[House Hearing, 110 Congress]
[From the U.S. Government Publishing Office]
HEDGE FUNDS AND THE FINANCIAL MARKET
=======================================================================
HEARING
before the
COMMITTEE ON OVERSIGHT
AND GOVERNMENT REFORM
HOUSE OF REPRESENTATIVES
ONE HUNDRED TENTH CONGRESS
SECOND SESSION
__________
NOVEMBER 13, 2008
__________
Serial No. 110-210
__________
Printed for the use of the Committee on Oversight and Government Reform
Available via the World Wide Web: http://www.gpoaccess.gov/congress/
index.html
http://www.house.gov/reform
U.S. GOVERNMENT PRINTING OFFICE
56-582 WASHINGTON : 2009
-----------------------------------------------------------------------
For sale by the Superintendent of Documents, U.S. Government Printing
Office Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; DC
area (202) 512-1800 Fax: (202) 512-2104 Mail: Stop IDCC, Washington, DC
20402-0001
COMMITTEE ON OVERSIGHT AND GOVERNMENT REFORM
HENRY A. WAXMAN, California, Chairman
EDOLPHUS TOWNS, New York TOM DAVIS, Virginia
PAUL E. KANJORSKI, Pennsylvania DAN BURTON, Indiana
CAROLYN B. MALONEY, New York CHRISTOPHER SHAYS, Connecticut
ELIJAH E. CUMMINGS, Maryland JOHN M. McHUGH, New York
DENNIS J. KUCINICH, Ohio JOHN L. MICA, Florida
DANNY K. DAVIS, Illinois MARK E. SOUDER, Indiana
JOHN F. TIERNEY, Massachusetts TODD RUSSELL PLATTS, Pennsylvania
WM. LACY CLAY, Missouri CHRIS CANNON, Utah
DIANE E. WATSON, California JOHN J. DUNCAN, Jr., Tennessee
STEPHEN F. LYNCH, Massachusetts MICHAEL R. TURNER, Ohio
BRIAN HIGGINS, New York DARRELL E. ISSA, California
JOHN A. YARMUTH, Kentucky KENNY MARCHANT, Texas
BRUCE L. BRALEY, Iowa LYNN A. WESTMORELAND, Georgia
ELEANOR HOLMES NORTON, District of PATRICK T. McHENRY, North Carolina
Columbia VIRGINIA FOXX, North Carolina
BETTY McCOLLUM, Minnesota BRIAN P. BILBRAY, California
JIM COOPER, Tennessee BILL SALI, Idaho
CHRIS VAN HOLLEN, Maryland JIM JORDAN, Ohio
PAUL W. HODES, New Hampshire
CHRISTOPHER S. MURPHY, Connecticut
JOHN P. SARBANES, Maryland
PETER WELCH, Vermont
JACKIE SPEIER, California
Phil Barnett, Staff Director
Earley Green, Chief Clerk
Lawrence Halloran, Minority Staff Director
C O N T E N T S
----------
Page
Hearing held on November 13, 2008................................ 1
Statement of:
Ruder, Professor David, Northwestern University School of
Law, former chairman U.S. Securities and Exchange
Commission; Professor Andrew Lo, director, Laboratory for
Financial Engineering, Massachusetts Institute of
Technology, Sloan School of Management; Professor Joseph
Bankman, Stanford University Law School; and Houman Shadab,
senior research fellow, Mercatus Center, George Mason
University................................................. 12
Bankman, Joseph.......................................... 61
Lo, Andrew............................................... 25
Ruder, David............................................. 12
Shadab, Houman........................................... 69
Soros, George, chairman, Soros Fund Management, LLC; John
Alfred Paulson, president, Paulson & Co., Inc.; James
Simons, president, Renaissance Technologies, LLC; Philip A.
Falcone, senior managing partner, Harbinger Capital
Partners; and Kenneth C. Griffin, chief executive officer
and president, Citadel Investment Group, LLC............... 114
Falcone, Philip A........................................ 157
Griffin, Kenneth C....................................... 166
Paulson, John Alfred..................................... 141
Simons, James............................................ 128
Soros, George............................................ 114
Letters, statements, etc., submitted for the record by:
Bankman, Professor Joseph, Stanford University Law School,
prepared statement of...................................... 63
Davis, Hon. Tom, a Representative in Congress from the State
of Virginia, prepared statement of......................... 10
Falcone, Philip A., senior managing partner, Harbinger
Capital Partners, prepared statement of.................... 160
Griffin, Kenneth C., chief executive officer and president,
Citadel Investment Group, LLC, prepared statement of....... 168
Lo, Professor Andrew, director, Laboratory for Financial
Engineering, Massachusetts Institute of Technology, Sloan
School of Management, prepared statement of................ 27
Paulson, John Alfred, president, Paulson & Co., Inc.,
prepared statement of...................................... 143
Ruder, Professor David, Northwestern University School of
Law, former chairman U.S. Securities and Exchange
Commission, prepared statement of.......................... 15
Shadab, Houman, senior research fellow, Mercatus Center,
George Mason University, prepared statement of............. 71
Simons, James, president, Renaissance Technologies, LLC,
prepared statement of...................................... 131
Soros, George, chairman, Soros Fund Management, LLC, prepared
statement of............................................... 117
Towns, Hon. Edolphus, a Representative in Congress from the
State of New York, prepared statement of................... 197
Waxman, Hon. Henry A., a Representative in Congress from the
State of California, prepared statement of................. 3
HEDGE FUNDS AND THE FINANCIAL MARKET
----------
THURSDAY, NOVEMBER 13, 2008
House of Representatives,
Committee on Oversight and Government Reform,
Washington, DC.
The committee met, pursuant to notice, at 10:06 a.m., in
room 2154, Rayburn House Office Building, Hon. Henry A. Waxman
(chairman of the committee) presiding.
Present: Representatives Waxman, Towns, Maloney, Cummings,
Tierney, Lynch, Yarmuth, Norton, Cooper, Van Hollen, Sarbanes,
Davis of Virginia, Souder, and Issa.
Staff present: Phil Barnett, staff director and chief
counsel; Kristin Amerling, general counsel; Stacia Cardille and
Erik Jones, counsels; Theodore Chuang and John Williams, deputy
chief investigative counsels; Roger Sherman, deputy chief
counsel; Michael Gordon, senior investigative counsel; Karen
Lightfoot, communications director and senior policy advisor;
Caren Auchman, communications associate; Zhongrui Deng, chief
information officer; Mitch Smiley and Alvin Banks, staff
assistants; Jennifer Owens, special assistant; Brian Cohen,
senior investigator and policy advisor; Earley Green, chief
clerk; Jennifer Berenholz, assistant clerk; Leneal Scott,
information systems manager; Lawrence Halloran, minority staff
director; Jennifer Safavian, minority chief counsel for
oversight and investigations; Ellen Brown, minority senior
policy counsel; Jim Moore, minority counsel; Christopher
Bright, minority senior professional staff member; Brien
Beattie, Molly Boyl, and Adam Fromm, minority professional
staff members; John Cuaderes and Larry Brady, minority senior
investigators and policy advisors; Patrick Lyden,
parliamentarian and Member services coordinator; Brian
McNicoll, minority communications director; and John Ohly,
minority staff assistant.
Chairman Waxman. The committee will come to order. The
focus of our committee today is the hedge fund industry. Our
four previous hearings have looked at failure. Our first two
hearings examined the collapse of Lehman Brothers and AIG. We
learned that these companies took on massive risk. When the
bottom fell out, senior management walked away with millions of
dollars, while shareholders and taxpayers lost billions. Our
third hearing focused on the role of the credit rating
agencies. At that hearing, we learned about the colossal
failures of these gatekeepers of the financial markets. As one
internal document said, ``We sold our soul to the devil for
revenue.''
At our fourth hearing, we examined the role of financial
regulators. Former Federal Reserve Chairman Alan Greenspan told
us that he had identified a flaw in the deregulatory ideology
he had championed. Today's hearing has a different focus. The
five hedge fund managers who will testify today have had
unimaginable success in the financial markets. Although there
is a variation on how much they made individually, on average
our witnesses made over $1 billion a year. That is on average
$1 billion a year.
There are two reasons we have invited these hedge fund
managers to testify. First, these are some of the most
successful and knowledgeable investors in our financial
markets. They each have valuable perspectives to share about
what has gone wrong and what steps we need to restore our
financial system. Second, their testimony and the testimony of
the independent experts on our first panel will help the
committee to examine three important issues. What role have
hedge funds played in our current financial crisis? Do hedge
funds pose a systemic risk to our financial system? And what
level of government oversight and regulation is appropriate?
Currently, hedge funds are virtually unregulated. They are
not required to report information on their holdings, their
leverage, or their strategies. Regulators aren't even certain
how many hedge funds exist and how much money they control. We
do know, however, that hedge funds are growing rapidly and
becoming increasingly important players in the financial
markets. Over the last decade, their holdings reportedly have
increased over five-fold, to more than $2 trillion. We also
know that some hedge funds are highly leveraged. They invest in
assets that are illiquid and difficult to price, and sell
rapidly.
And we know from our hearing into Lehman and AIG, combining
these factors can cause financial institutions to blow up. And
we will hear today some experts worry that the failure of large
hedge funds could pose a significant systemic risk to our
financial system. We also know that hedge funds can receive
special tax breaks. The five witnesses we will hear from today
earned on average of a billion dollars last year, yet the tax
law allows them to treat the vast majority of their earnings as
capital gains. That means that at least some portion of their
earnings could be taxed at rates as low as 15 percent. That is
a lower tax rate than many school teachers, firefighters, or
even plumbers pay. In our prior hearings, we have focused on
what went wrong in the past. Today's hearing lets us ask what
could go wrong in the future so we can prevent damage before it
occurs. Both types of hearings are essential. We need to
understand both what happened and what could happen in order to
solve the immense economic problems we are facing.
I want to thank all of our witnesses for appearing today.
Some of the witnesses readjusted their schedules to testify.
They all responded to our requests for documents. And I
appreciate their cooperation, and look forward to their
testimony. I want to now call on ranking member, Tom Davis for
an opening statement.
[The prepared statement of Hon. Henry A. Waxman follows:]
[GRAPHIC] [TIFF OMITTED] T6582.001
[GRAPHIC] [TIFF OMITTED] T6582.002
[GRAPHIC] [TIFF OMITTED] T6582.003
[GRAPHIC] [TIFF OMITTED] T6582.004
[GRAPHIC] [TIFF OMITTED] T6582.005
Mr. Davis of Virginia. Thank you, Mr. Chairman. Thank you
for calling the hearing today. Hedge fund losses, and in some
cases, complete liquidations are an effect of the current
financial crisis. It is unlikely they are the cause. The real
origin of this market contraction is the continuing collapse of
the U.S. housing market, triggered and fueled by preposterously
lax lending standards, loose management, aggressive lobbying,
and lavish perks, some at the quasi-governmental giants that
dominated the market, Fannie Mae and Freddie Mac. They helped
to create and enhance the ravenous hunger for mortgage-backed
securities, credit default swaps, and other highly
sophisticated byproducts of the housing boom that drew hedge
funds into the abyss. As a result, hedge fund redemptions of
stocks and others assets will continue to put downward pressure
on the market.
It wasn't supposed to be this way. Billed as purely private
gambles by sophisticated investors, hedge funds now pose very
public peril when the bets go bad. Designed as a strategy to
reduce investment risk, hedge funds now compound risk when
complex deals start to unravel and throw off unintended
consequences. Empowered by sophisticated computer models, hedge
fund trading was meant to capitalize on, not cause, global
market shifts. But now, due to their size and speed, hedge
funds often accelerate wild market fluctuations. So when these
unregulated private funds become a public problem, many see a
need for greater transparency in their operations and tighter
regulation on some hedge fund activities. Greater
standardization, registration, disclosure, and some regulatory
limitations could help the industry mature and survive.
Remember the automobile started out as a purely private, wholly
unregulated mode of transportation. But when widespread use of
the new and powerful machines began to pose public safety
issues, it became necessary to decide as a matter of public
policy who was qualified to operate a motor vehicle, how fast
they could go, where they could go.
We seem to be at the same crossroads for hedge funds. With
as many as 8,000 funds managing up to $1.5 trillion, hedge
funds are said to account for 20 to 30 percent of trading
volume in the United States in U.S. stocks. They may handle
even higher levels of transactions involving more specialized
instruments, such as convertible bonds and credit derivatives.
Their trades can move markets.
So this isn't just about sophisticated high stakes
investors any more. Institutional funds and public pensions now
have a huge stake in hedge funds' promises of steady above-
market returns. That means public employees and middle income
senior citizens, not just Tom Wolfe's masters of the universe,
lose money when hedge funds decline or collapse altogether.
Brittle complexity, huge transactions on computerized
autopilot, and other structural inadequacies make hedge funds
particularly, sometimes spectacularly vulnerable to financial
contagion, the downward spiral of lost value, margin calls, and
redemptions in the desperate search for cash. It is clear
investors and regulators need to know more about fund
investment strategies, leverage levels, and redemption terms to
reduce their systematic risk posed by hedge funds. The hedge
fund business model may become a casualty of the downturn or it
will adopt to new global realities. Going forward, hedge funds
will have to take account of a reduced tolerance by investors
and governments for an unregulated parallel financial universe
of exotic derivatives run by faceless quants that exerts
unpredictable gravitational forces on the open marketplace.
But again, we need to remember in the larger implosion of
the housing market, hedge funds are collateral damage. We
should avoid Congress's natural tendency to overreact and
bayonet the wounded. Today's witnesses bring extensive
expertise and experience to our discussion of hedge funds in
the current financial crisis. We appreciate their testimony.
[The prepared statement of Hon. Tom Davis follows:]
[GRAPHIC] [TIFF OMITTED] T6582.006
[GRAPHIC] [TIFF OMITTED] T6582.007
Chairman Waxman. Thank you very much, Mr. Davis. I would
like to introduce the four members of our first panel.
Professor David Ruder is a professor at Northwestern University
School of Law, and served as chairman of the SEC under
President Reagan from 1987 to 1989. Professor Andrew Lo is
director of the Laboratory for Financial Engineering at the
Massachusetts Institute of Technology's Sloan School of
Management. Professor Joseph Bankman is the Ralph M. Parsons
professor of law and business at Stanford Law School. And Mr.
Houman Shadab is a senior research fellow from the Mercatus
Center at George Mason University. I thank each of you for
being here.
It is the practice of this committee that all witnesses
testify under oath. So I would like to ask if you would please
stand and raise your right hands.
[Witnesses sworn.]
Chairman Waxman. The record will indicate that each of the
witnesses answered in the affirmative. You had prepared
statements, and we will insert your complete statements in the
record. What we would like to ask each of you to do is to try
to limit the oral presentation to around 5 minutes. We won't
bang you out of order after 5 minutes, but there is a clock
that will be green for 4 minutes, orange for the last 1 minute,
and then it will turn red. And when you see that it is red, we
would like you to then consider wrapping up the presentation to
us. Professor Ruder, there is a button on the base of the mic.
I ask you to press it in and pull it close enough to you so
that it will pick up everything you have to say. We are pleased
to hear from you first.
STATEMENTS OF PROFESSOR DAVID RUDER, NORTHWESTERN UNIVERSITY
SCHOOL OF LAW, FORMER CHAIRMAN U.S. SECURITIES AND EXCHANGE
COMMISSION; PROFESSOR ANDREW LO, DIRECTOR, LABORATORY FOR
FINANCIAL ENGINEERING, MASSACHUSETTS INSTITUTE OF TECHNOLOGY,
SLOAN SCHOOL OF MANAGEMENT; PROFESSOR JOSEPH BANKMAN, STANFORD
UNIVERSITY LAW SCHOOL; AND HOUMAN SHADAB, SENIOR RESEARCH
FELLOW, MERCATUS CENTER, GEORGE MASON UNIVERSITY
STATEMENT OF DAVID RUDER
Mr. Ruder. Chairman Waxman, Congressman Davis and committee
members, I am pleased to be here today. Hedge funds are risk
takers. They seek greater than market returns by identifying
pricing anomalies, by engaging in hedging strategies, by using
leverage, and by investing in derivative instruments. Hedge
fund investments and hedging activities make positive
contributions to capital formation, market liquidity, price
discovery, and market efficiency. Hedge funds, however, may
pose risks to investors and to the financial markets. They pose
risks to their investors because they may suffer substantial
losses, may not be able to repay investors in times of stress,
or may simply dissolve without returning any moneys to their
investors.
Dishonest hedge funds may injure investors by making
misrepresentations when they sell fund securities, falsifying
operating and valuation results, or by stealing fund assets.
Hedge funds can create negative results to the financial system
when their losses cause them to liquidate market positions,
resulting in downward pressures on the asset classes they are
selling. Their defaults may cause losses to their
counterparties.
This danger was dramatically illustrated in 1998 at the
time of the collapse of Long Term Capital Management, when the
implosion of one major hedge fund caused tremendous disruption
in the financial markets. Although hedge funds have been active
participants in the derivative and stock markets, they do not
seem to have played a major causal role in the events
precipitating the credit market crisis. Nevertheless, hedge
funds that have suffered major losses have contributed to
declines in stock and asset prices by liquidating assets in
order to meet other obligations and in order to pay investors
seeking to withdraw funds. Some hedge fund advisers are
registered with the Securities and Exchange Commission under
the Investment Advisers Act of 1940. Under that act, the
Commission has power to inspect hedge fund advisers for
compliance with Federal securities laws. In 2004, the SEC
sought the power to inspect all hedge fund advisers, but lost a
court case overturning the rule it adopted. Following that
decision, the SEC adopted a rule giving it strong powers to
bring enforcement actions against hedge fund advisers, whether
registered or unregistered, who defraud investors.
Nevertheless, the SEC still does not have the power to inspect
unregistered hedge fund advisers.
A primary problem identified in the credit crisis has been
the loss of confidence among market participants regarding the
ability of counterparties to honor contractual obligations and
to repay their debts. The main reason for this lack of
confidence is lack of information. Despite the fact that hedge
funds were not the primary actors in causing the credit crisis,
I believe that the Securities and Exchange Commission should be
given power to register and inspect all hedge funds. It should
have power to require hedge fund advisers to disclose the size
and nature of hedge fund risk positions and the identities of
their counterparties. It should have the power to monitor and
assess the effectiveness of hedge fund risk management systems.
Information the SEC receives should be shared on a
confidential basis with the Federal Reserve Board as the
Federal agency with primary responsibility for systemic risk
regulation. Although these new regulatory powers are important,
it is not desirable to impose regulation on hedge fund risk
activities, including use of leverage and derivative
instruments. Hedge funds should not be regulated in a manner
that stifles their innovative financial market activities. The
SEC is the proper entity to obtain hedge fund risk information
and to monitor and assess the effectiveness of hedge fund risk
management systems. The SEC understands the financial markets
and the need to allow innovative risk taking.
If the SEC is charged with increased inspection, risk
monitoring, and risk assessment responsibilities, it will need
substantial additional funding. These new responsibilities
would require increased numbers of SEC staff who can understand
and evaluate the complicated hedge fund environment. Hedge
funds are major users of non-exchange traded derivative
instruments. A tremendous void exists regarding the specific
characteristics of many of these instruments, the amounts at
risks, and the identity of counterparties. The terms of these
instruments are often unique and complicated. As a second
method of addressing the opacity and impact of derivative
instruments in our financial markets, I believe that the swaps
exclusion included in the Commodity Futures Modernization Act
of 2000 should be repealed so that trading in these non-
exchange derivative instruments can be regulated. Some of the
current uncertainties relating to derivative instruments can be
overcome by standardizing terms and causing the instruments to
be traded and settled on futures or options exchanges. I
understand that efforts are currently underway to provide a
platform for settling these instruments. Thank you for the
opportunity to express my views on these important matters.
Mrs. Maloney [presiding]. Thank you very much.
[The prepared statement of Mr. Ruder follows:]
[GRAPHIC] [TIFF OMITTED] T6582.008
[GRAPHIC] [TIFF OMITTED] T6582.009
[GRAPHIC] [TIFF OMITTED] T6582.010
[GRAPHIC] [TIFF OMITTED] T6582.011
[GRAPHIC] [TIFF OMITTED] T6582.012
[GRAPHIC] [TIFF OMITTED] T6582.013
[GRAPHIC] [TIFF OMITTED] T6582.014
[GRAPHIC] [TIFF OMITTED] T6582.015
[GRAPHIC] [TIFF OMITTED] T6582.016
[GRAPHIC] [TIFF OMITTED] T6582.017
Mrs. Maloney. Professor Lo.
STATEMENT OF ANDREW LO
Mr. Lo. Chairman Waxman, Ranking Minority Member Davis, and
other members of the House Oversight Committee, thank you for
inviting me to testify today at this hearing on hedge funds. In
the interests of full disclosure, I would like to inform the
committee that in addition to my faculty position at MIT, I am
also affiliated with an asset management company that manages
several hedge funds and mutual funds. I realize that the
committee has a number of questions for the panel, so I will
keep my introductory remarks brief. Over the past 10 years,
much of my research at MIT has been focused on hedge fund and
hedge fund industry. Part of that research has been devoted
specifically----
Mr. Lynch. Madam Chair, could we have the witness either--I
am not sure if your mic is on or you are not close enough to
it.
Mr. Lo. Sorry.
Mr. Lynch. No problem. Thank you very much.
Mr. Lo. Thank you. It used to be the case that systemic
risk was the exclusive domain of central bankers,
macroeconomists, regulators; and finance professors had little
to do with the subject. But the events of August 1998, the
collapse of LTCM and other hedge funds that year showed pretty
clearly that the hedge fund industry does have an impact on
what we think of as systemic risk. Since then, the hedge fund
industry has grown even bigger, and it has become even more
important to the growth and operations of the global economy.
And that is no exaggeration. Hedge funds control approximately
$1\1/2\ trillion of capital, but which is more like $3 trillion
with leverage.
Now that has come down quite a bit from just a year ago,
when it was $2 trillion of assets and $5.5 trillion with
leverage. And this decline is likely to imply several thousand
hedge funds going under between the years of 2007 to 2009.
Hedge funds are now involved in virtually every aspect of
economic activity, investing in every kind of market and asset,
making loans for all purposes, including mortgages, engaging in
market making activity, financing bridges, highways, tunnels
and other infrastructure in many countries, and even providing
insurance. It is the hedge funds' ubiquity, size, leverage,
illiquidity and lack of transparency that creates systemic risk
for the financial system.
Hedge funds now provide many of the same services as banks,
but unlike banks, hedge funds are not regulated. They are
outside the Federal Reserve system, which you may recall was
originally set up to deal with systemic risk in the banking
industry. Like banks, hedge funds provide liquidity. But unlike
banks, they can withdraw that liquidity from the marketplace at
a moment's notice. Like banks, hedge funds use leverage. But
unlike banks, they face no limits, other than those imposed by
their prime brokers and counterparties, nor do they face any
capital adequacy requirements, which means that hedge funds can
get wiped out completely. But of course, investors are prepared
for that. And when hedge funds were a cottage industry
consisting of small boutiques, that wasn't a problem.
In fact, that was very positive for the economy because
there are some risks that only hedge funds are willing to bear.
