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



 
  FINANCIAL SERVICES AND GENERAL GOVERNMENT APPROPRIATIONS FOR FISCAL 
                               YEAR 2009

                              ----------                              


                         WEDNESDAY, MAY 7, 2008

                                       U.S. Senate,
           Subcommittee of the Committee on Appropriations,
                                                    Washington, DC.
    The subcommittee met at 3:02 p.m., in room SD-192, Dirksen 
Senate Office Building, Hon. Richard J. Durbin (chairman) 
presiding.
    Present: Senators Durbin, Brownback, and Allard.

                  COMMODITY FUTURES TRADING COMMISSION

STATEMENT OF HON. WALTER L. LUKKEN, ACTING CHAIRMAN

             OPENING STATEMENT OF SENATOR RICHARD J. DURBIN

    Senator Durbin. I call to order this meeting of the Senate 
Appropriations Committee Subcommittee on Financial Services and 
General Government. The hearing this afternoon will consider 
funding requests for two Federal regulatory agencies that are 
part of the jurisdiction of our subcommittee. My colleagues 
will be joining me a little bit later.
    I am pleased to welcome Acting Chairman Walter Lukken of 
the Commodity Futures Trading Commission (CFTC), and I am told 
that CFTC Commissioners Mike Dunn--please indicate, Mike, where 
you are. Mike, good to see you again. Bart Chilton; is Bart 
here? Bart, thank you for joining us. Jill Sommers, present. 
Jill, thank you for attending. I also understand that Chairman 
Chris Cox of the Securities and Exchange Commission, if he's 
not here--he's enroute.
    I'm going to waive the reading of my opening statement in 
the interest of having more time to ask questions, and ask 
consent that it be put in the record. Without Senator 
Brownback's objection, it will be. So, Senator, if you would 
like to make any kind of an opening statement, you're welcome 
to.
    Senator Brownback. Before I start, Senator Shelby has 
submitted a statement that he would like to be included in the 
record.
    [The statements follow:]
            Prepared Statement of Senator Richard J. Durbin
    Good afternoon. I am pleased to welcome you to this hearing to 
consider the funding requests of two Federal regulatory agencies within 
the jurisdiction of the Appropriations Subcommittee on Financial 
Services and General Government.
    I welcome my colleagues who have joined me on the dais today and 
others who may arrive.
    I am pleased to welcome Acting Chairman Walter Lukken of the 
Commodity Futures Trading Commission (CFTC). I also note that CFTC 
Commissioners Mike Dunn, Bart Chilton, and Jill Sommers are present. 
Thank you for attending and for your service.
    I welcome Chairman Chris Cox of the Securities and Exchange 
Commission (SEC), and members of his staff. Thank you all for being 
here.
    The CFTC and the SEC enjoy unique histories, hold specialized and 
independent responsibilities, and take different approaches to markets 
that serve differing purposes. Yet the CFTC and the SEC both occupy 
pivotal positions at the forefront of stimulating and sustaining 
economic growth and prosperity in our country. Through their vigilance, 
the United States is better equipped to compete in today's evolving 
global marketplace.
    As the subcommittee prepares to make difficult funding decisions 
for the next fiscal year, I look forward to hearing from our witnesses 
about the particular challenges their respective agencies face in 
today's tumultuous economic environment. I welcome input on how we can 
best address those needs.
    Before hearing from our panelists, I'd like briefly outline the 
missions of these agencies and their budget proposals:
    First, the CFTC: It is charged with protecting the public and 
market users from manipulation, fraud, and abusive practices. It is 
also responsible for promoting open, competitive, and financially sound 
markets for commodity futures. The CFTC regulates the activities of 
nearly 70,000 registrants--from sales people to trading advisors to 
floor traders.
    The CFTC helps ensure that the futures markets are equipped to 
better perform their vital function in the U.S. economy--providing a 
mechanism for price discovery and a means of offsetting price risks.
    The CFTC's oversight and enforcement mission becomes tangible when 
you consider that futures prices impact what we pay for the basic 
necessities of our daily lives: Our food, clothing, shelter, fuel in 
our vehicles, and heat in our homes.
    We have witnessed a remarkable transformation in the nature and 
type of products listed by exchanges since the CFTC was established in 
1976. Thirty-two years ago, the vast majority of futures trading 
occurred in the agricultural sector--cattle, grains and crops, and the 
proverbial pork bellies.
    Today, novel and highly complex financial contracts are emerging, 
based on such things as foreign currencies, interest rates, Treasury 
bonds, weather, real estate and economic derivatives, and stock market 
indices. These now surpass agricultural contracts in trading volume. 
And the ever-expanding complexities pose ever-demanding challenges as 
new futures products emerge.
