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




 
                     HEDGE FUNDS AND SYSTEMIC RISK:
                   PERSPECTIVES OF THE PRESIDENT'S
                   WORKING GROUP ON FINANCIAL MARKETS

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

                                HEARING

                               BEFORE THE

                    COMMITTEE ON FINANCIAL SERVICES

                     U.S. HOUSE OF REPRESENTATIVES

                       ONE HUNDRED TENTH CONGRESS

                             FIRST SESSION

                               __________

                             JULY 11, 2007

                               __________

       Printed for the use of the Committee on Financial Services

                           Serial No. 110-48


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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             JIM GERLACH, Pennsylvania
ALBIO SIRES, New Jersey              STEVAN PEARCE, New Mexico
PAUL W. HODES, New Hampshire         RANDY NEUGEBAUER, Texas
KEITH ELLISON, Minnesota             TOM PRICE, Georgia
RON KLEIN, Florida                   GEOFF DAVIS, Kentucky
TIM MAHONEY, Florida                 PATRICK T. McHENRY, North Carolina
CHARLES WILSON, Ohio                 JOHN CAMPBELL, California
ED PERLMUTTER, Colorado              ADAM PUTNAM, Florida
CHRISTOPHER S. MURPHY, Connecticut   MICHELE BACHMANN, Minnesota
JOE DONNELLY, Indiana                PETER J. ROSKAM, Illinois
ROBERT WEXLER, Florida               KENNY MARCHANT, Texas
JIM MARSHALL, Georgia                THADDEUS G. McCOTTER, Michigan
DAN BOREN, Oklahoma

        Jeanne M. Roslanowick, Staff Director and Chief Counsel



                            C O N T E N T S

                              ----------                              
                                                                   Page
Hearing held on:
    July 11, 2007................................................     1
Appendix:
    July 11, 2007................................................    41

                               WITNESSES
                        Wednesday, July 11, 2007

Overdahl, James A., Chief Economist, U.S. Commodity Futures 
  Trading Commission.............................................    15
Sirri, Erik R., Director, Division of Market Regulation, U.S. 
  Securities and Exchange Commission.............................    17
Steel, Hon. Robert K., Under Secretary for Domestic Finance, U.S. 
  Department of the Treasury.....................................    12
Warsh, Hon. Kevin M., Member, Board of Governors of the Federal 
  Reserve System.................................................    14

                                APPENDIX

Prepared statements:
    Overdahl, James A............................................    42
    Sirri, Erik R................................................    49
    Steel, Hon. Robert K.........................................    61
    Warsh, Hon. Kevin M..........................................    67

              Additional Material Submitted for the Record

Frank, Hon. Barney:
    Financial Times article, dated July 10, 2007.................    80
    Article from Moody's Investors Service.......................    81
Bean, Hon. Melissa:
    Responses to questions submitted to Erik Sirri...............    85
    Responses to questions submitted to Hon. Robert K. Steel.....    88
    Responses to questions submitted to Hon. Kevin M. Warsh......    90
    Responses to questions submitted to James A. Overdahl........    93


                     HEDGE FUNDS AND SYSTEMIC RISK:
                    PERSPECTIVES OF THE PRESIDENT'S
                   WORKING GROUP ON FINANCIAL MARKETS