But when hedge funds become too big to fail, that poses a
problem for the financial system. As the hedge fund industry
has grown, so too has its contribution to systemic risk. And as
early as 2004, my co-authors and I uncovered indirect evidence
for increasing levels of systemic risk in the industry due to
apparent increases in assets under management, leverage,
illiquidity, and correlations among hedge funds in commercially
available data bases.
And I realize that this hearing is about hedge funds, so
that has been the focus of my comments and my written
testimony, but in the interests of fairness I should point out
that while hedge funds have taken on many of the same functions
as banks over the last decade, thanks to the repeal of the
Glass-Steagall Act in 1999, many banks have become more like
hedge funds. And over the past decade, commercial banks,
investment banks, and hedge funds have been locked in heated
competition with each other, all fueled by investors, including
pension funds, sovereign wealth funds, and government-sponsored
enterprises, seeking that extra bit of yield in a frustratingly
low yield environment. This economic free-for-all between
banks, hedge funds, government-sponsored entities, and Wall
Street is one of the main reasons for the magnitude of the
current financial crisis.
In my written testimony I provide several concrete
proposals for addressing these issues, but let me mention two
that pertain specifically to hedge funds. While I have written
about the possibility of systemic shocks emanating from the
hedge fund industry, the fact is that we cannot come to any
firm conclusions because we simply don't have the data. Hedge
funds don't have to report their monthly returns to any
regulatory authority, much less details about their risk
exposures.
So my first proposal is to require all hedge funds or their
prime brokers to provide certain risk measures to regulators
periodically and on a confidential basis. And I give examples
in my written testimony of the types of risk measures that
would be most useful from the systemic perspective. My second
proposal is to create an investigative office like the National
Transportation Safety Board to examine every single financial
blowup, not just the headline grabbers, and to produce publicly
accessible reports on what happened, how it happened, why it
happened, who caused it to happen, and how to keep it from
happening again. With greater transparency into the hedge fund
industry and a better understanding of blowups that contribute
most to systemic risk, both the public and the private sectors
will be much better prepared to handle any financial crisis now
or in the future. Thank you.
[The prepared statement of Mr. Lo follows:]
[GRAPHIC] [TIFF OMITTED] T6582.018
[GRAPHIC] [TIFF OMITTED] T6582.019
[GRAPHIC] [TIFF OMITTED] T6582.020
[GRAPHIC] [TIFF OMITTED] T6582.021
[GRAPHIC] [TIFF OMITTED] T6582.022
[GRAPHIC] [TIFF OMITTED] T6582.023
[GRAPHIC] [TIFF OMITTED] T6582.024
[GRAPHIC] [TIFF OMITTED] T6582.025
[GRAPHIC] [TIFF OMITTED] T6582.026
[GRAPHIC] [TIFF OMITTED] T6582.027
[GRAPHIC] [TIFF OMITTED] T6582.028
[GRAPHIC] [TIFF OMITTED] T6582.029
[GRAPHIC] [TIFF OMITTED] T6582.030
[GRAPHIC] [TIFF OMITTED] T6582.031
[GRAPHIC] [TIFF OMITTED] T6582.032
[GRAPHIC] [TIFF OMITTED] T6582.033
[GRAPHIC] [TIFF OMITTED] T6582.034
[GRAPHIC] [TIFF OMITTED] T6582.035
[GRAPHIC] [TIFF OMITTED] T6582.036
[GRAPHIC] [TIFF OMITTED] T6582.037
[GRAPHIC] [TIFF OMITTED] T6582.038
[GRAPHIC] [TIFF OMITTED] T6582.039
[GRAPHIC] [TIFF OMITTED] T6582.040
[GRAPHIC] [TIFF OMITTED] T6582.041
[GRAPHIC] [TIFF OMITTED] T6582.042
[GRAPHIC] [TIFF OMITTED] T6582.043
[GRAPHIC] [TIFF OMITTED] T6582.044
[GRAPHIC] [TIFF OMITTED] T6582.045
[GRAPHIC] [TIFF OMITTED] T6582.046
[GRAPHIC] [TIFF OMITTED] T6582.047
[GRAPHIC] [TIFF OMITTED] T6582.048
[GRAPHIC] [TIFF OMITTED] T6582.049
[GRAPHIC] [TIFF OMITTED] T6582.050
[GRAPHIC] [TIFF OMITTED] T6582.051
Mrs. Maloney. Thank you very, very much. Professor Bankman.
STATEMENT OF JOSEPH BANKMAN
Mr. Bankman. Chair Waxman, Ranking Member Davis, members of
the committee, thank you very much for asking me to come here
to testify. The views I express are my own, and are not
necessarily shared by Stanford University. I have been asked to
provide an overview of hedge fund taxation, focusing on some of
the benefits of hedge fund managers. My testimony, however,
will also include private equity fund compensation agreements
and tax benefits, since they are quite similar. Managers in
both these fields receive a management fee, typically set at 2
percent of the amount under management. They also receive a
profits interest, typically set at 20 percent of the fund's
profits. The profits interest is sometimes called the carried
interest, or simply a carry. The management fee is taxed as
ordinary income. The profits interest is taxed as capital gain
if and to the extent the fund itself is recognizing capital
gains. If it is long-term capital gain, that is at a tax rate
of 15 percent, as opposed to the 35 percent maximum tax rate on
ordinary income.
In addition, carry is exempt from payroll tax. The benefits
of this treatment have been estimated at over $30 billion over
the next 10 years. However, as I note in my written testimony,
most of the benefits treatment probably accrue to the private
equity side of the ledger rather than the hedge fund side of
the ledger. That said, the hedge fund and private equity
industries to some extent overlap. Hedge fund managers do
benefit from this preference, and change in trading strategies
might make this preference even more important in the future.
In my written testimony, I express my belief, and I believe the
belief of an overwhelming majority of my colleagues and tax
scholars, that this preference is misguided. The way to think
about it is to think of the choice our sons and daughters face
when they decide upon a career. If they are smart and
ambitious, they might become doctors or scientists or lawyers.
These occupations and countless other occupations are going to
produce income that is taxed at ordinary income rates.
Alternatively, they could go into the fund industry and
recognize some, and in some cases most of their income at
capital gain rates. That is simply unfair. It violates a common
sense maxim that if you have two people earning the same
amount, you ought to tax them at the same rate. It is also
inefficient. It reduces the size of our economic pie by
distorting the career choice our sons and daughters are going
to make.
It is sometimes argued that hedge fund managers ought to
be--and private equity managers--ought to be compared to
entrepreneurs. As I mention in my written testimony, I don't
think that comparison is apt. Hedge fund managers are more
similar, I think, to investment bankers or to executives at
public companies, all of whom recognize income at ordinary
income rates. There are other arguments made in defense of the
current tax treatment. It is said, for example, that this is
recompense for the risk fund managers take, that it is a good
way to favor certain industries, or to subsidize investment in
general.
As I note in my written testimony, I believe all those
arguments are incorrect. And I would be happy to discuss that
with the Members in question period. The capital gain
preference isn't the only tax preference hedge fund managers
receive. They have been able to defer recognition of gain,
defer tax on their management fees simply by leaving those fees
in the fund. And they have also been able to defer tax on the
income those fees have generated. Tax applies only when the
managers have decided, at their election, to withdraw the money
from the fund. The value of this benefit has been estimated at
about $20 billion over 10 years. This last benefit, the
deferral of fees, might be of interest for the committee in
discussing the relevant benefits and burdens of government
regulations and tax on the industry. It is not, however,
something of current interest in terms of legislation, since
under the Economic Stabilization Act it is scheduled to end at
the end of this year. However, the tax benefits of carry still
remain. The House has voted in June to tax all carry at
ordinary income rates. That was a measure I supported.
Unfortunately, it died in the Senate. I am hopeful that the
Members here and the House in general will again reenact that
measure.
In my written testimony, I suggest that the drafters look
at the remarks of the New York State Bar Association as to how
to draft that provision. And hopefully this time it will make
it through the Senate and become law. Thank you.
Mrs. Maloney. Thank you very much for your testimony.
[The prepared statement of Mr. Bankman follows:]
[GRAPHIC] [TIFF OMITTED] T6582.052
[GRAPHIC] [TIFF OMITTED] T6582.053
[GRAPHIC] [TIFF OMITTED] T6582.054
[GRAPHIC] [TIFF OMITTED] T6582.055
[GRAPHIC] [TIFF OMITTED] T6582.056
[GRAPHIC] [TIFF OMITTED] T6582.057
Mrs. Maloney. Mr. Shadab.
STATEMENT OF HOUMAN SHADAB
Mr. Shadab. Chairman, Ranking Member Davis, and
distinguished members of the committee, it is an honor to
testify in this forum today about the relationship between
hedge funds and the financial crisis. I am privileged to join
such a distinguished panel. My name is Houman Shadab, and I am
a senior research fellow at the Mercatus Center, and a
participating scholar in the center's financial markets working
group. The Mercatus Center is a university-based education
outreach and research organization affiliated with George Mason
University. My own research focus is on financial regulation. I
was asked to testify today on certain aspects of the role of
hedge funds in the financial crisis. I also have submitted
written testimony which provides more detail and background.
There are three important findings that I would like to share
with the committee. First, hedge funds did not cause the
financial crisis. And they are, in fact, helping to reduce its
damage and save taxpayers money. This may seem surprising, but
in fact, hedge funds have historically made markets more
stable, and have helped their investors conserve wealth in
times of economic stress. In other words, hedge funds are often
less risky than mutual funds. A typical hedge fund strategy
seeks to achieve higher risk-adjusted returns, but not
necessarily higher returns in other investment vehicles. And in
fact, throughout this crisis hedge funds have conserved wealth
much better than mutual funds have.
Second, short selling by hedge funds has helped draw
attention to the poor investment choices made by financial
companies in recent years, but did not cause them to collapse.
When hedge funds short-sell stocks of unhealthy companies, they
help to divert capital from companies that are fundamentally
unstable. This not only prevents stock market bubbles from
becoming worse, but it helps to ensure that companies that are
making good decisions are rewarded and are better able to
provide stable, long-terms jobs for their employees. Third,
existing laws and regulations should be strictly enforced
against hedge funds and their managers. And these include laws
prohibiting fraud, insider trading, abusive short selling, and
other types of market manipulation. But changing how hedge
funds are regulated could actually undermine the interests of
investors and heighten economic instability. While it may be
easy to lump hedge funds together with the financial
institutions that were directly involved with this crisis, we
must be very careful to make the appropriate distinctions to
ensure that policy responses to the crisis do not undermine the
ability of the economy to recover.
So what is a hedge fund? A hedge fund is a private
investment company that makes frequent trades in stocks and
other financial instruments, and compensates its manager in
part with an annual performance-based fee, typically 20 percent
of profits. Hedge fund managers also typically invest in the
funds they manage. This compensation agreement leads hedge fund
managers to strike a relatively healthy balance between risk
taking and risk management, and as empirical research has
found, to make the survival of the hedge fund a greater
priority than earning performance fees. Now, it may come as a
surprise to some, but hedge funds are not even actually a part
of corporate America. Hedge funds often take aggressive action
against company executives they think are paid too much or are
not properly running their companies.
Importantly, when hedge funds get other companies to more
properly manage their businesses, hedge funds help those other
companies provide more stable jobs for their employees. Now,
the financial crisis is the result of distortions in the
mortgage and banking sectors, and would have happened even if
hedge funds had never existed. Indeed, hedge funds were never
the major purchasers of mortgage-related securities. The major
purchasers were banks, insurance companies, pensions, and
mutual funds. The most meaningful role hedge funds have played
during the financial crisis has actually been to dampen its
cost to the economy. Large numbers of hedge funds, worth a
total of approximately $100 billion, have increasingly been
purchasing poorly performing assets, such as mortgage-backed
securities, and are helping to reduce the need for economic
bailouts funded by taxpayers.
Indeed, just yesterday the Treasury Department announced
that it may start requiring companies that receive government
funds to first raise private capital. Many hedge funds may be
poised to provide such capital, as a recent estimate found that
hedge funds are currently holding about $400 billion in cash.
Given the massive losses that have resulted from the financial
crisis, our system of financial regulation certainly needs
rethinking. Yet based upon the empirical evidence, changing the
already substantial body of law applicable to hedge funds will
not stop this crisis or prevent another one from happening.
Instead, lawmakers and regulators should focus on two things.
First, economic recovery may take place more quickly if
lawmakers make it easier for hedge funds and other private
investment funds to invest in banks. Second, lawmakers and
regulators may want to take a look at making it easier for
ordinary investors to have access to the investment strategies
offered by hedge funds. For example, reducing the restrictions
on mutual funds' investment activities may be a way for all
investors to benefit from the protection that hedge funds
provide, and not just the rich ones. Thank you very much for
the opportunity to share my research with the committee.
[The prepared statement of Mr. Shadab follows:]
[GRAPHIC] [TIFF OMITTED] T6582.058
[GRAPHIC] [TIFF OMITTED] T6582.059
[GRAPHIC] [TIFF OMITTED] T6582.060
[GRAPHIC] [TIFF OMITTED] T6582.061
[GRAPHIC] [TIFF OMITTED] T6582.062
[GRAPHIC] [TIFF OMITTED] T6582.063
[GRAPHIC] [TIFF OMITTED] T6582.064
[GRAPHIC] [TIFF OMITTED] T6582.065
[GRAPHIC] [TIFF OMITTED] T6582.066
[GRAPHIC] [TIFF OMITTED] T6582.067
[GRAPHIC] [TIFF OMITTED] T6582.068
[GRAPHIC] [TIFF OMITTED] T6582.069
[GRAPHIC] [TIFF OMITTED] T6582.070
[GRAPHIC] [TIFF OMITTED] T6582.071
[GRAPHIC] [TIFF OMITTED] T6582.072
[GRAPHIC] [TIFF OMITTED] T6582.073
[GRAPHIC] [TIFF OMITTED] T6582.074
[GRAPHIC] [TIFF OMITTED] T6582.075
[GRAPHIC] [TIFF OMITTED] T6582.076
[GRAPHIC] [TIFF OMITTED] T6582.077
Mrs. Maloney. Thank all the panelists for your testimony.
The Chair recognizes herself for 5 minutes. The current
financial crisis started over a year ago, with the collapse of
the subprime market. Through our hearings, we have learned
about the roles of lenders, bankers, brokers, and credit rating
agencies. One question that I have is how hedge funds may have
affected and contributed to this crisis. Since September, hedge
funds have faced a massive increase in withdrawals from their
investors. According to one report, they have faced redemptions
of over $50 billion.
As a result, many have been forced to sell assets to raise
cash. The hedge funds are selling into a down market, and this
further drives down stock prices. Bloomberg News described the
cycle recently as, ``downdraft of market declines, client
redemptions, demands from lenders for more collateral, and
forced asset sales.''
Professor Ruder, in your testimony you stated that hedge
funds have contributed to the decline in stock and asset prices
by liquidating stocks and other assets in order to meet other
obligations and in order to pay investors seeking to withdraw
funds. Is it your view that these hedge fund withdrawals are
affecting the broader market?
Mr. Ruder. Indeed, they are. The hedge funds, at least by
all reports, are selling massive amounts into the stock
markets, causing the stock markets to--assisting in the stock
market decline. We don't know how much they have contributed to
declines in other assets. But surely they are engaged in sales
of those assets as well. I know it is happening. I regard that
aspect of it to be a rather natural effect coming from the
credit crisis itself.
Mrs. Maloney. And Professor Lo, what is your view?
Mr. Lo. I agree with Professor Ruder that there is
certainly an effect of hedge funds unwinding their positions on
the marketplace. However, those effects are the unavoidable
aspects of a free capital market, and something that while we
need to be aware of and we need to prepare for, it may not
require any direct oversight.
Mrs. Maloney. OK. Market analyst Jeff Bagley has estimated
that hedge funds might be forced to sell half a trillion
dollars worth of assets as a result of this financial crisis.
And Professor Lo or Professor Ruder, what would be the impact
of forced sales like this?
Mr. Ruder. Well, it is clear that forced sales will affect
the markets. What we need to know in advance is what are these
positions so that the financial regulators can have some way of
attacking the problem of the massive amounts of moneys that are
held by hedge funds.
Mrs. Maloney. So there is a definite need for more
transparency?
Mr. Ruder. I certainly agree with that.
Mrs. Maloney. And Professor Lo, a recent report by the
Organization for Economic Cooperation and Development found
that hedge funds had purchased over 70 percent of the riskiest
tranches of collateralized debt obligations, the financial
instruments used to sell the subprime mortgages to investors
that are at the root of this crisis before us. What impacts did
these investments have on the financial crisis? And did hedge
funds facilitate the growth of the market for the sale of these
toxic CDOs?
Mr. Lo. Certainly I think they did facilitate the growth of
these markets by taking on the capacity for holding these so-
called toxic waste tranches. However, that again has both a
positive and a negative. The positive is that there are few
other investors in the economy that are willing to take such
risks, and so hedge funds provide a valuable service. However,
on the down side, when these particular risky assets end up
losing great sums of money, hedge funds are put under great
stress. And the unwinding of these portfolios can create
significant market dislocation.
Mrs. Maloney. Long Term Capital Management hedge fund
failed in 1998, and the Federal Reserve was so concerned about
market turmoil that they organized investment bankers to come
in and to really be supportive and to put them back on a sound
financial footing. What concerns me now is there are no
investment banks left to buy up hedge funds if they fail and
are causing systemic risk in our financial markets. And would
anyone like to comment on that? Yes, Professor Lo?
Mr. Lo. Yes, I agree that this is a significant issue,
which is one of the reasons that in my written testimony, I
call for further transparency into the so-called shadow banking
system. It is not at all clear that we need more regulation. I
think it is clear that we need more effective regulation. But
it is difficult for us to propose what that effective
regulation looks like unless we have more transparency into the
hedge fund industry. With that additional transparency we can
develop a sense of what exactly is needed.
Mrs. Maloney. Thank you very much. And I recognize Ranking
Member Davis for 5 minutes.
Mr. Davis of Virginia. Well, thank you very much, Ms.
Maloney. Do all of you believe that hedge funds are adequately
regulated? And could you also comment on the adequacy of the
disclosure requirements for these entities? I know you touched
on it in your statements, but I just----
Mr. Ruder. I would be pleased to expand on that,
Congressman Davis. There ought to be some way in which the
aggregate risk positions of the hedge funds and the risk
positions of their counterparties are revealed to a central
regulator. I don't really know what the central regulator will
do, but it is impossible for that central regulator to take
adequate steps to forestall calamities without having that
information. So the first step has to be an inspection system,
an assessment system. And as my prepared testimony says, I
think that the SEC should--or someone like the SEC should have
an opportunity to look at the risk management systems of the
hedge funds in order to see that they are not engaged in steps
which are going to create the kinds of calamities we have had.
Mr. Davis of Virginia. Professor Lo.
Mr. Lo. Well, Congressman Davis, I think that the
possibility of legislating losses away is obviously impossible
and unwise. Dislocation comes not from losing money, but from
the wrong investors losing money. And if we provide greater
transparency to the marketplace, I believe that a great deal of
the problems that we have been facing will take care of
themselves to a large degree. However, there is no mechanism
currently for that information to be provided to the public or
to regulators. So I agree with Professor Ruder that we do need
to have a mechanism for providing that level of transparency.
Beyond that, I think it is very premature to be able to say
what kind of regulations should be imposed.
Mr. Davis of Virginia. Thank you. Professor Bankman.
Mr. Bankman. Yes.
Mr. Davis of Virginia. You want to answer?
Mr. Bankman. No, I am just a tax expert. You don't want my
opinion on that.
Mr. Davis of Virginia. OK. Mr. Shadab.
Mr. Shadab. I think one of the underlying assumptions is
that somehow all of these risks are out there in the economy
and are known by some parties, and the only issue is simply
gathering them in a centralized source and then making
decisions on that basis. The problem with that perspective is
that the risks that hedge funds and their counterparties pose
to the economy are A, very highly complex, and B, constantly
changing.
And in fact, in 2006, Federal Reserve Chairman Ben Bernanke
rejected a proposal to create a centralized data base of hedge
fund positions for a couple reasons, one of which being that
type of information, in order to be gathered, would be required
to be gathered from all financial participants in the economy,
not just hedge funds, but also banks, their lenders, their
counterparties, and even investors and creditors to some
extent, too. Second of all, when that type of information is
created by regulators, it creates a false sense of security
among market participants that these risks are adequately being
monitored and managed.
And in fact, to a large extent the reason the investment
banks took on so much leverage and collapsed was because market
participants were under the false assumption that the
Securities and Exchange Commission, through their Consolidated
Supervised Entities Program, was monitoring the risks of
investment banks to their investors and to the economy, but it
was not doing so. By contrast, hedge funds, it is widely known
by market participants, have no oversight by any central
authority, and we can rely upon the market discipline of their
counterparties. And it is for that reason that losses from
hedge funds typically do not spread to the entire economy. This
idea of systemic risk is an idea, but it is really just a
hypothetical. It has not come to fruition and practice.
A much more instructive example of large hedge funds
collapsing is not Long Term Capital Management in 1998, but
actually Amaranth Advisors, which happened in 2006. That hedge
fund was much larger by at least $2 billion than Long Term
Capital Management. It disappeared almost virtually overnight,
or at least within 1 week, and the markets didn't even notice.
Why? Because Amaranth and its counterparties were engaging in
proper risk management, and it is true that investment banks
are no longer there to provide capital to purchase failed hedge
funds, but other hedge funds are there to purchase each
other's. And in fact, as we speak right now, new hedge funds
are being launched, which really displays and reflects the
vitality of that industry compared to, for example, the banking
sector. And I haven't heard many banks being created in recent
times. Thank you.
Mr. Davis of Virginia. Thanks. Let me continue. Mr. Shadab,
the briefing memorandum that was produced by the majority
implies that hedge funds were major drivers of the subprime
housing market through the large investments in collateralized
debt obligations backed by subprime mortgages. They cite
figures from the OECD estimating that hedge funds purchased 46
percent of all CDOs and over 70 percent of the most risky
portions of these investment vehicles. But in your testimony
you estimate that the hedge funds never had more than 29
percent of the CDO market, and probably less. I guess my
question isn't debating what the facts are, but were hedge
funds significant contributors to the growth of the subprime
mortgage market or weren't they?
Mr. Shadab. No, they were not. And this is not just based
upon the numbers. We take a step back and think what is the
purpose of a structured investment vehicle, a special purpose
vehicle that is going to put together a collateralized debt
obligation? The purpose of that vehicle is to provide higher
interest rates paid out by investment grade securities for
institutional investors such as pension funds and insurance
companies to be able to invest under a certain class of
security that has a certain safety rating, but nonetheless
gives them a higher grade.
Hedge funds have no genuine interest in purchasing CDOs,
because the CDO is to some extent another private investment
fund. If hedge funds want exposures to those types of risks
they can buy the underlying bonds or what have you. And in
fact, the reason hedge funds concentrated their investments in
the riskiest tranche was because first of all, it is an equity
tranche, which pays out a much higher interest rate because it
is more risky, and it is important to know that those equity
CDO tranches were five to less percent of a typical equity CDO
deal, which is primarily based upon, again, to get those
investment grade ratings.
Mrs. Maloney. Thank you. The Chair recognizes Congressman
Cummings for 5 minutes.
