Hearing Of The Financial Services And General Government Subcommittee Of The Senate Appropriations Committee - Fiscal Year 2010 Budget Request For The Department Of The Treasury And Internal Revenue Service

Statement

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SEN. DURBIN: Good morning. My apologies. (Audio break.) I was on the floor defending the administration. That's all I can say. (Laughter.) To my colleagues, I apologize.

(Strikes gavel.)

Pleased to convene this hearing to examine the fiscal year 2010 funding request of the Department of the Treasury, including the Internal Revenue Service.

Mr. Secretary, thank you for joining Senator Collins and my other colleagues this morning.

We know that IRS Commissioner Doug Shulman is also here and prepared to testify, and I'm going to waive the remainder of my opening statement, in the interest of time, until all my colleagues say a few words so that we can catch up with the schedule.

Senator Collins.

SEN. SUSAN COLLINS (R-ME): Thank you, Mr. Chairman.

Secretary Geithner, Commissioner Shulman, I'm very pleased to welcome you to this hearing, and I thank you for your service to our nation.

Mr. Secretary, you have so many challenging responsibilities that it's difficult to know where to begin. You're responsible for reinvigorating banks' lending to consumers and small businesses, stabilizing the housing markets, overseeing the automobile industry, and encouraging sustainable economic growth.

Most important, you must try to protect American taxpayers and their investments and promote the long-term financial security of the United States at a time of unprecedented debt.

The current financial crisis is rooted in a tangled web of high- risk financial instruments, backed by high-risk loans issued by high- risk individuals.

To emerge from this crisis and to overcome its effects, we must restore trust in our nation's financial institutions and financial markets. And in my view, that will require significant reforms in our system of financial regulation -- an issue that I want to discuss with you today.

Several developments are shaking Americans' trust in the economy. First among these is the dangerous increase in our nation's long-term debt.

While I supported the short-term fiscal stimuluses necessary to get our economy back on track, I am troubled that the president's budget proposes to double the debt in five years and triple it in 10 (years).

I'm concerned that the long-term debt of this administration poses a threat to the sustainability of our economy. Where would the money come from to pay these debts -- China, where you've recently visited; Saudi Arabia; sovereign wealth funds?

Will this public borrowing crowd out private investment and slow the recovery? Who ultimately will pay for this borrowing -- our children and our grandchildren?

We need to assess what we're doing to our country's long-term financial health.

Finally, Mr. Secretary, I remain very concerned, as I indicated to you in our conversation yesterday, about the management accountability and transparency of the TARP fund.

Originally, TARP was envisioned as a fund to prevent our largest banks and financial institutions from failing and to increase the liquidity in our credit market.

Today, however, TARP encompasses 12 different programs, not just for banks, but also for insurance companies and automobile manufacturers, and involves government funds combined with private funds adding up to almost $3 trillion.

It is disturbing to me that we really cannot assess what the impact of TARP funds has been on the recipients, whether it's truly increased lending.

And the Treasury Department has yet to articulate how it will measure whether this injection of capital has been an effective use of taxpayer dollars.

I'm concerned that we're being asked simply to trust that this large infusion of capital into the economy will lift us out of a severe financial crisis whose complex origins are still being untangled.

Secretary Geithner and Commissioner Shulman, you both face great challenges in managing the federal government's finances and attempting to reintegrate our economy. These truly are extraordinary times.

And I'm going to work very closely with you -- and I pledge to do so, as well as with our chairman -- to make sure that you have the staff, the authority and the resources that you need to serve the American people.

Thank you, Mr. Chairman.

SEN. DURBIN: Thank you, Senator Collins.

I'm going to invite my colleagues to make brief opening statements.

And Senator Lautenberg, I recognize you.

SEN. FRANK LAUTENBERG (D-NJ): Thanks very much, Mr. Chairman.

Greetings, Mr. Geithner -- Secretary Geithner. You've taken on a formidable task. And so far I think the score in the ball game certainly is going your way, but we are quite a distance from the ninth inning.

As we meet today, the economy's slowly beginning to show signs of a possible recovery. And -- the challenges still remain.

This recovery will require strong reforms to place our financial system on a firm footing. We've got to give the regulators the tools that they need to predict and prevent financial crisis.

And we've got to change corporate culture that says the people -- the leadership at the top can often take its compensation without regard for what happens with the employees or the future investing for the well-being of the company and taxpayers.

I am still on the board of the Columbia Business School, and some time ago I gave them a chair. I was out of the Senate for a couple of years; took a hiatus.

And what I proposed was that salaries at the top be related to salaries at the bottom, and -- instead of letting the ratio slip as it has from 40 times, typically, in the '80s, to 400 times in recent times.

And also -- and I don't know, Mr. Secretary, what kind of latitude you have or what kind of authority you have to suggest the conduct in the CEO's office.

But one of the things I think that we have to look at while we change this crooked culture is to make it clear that when an executive retires, that the reward ought to be -- my view -- in the performance of the company after the leader leaves. And the bonuses should be expanded as time goes by, and not simply related to the stock price, because stock price may be at the expense of investing in the future of the business.

Anyway, we're glad to see you here and urge you to carry on and work hard.

Thank you.

SEN. DURBIN: Senator Nelson?

SEN. BEN NELSON (D-NE): Thank you, Mr. Chairman.

Secretary, we're glad you're here. We appreciate the effort that you are providing and the progress that we hope will come -- will, in fact, come.

When I go home, I have people come to me complaining about the bailouts, complaining about TARP, complaining about putting the auto industry into bankruptcy. And they're all concerned about that.

They're concerned also about the growing deficit and the increasing budget.

One thing that they're now becoming alarmed about is government ownership of stock. And when we come to the questions, I've got some questions about that.

Because they come to me and say, look, aren't we drifting into socialism at a rapid rate? And I assure them that our goal is not to hold the stockholdings or warrants or any other financial instruments that we shouldn't be holding --

That our goal is to get these companies so that they're functioning on their own, so that they're either publicly traded or that they're privately owned, but not government owned.

So I'll be asking you for reassurance on that side. Because I hope, and I believe, that our goal is just as I've stated it -- to help these companies get on their feet and, when on their feet, to become private once again -- not to have the kind of public ownership that we currently have.

So I'll be anxious to get your take on that.

Thank you, Mr. Chairman.

SEN. DURBIN: Senator Tester?

SEN. JON TESTER (D-MT): Thank you, Mr. Chairman.

Mr. Shulman, Secretary Geithner, it's good to have Secretary Geithner and Commissioner Shulman here today. I've gotten to visit with Secretary Geithner on several occasions, and I look forward to the one today.

We have just experienced, over the last little over a year, the biggest economic downturn since the 1930s. We have seen irresponsibility on Wall Street.

We have seen irresponsibility in government, with a lack of regulation; in some cases, no regulation. We have, (one ?), stepped forth with the TARP program; we stepped forth with the recovery bill. You were the in eye of the storm.

I look forward to visiting with you about all those things that impact the economy and where we're going from here, and I appreciate your coming in front of the Committee.

Thank you.

SEN. DURBIN: Senator Bond.

SEN. KIT BOND (R-MO): Thank you very much, Mr. Chairman, Ranking Member Collins.

Welcome, Secretary Geithner.

Everybody knows over the past year we've had a major economic storm raging, with great damage to everybody.

The federal government has responded to the economic crisis with aggressive and unprecedented -- but unfortunately, I believe -- ad hoc actions to taxpayer-funded bailouts of too-big-to-fail private corporations, a trillion-dollar stimulus, foreclosure rescue programs, just to name a few.

We've seen some positive signs of green shoots, but there are some wondering whether they will wither away during continuing problems in the housing sector, consumer debt remaining high, significant de-leveraging occurring in the financial sector, and lingering questions about the solvency of banks.

Are we seeing a dead cat bounce in the markets? Economic and financial experts are telling us that economic recovery cannot occur or be sustained until we address the root cause -- the credit crisis.

That's what TARP was supposed to do, but it got up on the wrong foot last fall, in my view, and it's still there. And President Obama told us in January we can't have a recovery until we get the toxic assets out.

This is -- these are questions I want to follow up with. The size of the stimulus also is now causing questions from the Federal Reserve.

If we get in the position of monetizing our debt, we will face an unprecedented disaster and go the way, perhaps, of Argentina. And tripling the debt in 10 years seems to me to be a very risky approach.

We've seen the United Kingdom, which was recently warned about its credit rating. Perhaps that is the canary in the coal mine for our nation's own future.

Thank you, Mr. Chairman.

SEN. DURBIN: Thank you very much, Senator Bond.

Mr. Secretary, the floor is yours.

SEC. GEITHNER: Chairman Durbin, Ranking Member Collins and members of the committee, it's a pleasure to be before you today, my first time appearing before you about the Treasury's budget.

I look forward to building a close working relationship, and I look forward to having a chance to answer the many important questions you raised in your opening statements.

While we see some initial signs of economic improvement -- and I think you could say that the force of the storm is weakening a bit -- and although the financial system is beginning to heal, our country faces very substantial economic and financial challenges.

Now, the president and the administration are working to meet these challenges. We're working hard to get Americans back to work -- to get our economy back to a growth path again -- by committing to restoring fiscal discipline to ensure a sustained recovery, and by making the long-neglected investments in health care reform, in energy and education necessary to improve the productive capacity of our economy and to ensure, over the longer term, we enhance the competitiveness of the U.S. economy.

To achieve these goals, we're working to repair and reform our financial system so that it works for, not against, recovery. We're working to restore growth and meet our fiscal goals by redesigning our tax code and bolstering enforcement.

We're working to advance our interests globally, working with other countries to promote economic recovery and financial repair, and to ensure more open markets for U.S. businesses.

And to protect our nation's national security interests, we're deploying all the tools at our disposal to exclude terrorists, proliferators, and other illicit actors from the international financial stage, and thereby secure our financial system and prevent threats to our security.

Now, the fiscal year 2010 budget you have before you will allow Treasury to pursue these core missions. The $13.4 billion request includes a $676 million, or 5.3 percent, increase over the enacted 2009 levels.

Just a few brief highlights about the budget request:

Of the increase we're seeking, 14 million (dollars) would go to bolstering the staffs of our Domestic Finance and Tax Policy offices.

Now, these offices -- Domestic Finance and Tax Policy -- are at the center of the administration's efforts to support strong design, rigorous analysis, improve the financial system, reform the financial system, and implement reforms to our tax policies and tax code.