                              ----------                              


                        Wednesday, July 11, 2007

             U.S. House of Representatives,
                   Committee on Financial Services,
                                                   Washington, D.C.
    The committee met, pursuant to notice, at 10:04 a.m., in 
room 2128, Rayburn House Office Building, Hon. Barney Frank 
[chairman of the committee] presiding.
    Members present: Representatives Frank, Kanjorski, Waters, 
Maloney, Watt, Meeks, Capuano, Clay, McCarthy, Baca, Lynch, 
Scott, Green, Cleaver, Sires, Hodes, Klein, Mahoney, Boren; 
Bachus, Baker, Pryce, Castle, Royce, Shays, Capito, Feeney, 
Hensarling, Garrett, Brown-Waite, Neugebauer, McHenry, 
Campbell, Bachmann, and Marchant.
    The Chairman. The hearing will begin. This is a hearing of 
the Financial Services Committee with the members of the 
President's Working Group, which I guess is about 20 years old. 
And it is part of a series of hearings we are having on the 
issue of hedge funds and private equity, the increase in the 
amount of financial activity that goes through.
    We had a hearing earlier with some of the representatives 
of hedge funds themselves. We will continue to deal with this 
and we are pleased to have the President's Working Group before 
us.
    I think, as I read the testimony, we have a kind of uneasy 
consensus that there is a potential problem here that we wish 
we were more sure about how to approach. I, for instance, read 
with great interest the speech by Assistant Secretary Ryan of 
the Treasury a couple of weeks ago. I don't think anybody can 
be confident that all is entirely well here, but neither is 
there any obvious thing we ought to be doing.
    This is a matter for concern. It is an interesting issue in 
that it's a challenge to our regulatory system both within the 
United States and internationally. I mean the fact that we have 
a wide range of entities here, we have two quasi-independent 
commissions, and we have the Treasury and the Federal Reserve 
all with pieces of this.
    We have obviously a very important interface with the 
international community, and I know that people don't generally 
believe this, but it is the case that sometimes, not often, I 
acknowledge, but sometimes, congressional committees have 
hearings because they want to know things. That's not the norm, 
but it is true today.
    This is a subject of great importance and considerable 
uncertainty. There is obvious value to the activity of these 
entities. The market is not irrational. People profit because 
they are doing things that are ultimately beneficial, but there 
are also potential dangers.
    In particular from this community standpoint I think, not 
all of us but most of us, is the potential for systemic risk. 
We are not here largely in an investor protection capacity. 
Particularly after what the SEC has done, we are not talking 
about small investors.
    There is one exception to that. There is a great deal of 
concern about the potential for pension funds to get involved 
beyond what they should be doing. And I've talked to the 
chairman of the Committee on Education and Labor, Mr. Miller, 
who has jurisdiction there. We are going to be working at--one 
of the things we have to address is whether or not there should 
be some special rules regarding pension funds.
    But beyond that, the question is systemic risk. The 
question is whether, given the proliferation of forms of 
investment that have high leverage, whether or not if there is 
a rapid change in the basic financial environment, people will 
be able to deal with the consequences. So far, there have been 
some good signs.
    The Amaranth situation was a problem for people for whom it 
should have been a problem but it did not have broader systemic 
problems. It does not appear so now, but we'll be interested in 
people's sense of whether the Bear Stearns issue is going to be 
something that causes broader problems. But those have happened 
within a stable financial context.
    The question, I guess, is what happens if the current 
financial context regarding international liquidity and 
interest rates were to change. And I don't think anyone thinks 
that's going to remain forever in both contexts. So what we are 
talking about is, are we now ready to deal with a potential 
problem, and if so, what should we be able to do about it and 
how do we get ready to do that without causing some damage?
    So as I said, I regard this as a study that's ongoing, and 
I'm glad to say that it has been a collaborative one between 
the Congress and the various regulators and it's good to see 
them working together on this. And as I said, we are here to 
learn some things and to talk about things in general, and this 
is part of a continuing inquiry into this problem which is we 
have quantitatively, and as Marx said, ``Changes in quantity 
can become changes in quality.'' We have what could be a 
qualitative change in the extent to which investment is carried 
on.
    Our question is, does that pose potential problems, and is 
the regulatory structure adequate to this new set of issues. 
That's what we will be dealing with. I'll now recognize for 5 
minutes the ranking member of the committee, the gentleman from 
Alabama.
    Mr. Bachus. I thank the chairman. I thank you for holding 
this hearing.
    This is the third hearing we've held on the rapid growth of 
private pools of capital including hedge funds and private 
equity funds. I'd also like to associate myself with the 
remarks of the chairman when he said that we're unsure about 
what to do, and we're not confident about any action that we 
may take at this time.
    So that is, as he said, a clear indication that we ought to 
be listening, we ought to be learning, but we should not be 
taking legislative action. What we are doing, I think, is very 
appropriate. We're talking with each of you, your agencies, and 
we're confident that the regulators appreciate the problems and 
we're also confident that you know more about it than we do.
    We're really fortunate to have with us our four witnesses 
today. They are distinguished representatives of the 
Presidential Working Group on Financial Markets.
    And the President's Working Group, as you all know, but the 
audience may not know, was formed in the wake of the 1987 stock 
market crash. It is chaired by the Treasury Secretary, and it 
is made up of the Chairmen of the Federal Reserve, the 
Securities and Exchange Commission, and the Commodity Futures 
Trading Commission. It was formed to promote integrity, 
efficiency, orderliness, and competitiveness in our financial 
markets.
    Since then, it has issued periodic reports on these issues 
affecting the U.S. markets including the 1999 report on Long 
Term Capital Management.
    Earlier this year the President's Working Group endorsed an 
approach to hedge fund regulation that relies primarily on 
market pressures and incentives to contain risks. The group 
concluded, correctly in my opinion, that market discipline 
together with statutory limits restricting access to hedge 
funds to wealthy investors can sufficiently mitigate industry 
risk.
    By emphasizing the importance of free market forces, rather 
than the hand of excessive government regulation, I believe 
that the President's Working Group struck the right balance in 
regulating and overseeing the activities of these highly 
innovative investment vehicles.
    Hedge funds and private equity funds have in recent days, 
as we all know, become convenient targets for those favoring 
higher taxes and more government intervention in our capital 
markets. While this is certainly a debate worth having, I hope 
that it will be an informed debate, informed by the 
appreciation for the vital role that these private pools of 
capital play in an efficiently functioning market and their 
importance in maintaining America's competitive standing in the 
global economy.
    Hedge funds actively pursue arbitrage opportunities across 
markets, and in the process often reduce or eliminate 
mispricing of financial assets. That actually can bring 
stability to a market.
    As former Federal Reserve Chairman Alan Greenspan said, 
``Their willingness to take short positions can act as an 
antidote to the sometimes excessive enthusiasm of long-term 
investors. Perhaps more importantly, they often provide 
valuable liquidity to financial markets both in normal market 
conditions and especially during periods of stress.
    ``They can ordinarily perform these functions more 
effectively than other types of financial intermedia because 
their investors often have a greater appreciation for risk and 
because they are largely free from regulatory constraints on 
investment strategies.''
    Private equity funds offer tools for providing capital and 
expertise to underperforming companies and companies struggling 
with the tremendous pressure of the public markets to meet 
quarterly earnings expectations in order to improve corporate 
performance. Private equity funds recruit top managers and 
directly tie compensation to long-term performance and growth. 
They develop strategic business plans and implement operational 
improvements to revitalize these companies in a manner that can 
only be achieved when the firm's owners are directly and 
actively engaged in its management.
    Let me conclude by saying that hearings like the one we're 
having today are important because they allow Members of 
Congress to better understand the industries and markets we 
oversee. If Congress attempts to regulate or tax any specific 
sector of the financial services industry without a thorough 
understanding of the role it plays in our financial system the 
risk of unintended, unnecessary, burdensome and harmful 
regulation is real. The last thing we want to do is drive 
investment--whether it's hedge funds or private equity funds--
and their capital offshore.
    So I again commend Chairman Frank for his attention to this 
issue, and I welcome our distinguished guests.
    The Chairman. Next, the gentleman from Louisiana, Mr. 
Baker, is recognized for 4 minutes.
    Mr. Baker. Thank you, Mr. Chairman, and thank you, Ranking 
Member Bachus, for the time. I have some significant questions 
about where we stand with this matter.
    From the President's Working Group recommendations of April 
1999, there were at that point in financial history some 
observations I think worthy of reviewing. The Working Group 
recommendations at that moment emphasize the promotion of sound 
risk management practices by all market participants and to 
allow individual market participants therefore to make more 
informed investment and credit decisions.
    So the message in 1999 was to the market, get your act 
together so people can make informed decisions. I think some 
assessment of what has taken place from 1999 until now on the 
market side of the fence might be instructive for the committee 
to hear in light of the fact of market factors that have 
changed rather dramatically since 1999.
    There was legislation that was filed pursuant to the 1999 
report, H.R. 2924, implementing the Working Group 
recommendations, requiring, interestingly enough, the largest 
unregulated funds to disclose certain public information which 
was nonproprietary, including a new meaningful measurement of 
risk.
    I also note that the internationally generally accepted FSA 
regime does require the larger funds to make such disclosure of 
nonproprietary information to enable governmental regulators to 
assess not only leverage, but the potential for systemic risk 
events. Consistent with the 1999 Working Group, H.R. 2924 did 
not call--and I can't make this any more clear--for direct 
regulation, but instead provides for enhanced public disclosure 
by only those funds that, if large enough, if one were to fail, 
that failure could potentially pose systemic risks to those 
innocent third parties.
    That set of findings and comments were made by Mr. Sachs, 
who was then the Assistant Secretary for Financial Markets for 
the Department of the Treasury. Mr. Patrick Parkinson's 
comments, who was an Associate Director, Division of Research, 
for the Federal Reserve, went on to say that there was strong 
support for the 1999 Working Group recommendations and that the 
very largest funds should be required to publicly disclose 
information about their financial activities.
    The only modification to H.R. 2924 suggested by the Fed at 
that time was that the disclosure should be made to the SEC 
rather than the Federal Reserve Board because of the SEC's 
broader responsibilities in the field of public disclosure.
    My point is that from 1999 until now, it is not only the 
explosive growth in the number of funds, but the enormity of 
growth in individual's funds. The advent of the fund of funds, 
which enables the $25,000 investor to take on risks that were 
intended for sophisticated, qualified investors and that 
pension funds now, as a matter of practice, routinely invest in 
funds for which I do not believe fund managers necessarily are 
adequately equipped to assess the risk for which the third 
parties they represent are undertaken.
    I foresee a circumstance in which an Amaranth matter might 
lead to significant upheaval in State pension funds of some 
region. I can think of several in my own State that have 
displayed significant inadequate governance capabilities that 
would then lead to a school teacher or a fireman or a policeman 
to find their reserves for retirement dissipated because the 
fund manager did not fully understand the counterparty risk 
that the hedge fund investment really represented.
    I don't have a remedy for this problem, but I have an 
observation about what the recommendations may mean if not 
fully heeded by the market, if the 2007 Working Group 
recommendations and that message is not fully received. And I 
have concerns because the message was sent in 1999, and I don't 
know that market discipline has yielded any regulatory 
constraints in market practice. Should we have one of those 
undesirable events I read from the 1999 Working Group report, 
page 26, ``Generally government regulation becomes necessary 
because of a market failure or the failure of pricing 
mechanisms to account for all social costs. Government 
regulation of markets is largely achieved by regulating 
financial intermediaries who have access to the Federal safety 
net, the banks, that play a central dealer role or that raise 
funds from the general public. Any resort to governmental 
regulation should have a clear purpose and be carefully 
evaluated in order to avoid unintended consequences.''
    I think here my cautionary note is if self-regulation in 
the market does not work, and we have an untoward event, the 
resulting actions of this Congress will be very unhelpful to 
the market at large. This is no casual warning. This is a plea 
for the market to act, and if they do not, the consequences are 
very undesirable.
    Thank you, Mr. Chairman.
    The Chairman. The gentleman from Pennsylvania is recognized 
for such time as he consumes.
    Mr. Kanjorski. Thank you very much, Mr. Chairman.
    First of all, let me thank the chairman and ranking member 
for commissioning this hearing. It is certainly a topic in 
which all of us are interested, and I think that we have 
labored in the forest together with Mr. Baker over the years to 
get some information and enlightenment.
    From my perspective, I look forward to hearing a real 
definition of a hedge fund. I understand that you all have 
defined it today so that I will be able to clearly understand 
the entity with which we are dealing.
    But in all seriousness, the difficulty lies in defining 
what a hedge fund is and the import of how it operates in the 
marketplace; I myself am not worried about protecting 
individuals of high net worth or constricting their right to 
invest and participate in helping the marketplace to level the 
field and provide the liquidity that is necessary out there.
    On another point, I am disturbed about potential systemic 
risk and particularly about the great deal of financing that 
comes out of federally insured institutions. This leveraging 
could cause risk to the government or systemic risks to the 
system. I think we are going to rely on the testimony of this 
group today to see where we are headed and what the Congress 
should do in response to some of the existing problems out 
there.
    But, I would also agree with Mr. Baker: We hope self-
regulation can be the order of the day. However, if it fails, I 
hope we do not hear the cry that we have over-regulated because 
the Congress will be called upon to move in very swiftly and 
very deeply into a control situation. We hope that is not 
necessary.
    I look forward to the Working Group's report to the 
Congress today, and I look forward to working with them in the 
future.
    Thank you, Mr. Chairman.
    The Chairman. The gentleman from Delaware is recognized for 
2 minutes.
    Mr. Castle. Thank you, Mr. Chairman. I thank you and the 
ranking member for holding this hearing, and I agree with your 
comments, those of the ranking member and everybody else who 
has spoken, particularly Mr. Baker, with respect to pension 
funds and their investments.
    This Working Group has already indicated the tremendous 
influence hedge funds have on our markets. The hedge funds have 
more than doubled in the past 5 years, growing to over 9,000 
hedge funds. Since your last study in 1999, the industry has 
grown by more than 400 percent, now totaling nearly $2 
trillion. And the combined assets of the 100 largest hedge 
funds represent about 65 percent of the total industry.
    Secretary Steel further explained the vast amount of 
trading volume hedge funds are generating. It is speculated 
that they may represent up to 50 percent of trading in 
particular instances, which is something to think about. The 
group also discussed how institutional investors like pension 
funds constitute more than half of the investments in hedge 
funds.
    With pension funds placing more of their money in hedge 
funds, American workers, retirees, and other average investors 
may unknowingly be exposed to hedge fund losses. The 
President's Working Group recommended that investors in hedge 
funds gather necessary information regarding the fund's 
strategies, terms, conditions and risk management to make 
informed investment decisions and perform due diligence, yet 
hedge funds are not required to disclose this information.
    I am concerned with this lack of transparency because the 
manager of a pension fund cannot fulfill their fiduciary duty 
and may not understand the risk to their investments to perform 
due diligence before committing funds. The lack of transparency 
in the industry may also pose systemic risk. The long-term 
capital management incident showed how overexposure of 
counterparties had the potential to cause systemwide damage to 
financial markets.
    After LTCM, the Working Group recommended the very largest 
hedge funds be required to disclose information about their 
financial activities, including meaningful and comprehensive 
measures of market risk. The Working Group now concludes that 
no government agency needs any information about hedge fund 
activities and that we can rely on hedge fund investors 
themselves to protect the markets from systemic risk.
    It is unclear to me why the Treasury now appears a lot less 
cautious than they were in 1999 since the industry has grown 
considerably. More recently the New York Federal Reserve has 
repeatedly warned that hedge funds pose the largest risk since 
the LTCM crisis and Treasury officials have forewarned 
financial institutions about hedge fund vulnerability.
    There are many instances of pension fund involvement now. 
And the bottom line is that while I don't know the answers 
either, as the chairman and ranking member indicated, I do 
think we need to be looking very carefully at what we are doing 
here. I yield back the balance of my time.
    The Chairman. The gentlewoman from California for 2 
minutes, or as much time as she consumes.
    Ms. Waters. Thank you very much, Mr. Chairman and members. 
I want to thank Chairman Frank and Ranking Member Bachus for 
holding the second in a series of hearings on the issue of 
hedge funds.
    These hearings are designed to examine the emerging role of 
hedge funds and private equity pools in the United States and 
global markets. Indeed, this is a timely hearing because I have 
become somewhat fascinated by hedge funds and their dramatic 
growth over the last several years.
    The estimate suggests that hedge funds have grown in number 
to more than 9,000--double what they were just 5 years ago. The 
assets have also grown by some 400 percent to $1.4 trillion.
    The primary purpose of hedge funds is to reduce volatility 
and risk while attempting to preserve capital and deliver 
positive returns under all market conditions.
    Have the funds grown because they are the most flexible 
investment tool in today's volatile financial system? I ask 
this question because in the past few months it has been 
revealed that a number of hedge funds are heavily invested in 
mortgage backed securities related to subprime loans.
    According to the New York Times, the Bear Stearns Company, 
an investment bank, pledged up to $3.2 billion in loans to bail 
out one of the hedge funds that was collapsing because of bad 
bets on subprime mortgages. It is the biggest rescue of a hedge 
fund since 1998 when more than a dozen lenders provided $3.6 
billion to save Longterm Capital Management.
    Unfortunately, it is precisely this type of investment 
activity that raises concerns in the marketplace. I'm sure that 
we have just seen the tip of the iceberg as it relates to 
subprime lending, 2.2 million defaults, according to some 
estimates, by next year.
    Interestingly, some hedge fund strategies are designed to 
capitalize on these negative conditions in the market. So what 
are the cost benefits associated with hedge fund activity in 
the United States and in the global economy?
    I thank you and I look forward to hearing our witnesses 
today. I yield back the balance of my time.
    The Chairman. The gentleman from California, Mr. Royce, is 
recognized for 3 minutes.
    Mr. Royce. Thank you very much, Mr. Chairman.
    The Chairman. Before the gentleman begins, let me just say 
to the people here that we have a limited number of opening 
statements. We have about 10 more minutes of opening 
statements, so I do want to reassure people that we will get to 
you.
    The gentleman from California.
    Mr. Royce. Thank you, Mr. Chairman, and thank you for 
holding this hearing on hedge funds and the effect on our 
capital markets that they have. I'd also like to commend the 
members of the President's Working Group for their work on this 
issue.
    The role of hedge funds clearly continues to evolve, and as 
you've mentioned, the hedge funds have experienced incredible 
growth--the numbers I've seen, from $50 billion in assets in 
1988, to today totaling over $1 trillion. While both the size 
and scope of these private pools of capital have changed over 
the years, their unique ability to bring significant benefits 
to the financial markets still remain.
    The varying strategies utilized by hedge funds, which 
results in additional liquidity, has helped the U.S. financial 
markets become the deepest and most liquid markets in the world 
today. The ability of hedge funds to target price 
inefficiencies between markets has also proven to be a useful 
tool that has resulted also in more efficient markets.
    Furthermore, their ability to transfer and distribute risk 
allows market participants to more easily manage the level of 
risk held on their portfolio. While the broader financial 
system has gained from the presence of hedge funds, an inherent 
risk will always accompany those private pools of capital that 
we call hedge funds.
    Banks and other depository institutions that choose to 
extend credit or choose to be counterparties to hedge funds 
must make well-informed, sound business decisions. Regulators 
with authority over banking systems should focus their 
attention on preventing the institutions which they oversee 
from taking on excessive risk. If market discipline and prudent 
risk management is practiced, the likelihood of a systemic 
shock will be greatly reduced.
    Again, Mr. Chairman, I would like to thank you for 
exploring this issue today, and I look forward to hearing from 
our distinguished witnesses.
    The Chairman. The gentlewoman from New York, for 3 minutes.
    Mrs. Maloney. Thank you, Mr. Chairman, and Ranking Member 
Bachus, for holding this incredibly important hearing. I 
welcome the members of the President's Working Group, and I 
very much look forward to your testimony.
    I hope that I hear in your testimony answers to some of the 
concerns that my colleagues and I have about hedge funds. There 
has been a tremendous amount of media coverage of the potential 
that a fire sale of CDOs triggered by Bear Stearns hedge funds 
could have upon the entire financial system.
    At the heart of these concerns appears to be a fear that 
such a public sale of CDOs would clearly set market prices that 
are way below the value at which many pension funds and 
endowments and banks are carrying these products on their 
books.
    I specifically hope to hear what steps the President's 
Working Group is taking to ensure that there are best practices 
for evaluation of these types of securities and products across 
all types of institutions. I specifically want to hear, did any 
of the agencies comprising the President's Working Group weigh 
in with the creditors of the Bear Stearns fund to encourage 
them to forebear on selling off the collateral until such time 
as Bear could decide to back the funds with their own capital.
    I share the concerns of my colleagues of the impact this 
has on pension funds invested in hedge funds. I am deeply 
concerned and hope you will address what, if any, concerns you 
have with the size and complexity of collateralized debt 
obligations, these CDOs, especially the difficulty investors 
have in adequately understanding and identifying the true value 
of these securities.
    And given the difficulty in having a day-to-day value on 
collateralized debt obligations and given the sheer size of 
these CDOs, what concerns do you have about the systemic risk 
of these securities?
    I was really surprised and startled to learn from the head 
of the SEC, Chairman Cox, that he is investigating 12 separate 
investigations in this particular area, which raises a concern 
that he must have, and I want to know, do you share that 
concern, and what best practices and advice do you give us 
today? I thank you for your work and for your time.
    The Chairman. The gentleman from Texas, Mr. Hensarling, for 
2 minutes.
    Mr. Hensarling. Thank you, Mr. Chairman. I too look forward 
to this hearing.
    As of yet, I haven't seen evidence of a level of systemic 
risk that warrants direct Federal regulation but I certainly 
have an open mind so I look forward to hearing from the 
witnesses.
    I have noted in previous statements of our former Fed 
Chairman and our present Fed Chairman that have cautioned us 
about the risk involved in direct regulation of the hedge fund 
industry. And although it has been many years, and I hold 
myself as no expert, there was a time when I was employed at a 
hedge fund. And at that point I saw a level of expertise from 
the investors, endowments, pension funds, and charitable 
foundations that led me to believe that certainly private 
market discipline was alive and well and that properly informed 
sophisticated investors provide that level of discipline which 
is needed.
    We all know that there has been a certain amount of 
negative press recently regarding hedge funds and I hope we all 
remember in this committee the role that they play in helping 
create jobs and our economy, helping our investors receive 
superior returns, and keeping the economy growing.
    And as the gentleman, the ranking member from Alabama well 
noted, capital can move overseas. So the area of regulation is 
one that we need to approach, I believe, with some trepidation.
    Although this hearing is focusing on systemic risk, I am 
too disturbed, as the ranking member noted, by a flurry of 
proposals to do everything from increasing taxation on carried 
interest to penalizing tax exempt organizations that invest in 
hedge funds. And potentially these proposals may pose even a 
greater risk to our economy, and so I believe that should be 
duly noted.
    And I trust any of these proposals that come around will be 
thoroughly vetted and debated at some length. With that, I 
thank again, Mr. Chairman, for holding this hearing. I yield 
back the balance of my time.
    The Chairman. The gentleman from Georgia.
    Mr. Scott. Thank you, Mr. Chairman. This is indeed a very 
important hearing, but I think we have to look at the facts and 
be able to make some very objective decisions.
    Hedge funds are playing a very important and significant 
economic role in our economy. The whole private equity 
transactions in the United States last year totaled over $400 
billion, and between 1991 and 2006, created more than $30 
billion in profit for our investors.
    The funds hold unmatched sway over our markets. They are 
responsible for more than a third of our stock trades, control 
more than $2 trillion worth of assets, and each of the top 
hedge fund managers earned more than $1 billion in 2006. So 
this is a very serious and impactful area.
    My major concern is, taking the example of Bear Stearns, 
which recently admitted it would need to add some $1.6 billion 
to prevent the fund from a total collapse--now granted, many 
bankers and regulators consider this process to be one of the 
great advances in finance over the past 5 years, however the 
trouble, as Bear Stearns points out and shows that this system 
may not be as crash-proof as we once thought.
    How dependent has our system now become on hedge funds, for 
example? Are these trades becoming more risky? Should more of 
these funds begin to unravel? Who absorbs the losses and at 
what costs to all who are involved?
    What I'm really concerned about is that no one really 
knows, including the funds' lenders, what its exotic portfolio 
or risk mortgage derivatives is really worth.
    And finally, as hedge funds are purchasing all sorts of 
illiquid, hard-to-value assets, are we worried about or do we 
even care to know what these assets are really worth, and are 
we worried that hedge funds' managers are coming up with 
suspicious valuations using financial models that aren't 
necessarily based on what the assets would fetch in the open 
market?
    These are very serious questions. No decision has been made 
whether we--and what type of regulation, but it is very, very 
incumbent upon us to ask the serious, in-depth, clear, incise 
questions when you look at the extraordinary economic impact 
that hedge funds have in our investment community.
    Thank you, Mr. Chairman. I yield back the balance of my 
time.
    The Chairman. I thank the gentleman.
    As we proceed to the testimony, several of us have talked 
about the international aspect. We have, I am pleased to 
acknowledge, recognition of that because observing the hearing 
is Duzana Vavrova, who is the administrator in the directorate 
general on internal policies of the Committee on Economic and 
Monetary Affairs of the European Parliament, presumably our 
counterpart. So we welcome this.
    Several of us have been meeting with our European 
counterparts. Indeed, a delegation from this committee, members 
and staff, bipartisan staff met in both London and Brussels 
with EU and British regulators because of the importance of 
this.
    Secondly, I'm going to ask unanimous consent to introduce 
into the record two items. First, an item which is related, not 
specifically to hedge funds, but a very interesting and 
sobering comment from Moody's Investors Service, a special 
comment of July 2007 on rating private equity transactions 
expressing some concerns about their ability to do that and 
about the risks that are increasing.
    And second, an article from yesterday's Financial Times by 
Mohamed El-Erian, who runs the Harvard Firm, entitled, ``How to 
Reduce Risk in the Financial System,'' expressing concern that 
some of the investors in these funds are themselves regulated 
by entities that are not up to the job of regulating 
instruments of this degree of complexity. None of you here, 
you're off the hook. But they are talking about some of the 
buyers, and it relates to pension funds, insurance industry.
    As we know, one of the things that this committee will be 
looking at is the structure of the insurance industry because 
uniquely in America you have this very important financial 
industry, the insurance industry, particularly in the life side 
but in general that's entirely State-regulated. And what that 
means is to the extent that insurance companies are big players 
here, and pension funds to a great extent, none of you have the 
kind of supervisory role that you'll have over banks and other 
counterparties.
    And that is one of the issues that will deserve some 
attention, so I ask that these two articles be put into the 
record. There being no objection, they will be put in.
    And we will begin our testimony, and we will begin with an 
introduction. Our colleague from Connecticut, he's very busy 
when we deal with hedge funds because half the time he's 
introducing the people who run hedge funds, and live in his 
district, and then the other half he's introducing the people 
who regulate the hedge funds who live in his district.
    So if we just--we could probably move the whole thing to 
Greenwich and save a lot of travel time on witness fees. But 
the gentleman from Connecticut is recognized.
    Mr. Shays. Thank you, Mr. Chairman. I feel a little guilty, 
because last time I didn't introduce this individual, and I did 
introduce someone else, so I would like to welcome all our of 
witnesses, but in particular, Under Secretary Robert Steel, who 
hails from Connecticut's 4th District, and you nailed Greenwich 
pretty well, Mr. Chairman.
    The Under Secretary leads the Treasury Department's 
activities with respect to the domestic financial system, 
fiscal policy and operations, government assets and 
liabilities, and related economic and financial matters. I have 
appreciated the chance to get to know Secretary Steel, who has 
extensive experience in the private sector as well as academia. 
Bob Steel is straightforward, sharp, and someone whose 
perspectives and recommendations I appreciate and respect a 
great deal, and I welcome him.
    The Chairman. Thank you. Mr. Steel, with that, why don't 
you begin with you, and we'll down the list after that.