Mr. Cummings. Thank you all for your testimony. Let me make
sure I got this right, Professor Bankman. I would like to ask
you about your testimony that some hedge fund managers may
currently pay taxes at a lower rate than Americans who make
less money. If I understand your testimony correctly, the
earnings of hedge fund managers are called carried interest. Is
that correct?
Mr. Bankman. That is right.
Mr. Cummings. And to the extent that these earnings can be
tied to long-term gains, the tax rate is just 15 percent. Is
that right?
Mr. Bankman. That is right.
Mr. Cummings. I just want to make sure, because I thought I
was hearing something different. And I want to compare that 15
percent tax rate to the tax rates of some other working
Americans, very hardworking Americans. The Bureau of Labor
Statistics has calculated the median earnings for various
occupations in the American work force. The median earnings for
American school teachers were $43,000, Professor Bankman, to
$49,000 per year. What is the tax rate for a school teacher
with that income?
Mr. Bankman. Well, it depends on their marital status. But
if they are single, the 25 percent rate would start at about
$32,000, I believe. So they would be paying tax at 25 percent
on that income, and there would be payroll tax they would be
paying, too. So it would be a 40 percent higher rate, that is
25 as compared to 15.
Mr. Cummings. Jesus Christ. The median earnings for a
firefighter was 41,190. His or her tax rate would also I think
be around that 25 percent range that you just talked about. Is
that right?
Mr. Bankman. That is right.
Mr. Cummings. Now, the median hourly earnings for a
plumber, we have been talking about plumbers here a lot lately,
were $20.65 per hour. And that is about $41,000 per year. That
is also taxed about at the 25 percent rate. Is that right?
Mr. Bankman. That would be right. Of course, there may be
deductions from that, too. So we may be slightly overstating
the rate on some of those cases.
Mr. Cummings. Let me get this, let me ask it this way. So
Joe the plumber is being taxed at a higher rate than Joe the
investment banker. Is that right? Is that a fair statement?
Mr. Bankman. That would be true if it were Joe the fund
manager. The investment bankers actually don't get that break.
Mr. Cummings. OK. So the fund manager.
Mr. Bankman. Yes.
Mr. Cummings. All right. Now Professor Bankman, does this
seem fair to you?
Mr. Bankman. No.
Mr. Cummings. On the average, the witnesses on the next
panel made over $1 billion, $1 billion in 2007, yet at least
some portion of their earnings is being taxed at just a 15
percent rate. Is that fair?
Mr. Bankman. No, I don't believe that is either fair or
efficient.
Mr. Cummings. And why do you say that? Let's concentrate on
the word efficient. Why do you say it is not efficient?
Mr. Bankman. Well, a fundamental goal of tax policy is to
try to tax everything at the same rate. Otherwise the tax
system interferes with the flow of labor, the flow of
resources. So it is inefficient to give a tax break to one
occupation as opposed to another. We ought to start them off at
the same rate. And we can all debate what that appropriate rate
is, but nobody has ever offered a reason why this one slice of
highly paid professionals should be taxed at a lower rate than
other slices of either highly paid or less highly paid
professionals.
Mr. Cummings. Is there something that makes these guys so
special that they get this 15 percent rate? I mean because I am
sure people like Joe the plumber and others would like to try
get into that category. I mean is there something special about
these guys and ladies?
Mr. Bankman. Well, the rate has a long historical
explanation to it, which doesn't make hedge fund managers that
benefit from the rate special, but does give a little bit of an
explanation how we to some extent slipped into a situation
where so many of our most highly paid members are getting
preferential tax treatment.
Mr. Cummings. Let me just say this: This Congress, the
House twice voted to close this loophole, and it would have
generated more than $30 billion in tax savings according to the
Congressional Budget Office. Unfortunately, this provision has
not been passed by the Senate, and it was opposed, opposed by
the Bush administration. I hope we can correct this injustice
once and for all next year. Would you agree?
Mr. Bankman. Yes.
Mr. Cummings. All right. I see my time is about up. I yield
back.
Mrs. Maloney. Thank you very much. Congressman Issa.
Mr. Issa. Thank you, Madam Chair. Welcome all of you to the
Ways and Means Committee. It is very clear we have moved onto
tax policy. And I am actually glad we are, because I think it
reveals what we are in for in this Congress and the next
Congress. I am a Member of Congress who has my capital gains
treatment under the old tax law when I sold my business and
came to Congress. So I didn't get the 15 percent, and I did pay
10 percent or so to the State of California in addition. But
let me go through a couple of assumptions here since we are
playing tax policy. Professor Bankman, you lump together the
LBO firms, like the one that bought out my company, and the
hedge funds. Now, isn't it true that a leveraged buyout firm in
fact is a classic--I mean, these types of firms buy a company.
They put skin in it.
And over a long period of time, or sometimes short, they
hope to get a capital gains. Isn't capital gains over a hold of
more than 1 year by definition, yes or no, the existing tax
law?
Mr. Bankman. Yes.
Mr. Issa. OK. So we will just assume that you didn't really
mean to say people who buy whole companies should be somehow
not entitled to this. That is not the loophole that I think Mr.
Cummings was going to close.
Let me go through another question. You talk about a
doctor. Isn't it true that if a doctor forms a medical practice
and builds it up and then sells it, he gets capital gains
treatment on that?
Mr. Bankman. That's right.
Mr. Issa. OK. So the doctor really does have the same
opportunity, he just has to avail himself of it. If he works
for a hospital, and he doesn't own a piece of the clinic or
hospital, then he doesn't avail himself. If he does invest in
some sort of partnership, he gets that ability when it is sold;
isn't that true?
Mr. Bankman. That's right. But I think there is a
distinction when the doctor's regular income, which is taxed at
ordinary income rates, and the very occasional capital gain he
recognizes.
Mr. Issa. And I appreciate your feeling on that. And, look,
I am one of those people that thinks we should look at hedge
fund income, including profit sharing, and ask whether or not
that should be long term or short. I have no problem at looking
at it, but of course I am not on the Ways and Means Committee
normally, so I don't get that opportunity.
Let's go through a couple of other things--and by the way,
Professor Bankman, thank you for supporting the flat tax. I
appreciate that we should all be taxed at the same rate and we
shouldn't use tax policy to manipulate the economy.
Unfortunately, the Congress historically has not agreed with
that and they have micro-managed it in the other Ways and Means
Committee.
Professor Ruder, you sort of alluded to the problems of
lack of regulation, the SEC not getting authority. I just have
a brief question.
Would you agree that a size for SEC filing and regulating
of hedge funds so as to take the small firm--let's say you have
two clients, and no matter how much money, it is just two
clients that you are investing on behalf of--that those
wouldn't be sensible for a hedge fund or any fund to have to
report to the SEC, but if you had 2,000 you probably would fit.
Would you say that there are numbers, let's say a dozen or more
clients and more than $100 million under management, that would
trigger a SEC requirement?
Mr. Ruder. It is possible to arrange regulation in that
way. The Investment Advisers Act today, the legislation----
Mr. Issa. I believe it S. 17.
Mr. Ruder. Well, I am not talking about numbers of people,
but there is an inspection split between the States and the SEC
at $25 million. If there is less than $25 million under
management, it is not regulated by the SEC. And I would support
that kind of distinction. It is just a matter of deciding what
the number is. Is it $25 million? Is it $100 million? One has
to come to some conclusion about that.
Mr. Issa. I appreciate that. And I think you are right, if
we regulate we do have to recognize that we can't regulate
every entity.
Mr. Shadab, I have a couple of questions that you are
probably very equipped to answer. First of all, this whole
question of hedge funds, isn't it true that hedge funds
normally hedge both, if you will, long and short, and as a
result when they unwind they tend to unwind more neutral than
other long-only investments?
Mr. Shadab. That is fair to say, that is correct.
Mr. Issa. And isn't it true that some of the biggest
investors in hedge funds are union pension plans and even State
plans, that they will have a percentage, usually 5 percent or
less, but a percentage they are putting in hedge funds?
Mr. Shadab. Increasingly so, yes.
Mr. Issa. And isn't it true that the inefficiency in the
market is partially because we have built up a strategy of most
mutual funds not being able to go to all cash, not being able
to essentially leave a certain paradigm that they are in and,
to a great extent, if you want to limit risk and you are in a
fund that is 100 percent invested in small caps, or whatever,
that a hedge fund is often the way, if you are a big investor
like a union pension plan, that you hedge against your other
investments which are 100 percent long?
Mr. Shadab. Correct. Hedge funds are more flexible.
Mr. Issa. Thank you. Thank you, Madam Chair.
Mrs. Maloney. Congressman Tierney.
Mr. Tierney. I want to thank the witnesses here today. But
Professor Lo, I want to ask you something about what you said
in your testimony. You talked about the fact that we had not
yet seen the full impact of the unraveling and the deleveraging
of the hedge fund industry. And I think you predicted that we
could see thousands more of additional entities go under. So I
guess about 9,000 different hedge funds out there, estimates,
and you are talking about a good healthy percentage of them are
going under. What would be the potential impacts of the
collapse of that many hedge funds?
Mr. Lo. Well, it is hard to say because, as I mention in my
testimony, we don't have a lot of information about their
holdings, their leverage, the counterparties, or other aspects
of their exposures. I suspect that a large number of them will
be taken over by larger financial institutions, so the impact
for those may be relatively minimal. But there may be a small
number of very large hedge funds that have a variety of
different counterparty relationships that could cause some
market dislocation. And that is really the purpose of
transparency is to be able to tell whether or not we are
looking at a significant event or not.
Mr. Tierney. I think the general perception of the public
with respect to these hedge funds is that, if they go under, so
what? They are super rich people who understand the risk, are
somewhat sophisticated, what do we care? But I have heard
discussed here through some of your testimony that increasingly
State and local and private pension funds are invested in them.
So we really have a concern here about ordinary people involved
in this, whether they know it or not, retirees, students, it
could be millions of other citizens that are getting affected
by that. So tell me what the impact is, if they go under, how
does it affect Main Street?
Mr. Lo. Well, clearly there are going to be losses faced by
individual investors because one of the largest amount of
assets that have come into the hedge fund industry over the
last 5 years is pension funds. So there will be an impact
there. The question though is really whether or not that impact
is anticipated or not.
I mentioned earlier that dislocation happens not when
losses occur, but when losses by individuals that are not
prepared for those losses occur. The hedge funds that invest in
the worst risk tranches, they are prepared for losses; but when
money market funds, pension funds, mutual funds invest in AAA
securities that then lose substantial value, that is really the
cause for dislocation.
Mr. Tierney. And that is where the transparency aspect
comes in, I suspect. But the transparency you are talking about
is disclosure to the SEC in sort of a confidential way.
Mr. Lo. That's right.
Mr. Tierney. What transparency is there to investors from
these hedge funds? My understanding is that you could invest in
this hedge fund and have no particular rights to be able to get
information as to just what the investments are and what the
circumstances are; is that correct?
Mr. Lo. That's right. Let the buyer or let the investor
beware.
Mr. Tierney. So here you have a pension fund investing in a
hedge fund. Not only is whoever is managing the pension fund
unaware, but certainly the investors--the pensioners, or
whatever--are totally unaware. Do you think if that continues
to hold is a good policy, or do you think that there ought to
be more transparency to the investors from the manager of these
hedge funds?
Mr. Lo. Well, for the most part, investors would probably
not be able to make use of the kind of transparency that I am
proposing to the regulators. Most investors delegate their
decisions, particularly involving sophisticated and highly
risky investments like hedge funds, to professional managers.
So the managers and the ultimate institutional investors I
think would have the responsibility to monitor those kinds of
risks, and of course the regulators would be focused on a
different issue, which is the risk to the entire financial
system.
Mr. Tierney. Is it too late for transparency to help
individuals who belong to a retirement fund that is invested in
hedge funds that may go under at this stage?
Mr. Lo. I don't think it is ever too late. I think that
additional transparency even now will provide some sense of
what we are likely to expect to see over the next year or two,
and that could help investors with their own planning for
financial market dislocations yet to come.
Mr. Tierney. Does anybody on the panel recommend any
stronger intervention on behalf of these pensioners or the
State, local or private pension funds that are being invested
in hedge funds and that may stand the prospect of losing
significant amounts of money if as large a portion of the hedge
funds go under as some have predicted?
Mr. Shadab. I would just like to say that it is very
atypical, in fact unheard of, for hedge funds not to make
substantial disclosures to their investors, especially when
they are institutions like pension funds. Hedge fund investors
typically demand quite a bit of information from the fund and
funds in order to compete for investor wealth will make
substantial disclosures, and in fact more disclosures and in
fact higher quality and more easily understandable disclosures
than mutual funds make to their investors. It is actually much
easier to be able to contact and have a discussion with a hedge
fund manager about your investments in the hedge fund as
opposed to a mutual fund manager.
Mr. Tierney. That is interesting, Mr. Shadab, because some
of the information we looked at from the second panel on their
funds disclosed very little information. Professor Lo, would
you agree with that? I mean, it is not like they give out very
specific detailed information to their investors.
Mr. Lo. Well, that is right. I think it depends on the
hedge fund. But by and large, hedge funds are not obligated to
provide transparency to investors, and in many cases that is
one of the reasons managers decide to launch hedge funds as
opposed to mutual funds, to protect their proprietary
information that they are using to make money for their
investors.
I wanted to add one more comment to Congressman Tierney's
question about pension funds, which is that one issue that we
haven't talked about today is the impact of potential hedge
fund failures on the PBGC's ability to make good on pension
fund claims. The PBGC recently has faced significant losses
because of their internal investment policies. That might
actually hamper their abilities to make good on these
guarantees, and that is an issue that I think we need to
consider.
Mrs. Maloney. Congressman Souder.
Mr. Souder. I would like to continue to followup a little
bit with Professor Lo, because you have in your written
statement an extended discussion on risk, and it seems to me
that is one of the fundamental questions here.
In a general way, other than temporary aberrations, do you
know of any where the yield was disconnected from the risk? In
other words, has the market accurately reflected that wherever
you got a higher yield, you took more risk?
Mr. Lo. That has typically been the case, yes.
Mr. Souder. And wouldn't it also be true that the more you
invested in economies that were kind of away from established
economies, you would assume there would be higher risk?
Mr. Lo. That's right.
Mr. Souder. And wouldn't you assume that the less
transparency there was there would be higher risk?
Mr. Lo. That's right.
Mr. Souder. In other words, if you are a doctor or a lawyer
and you are investing in a fund that isn't very transparent, I
would think that you would assume in any logical way that you
were taking more risk.
Mr. Lo. You should, that's correct.
Mr. Souder. Now, what becomes fundamental here, and what a
lot of people--and understand that I voted for both versions of
the rescue package, but there is a lot of bitterness in my
district of Indiana, which is relatively conservative, and as
we see other parts of the country struggling, where they got
great rewards and now are getting penalized and expect the rest
of us to pick up some of their risk because they don't want to
assume the risk. Now, in your written comments, you more or
less compare that. You say people have a propensity to
irresponsible behavior, more or less comparing drunks, people
who drink too much and go out and drive, to some of the people
here who weren't paying attention to the risk part. But then
those of us who don't get drunk and go out and drive are now
expected to bail them out. And this is why there is so much
anger at the grass roots level because there seems to be a
disconnection from reward and risk because in fact not
everybody took those kinds of risks, not everybody invests in
the higher risk parts.
In this risk, as we look at the debate over hedge funds and
other things, how much do you believe this risk was a question
of the mortgage market than being the core of all the other
questions?
Mr. Lo. Well, I think that certainly the mortgage market
was the epicenter for this series of losses, and there is a
fundamental issue about how those markets grew so quickly over
time without the proper infrastructure to be able to support
that. And the idea behind regulation is to try to correct those
kinds of market failures.
Mr. Souder. Do you believe that the securitization of the
credit card market is starting to look like what happened in
the mortgage market?
Mr. Lo. It does have the same elements, yes.
Mr. Souder. And part of the question here is because, in
your discussion of risk and what you just said in response to
Mr. Tierney, is that part of the problem here is people who
really weren't thinking they were getting risk in their ability
to absorb risk suddenly found risk. The question there is is,
where were the pension managers? In other words, part of the
debate here is how much does government provide the regulation?
And I have a business degree and a management degree, and the
more we have these hearings, the more I am thinking is did
people pay any attention in class? Did any of them really know
what being a manager means? That maybe an individual goes out
and gets drunk and drives, maybe somebody does irresponsible
behavior, but that is why you hire pension managers. Where were
they?
Mr. Lo. Well, part of the problem that I mentioned in my
written testimony is that we didn't have enough expertise in
financial markets to properly assess these risks.
Mr. Souder. Let me interrupt a minute. You said--this is
basic stuff--that risk was correlated with return, that where
you put your money was related, that the housing market,
anybody could see it was going bananas out of doubling in
growth, that anybody in elementary could see that as you extend
it to six paths and different tranches, you are getting farther
and farther out, which normal basic management would say, go
check your base, the farther out you go, go check your base;
normal management would say that as you are doing more overseas
risky investment, you should do that. The pension fund
managers, while I understand that it wasn't perfect
information, that in a sense was a warning too, the less
information you have.
I am trying to come back here. Some of this has to be
blamed on incompetence of management, and yet nobody will take
the blame, no individual manager will take blame, no government
agency will take blame, and I would argue that in fact many
people got out of these markets, some funds didn't get into
these markets because in fact they saw it.
Mr. Lo. Well, as Warren Buffett said, ``a rising tide lifts
all boats.'' And during periods of great prosperity there is a
complacency that is induced by this kind of success that blinds
people to risks. And that is one of the purposes for better
transparency and, frankly, for regulation.
Mrs. Maloney. Thank you very much.
Congressman Lynch.
Mr. Lynch. Thank you, Madam Chair, for holding this
hearing, and I want to thank the panelists as well for their
thoughtful advice for the committee.
Just a quick comment. I know we are trying to make
comparisons to the Amaranth situation, the Amaranth collapse,
as well as Long Term Capital Management, and it is difficult to
make a broad projection from just a couple of examples. But I
do want to note that the Amaranth collapse was simplified in
some degree by the fact that it was largely an effort to corner
the market on one commodity, natural gas. And fortunately it
was a good time in the market. And you are right, Mr. Shadab,
that they were able to dump other higher quality corporate
equities into the market. And it was a good time to sell, so
they were able to cushion some of their losses.
However, if you look at the Long Term Capital Management
example, there was less than $3 billion in the fund, but they
had by leverage built that up to about $100 billion and
actually, by the use of complex derivatives, had a notional
value of over a trillion dollars; a trillion dollars notional
value, they had $3 billion in the fund. So that really spells
the possibility for systemic risk, at least to me.
Let me just go back. You all have said, to some degree,
with the exception of Mr. Bankman, I think, that hedge funds
didn't cause this collapse, they didn't cause it. And I agree
with that statement. However, I want to ask you, do you think
that the structure and the opacity--and let's remember now,
hedge funds have purchased the vast majority of these complex
derivatives and CDOs, they are the major purchasers here. Have
they amplified the negative impact of this economic downturn?
If they have not caused it, has their structure and the lack of
transparency and the concentration in those complex derivatives
and CDOs, has that amplified the impact of the crisis? I would
like you all to comment.
Mr. Ruder. I would like to take the first crack at that if
you don't mind. I think that is the case. I think that the
participation in the complex derivative markets by hedge funds
in large quantities have contributed to the complexity of the
market and to the risks that are there in the markets. And that
is why I think we should have some system for having the hedge
fund positions be known to a central regulator so that
regulator could look at all risk positions across the markets
and see where the systemic risk problems are. It might also be
able to identify the Long Term Capital Management twin in which
there is a single hedge fund participant who may itself bring
down the market.
Mr. Lynch. Professor Lo.
Mr. Lo. The short answer to Congressman Lynch's question
is, I don't know. I don't think anybody knows because we don't
have that kind of transparency to be able to say for sure
whether hedge funds have exacerbated or possibly ameliorated
the kind of market gyrations that have gone on in this
particular area. That is one of the reasons we need
transparency. However, it is the case that hedge funds, because
they take on these extraordinary risks, provide a valuable
service, but when those risks end up causing great losses, the
opposite side of that same coin is that they can provide great
dislocation.
Mr. Lynch. Mr. Shadab.
Mr. Shadab. A couple of things. The real core of this
crisis is that banking institutions, commercial banks and
investment banks, had these CDOs and other mortgage-related
securities on their assets. So to the extent that hedge funds
had purchased them from the banking institutions and other
investors, that purchase has been taken away from banks, they
have ameliorated the crisis to that extent. If these banks had
gotten all the bad assets off of their books, we wouldn't have
that core epicenter of a crisis happening from a banking
sector, which is so important for the entire economy happening
in the way we did right now.
In addition, it is important to distinguish between credit
default swaps, which are derivatives, and collateralized debt
obligations, which are actually securities. Now, hedge funds
were very large traders, but not the largest, it was banks, of
CDSs, credit default swaps. And their trading of those
instruments, along with banks' trading of those instruments,
have really brought liquidity and some price discovery and
transparency into the risks that are associated with their
underlying credit obligations. And, in fact, the fall of any
institution in relation to their----
Mr. Lynch. I am sorry, Mr. Shadab, you are burning my time.
Do you think it has amplified the impact, or no? And I
appreciate it, and I don't mean to cut you short, it is just
that with this structure we have very little opportunity.
Mr. Shadab. It is hard to be sure. I don't think so though.
Mr. Lynch. That is fair enough.
Professor Lo, just with the last few seconds I have, you
did mention the idea about this NTSB type organization to be
able to come in. The only problem I have with that is that the
NTSB usually comes and does accident reconstruction. They are
not very good proactively, but they are excellent in
forensically telling us what actually happened. I am out of
time, but at some point I would like to hear your thoughts on
how that would actually operate because I think that is
actually what we need.
And I thank all of the witnesses for your testimony today.
Mrs. Maloney. Thank you, Congressman Lynch. And if
Professor Lo would like to respond to your question.
Mr. Lo. Thank you, Congressman Lynch. I believe that the
National Transportation Safety Board is an incredibly valuable
tool for developing deeper understanding into a variety of
different failures and blowups. And while you are right that
the NTSB does not have any oversight responsibilities, the FAA
obviously controls issues regarding airline safety, the fact is
that by publishing a publicly available report that describes
the details of various accidents, the public learns an enormous
amount of what happened and how to prevent it from happening in
the future. And I think this is the most sensible starting
point for thinking about new regulations in this industry.
Mrs. Maloney. Thank you very much.
Mr. Lynch. Thank you. Thank you, Madam Chair.
Mrs. Maloney. Congressman Yarmuth.
Mr. Yarmuth. Mr. Shadab, I am going to start with you. We
are going to have on the next panel several people who are very
wealthy and who have been involved in these types of
activities. From a practical perspective, is there any
difference between what any one of these next panel of
witnesses can do and what a hedge fund can do; they can do as
individuals what a hedge fund can do?
Mr. Shadab. Do you mean a distinction between their own
personal----
Mr. Yarmuth. Yes. I mean, you have George Soros, with a net
worth of billions of dollars, you have a Warren Buffett--not on
the panel--but you have a Warren Buffett with billions of
dollars, you have a Michael Bloomberg with billions of dollars.
Is there anything that prevents them from doing what a hedge
fund does?
Mr. Shadab. With their own personal wealth, I don't think
there is anything that prevents them from doing the same thing.
