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U.S. House of Representatives,
Subcommittee on Domestic and International Monetary Policy,
Committee on Banking and Financial Services,
Washington, DC.

    The subcommittee met, pursuant to call, at 2:10 p.m., in room 2128, Rayburn House Office Building, Hon. Paul Ryan, [Member of the subcommittee], presiding.

    Present: Representatives Ryan of Wisconsin, Lucas, Toomey, and Moore.

    Mr. RYAN. Good afternoon. I would like to call the first hearing of the Monetary Policy Subcommittee. I would like to announce the first panel, Senator Charles Schumer. On the second panel we will have Paul McCulley, the Executive Vice President and Portfolio Manager for Pacific Investment Management Company; Robert Shiller, Professor of Economics at Yale University; and Steve Galbraith, a Principal Senior Research Analyst for Investment Banks and Brokers at Sanford C. Bernstein and Company.

    We will begin with the first panel, Senator Schumer. It is a pleasure to have you here today on the issue of margin lending. I would like to start with a brief opening statement.
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    I am very interested in this topic. It is one that has become quite a hot topic lately. Last month, the Federal Reserve Chairman, Alan Greenspan, testified before this committee here to give his view of the current state of the economy and monetary policy. At that hearing Chairman Greenspan stated, ''How the current wealth effect is finally contained will determine whether the extraordinary expansion that it has helped foster can slow to a sustainable pace without destabilizing the economy in this process.''

    While the Federal Reserve does not normally concern itself with the price levels of various indexes in the stock market, some economists argue that the Fed's recent focus on the wealth effect has led it to focus on equity price levels to a greater extent than ever before. Chairman Greenspan's latest testimony explains why stock market levels may have been one of the key factors in determining monetary policy. On February 17 his testimony observed that, ''Historical evidence suggests that perhaps 3 to 4 cents of every additional dollar of stock market wealth eventually is reflected in increased consumer spending practices. A sharp rise in the amount of consumer outlays relative to disposable income in recent years, and the corresponding fall in the savings rate has been consistent with the so-called wealth effect on household purchases.''

    Now, if you take the increase in market value of all stocks in 1999, and multiply it by 3.5 percent, you can determine that the rise in the stock wealth in 1999 increased annual consumption by roughly $96 billion. This accounts for about 30 percent of the growth in consumer spending. And because consumer spending accounts for two-thirds of overall U.S. economic growth, the Fed fears that continued acceleration in consumer spending will cause the economy to overheat.
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    After Chairman Greenspan's Humphrey-Hawkins testimony, finding a method to contain the wealth effect has become quite a hot topic of debate for Congress and market analysts. Many economists, including those of Morgan Stanley and DeutscheBank, argue that raising margin lending requirements may be a better approach than raising general interest rates, something we will be discussing here today. Our hearing will focus on whether or not the Federal Reserve interest rate decisions should be influenced by market valuation and speculation and, if so, the appropriateness of responding to the financial markets with general rate increases as opposed to marginal lending requirements.

    Raising short-term interest rates is the normal method by which the Fed FOMC usually influences the direction of the economy. The leading firms of Wall Street unanimously expect the Federal Open Market Committee will raise its Federal funds rate by about a quater point at the March 21 meeting. This would be the second rate hike this year after a similar move of the February 1 and 2 FOMC meeting and three others in 1999.

    What is the cause for these gradual interest rate increases? Normally, the Federal Reserve would look to signs of inflation in the labor markets, various commodity price indexes, and other leading indicators of inflation. Despite phenomenal growth in the economy and record levels of employment, these traditional inflation indicators show little signs of inflation at this time, excluding the sharp rises we are now experiencing in the oil industry sectors. In searching for a rationale behind the recent increases by the Fed, many economists have focused on the wealth effect and its relationship to stock prices.

    The wealth effect can be described as increased spending by consumers due to an increase in capital gains. The last few years have seen a meteoric rise in stock wealth and property values. These factors have contributed to increased spending.
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    Chairman Greenspan has often cited his concern that this additional spending may create greater demand than potential supply, which would result in inflation. The Fed's quarterly flow of funds report found that Americans held $13.33 trillion in stock, including individual investment accounts, mutual funds, and shares in employee controlled retirement accounts at the end of 1999. That is up from $10.6 trillion in 1998. Stock holdings meanwhile made up an ever larger share of overall household wealth, accounting for 31.7 percent of net worth in 1999, up from 28.34 percent in 1998. This additional stock wealth may partly account for the increasing role of stock wealth as a factor in the wealth effect.

    In his effort to contain the wealth effect, Chairman Greenspan has set the goal of limiting the increase in stock prices to match the growth in personal income which has averaged about 6 percent in recent years. By setting a target of the growth of the stock market, Chairman Greenspan appears to have set on a course of increasing general interest rates until stock prices fall into line with the more moderate growth of personal income.

    Normally when the Fed increases the short-term rates the dollar strengthens, bond rates rise, stock prices fall. But the Fed's recent spate of interest rate hikes have not been successful in lowering certain segments of the stock market and particularly not the so-called new economy stocks of biotech, Internet, and telecom companies. Recently the values of the new economy stocks listed on NASDAQ had greatly increased in relation to the value of old economy stocks. For instance, the Wilshire 5000 index has increased by nearly 23 percent for five years running, but it has risen very little this year. The same is true for the Dow Jones and the S&P 500. After years of market increases, they have fallen relatively flat since January 2000.

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    But on the other hand, the NASDAQ composite index, heavy in new economy stocks, is up around 40 percent this year in the last three months alone, despite some recent losses. This is leading us to the question of whether or not Chairman Greenspan's strategy is working for the stock market in general, but not for the hyperactive NASDAQ index. The new economy stocks are much less susceptible to increases in short term interest rates since the high tech companies can raise money through stock sales and therefore rely less on interest sensitive bank loans.

    How to tame these high flying stocks becomes even more critical as it appears that the Fed is resolved to lower the growth in stock prices with general interest rate increases which have negative secondary effects on the average Americans who want to purchase homes, cars, finance their children's educations and so forth.

    This is a great issue that we are here to discuss today. It is a new issue and I am very excited to hear from you, Senator Schumer, and from the forthcoming witnesses. If the Federal Reserve is concerned about these stock price levels in its effort to contain the wealth effect, then it would seem reasonable to consider focusing its efforts on the primary source of soaring stock increases, specifically the new economy stocks which are relying more on marginal lending than others.

    Let's have a good hearing to discuss these things. I am very interested in your opinions on this issue. This is something that I think we are going to be reading much more of and hearing much more of. With that, Senator Schumer, I welcome your testimony and thank you for coming today.

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    Senator SCHUMER. Thank you, Chairman Ryan. I want to thank you, as well as Chairman Bachus. I understand there are weather delays and no votes in the House until 7:00 tonight. I appreciate very much your being here to listen to the testimony as well as for your thoughtful opening remarks. I also want to thank all of the Members of the Committee.

    As you know, I spent eighteen years on this committee and had many, many fruitful and interesting and sometimes fruitful or interesting experiences in this room. I also would like to thank the economists who have come forward for this hearing. Disagreeing with Chairman Greenspan is always a risk in the economics profession. It is sort of like betting against the House. So I thank Messrs. Shiller, Galbraith, and McCulley for presenting testimony today.

    Mr. Chairman, despite the fact that the American economy is the strongest in the world, despite the increases in productivity that are fueling the unabated rise in GDP, and despite the fact that inflation is in check, the Fed is raising interest rates today. Why? Most economists, members of the Fed, including Chairman Greenspan, would say the wealth effect is the reason. And many believe one of the partners—there is some debate whether it is a junior or senior partner—of the wealth effect is margin debt.