We include in the budget a $137 million request to more than double our Community Development Financial Institutions, our CDFI fund, to ensure that the benefits of our financial efforts reach beyond the major banks and businesses to help economically distressed communities.

These communities were underserved by our financial system even before the current crisis, and they have been deeply hurt by the job losses and business failures that the crisis has exacerbated.

We propose a total of $332 million for new IRS enforcement efforts, including $128 million to add nearly 800 new IRS employees to combat offshore tax evasion and improve compliance with the U.S. international tax laws by businesses and high-income individuals.

Another $130 million would go to bolster the security of IRS information technology, improve the efficiency of its business systems, and upgrade its fraud detection capabilities.

Now, although not directly under the jurisdiction of this Subcommittee, I just want to note also that our budget includes funds to meet our international obligations and to help us craft a global response to the crisis in this more integrated global economic system we live in today.

Now, as we seek these additional funds to respond to our nation's immediate challenges, we have cut back on some programs that are either ineffective or we believe can be safely delayed.

Just one example: Even as we're trying to increase capital investment for the IRS, our budget would reduce the Department-wide -- Treasury's Department-wide capital investment account by 65 percent, for a modest savings of $17 million.

Now, just before I end, I want to say a few words about the Treasury staff.

I have the honor of leading a team of exceptionally smart and dedicated individuals who're working very hard to make our government more effective.

They're performing a great service for our country under challenging circumstances. I'm very grateful to them.

And I think if you look at the scale of what we've set in motion just in the last six months, they have done extraordinary things in a very short period of time.

Thank you, Mr. Chairman. I'd be happy to answer any questions.

SEN. DURBIN: Mr. Secretary, many of the questions we ask will be policy questions, somewhat global in scope. I'll try to bring those home to the actual budget aspects of this hearing as best I can.

Let me start with a topic you won't be surprised I'm interested in -- mortgage foreclosure. I have brought before the Senate twice now, unsuccessfully, an attempt to change the bankruptcy code so that we can create more incentives for renegotiating mortgages to avoid foreclosure.

I failed in both efforts. The last effort was opposed by virtually all of the banking institutions of the United States save one, Citigroup, that supported our efforts.

The Mortgage Bankers Association reported last week about 12.07 percent of mortgage loans were delinquent or in foreclosure in the first quarter, the highest level ever recorded since the survey was launched in 1972. Also for the first time, most mortgages in foreclosure were prime loans, 49.8 percent compared to 43.2 percent subprime, which we initially identified as our major concerns. Foreclosures bounced up 32 percent to 342,000 during the year-over- year period ending in April, according to Realty Track.

The Obama administration's Making Home Affordable program has resulted in only 55,000 mortgage modifications in the last two months. According to The Washington Post, experts say foreclosure prevention programs will not be successful unless they address homeowners who owe more than their properties are worth.

I sense that this was the catalyst that led us into this recession. It is my feeling that the previous administration and so far this administration has failed to come up with an approach which could dramatically turn around this increasing number of mortgage foreclosures. A year ago, the estimate was 2 million. This year, it's 8 million. Ultimately, one out of every six home mortgages faces foreclosure based on current predictions.

Do you agree that we need to strengthen incentives to modify more mortgages to turn this economy around? And wouldn't that help spur participation in Treasury's own mortgage modification program? And can you suggest a better method to give homeowners more leverage than to change the bankruptcy code?

SEC. GEITHNER: Well, Senator, you're right that housing is the center of this crisis. And of course, millions of Americans are losing their homes, including many who were very responsible and are suffering enormous damage simply because of the actions of those borrowers who lived way beyond their means and those banks that made a bunch of loans they should not have made.

And I agree with you, I think this government should have moved earlier to address this crisis. We were late as a country and behind the curve.

I do believe, though, that the president's program does provide a very powerful set of incentives to induce a substantial increase in successful modifications. We are at the very early stage of implementing that program.

It's true we've been in office now almost six months, and this program was laid out, in terms of its detail, only a few months ago. But there is a substantial increase in efforts -- (inaudible) -- put out notifications to potentially eligible borrowers. And I expect to see a very substantial acceleration of the pace of modifications.

Now, this program does create significant incentives for servicers to participate. It also does reach homeowners that are significantly under water. It won't reach all homeowners. There are some homeowners that simply got themselves to a point where they've got a completely unsustainable mortgage and are unlikely to be able to retain their house.

But the program is designed to reach homeowners that are living today with significant amounts of negative LTVs or high LTVs, negative equity.

Now, the program has been successful in helping bring down interest rates, working alongside the Fed. It has been successful in substantially increasing refinancing so that more Americans can take advantage of those lower rates. And as I said, we're just beginning to see the effects of these very substantial incentives we put in place to encourage modifications.

Realistically, I don't think we're going to know until probably early fall whether we've got the incentives right and whether they're going to prove powerful enough. But our judgment is that this is the best package of incentives which offers the best return for the taxpayer's resources we're going to use to help address the housing crisis.

SEN. DURBIN: I would just say I asked this question of your predecessor, in perhaps a little different form, and still remain skeptical that the voluntary approach to mortgage renegotiation is going to save us from this crisis that we're facing.

I think until we get an honest approach that really results in substantial renegotiation of mortgages that the real estate industry and the housing industry are going to continue to be weak. I don't know how we can build a strong American economy if our homes are losing value and we see our neighbors facing foreclosure as we find across this country.

SEC. GEITHNER: Senator, I understand your concern, and I commend you for your leadership and focus on this issue from an early perspective. But this program is a dramatically different program from what was tried under the previous administration. The financial incentives that we put in place here are very substantial, and it came alongside a substantial change in policies by Fannie and Freddie to help allow for a refinancing, even for homeowners who were slightly under water.

So I think that we all want to see results. And you should judge us by our results. And it will take a little longer, though, to judge whether this is as powerful as we expect it to be.

Now, I think if you just step back and look at what's happened in the housing markets over the last six months or so, partly because of the effects -- (inaudible) -- recovery program on confidence, partly because of the impact of the Fed's programs and the Treasury's programs, the pace of decline in house prices has started to slow. And that is early signs of us being able to look to the other side of this.

But realistically, I think you're going to still see a very challenging period ahead for many homeowners. Many more Americans are still at risk of losing their homes, and that's why we want these programs to work.

SEN. DURBIN: Senator Collins.

I might say that each member will have five minutes, and we'll have probably more than one round.

Senator Collins.

SEN. SUSAN COLLINS (R-ME): Thank you, Mr. Chairman.

Mr. Secretary, I want to follow up on the discussion we had about the use of TARP funds. It troubles me that banks have received billions of dollars without having to demonstrate that they've increased lending as a result and without having to be fully accountable and transparent in the expenditure of the funds they have received.

I mentioned to you that I've seen in my state a large recipient of TARP funding constrained credit to actually cut off lines of credit, to cease lending to a nonprofit hospital in my state, a major retailer. So I don't see, on the grassroots level, the benefits of putting billions of dollars into financial institutions, the intent of which was to prevent this constrained credit.

In addition, the special inspector general for TARP in his report in April criticized the Treasury for not adopting recommendations to require that all TARP recipients account for the use of the funds. So I'd like to ask you to comment on, why hasn't the Treasury made, as a condition of receipt of TARP funds, a condition requiring an increase in lending and full transparency?

SEC. GEITHNER: Senator, excellent question. Could I just start by saying that, you know, this is a crisis produced in significant part by two things. One is families across the country substantially increased the amount they borrowed, so household debt rose dramatically as a share of our overall economy. And we had pockets of excess leverage, too much lending buildup across the financial system.

Now, we're going through a very deep, wrenching recession. In any recession, the demand for credit falls because economic activity falls. In a recession that follows a long credit boom like this, you would normally expect credit to fall quite sharply.

That's an important connect because it's hard to know how best to measure the full impact of these programs because, again, under any circumstance we would have had a period where borrowing would fall as homeowners, as families decide to go back to living within their means, decide to save more, reduce their debt outstanding. And lending would fall as the weaker parts of the financial system decline to a more sustainable level.

Now, it is (dearly ?) important to us that we have better ways of measuring the impact of these programs. So when we came into office, we put in place a much more comprehensive set of reporting so that all banks that receive TARP assistance have a report monthly on what's actually happening to lending behavior.

We started with the major banks. We extended that now to all TARP recipients. And you'll be able to see monthly now on a Treasury website what banks are actually doing in terms of lending. And that is the ultimate measure of the impact of these capital assistance programs.

We are very committed to improving the overall quality of transparency and accountability across these programs. And each of the programs we designed provides for an exceptionally careful level of oversight and a level of transparency so people can measure the actual impact and effects.

Now, if there are other things we can do to strengthen that, we will do it, because nothing is more important to the credibility of these programs than a better sense among the American people that they have the chance to judge and measure impact.

Now, just to finish quickly where you begin. My own judgment is that the programs that the Congress authorized last fall and the actions that my predecessor took initially to put capital into the U.S. banking system were absolutely essential to prevent a catastrophic financial collapse. If you look back to that period of time, lending actually stopped. And because lending stopped and because confidence was so badly damaged, basic business stopped, and it happened around the world.

And when that capital was put into those banks initially, that was the first step in beginning to lay a foundation for recovery and repair.

We cannot know with certainty what would have happened in the absence of that action. But my judgment is that without those actions, you would have faced the prospect of a catastrophic failure of the U.S. financial system and much, much more damage to the economic activity than we already saw.

Now, today, we are seeing -- over the last several weeks, we have seen some very impressive, encouraging signs of improvement in the overall credit conditions. So if you look at concern about risk and exposure to banks, if you look at the ability of banks to go raise equity to replace the government's investment, if you look at what's happening to borrowing costs for businesses across the country, if you look at what's happening to mortgage rates and interest rates, there have been substantial improvements in those basic measures of these programs.

So my sense is it's early days, as I said, and this is just the beginning. But I think where the government has acted you can see very tangible benefits in improvement. Now, we have a ways to go. This crisis took a long time, the conditions of this crisis took a long time to build up. It will take us a long time to work through. But I think these programs are achieving traction, and they're the right mix of programs. And we will do everything we need to do to make sure that we are adopting sensible recommendations by not just the SIGTARP but by the congressional oversight panel and the GAO who are looking very, very carefully at all of these programs.

SEN. COLLINS: Thank you.