    For the CFTC, the President's budget requests funding of $130 
million, representing an increase of $18.7 million--a 17 percent hike--
over the fiscal year 2008 enacted level of nearly $111.3 million.
    Of the $18.7 million in increased funding for next year, $3.2 
million is slated for increased compensation and benefit costs for a 
staff of 465; $13.6 million will be devoted to increased operating 
costs for information technology modernization, lease of office space, 
and other services; and $1.9 million will support the salary and 
expenses of 10 additional full-time staff.
    Currently, with the $111.3 million provided for fiscal year 2008 (a 
14 percent increase over the $98 million in fiscal year 2007), CFTC is 
beginning an intensive hiring process to boost staffing from 447 up to 
465 and is making some initial investments to upgrade its information 
technology to keep pace with the rapidly-evolving technology-driven 
futures markets.
    In the past decade, trading volume has increased more than ten-
fold--reaching well over 3 billion trades in 2007, and actively traded 
contracts have quintupled--from 258 in 1997 to 1,540 in 2007. CFTC 
oversees $4.2 trillion of daily trades. But despite this phenomenal 
surge in activity, staffing levels have not kept pace, and in fact, 
have dropped 21 percent. As I pledged last year, I am committed to 
addressing this resource deficiency.
    I also understand that various components of the CFTC 
reauthorization, included as part of the farm bill, would impose new 
responsibilities for the CFTC. Among these elements are regulation of 
energy derivatives markets and increased penalty authorities for market 
manipulation violations, which may require additional resources not 
contemplated in the fiscal year 2009 request.
    I look forward to hearing more about CFTC's budgetary needs today, 
and the opportunity to discuss with Chairman Lukken a variety of 
issues, including the oversight and regulatory challenges and 
opportunities presented by rising commodity prices, particularly for 
agricultural items and oil.
    Turning to the SEC, its three-prong mission is to protect 
investors; maintain fair, orderly, and efficient markets; and 
facilitate capital formation.
    The SEC is responsible for overseeing more than 12,000 publicly 
traded companies, over 10,000 investment advisers that manage more than 
$38 trillion in assets, nearly 1,000 fund complexes, 6,000 broker 
dealers with 172,000 branches, and close to $44 trillion worth of 
trading conducted each year on America's stock and option exchanges.
    The strength of the American economy and our financial markets 
depends on investors' confidence in the financial disclosures and 
statements released by publicly traded companies. Investors expect the 
SEC to be the vigilant ``cop on the beat.'' This subcommittee wants to 
make certain that the SEC has the necessary resources to effectively 
fulfill its obligatory singular mission: protecting shareholders.
    Crucial to the SEC's effectiveness is its enforcement authority. 
Each year the SEC brings hundreds of civil enforcement actions for 
violations of the securities laws. Typical infractions include insider 
trading, accounting fraud, and providing false or misleading 
information. Serious, thoughtful questions have been raised about 
whether the proposed enforcement budget is adequate to keep pace with 
the growing demands.
    The SEC's budget request for fiscal year 2009 totals $913 million, 
a slight $7 million (0.8 percent) increase over the agency's fiscal 
year 2008 enacted level of $906 million. Part of the $913 million will 
be provided through $42 million of prior year balances, resulting in an 
appropriated level of $871 million. These funds are offset by 
registration and transaction fees. The fiscal year 2009 budget would 
fund 3,409 permanent staff, a reduction of 94 staff (a 2.7 percent cut) 
below the SEC's fiscal year 2008 level.
    What is troubling about the paltry increase is that it is 
insufficient to sustain the agency's salary needs at SEC's authorized 
personnel level and will actually require cutting nearly 100 staff. 
This reduction of personnel comes at a time when developments and 
trends in the market call for more, not less, vigilance to protect 
investors. Resources devoted to enforcement are declining in both 
dollar terms and proportionality.
    I am concerned this bare-bones budget will hinder the SEC's ability 
to accomplish its mission. I look forward to exploring this topic more 
fully with Chairman Cox. In addition, I also plan to delve into other 
issues including the recent SEC-CFTC Memorandum of Understanding, Sudan 
divestment disclosure, SEC's role with subprime mortgage markets, 
expediting Fair Fund disbursements to investor-victims, plans for 
greater oversight of credit rating agencies, and how availability of 
interactive data is simplifying investor understanding and access to 
corporate filings and financial information.
    I look forward to hearing from our witnesses about the resources 
they require to keep pace with change and achieve success in a 21st 
century world, while responsibly managing taxpayer dollars.
                                 ______
                                 