    Today, margin debt is a greater share of total market capitalization than at any point since the Great Depression. As the chart to my right, your left, Mr. Chairman, shows, particularly the yellow line, the margin debt as a percentage of total market capitalization is above 1.5 percent. The only time in recent history it came that close was on October 1, 1987, Black Monday. That is when the market crashed and that is indicated by the peak a little bit before about four-fifths of the way into the chart.
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    When Chairman Greenspan testified before the Senate Banking Committee in January, we pointed out statistics that show that margin debt in November and December were at record levels. His attitude was let's see if it continues. Well, it certainly has. In January and February of 2000 alone, margin debt has climbed 15 percent. In the last six months, margin debt has climbed $83 billion. That is 45 percent, while stock prices have risen 10 percent. That is quite a contrast.

    These numbers are an indication that margin borrowing itself may be fueling at least a good part of the market's rise. And that means speculation. Many investors are leveraging their investments to the maximum, betting that the market will continue to go up, and for almost ten years they have been right. It is hard to argue against experience. But there is now a whole generation of investors who are new to the market since the technological revolution ushered in an era of democratization. These new investors have only known the rising bull market. Some of them, we don't know how many, will buy a stock at 10, it will go up to 50, they will then borrow against that paper valued stock at 50 and buy new stock. And the cycle continues.

    As a result, we are a culture of confidence, and part of that confidence is brought on by the large increase in margin debt. We have confidence in the markets, we have confidence in the economy and technology, so why should we worry? Well, if history serves as our guide, confidence, no matter how rooted in rationality, cannot continue unchecked. And I am not sure all of it is based in rationality.

    What I have seen in my casual observations of the market is the fact that, until recently, while there were many stocks, technology stocks and others that had no profits or no revenues, there was a great deal of analysis as to what their product was and how it would serve in the future. In my judgment, the fact that stock does not have revenues or profits is not an absolute reason to avoid investing in that stock. If Thomas Edison came to you in 1870, in the early 1870's, and said ''Here is my plan for the light bulb, would you like to invest?'', you would have been very smart to invest, even though his company at that point had no revenues and no profits. But what seems to be happening more and more is that people invest in those stocks, not on the basis of what potential their future product might have, but rather that, ''Well, it is going to go up for a while just because it is a technology stock, just because it is a 'dot com,' and I will get out in time before it falls.''
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    That is a classic investor bubble, and classic investor bubbles burst. How many of the stocks that are riding through the market are like that? We don't know and it would probably be impossible to figure out. But we do know there has been some real sea change, that there has been the view of let's get the stocks out now even if the product is not ready, even if there are six competitors in the pipeline who might be doing a better job than we do, because the stock will go up.

    So the leveraging of the market, particularly by retail investors, means that a drop in the market could—not will, but could—set off a chain reaction of sell-offs by investors trying to meet margin calls. Obviously the most precarious is for certain tech stocks with no earnings and market capitalization regarded by most analysts as excessive. We should also be concerned, because since the last market crash of 1987, a far greater proportion of American families, 50 percent have equity investments, meaning that the effects of a serious decline of stock prices would be more pervasive and ripple through a greater portion of the economy.

    Now the Federal Reserve's reaction to the tremendous rise in the market and margin debt has been to raise interest rates, as they will today. But if we are concerned about the wealth effect, which we know Chairman Greenspan is in testimony before your committee and the Senate Banking Committee as well, if we are concerned about speculation in the market, the logical question leaps out at you. And that is why not raise margin debt instead of raising interest rates? Why not use a scalpel instead of a sledge hammer?

    Interest rates affect the economy up and down the line. Interest rates affect, as you noted, Mr. Chairman, the traditional stocks which have been less a product of speculation than they do technology stocks which—or many technology stocks, those that don't have revenues or earnings. They are not interested in interest rates at this point, because they are not borrowing yet. They are waiting for their IPO to bring in more—or the second IPO—to bring in more revenues.
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    And so the question leaps out, if we are concerned about the wealth effect, and let's not argue with Chairman Greenspan and others that we should be, why isn't margin debt the way to go? That is the fundamental question that many in the markets are scratching their heads and asking. Well, Chairman Greenspan has argued two reasons not to raise margin requirements. First, he says, it is not fair to smaller investors and, second, he says, and this is the more fundamental of his concerns, he says there is no evidence that raising margin affects stock prices.

    Now, with regard to smaller investors, and it is probably true that the large investors, the big banking houses and others can get around any kind of margin requirement rather easily. But if it is the smaller person who is more likely to invest based on less evidence and, more importantly, if it is the smaller investor who will be caught, because they don't have the cushion should the stocks turn down and their margin debt is excessive, then what is wrong with saying that these are the people that should be affected by margin debt?

    The stock market is not a democracy. We don't distribute stocks on an equal basis to everybody in the population. Some might argue we should, but that economic theory failed at least ten years ago, and probably longer.

    Mr. RYAN. I am glad to hear you acknowledge that, Senator.

    Senator SCHUMER. Thank you, Mr. Chairman. But the argument that smaller investors are the investors who are most hurt does not really hold water if they are the ones most out on a limb and most likely also to be hurt if the market turns down. There is evidence to suggest that many small investors are not aware of the risks of buying on margin, which jeopardizes the overall integrity of the market.
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    For example, the NASD, and this is probably true of the New York Stock Exchange, and the SEC is flooded with calls by retail investors uninformed or ill-informed about margins. And of course as I said, if the market takes a dip they are not the only ones that will be hearing about it. A constituent of mine called yesterday to complain that the biotech sell-off last week wiped out her savings. She never considered the risks associated with equities. She assumed it was like a bank account, that it would go up, but not go down. Now, she is paying the price.

    Now, what about the second argument that Chairman Greenspan has made, the correlation of margin requirements to stock prices? I would say that a full-scale investigation into the effects of margins has not been conducted by the Fed since it stopped using market requirements as a tool of monetary policy in 1974 and we are in a totally different world from 1974. What was true then may not be true now. Certainly as the chart shows, the percentage of margin debt is much greater now than it had been then. The increases in the market are greater now than they were then and I don't think that it is fair to make the analogy. It doesn't mean that margin debt necessarily will be affected in curtailing the wealth effect to a limited rational degree, but it certainly means that past history is not the only indication.

    So I am pleased that the Fed is working with the SEC to analyze the nature and pervasiveness of margin borrowing, and I am hopeful it will learn greater insight into what is driving this increase in margin debt. For example, are the hedge funds and day-trading funds most responsible for the rise? How many retail investors are using margin accounts and how are they backing up their accounts?

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    You just heard a story in San Francisco, one of the centers of this high tech—an epicenter of this high tech boom where people are using stock prices now to pay for houses and the value of homes on the market is just going through the roof, $5 million for a 2-bedroom house in a select neighborhood that is not very opulent.

    So I think we should analyze margin debt before fully making any decisions. But if the results demonstrate that margin requirements do affect investors' appetites for stocks, I hope the Fed and the SEC will not shy away from making difficult decisions that will certainly protect us in the long run.

    What are the alternatives? There are many, but each has costs and benefits. We could increase the initial margin requirement on Regulation T. This would have an immediate effect on margin borrowing. Second, we could increase the maintenance margin requirements for broker-dealers through the NYSE and NASD. According to an in-house survey, margin requirements vary by broker-dealer and that supports the theory that a smaller number of firms are probably responsible for much of the increase in margin debt.

    Many firms, of their own accord, have responded to the increase in margin debt and volatility of the markets by increasing maintenance margin and declaring some stocks ineligible. But in all likelihood there are less responsible firms that have failed to do so. Raising the floor of maintenance margin may reduce margin debt.

