[Senate Hearing 110-838]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 110-838
 
                   THE ROLE OF FINANCIAL DERIVATIVES
                    IN THE CURRENT FINANCIAL CRISIS

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

                                HEARING

                               before the

                       COMMITTEE ON AGRICULTURE,
                        NUTRITION, AND FORESTRY

                          UNITED STATES SENATE


                       ONE HUNDRED TENTH CONGRESS

                             SECOND SESSION


                               __________

                            OCTOBER 14, 2008

                               __________

                       Printed for the use of the
           Committee on Agriculture, Nutrition, and Forestry


  Available via the World Wide Web: http://www.agriculture.senate.gov



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           COMMITTEE ON AGRICULTURE, NUTRITION, AND FORESTRY



                       TOM HARKIN, Iowa, Chairman

PATRICK J. LEAHY, Vermont            SAXBY CHAMBLISS, Georgia
KENT CONRAD, North Dakota            RICHARD G. LUGAR, Indiana
MAX BAUCUS, Montana                  THAD COCHRAN, Mississippi
BLANCHE L. LINCOLN, Arkansas         MITCH McCONNELL, Kentucky
DEBBIE A. STABENOW, Michigan         PAT ROBERTS, Kansas
E. BENJAMIN NELSON, Nebraska         LINDSEY GRAHAM, South Carolina
KEN SALAZAR, Colorado                NORM COLEMAN, Minnesota
SHERROD BROWN, Ohio                  MICHEAL D. CRAPO, Idaho
ROBERT P. CASEY, Jr., Pennsylvania   JOHN THUNE, South Dakota
AMY KLOBUCHAR, Minnesota             CHARLES E. GRASSLEY, Iowa

                Mark Halverson, Majority Staff Director

                    Jessica L. Williams, Chief Clerk

            Martha Scott Poindexter, Minority Staff Director

                 Vernie Hubert, Minority Chief Counsel

                                  (ii)

  
                            C O N T E N T S

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                                                                   Page

Hearing(s):

The Role of Financial Derivatives in The Current Financial Crisis     1

                              ----------                              

                       Tuesday, October 14, 2008
                    STATEMENTS PRESENTED BY SENATORS

Harkin, Hon. Tom, U.S. Senator from the State of Iowa, Chairman, 
  Committee on Agriculture, Nutrition and Forestry...............     1
Crapo, Hon. Mike, U.S. Senator from the State of Idaho...........     7
Lincoln, Hon. Blanche L., U.S. Senator from the State of Arkansas     9
Lugar, Hon. Richard G., U.S. Senator from the State of Indiana...     5

                                Panel I

Black, William K., Associate Professor of Economics and Law, 
  University of Missouri, Kansas City, Missouri..................    13
Dinallo, Eric R., Superintendent, Insurance Department, State of 
  New York, New York, New York...................................    11
Lindsey, Richard, President and Chief Executive Officer, Callcott 
  Group, LLC, New York, New York.................................    17

                                Panel II

Duffy, Terrence A., Executive Chairman, CME Group, Chicago, 
  Illinois.......................................................    39
Pickel, Robert, Chief Executive Officer, International Swaps and 
  Derivatives Association, Inc., New York, New York..............    41
Radhakrishnan, Ananda, Director, Division of Clearing and 
  Intermediary Oversight, Commodity Futures Trading Commission...    37
Short, Johnathan, General Counsel, Intercontinental Exchange, 
  Atlanta, Georgia...............................................    42
                              ----------                              

                                APPENDIX

Prepared Statements:
    Black, William K.............................................    68
    Dinallo, Eric R..............................................    73
    Duffy, Terrence A............................................    81
    Lindsey, Richard.............................................    87
    Pickel, Robert...............................................   100
    Radhakrishnan, Ananda........................................   105
    Short, Johnathan.............................................   110
Document(s) Submitted for the Record:
Dunn, Michael:
    Written statement to the Committee, October 15, 2008.........   118
Question and Answer:
Chambliss, Hon. Saxby:
    Written questions to William K. Black........................   120
    Written questions to Richard Lindsey.........................   120
    Written questions to Robert Pickle...........................   120
    Written questions to Terrence Duffy..........................   120
    Written questions to Johnathan Short.........................   120
    Written questions to Ananda Radhakrishnan....................   121
Black, William K.:
    Written response to questions from Hon. Saxby Chambliss......   122
Duffy, Terrence A.:
    Written response to questions from Hon. Saxby Chambliss......   126
Lindsey, Richard:
    Written response to questions from Hon. Saxby Chambliss......   128
Pickel, Robert:
    Written response to questions from Hon. Saxby Chambliss......   129
Radhakrishnan, Ananda:
    Written response to questions from Hon. Saxby Chambliss......   130
Short, Johnathan:
    Written response to questions from Hon. Saxby Chambliss......   131



                   THE ROLE OF FINANCIAL DERIVATIVES
                    IN THE CURRENT FINANCIAL CRISIS

                              ----------                              


                       Tuesday, October 14, 2008

                                       U.S. Senate,
                                  Committee on Agriculture,
                                   Nutrition, and Forestry,
                                                     Washington, DC
    The committee met, pursuant to notice, at 11:03 a.m., in 
room 106, Dirksen Senate Office Building, Hon. Tom Harkin, 
Chairman of the committee, presiding.
    Present or submitting a statement: Senators Harkin, 
Lincoln, Lugar, and Crapo.

 STATEMENT OF HON. TOM HARKIN, U.S. SENATOR FROM THE STATE OF 
    IOWA, CHAIRMAN, COMMITTEE ON AGRICULTURE, NUTRITION AND 
                            FORESTRY

    Chairman Harkin. The Senate Committee on Agriculture, 
Nutrition, and Forestry will come to order.
    We are holding this hearing in the midst of the deepest and 
most far-reaching financial crisis in nearly 80 years. Major 
U.S. financial institutions which were thought to be rock-solid 
are now in bankruptcy, have been sold for pennies on the 
dollar, or are on life-support from the U.S. taxpayers. Money 
and capital are not flowing. Families and businesses cannot get 
the credit they need. Our already weak economy has sunk further 
into recession. U.S. economic growth is flat to negative. Jobs 
are being lost, and unemployment is climbing.
    Though stock prices rose yesterday, at the end of last 
week, the Dow Jones average had fallen 40 percent in the 
preceding year. Stocks in the Wilshire 5000 stock index lost 
$8.4 trillion in value in the same period last year. I might 
also mention that farm commodity prices are also falling 
dramatically.
    We all understand the urgent and critical need to revive 
the financial markets and return them to sound functioning. I 
emphasize that again, to sound functioning. I am not interested 
in returning the financial markets to the old heyday of CDSs 
and CMOs and CDOs, credit default swaps, collateralized 
mortgage obligations and collateralized debt obligations, and 
all the things that are swirling around out there. I mean 
return it to sound functioning.
    We in the Congress went along with a modified version of 
the administration's rescue plan because the stakes were so 
high. We hope that some of those outlays, which may exceed $700 
billion, will come back to the Treasury, but there is no 
assurance of that. How will it be paid for? By borrowing, by 
adding to the national debt. That means our children and 
grandchildren will be paying for it. What is more, saving the 
financial sector makes it all that much harder to pay for our 
nation's other needs, to fund the genuine investments in the 
future, such as education, a better health care system, medical 
research, renewable energy, roads, bridges, sewer and water 
systems, the infrastructure of our capitalist system.
    Well, if we are going to borrow against the future to save 
the financial sector, then we had better make sure the money is 
well spent. If Wall Street is an emergency room patient, we 
cannot just give a blood transfusion without stanching the 
bleeding, without attacking what really ails the patient. We 
have to get to the root of how our nation's financial system 
has fallen into this crisis and fix the problems in order to 
restore and rebuild fundamental soundness, confidence and 
integrity to those markets and our overall economy.
    We have all heard much about the impact of non-performing 
real estate loans. Real estate mortgages were packaged, then 
securities backed by those mortgages were sold to investors. 
But far too many of the securities sold to the investors were 
risky, certainly riskier than the ratings indicated, because 
the underlying mortgages were risky. I keep hearing the word 
``toxic'' being used now.
    Now, we are learning about another layer of risk that was 
added on top of the risk from junk securities. We now know this 
financial crisis and the collapse of key financial institutions 
owe a great deal to the extensive commerce in credit default 
swaps and similar contracts, like collateralized debt 
obligations, collateralized mortgage obligations.
    I wanted to do a little search here to find out, when did 
all these things start? When did all these things really come 
into being? Have they been around forever? No. Most of these 
began in the 1980's.
    Collateralized mortgage obligations, banks basically 
started in 1983 by Fannie Mae. They sort of went along at a low 
level for a while and then in the late 1980's and 1990's, they 
boomed.
    Collateralized debt obligations, invented by Drexel Burnham 
in 1987. They didn't do much for a while. Then they mushroomed 
in the 1990's and exploded again in the 2000's.
    Credit default swaps weren't around before the early 
1990's. Then they sort of went along at a low level, and then 
again ballooned in the 2000's.
    So these are not things that have been around in our 
financial system forever. These are instruments dreamed up by 
geniuses.
    Credit default swap contracts were written and sold to pay 
out in case of a loss on a variety of securities and financial 
obligations, including, as I said, those backed by unsound 
mortgages. In other words, credit default swaps were issued and 
used in ways that made highly risky investments seem sound. 
Now, as the losses mount on the securities and other 
obligations, those responsible under the credit default swaps 
have to pay up in amounts that greatly exceed anything the 
issuers and sellers of the swaps expected and anything the 
financial sector could withstand.
    The total outstanding notional--and we will hear more about 
that in the hearing--or face value of credit default swaps 
exploded to a high of some $62 trillion worldwide last year 
according to the International Swaps and Derivatives 
Association. That roughly equals the gross domestic product of 
the entire world for 2008. And the total face value of all 
types of financial swaps was some $587 trillion worldwide at 
the end of last year.
    I have a chart here that shows relatively what we are 
talking about, $62.2 trillion in the notional value of credit 
default swaps. U.S. household real estate value, $19.9 
trillion. Again, people say, well, notional doesn't mean that 
much. I mean, everything would have to collapse before you 
would ever reach that. Well, the same would be true in U.S. 
household real estate values, too, but again, it gives you a 
relative idea of what is going on there.
    What has happened is that the market in swaps is vastly 
greater than the value of any underlying assets. Now, one of 
the reasons for that is because the investor can enter the 
swaps market without owning a bond or any other interest at 
risk. It is a betting game, folks. It is a betting game.
    The huge multiplication of leveraging, with the help of 
credit default swaps, has now come home to roost with a 
terrible vengeance. That is why Warren Buffett called 
derivatives, and I quote, ``financial weapons of mass 
destruction.''
    Credit default swap contracts function somewhat akin to 
insurance, and we are going to talk about that with our first 
witness. But they are purposely not written like insurance. 
Why? To avoid the safeguards of insurance regulation.
    Swaps contracts also function much like futures contracts 
because the payout depends on something happening later on in 
the future, or not happening. But they are not regulated as 
futures contracts because a statutory exclusion passed by the 
Congress, signed by the President in the year 2000 excluded it 
from the authority of the Commodity Futures Trading Commission, 
which comes under the jurisdiction of this committee.
    So these swaps need not be traded on an open, transparent 
exchange. As a result, it is literally impossible to know 
whether swaps are being traded at fair value or whether 
institutions trading them are being over-leveraged or 
dangerously over-extended.
    Now, we have been told in the past that traders and 
institutions involved in financial derivatives are highly 
capitalized and, quote, ``sophisticated.'' They can look after 
themselves. Well, the credit default swaps and derivatives have 
been put together, they say, by mathematics and physics 
geniuses, but carried out without an understanding of human 
behavior and market behavior.
    What they thought were tools to manage and limit risk have 
actually turned out to magnify and amplify risk. I want to 
repeat that. What they thought were tools to manage and limit 
risk have turned out to magnify and amplify risk.
    Yes, these derivatives may be devised and traded by 
sophisticated parties, but the problem is that their 
miscalculations and blunders have put our national economy on 
the precipice. We cannot simply condone anything and everything 
done in the financial markets in pursuit of huge profits. What 
is good for Wall Street banks and money managers is not 
necessarily what is good for our sound economy and our society. 
We have seen that time and time again.
    We also must question the soundness of our economy's ever 
greater dependence upon the financial sector. In 1948, 56 
percent of the profits of U.S. companies were in manufacturing 
while 8.3 percent were in the financial sector. But in 2007, 
only 19 percent of profits were from manufacturing, 26 percent 
from the financial sector, and you can see that on the chart 
over there, if you can hold that up. You can just see where 
manufacturing keeps going down, financial profits keep going 
up.
    We have moved from sound, regulated capitalism to what has 
come to be known as market fundamentalism--market 
fundamentalism, the idea that the market knows best and must be 
allowed to freely make and correct its errors, forgetting about 
the manipulators and forgetting about human greed.
    Recent events have once again shown that the stakes are too 
high for our entire economy to follow this sort of rigid 
ideology. Regulations must be reasonable and allow financial 
markets to function effectively and efficiently to move capital 
and credit where they are needed in our economy. Yet we must 
have regulations that will protect the rest of our economy from 
the excesses--from the excesses in the financial markets, and 
to protect the rest of our economy and Americans from the 
collateral damage when the financial sector makes a blunder.
    Again, I want to get back to the issues from credit default 
swap. You know, I have been out in my State a lot the last 
couple of weeks, going around, and as I have gone to meeting 
after meeting, I offered this. I said, I have got 100 bucks in 
my pocket that I will give to any person who can explain a 
credit default swap in language that the average American can 
understand. You hear it talked about, but no one really knows 
what it is--billions of dollars, maybe even trillions, we don't 
know.
    So I had a chart drawn up to illustrate what a credit 
default swap was, tried to reduce it down to maybe something 
that the average person might hopefully understand. Hold that 
up so people can see it. So what you have got here is you have 
got mortgage lenders that loan money for people buying homes. 
We have got that. Now, in the past, these mortgage lenders 
tended to hang on to those mortgages. They were your savings 
and loans. They were your banks, other institutions like that 
basically held on to the mortgages.
    But then, as I said, beginning in the 1980's, they decided 
that they would start bundling these, collateralizing them, 
passing them on. And so these mortgage lenders then, would 
bundle the mortgages, they would collateralize it and that is 
what is called the reference obligation, or a bond, or whatever 
it might be.
    And then you have a protection buyer up there. Now, two 
things are important here. They can actually buy that reference 
obligation and hold it, or they go to Wall Street and what they 
do, Wall Street has devised this scheme whereby they say, okay, 
if these people down below don't pay, we will pay you. We will 
pay you. Now, that is like insurance to me. We will pay you if 
there is a default.
    Well, you might say, what is wrong with that? You buy 
insurance to pay off. Well, the problem is, it is not 
regulated. Therefore, we don't know whether the protection 
sellers have enough money to pay off if that credit reference 
obligation goes under. If these people at the bottom don't pay, 
does Wall Street have enough money to pay the protection buyer? 
We don't know that because they are not regulated like 
insurance. We don't mandate that they show us that they have 
enough money to back it up.
    Now, the other thing that can happen is this protection 
buyer doesn't have to own the reference obligation. They just 
bet that either it will be OK or it will not be okay, and then 
Wall Street comes in and sells them kind of an insurance policy 
made on that bet. Now, this is something that people don't 
understand. They don't even have to own it. They just bet on 
it. This is casino capitalism, that is what it is. It is casino 
capitalism.
    So hopefully, that kind of brings it home. It is hard to 
understand, and perhaps that is why it has gotten us in so much 
trouble.
    Well, as I said, we have got to have regulations to protect 
our economy from these excesses. It is like Franklin Roosevelt 
said when he first came to office. He said, we always knew that 
greed was bad morals. We now know it is bad economics. It was 
true then and it is true today.
    So in my mind, there is no question that we must adopt a 
stronger system of regulation and oversight for these swaps and 
derivatives and everything else that is out there. It is hard 
for me to see how we are going to put our financial sector and 
economy back on a sound footing unless we impose regulatory 
oversight.
    So I start off by asking two questions. One, shouldn't we 
just outlaw all of these fancy financial products? Just say, 
you can't do it. They are too injurious to our system.
    The second question I have is, if we can't outlaw them, 
shouldn't these be traded on an exchange where it is open and 
transparent, where you know how many are out there, what their 
real values are, and where they have to make their books 
balance every day? And shouldn't we then make sure that if it 
is an insurance kind of policy, that it is regulated by the 
insurance commissioners of our States so we know that the 
sellers have enough money to back up their obligations?
    So I ask those two questions and I intend to pursue them 
with our witnesses, and I thank them all for being here.
    With that, I would yield to our distinguished former 
Chairman of this committee, Senator Lugar.

STATEMENT OF HON. RICHARD G. LUGAR, U.S. SENATOR FROM THE STATE 
                           OF INDIANA

    Senator Lugar. Well, thank you very much, Mr. Chairman, for 
calling this timely hearing and likewise for your very expanded 
but important opening statement.
    I have a shorter one and the author is the acting Chairman 
of the CFTC, Walt Lukken, who wrote about a part of this 
problem in the Wall Street Journal last Friday. I want to quote 
relevant passages from Chairman Lukken's paper.
    He said the current financial crisis is requiring 
policymakers to rethink the existing approach to market 
regulation and oversight. Many observers have singled out the 
over-the-counter derivatives, including credit default swaps, 
as needing greater scrutiny and transparency. If we are to 
avoid repeating the mistakes of the past, we must strive to 
increase the transparency of these transactions and find ways 
to mitigate the systemic risk created by the firms that offer 
and hold these off-exchange instruments.
    While wholesale regulatory reform may require careful 
consideration, there is one immediate and proven solution at 
hand: Centralize clearing. Clearinghouses have been around 
almost as long as trading itself as a means of mitigating the 
risks associated with exchange-traded financial products. 
Whether the security is options or futures, centralized 
clearinghouses ensure that every buyer has a guaranteed seller 
and every seller has a guaranteed buyer, thus minimizing the 
risk that one counterparty's default will cause a systemic 
ripple through the markets. The clearinghouse is able to take 
on this role because it is backed by the collective funds of 
the clearing members.
    This clearing guaranty goes to the root of the problems we 
are confronting today, the constriction of credit due to fear 
of default. Indeed, for futures contracts, the standardized on-
exchange cousin of OTC derivatives, clearing has worked 
extraordinarily well in managing credit risk. The first 
independent U.S. futures clearinghouse was established in 1925 
and this model helped launch others. Today, the world's largest 
derivatives clearing facility is located in the United States, 
processing and guaranteeing more than two billion trades per 
year.
    For regulated futures exchanges, the clearing and 
settlement mechanism serves to lessen the likelihood that large 
losses by a trader will cause a contagion event. At least twice 
daily, futures clearinghouses collect payment from traders with 
losing positions and credit traders with profitable positions. 
This twice-daily mark to market prevents the buildup of 
significant losses and effectively wipes clean the credit risk 
inherent in the system. Importantly, no U.S. futures 
clearinghouse has ever defaulted on its guaranty.
    Just as significant, the clearing process provides 
transparency to regulators. When transactions are cleared, 
government and exchange regulators receive trader and pricing 
information, which helps them to police for manipulation and 
fraud and to uphold the integrity of the market.
    Now, can clearing work for OTC derivatives? The answer is 
yes. In fact, it already is working. After Enron's demise in 
2001, the OTC energy derivatives market locked up because many 
energy companies lacked the requisite financial standing to 
back their off-exchange trades. In response, U.S. futures 
exchanges sought and received approval from the Commodity 
Futures Trading Commission, the CFTC, in 2002 to clear OTC 
energy products for the first time. Today, a significant number 
of OTC energy derivatives are cleared through regulated 
clearinghouses, which has reduced systemic risk and allowed 
regulators a greater window into this marketplace.
    In conjunction with the President's Working Group on 
Financial Markets, the CFTC will continue to seek ways to 
provide clearing solutions for OTC derivatives. Last month, in 
a report to Congress, CFTC recommended the further use of 
clearing for OTC derivatives would statutorily fall outside 
CFTC jurisdiction but may opt to come on a regulated 
clearinghouse. There are several private sector clearing 
initiatives currently being considered by Federal regulators. 
It is imperative that policymakers work cooperatively and 
expeditiously to conduct their due diligence and allow 
appropriate programs to promptly begin operation.
    While needed reform of the financial regulatory structure 
will likely have to wait for the next administration and 
Congress, centralized clearing is one immediate step that can 
tangibly reduce risk in the markets and benefit the United 
States economy.
    I think that sums up at least a constructive position in 
terms of the immediacy and as we look at the regulatory 
situation down the trail. But this hearing is a good 
preparation for both and I thank you, Mr. Chairman.
    Chairman Harkin. Thank you, Senator Lugar.
    Senator Crapo.