STATEMENT OF THE HONORABLE ROBERT K. STEEL, UNDER SECRETARY FOR 
       DOMESTIC FINANCE, U.S. DEPARTMENT OF THE TREASURY

    Mr. Steel. Good morning, Chairman Frank, Ranking Member 
Bachus, and members of the committee. It's a privilege to be 
with you today. Thank you for holding this hearing and inviting 
the Treasury Department to present our perspective on the 
important topic of hedge funds and systemic risk.
    Today I am representing both the Treasury Department and 
more specifically, Secretary Paulson, in his capacity as the 
Chairman of the President's Working Group on Financial Markets. 
Fostering financial preparedness is part of the core mission of 
the Treasury Department.
    Under Secretary Paulson's leadership, the four members of 
the President's Working Group, along with the Office of the 
Comptroller of the Currency and the Federal Reserve Bank of New 
York, have issued a call to action directing all market 
participants to undertake efforts that mitigate the likelihood 
and impact of a systemic risk event caused by private pools of 
capital.
    Private pools of capital, which include hedge funds as well 
as private equity and venture capital funds, exemplify the 
innovation that make our capital markets the strongest in the 
world. These investment vehicles bring many benefits to our 
markets, including liquidity, price discovery, and risk 
dispersion. Yet the rapid growth in size and scope of private 
pools of capital has brought challenges to our markets, 
particularly in areas of investor protection, market integrity, 
and the potential for systemic risk.
    To address these challenges, the President's Working Group 
released principles and guidelines for private pools of capital 
in February. These ten principles and the clarifying guidelines 
do not represent an endorsement of the status quo, but instead 
reflects, we hope, the uniform view of all relevant regulators 
that heightened vigilance is necessary and appropriate.
    While it is not our current expectation, we should remain 
vigilant to the possibility that significant losses by a highly 
leveraged hedge fund could present systemic challenges to the 
broader financial system. Therefore, the principles and 
guidelines make a number of very specific suggestions for 
improved vigilance in market discipline so as to mitigate 
systemic risk.
    Hedge funds' clientele, originally wealthy investors, has 
shifted to become one that is comprised more of institutional 
investors, in many cases representing individual investors who 
may be less sophisticated. Investment fiduciaries, such as 
pension funds, do have a responsibility to perform due 
diligence to ensure that their investment decisions on behalf 
of these beneficiaries and clients are prudent.
    These principles also emphasize the responsibility of 
managers to provide accurate and timely information so that 
investors can make informed decisions. Additionally, 
supervisors must work within the existing regulatory framework, 
utilizing their broad anti-fraud and anti-manipulation 
authority to address these issues of investor protection.
    Our next step is to ensure that all four groups of the 
market participants--the regulators and supervisors, the 
counterparties, and the creditors, the actual managers of the 
private pools of capital themselves, and the pool investors--
adopt and use these principles and guidelines. We are very 
encouraged by the initial response, as much good progress is 
currently underway.
    Additionally, these principles and guidelines have been 
very well received by policymakers, regulators, industry 
leaders, and the general public, both in the United States and 
overseas.
    Regulators and supervisors are already involved in a range 
of important initiatives. Supervisors are engaged in ongoing 
reviews of creditors' and counterparties' practices. These 
efforts are aimed at improving the sophistication of stress-
testing practice, counterparty credit risk management and over-
the-counter derivatives, structured credit, hedge funds, and 
the post-trade processing infrastructure of the over-the-
counter derivatives market.
    Consistent with my representation that we are not standing 
still, just 2 weeks ago, Secretary Paulson announced that we, 
at the President's Working Group, will work with the private 
sector to develop and adopt industry best practices for both 
investors and the asset managers of hedge funds.
    The President's Working Group is facilitating the 
establishment of two separate yet complementary private sector 
groups, one comprised of hedge fund managers, and the other 
comprised of hedge fund investors. These two groups will 
develop best practices for their respective stakeholder groups 
that address investor protection, enhanced market discipline, 
and also help to mitigate systemic risk.
    The President's Working Group will serve as an ongoing 
facilitator for these groups. We are engaging a broad spectrum 
of market participants to develop high quality best practices. 
The nature of a competitive marketplace is such that when 
leaders adopt best practices, others in the industry feel 
pressure to do the same. All market participants must be 
accountable to help ensure the integrity of our capital 
markets.
    While substantial progress has already been made, there is 
still much work to be done. Building upon efforts to date, all 
stakeholders must continue to do more. We look forward to the 
development and implementation of coherent best practices for 
the investors and hedge fund managers.
    Our system works well when market participants recognize 
the benefits, mitigate the risks, and choose to be diligent. We 
look forward to a continued dialogue with this committee on 
these important issues.
    Thank you, sir, and I look forward to your questions.
    [The prepared statement of Under Secretary Steel can be 
found on page 61 of the appendix.]
    The Chairman. Next we'll hear from Kevin Warsh, who is a 
member of the Board of Governors of the Federal Reserve System.

