[House Hearing, 110 Congress]
[From the U.S. Government Publishing Office]




 
                        HEDGE FUNDS AND SYSTEMIC
                     RISK IN THE FINANCIAL MARKETS

=======================================================================

                                HEARING

                               BEFORE THE

                    COMMITTEE ON FINANCIAL SERVICES

                     U.S. HOUSE OF REPRESENTATIVES

                       ONE HUNDRED TENTH CONGRESS

                             FIRST SESSION

                               __________

                             MARCH 13, 2007

                               __________

       Printed for the use of the Committee on Financial Services

                           Serial No. 110-13


                                 ______

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                 HOUSE COMMITTEE ON FINANCIAL SERVICES

                 BARNEY FRANK, Massachusetts, Chairman

PAUL E. KANJORSKI, Pennsylvania      SPENCER BACHUS, Alabama
MAXINE WATERS, California            RICHARD H. BAKER, Louisiana
CAROLYN B. MALONEY, New York         DEBORAH PRYCE, Ohio
LUIS V. GUTIERREZ, Illinois          MICHAEL N. CASTLE, Delaware
NYDIA M. VELAZQUEZ, New York         PETER T. KING, New York
MELVIN L. WATT, North Carolina       EDWARD R. ROYCE, California
GARY L. ACKERMAN, New York           FRANK D. LUCAS, Oklahoma
JULIA CARSON, Indiana                RON PAUL, Texas
BRAD SHERMAN, California             PAUL E. GILLMOR, Ohio
GREGORY W. MEEKS, New York           STEVEN C. LaTOURETTE, Ohio
DENNIS MOORE, Kansas                 DONALD A. MANZULLO, Illinois
MICHAEL E. CAPUANO, Massachusetts    WALTER B. JONES, Jr., North 
RUBEN HINOJOSA, Texas                    Carolina
WM. LACY CLAY, Missouri              JUDY BIGGERT, Illinois
CAROLYN McCARTHY, New York           CHRISTOPHER SHAYS, Connecticut
JOE BACA, California                 GARY G. MILLER, California
STEPHEN F. LYNCH, Massachusetts      SHELLEY MOORE CAPITO, West 
BRAD MILLER, North Carolina              Virginia
DAVID SCOTT, Georgia                 TOM FEENEY, Florida
AL GREEN, Texas                      JEB HENSARLING, Texas
EMANUEL CLEAVER, Missouri            SCOTT GARRETT, New Jersey
MELISSA L. BEAN, Illinois            GINNY BROWN-WAITE, Florida
GWEN MOORE, Wisconsin,               J. GRESHAM BARRETT, South Carolina
LINCOLN DAVIS, Tennessee             RICK RENZI, Arizona
ALBIO SIRES, New Jersey              JIM GERLACH, Pennsylvania
PAUL W. HODES, New Hampshire         STEVAN PEARCE, New Mexico
KEITH ELLISON, Minnesota             RANDY NEUGEBAUER, Texas
RON KLEIN, Florida                   TOM PRICE, Georgia
TIM MAHONEY, Florida                 GEOFF DAVIS, Kentucky
CHARLES WILSON, Ohio                 PATRICK T. McHENRY, North Carolina
ED PERLMUTTER, Colorado              JOHN CAMPBELL, California
CHRISTOPHER S. MURPHY, Connecticut   ADAM PUTNAM, Florida
JOE DONNELLY, Indiana                MICHELE BACHMANN, Minnesota
ROBERT WEXLER, Florida               PETER J. ROSKAM, Illinois
JIM MARSHALL, Georgia                KENNY MARCHANT, Texas
DAN BOREN, Oklahoma                  THADDEUS G. McCOTTER, Michigan

        Jeanne M. Roslanowick, Staff Director and Chief Counsel


                            C O N T E N T S

                              ----------                              
                                                                   Page
Hearing held on:
    March 13, 2007...............................................     1
Appendix:
    March 13, 2007...............................................    49

                               WITNESSES
                        Tuesday, March 13, 2007

Brody, Kenneth D., Co-Founder and Principal, Taconic Capital 
  Advisors, LLC, and Chairman, Investment Committee, University 
  of Maryland....................................................     9
Brown, Stephen J., David S. Loeb Professor of Finance, Stern 
  School of Business, New York University........................    18
Chanos, James, Founder and President, Kynikos Associates, LP, on 
  behalf of The Coalition of Private Investment Companies........    10
Corrigan, E. Gerald, Managing Director, Goldman Sachs & Company; 
  Former President of the Federal Reserve Bank of New York.......     7
Golden, Andrew K., President, Princeton University Investment 
  Company........................................................    16
Hall, George, Founder and CEO, Clinton Group, on behalf of The 
  Managed Funds Association......................................    13
Matthews, Jeffrey L., General Partner, Ram Partners, LP..........    14

                                APPENDIX

Prepared statements:
    Bachus, Hon. Spencer.........................................    50
    Castle, Hon. Michael N.......................................    52
    Waters, Hon. Maxine..........................................    54
    Brody, Kenneth D.............................................    57
    Brown, Stephen J.............................................    71
    Chanos, James................................................    73
    Corrigan, E. Gerald..........................................    97
    Golden, Andrew K.............................................   111
    Hall, George.................................................   119
    Matthews, Jeffrey L..........................................   135


                        HEDGE FUNDS AND SYSTEMIC
                     RISK IN THE FINANCIAL MARKETS

                              ----------                              


                        Tuesday, March 13, 2007

             U.S. House of Representatives,
                   Committee on Financial Services,
                                                   Washington, D.C.
    The committee met, pursuant to notice, at 10 a.m., in room 
2128, Rayburn House Office Building, Hon. Barney Frank 
[chairman of the committee] presiding.
    Present: Representatives Frank, Maloney, Watt, Moore of 
Kansas, Capuano, Clay, Lynch, Scott, Green, Cleaver, Sires, 
Ellison, Klein, Murphy, Wexler, Marshall; Bachus, Baker, Pryce, 
Lucas, Gillmor, Manzullo, Jones, Shays, Feeney, Hensarling, 
Garrett, Neugebauer, Davis of Kentucky, Campbell, Bachmann, and 
Roskam.
    The Chairman. This hearing of the Committee on Financial 
Services will come to order.
    This is the first in a series of hearings we will be having 
on hedge funds and systemic risks in the financial markets. I 
do want to make a point that may encounter some skepticism, but 
it will not be the first time I have encountered skepticism. 
Sometimes congressional committees have hearings because they 
want to find things out, but I acknowledge that is not the 
normal reason for having hearings. Usually, we have hearings to 
make a point, to embarrass somebody, or to reinforce a 
position, but there are times when there is a genuine 
acknowledgment on our part that we need to know more about 
things.
    We are now going to have a series of hearings on the linked 
topics of hedge funds, private equity, and the role of 
derivatives. Those are conceptually separate things; they get 
merged. One of the things I hope we will do as a result of 
these hearings is to help people to understand that these 
topics are not all the same thing, and we will unbundle 
conceptually some issues.
    We will have two hearings with people from the private 
sector. The last hearing we are currently scheduled to have 
will be with the members of the Presidential Working Group. We 
thought it made sense, they having made their report, to then 
have some discussion of that, and then have them come back and 
respond to the conversation. We will at that point, too, be 
talking to some of the regulators, particularly in the bank 
area, who are given certain responsibilities under the approach 
of the President's Working Group.
    I just have some preliminary comments to make here. First, 
I believe there is strong support on the committee--it may not 
be unanimous and people can obviously speak for themselves--for 
the efforts the SEC has recently made in the area of investor 
protection. Among things we want to sort out is the question of 
investor protection versus the question of systemic risk. This 
hearing is called, ``Hedge Funds and Systemic Risks,'' not 
because we are assuming that there is a systemic risk, but 
because that is the question we intend to look at. This series 
of hearings is not going to be primarily about investor 
protection. The SEC has moved in that direction, I think, with 
some appropriateness.
    There is one sub-set of the investor protection issue, 
though, that we do plan to look at and that is the interaction 
between pension funds and the hedge funds. That one is not 
entirely within our jurisdiction, in fact, that became an issue 
last year when the pension bill was being voted on and that 
bill, of course, did not come to our committee at all, I 
believe, certainly not in any major way. There is interest in 
that in the Education and Labor Committee, which has 
jurisdiction over ERISA, and the Ways and Means Committee.
    Now, I will confess, and I have asked people to be looking 
into this, one of the concerns I have is the extent to which 
public pension funds get involved in hedge funds. It was not 
clear to any of us who exactly had jurisdiction over public 
pension funds. That may become an issue now because you have 
some of the States concerned about their GASB requirements 
regarding the accounting but there is some concern about public 
pension funds and hedge funds. Once you have that concern, of 
course even if you had it, it is not clear if you are going to 
put any protections in there, restrictions, on whom do they go? 
Do they go on the fund which receives the investment? Do they 
go on their investor? These are all questions that we will be 
examining.
    I will say from the systemic risk standpoint, it does seem 
to me that the form in which investments are made is less 
important by far than the type of investments. In particular, I 
think it is time for us to look into the question of 
derivatives.
    Now, I said that sometimes Members of Congress have 
hearings to try to find things out and not because there is a 
strong position. I am very proud of the level of the discussion 
that goes on in this committee. In fact, I think if people had 
been at the mark-up we recently had on the question of how to 
respond to the hurricane, they would have been very impressed 
with the degree of knowledge. I am not prepared to argue that 
if we got into a serious discussion of derivatives, that we 
would dazzle anybody with the depth of our knowledge and 
understanding. I have previously expressed the view, 
particularly with regard to accounting for derivatives when 
that has become an issue from time to time with Fannie Mae or 
elsewhere, that the current state of that appeared to me to be 
somewhere between alchemy and astrology. I undoubtedly do a lot 
of people an injustice when I say that, and I am prepared to be 
further educated.
    I just want to stress again that these are hearings that we 
are going to have because there is a new development in the 
American financial world to some extent, in the hedge funds, 
and there is also private equity. I should have added, I ask 
for just 30 more seconds. With regard to private equity, the 
concern here is not so much systemic risk as what the social 
implications are. In fact, our colleague from Florida, Mr. 
Feeney, commented the other day when we were having the 
executive compensation hearing that he worries about people 
going private because constituents that he represents could 
lose the opportunity to make good investments. That was an 
issue that the gentleman from Florida raised in terms of the 
implications of private equity.
    Many of us are also very concerned about the implications 
for private equity on the workers, and on employers. If you 
have in fact an increase in debt and the takeover of companies, 
what is the impact, short term and long term? Those are the 
questions that we want to look at. And, as I said, I personally 
have no pre-conceptions about this. Indeed, to be honest, in 
some cases I barely have conceptions much less pre-conceptions. 
It is a very important set of questions and it is the job of 
this committee to help I think both ourselves and our 
colleagues in Congress, and indeed many in the country to 
understand it.
    The gentleman from Alabama is now recognized for 5 minutes.
    Mr. Bachus. I thank the chairman. And let me reiterate what 
the chairman said: the purpose of this hearing is 
informational; the purpose of the hearing is not to legislate. 
I think it speaks well that in reading your testimony, it seems 
that all of the witnesses are pretty much in agreement, 
although I noticed that two of them want a greater level of 
maybe more disclosure and transparency and that is even a 
controversial subject. In executive compensation, one of the 
reasons I believe that executive compensation has grown as fast 
as it has is the SEC requirement that you disclose CEO pay.
    Warren Buffett, speaking last night, said that it was not 
greed that was driving executive compensation, it was envy. 
They see what each other makes and that actually that 
disclosure, which everybody thought was a good thing, may 
actually be the cause of a lot of the growth in executive 
compensation.
    One reason it is very important for the committee to 
understand the hedge fund industry and other alternative 
investment vehicles like private equity and venture capital is 
because of the tremendous growth we have seen in hedge funds 
and these other alternatives. There are over 9,000 hedge funds 
today. That is an explosive growth. They manage over 400 
percent more assets than they did in just 1999--$1.4 trillion 
of assets under management, 60 percent of that is just in the 
100 largest hedge funds.
    They also are generating an increased amount of trading 
volume. Some experts have represented that up to 50 percent of 
the trading in our markets in certain circumstances is hedge 
funds. The strategies employed by hedge funds vary 
significantly, although most of them hedge against down-turns 
in markets, which I think is good.
    The primary goal of many hedge funds is to reduce 
volatility and risk and simultaneously provide liquidity, 
preserve capital and deliver positive returns under all market 
conditions. We found that during our hurricanes in the past few 
years that it was hedge funds that actually provided the 
liquidity for insurance, property insurance coverage, a very 
positive benefit of our hedge funds.
    We all know hedge funds use complex, sophisticated 
strategies to achieve their investment goals. I suppose the 
first time most Americans heard of hedge funds, and many 
Members of Congress as well, was with the implosion of long-
term capital management in 1998. And you will recall that 
resulted in a bail out orchestrated by the Federal Reserve and 
the Treasury Department and other regulatory bodies, although 
it was a private bail out. And since that time the subject of 
systemic risks posed by the operation of large hedge funds has 
been a concern of financial regulators and members of this 
committee, and rightly so.
    Systemic risk is not theoretical, and if not properly 
contained and managed, it can threaten the stability and 
soundness of our financial markets. There is always the 
potential for a single event, such as a massive loss at a large 
complex financial institution to trigger a cascading effect 
that could impact the broader financial markets and ultimately 
the global economy.
    For this reason, and I think this is the right approach and 
I know that the witnesses have said this, last month's 
announcement by the President's Working Group on Financial 
Markets of the Principles and Guidelines of Private Pools of 
Capital is a welcome development. The President's Working Group 
appropriately focused on systemic risks to investor protection. 
Private pools of capital are a sophisticated investment used by 
sophisticated market participants. I am confident that these 
market participants, hedge funds and others, understand they 
must engage in constant due diligence and ongoing evaluation of 
market exposure and risks created by their relationship with 
hedge funds.
    I applaud Secretary Paulson, Chairman Cox, and other 
regulators who developed this guidance, and I am glad to hear 
the chairman also say that he thinks that this is the way to 
approach this, and that relies on market discipline and sound 
risk management techniques rather than the heavy hand of 
government regulation to achieve the desired objective.
    This is how I will sum up. The bottom line is that I 
believe an overly prescriptive rules-based approach to 
regulating these private pools of capital could stifle 
innovation and drive hedge funds and their capital offshore. 
Such an approach would not benefit the competitive standing of 
our capital markets, something we are very concerned about.
    So I thank you, Mr. Chairman.
    The Chairman. I thank the gentleman. I would just like to 
make it clear that in regard to hedge funds, I have come to no 
conclusion. My mind is pretty open on this.
    Next, we will hear from the gentlewoman from Ohio for 2 
minutes.
    Ms. Pryce. Thank you very much, Mr. Chairman, for holding 
this hearing today and for the promise of continued hearings on 
private pools of capital.
    I want to take a moment to thank the panel, also. This is 
very important information for us. These are very complicated 
issues that you can help shed some light on as we start today 
and continue down this series of hearings. There is really no 
doubt that the hedge funds provide significant economic 
benefits to the market and the Federal Reserve Chairman has 
cautioned against any heavy-handed regulation of the $1 
trillion industry. We all know that the President's proactive 
Working Group recently took steps to issue guidelines for hedge 
fund participants. I agree with the Working Group that the 
regulators' continued role must be to promote market discipline 
on hedge funds and to ensure that proper risk management is 
being followed.
    I think in this committee it is important that we closely 
examine why hedge funds do fail on occasion and why some 
failures are different than others. Why was the collapse last 
September of Amaranth advisors, which lost $6 billion in a 
matter of weeks, different from the failure of long term 
capital management in 1998 that sent shockwaves through the 
system? Is there systemic risk posed to our economic system 
today? And, if so, what are those risks? Are the protections 
that are in place adequate to provide market actors and 
regulators with the information needed to make informed 
decisions? Should we be doing more to protect unsophisticated 
investors? All are important questions that I hope we will 
begin to answer today and in future hearings.
    Just once again, Mr. Chairman, and our ranking member, Mr. 
Bachus, thank you for holding these hearings, I will look 
forward to all of the testimony, and I yield back.
    The Chairman. I thank the gentlewoman again, working off 
the list that the ranking member gave me, the gentleman from 
Delaware is recognized for 2 minutes. Is he here? Well, the 
gentleman was not recognized. Someone was posing as him. The 
gentleman from Connecticut is recognized for 2 minutes.
    Mr. Shays. Thank you very much, Mr. Chairman, for holding 
this hearing. I also thank my ranking member. I live in a 
district, in the greater New York area--we say that about 60 
percent of the hedge funds exist and in my district there is a 
claim that one-fourth to one-third of all assets under 
management are in actually the district I represent. I tell 
people that if you are from Iowa, you want to get on the 
Agriculture Committee, and if you are from Fairfield, 
Connecticut, you want to get on the Financial Services 
Committee.
    I would like to welcome all of our witnesses, but in 
particular a personal friend, Jeff Matthews, and also his wife 
is here, Nancy. Nancy is the chancellor of the diocese of 
Bridgeport. They are quite a force. Jeff is an accomplished 
hedge fund manager. He is an active member of his community, 
having served in Fairfield, Connecticut, not the county, on the 
board of finance and on the board of education. I love him for 
his good nature, his sharp, insightful mind, his candor, and 
his honesty. He is just a very welcome guest on this panel. 
Jeff, thank you for being here.
    Thank you, Mr. Chairman.
    The Chairman. I thank the gentleman. Next, the gentleman 
from New Jersey, Mr. Garrett, is recognized for 1 minute.
    Mr. Garrett. Thank you, Mr. Chairman, and thank you for 
holding this hearing. Thank you to the witnesses for being with 
us today. For those I have met previously, good to see you 
again. Also, I would like to thank my colleague who is not 
here, the gentleman, Congressman Castle, for his work and focus 
on this issue in the past term as well. Hedge funds, as you all 
know, are now at $1.2 trillion, truly a high stakes, high-risk 
investment. It originally started out for, I guess, the super 
wealthy or the very wealthy and have now extended to the 
pension funds, as the chairman says, both public and private. 
And it is for that reason that it is important, it impacts more 
on the middle class, millions of middle class Americans as 
well, that we have this involvement here today.
    I also would like to point out, just as a more personal 
point of view from us coming from New Jersey. My friend from 
the other side of the aisle and I, Albio and I, represent 
districts that have a strong nexus to the financial markets and 
so just as the gentleman behind us from Connecticut has that 
connection, I know we do as well and take this from both 
perspectives of our constituents here at home and across 
America as well. And, as the ranking member had indicated, I 
think it is important that we are able to have the benefit of 
the President's Working Group on this, that goes all the way 
back I guess to 1987, the stock market crash when that was 
created to try to take a look at the financial markets and try 
to gather up all the information that they can. And since that 
time, obviously I don't think you were talking about hedge 
funds that much back in 1987 but now we have, and they have 
grown in importance. And like the chairman, I am still trying 
to get my mind around all the issues involved, so I very much 
appreciate the testimony at this hearing today. Thank you, and 
I yield back.
    The Chairman. I thank the gentleman and now I will ask 
unanimous consent since 10 minutes has been consumed on the 
minority side to extend the time for opening statements for an 
additional 3 minutes. Is there any objection? Hearing none, we 
will go forward. And the final recognition is for the gentleman 
from Louisiana, Mr. Baker, for 3 minutes.
    Mr. Baker. Thank you, Mr. Chairman, for the courtesy. I 
think it important to recognize why we are actually here. Few 
people would trouble themselves if really wealthy people lose 
or make money, and so as long as this phenomena was relegated 
to a handful of sophisticated Wall Street types, there was no 
need for the Congress to be involved in this discussion.
    However, that has changed. As innovation has caused your 
reach of scope, economically and otherwise, to broaden, we are 
now concerned about the inadvertent consequence of a systemic-
like event which causes pensioners, who have no idea their 
manager has invested in a derivatives currency arbitrage, to 
lose money as a result of a Russian currency crisis. I think it 
is not quite clear to me what really constitutes a hedge fund. 
Is that necessarily to the exclusion of private equity or 
venture capital or does it go more to the aggregation of large 
sums of capital, which are deployed in a sophisticated manner, 
which is not subject to the same rules as a public operating 
company, for which there could be adverse financial systemic 
consequences. So, one, I think we have to define who is it we 
are trying to constrain, why are we trying to do it, or what is 
it we are trying to find out about them.
    In reading through testimony, it became clear there are 
certain best practices that each of you may have suggested 
would be appropriate, and I think that is highly desirable as 
opposed to a governmentally-driven remedy for the industry to 
come to some conclusion as to how we should define those who 
are engaging in this practice in a professional manner.
    Beyond that, I think the valuation issue that has been 
referenced and how do we know from an investor perspective that 
there is consistency between Fund A and Fund B and the values 
associated with your position in that particular exposure, that 
is not clear to me either.
    Finally, the manner in which the disclosure occurs cannot 
be paper-based because by the time you get it on a piece of 
paper, it is out of date. There has to be some net-based 
disclosure, electronic disclosure, of the essentials that are 
determined by the industry to the regulator of importance and 
not public disclosure and certainly nothing proprietary.
    I only make these comments because as the chairman was 
talking about having reached no resolution thereon, this 
Congress will come to resolution thereon if there is an adverse 
event that drives a number of pensioners into bankruptcy 
because a hedge fund guy was fast and loose with his investment 
protocol. You will then get a ``Sarb-Ox'' like response, 
applicable to whatever is defined as the hedge fund industry, 
and you do not want us to do that. I think this is a window in 
which there is great opportunity for the industry to coalesce, 
to produce a document which is defensible, and give the 
appropriate regulator the insightful information you know he 
should have to help throw the circuit breaker when things go 
bad. Absent that, we are going to get into a policy arena that 
I think will be very difficult for the industry and not helpful 
to our world economy.
    Thank you.
    The Chairman. I thank the gentleman, and we will now begin 
with the witnesses. And our first, just in the order in which 
somebody sat them, is Gerald Corrigan, formerly a very 
distinguished leader of the Federal Reserve system and someone 
who has been working closely on this issue. He is now managing 
director at Goldman Sachs. Mr. Corrigan, please.
    Let me say that without objection, the written statements 
of all of the witnesses will be included in the record. Mr. 
Corrigan, please go ahead.

