at the beginning of a housing downturn like this.

As a result of that, the investors ran away from the mortgage-backed securities market, which, until then, had been the largest market for financing mortgages. It was a worldwide market, and mortgage-backed securities formed a substantial portion of the assets of financial institutions all over the world. They had bought U.S. mortgage-backed securities because everyone believed one thing, and this is that Americans always paid their mortgages. And this was true in every one of our prior bubbles. Americans did pay their mortgages. The losses in the worst bubbles we previously had seen on mortgages were about 4%. However, it looks as if the losses on this bubble will be up 9- to 15%. That is unprecedented.

As a result of this, because those losses were foreseeable, the worldwide mortgage-backed securities market simply disappeared in 2007. Disappeared. Another unprecedented event. At that time, and now, accounting rules that required marking assets to market conditions required that institutions holding these mortgage-backed securities begin to value them based on the market price. As there was no market other than distress sales at that point, those values plummeted. Many, many financial institutions that were holding mortgage-backed securities looked as though they were weak, insolvent, unstable, and, as a result, investors fled from them.

The first of these institutions to have serious trouble was Bear Stearns, the smallest of the five investment banks and the most heavily invested in the mortgage-backed securities market. Bear Stearns, of course, was rescued in March of 2008. But then, in September of 2008, the next-largest of these firms, Lehman Brothers, failed, and at that point the market went into kind of a catatonic fit for a time. No lending was going on at all -- and that is what we mostly consider to have been the beginning of the worldwide financial crisis.

Why did this happen? Why was there this terrible freeze-up in the market after Lehman? It was not because Lehman's failure caused losses to other companies. It was not because of what is called "interconnection." When you hear President Obama or Secretary Geithner talking about what they want to regulate, they talk about regulating large, complex and "interconnected" companies. But Lehman, which was large and complex, was not apparently interconnected, because there is no record of any major losses by any of Lehman's counterparties(except a money market mutual fund that was holding Lehman's commercial paper) as a result of Lehman's failure. So we do not have to worry about interconnections. We do not have to worry about a systemic collapse if a large financial institution fails.

What we ought to be thinking about is using the bankruptcy system rather than the kind of special resolution process that the Administration has been proposing. This process, and the regulation of large non-bank financial institutions that the administration proposed would, of course, make them all too big to fail because they would appear to be backed by the government, they would be like Fannie Maes and Freddie Macs - all too big to fail.

Now, why did we have all of these bad mortgages? Of the 26 million subprime and Alt-A mortgages that I'm talking about, about 19 million are on the books of government agencies or on the books of banks that had to make these loans because of something called the "Community Reinvestment Act." They break down this way: Fannie Mae and Freddie Mac have about 12 million subprime and Alt-A mortgages; FHA, VA and, to some extent, the Federal Home Loan Banks have another 5 million, and then there are the four major banks -- Citi, Bank of America, JP Morgan Chase and Wells -- and they hold another 2 million mortgages on which they had to make loans under the "Community Reinvestment Act" to get government approval for mergers. Those 19 million mortgages turn out to be mortgages that are failing at very high rates. So government policy created, or was responsible for, almost three-quarters of the bad mortgages in our financial system today.

As I said, the members of the Financial Crisis Inquiry Commission on which I sit are considering the issue of what caused the financial crisis, and my view today is that government policy caused the financial crisis. However, if, in the course of the commission's work, something else comes to the fore, or there is evidence that something other than bad mortgages caused the financial crisis, I'll change my mind. But for months now we have been working on this subject, and nothing has appeared yet as a cause of the financial crisis that is even remotely as important as the mortgage problem.

So the point I'd like to leave with you today when we talk about the financial crisis is that it is not a problem of capitalism. It is not a problem that our financial markets were not sufficiently regulated. It is not a problem of greed on Wall Street. It is not the result of predatory lending. It is not all the things that the Obama Administration has been talking about, as far as I can tell, as causes of the financial crisis. And so the remedies for the cause of the financial crisis are not to regulate our financial system more heavily, but to change the government policies that created most of the weak mortgages that ware failing today.


Q: Can you give us an idea who else is on this Commission, and what their backgrounds and sponsorship might be, and does our favorite congressman from Boston have somebody on the committee?