    Then there are two other possibilities, neither of which seems to me to be as attractive as the first two, but the Fed should consider them. They could increase maintenance margin for certain volatile securities. I am reluctant for any kind of Government regulations to help people pick winners and losers even on the basis of performance, but Datek very responsibly raised margin requirements on 85 volatile tech stocks and that was done on its own. This would allow a tailored approach to speculation of certain types of stocks with the risks that we step over that line and start picking some and not others.
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    Then the fourth is to strengthen the standards for marginable securities; for example, excluding certain stocks with characteristics like exceptional volatility, no earnings, no revenues. This would reduce the proportion of marginable securities by taking away broker-dealer discretion on certain stocks. The downside is similar to the one in number three.

    In conclusion, Mr. Chairman, it is my hope that the Fed and SEC through their investigation will examine each of these possible actions, because whether we are concerned about the wealth effect or margin debt, a problem born of the stock market may best be resolved by treating the stock market. I want to thank Chairman Bachus for letting me testify today. I want to thank you, Chairman Ryan, for presiding today and I look forward to the subcommittee's work in this issue.

    Mr. RYAN. Thank you, Senator Schumer. That was very interesting testimony. I can tell that you have put a lot of thought in this. Let me just start with a couple of quick questions.

    I am not sure if you have given a lot of research to this, but I think we have had 23 margin budget requirement changes between 1936 and 1974, so there was a policy device used at that time. Have you taken a look at the connection between stock prices and those margin requirement changes that occurred between those times?

    Senator SCHUMER. That is a good question, Mr. Chairman. I have not, but Chairman Greenspan has. He says there isn't an effect. That is his number-one reason for opposing this. So let's accept him at his word, because he is a man who, as we know, when I first met him we had breakfast one morning when he had only been Chairman three months and I said, ''How do you like the job?'' He said ''It is great.'' I asked him what he liked best about it and his eyes lit up and he rubbed his hands and he said, ''the data.''
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    Mr. RYAN. So we could take him——

    Senator SCHUMER. So I take him at his word for that. He also looked like thinking about the data he would have to go take a cold shower afterwards. But in any case, the analogy may well break down, given what we see in that chart there. Such a huge percentage; not only is market cap greater, but the percentage increase in market debt is dramatic. That is why it deserves another look and I don't think you can just rely on 1936 to 1974 as an indication.

    Mr. RYAN. That is a valid point. We both represent constituents who are feeling these interest rate hikes. All other inflationary indicators are not on the horizon with the exception of the cartel-based commodity. So these interest rates—and I understand that it is just now being confirmed that the Fed did raise the rates today a quarter-point on the Fed funds rate and a quarter-point on the discount rate. So it is happening. And we are feeling it, our constituents are feeling it. The question is, is inflation there, is this a sledge hammer where a scalpel could be better used?

    This is a very interesting new issue. Now that we have a new economy stocks versus old economy stocks they seem to be growing at different rates and different directions in some cases. I think the point is a very valid one that merits further study.

    I would like to ask you, seeing your points, what legislative remedy, if any, do you think you would call for, and if not, what would you ask Chairman Greenspan right now if you were sitting here and he were sitting where you are?
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    Senator SCHUMER. Let me answer both. First, I would be very dubious of a legislative remedy. When I sat on that side of the table there were some in my party who wanted to sort of interfere with the independence of the Fed. I used to have big fights with Speaker Wright, who came from the Texas populist tradition, on this. I think monetary policy in general works very well in the present setup. As long as the Fed has the option of raising margin requirements I think our job is to speak our minds, to jawbone them, to ask them, as I have here, to continue their studies; but I would not—if they were to come up with another solution want to legislate it. I think that creates a very dangerous precedent. Even if it might merit itself in this particular situation it would not be worth a candle.

    Mr. RYAN. Mr. Lucas.

    Mr. Moore.

    With no further questions, Senator, we know you have a very busy schedule. Thank you very much for your thoughtful testimony and we appreciate your coming and sharing your thoughts today.

    Senator SCHUMER. Mr. Chairman, I thank you for your very intelligent discussion of this and que sera sera. We will see what happens.

    Mr. RYAN. Thank you, Senator.

    We now call the second panel. If we could have the second panel join us. I guess we will still go with Steve Galbraith on the third panel.
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    First is Paul McCulley. Paul McCulley is Executive Vice President and Portfolio Manager for Pacific Investment Management Company. He has served as Chief Economist for Warburg Dillon Read, and during 1996–1998 Mr. McCulley was named to six seats on the Internet Institutional Investor All America Fixed Income Research Team. He has sixteen years of investment experience and holds an MBA from Columbia University.

    Thank you for coming, Mr. McCulley.

    Our second witness today on the second panel is Robert Shiller. Mr. Shiller is the Stanley B. Resor Professor of Economics at Yale University. He is the Research Associate of the National Bureau for Economic Research and he is a member of the Academic Advisory Panel for the Federal Reserve Bank of New York and has written widely on financial markets and macro-economics and behavioral economics. His latest book, ''Irrational Exuberance,'' is an analysis of the stock market boom from 1982 to the year 2000. He is also the co-founder of Case-Shiller Weiss, Incorporated, an economic research and information firm in Cambridge, Massachusetts. Thank you for coming, Mr. Shiller.

    Mr. McCulley, would you please begin with your remarks?


    Mr. MCCULLEY. Thank you, Mr. Chairman. It is pleasure to be here. Senator Schumer is a tough act to follow. He covered a lot of ground that I want to go over today, but bear with me for a few moments. I would like to address a few major points.
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    The first point is that I think the issue that is before this subcommittee is hugely important, and was made even more important by Mr. Greenspan's own testimony at the recent Humphrey-Hawkins testimony. As was discussed, he identified the wealth effect as the ''skunk at the picnic'' in the economy at the moment and has told us that he plans to scotch it with continued increases in short-term interest rates.

    At the same time, ironically enough in response to questions from Senator Schumer, Mr. Greenspan said, ''the wealth effect is not all that closely linked to the stock market.''

    I certainly hope that Mr. Greenspan doesn't actually believe that. It seems to me that Mr. Greenspan would like to have an immaculate correction in the wealth effect without being named the father of a bear market in stocks. That is just not credible to me. He has testified before this subcommittee before that in his estimate—''Mr. Data''—his estimate is that one-sixth of the wealth effect effectually comes from equity extracted from our homes. By the process of elimination, five-sixths of it comes from somewhere else, and I think it comes from the overall equity market.

    In my prepared remarks you will see a graph that plots household net worth as a percent of income and that is a very important ratio, because Mr. Greenspan, as you note, Mr. Chairman, has told us that he is targeting that, told us that he wants net worth to grow in line with personal income. On the chart you will observe that the ratio of net worth to household disposable income moves almost tick for tick with the S&P 500. So it is incumbent on Mr. Greenspan to straightforwardly address the issue.
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    If he is targeting the wealth effect, then implicitly he is targeting the stock market, which means that we should address the full arsenal of tools that he has at his disposal. Right now he wants to use strictly one gun called interest rates. I think he should unholster his other gun and actually increase margin requirements for many of the same reasons that Senator Schumer addressed.

    Most importantly of those reasons is that the stock market has become a bifurcated beast. When you ask someone how the market is doing you always have to follow up in saying ''NASDAQ, the Dow, or the S&P.'' We clearly have a two-headed beast in the equity market. You have your old economy stocks and your new economy stocks, NASDAQ versus Dow, if you will. And again in my prepared comments I have a chart that shows the ratio of NASDAQ to the Dow and that ratio was very stable for a number of years. As you can observe, it has absolutely gone off the chart at this time.