  STATEMENT OF E. GERALD CORRIGAN, MANAGING DIRECTOR, GOLDMAN 
 SACHS & COMPANY, AND FORMER PRESIDENT OF THE FEDERAL RESERVE 
                        BANK OF NEW YORK

    Mr. Corrigan. Mr. Chairman and members of the committee, I, 
and I think all of us, appreciate your calling this hearing and 
the timeliness with which you have done it. My statement, as 
the others, will be accepted into the record.
    In the interest of time, let me just highlight several of 
the major points that I tried to make in my written statement. 
The first part of the statement essentially tries to quickly 
trace and highlight the evolution of the hedge fund industry 
since long term capital in 1998, and I think that is quite 
straightforward. The only thing I would want to emphasize, Mr. 
Chairman, is that I think it is entirely fair to say, as I do 
in my statement, that over recent years there have been very 
substantial improvements in business practices in the hedge 
fund industry in such areas as corporate governance, risk 
management, disclosures to investors, and operational 
infrastructure improvements. And in many cases, certainly not 
all, but in many cases, I think the capabilities in those areas 
within segments of the hedge fund community now has much in 
common with best practices across the financial system as a 
whole.
    The statement also does a little idle speculation about the 
future evolution of the hedge fund industry, which I will not 
go into except to say that, at least in my judgment, there is 
some prospect that the forces of competition probably will 
induce over time some further pressures on fees and therefore 
in my judgment the prospect of some further consolidation in 
the industry over time.
    I think it is very important for the committee to recognize 
that as the premium on performance intensifies what I will call 
the orderly attrition of under-performing funds may accelerate 
and inevitably a few funds will encounter serious financial 
problems. Such developments, as I see them, are a natural and 
healthy market-driven phenomenon, which need not have material 
adverse consequences for the stability of the financial system.
    The second part of my statement traces the relationship 
between hedge funds and large integrated financial 
intermediaries. The substance of that discussion, while 
obviously summarized, I think is indeed very important to this 
whole question about systemic risk. And what I try to 
illustrate is that the relationship between large financial 
intermediaries, which are typically major banks and securities 
firms, all of whom are subject to some form of consolidated 
supervision, it involves two separate but related phenomena, 
the first is the so-called prime brokerage phenomenon and that 
essentially involves a whole range of services, including 
providing credit by prime brokers to their hedge fund clients. 
And I do make the point that a well-managed framework within 
which prime brokers provide credit to hedge funds that is 
secured, following the procedures that I have outlined in my 
statement, is a relatively, I emphasize relatively, low-risk 
activity.
    The second class of activities that characterize the 
relationships between hedge funds and major financial 
institutions is the totality of what I call their counter-party 
relationships and those counter-party relationships are very, 
very complex and involve a whole range of activities and risk 
taking on both the part of the intermediary and the hedge fund. 
I take that discussion into a little sidebar discussion about 
risk management. And I think the fundamental point that I want 
to stress in terms of risk management, whether it is at a major 
intermediary or at a hedge fund, is that the foundation for 
effective risk management rests on what I like to call a 
``culture'' of sound corporate governance, collective analysis 
and decisionmaking, and above all, sound judgments by 
experienced business leaders. And it is in this sense, Mr. 
Chairman, that I believe that risk management is much more an 
art than it is a science. And I go on to illustrate in my 
statement some of the reasons why I think that is true.
    The next part of my statement talks about systemic risk. 
And I think that what I have tried to do here is in a very 
summary fashion try to help ensure that the committee 
realistically understands what systemic risk is and what it is 
not. And the characterization that I have used for years and 
years to describe systemic risk of a financial nature is to 
call it a financial shock that brings with it the reality or 
the clear and present danger of inflicting significant damage 
on the financial system and the real economy. And I draw a 
sharp distinction, as I have for years, between what I call 
``financial shocks'' and ``financial disturbances,'' the latter 
of which occur with some regularity.
    I stress the point when I began the work of the Counter-
Party Risk Management Policy Group a year-and-a-half ago, that 
the whole effort was shaped around three threshold conclusions 
about systemic financial risk. The first was that over time the 
already low statistical probabilities of the occurrence of 
systemic financial shocks had declined further but they were 
still well short of zero. The second, and this is the one that 
worries me, is that while the probabilities of shocks are 
lower, the potential damage that could result from such shocks 
is greater due to the increased speed, complexity, and tighter 
linkages to characterized a global financial system.
    And then finally, that our collective capacity to 
anticipate the specific timing and triggers of future financial 
shocks is extremely low, if not nil. Indeed, I argue that if we 
could anticipate these things, they would not happen.
    Now in those circumstances--
    The Chairman. Mr. Corrigan, we need you to get to a 
conclusion.
    Mr. Corrigan. The last thought, Mr. Chairman, that I have 
put emphasis on, strengthening what I call the shock absorbers 
of the system, and I do think that the President's Working 
Group exercise on hedge funds and private pools of capital is a 
very constructive move in that direction.
    Thank you, Mr. Chairman.
    [The prepared statement of Mr. Corrigan can be found on 
page 97 of the appendix.]
    The Chairman. Thank you. Our next witness is one who has 
appeared before us in other capacities when he was the head of 
the Export-Import Bank, over which this committee has 
jurisdiction, and he is now with Taconic Capital Advisors, Mr. 
Kenneth Brody.

   STATEMENT OF KENNETH D. BRODY, CO-FOUNDER AND PRINCIPAL, 
    TACONIC CAPITAL ADVISORS, LLC, AND CHAIRMAN, INVESTMENT 
               COMMITTEE, UNIVERSITY OF MARYLAND

    Mr. Brody. I thank Chairman Frank and Ranking Member Bachus 
for the opportunity to testify. In my former life as a public 
servant, under the jurisdiction of this committee and Chairman 
Frank, I have learned to be brief, to the point, and succinct, 
so let's go. I wish to address two issues, systemic risk and 
investor protection. The President's Working Group and 
virtually all knowledgeable professionals agree that systemic 
risk is best controlled by regulators overseeing the providers 
of credit. These providers of credit are primarily the large 
financial institutions, commercial banks and investment banks.
    Turning to investor protection, I believe it is another 
story. I am going to take a very unusual view for an industry 
participant. I believe that mandatory registration is good 
policy. It provides for better investor protection, and I think 
it should come about because the nature of the investors have 
changed. It is not just wealthy individuals but it is 
institutions of all stripes, including pension funds, who are 
getting more and more into investing in hedge funds. And with 
pension funds, the ultimate beneficiaries are regular working 
people.
    What registration primarily provides is a self-discipline 
and a self-policing because that comes with the threat of SEC 
examination. In my testimony, I have included many of the 
elements of such protections that are provided by registration 
with the SEC. Having said that, a better way to do registration 
is to introduce a principles approach instead of a ``tick the 
box'' regime. A principle approach will provide better investor 
protection and with greater efficiency.
    We are registered and a substantial number of hedge fund 
managers are registered. We think it is good policy for all. I 
thank you again for the opportunity to testify, and I welcome 
the opportunity to answer any questions.
    [The prepared statement of Mr. Brody can be found on page 
57 of the appendix.]
    The Chairman. Thank you very much, Mr. Brody, for your 
testimony and your example of how to testify.
    [Laughter]
    The Chairman. Next, we have James Chanos, who is chairman 
of the Coalition of Private Investment Companies. And, Mr. 
Chanos, please proceed.

   STATEMENT OF JAMES CHANOS, FOUNDER AND PRESIDENT, KYNIKOS 
     ASSOCIATES, LP, ON BEHALF OF THE COALITION OF PRIVATE 
                      INVESTMENT COMPANIES

