Opening Remarks of Assistant Secretary for Terrorist Financing
Patrick O’Brien at Treasury’s Charity Roundtable

Washington DC--Good Morning.  I would like to welcome you all to the Treasury Department for today's Charity Roundtable.  It is our hope that today's discussion will build upon the regular dialogue we have had over the years both here in Washington and in community events around the country.   Before I go further, I would like to extend my special thanks to Mr. Kareem Shora, National Executive Director of the American-Arab Anti-Discrimination Committee (ADC), and his capable staff for their assistance and leadership in organizing this event.

The United States government is committed to strengthening our relationship with Arab and Muslim-American communities.  For our part, the Treasury Department continues to engage with both the charitable sector and affected communities to advance our shared interests in a free, open, tolerant, and charitable society.  One that encourages charitable and humanitarian activities, while at the same time protecting those efforts from abuse.    

Over the last several years, the Treasury Department has established an important relationship and dialogue with the Arab and Muslim-American communities as we work together to address the threat of terrorist financing in the United States and the Muslim and Arab worlds.  This relationship is necessary as we work to protect and preserve the sanctity of charitable giving and zakat from terrorist groups like al Qaida, Hamas, Hizbollah, and others who have purposely usurped the goodwill and donations of Muslims around the world to fuel their terrorist agenda.  It is also critical to advancing our collective mission of promoting charitable relief and development around the world to those most in need of our assistance.  Although we may not agree on all points, an honest and frank exchange between the federal government and Arab and Muslim-American communities fosters mutual understanding and also serves as a basis for continued cooperation.

The Arab and Muslim-American communities are uniquely situated to advance our common interests in both promoting and protecting charitable activities.  Your engagement and leadership has the potential to affect global practices and perceptions that are essential to these interests and winning the long term battle against terrorism.

We anticipate that today will provide an open and informal forum to exchange thoughts and mutual concerns.  It is fair to say that our agenda is ambitious and engaging.  There is a diversity of interests and concerns that are reflected by speakers from Treasury, the Internal Revenue Service, the FBI, USAID as well as a number of charitable and advocacy groups, civil rights organizations and concerned individuals. 

Today's dialogue will be wide-ranging and focused on the following topi

• The nature of the threat of terrorist abuse of charities;
• Basic governance, accountability, and transparency issues which affect charities as well as hearing how the private sector implements such principles;
• Concerns of charities that operate in high-risk areas and measures they may voluntarily implement to minimize risks of abuse;
• Providing guidance to donors on charitable giving;  and
• Identifying ongoing and future challenges.

I would like to make a few general observations about the first topic on the agenda – the nature of the threat.  Absent a baseline understanding of this matter, the United States and the international community's response would not be well understood.  As has been noted on many occasions, the nature of terrorist financing is dynamic, evolving, and it often varies by the particular region.  However, the Treasury Department, working with its domestic partners and international organizations such as the Financial Action Task Force, has made a concerted effort to document the risks and typologies of terrorist exploitation through a number of publications.

Some believe that the terrorist financing threat in the charitable sector is limited to cases of diversion of funds or materials.  Diversion occurs when a charity ostensibly raises money for a legitimate goal, but then uses the funds for an illicit purpose.  In the broadest sense, this is fraud.  However, it is not the only problem we confront in the sector.  In addition to raising and moving funds as well as providing operational cover, it is well known that foreign terrorist organizations such as al Qaida, Hamas, and Hizbollah purposefully establish or exploit charities to gain support, recruit new members, and radicalize vulnerable populations.  Terrorist groups often supplant a weakened central government and in effect, develop social welfare arms.  They run the hospitals, schools, and clinics for these populations.  This gives terrorist organizations a seemingly reputable foundation for recruiting new members.

Many of these charities do provide actual services, as well as support terrorism.  It is this aspect of the threat the underlines our voluntary guidance covering the vetting of key employees and grantees of charities working in high-risk areas against lists of designated terrorist organizations, entities and individuals. This fact is supported by a number of different sources including law enforcement investigations, academic studies, media reports, and publicly available information that support Treasury Department designations.  In this regard, the public information concerning Treasury's designations of specific U.S.-based charities revealed that many of the charitable organizations engaged in actual charitable services.  However, they were unfortunately owned or controlled by, or acted for or on behalf of; or provided financial, material, or technological support. This is a violation of U.S. law, namely Executive Order 13224.  Organizations such as Benevolence International Foundation and Global Relief Foundation are prime examples of this type of illicit activity.  Furthermore, Treasury's recent designation of the Tamil Rehabilitation Organization (TRO) in Sri Lanka and a similar action taken by the Government of Canada illustrates that a wide range of foreign terrorist organizations that exploit charitable services.  In fact, almost all of the foreign terrorist organizations maintained by the federal government have some charitable component or function.   

The broader exploitation of charities operating in high-risk regions raises serious questions and challenges for the United States, the international community, and charities operating in high-risk areas.  Going forward, some key challenges include: adoption of best practices, utilizing alternative relief measures, and improving private sector relief efforts.  Let me just take a minute to briefly outline these areas.  

Adoption of Anti-Terrorist Best Practices

All charities working in high-risk areas should consider adopting specific anti-terrorist measures.  As guidance, Treasury published the Anti-Terrorist Financing Guidelines: Voluntary Best Practices for U.S.- Based Charities in consultation with a number of charitable groups.  In light of the risk of exploitation in certain regions and the need to comply with U.S law, these measures, among other things, recommend that a charity collect information on its grantees as well as key employees and then check such information against lists maintained by the Department of the Treasury.  It is important to note that such measures are risk-sensitive and recognize that charities may sometimes operate under exigent circumstances.  However, we understand that there has been significant discussion both within the charitable sector and affected communities regarding the feasibility, potential burden, and the effect of such measures, and hope we can examine these concerns during today's roundtable.  Going forward, Treasury will continue to work with interested parties to further refine its guidance in this area, including through the Treasury Guidelines Working Group forum.

Alternative Relief  

In some circumstances, effectively and safely operating in regions where there are known terrorist activities may require creating alternative distribution means.  Essentially, this type of partnership allows individual U.S. donors to tap into the government resources and distribution networks, thereby leveraging counterterrorism mechanisms only available to the government.  The aim is straightforward – to provide a safe and effective way for individuals to contribute to critical regions where aid is desperately needed, such as the West Bank and Gaza.  Such partnerships also have the potential to weaken the hold that foreign terrorist organizations have on vulnerable populations by harnessing a competitive force – the generosity of the American people.  Dr. Ziad Asali, the American Charities for Palestine, and other government partners who work with USAID are doing just that.  It is our hope that this type of collaboration will take root and serve as a model for other areas of concern as well as encompass other funding streams including that of the international community.

Private Sector Efforts 

Of course, the first line of defense against terrorist exploitation of the charitable sector lies with charities themselves.  On its own initiative, a Muslim-American advocacy group has started to educate its constituency and bolster the capacity of member charities.  Muslim Advocates has taken an important first step by partnering with the Better Business Bureau Wise Giving Alliance to develop a training and certification program encompassing transparency, accountability, and governance related issues.  We strongly support this effort and it is our hope that this type of program will be embraced by other groups and that the original scope will be expanded to also cover terrorist financing issues and preventive measures for charities working in high-risk regions. 

Conclusion

In closing, I hope today's Charity Roundtable discussion helps us all better understand how we can work together to advance our common interests in promoting and protecting charity.  The continued dialogue and work between the federal government and Arab and Muslim-American communities is a critical element in our collective effort to combat those aiming to corrupt our charitable institutions and destroy the liberties we enjoy every day as Americans.  We look forward to continuing our work together on these issues, and I thank you for your participation, concern, and leadership in moving this dialogue forward.