    So a key reason to think in terms of using more tools is that the stock market is not a homogeneous beast anymore. The stock market is indeed a two-headed monster with the new economy stocks driving the wealth effect.

    Third point I want to make today, and it is actually I think the most important, because I would like to quote a passage if I might from Mr. Greenspan himself, made in congressional testimony not this year, but actually back in January or February of 1999. It has not been widely reported, but I think that Mr. Greenspan provided one of the best, most eloquent explanations for what is going on in the NASDAQ that I have heard then or since. So if you would just bear with me, I would like to read a short quotation, actually about five paragraphs, into the record. Again this is from February of 1999, Mr. Greenspan speaking:
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    ''You wouldn't get hype working if there weren't something fundamentally sound under it. The issue really gets to increasing evidence that a significant part of the distribution of goods and services in the country is going to move from conventional channels into some form of Internet system, whether it is real goods or services or a variety of other things. The size of the potential market is so huge that you have these pie in the sky types of potentials for a lot of different vehicles. And undoubtedly some of these small companies whose stock prices are going through the roof will succeed. They may well justify even higher prices. The vast majority, however, are almost certain to fail. That is the way the markets tend to work in this regard.''

    Here is the important part: ''There is something else going on here though which is a fascinating thing to watch. It is, for want of a better term, the 'lottery principle.' What lottery managers have known for centuries is that you can get somebody to pay for a one-in-a-million shot more than the value of that chance. In other words, people pay more for a claim on some very big payoff. and that is where the profits from lotteries have always come from. And what that means is that when you are dealing with stocks, the possibilities of which are either going to be valued at zero or some huge number, you get a premium in stock prices, which is exactly the sort of price evaluation process that goes on in a lottery. So the more volatile the potential outlook—and indeed in most of these types of issues, that is precisely what is happening—you get a lottery premium in the stock.''

    That was an exquisite analytical framework for evaluating what is going on in the new economy stocks. It was a year ago and still is today. Investors are looking at new economy stocks in many respects as lottery tickets. All of us in this room would love to know with certainty who the next Microsoft is going to be. But we don't. So effectively, investors buy a basket of the stocks which, as Senator Schumer noted, have neither earnings nor revenue. They buy a basket of those stocks in hopes that one will pay off. To my way of thinking if the lottery principle is the correct way of looking at the speculation going on, and I think it is correct, then by definition you have a bubble. One minute before the announcement of a lottery the market value of all of the $2 tickets is always greater than the value of the jackpot. But, once the jackpot is announced, all of those $2 tickets but one goes to zero. So by definition, the market value of a lottery is a bubble, or else you wouldn't have the game going on.
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    Mr. Greenspan made this analysis, not me. But I think it is important for us to use it as a backdrop. He doesn't want to define whether or not the equity market is in a bubble as he stated just again recently before this committee, but by his own analysis the new economy stocks are overvalued, because the lottery principle is in play.

    My last and concluding thought is that, as Senator Schumer noted, the value of margin debt as a percent of the overall capitalization of the equity market is going up. That is true. And it is going up as NASDAQ has dramatically outperformed the Dow. So I think it is important to put those two things together, not just what Senator Schumer looked at, but the debt as percent of market capitalization, and then juxtapose it against how you got to the market capitalization. Was it a case of all stocks going up or was it a case of the new economy stocks—put differently, the lottery premium stocks—leading the way? And I can't help but conclude if you have a lottery-like principle working and lottery-like stocks are leading to increases in market capitalization, and if margin debt is going up as percent of market capitalization, then you have a problem that should be dealt with with something besides interest rates. Mr. Greenspan seems to be wanting to get the attention of the gluttons by starving the anorexics. I think that is bad policy. I think he needs to have a policy designed for reality. Thank you very much.

    Mr. RYAN. Thank you for your very colorful metaphor, Mr. McCulley. I appreciate your insight.

    Mr. Shiller.

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    Mr. SHILLER. Thank you, Mr. Chairman. I think that we are in a very unusual economic situation right now as exemplified by the high stock market valuations, but also by other indicators; for example, the record high consumer confidence. I think the current speculative environment is a very complex phenomenon. That is why I have just written a book ''Irrational Exuberance,'' in which I tried to describe in some detail what is going on. I can't summarize that in five minutes here. I think Senator Schumer described part of it very well, as did Mr. McCulley when he referrd to Alan Greenspan's comments about the lottery principle. I think these remarks are on target. However, I think the phenomenon is sufficiently complicated that some of us may look upon their brief remarks with some suspicion.

    There is, in fact, evidence for an overconfident situation in the economy, as I presented in my book. For example, I asked individual investors in 1999 whether they agreed with the statement that if the stock market were to crash as it did in 1987 it would surely be back up in a year or two. I got 91 percent agreement to that statement, which is quite remarkable since that statement contradicts the widely acclaimed random walk theory of stock prices. People today really think that they can't lose in stocks. It is very unfortunate that they think this when stocks are so overpriced. They can indeed lose in this situation of exaggerated confidence. It is a fragile situation which causes overinvestment in certain industries and may ultimately unravel in unfortunate ways. The situation is not as simple as suggested by a mechanistic view of the wealth effect as if the stock market was something exogenous hitting us and then we react to that. Actually the present level of the stock market is part of the whole picture of confidence. The phenomenon is unfortunately very psychological and difficult to deal with.
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    Now the issue is what should the Fed do. There are two policies under consideration: The policy of raising interest rates, which it has been doing and just did a matter of minutes ago, and the more selective measure as margin requirements which focus in on stocks. I believe that Senator Schumer and others advocating the latter are right, that there is something to be said for the selective measure of increasing margin requirements. However, I don't feel as enthusiastic about this, because I don't think this is a panacea. It is a useful measure to take, but it is not going to solve all of our problems.

    Let me step back and remember what Federal margin requirements are and how they were used in the past. In 1934 they were first put into play. As you know, there were 22 changes since then. The Fed was using them actively as a policy measure. Initially, when they were put in, the margin requirements were very important, because in the 1920's, the margin debt came close to 30 percent of the market capitalization. Later, Federal margin requirements were less important. As was noted, then margin credit had fallen to a much lower fraction of the market. Nevertheless, the Fed adjusted margin requirements up and down many times.

    I don't have a chart, but the figure accompanying my testimony shows that margin requirements had a very erratic course up and down over the years. There were sharp ups and downs between 50 percent and 70 percent. At one point the Fed pushed the margin requirement up to 100 percent and shut off margin completely. It is interesting to note what motivated these changes in the past. I would have thought that perhaps they were motivated by impressions that the market was overpriced or underpriced and you might have thought they would raise margins when the stock market seemed high by some standards. However, this doesn't seem to be a very accurate description of what they did.
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    Another theory is that they would raise margin requirements in volatile times in order to prevent the feedback of the pyramiding-depyramiding effect on volatility, that is, of the feedback from buying to more buying as prices increase, through increased margin available, and from selling to more selling through margin calls. However, the Fed never once in the entire history of margin requirement changes ever mentioned volatility as a reason for the margin requirement changes.

    So what was the Fed doing? What they were doing between 1934 and 1974 is very plain. Of the 22 changes, 12 of them were increases in margin requirements and 10 of them were decreases. If you look at the 12 increases, in each case the stock market had gone up in the prior six months. If you look at the 10 decreases in margin requirements, 9 of the 10 were preceded by stock market decreases. It is very plain that to summarize their reaction function was to lean against the market. But they weren't consistently looking at the levels. This is important to understand. The reason margin requirements were so choppy is they were always reacting to the short run in the last six months. They were never looking exclusively at the level of the market.