    Mr. Chanos. Chairman Frank, Ranking Member Bachus, and 
members of the committee, my name is Jim Chanos, and I am 
president of Kynikos Associates, an SEC-registered New York 
private investment management company I founded in 1985. I am 
appearing today on behalf of the Coalition of Private 
Investment Companies, whose members and associate managers 
advise more than $60 billion in assets. I would like to thank 
the chairman and ranking member for inviting us to participate 
today.
    The Coalition welcomes the attention of this committee on 
our industry. Rapid growth in all alternative investment funds, 
whether they call themselves hedge funds, private equity, or 
venture capital, has brought significant rewards to investors 
and the financial markets. But to paraphrase the great Stan 
Lee, ``With great growth comes great responsibility.'' This 
responsibility derives from the industry's more prominent roles 
in various parts of the financial markets and perhaps most 
importantly the trust placed on our managers to properly invest 
the assets of pension funds and endowments, institutions whose 
ultimate beneficiaries are not themselves wealth individuals. 
Consequently, hearings such as this present a unique 
opportunity for our industry to explain the way it works, 
dispel some of the myths and misconceptions that surround it, 
and make clear our commitment to work with policymakers in the 
Congress and in the financial regulatory agencies in order to 
improve those areas where the system of oversight may not be 
keeping pace with the growth of the sector.
    The Coalition would like to suggest a few ideas that may be 
useful in thinking about the issues associated with private 
pooled investment vehicles. First, almost all private 
investment pools, whether a hedge fund, a venture capital fund, 
or private equity fund, share many common characteristics in 
terms of their disclosures to their investors and counter-
parties without detailed government mandates. Consequently, we 
would suggest that policymakers, instead of creating 
distinctions between these types of entities, treat all private 
pool investment vehicles similarly, regardless of their 
underlying investment strategies. Even though we may all use 
the term ``hedge fund'' in the context of today's hearing, the 
most accurate phrase is not ``hedge fund'' but ``private 
investment company.
    Second, in terms of investment activity, the buying or 
selling of securities or commodities or derivatives, hedge 
funds are but one type of many market participants engaged in 
the same activity. Again, in order to gain the most complete 
understanding of the subprime mortgage market, to use a recent 
example, one should not focus solely on a single segment of the 
market but should look at all participants engaged in that 
activity. Looking at mortgage securitizations solely through 
the prism of hedge funds without looking at banks, investment 
banks, insurance companies, and other types of dealers and 
investors will create a distorted picture of how and why that 
market operates as it does.
    This is not to say that hedge funds should not be included 
at all in such a distinction, quite to the contrary, we are an 
important part of the equation. But hedge funds are not nearly 
so significant in and of themselves that they should be the 
focus of attention to the exclusion of other market 
participants doing the same thing. A focus on the activity, not 
the actor, is more likely to yield the information desired by 
policymakers in assessing the appropriate level of oversight 
and regulation.
    Third, the phrase, ``lightly regulated,'' which typically 
is applied to hedge funds and other alternative investment 
vehicles, is somewhat misleading as it really only applies to 
governmental regulation of the relationship between the fund 
and its investors. In this area, sophisticated or institutional 
investors are deemed by the government to have the capacity and 
equal footing to obtain the requisite information from fund 
managers on their own instead of relying on standardized 
government-mandated disclosures. In almost all other aspects of 
the U.S. financial system, hedge funds are subject to the same 
web of statutory and regulatory requirements as all other 
institutional market participants engaged in the same activity.
    And even with the interaction of the fund, the manager and 
the fund investors, despite lack of regulation, does not yield 
a lack of transparency, either to investors or to the counter-
parties providing credit and other financial support. In the 
case of my funds, for example, investors or their financial 
managers generally require us to provide answers to detailed 
questions regarding our background, strategies and research, 
personnel, returns, compliance programs, risk profile, and 
accounting and valuation practices. Prospective investors also 
review terms such as liquidity restrictions, management 
performance fees, and any applicable lock-up periods for their 
capital. Depending upon the nature of the investor, a person 
may meet an institution's portfolio managers or compliance 
officers.
    Some investors also ask to speak to our lawyers, auditors, 
and prime brokers for references. The process usually also 
includes any number of on-site visits by the potential investor 
or their representatives. The right to on-site visits continues 
after the investment is made as well as continued oral and 
written communication on a regular basis so that the investor 
can assure himself or herself that the representations that we 
made at the outset are being followed.
    Fourth, much of the secrecy surrounding hedge funds is 
frequently a consequence of both the proprietary nature of the 
investment strategies employed and of the mandates of the SEC 
itself. The Commission's restrictions on general solicitation 
and public offerings, under which all hedge funds operate, 
prohibit fund managers from discussing their strategies and 
performance in any venue or in any way that could be construed 
as a solicitation or investment from the general public. 
Certainly, it means that fund managers must limit the content 
of or access to their Web site and limit public interviews 
about their funds and investment strategies that could be 
viewed as designed to attract the interest of the general 
public to invest in the funds. Accordingly, most fund managers 
prefer to err on the side of less public discussion rather than 
risk running afoul of the SEC.
    Fifth, if there are gaps in the system of regulatory 
oversight, then there should be ways to address them consistent 
with the principles and guidelines recently issued by the 
President's Working Group. Such deficiencies are best addressed 
without trying to shoe-horn the institutional business and the 
statutes that were designed primarily for the interaction of 
investment professionals and the general public. In this 
regard, we have some suggestions for consideration that may 
provide some commonsense approaches to answering at least some 
of these concerns without re-engaging in the unproductive 
debate from 2 years ago surrounding mandatory registration 
requirements.
    Mr. Chairman, do I have another minute to give that 
suggestion?
    The Chairman. Yes.
    Mr. Chanos. As an example, the SEC in proposing the Hedge 
Fund Advisor Registration Rule hoped to gather census 
information about hedge funds. The SEC could, however, without 
mandatory registration obtain much of the information it seeks 
by amending Form D, a basic document used by issuers of private 
placement of securities to acquire some additional information 
if the issuer is a pooled investment vehicle. The form could 
include a variety of basic information that I set out further 
in my written testimony. The SEC could also require that the 
form be kept current or updated annually. With this kind of 
information, the Commission, and policymakers generally, would 
be in a better position to answer the question, ``Who is out 
there?''
    With respect to best practices, we believe that most 
investors already demand practices of their funds that are 
equal to or exceed the requirements of the Investment Advisors 
Act. Fundamentally, we believe the institutional investors 
operate on a fairly equal footing with hedge funds and by 
simply taking steps to protect their own assets and investments 
produce the desired effect. However, if there is a belief that 
certain practices are so commonsense, such as third-party 
custodianship of client funds or annual outside audits, that 
they deserve the added strength of SEC authority behind them, 
we believe the Commission could consider using its anti-fraud 
authority under the Advisors Act to require certain measures to 
be taken by both registered and unregistered votes in order to 
protect fraud.
    And with that, I will make the rest of my comments in the 
written testimony.
    [The prepared statement of Mr. Chanos can be found on page 
73 of the appendix.]
    The Chairman. Thank you, Mr. Chanos. We have that and of 
course, there will be questions from the members.
    Next, we have Mr. George Hall, who is testifying on behalf 
of the Managed Fund Association. Mr. Hall?

 STATEMENT OF GEORGE HALL, FOUNDER AND CEO, CLINTON GROUP, ON 
            BEHALF OF THE MANAGED FUNDS ASSOCIATION

    Mr. Hall. Mr. Chairman, and members of the committee, thank 
you for the opportunity to testify here today. I am here on 
behalf of the Managed Funds Association, the largest U.S.-based 
association representing the hedge fund industry with more than 
1,300 members in the United States and around the world. In 
addition to being a director of MFA, I am the founder and chief 
investment officer of Clinton Group, an investment advisor for 
a diverse group of institutional and high net worth individual 
investors. We greatly appreciate the interest of this committee 
in considering public policy issues relevant to our industry 
and the opportunity to share our views with the committee.
    Hedge funds have been closely monitored and reviewed by 
Congress and Federal regulators in the recent years. This 
intense review has led to a clear recognition that hedge funds 
play a critical role in the success story of the U.S. capital 
markets. Hedge funds have helped to disburse risks, enhance 
market liquidity and resilience, and increase overall financial 
stability. With this vital market role comes important 
responsibilities. We agree with the President's Working Group 
on Financial Markets that the hedge fund industry and other 
market participants, along with financial regulators, have a 
shared responsibility for maintaining the vitality, stability, 
and integrity of our capital markets.
    I would like to briefly address four points. First, the 
President's Working Group on Financial Markets. MFA fully 
supports the recent agreement of the President's Working Group 
issued in late February. The Working Group addressed both 
systemic risk and investor protection concerns in its agreement 
and concluded that, and I quote, ``Market discipline most 
effectively addresses systemic risks posed by private pools of 
capital.'' The agreement stated that a combination of market 
discipline and regulatory policies that limit direct investment 
in private pools of capital to more sophisticated investors 
would be the most effective way to address this issue.
    MFA not only agrees with the Working Group's conclusions, 
but has been working with its members to address these issues 
for a number of years. We are committed to working closely with 
regulators, counter-parties, investors, and our own industry to 
do our part to remain ever vigilant.
    Second, systemic risk. MFA has worked proactively with its 
members to develop very specific risk management and internal 
control guidance set forth in Sound Practices for Hedge Fund 
Managers first published in 2000. Our sound practice guidance 
has been revised and enhanced to take into account market 
developments and is currently undergoing its third revision to 
be issued later this year. The President's Working Group 
principles will be a guiding blueprint for this effort. MFA 
members have also worked extensively with the major derivatives 
dealer firms and Federal Reserve Bank of New York to improve 
market practices for credit derivatives and other derivatives 
in order to reduce systemic risk concerns.
    Third, investor protection. MFA supports increasing the 
accredited standard. We applaud the SEC for considering this 
issue and for its recent proposed rule. Based on all available 
data, hedge funds remain chiefly an investment vehicle for 
institutional investors and high net worth individuals. We 
support a significant increase in the financial thresholds for 
entry into hedge funds.
    Finally, pension plans. MFA endorses efforts to increase 
the understanding of hedge funds among pension plan fiduciaries 
and trustees and is committed to helping promote investor 
financial literacy through the development of due diligence 
materials.
    In conclusion, hedge funds have proven to be attractive 
investment vehicles for institutional investors seeking to 
diversify risk and enhance portfolio strength. They also play a 
key role in our capital markets. To assure that these benefits 
continue, and that any associated risks are fully addressed, 
MFA believes that the proactive efforts of its members to 
enhance market practices are vital. MFA pledges to continue 
these efforts and to work with all market participants, 
financial regulators and Congress.
    Thank you.
    [The prepared statement of Mr. Hall can be found on page 
119 of the appendix.]
    The Chairman. Thank you.
    Next we have Jeffrey Matthews, previously introduced by the 
gentleman from Connecticut. Mr. Matthews is general partner at 
Ram Partners.

    STATEMENT OF JEFFREY L. MATTHEWS, GENERAL PARTNER, RAM 
                          PARTNERS, LP

    Mr. Matthews. Mr. Chairman and members of the committee, 
good morning, and thank you for inviting me to speak. My name 
is Jeff Matthews, and I am general partner of Ram Partners, a 
hedge fund I formed in 1994 after working at another hedge fund 
for 4 years and starting my career at Merrill Lynch in 1979. My 
fund is small relative to the others represented here and 
rather old-fashioned. We buy stocks for the long term, we hedge 
against short term market fluctuations, and we do not do any 
derivatives. Nevertheless, 18 years in the hedge fund world 
does make me something of an old timer, and I do have views on 
the issues that you have raised.
    To understand the growth in hedge funds you might ask, why 
do people start them in the first place? The answer is quite 
simple: Hedge funds are private partnerships whose investors 
are wealthy individuals and large institutions. That private 
structure and more sophisticated investor base gives us 
flexibility to pursue alternative investments, take greater 
risks, and reap greater rewards than a more strictly regulated 
mutual fund. Furthermore, as a private partnership, hedge fund 
managers can charge what their investors are willing to pay, 
including a share of the profits the business generates.
    So a successful multi-billion dollar hedge fund manager can 
earn hundreds of millions of dollars while her mutual fund 
counterpart could not. And that is why people start hedge funds 
and that is why this industry has exploded. In fact, the single 
biggest change I have witnessed since I started is size. In 
1994, the biggest hedge fund I knew about had $6 billion in 
assets; $6 billion today would not rank in the top 50 hedge 
funds, and the three largest U.S. hedge funds now have over $30 
billion each.
    Along with that explosive growth has come diversity. Hedge 
funds no longer focus mainly on stocks, bonds, and currencies 
but have branched into subprime debt, distressed securities, 
real estate, uranium ore, and even grain silos. In fact, there 
are hedge funds that do nothing but invest in other hedge 
funds.
    The flood of money has also caused many so-called hedge 
funds to no longer actively hedge against market declines 
because hedging has been a drag on returns during the bull 
market. It has been like paying a premium for an insurance 
policy you never needed.
    However, the most significant change I have witnessed in 18 
years in this business is the increased use of leverage, 
meaning borrowed money to start new hedge funds. A $400 million 
hedge fund today, for example, might actually have only $100 
million of equity. The rest, the other $300 million, might come 
from a bank that sells a preferred class of equity that looks, 
acts, and smells like debt. That structure works fine if the 
value of the whole thing goes up, everyone makes money, and the 
bank gets paid back. But if it goes down, that equity gets 
wiped out, much like a house bought with no money down.
    What type of risks might this pose? Could the graded 
leverage cause another long term capital type catastrophe that 
brings the markets? Well, we had just such a catastrophe last 
year. Amaranth was a $10 billion hedge fund with sophisticated 
investors, run by intelligent people using computerized trading 
systems, and it collapsed in just 20 days after a huge complex 
bet on natural gas went wrong.
    What does that tell us? Number one, that hedge fund 
managers can do stupid things just like any money manager only 
in much bigger size.
    Number two, even sophisticated investors do not necessarily 
mind this kind of risk taking until it goes wrong and when it 
does, they pull the plug very quickly. Number three, the more 
exotic the investments, the harder it is for any outsider to 
know what is going on inside a hedge fund. After all, if 
Amaranth's general partner did not realize his business was at 
risk, how would the Fed or SEC have seen what was coming and 
act to stop it?
    There is, however, a fourth and more positive lesson from 
Amaranth, which was not foreseen by many observers at the time, 
it is this, a $10 billion fund could evaporate in a matter of 
months and yet aside from a couple of wild weeks in the natural 
gas pits, the system did not blink. Unlike long term capital in 
1998, which had to be bailed out by the Fed, other hedge funds 
stepped in, bought Amaranth's positions at a deep discount and 
the firm was liquidated. It is true that Amaranth's investors 
included public sector pension funds, and they lost a great 
deal of money, but the people who manage those funds should 
have known the risks they were taking.
    As I said, I run a smaller, old-fashioned fund, we do not 
do derivatives, and I am not defending my own business model 
generally represented here but these are my real-world 
observations, nor am I acting as a cheerleader for all hedge 
funds. There will be failures again, and they could get ugly.
    However, the presence of so many large hedge funds today, 
specializing in so many aspects of the world markets, means in 
my view that the systemic risk of broad failure is probably 
much lower than I have ever seen it in the last 18 years. I was 
there when long term capital blew up, I was there when Amaranth 
blew up, and luckily for us Amaranth turned out to be no long 
term capital.
    Thank you for inviting me to speak.
    [The prepared statement of Mr. Matthews can be found on 
page 135 of the appendix.]
    The Chairman. Thank you, Mr. Matthews.
    Next, we have Andrew Golden, who is president of the 
Princeton University Investment Company.