SEN. DURBIN: Senator Lautenberg.

SEN. FRANK LAUTENBERG (D-NJ): Thanks, Mr. Chairman.

Mr. Geithner, the financial crisis that we are seeing was, in my view, due in significant part to poor management of these companies and particularly (impinged ?), I must say, by the outcome of the management years of the automobile industry who refused to see what the public appetite was, when we refused to be competitive. And thus, jobs have been lost and an industry practically destroyed that we loved and admired for so many years.

Well, when we look at the risks taken by corporate executives, decisions made, many of these executive pay packages insulate CEOs from the risks. And again, I may -- I don't want to take you out of your bailiwick -- but to avoid this excessive mismanagement, should executive compensation be tied to the long-term health of a company? Do we -- where do we have a right to interject our views?

SEC. GEITHNER: Senator, this is a very important issue and I agree with you. I think although many things caused this crisis, what happened to compensation and the incentives that created for risk taking did contribute in some institutions to the kind of vulnerability we saw in this financial crisis.

And my view is that we need to help encourage substantial reforms in compensation structures -- particularly in the financial industry -- because of the dependence of the economy on a well functioning, more stable, better set of judgments by financial institutions.

I think boards of directors did not do a good job. I think shareholders did not do a good job in terms of disciplining compensation practices. And I think a centerpiece of sensible reform will be to tie compensation to better measures of long-term investment and return to adjust them to reflect the risk -- to reflect risk. That's part of the reforms. And we are, as part of our broader regulatory reform proposals -- our proposals to reform the whole framework of financial regulation in the United States -- will include some suggestions for trying to encourage reforms in compensation packages.

SEN. LAUTENBERG: Well, where does the start begin? Is it Treasury or IRS or the SEC? How do we get things introduced into the governance of these things?

SEC. GEITHNER: Well, as you'll hear from us the next few days, the SEC has some important responsibilities and obligations in this area and some tools and authorities they may seek in this area.

The bank supervisors, under the leadership Chairman Bernanke and others, have already initiated a process to define standards and principles that supervisors would use to help bring about reforms in compensation practices in the financial industry. Those are two ways we can have influence over the shape of practice in these areas.

There are other ways too, but my own sense is that the core will be those two authorities.

SEN. LAUTENBERG: Senator Nelson mentioned something about the government owning shares in these companies and it's -- I think it has to happen.

Who, for instance, would vote the shares -- would the government be -- American government -- likely to appoint the board of directors and have them make decisions?

SEC. GEITHNER: Senator, this is an enormously important set of questions. As we said before -- the president and I've said -- we are an extremely reluctant investor where we're an investor. We do not want to be in the business of managing these companies on a day-to-day basis.

We'd like to make sure we have the ability to get out as quickly as we can, have these companies emerge on their own as viable entities without government assistance on an ongoing basis and have the capacity to go raise capital in the markets to repay the government's investments.

To underscore that, we are -- we've designed a set of policies and mechanisms that will ensure that people understand that we only tend to use our voting rights for a very limited number of core judgments about the financial structure of the firm to make sure that there's a strong board and management in place at the time we take our equity investments of the taxpayers and ensure they're protected. So we have confidence in their ability to oversee a sufficiently robust restructuring plan.

We do not want to leave the impression or the reality in place that the government of the United States will be able to and will have the capacity to exercise judgments over the day-to-day operations of these businesses. We think that would be damaging to franchise value, damaging to the interests of the taxpayers and trying to make sure we can get out as quickly as possible. And our hope is we designed a set of institutional protections to avoid that risk.

SEN. LAUTENBERG: Thank you.

Thanks, Mr. Chairman.

SEN. DURBIN: Senator Bond.

SEN. CHRISTOPHER BOND (R-MO): Thank you very much, Mr. Chairman.

And Mr. Secretary, a lot of us in the heartland are wondering why you're treating failed financial institutions differently from GM and Chrysler.

The administration has orchestrated and forced the car companies into bankruptcy, but it seemed to be reluctant to force failed large financial institution like Citi into restructuring.

Now, we've seen in the past that large organizations -- not as large Citi, but IndyMac has gone through an FDIC cleansing program and this one is outside of politics. And when you do it through the FDIC, you don't get the political questions that are asked, you don't get the political involvement in it.

And as The Wall Street Journal asked today, if Citi is not forced into an FDIC-like restructuring, you know, how can you ensure the taxpayers that we won't continue to return for billions and billions of bailouts, which I think all of us have heard great concerns from our constituents?

SEC. GEITHNER: Senator, I share those concerns. And I think it's important to acknowledge that the actions that the government's had to take over the last 12 months, in particular, to help protect the economy from this financial crisis have created -- well, they've been exceptional-extraordinary and the have have created the risk that unless we reform the system, we're going to face a greater risk of financial crises in the future, because we will have created moral hazard that might make the system more vulnerable in the future.

I am deeply worried about that. I share that concern. And that is why it is so important that we put in place stronger protections against -- constraints on risk taking in the future.

A centerpiece of what the president will recommend in terms of financial reform will be a set of much more conservative set of constraints in risk taking across the financial system more evenly enforced with more effective oversight. And as part of that, we need to have a better capacity to deal with potential failures of large institutions.

Now, the system that you referred to -- the system that Congress helped put in place built around the FDIC, strengthened in the wake of the S&L crisis, is a very effective process, but it was designed to deal with relatively small banks and thrifts and it was not designed for a crisis of this severity. That is why we did not have -- and that system was not designed to deal with a more complex type of failure, for example, like AIG.

That's why a centerpiece of what the president will recommend will be stronger capacity to resolve, address, better manage the risks to the system posed by those type of institutions.

Now, I just want to underscore a couple of things about context: When I came into office, the government of the United States had already invested roughly $200 billion in our nation's banks. As I said to Senator Collins, I think that was a necessary thing to do. You would never want to do that, but it was essential to do.

SEN. BOND: Mr. Secretary, I'm running out of time.

But I think everybody would agree that the Federal Reserve came up and flooded the system with money. We put -- the TARP money went in. But now we're past that, and unless we take some steps to deal with too big to fail, we're going -- we've got that moral hazard.

And I'm also worried about the PPIP. A lot of people saying the banks aren't participating, because it looks like it's going to be political. And if they get in, who would want to get in partnership with the federal government when they see what some of our fellow members of Congress are doing?

Are you going to be able to get any of these toxic assets out with PPIP? Where are the participants?

SEC. GEITHNER: Listen, I just -- again I want to underscore that you're right. This issue (it could lead ?) a moral hazard is a really an important thing. That's why the president wants to move so quickly on legislation.

Now, on the issue of these legacy assets that are still on the books of the nation's banks: You're right that there is some concern in the market still about participation and whether that brings some risk of -- (inaudible) -- conditions imposed in the future and that could limit participation in the beginning and that would be an unfortunate thing. I think we all have a responsibility to act to reduce that sense of risk and uncertainty about the rules of the game.

It's also true that banks have found it more easy to raise equity than they thought. And that combined with the slight improvement and confidence in the system may also reduce participation.

In my judgment, though, these funds still are an important part of the necessary framework of tools to help get our country through this crisis. And I believe that it's important that we go ahead and put them in place, even if we see participation somewhat more limited than people would have expected because of both the political concerns and because the basic improvements --

SEN. BOND: I would hope that you would use the FDIC model. Chairman Durbin and I, and others, and Senator Dodd have proposed beefing up the FDIC. We need to use them. And I'll have further questions for the record.

And, Mr. Chairman, I ask that my full statement -- and all my good advice in it, be included in the record, in the hopes that somebody might read it some day.

SEN. DURBIN: We'll all look forward to reading that, and it will gladly be inserted. Thank you, Senator Bond.

Senator Nelson.

SEN. BEN NELSON (D-NE): Thank you, Mr. Chairman.

Secretary Geithner, you mentioned that we're reluctantly in a position of holding the shares of General Motors, and perhaps in a position of controlling other institutions -- but we're doing so reluctantly. I'm so reluctant to be one of those 'holders of that stock' that I'm introducing a resolution, as a sense of the Senate resolution that we begin the process to divest ourselves of that stock ownership over a reasonable period of time, making clear that we're only a temporary shareholder and that we should take, obviously, all steps to protect the American taxpayer dollars, and begin to divest the ownership as expeditiously as possible, and call for a GAO study to help determine the period of time that it may take to return GM and Chrysler's solvency and complete the divestiture.

I think that says what I'd like to say. In addition, I've heard it said that, for those who worry that somehow we're drifting into socialism, that socialism is where the government wants to take over "profitable" ventures -- (laughter) -- as opposed to being where we are right now. Apart from the levity, I think it is probably accurate.

And so I hope that the administration will be supportive of every effort to make the public statements that this is a temporary situation, not one that is optimum -- optimal, in terms of what we would prefer to do, but where we are at the moment. But, to make certain also that we're not going to stay there one day longer than we should in that position of ownership. And I'm encouraged where you say that we won't exercise day-to-day judgment over many of the decisions and opportunities that the industry will have.

I've got some other questions about that, and that relates to the dealerships. I know they're very concerned about summarily being dismissed after decades of relationships with the auto industry. Is there any effort to try to establish some sort of a recognition of the rights -- not just contractual rights, but somewhere the rights of dealerships in this dismissal, where any compensation is being directed toward those dealerships to soften the blows?

It's not taking their position that's so important, it's recognizing that in small communities all across America -- particularly in Nebraska, where dealerships are going to be lost -- people are going to lose their jobs as well in small communities where job replacement can be even more difficult than in the urban centers. I wish you might comment on that.

SEC. GEITHNER: Senator, can I just begin where you began to say -- and I think you said it right, in terms of the government's stake in these entities, where we take a stake: a temporary, clear path to exit; not a day longer than it's necessary; no ongoing role in day-to- day management.

And within that context, this broader question about the impact on communities of the substantial reduction in dealerships that the automobile companies have decided was necessary to get back on a path to viability. I just want to underscore that this -- these were their judgments, based on the careful analysis of what was necessary, again, to get them down to a cost basis that was tenable over time.

But, I understand the concern about the impact, and would be happy to explore with you, and talk to my colleagues about -- to make sure you have responses to your thoughtful questions about what the companies themselves might be able to do to help soften the blow.

SEN. NELSON: Appreciate that. Thank you.

SEC. GEITHNER: But, it has to be their judgments --

SEN. NELSON: Of course.