    Now, it seems to me if margin requirements were to be used correctly, one should look at the level of the market, and at times like this the requirements should be increased. Of course, in terms of setting margin requirements there is a problem, which is what is the right level? The level has stayed fixed at 50 percent since 1974 and yet our institutions have changed so much. Since 1974, we have expanded futures markets, exchange-traded options, credit cards, home equity loans. The institutions allowing people to assume financial risk have proliferated enormously and yet we have kept margin requirements at that same level. I don't think we have any good theory of what the right level is. And so when I say we might increase margin requirements at this time I am more thinking of it as signal.
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    One might have thought, given that the finance profession has become, in the last twenty years, heavily influenced by the notion that markets are efficient and optimal, that margin requirements would have been eliminated by the Fed by now. Why should the Government interfere with markets at all by setting such requirements? But part of the reason I believe why the Fed did not is that it would seem reckless to eliminate controls like that. Individual investors are sometimes reckless with their finances, and having marginal requirements in place helps prevent people from hurting themselves. The margin requirements serve a function and we don't want to eliminate them.

    In the last sixty-five years the Federal margin requirements have served that function. Since 1974 they have never been used as a policy tool to be increased or decreased in response to market conditions. Now, however, at this historic time it might be advantageous for the Fed to increase margin requirements. I am not advocating that we go back to the policy that was used from 1934 to 1974 in marking margin requirements up and down in response to every new glitch in the market, but at historic times when the market seems to be overpriced and with a speculative element, it is a time for the Fed to consider raising margin requirements.

    Now incidentally, the fact that the Fed studies have shown no effect on volatility in the short run seems hardly relevant to this issue. I think raising margin requirements now would be a good idea. At the same time I don't think this is going to solve all our problems.

    Mr. RYAN. You ran out of time, too. Thank you, Professor Shiller.
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    This is very fascinating. Professor Shiller, you mentioned that the ups and downs, I think 22 changes you mentioned between 1936 and 1974 was used in small increments, six-month increments, not looking at the old macro-level. You are advocating possibly raising the marginal requirement now, you don't know how high, but as a signal. Are you suggesting that is something that the Fed should do in lieu of raising interest rates?

    Mr. SHILLER. No. I think the kind of course that would be reasonable if present conditons continue is to raise interest rates a couple of more times, but also to increase margin requirements.

    Mr. RYAN. In addition too, OK. I am just going to bounce between the two of you. Mr. McCulley, you mentioned that now the stock market has become a bifurcated beast. That is a very compelling statement and I don't think that you will find many people disagreeing with you on that. How do we measure this bifurcated beast? How do we measure this new economy? That seems to be the big question. Do you believe there are other tools that we haven't been looking at other than the margin requirement that could be used to treat one head of the beast when the other head doesn't need treatment?

    Number two, should we do this on top of interest rate increases or in lieu of interest rate increases? And another question is, how do we measure these things? The key question that runs through my mind as I sit in this panel and watch Mr. Greenspan come twice a year and speak, is he is talking about an economy which no longer can be measured with conventional measuring sticks. We are talking about a new economy now which is extraordinarily difficult to chart and measure, because it is a different economy. Yet we measure and determine our policy directives, we measure and determine the actions of the Federal Reserve based on older models, based on old measuring sticks.
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    Do you believe that the Fed has an outdated model? I know they are updating constantly, but do you believe that we seriously need to wait, watch, try to reanalyze how the market is changing? Do we have old measuring sticks and therefore these remedies, are they limited in what they can do and are they shortsighted?

    That is the question that I would really pose to you on top of the other ones. I know that is a lot right there. Sorry about that.

    Mr. MCCULLEY. That is quite OK. I would like to compliment Mr. Greenspan for recognizing actually that the old models don't work very well. My profession wouldn't have dreamed of getting to a 4 percent unemployment rate five years ago, or having a trend growth in GDP with a 3 or 4 as the first number. So I think Mr. Greenspan has been very open-minded about speed limits on the overall economy reflecting the fact that the world has changed and I think that is the appropriate thing to do. So there I compliment Mr. Greenspan. Returning to the question of how do you measure, if you will, in stock market terms, old economy versus new economy. To me that is a lot easier, because you have stocks that represent the old economy and stocks that represent the new economy. Old economy stocks are valued on traditional models where you have a cash flow and you discount it back to the present via some interest rate. So the old economy stocks can be measured, call them the Dow if you want to, and the new economy stocks can be observed. But there, anybody who tries to use the traditional valuation framework will go mad. I think the right valuation framework for the new economy stocks is the one that Mr. Greenspan gave us, which is to apply the analogy of a lottery, and therefore you can understand why people would pay more than something seemingly is worth, because they are betting on one ticket paying off.
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    So, on the economy, I think Mr. Greenspan has done a good job of being open-minded. On the stock market, however, he seems not to want to recognize the two-headed beast, and there I think you have to have different tools, because the new economy stocks, if they are a lottery, are not that particularly responsive to interest rates. I have never seen a lottery that was cooled off by changes in interest rates. It is cooled off by effectively announcing the jackpot. So I think that it is reasonable for him to apply the margin tool basically to say ''It is OK for you to foolishly buy lottery tickets if you want, but thou shalt not buy them on credit.''

    Mr. RYAN. Given that we are talking about a bifurcated beast here, do you have concerns that increasing margin requirements would have the unintended consequence of hurting old economy stocks while trying to dampen new economy stocks with the margin requirement? I understand that we are trying to find a way to take one slice of the new economy versus the old economy. Are you concerned that we are going to affect the old economy stocks when we increase margin rates and don't you think that is a bad thing?

    Mr. MCCULLEY. I think what would happen would be exactly the opposite.

    Mr. RYAN. You think you would see a flood going from one to the other?

    Mr. MCCULLEY. You have had NASDAQ dramatically outperform the Dow over the last year. Over the last several days you have seen a reversal in the other direction as people recognized that old economy stocks have become very cheap. But, I think responding directly to your question, if the Fed were to use the margin tool for the new economy—they are using it for all stocks, but directing it at the new economy—you would get an absolutely massive rally in the old economy stocks for the simple reason that the market would lower its expectations of increases in interest rates.
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    Mr. RYAN. So you are suggesting that we should raise margin requirements for new economy stocks and not for old economy——

    Mr. MCCULLEY. No, I think you should raise them for all stocks, but I think the gong would be heard in NASDAQ.

    Mr. RYAN. Something like what happened Thursday, didn't we get a 500 point increase and everyone went back to blue chips.

    Mr. MCCULLEY. Exactly. And if you wanted to continue that trend I think you would want to reduce market expectations about interest rate hikes. So if it looks like Mr. Greenspan is going to be using two tools—and I concur that that margin is not a substitute for interest rates—if the Fed is going to use the margin tool to deal with speculation in the equity market, then the overall economy and the old economy stocks could reduce their expectations of Fed rate hikes, and I think the effect on old economy stocks and the old economy would be very positive, because they are the ones that are under the boot of interest rate hikes right now.

    Mr. RYAN. Of course the opportunity cost would be potential loss, gains, potential depression of the next Yahoo, or the next Amazon, the next wonderful new economy stock that could have been that didn't occur. There is never a way to measure that. Professor Shiller, do you agree with most of what Mr. McCulley just stated?

    Mr. SHILLER. I feel a little bit uncomfortable about advocating too much intervention in markets. Let me say that I think it is a sensible gesture to raise margin requirements, because it is a consumer protection measure, something that I can't quite justify in terms of pure financial theory. It is analogous to why we put warnings on liquor bottles. Some would say that if markets worked well we shouldn't do that. But there are certain kinds of consumer protection measures that I think the Government ought to take.
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    On the other hand, I would like to say that despite my claim that there is at present irrational exuberance in the stock market, I am a believer in markets and I think they allocate resources well. And one of the great strengths of this country is, of course, that we have free markets.