Mr. Yarmuth. So in your testimony, when you say that there
is a danger in regulating hedge funds because they would lose
their unique benefits, why does it present a unique benefit
when any individual with a lot of money can do the same thing?
Mr. Shadab. Because it allows an investment manager not to
use their own personal wealth, but to pool it from others.
Sure, there are exceptions when you have hedge fund managers
who over time accumulate their own large personal wealth and
can basically run their own hedge funds without having to go to
investors. But typically a hedge fund manager, in order to
implement their trading, will need wealth from other investors.
Mr. Yarmuth. So the hedge fund manager who is putting these
deals together, when you mentioned the societal benefits of
hedge fund managers, that is really not what the hedge fund
manager is interested in, he or she is not interested in
necessarily highlighting the deficient management style of a
corporation?
Mr. Shadab. They don't need to be to create those benefits.
Mr. Yarmuth. But that is not their motivation?
Mr. Shadab. I would say unlikely that is the case, correct.
Mr. Yarmuth. So if we are worried about the impact, whether
or not, as Professor Ruder described, we can definitively
describe what the systemic risk is, we similarly cannot
describe the systemic benefit of hedge funds, it seems to me
either, can we, Professor Ruder?
Mr. Ruder. We could, by aggregating information, know where
the hedge funds as a group are headed and be able to find out
where they are hedging and what they are doing. I don't think
that would be the purpose of the aggregation of risk
information, but a regulator gathering information from all
sources would be able to reach some conclusions and take some
action, and may also even be able to issue some public
statements which would help the public to know what is going
on.
Mr. Yarmuth. I mean, I have a little hard time grasping
this philosophically because, again, if all we are talking
about is a group of individuals, let's say the members of our
next panel all got together and they say we are just going to
do our own hedge fund, we are going to sit together in a living
room and embark upon these strategies, there would clearly be
no governmental interest that I could define except maybe some
kind of a conspiracy to disrupt the market. So is that really
what we are talking about, is a distinction without a
difference?
Mr. Ruder. I think you are talking about the aggregation of
assets by the hedge funds in ways that will far surpass the
billions of dollars that these individual investors have. And
that is the reason that we are concerned about it.
Mr. Yarmuth. So this is a question of size. This is the
whole argument about being too big to fail that we have dealt
with with AIG and some of the other entities that we are
talking about.
Mr. Ruder. Well, I am not talking about too big to fail in
the sense that when we find a hedge fund that is going to fail
that we run to bail it out. I think we need to know what the
effects of that failure will be on our system and, if
necessary, take some preventative steps.
Mr. Yarmuth. I tend to agree with you, that is why I am
trying to ask this series of questions. Because when I read
that in some cases that all the trades on the New York Stock
Exchange, 5 percent of all the trades were controlled by one
trader in a particular session, that is very disturbing because
that is an unbelievable amount of market power.
I want to ask one question of Professor Bankman, also. I
have a friend who is a person I call upon to discuss these
things. He is a master of the universe, he will remain
nameless. And when I talked about carried interest with him
several months ago, he said the problem with doing anything
with carried interest is that all the hedge funds will do is
restructure their organizations so that they will convert
everything into pure capital gains. They will take equity
interest in the entity and then take capital gains, in which
case the revenue to the Federal Government will actually be
delayed--it will not increase it, it will be delayed because
they will just hold the investments longer. Do you have a
response to that argument?
Mr. Bankman. Yeah. I don't think that is going to happen.
Whenever you pass a tax measure, it is always imperfect and
there is always ways to get around it. And so you are always
trying to come up with a compromise that is going to get
revenue and hopefully not make the law too complicated and
improve efficiency and equity, and there will always be ways
around it. I have read the arguments that the industry is going
to reorganize. And you know, the two and twenty and present
form of industry organization have been around for a long time
even when, by the way, capital gain was not a factor as it is
not with respect to certain hedge funds. And I think experience
shows that reorganizing industries and changing the way people
do business is very costly and it doesn't happen very easily.
So while I think that is something to watch, I amnot
convinced that is the concern that some people think.
Mrs. Maloney. Thank you very much.
Chairwoman Norton.
Ms. Norton. Thank you, Madam Chair.
I am interested in a subject that is raised time and time
again during this crisis, and that is the notion of regulation.
It appears that we may have moved out of the mode we have been
in in a kind of to be or not to be--to regulate or not to
regulate, that is--to something we don't hear a lot of
discussion about, if you want to regulate, who is going to do
it, who is going to do it? Not a lot of meat on those bones.
Indeed, there may be a contest among various agencies. So I
looked at your testimony.
Let's start with you, Professor Lo. You raised the idea,
and it is interesting, you say that one would have to expand
the scope--of course one would, one doesn't think of the
Federal Reserve as such a regulatory agency--but you raise the
notion of the Federal Reserve as the direct oversight agency
for these largest of these funds. Why do you think the Federal
Reserve is the best of the agencies to do such regulation?
Mr. Lo. Well, primarily because the main issue regarding
hedge funds and systemic risk is their impact on the liquidity
of markets. And as we know, the Federal Reserve is the lender
of last resort, they are the manager of market liquidity. So if
it is a liquidity issue that threatens the global financial
system through the hedge fund industry, the Federal Reserve
would be the natural regulatory agency to focus on that.
Ms. Norton. Chairman Ruder, in your testimony you suggest
the agency you chaired, the SEC, to essentially have hedge
funds register with the SEC. How do you think a rule to
register with the SEC would improve its ability to monitor
and--think this crisis now--would help to reduce the systemic
risks we have seen?
Mr. Ruder. Well, first of all, I think that the
registration provisions ought to extend to hedge funds, as they
do not under the current law. Second, the registration would
allow the SEC to engage in inspection activities. But currently
they do not have the power, even in the inspection of
investment advisers, to seek risk management information. And I
would expand that inspection power so that they would be able
to go into a hedge fund adviser and find out what are the risk
management systems that are being used; what are the nature and
extents of the risks, and who are the counterparties. And that
would help the SEC, first of all, to make some judgments about
whether the risk management systems are good and, second, to
pass information on to a central regulator, such as the Federal
Reserve Board, to aggregate that information and come to some
decisions about how to manage the liquidity risk on the
economy.
Ms. Norton. I wish you would tell me the difference between
what you are proposing now and the rule apparently in 2004 that
the SEC actually passed. The hedge fund sector, however,
heavily lobbied against the rule, and it was ultimately
overturned by the courts. Chairman Cox from the SEC did not
seek to appeal it and did not come to Congress for new
authority. So the SEC, I take it, has no authority now, not
even the authority under that rule. What is the difference
between that rule and the rule, if any, that you have in mind?
Mr. Ruder. Well, the Goldstein case overruled the SEC's
attempt to have inspection rights over hedge fund advisers, and
the Commission did not appeal that ruling.
Ms. Norton. Did you support that rule?
Mr. Ruder. Yes. I support the fact that they should have
inspection right over all hedge fund advisers. And as I said, I
think that is going to take congressional action. And I think
the inspection power ought to be increased so that they are
able to get the kind of risk management information that is
needed to protect society.
Ms. Norton. Well, Professor Lo, do you see this kind of
marriage between the SEC and the Federal Reserve that could
come out of, listening to both of you, that the information
would be passed on to the Federal Reserve and then you would
have a regulatory setup that we could have confidence in?
Mr. Lo. Well, no, I don't, Congressman Norton. I feel that
there is a different--there is a different purpose for
registration under the 1940 act, which is investor protection.
Investor protection is a separate issue from systemic risk. And
I believe that even now, if you ask all hedge funds to register
under the Investment Advisers Act, they will not provide the
kind of information that we need in order to get transparency.
Ms. Norton. So transparency is not enough, you need
somebody to be a regulator; and you think that should be the
Federal Reserve?
Mr. Lo. That's right.
Mr. Ruder. Could I just comment? What I am saying is you
need to have an expansion of the inspection power. The Federal
Reserve already can receive information from the banking
sector. And the Federal Reserve's administration of the banking
sector has different objectives than the SEC's regulation of
the securities sector. Banking regulators are concerned about
safety and soundness of banks; the SEC is concerned about the
capital markets and the matter of risk-based activities. I
think we need two regulators sharing information rather than a
single regulator.
Ms. Norton. Professor Lo, would you like to respond to
that?
Mr. Lo. It is always dangerous to disagree with a former
chairman of the SEC, but let me say that I think the
information regarding systemic risk is different from the
information under the Investment Advisers Act. And with regard
to garnering information about systemic risk, it is possible to
obtain that, not necessarily directly from hedge funds, but
from the prime brokers that have all of the positions, all the
leverage and all of the counterparties among the hedge funds.
So it is now possible to obtain that information very
efficiently from a very small number of prime brokers.
Ms. Norton. Thank you very much, Madam Chair.
Mrs. Maloney. Mr. Cooper is recognized for 5 minutes.
Mr. Cooper. Investors need to know how to swim, but we have
also got to keep the sharks out of the pool. When you have
large pension funds investing in hedge funds, shouldn't there
be truth in advertising so that they know whether it is a true
hedge fund or whether it is not hedging at all, but in fact
speculating heavily? And shouldn't, perhaps, the speculative
funds be called speculative funds? But the current situation
with trade secrets, a black box surrounding the true investment
strategy, pension managers don't really know whether they are
getting hedging or speculation.
Professor Lo.
Mr. Lo. What I would argue is that it is always a good idea
to have truth in advertising, and certainly that applies to the
hedge fund industry as well as any other. Another example of
truth in advertising is money market funds that have the one
dollar NAV, but in fact don't have that kind of guarantee for
that one dollar and they break the buck. That is another
example of less than truth in advertising.
Mr. Cooper. What about volatility-only strategies? The
roller coasters we see in the market, 500 point swings in a
day, that is neither long or short. Is that productive
behavior? When Joseph Schumpeter said capitalism is the process
of creative destruction, he really didn't endorse the roller
coaster at the same time, did he?
Mr. Lo. Well, in a way I think Schumpeter did because his
argument is that free flowing capitalism is going to require
occasional blowups just like what we are going through now, and
out of the ashes a much stronger capitalistic system should
arise.
Mr. Cooper. Well, why not 1,000 point swings in a day, or
2,000 point swings; wouldn't that be even more productive?
Mr. Lo. Not necessarily. It depends upon whether the
underlying economics justifies it. But as I said, if you have
the proper disclosure for investors, if they are prepared for
those kinds of swings, then that would be fine.
Mr. Cooper. ``If'' can be the longest word in the English
language. What about want-to-be hedge fund managers, not just
rogue traders for folks inside perhaps large commercial banks
who get enough leeway to pretend they are hedge fund managers,
how significant a sector would this be and how dangerous are
they?
Mr. Lo. Well, clearly that does pose a danger, but
hopefully over time those managers ultimately get weeded out.
And the process of hedge funds closing and new hedge funds
rising I think really underscores that kind of birth and death
process.
Mr. Cooper. Well, these wouldn't necessarily be authorized,
the push for yield is so great. Sometimes you can look the
other way and these operations are so vast you don't
necessarily know what in fact is being done.
Mr. Lo. I agree.
Mr. Cooper. Is there a way to measure the size or
significance of a want-to-be hedge fund?
Mr. Lo. Currently, no, there is no way because we don't
have that level of transparency. That is one of the reasons
that I think all of us are calling for that.
Mr. Cooper. I think the key area is going to be the
interaction between hedge funds and derivatives. As I
understand derivatives, it is possible to buy derivative
products with embedded leverage. So when you, in your excellent
testimony, cited relatively low leverage ratios, especially
recently, you have to really look at the combined measure of
leverage, don't you? And still the committee is without
information on that, the true leverage that is in fact
involved.
Mr. Lo. That's right. That is another area where I think
greater transparency is necessary. Leverage by itself is not
necessarily a bad thing, but undisclosed it can be.
Mr. Cooper. Should there be capital requirements for
derivatives?
Mr. Lo. I agree with Mr. Ruder that we need to have
organized exchanges, standardized contracts, and a clearing
corporation for certain OTC derivatives like credit default
swaps.
Mr. Cooper. How are these hedge funds going to operate
without investment banks now that all the major investment
banks have converted into bank holding companies? And I guess
the real question is, how are they going to operate without the
deep capital markets that they were accustomed to?
Mr. Lo. Well, hedge funds are nothing if not adaptive. And
my sense is that they will certainly adapt to this new economic
reality very quickly; in fact, I believe that they already
have. And new hedge funds are being started to take advantage
of the kind of opportunities that are presented by current
market conditions.
Mr. Cooper. I see that my time is expiring.
Chairman Waxman. Mr. Sarbanes.
Mr. Sarbanes. Thank you, Madam Chair. I thank you all for
your testimony.
I wanted to get to this concept of the sophisticated
investor a little bit more because it is sort of the
underpinning of the original exemptions from the statutes that
are quite old now, and must have been based on premises and a
rationale that is obsolete in many ways. And as I listen to
this discussion, the exemptions are designed for people who are
sophisticated, for institutional investors and so forth. But it
seems like the standard for exemption ought not to be so much
the sophistication, although I would like you to tell me if you
think, Professor Bankman, for example, whether anyone can be
sophisticated enough these days to warrant an exemption? But
the standard maybe ought to be not how ``sophisticated'' you
are, but what kind of investments you are holding, who is
giving you their money to invest and how much damage can you do
with it.
So speak to that, because I think that is going to--
reassessing this concept of the sophisticated investor may be
the foundation for the overall redesign of the regulatory
framework in this particular arena. So maybe you can talk to
that.
Mr. Bankman. Well, you probably don't want the tax guy on
the panel. So I think I should throw that to my colleagues here
probably.
Mr. Ruder. Well, the Securities and Exchange Commission has
recognized the need for higher dollar limits to create a
threshold for accredited investors. And it has a proposal it
has made but not adopted saying that you have to have $5
million in investable assets in order to become a sophisticated
investor and be able to invest in a pool of vehicles. That is a
very good step in the right direction. The problem is, as we
begin to say who is sophisticated and who is not sophisticated,
it is not always that dollar levels are going to be the
determining amount.
We have already been wondering how some of the pension
funds got involved in the hedge fund area, and there all I can
say is that we have to draw a line someplace and say we are
going to put the responsibilities on the stewards of other
people's money to make proper investigations. We can't proceed
by bright line dollar numbers in every case to make
distinctions because at some point by putting bright dollar
levels at the high, high levels we are going to prevent the
kind of investment we have had.
So I think the Commission is on the right track going
toward a $5 million assets under investment as a bright line.
Mr. Sarbanes. Professor Lo, do you want to talk about this
sophistication concept?
Mr. Lo. Sure. You know, in financial markets there is a
common risk of confusing your W-2 with your IQ. Just because
you are wealthy does not necessarily make you sophisticated. So
I have always thought that the sophisticated investor threshold
was really more about the ability to withstand losses. But I
think when it comes to institutional investors where there is a
fiduciary responsibility, for example, pension plan sponsors,
it may make sense to actually impose some kind of an
educational minimum so that we can be assured that a pension
plan sponsor that has fiduciary responsibilities to pension
plan participants would be investing wisely.
Mr. Sarbanes. I guess what I am struggling with is you are
looking at this in terms of what the burden is on the investor
to demonstrate their sophistication and I am thinking about it
in terms of the arena into which that investor goes and whether
that arena is regulated. The concept seems to be that once a
group of people are determined to be sophisticated then you are
going to let them into a ring that is completely unregulated
because they are sophisticated. But you may be letting them
into a ring where they can do a lot of damage, where they can
run over a lot of innocent bystanders and so forth. So that
standard ought to be operating more than it has in terms of
deciding whether to regulate that area.
Mr. Lo. Well, I would agree with that wholeheartedly, but I
would also add that, in defense of pension plan sponsors that
have put money in hedge funds, first of all, by and large their
amount of investments that they have put into hedge funds is
fairly low, probably less than 5 percent of pension assets in
the aggregate.
Second, if you look at the performance of hedge funds as a
category, as a broad group for 2008, hedge funds are probably
down on average 10 percent to 15 percent for the year, where as
the S&P is down about 30 to 35 percent for the year. And so the
idea behind hedge funds being able to take short positions and
benefit from down markets, that is something that pension plans
have benefited from. However, there are blowups that occur, and
that is one of the reasons I have argued that we need to
examine those blowups to make sure that other investors,
including pension plan sponsors, are fully aware and fully
prepared for those eventualities.
Mr. Sarbanes. And of course, as we discussed with Chairman
Greenspan, when blowups occur the people that get hurt are not
just the ones that are driving the train or driving the car, or
whatever, it is this group of bystanders that gets pulled in as
well.
Thank you.
Chairman Waxman [presiding]. Thank you, Mr. Sarbanes.
Mr. Van Hollen.
Mr. Van Hollen. Thank you, Mr. Chairman. And I thank all of
you gentlemen for your testimony.
Professor Ruder and Professor Lo, I have some questions
related to your proposal to require greater transparency. I
think we have talked a little bit about the history of efforts
to provide greater transparency and reporting requirements, for
example, putting hedge funds under some of the reporting
requirements and jurisdiction of the SEC, both to protect
investors, including, as we have heard, lots of pension funds,
as well as to address the potential for systemic risk and have
an early warning system to detect that.
Let me just take that one step further. Assuming we change
the law and provide for greater transparency and allow the SEC
to get this information--I understand you are suggesting on a
confidential basis--what powers would you suggest the SEC have
when it looks at that information and says that either the
investors are at risk or you face a systemic risk? Would you be
proposing the SEC also have additional powers, for example,
changing leverage requirements with respect to a particular
hedge fund if, based on the information they collect, they say
hey, we have a real problem here? What additional powers would
you give to the SEC if they reveal, through their
investigation, a serious threat either to the investors or a
systemic risk?
Mr. Ruder. I am not suggesting that the SEC be given that
kind of power. I think the SEC should learn what the management
systems are, inspect those management systems, risk management
systems, and criticize the way they are operating.
With regard to the broad information about leverage, about
risk positions, I think that should go to a regulator such as
the Federal Reserve Board, which would then be able to
aggregate that information and take some steps regarding the
entire economy. I think it would be wrong for the result of
this regulatory reform that we are going through to have some
government agency try to tell investors what their leverage
should be. The exception of that, of course, is in the banking
area, where the banking credential regulators do impose
leverage requirements. But I think for the high-risk
individuals, including the hedge funds, we should not be doing
that.
Mr. Lo. Well, at this point, I think it would be premature
for me to propose any kind of additional powers to be granted
to the SEC or any agency since there is so little that we know
about the sector. But as a hypothetical, if the kind of
information that Professor Ruder and I propose to be disclosed
shows a very large and isolated risk for one or two too-big-to-
fail organizations, at that point it may be the case that the
Federal Reserve would be called in to impose either capital
adequacy requirements or maximum leverage constraints on that
too-big-to-fail institution. But that is still very much a
hypothetical.
Mr. Van Hollen. Let me just followup a little bit on that
point. I mean, the Federal Reserve today would have the power
to go and do that now, so let me make sure I understand both
your testimony. You, Professor Ruder, wouldn't give that to the
SEC. And I understand, Professor Lo, you would say that if the
SEC found something that would be a big problem for the
economy, they would then go to the Federal Reserve. But let me
just make sure I understand. Would that require that Congress
provide the Federal Reserve with additional authorities with
respect to hedge funds in this area to take action?
Mr. Lo. I believe so.
Mr. Ruder. I believe so, too. It probably should be the
Federal Reserve, but you have the Treasury blueprint talking
about a market stability regulator, somebody that might play
that function. I happen to think that the Federal Reserve is
the right agency to do that.
Mr. Van Hollen. If I could just ask you a quick question on
the short positions. There is a lot of discussion about the
role of hedge funds and naked short selling. Of course the SEC
took action. Do you think that hedge funds should be required
to disclose their short positions on an ongoing basis?
Mr. Lo. Well, I believe that under certain conditions it
may be advisable for hedge funds to disclose, but not
necessarily publicly. Hedge funds spend a lot of time and
effort developing models and information about over-valued
companies. That information is extraordinarily important to get
into the capital markets. If we eliminate the incentives for
them to do so, we will hurt the informational efficiency of
markets. But there are certain situations that may call for
kind of a 13-F filing for short positions, but not necessarily
to be made public, but to be given to regulators.
Mr. Van Hollen. But let me just ask you; would you, on a
confidential basis to the regulator, would you have that on an
ongoing basis, the short selling disclosed?
Mr. Lo. Yes.
Mr. Van Hollen. Professor Ruder.
Mr. Ruder. I agree with that. He refers to 13-F. That is
the kind of filing that is required when the numbers get fairly
high. So that we wouldn't be just asking for all short sale
positions to be revealed, but only the very large ones.
Mr. Van Hollen. Thank you, Mr. Chairman.
Chairman Waxman. Mr. Shays.
Mr. Shays. Let me ask you this basic question: What is the
greatest value--I realize you can't repeal the law of gravity,
so I am not looking to get rid of hedge funds. But tell me the
greatest advantage or value to society of hedge funds and the
greatest disadvantage of hedge funds. I would like to go down
the line.
Mr. Ruder. Well, the hedge funds provide liquidity to the
system because they invest and they sell short. They provide
price discovery by choosing the way they invest. They provide
the additional benefits of being large participants in the
system.
Mr. Shays. Would anyone add any additional advantage to a
hedge fund? Yes, sir.
Mr. Shadab. One additional social benefit that hedge funds
have created is disciplining corporate managers with whom they
invest. Not a large percentage of hedge funds are devoted to
being corporate activists, but the ones that are corporate
activists actually do very well at disciplining management. For
example, a recent study has shown that if a hedge fund takes a
corporate activist position in a company, CEO compensation
would typically decrease by, let's say, a million dollars, and
an overall long-term value is created for the other company
shareholders.
Mr. Shays. Any other advantage?
Tell me the greatest disadvantage or greatest risk of hedge
funds.
Mr. Ruder. Well, the hedge funds do take positions,
particularly in the derivatives market and particularly at
using leverage, which create tremendous risks. And it may be
that one hedge fund would be in a position to create calamity
in the market, or it may be the aggregation of a number of
hedge fund positions might cause problems.
Mr. Shays. Anybody want to add something to that?
Mr. Ruder. I would add one more. When they begin to sell in
times of stress, they do cause dislocations in the market in
terms of asset sales and stock sales.
Mr. Shays. I represent--at least until the end of next
month--the largest concentration of hedge funds I think in the
world in the Fairfield County/New York area. In other words,
they either sleep in the district and work in New York or they
actually work in the district as well. And their argument to me
constantly was, you know, these folks know what they are doing,
they have the money to risk and they know what they are doing,
they are wise investors and they would suggest large, you know,
universities and so on who know the risks. And never then was
it discussed that, in a sense, Wall Street could bring down
Main Street.
Was it obvious to all of you in the last 5 or 6 years that
we were going to encounter what we are encountering now? I
would like to ask each of you. And let me start backward.
Mr. Shadab.
Mr. Shadab. Yes, because housing prices could not keep
going up forever.
Mr. Shays. But this was obvious to you, that we would be
dealing with the kind of mess we are in right now?
Mr. Shadab. Not necessarily the extent of it, no.
Mr. Bankman. Well, I am just a tax guy. So I am going to
pass to Professor Lo.
Mr. Shays. You are just a coward.