STATEMENT OF ANDREW K. GOLDEN, PRESIDENT, PRINCETON UNIVERSITY 
                       INVESTMENT COMPANY

    Mr. Golden. Chairman Frank, Ranking Member Bachus, and 
members of the committee, thank you for the opportunity to 
share my perspective today as someone who has been an 
institutional investor in hedge funds for almost 2 decades. For 
the past 12 years, I have been the president of Princeton 
University Investment Company, the university office that has 
responsibility for investing Princeton's $14 billion endowment. 
With a staff of 25, we develop asset allocation plans, and 
select and monitor a roster of 140 external managers. We 
essentially act as a large fund of funds.
    Princeton's hedge fund investment approach illustrates that 
taken by a number of sensible investors for whom hedge funds 
need not entail great risk. Indeed, for us hedge funds can be 
an important tool for reducing risk. Princeton has enjoyed 
success as an investor with annual returns during the past 10 
fiscal years of 15.7 percent versus 8.3 percent for the S&P 
500.
    We have enjoyed particular success as an investor in hedge 
funds, but before going any further, let me say that all my 
comments today are complicated by the fact that hedge funds do 
not represent a distinctive asset class like real estate or 
venture capital. Rather, hedge funds are a relationship format 
defined by the nature of the contractual arrangement between an 
investment manager and his or her clients. At Princeton, we use 
the hedge fund format to pursue a broad variety of strategies 
across a spectrum of markets. Roughly 45 percent of the 
endowment is invested via the hedge fund format. One-third of 
that amount is invested in 14 funds that pursue traditional, 
unleveraged, long-only investment strategies. These funds tend 
to walk and quack like mutual funds, albeit ones managed very, 
very, very well with superior track records.
    The hedge fund format entails a higher fee schedule than 
that of traditional institutional accounts, yet it better 
aligns the manager's interest with their own, creating an 
environment for superior returns net of fees. Notably, 
Princeton's hedge fund managers are dis-incentivized from 
taking inappropriate risks as all have a significant share, 
typically the vast majority of their personal net worth, 
invested side by side with us.
    Approximately 30 percent of the endowment is invested in 16 
hedge funds that do pursue less traditional strategies, 
including for example selling short and investing in bankrupt 
companies. We categorize these managers as independent return 
managers. They seek returns that are equity-like but with 
correlation to most broad market moves. This low correlation 
means that our independent return program has been particularly 
effective at reducing the endowment's total risk. We do not 
invest with managers pursuing inherently opaque strategies. Our 
managers do not employ significant leverage, yet our low octane 
independent return program has generated a very strong 16.4 
percent 10 year annualized return with half the volatility of 
the stock market.
    While we have some natural advantages of the hedge fund 
investor, our success largely reflects hard work. We spend at 
least 400 person hours in our due diligence process before 
investing in a hedge fund. Post-hire we spend for each manager 
70 person hours per year monitoring activities.
    The single most important factor behind our success, 
however, has been that we have always been guided by a simple 
over-arching rule: we will not invest in something we do not 
understand. Princeton requires that our hedge funds provide 
substantial transparency. No one has ever been forced to invest 
in any particular hedge fund. I do not believe that 
sophisticated investors who willingly invest in anything 
without assuring that they have adequate information and 
understanding deserve any sympathy, let alone any additional 
regulatory safeguards. Indeed, I believe that fiduciaries who 
fail to assure their own understanding of investments may 
deserve to be sued or prosecuted.
    Understanding investment, however, does not guarantee happy 
results. It is a certainty that at least some investors will 
suffer significant losses in their hedge fund investments. 
However, for perspective, it should be remembered that when the 
tech bubble burst, U.S. stock investors collectively lost 
almost $7 trillion. Among the losers were sophisticated and 
unsophisticated investors. The losses were suffered through the 
entire spectrum of relationship formats including mutual funds. 
The $7 trillion losses give interesting context to worries 
about the hedge fund industry, to which we have all been 
estimating total investor exposure is between $1- and $2 
trillion.
    I suspect that there are some hedge funds using imprudent 
leverage with likely unpleasant consequences for their 
investors at some point in the future. However, when I think 
about the important systemic risk facing markets today, hedge 
fund leverage is less of a concern than say mortgage or Federal 
debt levels. The markets for institutional client money 
provides some discipline with regard to what a particular hedge 
fund manager will flourish but then again not so much to 
prevent an Amaranth. However, as others have noted today, the 
resolution of Amaranth was quite orderly.
    The Chair asked that I comment on current levels of risks 
in the markets, and actually could I have one more minute to 
deal with that?
    The Chairman. Yes.
    Mr. Golden. And I think you cannot refer to risk without 
referring to price. If prices are high, likely investors are 
not getting compensated for the risk present today but who 
knows if the resolution of that will be a sharp down draft or 
more prolonged periods of mediocre results?
    I was also asked to comment on market practices since the 
issuance of the CRMPG II report, and I can echo others' 
comments that market practices have matured with much greater 
discipline in trade documentation.
    Finally, let me give my views on the appropriate role of 
government with regard to hedge funds, their activities and 
markets. And, basically, the bottom line there is I think the 
President's Working Group essentially has it right. I would 
wonder whether or not the minimum wealth test should be set 
even higher than what has been anticipated.
    With respect to the regulation of hedge fund activity in 
the markets, I think the PWG again has it right, to assure fair 
markets and control systemic risks, it makes most sense to 
focus regulatory and private oversight bandwidth on large 
financial institutions that act as counter-parties and lenders. 
Perhaps we should accept guidance from the bank--and direct our 
activities to where they keep the money.
    Thank you.
    [The prepared statement of Mr. Golden can be found on page 
111 of the appendix.]
    The Chairman. Thank you.
    Our final witness is Stephen J. Brown, who is a David S. 
Loeb professor of finance at the NYU Stern School of Business.
    We have appropriately thanked all the donors here, the 
Loebs and the Sterns. They all have their names in it.
    Please go ahead, Mr. Brown.
    By the way, the business schools practice what they preach. 
Most medical schools and law schools are not named for people. 
Every business school is. They do understand marketing and put 
it into practice.
    [Laughter]