SEC. GEITHNER: -- (inaudible) --

SEN. NELSON: Of course.

In terms of financial regulation, can you give us a preview of what you have planned for financial regulation? For example, are there any plans to change the state-based regulation of insurance? Will you propose an office of insurance information, or a similar position? Or will you seek authority to regulate insurance at the federal level?

SEC. GEITHNER: Senator, I don't want to get ahead of the president of the United States on this. He's going to lay out a comprehensive set of proposals next week. In that context, we'll lay out our judgment about what we think is the most practical way to help begin the process of ensuring more effective supervision of -- at least parts of our insurance industry. But, I don't want to get out in front of him.

But, we've been taking a careful look at what's the most practical way to help begin that -- begin progress against that objective.

SEN. NELSON: Well, as you take a look at the case of AIG, although it's an insurance holding operation, keep in mind that the insurance subsidiaries were profitable; that they didn't have bad assets; that this is not a -- this is not something that has rippled through the insurance industry. But, focus on what happened with the Glass-Steagall modifications that permitted AIG to do what it did.

And so let's don't cure problems that don't exist as we try to take a, quote, unquote, "comprehensive approach." Let's just make sure that it's not so comprehensive that we sweep in regulatory schemes and mechanisms that are currently working.

SEC. GEITHNER: Senator, I completely agree. And we're bringing a broader pragmatic spirit to this exercise, and trying to focus on things that were central to the crisis, not things that were not; on things that are necessary to do, not just those -- not those that would be desirable to achieve over time.

Now, we may not all agree on the judgments we're making, but that's the pragmatic framework we're trying to bring to this.

SEN. NELSON: Well, apparently, you're making a commitment not to have collateral damage, right?

SEC. GEITHNER: Well, that is something that -- an obligation that we all share, and we're very careful, very careful to try to avoid that.

But, Senator, we did have, really, systematic failures across the regulatory framework in the United States, and we are going to have to change a lot of things to address those failures.

SEN. NELSON: Thank you.

Thank you, Mr. Chairman.

SEN. DURBIN: Thanks, Senator Nelson.

Senator Tester.

SEN. JON TESTER (D-MT): Thank you, Mr. Chairman. So many questions, so little time.

Secretary Geithner, in your budget there's a Financial Stabilization reserve of $250 million. In front of Banking last week, Herb Allison was there -- he's going to oversee the TARP, hopefully. He talked about, he called it "head room" -- I interpreted it as being reserve of $100 billion. Can you tell me why we need $250 million in the budget?

SEC. GEITHNER: Senator, can I just begin by saying that I announced this morning that banks have -- we've indicated to banks that, the Fed has indicated to banks that they could have the right to repurchase $68 billion in returns, $68 billion of those initial investments. And those will be coming back into the general fund.

Now, the way the EESA legislation is designed, that does create additional flexibility to allow us to use those funds if we believe there is a strong, compelling case. And since we're -- although things are getting better in the financial system, I think, to be realistic, there's a lot of risk ahead for us and we need to be careful to remind people that that flexibility authority is important.

Now, in the reserve fund, the president put in the budget this additional reserve fund -- in an abundance of caution, against the possibility that we could face a deepening crisis. Now, we do not expect, at this time, to come back to Congress to ask for authority to use those resources.

I began by pointing out this $68 billion repayment thing because it does provide some modest encouragement, I think, that we're going to be able to get through this without having to put you in the position of coming back for substantial additional funds.

SEN. TESTER: And we appreciate that.

I guess the question is, out of $700 billion, $250 million -- even though it's a ton of money, is like spitting in the ocean.

SEC. GEITHNER: Well, you're right. We're a $14 trillion economy. This is a very severe financial crisis, the worst in generations. And financial crises are expensive to solve, particularly if you wait --

SEN. TESTER: All right.

SEC. GEITHNER: -- to solve them.

SEN. TESTER: I interpreted by your answer to the last question that you anticipate the money that's going to be paid back will go into the general fund and not reinvested into other troubled banks?

SEC. GEITHNER: By law, it goes into the general fund. But, it also does, as the law is written -- I think this was why, it does give us flexibility to use that, again, if we think there's a compelling case --

SEN. TESTER: Okay.

In the end -- well, you have an opportunity to extend it to fall of 2010 -- the TARP program.

SEC. GEITHNER: We do.

SEN. TESTER: Do you anticipate that that trigger will be asked for?

SEC. GEITHNER: I don't know at this stage. There's a range of exceptional programs we put in place, as Senator Collins has said, and some of them expire at the end of October. Some of them have a longer fuse on them. Some of them can be extended. We'll have to make that judgment as we get a little more --

SEN. TESTER: If you asked for an extension, I assume it applies to all the money, and just not a portion? Is that correct?

SEC. GEITHNER: That's right. I believe that the way the law is structured that the authority is about $700 (billion), and it applies to the full $700 (billion).

SEN. TESTER: Okay.

You talked about -- and it's been referenced before -- about reluctant investor, not involved in day-to-day decisions. It's been pointed out to me that some of the TARP funds are being used by banks for speculation in the oil market and the commodities market.

Is there enough transparency in how they're using the TARP funds for you to know that?

SEC. GEITHNER: Well, I think that's really a question that I would have to refer to the supervisors.

The supervisors of those banks that received assistance have the full capacity to judge what kind of risks they're taking generally and whether those risks are appropriate, given the conditions of the (TARP ?).

(Cross talk.)

SEN. TESTER: I know you don't want to be on -- and I don't want you to be on the day-to-day decisions. The question is do you think that's an appropriate use of TARP monies?

SEC. GEITHNER: Look, I would make a big distinction between banks and others.

Banks, because of the risks they pose to the economy, because of the protections they enjoy, they are subject to a very intensive level of supervision and regulation by the nation's banking authorities.

That was not strong enough, in some cases. It needs to be stronger.

SEN. TESTER: Yeah.

SEC. GEITHNER: But that is a perfectly legitimate public policy interest, because the interest in the system is -- (inaudible).

I would distinguish that from the role of the government as temporary shareholder.

SEN. TESTER: Okay.

The previous question, you said that as far as closing down dealerships, that was their decision. Who's "they"?

SEC. GEITHNER: The companies themselves and their boards.

SEN. TESTER: Okay.

In the plan for GM, the investment of billions of dollars into that, were there any assurances that they wouldn't move manufacturing overseas?

SEC. GEITHNER: In the (context ?) of GM, the company has publicly committed to, laid out, a path for production in the United States as a share of total production.

And in those plans, they're -- they've indicated that they expect production in the United States to be maintained at current levels and perhaps expand slightly as they build this new plan for small cars.

So their plans now are -- and these were part of the framework established, for a bunch of reasons -- they expect production in the United States to not just level off, but expand slightly.

SEN. DURBIN: Thanks, Senator Tester.

Going back to the repayment under TARP of $68 billion which was announced this morning, so -- what is the expected return on investment for taxpayers?

SEC. GEITHNER: The way the terms were initially established, these preferred investments of stock came with a 5 percent coupon. I don't have my press statement with me, but the Treasury's already earned several billion dollars in terms of those dividend payments on the preferred.

Now, the full terms for the government include the value of the warrants that Treasury took as part of these investments. We're in the process of going through a judgment about what the fair market value for those warrants is likely to be.

And in the release we put out this morning is -- I'm not sure we made an estimate, but some of the estimates now are in the several- billion-dollar range for those initial banks that are repaying government.

So, people will bring all sorts of financial prisms to judge the return. Of course, you have to look at the returns of the country -- not just in terms of the direct financial returns to the taxpayer, which are significant; they really are quite significant -- but you have to look at the broader benefit in avoiding financial collapse.

Because there is dramatically more credit available today than there would have been if these banks were forced to shrink dramatically.

SEN. DURBIN: That's the second question.

Assuming that you wouldn't've allowed repayment if there was any question of soundness of the institution, what kind of assurance do you have that these banks that return this money are going to be issuing credit, which was one of the original goals?

SEC. GEITHNER: Right.

Well, the judgment under the law was made by the federal banking agency that's responsible. So they did a very careful process of judging whether they really could prudently repay this money. And the figure right now for this morning reflects the judgment of the federal banking agencies.

That means these banks are in a position now where they can make normal business judgments about lending. And I think by many measures, lending is a very economic -- expanding credit is a very economic thing to do today.

But as I said, we are in a recession that followed a huge boom in credit, so it's going to be -- for many parts, many families, many businesses, borrowing will decline as we go through this. And that is a healthy, necessary thing.

It makes it very hard to judge, because you don't know what would have happened; in the absence of these investments, what lending would have been produced.

But I think you have a financial system today that is substantially stronger than it was two, three, six, nine months ago, and is in a much better position to provide the credit necessary to help us get through this recession and get back on a growth path again.

SEN. DURBIN: Mr. Secretary, we recently enacted, or passed, in the Senate an historic credit card reform bill which I want to commend my colleague, Senator Dodd and all those on the Banking Committee who worked so hard on it. It's been 25 years or more since we've done anything in that field.

There was a third rail in this discussion which we couldn't bring up and couldn't discuss, for fear it would explode the whole process: interchange fees.

Interchange fees are the fees that are charged by credit card companies and imposed on retailers.

And there's very little room, when it comes to retailers, to negotiate these fees. Approximately 2 percent of our purchases using credit cards are paid back to the credit card company in interchange fees.

And the retail establishments across America are very concerned about this, because they have little or no voice in that.

I'd like to ask you two questions about interchange fees. First is a more general question about what the Treasury is doing, if anything, to look into the interchange fee system.

But then, in particular, since it turns out that the federal government is now accepting credit cards. It turns out there are over 200 federal entities that accept credit cards: Amtrak, the Postal Service, the Treasury's Financial Management Services.

It turns out that our government paid these credit card companies over $200 million in interchange fees, to Visa and MasterCard, in fiscal year 2007.

I've repeatedly asked the credit card industry and the banks to demonstrate that the rates that they've established are legitimate to process the card transactions and, unfortunately, they have not been able to provide any data or information to suggest that the amount charged even to the federal government represents a reasonable fee.

In fact, the GAO report on this recently said that the FMS tried to negotiate lower interchange fees with Visa and MasterCard. The negotiations were not successful.

So in addition to the general question of interchange fees on retail establishments across America, what is the status of your effort to make sure that Uncle Sam isn't paying too much to these credit card companies for the use of the credit cards?