A: You mean Barney Frank? He might have a supporter on the Commission, but I can't tell. Nancy Pelosi made the three Democratic appointments from the House of Representatives; Harry Reid, made the three Democratic appointments from the Senate side. I was appointed by the House Republicans, and my two Republican colleagues were appointed by the Senate Republicans.

Now, of all of the people who were appointed by the Democrats are very fine people and very bright but, the only one you are likely to know is Brooksley Born, the celebrated former head of the Commodity Futures Trading Commission [CFTC]. She has gotten a tremendous amount of support and backing and kudos for her efforts to regulate credit default swaps at the end of the Clinton Administration.

The Chair of the Commission is Phil Angelides, a Democrat who ran for Governor of California in the most recent election and lost to Arnold Schwarzenegger.

On the Republican side, we have, I think, two very well qualified people. One is Doug Holtz-Eakin, who was the head of the Congressional Budget Office for several years when the Republicans were in control of Congress, and a very sophisticated economist. The other is Keith Hennessey, who was the head of the National Economic Council toward the end of the Bush Administration. He is young, but he is a very bright young man.Those two are fairly sophisticated about finance.

The Vice Chair is a Republican, Bill Thomas, whom most of you may know as having been the Chairman of the Ways and Means Committee in the House for a number of years.

So I have some hope that we can actually come to a conclusion here that would be close to what I believe is the cause of the financial crisis. And that is because the Democratic members are not political appointees. They were appointed politically, to be sure, but as far as I can tell, with the exception of Phil Angelides, the Chairman, they have not ever had any particular activities in the political area. So I am hopeful that they are not necessarily going to be concerned about avoiding embarrassing Barney Frank and others who are major supporters of U.S. government housing policies over many years, including Fannie Mae and Freddie Mac. I do have some hope.

One thing I have learned from following the politics of the financial crisis is that the first media narrative that is established about anything like a financial crisis becomes almost impossible to overcome. The narrative that was first established right after Bear Stearns was rescued is, as I said earlier, that these companies were all interconnected, and they have to be protected and regulated, because if any one of them fails there will be a massive collapse in the international markets. This narrative, which was then attached to the greed on Wall Street idea, the predatory lending idea, and the notion that the real underlying problem is lack of regulation, is the way that most people in the United States understand the financial crisis today.

So this is one of the reasons why I am working so hard to make sure people understand that there really is another narrative -- that the government's housing policies caused the crisis.

Q: Two related questions: The first is, in the mandates of the Community Reinvestment Act, was there a push not only to lend money for houses to a pool of lenders that had never before borrowed, but also to do so by enabling them not to put up money, to have low or no documentation, to have these teaser loan features? Because if so, this is the stuff that provided the raw material for the losses that are coursing up in the securitizations.

The second part is, in assessing the causes of the crisis, the leverage ratios of the major financial institutions, the investment banks and the banks, rose to unprecedented levels, generally 30 to 40 to 1. At 30 to 1, something like a 3% decline in asset value causes the company to become insolvent; and way before that, the company is in trouble because nobody wants to trade with those companies. And, of course, what the source was of the losses that people started to experience, and that caused people to back away from institutions, was not the securitizations of real estate, but the second-order securitizations, the so-called CDOs, the collateralized debt obligations, and that is what Merrill Lynch and Lehman ended up having on their balance sheets.

So taking 30 to 40 to 1 leverage was voluntary behavior on the part of the financial system. Does that enter into your matrix of what was the possibly proximate cause of the crisis?

A: Let me take one at a time. The CRA requires that insured banks make loans to people who are at or below 80% of the median income. Now, if you are going to be making these loans, it is going to be hard to find a traditional residential mortgage borrower that meets the usual standards of a down payment of maybe 10% or 20% and unblemished credit. You actually have to find borrowers who do not meet those standards.

So lenders were required, under the CRA, to be flexible and innovative in their lending, but, of course, not to do anything that was not prudent. Of course, everyone looked the other way about the prudent part. They just wanted to make sure that the lenders were making these loans. So the CRA became a major source of problems.

A group called the National Community Reinvestment Coalition is made up of many groups that were in support of the CRA. In 2007, they published an annual report at a time when people were pretty pleased with what had happened under the CRA. This was before the bubble topped out, and many of these loans were not defaulting, because as long as housing prices were going up, you could always refinance if you could not pay for your mortgage. So the losses were actually pretty low, and home ownership in the United States was increasing. It increased 5% between the middle of 1995 and about 2005. It had been about 64% for 30 years, and by 2005 it was 69%. So people were pretty happy about how all of this was working, until it stopped working.