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Remarks by Secretary Henry M. Paulson, Jr.
on the Markets and Economy
at the Exchequer Club

Washington - Good afternoon. Thank you for the opportunity to share my thoughts on the current state of the U.S. economy, and our housing and capital markets.

Data released this morning show that our economy expanded in the second quarter – GDP growth was 1.9 percent. This despite an unusually large inventory reduction which subtracted 1.9 percentage points from growth. Consumption added 1.1 percentage points – with a good boost from the stimulus. Trade continues to drive growth, adding 2.4 percentage points. Earlier this year, before the bipartisan stimulus plan was enacted, many had predicted far slower growth, even approaching zero. Clearly, the stimulus plan has supported the U.S. economy during this difficult period, and couldn't have been timelier. American families spent; companies invested and benefited from strong export growth.

I spent time last fall and winter traveling the country, and heard from many homeowners about their mortgage and other housing difficulties, and of their concerns about the broader economy. I also talked to people in a variety of industries and asked them what their business was telling them about where the economy was headed. My travels, my discussions with industry leaders and a review of the economic data with the rest of the President's economic team convinced me in mid-December that the economy had taken a sharp turn for the worse and the risks were to the downside going forward. President Bush recognized the downturn early, and directed me to work with Congress to craft legislation to bolster both consumer spending and business investment to protect the health of our economy. We all worked together quickly to enact a stimulus package that is temporary, targeted, big enough to have an impact and easy to implement quickly.

On April 28, just 75 days after the President signed the Economic Stimulus Act of 2008, the first electronic deposits were sent into Americans' bank accounts. One week later, the first week of May, paper checks were being printed and mailed. In the second quarter, Treasury employees sent almost 95 million payments totaling over $78 billion to American households. The Financial Management Service managed the high demands of tax season and simultaneously printed stimulus checks; the IRS has handled millions of taxpayer inquiries over the phones and through its website. Given the enormity of the effort, it was accomplished effectively and with minimal disruptions.

The private sector offered promotions that increased stimulus payment buying power. Local and national retailers, from vacation planners to supermarkets, gave incentives, sometimes as much as a 10 percent bonus, to those who spent their checks at those businesses.

We also know that companies are taking advantage of the stimulus package's temporary tax incentives. Businesses ranging from restaurants to computer service providers are using these provisions to invest in their companies and grow. We expect the stimulus to continue to support the economy in the second half of the year.

While the stimulus is making our economy stronger than it would have been otherwise, the housing correction, credit market turmoil, and high energy prices remain a considerable drag on the economy – and the effects of this drag can be seen in the soft job market.

Record high oil prices, which have increased dramatically since year-end, are putting a large burden on the U.S. and the world economy and creating hardships for families, households and industries everywhere. There are no simple or quick remedies for this. High oil prices are the result of supply and demand factors that are likely to persist for some time.

On the positive side, global economic growth from 2002 through the end of 2007 was remarkably strong, averaging over 4 percent. This growth, led by emerging market economies like China and India, has lifted millions of people around the world out of poverty. As living standards improve in emerging economies, demand for oil will continue to rise. Producers, unfortunately, have not made the investments necessary to keep pace with this growing demand. Because production capacity and investment has been curtailed over the last decade, supply now barely offsets declining production in older fields, let alone meets new demand.

Successfully alleviating the pressures in oil markets will require a long-term, comprehensive effort to keep supply on pace with demand. On the demand side, we need to allow market forces to work, to avoid subsidies and other potentially distorting policies. We also need to reduce oil dependency through investments in renewable fuels and alternative technologies, and improved energy efficiency and conservation.

While our economy faces substantial difficulties that will continue to be a drag on growth in the short term, it is important to remember that our long term fundamentals are strong. Recognizing the challenges ahead of us, I expect our economy to continue growing this year although at a moderate pace. We are making progress although not in a straight line; housing continues to be at the heart of our economic challenges and remains our most significant downside risk. We must work through the necessary adjustments in housing and credit markets to return to stronger growth next year and beyond.

It took years of excesses – lax underwriting standards, excessive home price appreciation and overbuilding – to sow the seeds of the housing correction.

That said, we need to recognize that there is not a national housing market, but a collection of regional markets. The severity of the current correction varies widely by state and region. Areas that had some of the most pronounced price appreciation are facing the most pronounced price declines and foreclosure increases. Of course, that does not mean the correction isn't being felt across the nation. Foreclosure starts as a share of total outstanding mortgages have risen from 0.4 percent to 1.0 percent since the beginning of 2006. However, OFHEO's home price data shows that home prices actually rose in about half of the states in the first quarter.

Due to overbuilding in prior years, home inventories are now far above normal levels. At the current sales rate, there is a ten month inventory of new single-family homes on the market, and an 11 month inventory of existing single-family homes. This compares with a historical average of about six to seven months. The key to stabilizing the housing and financial markets is to work through these home inventories as quickly as possible.

Inventories decrease in two ways – fewer homes are built, and more buyers come into the market. We are seeing the necessary sharp decline in homebuilding. Single-family housing starts are down 65 percent from their 2006 peak and look to remain weak through this year.

New home sales appear to have stabilized to a degree – sales of new single-family homes are down 62 percent from their peak; and sales have been flat, rather than declining, for three months now. The drastic slowing in new construction has helped reduce the number of new single-family homes on the market, which is down 26 percent since its 2006 peak. The number of existing homes on the market remains elevated, but there are also tentative signs that sales in this category have been stabilizing since early 2008.

We all recognize that foreclosure sales increase inventories and, as foreclosed homes are put on the market, they drive down prices. Foreclosures and short sales now make up about one-third of existing home sales.

Treasury has worked closely with lenders and key industry participants on an aggressive strategy to do everything possible to help avoid preventable foreclosures. Last summer, we foresaw a wave of struggling homeowners and recognized that without some changes, the industry's protocol would not be able to handle the volume of homeowners seeking assistance. We supported the creation of the HOPE NOW Alliance of industry participants to work to avoid a market failure, in which homeowners who otherwise would have been able to modify or refinance into an affordable mortgage instead lost their homes simply because the system was too overwhelmed to help them. HOPE NOW has been instrumental in this effort and the industry reports that it has helped 1.9 million homeowners avoid foreclosure through loan workouts since last July. At the current pace, nearly 200,000 additional borrowers are helped every month.

From the outset of the HOPE NOW process, I have measured success by whether a borrower who has made all the payments at the initial rate, but couldn't afford the reset and reached out for help avoids going into foreclosure. And so far, the data on this question show an unqualified success. However, given the lax underwriting standards that preceded this correction, some people bought homes that they simply cannot afford. Many of them will become renters again.

Foreclosures and existing home inventories are likely to remain substantially elevated this year and next and home prices are likely to decline further on a national basis. The key question is, "When will the correction be largely behind us?" While home price adjustments will continue for some time, and certainly well beyond the end of the year, I believe we can move through the bulk of the correction in months rather than years.

Of course, to turn the corner mortgage financing must be available. We need more homebuyers to return to the market and buy homes, and to do that they need available and affordable mortgage financing. We have taken several steps to support the mortgage financing market now, and to address some of the structural issues that contributed to the current credit contraction.

In the past year, the FHA has implemented several initiatives to expand access to mortgage credit to troubled borrowers and since last August, nearly 300,000 borrowers have refinanced into affordable FHA fixed rate mortgages. Yesterday, President Bush signed the Housing and Economic Recovery Act into law, which will modernize FHA programs to provide greater access to FHA mortgages, including to some borrowers who are underwater on their mortgage.