SEC. GEITHNER: Senator, this is a very complicated question and, to be honest with you, I have not thought about this very much yet.

But I will be happy to spend some time with you and your staff understanding your concerns about this, then taking a careful look at both questions you raised.

If I'm not mistaken, I think that you've asked for GAO to do a study of one of these dimensions, and of course we would look carefully at the conclusions of that study.

But I'm happy to commit to spend some time on this and to see if we can see if there are sensible things we can do to protect the government's interests, not just (adjust ?) the broader reform question you raised.

SEN. DURBIN: If Senator Collins will just bear with me for one more question.

I think, with the establishment of TARP under the previous administration, its continuance under this administration, there has been a shift of personnel within the Department of Treasury to deal with the obvious demands, administrative demands.

Can you give me a general impression of whether or not this has created dislocations in other parts of the Treasury Department which need to be addressed and whether the repay, or the payback on these TARP funds is some indication that we may be getting out of this business and can get back to business as normal?

SEC. GEITHNER: The way the EESA legislation was written, it provides funding for the administrative resources required to design and run these programs. And we had substantially increased resources using that authority to staff that part of the Treasury, the Office of Financial Stability.

But we're also going to have to increase those -- (inaudible) -- in the budget, the rest of the Domestic Finance staff, because they've got this greatly expanded, much more complicated set of challenges in a range of policies, including the one you just raised.

And we did announce several weeks ago the appointment of a new deputy assistant secretary for consumer policy issues in the financial sector.

I do not believe we've had to devote resources from other parts of the government to these financial crisis imperatives on a scale that would jeopardize our capacity to carry out those broader responsibilities, and we'll be very careful to avoid that risk.

But there are parts of the Treasury, as I've suggested, where we think that we're going to need to have some modest increases in baseline, like in tax policy, which is outside Domestic Finance.

And I think - with that support, I think we'll be in a stronger position to meet these broader objectives.

But I think my basic answer to your question is no, I am not concerned now that we've had a substantial diversion of resources, as important as the financial crisis is, at the expense of other core priorities of the government.

SEN. SUSAN COLLINS (R-ME): Thank you, Mr. Chairman.

Mr. Secretary, I want to follow up on the questions that Senator Nelson asked you with regard to the decision of GM and Chrysler to terminate dealerships.

This decision has been perplexing to many of the automobile dealers in my state. Everyone understands that GM and Chrysler have to restructure and shed costs in order to survive.

But the dealerships in Maine tell me that they pay for the cars, that they pay for the shipping, that they own their own showrooms, they pay for their salespeople. So they've raised the question of how does this save money for the automobile manufacturers to have fewer people promoting their products?

Could you shed some light on this for us?

SEC. GEITHNER: Senator, it's a excellent question.

And I've spent some time -- I've never run an automobile company, but I've spent some time trying to understand --

SEN. COLLINS: Till now. (Laughter.)

SEC. GEITHNER: (Chuckles.) Don't expect to be running one now, either.

But I've spent time looking at this, and I guess I would say -- I'm not sure this'll be convincing or persuasive to you -- but if you look at --

I think the broad consensus of people that've looked at what's going to be necessary to put these companies back on a better financial foundation, I think there is a very broad consensus that to do that, they need to get the distribution costs down and the distribution system more efficient.

And that's why the companies themselves, at the center of their plans, have proposed very substantial reduction in number of dealers.

Now, I know that it's -- I'm not sure that's persuasive, but my sense again, reading a bunch of -- then listening to a bunch of people who've studied these companies and looked at them, say there's very broad consensus that this is a part of, an important part of that effort to get them down to a cost base that allows them to be viable.

Now, it comes with enormous damage in those communities, and it is a wrenching adjustment. But the reality is that these restructuring programs will leave the country with many, many more dealers than would have existed in the absence of these programs.

The balance -- the companies, (they/we) may not get (into/them to) balance perfect, but I think my sense in looking at it is that this is a necessary part of their efforts to get back to a path where they don't need the government.

SEN. COLLINS: Was the decision to reduce dealerships made by the manufacturers or was it imposed upon them by the Auto Industry Task Force?

SEC. GEITHNER: It was not imposed by the Auto Industry Task Force. It was a judgment made by those boards of directors and their management, again, about what was a critical part of a restructuring plan.

SEN. COLLINS: Thank you.

I'd like now to turn to the issue of financial regulatory reform. I introduced a bill in March to create a council of regulators to act as the systemic risk monitor.

I know the other model for that is to have the Federal Reserve assume that responsibility. I think there's widespread consensus that we do need to have a systemic risk monitor so that someone or some entity is looking across the financial system and identifying high- risk practices, policies, or products, and regulatory black holes so that we don't have the problem of no one regulating fully credit default swaps or the next product that comes along.

The reason that I support the council is I believe there's value in bringing many perspectives to the table and many areas of expertise.

The Fed, frankly, has its hands full. There are also issues about congressional oversight. We want the Federal Reserve to be independent in order to set monetary policy.

If it's also going to be the systemic risk monitor, there's going to have to be more congressional oversight of its operations.

So tell me -- I know you don't want to precede the president in announcing his plan, but discuss with me the pros and cons of the two approaches.

SEC. GEITHNER: Well, I should begin by saying although I'm not going to get out ahead of the president that we share many of the objectives you laid out.

I think a necessary part of the solution for the U.S. financial system will be a more effective body to bring together the responsible supervisory agencies alongside the Fed, to make sure we're looking across the system as a whole, that we're keeping abreast of changes in the structure of the system so we can better limit risk in the system.

And I think a council has a lot of merits in that context. And I don't believe it's necessary or desirable for us to concentrate all authority for dealing with future risk to the system in one part of our complicated governmental structure.

So although we're going to propose some important streamlining consolidation and simplification of the oversight regime, we're not going to propose to concentrate all authority for systemic issues in only one place. It's too complicated, really, to do that.

I think the really important thing is, again, is that we have more effective oversight over the core institutions that are critical to the system, that we bring critical markets like derivatives under an effective framework of oversight and protections there, that we have much better enforcement, with tougher rules for enforcement for consumer investor protection, that we have better tools for managing future crises.

And we're going to have to have tougher constraints on risk taking involving better constraints on leverage and capital so that you have thicker shock absorbers, thicker cushions against future crises; we're more able to let firms fail -- the system is more robust to potential failure.

So those are the broad objectives that underpin our approach. But you'll find many of the concerns and objectives you laid out present in our recommendations.

SEN. COLLINS: Thank you.

SEN. DURBIN: Senator Tester?

SEN. TESTER: Thank you, Mr. Chairman.

I don't want to beat this horse, but I will just say this -- and I like you -- there's an overwhelming attitude in this country that bigger is better.

And I think what we're allowing GM and Chrysler to do by closing down these small dealerships is putting all the forces into a few big dealerships because, number one, they're -- easier to deal with a few people than it is a lot and, number two, it'll reduce competition. And I'm going to tell you, if a dealership's making money, I don't see any criteria for shutting them down, and that's my only editorial comment I will tell you.

And the only other thing to keep in mind is in rural America it's a heck of a lot different than it is in urban America. You shut down some of these small dealerships in some of these small towns that are making money, that GM's making money off of, it's going to have an incredible impact on the economy. That's all. And I know you aren't making the decisions, but if you could pass that along to the powers that be, I would appreciate it.

MR. GEITHNER: And that's assuredly received.

SEN. TESTER: Okay, thank you. The -- Chairman Bernanke talked about restoring fiscal balance. Could you just comment on that and where you see us going over the next few years, assuming the economy gets turned around?

MR. GEITHNER: It is critically important for this country. It's central to the process for recovery that we put in place a framework that gives confidence to Americans and investors around the world that we're going to have the ability and the -- the will and the ability to bring our fiscal deficits down to a sustainable position over the medium term. That's why the president in his initial budget laid out a path for dramatic reductions in the deficit. It would bring them down over a five-year period to a level at which our overall debt burden is no longer growing and can start to come down.

SEN. TESTER: I just heard the debt was going to triple in 10 years not more than a half hour ago.

MR. GEITHNER: Yeah. Well, you know, we came in to -- you know, I last served, Senator, in the administration during a period where we had an extraordinary accomplished record of fiscal discipline, produced surpluses, helped bring down interest rates, helped lay the foundation for not just a strong dollar but a(n) incredibly long period of private investment growth, productivity growth. So we -- I am a deep believer in, have deep conviction in the central importance of fiscal responsibility for this country.

Now, we started this year in the worst financial crisis in decades. And because of that crisis and the damage done to the financial system, we had to do, with the Congress, extraordinary things. And those, by necessity, produced a short-term, temporary increase in our deficits. There was no path through this crisis that did not involve some temporary, short-term increase in borrowing.

But at the time we proposed that -- again, the president proposed and he acknowledged that we're going to have to bring those deficits down over time, and that's something we're going to have to do with the Congress. It's going to be difficult to do. But if -- and it's going to be important to do, because, again, we're going to find recovery will be weaker, private investment will be weaker, interest rates will be higher unless we're able to convince people that we're going to have the will and the ability to do that.

SEN. TESTER: Okay. Too big to fail -- it can't be an option in any industry. And I think we may be there in energy; we may be there in food systems; we're absolutely there in the banking industry. How do we -- how do we fix it? Do we fix it with regulation? How do we fix it?

MR. GEITHNER: I think there are -- I would just mention a few things, and they'll be the core of what the president lays out soon. First, you have to have better design, tougher constraints on leverage, on risk-taking in the core parts of the system. You have to have better oversight of the central markets like derivatives, because those are the markets that sort of affect whether failure is going to risk wrecking the system or whether failure can be absorbed and accommodated. So you need thicker shock absorbers in those central markets, too. You need resolution authority, as I said in response to Senator Bond's comments, that allows to deal with the prospective failure of a large, complex institution like AIG. Those are some of the things you need.

And I would just make one observation, Senator, just to show how hard and complex this is. It's not just the size. In some ways, size is not the most important factor. It's the role the firm plays in the system, how connected it is, what impact its failure has. And you've had in this crisis what are not the largest institutions in the world prevent, you know, risk of catastrophic damage because of how interconnected they are.

So better capital applied across the system to limit scale of leverage, much better oversight and shock absorbers in the central infrastructure to limit contagion, limit the risk of -- the damage caused by failure, and better resolution tools.