  STATEMENT OF THE HONORABLE KEVIN M. WARSH, MEMBER, BOARD OF 
            GOVERNORS OF THE FEDERAL RESERVE SYSTEM

    Mr. Warsh. Thank you very much, Chairman Frank, Ranking 
Member Bachus, and other members of the committee here today. I 
appreciate the opportunity to appear on behalf of the Board of 
Governors of the Federal Reserve System to discuss the systemic 
risk implications of hedge funds.
    The Board believes that the increased scale and scope of 
hedge funds has brought significant net benefits to financial 
markets. Indeed, hedge funds, as many of you have mentioned in 
your opening statements, have the potential to reduce systemic 
risk by disbursing risks more broadly and by serving as a large 
pool of opportunistic capital that can stabilize financial 
markets in the event of disturbance.
    At the same time, the recent growth of hedge funds presents 
some formidable challenges to the achievement of key public 
policy objectives, including significant risk management 
challenges to market participants. Of course, if market 
participants prove unwilling or unable to meet these 
challenges, losses in the hedge fund sector could pose 
significant risks to financial stability.
    The Board believes that the principles and guidelines 
regarding private pools of capital issued by the President's 
Working Group on Financial Markets, just in February, provide a 
sound framework for addressing these challenges associated with 
hedge funds, including the subject of today's hearing, the 
potential for systemic risk.
    The Board shares the considered judgment of the PWG: The 
most effective mechanism for limiting systemic risks from hedge 
funds is market discipline. And the most important providers of 
market discipline are the large global, commercial, and 
investment banks that are their principal creditors and 
counterparties.
    This emphasis on market discipline neither endorses the 
status quo nor implies a passive role for government. In recent 
years, the global banks have significantly strengthened their 
practices and procedures for managing risk exposures. But 
further progress on this front is needed, in no small part 
because of the increasing complexity of structured credit 
products such as collateralized debt obligations.
    The Board believes that even those banks with the most 
sophisticated risk management practices must further strengthen 
their enterprise-wide systems to put the PWG principles fully 
into practice. As these principles rightly emphasize, 
supervisors of global banks are responsible for promoting 
market discipline by monitoring and evaluating banks' 
management of their exposure to hedge funds.
    As the umbrella supervisor of U.S. bank holding companies, 
the Fed continues to pay keen attention to hedge fund exposures 
and is working to ensure stronger risk management practices. In 
addition, through the Reserve Bank of New York, the Fed is 
actively facilitating collaboration and coordination among 
domestic and international supervisors of these global banks 
that are key counterparties and key creditors.
    This area of significant focus targeting management of 
exposure to hedge funds is part of a broader, comprehensive set 
of supervisory initiatives that seeks to ensure that banks' 
risk management practices and market infrastructures are 
sufficiently robust to cope with stresses that may accompany a 
deterioration in market conditions.
    To this end, the Federal Reserve has been focusing on five 
key supervisory initiatives: First, comprehensive review of 
firms' stress-testing practices; second, a multilateral 
supervisory assessment of the leading banks' current practices 
for managing their exposures to hedge funds; third, a review of 
the risks associated with the rapid growth of leveraged 
lending; fourth, a new assessment of practices to manage 
liquidity risk; and fifth, continued efforts to reduce risks 
associated with weaknesses in the clearing and settlement of 
credit derivatives and other over-the-counter derivatives.
    Indeed, this committee should be assured that the Federal 
Reserve has taken on these initiatives with great purpose and 
resolve. The initiatives are fully consistent with the founding 
purpose assigned to the Fed by Congress to help mitigate the 
risks to the financial system and the broader economy caused by 
periodic bouts of instability and financial stress.
    Thank you again, Mr. Chairman. I'd be happy to respond to 
your questions.
    [The prepared statement of Governor Warsh can be found on 
page 67 of the appendix.]
    The Chairman. Next, Mr. Jim Overdahl, who is the Chief 
Economist at the Commodity Futures Trading Commission. We 
welcome you in your rare appearance away from the Agriculture 
Committee here, where you really belong.
    [Laughter]

STATEMENT OF JAMES A. OVERDAHL, CHIEF ECONOMIST, U.S. COMMODITY 
                   FUTURES TRADING COMMISSION

    Mr. Overdahl. Thank you, Mr. Chairman, Congressman Bachus, 
and members of the committee. I am pleased to have this 
opportunity to testify on behalf of the CFTC regarding hedge 
funds and systemic risk.
    The Chairman of the CFTC is a member of the President's 
Working Group on Financial Markets, and he participated in the 
deliberations that resulted in the agreement announced by the 
PWG in February, setting out principles and guidelines 
regarding private pools of capital, including hedge funds.
    I will focus my remarks today on how hedge funds intersect 
with the CFTC's responsibilities under its governing statute, 
the Commodity Exchange Act, or CEA. At the outset, I should 
emphasize that the CFTC does not regulate hedge funds per se. 
However, the CFTC encounters hedge funds as it performs two of 
its critical missions under the CEA--promoting market integrity 
and protecting the public from fraud in the sale of futures and 
commodity options.
    Hedge funds are on the CFTC's market surveillance radar 
when they trade in regulated futures and commodity options 
markets regardless of whether their operators and advisors are 
registered or not. With respect to investor protection, if a 
collective investment vehicle such as hedge fund trades futures 
or commodity options, the fund is a commodity pool, and its 
operator and advisor may be required to register with the CFTC 
and meet certain disclosure, reporting, and recordkeeping 
requirements.
    Futures markets serve an important role in our economy by 
providing a means of transferring risk from those who do not 
want it to those who are willing to accept it, for a price. In 
order for businesses to hedge the risk they face in their day-
to-day commercial activities, they need to trade with someone 
willing to accept the risk the hedger is trying to shed. Data 
from the CFTC's larger trader reporting system are consistent 
with the notion that hedge funds and other professionally 
managed funds often are the ones absorbing the risks hedgers 
are trying to shed.
    Hedge funds also play a vital role in keeping the prices of 
related futures contracts in proper alignment with one another. 
In addition, hedge funds add to overall trading volume, which 
contributes to the formation of liquid and well functioning 
markets. Over the past decade, the average number of funds 
participating in futures markets has grown across nearly all 
market segments. Also it appears that funds, on average, hold 
positions in more markets today than they did a decade ago.
    One notable development over the past 5 years has been the 
increased participation by hedge funds and other institutional 
investors in futures markets for physical commodities. These 
institutions have allocated a portion of the investment 
portfolios they manage into commodity-linked investment 
products. A significant portion of this investment finds its 
way into futures markets, either through the direct 
participation of those whose commodity investments are 
benchmarked to a commodity index, or through the participation 
of commodity index swap dealers who use futures markets to 
hedge the risk associated with their dealing activities.
    The CFTC relies on a program of market surveillance to 
ensure that markets under CFTC jurisdiction are operating in an 
open and competitive manner. The heart of the CFTC's market 
surveillance program is its large trader reporting system. For 
surveillance purposes, the larger trader reporting requirements 
for hedge funds are the same as for any other larger trader. In 
addition to regular market surveillance, the CFTC conducts an 
aggressive enforcement program that deters would-be violators 
by sending a clear message that improper conduct will not be 
tolerated.
    The financial distress of any large futures trader poses 
potential risks to other futures market participants. With 
respect to commodity pools operating as hedge funds, the CFTC 
addresses these risks through its oversight of futures 
clearinghouses and the clearing member firms of each 
clearinghouse. This oversight regime is designed to ensure that 
the financial distress of any single market participant, 
whether or not that participant is a hedge fund, does not have 
a disproportionate effect on the overall market. It is through 
this oversight regime that the CFTC does its part in helping to 
mitigate systemic risk.
    In closing, the CFTC will remain vigilant in utilizing the 
tools provided in the CEA: Market surveillance; disclosure; 
reporting; recordkeeping; and enforcement authority, to fulfill 
its statutory responsibilities as hedge fund participation in 
futures markets continues to expand.
    This concludes my remarks, and I look forward to your 
questions.
    [The prepared statement of Mr. Overdahl can be found on 
page 42 of the appendix.]
    The Chairman. Next, Dr. Erik Sirri, who is the Director of 
the Division of Market Regulation at the SEC.