   STATEMENT OF STEPHEN J. BROWN, DAVID S. LOEB PROFESSOR OF 
     FINANCE, STERN SCHOOL OF BUSINESS, NEW YORK UNIVERSITY

    Mr. Brown. Absolutely. I agree 100 percent.
    It is a very distinct honor to be invited to testify before 
this committee, and I really thank Chairman Frank and Ranking 
Member Bachus for this honor.
    The President's Working Group on Financial Markets tells us 
that private pools of capital bring significant benefits to the 
financial markets.
    What are these benefits? Some would tell us that their only 
objective is to enrich themselves and their rich clients.
    The industry needs to show that these benefits outweigh any 
problems they might cause. A premise of the PWG is that hedge 
funds do not pose a systemic risk for the financial markets.
    What is a ``hedge fund?'' The term actually comes from 
Carol Loomis, a Fortune journalist writing in 1966 about the 
strategy of AW Jones who invested in under valued companies 
financed in part by short positions in companies he felt were 
over valued. In this sense, the investment was ``hedged'' 
against general market movements.
    The term ``hedge fund'' was a stretch even for AW Jones, as 
his short positions never equalled in size or economic 
significance of his long positions. Subsequent funds adopted 
the regulatory form of AW Jones but not his investment 
philosophy. Indeed, the term ``hedge fund'' belies their 
considerable risk.
    Sophisticated investors ought to be allowed to do as they 
please, provided they not hurt innocent bystanders. 
Unfortunately, the industry interprets the general solicitation 
ban as limiting all kinds of public disclosure. Indeed, some 
view the lack of transparency as part of the business model the 
very reason for their success.
    I argue that it is this lack of information, this lack of 
transparency, at an industry level, that is of greatest 
concern. Absent industry-wide disclosure, the only reliable 
information we have is a purely voluntary disclosure to data 
vendors, such as Lipper TASS.
    According to their numbers, U.S. domiciled funds have grown 
from close to $20 billion under management in December 1995 to 
$131 billion today, although the growth has leveled off 
recently.
    I should add that the trillion dollar number that people 
cite includes both domestic and foreign funds.
    The data show remarkable diversity of styles of management 
under the ``hedge fund'' banner. The AW Jones long/short 
strategy captures about 30 to 40 percent of the business.
    The style mix has been fairly stable, although there has 
been a dramatic rise in assets managed by funds of funds. These 
diversified portfolios of hedge funds are attractive to an ever 
increasing institutional clientele, which a decade ago did not 
exist, but now is about 52 percent of the total.
    Event driven funds focusing on private equity, mergers and 
acquisitions and such, have risen in market share from 19 to 25 
percent over the past decade, while the global macro style 
popularized by Soros has actually fallen from 19 to 3 percent.
    There is a concern of the committee about the role of hedge 
funds in the credit derivatives and CDO markets. How big is 
this issue? We do not know since the industry is not required 
to tell us, but based on TASS, fixed income arbitrage, which 
involves these kinds of strategies, is just 4 percent of the 
business.
    I think the industry should make the case that entering 
this market, their ``rich clients'' are taking on significant 
risk, which would otherwise fall on the banking system. They 
are thus reducing systemic risk, not increasing it.
    What about leverage? According to TASS, the fraction of 
funds that use leverage has fallen from 69 percent in 2002 to 
57 percent today. In addition, there are vast differences in 
degree of leverage across funds. Strategies that report the 
highest degree of leverage have quite small market share.
    More information would certainly help. Does this detract 
from due diligence of sophisticated investors? With colleagues, 
I studied the recent controversial and ultimately unsuccessful 
SEC attempt to increase hedge fund disclosure.
    We examined disclosures filed by many hedge funds in 
February 2006. Leverage and ownership structures as of the 
previous December suggest that lenders and hedge fund equity 
investors were already aware of hedge fund operational risk 
revealed in these forms.
    However, operational risk does not mediate the naive 
tendency of investors to chase past returns. Investors either 
lack this information or regard it as immaterial.
    What is the role of government? Perhaps Congress needs to 
re-visit the 1940 Act. The ``sophisticated investor'' exemption 
seems quaint these days.
    Industry argues that the ban on direct solicitation 
inhibits disclosure, and perhaps it does. However, Congress can 
mandate any level of selective disclosure necessary for 3C1 or 
3C7 exemption. There is no need to know proprietary trading 
information.
    However, by being just a little bit more forthcoming, the 
industry could allay public concern about systemic risk and 
operational risk.
    Thank you, Mr. Chairman.
    [The prepared statement of Mr. Brown can be found on page 
71 of the appendix.]
    The Chairman. Thank you. I thank all the witnesses. I think 
many of us will be reading in detail particularly what you have 
submitted.
    Let me begin with Mr. Corrigan. Obviously, our job is to 
think about whether or not there is any public policy 
implications.
    You talked about the need or the desirability of increasing 
the shock absorbers. What would they be and would we have any 
role in trying to do that? That would seem to me to be what we 
ought to be focusing on to the extent that there was something 
for us to do.
    Mr. Corrigan. Certainly, to answer your last question 
first, I think your oversight role is very important. As to the 
shock absorber concept that I have used, I have tended to put 
my favorite shock absorbers, if you will, into basically six 
categories.
    One is corporate governance. I cannot begin to underscore 
how important the details of what corporate governance really 
means is for this purpose. It is a lot more than having a few 
independent directors. The second is risk management and risk 
monitoring. The third is what I call financial infrastructure, 
and these are some of the problems that we encounter with 
backlogs of derivatives and so on and so forth. The fourth is 
better understanding in managing these highly complex products. 
The fifth is a multiple four legged table of enhanced 
disclosure, and the sixth is what I like to call reputational 
risk management.
    The Chairman. Let me go to the one that may potentially 
involve us, number five, the disclosure. Would you change the 
disclosure regime that we now have?
    Mr. Corrigan. Most of the time when we talk about 
disclosure, we are thinking about public disclosure. One of the 
issues that I raised in my statement in terms of suggesting 
some enhancements to the President's Working Group approach is 
to better recognize that in the context of financial stability 
issues.
    Disclosure is a four legged table. The first has to do with 
disclosure of a bilateral confidential nature say between a 
hedge fund and its prime broker.
    The second has to do with disclosures that are made by 
hedge funds or private equity funds to their investors or 
prospective investors.
    The third has to do, and this is very important, with what 
I like to call voluntary informal exchanges of largely 
confidential information between hedge funds or private equity 
funds and regulated institutions with the regulatory community. 
The last is public disclosure.
    I firmly believe, Mr. Chairman, that again, in the context 
of shock absorbers and financial stability, there is more pay 
dirt in those first three legs than there is the last, in part 
because public disclosure is suffering from a very chronic 
information overload problem.
    The Chairman. I accept that. Is there a role for the 
government? Again, I ask this without any preconception.
    ``Public'' can mean two things. It can mean public in that 
it is to some extent compelled by public agencies, and it can 
also mean that the actual information is made public.
    Is there a role for the government in increasing the flow 
of information in the first three categories?
    Mr. Corrigan. Yes, there is. Again, one of the suggestions 
in my statement, Mr. Chairman, was that in the context of the 
so-called systemic risk principles of the President's Working 
Group, I suggest in my statement that one thing I would like to 
see happen would be an effort to quickly develop best 
practices, make them public, so that we have benchmarks, 
including in this area of transparency--
    The Chairman. Would you recommend that any public agency 
have the responsibility to monitor whether or not the best 
practices were being followed?
    Mr. Corrigan. I would expect in this context that the 
supervisory authorities would indeed do that. I believe, if I 
take as a point of reference the recommendations of our risk 
management policy group, that has happened.
    The Chairman. That would be the supervising authorities 
obviously for the depository institutions. Would that also mean 
by anybody for the hedge funds themselves? I understand on the 
counterparties.
    Would you recommend there be any governmental 
responsibility to monitor whether best practices were being 
followed by the investment entities themselves?
    Mr. Corrigan. I think that it is in the best interest of 
the hedge funds themselves to put themselves in a position in 
which they voluntarily make their practices public.
    The Chairman. I understand. Every time people tell me 
something would be good if it was done voluntarily--if 
everybody did everything voluntarily, I would be out of a job. 
Maybe that would be a good thing. We are in the involuntary 
part of this.
    If people do not do it, should somebody at least be 
checking to see who does and who does not do it voluntarily?
    Mr. Corrigan. I think that will happen; yes.
    The Chairman. Thank you. Mr. Bachus.
    Mr. Bachus. Thank you. Let me ask all the panelists. We 
have talked about the President's Working Group and they are 
going to come up with some recommendations.
    Would your advice to us be to wait on their final 
recommendations before we considered any action?
    I will start with Mr. Corrigan.
    Mr. Corrigan. Yes. I would suggest, and I don't think that 
is going to take all that long. I think there is enough in the 
pipeline right now that the committee, in my judgment, should 
continue to exercise its oversight function as it is doing 
today.
    I do not see the need for anything beyond the continued 
effective exercise of that oversight function.
    Mr. Bachus. Mr. Brody?
    Mr. Brody. I guess it would depend upon how long it takes. 
If it is done in a sensible and timely way, I think it is 
absolutely appropriate for the committee to wait.
    If it takes an extensive period of time, then it is 
probably proper to move without it.
    Mr. Bachus. All right. Mr. Chanos?
    Mr. Chanos. I would echo Mr. Brody's comments on that. I 
think if we are looking at a long process, I think it would 
behoove the committee to keep moving at all due speed. I 
suspect the report will be out relatively soon.
    Mr. Bachus. Is 6 months a reasonable amount of time?
    Mr. Chanos. If there are no financial hiccups, I would say 
yes, 6 months seems reasonable.
    Mr. Bachus. We probably would not know until after the 
hiccup, I guess. By ``hiccup,'' you do not mean a failure of a 
hedge fund. You mean?
    Mr. Chanos. A broader market problem that would include but 
not be exclusive to hedge funds, that would move things 
quicker.
    Mr. Bachus. Some of the things that have been advised still 
would not prevent that, would it?
    Mr. Chanos. Absolutely not. I am a realist as well as an 
idealist. I understand, as one of the members said earlier, 
that the industry will come under greater scrutiny should there 
be such a hiccup.
    Mr. Bachus. Mr. Hall?
    Mr. Hall. I would agree with that, that the committee 
should wait for the President's Working Group. We believe they 
are on the right track. They have identified what we think are 
the important issues, and they have also identified what the 
potential failures could be of aggressive regulation.
    I think, as Mr. Baker pointed out, overreaction based on a 
hiccup is in the long run not going to serve the industry or 
the economy as well either. We need to be very careful and 
hopefully they will move quickly and get it taken care of.
    Mr. Bachus. Mr. Matthews?
    Mr. Matthews. I agree with my colleagues.
    Mr. Bachus. To wait?
    Mr. Matthews. Yes.
    Mr. Bachus. A reasonable amount of time?
    Mr. Matthews. Yes.
    Mr. Bachus. Mr. Golden?
    Mr. Golden. There is a downside to being on this end of the 
table. It's all been said before.
    Mr. Brown. I agree also.
    Mr. Bachus. Thank you. Mr. Brody, you mentioned 
registration with the SEC. What does that mean? In your mind, 
what is registration with the SEC?
    Mr. Brody. It gives oversight by the SEC. Let me just tick 
off some of the things that are required in registration, 
realizing that I would have the SEC go to a principles-based 
approach.
    Some of the things they do now is they require a chief 
compliance officer. They require a set of written compliance 
policies and procedures. They require a code of ethics. They 
require a filing of a public information form. They require 
independent custodian requirements, which leads to a financial 
audit, and they do on-site inspections and examinations, and 
they require retention of books and records.
    There are obviously more things, but those are key elements 
of registration that give protection to the more 
unsophisticated investors.
    Mr. Bachus. Some of you mentioned the traditional hedge 
fund and then the ones that are private equity, and then the 
ones that are leveraged that are borrowing a lot of their money 
from financial institutions.
    One thing that should be happening right now at the Federal 
Reserve, Mr. Corrigan, you were on it, is that the Federal 
Reserve should be looking at our financial institutions and 
seeing their investments. In that regard, that is already a 
regulated part of the process, is it not?
    Mr. Corrigan. It is. That is correct.
    One of the very constructive things that has happened just 
in the recent past that I might add is consistent with this 
whole notion of principles based oversight is that the Federal 
Reserve, in cooperation with the SEC, and interestingly with 
the U.K. FSA, went through an exercise, again, in a largely 
principles-based approach.
    They spent a very substantial amount of time with each of 
the major banks and securities firms that have prime brokerage 
activities, in an effort to systematically review and 
understand the nature of those relationships, out of which they 
will be developing a statement of best practices to be used 
prospectively in order for them to be able to better judge how 
individual institutions perform this function.
    This, to me, is a terrific example of adapting the approach 
to prudential oversight to the real world in which we live, and 
I think it is enormously constructive. I think it provides a 
framework for the future that can be applied in other areas as 
well.
    Mr. Bachus. My final question, if I can, Fortress 
Investment Group, which is the first IPO of a hedge fund, at 
the New York Stock Exchange, that is an example of a hedge fund 
that is being basically offered to anyone.
    Should there be maybe a different rule for that, or would 
you depend on the New York Stock Exchange?
    Mr. Corrigan. Others, I am sure, will want to comment. It 
is important to keep in mind that in the Fortress case where 
there is an IPO, by definition, as part of the IPO process. 
Fortress and the new public entity is subject to a whole 
further raft of regulations that apply to listed companies in 
general.
    Not only do they have the regulations that others talked 
about earlier, but in addition, they now are subject to all of 
those regulatory requirements as well.
    Mr. Bachus. Mr. Brody?
    Mr. Brody. There is an important distinction to make 
between a public offering of the fund and the public offering 
of the management company. In the Fortress case, it was a 
public offering of the management company. That is the entity 
that is responsible for advising the funds.
    I think, so far in the United States, we have not had 
significant, or even any, public offerings of hedge funds. In 
Europe, there have been.
    Mr. Bachus. This was the management company, not the 
participating hedge fund.
    Mrs. Maloney. [presiding] The gentleman's time has expired. 
Thank you, and I thank all of the witnesses. Coming from New 
York, I certainly appreciate the significant role that hedge 
funds have come to play in our markets and our economy.
    I want to thank the chairman for holding this hearing to 
review the growth in hedge fund activity and whether that 
growth needs additional transparency or constraints.
    Certainly, hedge funds operate in a regulatory scheme that 
has not been adjusted much to reflect their new activity. Many 
of you testified to the tremendous growth in hedge funds, the 
change in leverage, and this may well be out of date.
    The SEC is taking a few small steps to tweak the rules, 
such as raising the threshold for individual investors, but 
such investors are only a very small part of the hedge fund 
market, so these are very minor adjustments.
    I would like to go back to Mr. Brody's statement and 
support of requiring all hedge funds to register as investment 
advisors. I would like to go down the panel and see if you 
support this idea, yes or no.
    Would you support that, having Mr. Brody's strong statement 
in support of having them registered as investment advisors?
    Mr. Corrigan, would you support that or not?
    Mr. Corrigan. I would not. At this juncture, I would not.
    Mrs. Maloney. You would not. Why would you not support 
that?
    Mr. Corrigan. Because I think that the central thrust of 
the approach suggested by the President's Working Group can 
achieve what we really need to achieve.
    Many of the witnesses have suggested this idea that hedge 
funds are unregulated, and it is a bit misguided. There is a 
lot of regulation.
    I do not see any need at this point to go that distance, 
and I would emphasize, Congresswoman Maloney, that I have 
debated this thing with myself for years. What always stops me 
from going there is the so-called moral hazard problem, the 
danger that by going to that place, we effectively encourage 
people to believe that the government will protect these 
organizations, even in very dire circumstances. 
Philosophically, I am just not ready.
    Mrs. Maloney. Thank you. Mr. Chanos, yes or no?
    Mr. Chanos. No. I believe that through--
    Mrs. Maloney. Thank you. Mr. Hall, yes or no?
    Mr. Hall. No.
    Mrs. Maloney. Mr. Matthews, yes or no?
    Mr. Matthews. I think if you take public pension money, you 
should. If you do not, why should you. You are no different 
than a partnership that invests in a shopping mall, and those 
are not regulated.
    Mrs. Maloney. Thank you. Mr. Golden?
    Mr. Golden. No, I would say no. I would note that we do the 
same extensive due diligence on registered advisors as non-
registered's. It gives no real protection.
    Mrs. Maloney. Mr. Brown?
    Mr. Brown. I would say no in the current way the 
registration works because my research shows that sophisticated 
investors already understand what is in those forms. 
Unsophisticated investors either did not know or did not care.
    Mrs. Maloney. Thank you. I would like to ask anyone on the 
panel, starting with Mr. Brody, about the credit derivatives, 
the credit default swaps. They have been criticized as unduly 
risky and have raised issues of systemic risk, which regulators 
worked to resolve in the 2005 Novation Protocol.
    Maybe these credit default swaps are the canaries in the 
mine of the subprime lending which we are reading about in the 
Tsunami Daily as it unravels.
    A few months ago, the ABX Index that tracks the credit 
default swaps suggested that the subprime market was headed for 
a fall and now we have seen that is now taking place.
    Do you think the CDS investments can soften the impact on 
the markets of events such as the subprime challenge or crisis 
that we are seeing today, or do they inherently aggravate 
market swings, or are they neutral in their impact?
    Mr. Brody. Let me first make a comment on derivatives, CDS' 
and hedge funds. The reality is that these instruments are used 
throughout the investment community. They are used 
substantially by investment banks. They are used substantially 
by commercial banks. In general, these instruments serve the 
laudable purpose of dispersing risk, putting risk in many 
hands.
    However, that dispersion of risk does not prevent failure. 
We are seeing right now in the subprime market some degree of 
failure.
    Mrs. Maloney. Anyone else?
    Mr. Hall. I would be happy to comment. I agree their 
purpose is to disperse risk. I think they are really no more 
risky than the underlying investment. If you can buy the 
underlying investment, the derivative is a more efficient way 
to take advantage of that.
    It can be used as a hedging instrument and as you pointed 
out with the ABX Index, it can lead to price discovery that 
might not as readily be seen in the underlying prices of 
illiquid bonds.
    I think they are an important risk mitigator in the system.
    Mrs. Maloney. Would anyone else like to comment?
    Mr. Brown. The hedge funds are actually taking the risk 
away from the financial system. They are giving it to the high 
net worth individuals who are in the best position of society 
to afford that risk.
    The other thing is that they are such a small part of this 
business. There is a real problem, I think, in the public 
perception of seeing all the hedge funds as the same, that the 
danger is that the sins of the few will be visited upon the 
many, and if there is a problem in that little section of the 
market, it may affect public perception of the whole market.
    No. The whole purpose is to take risk away from them.
    Mrs. Maloney. Mr. Chanos?
    Mr. Chanos. I would like to make two points on that. The 
derivative swap market, which has grown dramatically, has not 
only dispersed risk but it has given us new informational 
content.
    Over and over again, we see the credit default swap market 
show us prices ahead of the rating agencies, pointing out risks 
that the market may not have completely understood.
    I would also point out that hedge funds themselves, through 
their effort of shorting the ABX market, were sending an 
important signal back in the fall that the subprime market was 
headed for problems.
    Again, this was more information, not less, for those who 