But the Community Reinvestment Act was a major source of funds for these mortgages, and when the National Community Reinvestment Coalition published its annual report, it pointed out that its members had succeeded in getting banks to commit to $4.5 trillion in CRA loans between 1995 and 2007. $4.5 trillion is a significant part of our mortgage system, and by 2007, about $3 trillion of those dollars had actually been committed to loans by the major banks. So that is a major part of the problem that we have in our financial system -- the CRA, and low standards created large numbers of low quality mortgages that went to Fannie Mae and Freddie Mac, to FHA or are held on the balance sheets of four major banks. They are suffering losses as a result of holding these mortgages. So there is a problem with CRA, another one of the housing policies of the U.S. government that I think are responsible for weakening the residential mortgages, and one of the underlying bases of our financial system.

Then we get to this question of liquidity and leverage, which I really think of as a liquidity problem, too. Remember, I mentioned that at the end of 2007, the mortgage-backed securities market completely collapsed, disappeared. This had never happened before. But these securities, in one form or another, were on the balance sheets of all of those companies that you mentioned. They were CDOs and also just plain old mortgage-backed securities, and they were regarded up until that time as highly liquid securities. You could repo these securities and get the financing that you needed, and, if you needed cash, you could sell them.

But you could not sell them after the middle of 2007. What happened is that no one foresaw the possibility that an entire worldwide market, which was very active on a daily basis would simply disappear. So if you had a 30 or 40 times leverage, and what you were counting on to raise the cash that you needed in the event that you needed cash became suddenly unavailable, you were going to be in serious trouble.

But it was not the leverage that was the problem, it was the fact that the market people were relying on disappeared, and the market that people were relying on was supported at its base by very weak mortgages that no one actually understood were there. Hardly anyone knew. Hardly anyone knows even today that there were 26 million subprime and Alt-A loans underlying our mortgage system, because we had never had so many. I am not one who believes that a 30 or 40 times leverage ratio was inherently immoral or stupid, because much of the underlying assets of these companies that had this high leverage ratio were, up to the middle of 2007, highly liquid.

But when these assets became highly illiquid, when these companies became, in effect, unable to raise the necessary cash, well, then bankruptcies would result. I do not think there is anything wrong with that, either. If you have not anticipated turns in the market like this, even though that was a one-in-a-century kind of thing, you have to suffer the necessary losses.

Q: My impression has somewhat changed because you sort of responded to it with the first question, but it was really about the way the crisis has portrayed capitalism and free markets -- has portrayed government as a savior as opposed to government as the problem. It seems that our side is more interested in doing white papers and long explanations, and they do sound bites and bumper stickers. And it is so much easier and also appeals to the whole class-war thing to talk about "the greedy rich," "the greedy bankers", "the greedy capitalists," and never about the greedy politicians, or the inefficient politicians. who should have been regulating anyway.

Now, the average voter does not want to hear that hardworking Americans were to blame because they took loans they should not have taken. And of course, the hardworking Americans, many of them did not have any jobs anyway. But it is a really tough sell to point the finger at government in such a way that it markets well. So how do you suggest that maybe we can address this, and what you think is missing from this argument?

A: Unfortunately, I am an academic. I am not good as a marketer, or as a publicist, so to turn this into something that would be a bumper strip or a sound bite, or something that could make people understand it, is difficult. But I am not so sure that I agree with your proposition that it is hard to make a case against government policy. It seems to me that if we look at the polls and what is happening in the country today, there are an awful lot of people who are ready to believe that the problem is mostly a government problem.

It is quite interesting to me, when the Democrats came in, in 2009, they were saying this was going to be a new New Deal. The country was going to move left. The election of Barack Obama proved this, so we were now going to finish what Franklin Roosevelt only started, and we were going to do that in part by regulating the financial system. We were going to have health care, and all the rest of those things.

Well, it has turned out not to be true. It took, as we know, fifteen months to get a health care bill, and we do not have any new financial regulation. This is now the next one up on the congressional floor, but I'm not entirely sure that they are even going to get that, because the Republicans -- almost all of the Republicans - do not seem to be in favor of the bill that Senator Dodd has reported from the Senate Banking Committee. I will not go into all the details about it, but my view is that what happened in this country is what no one expected: Instead of moving left when the financial crisis occurred, the country moved right and concluded that, "Wait a minute. The problem is really that the government has made a lot of mistakes."