   STATEMENT OF ERIK R. SIRRI, DIRECTOR, DIVISION OF MARKET 
      REGULATION, U.S. SECURITIES AND EXCHANGE COMMISSION

    Mr. Sirri. Chairman Frank, Ranking Member Bachus, and 
members of the committee, on behalf of the Securities and 
Exchange Commission, I appreciate the opportunity to speak to 
you today regarding recent initiatives being taken by the 
Commission with respect to hedge funds.
    As you know, the President's Working Group released 
principles and guidelines regarding private pools of capital. 
These principles complement and inform the regulatory and 
supervisory work of each of the PWG agencies with respect to 
investors, fiduciaries, creditors, and counterparties.
    Even as the Commission believes that private pools of 
capital such as hedge funds bring significant benefits to 
financial markets, the Commission is also working diligently to 
protect hedge fund investors and other market participants 
against fraud, and to ameliorate, through its oversight of 
internationally active securities firms, the broader systemic 
risks such funds potential pose to our financial system.
    The Commission's work in this area includes vigorous 
enforcement activities related to the Federal securities laws, 
the Commission's Consolidated Supervised Entity Program, and as 
appropriate, regulatory improvement.
    I will focus my oral remarks today on the oversight 
function. At present the Commission supervises five securities 
firms on a consolidated or groupwide basis. These include Bear 
Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and 
Morgan Stanley. These firms are known as the CSEs. For such 
firms, the Commission oversees not only the registered broker-
dealer but also the consolidated entity; that is, the holding 
company, which may include regulated entities, such as foreign-
registered broker-dealers and banks, as well as unregulated 
entities, such as derivatives dealers and the holding company 
itself.
    The Commission's CSE program is designed to provide holding 
company supervision in a manner that is broadly consistent with 
the oversight provided to bank holding companies by the Federal 
Reserve. The aim of this program is to diminish the likelihood 
that weakness in the holding company itself or any of the 
unregulated entities places a regulated entity, such as a bank 
or a broker-dealer, or the broader financial system, at risk.
    The CSEs are subject to a number of requirements under the 
program, including monthly computation of a capital adequacy 
measure consistent with the Basel II Standard, maintenance of 
substantial amounts of liquidity at the holding company level, 
and documentation of a comprehensive system of internal 
controls that are subject to Commission inspection.
    The primary concern of the CSE program with regard to hedge 
funds revolves around the risks they potentially pose to CSE 
firms specifically, and through CSEs to the financial system.
    The Commission's CSE program monitors and assesses these 
risks in several ways.
    First, the Commission staff meets at least monthly with 
senior risk managers at the CSEs to review market and credit 
risk exposures, including those to hedge funds. The process 
provides information not only concerning the potential risk to 
CSEs, but also a broader window into the relationship with 
hedge funds, and those hedge funds' potential impact on the 
broader financial markets.
    Second, Commission staff has recently engaged in targeted 
discussions with the CSEs about the challenges of measuring 
credit exposures to hedge funds.
    And finally, the Commission's staff has embarked on a joint 
project with the Federal Reserve and the UK's Financial 
Services Authority to understand current in Street practices of 
banks and broker-dealers in managing their exposures to hedge 
funds. The agencies have identified a number of issues related 
to the extension of credit to hedge funds and are now 
addressing those issues in a second phase which entails more 
detailed work by the principal regulator of each firm.
    Taken together, these efforts allow us to identify some 
trends that we and our supervisory colleagues, as well as the 
risk managers at the large banks and securities firms, will 
follow more closely. The demise of Amaranth and the issues 
associated with the Bear Stearns managed hedge funds also 
provide some interesting datapoints to consider.
    First, some of the largest and most systemically important 
hedge funds are beginning to look more and more like mature 
financial institutions, diversifying their portfolios beyond 
leveraged equity and fixed-income strategies, and diversifying 
beyond their activities in proprietary trading.
    Second, hedge funds generally have become more 
sophisticated about risk management, in part by negotiating 
more flexible credit terms with dealer banks.
    Third, in some markets, hedge funds are the major providers 
of liquidity. The impact that the Bear Stearns' hedge funds 
losses is having on the subprime market illustrates this point.
    Finally, leverage can be achieved in a myriad of ways. The 
ability to engineer economic leverage through structured 
products is almost infinite, and that can be seen in the CDO 
markets.
    The supervisory focus on excessive leverage, we believe, is 
the right one. It is far from simple in today's innovative 
financial markets. While these trends will continue to 
challenge the regulated institutions and their supervisors, the 
focus in recent years on counterparty credit risk management 
has clearly been good for financial institutions and the 
financial system as a whole.
    After the failure of long-term capital management in 1998, 
the Counterparty Risk Management Policy Group brought together 
senior policy managers from the major commercial and investment 
banks--excuse me, senior risk managers--to consider the lessons 
of that event. The report addressed systemic risk concerns by 
articulating best practices in counterparty risk management 
appropriate to such regulated entities such as banks and 
securities firms.
    The Counterparty Risk Management Policy Group also issued a 
second report in July of 2005 that dealt with developments 
since the initial report, including the proliferation of 
products with embedded leverage and securitization. More work 
remains to be done in these areas, and we must not in fact 
become complacent here.
    In conclusion there is no guarantee that the favorable 
conditions that allowed for the orderly unwinding of Amaranth, 
and thus far Bear Stearns managed hedge funds will persist. We 
must assume, in fact, that they will not. The supervisory 
community must continue to engage with systemically important 
banks and securities firms and encourage additional efforts to 
expand their risk management capabilities.
    We will continue to work with our PWG colleagues and other 
market participants, hopefully including some of the larger 
hedge funds, to further this agenda.
    I thank you for the opportunity to testify today, and I'd 
be happy to take any of your questions.
    [The prepared statement of Mr. Sirri can be found on page 
49 of the appendix.]
    The Chairman. Thank you. I'm going to begin with a very 
specific question. It would be aimed to probably the SEC. When 
we had the hedge fund managers, a panel of them before us, one 
issue that came up was that they noted that many of them are 
already required to register with somebody or another. Ms. 
Robinal mentioned many of them do that.
    One suggestion that somebody made, I forget who, but they 
all seemed to agree with was this: There is a potential for 
insider trading here because of the kind of integrated degree 
of activity. There was a proposed suggestion that all of them 
agreed to that over and above any other form of regulation or 
registration, there be a document retention requirement so that 
if allegations came up of inappropriate practices, that could 
be done.
    You mentioned, Dr. Sirri, that you're working on 
enforcement. What would your response be to a document 
retention requirement for those entities that did not otherwise 
have one because they were required to register for some other 
reason?
    Mr. Sirri. Well, I think it's important to consider the 
Commission's authority over hedge funds. You quite correctly 
make the distinction that there are two groups of hedge funds. 
There are those that are registered--there are about 2,000 of 
those--and then there are those that are unregistered.
    But it's important to realize that with respect to either 
of those, the Commission maintains anti-fraud authority--
    The Chairman. Well, I understand that. But what some people 
suggested was that the ones that are unregistered don't have a 
document retention requirement. And the suggestion was simply 
to give a document retention requirement to those so that was 
there if you needed enforcement.
    Mr. Sirri. Sure. And on the registered end, books and 
records requirements are in place. For the unregistered 
entities, we would have no authority to require that. That may 
be--
    The Chairman. Well, I understand that. But you're not 
before a court now. You're before the Congress. We make the 
laws, sometimes. Sometimes we don't. My question to you, I'm 
sorry if it wasn't clearer, is what would you think about our 
passing a law that would enhance your authority to require 
document retention among the unregistered?
    Mr. Sirri. I think we'd have to be very careful of the 
tradeoff there. The potential benefit of something like that 
has to do with fraud in the markets and the example that you 
gave. The potential cost of something like that is to cause 
those hedge funds to leave the United States and perhaps locate 
overseas.
    The Chairman. But I will say, none of them raised that when 
we asked them. They all--or maybe we had an unusually quiescent 
group. I don't think we tried to find that.
    Let me just ask you, with regard to registration, Mr. 
Overdahl, you mentioned that some are registered with you. Now 
you say 2,000 are registered with the SEC. Are there funds that 
register with the CFTC that don't register with the SEC?
    Mr. Overdahl. We do not register funds per se. We register 
advisors and operators.
    The Chairman. Right.
    Mr. Overdahl. And there will often times be overlap 
between--
    The Chairman. Are there some that register with you, 
though, that don't have to register with the SEC?
    Mr. Overdahl. Absolutely. There are some funds or operators 
of funds that are operating pools that are exclusively futures 
pools that will be registered with us as opposed to the SEC.
    The Chairman. Is that at all a problem that jurisdiction, 
should you share information about them? How does that work? We 
have entities that many of us would think are doing very 
similar things, and some of them aren't registered at all, and 
some are registered with the SEC, and some are registered with 
the CFTC. My sense is that was due to nobody's plan, but that 
just was a result of other decisions. Is that something we 
ought to be trying to rationalize? Let me ask Mr. Steel, what's 
your sense of how that breaks out? In terms of the split 
between those that register at the CFTC, those that register at 
the SEC, and those that aren't registered--is that a rational 
distribution now, do you believe?
    Mr. Steel. No. I think that consistent with things that 
we've talked about at Treasury, this has developed in a 
patchwork basis, and there isn't an overarching strategy, that 
people have chosen a regulator or chosen not to be regulated, 
and that's the reality of the situation today.
    The Chairman. Should we change that if we could work 
together on a collaborative way to do that?
    Mr. Steel. Well, I think that there's no question. Just a 
week or two ago, Secretary Paulson announced that one of the 
goals he had was to look at this on a holistic basis, and I 
would think that as part of that examination, with the goal of 
writing a blueprint of what regulations should look like--
    The Chairman. Very good.
    Mr. Steel.--that this would be part of that.
    The Chairman. Well, I appreciate it. So in other words, 
when we talk about the regulation, which includes banking and 
other things, I think that's--I mean, whatever one thinks about 
what degree of registration or whether there should be or 
shouldn't be, it ought to be the result of conscious decisions 
by people, not just random.
    Let me say in closing, and I understand we're not rushing 
to register and regulate, but regulation shouldn't be a bad 
word. As we look at the subprime crisis, it strikes me that 
there are two groups of entities that have made loans to people 
in the subprime category: regulated entities, i.e., depository 
institutions regulated by the banks; and unregulated entities, 
brokers and others, who are subject to no such regulation.
    I think it's fairly clear. If only regulated entities had 
made subprime loans, we wouldn't have a crisis. The 
overwhelming number of loans that have caused problems were 
made by unregulated entities. And it does seem to me an 
argument for the sensible kind of regulation that I believe we 
have with regard to depository institutions. So I would hope 
that people would not automatically assume that regulation has 
to be a bad thing. If we would have had more regulation of 
lenders in the subprime area, we would have had less of a 
subprime crisis.
    The gentleman from Alabama.
    Mr. Bachus. Thank you, Mr. Chairman. Mr. Chairman, first 
I'd like to acknowledge our former staff director of the 
committee, Bob Foster. Bob, if you'd stand up, we welcome you 
back to the committee. You did a very professional job here, 
and I think you will do the same at the Treasury Department.
    The Chairman. You haven't mentioned his new position. You 
just had him stand up. You didn't mention his new job.
    Mr. Bachus. He is--Under Secretary Steel, is he--
    Mr. Steel. He's working in Legislative Affairs as a Deputy 
Assistant Secretary, and we welcome him to Treasury with his 
good wisdom.
    Mr. Bachus. Thank you.
    The Chairman. And he comes with a due respect for 
congressional prerogative.
    [Laughter]
    Mr. Bachus. Or disrespect. Let me start by saying, I don't 
think anyone on the Republican side discounts the existence of 
risk. In fact, you know, risk is inherent in the market and 
probably--the markets, so there's a high degree of risk in the 
markets at this time. I think the President's Working Group has 
acknowledged that some of these sophisticated investments, 
although they diminish risk in many respects, there is the 
potential for systemic risk.
    I think what many of us, Mr. Hensarling and I particularly 
discussed in our opening statements, what we discount is the 
ability of Congress to intervene constructively at this point. 
In other words, as the chairman said, pass a law.
    I'm not sure that that--I don't see that bringing stability 
to the market. In fact, especially some calls recently to 
increase taxation on capital, I don't in any way see how that 
could bring stability or have a positive effect on the market. 
So, in fact, I see them having a very detrimental effect at 
this particular time.
    Some of the members in their opening statements also 
mentioned transparency and disclosure. You know, we talk about 
those terms almost as ``mom'' and ``apple pie.''
    But--Secretary Steel, you made a speech to the Manhattan 
Institute when you talked about one potential problem with 
further regulation, and that's that investors begin to take 
comfort in, you know, the--almost like a stamp of approval. The 
government is regulating these. Would you like to comment on 
that?
    And before you do, Dr. Sirri pointed out something else. 
Yes, you know, we could require or regulators could require 
more disclosure, more transparency, but, you know, we run into 
two things, two problems there that I see. One is that a lot of 
this is proprietary. These are proprietary methods. There are 
strategies that they engage in, and I'm not sure that would not 
have a chilling effect, and I'm not sure even some 
constitutional limitations we may have on asking people to give 
out their proprietary--you know, their actually property right.
    But as Dr. Sirri pointed out, they have an option to 
disclose. They have an option to paying greater taxes, and that 
option is taking that capital to China or India or South 
America or offshore. And I can tell you, if anything that I do 
believe this morning, withdrawing capital out of the United 
States, I do know that would have a destabilizing effect on our 
economy and our market, and just the last thing we need at this 
time is taxation or regulation that would cause a flight of 
capital out of the United States.
    So with that, let me ask Secretary Steel, would you comment 
again on your remarks at the Manhattan Institute, which I 
believe are very valid?
    Mr. Steel. I think if I could frame this through the lens, 
as you said, of the important issues of transparency and 
disclosure, and then I think you asked me to comment further on 
the issue of moral hazard, I think that you're correct. 
Transparency and disclosure are important issues, but I would 
want to frame it with to whom and for what end.
    Basically, we believe the key aspects of transparency and 
disclosure in the President's Working Group, that we've tried 
to codify in the principles and guidelines, really relate to 
two specific areas--very good transparency and disclosure from 