 STATEMENT OF HON. MIKE CRAPO, U.S. SENATOR FROM THE STATE OF 
                             IDAHO

    Senator Crapo. Thank you very much, Mr. Chairman, and I 
want to thank you personally for holding this hearing. I 
particularly appreciate the title of it, ``The Role of 
Financial Derivatives in the Current Financial Crisis,'' an 
incredibly important question.
    Derivatives have come to play an extremely important role 
in our economy and now we are--the term ``derivative'' is 
almost becoming a household word as people are learning about 
it and facing the ripple effects of what we have seen in our 
economy in the last few months, just as much as credit default 
swap and the other types of financial instruments that we are 
all unfortunately taking a crash course on learning about.
    As you know and all of us here know, we have been dealing 
with what is the proper way to manage and regulate derivatives 
for a number of years in this committee and we will continue to 
do so.
    One of the main reasons that credit derivatives and the 
market--and the over-the-counter markets have grown so rapidly 
is that market participants have seen substantial benefit to 
customizing contract terms to their individual risk management 
needs. As the Chairman has so well pointed out, we have now 
learned painfully that there is not only a risk between highly 
sophisticated buyers and sellers and those who deal in these 
transactions at a very highly sophisticated level, but there is 
a systemic risk if we do not understand and correctly manage 
it.
    At the same time, recent events in the credit markets have 
highlighted the need for greater attention to risk management 
practices and the counterparty risks in particular, and I 
appreciate Senator Lugar's comments about the recommendations 
of Walt Lukken. There are a lot of very solid thinkers out 
there who understand the market well and who are evaluating 
what is it that has caused the problem we have today and what 
role do derivatives play in that.
    That is why earlier this year, the President's Working 
Group on Financial Markets called for market participants to 
take collective action to strengthen the infrastructure for 
clearing and setting credit default swaps and other over-the-
counter derivatives. Just last Friday, the Federal Reserve Bank 
of New York hosted its second meeting to discuss industry 
progress toward creation of a central clearing system for 
credit default swaps, and I understand several of our witnesses 
today were at that meeting and have been participating in that 
process, and I will be interested in knowing what they feel 
about those discussions.
    President Bush announced this morning that the U.S. 
Government is going to take financial stakes in our nation's 
top financial institutions as a part of a new plan to restore 
confidence in the U.S. banking system, and I am interested in 
how the topic we are discussing today is impacted by that 
decision as well as the troubled asset recovery plan that 
Congress and the Secretary of Treasury worked on in the past 
few weeks.
    There are all kinds of issues that we need to understand 
clearly as we move forward, but as both the Chairman and as 
Senator Lugar have indicated, there are really sort of two 
aspects of this. There is the short-term approach, which in my 
mind is being handled, at least at this point, in terms of the 
efforts to evaluate some type of a central clearing system or 
whether we need to deal with some other type of new regulatory 
approach.
    But there is also the wholesale regulatory reform issue, 
not just with regard to the CFTC but with regard to the entire 
system that we have in this country in terms of the regulatory 
approach to our financial markets. As I have calculated it, 
depending on what part of the financial industry one might be 
participating in, there are up to seven different Federal 
regulators and 50 different State regulators for different 
types of financial activity and there has been a strong 
suggestion made by our Secretary of Treasury in the blueprint 
that he put forward that we look at streamlining and making 
more efficient and more focused that regulatory system so that 
we accomplish those two objectives that our Chairman mentioned, 
the one being the objective of making sure that whatever system 
we have in this country, it allows capital to move freely and 
efficiently and that we allow free markets to operate, but that 
at the same time, we protect against anti-competitive 
manipulation of markets or practices that increase systemic 
risk in a way that is unfair to the economy and to the American 
taxpayer.
    It is my hope that today, as we proceed in this hearing, 
that we can not only understand what the role of derivatives is 
in our economy and what role it has played in the current 
economic circumstances that we face, but that we can also 
discuss some of the ways that we can approach these general 
objectives in broad regulatory reform, namely, once again, 
making sure that we allow capital to move freely and 
efficiently in a market system, in a free market system, but 
also making sure that we protect against inappropriate 
manipulation of markets, and beyond the manipulation issue, the 
question of simply behavior that will increase the systemic 
risk to our economy and to our people that should at least be 
brought into a much greater focus and into a circumstance in 
which we have the kind of transparency and control that we need 
to make sure that our citizens are protected.
    So again, thank you, Mr. Chairman, for holding this 
hearing.
    Chairman Harkin. Thank you very much, Senator Crapo.
    Senator Lincoln.

  STATEMENT OF HON. BLANCHE L. LINCOLN, U.S. SENAT0R FROM THE 
                       STATE OF ARKANSAS

    Senator Lincoln. Thank you, Mr. Chairman, and a special 
thanks to you, Chairman Harkin, for holding the hearing and 
bringing this group of experts together to discuss certainly 
the roles that derivatives have played and that they will play 
in our economy, but certainly the role that they have played in 
the most recent and probably worst financial crisis in our 
nation that we have seen since the 1930's.
    While the signs on the stock market were more positive 
yesterday, we are still confronted with an economy that is in 
severe trouble. It has got a downward swing. We are seeing 
American families--I don't know about you gentlemen, but I have 
been home in Arkansas and American families are paying more 
than ever at the pump. It is going down, but they still realize 
that it is going to probably go back up. Food prices have 
risen. Their wages have not necessarily. Housing prices 
continue to fall precipitously. Job losses are mounting every 
day.
    We can talk all day about derivatives and the incredible 
mathematicians that designed a lot of these, but until we 
really get down to how it affects people in their daily lives 
and how this economy is affecting people in their daily lives, 
we won't actually be doing our work.
    You know, as a result of the economic crisis on Wall 
Street, we know that our credit markets have tightened and we 
see failing banks are being bought out and the stock market is 
down. It is truly a time of uncertainty, economic uncertainty, 
and it creates fear in people who are living paycheck to 
paycheck and who are worried about what and who is going to 
take care of them in their old age. How are they going to help 
pay for their aging parents' prescription drugs and still be 
able to have somewhat of a nest egg or savings to be able to 
send their kids to college or retire themselves?
    And, you know, it is unbelievable because we have been 
begging--begging--to be a part of the global economy, and now 
the global economy is here and we are a part of it and we are 
going to have to figure out a way to behave in it and to behave 
with others that are there, because the global economy is more 
complex and intertwined than ever. All you have to do is look 
at today's discussion and the topic that we have got here 
today.
    I probably look at it from a little bit of a different 
perspective than some of my colleagues, but when I sent a kid 
off to school today, we had to try on three pair of blue jeans 
because he had outgrown them. We have outgrown a lot of the 
system that we have in place today and we have got to do 
something quickly about making sure that we are serious of how 
it is we provide the protection for consumers, more importantly 
that we keep an open market and that we continue to play in 
that global marketplace.
    And it is not going to be easy coming up with these 
solutions, and we are pleased that you are here today to share 
with us the ideas that you may have on what we do. But outside 
of Wall Street, we look at the regulatory bodies of the CFTC 
and the SEC and the staff of this committee and others, few 
people knew about derivatives or credit default swaps. I think 
the first were started in the mid-1990's, perhaps. Other 
financial institutions have shaken the foundations of some of 
our strongest and oldest financial institutions.
    And when we talk about clearinghouses, a central 
clearinghouse is a good idea if we can implement it, if we can 
make it happen, and if we can still maintain our spot in that 
global economy. The Chicago Mercantile, I think CME has an 
ability to clear OTCs or the over-the-counter, at least that is 
my understanding of it. Again, I am not an expert on these 
issues. But that is not where people are going to go if the 
other is an option. So we certainly have to look at that.
    It is clear, I guess, in hindsight that these troubled 
financial institutions and what we have seen did not fully 
comprehend the risk that was involved, or maybe they did and 
maybe that was their business. As Chairman Harkin mentioned, 
greed plays a big role in a lot of what happens and it has been 
around since the beginning of time. There are also the issues 
that we have to work through in terms of what people are going 
to use as a commodity and being able to look at the risk of 
somebody else and use that as a commodity. I don't know, it is 
a very difficult thing, I think.
    Again, having just told my children that you can't be 
gleeful about somebody else's misfortune, it is a marketplace 
that I think gets very, very dangerous in terms of how it 
defines itself and the position it puts us in as individuals.
    But I think our purpose--my purpose, certainly, in being 
here today, Mr. Chairman, is to better understand how it is 
that Congress can help and what it is that we can do. We by no 
stretch of the imagination, or I certainly don't as a member of 
the U.S. Senate, profess to have any or all of the answers. We 
will be looking to the professionals for help in figuring how 
it is that we do provide the kind of transparency that is 
necessary but still maintain our ability to work in a global 
marketplace and not get left behind, and I hope that we will, 
and I know that with the dedication of this committee and 
others, we will find those solutions.
    Thank you, Mr. Chairman.
    Chairman Harkin. Thank you very much, Senator Lincoln.
    I want to thank my colleagues for being here today. This is 
extremely important--I don't need to say that the issue that 
confronts us and that the Congress is really going to have to 
dig into in the next few weeks, hopefully a few weeks, or a few 
months.
    Again, just for the public and for the people who are here, 
why is the Senate Agriculture Committee having this hearing? 
Because this committee has jurisdiction over the Commodity 
Futures Trading Commission. Many of these instruments that we 
are talking about have the features of commodities and many of 
them have the features of futures contracts. As I said in my 
opening statement, they were exempted in the early 1990's and 
then excluded in 2000 from the CFTC's jurisdiction, but again, 
we are trying to find out what is the role of these derivatives 
and what is the appropriate role for the Commodity Futures 
Trading Commission in regulating these financial instruments. 
We all serve on other committees we are on, too, and we are all 
going to have to address this in other forums, other committees 
and perhaps on the floor of the Senate, so it may not be just 
limited to the Commodity Futures Trading Commission as such.
    I want to thank all of our witnesses for coming today. I 
have read all of your testimonies. They are very good. I would 
say that all of your testimonies will be made a part of the 
record in their entirety and I would ask that you summarize 
them so that we can get into a general discussion perhaps.
    We have two panels. Our first panel will be led by Mr. Eric 
Dinallo, who is the Superintendent for the State of New York 
Insurance Department for the State of New York. Then we have 
Dr. William Black, an Associate Professor of Economics and Law 
from the University of Missouri in Kansas City, and Dr. Richard 
Lindsey, President and CEO of the Callcott Group in New York.
    So again, I welcome and thank you for being here. We will 
start with Mr. Dinallo, and again, if you could summarize in, 
oh, I don't know, seven, eight minutes or something. We are not 
going to time it completely, but summarize as best you can. We 
would appreciate it.

    STATEMENT OF ERIC R. DINALLO, SUPERINTENDENT, INSURANCE 
       DEPARTMENT, STATE OF NEW YORK, NEW YORK, NEW YORK

    Mr. Dinallo. Thank you, Chairman. Thank you, Senators. Your 
opening statement to me was a tour de force and you don't 
really need to add much on the substance of credit default 
swaps. It sounds like you understand them real well, actually, 
from my modest perspective. So I will give you a couple of 
personal thoughts and then I will tell you what I think the 
history was, which I think could be enormously helpful for you.
    I think that there is one observation I would make, which 
is that we seem as a society right now very concerned with the 
shorting of equity and naked shorts on the equity side, but yet 
a far larger by orders of magnitude exposure is on the credit 
side, on the bond side, on credit worthiness, which is 
essentially what credit default swaps are about and naked 
credit default swaps.
    Naked credit default swaps I use to mean where you don't 
have that interest. You are not holding the bond. You are just 
doing the bet that you described before. That is possibly as 
big as ten times the original hedging enterprise that was 
developed. So people developed credit default swaps to do what 
you said, which was to hedge or ensure their exposure. They 
held bonds in a company and they were afraid the company might 
default so they swapped--that is the swap--they swapped their 
exposure to that default with somebody else. They bought 
insurance, essentially.
    But that was far eclipsed by the naked credit default swap, 
where you didn't own the bonds, had no exposure to the 
reference entity, as you put it. You just wanted to place a 
bet, a directional bet, as Wall Street calls it, on the future. 
And that now has grown in a number that is possibly as much as 
80 or 90 percent of the marketplace, that $62 trillion 
marketplace that you described that is completely unregulated.
    And what is interesting is that it wasn't insider trading 
or late trading or off-balance-sheet transactions that hurt us. 
It wasn't firm regulation or soft regulation or strong 
enforcement or lax enforcement that apparently helped to blow 
up the global economy. It is what we chose not to regulate. 
That is kind of an irony about this, is Wall Street is, as you 
would expect, going to fill a vacuum. So if you tell them 
everything over here is unregulated, they are going to kind of 
reproduce their activity in the more inexpensive, less capital 
intensive way in unregulated areas, and credit default swaps 
and other derivatives brilliantly permit them to do that and 
that is, I think to a large extent, what this is about.
    So how did we get here? It didn't used to always be this 
way. In 1907, there was the great crash and market failure that 
caused J.P. Morgan to bring everyone in a room and led to 
central banking, et cetera, and very soon thereafter, there 
were laws that were developed to address the very activity that 
contributed to that failure, and those were commonly called the 
bucketshop or the gaming laws of the various States.
    The activity that was going on there was not very much 
different, if even distinguishable, from credit default swaps. 
It was uncovered, on margined or credit betting, essentially, 
on how markets were going to close, what the prices were going 
to be. It was speculation, rank speculation, without holding 
the actual instruments, with, quote, ``no intent to buy or sell 
the referenced security,'' which is like a credit default swap. 
You don't actually own it, right? We just said that.
    So the laws were there since 1909. They are very clear. I 
have put them in the record. And they operated fairly well for 
a long time and then someone decided we had kind of grown out 
of our blue jeans, as you said. I don't think we did grow out 
of our blue jeans. I think a lot of this stuff is kind of 
either religious or spiritual or even Euclidian. There are 
certain first principles that people discover along the way. 
They put them in place and then they just kind of forget about 
them or they think--they kind of smart themselves into thinking 
that the precepts have changed.
    So by 2000, we engaged in the Commodities Futures 
Modernization Act, which specifically did a few things. It made 
credit default swap not a security, so it couldn't be regulated 
as a security. As you said, put it out of the reach of the 
CFTC. And it says this Act shall supersede and preempt the 
application of any State or local law that prohibits or 
regulates gaming or the regulation of bucketshops. So it wasn't 
anything. It became a private contract, as ISDA will tell you, 
but it hadn't always been that way. It had either been 
considered generally either gaming, insurance if it was a 
covered variety, securities, or some kind of a futures, and we 
decided that it wasn't going to be any of those because we had 
as a global economy outgrown the pants.
    I think to a large extent, that is what this is about, is 
for you to sort of think about a revisitation of that. The 
Governor of New York, Governor David Patterson, stepped up a 
couple of weeks ago and said, we are willing to regulate the 
portion that is clearly insurance, where you have an insurable 
interest, where you own the reference obligation, and then soon 
thereafter--I think the next day, Chairman Cox said he would 
like to have jurisdiction over CDSs, credit default swaps, and 
other kinds of derivatives. And then people began to talk about 
a more holistic solution like you are discussing, whether it is 
an exchange or clearing corp.
    We are kind of agnostic to some extent on all those. I 
would like us to see as a country a holistic solution. I would 
just give you sort of the earmarks of a good holistic solution, 
I think.
    I think they are that it would be optimal to have a central 
counterparty, so you have strong capital behind those bets, you 
have a very capitalized, very robust central counterparty that 
has a guaranty fund and the earmarks of sort of a solvency or 
capital regime. That you have clear margining rules so you know 
exactly how much people are putting up on each transaction. You 
have rules of event determination, because you have got to all 
agree on when someone did file for bankruptcy or insolvency or 
default so there are no squabbles about what event triggered 
the payment on the obligation. And last, sort of the same as 
rules of dispute resolution, so you can quickly resolve those 
arguments and so capital, as you said before, can quickly and 
freely flow.
    I think regulation would be excellent for this market. I 
think it has seized up now completely because of a lack of 
regulation and a complete lack of faith in it. And so I think 
you are going in exactly the right direction. The State 
government is only sort of showing the way by saying that which 
is obviously insurance, we are ready to step up and revisit 
some of the decisions we made, too, because we certainly in 
2000 issued an opinion letter that said for naked credit 
default swap where there was no proof of loss required, we were 
not going to call that insurance. We should have been probably 
more aggressive and asked or pointed out that there might have 
been some forms of insurable interest that we do need to 
regulate.
    So this is not political. I think collectively as a 
society, bipartisan in 2000 that it was, we agreed, and it is 
amazing that only in 8 years, look what happened. And I think 
that is the shorter history. I will put these documents, the 
bucketshop laws for New York, and if each State has one. The 
CFMA, you obviously have, but I will put it in the record for 
you so you have the clip there.
    But I think that is from my perspective, given your already 
impressive explanation of what credit default swaps are, what I 
would contribute to this, and I can answer questions from the 
written testimony or anything else at your pleasure. Thank you 
very much.
    [The prepared statement of Mr. Dinallo can be found on page 
73 in the appendix.]
    Chairman Harkin. Thank you very much, Mr. Dinallo. As much 
as I have been into this and reading and trying to understand 
it, I never thought about the comparison to bucketshops. 
Interesting. An interesting comparison to the old bucketshops 
as a credit default swap. I think now I see it more clearly.
    Dr. Black, again, welcome to the committee. We will go 
through the witnesses and then we will open it for questions 
and discussion. Dr. Black, again welcome, and please proceed.

STATEMENT OF WILLIAM K. BLACK, ASSOCIATE PROFESSOR OF ECONOMICS 
     AND LAW, UNIVERSITY OF MISSOURI, KANSAS CITY, MISSOURI

    Mr. Black. Mr. Chairman, thank you, and committee members. 
Your broader question was about derivatives and, of course, 
there are many more derivatives involved in this crisis and the 
one to start with, I think, is mortgage-backed securities, 
which are a financial derivative, and that takes you inherently 
to looking at the underlying, because, of course, it is a 
derivative from the underlying, and that is where you have a 
central area of problem. So whenever you think of derivatives, 
also think of the underlying, because any problems in the 
underlying will be brought forward in the derivative process.
    So what went wrong in that area, first? Fundamentally, 
perverse incentives, and perverse incentives on the 
compensation side. Senator Crapo properly said we would like 
capital to move freely and efficiently, but those two goals are 
inconsistent in practice, right? We had capital move freely 
through this process and it moved inefficiently. Our markets 
are less efficient because of the way mortgage-backed 
securities moved in the case of subprime. I mean, we have 
created, instead of efficiency, a worldwide crisis, right?
    So yes, those two goals are important, but the efficiency 
is the only real goal. Moving freely is just a way to get to 
the goal of efficiency, and if it doesn't produce efficiency 
but a disaster, then you don't want it to move freely because 
it is not moving in accordance with appropriate market forces, 
right? And that is what we have seen in the subprime and alt-A. 
I don't think that is controversial to people at all, and we 
have seen that this can produce an astonishingly large crisis 
because of the connections.
    We are seeing fraud incidents in subprime and alt-A of 40 
percent or more. The FBI has been warning since September 2004 
of, quote, ``epidemic,'' unquote, mortgage fraud. In 4 years, 
investment bankers who purchased, pooled, and created the 
nonprime mortgage-backed securities made an average of one-half 
of one criminal referral per firm, with a fraud incidence of 40 
percent or more.
    Chairman Harkin. Say that again, Mr. Black.
    Mr. Black. There were roughly 46 criminal referrals from 
roughly 24 investment banking firms over 4 years, and they 
handled roughly two million subprime and alt-A mortgages, with 
a fraud incidence ranging around 40 percent. That is why we 
have a disaster.
    Yes, greed, we have always had with us, so something else 
has been added to greed and the something else is a derivative. 
It is called a mortgage-backed security. It is a derivative 
that doesn't exist in the market now because it is a non-prime 
mortgage-backed security and the markets have finally shut it 
down.
    But I would add that the norm is that there was never such 
a market. There is only about 8 years of the history of the 
world where there was such a market and we are treating it as 
if it were the norm. It isn't. Non-prime mortgages were never 
appropriate candidates for securitization under the theory of 
securitization. They are not remotely homogeneous.
    And when you have huge fraud incidence, you can't have a 
subprime market--I am sorry, a secondary market, because the 
theory of the secondary market is, I don't have to carefully 
underwrite the stuff that is underlying. It is supposed to have 
already been vetted, right, and you can't have a secondary 
market where everybody has to check everything all the time.
    Private market discipline was supposed to prevent this. It 
was supposed to be the thing that would move money if it moved 
freely capital to efficient purposes. It doesn't work that way 
when the compensation system is perverse. When the rating 
agencies give AAAs to stuff that was formerly known as toxic 
waste, then more capital will move to toxic waste and you will 
have a toxic crisis, and that is exactly what we have.
    The Brits, in soccer, we would call this the greatest own 
goal in the history of the world in terms of the deregulation, 
the de-supervision, and----
    Chairman Harkin. What do you call it?
    Mr. Black. Own goal. It is a term when you score against 
yourself.
    Chairman Harkin. Right.
    Mr. Black. You kick it into your own goal instead of the 
other team's goal.
    Chairman Harkin. I have got it.
    Mr. Black. Soccer is our family passion. Sorry.
    And to bring it back to incentive structures. There have 
been a series of scandals in China, for example, of putting 
poisons in infant formula. Why do people do that? They did that 
to make money and to win in terms of competition.
    What happens if you let them get away with that? What 
happens if you let people gain a competitive advantage by 
cheating? Then you create a system where cheaters prosper and 
that is what happened--we call this in economics a Gresham's 
dynamic, where bad ethics drives good ethics out of the 
marketplace if the incentive structure becomes so perverse that 
cheaters prosper.
    So think of yourself as a potential chief financial officer 
3 years ago. You know that this stuff has been called toxic 
waste. You know that you are in the midst of what is going to 
be the largest bubble in the history of the world, financial 
bubble, which is the U.S. real estate bubble. You know how 
badly this is going to end. But what happens if you don't 
invest in subprime and alt-A and your competitors do? During 
the bubble phase, there are very few defaults on subprime 
because you simply refinance it. There are much higher fees and 
somewhat higher interest rates. So the people that do lots of 
subprime and alt-A report that they have the highest earnings. 
Their bosses earn the biggest bonuses. Their stock appreciates. 
Their options become more valuable, et cetera, et cetera, et 
cetera.
    If you as a CFO refuse to do that--the average CFO in 
America lasts less than 3 years. Think of the incentive for 
short-time approach. If you don't do it, not only do you not 
get your bonus because you don't hit the high target figures, 
but your boss, the CEO, doesn't get his full bonus, and all of 
your peers don't get their bonus. And so you rightfully fear 
that you will lose your job, as well.
    Does everyone give in to this? Of course not. But enough 
people do that we call--that is why we call it a Gresham's 
dynamic. It is well known in economics and it means that you 
need the law enforcement, you need regulation to change the 
incentive structure so that cheaters don't win, they don't 
prosper.
    The key thing with many of these financial derivatives was 
not their risk, but the fact that they were over-the-counter, 
that they had no readily verifiable asset value, because that 
is what you use for accounting fraud, things that are hard to 
value, right? We did it in the savings and loan crisis. You get 
unique office buildings because then there is no clear 
comparable, so the value is provided by an appraiser. Well, how 
difficult is it to get an appraiser to dramatically overstate 
asset values? We have just had a real-world experiment, and 
they did it a million times with subprime and alt-A.
    So these derivatives, and let me just briefly go to the 
ones you have been talking about more, the credit default swaps 
and the collateralized debt obligations, which in many ways are 
even worse on an individual basis than the CDS.
    The CDS--credit default swaps were created primarily for 
not very good purposes. Now, you have heard that one of the 
stated purposes was to reduce risk, and there was some truth to 
that, but as you can see, in fact, systemically, it increased 
risk. In Paul Volcker's telling phrase, they have failed the 
test of the marketplace, and that is the only test that counts, 
frankly, in this regard.
    But the real purpose in the ones I deal with more is banks 
who are massive players, and banks did credit default swaps 
primarily so that they could increase their leverage by taking 
things off of their balance sheet and reducing greatly their 
capital requirements under what is called Basel II.
    And the second major purpose and the largest one probably 
by volume is to do shorting, and there were already instruments 
available to short. They were simply more transparent, and so 
they deliberately picked a mechanism that is not only not 
regulated, but because it is not regulated, is incredibly 
opaque.
    So the first thing I would suggest to you is we need 
information, because one of the scariest things is nobody 
knows, and that has enormously made it more difficult for the 
Fed and Treasury to respond to the existing crisis.
    The second thing is you can't simply ask for data. Mr. 
Dinallo appropriately said the market seized up because of a 
lack of trust, all right. He gave an example previously. Well, 
think about that. At law, the defining element of fraud that 
separates it from other forms of theft is deceit. Fraud is all 
about creating trust in your victim and then betraying that 
trust. There is no more effective way, therefore, to destroy 
trust than to have significant accounting fraud of the kind 
that we have pervasively.
    And when people don't trust--if you know that one in 100 of 
these bottles is contaminated, how many of them are you going 
to drink? Fraud doesn't have to become endemic to cause markets 
to seize up because of a lack of trust. When you know that 
there are very large losses out there but you don't know where, 
when bankers no longer trust bankers because they don't know 
which balance sheet is contaminated, then entire markets seize 
up and we have to change that by creating credible information 
and data, and that is going to require regulation. A 
clearinghouse is a valuable step, but it will not protect you 
against financial bubbles.
    During the expansion phase, you would have done the daily 
mark to market in your clearinghouse and everyone would have 
said, no problem here, but there would be a trillion dollars of 
losses building up. So it is a good but not sufficient response 
in terms of for any future systemic crises.
    I think I have used an appropriate amount of time or more. 
Thank you very much.
    [The prepared statement of Mr. Black can be found on page 
68 in the appendix.]
    Chairman Harkin. Well, Dr. Black, thank you very much. That 
was provocative in a very good way, I think. It makes us think 
about just what these instruments are.
    Now we turn to Dr. Lindsey, President and CEO of the 
Callcott Group. Dr. Lindsey, welcome.