wanted to look at it and draw the proper conclusions.
    Thank you.
    Mrs. Maloney. Thank you. Yes, sir?
    Mr. Corrigan. One thing I would want to emphasize is that 
there have been several comments earlier about leverage. Most 
of those comments deal with what I think I would consider to be 
balance sheet leverage, equity to asset ratio's and things like 
that.
    Credit default swaps are in the family of what I would 
consider to be fairly complex financial instruments. One of the 
reasons why they are complex is that depending upon market 
conditions, they can have the characteristics of what I like to 
call ``embedded leverage.'' Embedded leverage is different than 
balance sheet leverage because it is a measure of how a given 
instrument, like a credit default swap, can change in value 
based on a shock.
    When we talk about these complex instruments, we have to 
recognize the distinction between balance sheet leverage on the 
one hand and so-called embedded leverage on the other.
    Having said that, I want to emphasize credit default swaps 
have been a tremendously constructive innovation for the 
financial markets generally.
    The Chairman. The gentleman from Louisiana.
    Mr. Baker. Thank you, Mr. Chairman.
    Mr. Hall, I am going to address my sort of series of 
questions to you, since you are representing an association.
    Generally, what happens within a fund, and I am not even 
going to call it a ``hedge,'' I am just going to say a private 
investment opportunity company, is of no concern to anyone as 
long as it is operating in an expected and anticipated way.
    We are dealing with a circumstance where there is an 
unanticipated loss that brings about consequences that are 
adverse financially to other parties. That is the focus of what 
we are about.
    If you limit those who participate in that activity, that 
is one way to stem the scope of adverse consequences. It has 
been mentioned by several that the current definition of 
sophisticated or qualified investors does seem inadequate.
    My observation is that a dollar figure does not necessarily 
equal sophistication, as in a young person who is the 
beneficiary of a substantial trust. They will be relying upon a 
third party to make investment decisions on their behalf, 
whether hedge fund or otherwise.
    The suitability of that person in conducting that financial 
or fiduciary responsibility is pivotal in this case. That goes 
to the pension fund question and whether the school bus driver 
ought to be exposed to some derivative transaction with 
embedded leverage.
    Beyond the question of who gets in, it is the elements that 
constitute the organizational activity of that fund itself, 
going to the question of leverage defined broadly.
    Someone in a sophisticated regulatory position needs to 
understand that leverage position so we do not have an LTCM 
like event, and I do not mean that somebody loses money.
    I mean when people showed up in the work out room, 
everybody was surprised by who was at the table, that there is 
some sense of systemic scope of what that hedge fund is engaged 
in, and that gets you to the counterparty risk.
    Although there is a counterparty risk management policy 
group that Chairman Bernanke referenced in recent testimony, 
and generally speaking, if we are going to constrain the hedge 
fund activities by limiting their access to capital, which is 
not true equity, then we really begin to sit heavily around the 
neck of these operations and potentially minimize the systemic 
risk potential that everyone seems to express concern about.
    Is there anything inconsistent with your view of market 
function about those areas of focus? Who gets in a regulatory 
responsibility to understand leverage, embedded or otherwise, 
and counterparty risk management tools to watch?
    In my judgment, registration does not work. All that does 
is just say you have a label on your door and you can still be 
a bad actor.
    Mr. Hall. I appreciate your comments and I thank you for 
addressing the question to me. I am happy to discuss this.
    I think you have isolated two very important points. 
Effectively, what is it that lawmakers have to worry about? You 
pointed out investor protection, who loses the money, and is it 
okay if it is wealthy people or retail investors.
    You make a very good point. An example that I use many 
times is that finance professors probably would not be able to 
pass the net worth test, even though they are qualified to 
invest in these instruments.
    Mr. Baker. For some folks, you could move their Bentley and 
they would not be able to find it.
    Mr. Hall. That is true. There are other wealthy people who 
should not be investing.
    I think ultimately the link between sophistication and 
wealth is really not the basis for this, even though many times 
people say that.
    The real link is who can afford to lose it. If you have a 
Bentley, you probably also have a Rolls Royce. If you lose the 
Bentley, you are still going to be okay.
    It is not the best system for determining who is 
sophisticated enough, but it is really the best we have to 
prevent things from coming across your desk that you need to 
worry about.
    The second issue, aside from investor protection, is the 
systemic risk. I firmly believe the President's Working Group 
believes is best handled at the counterparty level, through the 
banking system, the brokerage system.
    Mr. Baker. Excuse me for interrupting. Does that not 
necessitate a more standardized methodology of disclosure and a 
disclosure of values to that counterparty for them to be able 
to make appropriate judgments about risk?
    Mr. Hall. I think that already happens. I think the 
relationship between hedge funds or private investment pools 
and their prime brokers, if they are borrowing money, the prime 
brokers and the counterparties demand an enormous amount of 
information and transparency.
    Mr. Baker. What I am getting to is that methodology for 
oversight will vary from practitioner to practitioner. There is 
not some kind of standard boilerplate. If I am at Bank ``X'' 
which is generally viewed as a good management team, but their 
practices are a little weak in this arena, is there any 
advisability, not in Congress but in a regulatory overview of 
the consistency of those practices?
    That is what bothers me, not just from hedge fund to hedge 
fund, but from bank to bank. How capable are those folks in 
asking the right questions?
    Mr. Hall. My own experience is it is relatively consistent 
across the sophisticated brokerage firms and banks. The most 
important shock absorber, I think, for the system is capital. 
The capital charge against these types of loans that banks and 
brokers would make is in the regulations, and ultimately they 
will evaluate whether making a loan gets them the appropriate 
return on capital.
    I think there is a reasonably consistent methodology that 
has been put in place by the capital charges.
    Long term capital comes up a lot. Prior to Amaranth, that 
was the last big blow up in a hedge fund. We have had more blow 
up's in the stock market since then.
    The President's Working Group of 1999 pointed out that long 
term capital had enormous amounts of leverage relative to their 
peer group. They were on a plateau of their own in terms of 
their ability to get leverage, and frankly, I think the message 
is that even the banking and brokerage community overextended 
themselves to long term capital.
    Mr. Baker. My point exactly. Thank you.
    Mr. Hall. If I have answered your question, I am finished. 
Thank you.
    Mr. Baker. Thank you.
    The Chairman. The gentleman from North Carolina.
    Mr. Watt. Thank you, Mr. Chairman.
    Let me focus, if I can, on two areas. One of the witnesses 
raised the question of whether the Working Group's proposal 
about who qualifies as an accredited investor is or is not the 
appropriate definition. I cannot remember which witness it was. 
Maybe Mr. Brown, Dr. Brown.
    I wanted to follow up on Mr. Baker's question and be a 
little bit more pointed on that issue. Is that the appropriate 
level or should it be a different level?
    Dr. Brown, was it you who made that point?
    Mr. Brown. I made it, as well as another gentleman.
    Mr. Watt. Let's start with you and get the perspective of 
the other gentlemen on the panel.
    Mr. Brown. When I teach, I often have aggressive students 
who say, you know, if you are so smart, why are you not rich. 
The temptation is always to say well, how do you know I am not 
rich.
    Another possible response is you know, if you are so rich, 
why are you so stupid. Wealth and intelligence, particularly in 
investment matters, is not at all related.
    I can point to many anecdotes and many cases.
    Mr. Watt. I think I did accept the proposition that the 
monetary figure is appropriate as opposed to--how are you ever 
going to evaluate somebody's sophistication and evaluate their 
financial well being or worth or ability to lose.
    Mr. Brown. That is right. You have exactly the point.
    Mr. Watt. It is the monetary figure that I am zeroing in on 
more than the sophistication issue that Mr. Baker was zeroing 
in on.
    Is the net worth figure an appropriate figure?
    Mr. Brown. I have various thoughts about this. For a high 
net worth individual, they know what they are doing and there 
is no real business for us to be too concerned about what they 
do.
    I must confess to some concern about the level of 
involvement of pension funds and the ability of the pension 
benefit guarantee corporation and absorbing any potential 
losses that come through investing in these vehicles.
    The issue is really to look at risk, I think, and to 
understand what the financial resources are of the sponsoring 
organization of the pension, any defined benefit pension plans.
    I am concerned about that.
    Mr. Watt. Let's start with Mr. Golden and go all the way 
down. What do you say in response to the question I asked, and 
to Dr. Brown's comments?
    Mr. Golden. I commented earlier that I think the capital 
test should be raised. I do not know how high they should go. 
That is something that I think could be derived through a lot 
of conversations with the participants.
    I do wonder about this issue of assuring that people can 
afford to lose money in this. I am not convinced that any 
particular hedge fund investment is any more risky than a 
single stock investment in a single company. We do not have the 
same kind of concerns about people losing money in those 
particular investments.
    Mr. Watt. You are not advocating to lower the threshold?
    Mr. Golden. Absolutely not. I think it should be raised. 
The fact of the matter is people--we need to make the bite size 
with which they invest to be small enough that they can weather 
the storm. The diversified portfolio is a really important 
measure of protection.
    Mr. Watt. You all may need to speed up your responses if I 
am going to get all the way down the panel.
    Mr. Matthews, Mr. Hall, Mr. Chanos.
    Mr. Matthews. Personally, my feeling is that the question 
is, can you afford to lose it? That is the question that should 
be asked. I do not know what that means in terms of the level 
you set.
    Mr. Hall. That is correct. It is an issue of net worth. It 
is an issue of income. It is an issue of investing experience. 
I think actually some of my colleagues at the MFA have done 
some work and we would be happy to present you with some more 
definitive information on our recommendations.
    Mr. Watt. That is consistent with the Working Group or 
different from the Working Group?
    Mr. Hall. Consistent with the Working Group.
    Mr. Chanos. I would echo most of these comments with the 
one exception that we do have members in our Coalition who make 
the very good point that, for example, the people who were made 
very wealthy by a man named Warren Buffett, who ran his 
partnership as a hedge fund for 20 years, would not have been 
accredited investors under the standard.
    It is a good point. We have to understand that these 
numbers are arbitrarily policy driven numbers, not economic 
numbers. The industry and the proper authorities have to 
coalesce around figures that broadly represent the ability of 
investors to shoulder the risk, as my colleague said.
    Mr. Watt. Mr. Brody?
    Mr. Brody. It is probably not a bad number. It is hard to 
determine what it should be. I think nobody has great wisdom on 
this score. The number serves as an imperfect proxy for 
understanding, and the reality, as has been mentioned earlier, 
is hedge funds in general are not riskier than most other 
investments.
    Mr. Watt. Mr. Corrigan?
    Mr. Corrigan. I would raise the limit to at least what is 
being contemplated by the SEC's current proposals. These 
standards are not perfect, but they are easy to understand. We 
have standards like that in a lot of places. That is probably 
the best we can do.
    Mr. Watt. Thank you, Mr. Chairman.
    The Chairman. I thank the gentleman. I do have to interject 
for 30 seconds, as we talk about the level at which we protect 
people.
    I am going to propose with regard to the bill that we 
passed last year that prevents anybody from betting on 
blackjack, that maybe if you can invest in a hedge fund, we 
will at least let you gamble. This committee decided that we 
would protect people from gambling at all; maybe we can link 
the two.
    The gentleman from Texas.
    Mr. Hensarling. Thank you, Mr. Chairman. I certainly 
appreciate you calling this hearing. It is an important 
hearing. Clearly, I think the committee has identified several 
areas of legitimate concern.
    First, are investors possibly being misled? Do we have the 
proper level of transparency? Second, is there a legitimate 
issue of systemic risk? Third, as the gentleman from Louisiana 
has pointed out, we certainly have a concern about the 
institutional investor represented by pensions, and what could 
happen to individual pensioners, much less the American 
taxpayer who might have to bail out the PBCG.
    Having said all of that, although I am not a physician, I 
am reminded of the Hippocratic Oath; first, do no harm. It 
should also apply to Members of Congress.
    I recently came across a couple of statements of our 
present and former Fed Chairman, and apparently Chairman 
Greenspan said it would be counterproductive to directly 
regulate hedge funds.
    I know that Chairman Bernanke has been quoted as saying 
that direct regulation of hedge funds would impose costs in the 
form of moral hazard and the likely loss of private market 
discipline, and possible limits on funds' ability to provide 
market liquidity.
    My first question, which is kind of tossing the ball up in 
the air for anybody who wants to take a strike at it, is if we 
do not get the regulation right, what harm might we do, and 
particularly if you could comment on Chairman Bernanke's 
statement about possible moral hazard.
    Dr. Brown, it looked like you were reaching for the button 
first.
    Mr. Brown. There is an issue with the tendency of the 
industry to be more expanded overseas than it is here. I have 
different views on this.
    I do not hold with the view that industry is going to 
disappear any time soon. The plain fact is that other 
jurisdictions have a much more significant regulatory 
environment than we do here. I do not think there is any danger 
of this industry going anywhere very soon.
    Mr. Hensarling. Anybody else care to comment?
    Mr. Hall. The one thing to be cognizant of is if there is 
regulation that keeps hedge funds from doing their business, 
which is out of the ordinary.
    One of the great things about what I think private pools of 
capital do is they do things that are out of the mainstream, 
like investing in insurance risk after the hurricanes.
    If there is regulation and it is inappropriate regulation 
or if it overly restricts the ability to make these types of 
one off investments or out of the mainstream investments, then 
the economy will overall suffer from that.
    Mr. Hensarling. The investment capital represented by the 
hedge fund industry, just how fluid is it? Some of us have been 
concerned about certain provisions of Sarbanes-Oxley that might 
be helping drive capital to overseas markets, the number of 
IPOs that have taken place on domestic markets versus 
international markets.
    Just how easy is it to locate these investment vehicles 
overseas and if it is easy, is that something that Congress 
should be concerned about?
    Mr. Chanos?
    Mr. Chanos. I can speak personally to that, because I set 
up an operation in London a few years ago to complement our New 
York office.
    There is a lot of concern about capital moving overseas. We 
hear about this. Capital can move overseas at the flick of a 
button and does so all day long all around the world. Capital 
moves around. The bigger issue, I believe, and have told my New 
York political friends this, is the human capital that moves.
    When I set up an office in London, I am now paying people 
overseas. All of those effects of economy are benefitting the 
U.K. directly and not the United States.
    I am more worried about that and losing our competitiveness 
of keeping good people and keeping our financial primacy in the 
United States from the human side and the organizational side 
than the capital side. Capital flows very freely across borders 
all day long, 365 days a year.
    Mr. Hensarling. If I could hit the risk issue again. I 
certainly hold myself up to be no expert, but for a couple of 
years in the early 1990's, I was actually an officer in a hedge 
fund.
    It basically ran a very classic AW Jones kind of operation, 
classic stock pickers, long, short, they levered it up 2:1.
    I was able to invest in the fund as an officer, and during 
the time I was there, I discovered that our investment fund, 
number one, gave a greater rate of return to my family than my 
alternative investments at a low correlation to the market and 
had less volatility.
    I am kind of asking the question, what is wrong with this 
picture? Is there anything inherently risky, since I think it 
was Mr. Golden who said that hedge funds are not a distinctive 
asset class, it is more of a structure, is there anything about 
the structure of having a private investment vehicle that has a 
performance fee that leads these investments to be more risky 
than alternative investments that might be found in the mutual 
fund industry?
    Mr. Matthews?
    Mr. Matthews. Absolutely. It is the 20 percent performance 
fee. If you can make 20 percent on $50 million that you earned 
for your investors, that is pretty good. If you can make 20 
percent on $50 billion, that is even way better.
    The inclination is to take on more investors, more 
leverage, and greater risk to try to hit the jackpot. That is 
why hedge funds occasionally do fail, and mutual funds never 
fail. Mutual funds do not take the leverage but a hedge fund 
does.
    Mr. Corrigan. We get a little bit bogged down here because 
we use this term ``hedge fund.'' There is an enormous 
dispersion in terms of the behavioral characteristics of hedge 
funds, and in particular, the extent to which individual hedge 
funds take more risk, have higher risk profiles than other 
hedge funds.
    I think it is fair to say that if you look at the universe 
as a whole, the characterizations that have been made by 
several of the other witnesses are correct. It is not so true 
that to the extent one or more individual hedge funds are 
reaching for extraordinary returns, by definition, they have to 
be taking extraordinary risk.
    That is where the dilemma lies. How do you square the 
circle in terms of performance in general with outliers?
    I want to add, if I could, very quickly, Mr. Chairman, a 
point about Amaranth. Several people have noted that Amaranth 
worked itself out in a very, very successful fashion, and it 
did. I, like others, take a lot of comfort from that.
    In my statement, I have identified several factors 
associated with the Amaranth event which I think warrant a 
fairly high degree of caution as to how one should judge the 
Amaranth episode in a vacuum compared to a similar type of 
episode under different circumstances in the future.
    The Chairman. We will go to the gentleman from 
Massachusetts.
    Mr. Lynch. Thank you, Mr. Chairman. First of all, I want to 
thank you and the ranking member for having this hearing, and 
also thank the panelists for helping us with our work.
    To begin with, I think that we all take the position that 
the best regulation is self-regulation. As the chairman 
indicated before, it actually allows us to focus on some other 
things.
    Given the size of these hedge funds and the possibility 
that at least in the currency exchanges, there is a possibility 
of hedge funds working in concert, not necessarily 
deliberately, but their impact could be multiplied, and the 
sort of mercenary strategy, it could be good mercenaries, but 
it is definitely geared strictly to the investor, and the OPIC 
nature of these hedge funds, the secretive way in which they 
operate, it does raise some concerns in a number of areas.
    The chairman mentioned in his opening remarks the situation 
with our pension funds, and while the Amaranth work out might 
have been suitable for some, I am not sure that the pensioners 
who were affected would come to the same conclusion.
    I know that Mr. Matthews raised the possibility that it 
might be good to look at some limits, not necessarily on hedge 
funds, but on pension funds that would invest in a hedge fund, 
and maybe put some limits on either a percentage or based on 
their unfunded liabilities, their exposure. We might do that.
    The other area I am concerned about, and this goes to the 
mortgage issue and somewhat the subprime market, but in the 
area of mortgage backed securities held by hedge funds and what 
could happen if a hedge fund dumps those securities back into 
the market, putting downward pressure on those securities, what 
could happen to the distribution of capital available for 
housing.
    That is an essential good in terms of affordable housing, 
that I am concerned about.
    The last dimension of this that concerns me is I also wear 
another hat sort of ancillary to my work on this committee, and 
that is as the chairman of the Taskforce on Anti-Terrorist 
Financing. I work a lot with Treasury. I work a lot with FinCen 
and a number of our counterterrorist organizations.
    They say that it is very difficult to track and to 
scrutinize these hedge funds to make sure that the proper anti-
money laundering and anti-terrorist financing protocols are in 
place.
    That concerns me greatly, given the amount of money that is 
flowing here. I will just let the panelists take a crack at 
what might we do, with your cooperation, rather than acting 
upon the hedge fund industry, what can you give us? We would 
rather have the suggestions come from you as to ways to address 
these concerns rather than us trying to do it from whole cloth 
from this side of the table.