the fund manager to the regulated entities that are providing 
the capital and loaning them money, and the disclosure there 
should be quite good. In our guidelines, we've written about 
this and tried to give very specific examples of the type of 
transparency and disclosure that's appropriate. And if you 
don't have that type of very, very high transparency and 
disclosure, it should be reflected in margin and the terms of 
credit. And that should be the Governor on that issue to 
provide the protection, the best protection that we could, for 
mitigation of systemic risk.
    The second key issue of disclosure really is between the 
investor and the fund manager. And once again, in our 
guidelines and principles, we tried to give very specific 
examples of what one should expect so as to invest. And 
hopefully raising that standard, and we intend to raise the 
standard further with specificity with the committees that I 
described, then we think that's the key issues of disclosure 
and transparency.
    With regard to the more specific issue about the talk that 
I made on moral hazard, I think there's a clear issue. These 
are investments of a certain type. They're less liquid. They're 
private partnerships, and they're different than buying and 
selling a security that offers instant liquidity. And so there 
are very specific requirements for investors to meet which the 
SEC has outlined historically and is now in the process of 
adjusting.
    And, therefore, the idea that approval or regulation or 
registration provides a comfort, it would be a false comfort 
that might not--has the potential to be a false comfort--that 
does not recognize the distinct characteristics of the private 
pools of capital.
    Mr. Bachus. And Governor Warsh, both you and Secretary 
Steel have talked about that you all have made recommendations, 
principles which you have asked all the stakeholders to put 
into practice. How do you assure that they do this? How do you 
assure that they do move towards market discipline?
    Mr. Warsh. Thank you. I would say that one thing that is 
certain, which is by virtue of the oversight that this 
committee and others can bring to bear, by virtue of the 
discussions that Under Secretary Steel and I have, is that 
there is a laser-like focus in the markets on trying to ensure 
that all of the stakeholders around hedge funds really need to 
continue the progress that has been made in recent years on 
subjects of due diligence and valuation, and making sure that 
stakeholder community is fully vested and fully understands 
what is going on.
    This is, I think, an important opportunity for them to step 
up to the challenge put before them by the principles outlined 
by the President's Working Group.
    Moreover, I would say for these hedge funds, the group that 
has the most skin in the game--the most responsibility, the 
most focus on ensuring that they have the right collateral--are 
these very counterparties and creditors that we're talking 
about. They are the life blood for hedge funds, maybe equal to 
importance of the investors themselves.
    And when we talk about market discipline, we say that they 
really need to make sure that they're putting their money where 
their mouth is, and we are very encouraged by the discussions 
that have commenced that they're going to adopt these 
principles and put them into action. And, obviously, those of 
us here at the table will do our best to make sure of that.
    Mr. Bachus. You know, when you have somebody who is both a 
creditor and investor and a counterparty at the same time, it 
does become very difficult to do that. But I would like to 
commend all of you. I believe that you are very active on the 
job. You appreciate the danger that you are working with the 
stakeholders and market participants, and I commend you for 
what you've done.
    Mr. Kanjorski. [presiding] Thank you, Mr. Bachus. In the 
absence of our chairman, I will take my questioning period now, 
if I can.
    I am really interested more in the process of what the 
Working Group represents and whether or not they have created 
certain authorities and where these authorities, whatever 
authority that they use, emanate from. One of the important 
questions that I have raised up here on the Hill is that so 
often now, we fail to provide legislative leadership as to 
where we should go: We hold a hearing such as this one where we 
invite up a working group about which I am not at all sure. 
Maybe I will ask: Who wants to represent the role of chairman 
here? Where do you come from? I mean, can you name your 
parents? Does anybody want to answer? You know, it is a simple 
question, and it is an honest question.
    Mr. Steel. Let me start, sir, and I'll invite my colleagues 
to comment. The establishment of the President's Working Group 
in 1988 was born out of an issue which was basically 
understanding and learning from the market dislocation of 1987.
    Mr. Kanjorski. Right.
    Mr. Steel. And President Reagan had the idea that you 
needed to have this multi-headed group look at these issues, 
because they crossed borders, crossed markets, and crossed 
different jurisdictions, and that was the idea.
    And in my brief period, I think that this is the 
appropriate way to consider them, and Secretary Paulson has 
convened the President's Working Group actively and with all of 
the principals of the President's Working Group in, as Governor 
Warsh said, in a laser-like way, to use his word, focused on 
these issues. And so the idea of financial preparedness, which 
really is the link-up to systemic risk, has been the focus, one 
of the key focuses of the President's Working Group.
    Mr. Kanjorski. Obviously, the Working Group is a continuing 
body. As I understand, it emanates from a former White House 
executive order in 1988. Has that order been enlarged upon or 
drafted subsequent to 1988 to include more authority?
    Mr. Steel. Not that I know of. But I would comment that the 
Secretary doesn't view our lens on these issues as being 
limited or circumscribed--needing any additional scope or 
aperture.
    Mr. Kanjorski. Now, under normal circumstances, I would 
agree with you. But, now you are really propounding regulations 
or guidelines. I think you call them guidelines. That is very 
interesting. They are not legislatively constructed guidelines. 
They are from the Working Group.
    Mr. Steel. Yes, sir.
    Mr. Kanjorski. And, of course, they come out of the Working 
Group's office downtown?
    Mr. Steel. They come--Treasury is the convener, as I said.
    Mr. Kanjorski. I was being facetious. If I try to locate 
the Working Group's office, where would I go?
    Mr. Steel. You can call mine, I guess. But the Secretary of 
the Treasury is the convener.
    Mr. Kanjorski. I understand, and as an initial study group, 
it worked well. But why have you not all felt that perhaps 
there was a time since 1988--that is 19 years ago--to come to 
the Congress to get some legitimate legislative authority to 
pursue formal activity? If you really analyze what you're 
doing, your whole sense of controlling or influencing industry 
and the participants is the threat of your capacity to 
regulate. That is a pretty dangerous way of operating within 
our system.
    You call in the people that you regulate, and you say we 
are going to construct guidelines for you. We have no 
legislative authority to do that. There is no law allowing us 
to do that, just an executive order. But, we anticipate that 
you are going to participate and follow those guidelines.
    You don't seem to ask why, and I'm just asking the question 
now: Why would they follow your guidelines? Other than the fact 
that they have the fear of God that if they do not, they have 
four massive regulators that are going to come down on them in 
some way? Is that a good principle to get things done?
    The other area I wanted to ask you about is who is your 
counterparty in the Legislative Branch of Government? Who do 
you talk to up here on the Hill?
    Mr. Steel. Well, the other regulators or people--members 
can speak for themselves, but from the Treasury Department, 
we're in constant communication and regular communication with 
the leadership on the Hill and describing what we're doing 
both, as I said when I began, I appear here today as a 
representative of the Treasury Department and also Secretary 
Paulson as Chairman of the President's Working Group.
    And so the regular dialogue that the Secretary has with 
leaders in Congress includes that same duality of 
responsibility. And I can comment from having been in meetings 
that both of those perspectives are discussed and considered.
    Mr. Kanjorski. I just want to break into that response 
because of a side question that I had. There is a rule in this 
Administration that no group or representative of the 
Administration comes to the Congress and makes a speech without 
having their remarks vetted by the Office of Management and 
Budget. Mr. Steel, were your remarks vetted today by the Office 
of Management and Budget?
    Mr. Steel. Not that I'm aware of, sir.
    Mr. Kanjorski. Was anybody else's here?
    Mr. Warsh. No, sir.
    Mr. Kanjorski. So you have no vetting responsibility any 
more in this Administration? I mean, that is great if you do 
not. But I understood that you just don't make--
    Mr. Steel. Testimony is run by our colleagues and 
counterparts in other offices.
    Mr. Kanjorski. Who do you vet with?
    Mr. Steel. Within Treasury and discuss with other people.
    Mr. Kanjorski. Who were those other people?
    Mr. Steel. In Treasury, different divisions and different 
parts.
    Mr. Kanjorski. In Treasury? Nobody outside of the 
Department?
    Mr. Steel. Well, we would also discuss with people at the 
NEC and other areas where we work on economic issues 
continually. I think the idea of having a flat organization and 
getting the benefit of other people's perspective, but the idea 
of vetting, which was your choice of words, would not describe 
the situation at all.
    Mr. Kanjorski. Do you vet your material with these other 
agencies, like your speech?
    Mr. Steel. Vet with? With these--my colleagues here?
    Mr. Kanjorski. No. I mean, with the other agency. You 
mentioned the National Economic Council?
    Mr. Steel. They--we shared our perspective with them and 
have the benefit of ongoing discussions on economic policy 
continually.
    Mr. Kanjorski. You have on occasion, as a Working Group, 
sent material to the Congress to consider for legislation, have 
you not?
    Mr. Steel. Not that I'm aware of.
    Mr. Kanjorski. Nothing over the 20 years that you've sent 
up?
    Mr. Steel. Not that I'm aware of.
    Mr. Kanjorski. It has never dawned on anyone that it may be 
wise to codify guidelines that are going to be worked with?
    Mr. Bachus. Would the chairman yield?
    Mr. Kanjorski. Oh, surely.
    Mr. Bachus. Actually, I think the President's Working 
Group, after Long Term Capital and 9/11, submitted requests to 
Congress. That's my recollection, but--
    Mr. Warsh. Congressman, at the request of Congress, as you 
know, the President's Working Group as its constituent members, 
have responded to questions and queries that have come up. 
We've certainly provided technical assistance. I think the 
point worth reiterating is that none of us, at least speaking 
on behalf of the Federal Reserve, cede any of the authorities 
which Congress has granted to us, to members of the PWG. That 
is, the PWG has consulted--
    Mr. Kanjorski. Do not call it that. It so disturbs me to 
have those initials used. Call it the President's Working 
Group. I hate the initials in Washington. It really 
illegitimizes your organization, if you know what I mean.
    Mr. Warsh. So the point I was trying to make, Congressman, 
only is that each of us have authority. Certainly the Federal 
Reserve has authorities granted to us by Congress. We're 
overseen by this committee in the House.
    Mr. Kanjorski. No, but you understand why I am getting a 
little disturbed here. I heard in earlier testimony that you 
are creating two more working groups. You are having babies. A 
new generation is being born here, and I am trying to figure 
out when your marriage was held. Where do you think you have 
the right to form other groups that will exist out there 
interminably and be exercising leadership by virtue of the 
coerciveness of regulation?
    I mean, does that not disturb anybody at the table?
    Mr. Steel. I'll try to describe it, sir, in a way that's 
not disturbing, but I view it as encouraging. And basically, 
what we're trying to do, as we've described in the guidelines 
and principles, is to get people together to share the very 
best practices--
    Mr. Kanjorski. Admirable.
    Mr. Steel. Excuse me.
    Mr. Kanjorski. I do not disagree with that, Mr. Steel. I am 
saying that what it is a sort of ethereal structure.
    Mr. Steel. Excuse me?
    Mr. Kanjorski. There is no body to it. There is nothing we 
can identify, you know, who is leading it and what rights it 
has. We do not know how big you are. We do not know how many 
people you have. You probably have the combined number of 
employees that exist in every one of your respective 
organizations and other people that you can get to participate 
in government. You start to become a very large umbrella 
operation, and probably find little need to go through the 
legislative process.
    And then finally, one of the questions I am asking is: What 
do we have as a countervailing weight to you up here in the 
Legislative Branch of Government? You know, if I want to get 
tremendous expertise, I do not have the Congress Working Group 
filled with experts of huge abilities. They are not around. How 
many people do we have, Mr. Chairman, on the committee? We have 
eight people.
    The Chairman. Seventy.
    Mr. Kanjorski. Seventy on the full committee, but in terms 
of securities staff and things like this, what do we have, 
eight or ten people? But you have literally hundreds or 
thousands, and yet I thought under our structure we are 
supposed to be creating and passing the laws that implement 
you, that give you the authorities you will exercise. I am 
going to try and find your address downtown so that I can 
either come down and meet with you there at the President's 
Working Group headquarters, wherever that may be.
    Mr. Chairman.
    The Chairman. The gentleman from Louisiana, Mr. Baker.
    Mr. Baker. Thank you, Mr. Chairman. Dr. Sirri, I don't have 
a question, just an observation. In reading over your rather 
distinguished resume, I noted your expertise in extra-planetary 
exploration, and at first wondered how someone with that 
suitability would be a hedge fund expert. But then when I 
started thinking about it, anybody who could talk about the 
details of exploration of Pluto probably has a pretty good 
grasp of what's going on in a hedge fund. So, I welcome you to 
the hearing with that acknowledgement.
    Mr. Sirri. Thank you.
    Mr. Baker. Mr. Overdahl, I was curious. In looking at the 
1999 President's Working Group report, there was a 
recommendation relative to CPO filings. What is the Commodity 
Pool Operator filings? Can you tell me what the current 
frequency of reporting is today? Is it still annual, or is it 
quarterly?
    Mr. Overdahl. I'll have to get back to you on that.
    Mr. Baker. Well, my reason for asking is it was annual. The 
report suggested that they at least move to quarterly, and the 
reason for that suggested modification was to provide 
additional transparency to market participants.
    Mr. Overdahl. Right.
    Mr. Baker. That brings to the fore my generalized 
observation about this problem. We can't really describe who it 
is that we would like to subject to whatever regulatory regime, 
be it self-regulation or government regulation, who should 
report. We don't know what it is they should report if we could 
identify who they are.
    But the most troubling aspect of it all is the frequency of 
reporting is so insufficient in light of the trading 
strategies, that all you would be able to do is get the license 
tag number of the truck that just ran over you. You wouldn't 
really get anything that could be instructive before the 
untoward event were to occur.
    That all leads me to wonder if we couldn't have some set of 
triggering devices. For example, those commodity pool operators 
have some set of requirements which they must report to you. 
But not all hedge funds are registered CPOs. So you have people 
outside your regulatory regime, and not all CPOs are hedge 
funds. So we seem to have some regulatory arbitrage that would 
lead a smart business practitioner to figure out where the 
radar is weakest, and that's where I make my border crossing.
    If, on the other hand, we had a multi-regulatory team agree 
that under certain triggering circumstances--and Mr. Steel, I'm 
going to jump to you after I hear Mr. Overdahl's response--if 
under certain circumstances, for example, high concentration in 
one economic activity, subprime lending, where it represents 
some agreed-upon percentage of business activity that would be 
generally viewed as aberrant.
    In bank terms, we have limits on loans to one borrower. As 
a, for example, parallel, where that individual firm is engaged 
in a counterparty relationship where the counterparties from a 
regulatory perspective might not be as strong financially as we 
would like, where that fund has an excessive investment from 
certain protected classes; for example, a high degree of 