I think a case can be made there, too, because -- and I say this all the time -- "Wait a minute. If the problem is insufficient regulation, look at the banks. The banks are the most heavily regulated part of our economy, and they were at the center of this financial crisis." So you cannot actually make the argument that we ought to regulate more of the economy when the part that was already heavily regulated caused, or was at least a major victim of, the financial crisis.

Q: The Honorable Marc Nuttle, who was not only the youngest White House counsel in the Reagan Administration, but also an economist, has a new book out, and one of the things I am not hearing you talk about in your committee's inquiry process is foreign influence. About leverage, we, as a nation, obviously, are subject to extraordinary foreign pressure and leverage. Forensic accounting has revealed some pretty interesting things in the last few years, including the BBC inquiry, which revealed the food-for-oil scam went to the highest levels of the United Nations. Do you find that there is a place for this kind of international forensic accounting, or any kind of accounting that would look at foreign pressure?

I have been told by a forensic accountant that very few people have brought in a light to the fact that there was some very specific speculation going on from banks with a very pronounced Middle Eastern investment influence, and that has not come out in any of the papers that I have seen or stories that I have followed.

Also, a larger perspective on this: it is interesting to note that the CIA and the intelligence community added economic terrorism to the list of threats and developed a division in the intelligence community for economic terrorism last year in light of the events of 2008, and that the 105-page report delivered to the Senate Select Committee on Intelligence this year included a very significant look at international economic terrorism. Will your group look beyond domestic influence?

A: If there were any foreign involvement in the financial crisis, it has not been sufficiently reported so that it would be something we would be looking at. And I'm skeptical, frankly, that there was, because we are talking about trillions of dollars in losses that would be very hard for any terrorist group -or even a concerted group of investors -- to accomplish. I do not see that this would happen. If there is that information, I would be happy to look at it, we will get the staff of the commission to look into it. If this forensic economist you talked to says that this information is available, it would be worth looking at. I would be skeptical about it to start with, but I would certainly be interested in looking into it.

Q: I just would like to hear your thoughts on comparison of this crisis with the S&L crisis of the early 1990s.

A: I find there is a lot of similarity there because both of them were caused by the government. The S&L crisis was a classic example of a government problem. The S&Ls were government-backed, as we know. Their deposits were guaranteed by the government, insured by the government, just like bank deposits were, and they took tremendous risks with that money, and were not sufficiently regulated.

Now, let's talk about why regulation is necessary. Why do we have regulation? We have regulation because market discipline has been weakened or eliminated, and this is true in any situation in which people believe that the government is backing a particular institution. This was the problem with Fannie Mae and Freddie Mac. There was no market discipline of Fannie Mae and Freddie Mac, and the regulation, which is supposed to substitute for market discipline, was very, very weak. The same exact thing was true with the S&Ls. They were backed by the government. People would deposit money with the S&Ls without any worry about what risks those institutions were taking, and it turns out they were taking enormous risks and suffering tremendous losses when there was a downturn in the economy.

What happened to the S&Ls was not just excessive risk-taking, although that was part of the problem. They were originally weakened by inflation, because they were holding 30-year loans, for which they were being paid 5% -- but they had to borrow money at much higher rates at the time. So S&Ls were bound to suffer tremendous losses. But why? First of all, why were they assuming that they were going to be able to carry a 5% mortgage for 30 years?

Under Regulation Q, banks were limited to paying 5% deposits, and S&Ls could pay 5¼%. So the S&Ls believed that this would go on forever - that they were always going to be able to get deposits from ordinary people at 5¼% because people had nowhere else to put their money. If you went to the international capital markets, you had to have $100,000 to buy one of the securities that were available, so people had to deposit their money in banks and S&Ls at a low fixed rate. So we were actually forcing consumers to take a lower rate of interest than they might have gotten in the capital markets.

But something occurred, a technological change. That is: computers arrived, and made it possible for money market mutual funds to divide up a very large investment in the international capital markets into a number of shares and report the value every day. Suddenly people could get their share of the much higher rates that were being paid in the international money markets. So the money was drawn out of banks and S&Ls and went into money market mutual funds.