    Mr. Brown?
    Mr. Brown. I think first of all, you have to understand the 
international nature of this business. This body cannot even in 
principle examine the very important issues you raise about 
terrorist financing through vehicles of this kind because the 
international business is far greater than the national 
business, the U.S. domiciled business--
    Mr. Lynch. I am not talking about just us. We are working 
with the Egmont Group, which is made up of FIUs from all over 
the globe, 94 countries. I would not suggest us doing it alone; 
we would work with our international counterparts.
    Mr. Brown. Okay, great. I am also a little concerned about 
the anecdotal evidence on systemic risk that you referred to.
    My own research, for example, for the most obvious example 
is the Asia currency crisis in 1997, and the allegation that 
Mahathir Mohamad, the Prime Minister from Malaysia, made that 
George Soros had engineered the whole affair for his benefit.
    I looked at the numbers, and it turned out that the hedge 
funds actually were very risk adverse during that period and 
had pulled out of the markets, and in fact, George Soros had 
lost 10 percent, hemorrhaging 10 percent right through that 
period.
    The anecdotal evidence of massive systemic risk, I would 
argue, is just not there. Yet, a lot of central banks, in 
particular, the Australian Central Bank, were trying to get 
actively involved.
    Mr. Lynch. I appreciate that remark. If you could focus on 
the question, the pension funds. Two, mortgage backed 
securities. Three, anti-money laundering protocols that are not 
in place right now with hedge funds. If you could just address 
that question.
    Mr. Brown. I am sorry. The pension funds, I do agree there 
is an issue there and we have to examine the amount or the at-
risk status of pension funds with regard to any kind of high-
risk investment, in particular, hedge funds, and we may have to 
look at ERISA to do that.
    On mortgage backed securities, I am less concerned because 
that is not a huge amount of this business. The hedge funds are 
only involved in about 4 percent of that business. It is not a 
big thing.
    That is about all I have to say.
    Mr. Hall. If I may.
    Mr. Lynch. Sure, Mr. Hall.
    Mr. Hall. In this hearing, we have talked about Amaranth in 
2007, and long term capital in 1998, two high profile blow up's 
that were terrible for a lot of investors.
    We really have not talked at all about the fundamental risk 
of the stock market. If you look at the 2001 crash of the stock 
market, and you look at the fact that it was only recently that 
the S&P actually recovered all the losses over the last 6 
years, ultimately, it has not made much money in the last 5 or 
6 years, whereas hedge funds have actually generated positive 
returns, with much less volatility than the stock market.
    In terms of investments in hedge funds, if we look at the 
pension market, which you asked about, no one disagrees, or 
very few disagree, that pension funds should not be investing 
in common equities.
    Unfortunately, I think the reality is--I should not say 
unfortunately--I think the reality is that common equities in 
most cases may be more risky than the overall hedge fund 
market.
    The Chairman. We are going to have to wrap this up.
    Mr. Hall. In terms of the housing issue, I will address it 
quickly. I think it will probably be if a hedge fund blows out, 
as you point out, of securities, it will be another hedge fund. 
It has the flexibility to enhance their leverage and buy these 
assets and provide that shock absorber for any liquidations 
that will occur.
    The Chairman. Thank you. Mr. Shays of Connecticut.
    Mr. Shays. Thank you very much, Mr. Chairman. Again, thank 
you for holding this hearing, and I thank the ranking member, 
as well.
    Long term capital and Amaranth were both from the Fourth 
Congressional District, one from Greenwich and one from 
Westport.
    I wrestle with memories of savings and loans, and I wrestle 
with memories of when we changed the tax laws, what happened to 
real estate, and it kind of stared us in the face, and we all 
kind of knew it was going to happen. I think all of us are just 
trying to look for assurances that you will not just see 
another day like that.
    What I wrestle with is long term capital basically was 
dealt with with a proactive--as you point out, Mr. Matthews--
effort on the part of the Fed.
    How did Amaranth resolve itself, Mr. Matthews? What took 
place and why would I feel comfortable that would happen again? 
In other words, that people would buy a lesser position? What 
happened?
    Mr. Matthews. The prime broker for Amaranth, J.P. Morgan, 
the prime creditor, that had the most at stake, took over the 
natural gas portfolio and re-sold it. They made a low ball bid 
that Amaranth was forced to take because Amaranth needed to 
liquidate and pay back other creditors.
    J.P. Morgan turned around and re-sold the same positions to 
other hedge funds. Those other hedge funds provided the 
liquidity that caused it to not spread.
    Mr. Shays. The question I have, and I would ask all of you, 
is when that happens again, and it will happen again because 
there will be foolish mistakes done by foolish people or very 
smart people who do foolish mistakes, which model is most 
likely to occur, the long capital or Amaranth? Tell me what 
model is likely to occur in the future.
    Mr. Corrigan. I will take a stab at that. The answer is we 
do not know. I think one can argue about probabilities, but we 
do not know.
    As I said before, if you look at Amaranth and you contrast 
it with long term capital, the world of long term capital does 
not exist any more, in terms of the way that fund was run and 
the mesmerizing effect--
    Mr. Shays. Then let me ask you this. What is the likelihood 
then, instead of one company going under, and evidently, I 
guess they both were from Greenwich, not Westport, but what is 
the likelihood that instead of one, you would have three, four, 
or five?
    What would be the kind of circumstance that would create it 
happening for more than one company?
    Mr. Corrigan. Let's look at the characteristics of Amaranth 
for a minute in terms of why that worked out as well as it did.
    There are a couple of things that I think are very 
important. One, the instruments that were used to construct 
those natural gas trades, by today's standards, were relatively 
simple and straightforward.
    Mr. Shays. I need you to give me as short an answer as you 
can, because I have another question.
    Mr. Corrigan. The short answer is I cannot tell you the 
probability--low, but not zero.
    Mr. Shays. Let me ask you this. Are any of you concerned 
that you could have three or four companies go down at the same 
time and then would we still see the Amaranth model working out 
or would the Fed or someone else have to step in, if you had 
two or three companies go down at once?
    Mr. Brown. I think the important thing you have to note is 
the incredible diversity of the fund business. I think the 
industry is not doing itself a service in really explaining 
this to the world, and the fact that we have so focused on 
Amaranth and long term capital management and assume this is 
the whole industry--
    Mr. Shays. One answer is just diversity?
    Mr. Brown. Diversity. Incredible diversity of this business 
is a great protection, I think.
    Mr. Shays. Can anyone else give another reason or diversity 
would be the biggest?
    Mr. Matthews. Diversity and size of capital. As I point out 
in my testimony, there are three hedge funds in the United 
States alone with $30 billion or more in assets. That did not 
exist in Amaranth and long term capital's day. It just did not 
exist.
    Mr. Shays. One of my friends owns a hedge fund and they had 
three partners. They bought out one because one partner wanted 
to keep expanding and they were happy making millions and 
millions of dollars, but they did not want to keep adding 
because they did not think they could service their clients as 
well.
    I frankly thought it was remarkable. Obviously, he makes 
about $10 million a year, each of them do. It is not like they 
are suffering.
    They had a chance of making more, but they honestly could 
not service their customers as well the larger they became.
    Why is it the larger you become sometimes you cannot get as 
good a return? I do not understand that.
    Mr. Hall. If I may, the answer to that is an important part 
of the distinction between the classic mutual fund long only 
business and hedge funds. Hedge funds, because they have an 
incentive fee, they look at the opportunity set and they have 
no interest in increasing assets under management unless it is 
in fact going to yield an appropriate marginal return. When 
that marginal return decreases, they have no incentive.
    Hedge funds for years and years have been giving back 
money, closing, not taking any new money. If you contrast that 
to the long only business, frankly, they are asset gatherers, 
in my view, and they pretty much take as much money as they can 
because as they take new money, it is greater fees, but not 
necessarily greater marginal opportunities to invest in.
    Mr. Brown. I can address that issue as well. The evidence 
does show that there is some economies of scale that hedge 
funds face. Interestingly enough, if you look at funds of 
funds, there is actually economies of scale, because of the 
important due diligence function that they serve in vetting out 
the funds under their management, and the funds that have the 
greatest amount of assets under management are the ones that 
can afford to do the greatest amount of due diligence on behalf 
of the institutional clients they serve.
    Mr. Shays. Thank you. Thank you, Mr. Chairman.
    The Chairman. The gentleman from Georgia.
    Mr. Scott. Thank you, Mr. Chairman. This is a fascinating 
hearing on the evolving topic of hedge funds.
    My understanding of hedge funds, I want to make sure I am 
right on this, and if I am not, you all correct me, is that 
they are massive unregulated investment pools that are 
typically invested in only by institutional investors or 
wealthy individuals, that try to hedge the value of assets it 
holds and provides returns to investors that are not correlated 
to those of traditional stock or bond markets.
    Is that a fairly good assessment there?
    Mr. Matthews. My only correction would be they are not 
necessarily all massive. It is like the retail business. You 
have Wal-Mart, Target, and Home Depot, but you also have a lot 
of local mom and pop's, like myself.
    Mr. Scott. I am very glad that you said that, because that 
leads into my question in terms of the retail. As many of the 
particularly retail industry giants move closer to departure 
from this traditional form of long-standing traditional 
industry practices, it has somewhat created an interest and an 
apprehension for what is on the horizon for some of these 
companies.
    Let me give an example of what I am talking about. If we 
take Sears, for example, Sears is now being classified as more 
of a hedge fund over its traditional role. Granted, Mr. 
Lambert, who was the chairman of Sears, has done a great job 
for the company as far as investments and the like.
    Are you worried that more and more of our Nation's stores, 
especially retailers, will turn more to hedge funds and 
unrelated investment strategies to survive, and do you believe 
that more and more corporations whose sales are hurting will 
move in this same direction?
    Do you believe we have a worrisome trend here? This is kind 
of a lead in to that. Is there a concern that the more 
unpredictable ventures like hedge funds may lead to yet other 
problematic issues in corporations? Should they stick to what 
they were formed to do and work on inventive and further 
creative ways of bringing in the customers instead of focusing 
more on unrelated investments like hedge funds?
    Are they counting more primarily on these hedge fund 
investments over store performance, as sales decline, stores 
lose customers, and those customers are finding other places 
that address their needs or the prices.
    This way of doing business is good for shareholders, but 
what about retailers? Do you believe this will further become 
the ongoing trend, retailers taking their focus off the classic 
focus of same store growth, market share, and store spending, 
and substantial losses in the long run?
    What I am asking is the impact of this trend on some of our 
retail giants, like Sears.
    Mr. Brody or Mr. Chanos or Mr. Hall?
    Mr. Brody. I will give it a quick try. The rationalization 
of businesses really has little to do with hedge funds. What we 
see over time is that some businesses are successful and some 
businesses are not successful. Some retailers are successful 
and some retailers are not successful.
    When a retailer has ``X'' number of stores and a bunch of 
them are not successful, if the retailer is to survive, it 
needs to rationalize itself, get out of some stores, and change 
its merchandising. We have seen that in the retailing business 
and we have seen that in many, many industries in the United 
States.
    I guess what I would say is that sound management is needed 
for all businesses and it has little to do with hedge funds.
    Mr. Scott. Do you believe that down the road, some sort of 
reform will need to take place to address hedge funds with 
respect to their size and scope?
    Mr. Brody. Let me just make a comment on size. Many of the 
top 10 hedge funds by assets are terrific performers, and I 
think it just depends upon hedge fund by hedge fund, their 
management, the activities that they invest in, and each, in my 
view, in our capital system, should be free to make the 
economic choices that they do.
    Mr. Scott. Am I being over cautious or overreacting in my 
concern that a lack of transparency in the current hedge fund 
market could lead to volatility down the road?
    Am I seeing something that is not there? Is there anything 
to worry about with this move towards hedge funds?
    Mr. Brody. I think there are always plenty of things to 
worry about, not just with hedge funds, but probably everything 
else in life.
    Mr. Scott. Is there volatility?
    Mr. Brody. The hedge fund world actually has less 
volatility in the aggregate than the stock market world does, 
and Mr. Corrigan went through a very useful notion of 
transparency and transparency to whom, to the regulators, to 
the prime brokers, to those who are lending you money, to the 
institutions that are investing in you, and to the general 
public.
    I think the major point is that where the transparency is 
needed, it exists.
    Mr. Scott. Was it hedge funds that--my final question, my 
mind is foggy. Did hedge funds play a role in the situation 
regarding Fannie Mae?
    Mr. Brody. No.
    The Chairman. If the gentleman will yield to me, I think 
Fannie Mae got in trouble over their own accounting for 
derivatives. It was their own derivative investments and the 
dispute over the accounting standard that was the last straw.
    The gentleman from Illinois.
    Mr. Corrigan. Mr. Chairman, can I just see if I can help a 
little bit.
    The Chairman. Yes.
    Mr. Corrigan. I am one of the world's great worriers. I 
worry about those things, too. If you look at the size of hedge 
funds, the threat of retailers going amuck via financial 
activities, those risks really are very, very small. I 
appreciate your concern. There are more important things I 
think in this area to worry about than those.
    The Chairman. The gentleman from Illinois.
    Mr. Roskam. Thank you, Mr. Chairman.
    I just wanted to follow up briefly on what Mr. Shays was 
bringing up and to put it in a context. I apologize. I went out 
for three constituent meetings in the hallway that started with 
your testimony, Mr. Corrigan, and I came in, Mr. Brown, as you 
were clearing your throat at the end basically. I missed all 
your good stuff.
    That being said, could you comment--I will just open it up 
for anybody who has anything interesting and insightful to 
say--could you comment on the characterization of long term 
capital management, the environment where the Fed obviously 
came in and intervened, the Amaranth situation--which I think 
the best phrase today, by the way, was that it worked itself 
out. I just thought that was a brilliant nice use of language, 
that it sort of worked itself out.
    What is different today in terms of the sophistication in 
the marketplace so that we do not have to have that sort of 
intervention that we saw in the late 1990's?
    I think, Mr. Matthews, you mentioned diversification, and 
then you also referenced the size of several funds.
    Could you go further on that? I did not follow what you 
meant by that.
    Mr. Matthews. It is those two issues, diversification and 
size. Back when long term capital blew up, I think they lost 
$4.5 billion. I think that was the number.
    There were no other $4.5 billion funds around that either 
could or had the ability to or wanted to step in and help. They 
could not do it. You needed the Fed to step in.
    Today, we have three funds alone that have $30 billion each 
in the United States. There is one in London that has $60 
billion, I believe.
    There is tons of capital around. They do a lot of different 
things. They have branched into all kinds and all different 
classes of financial instruments and commodities and markets 
around the world.
    It is simply not at all the kind of environment that long 
term capital was. They were the biggest and there was nobody 
out there who could rescue them.
    Mr. Roskam. The old notion of being too big to fail is 
really the marketplace has matured since then, and now there 
are others who would be big enough to assume that market share?
    Mr. Matthews. It has. There is an issue that gets back to 
Mr. Scott's question about are they not too big or can they get 
too big.
    There is a very Darwinian factor to our business model. The 
person who runs the management firm gets 20 percent of the 
profits. The investors know this. They are paying that money. 
If they are not getting a return on that investment, they are 
out of there very quickly.
    A fund cannot keep growing forever just for the heck of it. 
The investors have to be satisfied or the money will go 
elsewhere. It is a very efficient marketplace.
    Mr. Roskam. Could someone comment on the failure of hedge 
funds? I assume it is the natural thing, right? Some flourish. 
Some diminish. They do well and they stumble, like normal, and 
we ought not overreact to hedge fund failures?
    Mr. Hall. One of the things that I think the President's 
Working Group points out is that there is responsibility on the 
part of investors themselves.
    I think there was clearly a failure in the long term 
capital situation on the part of the counterparties, but it was 
not a system wide failure. There is clearly long term capital, 
I think, arrangements that were extended credit that other 
people did not get, so it was not a systemwide problem.
    The Amaranth problem is strictly investors losing money. I 
do not think there was any threat to the system. Ultimately, 
due diligence is important and investors have to focus on due 
diligence, and keep in mind that Amaranth advertised and 
achieved extraordinarily high returns in the years subsequent 
to that.
    You get higher returns from taking high risk. Investors 
knew that going in, I would assume. If they did not know, then 
we really need to focus on the due diligence aspect.
    It is really going to be difficult to regulate the due 
diligence process, and the MFA is doing the best it can with 
creating standardized due diligence forms and processes.
    Mr. Roskam. Mr. Chanos?
    Mr. Chanos. I would like to point out that hedge funds 
actually are very fragile vehicles. I would like to amplify 
what Mr. Matthews said; 10 to 20 percent of all hedge funds go 
out of business every year. It is a very large number. They do 
not because of stupendous losses, but for the very Darwinian 
thing that he mentioned, investors are constantly looking for 
the best return in this area, even though the evidence is 
exactly the opposite, that returns have been relatively high 
with less risk in aggregate.
    However, investors are shopping for the best returns in a 
very high fee world and tend to move very quickly out of 
something that is not performing, and therefore, keeping the 
market disciplined in that way.
    Mr. Roskam. Thank you.
    Mr. Brody. I think an important thing is to make sure that 
the investors get a fair shake. I think that is what 
registration does, it surely does not guarantee investors that 
they cannot lose their money.
    Mr. Corrigan. Just very quickly on long term capital. We 
should not forget the circumstances in which long term capital 
happened. Long term capital was horribly mismanaged, the fact 
of the matter is that coming off the Asian crisis and the 
Russian crisis, that combination of circumstances in 1998 made 
long term capital a hell of a lot harder to deal with than it 
would have been had it happened in a more tranquil environment.
    The Chairman. We should make sure that there are no hedge 
funds around when we have a crisis?
    [Laughter]
    Mr. Corrigan. We are not going to be that lucky.
    The Chairman. The gentleman from Texas.
    Mr. Green. Thank you, Mr. Chairman. I thank the witnesses 
for your testimony. Our friends, it seems to me that every 
failsafe system is failsafe until it fails to be safe. And 
before long-term capital, there was no long-term capital. And 
my suspicion is that there is something else out there that we 
cannot prognosticate currently that may manifest itself, and 
then that will be the pariah paradigm that we'll have hearings 
about and talk about.
    So, it seems to me that we do have to concern ourselves 
with the taxpayers in this paradigm, because the taxpayers are 
at the very foundation of the payout, because we now have the 
commingling of sophisticated and unsophisticated capital, and 
that occurs through the pension funds.
    The sophisticated investor, as Mr. Golden said, is one that 
you may have little sympathy for. But I have a great deal of 
sympathy for the pension fund that happens to have pensioners 
who are unsophisticated investors who happen to be a part of 
this system that necessitates sophistication.
    And I might add also that sophisticated investors make some 
very unsophisticated decisions, and I think we have to be 
mindful of this. So, if the--just to take us through it, if the 
sophisticated investor puts his money in the hedge fund, that's 
great. The pension is in the hedge fund. At some point, the 
pension fails. And at this point, the person who receives his 
benefits from the pension then relies on the taxpayer, perhaps 
through some sort of social program.
    So in the final analysis, the taxpayers have a vested 
interest in what happens with funds that are supposed to be 