More importantly to our system, the new law also includes significant, temporary provisions that will boost market confidence in the two current, largest sources of U.S. mortgage finance, the housing GSEs Fannie Mae and Freddie Mac, and establish the world-class regulator needed to address the systemic risk they pose.

Fannie and Freddie's continued activity is central to the speed with which we emerge from this housing correction and remove the underlying financial market and financial institution uncertainty. The temporary liquidity and capital backstops included in this new law are aimed at supporting the short and longer term stability of financial markets, not just these two enterprises. I would rather not have been in the position of asking for extraordinary authorities to support the GSEs. But I am playing the hand that I have been dealt. We saw a clear need to strengthen Fannie and Freddie's ability to continue to play their important role in financing mortgages and in our capital markets more broadly. There are no plans to access either of these temporary backstops. If accessing them becomes necessary, we would do so only under terms and conditions that protect the U.S. taxpayer.

Over the longer term, it is just as vital to our housing markets and our capital markets that structural concerns about the GSEs be addressed. We have long maintained that the GSEs have the potential to pose a systemic risk and recent events remove any debate on that question. Congress now has created a GSE regulator with authorities appropriate to the task and on par with other financial regulators. We have long sought this result, and our work is far from done. All parties must get to work immediately to begin to address the systemic risk issues posed by the GSEs.

In addition to securitization done by Fannie and Freddie, private mortgage-backed securitization provides additional mortgage funding for U.S. homebuyers. This private-label securitization has become severely strained. The sooner we work through the housing correction stabilizing home prices will do much to alleviate uncertainty about the values of mortgage-related assets. The private-label market will evolve in response to current challenges, and I expect it to return with greater risk-awareness and investor discipline.

As we focus on reinvigorating the traditional sources of mortgage financing, we have studied the range of other available choices. Three days ago, Treasury and U.S. regulators were joined by the nation's four largest banks to announce a Best Practices guide to kick-start the residential covered bonds market. Covered bonds are used for mortgage financing throughout the United Kingdom and Europe, and I believe covered bonds are a promising path for a new source of mortgage financing that will complement our existing system.

The housing correction has fostered capital market strains that are having an impact on the broader economy. Tighter credit standards and increased interest rate spreads affect anyone who wants to buy a house or a car, get a credit card, or take out a loan to pay for school. Credit market strains affect cities, institutions and companies looking to fund long-term projects. Along with the Federal Reserve, we have taken aggressive actions to provide confidence and stability to financial markets, and I continue to urge financial institutions to strengthen their balance sheets by raising capital, de-leveraging and reviewing dividend policies so that they continue to play their vital role in supporting economic growth.

Even in this difficult environment, financial institutions have raised $190 billion in capital. Markets and financial institutions continue to reassess risk and re-price securities across a number of asset classes and sectors. This is a positive return to market fundamentals, and we are making progress. However, until the housing market stabilizes further we should expect some continued stresses in our financial markets.

Our first and most urgent priority is working through the housing downturn and capital market turmoil, and that will be our priority until these situations are resolved. At the same time, we are also examining and addressing the policy issues raised by the events of recent months. Our regulators are shining a light on our challenges, and market practices and discipline on the part of financial institutions and investors are improving. Through the President's Working Group on Financial Markets, the PWG, we have issued a report analyzing the causes of the current turmoil and recommending a comprehensive policy response, implementation of which is well underway. Regulators are enhancing guidance, issuing new rules, and communicating more effectively across agencies – domestically and internationally.

In addition to these immediate actions, the Bear Stearns episode and market turmoil more generally have placed in stark relief the outdated nature of our financial regulatory system, and reinforced my view that it must be updated.

In March, after almost a year of study and analysis, we released our recommendations in the Blueprint for a Modernized Financial Regulatory Structure. It is as compelling now as ever that we need a financial regulatory structure better suited to protect investors, protect the stability of the financial system, support the innovation and risk-taking that fuel our economy and improve both market oversight and market discipline.

In our Blueprint, we recommend a U.S. regulatory model based on objectives that more closely link the regulatory structure to the reasons why we regulate. Our model proposes three primary regulators that are organized by objective rather than functional financial institution category: one regulator focused on market stability across the entire financial sector, another focused on safety and soundness of institutions supported by a federal guarantee, and a third focused on protecting consumers and investors. This structure takes into account the new financial landscape and the role played by non-bank institutions and can more easily adapt to the ever-changing marketplace. Our Blueprint also recognizes the critical role market discipline plays in maintaining stability.

When we released the Blueprint, I was clear that it was a long-term vision that would take time to consider and implement. That is still the case, but today we have both a clear need and a unique opportunity to accelerate this process.

Whether it was Long Term Capital Management in 1998 or Bear Stearns this year, Americans have come to expect the Federal Reserve to step in to avert events that pose unacceptable systemic risk. But, as we noted in our Blueprint, the Fed has neither the clear statutory authority nor the mandate to attempt to anticipate and prevent risks across our entire financial system. Therefore we should consider how most appropriately to give the Federal Reserve the information and authority necessary to play its expected role of market stability regulator. The Fed would need the authority to access necessary information from complex financial institutions -- whether it is a commercial bank, an investment bank, a hedge fund, or another type of financial institution -- and the tools to intervene to mitigate systemic risk in advance of a crisis.

This is a tall order. History teaches us that in a dynamic market economy regulation alone cannot eliminate instability. To be clear, I do not believe that we can eliminate, by regulation or otherwise, all future bouts of market instability -- they are difficult to predict and past history may be a poor predictor of the future. However, just because the overall task is difficult, we should not stop trying to understand and mitigate instability.

To that end, we should create a system that gives us the best chance of foreseeing a crisis, including a market stability regulator with the authorities to avert systemic issues it foresees and providing the information, tools and authorities to deal better with unexpected events when they inevitably occur.

To complement this regulator's efforts, we must have strong market discipline to reinforce the stability of our markets. Market discipline constrains risk most effectively when a financial institution can fail without threatening the overall system.

However, two concerns underpin expectations of regulatory intervention to prevent a failure. They are that an institution may be too interconnected to fail or too big to fail. We must take steps to reduce the perception that this is so -- and that requires that we reduce the likelihood that it is so.

Strengthening market infrastructure will reduce the expectation that an institution is too interconnected to fail. We need to strengthen our practices and financial infrastructure in the OTC derivatives market and in the tri-party repo system. Important work is underway in each of these areas, and needs to be completed quickly.

To address the perception that some institutions are too big to fail, we must improve the tools at our disposal for facilitating the orderly failure of a large complex financial institution. Today, our tools are limited. We have specialized resolution provisions that apply solely to insured depository institutions. For these institutions, this special insolvency regime was deemed necessary because of the role these institutions play in the overall financing of economic activity and the presence of a government guarantee.

In contrast, bankruptcy law serves as the resolution regime for non-depository financial institutions and most corporations. These two very different approaches for resolution have advantages and disadvantages. Bankruptcy imposes market discipline on creditors, but in a time of crisis could involve undue market disruption.