At that point, Congress had a choice. They could regulate the mutual funds and force them to offer a rate of interest that was fixed, or they could free up the banks and the S&Ls. Fortunately, Congress decided that they would free up the banks and S&Ls, and Regulation Q was eliminated by the Monetary Control Act of 1980.

After that, S&Ls and banks could offer any rate of interest they wanted, and that made things a lot easier in terms of getting loans at a time when interest rates were quite high. Before that, banks used to stop lending when money rates rose above deposit ceilings. Normally, banks ran out of money at that point, because then depositors went to the money markets.

But the point here is that all of these things were the result of a government process that set up a special set of institutions that were to invest in mortgages, which are long-term assets, but could only support themselves with money that came in in deposits at a very short-term rate. And as soon as the government support for that was eliminated, the S&Ls were free to pay whatever they wanted for deposits. However, most of them were so far gone at this point that they made very bad investments while "gambling for resurrection."

So I see the S&L problem as exactly the same problem as the financial crisis. As long as the government is involved in these things, as long as the government sets these policies, we are going to have these problems again and again. And the way to avoid this is to get the government out of the financial business. That sector can run perfectly well without any government activity.

Q: Could you comment on the model used by the rating agencies? And is it true that they got their fees up front?

A: Sure, they did. Now, I do not know everything I would like to know about the rating agencies. We are actually just starting on that in the Financial Crisis Inquiry Commission. But I will say that one of the very unusual things that occurred in the financial crisis was that Fannie and Freddie, when they were making these subprime and Alt-A loans, were reporting them to various organizations that gather information about the mortgage markets in the normal way. They would report that they made X number of loans in such a month, but they did not say what kind. It had always been assumed that Fannie and Freddie were making prime loans, so when Fannie and Freddie reported these loans, they were considered to be, and categorized as, prime loans.

So anyone at a rating agency, who was working on a model of what was going on in the financial economy at the time they were trying to rate a pool of mortgages, would assume that there were -- by 2008 -- 12 million more prime mortgages in our economy than in fact there were, and 12 million fewer subprime and Alt-A loans than in fact there were. Now, I do not know whether this had any effect on what the rating agencies did, but you could imagine that their models would be terribly screwed up unless they knew that the makeup of the mortgages in the financial system were a lot different from what was being reported generally.

Beyond that, there is certainly a good case to be made that the rating agencies could have been suborned by the issuers of the mortgage-backed securities. That is the narrative. But the narrative is not always correct. In fact, I think the narrative is mostly wrong. There is good academic work that indicates that the borrowers were putting pressure on the rating agencies for these AAA securities, and not the issuers. And why were the borrowers doing it? Because there were laws all over this country that said -- if you were a union pension fund, state pension fund, or the city pension fund -- that you could not invest in a security unless it was AAA. They wanted the higher returns, the higher yields that they could get from these mortgage-backed securities, but they could only get them if the things were rated AAA. So they were the ones who were putting pressure on the rating agencies for those AAAs. I do not know whether that is true, but there are academics who have made an argument along those lines.

Q: It is very dangerous to ask an economist a philosophical question, but I'm going to ask you one anyway.

A: Good. I'm a lawyer.

Q: One of the issues that emerges in a democratic republic is the extent to which politicians are eager to obtain votes. If you go back to the New Deal and the subsequent period, you find that there is a seduction that has taken place in American life. Even people who call themselves conservatives by and large have been seduced by the role of government. How do you then look at this CRA, the legislation that came out in 1987? It was largely populist legislation designed to attract votes because the Black Caucus in the Congress said 70% of Americans should be homeowners. Not only that, but you had Congressional testimony which suggested very much the same thing -- 70% of Americans should be homeowners.

Well, if you are going to do that and provide this kind of subprime loan, obviously what you are doing is that you are buying votes. People are then seduced. And then the seduction occurs in a variety of ways where government continues to provide the goodies, taking from Peter to give to Paul. Paul is always happy about that arrangement. But the problem, of course, is at some point it has to end. How does it end? I want to know what the endgame is. That is, is it a question of inflation that is a kind of tsunami-like rate, or are we going to be at a point where insolvency is clearly what the United States will live with, not unlike what Japan is about to face? What is the endgame based on this scenario?