  STATEMENT OF RICHARD LINDSEY, PRESIDENT AND CHIEF EXECUTIVE 
        OFFICER, CALLCOTT GROUP, LLC, NEW YORK, NEW YORK

    Mr. Lindsey. Good morning, Chairman Harkin and members of 
the committee.
    In my written testimony, I attempt to correct several of 
the widespread misconceptions associated with credit 
derivatives, for example, concerns about the outstanding 
notional value. Briefly, the notional value represents the 
amount of money that protection sellers would owe protection 
buyers if every single underlying credit entity defaulted and 
the value of their debt went to zero. Given the primary credits 
on which credit default swaps have been written, focusing on 
the notional value would mean that the companies General 
Motors, Ford, AT&T, Eastman Kodak, Time Warner, General 
Electric, Telecom Italia, France Telecom, and the countries of 
Brazil, Mexico, Turkey, France, Italy, and Japan all defaulted 
simultaneously and the value of their debt went to zero. That 
scenario, in my view, is highly improbable.
    But rather than devote time to each of the issues with 
misconceptions this morning, I will instead touch on the four 
things that should be done to reduce systemic risk associated 
with credit derivatives.
    No. 1, a centralized clearing organization should be 
created for default swaps. This would place a clearing 
organization on each side of a credit default swap, thereby 
reducing the counterparty risk, which is really the primary 
risk we have been seeing in the market today, with a 
centralized clearing party.
    No. 2, appropriate capital requirements should be 
established. Capital charges should not be solely based on the 
level of market risk associated with the swap book but also of 
counterparties. While multiple counterparties may diversify a 
risk to some extent, the capital charges should increase with 
aggregate exposure to those counterparties. In other words, 
even if the market risk cancels in a hedge transaction, the 
counterparty risk, at a minimum, should double unless it is a 
true cancellation of the contract.
    No. 3, we should increase the transparency associated with 
each reporting company's use of credit derivatives. The soon to 
be effective FASB amendments will go a long way to meeting this 
objective, in my view.
    Finally, and in my view the most important, corporate 
senior management and boards of directors must recognize their 
responsibility to understand and control the risks that their 
firms are assuming through both business operations and 
financial market activity. It is not sufficient to receive 
assurances that everything is well controlled. Each individual 
has a duty to probe, to challenge, and to ensure that he or she 
has confidence in and understands the answers. It is not the 
board's responsibility to know and understand every single 
trade, but each board member must understand the firm's 
business lines and the use and misuse of derivatives. If a 
board is not truly confident in its understanding of 
derivatives and the associated risk controls, then the firm 
should not be allowed to use or trade derivatives.
    Thank you for your time and attention. I will be happy to 
answer any questions.
    [The prepared statement of Mr. Lindsey can be found on page 
87 in the appendix.]
    Chairman Harkin. Mr. Lindsey, thank you very much, and 
again, I thank all of our panelists for being here.
    It is hard to know where to begin sometimes in this, but I 
guess one of the first questions I have has to do with opening 
the books. It kind of gets to what you were saying, Dr. Black. 
We are being asked--well, we have been asked and we have done 
it--we have provided for the U.S. Treasury and the Secretary of 
the Treasury to use up to $700 billion to buy paper from these 
companies that are going to auction them off in a reverse type 
of an auction.
    I raised the point with Secretary Paulson once, and I 
wouldn't paraphrase his answer here, he can do that on his own, 
but what bothers me is that it is like a bank. We taxpayers are 
sort of like the bank. We put all this money up to buy this 
paper. We don't know what it is worth. They say it might 
increase in value over time, okay, but we don't know. But at 
any bank, if someone who is bankrupt, if a company that is 
bankrupt goes into a bank and wants to get bailed out to 
survive, surely the bank is going to want to look at the books. 
Am I wrong?
    And so, therefore, it is not just the balance sheet that we 
need to look at in these companies. That doesn't tell you much. 
It tells you what their indebtedness is, but it doesn't tell 
you how they got there. And I think you kind of touched on 
that, Dr. Black, maybe Mr. Dinallo, I don't know, but my 
question is, shouldn't we want to know how these companies--if 
we are buying their paper, shouldn't we want to know how they 
got there? What were their proprietary formulas? What were 
their mathematics? What were their probability tables? What did 
they use to value those? Not just their balance sheets, but 
what were the models they used? To me, that--is that good 
information that we should have? Should we insist on that? If 
they want the taxpayers to buy their paper, shouldn't we insist 
to know the models that they have used to value those assets. 
Am I clear or not?
    Mr. Black. Yes, and I even wore a prop today. It is the 
tie. This is a reproduction of a portion of Lewis and Clark's 
journal from their voyage of exploration, when we knew nothing 
about the land out there in the West and we needed to find out 
and we sent people out who kept incredibly good records and 
tried to be accurate, and we need that desperately today 
because we do not know.
    So two things you have to understand about either 
deregulating or desupervising. One is de facto, you 
decriminalize it because the only cops on the beat in white 
collar crime are the regulators.
    The second thing is you make the industry opaque and you 
create an inherent trust problem if the numbers they generate 
come not to be trusted, because no one can verify them.
    So what do we need to do? Yes, we need reporting, but you 
need more than reporting, and you are quite right that you need 
to know how the models worked and how they changed over time. 
But you also have to know about their accounting, right, 
because the numbers generated by the models may not drive their 
accounting purposes. And what you have just seen with all of 
these major failures--there has been all this stuff about mark 
to market, but none of them were marking to market and you can 
tell that because of the losses they had to recognize in 
connection with the failures and because when potential 
acquirers went in and did due diligence, they ran away 
screaming.
    Chairman Harkin. So what you are saying is we need two 
things, not only look at the books and the formulas and the 
proprietary models they use, but also how did they do the 
accounting after they used those models.
    Mr. Black. That is correct, and you have to look at the 
purpose--I think you were asking about this, as well. Often the 
purpose of the investment is critical and often it is 
misstated. There will be a purported hedge. It will actually 
have been increasing the speculating. That is very common.
    Chairman Harkin. Again, I want to get to this question of 
shouldn't we insist on knowing their proprietary models. You 
have given me another thought on their accounting. I didn't 
quite think about that. Mr. Dinallo? Dr. Lindsey?
    Mr. Dinallo. I think, Chairman, to a large extent that is 
what you see in insurance regulation. You see sort of an 
overview of the underwriting decisions and the reserving 
against the risk written in the capital requirements. It is, in 
my mind, one of the earmarks of what we have gone through, is 
that people didn't own the risk that they wrote. We engaged in 
the ultimate moral hazard here, both as a society on the front 
end and to some extent the actions by the Federal Government 
are consistent with that to some degree.
    We sent people out there giving loans. The first round of 
loans that was securitized performed really well. They were 
based on the fundamentals of people owning a home and banks 
understood they would own the defaults if people didn't pay, so 
they made those underwriting decisions very well.
    There was probably a second round that the banks, the local 
banks said, I wish I could give a second round because I saw a 
lot of people who deserved a loan but I had to make some tough 
decisions. So Wall Street helped with securitization, a 
wonderful tool.
    But after the seventh or eighth iteration of that, we 
basically--we correlated the risk because we made non-natural 
loan performance kind of a hallmark of our society and no one 
owned the downside of their underwriting decisions because the 
banks passed it to Wall Street to securitize it. Then investors 
bought it in the form of CDOs. And then they took out CDSs, and 
nowhere in that chain did anyone say, you must own that risk.
    And I think to a large degree, when I talk about this, 
there are three things I talk about: CDSs, which we have talked 
about; that endless securitization, we have to sort of make 
people own their underwriting decision; and the third is 
possibly a revisitation of the modifications to Glass-Steagall, 
which I think is for a different day. But that, to me, is a 
large--you should be looking at the books, yes.
    Chairman Harkin. Dr. Lindsey.
    Mr. Lindsey. I actually don't think----
    Chairman Harkin. Again, my question is, should we, if we 
are going to buy the paper, insist that they show us their 
books and the models that they used to reach those--how they 
did those different iterations in those derivatives.
    Mr. Lindsey. Well, I actually don't think looking at the 
models does very much for you because, in part, of course, they 
are what they are. However they got there, the positions and 
the values of the securities are what they are today. So what 
you need is actually a forward-looking way at the values of 
those securities. So how they modeled it 3 years ago is almost 
irrelevant in terms of what does it mean going forward.
    Part of the problem, of course, was that the default 
history, or the history of transactions associated with these 
securities, was very short, so in the early stages, people did 
not see the number of defaults, so they were relying on models 
and a time series of data that was misleading.
    I think, though, that I also want to point out that buying 
the paper that is in default is perhaps a somewhat inefficient 
way of dealing with the issue. As has been pointed out by both 
of my fellow panelists, many times, multiples of the mortgages 
have been written and in some cases by people not even owning 
the mortgages. But underlying all of this is really the 
mortgage, and the mortgages that are in default, those 
mortgages that are in default are still going to be in default 
no matter what happens. And in some cases, I think it was 
pointed out that the paper may be ten times the underlying 
level of mortgage that were in default.
    So if I recall the chart that you put up earlier, it showed 
something like about $19 trillion of total home equity 
ownership in the United States. Well, not that many are 
mortgaged. It is not quite $19 trillion. But somewhere around 
10 percent of those are in default, so we are looking at a 
little over a trillion dollars of mortgages in default.
    A more efficient way to inject certainty into the 
marketplace without buying paper upon paper upon paper is 
actually just to stand behind the mortgages. I talked about 
this a little bit in my written testimony, but one of the ways 
to modify this and inject certainty immediately is actually 
just to guarantee the mortgages. Probably more efficient and 
you end up with real estate rather than with a lot of paper.
    Chairman Harkin. Well, that would seem to me, then, you 
would let the mortgage lenders off the hook. They get the 
inflated price of what they lent and they walk away with the 
money under your formula. Do you see what I am saying? They 
made these huge subprime loans and stuff and now you are just 
going to buy them at that value?
    Mr. Lindsey. Where are we buying them now?
    Chairman Harkin. You are not.
    Mr. Lindsey. I believe we are.
    Chairman Harkin. As I understand what we are going to do, 
it is going to wring this out of the system and a lot of these 
lenders are going to have to swallow a lot of those losses.
    Mr. Lindsey. There will be losses swallowed someplace. 
There have to be.
    Chairman Harkin. But under your formula, they wouldn't take 
a loss.
    Mr. Lindsey. Some people would take losses. Anybody that 
was short the mortgage market would actually take a loss.
    Chairman Harkin. Well, I would have to think more about 
that. I don't know if I understand it fully.
    I think I have exercised all my time. I do have one last 
thing. Again, I was trying to get at this idea--Dr. Lindsey, 
you said it wouldn't do any good to look at these books because 
that is the past. Go into the future. But it would seem to me 
that we would want to know whether or not there really, truly 
was accounting fraud going on in the way they used those models 
and the way they accounted for them.
    I have been told that that is one of the reasons they don't 
want to open their books, is because there has been a lot of 
accounting fraud going on. I don't know if that is true or not. 
I have been told that. But it would also seem it would be 
important for us to know how they got there, to see if there 
was accounting fraud and also to make sure that if, in fact 
there was, we are going to have an open and transparent system 
in the future, that we don't rely upon those kind of models.
    Mr. Lindsey. If there was indeed accounting fraud, the SEC 
has sufficient jurisdiction, of course, to investigate and 
pursue accounting fraud, and they should.
    Chairman Harkin. But we wouldn't know that unless we really 
got into these books.
    Mr. Lindsey. But they have the ability to do that.
    Chairman Harkin. Who is ``they''?
    Mr. Lindsey. The SEC and the accounting firms.
    Chairman Harkin. I didn't know that. Did you have any other 
observations on my question?
    Mr. Black. I have a couple. First, you also want 
desperately to look at not simply their books, but they need to 
look at the actual assets. It is clear from the fraud incidents 
that nobody has cracked a file and done real underwriting. In 
other words, open the files. Fitch did this--this is one of the 
rating agencies--and they are the ones who found 40 percent 
fraud rate just from a file review. That is not private 
detectives going out and looking, just obvious on the face of 
the file. That tells you, since two million pieces of this 
paper were traded, that nobody looked. And so the desperate 
thing we need to know is credit quality and we know that they 
are not looking. So that is first. They need to look and we 
need to look at what they are finding.
    Second, the FBI has said that 80 percent of the mortgage 
fraud was induced by the lenders. I think that is relevant to 
your question of if somebody is going to get bailed out, or 
bear a loss, who should it be, and I would simply concur with 
you. You need to know about the old models and there is not a 
comprehensive Securities and Exchange Commission investigation 
after the greatest crisis since the Great Depression. The SEC 
is overwhelmed. It is a simply a commercial. I don't work for 
them, but they desperately need more resources. That is a plug.
    Chairman Harkin. Thank you all very much.
    Senator Lugar.
    Senator Lugar. Thank you, Mr. Chairman.
    You have made a good number of points, each one of you, 
about transparency, but one of the transparent parts of this 
you have just discussed, Dr. Black, is the officers of the bank 
or its directors and the amount of knowledge that they have of 
the business that they are conducting. I don't know how you 
have a post-mortem examination of each of these boards as to 
how competent they were, whether they fulfilled their 
responsibilities, but it is an interesting question, well 
beyond the scope of our situation now. What constitutes capable 
management in this country? What is the responsibility of these 
people who are receiving salaries and who are receiving fees 
and so forth to their own stockholders, quite apart from the 
other people?
    I will leave that one aside but simply say, clearly, the 
Congress and the public sector have some responsibility here, 
and it is a benign one, namely that it has been the hope that 
all Americans could own their own homes. We often have had 
statistics in the past that 60 percent, more or less, of 
Americans own their own homes. There is a high degree of 
idealism that has pushed that idea to get farther.
    Now, let us say you were junior loan officer at a bank and 
you had at least a possibility of issuing subprime mortgages to 
people. You could say you are doing the Lord's work. You are 
attempting, in fact, to get people into homes. And if the time 
and economic cycle is right, you could probably make a lot of 
loans to people. You may not have examined carefully or barely 
at all, really, their capability of repaying it, nor did maybe 
some of the people who are borrowing the money anticipate that 
there would be trouble in what seemed to be a rising set of 
home values.
    But at the same time, we now have a situation in which very 
clearly we are going to say for a moment this is not the 
American dream. It is an American nightmare for a great number 
of people who made the loans, and likewise those who can't 
repay.
    Now, the dilemma that you have all described today is that 
since the people making the loans in most cases no longer own 
the loans or have really much responsibility, or maybe even a 
track because of the bundling and then the down-trail 
situations, the responsibility of people involved in the 
business is gone. There has not been an examination apparently 
by the directors of the bank or its officers. You have 
described situations in which maybe their salaries and bonuses 
may be based upon the sheer volume and the numbers that they 
created in this process.
    So I don't know how, once again, we remedy all of this, the 
morals involved in it or the bad management. But at the end of 
the trail, you have made a suggestion that I am intrigued with 
and I just ask for your opinion, Mr. Black, or anyone else's, 
and that is that we have talked today about this insurance 
policy that Senator Harkin described in his chart in which if 
somebody is obtaining these pieces of bundles, they might say, 
we are not altogether sure what is in the bundle and therefore 
we would like to get some insurance. So we are willing to pay a 
fee to somebody to relieve us of the load, or whatever 
percentage of insurance you want to get. Now, that seems to me 
to be probably a prudent thing to do by the time you go to a 
second or third bundling of this, to at least have some 
insurance.
    But what you are suggesting is that, in fact, if I gather 
you right, 80 to 90 percent of the items being insured were not 
owned. There wasn't this responsibility. In other words, it 
became a naked gamble. Somebody said, the market seems to be 
going right. Why not bet on it one way or the other by taking 
out the insurance on something I really do not have?
    It seems to me as a matter of public policy, as we are 
thinking about prohibitions today, that is a practice that 
should be banned. There is no legitimate public purpose for 
this occurring. I can imagine if we have market theoreticians 
in here, or even extremists in terms of the free enterprise 
system, they would say, well, this is one of the ingenious ways 
in which the market has worked better.
    But in this particular case, given lack of observation by 
officers and boards to begin with, then bundling, an attempt 
finally to insure mistakes that somebody else made and may not 
have thought about, but you find you have just a few people 
insuring and the bulk of them gambling in this particular 
mechanism. That simply cries out for reform. And my own 
judgment is, if not prohibition, something pretty close to 
that.
    Does anyone have a comment about my phobia with regard to 
all this?
    Mr. Lindsey. Well, what I was trying to explain before is 
in or around 1909, it was, in fact, essentially illegal to do 
that kind of activity. I do believe, though, having now studied 
this for a bit, there are some gray areas that have to be dealt 
with. So you have something between the sort of orthodox or 
sartorial credit default swap, where you really do have an 
insurable interest, you own the bonds or you own the CDOs and 
you are buying that cover----
    Senator Lugar. But you own it at that point.
    Mr. Lindsey [continuing]. And you have the pure naked 
directional bet. It is you and me just betting on whether Ford 
is going to default or not. We have no otherwise interest in 
Ford. But in between, there are, as we put in our written 
testimony, there are some gray areas. You might be long stock 
and want kind of a way to balance that. You might have 
receivables with the company, and in case the company defaults, 
you want to have something to sort of make up for the loss you 
are going to end up taking in a bankruptcy. I mean, there are 
gray enough areas that I think that what we hope comes out is 
that we set some sort of holistic solution that has one of its 
earmarks is a lot more capital behind all those activities.
    So what you are saying, Senator, is essentially correct, 
and the way you would come close to prohibiting it, so to 
speak, but not really is if you made it a little more or a lot 
more capital intensive by either having an exchange that had 
certain capitalization requirements or that people 
participating in it have certain capital requirements by their 
regulators, which I think is sort of what is going to end up 
happening. You would essentially make it so that it would be 
expensive enough that you really would need to have an interest 
to want to go out and do that kind of activity.
    Senator Lugar. You need ownership along the way, would be 
another way of looking at it.
    Mr. Lindsey. Yes, or you would have to, like an insurance 
company has to do, have a certain amount of capital behind that 
bet that you are taking or making.
    Senator Lugar. At the bottom of all of this, we have talked 
about transparency, and that is clearly the case. But it had 
not been clearly the case in many of the transactions we are 
talking about now. It is sort of a cardinal virtue. It may be 
transparent and still the bank officers and the bank directors 
don't read the papers, or they don't have investigators looking 
at what they have actually got in the vault, so there is a 
degree of due diligence, much more due diligence involved in 
all this. But how do we obtain that? In other words, can you 
contrive a situation in which officers and directors who are 
inefficient or incompetent are penalized, aside from the fact 
that all their banks fail at one time and the Federal 
Government then is asked to come to the rescue?
    Mr. Black. We have to be, I think, more blunt than we 
usually are in the regulatory financial world. Yes, more 
capital would be a very good thing, but these instruments 
proliferated precisely as a way to reduce capital. Yes, 
transparency is a good thing, but these instruments were 
designed specifically because they were opaque. Indeed, in many 
ways, they are worse than opaque. We think the opposite of 
transparency in terms of badness must be opaque.
    But to me, the appropriate metaphor is the one you see in 
the passenger mirror in your car, that image that looks so 
absolutely clear but it has a warning and it has a warning 
precisely because it looks clear, that objects in the mirror 
are closer than they appear. And when you game the accounting, 
insolvency is closer than it appears. In fact, it arrived 6 
months ago, is what we are finding in these circumstances.
    So we have--now the suggestion is we come and we fix all of 
these things with capital, but they are just going to look for 
weak areas and push in because their goal consistently will be 
to find opaqueness and reduce capital, because leverage is what 
it is all about. So I think you have to think more 
fundamentally and we have to be more candid about whether 
trying to prescribe capital is really going to fix this.
    Senator Lugar. My time is up, but Dr. Black, it would 
probably be helpful, at least to my understanding, if you could 
make a list of specifically what are the instruments that 
should be stopped.
    Mr. Black. All right.
    Senator Lugar. In other words, if, in fact, we are 
depreciating by finding new ways to cheat the system, as fast 
as we regulate, why, somebody else contrives something, but you 
have described at least a few of these instruments this 
morning, and I tried to make notes quickly. But if you were to 
be a legislator and you would say, if we stopped this 
instrument and this second and this third and this fourth, we 
would have a better system, that would be helpful. Then we can 
argue about that.
    Mr. Black. I won't be a legislator, but I will act like a 
staffer.
    Senator Lugar. Very good. Thank you.
    Chairman Harkin. Senator Crapo.
    Senator Crapo. Thank you, Mr. Chairman. I appreciate 
Senator Lugar's questions because he went into the first area 
that I wanted to go into, the issue of the naked swaps and 
whether there should be greater capital behind them.
    And just to wrap up on that very quickly, as I understand 
it, Mr. Dinallo, up to 80 to 90 percent of the swap market is 
naked swaps. Is that what you said in your testimony?
    Mr. Dinallo. Yes, and you could--just parenthetically, you 
could question whether credit default swap as opposed to the 
naked ones is a totally oxymoronic concept because you had no 
risk until you entered into the contract. In other words, you 
are sitting in your home. You don't have any exposure to the 
third race at Belmont until you go to the track and place the 
bet. So I am not clear what the mitigation of risk there was. 
It was the swap is what created the risk.
    Senator Crapo. The one thing I wanted to clarify there is 
exactly what you are talking about. When you talk about a naked 
swap, are you including circumstances like you indicated in 
your response to one of the questions where an individual might 
be long in the stock of a company or might have receivables or 
something other than the actual underlying asset to which the 
swap relates?
    Mr. Dinallo. I think--I believe that in sort of classic 
insurance law, you would consider that arguably as insurable 
interest, but it is very hard to get your arms around, so it 
might be----
    Senator Crapo. But are those situations part of the 80 to 
90 percent----
    Mr. Dinallo. Oh, yes, sir. Yes, sir.
    Senator Crapo. That is the only question I was trying to 
clear up there.
    Let me move on to another issue and that is an issue that 
all of you, I believe, have talked about, but Mr. Black, you 
indicated that one of the concerns you had with the 
clearinghouse approach, not so much that you were concerned 
with the approach but that it wasn't a perfect solution, is 
because it does not stop losses from building up in the system. 
Am I correct that this was your statement?
    Mr. Black. Yes. During a financial bubble, you would still 
have huge losses building up that wouldn't be netted out on a 
daily basis because they wouldn't be showing up yet.
    Senator Crapo. Mr. Dinallo and Mr. Lindsey, do you agree 
with that or does the clearinghouse or creating a central 
clearing entity help to mitigate that buildup of loss? I 
thought that it would. That is why I am asking the question.
    Mr. Lindsey. As long as the buildup of loss, as Dr. Black 
is pointing out, is built up by an increase in what people 
believe to be the value of the underlying asset, no, a 
clearinghouse doesn't mitigate that loss. All it does is 
replace counterparties with a central clearing party.
    Let me make one point, though, about this, whether we call 
it naked swaps or otherwise. It is important to remember, of 
course, that futures, which I believe this committee is 
probably well versed in, is just a form of insurance for 
farmers, because a farmer can hedge the price associated with 
their crop. So if you think about banning product or trading of 
activity associated with somebody that doesn't have an existent 
exposure to it, it is the same thing as cutting out the vast 
majority of the futures market, which, of course, is what 
drives part of the price transparency and part of the ability 
to see where prices are going with agricultural futures.
    I do not think that you really want to think about banning 
a particular product. Without a doubt, there needs to be more 
capital control, more supervision and regulation associated 
with this product, more transparency, and I think centralized 
clearing would help a lot. It is not the answer to everything. 
But you don't want to get rid of the ability to discover price.
    Senator Crapo. Thank you very much.
    Mr. Dinallo.
    Mr. Dinallo. I would disagree on one and agree on the 
other. I think the futures or the farmer example is more akin 
to the gray area that I discussed, where you do have exposure. 
It is of a second order, but you do have exposure. You are 
buying some kind of insurance against crop failure, et cetera, 
or the market vicissitudes.
    On the second, it is sort of--this would be the order of 
interest to me. You would have a clearing corporation which 
would give you some enumerocity so you would know about how 
much CDS was written out there. We never knew how much had been 
written on AIG, et cetera. Then you have an exchange. But I 
think that if you really want to get at this issue that they 
are talking about, you need to have this central clearing 
party--central counterparty that has capital that is the 
ultimate insurance company or house against those bets. So the 
capital rises, the reserved capital rises as the values go up 
so then there is, in fact, something behind the bets.
    Senator Crapo. So you are talking about not only a central 
clearing party, but a guaranteed fund of some sort or----
    Mr. Dinallo. Yes, sir. Exactly.
    Senator Crapo [continuing]. That would need to be 
initiated, as well. I appreciate that.
    I want to move for the last 2 minutes I have here or so to 
another issue entirely, and it gets to the suggestion that you 
made, Mr. Lindsey, about the fact that we should stand behind 
the mortgages rather than to buy the toxic securities, which I 
tend to agree with the notion that the plan that Congress 
passed was one that basically put the taxpayer in the front 
position to assume a whole lot of risk in an entire 
marketplace, basically, that did not necessarily need to be 
done that way.
    The question I want to get at here is what kind of losses 
there are. We have talked about the fact that we have a $19 
trillion real estate asset, ownership in the United States, and 
if I understand your testimony, Mr. Lindsey, something like 10 
percent of that might be--well, it is not all mortgaged and 10 
percent of the mortgaged part of it might be in default, is 
that correct?
    Mr. Lindsey. That is right. That is correct. Somewhere 
around a trillion-two is in default.
    Senator Crapo. And in that context, we don't know what--I 
think the bottled water example of Mr. Black was a good 
example. We don't know what percentage of that is in each of 
these mortgage-backed securities that the U.S. Treasury is 
looking at purchasing, is that correct? And that is part of the 
reason we have the problem in the economy, is nobody knows 
where it is, but nobody is willing to buy on the bet.
    Mr. Lindsey. That is correct. There is a great deal of 
uncertainty. You don't know which bottle contains the 
contamination, so there is a great deal of uncertainty in terms 
of buying any bottle.
    Senator Crapo. I guess what I am trying to get at is I 
agree with the Chairman's comment that--at least, I assume that 
you meant this--that whatever we do as a government, we should 
try to do so in a way so that the losses are incurred by those 
who engaged in the risky behavior rather than the taxpayer. And 
as I look at different options, and I have already talked 
myself out of my time, but as I look at different options that 
the Federal Treasury has right now, like I say, I was not 
convinced that the one we got on the table was the right 
option. The one that you suggested, Mr. Lindsey, I think was 