We need to consider broadly the resolution regime in light of a changed financial landscape where non-bank financial institutions play a significantly greater role. It is clear that some institutions, if they fail, can have a systemic impact, so we must give regulators the authorities to limit that impact and facilitate an orderly failure. In my view, looking beyond the immediate market challenges of today, we need to create a resolution process that ensures the financial system can withstand the failure of a large complex financial firm. To do this, we will need to give our regulators additional emergency authority to limit temporary disruptions. These authorities should be flexible and -- to reinforce market discipline -- the trigger for invoking such authority should be very high, such as a bankruptcy filing. As part of this process we should consider ways to ensure that costs are imposed on creditors and equity holders. Any commitment of government support should be an extraordinary event that requires the engagement of the Executive Branch. It should be focused on areas with the greatest potential for market instability and should contain sufficient criteria to ensure that the cost to the taxpayers is minimized.

This period of market stress has revealed broader financial regulatory issues, and we are working to address these on a number of fronts as I have described. We remain focused and vigilant. I am confident that we will work through current challenges and Americans will benefit from an economy that emerges stronger and better poised for robust growth.

Under Secretary for International Affairs David H. McCormick
Remarks at the Peterson Institute for International Economics

“Oil Markets: Principles, Perceptions, and Prices” 

Washington - These are challenging times for the U.S. economy. The economy is slowing in the wake of a significant downturn in the housing sector, tenuous financial markets, and unprecedented commodity prices. Chief among the concerns on the minds of most American consumers is the dramatic rise in the price of oil. High oil prices are an enormous burden on American families and the U.S. economy, as well as families and economies around the world. Further, the growing financial imbalances created by the flow of oil and money between consumers and producers are both concerning and unsustainable.

In January 2002, a barrel of oil cost about $20. By January 2005, the price had more than doubled, and by January of this year, the price had doubled again. Earlier this month, the price approached $150 per barrel. More recently, as concerns about the slowdown of the global economy increased and as fears of hurricane-related disruptions of oil production in the Gulf of Mexico dissipated, the price of oil dropped to its current level of about $125 per barrel.

Today I'd like to discuss why this dramatic increase in price has happened and what we should do about it. Simply put, the world economy – and with it global demand for oil – has been growing rapidly, and the supply of oil has not kept pace. In response, prices must rise to allocate limited supply. These long term trends are indisputable, and they are the primary drivers of the increase in oil prices.

Our challenge is complicated, however, by the fact that the difficulties we face in achieving a secure, stable, and cost-effective worldwide supply of energy are the flip side of the pressing need to address global climate change. There are no simple solutions to these deeply interconnected problems. But there are steps that policymakers can pursue now to put us on a path to a more stable supply of lower cost energy while also reducing the emissions of greenhouse gases. While my remarks today focus on high oil prices, the actions we take on this front -- and in achieving energy security more broadly -- can and must be consistent with our efforts to protect the planet.

On the demand side of the fundamentals story, we start with a positive development. Global economic growth from 2002 through the end of last year was remarkably strong, averaging about 4.25 percent in real terms, led by emerging market economies, like China and India. This has not only benefited millions of people within these countries, but also strengthened industrial economies through access to dynamic, high-potential export markets.

Most of the world's largest energy consumers are industrialized economies. But the growth in emerging markets has been accompanied by an increasing thirst for electricity and automobiles and the consequent extraordinary growth in demand for oil. According to the U.S. Energy Information Administration (EIA), global oil consumption jumped about 9 million barrels per day since 2001, with the lion's share of this increase concentrated in economies where per capita consumption of oil is relatively low.

On the other side of the equation, global oil supply has not kept pace with the remarkable growth in the global economy and oil demand. Between 2002 and the present, the quantity of oil produced has risen at an average annual rate of about 2 percent, less than half the rate of expansion of the global economy. The economics are clear: With strong growth in demand and sluggish increases in production, the price must go up to allocate the limited oil available. This is what we have seen over the past several years.

Why has oil supply growth been slow? First, real investment in new capacity to produce oil has been weak around the world. Oil prices troughed after the Asian crisis in 1997, at one point going below $10 per barrel, as hard as that is to believe right now. At that price, there was minimal investment, capacity and workforces were cut, and spending on exploration fell sharply. In addition, the wave of nationalization of oil production and the increasing concentration of oil resources in global hot spots has resulted in reduced investment.

Most oil fields take years to develop, and in some cases a decade or longer. Because investment has been curtailed over the last decade, we now barely have the oil needed to offset declining production in older fields, let alone increase production to meet new demand. And looking ahead, it is increasingly the case that oil reserves are located where it is geologically difficult to develop them, and even greater investment will be needed to tap these resources.

Second, oil fields go through a natural progression. They start up, peak, and slow down. Over the past few years, a number of major fields are producing significantly less, and that loss has to be made up simply to keep global production flat.

This rising demand and stagnant supply has steadily chipped away at global spare capacity. In the 1990s, spare capacity averaged over 4 million barrels per day. Over the last five years, however, spare capacity has averaged less than half that amount and has dropped even more dramatically as a share of global consumption. Into this mix, we throw the third key factor that has affected the supply of oil – disruptions, or the perception of growing potential for disruption, resulting from events such as wars, civil turmoil, or hurricanes in the Gulf of Mexico. With little spare capacity to buffer against these events, these disruptions, and the fear of possible future disruptions, feed directly into higher prices.

Turning to this year, expectations of supply and demand have changed significantly, and account for most of the rapid run up in price over the past six months. This development is explained by the fact that perceptions about future supply and demand can and do affect prices today.

For example, suppose it becomes clear that there will be a significant decline in the supply of oil six months from now. In that case, if you were a large consumer of oil, what would you do? You would likely buy as much oil as you could now, to avoid paying the future higher price. Yet, by buying the extra oil now, you would motivate the very price increase you anticipated. This also works in reverse. Expected future increases in supply, or future declines in demand, or some combination of the two, decrease the current price.

Over the past year, the market has gradually factored in the realization that supply is not keeping pace with demand. There was no one event that led to this realization. But a collection of small events -- production delays for new oil fields, shortages in oil drilling equipment, surprising resilience of emerging markets as the global economy has slowed, and growing geopolitical uncertainty in the Persian Gulf -- changed market perceptions about current and future oil supply and demand.

We also see that even small changes in fundamentals can have large effects on prices, particularly in tight markets with a limited buffer between supply and demand. Again, back to basic economics: If supply falls by one percent, consumption must decline by an equal amount. That decline is brought about by an increase in price. Unfortunately, it is difficult to get people to reduce oil consumption, because it is so fundamental to everything we do and there are no close substitutes for it at present. Therefore, the price has to rise sharply to induce the necessary changes in consumption. We see this inelastic demand in current prices and feel its effects in our day-to-day lives.

So far, and despite their prominence in the news, I have not mentioned either speculation or currency depreciation. The reason is simple. The effects of these two factors are relatively minor in comparison to changes in the fundamentals that have been building up for a decade or longer. I am not dismissing them completely, but I want to put them in proper perspective. We must not let concerns over these second-order factors distract us from focusing our attention on the root cause of dramatic increases in price – a growing gap between the world's desire to consume oil and its capacity to produce it.

Other Contributing Factors

In oil futures markets, there are three types of participants: hedgers – these are market participants with commercial interests in oil, like oil companies or airlines, that need futures markets to offset the business risk created by volatile prices. Pension and index funds – these are typically funds that seek to diversify their assets with investments in commodities and who buy and hold for the long term. And, short-term investors often referred to as speculators – these are market participants with no commercial interest in oil who bet on future changes in the price.