Mr. Lo. Well, I may not use the word ``obvious,'' but
starting in 2004 I published a series of papers highlighting
the fact that there was growing indirect evidence that a
dislocation in the hedge fund industry was building, and so
certainly the indirect evidence seemed to show that was the
case.
Mr. Ruder. In 1998, I testified before the House Banking
Committee suggesting that there be the kind of information
disclosure I suggested today, so that 10 years ago I was
concerned about this problem of opacity in this market.
Mr. Shays. Well, part of my question for asking is--good
for you. And, you know, sometimes we don't notice the people
who were out in front years ago attempting to make this point
heard.
The head of Lehman Brothers, Dick Fuld, in a hearing before
this committee, laid a large deal of blame for Lehman's
collapse on hedge funds shorting the stock. Would any of you
care to comment on that?
Mr. Shadab. I think that is sort of reversing the cause and
effect. A prominent hedge fund manager, David Einhorn, back in
March of this year, he called out Lehman Brothers' financial
statements and saying, wait a second, you are not fully
disclosing all of your risks with investors. He sold the stock
short. So the problem was Lehman Brothers, not the short
sellers. They attracted the short sellers because of their
financial mismanagement.
Mr. Shays. So the bottom line is you don't agree?
Mr. Shadab. Correct.
Mr. Lo. I would say don't kill the messenger.
Mr. Ruder. And I don't, no.
Mr. Shays. Don't kill the messenger. Who is the messenger?
Mr. Lo. The messenger in the sense are the short sellers
that are trying to get the message across that a company is
overvalued.
Mr. Shays. Is it necessary to increase regulation on hedge
funds, or would creating an exchange for derivatives trading be
sufficient?
Mr. Ruder. I think the creation of standardized derivative
contracts and this clearing and settlement and exchange trading
would be a very fine step in the right direction. We are having
today steps toward creating a clearance and settlement platform
for derivative contracts. I think that is a very good step in
the right direction to overcome the opacity and counterparty
risk problems we have.
Mr. Lo. I agree, but I don't think that we know whether or
not it would be sufficient.
Mr. Shadab. I think that goes too far to push all
derivatives onto a centralized exchange. I think the only
problems that we have had with the credit default swaps is with
either involvement with insurance companies and model line
insurers, not a typical derivatives trader.
Mr. Shays. Thank you, Mr. Chairman.
Chairman Waxman. All Members having asked questions, I want
to thank this panel for your testimony. It has been very
helpful to us, and we appreciate you being here.
We are going to take a 5-minute recess while we seat the
next panel. So we will reconvene in 5 minutes.
[Recess.]
Chairman Waxman. The committee will please come back to
order.
Our second panel consists of five of the most successful
hedge fund managers of 2007. George Soros is the chairman of
Soros Fund Management. James Simons is the president of
Renaissance Technologies. John Paulson is the president of
Paulson & Co. Philip Falcone is the senior managing partner of
Harbinger Capital Partners. And Kenneth Griffin is the
president and chief executive officer of Citadel Investment
Group.
And we are pleased to welcome all of you to our hearing
today.
I appreciate your being here and cooperating with our
committee. I understand Mr. Falcone had to reschedule an
overseas business trip to join us today, and I particularly
appreciate the fact that he is here.
It is the practice of this committee that all witnesses
that testify before us do so under oath. So I would like to ask
each of you before you even begin giving your testimony that
you stand and raise your right hands.
[Witnesses sworn.]
Chairman Waxman. Thank you.
The record will indicate that each of the witnesses
answered in the affirmative.
Your prepared statements will be in the record in full.
What we'd like to ask each of you to do is to make a
presentation to us, mindful of the fact that we will have a
clock that will be green for 4 minutes, orange for 1 minute and
then red at the end of 5 minutes. And at that point, if you see
that it is red, we would like to ask you to conclude your oral
presentation to us. We are going to want to leave enough time
for questions by the Members of the panel.
Mr. Soros, we'd like to start with you. There is a button
on the base of the mic, be sure it is pressed in. Proceed as
you see fit.
STATEMENTS OF GEORGE SOROS, CHAIRMAN, SOROS FUND MANAGEMENT,
LLC; JOHN ALFRED PAULSON, PRESIDENT, PAULSON & CO., INC.; JAMES
SIMONS, PRESIDENT, RENAISSANCE TECHNOLOGIES, LLC; PHILIP A.
FALCONE, SENIOR MANAGING PARTNER, HARBINGER CAPITAL PARTNERS;
AND KENNETH C. GRIFFIN, CHIEF EXECUTIVE OFFICER AND PRESIDENT,
CITADEL INVESTMENT GROUP, LLC.
STATEMENT OF GEORGE SOROS
Mr. Soros. Thank you, Mr. Chairman.
We are in the midst of the worst financial crisis since the
1930's. The salient feature of the crisis is that it was not
caused by some external shock, like OPEC raising the price of
oil. It was generated by the financial system itself.
This fact, that the defect was inherent in the system,
contradicts the generally accepted theory about financial
markets. The prevailing paradigm is that markets tend toward
equilibrium. Deviations from the equilibrium either occur in a
random fashion or are caused by some sudden external event to
which markets have difficulty in adjusting.
The current approach to market regulation has been based on
this theory. But the severity and amplitude of the crisis
proves convincingly that there is something fundamentally wrong
with it.
I have developed an alternative paradigm that differs from
the current one in two important respects: First, financial
markets don't reflect the underlying conditions accurately.
They provide a picture that is always biased or distorted in
some way or another.
Second, the distorted views held by market participants and
expressed in market prices can under certain circumstances
affect the so-called fundamentals that market prices are
supposed to reflect. I call this two-way circle of connection
between market prices and the underlying reality
``reflexivity.'' I contend that financial markets are always
reflexive, and on occasion, they can be quite far away from the
so-called equilibrium. In other words, it is an inherent
characteristic of financial markets that they are prone to
produce bubbles.
I originally proposed this theory in 1987, and I brought it
up to date in my latest book, ``The New Paradigm for Financial
Markets: The Credit Crisis of 2008 and What It Means.'' I have
summarized my argument in the written testimony I have
submitted. Let me recall briefly the main implications of the
new paradigm for the regulation of financial markets.
The first and foremost point is that the regulators must
accept responsibility for controlling asset bubbles. Until now,
they have explicitly rejected that responsibility.
Second, to control asset bubbles it is not enough to
control the money supply. It is also necessary to control
credit because the two don't go in lock step.
Third, controlling credit requires reactivating policy
instruments which have fallen into disuse, notably margin
requirements and minimum capital requirements for banks. When I
say reactivate them, I mean that the ratios need to be changed
from time to time to counteract the prevailing mood of the
markets because markets do have moods.
Fourth, new regulations are needed to ensure that margin
requirements and the capital ratios of banks can be accurately
measured. The alphabet soup of synthetic financial instruments,
CDOs, CDSs EDSs and the like, have made risk less apparent and
harder to measure. These new products will have to be
registered and approved before they can be used and their
clearing mechanism has to be regulated in order to minimize
counterpart risk.
Fifth, since financial marketings are global, regulations
must also be international in scope.
Sixth, since the quantitative risk management models
currently in use ignore the uncertainties inherent in
reflexivity, limits on credit and leverage will have to be set
substantially lower than those that have been incorporated in
the Basel Accords on bank regulation. Basel 2, which delegated
authority for calculating risk to the financial institutions
themselves, was an aberration and has to be abandoned. It needs
to be replaced by a Basel 3 which will be based on the new
paradigm.
How do these principles apply to hedge funds? Clearly hedge
funds use leverage and they contribute to market instability in
times like the present when we're experiencing wholesale and
disorderly de-leveraging. Therefore, the systemic risks need to
be recognized and more closely monitored than they have been
until now. The entire regulatory framework needs to be
reconsidered, and hedge funds need to be regulated within that
framework. But we must be aware of going overboard with
regulation.
Excessive deregulation is at the root of the current
crisis, and there is a real danger that the pendulum will swing
too far the other way. That would be unfortunate because
regulations are liable to be even more deficient than the
market mechanism itself. That's because regulators are not only
human but also bureaucratic and susceptible to political
influences.
It has to be recognized that hedge funds were an integral
part of the bubble which has now burst, but the bubble has now
burst, and hedge funds will be decimated. I will guess that the
amount of money that they manage will shrink between 50 and 75
percent. It would be a grave mistake to add to the forced
liquidation currently depressing markets by ill-considered or
punitive regulations. I'd be happy to expand on these points in
greater detail in answering your questions.
[The prepared statement of Mr. Soros follows:]
[GRAPHIC] [TIFF OMITTED] T6582.078
[GRAPHIC] [TIFF OMITTED] T6582.079
[GRAPHIC] [TIFF OMITTED] T6582.080
[GRAPHIC] [TIFF OMITTED] T6582.081
[GRAPHIC] [TIFF OMITTED] T6582.082
[GRAPHIC] [TIFF OMITTED] T6582.083
[GRAPHIC] [TIFF OMITTED] T6582.084
[GRAPHIC] [TIFF OMITTED] T6582.085
[GRAPHIC] [TIFF OMITTED] T6582.086
[GRAPHIC] [TIFF OMITTED] T6582.087
[GRAPHIC] [TIFF OMITTED] T6582.088
Chairman Waxman. Thank you very much, Mr. Soros.
Mr. Simons.
STATEMENT OF JAMES SIMONS
Mr. Simons. OK. Well, good morning.
Chairman Waxman. There is a button at the base of the mic
you have to press----
Mr. Simons. I think it's on.
Chairman Waxman. OK. Good.
Mr. Simons. Good morning, again Chairman Waxman and Ranking
Member Davis. Members of the committee, I'm James Simons. I'm
chairman of Renaissance Technologies, and in my opinion, this
series of hearings is quite important. And I appreciate your
interest in trying to understand what this is all about.
Now, in my view, this crisis has a number of causes: The
regulators who took a hands-off position on investment bank
leverage and credit default swaps; everybody along the
mortgage-backed securities chain who should have blown a
whistle rather than passing the problem on; and in my opinion
the most culpable, the rating agencies, which in effect allowed
sows' ears to be sold as silk purses.
Before addressing the committee's questions, I would like
to say a little bit about myself and my company because
Renaissance is a somewhat atypical investment management firm.
Our approach is driven by my background as a mathematician. We
manage funds whose trading is determined by mathematical
formulas. We operate only in highly liquid publicly traded
securities, meaning we don't trade in credit default swaps or
collateralized debt obligations or some of those alphabet soup
things that George was referring to. Our trading models
actually tend to be contrarian buying stocks recently out of
favor and selling those recently in favor.
We manage three funds. Our flagship fund, Medallion,
accounts for nearly all of our income and is almost entirely
owned by Renaissance employees. We charge ourselves fees, which
has the effect of shifting income away from the largest owners
of the firm, like me, to the rest of the employees. Our two new
funds designed for institutional investors are both lightly
leveraged and charge fees roughly half of those charged by most
hedge funds.
I will now turn briefly to the questions that the committee
asked. Do hedge funds cause systemic risk? In my view, hedge
funds were not a major contributor to the recent crisis, and
generally, hedge funds have increased liquidity and reduced
volatility in the markets. Moreover, because of their
remarkably diverse strategies, hedge funds as a class are
unlikely to create systemic risk, although it is not out of the
question that they could.
Hedge funds do use leverage, and--but here is an important
point--each hedge fund's leverage is controlled by its lenders
which is far more than one could say for investment banks.
Will hedge funds require further regulation? I do think
additional regulation focused on market integrity and stability
will be useful, and I will get back to that.
Should hedge funds be registered with the SEC? Well, we
have always been registered, at least for 10 years, and we are
certainly not opposed to an appropriate registration
requirement.
Should hedge funds be more transparent? Well, transparency
to appropriate regulators can be helpful. And as Professor
Ruder said very well--described a procedure which was also in
my written testimony--you may wish to consider requiring all
market participants to report their positions to an appropriate
regulator and then allowing the New York Fed to have access to
aggregate position information and to recommend action if
necessary.
This is pretty much what Ruder said. I'll say it again. I
stress, however, that the fund-specific information should not
be released publicly, which could do more harm than good.
Does the compensation structure of hedge funds lead to
excessive risk taking? This question doesn't really apply to us
as almost all of our income is based on profits on our own
capital, but generally speaking, I think not. The statistics
bear this out to some extent. Compare the 7 percent annual
volatility of the hedge fund index to the 15 percent annual
volatility of the S&P over the last 10 years. Thus hedge funds
appear to be at least on the cautious side. Moreover--obviously
there are exceptions. Moreover, typically a manager's largest
investment is in his own fund.
Is special tax treatment for hedge fund managers warranted?
Well, I would only say that, if Congress decides that it is
good policy to alter the tax treatment of carried interest,
that change should apply to all partnerships, private equity,
oil and gas, real estate, etc., all of which are based on that
same principle, not just hedge funds. And I personally would
have no objection whatsoever to such a change.
Before concluding I would like to reflect on how we could
help get out of this hole and make proposal to prevent us
getting back in.
So I think that in the near term the most important thing
we can do is keep people in their homes, even if their
mortgages are in default. This would help millions of families
already coping with a tough economy and would maintain higher
home values than would foreclosure. This would also mitigate
losses on the securities collateralized by these mortgages.
Now, there have been a number of proposals on how to do this,
and I won't opine on which is best.
Now, Mr. Chairman, you mentioned you had a hearing on the
failure of the credit rating agencies. And I particularly
appreciate your attention to that issue. I propose a new rating
agency. Historically the bond rating agencies were paid by the
bond buyers, which was natural because it was they whom they
were supposed to be serving. But in the 70's, the agencies
began to be paid by the bonds issuers. Now, despite the obvious
conflict of interest, the new model worked OK with conventional
type bonds, but until the advent of financially engineered
products.
Now even though I don't trade these products, I believe in
their value. I think they are good. But the organizations
rating them must owe their allegiance to buyers, not to
issuers.
I, therefore, encourage the major holders of these bonds
such as CalPERS, TIAA, PIMCO, etc., to sponsor a new nonprofit
rating agency focused on derivative securities. Congress might
consider chartering such an organization, having board
representation from appropriate regulators. Revenues could come
from buyer-paid fees on each transaction, which I think would
be minuscule. These complex instruments would then be subject
to proper analysis and rating. The interests of buyers and
raters would be aligned, and the likelihood of again seeing a
problem like this one would be dramatically reduced.
Thank you, and I look forward to your questions.
[The prepared statement of Mr. Simons follows:]
[GRAPHIC] [TIFF OMITTED] T6582.089
[GRAPHIC] [TIFF OMITTED] T6582.090
[GRAPHIC] [TIFF OMITTED] T6582.091
[GRAPHIC] [TIFF OMITTED] T6582.092
[GRAPHIC] [TIFF OMITTED] T6582.093
[GRAPHIC] [TIFF OMITTED] T6582.094
[GRAPHIC] [TIFF OMITTED] T6582.095
[GRAPHIC] [TIFF OMITTED] T6582.096
[GRAPHIC] [TIFF OMITTED] T6582.097
[GRAPHIC] [TIFF OMITTED] T6582.098
Chairman Waxman. Thank you very much, Mr. Simons.
Mr. Paulson.
STATEMENT OF JOHN ALFRED PAULSON
Mr. Paulson. Chairman Waxman, Ranking Member Davis, and
members of the committee, thank you for inviting me to appear
today.
Paulson & Co. is an investment advisory firm that was
founded in 1994. We currently manage assets of approximately
$36 billion using event driven strategies. We are based in New
York and also have offices in London and Hong Kong. We have
approximately 70 employees.
Chairman Waxman. There is a question whether your mic is
on. Is the button pressed?
Mr. Paulson. All of the investment funds we manage are open
only to qualified purchasers, those with a minimum $5 million
in investable assets if they are individuals and $25 million in
investable assets if they are institutions. Our investors
include pension funds, endowments and foundations.
These investors look to us to protect their capital and to
show positive returns in both good and bad markets. We do this
by going long securities that we think will rise in value and
by going short securities that we think will decline in value.
We have been able to operate profitably in 14 out of the
last 15 years, including this year when the S&P is down over 40
percent.
We believe that our ability to protect our investors'
capital and generate positive returns over the long term is the
reason we have grown to be one of the largest hedge funds in
the world.
Regarding compensation, we share profits with our investors
on an 80/20 basis, where 80 percent of the profits go to the
investors and 20 percent remains with us. We only earn
performance allocations if our investors are profitable. All of
our funds have a high water mark, which means that if we lose
money for our investors, we have to earn it back before we
share in future profits. Some of our funds also have a claw-
back provision which requires us to return profits earned in
prior periods if we lose money in subsequent periods. In
addition, we invest or own money alongside that of our clients,
so we share investment loss along with gains.
We are a private company and have no public shareholders.
We receive no taxpayer subsidies. All of our investors invest
with us on a voluntary basis. We also use very little leverage.
Over the past 5 years, for over half the time, our base
portfolios were not funded with any borrowed money, and our
maximum borrowing over the last 5 years as a percentage of
equity capital was only 33 percent.
In February 2004, we voluntarily registered with the SEC as
an investment advisor. As a Registered Investment Advisor we
are subject to periodic inspections, focused reviews, and ad
hoc requests for information. We are also subject to stringent
recordkeeping requirements and have to file information
regularly with the SEC.
We comply with all rules and regulations, not only in the
United States but in each of the over 15 countries where we
invest.
As Americans, we are proud of the leadership position the
United States occupies in this industry, the jobs our industry
has created, the export earnings we have produced our country,
and the taxes that we generate for the Treasury. For example,
over the last 5 years, our firm has increased our employee
count by 10 times, creating numerous high-paying jobs for
Americans.
In addition, 80 percent of our assets under management come
from foreign investors. The revenues we receive from foreign
investors allow us to contribute to the U.S. economy like an
exporter of goods bringing in money from abroad.
In 2005, our firm became very concerned about weak credit
underwriting standards, excessive leverage amongst financial
institutions, and a fundamental mis-pricing of credit risk. To
protect our investors against the risk in the financial
markets, we purchased protection through credit default swaps
on debt securities we thought would decline in value. As credit
spreads widened and the value of these securities fell, we
realized substantial gains for our investors.
We have offered suggestions on the causes of the credit
crisis and what the U.S. Government can do to help the
situation. I also have some recommendations on how future
purchases of preferred stock under the TARP can be structured
both to protect taxpayers better and to provide greater
stability to financial institutions, and I would be pleased to
share those thoughts with you.
Again, thank you for the opportunity to address this
committee.
[The prepared statement of Mr. Paulson follows:]
[GRAPHIC] [TIFF OMITTED] T6582.099
[GRAPHIC] [TIFF OMITTED] T6582.100
[GRAPHIC] [TIFF OMITTED] T6582.101
[GRAPHIC] [TIFF OMITTED] T6582.102
[GRAPHIC] [TIFF OMITTED] T6582.103
[GRAPHIC] [TIFF OMITTED] T6582.104
[GRAPHIC] [TIFF OMITTED] T6582.105
[GRAPHIC] [TIFF OMITTED] T6582.106
[GRAPHIC] [TIFF OMITTED] T6582.107
[GRAPHIC] [TIFF OMITTED] T6582.108
[GRAPHIC] [TIFF OMITTED] T6582.109
[GRAPHIC] [TIFF OMITTED] T6582.110
[GRAPHIC] [TIFF OMITTED] T6582.111
[GRAPHIC] [TIFF OMITTED] T6582.112
Chairman Waxman. Thank you very much, Mr. Paulson.
Mr. Falcone.
STATEMENT OF PHILIP A. FALCONE
Mr. Falcone. Thank you, Chairman Waxman, Ranking Member
Davis, and other members of the committee.
My name is Philip Falcone. I am the senior managing
director and cofounder of the Harbinger Capital Partnership
fund. I'm extremely proud of the work that we have done at
Harbinger. Year in, year out, we have generated substantial
returns for our investors, which include pension funds
endowments and charitable foundations. We have achieved our
success for our investors by doing things the right way.
Through our investments we have also provided much-needed
Capitol to American companies, supporting them as they pursue
their business plans and giving them a second chance to reach
their potential.
I appreciate the committee holding today's hearing in order
to learn more about hedge funds and their positive role in the
financial markets. I am hopeful that this committee can take
four points away from today's testimony.
No. 1, compensation in the hedge fund industry is
performance based. I think that is the right way to do business
because it creates incentive for hard work and innovation.
No. 2, hedge funds use a variety of investment strategies,
including traditional approaches. Investors, especially large
institutions, want a broad array of strategies and disciplines
so they can diversify their portfolios.
No. 3, short selling is a valuable longstanding feature of
our markets. It isn't short selling that puts companies out of
business but rather over-leveraged balance sheets, poor
management decisions, and flawed business plans.
No. 4, I support greater transparency and better reporting
in the hedge fund sector.
I would like to take a moment to tell you a little bit
about myself. I currently reside in New York City with my wife
of 11 years and two children. By way of background, I was born
in Chisholm, MN, population 5,000 on the Iron Range of northern
Minnesota. I was the youngest of nine kids who grew up in a
three-bedroom home in a working class neighborhood. My father
was a utility superintendent and never made more than $15,000
per year, while my mother worked in the local shirt factory.
The point of all this is I take great pride in my
upbringing, and it is important for the committee and the
public to know that not everyone who runs a hedge fund was born
on Fifth Avenue. That is the beauty of America and the beauty
of the potential in our industry.
Through hard work and perhaps a little bit of luck,
Harbinger Capital Partners has been able to generate
substantial returns for our investors since 2001. Our
investment philosophy is very simple: We study, often for
months, the fundamentals of companies to identify those that
are undervalued or overvalued, and we act decisively when
opportunities present themselves. We are not momentum traders
nor are we day traders. We are investors. It is not magic. My
analysts perform thorough due diligence rather than relying on
rating agencies or other research reports, like many of the
reports that improperly valued securitized mortgage products
over the past few years.
My compensation is based upon the returns that we generate
for our investors, which have far exceeded the performance of
the overall market. There is no doubt that as result of the
success of Harbinger Funds, I have done extremely well
financially. But this is not the case where management takes
huge bonuses or stock options while the company is failing. My
success is tied to that of my investors, and I have reinvested
a substantial portion of my compensation over the years back
into the funds alongside my investors who are fully aware of
the compensation formula when deciding whether to place their
money with us.
Because of the events of the past few months, the American
public, including my investors, have justifiable concerns about
our financial markets and the economy. The important thing to
remember, however, is that we must keep things in perspective
and not overreact, misperceive or misrepresent what has
happened. We are a resilient society. We must focus on the
positives and continue taking the positive steps forward,
rather than backward.
Hedge funds play an important role in the economy by
providing needed capital and encouraging creativity and
outside-the-box thinking. Many viable companies struggling
under a huge debt load or poor cash-flow have not only survived
but flourished through an infusion of hedge fund capital,
saving thousands of jobs. I am proud of Harbinger's track
record of helping these types of companies emerge from
bankruptcy and helping others avoid filing in the first place.
Finally, I would like to offer a thought or two on how
Congress and the hedge fund industry can work together to
increase public confidence not only in our industry but in the
financial markets as a whole.
I support some additional government regulation requiring
more public disclosure and transparency for hedge funds as well
as for public companies. All investors, whether individual or
sophisticated institutions, have a right to know what assets
companies have an interest in, whether on or off their balance
sheets, and what those assets are really worth.