probably a better option, but still has the Federal Government 
stepping in and guaranteeing that loss, basically. Is there a 
way that we could, through some kind of an equity position, 
have the Federal taxpayer, instead of guaranteeing a loss or 
purchasing toxic assets, have the Federal Government step in 
and provide needed liquidity where it was needed but do so in a 
way that we took back a very strong equity position that put 
the shareholders or the prior bond holders and those who 
financed this risky behavior in the position of looking at that 
loss?
    Mr. Lindsey. You would inherently be doing that if you 
didn't buy it back at book, right? You should buy it back at a 
substantial discount from book if the lender is----
    Senator Crapo. But if you do that----
    Mr. Lindsey [continuing]. The cause of the loss.
    Senator Crapo. If you do that, don't you defeat the very 
purpose of trying to put liquidity into the system?
    Mr. Lindsey. No, because they are two different things. 
They are credit and liquidity. There are credit losses--they 
are certainly related, but they are not the same thing, and I 
think that if Treasury had it to do over again, they would have 
done a number of the things they have done most recently that 
are more specifically addressed to liquidity----
    Senator Crapo. Such as the President's announcement today?
    Mr. Lindsey. Such as that, such as--there are things that 
we can do to restore the inter-bank lending very quickly that 
have very little loss exposure to the public that we are now 
putting into place. Some of us argued weeks ago that that 
should be a priority. I mean, I am not blaming Treasury. They 
are in a crisis.
    Senator Crapo. Certainly.
    Mr. Lindsey. But I think that would be their view, as well, 
now.
    Senator Crapo. Thank you, and Mr. Chairman, I know I am way 
over time, but could I allow Mr. Lindsey to answer that if he 
has an opportunity, and Mr. Dinallo?
    Chairman Harkin. Go ahead.
    Mr. Dinallo. I was just going to say, I think that is what 
we did when we were involved in the AIG transaction. To a large 
extent, that is what we did. The Federal Government extended a 
fairly usurious loan to AIG to give them time to unwind the 
value in the insurance companies because of sort of the sins of 
the holding company and the hedge fund that was attached to 
AIG, and those have been kind of wiped away and equity is going 
to get, you know, not a happy day and the notes. But 
ultimately, the value of the policy holders is being saved. The 
value there is being saved through essentially a timing, sort 
of a temporization through the loan, and then the equity 
ownership, so that people of the country may get a lot of 
upside from what gets released in the insurance operating 
companies through those sales, but at least there is some 
participation in the upside, yes.
    Senator Crapo. That is my understanding, too.
    Dr. Lindsey.
    Mr. Lindsey. Well, I think that in part, that it is 
probably late to try to do something that doesn't involve 
government funds here. One of the things, though, that I don't 
think has gotten a great deal of focus is that there is going 
to be a little bit of a feed-forward effect associated with 
this because under the Basel capital standards, banks were 
taking capital charges based on the historic performance of 
loans. Now, the historic performance of loans and their 
extensions of credit against those things are going to raise 
dramatically. They are going to have to hold more capital to 
offset that under the Basel capital standards. So you have a 
buildup of the need of more capital in the system.
    Senator Crapo. Thank you. Mr. Chairman, I am sorry to go on 
so far.
    Chairman Harkin. Good questions.
    Senator Lincoln.
    Senator Lincoln. Thank you, Mr. Chairman. We all learn from 
those good questions.
    I had several questions and I thought I would just throw 
them out and then maybe you all could answer whenever. Mr. 
Dinallo, I know that you mentioned Governor Patterson had 
announced that New York would take some steps to regulate the 
credit default swaps but also made it clear that Federal 
assistance was going to be necessary. Maybe you could at some 
point outline the Governor's plan that he is going to be taking 
and how you think that the Federal Government should respond.
    Dr. Lindsey, you mentioned, as was talked about, the 
purchasing of those derivative contracts which have those 
mortgages underlying them and that the Treasury should take 
over ownership from defaulting mortgages and guarantee that 
original mortgage payment. I would just be interested, since it 
is something that you do advocate--I think it is a plan from a 
colleague of yours or at least somewhat like that--what you 
think the drawbacks of that proposal, what would be your 
cautions to the proposal that you recommend, and how long when 
you talk about--I think none of us, we are such a society of 
immediate gratification, we all want to just take a pill and 
all be better and it is going to take time for much of this to 
unravel and to figure out how we are going to right ourselves 
and whatever we invest in it, but allowing the market the time 
to right itself, as well. I would just be curious to know how 
much time you would think a proposal like that would take to 
implement.
    And then, last, in the SEC Chairman Chris Cox's testimony 
before the Senate Banking Committee, his quote was that there 
is a regulatory hole that must be immediately addressed to 
avoid serious consequences. The $58 trillion notional market in 
credit default swaps, double the amount outstanding in 2006, is 
regulated by no one. Neither the SEC nor any regulator has 
authority over the CDS market, even to require minimal 
disclosure to the market. I know Mr. Cox, he has certainly been 
under tremendous scrutiny, as well, but he is the cop on the 
beat and when he says that we need someone on patrol, I mean, 
my question is, who is on patrol and is there anybody 
monitoring these?
    You mentioned, Dr. Lindsey, that--at least I gathered from 
your comment that you didn't think that it was necessary to go 
back and review these instruments or these products and how 
they were devised. I can't help but remember watching ``Dr. 
Zhivago'' with my dad and his comment to me was, ``If you don't 
understand history, you are doomed to repeat it,'' and how 
important it is for us to understand, if we are going to 
regulate, to better understand how these came about and where 
are the places where regulation makes sense, or transparency.
    I mean, you are saying that the SEC has the ability to do 
some of that, but why didn't they? Who was not there? Why did 
they not get looked into? If the books--I mean, what are the 
procedures there that have to happen in order for some of those 
things to happen?
    So I don't know. I mentioned Chairman Cox's comment because 
I know here we are having this hearing right here, and I 
certainly defer to Chairman Harkin in terms of what legislation 
may be coming around the bend, but we want to make sure from 
Congress's standpoint that we address all the concerns that are 
out there in the public, particularly for our constituency, and 
if the purpose of a credit default swap is to manage risk, 
which is what we are--I mean, it is an insurance in terms of 
risk, the CFTC has had a long history of policing risk 
management markets and that has been their responsibility. I 
don't know if you have an opinion as to whether or not that is 
an appropriate place or not to go. So those are my questions.
    Mr. Lindsey. Well, let me try to take some of them, anyway.
    Senator Lincoln. Sure.
    Mr. Lindsey. I would start with the fact that, of course, 
under the CEA, the CFTC has sole jurisdiction over OTC 
derivative contracts, and then under the 2000 Amendments to the 
CEA, there were specific exemptions that were granted which 
included, as I recall, specifically enumerating credit default 
swaps as one of those exemptions.
    So in some part, I would argue, and being an ex-SEC person, 
I guess I would argue that it seems strange for the SEC to ask 
for jurisdiction over something that lies within the CFTC's 
jurisdictional authority. So indeed if there is a change of 
view associated with that, it would strike me that the CFTC 
might be the appropriate place to house that authority and that 
responsibility for oversight of the OTC derivative market.
    In terms of the SEC looking, and what I think I was 
addressing at the time when I said that I don't think it makes 
very much sense to go back and look at models from three or 4 
years ago and try to figure out how people priced and conducted 
the instruments at that point in time, that was not meant to 
say that if we think that there was accounting fraud, and I 
have no reason to believe that there was, that that shouldn't 
be investigated, and clearly the SEC has that jurisdiction and 
can go ahead and do that.
    But remember, fraud is only something that you can discover 
afterwards. It is very difficult to discover it a priori and it 
is also extremely difficult to discover it contemporaneously. 
We don't have a regulatory system where SEC accounting staff 
are sitting in each and every reporting company, checking every 
line item associated with their accounting reports, and I don't 
think we want a system like that. So that would be my answer to 
those things.
    In terms of the----
    Senator Lincoln. Of course, that is the same thing with the 
CFTC. I mean, they don't regulate over-the-counter trades as 
they are occurring. It is only after the fact.
    Mr. Lindsey. Exactly.
    Senator Lincoln. Right.
    Mr. Lindsey. But at the same time, of course, you can 
provide oversight and some form of prudential supervision for 
the companies that are engaged in that type of activity. I 
always come back to the fact that transparency, capital, and 
some way of mitigating the counterparty risk, which is the 
centralized clearing organization, really would have prevented 
or resolved many of the types of issues that we have seen. Now, 
we have a problem where we are trying to get ourselves out of a 
hole that we have dug over time. The proposal----
    Senator Lincoln. Well, the list of things that you just 
mentioned--so in essence, you are just saying that they should 
be bonded.
    Mr. Lindsey. Well, bonded is really a form of insurance and 
you are----
    Senator Lincoln. But that is what you are--I mean, if they 
have to establish capital and they have to be able to say, we 
can insure ourselves, we can----
    Mr. Lindsey. Well, it is----
    Senator Lincoln. We are credit worthy.
    Mr. Lindsey. It is what Mr. Dinallo has mentioned many 
times. An insurance company, of course, is making a bet that, 
if it is a life insurance company, that you are going to pay 
them more money than they are going to have to pay you before 
you die, if we want to call that a bet, which in many cases it 
is. What we have, of course, is an insurance company is 
required to keep capital associated with its diversified pool 
of bets against people's lives. So what you want is for these 
companies to have to hold capital that are associated with the 
transactions that they are engaged in, that are sufficient to 
protect in normal times the activity that they do.
    I agree with Dr. Black that many of the uses of these 
products have to do with ways of reducing capital for 
organizations and to some extent decreasing the transparency in 
the market.
    Senator Lincoln. Do you have any suggestions of what we can 
do to help along the lines of what you intend to do in New 
York?
    Mr. Dinallo. Yes. Let me--so, Senator, I will just lay out 
quickly what I think the Governor was saying and what the plan 
is. He announced that there was a section of the market, which 
I think we all agree is some kind of insurable interest and 
form of insurance. I think he showed a leadership in saying we 
are willing to take responsibility for this because someone has 
to step up and start talking about it and frame the dialog.
    Subsequently, others said that they wanted to have other 
ways of doing it, whether it was Chairman Cox or now you hear 
stories that the Federal Reserve is sort of trying to drive 
some of the solutions we have talked about today. And the 
Governor subsequently said that he would be very interested in 
cooperating and trying to be part of a holistic solution. 
Nobody wants to segment the markets. It is not healthy for 
anyone, and I don't think that that was the intent. It was an 
intent to kind of get to where we are today, which is a really 
kind of robust, quick discussion about how to do it.
    Bonding is a very kind of insightful way of saying it. You 
are 100 percent right. That is why there used to be laws 
against doing it in a completely unbonded or naked way, 
because--and I just want to underscore that these bucketshop 
laws we talk about, they are not about, like, the racetrack and 
stuff. This was about securities betting. I mean, they were 
written for what we are talking about today. It is not like a 
misapplied gambling law, you know. It happened before, almost 
exactly 100 years ago today. This is about as ``Dr. Zhivago'' 
as you are going to get.
    Senator Lincoln. Thank you.
    Mr. Dinallo. You are welcome.
    Senator Lincoln. Thank you, Mr. Chairman.
    Chairman Harkin. All right. We will try to do one more 
round of 5 minutes each.
    In 2002, Warren Buffett, I think we all know who he is, 
said and I quote, that derivatives are financial weapons of 
mass destruction. In fact, as early as 1981, Mr. Buffett had 
written about the dangers of derivatives.
    So I want you each to comment on that statement, that they 
are financial weapons of mass destruction, if you agree or 
disagree. I guess if you agree, and if 80 to 90 percent of 
these credit default swaps are naked swaps, bets, why don't we 
just outlaw them? In my reading of the history of derivatives, 
these derivatives were conjured up not to meet a pressing need 
in the marketplace. They were conjured up to make money on 
money. And so if that is the case, and they have been touted as 
reducing risk, but as we have seen, they have actually 
increased the risk, the systemic risk to the whole society, so 
are they financial weapons of mass destruction? If so, why 
don't we just ban them?
    Mr. Dinallo.
    Mr. Dinallo. I think that in a completely unregulated, 
uncapitalized, opaque way, they are weapons of mass 
destruction. They are even actually a little more insidious 
than that because they have kind of a plague-like way about 
them that we are discovering, where no one knows which bottle 
has it in it. So you can't even necessarily come to quick 
solutions.
    I don't believe that Mr. Buffett meant that all credit 
default swaps are inherently wrong. I think, in fact, some of 
his insurance businesses use them. There are appropriate uses 
for them. They are usually done with a lot of capital behind 
them when done correctly, or there may be areas which we have 
discussed today where they are almost necessary because there 
is no other way--let us be clear about one thing. If you talk 
to people who you would otherwise respect, I think, they will 
tell you there is no other way to--this is not a bad word--to 
short the bond market, to short the credit market.
    In other words, we seem to be comfortable with us shorting 
the equity market. We seem less comfortable with naked shorting 
of the equity market, and it is still outlawed, I think, as of 
today. It used to be outlawed. But we have no way of shorting, 
in a sense, the bond or credit market. So I don't think there 
is anything wrong with that, but I think that you have to get 
down to what you are really doing and you have to have the 
appropriate mechanisms in place, like the ones we have 
discussed today.
    Chairman Harkin. Dr. Black.
    Mr. Black. Well, it is----
    Chairman Harkin. My question again is, are they financial 
weapons of mass destruction and should we just ban them, ban 
the trading in them?
    Mr. Black. The problem is the use of the word ``they.'' 
There are many financial derivatives. Some of them are very 
useful. So prime mortgage-backed securities are a pretty useful 
thing. Futures and forwards the way farmers have used in many 
countries for hundreds of years are often constructive things. 
Interest----
    Chairman Harkin. That is hedging with a commodity that has 
to be delivered, Mr. Black. That is not a derivative.
    Mr. Black. It is a derivative, but it is real hedging.
    Chairman Harkin. That is right.
    Mr. Black. So it is not that it is a derivative, it is that 
it is--is it being used as a real hedge? Real hedges are often 
valuable and some of the real hedges, like an interest rate 
swap, is a derivative. These are all derivatives 
definitionally.
    So I would ask the question slightly differently, and like 
Mr. Dinallo, I think that Mr. Buffett would say the same thing, 
that where you have real hedges that perform, where it is the 
dog wagging the tail instead of the tail wagging the dog, then 
there is a role for these things.
    But if you take this analogy--you know, dogs and other big 
animals that run fast have tails for a good reason. They have 
got to change, and the tail is the counterbalance, right, and 
it serves a useful purpose when it works in coordination with 
the animal. What happens when the tail just starts swinging 
crazily? All kinds of volatility. The dog careens left, right, 
bounces into walls, falls over, and things like that. What 
happens if the tail actually drives the dog? It has got a 
consistent bias, right? The dog will spin in circles and you 
will get nowhere with your real economy.
    And that is what can happen when derivatives become 
dominant and you lose sight of, hey, this is only supposed to 
be relevant to help the farmer who has a timing problem with 
cash and has a risk problem because the rain and the sun are 
quite--not under his or her control. Once we lose sight of that 
and the derivatives become the economy, become much bigger than 
the economy in many ways, then we will either wildly go crazy 
or we will run in circles and we will lose our productive 
edges. Our best and brightest people don't go into figuring out 
how to make good products.
    Chairman Harkin. Dr. Lindsey.
    Mr. Lindsey. So, in fact, while that is an oft-quoted 
remark by Mr. Buffett, what is not often followed on is the 
second part of what he said, which was that is if they are 
misappropriately used. That is not an exact quote, but 
basically he says that they are weapons of mass destruction if 
they are not used for appropriate reasons and appropriate 
purposes. That was not intended, I think on his part, to be a 
universal condemnation associated with OTC derivatives.
    I would point out, of course, to bring it back to the 
futures markets, about 80 percent of the activity in futures 
markets is speculative activity, as that word is used. It is 
not farmers hedging. It is people that are trading futures to 
try to make money on futures. That is not a lot different than 
what we have been talking about with this particular market, 
and many futures contracts, as I am sure the Chairman knows, 
are indeed cash settled. Not everything is a commodity 
delivered against the contract.
    Chairman Harkin. Very few, as a matter of fact. Thank you 
very much.
    Senator Lugar.
    Senator Lugar. Mr. Chairman, I will pass and wait for the 
next panel.
    Chairman Harkin. Okay, thank you.
    Senator Crapo.
    Senator Crapo. Thank you very much, Mr. Chairman.
    I would like to go back to this notion of transparency. We 
always say that word and I often wonder what we mean. Would 
each of you discuss just briefly--I think we have all agreed 
that we need more transparency. What does that mean? What 
should we do? And when I say ``we,'' I don't mean just the 
Congress. If it requires a Congressional act, I would like you 
to tell me that. If it requires a regulatory act or something 
else, I would appreciate that, as well. But what do we need to 
do to make sure we have the appropriate transparency in this 
market?
    Mr. Dinallo.
    Mr. Dinallo. I think--I am not sure I can mechanically tell 
you how these exchanges should work, but I will tell you some 
of the earmarks that would help. You had until you come up with 
a solution sort of an unbridled assignability of these 
contracts, so you could sort of send it to anyone. So you might 
do a CDS with a counterparty, but eventually through assignment 
it would end up with an entirely different counterparty and 
that is kind of one of the issues I said about insidious. They 
end up in places that no one knew that they were going to end 
up in. It is very hard to track them down and it is very hard 
to know which is going to be the weak link in the chain, 
therefore, that will start the run of defaults.
    The second thing is I think it is incredibly important, is 
we have no idea how much credit default swaps are written on 
any particular company, municipality, or credit issuer. I just 
think that is--of the $63 trillion, I can't tell you how much 
was written on AIG. I can tell you how much AIG wrote out of 
the Financial Products Division. I think it, like, about $460 
billion or so. But I can't tell you, of the weapons of mass 
destruction, how many were pointed at AIG.
    And the reason that is important is I believe--I wasn't in 
the Treasury's mind, but I assume that when they decided to 
help AIG in coordination with us and when we decided to help 
the bond insurers, like MBIA and Ambac, part of our fear of 
letting them file for bankruptcy or putting them into what is 
called rehabilitation on the State side, was that no one would 
know how much was going to be triggered in CDSs and what the 
worldwide cascading effects of that were going to be. That, to 
me, is just--of all the things to me, that is just one of the 
most unacceptable states that we are in, that regulators can't 
tell you what the implication is going to be of financial 
services failures.
    Senator Crapo. Mr. Black.
    Mr. Black. The only thing worse than no data is bad data 
that you think is good data. It is the old line about it is not 
the things you don't know that cause really big crises, it is 
the things you do know that aren't true. So transparency has at 
least those two elements, not simply that there is reporting, 
but that there is reliable reporting.
    And Warren Buffett has another famous line and that is 
directly relevant to our discussion, and that is that this 
isn't mark to model, this is mark to myth. So we need to know 
those models, and I would disagree a bit from my colleague and 
say we have strong reasons to believe that there is very 
substantial accounting fraud because we have massive incidents 
of fraud in the underlying, and it was not reflected in the 
value of those institutions. And that is why we have failure 
after failure.
    I was a government witness for OFHEO in the Fannie Mae case 
against the former senior managers. There was real life 
accounting fraud at Fannie and Freddie, but those were 
investigated. In general, the Securities and Exchange 
Commission has not chosen recently to investigate these very 
well.
    And again, please don't focus just on CDS.
    Senator Crapo. Certainly.
    Mr. Dinallo. The collateralized debt obligations, the 
structured finance, are vastly more complex than credit default 
swaps. And while I have you, the thing called dynamic hedging, 
which is also done with financial derivatives, the Federal 
Reserve has long warned poses great systemic risk. This is not 
the perfect storm. Many more things could have hit at the same 
time and will unless we clean this up.
    Senator Crapo. That is very comforting to hear.
    [Laughter.]
    Mr. Dinallo. As I say, when my area is hot, it is bad for 
the world. I am a criminologist.
    Senator Crapo. Thank you.
    Dr. Lindsey.
    Mr. Lindsey. Well, in part the disclosure, of course, has 
to reflect into the marketplace what the overall exposure is, 
and that exposure has to not only include the notional amount 
that a corporation is exposed to, but the diversification of 
that portfolio, how many counterparties they are exposed to, 
what future payments they might expect to have to make if they 
have written default protection, and what offsets there might 
be associated with that, along with an enumeration to some 
extent of the purposes and reasons that they have increased it.
    That would at least give some insight into the overall 
growth. Part of the problem associated with credit default 
swaps, and indeed with some of these other products, is that 
there is not a clear idea of what the total overhang is in the 
market. You have no idea how many of these contracts are really 
written, and when you are writing contracts with the 
counterparties, what they have. So you might care a great deal 
about whether or not the person that is on the other side of 
the trade is highly indebted to a great number of these other 
trades.
    Senator Crapo. Thank you.
    Mr. Black. Can I just say one thing that hasn't been 
mentioned? Unless you get a handle on the offshore stuff, you 
are never going to get this done. The tax havens also serve as 
ways of keeping opaque key information in financial 
derivatives, and unless we crack down on that, you will not get 
transparency.
    Chairman Harkin. Senator Lincoln.
    Senator Lincoln. Well, Mr. Chairman, that kind of leads 
into the last question I wanted to ask, and that is that when 
we talk about the weapons of mass destruction or whatever and 
should they be eliminated, the cat is kind of out of the bag 
here. I mean, if this is a product that the market has for 
whatever reasons, good, bad, or ugly, chosen to design or even 
patent in a way, I mean, the key for us is to look for a window 
to be able to see these products, because, I mean, I am 
assuming, and maybe I shouldn't, and you all should tell me 
differently if not, that this business could just as easily be 
practiced somewhere else and probably is. I mean, the ability 
to leverage all of this risk and to use it as a product is 
something that globally is going to happen anyway, is it not?
    Mr. Lindsey. Well, I think you made the point earlier, 
Senator, that we are now in a global economy----
    Senator Lincoln. Yes.
    Mr. Lindsey [continuing]. And there is nothing when it 
comes to financial products that cannot easily be moved 
elsewhere. At the same time, I am not advocating that we have 
what could end up being a race to the bottom in terms of 
regulatory oversight because you can always find a regulatory 
jurisdiction that is going to be less onerous than almost any 
scheme that we ever want to choose to have here in the United 
States.
    We can, however, regulate those entities that do business 
in our markets and do business--are registered, reporting 
companies in our marketplaces, and we should. And we can have--
accounting actually is on a consolidated basis. It does take 
into account what is done in the legal entity offshore. If, 
however, special purpose vehicles or other types of mechanisms 
are used to take something off a company's books, that is much 
harder to get to.
    FASB has been trying to get closer and closer to having 
accurate reporting associated with these types of instruments 
and these types of vehicles. We still have a long way to go, 
but there is that delicate balance about how do you maintain a 
viable business activity that we can see and we can regulate 
from U.S. jurisdiction.
    Senator Lincoln. Well, it seems to me that we have to keep 
that in mind, that there are international markets where there 
is going to be a lot that goes on. But kind of what you are 
saying is that the biggest asset we have is the U.S. customer, 
because that is what everybody out there wants, isn't it?
    Mr. Lindsey. The biggest asset we have is the U.S. 
customer, and I would argue that another asset that we have is 
the U.S. regulatory system, which does tend to protect our 
investors. It doesn't work perfectly, but it works better than 
many other regulatory systems.
    Senator Lincoln. Which, in other words, people are going to 
see us hopefully, if we can come forward with the types of 
regulation and oversight and transparency that needs to happen, 
then we would be seen as the most dependable market and 
probably therefore the most likely market that people would 
want to come to.
    Mr. Lindsey. That is a strategy that we have relied on for 
the better part of a century, yes.
    Mr. Dinallo. There are two points about that. Overseas is 
sometimes overrated if you are also worried about having your 
contracts enforced. So a lot of reasons that people do the 
business and demand that they often have New York, for 
instance, as their reference point for contract disputes is 
there is a certain certainty in dispute resolution, which is 
very valuable in this area.
    The second is while you are correct they could be doing it 
offshore somewhere, as you confront this as a regulatory 
regime, I think what is going to happen, it is pretty clear to 
me, you are going to have the Fed or Reserve, other regulators, 
but there are only maybe two or three that would capture all 
the major banks in the world. Those are the ones that 
essentially are the counterparties for this. And if you tell 
them, in essence, you either put it on this exchange and get 
better capital treatment, but if you do it off-balance sheet, 
we are going to kill you on capital treatment, they are going 
to put it in the exchange, in part because they are going to 
have the guarantees, the things that we listed before, dispute 
resolution, a guaranty fund, event determination. They actually 
want that. It becomes much more efficient and cheaper to do it 
on the exchange than do it off-balance sheet, so to speak.
    So I actually think there is a way to do this that will 
come about either through an exchange or some kind of a central 
counterparty set-up that will basically crush down most of the 
off-balance sheet transactions.
    Senator Lincoln. Thanks, Mr. Chairman.
    Chairman Harkin. Senator Crapo had a follow-up.
    Senator Crapo. Thank you. I just had one last question of 
Dr. Black in helping me get my head around this notion of what 
the asset value of these assets are in the country. You 
indicated that there was a 40 percent level of fraud in the 
subprime mortgage origination industry, is that correct?
    Mr. Black. In subprime and alt-A, that is what the Fitch 
reviews showed of just the document review.
    Senator Crapo. So 40 percent of the mortgages that were 
originated in that area had some type of fraudulent activity?
    Mr. Black. Obvious from simply reading the file. So I am 
saying the incidence is going to be higher than that.
    Senator Crapo. Okay. And the question I have is, is there a 
particular type of fraud that is most prevalent there, for 
example, over-valuation of the asset? Is that the fraud we are 
talking about, or are we talking about something else?
    Mr. Black. Two are most common. One is inflating the 
appraisal and the second was often whether you were going to be 
owner-occupied.
    Senator Crapo. All right. Thank you very much.
    Chairman Harkin. I thank the panel very much. This has been 
very enlightening and very informative, somewhat provocative, 
and I really appreciate your input on this as we move ahead. 
Thank you all.
    Mr. Black. Thank you.
    Chairman Harkin. If we could, we would like to call our 
second panel to the table, Mr. Ananda Radhakrishnan, who is 
Director of the Division of Clearing and Intermediary Oversight 
for the Commodity Futures Trading Commission; Mr. Terrence 
Duffy, Executive Chairman of the CME Group; Mr. Robert Pickel, 
Chief Executive Officer of the International Swaps and 
Derivatives Association; and Mr. Johnathan Short, General 
Counsel for the Intercontinental Exchange.
    [Pause.]
    Chairman Harkin. Excuse me. Again, thank you very much for 
being here and thanks for your patience. As you can see, we had 
a lot of questions of that last panel and I am sure we are 
going to have a number for this panel, also. We will go in 
order and ask if you could summarize your statement in five to 
seven minutes. As I said before, your statements will be made a 
part of the record in their entirety and we will just go in the 
order I called.
    First, we will call on Mr. Radhakrishnan--I hope I 
pronounced that correctly----
    Mr. Radhakrishnan. Yes, sir.
    Chairman Harkin.--Director of the Division of Clearing and 
Intermediary Oversight of the U.S. Commodity Futures Trading 
Commission.