Investors, whether focused on the long-term or short-term, play a crucial role by supporting a large and liquid oil market that makes it easier and cheaper for hedgers to minimize their business risks. Of course, there are well-documented examples of how small groups of investors have cornered markets in the past by hoarding physical commodities. This behavior is better known as "manipulation," and is rightly illegal. The Commodities Futures Trading Commission (CFTC) routinely polices markets and prosecutes such manipulation, and currently there is no evidence of hoarding. According to the EIA, inventories in the United States, and industrial countries more generally, are falling. Moreover, the CFTC's market monitoring shows that net positions of short-term investors have not grown relative to the overall market over the past two years, precisely the time at which they are being accused of causing the price of oil to soar.

Short-term investors can move prices – sometimes in a good way, like when they quickly move the market to incorporate the latest information, and sometimes in a bad way, like when they get caught having to "buy back" large bets on price swings that don't materialize. Clearly, they can contribute in this way to the volatility in prices that we have seen in recent months. However, by creating a large and liquid market, they also help reduce volatility, and over the longer haul, short-term investors do not systematically move prices away from the levels dictated by the fundamentals of supply and demand.

Some also assert that investors pouring money into oil futures contracts are driving up the price. Once again, however, there is little evidence to suggest that investment flows into futures are causing the rise in the price if oil. For example, the prices of other commodities, for which there are no futures markets and in which these funds are not investing, have risen as much or more than oil. As with oil, global demand for these commodities has increased dramatically, while supply has not kept pace. Fundamentals, not investment flows, are driving increases in these commodity prices and in oil.

Similarly, the effect of the depreciation of the dollar on oil prices is relatively small. The price of oil has soared regardless of the currency in which its price is quoted. For example, since early 2002, the euro-price of oil has shot up 250 percent, and the yen-price jumped 400 percent. Further, in the past 120 days, the dollar price of oil has risen more than 20 percent, while the real value of the dollar has changed very little.

It is true that a decline in the value of the dollar could result in higher demand for oil in countries whose currencies appreciate against the dollar. Everything else being equal, the price of oil in their local currency is cheaper and therefore could stimulate demand. However, over the last two years, consumption of oil in Europe has been flat, despite a strong appreciation of the euro against the dollar, suggesting that there are other factors more important than currency movements.

In many ways, I wish the problems we face were as straightforward as speculation or currency depreciation. Unfortunately, in addressing long-term trends in the supply and demand for oil there are no easy solutions. We must take significant, credible, and comprehensive action today to change the dynamics of energy supply and demand in the longer term. Such steps will not only help over time to resolve the gap between supply and demand, but will also result in lower prices in the present.

First, we must better understand this rapidly changing market. Efforts to study the dynamics of the oil market are already underway. The International Energy Agency and the IMF have been charged by the G-8 Finance Ministers to dig deeply into the root causes of this problem. Similarly, the interim CFTC report released last week and the final study to be released in September are an important contribution to this debate. There are also much needed efforts underway to improve the available data on financial flows in oil futures markets, oil inventories, and proven reserves. Better data and more transparency will greatly reduce the uncertainty that contributes to higher prices.

Second, in terms of supply, we must cultivate an open investment climate at home and abroad through bilateral investment treaties, free trade agreements, and pro-investment policies. Greater investment in oil production and refining capacity, as well as in alternative sources of energy, is urgently required. Production in key countries such as Mexico, Russia, and Venezuela is declining, the vast majority of the world's oil reserves are nationally-owned, and one third of reserves are in countries that allow no foreign investment. Policies that restrict market access deny these markets much needed capital, know-how, cutting-edge technology, and entrepreneurism.

We also need to invest more within our own borders, and we need to do so in an environmentally sustainable way. A few weeks ago, the President lifted the executive ban on exploration of the Outer Continental Shelf, and he has called for America to do its part to increase the global supply of oil by increasing domestic exploration, leasing oil shale on federal lands, and streamlining the refinery permitting process. These measures have the potential to increase domestic supply in the long run and to bring far greater credibility to our efforts to encourage increased production overseas.

We must also pursue energy diversification by increasing investment in alternative sources of energy in the United States and around the world. In this regard, the government can play an important role by supporting basic research on critical technologies and creating market incentives for the private sector to develop and rapidly deploy alternative energy sources. Under President Bush's leadership, the United States has made real progress in these areas. Since 2001, we have spent more than $12 billion to research, develop, and promote alternative energy sources. Similarly, as a result of the President's renewable fuels mandate, use of these types of fuels is projected to exceed 8 percent of the U.S. gasoline supply by 2015, more than double the 4 percent that it is today.

Of course, with the price of oil at roughly $125 per barrel, the private sector has every incentive to invest in alternative energy, and here we see market forces already at work. For example, electric cars are actually being produced by several start-up companies, and established U.S. automobile manufacturers plan to introduce their own electric vehicles as early as 2010. Given the magnitude of the challenge, we and other nations must accelerate our efforts to develop and deploy these and other game-changing technologies, such as modern, safe nuclear facilities, wind power, and carbon capture and sequestration that are on the cusp of widespread commercialization.

Third, we must take steps to stem global oil demand. To this end, President Bush has implemented the first significant increase in car fuel economy standards in more than two decades. We can also work to better educate consumers on how they can conserve as they make energy conservation a social and financial priority. For example, in response to high fuel prices, a recent Gallup poll indicated that more than 80 percent of Americans are taking steps to cut back on their daily driving, and we already see the effect in a four percent decline in U.S. gasoline consumption this year.

Also on the demand side, we should ensure that critical price signals are not obscured by subsidies. Currently over 50 percent of the world's population has access to subsidized fuels (and 22 percent of all gasoline purchases are subsidized). We don't expect countries to remove all subsidies tomorrow, and we welcome the steps that some countries, like China and India, have already taken. But the countries that subsidize need to develop a plan to eliminate subsidies over time. Just formulating and beginning to implement a credible plan could impact current oil prices. Not only will such efforts result in greater market transparency that will allow price signals to lower global demand for oil, but they will remove a significant economic burden on governments that subsidize, allowing them to dedicate these resources to more productive purposes.

The list of potential policy options is long, and I have only highlighted a few of the many that should be pursued. Ultimately, a complete package of actions must be taken by energy producers and consumers alike to reduce oil consumption, increase the diversity of energy supply, and put prices on a lower and more stable trajectory.

We face a great challenge, but we are no strangers to adversity. Addressing it will require new investment, new innovation, and significant changes in how we consume and conserve energy, but in a way that maintains the vibrancy of America's economy.

Because the dramatic rise in the cost of oil is a global dilemma, it is one that we must tackle in concert with others. Affordable, environmentally-sound, and economically sustainable energy supply is in the interest of the entire global community -- producers and consumers, developed countries, and those developing. Success will require us to take tangible, credible, and significant steps to address the fundamentals of supply and demand, and, to do so in a way that substantially reduces global carbon emissions in the coming decades.

To overcome this enormous challenge, Americans must do what we have always done – adapt, innovate, persevere, and prevail. I am confident we are up to the task.

Remarks by Secretary Henry M. Paulson, Jr.
on Reinforcing Market Stability and Confidence
at the New York Public Library

Washington, DC-- Thank you, Catie. I appreciate this opportunity to join you this morning to give my thoughts on current market conditions.

As we all know, the U.S. economy and our financial markets are undergoing a period of stress. We will work through this period, as we always do. Our workers, industries and companies are the most productive, resilient and innovative in the world. Periods of economic difficulty are not new. They are, unfortunately, inevitable. Yet, after every such period, the United States emerges stronger and better poised for robust growth. This time will be no different.

My focus and highest priority is on stability and confidence in our markets and our financial institutions. Orderly and stable markets are critical for the functioning of our economy and to minimize the impact of the current turmoil on the broader economy. Through stable markets, financial institutions make funds available for small and large companies to borrow and grow, for the entrepreneur to start a new business, for families to buy homes and cars and pay for their children's educations. When people and companies save, borrow, and invest, they put their faith in our markets and our financial institutions.