    You said something about doing different margin requirements for different stocks. That is going a little far. I have in mind just a gesture in terms of a traditional framework. And it doesn't sound right to me to put different margin requirements——

    Mr. RYAN. I thought so as well. I agree that would be crazy. So you are saying, Dr. Shiller, that let's not use it as a new tool to be used continuously by the Federal Reserve, but use it once as sending a signal. Is that essentially what you are saying?

    Mr. SHILLER. I think if you look at the pattern of margin requirements used in the past it looks sometimes absurd to me. I don't know what they were doing in some of those times. I think at a time like this would warrant some increase.

    Mr. RYAN. That is very intriguing. I would like to see a little bit more on what was the rationale for the Federal Reserve market requirement changes that occurred during that period. That would be something that I think would be very interesting to look at that data.

    I see that my time has expired.

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    Mr. Lucas.

    Mr. LUCAS. Thank you, Mr. Chairman.

    Mr. Shiller, in looking at your testimony you note that margin credit in the days of the 1920's, 1929, might have approached as much as 30 percent, yet in recent times it is more or less 1.5 percent of market capitalization. Clearly, seventy years ago, eighty years ago, with so much of the capitalization being driven by margin credit, it had much more of an impact. But, isn't this kind of like firing off a pop gun in essence, if there is 1.5 percent of the market capitalization?

    Mr. SHILLER. 1.5 percent of the market capitalization is still greater than the percent of market capitalization that trades in a day. There still could be a feedback effect of selling triggering margin calls and then more selling that the margin requirements might help mitigate. The thing that I also say in my book is that the kind of feedback effect that works directly through margin requirements is only one of many feedback effects. In fact, the stock market crash of 1987 was exacerbated not primarily by margin credit, but rather more by something called portfolio insurance, which engenders another sort of feedback mechanism. But margin credit and the resultant margin calls in a down market is a potentially somewhat important source of fragility in financial markets.

    Mr. LUCAS. As I travel around my district I listen to people talk about using home equity loan proceeds to invest in the stock market, some of the most amazing sources of capital. That is why I asked my question. Both of you are—perhaps more Mr. McCulley—referred to the concept of the lottery and the drawing of a ticket and how expectations build up until that moment that the winner is drawn. But at that moment the winner is drawn the lottery is over, the bubble is bust, and the enthusiasm is gone. I guess my question would be, within the resources available to us, how do we make that lottery go on forever, but not quite be drawn?
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    Mr. MCCULLEY. My response is that you would like to have the new economy funded with honest-to-God capital as opposed to leveraged capital. That is one of the issues of hiking margin requirements. I think that the frontier of America would be funded. Venture capital, which is actually real capital, not borrowed capital, is alive and well and is actually the marginal source of capital for new firms. And then they go public effectively to monetize their good idea and then mom and pop are brought into the game to buy the IPO. So I don't think that you would have to worry about really thwarting innovation and technology and progress at the frontier in America if you effectively cut back on borrowing on public shares, because the whole margin issue only happens once a company goes public; whereas the funding for bright new ideas, the proverbial garage, is more than adequate these days via the venture capital arena.

    Mr. LUCAS. Thank you.

    No further questions, Mr. Chairman.

    Mr. RYAN. Mr. Toomey, do you have any questions at this time? Thank you, gentlemen, very much. I appreciate you coming down here and sharing your testimony with us.

    We now call the third panel, Mr. Steven Galbraith. Thank you, Mr. Galbraith. Mr. Steven Galbraith is a Principal Senior Research Analyst for Investment Banks and Brokers at Sanford C. Bernstein and Company. He spent fifteen years working in and around the securities industry with companies, including Chase Manhattan Bank and Pzena Investment Management. His responsibilities have included internal consulting, financial institutions, and consumer products corporate finance. Steve and his wife live in Darien, Connecticut, with their daughter Katie and son Harry. I am glad you added that in your bio. It is nice to know.
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    I hope to hear somebody who may say don't raise interest rates, maybe do something else. I don't know what your take on this is going to be, Mr. Galbraith. The burning question I have for you right now is, before you start, is there any relationship to your other namesake?

    Mr. GALBRAITH. No. I was going to comment I am the only non-economist here despite my last name.

    Mr. RYAN. Thank you very much. We look forward to your testimony.


    Mr. GALBRAITH. The way I would like to do this, if possible, is hopefully you have a working deck of my slides, because I am basically going to tell a story of what is going on so that the peanut gallery can see what is going on as well. I really have two or three points right up front.

    First, without question, margin debt by any measure is at record highs. That is well-known, we all know that, that is the testimony that we have had. What I don't think is necessarily that well understood is the changing composition of margin debt. To me that is the whole story, who is doing the lending and the borrowing. I think that has changed a lot. In fact, I think where it has all gone is to the retail arena.
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    The third arena that you folks are probably interested in is what is going on in the institutional arena. What are the hedge funds doing? That is really difficult as an analyst to uncover, because there are all of these ways around it through the use of options, financial futures, and things like that. It is somewhat opaque to me, but having interviewed all of the big brokerage houses, my gut and my instincts tell me they have seen all kinds of market conditions. This isn't new to them in fact. The guys that are running these businesses were around in the nifty fifties. What is new is the retail phenomenon, the online phenomenon. My sense is that is where the risk is.

    What I am going to do is really quickly walk you through the market. What I want you to do is look at the asset side, what is being borrowed against and what is the nature of that and the liability side, who is lending the money. If you would bear with me let's go through the presentation.

    Flip first to page 5. I think this is symptomatic of what is going on with the markets today. The point I would draw you to is the third line down, the second and third lines down. The U.S. stock market today is turning over 120 percent a year. What does that mean? It means the average holding period of a stock now for U.S. investors is less than a year. Let's look at the NASDAQ. 221 percent. That is 3 times more rapidly than any market in the world. The only market that is close is Hong Kong, where I am sure you know, gambling is the number one pastime. So what the NASDAQ is telling us is the average holding period of a NASDAQ stock is five months. So much for long-term investing.

    Page 6, if you will. One of the things we wanted to do obviously is—averages can always be misleading, so I wanted to take a look at what kind of turnover rates are we seeing in some of the ''new age'' brokers. What are the investors of these companies doing? What is their risk profile, their risk tolerance? And you will see what this is showing is the number of times the average client at these individual firms is turning over his portfolio per year. And so what you will see with Datek, for instance, their average holding period is one month.
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    And then will you go all the way down. As you get further down the ''advice scale,'' where you actually have a human intermediary, what human beings do is they slow you down if you are engaging in reckless behavior. They are not just giving you advice, but it may be the simple embarrassment factor. If you can trade online no one has to know you are blowing up. It is all private in your own house. So one of the things I am sure you will be struck by is just the sheer velocity of the asset side—again what is being margined.

    Look at the next page if you will, page 7. Taking this point one step further, I wanted to look at, say, the top 25 performing stocks in the NASDAQ—and this data was as of December, so it has changed, but the names may have changed, but the characteristics are quite similar. You will see the performance is extraordinary, a 2,000 percent return. That is unheard of. And then we look at the turnover, the number of times those stocks are turning and then in the third column is are they making money. What you will see is in the most extreme cases in NASDAQ, the best performing stocks, less than one-third of them make money. And the average holding period of—I use inverted commas or quotations—investors is 60 days.

    Flipping to the next page, again to give you a feel for the market environment this is just a simple measure of NASDAQ and S&P volatility over time. It has basically doubled in the last six years and it is now higher than the 1987 levels. Again just to give you a feel for the flavor of the market.