reliance on pension fund monies, where that fund has changed 
its profile within a certain period of time from its routine 
practice.
    Now, all of that said, those are parameters you all should 
decide. But under those circumstances, what would be wrong when 
we identify that kind of aberrant actor from making a nonpublic 
disclosure to the appropriate Federal regulator for the purpose 
solely of insulating as best we can from a systemic risk shock? 
Do you have a view? Well, either one.
    Mr. Overdahl. The way we've handled that at the CFTC, that 
is a delegated responsibility of the National Futures 
Association. My understanding is that these are annual 
disclosures. And beyond that, we do see the operators of the 
pools, when they're operating within our markets through our 
large trader reporting system, and that's going to be there 
whether they're registered, whether they're filing reports or 
not. And that's going to be true with--
    Mr. Baker. Well, because my time is about to expire, and I 
apologize for curtailing it. But I'm just saying a certain set 
of factors that would lead one to identify a fund practice as 
perhaps aberrant with market practice, shouldn't those folks be 
subject to some sort of required disclosure in that event? Mr. 
Steel?
    Mr. Steel. I agree with you completely that the issue of 
transparency to the funding so as to understand these types of 
challenges is exactly a good question. I think that the way 
we've thought about this is I'm going to defer to Governor 
Warsh, who can describe to you how they're convening all of the 
regulators to talk about best practices and sharing expertise 
to exactly accomplish what you're describing.
    Mr. Warsh. Congressman Baker, as you know, these are issues 
that cross agency lines. What we've tried to do is to really 
have a supervisory review that does the same. Working with the 
SEC, the OCC and others, domestically and internationally, we 
at the Federal Reserve have tried to track what these risks are 
and to compare best practices.
    Mr. Baker. Well, it is possible, depending on the funding 
source, where a fund could be fairly large and not be subject 
to anybody's direct regulation at the table?
    Mr. Warsh. Absolutely. I think--
    Mr. Baker. Or even reporting? I hate to say ``regulation.'' 
I'm just talking about a private reporting regime so you can 
act on our social benefit behalf.
    Mr. Warsh. As you and others have rightly pointed out, the 
regime of regulating hedge funds, for example, within the 
borders of the United States, is a difficult exercise. This 
capital is remarkably nimble, and as a result, we're finding 
ourselves increasingly working with our counterparts overseas 
to accomplish many of those same objectives.
    I think the principles set out by the President's Working 
Group have been echoed in substantial respects by many of those 
regulators, so I have some degree of confidence that progress 
is being made across these jurisdictional lines.
    The Chairman. Thank you. Let me just announce, we have 
votes in 15 minutes, so I'll ask the indulgence of the panel. 
We will have Ms. Waters' questions, and we will then adjourn to 
vote. We should be back in less than 40 minutes from the 
voting, and the committee will resume as soon as the people 
have gotten a chance to vote on the fourth vote.
    The gentlewoman from California.
    Ms. Waters. Thank you very much, Mr. Chairman, and I'd like 
to thank the members of the President's Working Group for being 
here today. I am focused on what has happened in the subprime 
market. And I'm very much aware of the foreclosures that are 
devastating communities across this country. I've been in 
communities and cities such as Cleveland, Ohio, and now in 
Atlanta, and other places where whole blocks are boarded up. 
You know, people are losing their homes, and we all know why. 
We know that they were offered exotic products that they could 
not afford.
    And what we did not know and what we did not understand was 
Wall Street's role in these loans that were being extended and 
afforded to people, many of whom certainly could not repay 
them. We are learning about products such as no verification of 
income, of course, the interest only, and on and on and on.
    My question is--well, and also understanding and knowing 
Bear Stearns' exposure to the subprime loans recently required 
the firm to bail out two of its hedge funds. Bear Stearns put 
up $3.2 billion to rescue the two funds. What can you tell me 
about other hedge funds that might be in trouble because of 
exposure to subprime loans? And can we expect, as some are 
predicting, a collapse in the financial markets as a result of 
the subprime crisis? And recent loan performance in the 
subprime market appears to support the premise that the crisis 
certainly is not over, particularly with huge numbers of 
adjustable rate mortgages setting as we speak here today.
    Again, what do you know about this and other hedge funds 
that may be in trouble? Why didn't you see this coming? And how 
are we going to correct this?
    Mr. Sirri. Congresswoman, the question about hedge funds 
and what we know about hedge funds, let me address that first, 
because your question raised many issues. With regard to--and I 
don't want to focus too much on any one event such as Bear 
Stearns. But let me explain to you a bit about the funding 
situation there.
    You raised the point about $3 billion being used to bail 
out the funds managed by Bear Stearns. The way that funding is 
done is on a secured basis, by which I mean funds are lent 
against actual securities themselves. So in that sense, capital 
was provided to support that fund, so it was actually only to 
one of the two Bear Stearns funds as far as we know, and we 
think that number was a little less than $3 billion. We think 
it was slightly over $1 billion at the point.
    But moving beyond to the general point of your question, 
how would we know whether more of this is coming, our main 
window--and some of the other questioners asked questions that 
were related to this--our main window into this is indirect. 
It's through the providers of capital into the financial 
systems. The regulated banks and the regulated securities firms 
are the primary providers of capital to hedge funds, who in 
turn purchase securities or instruments linked to subprime 
mortgages.
    When we go in to inspect those providers of capital, in the 
case of the SEC, we're going to look at prime brokers, the Bear 
Stearns, the Morgan Stanleys and such, we look very carefully 
at their practices for funding those instruments. We look at 
their ability to manage those risks. We look at the valuation 
practices that they have.
    We look at all of those things holistically and make sure, 
as best we can, that they are not impairing the financial 
health of the regulated entity itself or of the holding 
company. In that sense, by doing that, we believe that we're 
appropriately minimizing the risk and managing the risk that a 
failure of a large, systemically important firm, such as big 
investment bank, would in fact bring risk to the financial 
system.
    Ms. Waters. Would anyone else like to comment?
    Mr. Warsh. Thank you, Congresswoman. Let me speak 
principally on the subject of the financial markets, which I 
think you raised. Certainly the tumult that you've described 
and that is no doubt happening, particularly in certain 
communities, is very real and is generating very real losses in 
the financial markets.
    From the Federal Reserve's perspective, I think our overall 
view is that there are certainly concerns that we might not be 
at the bottom of this tumult. But these losses don't appear to 
be raising, to this point, systemic risk issues. That in no way 
would suggest that the very real problems that some of your 
constituents and others are having aren't real. And, obviously, 
the Federal Reserve, working with other regulators, is doing 
its best to try to address those issues.
    But the financial markets are certainly repricing risk in 
this environment in the housing markets and more broadly. The 
losses that have been felt by hedge funds and other financial 
intermediaries are certainly forcing them to go back to first 
principles, revisit their exposures. And what we're trying to 
do in our supervisory capacity is ensure that they still have 
adequate cushions, that they still have sufficient capital so 
that they can operate robustly in these markets. From the 
perspective of the institutions we oversee, we don't see any 
immediate systemic risk issues that are brought to bear.
    Ms. Waters. Thank you very much, Mr. Chairman. I yield back 
the balance of my time.
    The Chairman. We'll recess and return in 35 minutes or so, 
as quickly as we can. I thank the panel.
    [Recess]
    The Chairman. The hearing will reconvene. That means the 
two people over there talking will please take seats. Sorry 
that we are late, but I do not want to inflict any more time 
constraints. Let's get those doors closed, please.
    And in a very easy choice, I now recognize the gentleman 
from Delaware.
    Mr. Castle. Thank you, Mr. Chairman. I am glad to be an 
easy choice.
    Dr. Sirri, I think this question should be addressed to 
you. In just reading Business Week in the last week or two, the 
magazine, there are all kinds of questions about hedge funds, 
etc. One of the ones that caught my attention was in the last 
couple of weeks. It says, ``The Street's Next Big Scandal,'' 
and it goes on to talk about traders and hedge funds colluding 
to profit from privileged information. I will not go into a lot 
of details on this, you can sort of figure out where it is 
going.
    They believe, this particular author believes, that the 
next big scandal will most likely involve brokerage activities 
and proprietary trading which long ago surpassed investment 
banking to become Wall Street's chief profit center, that is, 
trading on their own accounts in a variety of ways.
    At the heart of the new collusion is the practice of 
frontrunning, essentially trading ahead of big buy and sell 
orders to profit unfairly from the resulting ups and downs in 
prices. The concern is that prime brokers are not only tipping 
off their own traders about big mutual fund orders on deck, but 
also giving the heads up to their hedge fund clients. The 
banks' rewards are two-fold, etc., as you can imagine profits 
on commissions and profits on the trades.
    Meanwhile, mutual funds unwittingly subsidize this scheme 
by buying stocks at higher prices or selling at lower ones than 
they otherwise would. It's a slippery, slimy slope, lamented a 
mutual fund manager, adding that all these leaks make pure 
beating returns harder to achieve.
    And then it says, ``Regulators have been slow to crack down 
on what has quickly become an open secret. The U.S. Attorney's 
Office and the SEC have accused brokers from various companies 
of allowing clients to listen into their internal speaker 
systems.'' A series of things.
    I mean the probably--I share very much what the chairman 
said, and what the ranking member said, and that is, it is hard 
for us to get our arms around exactly what the problems with 
hedge funds may be. But I know one thing. When you get a big 
money operation like this, people are trying to make money on 
it and, obviously, if brokers can take advantage of this, they 
may do that. There is just a lot of things we have to do.
    And again, like the chairman, and the ranking member, and 
all of you, to a degree, I am not sure what we should be doing. 
I do not want to over-regulate. I happen to believe that there 
is tremendous equity advantage in hedge funds and private 
equity capital in terms of our markets and I think, frankly, 
all of you do a good job.
    It is just that this is sort of new to everybody. And I am 
going to get into pension funds here in a moment, but I am 
concerned about those allegations. And I am concerned about 
what we are doing that might prevent that from happening in the 
future without really judging whether it is really happening 
now or not and what perhaps, if anything, the SEC is doing in 
that particular area of this whole business of collusion and 
people just simply take advantage of information and knowledge.
    Mr. Sirri. Sure. Let me address that question. First let me 
say it is a very important question. It is one that runs to the 
heart of the SEC's mission of providing fair capital markets 
and investor protection. So there are two things that you put 
together that at times I think make sense in this context.
    One is the behavior of a broker dealer protecting customer 
information and the other is, as you pointed out, the 
concentration of wealth and hedge funds and the fact that they 
are large entities that, that like they are big clients of the 
brokers.
    We should be very clear about one thing. The broker dealers 
have an obligation to protect the proprietary nature of 
customer's order flow. To not do so would violate the 
securities laws.
    Regardless of whether it is a single entity that is a 
person who is being tipped or a large hedge fund that is being 
tipped, the broker dealer must protect the confidential nature 
of that order flow and not leak it out to people for their own 
benefit or for the benefit of their clients. That is a 
violation of the securities' law. We have adequate authority to 
go after that. And, as you have noted, we have gone after such 
behavior. We have brought cases out in that way.
    With regard to what you specifically mentioned with hedge 
funds having access to such things, our Office of Compliance, 
Inspections, and Examinations, has actually publicly said that 
we are looking exactly for that.
    We have gone and requested out of a large number of broker 
dealers information, data, actual detailed trading data and we 
are trying to piece together and look for exactly, the 
footprint of exactly what you are citing. That is, a tip or a 
trade coming and then or an order coming and other trades 
front-running the eventual consummation of that trade 
benefitting some other parties who were actually in process or 
looking for that.
    So I would say that it is probably, you know, the article 
may have characterized the idea that we are running behind 
there, but I think we are very much aware of that. The 
difficulty, of course, is detecting, but we are looking with 
all our tools to detect that. I think we are crystal clear that 
violates Federal securities laws.
    Mr. Castle. And I didn't read the entire article to you 
obviously, but you may have read it yourself. But it goes on to 
say how difficult it is to prove all these things. It is hard 
to get cooperative witnesses, etc. So your work is cut out for 
you and we appreciate what you are doing on that.
    Mr. Sirri. Thank you.
    Mr. Castle. Secretary Steel, let me turn to an area that 
concerns me that I mentioned. You have talked about the 
principles and the guidelines which were revealed earlier this 
year and the discussion of the industry's best practices.
    My concern--and I'm not that concerned about the extremely 
wealthy investors in hedge funds, but I am becoming 
increasingly concerned about the institutional investor, 
particularly pension funds. There are many individuals who are 
not wealthy who may receiving a payment or will receive a 
payment from that pension fund, the fiduciary which decides to 
get into a hedge fund. And I am not sure what knowledge they 
actually have.
    I do not know--in some of the due diligence you have spoken 
about, in some of the best practices you have adopted in your 
principles and guidelines are--is this information which is 
available to the individuals who are going to be actually 
getting involved in that investment or is it just to you as 
regulators?
    I mean I want to make sure these people who are 
representing more middle America, if you will, actually know 
what the heck they are getting into. I cannot judge whether 
they are good investors or not. But at least they would have 
full knowledge. Is it moving in that direction?
    Mr. Steel. Congressman, you ask an important question. And 
in my opening comments I chose or tried to highlight this, that 
we at Treasury and the President's Working Group think this is 
a crucial issue.
    As I said, when hedge funds began, it was the province of 
wealthy individuals and then it spread to foundations and 
endowments. But today it is basically pulling others into the 
area where they are affected and in particular through pension 
funds and things of that ilk.
    When we wrote the principles and guidelines, we dedicated 
one of the principles to this specific issue. Principal Number 
5 basically talks about the importance of this trend and that 
the key front-line defender has to be the fiduciary. And the 
fiduciaries representing these people should be a very 
demanding investor.
    We give specific examples of what they should want to 
understand, the importance of diversification as they construct 
the proper portfolio for that pension plan.
    Next, I'm quite comfortable that the way we're going and 
the forward-leaning perspective with our declaration that we 
are not confirming the status quo. Instead when we convene the 
group of people to help us think about the investors and the 
best practice for investors, our plan is to include as key 
members of that group the very best people from the pension 
world to help set standards and rules that can be a signpost 