Working through the current turmoil will take additional time, as markets and financial institutions continue to reassess risk and re-price securities across a number of asset classes and sectors. I have and will continue to encourage financial institutions to strengthen their balance sheets by raising capital, de-leveraging and reviewing dividend policies so that they continue to play their vital role in supporting economic growth. Even in this difficult environment, U.S. financial institutions have raised over $150 billion.

Yet, market challenges have also required policymakers to develop unique solutions. In the Bear Stearns situation, the Federal Reserve took the appropriate and necessary actions for market stability, not just by accepting collateral for a loan to JPMorgan Chase to finance the purchase of Bear Stearns, but also in opening a lending facility for investment banks. Today, our number one priority is market stability as we work through the current market stress. Looking forward, we must balance two very important priorities – better regulation through a more effective updated regulatory structure on the one hand and market discipline to limit moral hazard on the other. A stable system requires that risk-taking bring both reward and loss. Market discipline plays an enormous role in curtailing excessive risk-taking, a role that neither can nor should be completely executed by regulators.

Following the Bear Stearns episode in March, markets became calmer. However, as I often note, our markets won't make progress in a straight line and we should expect additional bumps in the road. We have been experiencing more bumps recently, and until the housing market stabilizes further we should expect some continued stresses in our financial markets.

Last week, our markets witnessed the failure of IndyMac Bank. It was the third largest bank failure in U.S. history and worthy of attention. Yet as large as IndyMac is, it represents only 0.2 percent of total banking industry assets. Well-defined policies and procedures exist for those relatively few times when a federally-insured bank does fail, and these protect deposits which are insured up to $100,000 per account and help prevent one failure from destabilizing broader financial markets. We saw this in practice at IndyMac. The FDIC took over the bank on a Friday, worked effectively over the weekend, and on Monday morning the bank re-opened for business as usual. No one has or will lose a penny of insured deposits.

The American people have every reason to remain confident that the U.S. banking system is sound. The FDIC has made clear that of the nearly 8,500 insured banks and thrifts that comprise the U.S. banking system, 99 percent are well-capitalized. One thrift and four commercial banks have failed this year; during the 1980's Savings & Loan Crisis there were an average of 255 failures per year – the circumstances then are hardly comparable to today.

And bank failures do not spring up overnight. Regulators carefully monitor all insured banks' adherence to capital ratios and, if an institution is troubled, the bank and the regulators actively work together to avoid a failure.

Beyond the insured depositories the financial services industry has changed, and non-bank financial institutions now play a significantly greater role. Our current financial regulatory structure does not adequately reflect this new reality.

Treasury made our recommendations for an optimal structure when we released our Blueprint for a Modernized Financial Regulatory Structure last March. We recommend a U.S. regulatory model based on objectives that more closely link the regulatory structure to the reasons why we regulate. It takes into account the new financial landscape and the role played by non-bank institutions. Because our model is organized by regulatory objective rather than by financial institution category, it can more easily respond and adapt to the ever-changing marketplace. Our Blueprint also recognizes the critical role market discipline plays in maintaining stability.

Looking beyond today's market challenges, we need to get to the point where large, complex financial institutions are not perceived to be too big or too interconnected to fail. Essential to this objective is improved market infrastructure and operating practices to increase transparency and efficiency, especially in the OTC derivatives market and the tri-party repo system. Improved infrastructure will add to market stability and mitigate the likelihood that a failing institution can spur a systemic event. We also need additional powers to manage the resolution, or wind-down, of large non-depository financial institutions, such as larger hedge funds, so as to limit the impact of a failure on the broader financial system.

Finding the right balance between market discipline and market oversight is going to require additional progress on the part of market participants and policymakers. While doing so, it is critical that we maintain the market stability and innovation necessary to support vibrant economic growth.

Over the last several weeks, the need to move more quickly toward an optimal regulatory structure that establishes a prudential financial regulatory system, focused on promoting long-term market stability has become all the more apparent. I look forward to working with Congress and government regulators to achieving this goal.

As you know, today we are also working closely with Congress to immediately address the current challenges presented by the housing GSEs Fannie Mae and Freddie Mac, which are among the largest and most interconnected of all global financial institutions. Of the $5 trillion in debt and mortgage backed securities guarantees issued by these two GSEs, over $3 trillion is held by domestic financial institutions including commercial banks, savings and loans, and credit unions, and over $1.5 trillion is held by institutions and central banks overseas. Because of their size and scope, Fannie and Freddie's stability is critical to financial market stability. Investors in our nation and around the world need to know that we understand how important these institutions are to our capital markets broadly, and to the U.S. economy.

The GSEs are also currently the largest sources of mortgage finance in the United States. Their continued activity is central to the speed with which we emerge from this housing correction and remove the underlying uncertainty in our financial markets and financial institutions.

Turning the corner on the housing correction requires homebuyers to return to the market, and homebuyers need available and affordable mortgage financing. Housing is not only important to our economy; it is also the largest factor currently impacting our financial markets. The sooner we work through the housing correction, the sooner home prices will stabilize, and uncertainty about the values of mortgage-related assets will be more easily determined. So now, more than ever, we need Fannie and Freddie out there, financing mortgages. That means we must, in the short term, take steps to boost confidence in the GSEs, while also taking steps to address the potential systemic risk they pose.

My views on their structure are well known – they are an odd construct, with a difficult dual mandate to serve both a public mission and private shareholders. The GSEs are providing an essential function when they securitize and guarantee high-quality mortgages. This attracts capital into mortgage markets and lowers borrowing costs for homebuyers.

For years, we have advocated that the GSEs need a stronger and world-class regulator, with the authorities appropriate and necessary for the task. From the time I arrived in Washington I have worked with Congress to achieve this objective. Congress is very near completing its work to create that regulator, and it must do so quickly. And, as it does so, last week we asked for the addition of temporary provisions to promote market stability and confidence – not just in the GSEs but throughout the financial system.

Recent developments convinced policymakers and the GSEs of the need to increase confidence and respond to market concerns by providing assurances of their access, if necessary, to liquidity and capital on a temporary basis.

After consultations with Congressional leaders and U.S. financial regulators, last week I put forward a proposal that will accomplish this in two phases. The proposal is aimed at supporting the short and longer term stability of financial markets, not just these two enterprises. I would rather not be in the position of asking for extraordinary authorities to support the GSEs. But I am playing the hand that I have been dealt. There is a need to support efforts that strengthen Fannie and Freddie's ability to continue to play their important role in financing mortgages and in our capital markets more broadly.

The first phase of our proposal is aimed at immediate market confidence and stability. I have asked Congress to provide temporary authority for 18 months to provide a liquidity backstop and a capital backstop to the GSEs. There are no plans to access either of these. As I assured Congress last week, if using either of these authorities does become necessary, we would do so only under terms and conditions that protect the U.S. taxpayer and are agreed to by both Treasury and the GSE.

We need to act in the short-term because the GSEs are vital institutions in our capital markets today and are vital to emerging from the housing correction. We also know that for long-term market stability we must address the potential systemic risk these entities pose to taxpayers and markets going forward

That's why we are urging Congress to finish legislation creating a world-class GSE regulator, including a consultative role for the Federal Reserve in the new GSE regulator's process for setting capital requirements and other prudential standards. As this new regulator implements its mandate, we expect and welcome a larger examination of the structural issues inherent in these GSEs, so that we don't find ourselves in this same position again in the future.