SEN. TESTER: Okay. I want to step back -- step back for just a second.

Neel Kashkari said that the big guys had an advantage over the community banks in particular because of their access to credit, due mainly to TARP, I would imagine. Do you think that they have an unfair advantage? And --

MR. GEITHNER: I don't -- I don't -- you know, we have 9,000 banks in this country. I expect that 10 years from now, we will still have a financial system -- and it's really important that we have a financial system that has thousands and thousands of small community banks operating across the country. I think it makes our system more resilient and stronger. I think this crisis would have been worse without that basic strength.

And one of the importance (sic) of the reforms we're going to lay out is to make sure that the largest institutions have constraints on leverage that are appropriate given their scale and risk. And that will help offset some of the potential concerns you raised about level playing field for community banks.

SEN. TESTER: Thank you very much.

Thank you, Mr. Chairman.

SEN. DURBIN: Mr. Secretary, I was glad the president announced recently his support for the concept of financial products safety commission. I introduced that bill first part of March, and I think that -- to have an agency that tries to protect consumers from predatory tricks and traps is a good idea, could have -- could have spared us some of the problems we're currently going through with prepayment penalties on mortgages, for example.

But in a way, that is the easy part of my question. The tougher part gets to the heart of the issue, and the heart of the issue would be an interest rate charge. Is there too much -- is there an interest rate that is too high in America? Can we have an obligation, as a country, to say that certain levels of interest rates are unconscionable, intolerable, illegal, unacceptable?

I put in a bill to put the usury rate at 36 percent, because I thought that was so high that we'd be just fine. As I said, if you wanted to start a snake farm, you should put in a usury bill and watch what crawls under your door. The folks that came in from title loans and payday loans could sit and say to me with a straight face, "Senator, you're going to put us out of business." "Thirty-six percent will put you out of business?" "Yes." I'd ask them, "How much do you charge for the loans?" "Oh, somewhere between 58 percent and 800 percent."

People used to go to prison. They called it "juice" in the old days, when people were engaged in that sort of thing, you know, in the back alleys. Now it is acceptable, legal in this country.

Is there -- should there be a consideration about limiting interest rates charged for certain products in America?

MR. GEITHNER: Senator, I believe that we have to have a much stronger set of protections for consumers, particularly in the area of financial products that involve debt and credit. Those were where the failures were most stark. And I think it's going to require more than institutional changes, and I agree with you. The -- (inaudible) -- commission doesn't -- it may be necessary, but it's not sufficient for that. So I think we need to have stronger protections. I think the credit card reform bill is a good step, but it's a not sufficient step, and we are going to propose what we believe and the president believes will be a necessary set of much stronger protections.

Now, I understand your -- the reason why you're supportive of a cap on interest rates. And you've been exposed to a lot of the concerns on the other side of that, in terms of whether that would have unintended effects in terms of denying people the rights to some forms of credit. I think you're right it's sort of hard to make the case for why some of those products are necessary and desirable. But I do not believe those caps are a necessary part of a strong, credible consumer protection regime. And what I'd suggest is -- I hope that when you -- when we lay out our proposals, we have a chance to look at those and talk to you about whether those go far enough to meet your concerns.

SEN. DURBIN: Can I ask you also to consider the following, if we can't sell the notion of a usury cap? Shouldn't we prevail on institutions -- I mean, credit unions have been coming to me for over two decades, saying, we're different; we're not greedy like banks; we're just trying to serve our little group of people that save there and we loan to them. Shouldn't we be talking about making credit available to the poor people who are lured into these payday loans and title loans -- have the credit available in lower amounts at reasonable interest rates so that these people are not exploited? I just don't think we can continue to look the other way.

I've challenged the credit unions to do it. They haven't responded. But perhaps the banks bear some responsibility here. If we're going to have credit available for people who are truly struggling in this economy, why do we throw them to the wolves with these payday loans and title loans?

MR. GEITHNER: I agree. I think -- I think people who spend their lives, like you, thinking about these issues, believe that an important part of the solution is to make sure that all our citizens feel they have the capacity to be part of the broader financial system that has these protections. And one step towards the objective you laid out is to make sure that they have bank accounts, have a -- which would allow them to access credit which is going to be on less -- on forms where they're less vulnerable to predation. I think that's an important thing.

One of the president's -- the president's nominee for assistant secretary for financial institutions at the Treasury, whose name is Michael Barr, has spent his life's work on these kind of questions. And he is one of the more thoughtful people in the country, thinking about how to bring about reform in those areas.

SEN. DURBIN: Thank you.

Senator Collins?

SEN. SUSAN COLLINS (R-ME): Thank you, Mr. Chairman.

Mr. Secretary, another issue that keeps coming up is regulatory shopping. In other words, financial institutions will figure out which regulator gives them the most advantages. I saw this on the state level 20 years ago, where we would have a financial institution come in and threaten to switch to a federal charter, because our audits were too tough or our consumer protections were too strong.

I don't think that it's a coincidence that AIG bought a small, federally chartered thrift -- or established a small, federally chartered thrift in order to get onto the regulation of the Office of Thrift Supervision, OTS, which is generally viewed as being a weaker regulator than the comptroller of the currency. Are you looking as part of your reforms on combining the OTS with the OCC? That's what my bill does -- (inaudible). I think it's a brilliant idea and needs to be done.

MR. GEITHNER: Senator, you're absolutely right that one of the things that helped produce this crisis was, in our country, we allowed people to choose their regulator, to put risk in areas where they thought it was going to be least well-regulated. And that level of unevenness in the basic standards of protections in our system proved tragically damaging to the stability of our system. And fixing that will be critically important.

And as part of that, we are looking at the areas in our system where we were most vulnerable to that kind of shopping for regulators and regulatory arbitrage. You pointed out one example. I think it is one of the more compelling examples of that failure and weakness in our system. But just to say that we're looking beyond that -- of course we're looking at that -- we know this is something we need to do globally, too, because we need to make sure that we're not vulnerable in the future to risk -- if we get the standards better here -- risk just moving offshore to other areas where it could still present bigger risk for our system. So we want to have a level playing field, more conservatively set, more evenly enforced across the U.S. financial system. We want to try to bring the world to those higher standards as well.

SEN. COLLINS: You know, you also made an excellent point when you talked about the excessive leverage in the system. I think when Bear Stearns failed, its leverage ratio was an astonishing 30 to one, something that a small community bank or credit union never would have been allowed to have under our regulatory process. So I hope as you look at this issue that we're going to be establishing safety and soundness requirements, regardless of the type of institution. It seems to me that Bear Stearns, the large investment banks, all of which have either disappeared, been acquired or no longer exist, should have been required to meet the same kinds of capital requirements and leverage ratios that we would impose upon a community bank or a credit union.

MR. GEITHNER: Senator, I have a lot of sympathy for that view, and I think that, again, a centerpiece of what we need to do for this country is to make sure there are more conservative, better designed constraints on leverage applied more evenly across those core institutions that play a critical role in how our markets function, both in normal times and in distress.

Now, it is true in the United States we were fortunate to have across the banking system a very simple, easily enforceable crude constraint on leverage. And for that reason, in many ways, our financial troubles today are much less acute than they are for countries around the world where that kind of constraint did not exist. So just an example, banking assets in our country today are about one times GDP. They're between two and eight times GDP in -- across Europe, in part because they did not have in place that kind of simple, crude constraint on leverage. So you're right that's an important part of reforms.

We want to have, as I say, thicker shock absorbers in the system, thicker cushions of capital against risk that are more simple, more evenly enforced and are less pro-cyclical, you know, that they dampen future crises rather than amplify them. And that will be a part of what we propose.

Now, I want to just say that these are things that we're not -- these are very complicated things. Of course, we want to get them right. And we're going to go through a very careful process to bring experts together in thinking about what the right mix of those constraints are so that we have them in place before we start to see the seeds of the next boom.

SEN. COLLINS: If you haven't already looked at them, I would encourage you to look at the Canadian and the Australian twin peaks system, which I think also have benefits to them. Canada has not had the kind of financial crisis that we've had, and it's very interesting, the differences in their regulatory structure, their mortgage lending, their tax deductions. It's fascinating to look at and then look at the results.

My time has expired, so I'm going to submit to the record, with the chairman's permission, some questions on our debt level, because I wasn't able to get to that important issue today. Thank you.

SEN. DURBIN: Of course, Senator Collins, your question will be submitted for the secretary, along with others for him to consider.

The last question will come from our organic farmer from Montana, Senator Tester.

SENATOR JON TESTER (D-MT): Thanks, Mr. Chairman.

The Congressional Oversight Board issued a report this morning stating that additional stress tests may be necessary -- what are your -- due to uncertain economic conditions. What are your thoughts on this?

MR. GEITHNER: You know, I haven't had a chance to look at the report, but of course I'll look at it and read it when I get it. But I want to -- I did see some of the initial coverage of the report. I think I should say that -- just two things.

The process was designed by the Federal Reserve. It was a very conservative test. And I'd just -- I want to cite one example. People have focused, like the Congressional Oversight Panel did, on the unemployment assumptions in the initial scenarios. Those were not the binding constraint. The loss estimates the Fed used for its estimate were more conservative than the worst two-year period in the Great Depression, when unemployment was in the high 20s, 30s for a period of time. Those are the -- those were the parts of the test that were the constraint; they're the ones -- the most important part of the test. I think it was a reasonably conservative -- and in some ways, the best test of that was that in the wake of that, the conclusion of those results, we've seen a very, very substantial amount of equity come back into the financial system because it provided a level of clarity and disclosure about bank balance sheets that did not exist before. And I think that's a good test.

Now, markets don't get everything right. And, you know, we're still going through a deep recession, and we're at the early stage of repair and recovery. And the light is uncertain; there are risks ahead. But I think it was a very carefully designed, conservative test, and I think it's helped play an important role in improving confidence in the system.

SEN. TESTER: Okay. The administration -- you've referenced several times -- is going to be sending out a plan to Congress on modernization of regulation of our financial markets. Will there be a recommendation for Freddie Mae -- I mean, Freddie Mac and Fannie Mae?

SEC. GEITHNER: The future of the GSEs, including Fannie and Freddie, will be an important -- is an important challenge for us, but we are not going to -- I'm violating my rule of getting ahead of the president. We are not going to recommend in our initial proposals for reform, precisely what we think the future of those institutions should be. We're going to begin a process of consulting with the Congress and a broad, broad section of housing experts on what we think the range of options are. But we're going to defer recommendations on those things for a bit longer.