for people who want to understand best practices as fiduciaries 
as they consider allocating part of the assets of a pension 
fund to alternative asset products.
    Mr. Castle. My time is up. If I could just ask one very 
brief--I cannot.
    The Chairman. If you want to make a statement?
    Mr. Castle. Well, the only statement I was going to make, 
Mr. Chairman, is--and I did not get a chance to say this per 
se--I understand the fiduciary's responsibility, but ultimately 
I think it is very important to make sure that the fiduciary 
has the information to be able to make that decision.
    I am not 100 percent comfortable with that now although 
perhaps I can be persuaded with a little more attention to it.
    The Chairman. I think that is right, that is the fiduciary 
after all is a fiduciary for other people. We have some 
obligation to make sure that if the fiduciary screws up, it is 
not only the fiduciary who suffers. So, it is not enough to 
say, ``Well, it was the fiduciary's fault.'' Because we have to 
protect the people who are the fiduciaries' presumed 
beneficiaries.
    Mr. Castle. Yes, sir.
    The Chairman. Let me just say, Mr. Secretary, I think you 
kind of summed up the message. I hope people have taken this 
which is the fact that there have not been any new proposals 
for increased regulation, etc., is not an endorsement to the 
status quo. I think that is the important lesson for people to 
take. That there is a recognition that this is an ongoing 
issue. The absence of any specific new regulatory scheme right 
now is not an endorsement of the status quo. I appreciate your 
putting it that way.
    The gentleman from Texas.
    Mr. Green. Thank you, Mr. Chairman.
    I thank the witnesses for appearing today. I also thank the 
ranking member, in his absence, and I would like to pick up 
where the chairperson left off with the responsibility of the 
fiduciary. But let us start with the notion and premise that 
historically hedge funds have been available to sophisticated 
investors. Sophisticated investors are not sophisticated by 
virtue of their knowledge. Knowledge alone does not make one a 
sophisticated investor.
    Unfortunately or fortunately as the case may be, to become 
a sophisticated investor, one has to have a certain amount of 
assets. Does anyone differ with that premise? That you have to 
have a combination of assets and knowledge to be a 
sophisticated investor for the purpose of investing in a hedge 
fund traditionally as we define sophisticated investor.
    Mr. Sirri. The Federal securities laws provide for various 
tests: Income levels, in some instances investments, and in 
other instances assets
    Mr. Green. Okay. So the assets are important to this 
process. And my concern, and it is a serious concern, is the 
problem that we have when we commingle sophisticated funds with 
what Mr. Steel calls less sophisticated and some others may 
have utilized this terminology, I use the term 
``unsophisticated'' funds.
    When you have these funds commingled, then we have a 
problem because no matter how much knowledge the people acquire 
who are part of a pension fund, they will not become a 
sophisticated investor. The knowledge alone will not make them 
sophisticated investors.
    Traditionally the reason we have had these sophisticated 
investors in hedge funds is because they could suffer the loss. 
If they suffered a loss, we had an individual or family that 
lost money and as bad as that is, it would not have the kind of 
impact that we can have on a market that the system itself, the 
people who happen to be a part of society because if a pension 
fund takes a serious hit, then we have a lot of people that we 
have to concern ourselves with as opposed to a family, as 
opposed to an individual who has an inordinate amount of money 
and God bless the person who has it. I think everybody ought to 
be a millionaire in a country where 1 out of every 110 persons 
is a millionaire.
    In fact, in this country, it is almost unhealthy not to be 
a millionaire, so everybody ought to want to try to become a 
millionaire in America. This is the richest country in the 
world, a country where we can spend $353 million a day on a war 
and still do well.
    So my question and my concern have to do with having these 
persons who have their pensions who are not sophisticated even 
if they have Ph.Ds in economics, they are still not 
sophisticated investors.
    And when this, if something goes belly up and the stock 
market of 1929 would never have gone belly up, should not have 
gone belly up, but it did. Enron should not have failed, but it 
did. We have had other instances where institutions, long term 
capital should not have failed, but it did. And nothing fails 
until it does. And when it does, then we have problems and 
taxpayers pick up a large portion of the tab because people 
eventually who are pensioners will go to the public trough in 
the form of public assistance and they need assistance and they 
ought to receive it by the way.
    So I do concern myself with this notion of a fiduciary 
being able to shoulder all of the burden for what can happen 
when those funds are intermingled and we have a loss. That is a 
real concern for me. And I don't know that I have heard 
anything that addresses this concern to the extent that I feel 
comfortable with this, the continuation of this as it is 
currently.
    Perhaps there is a way to do this and my chairman is very 
enlightened and I am sure that he will help me through it as 
well as others, but maybe there is a way to do this and not 
create the consternation that we are going to--that I have and 
maybe it is just me but that I have on behalf, I think, of the 
working people in this country who are finding more and more of 
their money going into the sophisticated market. This is a 
sophisticated market. And people who engage in this ought to 
have a better understanding and the capital to back up the 
losses that they may suffer.
    Is that my time, Mr. Chairman?
    The Chairman. You still have about 30 seconds.
    Mr. Green. Thirty seconds. The question would be this. 
Explain to me how we can allay the concern that I called to 
your attention with reference to the sophisticated and 
unsophisticated or non-sophisticated or less sophisticated 
monies being commingled.
    Mr. Sirri. Congressman, let me see if I can shed some light 
on this. You are quite correct in how you have characterized 
sophistication. The Federal securities laws provide that you 
have to be--have some little wealth, income or assets to buy a 
hedge fund as an individual and that is as you have stated.
    You bring up the issue of the fiduciary. One of the 
reasons--and you are noting that there seems to be something 
that does not match because unsophisticated people find 
themselves invested in investments that are normally held by 
sophisticated entities.
    I think there are two things. One, the first, is what you 
observed, the fiduciary. That person has a heightened 
responsibility to invest for those people. But the other is the 
amount of investment that is made.
    A fiduciary, if acting properly for say a pension fund, 
would never plunge 50 or 80 percent of their assets into one or 
more hedge funds. They would prudently place a small amount of 
assets in a hedge fund.
    When you turn to an individual, one of the reasons why we 
have wealth and income standards is there is a chance that an 
individual investor might place half of their wealth in a hedge 
fund, and that is dangerous. That is why we have the high 
wealth standards.
    What I am about to point out is that when a fiduciary is 
acting, and they are investing a pool of say, pension fund 
monies, it is not going to be the case that 30, 50, or 90 
percent of that pool is in hedge funds.
    It is going to be the case that hopefully a prudent amount 
is in hedge funds and it depends on the purpose. And so the 
exact quantity will serve to protect you.
    Mr. Green. Just a quick response, Mr. Chairman, and then I 
yield back my time.
    But there is nothing that thwarts a fiduciary from doing 
the opposite, the antithesis of what you just said.
    Mr. Sirri. Well, the fiduciary has an obligation to invest 
prudently and what you are pointing out is that fiduciary would 
not have the best interests of their beneficiaries in mind.
    If that is the case--I am not saying that could not happen. 
But if that is the case, that fiduciary could have just as well 
put 100 percent of their investments in tech stocks in the late 
1990's.
    The Chairman. Would the gentleman yield to me?
    Let me say this because I think he is on a very important 
point and it is really related to what the gentleman from 
Louisiana had said and the gentleman from Delaware. Yes, it is 
the fiduciary's responsibility, but if we are talking about an 
individual investor, if an individual mis-invests several 
million dollars of her own money that is too bad for her. With 
a fiduciary, it is other people.
    And I think the point is this: You are right. That has 
always been a problem. The problem is that hedge funds appear 
to many of us to be a new and more enticing opportunity for the 
unwary fiduciary. And the problem we think is not just the one 
who does not have his or her client's interests at heart or 
beneficiaries, but who does not have the smarts to do it.
    And that is why we think this increased set of very complex 
opportunities promising a very high rate of return create a new 
potential problem that particularly with regard to fiduciaries 
that we may have to do some new things.
    The gentlewoman from New York has arrived and is now 
recognized to ask some more questions.
    Mrs. Maloney. Thank you very much.
    Going back to my original questions, my concern about the 
Bear Stearns funds is not whether the funds themselves go 
under, or even if a major firm loses money, my main concern is 
what effect a sale of CDOs assets would have had on all 
institutions holding similar securities. And do each of you 
believe that the institutions that you oversee are valuing 
those assets properly? Are the credit rating agencies acting 
with appropriate speed to downgrade assets that no longer 
warrant their investment grade?
    And what about the customers such as pension funds, 
endowments, and so forth to whom these securities are sold, the 
CDOs, other mortgage derivatives. What about them? Are they 
valuing them properly?
    And what is the systemic consequences of a broad downgrade 
or significant deterioration of those types of securities' 
values?
    So I would like everyone to respond on whether you feel 
they are valued. Is there a bubble there? And what is the 
systemic, the systemic effect really on the markets with 
properly valuing them?
    Mr. Warsh. Thank you, Congresswoman. Perhaps I will go 
first, but I will defer on the specific matter of Bear Stearns 
that you referenced to my colleague from the SEC who has 
oversight over them.
    Let me talk a little bit more broadly--
    Mrs. Maloney. I want to make it clear. I am not asking 
about Bear Stearns. I am not talking about a major firm losing 
money, but what effect it has on the value of the CDOs and the 
systemic problem it could have on the markets and on the proper 
valuing of the CDOs.
    Mr. Warsh. As you heard from us at the outset, market 
discipline is going to have a critically important role to play 
here. Market discipline is tough medicine and I think, 
Congresswoman, to your point, losses will no doubt be held by 
some individuals and institutions that own collateralized debt 
obligations and other securities as the markets turn against 
them.
    And it is these losses which force all institutions to go 
back to first principles, revisit their valuations, revisit the 
ratings that have put on these securities to make sure they 
know where their risks are. The Federal Reserve, as regulators 
and supervisors of U.S. bank holding companies, is keenly 
focused on ensuring that the risks held by these institutions 
are manageable.
    We are not in the business of trying to ensure that there 
are not losses but only to ensure that there are capital 
cushions, risk management processes, and proper oversight to 
ensure that those losses do not become systemic.
    Mrs. Maloney. But do you believe that these, that they are 
being valued--are these assets being valued properly? The 
credit agencies are still giving them 100 percent rating. Some 
analysts are saying they are really worth 20 percent. This is 
problematic.
    Do you believe they are being valued appropriately?
    Mr. Warsh. I would expect that--
    Mrs. Maloney. Is there a bubble out there?
    Mr. Warsh. I would expect that the valuations of these 
securities are at the crux of what regulated institutions are 
reviewing as we speak. The valuations that have been put on 
securities that tend to be more complex, that tend to be less 
liquid, is both art and science. And I think that those 
institutions that rely wholly on models, that rely wholly on 
history of the last 4 or 5 years, are learning market lessons. 
That is, many of these new products--though they have been 
tested to some degree in recent months--may not have been 
subjected to the most adverse stress test.
    Speaking for the Federal Reserve, that is part and parcel 
of one of our priorities to ensure that the stress test work 
that we have done with our regulatees is taken to the next 
level to ensure that there are not risks that should be brought 
to bear.
    Mrs. Maloney. Some analysts have said that they believe 
there should be broad downgrades. What is the systemic 
consequence of broad downgrades on these assets? And I would 
like to go to someone else on the panel.
    Mr. Warsh. Would you like me to briefly answer that and 
then I will defer to--
    Mrs. Maloney. I would like to let someone else speak.
    Mr. Steel. Thank you. You asked an important question and I 
think my response would be in line with Governor Warsh's, that 
the key issues here are current pricing which you keep poking 
at and the issue of cushions or liquidity margin against them.
    And I think that right now the market is adjusting and 
seems to be settling at new prices. And right now there is 
stress in the subprime market. It does not seem to be a 
systemic issue which you have asked repeatedly and that would 
be the representation we would make. But it is going through an 
adjustment process. And so that will happen as the market 
develops and it seems as though it is happening in an orderly 
way.
    We have the largest residential financial market for 
housing in the world. It is $10 trillion, and it is a terribly 
important asset to the economy and to the housing market.
    It is now going through a process of revaluing certain 
parts of it, but I would not describe it in any alarming way 
other than it is going to go through the process of resetting 
prices, people readjusting their margin as the market adjusts 
and as Governor Warsh said, the harsh medicine of market 
conditions and the truth of the marketplace.
    The Chairman. Thank you. Actually I would say to Governor 
Warsh that I think people are very happy that the Fed is 
dealing with stress test. The fear is that they will do a 
little stress reality with interest rates. That will be the--
stick with the tests.
    The gentleman from Texas is now recognized for one last 
question and then the hearing will adjourn.
    Mr. Green. Thank you, Mr. Chairman.
    This will be to Dr. Sirri. Sir, would you oppose a 
codification of what you expressed in terms of a judicious 
prudent manager surrogate, if you will, having to invest not 
more than a certain percentage of a certain pension in a hedge 
fund?
    Mr. Sirri. I do not, you know--
    Mr. Green. The fiduciary.
    Mr. Sirri. Sure. I think it is very difficult to place that 
kind of a structure. I understand what you are getting at and 
let me tell you why. A hedge fund could be in fact a long only 
equity fund and be a perfect substitute for a common mutual 
fund that you find today. And some hedge funds do exactly that.
    Other hedge funds as we have been talking about invest in 
exotic instruments. So it is actually the job of the fiduciary 
to see through all of that and to find in fact a prudent 
packaging of instruments for the beneficial owners.
    It is really--it is very, very difficult to take the 
fiduciary off the hook in my view here. That is really where 
the rubber meets the road. And it extends to the point where a 
diligent fiduciary in many ways--for example, a fiduciary 
looking to invest for people's retirement who didn't select a 
small portion of say alternative investments may not always be 
acting in the best interest of investors.
    Mr. Green. I yield back. Thank you, sir.
    The Chairman. I thank you for returning. The hearing is 
adjourned. I must say that I think this has been very useful, 
and I hope that people will pay serious attention. We have, I 
think, a pretty good consensus that this is an issue that we 
have to remain seriously on top of. We have to be considering 
it and the final chapter has not been written. I think people 
should have some assurance, though, that there is an awareness 
of the problems and the risks and serious people are attuned to 
it.
    [Whereupon, at 12:45 p.m., the hearing was adjourned.]


                            A P P E N D I X



                             July 11, 2007



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