I have been consulting closely with members of Congress from both houses and both sides of the aisle. I am confident they recognize the demands of the current situation, and will act to complete work on this legislation this week.

I am well aware that financial market and housing challenges continue to concern America's families. Progress has not come in a straight line, and we need to remain patient as we work through these challenges. Policymakers and regulators are vigilant in our efforts. We are using all available tools and seeking new ones, not merely for immediate concerns but also to do what we can to ensure that these issues do not recur.

I believe that the United States is on the right path to resolving market disruptions and building a stronger financial system. Increasingly, our capital markets will reflect the underlying economy, and here we are fortunate that our long-term fundamentals are strong. Thank you and I am pleased to answer your questions.

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Acting Under Secretary for Domestic Finance Anthony Ryan
Remarks on Effective Capital Markets and Market Discipline

Boston- Good afternoon and thank you for inviting me to join you today.  Before moving to Washington, D.C., I spent twenty years working in financial services here in Boston and so it's good to be back.  As a Red Sox fan like many of you, I regularly read the great sports-writers of the Boston Globe as they contribute to the perennial sports debate about how offense sells tickets but defense wins championships.  While the debate can make for good talk radio, successful coaches can attest that you need both to be competitive over the long run.

Good pitching and good hitting complement one another.  Strong defensive players create opportunities for the offense.  Likewise, the opposite is also true.  Good offense helps defense.  You can't tell me that when Big Papi hits a three run shot during the bottom of the 8^th inning, that Jonathan Papelbon doesn't feel a bit more confident when he takes the mound to start the 9th inning.  The reality is, they are complementary, and collectively they define a winning strategy.

Today, I would propose that the strategy for developing strong, competitive, sustainable and efficient franchises, is not limited to just sports teams, but can be applied to capital markets as well.  The hallmarks of a successful player or sports franchise, innovation, flexibility, leadership and discipline, are also traits of successful financial institutions.  These traits are also complemented by appropriate oversight and regulations.  Collectively, these efforts create a system that delivers benefits to the broader group: in the case of a sports franchise, to the league and business, and in the case of capital markets, to our economy.

During the last several weeks, we unfortunately have seen the consequences of having large, innovative financial institutions without appropriate oversight.  Fannie Mae and Freddie Mac are currently the largest sources of mortgage finance in the United States.  Their operations grew exponentially over the last decade.  This Administration has pushed hard for many years to update and strengthen the GSEs' regulator, so it has powers comparable to bank regulators.

There is little doubt Fannie Mae and Freddie Mac have an effect on overall market stability and must have improved oversight.  To address market stability issues immediately, the Secretary has asked for temporary authority to extend an increased line of credit as a liquidity backstop and for the ability to provide a capital backstop to the GSEs.  The second part of the Secretary's proposal is to include a consultative role for the Federal Reserve in the new GSE regulator's process to set capital requirements and other prudential standards.  The Secretary has asked that these new provisions be included in the House- and Senate-passed GSE legislation.  We have been working closely with Congress and expect this legislation to be completed soon.

Market Discipline

Effective capital markets and effective regulatory policy do not happen independently; quite the contrary.  The fact is, success is inter-dependent, and the relationship requires cooperation, interaction, and some level of mutual dependence.

In seeking to achieve investment objectives, you and your clients confront many types of risk, ranging from counterparty and liquidity issues to reputational and even career risk.  Successful investors must recognize and manage these and other risks effectively.  When private-sector participants act in their own self-interests, they exercise their powers of analysis and reason, in turn defining and establishing market discipline.  Market discipline is critically important and serves multiple purposes.  It serves to aid investors individually, and it also serves to mitigate the likelihood and severity of a systemic event.

However, despite its many virtues, the presence of market discipline should not be taken for granted.  Simply put, it can be compromised and undermined.  Potential costs, complacency, and the search for fast and easy rewards can weaken such self-restraint.

In fact, the erosion of market discipline contributed greatly to the challenges we are addressing today.  These breakdowns in the system will continue to occupy policy makers and market participants for years to come.

In order to sustain a recovery, we need to see changes in market practices and today I want to discuss the reforms outlined by the President's Working Group on Financial Markets (PWG).  However, recommendations alone will not fix this problem.  Meaningful change is difficult and it will require leadership.  As leaders within your field, you are the ones who can provide the necessary leadership to implement the reforms that are required to restore market disciple and help bring stability back to the financial markets. 

After undertaking a rigorous review of the underlying causes of today's turmoil, the PWG released a policy statement in March that included specific recommendations to address the underlying weaknesses that caused the disruptions in our capital markets.

These recommendations cover the practices of a broad array of market practices and participants, including originators of credit, financial institutions, rating agencies, investors, and regulators.  The implementation of these recommendations has already begun moving forward, with all parties playing a role.  Let me share with you an interim status report. 

Mortgage Origination

The first area addressed by the PWG was mortgage origination.  In order to restore market discipline, the PWG called for several areas of reform: stronger government oversight of brokers and others involved in the origination process; stronger incentives for originators to use robust underwriting standards and procedures; and vigorous enforcement related to fraudulent transactions and schemes that take advantage of households facing foreclosure.

A Nationwide Mortgage Licensing System has been established to ensure strong, uniform licensing standards for mortgage brokers across all fifty states.  Additionally, both the House and Senate have passed legislation that would set minimum standards for licensing and require states to participate in the licensing system or else be subject to a similar licensing database and registration system created and overseen by the Department of Housing and Urban Development.

Federal supervisory agencies have also adopted new policies that will improve mortgage origination.  First, federal regulators have issued guidance to improve the underwriting of subprime mortgages, and state authorities have issued comparable guidance in this area.  Second, the Federal Reserve has approved changes to Truth in Lending Act (TILA) rules to address concerns about incomplete or misleading mortgage loan advertisements and to require lenders to provide mortgage disclosures more quickly. 

The Federal Reserve is also reviewing TILA rules relating to disclosure and is testing potential types of disclosures with consumer focus groups.  This work will continue into early 2009.   Additionally, under its HOEPA authority the Federal Reserve has finalized new rules that address abuses related to prepayment penalties, failure to escrow for taxes and insurance, stated-income and low-documentation lending, and failure to give adequate consideration to borrowers' ability to repay. 

Finally, working together, federal and state authorities have initiated a pilot program to review compliance with consumer protection laws and regulations on underwriting and management oversight at selected non-depository lenders having significant subprime mortgage operations.

Ratings Practices

The second area the PWG addressed was ratings practices.  Here we sought reforms to the processes for rating structured credit products to ensure integrity and greater transparency so that investors can make better-informed decisions.  To achieve this goal, the PWG recommended that the credit rating agencies disclose their review of originators and underlying collateral, assumptions and models, performance measures, and any conflicts-of-interest.  We also want clearer explanations of the meaning and methodology for ratings of structured products.   

Actions are being taken here too.  A group led by the Securities Industry and Financial Markets Association (SIFMA) is responding to the PWG recommendation with representatives of all constituents to develop further steps that can be taken to ensure the integrity and transparency of ratings, and to foster appropriate use of ratings in risk assessment. 

On the supervisory front, the SEC recently issued three sets of proposed rules.  The first two bring increased transparency and integrity to the credit ratings process.  The third set encourages independent risk analysis by investors and makes clear the purposes and limits of credit ratings for structured products.  Taken together, these proposed rules will bring a number of specific improvements to the ratings process.  First, they address conflicts of interest by prohibiting credit rating agencies from rating products that they structure.  Second, they require rating agencies to review and publicly disclose information on the underlying assets before a rating is released on a structured product. 