entirely supported by sophisticated investors. So the question 
for me becomes this, that I'd like to have each of you address. 
Do you agree, each of you, that something must be done about 
the commingling of sophisticated and unsophisticated funds? And 
I'll start with Mr. Brown.
    Mr. Brown. Thank you.
    Mr. Green. If you could start with a yes or a no. And I say 
this only because sometimes when folks finish, I don't know 
whether they've said yes or no.
    Mr. Brown. I think there is an issue, and I think that 
there are a lot of hedge fund salespeople out there who will 
tell you about S&P returns and Treasury bill risk and that you 
need to be sophisticated in terms of your ability to understand 
the markets, although--
    Mr. Green. Mr. Brown, if I may, would you then say yes is 
the answer, that there should be something done about this 
commingling of sophisticated and unsophisticated funds?
    Mr. Brown. I'm concerned about it, but I'm not sure what to 
do.
    Mr. Green. Okay. In a world where something can be done, 
would you do something?
    Mr. Brown. I think I probably would.
    Mr. Green. Okay. Mr. Golden?
    Mr. Golden. I'm not entirely sure I understand the 
question.
    Mr. Green. Well, it gets to the pensions. The pensions. The 
guy who happens to be a pipefitter who happens to have his 
pension fund invested in the hedge fund, he, by definition, may 
not be a sophisticated investor. You could have a Ph.D. and not 
be a sophisticated investor. So, he's not a sophisticated 
investor. What about him? What about the fact that the taxpayer 
eventually picks up the tab if that pension fund loses money 
and he then has to have some sort of social benefit that 
taxpayers cover?
    Mr. Golden. I think the answer is no. I think it's 
definitely no at the level of the hedge fund. I think we have 
concerns about the safety of pension funds, and we should be 
focusing attention on those who manage the pension funds, and 
seeing whether or not they are operating in a prudent fashion, 
using proper elements of diversification.
    Mr. Green. But your answer is that we should not do 
anything with reference to the commingling of the sophisticated 
and unsophisticated money?
    Mr. Golden. I guess I'm not sure that the pension fund 
money is unsophisticated, because there is a fiduciary involved 
at that point.
    Mr. Green. Well, the guy who manages the pension fund, 
we're going to assume that he's sophisticated. But the guy who 
benefits, the person who receives the pension, I think we all 
agree that the overwhelming majority of them would not be 
classified as sophisticated investors, correct?
    Mr. Golden. Yes.
    Mr. Green. All right. So they're the people who lose. And 
then the taxpayers pick up the tab. Should we do something to 
avoid that type of occurrence? And your position is you'd do it 
with the manager as opposed to with the fund itself?
    Mr. Golden. Right. Right. I agree with that. The manager of 
the San Diego pension fund that invested in Amaranth made a bad 
decision. They put too much money in Amaranth. Something people 
should be asking--the pipefitter should be asking the pension 
fund manager for San Diego why did you do that? And I--
    Mr. Green. I agree with you, sir, that the pipefitter 
should pose this question, but the problem becomes the 
pipefitter still needs the social services. He has a family; he 
has children, and they need the social services that we, the 
taxpayers, seem to provide. So we still get back to the 
taxpayer having a vested interest in what happens to the 
pipefitter who had a manager who made an unsophisticated 
decision who is a sophisticated investor.
    Mr. Golden. So--and I understand completely, and I think 
the regulation should--the concern you should have is who is 
running these funds? If they're making bad decisions regularly, 
that's a real problem. The hedge fund is just doing its job, 
and I don't know if you can regulate that.
    Mr. Green. Well, tell me this. How would you manage the 
managers such that we can do exactly what you're talking about?
    Mr. Golden. It's a great question. Off the top of my head, 
I don't know.
    Mr. Green. Does anybody have an answer? Yes, sir?
    Mr. Chanos. Aren't we really talking about an ERISA issue 
here?
    Mr. Green. Say again?
    Mr. Chanos. Aren't we really talking about an ERISA issue 
here, which is the way in which pension funds are managed and 
how those pension funds are advised? For example, self-directed 
pension plans and 401(k)s, which we be more direct to what 
you're saying, aren't investing in hedge funds.
    So really, that pipefitter is getting advice, or should be 
under ERISA, getting fiduciary responsible advice from an 
advisor, and that's always the case, for example, in our fund. 
We never talk to the underlying investor directly. There's 
always an advisor. That is where the nexus of this concern 
should be, and I think it is a really good question. But I 
think we're looking at it from the wrong side of the telescope.
    Mr. Green. Do you really think that the majority of people 
who are pension investors, they have money in pension plans, do 
you really think that the majority of these persons are 
receiving the level of advice that they need in terms of what a 
sophisticated investor is and how that impacts their 
investments?
    Mr. Chanos. Well, if they're in a defined benefit plan, 
generally, yes, they are. I don't know of any pension, large 
pension funds that have failed due to one hedge fund 
investment.
    Mr. Green. But we're not talking about the ones that have. 
We're looking to the future. Eventually we'll have that 
discussion. Thank you, Mr. Chairman.
    The Chairman. And I would also note, one of our concerns is 
the public pension funds, so that you don't have the ERISA 
rules, and that is something we'll be looking at. Mr. Campbell?
    Mr. Campbell. Thank you, Mr. Chairman. Mr. Matthews and Dr. 
Brown, both of you in your presentations talked about leverage 
in hedge funds, and I don't mean the leverage in the 
investments, Mr. Corrigan, but the actual leverage in the fund 
investment itself. Is the degree and amount of that leverage 
transparent to the investors?
    Mr. Brown. To the informed investor, there's a whole 
industry out there for people to investigate and do due 
diligence. And if I were investing--I'm not a qualified 
investor--if I were investing a substantial portion of my 
wealth, I would certainly investigate. And the investor has 
every right to demand any kind of information they need to make 
an informed decision.
    Mr. Campbell. So I guess my question is that's not 
information that is readily available to an investor so an 
investor could be, I think Mr. Matthews had talked about a 
three to one leverage fund.
    Mr. Brown. Right.
    Mr. Campbell. So someone investing in that might not know--
a sophisticated investor, I realize, or pension fund?
    Mr. Brown. My evidence is that sophisticated investors, as 
indicated by people who grant the leverage, the counterparties, 
they know and they have access to that information already, and 
it's evidenced by the fact that if you look at the ADV filings, 
and I've looked at 2,270 of them, that the sophisticated 
investors lending money already knew of the operational risk 
characteristics that were revealed in those forms. So they've 
done their homework, and the people who are lending money, and 
that's really the systemic risk concern that we have is what 
effect this is going to have on the financial system as a 
whole.
    Mr. Campbell. Does anyone else want to comment? I mean, 
just from my perspective, obviously, we're talking about 
multiplying the risk--
    Mr. Brown. Right.
    Mr. Campbell.--dramatically when you take what hedge funds 
invest in and add to that degrees of leverage. Yes, Mr. Brody?
    Mr. Brody. There's a wide range of sophistication among 
investors, and some will have a very good idea of what they're 
getting into and what the leverage is, and some will not. My 
view on the proper kind of registration is that a principles-
based registration would require the disclosure of the 
important items to all investors, and that kind of disclosure 
then would benefit the unsophisticated--
    Mr. Campbell. Do any of you disagree with that?
    Mr. Hall. Well, I'd put that in perspective. I think 
``leverage'' is too simple a term to really have a whole lot of 
meaning. If you leverage Treasury bills or if you leverage 
Internet stocks, you have--or Internet stocks without leverage 
can be significantly more risky. So I'd be concerned about 
providing rules-based disclosure as opposed to principle-based 
regulation that makes people feel comfortable but they're 
really not.
    Mr. Campbell. Do any of you believe there's a proprietary 
issue there? I mean, part of the reasons that hedge funds don't 
disclose, as you said, is because they're using oftentimes 
proprietary methods. Yes, Mr. Chanos.
    Mr. Chanos. I think there's a big proprietary issue at work 
here, and we need to make the distinction between disclosure of 
leverage and positions to our investors and our counterparties 
and our custodians, and disclosure of positions to the general 
public.
    Mr. Campbell. Right.
    Mr. Chanos. And I think that's an important distinction, 
and I think that the committee understands, but I want to 
emphasize it. But quite frankly, and I know a number of people 
in the written testimony have touched upon this, I run a fund 
in addition to being an industry person, and our investors all 
have on-site inspection ability, and they take advantage of it.
    They routinely come in, look at our books, look at our 
positions, query us over and over and over again. Talk to our 
counterparties, talk to our prime brokers. This type of due 
diligence is done all the time and increasingly so both from 
high net worth individuals, public and private pension funds. 
These people are doing their work. When we have these blow-ups, 
they are very much the exception to the rule.
    Mr. Campbell. Okay. The second question is about accredited 
investor. Do any of you, and anybody, you can answer this. 
Should that be changed? Is it right? Do you support the SEC's 
proposal to change the threshold? Anybody want to take that?
    Mr. Hall. Well, I would support it. On behalf of the MFA, 
we would support it.
    Mr. Campbell. You support the SEC's proposal?
    Mr. Hall. Yes.
    Mr. Campbell. Anybody else? I mean, do we have the right 
definition of accredited investor, or should it be changed?
    Mr. Corrigan. I think the definition is as good as it's 
going to get. There's no way to perfectly define these things.
    Mr. Campbell. And the threshold is okay?
    Mr. Corrigan. The threshold proposed by the SEC is a big 
improvement. I actually might go a little bit further, but 
that's another story.
    Mr. Brown. As one of the members said, it's not an issue of 
intelligence about such matters, it's about the degree to which 
you can afford any losses that you may incur. And that's the 
reason for that standard.
    Mr. Campbell. Okay. And then one last question.
    Mr. Golden. Can I just add?
    Mr. Campbell. Sorry.
    Mr. Golden. I'd like to see the threshold raised as high as 
is politically feasible, at least as high as the SEC's.
    Mr. Campbell. And one last little question for Mr. Chanos. 
We talked about this fortress company that went public and you 
said it was the management of the hedge fund. I'm just curious. 
People access the public markets for capital. Why would a 
manager of a hedge fund require capital?
    Mr. Chanos. Well, I think that it's not only for requiring 
capital but to possibly use their stock as currency for 
possible acquisitions, or to incentivize their senior and mid-
level people perhaps through stock options. There are all kinds 
of reasons why companies go public that don't necessarily need 
the capital, so I think that's sort of a broader issue, perhaps 
beyond the purview of this panel.
    Mr. Campbell. All right. Thank you. I yield back, Mr. 
Chairman.
    The Chairman. Thank you. I did just want to add one thing 
to Dr. Brown and the very useful and interesting questions Mr. 
Campbell is asking about what people know. Did I read you 
correctly as basically saying that even if you tell them, they 
don't pay any attention, they just chase returns? I mean, is 
that an accurate statement?
    Mr. Brown. That's an accurate statement.
    The Chairman. So that you tell them that, but they don't--
even the sophisticated ones, don't factor into account and 
just, as you say, chase returns?
    Mr. Brown. That's what the evidence seems to suggest. 
Either they don't know the information and they can't have 
access to it, which I find rather unusual, or they do have 
access to it and it's immaterial.
    The Chairman. The gentleman from Missouri.
    Mr. Cleaver. Thank you, Mr. Chairman. I just have one 
question for the entire panel. Mr. Chanos, you earlier brought 
up Warren Buffett and his hedge fund history. He's fond of 
using the adage in describing hedge funds if a man with money 
proposes a deal to a man with experience, the man with money 
ends up with the experience and the man with the experience 
ends up with his money.
    That's kind of the theme of what's been going on, and Mr. 
Buffett has become very critical of the hedge fund fee 
arrangements, as you may or may not know, and he calls the 
managers the 2 and 20 crowd. And I frankly think that he raises 
some very pertinent issues. How would you characterize the 
fairness and the accuracy of Mr. Buffett's comments?
    Mr. Chanos. Well, I don't want to put words in Mr. 
Buffett's mouth, but I--
    Mr. Cleaver. No, I'd like to give an exact quote. Hold on 
just a second. ``It is a lopsided system whereby 2 percent of 
your principal is paid each year to the manager even if he 
accomplishes nothing, or for that matter, loses you a bundle 
and additionally, 20 percent of your profit is paid to him if 
he succeeds, even if his success is due simply to a rising 
tide.''
    Mr. Chanos. All right. Well, I think those, while factually 
accurate, and he's entitled to his opinion, I would point out 
Mr. Buffett ran a hedge fund for 20 years, just about.
    The Chairman. Well, it takes one to know one.
    [Laughter]
    Mr. Chanos. So, again, perhaps he's speaking from personal 
experience, I don't know. But every hedge fund is different. 
Every business is different. Everything should be judged on the 
merits of its management team, its performance, and its fee 
structure, and to make blanket statements about every single 
hedge fund, something like that seems to me to be a bit strong. 
It's like saying, well, all of corporate America is not 
performing well for its shareholders, or every corporate 
executive is making too much money.
    I mean, these are individual cases, and I think that while 
there's plenty of examples of hedge funds that aren't probably 
doing a good job and are charging fees that are too high, as 
one of my panelists said here that this market is pretty 
Darwinian, and it weeds out those people pretty quickly. If 
you're not performing, you don't tend to keep those assets very 
long.
    Mr. Cleaver. So the 2 and 20 crowd is actually a small 
crowd?
    Mr. Chanos. It's not a small crowd. In fact, it's a growing 
crowd.
    Mr. Cleaver. Or is it the in crowd?
    Mr. Chanos. But there's a reason it's growing, Mr. Cleaver, 
in that there is a reason. No one here has asked the question, 
why are we having this--because of the growth of the industry, 
obviously something must be happening here where relatively 
sophisticated investors want to put more money with these 
managers. It's not because simply they're hanging out a shingle 
in front of their house. There is good performance being done 
with less risk. That's why it's attractive in the aggregate. 
But individually and specifically, there will always be, as one 
of our members said, the fools and the frauds are going to make 
things difficult for most of the good actors.
    Mr. Hall. If I may, it's important in my view, a semantic 
issue about the 2 percent of the 2 and 20 is on capital. And 
that doesn't, if you look at--if someone manages $100 million 
and takes a smaller fee, but 90 percent of their fund is 
coincident with the index, then they're really--their marginal 
benefit is only on a small portion of that $100 million, $100 
billion.
    So a hedge fund may manage a smaller amount of capital and 
charge a higher fee on a smaller amount of capital, then they 
also manage leverage, they manage short positions, they manage 
hedges. So, you really have to look at the services that one is 
providing for that fee, and percentage of fee on capital is not 
necessarily what the manager is ultimately getting compensated 
for.
    Mr. Brown. I need to make one clarification point on the 2 
and 20 issue. You only earn the 20 once you've won back any 
losses that you've incurred in the past. It's called a high 
water mark provision.
    It's that high water mark provision that really enforces 
the Darwinian aspect of it, and, in fact, hedge funds are like 
radioactive substances. They have a half-life of 2\1/2\ years, 
typically, because, you know, you lose, you lose, you die in 
this world very quickly because you just aren't earning any 
returns.
    Mr. Cleaver. I yield back my time.
    The Chairman. Thank you. Let me just ask two quick 
questions. One, we will be talking next time about--we were 
talking about how these things should run and do run in 
general. There are always aberrations with anything. The 
insider trading issue is one of the issues that we will be 
looking at next time, the SEC has been involved in.
    One of the questions is, record retention for entities that 
are otherwise unregulated. Is that an issue? Should we look at 
that? That is, over and above everything else, there is an 
argument for record retention to be able to help law 
enforcement for the aberrant cases. I'd be interested in any 
comments.
    Would there be objections to some kind of record retention 
requirement that for those--and I realize a lot of them already 
have them, because they're otherwise regulated. But would there 
be any objection to a generalized sort of record retention 
requirement for entities that otherwise didn't have them? Mr. 
Chanos?
    Mr. Chanos. I don't think our members would have--we have 
not canvassed them, but I don't think our members would have a 
problem with that.
    The Chairman. Mr. Hall?
    Mr. Hall. I think we would have no objection.
    The Chairman. All right. I'm quitting while I'm ahead. The 
next question is one of the ones that some of the staff have 
suggested, and that is on the counterparty issue, the--who's in 
charge of the aggregates? I mean, obviously, you have each 
individual counterparty, but is anybody looking at the 
aggregate counterparty responsibility, and is that something 
that somebody should be looking at? Mr. Corrigan?
    Mr. Corrigan. That--the short answer to that is no, 
because--
    The Chairman. Nobody's looking at it or nobody should look 
at it?
    Mr. Corrigan. Well, we should look at it, and we are making 
efforts through the regulatory process to better look at it 
through the regulated institutions, yes. But it's not easy.
    The Chairman. Again, would there be objection if there was 
a way to do that that did not impinge on proprietary concerns?
    Mr. Brown. I would agree with that.
    The Chairman. Mr. Chanos? Yes?
    Mr. Chanos. Let me just point out. We could look across the 
pond to our financial cousins in the United Kingdom who have a 
very interesting process through their FSA. Their FSA, it's my 
understanding, occasionally canvasses all of its major prime 
brokers and then canvasses them separately in relation to their 
specific hedge fund exposure and looks for cross--
    The Chairman. So that would be a good thing to do?
    Mr. Chanos. I think it would be--
    The Chairman. Well, good. If the FSA is-- Mr. Corrigan?
    Mr. Corrigan.--here, too, right now.
    The Chairman. What's that, Mr. Corrigan?
    Mr. Corrigan. We do that right now here.
    The Chairman. Well, we might want to improve on that. These 
days if the FSA is doing it, one of the great passionate love 
affairs in the world today is between the American financial 
community and the FSA, except where it comes to executive 
compensation.
    I understand no love affair is perfect, and the lover may 
have a blemish. And in fact, McCarthy was here the other day 
and said, yes, he is enjoying being the flavor of the month 
through the FSA. So both of those are areas I think we would 
pursue.
    If you'll indulge us, the gentleman from Louisiana had one 
last question.
    Mr. Baker. I thank you, Mr. Chairman. Mr. Corrigan, I went 
back and looked at the written statement relative to Amaranth, 
and what I drew from your comments was had Amaranth occurred in 
an illiquid market, or where there was a crowded trade going 
on, the unwinding of it all may have been less pretty.
    Mr. Corrigan. That's correct.
    Mr. Baker. And so the cautionary tale was, although we 
escaped it, let's not assume our system is functioning exactly 
as we would like to that end. I just wanted to do a quick wrap-
up of sort of the elements I've drawn from this. Limitation on 
who gets in needs to be reviewed whether it's the individual's 
net worth standard, or whether it's pension fund management 
capability. And I'm adding one to the list which I don't think 
I've heard, and that is limitations more restrained on the fund 
of funds, the $25,000 entry fee into that, I think, is highly 
inappropriate in today's world.
    Then establishing a benchmark of best practices, not only 
for the private investment company side, but--and I'm asking 
here--but shouldn't we do that as well on the counterparty side 
with the broker-dealer community, financials, insurance, 
whoever is playing with these guys needs to be required. And 
then last would be some sort of formal and/or informal 
exchange. For example, I'm not clear today, if I'm the 
counterparty and I see something that I think is ill-advised, 
when am I obligated to notify my regulator as to the hedge fund 
conduct, not my conduct, which I think is a lower standard of 
responsibility?
    If we were to address those issues, do you feel that is an 
appropriate litany of steps to take in light of the relatively 
low systemic risk potential we think is likely to be in the 
near term?
    Mr. Corrigan. I think the list is approximately right, and 
so long as we do it in a way that honors this more principles 
based as opposed to checking boxes approach, I think that's 
right.
    Mr. Baker. Thank you. Anybody want to comment? Mr. Hall?
    Mr. Hall. I would agree with that.
    Mr. Baker. Great. Thank you very much, Mr. Chairman.
    The Chairman. I thank you all. This is very useful in 
advancing our understanding, and the hearing is adjourned.
    [Whereupon, at 12:43 p.m., the hearing was adjourned.]


                            A P P E N D I X



                             March 13, 2007


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