A: Well, first let me talk about the question of buying votes and things like that. Look, this is a democracy, and we should have policies that the majority of people want. We have to ask for some responsibility from our representatives, but that is what happens in a democracy. The difference here with CRA and Fannie Mae and Freddie Mac and so forth, is that Congress did not do it the honest way. The honest way is that if we think homeownership should be increased -- and Americans have always been admirers of homeownership -- then the government should in its budget provide the funds for that, right?

But that is not what they did. Instead of providing the funds for doing it, they distorted the financial system. They asked Fannie Mae and Freddie Mac to provide the funds, off-budget. Nobody knew anything about it. It was just taking the money from a couple of private companies, distorting their mission so that they were no longer interested solely in profit, but were required to meet certain government standards when they made mortgage loans. Similarly, they took the insured banks, over which they have some control because they are regulated, and forced them under the Community Reinvestment Act to make the same kinds of bad investments.

I have no problem with the government subsidizing homeownership so that more people can have homes. I just say if that is what we want in this country, then we ought to have the taxpayers pay for it in the usual way. But that is not what we did. Now, with Fannie Mae and Freddie Mac, we are going to suffer $400 billion in losses, at least, by the time all of their problems are wrapped up. If we had taken $400 billion and we had used it for assisting people in buying homes in some way, maybe making government loans directly to them or providing them with down-payments so that the government would take the equity position in these mortgages, well, maybe we might not have had this crisis. So, I mean, I am not sure it isn't a good idea to be fostering homeownership. What I do think was a bad idea is distorting the financial system in order to do it.

Now, how do we get out of this? I mean, I actually do not see any way that we get out of this without inflating the currency, and what is amazing to me is, when I look at the long-term rates in the money markets, that I do not see this showing up at all. I do not see the kinds of interest rates that anyone who was buying a 30-year U.S. government bond would expect to get on that. 30 years invested in the U.S. government? I mean, God knows where these interest rates are eventually going to have to go when the fact that the government can only meet its obligations under Social Security and Medicare, and now this new entitlement, through inflating the currency. I cannot see any other way it can be done. You cannot tax enough to cover these obligations, and yet the market does not seem to be considering this at all. So I am quite worried. I have never been so worried about this country.

Q: How do you feel about the Volcker proposal to separate commercial banking from prop trading?

A: We have a terrible problem with banks. When I use the term "banks," I am really using it in the defined way -- those institutions that take deposits, take insured deposits. And let's make sure we are talking about that, because there are all kinds of things that are called banks just because they make loans. They are not banks. They are called the shadow banking system. I do not know what that means, but they are not banks. Banks by definition take deposits and make loans.

Our problem with banks is that they have very few good investments to make anymore. The reason is, banks originally used to finance business. They do not anymore. They can finance small business, but any institution that has become a public company can finance itself much more cheaply, much less expensively, in the securities markets. There are all kinds of short-term, medium-term and long-term financing instruments available in the market, and it is much better than borrowing from a bank. So banks are limited now to small business and we are talking, in most cases, about very small business, credit cards, consumer loans -- also a very cyclical business -- and real estate.

In 1965, of all bank loans, 23% were to commercial and residential real estate. In 2007, that number was 55% and it was still rising. This is a very dangerous trend, because real estate of all kinds is highly cyclical, and every time we have a real estate bubble and a real estate collapse, we have an associated bank crisis. We have to figure out a way to solve that problem.

So what is Paul Volcker recommending? The very opposite. He is recommending taking away another one of the ways that banks, within Glass-Steagall -- always within Glass-Steagall, because it still applies to banks - can still make money. They were engaged in proprietary trading, trading mostly mortgage-backed securities or other kinds of securities or debt securities, which they have always been allowed to buy and sell, and that was a perfectly legitimate business, and no indication that that business caused losses at banks.

So I think this is a very bad policy, and I cannot actually explain why Paul Volcker, who should be an expert in this business, is recommending a further weakening of the banking system. But even if banks are permitted to continue prop trading, we still have to solve the problem of what activities banks in the future are going to be able to engage in.

Q: If you get voted down in your commission, are you able then to go as a private person and disclose a different set of opinions? How do we get information that is not politicized?

A: Well, I expect that if the commission does not adopt my view of what caused the financial crisis - and I still believe at that point that I am correct --that I will be able to write a dissent.

Delivered to the Hudson Institute-New York at the Four Seasons Restaurant, March 30, 2010

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