   STATEMENT OF ANANDA RADHAKRISHNAN, DIRECTOR, DIVISION OF 
CLEARING AND INTERMEDIARY OVERSIGHT, COMMODITY FUTURES TRADING 
                           COMMISSION

    Mr. Radhakrishnan. Thank you. Good morning, Mr. Chairman 
and distinguished members of the committee, and thank you for 
the invitation for me to discuss risk management for financial 
derivatives.
    Mr. Chairman, as you and members of the committee here have 
spoken about in your opening statement, I think you have 
adequately framed the magnitude of the problem here, so I will 
confine my remarks to clearing and how clearing could prove to 
be a solution for some of the problems.
    As Senator Lugar mentioned in his statement, the benefits 
of clearing is that it brings a central counterparty to both 
sides of the transaction. It guarantees the performance on an 
obligation to both the long and the short on the contract and, 
assuming that the clearinghouse does risk management properly, 
it brings a lot of benefits to derivatives.
    As the committee is aware, the CFTC and the clearinghouses 
that it regulates have experience in clearing. Congress 
specifically gave us the authority to regulate clearinghouses 
in the CFMA and Congress gave us 14 core principles by which to 
oversee clearinghouses. Since 2000, we have seen a tremendous 
explosion in the number of contracts traded and listed and 
there has been no issue with clearing in the regulated markets, 
or the markets that we regulate.
    I should mention that clearing, while it may prove to be a 
solution, is not a panacea to all evils because the issue is 
you are going to be clearing a whole bunch of transactions that 
are already out there, that are already in existence, and the 
issue is what kind of risk the clearinghouse is going to take. 
But clearing does bring benefits.
    It brings, as I mentioned, the concentration of risk within 
one clearinghouse, or within one central counterparty. It 
brings the benefits of credit intermediation. It brings, 
certainly in the instance of clearinghouses regulated by us, it 
brings the benefit of twice-daily marking to market of all open 
positions and the settlements of losses and the resulting gains 
after the mark to market process is done. In fact, just 
yesterday, the Chicago Mercantile Exchange set a record for the 
amount of settlements that it moved, some 16 or 18--$18 
billion, if I am not mistaken, and there was no hitch in that 
process.
    The other thing that clearing will produce, or the other 
benefit that it could produce for the CDS market is as members 
of this committee are well aware, there is an issue with 
processing of these transactions. I have attended meetings at 
the New York Fed and I believe it is fair to say that nobody 
knows, not even the dealers know the amount of deals that are 
done with each other. It has been well documented that the New 
York Fed has been trying to get the dealers to come to a 
solution, but so far, none has been forthcoming. And this is an 
issue because if you don't know what your exposure is to each 
other, then you might get an unpleasant surprise when you 
eventually do find out what your exposure is.
    So the benefits of a centralized clearinghouse is that it 
aids in the processing. In the futures industry, trades are 
processed within 30 seconds to a minute after which they are 
done and they are marked to market and settled at the end of 
the day.
    As this committee is aware, under existing law, any 
derivatives clearing organization that is registered with the 
CFTC may clear any OTC derivative without further regulation. 
Pursuant to the CEA, the CFTC regulates DCOs and has the 
mandate to ensure that the financial integrity of transactions 
subject to the CEA and to avoid systemic risk. As I mentioned, 
we have 14 core principles by which we regulate DCOs.
    Although DCOs do not need pre-approval from the CFTC to 
clear OTC derivatives, they do need advance approval if they 
wish to clear them in the customer segregated fund account. 
And, in fact, two DCOs have sought such approval from the CFTC, 
the New York Mercantile Exchange in 2002 and the Chicago 
Mercantile Exchange in 2004, and in both instances, they did 
receive permission to co-mingle the funds associated with OTC 
derivatives with the funds associated with regulated futures 
contracts. In fact, we have seen that the amount of activity in 
the New York Mercantile Exchange, particularly in the clearing 
of energy derivatives, has risen quite substantially.
    So in conclusion, members of the committee, the CFTC is 
committed to working with Congress and other financial 
regulators to move toward a solution that balances the need for 
responsible innovation in risk management solutions with 
protecting customers and managing counterparty risk. We thank 
you for your leadership and we look forward to participating 
fully with Congress, and I will be pleased to answer any 
questions that you may have. Thank you.
    [The prepared statement of Mr. Radhakrishnan can be found 
on page 105 in the appendix.]
    Chairman Harkin. Thank you, Mr. Radhakrishnan.
    I also have a statement from Commissioner Dunn, which I 
would insert in the record at this point, in support of your 
testimony.
    [The prepared statement of Mr. Dunn can be found on page 
118 in the appendix.]
    Mr. Radhakrishnan. Thank you.
    Chairman Harkin. Next, we will turn to Mr. Terrence Duffy, 
Executive Chairman of the CME Group. Mr. Duffy, welcome.

STATEMENT OF TERRENCE A. DUFFY, EXECUTIVE CHAIRMAN, CME GROUP, 
                       CHICAGO, ILLINOIS

    Mr. Duffy. Thank you, Chairman Harkin. I want to thank the 
members of the committee for having us today. You asked us to 
discuss the role of financial derivatives in the current 
financial crisis.
    Financial derivatives cover a very broad array of product 
types. They include regulated futures contracts, collateralized 
obligations packaged as securities, including subprime mortgage 
obligations, and pure vanilla swaps that are unregulated 
versions of futures contracts.
    Dozens of scholarly books and articles, as well as numerous 
class action and shareholder lawsuits, have attempted to answer 
your question. There seems to be a consensus that financial 
crisis is not a consequence of these instruments. It is linked 
to other factors, including distribution, collateralization, 
risk management, and trading and accounting for financial 
derivatives in the unregulated over-the-counter market.
    Financial derivatives are tools for managing a firm's 
risks. Like all tools, they are neither beneficial nor harmful 
in themselves. The dire consequences have occurred in the OTC 
market, where there has been a lack of price transparency and a 
failure to properly measure and collateralize the risk of those 
instruments.
    In stark contrast, trading in financial futures on 
regulated futures markets subject to the oversight of the 
Commodity Futures Trading Commission has been a net positive to 
the economy. It has caused no stress to the financial system 
and has easily endured the collapse of one and near collapse of 
two firms that were very active in our markets. This is a 
record of which this committee, the CFTC, and our industry can 
be justifiably proud.
    When Lehman Brothers filed for bankruptcy last month, no 
futures customer lost a penny or suffered any interruption in 
their ability to trade. The massive proprietary positions of 
Lehman were liquidated or sold with no loss to the 
clearinghouse and no disruption to the market. This tells us 
that our system works in times of immense stress to the 
financial system.
    Rather than looking back and trying to blame the 
unregulated market, we want to move forward. Let me explain how 
we are planning to help alleviate the risks to the economy 
current represented by the almost $600 trillion in outstanding 
notional value of OTC swaps.
    We are in the process of offering a means to convert a 
significant portion of outstanding OTC interest rate swaps into 
regulated exchange traded futures. If the dealers and their 
customers accept this program, we expect that we will see 
standardization of these outstanding contracts. In addition, 
our clearing system will permit a multilateral netting process. 
This process will reduce the outstanding exposure on the 
instruments submitted to the clearing system by a factor of at 
least five. Coupled with this reduction, an appropriate mark to 
market and CME's margining expertise, and we are one step 
closer to coming to grips with this monster.
    I particularly want to focus on our plans to play a role in 
the credit default swaps market. The CDS market has grown 
because credit derivatives permit allocation and realignment of 
credit risks. These instruments are tremendously valuable 
financial tools if used properly. However, the individual and 
systemic risk created by the rapid growth of such contracts has 
been poorly managed. This mismanagement is due to several 
factors: Lack of transparency pricing; lack of standardization 
contract terms; lack of multilateral netting; and lack of other 
advantages that flow from an integrated trading and central 
counterparty clearing system. By not having these in place, we 
have compounded risk and driven uncertainty in the CDS market, 
which has a gross exposure of about $55 trillion.
    There is a solution. CME Group and Citadel Investment Group 
offer an effective method to monitor and collateralize risk on 
a current basis. It is estimated that portfolio compression by 
netting could shrink the $55 trillion exposure by a factor of 
ten. This will help reduce systemic risk and enhance certainty 
and fairness for all participants. We are working with the New 
York Federal Reserve, the CFTC, the SEC, to find a way to bring 
our solution to market quickly. We are encouraged that the 
regulators are highly motivated to contain the problem without 
delay. If they continue to work together, we feel that we will 
be able to eliminate the jurisdictional and regulatory 
uncertainties that might otherwise delay a solution.
    I want to thank the committee for holding this hearing 
today and I look forward to answering your questions. Thank 
you, Mr. Chairman.
    [The prepared statement of Mr. Duffy can be found on page 
81 in the appendix.]
    Chairman Harkin. Mr. Duffy, thank you very much for that 
testimony and for being here.
    Now we turn to Mr. Robert Pickel, Executive Director and 
CEO of the International Swaps and Derivatives Association. Mr. 
Pickel?