    Page 9, which will be the last commentary, if you will, on the asset side of the equation, the type of volatility or stocks that can be borrowed against, this is showing the beta of Knight-Trimark's chief volume leaders. For those of you who don't know, Knight-Trimark is a NASDAQ market maker. It is the primary conduit for most of the e-brokers. It is where they send their orders to be executed. Again, just not to be too arcane, beta is simply a reflection of a stock's volatility relative to the market. If you have a beta of 2, simplistically it means when the market goes up a buck your stock is going to go up two bucks. When it goes down $1, your stock is going down $2. What you will see here is the beta of the average stock of the Internet brokers or clients is approaching 2. So it tends to be twice the level of the market.
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    Flipping to page 10 real quickly, the history of Fed moves. As you will note, there have been no changes really since 1974. So my basic comment here is clearly the risk profile of U.S. investors has risen. And so if we are not going to use the margin as a policy instrument today, I think you can make a very strong case we should never use it. Why should it exist in the circumstances where we have investors turning stocks over 5 to 6 times more rapidly than the market with a beta of 2. And now as we get to on leverage, if you are not going to use it on these circumstances, I would suspect you might want to disband it altogether as a policy instrument.

    Page 11, real quickly, this was shown earlier by both Mr. Schumer and the prior witnesses. Again, margin debt as a percentage of market cap.

    Page 12, which I think is more revealing and what you should think about when Mr. Lucas talked about his constituents, this is real, this is what is going on, folks. This is showing margin debt as a percent of consumer credit. This is showing the liability side of the average American's balance sheet. X, the mortgage market. What it is telling me is margin debt as a percent of consumer credit has gone to 16 percent, which is roughly 2 times fifty-year norms. In laymen's terms, people are no longer borrowing to buy a washer or dryer, they are borrowing to buy Yahoo. That is what is going on.

    Page 13, this just shows the different constituents in the market. These are the main brokers, Ameritrade, DLJ Direct, Waterhouse, E-group, Schwab, Bear Stearns, Merrill Lynch, Morgan Stanley, names you are familiar with. What this chart just shows is margin interest, for example margin income, is a pretty important part of the new economy broker's profit bottles. It is quite an important part. I think what you are going to see in this space is competition, right? When the Latin American economies were all booming in the 1970's, all of the banks had a lot of capital and they lent more money.
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    Look at the history of real estate lending in the U.S. You could make the case this is not dissimilar. It is an important part of the profit structure. Having said all of this, I have interviewed the folks at E-group and Schwab. They are not oblivious to this. They have controls in place and they are trying as best they can to vet their consumers, but risk is clearly building.

    Page 14, real simple chart shows the increase in S&P valuation over the last four years—five years rather. Increase in NYSE margin debt has been about 16 percent points higher. And you will see the real growth has come from Schwab and online brokers. So again, what I am hoping to do here is give you the data. We have had testimony about stock. This is where it is actually coming. This is where the margin debts come through.

    Page 15. A simple chart showing the debt, the loan relative to the customer's stock ownership. You will see the average on the NYSE is 1.6, 1.7 percent of the market cap. As you move down the curve toward the Internet brokers, you end up getting numbers closer to 10 percent. Is 10 percent even high? Well, think about it. It is a ratio, right. The numerator is the loan. The denominator actually isn't the entire asset pool, it is the pool of the people that use the margin. There is an 80–20 rule at work here. Not everybody is using margin debt. So in reality you don't want to use the whole denominator. You can't use Mr. Smith's stock to repay Mr. Jones' loan. So in reality if you see a 10 percent number here, the actual debt-to-asset to a security will be 30, 40 percent. So getting back to 1929-type numbers, if you will, in individual cases; again, not everybody is engaging in irrational behavior or even in highly risky behavior.

    Page 16, we have done a survey of Internet brokers and this you will find interesting. These are stocks, tremendously successful investments moving up thousands of percentage points that are marginable against. You can borrow against this stock. When you have a stock that has moved 2,000 percent, 50 percent may not be that much protection in reality. We saw a local example here yesterday with MicroStrategy. You have a risk appetite on the lender's side that I would argue is reasonably high.
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    Page 17. What kind of risk—and again in no way am I saying that is an S&L bailout that you are going to have on your hands. I want to make that clear. Having said that, one of the simple ways of looking at margins in the system is how much do these guys have in loans relative to their equity. So Charles Schwab has $17 billion in margin loans and $2 billion and change in equity. Well, if 20 percent of their margin loans default, their equity goes away.

    Again, I wouldn't posit the 20 percent will default, but again, what you will see is that one of the characteristics is that the more highly leveraged lenders tend to be new economy brokers as opposed to the old economy folks.

    Finally, wrapping up—you have been patient—page 18. The single best proxy for hedge fund lending or institutional margining is a company called Bear Stearns in New York. They are a big clearing house for all of these hedge funds and they have been in this business forever. They saw the Long-Term Capital Management correction. They were around in 1987. The same people running it then are running it now. It is an amazing operation, the experience there.

    The only point I wanted to make with this chart is looking from December of 1997 to January 2000 you will see it really hasn't spiked up. This is showing Bear's margin debt as a percent of the total, it hasn't gone up dramatically. That kind of supports my view that the bulge bracket, if you will, of borrowing has come at the retail level.

    So in summary, margin debt, everybody knows that it is at all-time record levels. What I think is different at this time is it comes at the retail space. I think it is coming with investors that don't have a long experience and it is coming in lenders that haven't necessarily been around either. So if I had to pinpoint a risk, that is where the risk is in the system today.
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    Mr. TOOMEY. [presiding.] First, let me thank the gentleman for his presentation. That is certainly very informative. I just have a couple of questions that I would like to—perhaps you could shed some light on. First of all, could you just review for us what the existing legal requirements are—and restrictions are—around margin lending for retail customers?

    Mr. GALBRAITH. The legal restrictions will be dictated by Fed policy, which will be an initial margin requirement, and then minimum maintenance requirements are actually dictated by the NYSE. Having said that, beyond that point it is all good old American individual behavior in the sense that different brokers will deploy dramatically different margin requirements at their own real discretion. When I went through this list of really volatile stocks, were they marginable, in many instances Schwab would not lend against them at all. 100 percent was their margin requirement whereas other institutions would view risk differently and actually lend against them. The minimums are set by the Fed or the NYSE and then prudence is required thereafter.

    Mr. TOOMEY. What are the current minimums?

    Mr. GALBRAITH. 15 and 25 percent.

    Mr. TOOMEY. So in layman's terms, in order for a retail investor to make a margin purchase of stock they have to put up 50 percent in cash and they can only borrow 50 percent. Where does the 25 percent come in?

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    Mr. GALBRAITH. Say day two, you put up the 50 percent and the bigger stock actually goes down, you don't have to immediately pony up to keep it at 50 percent at all times. The 25 percent, if it falls below 25 percent, you do have to pony up incremental cash to keep the ratio at that level. One is an initial concept and one is incremental.

    Mr. TOOMEY. Then there are various firms that take very wide and varying approaches to this by, in some cases, excluding all stocks from being eligible for margin purposes at all?

    Mr. GALBRAITH. Correct. You are going have dramatically bifurcated loss experiences. It is like any other lending process where you have certain people that just don't believe stocks will go down, will make loans against riskier stocks, and they will suffer losses.

    Mr. TOOMEY. As far as the—let's start with the large broker-dealers, the old broker-dealers. They tend, I gather from your presentation, to be more conservative than say online trading and some of the newer—is that a fair generalization?

    Mr. GALBRAITH. Yes, and it is reflected, I think, in the fact that their growth in margin debt for the most part has been slower than the market's growth in margin debt. I think that is a reasonable representation of conservatism at some levels. Also if you look at their restricted list, stocks you cannot borrow against, they tend to be higher as well.