I also support the creation of a public exchange or
clearing house for derivatives trading, especially credit
default swaps. An open and transparent market for these
transactions would reduce confusion and improve understanding
as well as help with valuation issues.
In summary, while I was growing up, my family may have
lacked money, but one thing we didn't lack was integrity and
pride in what we did and how we did it. It was a cornerstone
then, and it remains the cornerstone of my family and my
business today. In 1990, one of my investors once told me
something that continues to resonate with me today. He said, I
can't guarantee that if you work hard, you will be successful;
but I can guarantee that if you don't work hard, you won't be
successful. We should never lose sight of that.
Needless to say, I love this country, and I am grateful for
the opportunity that I have been provided. That being said, we
are living in difficult times now. Consequently, I hope that
this committee and indeed the entire Nation will look the at
hedge fund industry as part of the solution to our economic
turmoil.
Given the tightening of credit markets, access to capital
is more important than ever, and I believe that hedge funds can
and should be a source for this capital. Thank you for
permitting me the opportunity to make this statement, and I
would be happy to answer any questions that you may have.
[The prepared statement of Mr. Falcone follows:]
[GRAPHIC] [TIFF OMITTED] T6582.113
[GRAPHIC] [TIFF OMITTED] T6582.114
[GRAPHIC] [TIFF OMITTED] T6582.115
[GRAPHIC] [TIFF OMITTED] T6582.116
[GRAPHIC] [TIFF OMITTED] T6582.117
[GRAPHIC] [TIFF OMITTED] T6582.118
Chairman Waxman. Thank you, Mr. Falcone.
Mr. Griffin.
STATEMENT OF KENNETH C. GRIFFIN
Mr. Griffin. Mr. Chairman, Congressman Davis, and
distinguished members of the committee, my name is Kenneth
Griffin, and I am the founder and CEO of Citadel Investment
Group. Thank you for the opportunity to address this committee.
Today, our Nation is working through the worst financial
crisis since the 1930's. It is imperative that we as a Nation
continue to take actions to mitigate the impact of the credit
crisis on our broader economy in the hopes of keeping Americans
employed and productive. I appreciate your leadership on this
important undertaking.
I am proud that in the 18 years since I founded Citadel, it
has grown into a financial institution of great strength and
capability. With a team of over 1,400 talented individuals,
Citadel manages approximately $15 billion of investment capital
for a broad array of institutional investors, high net-worth
individuals, and Citadel's employees.
Citadel's Capital Markets Division plays an important role
in our Nation's market. Our broker dealer is the largest market
maker in options in the United States, executing approximately
30 percent of all equity option trades daily. In addition,
Citadel accounts for nearly 10 percent of the daily trading
volume of U.S. equities.
All businesses take risks. In some industries we refer to
risk-taking as research and development. At financial
institutions, we often take risks by investing in securities.
Failure to understand and manage risk can be severe, as we have
seen far too often in recent weeks. Although the financial
crisis has affected virtually every participant in the
financial markets, including Citadel, I believe that Citadel's
constant and consistent focus on risk management has been a key
asset in successfully navigating this financial crisis and will
continue to serve us well in the years to come.
In this crisis, the concept of ``too interconnected to
fail'' has replaced the concept of ``too big to fail.'' The
rapid growth in the use of derivatives has created an opaque
market whose outstanding notional value is measured in the
hundreds of trillions of dollars. As a result, there is great
concern about the systemic effects of the failure of any one
financial institution.
In the area of credit default swaps, for example, there is
an estimated $55 trillion of outstanding notional contracts
between market participants. This number is almost four times
the GDP of our Nation.
The creation of central clearinghouses to act as
intermediaries and guarantors of financial derivatives such as
credit default swaps represents a straight-forward solution to
the issues inherent in today's opaque over-the-counter market.
Of greatest importance, such a clearinghouse will dramatically
reduce systemic risk, allowing us to step away from the ``too
interconnected to fail'' paradigm. Numerous other benefits will
accrue to our economy. Regulators, for example, will have far
greater transparency into this vast and important market.
In recent months, Citadel and the CME Group have partnered
in building such a clearinghouse for credit default swaps. Our
solution is an example of how industry in cooperation with
regulators can solve complex market problems.
I believe and have said before that our financial markets
work best when they are competitive, fair, and transparent.
Proper regulation is critical, but the best regulation is
created with an eye toward unleashing opportunities, not
limiting possibilities. To achieve this, Congress, regulators
and industry must all work together. Our markets are complex,
and they must be well understood if they are to be well
regulated.
We must solve the serious issues we face but not in a way
that stifles the best innovative qualities of our great capital
markets.
I thank the committee for holding this hearing today, and I
look forward to answering your questions, thank you.
[The prepared statement of Mr. Griffin follows:]
[GRAPHIC] [TIFF OMITTED] T6582.119
[GRAPHIC] [TIFF OMITTED] T6582.120
[GRAPHIC] [TIFF OMITTED] T6582.121
Chairman Waxman. Thank you very much, Mr. Griffin.
We are now going to proceed to questions by Members of the
panel, who will each have 5 minutes each.
I want to remind the Members that the hearing today is
about hedge funds and the financial markets, and questions
about other topics are not relevant to the hearing. The Chair
won't bar any Member from asking any particular question or a
witness from answering a particular question, but witnesses
will not be required to answer questions unrelated to the topic
of today's hearing. So I urge Members and witnesses to keep
their questions and answers focused on the topic of today's
hearing.
I'm going to start with myself. Let me start off by asking
about systemic risk. In 1998, Long Term Capital Management was
one of the Nation's largest hedge funds. It had about $5
billion in capital and was leveraged at a ratio of 30 to 1. It
had made investments worth about $150 billion, and when those
investments went bad, its capital was quickly wiped out.
The Federal Reserve became so concerned about the broader
impacts of this collapse that it organized a multibillion
dollar bailout. That was in 1998 when only about 3,000 hedge
funds managed approximately $2 billion in assets. Current
estimates suggest that there may be 9,000 hedge funds managing
assets worth more than $2 trillion. Some say hedge funds have
become a shadow banking system.
So I'd like to ask each of you two questions: Do you
believe that the collapse of large hedge funds could pose
systemic risks to the economy? And if so, do you believe this
justifies greater Federal regulation?
Mr. Soros, why don't we start with you and go straight down
the line?
Mr. Soros. Yes, I think that some hedge funds do pose
systemic risk. And I think particularly leveraged capital was
built on a false conception--I talked about the false paradigm
on which our financial system has been built. And that was
actually embodied in leveraged capital, which was very--which
basically assumed that deviations from--are random.
Chairman Waxman. Do you believe this justifies greater
Federal regulation?
Mr. Soros. Pardon?
Chairman Waxman. Do you believe this justifies greater
Federal regulation?
Mr. Soros. Yes, it does.
Chairman Waxman. Thank you.
Mr. Simons.
Mr. Simons. Yeah, well, certainly----
Chairman Waxman. Is your mic on?
Mr. Simons. Certainly the possibility exists that an
individual hedge fund or hedge funds in aggregate could be a
cause of systemic risk. And I think that regulation in the form
of reporting up to the SEC, for example, in a more detailed
manner than is presently done with those things aggregated--
that information aggregated, passed on to the Federal Reserve
or some such would be a good approach. So, yes.
Chairman Waxman. Thank you.
Mr. Paulson.
Mr. Paulson. I think the risk--I think the systemic risk in
the financial system, and that includes hedge funds as well as
banks and other financial institutions, is due to too much
leverage; that when banks or hedge funds use too much leverage,
you only need a small decline in the value of the assets before
the equity is wiped out and the debt is impaired. I do think
there is a need for more stringent leverage requirements on
banks, financial institutions and, where, necessary on hedge
funds.
The amount of common equity that institutions are operating
with is simply too thin to support their balance sheets. The
primary reasons why financial firms have run into trouble,
whether Lehman Brothers, Bear Stearns or AIG, is they have way
too much leverage. Lehman Brothers, as an example, had over 40
times the assets compared to their tangible common equity. They
just didn't have enough equity. Every hedge fund that has had a
problem, whether it was the Carlisle funds, the Bear Stearns
funds or Long Term Capital before, was because of the use of
too much leverage.
Chairman Waxman. Do you think, therefore, that there ought
to be more government regulation of the hedge funds and
particularly on leverage?
Mr. Paulson. Yes, I think the equity requirements of
financial institutions need to be raised, and the margin
requirements, the amount capital institutions or investors have
to hold to support individual securities, should also be
raised. And by doing that, that would reduce the risk in the
system.
I may add just one point is that in all the trillions of
government support globally to try and stem this financial
disaster, not $1 yet has been used to support a hedge fund. So
the problems have been with our investment banks with other
financial institutions. And although Long Term Capital was
large, a $4 billion hedge fund, that problem was also solved
privately without any government intervention. And the problems
of Long Term Capital, which today was the largest hedge fund to
experience a problem, are minuscule compared to the $150
billion that was required to bail out AIG, the $700 billion
billion in the TARP program, or the $139 billion that was just
advanced to GE in the form of guarantees.
Chairman Waxman. Good point. Thank you.
Mr. Falcone.
Mr. Falcone. Yes, I think that any institution that has a
pool of capital at its availability and uses reckless leverages
indeed poses a systemic, potential systemic risk to the
marketplace. I think that when you look the at hedge fund
industry with the trillion or trillion and a half dollars
outstanding, that the leverage aspect of it is a bit isolated.
And there are certain institutions that may pose risks, but I
would suspect that for the most part the industry in general is
not nearly as leveraged as some of the banking institutions
that we were dealing with over the past 4 or 5 months.
And I do support additional regulation as it relates to
that, because I don't think it's in anybody's best interest to
see these institutions unravel and create a domino effect.
Chairman Waxman. Thank you.
Mr. Griffin.
Mr. Griffin. Mr. Chairman, as you referred to Long Term
Capital's consortium bailout in 1998, it is important to
remember, it was a private market solution to a very
challenging problem. Just a few years ago, Citadel and JP
Morgan created a private market solution to the challenges
faced by Amaranth and its shareholders when they incurred even
greater losses in the natural gas market. Private market
solutions can address crises. And we should keep in the center
of our mind that we want to foster private market solutions as
the way to handle crises first and foremost.
Of second point, hedge funds are already regulated
indirectly by the fact that the banking system is regulated and
the banking system is the primary extender of credit to hedge
funds. And last but not least, I think it's important that we
keep in mind, it's very convenient to say we should simply have
more equity in the system, but equity is very expensive, and if
we wish to reduce the cost of loans to consumers and loans to
homeowners, we need to think of capital structures that have
the right mix of equity to debt.
Thank you.
Chairman Waxman. Well, the private market solution was
organized by the Fed. So it wasn't without some public
intervention. Is it your conclusion that we do need some
greater Federal regulation because of the systemic risks?
Mr. Griffin. No, it is not my belief that we need greater
government regulation of hedge funds with respect to the
systemic risks they create. And to be very direct, we have gone
through a financial tsunami in the last few weeks, and if we
look at where the failure stress points have been in the
system, they have been in the regulated institutions; whether
it is AIG, an insurance company, Fannie or Freddie, the banking
system. We have not seen hedge funds as a focal point of
carnage in this recent financial tsunami.
Chairman Waxman. Well, our expert witness in the first
panel testified they believe hedge funds do pose systemic risk.
Former SEC Chairman David Ruder said this: Highly leveraged
hedge funds that borrow large sums and engage in complex
transactions using exotic derivative instruments may severely
disrupt the financial markets if they are unable to meet
counterparty obligations or must sell assets in order to repay
investors.
And Professor Andrew Lo gave similar testimony.
My concern is that our regulatory system has not recognized
these potential risks. The hedge fund industry is getting
bigger. The systemic risks are growing larger, and yet Federal
regulators have virtually no oversight of your industry, and
that is a potentially dangerous situation. So I appreciated
hearing each of your views on that subject.
Mr. Davis.
Mr. Davis of Virginia. Thank you, Mr. Chairman.
I would ask, let me just amplify your question, and they
can answer the question you just posed. Because our first panel
of witnesses did propose requiring hedge funds to divulge
comprehensive risk to regulators. But I have heard some concern
here and elsewhere that you need to keep such data in an
aggregated and confidential format. And so I would ask, along
with Mr. Waxman's question, is there a danger of too much
transparency in the hedge fund industry, and what is that?
Mr. Griffin, I will start with you. I think you have some
limits on regulation and ask you to address that, and then I
will move right down.
Mr. Griffin. On the issue of disclosure of positions or
aggregate risk factors, we at Citadel would not be adverse to
that so long as the information was maintained confidential and
in the hands of the regulators. To ask us to disclose our
positions to the open market would parallel asking Coca-Cola to
disclose their secret formula to the world.
Mr. Falcone. I agree. I think that it is important to
disclose the information to the appropriate regulatory
agencies. We work long and hard in developing our ideas, and to
make them public I don't think is the right thing to do. And
the public would not necessarily use them in the same way,
shape, or form that we would use our ideas.
Mr. Davis of Virginia. Mr. Paulson.
Mr. Paulson. Yes, as you know, we voluntarily registered
with the SEC in 2004. We believe, to the extent, having a
regulatory oversight over the policies of hedge funds, to the
extent it provides greater comfort to the public sector and to
private investors is a beneficial thing.
Mr. Simons. I don't have much to add. I have already said
that reporting up to the regulators is a good idea, more so
than is now reported. I agree with the others that it should
stay with the regulators or with the Federal Reserve. It should
not be reported in the New York Times.
Mr. Soros. As I have said, I think the regulators need to
monitor positions more closely than they have done until now.
But disclosing it to the public can be very harmful in many
ways. And I think that the publication of short positions, for
instance, practically endangers the business model of long-
short equity investors--it is not our business, it is the other
hedge funds that do that--because of the reaction of the
companies whose shares they were selling short.
Mr. Davis of Virginia. Let me ask this. I asked Mr. Waxman,
and he is comfortable with me asking this. Do you have any
opinions on what the Treasury Department is doing now with the
Troubled Asset Recovery Plan? How they can deploy that maybe
better than they are doing? In light of the fact that the $700
billion is not actually being used to buy up troubled assets
but to purchase equity stakes in financial firms, Secretary
Paulson has indicated that Treasury may start purchasing stakes
in nonbank financial firms. And do you think any hedge funds
might take advantage of such an offer? Anybody want to opine an
opinion on that?
Mr. Griffin, I will start with you.
Mr. Griffin. Congressman Davis, I believe that the decision
to focus on injecting equity or preferred equity into the
banking system versus buying assets will create a larger effect
for all of us and is a good decision on a relative basis. So,
in other words, I applaud the Secretary of Treasury for making
the decision to increase the equity capital base of the banking
system at this moment in time.
Of course, we have a difficult decision to make ahead of
us: Do we expand TARP to include the nonbanking sector? And if
we do so, where do we draw the line? I think that is a very
difficult decision that we have to make in the weeks and months
ahead. Obviously, the economy as a whole is slowing down, and
we need to keep Americans employed. And I believe that we are
going to need more stimulus packages to keep our economy as
close to full potential as possible.
Mr. Falcone. I have been in favor of TARP to a certain
extent considering that it could be a safety net for isolated
incidents. I don't believe, however, that the money should be
used for random purchases of assets because of the lack of
clarity as it relates to what the institutions will do with
that capital and what benefits it will do for the individual
consumer. And I furthermore do not think that it should go
above and beyond the financial institutions.
Mr. Paulson. Congressman Davis, I do think it was a
tremendous improvement shifting the focus of TARP from buying
assets, which has very little impact on recapitalizing banks,
to directly buying equity. I think the problem in the financial
sector is one of solvency. Financial firms don't have enough
equity. And injecting equity is the solution to the problem.
I also think the list of recipients needs to be expanded to
include other types of financial firms whose failure could pose
systemic risk. That may include auto finance companies other
finance companies, and insurance companies.
However, I do think the structure of TARP investments can
be improved. I think the current terms are overly generous to
the recipients, and I will give you some examples. When
Berkshire Hathaway bought preferred stock in one of the
investment banks, they received a 10 percent dividend and
warrants equal to 100 percent of the value of the investment.
Under the TARP program, the yield was only 5 percent and
warrants equal to only 15 percent.
In the U.K. And Switzerland, when they invested preferred
knock their financial companies, they got a 12 percent yield,
also substantial equity stakes.
By investing proceeds at less than market rates and less
than other governments are doing, it's in effect an indirect
transfer of wealth from the taxpayers to these financial
institutions.
In addition, in the U.K., Switzerland and all other
governments, when government money was required to help out
financial institutions, there were restrictions on common
dividends and on executive compensation. In the U.K. And in
Switzerland, as long as government money is inside these
companies, there are prohibitions on the payment of common
dividends and caps on executive compensation. And this is
essential in order to increase the retained earnings and common
equities of the banks. It doesn't seem to make sense to me that
the banks are short of capital, the government puts in capital,
and then that capital comes out the other door in the forms of
dividends and compensation.
I would make two suggestions that I think should be
required of any financial firms that receive preferred stock
investments or any form of guarantee from the Federal
Government on their debt or other securities. One would be,
while that guarantee is outstanding or while the preferred
investment is made, that cash common dividends be eliminated
and any dividends be restricted to dividends in additional
shares of common stock.
Second, as other governments have required, there should be
restrictions on cash compensation, and any bonuses or payments
above that amount should be paid in common stock. By making
those three adjustments, first increasing the terms of the
preferred in terms of yield and equity to benefit the taxpayer;
second, eliminating cash dividends; and third capping executive
compensation, that would both protect taxpayers and restore the
badly needed equity capital to these institutions.
Mr. Simons. OK. Well, it was generally agreed that the
original goal of TARP to buy some of this paper was perhaps not
the best idea and more leverage would be created by
capitalizing the banks and so on. On the other hand--and I more
or less agree with that--but nonetheless, something has to be
done about this paper. No one knows what much of it is worth,
and it's in weak hands. People don't know how to, you know,
appraise the balance sheets of the companies that are holding
it and so on. So it is a problem, and it is a big problem.
I had suggested to Bob Steel when he was Under Secretary of
the Treasury that rather than buy this stuff, they organize an
auction, a two-sided auction dividing the paper up into various
categories and so on and conducting auctions that people could
buy and sell. And hopefully buyers would come in, and sellers
would put up, and the market would kind of get cleared.
It is a pretty good idea, but it is a dangerous one because
the prices might not make some folks very happy, people who
maybe aren't selling but all of a sudden their balance sheets
get whacked way down. But sooner or later we have to face the
question what is this stuff worth and how do we get it out of
weak hands, where much of it is, and into strong hands? And
because only with the paper being in strong hands can the
issues, some of these issues be dealt with. If a mortgage is
chopped up into a million pieces and owned, fractions of its
cash-flow is owned by all kinds of people, it is very hard to
deal with that homeowner and renegotiate the terms. But if you
have bought this mortgage at, OK, a discount, then you can go
to the fellow, and I am of course projecting this on a much
wider scale, and say, OK, you can't make your monthly payments,
but could you make it half? And can we make a deal here? And
because he or she bought this paper at a substantial discount,
everyone can make out OK in a reduced way. Somehow or other
that paper has to be dealt with. And that is all I have to say.
Mr. Davis of Virginia. Mr. Soros.
Mr. Soros. I am on record being very critical of the
original TARP proposal. And I would like to go on record saying
that while it is a great improvement that it is not used for
removing toxic securities, but for equity injection, the way it
is done is not an adequate or acceptable way, that if it were
properly done then $700 billion would be more than sufficient
to replenish the gaping hole in the banking system and to
encourage the banks to start lending again. And the way that
this should be done would be to ask the examiners to determine
how much capital each bank needs to bring it up to the required
8 percent. Then the banks would be free to raise that capital
or go to TARP and get an offer. But TARP should only underwrite
the issue, and not actually take it on. But underwrite it on
terms that the shareholders would be likely to take it on. And
only if the shareholders don't take it would TARP take it on.
Then you would have replenished the banking system, you would
then reduce the minimum lending requirements from 8 percent,
let's say, to 6 percent--the minimum capital requirements--and
the banks would be very anxious to put that very expensive
capital, because equity capital is expensive, to good use to
get a good return on it by actually lending.
So that would solve that problem. And as far as the toxic
securities are concerned, I think the first thing is to
renegotiate the mortgages so that people would actually stay in
their houses, and you remove the pressure of foreclosures,
which are liable to push down the value of mortgage securities
way below that. That is an undone business that has to be
urgently attended to.
Mr. Davis of Virginia. Thank you all.
Mr. Towns [presiding]. Let me tell my colleague he has no
time to yield back. Let me just ask the question and just go
right down the line and get an answer from each of you.
All of you have successfully navigated the recent problems
in the economy which appears to have blind-sided the people on
Wall Street, and of course the people here in Washington. I
don't think we can pass up this opportunity to explore what it
is that you knew that allowed you to get so far ahead of
everyone else when it came to predicting what would happen in
the markets.
I would like to go right down the line. Right down the
line. We will start with you, Mr. Griffin, go right down the
line.
Mr. Griffin. Sir, the last 8 weeks have been a challenging
8 weeks for Citadel. We have had a very successful 18 years
holistically, but we have had a tough time in the last 8 weeks
as the banking system around the world came close to the verge
of collapsing. I think what is very important to note is what
has happened in the last 8 weeks looks like nothing that any of
the traditional risk management metrics would have shown as a
realistic possibility.
I think it is very important for everyone to keep in mind
in terms of policy decisions on a going forward basis we had a
panic in the money market system, we had a panic in the banking
system, and we have had very negative consequences as a result
of that in the entire Western world's financial system.
I think if we look at the firms that have done well over
the last 8 weeks, they came into this position with portfolios
of both credit risk and equity market risk that could tolerate
extreme moves, which we have witnessed. And they have come into
this crisis with very solid financing lines, which have been
important in terms of weathering the storm that we have just
gone through.
Mr. Towns. Mr. Falcone.
Mr. Falcone. I think in looking at what has happened over
the past 8 weeks versus what has happened over the previous
history in the financial markets is a very unique point in
time. The markets are very irrational right now. And I have
always said you could be right fundamentally and wrong
technically. And the technical situation in the marketplace is
putting a lot of pressure on a lot of institutions.
How we have weathered the storm and how we have done over
the past has really been a function of our diligence. And I
think in looking at where we have been successful, we have
taken our time and been methodical and really thought things
through. And we were very involved in the mortgage market over
the past couple years. And it has been to a point--it was to a
point where it took me about 8 to 12 months of some pretty
substantial analysis before we put that trade on, or trades
like that on.
So I would say that over the past couple of months it again
has been very irrational, and been very difficult to avoid, no
matter what type of institution you are, to avoid the pitfalls
of what has been taking place. And I think in order to succeed
going forward, the proper liquidity and the proper lines with
the right institutions are a very critical and very important
thing.
Mr. Towns. All right. Mr. Paulson.
Mr. Paulson. Mr. Chairman, we conduct a lot of detailed
analysis independent of the rating agencies.
Mr. Shays. Lower your mic just a bit.
Mr. Paulson. Yes. Our firm conducts a lot of detailed
independent research that is independent of what the rating
agencies do. And we determined late in 2005 and early in 2006
there was a complete mispricing of risk of mortgage securities.