     STATEMENT OF ROBERT PICKEL, CHIEF EXECUTIVE OFFICER, 
  INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION, INC., NEW 
                         YORK, NEW YORK

    Mr. Pickel. Senator Harkin and members of the committee, 
thank you for inviting ISDA to testify here today before the 
committee on the role of financial derivatives in the current 
financial crisis. ISDA, which represents participants in the 
privately negotiated derivatives industry, has over 830 member 
institutions from 56 countries. These members include most of 
the world's major institutions that deal in privately 
negotiated derivatives, which they use to manage their 
financial market risk inherent in their core economic 
activities. Among other types of documentation, ISDA produces 
definitions related to credit default swaps.
    Credit derivatives serve multiple uses. A CDS can be used 
by the owner of a bond or loan to protect against the risk that 
a borrower won't make good on his promises. A CDS can also be 
used to hedge against other risks related to the potential 
default of a borrower, or CDS can be used to express a view 
about the health of a particular company or the market as a 
whole.
    An investment fund might believe that there will be a large 
number of corporate bankruptcies in the future. In order to 
meet its fiduciary duty to invest its clients' money prudently, 
the fund might seek to generate returns during those 
bankruptcies by purchasing credit protection on one or more 
companies the fund believes are most likely to default.
    Use of credit derivatives in this manner is similar to 
someone who sells wheat futures or buys put options on a 
security when they don't own the underlying wheat or shares. In 
each case, the idea is to maximize profits from a decline in 
prices. These are distinct from the securities such as asset-
backed securities and collateralized debt obligations which the 
first panel talked about, and I would be happy to talk more 
about some of those distinctions.
    The last several weeks have seen major credit events. 
Fannie Mae and Freddie Mac, two of the world's largest issuers 
of debt, were taken into government conservatorship. Shortly 
thereafter, Lehman Brothers, one of the largest OTC derivatives 
dealers, filed for bankruptcy. Then Washington Mutual likewise 
filed for bankruptcy protection.
    All of the above companies were referenced under a large 
number of credit default swaps. They also tended to be 
counterparties to a large number of other types of derivatives 
trades. Despite defaults by these firms, the derivatives 
markets and in particular the CDS market has continued to 
function and remain liquid. This is true even while other parts 
of the credit markets have seized up and the equity markets 
have declined precipitously. Credit derivatives remain one of 
the few ways parties continue to manage risk and express a view 
on market trends.
    Under U.S. law, the counterparties to a failed firm like 
Lehman Brothers are able to net out payments owing to and from 
the bankrupt counterparty without having to wait for a 
bankruptcy judge to resolve all claims. The failure of this 
large Wall Street firm has not caused the failure of its 
derivatives counterparties. That risk was contained because of 
the prudent structure of insolvency law in the U.S. and the 
apparently sensible collateral requirements of Lehman's 
counterparties.
    As has occurred in previous credit events, ISDA held an 
auction to determine the cash price of the outstanding debt of 
Fannie, Freddie, and Lehman. These auctions were done according 
to well-established procedures and resulted in the successful 
settlement of the outstanding CDS trades on these three 
companies. As has occurred in the case of previous credit 
events, participants in the CDS business have seen their trades 
settled in an orderly fashion and according to swap 
participants' expectations.
    There is little dispute that ill-advised mortgage lending 
coupled with improperly understood securities backed by those 
loans are the root cause of the present financial problems. It 
is also true, however, that recent market events clearly 
demonstrate that the regulatory structure for financial 
services has failed. Laws and regulations written in the 20th 
century need to be changed to account for 21st century markets 
and products.
    An in-depth examination of the U.S. regulatory structure is 
warranted and is, in fact, instructed by the rescue bill passed 
recently by Congress. In this examination, it is ISDA's hope 
that the facts surrounding OTC derivatives and the role they 
continue to play in helping allocate risk and express a view on 
market activity will highlight the benefit of derivatives and 
of industry responsibility and widely applied good practices.
    Thank you, Mr. Chairman, and I look forward to your 
questions.
    [The prepared statement of Mr. Pickel can be found on page 
100 in the appendix.]
    Chairman Harkin. Thank you very much, Mr. Pickel.
    Now we turn to Mr. Johnathan Short, Senior Vice President, 
Secretary, and General Counsel of the Intercontinental 
Exchange. Welcome, Mr. Short.