Next, the proposed rules will require public disclosure of ratings actions and ratings performance measures.  In addition, the rules specify disclosure of the way that rating agencies rely on third-party due diligence, how frequently credit ratings are reviewed, whether different models are used for surveillance than for initial ratings, and whether changes made to models are applied retroactively to existing ratings.

Notably, the rules also call for differentiation of ratings for structured products from ratings for corporate and municipal securities.   This may be accomplished either through different symbols or by issuing a report disclosing the differences between ratings of structured products and other securities.  Finally, other rules seek to ensure that the SEC's own regulations do not encourage investor over-reliance on ratings issued by ratings agencies.  The SEC currently is accepting comments on these rule proposals and likely will promulgate final rules later this year.

The PWG is reviewing these changes to determine if these reforms are sufficient to ensure the integrity and transparency of ratings.

Investor Awareness of Risk

With the erosion of market discipline many market participants lost sight of the need for robust risk awareness, and so the PWG also made several recommendations in this area.  First, the PWG called for stronger independent assessment of information by investors, fiduciaries, and asset managers to reduce the reliance on ratings agencies.  In order to facilitate this independent risk assessment, the PWG also called for enhanced disclosure by originators, underwriters, and sponsors about the collateral used in structured credit products.  Finally, the PWG recommended that firms need to improve their disclosure about exposure to off-balance sheet vehicles such as asset-backed commercial paper conduits. 

There are many actions are being taken on this front as well.  The PWG recommended the formation of another private-sector group to develop recommendations and best practices for improved disclosures for structured products.  A group led by the American Securitization Forum (ASF) has developed a draft template for information that should be disclosed to investors that will serve as the basis for disclosure templates for other structured products.  The industry already has a template for the disclosure of critical information to asset backed commercial paper investors that is gaining widespread acceptance and is being rapidly adopted by industry participants.  Other recommendations from this broad coalition of industry participants are expected later this year.

Overseers of institutional investors are providing guidance for investors and asset managers regarding obtaining sufficient information from sponsors and underwriters about the risk characteristics of structured products.  Supervisors are planning on issuing guidance for underwriters and sponsors of structured finance products requiring them to publicly disclose ratings shopping.

Risk Management

Risk management is another area where we must have improved risk management practices.    Strengthened risk management practices at financial institutions, increased oversight of institutions' risk management practices, and more robust valuation models for complex, mortgage-related, and structured products are requirements for strong capital markets.  

Global financial institutions are already identifying and are working to address weaknesses in risk management practices.  The PWG supported the formation of a private-sector group to reassess implementation of the Counterparty Risk Management Policy Group II's existing guiding principles and recommendations regarding risk management, risk monitoring, and transparency, and to modify or develop new principles and recommendations as necessary to incorporate lessons from the recent turmoil, including lessons regarding valuation practices.  This new group intends to issue a report later this summer that focuses on four areas of reform:  financial institutions' risk management practices; complex financial products; off-balance sheet activities, including accounting policy and disclosure; and financial market infrastructure, including OTC derivatives.

Supervisors of global financial institutions are closely monitoring the firms' efforts to address risk management weaknesses and taking action if necessary to ensure that weaknesses are addressed.  U.S. banking regulators and the SEC are assessing current guidance and developing common guidance to address risk management, including improvements to management information systems; concentration risk management, liquidity risk management, stress testing, and other risk management practices that are necessary to ensure that liquidity and capital cushions are sufficiently robust to absorb extreme system-wide shocks. 

U.S. authorities are encouraging other supervisors of global firms to make complementary efforts to develop guidance along the same lines.

Regulatory Practices and Market Infrastructure

The PWG also is working on implementing initiatives regarding two other areas: regulatory practices and market infrastructure.  Here we are enhancing regulatory policies to ensure strong risk management practices.  We are addressing regulatory capital requirements for firm-wide exposures and both on- and off-balance sheet exposures, and ensuring liquidity cushions are forward looking and adjust appropriately through credit cycles.  We also are engaged in efforts to ensure that reporting and disclosure of off-balance sheet vehicles is enhanced.

With respect to market infrastructure, we are encouraging the development of an integrated operational infrastructure for the over-the-counter (OTC) derivatives market that ensures accuracy and timeliness of trade data submission, resolution of trade matching errors, and integrated processing.  We are calling for a cash settlement protocol adopted by market participants and incorporated into standard documentation, and for netting, novation and clearing of OTC derivatives contracts by a centralized counterparty.  In addition, we are addressing the risks surrounding tri-party repurchase agreements, and the short-term financing and systemic risk implications for capital markets.

Hedge Funds

As hedge fund managers, there is a special role you must play.  Over a year ago, the PWG released principles and guidelines regarding private pools of capital.  While private pools of capital bring many advantages to our capital markets, they also pose challenges, including systemic risk and investor protection.  We must rely on a combination of strong market discipline and regulatory policies to address these risks. 

In September 2007, the PWG tasked two private-sector committees, an Asset Managers' Committee and an Investors' Committee, to develop best practices for their respective groups.  Their draft practices were released for public comment in April, and the groups will release final reports this summer.

Similar to your "Sound Practices for Hedge Fund Managers," the draft "Best Practices for Asset Managers" calls on hedge funds to adopt comprehensive best practices in all aspects of their business, including the critical areas of disclosure, valuation of assets, risk management, business operations, compliance and conflicts of interest.  The report recommended innovative and far-reaching practices that exceed existing industry standards, and calls for increased accountability for hedge fund managers.

The "Best Practices for Investors" includes both a Fiduciary's Guide and an Investor's Guide.  The Fiduciary's Guide provides recommendations to individuals charged with evaluating the appropriateness of hedge funds as a component of an investment portfolio.  The Investor's Guide provides recommendations to those charged with executing and administering a hedge fund program once a hedge fund has been added to the investment portfolio.  These best practices offer a guide for responsible investment in hedge funds.  It is critical to see them implemented.

There also is a need to move forward on a longer-term, strategic basis.  Treasury released a Blueprint for Financial Regulatory Reform in March 2008.  The current U.S. regulatory structure is not optimally positioned to address the modern financial system with its diversity of market participants, innovation, complexity of financial instruments, convergence of financial intermediaries and trading platforms, and global integration and interconnectedness.

We suggested in the Blueprint a new framework, one that includes a market stability regulator with broad powers focusing on the overall financial system.  The market stability regulator would have the ability to evaluate the capital, liquidity, and margin practices across the entire financial system and their potential impact on overall financial stability.

To do this effectively, the market stability regulator would have the ability to collect information from commercial banks, investment banks, insurance companies, hedge funds, and commodity pool operators.  Rather than focus on the health of a particular organization, the market stability regulator would focus on whether a firm's or industry's practices threaten overall financial stability.  It would have broad powers and the necessary corrective authorities to deal with deficiencies that pose threats to our financial stability.

Our ambition is to frame the debate and put forth a model that can guide all stakeholders as we seek to modernize our financial regulatory structure.

Conclusion

We have a great deal to accomplish in the months ahead.  As stakeholders in the asset management industry you must continually uphold and enhance the highest quality standards of excellence.   Failure to do so only compromises an industry with deep roots and a proud legacy.   It is a privilege to be entrusted with the public's interest and capital.  With such a privilege comes great responsibility.  To achieve our goals we need to recognize that the responsibility is borne by both the private and public sectors.  Building upon the efforts to date, all stakeholders must continue to do more.  Collectively, we can strengthen the vitality, stability and integrity of our capital markets. 

Thank you again for the opportunity to speak here today.

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