    Mr. TOOMEY. OK. How about the personal wealth requirements that are imposed upon people who intend to use margin to buy stocks? Is that regulated by law or is that a discretion of firms also?
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    Mr. GALBRAITH. You have caught me short. I suspect that it is regulated by the firms, because you have some—in some instances I know from just reading the ads, folks with a $2,000 account can open up a margin account. So, the minimums are quite low, even if they are regulated.

    Mr. TOOMEY. I am not disputing you, except that it could be, of course, that you have to demonstrate and prove that you have a very large net worth and then you may do so with a relatively modest account.

    Mr. GALBRAITH. I take your point.

    Mr. TOOMEY. That is an open question as to whether there is actual legislation. How about the practices of the big securities firms? It seems to me like the big securities firms have pretty rigorous requirements. They generally require pretty substantial net worth and pretty substantial liquid assets in addition to that before they will allow you to use margin. Is that still the practice as you know it?

    Mr. GALBRAITH. I think it is. The one area where you may see risk building in the big old line firms is they are actually taking a number of these ''dot coms,'' if you will, public and quite often that person will be cash poor. They will be very stock rich, but they won't have any money. And so the companies will actually lend them against the IPO proceeds. That is an area where you have seen increased activity at the big main line, the Goldman Sachs and Morgan Stanleys of the world.

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    Mr. TOOMEY. If we look back at the historic chart that you provided, margin debt as a percentage of market capitalization, it is less than 1.6 right now. That strikes me as a relatively low number. Now 1999, it reached 30 percent. 1.6 versus 30 is still a vastly different ballpark orders of magnitude. As long as this stays a small percentage of the total market cap is that not a suggestion that we don't have a big systemic risk? Is that not a good barometer?

    Mr. GALBRAITH. I should have stated this up front. I don't think there is massive systemic risk here. I think you are wise to say that. But I do think it is isolated. The one thing I would point out that may be a little bit different from 1929 is the proliferation of so many different types of financial instruments. In other words, from an option or another derivative instrument you can get a loft leverage and those are new creations. So I actually think the 1.5, 1.6 is a good proxy for what is going on in the institutional arena, whereas I think those charts I showed you about the percent of margin debt relative to the online brokers assets are also noteworthy.

    That is the analysis I would suspect that the SEC or the Fed would want to do. They are very different markets. One is almost a corporate market and one is truly a retail business, retail market.

    Mr. TOOMEY. So if I can just understand this correctly, it seems to me your focus in terms of the increase in risk is at the level of the retail individual investor and even a subset of that, it strikes me, as perhaps those investors who are using the newer less traditional systems. Do you recommend any specific policy change to deal with that situation?
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    Mr. GALBRAITH. No. I honestly wouldn't, because I think the markets is really fierce in their punishment of the people with imprudent practices. It is clear to me—I spent a fair amount of time with the folks at E-group and Schwab—that they take this very seriously. I haven't had the opportunity to interview every single new online broker, but if you just read their margin requirement differences, what stocks they allow to be margined, that speaks volumes. If you are letting someone borrow against a stock that was an IPO done six months ago that is up 2,000 percent with no earnings history, you have a high tolerance for risk; whereas the folks at Schwab and E-group and some of the other folks—to give you some numbers, a year ago I think E-group had 65 stocks on its restricted list. Today there is 300.

    So the individual companies are addressing it differently and this is beyond the scope of the work that I have done. But just looking at the margin list, I can tell you you are going to get very differentiated loss experience among the online guys. So I couldn't see how policy would necessarily help.

    Mr. TOOMEY. The loss experience that you are referring to is the loss experience that would be incurred by those providing marginal lending, not so much the retail investor who is going to take a loss on their portfolio.

    Mr. GALBRAITH. They will both lose. The reality is—if you had a really dislocated market they would both lose; a down 30 percent market it would cause losses to both.

    Mr. TOOMEY. Presumably a prudent way to manage this risk from the point of view of a securities firm would be to say to the extent that we provide margin on even a high flying stock that has some spectacular price movement, which is therefore assumed to be perhaps risky, would be to make sure that there are other assets, that the individual has a net worth and liquid assets to cover even a disastrous performance. Is it your impression that these institutions are not requiring that individual investors demonstrate the ability to incur these losses?
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    Mr. GALBRAITH. No. I think certainly at the larger firms they will almost have a blanket lien on all of your assets. They would be part of the general creditor pool and then have the explicit right of offset against your stock portfolio. So it is real easy, just literally——

    Mr. TOOMEY. They have a mechanism to go in and take them and liquidate them, which is a well-established part of their business.

    Mr. GALBRAITH. Absolutely. In fact, when you talk or when folks go through with the newer participants, as opposed to just using ''online'' as a pejorative term, when you talk to the newer participants that is really what I try to get behind, is to make sure that it is very highly automated such that there isn't room for errors if you have a dislocation. It should be immediate when it is called for.

    Mr. TOOMEY. Right. I have a question about the chart that you have on page 13. You show margin interest as a revenue source. And the column reflects a percentage of total revenues. Is this only the net interest income?

    Mr. GALBRAITH. Yes. The point is it is a big number. You are right. It is a net number. In fact, if you think about it, it is probably an even larger percent of profits or cashflow. So this is a hugely lucrative business. So the incentive to cheat or go out the risk curve is quite high, because you are making a lot of money on it.

    Mr. TOOMEY. And do all of the firms have the same rate structure pretty much on this?
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    Mr. GALBRAITH. No, that is the other interesting thing. I suspect if you look back two or three years ago they were quite close.

    Now, while it hasn't quite gone to this extreme you may get teaser rates or things like this where you will have discounting on your lending. You are definitely seeing it. You are seeing it not only on the exception on raising rates, but also frankly on competition of which stocks you are allowed to lend, because I think the way the folks that are further out on the risk curve think about it is, OK, I might in aggregate, looking at it as a basket analysis, take higher losses, but if I get ''X'' more customers it is an offset. It is really the problem part of the competitive landscape in the business.

    Mr. TOOMEY. What kind of—how do they structure their margin interest rates? Is it a spread over Fed funds?

    Mr. GALBRAITH. It will vary from broker to broker, but typically a spread over prime rate, for instance. They will clear 250 to 300 basis points, which is 2.5 to 3 percent. This is not a bad business proposition for them when things are going well.

    Mr. TOOMEY. It also—of course, just to think about this in various aspects, if you can consistently earn 2.5 to 3 percent as a net interest margin on this kind of lending, of course you can justify taking some hits every once in a while on a portfolio of that nature?

    Mr. GALBRAITH. You are absolutely right. Kind of the way I suspect you want to look at this whole process is a traditional bell curve. This is one of those tail events. That is what you have to worry about. Under normal economic theory you could price it appropriately. But if it is—if we are off on an extreme, all of that analysis will prove just completely useless.
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    Mr. TOOMEY. Do any of the firms we have been discussing take the approach that says certain stocks ought to be at prime plus one-and-a-half and others ought to be lent at prime plus-five?

    Mr. GALBRAITH. No, that hasn't happened yet. I thought that might be a capitalist way of dealing with it, price your risk according to the reward. But as of yet you haven't seen it. That is an interesting suggestion, though.

    Mr. TOOMEY. OK. Did you have any other comments or any summary comments you wanted to make?

    Mr. GALBRAITH. That is it.

    Mr. TOOMEY. Well, I am supposed to read that any Member who would like to submit any additional comments will have five days to do so. And hearing no objections, I want to thank the witness very much for your informative testimony. The hearing is adjourned.

    [Whereupon, at 3:44 p.m., the hearing was adjourned.]