We found Moody's and S&P rating various securities investment
grade, including as high as triple A, that we thought would
become worthless. The reason we had this opinion was we looked
at the underlying collateral of these securities. The subprime
securities were comprised of mortgages that were made with 100
percent financing and no down payment. They were made to
borrowers that had a history of poor credit. There was no
income verification. And the mortgage value was based on an
appraisal that was typically inflated. We felt this was very
poor underwriting quality, that the default rates in these
mortgages would be very high, and that securities backed by
these mortgages would also--would likely also have very high
defaults. And it was that analysis that allowed us to buy
protection on these securities, which resulted in large gains
for our funds.
Mr. Towns. Thank you. Mr. Simons.
Mr. Simons. OK. Well, I didn't have that kind of wisdom.
Happily, the funds that we operate didn't require that kind of
wisdom. So our principal fund, called Medallion, is long and
short equal amounts of equity, and is not necessarily affected
by the rises and falls in the stock market, and in fact has
done fine through this period.
A second fund which is designed to be a dollar long, that
is for outsiders, not employees, obviously has--it is long more
than it is short, so it is net long a dollar if you invest a
dollar. That has obviously had some declines with the stock
market down 40 percent, but considerably less than the declines
of the market. And our investors in that fund are quite happy,
because that is what they--that is what we advertised would
happen, and so that is fine.
An outside futures fund we have was hurt by the explosion
of volatility in October. I couldn't have predicted that. Maybe
I should have. I didn't. It was on the wrong side of a few
things and suffered some losses in October. But by and large,
our business is not highly correlated with the stock market.
And so that is how we have skated along here.
Mr. Towns. Mr. Soros.
Mr. Soros. What was your question? I didn't fully
understand your question. Was it how it affected our----
Mr. Towns. Yes. How you seemed to have been able to
anticipate when others were not able to anticipate, especially
Wall Street and Washington.
Mr. Soros. I fully anticipated the worst financial crisis
since the 1930's. But frankly, what has happened in the last 8
weeks exceeded my expectations. The fact that Lehman Brothers
was allowed to go declare bankruptcy in a disorderly way really
caused a meltdown, a genuine meltdown of the financial system,
a cardiac arrest. And the authorities have been involved since
then in resuscitating the system. But it has been a tremendous
shock, the impact of which has not yet been fully felt.
Now, as far as my own fund is concerned, I came out of
retirement to preserve my capital, and I have succeeded in
doing that. So we are flat for the year, because by taking the
necessary steps I was able to counterbalance the losses that we
would be suffering otherwise, which would be quite substantial.
Mr. Towns. Thank you very much. Thank all of you for your
answers.
The gentleman from Indiana.
Mr. Souder. Thank you, Mr. Chairman. And I understand this
is a financial hearing, and I am not going to get into other
questions, but I just want to say, Mr. Soros, we have had deep
disagreements over the years on the heroin needles promotions
and your promotion of different what I believe are back-door
legalization of marijuana. And I believe while you have done
humanitarian efforts around the world, your intervention in the
drug area has been appalling. And I haven't had the chance to
talk to you directly, and I wanted to say that because I
believe it has damaged many Americans. And I hope you will
reevaluate where you put your money.
But I do have a question directly to you on your question
on equilibrium, that don't hedge funds provide some of that
equilibrium by buying long and selling short and going after
companies that haven't been responsible? And why do you think
there wasn't more of that in this case?
Mr. Soros. Well, to some extent hedge funds do. And of
course we shouldn't put all the hedge funds in one category.
There are different strategies and they have different effects.
And definitely selling short is a stabilizing factor, generally
speaking, in the market. In other words, the markets that allow
and facilitate short selling tend to be more stable than those
that prohibit them.
At the same time, hedge funds do use leverage. And leverage
by its very nature has the potential of being destabilizing,
because as the market goes up the value of the collateral
increases, you can borrow more, and also maybe since you are
making profits your appetite for borrowing more is increasing.
So there is greater willingness to lend by the banks.
So this is the--generally speaking, bubbles always involve
credit. And since hedge funds use credit, they are contributors
to the bubbles. It is nothing specific to hedge funds, it
relates to everyone who uses credit.
Mr. Souder. Mr. Paulson, you said a little bit ago that you
felt that the government needed to get more involved in the
fact that some use too much leverage, and that it is kind of a
slippery slope because, as Mr. Soros just suggested, that in
fact hedge funds use some leverage as well, and in fact while
you serve a function for equilibrium, you often exaggerate the
extremes of that through selling short or buying long.
Could you respond some to what Mr. Soros said? How do you
feel? Do you still feel you shouldn't have additional
regulation with that? And how do you respond to the fact that
you do in fact exaggerate some of these trends?
Mr. Paulson. Well, I think what leverage does is it
exacerbates any move----
Mr. Shays. Is your mic on, sir?
Mr. Paulson. Yeah. The danger of leverage is that
exacerbates any type of market move. So almost every financial
firm that has run into problems, not only hedge funds like Long
Term Capital, but Lehman Brothers, AIG, has because they used
too much leverage. And a small decline in the value of their
assets wiped out their equity. So I think that there is a need
to raise the margin requirements on particular asset classes
and to require stronger equity positions in banks so that--and
that would reduce the risk of failure.
Mr. Souder. Mr. Griffin, you have been the most aggressive
in saying that there shouldn't be regulation. How would you
respond to the comments there?
Mr. Griffin. Let me be very direct on the point of
regulation. Good regulation is good for every market
participant. I mean, for example, in the middle of the
financial crisis we worked hand in hand with the SEC to create
the necessary exemptions to allow Citadel to continue to make
markets every day in options to millions of retail investors.
And every day during this crisis we have provided liquidity in
the equities markets to millions of retail investors, whether
they are at Schwab or Fidelity or Ameritrade or E-Trade. I am
very proud of my firm's commitment to providing liquidity to
retail investors in America. We have also worked hand in hand
with the Federal Reserve Bank of New York for creating a
clearinghouse for credit default swaps.
I think that as a Nation we need an intelligent dialog
about the right regulatory frameworks to encourage markets that
are transparent, that have the appropriate amount of leverage
in the system, and that create value for society. The point of
our capital markets is to allocate capital efficiently, to
allow corporate America to raise equity, to grow, and to allow
America to be more competitive in the world markets. And any
regulation that furthers those key goals of our capital markets
is regulation I would support.
Mr. Souder. May I ask a brief--if regulation goes too far
would your funds, because I assume you all have foreign
investment, would we see this move offshore either to Europe or
Asia or other places?
Mr. Griffin. It breaks my heart when I go to Canary Wharf
and I look at the thousands and thousands of highly paid jobs
in London in the derivatives markets that belong in America. We
went through a period of regulatory uncertainty with respect to
derivatives that pushed thousands of high-paying jobs abroad,
jobs that belonged in our country.
Mr. Souder. Thank you.
Mr. Towns. Thank you very much. The gentlewoman from New
York.
Mrs. Maloney. Thank you. Thank you very much. And I would
like to ask a question about a specific regulatory proposal,
which is to require hedge funds to disclose information to
regulators. This is an idea that was proposed in the prior
panel by both Mr. Ruder and Professor Lo.
Right now the SEC, the Fed, and other entities have
virtually no information about hedge funds. As a result, they
have very limited ability to assess systemic risk. As Professor
Lo testified, one cannot manage what one cannot measure. He
said that it is, ``an obvious and indisputable need to require
financial institutions to provide additional data to
regulators.'' Chairman Ruder made the same point when he said,
``I continue to believe that a system should be created
requiring hedge funds to divulge to regulators information
regarding the size, nature of their risk positions, and the
identities of their counterparties.'' And I see you have your
book with you, Mr. Soros, and in your book you said, ``there
are systemic risks that need to be managed by the regulatory
authorities. To be able to do so, they must have adequate
information. The participants, including hedge funds and
sovereign wealth funds and other unregulated industries, must
provide that information even if it is costly and cumbersome.
The costs pale into insignificance when compared to the costs
of a breakdown. And we are now experiencing a major
breakdown.''
And so Mr. Soros, would you support a requirement for hedge
funds to report financial information to regulators?
Mr. Soros. Yes.
Mrs. Maloney. And Mr. Simons, you also in your testimony
made a similar statement about transparency and appropriate
regulation. So would you agree also that it is correct to have
more----
Mr. Simons. Yep.
Mrs. Maloney. And also Mr. Paulson, Mr. Falcone, and Mr.
Griffin, would you support additional information and
transparency to regulators?
Mr. Paulson. Congressman Maloney, you make a very good
argument. I think given the size of the industry and the
potential for systemic risk----
Mr. Towns. We are having trouble hearing you.
Mr. Paulson. Congressman Maloney, I think you make a very
good argument that given the size of the industry and the
potential for systemic risk, greater disclosure and
transparency would be warranted.
Mrs. Maloney. Mr. Falcone.
Mr. Falcone. I agree. I think providing information to the
regulatory agencies is very important. I think, however, it is
very critical what they do with that information, and that we
have to make sure that it is properly analyzed. And I think
that can go a long way, as opposed to providing the information
and just seeing it filed away.
Mrs. Maloney. Mr. Griffin.
Mr. Griffin. I think one of the challenges that we need to
address before we can get to the goals that you want to get to
is to have a common language to describe derivatives.
Mrs. Maloney. That is important.
Mr. Griffin. Every firm uses a different set of
terminologies, a different set of representations to describe
their derivatives portfolios. Until we create central
clearinghouses for over-the-counter derivatives, any reporting
that we are likely to create will be inscrutable to regulators.
Mrs. Maloney. We are moving toward that direction. As you
have read and know, the Fed is moving in that direction.
Mr. Paulson, I would like to ask you to comment on an
article that you wrote for the Wall Street Journal on the TARP
when it first came out. Along with many of us in Congress, you
argued that we should not be investing in these--in a toxic
asset purchase, but to move into an equity injection. And some
people, including yourself and others, have argued that why are
we being treated differently as taxpayers in America as opposed
to Great Britain. We have a 5 percent return, they have a 12
percent. Switzerland a 12\1/2\ percent. Mr. Buffett got a 10
percent.
Would you comment further on this and how the TARP possibly
should be structured in a way that is more beneficial to the
economy and to the American taxpayer?
Mr. Paulson. Well, certainly. In terms of----
Mrs. Maloney. And could you speak up?
Mr. Paulson. Certainly. In terms of using the TARP money
for equity instead of buying assets is much more beneficial.
And the benefit can be described very simply. If you put a
dollar of equity in a bank and a bank uses 15 to 1 leverage,
then that dollar would support $15 of new lending. If you
merely use that dollar to buy a toxic asset from a bank for a
dollar, it doesn't increase the equity and doesn't provide for
any new lending besides the dollar of equity provided.
So the leverage to support the system and provide for
liquidity and new lending is far more efficient by putting it
in equity rather than buying assets. So I think the----
Mrs. Maloney. And could you comment on the difference
between the equity return to the taxpayer, 5 percent versus
Great Britain, Switzerland----
Mr. Paulson. Yes.
Mrs. Maloney [continuing]. And even Mr. Buffett?
Mr. Paulson. Yes. So the change in TARP to buy equity
instead of assets is very beneficial. But second, the terms
that the Treasury has been providing equity, it seems to be
very generous to the recipients, that it is way below what
market terms are, what the firms would have to pay if they
raised this money privately, and is also considerably below the
returns that other governments get when they are forced
involuntarily to support the financial institutions with
equity.
So I think the three----
Mrs. Maloney. Thank you. Go ahead.
Mr. Paulson. The three changes I would recommend is that
for future equity injections the government should get a higher
dividend, perhaps around 10 percent, and warrants that equal a
greater percentage of the investment than they are currently
getting.
Second, in order to restore the equity in the financial
firms, I think it is imperative that while that preferred stock
is outstanding that common--cash dividends on common be
prohibited. And as an additional means of creating more equity
that ultimately will allow the company to pay back the
preferred, that cash compensation be capped and bonuses above
that amount be paid in additional shares of common stock. That
will go a long way to restoring the equity in these financial
firms.
Mrs. Maloney. My time has expired. I wish I could ask many
more questions. Thank all of you for your very insightful and
important testimony. I yield back.
Mr. Towns. Thank you very much. And the gentleman from
Connecticut.
Mr. Shays. Thank you, Mr. Chairman. I only have 5 minutes,
so I would love some short answers, and then I am going to just
focus on one individual, just so I can pursue a little more in
detail. I would like to ask each of you, and I will just
preface it when I meet with hedge fund partners and they are in
a room and I ask them about treating capital gains--income as
capital gains or as regular income, when they are with their
colleagues they say we should have capital gains treated the
way it is. And when they meet with me privately, they put their
arm around me and say Chris, this is crazy, they should be
treated as ordinary income. So, you know, the people that I
respect look me in the eye and say it should be treated as
regular income. I would like each of you to tell me capital
gains or regular income? Mr. Soros.
Mr. Soros. I think earned income should be taxed as earned
income. If you have a partnership arrangement and you--and that
allows you to take capital gains and you want to change that, I
think that would be appropriate. It would be inappropriate to--
--
Mr. Shays. Let me just cut you off, Mr. Soros, because you
have all answered the question. Do you all agree with or
disagree with----
Mr. Soros. I am in agreement with it being taxed as earned
income. But I would take exception if this was only applied to
hedge funds, and not other forms of partnership.
Mr. Shays. I am sorry. I thank you for finishing the
answer. Do any of you disagree with that answer?
Mr. Falcone. I disagree to a certain extent. I think that
hedge funds shouldn't be looked at differently. And it is
really a function of the underlying asset. If you have an asset
and you hold it for longer than 12 months, then you should be
subject to capital gains tax like any other individual or real
estate partnership or any investor.
Mr. Shays. OK. You have answered the question. I just have
so little time. I don't mean any disrespect.
Mr. Falcone. OK.
Mr. Shays. Mr. Griffin, I am just going to focus in on you
because I just have to isolate one, and you are the furthest
away from my district, so if I offend you it won't bother. I am
told you can only have 99 members as part of a particular hedge
fund. It is 99 or less. Is that correct?
Mr. Griffin. The rules have changed over the years. That is
not necessarily applicable any more.
Mr. Shays. But it is limited?
Mr. Griffin. Yes.
Mr. Shays. What concerns me is that some funds say 20
percent profit, 1 percent management fee. I am told that you
don't do 1 percent management fee, you do costs. And that can
be closer to 8 percent. Is that accurate or not?
Mr. Griffin. We do pass through costs. Costs as we define
will include, for example, commissions paid to other firms.
Mr. Shays. So does it amount to more than 1 percent?
Mr. Griffin. Yes, it does.
Mr. Shays. OK. I am also told that some of your funds have
done well and some haven't. And the accusation was that the
funds that have done better are the ones you have your own
money in, your own personal money, and the funds that haven't
have not. And I want to know if that is accurate.
Mr. Griffin. That is completely inaccurate. I am the single
largest investor in our largest funds by a significant margin.
I am also the largest investor in some of our funds that have
been very profitable this year.
Mr. Shays. So would your statement for the record be, and
under oath, that you have investment in every fund that you
have or just some of the funds?
Mr. Griffin. I have a material, several billion dollar
investment in Wellington and Kensington.
Mr. Shays. Right.
Mr. Griffin. And I have an investment in the several
hundred millions of dollars in our other funds.
Mr. Shays. And the one that you have the most investment
in, has that done the best or the worst or somewhere in
between?
Mr. Griffin. Regretfully, it has done the worst.
Mr. Shays. OK. Let me ask all of you then, do you think
that you should be required to have your funds, your own
personal funds in every fund that you have? The implication is
that since you make 20 percent of the profit, that you might
tend to be more risky with the funds you may not have your own
money in because you still make 20 percent. And if you lose, if
the funds lose, you don't lose anything.
So let me ask you about that. Mr. Soros.
Mr. Soros. Exactly in order to avoid this kind of conflict
of interest, I only have one fund and all my assets are in that
fund.
Mr. Shays. I see. Has that fund done better or worse than
your other funds?
Mr. Soros. There is no comparison. It is the only one.
Mr. Shays. I am sorry, you just have one fund. I am sorry.
Thank you.
Mr. Simons. OK. Well, no, I have----
Mr. Shays. I can't hear you. You are mumbling.
Mr. Simons. Well, all right. Is that better?
Mr. Shays. Yeah.
Mr. Simons. All right. I have substantial amounts of money
in the three different funds that we manage. I think that
question is generally asked in due diligence by people
considering investing in hedge funds. We always do. We invest--
the family invests in many, many hedge funds. And that is the
first due diligence question, does the fellow have skin in the
game or whatever? Does he have--so to a large extent I think
that issue is taken care of by the market.
Mr. Shays. You have answered the question. Thank you. Mr.
Paulson.
Mr. Paulson. Yes, all my assets are invested in the funds
that we manage. I don't have any outside investments.
Mr. Falcone. I think it is very important that the manager
aligns himselves with the investors, and in my situation I am
the largest investor in both of my funds.
Mr. Shays. Thank you all. Thank you.
Mr. Towns. Thank you very much. The gentleman from
Maryland.
Mr. Cummings. Thank you very much, Mr. Chairman. Mr. Soros,
Mr. Souder had some comments about you a little bit earlier,
and I just want to let you know that I thank you for what you
all have done for the citizens of Baltimore in my district. It
has been simply phenomenal, and I thank you and the Open
Society Institute.
Let me go to all of you and just to kind of piggyback on
some of the things that Mr. Shays was just talking about. Each
of you appearing here, my neighbor on his way to work this
morning said to me, he said how does it feel to be going before
five folks who have more money than God? And I am sure you will
disagree with him. But you are private citizens, and your
income is not required to be publicly disclosed, so I am going
to respect your privacy and not disclose your specific
compensation. But you have provided information about your
income to the committee, and it shows that although there are
individual variations, on the average each of you made more
than $1 billion in 2007. I've got to tell you that is a
staggering amount of money. And I am not knocking you for it.
But even though you made enormous sums, you are not taxed like
ordinary citizens, like the guy that said what I told you. Your
earnings are not taxed as ordinary income. Instead, the fees
you receive are called carried interest, which means that they
are taxed at capital gains rates. There are two capital gains
rates, a low 15 percent rate for long-term gains, and a higher
rate for short-term gains. What this means is that to the
extent your earnings are based on long-term gains, the tax rate
is just 15 percent.
My question for you is whether this is fair. A school
teacher or a plumber or policeman makes on the average of
$40,000 to $50,000 a year, yet they have to pay 25 percent tax.
You make $1 billion, yet your rate can be, can be as low as 15
percent. Is that fair, Mr. Paulson? I want to start with you,
because I understand that a significant part of your earnings
can be short-term gain, but not all of it is. And Mr. Paulson,
press accounts say that you earned over $3 billion in 2007. If
just 20 percent of your income is long-term gain, that is over
$600 million in income that is being taxed at a low rate. And
so I will start with you, and we will just----
Mr. Paulson. Well, we certainly appreciate----
Mr. Cummings. I want you to keep your voice up for my
questions.
Mr. Paulson. Yeah. We certainly appreciate your concern for
fairness in the Tax Code. But what I will say, I believe our
tax situation is fair. If your constituents, whether they are a
plumber or a teacher bought a stock and they owned that stock
for more than a year, they would pay a long-term capital gains
rate. So for our investments, to the extent I own investments
for more than a year, I also pay a long-term capital gains tax.
If we own an investment for less than a year, we pay short-term
capital gains, which is taxed as ordinary income. And any fee
income we receive, such as management fees, for that it is
strictly ordinary income.
Mr. Cummings. But this is about money that you are managing
for other people. It is not your money, right? In other words,
you said if I hold certain things for someone. But you are
actually getting paid for what you do, the work that you
perform. Isn't that right?
Mr. Paulson. The way partnership accounting works, if the
partnership owns an asset for more than a year, that asset is
taxed at long-term capital gains. And that tax is passed along
to all the partners in the same way. If the asset in the fund,
in the partnership is a short-term capital gain, then all the
partners, including the general partner, pay short-term capital
gain.
Mr. Cummings. Do you have an opinion, Mr. Falcone?
Mr. Falcone. Yes, I do. I think that the important thing to
realize is that hedge funds, quite frankly, are not and
probably should not be treated any differently than any other
investor. And as the case may be with my particular situation,
last year approximately 98 percent of my taxable income was
taxed under ordinary income. But I think it is important not to
differentiate between hedge funds and the rest of the
investment community, whether a private equity or real estate,
or even individuals or the doctor that may own his hospital and
decide to sell it.
Mr. Cummings. So would any of you support repealing this
tax loophole and taxing your income at regular income rates?
Mr. Soros.
Mr. Soros. I do.
Mr. Cummings. I can't hear you.
Mr. Soros. I agree to it. I have no problem with it.
Mr. Cummings. Mr. Simons.
Mr. Simons. Yeah, I said the carried interest portion
represented by other people's money, if that were raised to
higher levels that would be OK with me.
Mr. Cummings. Mr. Falcone. You just stated your position, I
think, right?
Mr. Falcone. Yes, I did.
Mr. Cummings. Mr. Paulson.
Mr. Paulson. Yeah, I would--I don't think it is a loophole.
The carried interest merely passes through the nature of the
income to the partners. If it is short-term capital gain, we
are taxed at short-term capital gain. If it is long-term
capital gain, it is taxed at long-term capital gain.
Mr. Cummings. Mr. Griffin.
Mr. Griffin. I think tax equity is incredibly important.
And most of the income, if not all of the income that I
generate is subject to either ordinary or short-term tax rates,
the highest marginal rate. But if you and I were to start a
restaurant together, and I was to be the chef and operator and
you were to put up the capital, even though my labor goes into
making that restaurant work every day, if we sell that business
2 or 3 years down the road I will get long-term capital gains.
Our society preferences long-term capital gains from a tax
perspective. And I think what we should seek to have is
consistency in how we treat long-term capital gains, whether it
is the hedge fund manager, the private equity manager, or the
entrepreneur who starts a restaurant together.
Mr. Cummings. I see my time is up. Thank you.
Mr. Towns. Thank you very much. Mr. Tierney.
Mr. Tierney. Thank you. Just to followup on that, Mr.
Griffin, when you use your analogy about the restaurant, when
you are the chef the money you earn from being the chef gets
taxed at a regular income rate.
Mr. Griffin. That is correct, sir.
Mr. Tierney. When you are managing other people's money,
you are in effect the chef of that process, you get taxed for
those earnings at the regular income tax rate.
Mr. Griffin. And management fees are taxed as ordinary
income, sir.
Mr. Tierney. Well, which way do you determine the
management fees? The 1 or 2 percent or the 20 percent?
Mr. Griffin. The management fees are generally taxed as
ordinary income for most firms.
Mr. Tierney. What are you referring to as the management
fees?
Mr. Griffin. The 1 or 2 percent.
Mr. Tierney. One or 2 percent. Set that aside. You get 20
percent and the other partners get 80 percent of the earnings,
correct?
Mr. Griffin. That is correct.
Mr. Tierney. You get 20 percent for the effort you made in
managing those funds, making those investments, and doing that
type of work. That is being the chef, not in terms of selling
the product. I know what you want to do, you want to wash it
all through and come out the other end. But the fact of the
matter is that is compensation for your day-to-day efforts of
managing those funds, is it not?
Mr. Griffin. Well, let's go back to the story of the chef.
The chef in his salary every year is taxed as ordinary income.