STATEMENT OF JOHNATHAN SHORT, GENERAL COUNSEL, INTERCONTINENTAL 
                   EXCHANGE, ATLANTA, GEORGIA

    Mr. Short. Chairman Harkin, Members Lugar, Crapo, and 
Lincoln, thank you very much for the opportunity to be here 
today. ICE is very appreciative of the opportunity to appear 
before you to discuss the role of credit derivatives in the 
financial markets and discuss ICE's efforts, along with those 
of other market participants, to introduce transparency and 
risk intermediation into the OTC credit markets.
    Like CME, ICE is proud to be working with the Federal 
Reserve Bank, the Commodity Futures Trading Commission, and the 
Securities and Exchange Commission on these efforts that are 
vital to the health of our financial markets and believe that 
we have important domain knowledge to bring to bear to this 
effort. As background, ICE operates three regulated futures 
exchanges, ICE Futures U.S., ICE Futures Europe, and ICE 
Futures Canada, together with three regulated clearinghouses.
    ICE recently acquired Creditex Group in August of 2008. 
Founded in 1999, Creditex is a global market leader in the 
execution and processing of credit derivatives. In the last few 
years, Creditex has worked collaboratively with market 
participants on a number of important initiatives which 
directly address calls by regulators, most notably the Federal 
Reserve Bank of New York, for improved operational efficiency 
and heightened transparency regarding risk exposures in the 
credit derivatives market.
    In 2005, Creditex helped to develop the ISDA cash 
settlement auctions, which are the market standard for credit 
derivative settlement, and have long been used--or, excuse me, 
have been used in recent weeks to allow orderly settlement of 
CDS contracts, referencing among others Fannie Mae, Freddie 
Mac, and Lehman Brothers. Creditex has also worked 
collaboratively with the industry participants to launch a 
platform to allow efficient compression of offsetting CDS 
portfolios of major dealers. The platform reduces operational 
risk and provides capital efficiency.
    But to be clear, more must be done. While credit 
derivatives serve an important role in the broader financial 
markets, improving the market structure pursuant to which 
credit derivatives are traded is essential, and it candidly was 
an opportunity that ICE recognized at the time it completed its 
acquisition of Creditex in August.
    Presently, the credit markets operate very similar to the 
way that energy markets worked earlier in this decade. Most 
transactions are executed bilaterally through brokerage firms. 
This is neither a transparent nor efficient way for a market to 
operate. Critically, the bilateral nature of the market leaves 
participants exposed to counterparty risk. In times of great 
financial distress, like at the present, this risk can have 
systemic implications. When financial counterparties do not 
trust each other, they then stop lending to one another and the 
credit markets freeze. In addition, the failure of a large 
counterparty can spread risk within the markets, especially 
where the market is opaque and the true extent of risk is not 
known.
    The question, I think, that is before us today is how to 
bring appropriate transparency to the credit derivatives 
markets as well as how to appropriately mitigate counterparty 
credit risk. ICE believes that the mutual goals of transparency 
and mitigation of counterparty credit risk and systemic risk 
can be achieved through the introduction of clearing and the 
appropriate reporting of positions and obligations to 
regulators, a solution that was mentioned in the introductory 
remarks of Senator Lugar, as suggested by the Acting Chair of 
the CFTC, Walt Lukken.
    ICE's proposed solution is a--we have announced an 
agreement in principle with the Clearing Corporation, major 
market participants, Market, and Risk Metrics to introduce a 
central counterparty clearing system to address the credit 
derivatives problem. To clear credit default swaps, ICE will 
form a limited purpose bank, ICE U.S. Trust, which will be a 
New York trust company that will be a member of the Federal 
Reserve System and therefore will be subject to regulatory and 
supervisory requirements of Federal Reserve System as well as 
the New York Banking Department.
    ICE U.S. Trust will offer its clearing services to its 
membership, and membership will be open to market participants 
that meet the clearinghouse's financial criteria. Third parties 
who are unable to meet these financial criteria, however, will 
be able to trade through existing members of the clearinghouse.
    ICE U.S. Trust will review each member's financial 
standing, operational capabilities, systems and controls, and 
size and nature and sophistication of its business in order to 
meet comprehensive risk management standards with respect to 
the operation of the clearinghouse. In addition, ICE will make 
available its T-Zero trade processing system to facilitate 
same-day trade matching and processing.
    Finally, a word about regulation. Appropriate regulation of 
credit derivatives is of utmost importance to the financial 
system. Presently, the credit derivatives market is largely 
exempt from regulation by the Commodity Futures Trading 
Commission and the Securities and Exchange Commission. As 
recent events demonstrate, the credit markets are intricately 
tied to the banking system, with many credit derivative market 
participants being banks that are subject to regulation by the 
Federal Reserve. Given the central role that the Federal 
Reserve has played in addressing both the current credit crisis 
and issues related to credit markets in general, ICE 
proactively sought to ensure that its clearing model would be 
subject to direct regulation by the Federal Reserve System.
    ICE understands that Congress may choose to enact 
additional financial market reforms, including taking steps to 
broadly reform the financial regulatory system as a whole. ICE 
would stand ready to work with all appropriate regulators in 
this effort.
    Thank you very much and I look forward to answering your 
questions.
    [The prepared statement of Mr. Short can be found on page 
110 in the appendix.]
    Chairman Harkin. Thank you very much, Mr. Short. I thank 
all of the panel.
    Well, it seems this is the second question I asked when I 
first started and that is just this. If derivatives are a 
necessary part of the functioning of our system--I am still not 
convinced they are, but if they are, then should they not be 
forced to be traded on an exchange, on an exchange where, as 
you point out, Mr. Duffy, you have to clear it every day, where 
you have requirements twice a day, call requirements, where it 
is transparent. The problem with over-the-counter derivatives 
now is we just don't know how many are out there. We don't know 
what they are, who is trading them, what their values are. They 
are about as opaque as you can get, and look at what they are 
doing to our system.
    So my question is, should we not as Congress mandate that 
all of these derivatives have to be traded on a regulated 
exchange? I didn't say a clearinghouse. I perceive there is a 
little bit of a difference between clearing and exchange. Maybe 
you are using those terms interchangeably; I don't know. But I 
mean on a regulated exchange. Should they be? Should all these 
derivatives be forced to be traded on a regulated exchange?
    Mr. Radhakrishnan.
    Mr. Radhakrishnan. Thank you for that question, Mr. 
Chairman. I guess the answer to that is something that you are 
exploring and other policymakers will be exploring. Certainly, 
our experience has suggested that the trading of products on a 
regulated exchange and the attendant clearing, because under 
the scheme in the Commodity Exchange Act, any transaction that 
is traded on a designated contract market has to be cleared by 
a registered DCO, registered with us, and that we have found 
enhances price transparency, liquidity, and order processing, 
and you have the benefit of a centralized counterparty.
    Chairman Harkin. Okay.
    Mr. Radhakrishnan. However, on the other hand, some would 
argue that by forcing it on an exchange, you lose the benefits 
of customized transactions because the issue is, can an 
exchange think about all of the contracts that people need? And 
so that is the tradeoff that you have.
    Chairman Harkin. Okay, Mr. Duffy.
    Mr. Duffy. Well, obviously, Mr. Chairman, we have been on 
record for many years in this town talking about the model that 
the CME Group provides, and that is a transparent, essentially 
limited order book, and essentially cleared marketplace in a 
regulated platform, and we think that is the model that suits 
these products quite well.
    My colleague from the CFTC brings up an interesting point 
about some of these customized products and how they may not 
fit a standardized exchange-listed product for central 
clearing. In our proposal on credit default swaps, in our 
initiative with Citadel, we have looked at this hugely 
outstanding market of all these CDSs, and obviously there are 
some of them that you would not want to clear. They are just 
completely things you do not want to have any part of. But we 
have also come up with a formula on a risk management which we 
have done a very good job over the last 150 years of risk 
managing, making certain that a customer has never lost a penny 
at the CME Group due to a default of one of our clearing member 
firms. We hold that very sacred. So we have come up with some 
formulas on how to list these products for trade and clearing. 
So we think we can eliminate some of that risk.
    So I do agree that there are some customized products, but 
some of those customized products may need to go away.
    Chairman Harkin. I would like to get into that with you, 
too, but I want to finish the rest of this question on should 
they be, all these derivatives be forced to trade on a 
regulated exchange.
    Mr. Pickel.
    Mr. Pickel. Mr. Chairman, I think that if we go back to 
2000 with the Commodity Futures Modernization Act, there were 
several things in there that I think are still very much the 
correct policy. There was legal certainty for OTC contracts, 
which include creditors which existed at the time. There was 
regulatory relief for the exchanges and allowed them to thrive 
over the last seven or 8 years, as we have seen. And also this 
structure for a clearing, the derivatives clearing 
organizations which Mr. Radhakrishnan mentioned, and I think 
those are all very positive steps in the overall structure.
    I think that the point that there is a role for exchange 
traded in the more standardized products is certainly the case. 
One thing I would note with credit default swaps is in the OTC 
space, there has been a greater standardization, I think, in 
the terms and the trading of some of these things. For 
instance, quarterly payment dates as opposed to more 
idiosyncratic payment dates that are tied to underlying debt. 
So quarterly payment dates. Those types of standardization 
steps have already occurred in the OTC space, which is one 
reason I think the exchange-traded product has not developed as 
a matter of market demand. But I think we will see that develop 
over time.
    I think the steps toward clearing are ones that are very 
important and ones that the industry is very committed to 
following. But in all those situations where clearing applies, 
as I understand the proposals that are being discussed at the 
New York Fed, it would still rely on the definitions of, for 
instance, the ISDA and the OTC market have put in place, and in 
many cases the settlement process to be utilized last week with 
Lehman, Fannie, and Freddie, the auction process. So there will 
be a definite connection between any exchange-traded product 
and these OTC products.
    Chairman Harkin. Mr. Short.
    Mr. Short. Chairman, I think the issue is really about 
credit intermediation through a central counterparty and 
transparency. I am not convinced that a product has to be 
traded on an exchange to achieve those two goals. Certainly, 
central counterparty and clearinghouse intermediation is a part 
of the exchange model, but there are portions of ICE's business 
as well as Mr. Duffy's business that actually process OTC 
transactions which are immediately submitted to a central 
counterparty for clearing and risk intermediation and 
appropriate reporting. So I don't think it is a requirement 
that something be executed on an exchange.
    Chairman Harkin. If Congress were to require that all 
financial derivatives trade on regulated exchanges, Mr. Duffy, 
would CME be able to handle that, or Mr. Short, would ICE be 
able to handle that?
    Mr. Duffy. Well, we are--I think you stated in your remarks 
at the outset that CME Group cleared over 2.2 billion contracts 
last year and we have capacity always twofold of what we did on 
a prior year. So we feel very comfortable that we could take on 
this credit default swaps market. Now, again, we think we could 
bring it down in size. In fact, there is a five and ten 
respectively between interest rate swaps and credit default 
swaps. But again, we are very comfortable that we have the 
capabilities to list this product for trade and to clear it.
    Chairman Harkin. Mr. Short.
    Mr. Short. ICE runs a regulated designated contract market, 
ICE Futures U.S., so we would have the ability to transact or 
have CDS transacted in a regulated exchange environment. I 
think the way ICE has come at the problem, looking at the real 
systemic issue out there, is to try to find a clearing solution 
that immediately addresses the market as it exists today, and 
given the existence of making clearing available to OTC 
products. We think the most important thing to do is to get a 
clearing solution in place today, get transparency in place 
today, and then at a later date, if Congress decides that 
everything should be traded on an exchange, we would obviously 
address it at that point.
    Mr. Radhakrishnan. Mr. Chairman, if I may, if Congress does 
mandate that all derivatives be traded on an exchange, 
especially an exchange regulated by the CFTC, then I think it 
is clear that the CFTC would need a significant amount of 
resources, more than what we have right now.
    Chairman Harkin. You would also need a change in the law, 
too.
    Mr. Radhakrishnan. That is correct, sir.
    Chairman Harkin. Thank you very much.
    Senator Lugar.
    Senator Lugar. I want to raise a question with this panel 
which has not come up, I think, in your testimony, at least to 
a great extent. We touched upon it in the last round of 
questioning. What happens, as is often testified in panels like 
this, that if a great deal more regulation occurs which is 
uncomfortable to any of the parties that are now dealing, for 
better or for worse, in all of this, that there are other 
markets to move to? After all, the United States does not have 
a unilateral function in this respect. Some would say the 
London market is much larger. Others would find more exotic 
situations.
    And given electronic transfer, international banking 
systems generally, why are we likely to see reform in our 
situation here inhibit anybody from moving off, if they have 
nefarious purposes, or at least maybe they feel they are 
perfectly legitimate purposes, if they like markets without 
limits and they can find them somewhere else? And if they do 
this, what are the ramifications, then, not only for the volume 
of business being done on our markets, but getting back to the 
gist of our discussion today, some degree of regulation of 
difficult practices? Does anyone have a thought about the 
international market predicament?
    Mr. Pickel. Senator Lugar, if I might start off, I am sure 
the others will have some views, as well, I think that is one 
of the reasons we need comprehensive solutions to the 
regulatory structure. I alluded to that in my oral remarks, 
went into a little more detail in my written remarks, that if 
we are rethinking the landscape, and I think one lesson we know 
we have learned is we need to rethink the landscape, that is 
done in a comprehensive way. If we just focus on pushing down 
on one product area, it will very likely move elsewhere.
    For instance, on this whole insurance point, which I know 
was a lot of discussion in the first panel, it is very clear 
under U.K. law that these products are not insurance, would not 
be treated as insurance, and therefore they will continue to 
trade there and I am sure trading will increase as a result.
    I would also suggest that comprehensive international 
solutions, as we have seen with the coordination just over the 
last few weeks, but also in existing forums like the Basel 
Committee of Bank Supervisors and also IOSCO, the securities 
commissioners, and other international forums, that there be a 
comprehensive solution discussed, and certainly on the capital 
level, which I think will be a significant part of the 
discussion going forward, the appropriate capital levels and 
how certain products are treated for capital purposes, that 
will proceed as it currently is at the international level.
    Senator Lugar. Let me just pick up that point, because many 
people have commented, say, in the last 72 hours, that the 
coming together of the banking leadership of major countries 
has been unprecedented and very constructive. This leaps ahead 
of where we are in this conference today, but should this not 
be an objective of our banking system, those representing the 
United States in these interparty talks, to get involved in 
what we are talking about now so that, in fact, we do not 
undercut each other, and at least in the major systems, this 
may in the past have been perfectly fair game in competitive 
situations. But right now, we are understanding that this 
degree of competition may be invidious to all of our interests. 
Is there likely to be any reception with the banking leadership 
of other countries to the kinds of reforms we are talking about 
today?
    Mr. Pickel. I think just quickly, and then I will turn it 
to Terry. I know he wants to say something. These are global 
products. They are traded globally. The parties who are most 
active in these markets are global parties. They are active in 
many different jurisdictions. And therefore, I think that 
whatever the solutions may be, they do need to be discussed 
here in Congress but also at that international level, as well.
    Senator Lugar. Mr. Duffy, did you have a comment?
    Mr. Duffy. I just have a couple of comments, sir. You know, 
I think it is imperative that we coordinate with the U.K. and 
with Europe like you are discussing. Obviously, I don't have 
any feel for how that is going other than what I read in the 
papers, also. But there needs to be a value-add and I think 
that is exactly what the CME Group has been trying to do for a 
number of years, is have the value add. And when you can bring 
transparent markets and open markets so everybody can see them 
and see what the prices is, that is a value add.
    And I think also, when you are seeing unprecedented 
counterparty failures by some of the biggest people in the 
world, it is bringing people to look at the model of a flight 
to quality. I mean, we saw what the Treasury market did after 
this recent downturn and people's just a flight to quality to 
get their money converted to cash or government securities. So 
we have been battling this battle for a lot of years. We think 
we are going to continue to fight it. But I think it is really 
imperative of the governments to come together at the banking, 
like they did over the weekend, and continue those talks.
    Senator Lugar. It is interesting that as markets opened up 
at different hours in the last couple of days, the 
international cooperation has given heart to investors all over 
the world, although some may say, after all, if you invest in 
the United States, you may as well be investing in London and 
vice-versa. These markets are not simply local.
    Let me just ask for a moment, Mr. Short, you mentioned in 
your testimony, and this sounds very constructive, that ICE has 
already announced an agreement to work with various entities, 
and as you proceed then through the testimony, you really go 
into some detail as to some things that ICE can do now, which I 
thought was very important. I gather that you don't need 
further legislation and that all the reforms that you are 
suggesting in this testimony are within your purview if you 
have got the cooperation of the others that you feel you have. 
Is that true, or is this over-reading action that you are 
taking now and we will see being unveiled in weeks and months 
ahead?
    Mr. Short. I think that is accurate. I think we do have 
what we need to put a solution in place, working constructively 
with the Fed and the New York Banking Department.
    Just circling back on one point you made about the global 
nature of this business. I do think one of the silver linings 
that may come out of this is the enhanced international 
regulatory dialog and that is something that ICE in particular 
is very familiar with because we operate regulated markets not 
only here in the United States, but in the United Kingdom, 
subject to Financial Services Authority jurisdiction.
    One of the things that we intend to do parallel with this 
process here in the United States of establishing ICE U.S. 
Trust is to offer the same central counterparty credit 
intermediation for credit default swaps in the United Kingdom, 
in Europe through our U.K. clearinghouse, and as the 
cornerstone of that effort, we would ensure that there was 
adequate regulatory dialog between each of the domestic 
regulators to get a full picture of the market, because as you 
correctly note, this is a global market and just seeing one 
piece of the puzzle doesn't necessarily give you the entire 
picture.
    Senator Lugar. Thank you all very much. I just find it to 
be very heartening at the moment that the Chairman has called 
this meeting, especially timely given the dialog of the last 72 
hours in which, as you state, for the first time there may be 
some movement with regard to other countries working with us 
and all together in a way we could not have thought of before. 
When we have had hearings before, we always had to have a 
cautionary look over the shoulder as somebody who didn't really 
see a problem in their country or somewhere else. But seeing 
the common worldwide dilemma we have, I think the agenda may be 
changing and this is a good opportunity for reforms here, but 
likewise working with others to make certain this is a more 
universal product.
    Thank you, Mr. Chairman.
    Chairman Harkin. Thank you.
    Senator Crapo.
    Senator Crapo. Thank you very much, Mr. Chairman.
    I want to get into the clearing counterparty issue with the 
panel. But before I do so, Mr. Pickel, I have a question for 
you. In the previous panel, we had quite a discussion about 
naked credit default swaps, and as we were having that 
discussion, which I found to be a very interesting discussion, 
I was thinking about ISDA and wondering if ISDA had a 
perspective on the whole issue of the different types of credit 
default swaps and the approaches that we may take to this 
issue. Do you have a take on the previous discussion we had?
    Mr. Pickel. Well, I think as Superintendent Dinallo 
acknowledged, there is a range of transactions that, in his 
sense, sartorial or covered or whatever, might apply to holding 
the bonds, having some other relationship, taking a view on the 
credit. And so where in the spectrum, whatever your notion of 
what naked shorting may be, it is not clear to me how you would 
make that distinction.
    And one of the fundamental facts about markets that work 
effectively and have sufficient liquidity is that you do have 
people engaging in that market who don't necessarily have a 
direct interest, but they are willing to take a view, they are 
willing to provide some liquidity to the market, and I think 
that that is a very important part of all well-functioning 
markets and that is true of the credit default swap market, as 
well.
    One other thing to keep in mind is that in any credit 
default swap, again, a bilateral contract, there is a Party S 
who is shorting that credit who is taking a view that that 
credit may deteriorate over time, but there is also the other 
party who is taking the long position. They are taking the view 
that at that price, they are willing to take exposure to that 
underlying credit. So it is a very dynamic relationship there 
that the whole over-the-counter or privately negotiated 
derivatives business is based on.
    Senator Crapo. Well, thank you. This is an incredibly 
complex issue, as I am sure everybody will acknowledge, and I 
am sure that our committee will need to have a lot more input 
from all the parties on how to understand this as we move 
forward with possible Federal regulation.
    With regard to the clearing system that we have all been 
talking about, I think several, if not all of the members of 
this panel have probably been involved with the discussions 
that have been going on with the Federal Reserve about trying 
to develop some kind of a clearing system. I note that we have 
CME and we have ICE and others, we have the New York Stock 
Exchange and others who are all interested in performing this 
function.
    So my first question to the panel--this is probably for Mr. 
Duffy and Mr. Short, but anybody can jump in here--is, is there 
any reason why there need only be one clearing counterparty or 
could all of you do what you are talking about, and others jump 
in, as well. Are there benefits or disadvantages to a multi-
clearing party approach?
    Mr. Duffy.
    Mr. Duffy. I always believe there is room for competition, 
so we don't have issue with that. Again, the CME has had a 
great history in this business, longer than anybody else, I 
believe, in the business of clearing products. So we feel, 
again, Senator, very comfortable and confident that the Federal 
Reserve and other regulators will look at us and say that we 
are a competent model to do this type of business. So as far as 
the competition goes, I would be very surprised if the U.S. 
Government was to try to anoint anybody a winner in clearing of 
any type of products when there are multiple parties to do so. 
So I look at this and say that it is competition like we have 
on all our products and we will compete for this business.
    Senator Crapo. Thank you.
    Mr. Short.
    Mr. Short. I share Mr. Duffy's view on that. I wouldn't see 
the Fed anointing a single entity to do this, and I think there 
are definitely some benefits from competition in terms of 
getting the clearing solution right. Competition ultimately 
drives innovation, and I think it's important not to lose sight 
of that.
    Senator Crapo. Well, thank you. I would like to just ask a 
general question of the entire panel and have anybody who wants 
to jump in here, but again, we use the terms clearing 
counterparty or a clearing system or whatever. What exactly are 
we talking about there when we talk about establishing a 
clearing counterparty or a clearing system?
    Mr. Duffy.
    Mr. Duffy. I will be happy to. What we are talking about is 
obviously the exchange is acting as the buyer for every seller, 
the seller for every buyer, doing a mark to market twice daily, 
doing the pays and collects twice daily. So that is essentially 
what we do, and we risk manage each and every one of these 
products throughout the day. So if we see the product moving in 
a certain direction, we have the ability to call for margin 
from the people who are on the one side of the trade and they 
have up to--well, as less time as an hour to go ahead and 
facilitate that money so we can pay the other side of the 
transaction.
    Senator Crapo. Let me interrupt here----
    Mr. Duffy. We truly act as a clearing--and we hold $1.6 
billion in guaranteed funds and hold an additional close to 
$100 billion in funds to protect all these positions.
    Senator Crapo. Let me interrupt you right there and ask, in 
your testimony, you indicated that if you were to do this, you 
thought you could reduce the exposure, and I assume this is in 
the credit default swap market, by a factor of ten.
    Mr. Duffy. Yes.
    Senator Crapo. What are you talking about there?
    Mr. Duffy. We would net them down. Right now, these 
exposures, as they talk about them in the notional value of $55 
trillion or $600 trillion in the total marketplace, that is 
taking account for both sides of the market. We would take them 
into the clearinghouse and net all these positions out, and so 
you would net out and compress down the risk associated with 
them.
    Senator Crapo. So the net risk would be dramatically 
reduced----
    Mr. Duffy. Reduced by ten is the way we figure it right 
now, yes, sir.
    Senator Crapo. All right. Thank you. Does anybody else want 
to jump in on that? Mr. Short?
    Mr. Short. We would have a similar model involving a 
central counterparty with comprehensive risk management systems 
and margining of positions. I guess in distinction from what 
Mr. Duffy described, we would be a New York trust company, a 
regulated bank, special purpose bank to which people or major 
market participants would become members and those who were not 
members would trade through members. But from a risk management 
standpoint, it would be very similar to what Mr. Duffy 
described.
    I think one distinction would be this would be a special 
purpose clearing entity solely for credit default swaps. We 
understand there is some concern about the idea of mingling 
credit default swap risk with other risks that broader markets 
serve. So this would be a special purpose entity that solely 
clears CDS and credit exposures. It wouldn't touch agriculture. 
It wouldn't touch other futures or exposures.
    Senator Crapo. Thank you. Let me just ask one last quick 
question. In a July hearing that we held, and actually this was 
in the Banking Committee, I asked one of the witnesses whether 
there was a danger in centralizing the credit risk in one 
institution and whether that could actually increase systemic 
risk. That kind of gets back to my first question as to whether 
we should have one clearing system or not. But is there a 
danger if we were to centralize all of this risk too much in 
terms of creating a systemic risk?
    Mr. Duffy. I will just speak on behalf of the CME Group. I 
don't believe so, Senator. I mean, you look at the products 
that we trade today. ICE has basically some exclusives on some 
of their products, one being the Russell 2000 futures 
contracts, so they are the only one that is able to trade that. 
They can manage that risk. The CME Group has exclusives on S&P 
500 and Nasdaq and other products. So we have been able to 
manage that risk as one entity, so I don't see that as an 
issue.
    Senator Crapo. Mr. Pickel and Mr. Short?
    Mr. Pickel. Okay. I think that in our area, of course, that 
is all very decentralized. We have got all these bilateral 
relationships and parties should be managing those 
relationships. To the extent they haven't, that is something 
that they should improve in terms of their internal processes 
and risk management. But there are protections in place, 
including regular calls for collateral, movements of collateral 
even on a daily basis between counterparties.
    In fact, a situation like AIG, what they had agreed to was 
not regular exchange of collateral for their positions, but 
provision of collateral only upon a downgrade. And so when they 
were downtraded, all of a sudden they had a significant 
liquidity requirement to post collateral for those trades. If, 
as we think is the better practice, and I think banking 
supervisors encourage their banks to do this, they have regular 
collateral exchanging in the relationship. If you see your 
position declining, you have that additional discipline as well 
as the credit protection of collateral that you have introduced 
to that relationship.
    So certainly the clearinghouses have a good record of 
managing that risk and being able to take on significant risk 
and managing it effectively, but there is also a great benefit 
to having this diffuse nature of managing risk on a bilateral 
basis.
    Senator Crapo. Thank you. My time is up.
    Chairman Harkin. Thank you.
    Senator Lincoln.
    Senator Lincoln. Thank you, Mr. Chairman. This is a lot. I 
am getting it all down here.
    Mr. Radhakrishnan, just so I understood what you said 
earlier, you did say that the CFTC felt like it definitely had 
the Congressional authority to establish a clearinghouse for 
derivatives, is that correct?
    Mr. Radhakrishnan. Yes, ma'am. The CFTC does have the 
authority to regulate a clearinghouse. Let us say Mr. Duffy's 
clearinghouse----
    Senator Lincoln. Right.
    Mr. Radhakrishnan [continuing]. Were to provide this 
solution. They have the authority to do it under the law and we 
have the right to regulate them in that activity.
    Senator Lincoln. Right. Was there ever any concern among 
regulators at CFTC that derivatives and those that were based 
on underlying mortgages could pose a threat to the stability of 
the market?
    Mr. Radhakrishnan. Not currently, because all of the 
products that are cleared by the DCOs that are regulated by us 
are either exchange-traded products----
    Senator Lincoln. Right.
    Mr. Radhakrishnan [continuing]. Or in the case of NYMEX, 
energy products, and in the case of the CME, interest rate and 
foreign exchange products. All of those products, OTC products 
which they clear, basically priced off a deep and liquid 
futures contract. In the case of the NYMEX OTC clearing 
initiative, the OTC products that they were clearing were 
priced off of the NYMEX natural gas contract. In the case of 
the CME initiative, they were priced off a deep and liquid 
contract--the Euro dollar contract and foreign currency 
contracts that the CME trades on its exchange.
    Senator Lincoln. So the regulators there at CFTC had no 
concerns about their oversight over the counterparty clearing, 
is that correct? I am trying to get the terminology correct.
    Mr. Radhakrishnan. Yes, ma'am. So far, we have no concerns 
with the clearinghouses that we regulate. We have a constant 
dialog with our clearinghouses----
    Senator Lincoln. Now, do you have that oversight over ICE?
    Mr. Radhakrishnan. We have oversight over ICE Clear U.S., 
which is a----
    Senator Lincoln. Did the CFTC ever use its special call 
authority to get any information from ICE with regard to 
derivative trading?
    Mr. Radhakrishnan. I believe it did with respect to trading 
ICE's exempt commercial market. We did use our special call 
authority to get information with respect to trading on that 
platform, which is not an exchange that we regulate.
    Senator Lincoln. That is----
    Mr. Radhakrishnan. It was not, until passage of the Farm 
Bill of 2008.
    Senator Lincoln. It is not. Okay. But, I mean, it works 
when you have the ability to gather that information or when 
you have transparency or that window into what you can look at. 
Then you have the authority to call under that?
    Mr. Radhakrishnan. Yes, ma'am.
    Senator Lincoln. I kind of asked a similar question--and 
there was one other question I actually had for Mr. Duffy. When 
CME--I mean, you can do swaps on your platform and you have 
that ability to clear what you need, and that is done in-house, 
is that correct?
    Mr. Duffy. Correct.
    Senator Lincoln. Okay. Now, what volume do you do on your 
platform compared to the volume that we have seen in terms of 
other swaps, in terms of these other--I mean, is it a 
compatible volume?
    Mr. Duffy. No, ma'am. We do not clear much in the way of 
OTC-type transactions today. What we do clear in OTC is the 
transaction with the New York Mercantile Exchange. When we 
acquired them, they have something called Clearport.
    Senator Lincoln. Right.
    Mr. Duffy. So that is an OTC platform that these contracts 
get submitted and then they get turned into futures contracts 
and then we clear them. It is a small part of our business.
    Senator Lincoln. So it is kind of apples to oranges?
    Mr. Duffy. It is in that respect. Otherwise, at the CME 
Group, the only other product that we have like that is 
ethanol. So the rest of our products are all standardized 
futures contracts that we clear. That is the 2.2 billion 
contracts that I mentioned earlier on.
    Senator Lincoln. Right.
    Mr. Duffy. Now, you have got to take the over-the-counter 
market and multiply that times five, six, seven times the size 
compared to the regulated exchange market on clearing. So we 
clear very, very small amounts of OTC----
    Senator Lincoln. In terms of----
    Mr. Duffy [continuing]. Of OTC products.
    Senator Lincoln. From the platform that you use with those 
OTCs. So being able to----
    Mr. Duffy. We have the ability to do so. We have the 
ability to do more and we are trying to get into the business.
    Senator Lincoln. The key would be if we could magnify that 
to the degree that we would need it for other instruments or 
other products that might be out there in terms of what you all 
do.
    There was a question I had asked the first panel, but Mr. 
Radhakrishnan, I would like to ask you. Jurisdiction in the 
credit default swaps. These instruments can sometimes be based 
on an event, for example, a bankruptcy or another credit event. 
I was trying to explain it to my kids and it was very 
difficult, since we are talking about an event here, perhaps, 
as opposed to what that underlying debt instrument would be, 
such as a bond. If that is the case, would you say that there 
is no jurisdiction for these instruments to be regulated in any 
way as equity swaps, since there is not a--I mean, the equity 
is an event as opposed to--I don't even know if you can say 
equity is an event, but--they are not to be regulated as equity 
swaps, but there is some argument for their regulation. Who is 
going to be the regulator? Who do you think would be the most 
appropriate regulator, if there is one that exists, or do we 
need to create one?
    Mr. Radhakrishnan. I think right now, I think it is clear 
the CFTC has no jurisdiction over them, and I am not a 
securities law expert, but I believe that when Congress passed 
the CFMA, it made it clear that the Securities and Exchange 
Commission did not have any jurisdiction.
    Senator Lincoln. Right. I think that is correct.