SEN. TESTER: Okay. Can you give me -- can you give me any kind of time frame that you're looking at?

MR. GEITHNER: I can't yet, but we probably will next week when we lay it out.

SEN. TESTER: Okay. That's fine.

MR. GEITHNER: But it's just a little early --

SEN. TESTER: That's fine.

MR. GEITHNER: -- just given the scale of the stuff we're trying to get -- to take on, we want to do this carefully.

SEN. TESTER: No problem. Thank you.

SEN. DURBIN: Mr. Secretary, thank you for your time here today. We're going to allow you to leave, of course, and go about your business of saving the American economy or lunch, whatever's on your schedule. (Laughter.) But we thank you very much for being here. We'll send you some questions that you might consider.

And while we're changing witnesses here -- Commissioner Shulman is going to come up here. The IRS always has the last word. We want him to take the table.

MR. GEITHNER: Thank you. He's done a great job, and I hope you give him the support he needs.

(Recess.)

SEN. DURBIN: Pleased to welcome Douglas Shulman, now well immersed in his second year of a five-year term as the 47th commissioner of the Internal Revenue Service. Thank you for your service and your pledge to lead the IRS from good to great.

Each year, IRS employees make hundreds of millions of contacts with American taxpayers and businesses and represent the face of our government to more U.S. citizens than any other agency. Approximately 93,000 employees -- the IRS is effectively the accounts receivable department of the U.S. In fiscal year 2008, the IRS collected $2.7 trillion, 96 percent of total federal receipts. Simply stated, the more revenue the IRS collects, the more revenue Congress has available to deal with some of the challenges facing our nation and the more revenue we have available to ease the tax burden on those citizens we believe to be deserving of that. Conversely, the less revenue, the less revenue Congress has for tax cuts or for worthy expenditures.

The president's proposed a budget of 12.26 billion (dollars) for the IRS. It's an overall increase of 5.2 percent above the fiscal year 2009 enacted level, would support 95,081 FTEs, an additional 2,376 above the current fiscal year 2009 base.

Mr. Commissioner, thank you for your patience. Thank you for joining us. Senator Collins and others may have some questions, join me, after you've given your presentation. The floor is yours.

MR. SHULMAN: Thank you, Chairman Durbin, Ranking Member Collins. I appreciate the opportunity to testify about the IRS's fiscal year 2010 budget.

Over the past year I think the agency has shown that it can improve performance and be agile and respond to changing situations. I often say that we need to excel at both service and enforcement. It's not an either/or proposition. And I believe this budget will allow us to make continuous improvements in both our service, our enforcement, as well as technology and workforce.

As the secretary mentioned, the president's budget requests 332 million (dollars) in additional enforcement initiatives. This includes a robust set of international enforcement initiatives that the president, the secretary and I unveiled on May 4th. Increased resources for IRS compliance initiatives have direct, measurable results through return on investment. And this 332 million (dollars) will yield about 2 billion (dollars) a year, once it becomes fully operational in 2012.

In addition, we've asked for money so we can continue to improve our service, including face-to-face, telephone, web-based and self- service service models. I believe it's incredibly important and fundamental to keeping honest taxpayers in the system that we have world-class service. And it's a -- it's a key part of bringing in the $2-1/2 trillion it takes to run the government every year. And as you mentioned, Mr. Chairman, we are the face of the American government to more people than any other agency.

In this regard, I also want to point out to the committee that I plan to deliver recommendations to the president and the Treasury secretary by the end of this year on how we, the IRS, can better leverage the tax return preparer community to increase compliance and ensure high ethical standards of conduct for paid preparers. Over 80 percent of the American people use either tax software or a paid preparer to prepare their return each year. This has been a transformational shift in the way taxes are prepared. And because paying taxes is one of the largest financial transactions that individual Americans have each year, we need to make sure that the professionals who serve them are ethical and that they ensure the right amount of taxes paid.

I'm also pleased to report we've moved now for the second year in a row to enact stimulus legislation. This year, we implemented major provisions of the American Recovery and Reinvestment Act, getting money into the hands of individuals as well as small businesses.

Let me turn briefly to our ongoing effort to modernize our core taxpayer account database. We consistently delivered on commitments over the last several years. This year, I have adopted a much more focused strategy, which will allow the IRS to complete the taxpayer database conversion on an accelerated time frame. We're doing this by gradually shifting course from simultaneously developing the database and the associated applications to a more streamlined focus on completing the modernized database. This is going to be key to our future success, the future online services and to new compliance and enforcement systems.

This budget also reflects our long-term commitment to efficiency savings and productivity. With e-filing going up, I'll just note, we've consolidated processing centers into five sites instead of 10, which -- and we already project five-year savings to be over $100 million.

And finally, let me just point out three important legislative changes in the president's budget. There's many which we worked on. I support them all. Three very important ones are, one, the robust set of international legislative proposals, which will be essential to us curbing offshore tax abuse. Second is a proposal to require tax preparers, who have a certain volume of tax filings to file electronically. And the third is a proposal that we eliminate the 20 percent down payment for a taxpayer who comes in trying to get an offer in compromise for us. Those are often taxpayers in financial distress. Right now, they have to put 20 percent down. There's been some decrease in the program. We want to get the program back up. And so we're recommending getting rid of that 20 percent down payment.

Mr. Chairman, Ranking Member Collins, thank you again for the opportunity to testify. I'm happy to answer any questions.

SEN. DURBIN: Thank you, Mr. Shulman.

Three states that I know of here -- the staff has found Oregon, California and Alabama -- already regulate tax preparers. Can you find in their state regulation evidence that their tax preparers in those states are doing a better job?

MR. SHULMAN: Some of this regulation's pretty recent, and it's a relatively small subset. GAO has actually done some studies of state regulation and what's effective, and it kind of is across the board, everything from registration to registration and licensing to actual continuing education.

What I announced last week is I'm going to have a wide-open discussion about this. We're going to invite the industry in; we're going to invite taxpayers in; we're going to invite consumer advocates in -- I'd love to work with the committee on this -- and look and say, what's the most effective way for us to work with that community to make sure there's good compliance? And that could include service and education. It clearly will include ramped-up enforcement of the bad preparers. And then regulation is on the table. And we'll closely look at the state --

SEN. DURBIN: Are there some parts of the 1040 or schedules and such where you most often find mistakes being made?

MR. SHULMAN: The most often mistakes -- so there's complicated mistakes. Refundable credits is one place there's quite a bit of mistakes, including the Earned Income Tax Credit. The most common mistakes are math error mistakes, not putting your Social Security right. One of the reasons we encourage electronic filing is it often catches math errors. You can't submit it until the form is complete.

SEN. DURBIN: Years ago, my bookkeeper in Springfield, Illinois, passed away. I said, listen, I'm a lawyer. I took a tax course. I'll do my own tax return. I think every member of Congress should be required to do their own tax return. I think we'd have tax simplification in a hurry in this country.

And as you might guess, the IRS sent back my tax return and said, you did a math error here, Mr. Durbin, which was a humbling experience. It disqualifies me from service in the president's Cabinet, but -- (laughter) -- having said that, it was an eye-opener.

May I ask you about refund-anticipation loans? I don't know if you're familiar with these. I've cosponsored legislation to require companies operating as refund loan facilitators that offer loans to register with the federal government. The National Consumer Law Center found that the effective annualized rate -- interest rate for a refund-anticipation loan can range from 50 percent to 500 percent. Is the IRS doing anything at this point to address concerns about refund- anticipation loans?

MR. SHULMAN: A couple things: One of the most important things we do is continue to get our technology in order so that we can get refunds out quick to people so they can get money in their pockets without having to take a RAL. We -- now if you electronically file and get a direct deposit, you'll get your refund back in under 10 days, and anecdotally it'll come back in two, three, four days usually. If we can finish our modernized taxpayer account database, every taxpayer will have the opportunity to get a quicker refund back. So that's one key, is get rid of the -- rid of the need.

I personally think that it's incredibly unfortunate that people's financials are in a state -- many times often not their own doing -- that they need to take a high-interest loan to wait -- you know, they can't wait 10 days to get this. As we look at the whole preparer issue, refund-anticipation loans are clearly an associated service that some preparers provide. And we will take a look at this. The focus is on preparer conduct, but clearly all the related industries will be part of the preparer review.

SEN. DURBIN: What about answering the phone at the IRS? You reduced your performance goal for providing telephone assistance from 82 percent last year to 77 percent this year. I wonder why you did that. And what steps are you taking to improve IRS's telephone performance for next year?

MR. SHULMAN: Yeah. Phones has been stressed after last year sending checks out to all the American people, this year doing the Recovery Act and truing up the checks that were sent out last year. Just to give you a sense, 2007, we had 48 million calls between January and May; 2008 we actually had 64 million; 2009 we had 74 million.

And so one thing we are -- have done as a result of that is we've redone our call routing to make it quicker that people get in the right queue and the most important questions actually get answered quickest for people, the kind of filing-dependent questions. Second is we're trying to push more to the web. So, for instance, one of the reasons the decline this year, about 5 million people called and said, what's my adjusted gross income? Next year, we'll have a web service that allows you to get your adjusted gross income. And then, third, we've actually added an estimated wait time, so if you call and we say it's going to be 15 minutes before we get to you, you can hang up and call back when it's not as busy.

So we're doing a lot of refinements. I think the reality is lots of government services are competing for money. We're trying to figure out the right number. I think the 77 percent doesn't mean 23 percent are unhappy. Only 7 percent actually got a busy signal or disconnected; it's a much smaller number. And so we're trying to get better at the web and figure out the right level of service.

SEN. DURBIN: Two weeks ago, I got the best e-mail that I could possibly imagine. It was from the IRS, and they told me that I had a refund coming. I was elated. Six hundred dollars, that's terrific. I'll think of something to do with that.

Of course, you know, as I know, right off the bat, there's something wrong with this. Can you tell me what it is?

MR. SHULMAN: We don't send e-mails to people soliciting things.

SEN. DURBIN: So there are lots of scams like that out there. This person wanted me to send back some information so they could send me my refund check, nominally in the name of the IRS. Do you go after these folks? Do you try to initiate prosecution?