But if the restaurant has capitalizable value----
Mr. Tierney. But you are not selling anything when you are
getting compensated for the day-to-day management efforts that
you make.
Mr. Griffin. If I make an investment that creates long-term
capital gains, so I invest in a biotechnology company where the
stock appreciates----
Mr. Tierney. A good portion of that money isn't yours.
Right?
Mr. Griffin. That is correct.
Mr. Tierney. So when you get 20 percent, it is for
investing other people's money as well as your own.
Mr. Griffin. That is correct.
Mr. Tierney. And some of that compensation is for your
efforts in managing and investing those other moneys.
Mr. Griffin. That is correct.
Mr. Tierney. Right. And that, my friend, I suggest to you
is what we are saying ought to be taxed as regular income. You
can disagree, but I just don't want you to take the chef
analogy too far on that.
Mr. Griffin. Just to be very clear, all of my income, or
virtually all is taxed at the highest marginal rates.
Mr. Tierney. As it should be.
Mr. Griffin. All right. So I speak to you from a
conceptual----
Mr. Tierney. We don't disagree on that. I don't want you to
take your chef analogy and confuse people with that.
Mr. Paulson, except for our disagreement on that particular
issue, I was thinking that we probably had the wrong Paulson
handing out the TARP moneys here, because I agree with you in
essence about us not getting the deal as taxpayers that we
ought to be getting. And fairly adamant. And I can daresay that
you can't walk down the street at home in any of our districts
that people don't make that point, is what the heck are we
doing giving money to these institutions, and they are out
there giving bonuses, paying high salaries without being
capped, and then waltzing around giving dividends. I think that
is an important point, and I know you have already mentioned
that twice now, but I think it probably can't be mentioned
loudly enough and clearly enough while the other Mr. Paulson is
busy determining what he is going to do.
What I would like to know is whether the other four
panelists here agree with our Mr. Paulson here that if we are
going to have taxpayer money go to any of these institutions,
we ought to get a better deal, you know, better security on
that, make sure the compensation isn't excessive, and make sure
in fact that dividends aren't given out in cash during that
period of time when we have the guarantee of the investment
made. Mr. Soros.
Mr. Soros. I am sorry, I didn't follow the question
properly. I am sorry.
Mr. Tierney. In my old business we used to be able to have
it read back. Do you agree with Mr. Paulson that as long as
taxpayers' money is being given to these institutions for the
purposes of thawing out the so-called credit freeze that we
ought to be getting a better deal for the taxpayers? We ought
to be getting better security for that investment? We ought to
be making sure that the banks or the entities are not giving
excessive compensation with it, bonuses and things of that
nature, and are not giving cash dividends while the
stockholders, the taxpayers' money is there?
Mr. Soros. I am not sure that I would agree with Mr.
Paulson on that.
Mr. Tierney. Why not?
Mr. Soros. I think that if you have a capital increase in
the banks, then I think that as long as the money is put up by
the shareholders, there should be no change in the--it is up to
the shareholders how they compensate.
Mr. Tierney. But this is taxpayer money, not shareholders'
money we are talking about.
Mr. Soros. When it is taxpayers' money, no, that I agree.
Yes. Yes.
Mr. Tierney. Thank you.
Mr. Simons, do you also agree?
Mr. Simons. Generally speaking I do, although I will make
the point that when this first round of money was put into
these banks some of them didn't want to take it. And then
Paulson said everyone has to take it. And therefore, if you are
going to--because he didn't want the public to distinguish
which bank is stronger and which bank is weaker or so on, which
maybe was a good idea, maybe wasn't. But the result is that
everyone had to take it. And if you have to take it, well, then
you can mitigate that a little bit by saying, OK, I won't gouge
you too much or whatever it would be. So I am not saying the 10
percent is gouging, by the way, but some of this money was not
requested by some of these banks. To the extent that it was, I
think it was quite a sweet deal.
Mr. Tierney. I think whether you request it or not, you
ought to have a fair deal, not a lopsided deal on that. But we
can discuss that later.
Mr. Falcone.
Mr. Falcone. I agree. I think that to the extent that the
capital is infused into some of these companies it should be
more along the lines of market rates.
Mr. Tierney. Mr. Griffin.
Mr. Griffin. I believe that market rates for many of these
companies would be extremely high. And if one of our goals is
to reduce the cost of consumer credit, this is in essence an
indirect subsidy to the banking system that I hope they will
pass on in some form or another to the ultimate consumers to
whom they lend to.
Mr. Tierney. Thank you all for your answers. Thank you, Mr.
Chairman.
Mr. Towns. Thank you very much. Mr. Yarmuth.
Mr. Yarmuth. Thank you, Mr. Chairman. I want to thank the
panel. The testimony has been, I think, unusually candid and
thoughtful, and I appreciate that very much. I am going to
probably cross the line a little bit that Chairman Waxman set
down, but I am going to try to draw the connection.
We have had a number of hearings related to the immediate
financial crisis. And even going back some months we had a
hearing on corporate compensation and its connection to the
housing crisis. And we had a panel back then that included the
former CEO of Time Warner, the former CEO of Merrill Lynch,
Citigroup, and we had Mr. Mozilo from Countrywide. And one of
the questions that I asked was when all these corporate
executive compensation committee meetings met, was there ever a
discussion of things like employee welfare, the communities
that the corporation served, so forth, general corporate
policies, or was there--the discussion always about stock
price? And with unanimity they said the conversations were
always about stock price. And one of the things that has become
a common theme in hearings we have had is that when you tie
everyone's compensation to stock performance, and relatively
short-term stock performance, then you have an incentive or
pressure for maybe riskier behavior that might have contributed
to a lot of the crisis that we have.
So I ask you, as people who own significant positions in
some of these companies, whether you have a concern about the
corporate governance structure in this country and whether we
should be doing things, whether it is related to corporate
compensation generally or general corporate governance laws
that might ameliorate some of this issue if you think it is a
problem? Mr. Soros, would you like to start?
Mr. Soros. I am definitely at a loss because it is not a
subject that I have really given a lot of thought to.
Mr. Yarmuth. Chairman Waxman excused you.
Mr. Simons.
Mr. Simons. I haven't thought about it a great deal, but
generally speaking I am more of a fan of profit sharing for
CEOs than I am of stock options. The latter is very volatile,
and you never know quite what he is getting.
Mr. Paulson. In this case I would echo Mr. Simons'
comments.
Mr. Falcone. I am inclined to agree with Mr. Paulson and
Mr. Simons that it is important to participate, from a
compensation perspective as it relates to profit sharing, along
those lines.
Mr. Yarmuth. Mr. Griffin.
Mr. Griffin. I will concur with the other panelists.
Mr. Yarmuth. In today's Financial Times, Professor Malkiel
from Princeton suggested that one of the things that might be
considered is when you have compensation tied to stock options
and so forth that it involve restricted stock that the CEO
could not sell until sometime after he or she left the company,
and therefore the concern would be more in the long-term
interests of the corporation rather than short-term stock
performance. Is that something that resonates with any of you
that you think might be a good idea? You can say you didn't
think about it.
Mr. Griffin. I think that would be a terrible idea.
Mr. Yarmuth. Terrible idea?
Mr. Griffin. And part of the reason is that we need
executives in America to take risks. Whether it is to put the
money down on the line for R&D in drugs or willing to try to
create new ways to power America, we need executives to take
risk. And what we find is as executives become more successful,
they actually become more risk averse often. And so if you have
their entire net worth tied up in stock options, which are
inherently risky, and then they cannot monetize any portion of
that until after they retire, I would be gravely concerned
about the reduction in risk taking by America's corporate
leaders. It sounds good on paper. I don't think it will give us
what we need as a country. We need innovation.
Mr. Yarmuth. Does anybody else want to address that? I
don't have any other questions. But if you don't, that is fine.
Thank you, Mr. Chairman.
Mr. Towns. Thank you, very much. Thank you. The gentleman
from Tennessee, Mr. Cooper.
Mr. Simons. I would like to excuse myself for a moment. I
will be right back.
Mr. Towns. Sure.
Mr. Cooper. Thank you, Mr. Chairman. The headline of this
hearing is definitely Paulson v. Paulson. As has been
enumerated, John Paulson accuses Henry Paulson of botching the
bailout. Because taxpayers do want a good return for their
money, and they are very worried when we are only getting 5
percent interest on the preferred stock, and not getting
sufficient warrant positions. But I think the real purpose of
this hearing is to understand better the role that hedge funds
play. And I asked the previous panel, professors largely, if it
is possible to distinguish between hedge funds that hedge and
funds that are more speculative. Because Mr. Paulson, for
example, bet right on the down housing market, but that was not
necessarily a position--you know, for example, if you had taken
that position 3 or 4 years ago you wouldn't be as wealthy as
you are today. The only thing worse than being wrong about the
market is being right too early. So is it possible to
distinguish between hedge funds that hedge and those that are
speculative?
Mr. Paulson. Well, let me first say I hope this is not
Paulson v. Paulson, or that I am accusing a Paulson of botching
anything.
Mr. Towns. Would you pull that mic? We have a great
difficulty hearing you, so could you pull the mic closer to you
or talk a little louder?
Mr. Paulson. Absolutely. I will be glad to do that, Mr.
Chairman.
I in no way want to be critical of Mr. Paulson. He has done
a tremendous amount for our country, is willing to change his
position when the circumstances change, and I think he has
reoriented the TARP program in the right direction.
The second part of your question--or I really wasn't sure
what it was again.
Mr. Cooper. For example, Mr. Simons doesn't purchase credit
default swaps, he is not leveraged much. Other hedge funds have
quite different strategies. We will never know because it is a
black box trade secret. But is it possible for the pension fund
and other investors to know in advance whether they are buying
interests in a hedge fund or a speculative fund? I know in the
private conversations you reveal a little bit more of your
operations. But most people have no idea whether it is a hedge
fund that hedges or it is not. It is a question about truth in
advertising.
Mr. Paulson. Congressman Cooper, that is a very good
question. Investors never have to invest in a hedge fund.
Mr. Cooper. I know.
Mr. Paulson. If they don't get the proper transparency----
Mr. Cooper. They don't, but there is a Wisconsin school
board that put money in SIVs that got traced all around the
world. You know, a lot of investors don't necessarily know. So
right now we have a hedge fund as a category that is not
defined, and some of which hedge, but many of which do not. And
people have no advanced notice. So there is no truth in
advertising.
Mr. Paulson. Well, we for one give a lot of transparency to
our investors. And while we don't disclose them publicly, we do
disclose a great deal about what we are doing to our investors.
So I would encourage investors such as pension funds, that they
invest with managers that give disclosure so the pension funds
know what they are investing in.
Mr. Cooper. Do any of the witnesses know? Mr. Soros.
Mr. Soros. I think that hedge funds, several hedge funds
have claimed to follow a market neutral strategy exactly
because institutional investors want to see low volatility, and
I think that was rather misleading. I don't think it was
deliberately misleading, but actually because there is this
false paradigm that has prevailed, that has pervaded the
thinking on this subject, people thought that they were market
neutral, and in actual fact when an event occurred that was not
a random fluctuation or deviation, then it turned out to be
non-market neutral.
Mr. Cooper. Thank you. You mentioned that investors usually
want low volatility. The markets have been unusually volatile
recently, and some trading strategies depend on volatility. How
much volatility is enough?
Mr. Soros. Well, see----
Mr. Cooper. 200 points a day, 500 points a day, a thousand
is more better?
Mr. Soros [continuing]. Basically, what the prevailing
paradigm has neglected is the uncertainty that is connected
with this reflexive connection. We have become very adept in
calculating risk. And by focusing on risk, we have left out
uncertainty. And that has been our undoing in this particular
case.
Mr. Cooper. How about the other panelists? Is a volatility
only strategy appropriate? And if so, is more volatility always
better?
Mr. Soros. Well, you see, I think volatility is an
indication of uncertainty. And the fact that normal volatility
is 30, and it shot up to 50 and 70 and 80, it just shows the
increased uncertainty that is currently pervading the markets.
Mr. Cooper. Does the government have a role in limiting
excessive uncertainty?
Mr. Soros. Well, I think that regulators have to understand
that there is this uncertainty in markets. And that is why the
risk management methods used by individual participants who are
only thinking of their own risk is not appropriate in
calculating systemic risk. And to protect against systemic
risk, you have to impose restrictions on the amount of credit
or leverage market participants can use. That is actually the
core of my argument that I am putting forward.
Mr. Griffin. Congressman Cooper, if I may.
Mr. Cooper. Yes.
Mr. Griffin. Good regulation, good policy helps to reduce
volatility in the market. And we are extremely invested in the
safety and soundness of our financial system.
Mr. Cooper. But doesn't your firm have a conflict of
interest in grouping with CME to create clearinghouses and
other means that might somehow prejudice the market?
Mr. Griffin. In the sense of?
Mr. Cooper. Well, if you are partnering with the market
maker or the clearinghouse, how do people know it is going to
be a fair market?
Mr. Griffin. Well, we would clearly have a very sharp
distinction between our role as a contributor of intellectual
property and know-how to the CME to expedite the launch of this
clearinghouse from the day-to-day management of the
clearinghouse. We will have no involvement in the day-to-day
management of the clearinghouse. Because the positions of other
market participants should not be made available to Citadel.
Mr. Cooper. That makes investors rely on a Chinese Wall
instead of a greater separation.
Mr. Griffin. Well, CME will be running the clearinghouse.
So we are not running it, just to be very clear on the record.
Mr. Cooper. Thank you, Mr. Chairman. I see my time has
expired.
Chairman Waxman [presiding]. Thank you, Mr. Cooper.
Mr. Van Hollen.
Mr. Van Hollen. Thank you, Mr. Chairman, and thank all of
you gentlemen for your testimony. We have had a lot of
discussion about trying to create greater transparency over
hedge funds. And as I understand all of your testimony, you
agree with the idea that at least on a confidential basis it
would be appropriate for some Federal agency, the SEC or some
other Federal agency, to monitor and obtain that information
for the purpose of making a determination whether there is
systemic risk, putting the taxpayer at risk. Am I right about
that?
Mr. Soros. Yes.
Mr. Simons. Yes.
Mr. Falcone. Yes.
Mr. Van Hollen. Now, we had just before you a panel of a
number of professors, including Professor Lo and Professor
Ruder. And the question I posed was OK, let's say you are the
SEC or the regulator and you are getting this information and
data and you see your alarm bells go off. You say look, we
really do think we have a problem here, whether it is to the
investors or systemic risk. What authorities should they have
then with respect to the hedge fund? And the response we got
was maybe the SEC shouldn't have that authority, but they would
provide the Federal Reserve with that authority, which
according to their testimony would require additional
congressional action.
So my question of you gentlemen is, is that something you
think would be necessary? Because the obvious question that
comes up once you say it is OK to collect the information is
OK, you got it, now you make a determination that something is
going wrong, shouldn't we also make sure they have the
authority to deal with it? Especially in light of the fact that
what we have learned, at least with respect to the investment
banks, is that the taxpayer is of course sort of holding the
risk as a last resort and is going to be asked and has been
asked anyway to go in? So I would pose that question to you,
gentlemen, whether you think, whether it is the SEC or the
Federal Reserve, they should also have additional authorities,
whether it is leverage requirements or some other powers that
they can intervene with respect to a particular hedge fund that
they determine is causing systemic risk?
Mr. Soros. Well, I would definitely argue that is exactly
what you need. That is what currently is missing and it needs
to be introduced. We used to have that kind of authority. In
earlier years, in my youth I used to be aware of them. They
have fallen into disuse. And I think they have to be brought
back, because there is a distinction between money and credit,
and markets don't tend toward equilibrium, and it is the job of
the regulators to prevent asset bubbles from developing.
Mr. Simons. Yes.
Mr. Paulson. I would agree with that.
Mr. Falcone. I would agree as well. I'm not so sure it
should be the SEC or the Federal Reserve or a new regulatory
agency, but I think it's a very good idea.
Mr. Griffin. I think what is important in the concept is
for the hedge funds that are subject to this new paradigm to
understand the rules of the road. Are we heading toward a Basel
2 requirement for hedge funds, for example? So long as I know
what the rules of the road are, I can conduct my business in a
way to be well within the lines.
Mr. Simons. That's a very good point, I think.
Mr. Griffin. And I would like to clarify one previous
statement. On the issue of clearinghouses for credit default
swaps, there were two primary solutions proposed over the last
couple of weeks; one was the dealers in the consortium called
TCC, the other is a solution by Citadel on the CME. A key
distinction between these two solutions just a few weeks ago
was that the CME solution is open to all financial market
participants, both the buy side and the sell side.
Whereas the TCC solution, the dealer solution, was to be
open only to the dealer community. And I believe that all of us
on the buy side, whether we are Pemco, Black Rock, Citadel,
Paulson, would want a platform that is open to all. It goes
back to transparent and fair markets. And we have seen the
dealer community trying to create doubts as to why the CME
solution is the best one, this issue of Chinese walls. Let me
just make it clear; we need a solution to meet the needs of all
market participants. And I believe that our work with the CME
to do so is in the best interest of our Nation and the entire
world's financial system.
Mr. Van Hollen. Thank you for that. Let me also just say,
with respect to your answer to the previous question, we
appreciate it. We may need all of you gentlemen to continue to
provide that input as we go forward. Because, as you know, just
the notion of providing greater transparency has been proposed
in the past, it was proposed after the failure of Long Term
Capital Management took a case to the Supreme Court that you
are all very familiar with. And the fact of the matter is, not
you as individuals, but certainly the industry, fought efforts
to provide greater transparency, to provide greater oversight
and some of these things. So as we go through this effort to
provide reasonable regulation of the financial markets, we
appreciate your input going forward as well as today.
Thank you, Mr. Chairman.
Chairman Waxman. Thank you, Mr. Van Hollen.
Mr. Issa.
Mr. Issa. Thank you, Mr. Chairman.
Mr. Soros, it's good to meet you at last. I'm very
intrigued at some of your comments, and one of them
particularly has to do with leverage. Is it enough, or would it
be at least a good quick beginning if the Congress--obviously
with the President--were to create a truth in, if you will,
transparency of leverage, require standards and disclosure as
to leverage, and of course that means that, derivatively, if
you leverage something and then you go to resell it, it would
be standard so that if you leverage a leverage a leverage, then
that would have to be transparent and flow through. If that
were one of the items on President Obama's short list of things
to be done in that first 100 days, would it go at least a long
way toward preventing the kind of over-leveraging that you're
speaking of, at least the lack of visibility on over-
leveraging?
Mr. Soros. Well, certainly the introduction of newfangled
financial instruments has made it much harder to calculate
leverage because some of those instruments are leveraged
instruments. So, given all the derivatives that have been
introduced, calculating the leverage becomes a very, very
complicated problem. And especially if you have tailor-made
instruments, then it becomes even more difficult. So I think
that it may be necessary to actually--while it is certainly
necessary for the regulators to understand what they are
regulating, and if they don't, they should perhaps not allow
some of those instruments to be used. So I think that the
instruments themselves would have to be authorized, approved by
the SEC, or whatever, before they could be used.
Mr. Issa. Good point.
Mr. Paulson, first of all, congratulations. I'm not an
investor with your fund, but I've noticed that you manage to be
still up about 1 percent at a time in which the walls are
falling all around most other people. In order to have the kind
of stellar gauge you've had, including obviously dealing with
some of what we rename, we call them, you know, caustic and
corrosive and acidic products, were you able to make sound
decisions as to the real leverage that you were buying into in
your investments?
Mr. Paulson. Absolutely. What we did was primarily buy
protection on debt securities. And at the time, we bought this
protection, it's like buying an insurance policy, the premium
was very, very low, on the order of 1 percent. So if the debt
security never fell, we would lose the value of that premium.
But that premium in our base funds was only about 1 to 2
percent, and that was the extent of loss we would realize if
our investments didn't pan out.
Mr. Issa. So to characterize what you've just said, you
gambled less than those who went routinely long on any
investment.
Mr. Paulson. I believe that's the case.
Mr. Issa. So the people who invested with you, including
the pension funds and so on, were gambling less because of your
technique--which was available to them and you have a track
history since 1994--they were gambling less because you told
them that you had, in fact, hedged outcomes in order to protect
their investment.
Mr. Paulson. I prefer not to use the word ``gambling.''
Mr. Issa. And I didn't use it for you, I used the word
``hedge'' for obvious reasons. And the term ``gambling,'' and
just correct me if I'm wrong, most mutual funds, whether
they're in small cap, mid cap, large cap, foreign, they
basically tell you they're going to be 100 percent invested or
they're going to have a ratio. And no matter what happens in
the market, they don't go to all cash, and many of them refuse
to go short to market as a matter of it's in the prospectus;
isn't that right?
Mr. Paulson. That's correct.
Mr. Issa. So your technique and the technique of virtually
all hedge funds is, in fact, to limit risk by stating how you
will maneuver in a market as it becomes less than one
directional up; isn't that true?
Mr. Paulson. That's true. An important goal of our funds is
to limit risk and reduce volatility.
Mr. Issa. Last question, if I could, Mr. Chairman.
There was some talk on the earlier panel about tax
treatment--and I know this isn't the Ways and Means Committee
so I want to limit it, but do any of you see a way in which we
could look at the long term gains that you and your investors
achieve when you're long for a period of more than a year and
differentiate between those and any other investor in stocks
and other equity products or debt products? Do any of you see a
way in which you could effectively differentiate, because we're
often talking about hedge funds and saying, well, we've got to
get rid of their capital gains treatment, the only reason I ask
is, can any of you--because you're very smart people--think of
a way that we would separate your category from every other
mutual fund, if you will, and the capital gains treatment they
get?
Mr. Falcone. If I may, if you plan to go down that road,
there might be one possibility where----
Mr. Issa. By the way, I don't plan to go down that road.
Mr. Falcone. Instead of having the horizon be 12 months,
maybe make it a little bit longer for hedge funds. I would hate
to see that eliminated in its entirety because there are truly
individuals in the hedge fund market that are investors, and if
you extend that timeframe, that could be one way of looking at
it.
Mr. Issa. Thank you, Mr. Chairman.
Chairman Waxman. Thank you, Mr. Issa.
I want to thank the Members of this panel. The Members, I
think, have asked very important questions, and you gave very
thoughtful answers which is very helpful to us. Congress
usually has trade associations at hearings, and they give the
predictable responses, which are in what they see their self
interest. And that's why we wanted to have you testify here
today to get an unfiltered response, and your comments and
recommendations were very helpful.
I believe there has been a consensus or near consensus that
hedge funds can pose systemic risks. And there has been a
similar consensus that there should be more disclosure about
the activities of such hedge funds. Several of you have urged
more oversight and reasonable restrictions on leverage and
closing the tax loophole that benefits hedge fund managers. You
have also provided insightful criticisms of the Federal
response to the financial crisis.
We're facing a terrible economy and enormous disruption in
our financial markets, and I think your testimony is very
helpful to us in pointing out ways that Congress and Federal
regulators can help restore our markets. So I thank you very
much for what you have done today.
That concludes the business before the committee, and we
stand adjourned.
[Whereupon, at 2:03 p.m., the committee was adjourned.]
[The prepared statement of Hon. Edolphus Towns follows:]
[GRAPHIC] [TIFF OMITTED] T6582.122
[GRAPHIC] [TIFF OMITTED] T6582.123