    Mr. Radhakrishnan. I think Chairman Cox said so. As for who 
should be the appropriate regulator, ma'am, that is not a 
question that I think would be appropriate for me to answer. 
That is a question for the policymakers to answer. I think it 
would be appropriate for this committee and for other Members 
of Congress to listen to a whole wide variety of views as to 
who would be the most appropriate regulator, although the one 
thing I can say is that should Congress give this--I know I am 
sounding like a broken record, but if Congress should decide 
that a Federal regulator was to regulate this, then Congress 
should make sure that the regulator has sufficient funds to 
regulate it.
    Senator Lincoln. Well, that kind of leads to, I think, some 
of the other things that we have discussed in this committee in 
terms of the CFTC, and that is whether you have got the 
resources and the manpower to do all that needs to happen. Do 
you have any comments on that?
    Mr. Radhakrishnan. Ma'am, I think our budget requests, you 
know, we have made significant requests to Congress. We could 
always use money. I think you are asking the wrong person, 
because I could always use more money because I could hire more 
people, do more things. I leave it at that.
    Senator Lincoln. What about the requirements to meet the 
new farm bill responsibilities that we have put upon you all? I 
mean, is there enough? Do you have enough resources in terms of 
people and other resources to be able to meet those demands?
    Mr. Radhakrishnan. I am speaking for myself, ma'am. No, I 
do not.
    Senator Lincoln. Okay. Thanks, Mr. Chairman.
    Chairman Harkin. Thank you, Senator Lincoln.
    Mr. Pickel, in preparing for the hearing and through my 
reading of everything that has gone on the last month or so, I 
came across an article that was in the New York Times, February 
17 of 2008. Quote, ``'The theme had been that derivatives are 
an instrument that helps diversify risk and stabilize risk 
taking,' said Henry Kaufman. 'My own view of that has always 
been highly questionable. Those instruments also encourage 
significant risk taking and looking at risk modestly rather 
than incisively,''' end quote.
    ``Officials at the International Swaps and Derivatives 
Association, a trade group, say they are confident that the 
market will stand up, even under stress. 'During the volatility 
we have seen in the last 8 months'''--this article was written 
in February of 2008--``'credit default swaps continue to trade 
unlike other parts of the credit market that have shut down,' 
said Robert G. Pickel, Chief Executive of the Association. 
'Even if we have a series of credit events at the same time, we 
have the processes in place to enable the market to deliver.'''
    Well, I don't know. Today in your testimony, you talked 
about the process of selling swaps protection, the Lehman 
Brothers case and bankruptcy. Then we have the scenario with 
AIG, where the derivatives transactions failed and the U.S. 
Government stepped in. So it seems to me that bankruptcy plus 
the U.S. Government stepping in is not the market delivering, 
and the market is not functioning. So I just wonder if you have 
a comment on that.
    Mr. Pickel. Well, Chairman Harkin, these are certainly very 
extraordinary and difficult times. I think that my remarks in 
February referred to the fact that we have, as an organization, 
working with our members who are the active market 
participants, have put in processes that anticipate the 
possibility that these events might occur and it has been very 
important for us to focus our initiatives to make sure that 
those processes are robust and can absorb these events, even 
though we hoped they would not occur. And in fact, over the 
last several weeks, the master agreement which we publish which 
allows counterparties to Lehman Brothers who have a range of 
derivatives transactions, not just CDS, they have been able to 
proceed to liquidate those positions and value those positions.
    And then most prominently, as you refer to, with the 
bankruptcy of Lehman Brothers, with the credit events arising 
out of the Fannie and Freddie situation, which was a credit 
event under the definitions of our credit default swaps but 
because of the legislation passed this summer by Congress, it 
was not an event, a default under the master agreements, we 
went forward with an auction to value positions for Fannie and 
Freddie last week. So those are in the process of closing out.
    And again, as far as AIG, the credit default swaps were 
effectively the conduit by which they took underlying risk 
principally to these collateralized debt obligations, many of 
which of them were in turn exposed to subprime exposure, which 
I think your chart very effectively demonstrated, that it is 
from that base of the mortgages packaged into ABS, further step 
typically of packaging into collateralized debt obligations. In 
that situation, people like Merrill Lynch, like Lehman 
Brothers, like other firms on Wall Street, purchase protection 
against a possible default on those collateralized debt 
obligations, a prudent step for them to take in terms of 
managing the risk and exposure that they had to those 
underlying risks.
    Chairman Harkin. Well, I come back again to this idea of 
whether or not, talking about the risk to the overall financial 
system, some $365 billion still has to be paid. So again, it 
still leaves--I don't know that I understand your answer 
completely, but it seems to me we still don't understand the 
overall risk to the overall financial system of this. You can 
talk about, well, AIG or Lehman Brothers here, but what does 
this mean to the overall system? People keep saying systemic 
risk. Well, the overall system and what this means.
    Again, and I kind of loop back to this. Again, this is my 
own opinion, obviously, as you may have gleaned that I am not 
convinced that swaps and derivatives are--no matter what the 
category that they are in, are all good for our economy. So it 
comes back to this. I mean, again, financial systems have 
developed different products. In my reading of the history of 
some of these, it is not that there was a need out there for 
any of these. It is just that some financial geniuses conjured 
up collateralized mortgage obligations or collateralized debt 
obligations or credit default swaps. We never had credit 
default swaps before the early 1990's. I mean, my wife and I 
bought a house back in the 1970's. We were fine. We had a 
fixed-rate mortgage. So why didn't the world fall apart before 
the 1990's, before we had credit default swaps?
    So I keep coming back to this, and I know some people say, 
well, that is not the whole problem. Well, maybe it is not the 
whole problem, but it is a big part of it right now. So maybe 
we ought to at least ban these naked credit default swaps, 
where it is just a bet between two companies. Or again, as I 
say, put them on a regulated exchange so that we know who you 
are, how much you are doing, we can set position limits, we can 
demand collateral, we can demand that you prove up on a daily 
basis. And I still haven't gotten an adequate answer on that 
one yet. It seems to me that could easily be done.
    So again, I ask the question, Mr. Pickel, why can't we just 
say we are going to put all of these on a regulated exchange 
and you can't have them off of a regulated exchange? I mean, 
Mr. Short, they do a job of over-the-counter exchange. They do 
over-the-counter trades. We still have this problem of 
customized trades and stuff. I don't know how much there is of 
that, but it seems to me that if you want to do a customized 
trade, do it on the board. You say you can handle it.
    So why shouldn't we do that, Mr. Pickel? I mean, why 
shouldn't we put these derivatives, these swaps, these 
derivatives on a regulated exchange and make them fully 
transparent, regulate them, position limits, everything else we 
do, because they are, and you can correct me if you think I am 
wrong, I don't mind that, but they are by their nature a kind 
of a futures contract.
    Mr. Pickel. Again, we have focused in this industry, the 
over-the-counter privately negotiated industry, on the ability 
to respond to customer requirements and customer needs, which 
are often quite diverse and don't fit into the structures of a 
highly standardized contract traded on a futures exchange, and 
that has been our focus over the years, is to provide the 
ability to develop a flexible, privately negotiated, custom-
tailored transaction to deliver value to the customer, and, for 
instance, again, a very good example are these collateralized 
debt obligations, which again, keep in mind, those are 
securities. They are put together as securities. They are 
distributed as securities.
    And what you had with a situation like Merrill Lynch was 
they found--and they are fairly customized securities and the 
exposures on the books of, say, a Merrill Lynch for the AAA-
rated, highly rated tranches of those securities were building 
up and somebody at Merrill Lynch, wisely, I believe, said we 
can buy credit protection via credit default swaps to give us 
some element of protection against the exposure that is 
building up on our balance sheet. And so they went out into the 
market and they bought that protection from various entities 
who were willing to sell that protection. But it was very much 
customized to the particular securities, to the particular 
collateralized debt obligations that existed.
    Mr. Duffy. Senator, may I?
    Chairman Harkin. Yes, Mr. Duffy.
    Mr. Duffy. I would be remiss if I didn't take the 
opportunity, sir, to echo what you just said. We have been in 
these halls of Congress for many years saying what you just 
said. It has come time that we put these products on a 
regulated platform. It is time for people to see the 
transparent prices that an exchange provides. It is time for 
people to have a central clearing that brings the benefits to 
the economy and the users of this marketplace.
    For customized contracts, we have come up, and I said 
earlier in my testimony that we have formulas to standardize 
these type of products so we can take them away from the 
customized way, standardize them, use our IMM dates, our 
International Monetary Market currency dates to do this type of 
business. This business belongs on an exchange if it is to 
continue, sir. And again, I think our model of 150 years with a 
zero default has been one of the few models in this country 
that can say that.
    I believe that central clearing and a central limit order 
book, for the world to see what the price is being traded so we 
know if we want to buy, we know we want to sell. We have no 
idea how many of these outstanding credit default swaps are 
even out there because there is no value or price to them. How 
are we supposed to trade them? The only way to do that is in a 
central limit order book and in a clearinghouse, such as CME 
Group. Thank you, sir.
    Chairman Harkin. Thank you, Mr. Duffy.
    Mr. Short.
    Mr. Short. Chairman Harkin, I disagree with what Mr. Duffy 
said and agree in part with what Mr. Pickel said. I think the 
real issue here is about transparency and risk intermediation. 
I think one of the problems in thinking about putting something 
on an exchange is that it doesn't take into account the fact 
that there are some very legitimate needs for bespoke 
customized, tailored swap products. I think the problem is we 
didn't have appropriate transparency and proper risk systems to 
manage a lot of that exposure.
    I think one of the risks of only saying you are only going 
to be able to eat vanilla ice cream is that it chokes off 
financial ingenuity. That is not to disregard the need for 
appropriate regulation and credit risk intermediation that a 
central counterparty would bring here. I think it is a more 
nuanced response. There certainly needs to be the proper level 
of regulation, but I don't think saying it has to be traded on 
an exchange is necessarily the answer because that means the 
exchange is the only party that determines what the product is, 
and by definition, exchange products are standardized. There is 
only one flavor.
    Chairman Harkin. Mr. Duffy, your response?
    Mr. Duffy. Senator Harkin, I am sorry, but we have clearly 
stated in our proposal we can take these customized products 
and make them standardized in our clearing processes, and I 
think that if our model was not one to emulate, then I quite 
surprised why ICE and others have decided to recapitalize the 
Clearing Corp and emulate the CME Group's model to do exactly 
what we are trying to do. So I am a little surprised by the 
answer. Thank you, sir.
    Chairman Harkin. I am, quite frankly, surprised by the 
answer, too. Mr. Short, do you want to respond?
    Mr. Short. Sure. I would be happy to respond. I don't think 
we are necessarily emulating anyone's model and we are talking 
about bringing in positions that exist in the credit default 
swaps market and bring them into a clearinghouse. I think the 
question was whether that needs to be traded on an exchange. 
That was the answer or question I was addressing.
    Chairman Harkin. Thank you very much. I have another 
couple, but I have used up more than my share of time on this.
    Senator Lugar.
    Senator Lugar. Thank you, Mr. Chairman.
    Mr. Pickel, in your written testimony and somewhat in your 
oral testimony, you mentioned these customized responses to 
clients that you are able to handle, but you also indicated 
that beyond that, that is what normal persons like ourselves 
talk about insurance, people can express opinions about the 
market, and you legitimize that in your written testimony by 
saying, after all, if you are making some loans in a particular 
industry but you notice everybody else in the industry seems to 
be in trouble, your client and his party might be, too, at that 
point, so you place some bets against the industry. As a 
result, if one loan doesn't work out, you might pick it up as 
the whole thing crashes.
    This is an interesting concept. It sort of gets back to the 
original chart that Senator Harkin had in which we talked about 
insurance for somebody who might buy it, but this is something 
beyond that and all these bets one way or another are not very 
transparent. No one is totaling up the score except ultimately 
people do.
    Now, the point of my bringing all this to the attention is 
a rather striking and dramatic chart offered in Financial Times 
today, ``Emerging Nations Hit by Growing Debt Fears.'' And 
here, essentially, they are using the swap markets, the credit 
default swaps, to engage the likelihood that various countries, 
in fact, will default. That is, the whole country will default 
on debt. You have the flags of the countries and Pakistan, 
according to the credit default swap situation, has a 90 
percent chance the country will default on its debt. Argentina, 
85 percent chance. Ukraine, 80 percent. Iceland, 80 percent, 
much in the news. Pakistan, at least 60 percent.
    These are whole countries that are likely to default. They 
may or may not have ramifications on the United States. They 
will have ramifications on somebody. And the point of the 
article is that even as the ministers of the major banks are 
meeting here today, they are looking over their shoulder and 
wondering, for instance, in a country such as Iceland, where 
the government clearly is willing to try to measure up in every 
way it can, it may be incapable of doing so under these 
circumstances.
    Now, I mentioned these countries specifically, although 
this could be a different forum, that we have a considerable 
stake in Pakistan in terms of our foreign policy. This is a 
crucial element quite outside our discussion of swaps today, 
and the fate of Pakistan may have a great deal to do about the 
fate of our military budget, our armed forces, a lot of people 
in the Middle East, as a matter of fact.
    Likewise, Ukraine, much in the news. I visited with 
President Yushchenko just a few days after I visited with 
President Shakashvili in Georgia in August and I would say the 
eyes of the world are on Ukraine and its relations with Russia 
as well as with NATO and with various other things. And here 
you have in Financial Times an 80 percent chance that they are 
going to default on their basic obligations. With a divided 
government now and a snap election called, a crucial problem in 
terms of our foreign policy.
    You could say much the same thing when you get down to 
Kazakhstan at only 60 percent, but here we have a question 
which our whole energy policy in the world revolves around will 
Kazakhstan diversify its energy portfolio, in essence, send 
more oil and natural gas south as opposed to north. It makes a 
huge difference in our economy, in the world economy.
    So when we are talking about this in the international 
context, this is not only serious, but it has dimensions well 
beyond sort of the interest of the markets going up and down 
presently, and it is all being defined in this chart by the 
very thing we are talking about today, these swaps.
    This is why, in my judgment, I sort of listened today 
dispassionately, but I have come to much more of a feeling this 
is an area that is going to have to have some controls and some 
very rigid management. I wish that, in fact, the theoreticians 
who say, let the market work, and so let all fly out and price 
finding and all the rest of it, and I think that is 
fascinating. But the repercussions of this are awesome on the 
other side.
    Therefore, I am willing to take a chance that somehow, 
there are some of these small limitations to a market economics 
that we are going to have to find. So I am encouraged about 
what you are saying, Mr. Short. You can do some things now, 
even without Congress moving or the President or the changes of 
administrations, but now, because the whole point of this 
default article is the fear of the major banking systems right 
now that time is not on their side and that, as a matter of 
fact, there are going to be changes in governments, including 
our own. It takes time for new Treasury Secretaries to be 
confirmed and new Congresses to formulate.
    If there is not somebody out here in your province that can 
actually move and work at this point, why then the great fear 
also expressed, not only in Financial Times but everywhere 
else, is whatever happened this weekend will not be soon enough 
and that the recession coming on, the unemployment, the 
continued defaults and so forth are going to lead to a new 
pessimism with regard to our publics, not just in this country 
but elsewhere. And more power to you. I hope, likewise, over at 
the CFTC people are paying attention to what you are saying 
today, because I think it is crucial, not a total step but an 
important one.
    I just take my question period to offer this editorial, Mr. 
Chairman, because I think some of these points are important to 
make. Thank you.
    Chairman Harkin. Very good. Thank you, Senator Lugar.
    Senator Lugar. Would you like to reply, Mr. Pickel, since I 
quoted you in the paper.
    Mr. Pickel. Yes. Senator Lugar, thank you for giving me the 
opportunity to comment. I think it is a very interesting 
observation you have made and obviously I am well aware of your 
involvement in international relations over the years, 
including meeting with all those leaders around the world.
    If we look back at some financial crises in the past, Asian 
currency crisis, Latin America crisis, other defaults by 
countries, those all took place in an era before credit default 
swaps. You weren't able to have any mechanism to hedge against 
a possible default. No one is saying that just because of those 
probabilities that it is a certainty.
    And in fact, I am always very careful. When somebody calls 
me up and says, well, this company's credit default swaps are 
now trading at X amount, does that mean they are going into 
bankruptcy, and the answer is always it is further information 
for the marketplace to absorb. It is information that did not 
exist in the marketplace 10 years ago. So this is very 
important in terms of transparency and understanding what the 
exposures of underlying risk is. So by no means, it is a death 
sentence just because spreads go up a certain amount. It is 
information that is important to the market to obtain and 
absorb, and it is information that did not exist even eight or 
10 years ago.
    Senator Lugar. Thank you.
    Chairman Harkin. Thanks.
    Senator Crapo.
    Senator Crapo. Thank you very much, Mr. Chairman. I was 
going to try to return to the big picture in my question and 
Senator Lugar really expanded the vision there.
    What I would like to do is--there are a lot of things I 
would like to get into with the panel. We can do it after the 
hearing in our dealings. Mr. Pickel has raised the broad 
question of the need for a completely new regulatory system, a 
21st century regulatory system for financial markets, and I 
totally agree with that.
    We have got the issue of customized derivatives that we 
have already gone into somewhat and the issue of naked short 
selling and just what that is and how we should approach all of 
these transactions. But I have only got just a few minutes left 
in my final question period and what I would like to do is to 
return to the first question of the hearing, or the purpose of 
the hearing, and ask each of you if you would just take a 
minute or so and try to be as succinct as you can, because I am 
going to ask all of you to respond, but what is the role of 
derivatives in the current credit crisis?
    We have talked a lot in the context of that. Mr. Black in 
his testimony reminded us that mortgage-backed securities are a 
derivative, and we have got the collateralized debt obligations 
and we have got credit default swaps. I guess I really would 
like to focus my question on what is the role of mortgage-
backed securities and collateralized debt obligations versus 
the role of credit default swaps in terms of the economic 
circumstances that we face today? Big picture.
    Mr. Radhakrishnan.
    Mr. Radhakrishnan. Thank you for that question, Senator 
Crapo. I would prefer to answer your broader question----
    Senator Crapo. Sure.
    Mr. Radhakrishnan [continuing]. Because I am not that 
familiar with mortgage-backed securities and so on. But I 
think--my understanding has always been that the role of 
derivatives is to enable people to manage risk and to allow 
people who are willing to take on that risk to do so for a 
price. I think that has been the hallmark of trading on our 
markets and it has allowed people to expand their business.
    But I think you have correctly asked the right question, 
which is if it doesn't do that but does something else, then 
does it serve a purpose, and I guess that is why we are here.
    Senator Crapo. Thank you very much.
    Mr. Duffy.
    Mr. Duffy. Senator, you asked what the role of derivatives 
is and I think it is really important to distinguish the 
difference between derivatives, and there are two sets, 
obviously. There is the unregulated derivatives and then there 
is the regulated derivatives. Everything that we have heard 
today from a lot of the witnesses from the first panel, I think 
were referring to unregulated derivatives. I don't think 
anybody has made any mention about regulated derivatives and 
what role they play on a negative side. I think everyone 
understands that these products play a huge role in the risk 
management for corporations and businesses all throughout the 
world, and that is exactly what we have at the CME Group. We 
have all these different benchmark products.
    So again, I think the role of regulated derivatives plays a 
crucial role in the economy here in the U.S. and I think it has 
benefited the taxpayers immensely--immensely--over the years by 
letting people compete for Treasuries on the regulated market, 
such as the Board of Trade, where the government can buy debt 
much cheaper. So there is a lot of positives to these listed 
products.
    Senator Crapo. Thank you.
    Mr. Pickel.
    Mr. Pickel. Senator Crapo, to answer your specific question 
about mortgage-backed securities, CDOs, versus credit default 
swaps, as I have mentioned, the mortgage-backed securities, 
CDOs, are securities. They are packaged together as securities. 
They are distributed as securities. And typically from the 
bank's perspective, let us say, in going back to Chairman 
Harkin's chart, you have got those mortgages that are packaged 
into some kind of security. By putting those mortgages into a 
special purpose vehicle, the bank can basically get those off 
of its books into this SPV and often will arrange the 
underwriting of that and distribution of that.
    With a credit default swap, and this is a critical 
difference, again, it is a bilateral contract. That bank is--
first of all, they are typically maintaining--let us take an 
example of a borrower the bank has lent to. They are 
maintaining that relationship. Even if they have bought 100 
percent protection in the credit default swap market, they 
still have the loan on the books. They have to maintain that 
relationship. Furthermore, they have paid money to buy that 
protection. It is not cost-free. They have got to pay money to 
the protection seller to get that protection. And furthermore, 
and this is very important, they are taking on credit exposure, 
additional credit exposure to the credit seller.
    And so anybody who is using these credit default swaps 
needs to understand that very dynamic nature. It is quite 
different from taking the obligations and putting them into an 
SPV and distributing them in the securities networks.
    Senator Crapo. Thank you.
    Mr. Short.
    Mr. Short. I would concur in part with what Mr. Duffy said. 
I think--well, I guess I would first like to say I don't think 
I am qualified to address the broader question of the exact 
role that mortgage-backed securities and CDS have played in the 
current financial crisis. But I guess I would note that 
derivatives in and of themselves are not bad. They serve very 
useful purposes. They allow parties to shift risk and 
ultimately allow businesses to operate more efficiently. I 
mean, talking about mortgage-backed securities, they probably 
allowed Americans to get cheaper mortgages than they otherwise 
would have gotten.
    I think the real issue here is when you have derivatives 
and you don't have appropriate transparency, you don't have 
appropriate controls, you don't have appropriate risk 
intermediation, that is where the problems really arise. But it 
is not the derivative itself. It is how they are regulated and 
ultimately overseen.
    Senator Crapo. Thank you. Thank you, Mr. Chairman.
    Chairman Harkin. Thank you.
    Senator Lincoln.
    Senator Lincoln. Well, just one last question, Mr. 
Chairman.
    Mr. Pickel, given the fact that there is an unprecedented 
price movement in commodities, it doesn't appear to be solely 
due to fundamentals in some cases. Do you think it is time that 
the Federal regulators have a clear window as opposed to just 
moving it to another exchange or whatever, I mean, just a clear 
window in terms of non-traditional speculative activity in the 
commodities market?
    Mr. Pickel. Well, that is certainly something that we have 
been engaged with this committee and other Members of Congress 
in the debates over the last several years and that led to some 
of the changes that were agreed to in the farm bill when the 
CFTC was reauthorized, and I think that the steps that were 
taken there were appropriate and reflected----
    Senator Lincoln. Do they need to go further?
    Mr. Pickel. Well, I think that--I do think, and we have had 
a lot of discussions about the fundamentals here, and I think a 
number of reports to Congress, comments from the President's 
Working Group, have indicated that the fundamentals continue to 
apply. Now, we are talking about supply and demand. We are 
talking about expectations about supply and demand. And since--
--
    Senator Lincoln. What about the OTC, the over-the-counter?
    Mr. Pickel. Well, the over-the-counter market will 
typically reference the prices that are obtained in the 
exchange-traded markets, so it is very much the exchange-traded 
world, whether it is the NYMEX platform that is owned now by 
the CME or the ICE platform, will provide the prices that are 
utilized in these transactions.
    Senator Lincoln. Mr. Radhakrishnan, you may not be able to 
answer this question, but I know that there was obviously the 
OTC in terms of commodities trading is very different than some 
of the regular commodities trading. But we saw in the spring a 
real spike in cotton prices, which the CFTC, I think, is 
investigating now. Do you have any knowledge of that or any 
feedback? I have a lot of growers that were left high and dry.
    Mr. Radhakrishnan. No, ma'am. But I know that my colleagues 
in the Market Oversight Division are always looking at price 
spikes to see if there is any manipulative activity involved. 
But----
    Senator Lincoln. It was pretty high and pretty quick, so I 
just was--but we will probably send a letter and see if there 
is anything that has come out of those investigations.
    Mr. Radhakrishnan. Yes, ma'am.
    Senator Lincoln. Thank you, Mr. Chairman. I appreciate the 
hearing today. It has been very helpful.
    Chairman Harkin. Thank you very much, Senator Lincoln.
    I just have a couple of things I wanted to clear up here. 
Mr. Pickel, Mr. Dinallo in our first panel said that he 
estimated that 80 or 90 percent of credit default swaps are not 
customized risk. They are just those directional bets I had on 
the chart going back and forth. If that is the case, why can't 
those be standardized, if they are 80 to 90 percent? But maybe 
you don't agree with that figure because I don't know, either.
    Mr. Pickel. Well, I think even Superintendent Dinallo 
mentioned that 80 to 90 percent includes a whole range of 
transactions that might be entered into for different purposes, 
whether it be--I think his example of the----
    Chairman Harkin. But they were still directional bets. That 
80 to 90 percent were----
    Mr. Pickel. They may have had--I thought what he commented 
was that they might reflect some underlying interest that might 
be other than a bond or a loan, but nevertheless some 
underlying exposure either to the particular credit or to the 
particular industry and that would be appropriate for that--the 
party that has that exposure to utilize these products in some 
way. So I think he was suggesting that those that are taking a 
view on credit, and that is what is happening here, is you have 
got people here who think that the price of a particular credit 
default swap for a particular name is relatively cheap or 
relatively expensive, and these could be investment managers.
    In fact, it was mentioned before, the famous quote from Mr. 
Buffett, but also acknowledged the fact that he has actually--
his company is a very active user of credit default swaps, and 
I think that he is looking at those as investment opportunities 
for return to better serve his shareholders. So I think he is 
very much motivated by that.
    Now, keep in mind he is a very savvy investor. He 
understands these products. The people who work for him 
understand these products. So they engage in these in a prudent 
way utilizing collateral, making sure that they have done 
sufficient credit checks of their counterparties. All those 
protections are critical in the OTC world for these products, 
whether you have got the underlying exposure or whether you are 
taking a view on where credit may move over time.
    Chairman Harkin. Thank you.
    Mr. Duffy.
    Mr. Duffy. I disagree just a little bit. I know there are 
some--on the 80 to 90 percent, we are not quite sure of the 
number, but there are some receivables that are against these 
contracts, so I will give that benefit. But in our research, 
and again, we don't take this lightly. We would not be getting 
into this business if we didn't feel that we could standardize 
it and essentially clear it. We believe that 80 to 90 percent 
of that trade can be standardized because it is going to be a 
lot of participation by hedge funds and other participants that 
you were referring to earlier in your comments, Mr. Chairman.
    Chairman Harkin. Does anybody else have a comment on that?
    The last thing I just wanted to point out, it has been said 
a number of times about the President's Working Group and their 
position. I am reminded that in 1999 in a hearing before this 
committee, and in 2000--I think there were two hearings--the 
President's Working Group was the one that advocated--
advocated--the exclusion of these instruments from the 
Commodity Futures Trading Commission. So if people are trying 
to convince me that the President's Working Group has all the 
knowledge in the world, I am sorry. I don't buy it any more 
after that one. So they have their views and that is about it.
    Senator Klobuchar wanted me to mention that she regrets 
being unable to attend the hearing but would like to submit 
questions for the record on this important issue. I forgot to 
mention this earlier, but to all on this panel and the previous 
panel, we would like to be able to submit questions in writing 
from Senators who are not here for one reason or the other that 
might want to follow up, or maybe some here might want to 
follow up with written questions, also.
    Did you have something?
    Senator Crapo. Mr. Chairman, I just wanted to comment on 
the line of questioning you were just engaging in. I think that 
is a very critical issue, this notion of regulated versus 
unregulated credit default swaps. Ultimately, I assume that a 
lot of that could be worked out in the negotiations and 
discussions that are being had with the Federal Reserve. But I 
just would say to the panel, if there is any more data that 
could help us, I would welcome you submitting it. I know Mr. 
Duffy indicated you have done some analysis, and I know Mr. 
Pickel has a perspective, as well, and others.
    But I think that is a very critical issue, because really, 
what we need to find out here is the answer to the question 
that this hearing raised. What is the role of derivatives? I 
think we have opened up the issue here and we have peeled back 
a couple of layers, but we still need to get a little deeper 
into this to find out.
    Chairman Harkin. Did you have something you want to add? 
No?
    Well, I don't mean to put a valedictory on this, but I have 
a couple of charts I just wanted to bring back here again. Just 
the one there, the sources of U.S. corporate profit, where we 
have seen over the years manufacturing going down and finances 
going up. Now, maybe those in the financial community say that 
is not a big worry, but there is something about that that 
bothers me. We just seem to be making more money on money.
    I have a quote here from Raymond Dalio of Bridgewater 
Associates, who said the money that is made from manufacturing 
stuff is a pittance in comparison to the amount of money made 
from shuffling money around. Forty-four percent of all 
corporate profits in the U.S. come from the financial sector, 
compared with only 10 percent from the manufacturing sector. 
Well, this chart doesn't show it is that bad, but I don't know 
whether he is right or this chart is right.
    But I think that for some reason, that concerns me, that we 
are just developing these instruments, as I mentioned, the 
collateralized debt obligations, the collateralized mortgage 
obligations, the credit default swaps, all these things going 
back, even back when Fannie Mae started those things back in 
1983. And I am not certain, I am not convinced that there was a 
demand out there for these. It is just people got together and 
said, we have got a new product here. We can market it and we 
can make money on it. And they kind of took on a life of their 
own.
    Now, the next chart I have kind of in concert with that is 
the credit debt as a share of U.S. GDP, and that also bothers 
me. When you see for all the years from basically World War II 
up until about 1990, it was pretty stable. But from about 1990 
on, it just skyrocketed. And I guess what bothers me about that 
is that we are getting further and further in debt. I don't 
just mean government debt. I mean personal, private debt out 
there, credit cards and everything else. And as that happens, 
it strikes me that it crowds out the kind of necessary 
investments that we may need to make in--well, I said that in 
my opening statement, things like health care, medical 
research, the infrastructure of America, retooling our 
manufacturing for the new energy era that hopefully is coming. 
And that just--for some reason that chart kind of bothers me, 
that credit debt as a share of U.S. GDP is now up to 360 
percent of GDP and climbing.
    It seems to me that at some point, there has to be a 
reckoning coming and we have to start unwinding some of this 
debt. I hope we can do it in a way that doesn't create too many 
dislocations, but I just wonder if we haven't gotten too far 
into credit debt in this country and into using financial 
instruments as a way of making money.
    I am not saying they are all wrong, but I think it just got 
out of hand, and that is what this derivatives--that is why I 
am concerned about the amount of derivatives that are out there 
and how they keep growing and how we are not leveraging two or 
six or seven. We are leveraging 30, 35-to-one on some of these 
instruments. I just can't believe that is healthy for this 
country.
    I don't mean to have the last word. If somebody else wanted 
to say something, I would be glad to yield to anybody here. But 
I want to thank all of you very much. We as a Congress, we have 
got to wade through this. We have got to get the best data and 
the best facts we can and try to not only do something about 
the present situation, but also find solutions for the future. 
What do we do down the road to make sure that these kinds of 
things don't happen again?
    So I thank you all very, very much for being here and the 
committee will stand adjourned.
    [Whereupon, at 1:19 p.m., the committee was adjourned.]
      
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                            October 14, 2008



      
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                         QUESTIONS AND ANSWERS

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