MR. SHULMAN: Yeah, we -- we're very troubled. A, we like to get the message out that you're not going to get an unsolicited phone call or an e-mail from the IRS telling you you have some special deal with the IRS, and so people should just delete that. We shut down about 2,000 sites this year. It's called phishing. They're sending out, pretending like they're IRS.

We work with law enforcement authorities when we see these. We have hotlines. We have lots of people reported in to us. We go in and coordinate, and so 2,000 Internet sites have been shut down just this filing season. And we're very aggressive about it. People are -- some of these are originating from overseas. It's hard --

SEN. DURBIN: Our friends in Nigeria have ongoing correspondence with us.

Thank you very much.

Senator Collins.

SEN. COLLINS: Thank you, Mr. Chairman.

I just want to associate myself with the chairman's last question, to express concern and the need for more enforcement and education to deal with these scams. They are pervasive. I've talked with the FTC, but the IRS can certainly play an important role as well in alerting consumers.

Consumers are particularly confused, because two years ago there were rebate checks. So then they get an IRS -- a message, an e-mail message, supposedly from the IRS, saying that "Your stimulus check is now available." They equate it to the rebate checks.

So I just want to second Senator Durbin's concern in that area. I think we need to do more both to educate consumers and go after the people who are perpetrating these scams, which is difficult to do in an Internet world.

Let me switch to some other issues. The IRS Oversight Board, in its statement to this committee, identified two serious weaknesses of our tax administration system. The first is the $290 billion tax gap, and the second is what the board referred to as the archaic nature of IRS information systems. And I'm well aware of that second issue, because the GAO, year after year after year, puts the IRS's information system on its high-risk list.

I'd like to start with the tax gap issue and ask you what you think should be done to address the tax gap in addition to better enforcement.

MR. SHULMAN: Yeah. One is, I would say that tax gap numbers are imperfect, and a lot of them are extrapolated numbers from 1980 data. So the only way to really get tax gap numbers is to do randomized audits, and we actually like to do our audits in a more focused, risk- based way, and so it ends up being a burden on people, et cetera. With that said, we take it very seriously.

I think there's three important things that can be done with the tax gap. One is simplification. As long as the tax code is this complex, people are going to make mistakes and people are going to have opportunities to use the complexity of the system for evasion.

Second is information reporting. All the statistics show if we get a W-2 from an employer and it's withheld at the source, we have 99 percent compliance. Where people operate cash businesses and there's no information reported to us -- it's all voluntary -- the reporting is much -- or the compliance rate is much lower.

Congress passed a couple of very important information reporting provisions last year, credit card reporting for small businesses, as well as basis reporting. They'll be helpful. The president's budget this year has very important information reporting, especially in the international context, where we get more information about cross- border wire transfer, so that's going to be important.

And so, first is simplification. Second is information reporting. We also are taking a look at this whole issue of how do we leverage preparers to be part of the system. You know, if you think about the image of someone sitting down with a 1040 and a pencil, the chairman notwithstanding a couple of years ago, not many people do that anymore. People are using a third party, someone intermediating.

Those people need to be part of the solution of getting people to pay the right amount of taxes, because when they don't, it's actually a huge disservice to an American person. You know, if you end up paying penalties and interest and having trouble with the IRS, your preparer hasn't done you any favors. And so I think the whole issue of leveraging preparers is going to be part of our whole tax gap strategy.

SEN. COLLINS: Let me follow up on the issue of so-called bad preparers. Do you make referrals to state licensing boards when you identify a, quote, "bad" preparer who is a CPA? Because they're the ones who have the ability to impose sanctions.

MR. SHULMAN: We actually, under Circular 230, have the ability for anyone who represents a person before the IRS to impose sanctions. We can also give preparer penalties, and then we coordinate with states. And so we do all of the above.

I would posit to you, though, it's such a transformational shift that so many people are using a third party standing between them and the IRS that we need to have this overall strategy, which includes the punitive aspect of enforcement, but also includes making sure we're getting the right education, the right services, to preparers so that they can serve the American people well.

SEN. COLLINS: Does the IRS have an estimate of the tax gap attributable to international activities? The reason I ask this is you mentioned in your opening statement offshore tax abuses, and it seems that that is the focus of your fiscal year '10 enforcement initiative.

MR. SHULMAN: Senator, the short answer is no, we don't have a good international tax gap estimate. The reason for that is to get good estimates that we're willing to put out, we actually have to do randomized audits. To do them internationally, we have to coordinate with other law enforcement agencies. And by its nature, the reason that people evade paying taxes overseas is it's hard for the U.S. government to get to them.

There are some wildly, what I would think, high estimates that are based on total deposits and how many they think are overseas, and assuming nobody's paying taxes on them. So there are some numbers that get bandied about as part of the debate.

For me, when I think about tax gap and I think about enforcement, I think about the dollars we're going to bring in directly. But I also think about the deterrent effect and how we project fairness to all American people. And so the international issues for me are very important, A, to go get the money that's being hidden offshore, but also I think ordinary Americans need to know that if you're wealthy and you have enough assets to hide overseas and play in the international capital market, that you're not getting a free pass while firemen and teachers are actually paying their fair share of taxes.

And so it's a long way of saying it's actually part of collecting the $2.5 trillion you need to run the government, and it is a matter of fundamental fairness and deterrent effect. And people need to know the U.S. government is on the job.

SEN. COLLINS: Thank you.

SEN. DURBIN: I'd like to ask only one follow-up question here, and it's on CADE, Consumer -- pardon me -- the Customer Account Data Engine. I've been kind of noticing -- I worked with Senator Collins on this issue after 9/11 on technology in the federal government. And I have to tell you, having followed it over the years, it's been a source of frustration about how many bad starts we've had in different agencies, trying to bring modern technology. Maybe the private sector has the same problem, but it seems to be endemic at the federal level.

Your CADE system, a core component of BSM, the business systems modernization, was intended to replace the individual master file, has now cost over $400 million since work began almost five years ago. But it's only delivered about 15 percent of the full capability intended. The FY '10 budget request proposes a 10 percent increase for BSM, or about $24 million above the $229.9 million enacted last year.

Has the IRS taken actions to address GAO's recommendations to fully revisit the vision and strategy for business systems modernization, including developing long-term plans for completing the program?

MR. SHULMAN: Yeah, I'm aware of the GAO report that came out yesterday. A couple of things. The first thing I did when I came in is I talked to lots of stakeholders. I talked to GAO and our auditor and I said, "Tell me about CADE." To put it in perspective, CADE is a 50-or-so million-dollar project each year, with a $1.5 billion technology portfolio. And so it's important, because it's our core data base. It's not everything we do in technology.

What I would (hope by ?) overseers is we've made great progress. We've proven that we can do systems development. But they don't see a path to finishing CADE. And the internal projections were 2015, 2017, 2020. I believe technology projects need to get -- the way you get them done is you have leaders, not just technology leaders but owners, you know, the people who run agencies, focus on them and drive towards results.

And so what we've done is refocus the effort and we've split apart, trying to do all the application work at the same time we do the data base work, because the core is getting the data base done. If we can get the data base done, we'll get refunds out quicker. We'll address material weaknesses. We will be able to use data for enforcement programs. So the real business value of CADE comes out of the data base. We're focused on getting that done now, and we're slowing down application development and just focusing on conversion of the data base.

The other thing that I think is important from that report that came out is the vast majority of that $400 million is being put to good use. It is -- the key is getting a data model with consistent definitions that all our systems use. That goes under that umbrella. We've put out refunds in five days to millions of taxpayers, using the money that's been spent. Especially in this difficult economic time, that's been real important. And we're using a huge amount of the software and hardware.

So this is a shifting focus, gradual. It's what you do with any big technology project as you learn, as you go along. I certainly would hope it's not put in a category of -- you know, I don't believe it's failed at all. What I did is stepped in and said, "What can we get done during my five-year tenure?" And that's what we're trying to get done.

SEN. DURBIN: Senator Collins.

SEN. COLLINS: Thank you, Mr. Chairman.

Just one final question, and the rest I will submit for the record. I appreciate the chairman bringing up the CADE strategy, because that has been of concern to me. The other issue that concerns me has to do with the IT security weaknesses. How much improvement in data protection do you believe the IRS will be able to make with the $90 million that you're requesting for IT security? Give us your assessment of the vulnerabilities and whether that is, in fact, a sufficient amount to address the problem.

MR. SHULMAN: Yeah. So when I came in, everyone, all they talked about was modernization. And I actually believe that if you're going to run a big technology portfolio, you need to worry about current systems, updating those so your workers actually have tools along the way, making sure there's the right security and infrastructure. You need to worry about data security, especially when you hold the taxpayer records of the United States. And then you have to worry about your new systems.

So one of the things this budget reflects is me rebalancing the portfolio, so we're not myopically focused on modernization, that we actually care a lot about security and data. There's $90 million in there to -- in the budget, a request to upgrade the security posture and infrastructure. It's incredibly important.

I think, you know, knock on wood, we haven't had major data breaches. There's always going to be a spectrum of weaknesses that overseers are going to point out, and you have to do risk-reward evaluations. You're never going to get to every single piece of potential weakness, but you have to figure out what's important.

I've paid a lot of attention to GAO integrity reports. All development is now new development. We're having audit logs, which are incredibly important for internal threats. We're consolidating our -- the access points into our network so that we have perimeter security. A lot of data security is cultural. You want people who have access to data to wake up every day and feel it's their responsibility to lock down the data.

So we had something called Operation Red last year, where we stood every employee of the IRS down for two hours to talk about what data is under their sphere and what can they do to better protect it, everything from file cabinets to safes to the technology.

So I would say we are in a better security posture than when I got in. The people who are interested in breaching data security are always going to be innovating, and so we're going to need to stay ahead of the curve. But I think the money requested in this budget will allow us to keep improving our game.

SEN. COLLINS: Thank you.

Thank you, Mr. Chairman.

SEN. DURBIN: I'd like to say the IRS Oversight Board has submitted for inclusion in the record preliminary recommendations on the FY 2010 IRS budget proposal. The GAO office, at my request, has evaluated the budget proposal, has submitted its analysis and recommendations. Colleen Kelly, president of the National Treasury Employees Union, on behalf of the employees, has submitted a statement. And without objection, these will all be made part of the record.

The record will remain open, Mr. Commissioner, until Wednesday, June 17th, for subcommittee members to submit statements and questions to be submitted to you for consideration.

We thank you for your appearance today. And thanks, Senator Collins.

The subcommittee stands adjourned.

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