            Prepared Statement of Senator Richard C. Shelby
    Chairman Cox, in your testimony today you state your support for 
providing dedicating funding for the SEC's Consolidated Supervised 
Entities (CSE) program. However, this program has never been explicitly 
authorized by Congress. Rather, it was created by the SEC. Unlike the 
Fed's regulation of bank holding companies and the OTS's regulation of 
thrift holding companies, the SEC's regulation of investment bank 
holding companies under the CSE program is not authorized by statute. 
The CSE program is entirely the SEC's creation.
    Normally, Congress is responsible for making policy, while the SEC 
implements that policy. In this case, however, the SEC decided that the 
CSE program was needed and then took it upon itself to create the 
program. Before the SEC now decides that a CSE program needs dedicated 
funding, I believe the SEC needs to take a step back and let Congress 
decide how investment banks should be regulated.

                   STATEMENT OF SENATOR SAM BROWNBACK

    Senator Brownback. I appreciate your way and means of doing 
this, and I'm going to do similarly because I've got a lot of 
questions.
    I would like to, though, point out two things very quickly 
if I could. First, welcome, Chairman Lukken. I appreciate you 
being here. And Securities and Exchange Commission (SEC) 
Chairman Cox is on his way.
    We put these in the record last week at the Joint Economic 
Committee on ending stocks of wheat and rice. I think it's 
important to get some factual basis out there. We are at a 27-
year low on ending stocks of wheat, I believe. We had a 
terrible crop last year in the Midwest. You guys don't grow any 
wheat, but we do, and we didn't grow much last year. And then 
they didn't in Australia and a number of other places. A 
similar thing happened on the rice markets as well.
    But you can look at other markets that didn't have much of 
a problem, and yet you've seen this huge rise in prices. I want 
you particularly to address some of that if you would, because 
it strikes me that we do have people taking resources and 
putting them into commodities which drives up some commodities, 
not based on the fundamentals. There are crop movements that 
are based on the fundamentals; there are some that are not 
based on it.
    I really hope we can look at that particular issue and the 
potential manipulation of the market by large hedge funds or 
index funds, of taking money that they would normally put in 
other places, maybe even put it in commercial real estate, but 
with the declining value of the dollar shifting into the 
commodity markets, and then driving up those market prices 
above what the fundamental would support. I want to ask you 
what you anticipate doing to try to address that issue.
    Mr. Chairman, thanks for the hearing.
    Senator Durbin. Thanks.
    Chairman Lukken, your opening statement. We'll put whatever 
you like officially in the record and invite you now to give us 
a few minutes of the introduction to your statement.

                 SUMMARY STATEMENT OF WALTER L. LUKKEN

    Mr. Lukken. Thank you, Mr. Chairman and other Senators of 
the subcommittee. I am pleased to be here to testify on behalf 
of the Commodity Futures Trading Commission. The CFTC is the 
agency charged with overseeing and regulating the U.S. 
commodity futures and options markets. These markets play a 
critical role in the U.S. economy by providing important risk 
management tools for market participants. The futures markets 
also serve to discover prices that accurately reflect supply, 
demand, and other economic factors.
    These are extraordinary times for our markets, with 
commodity futures prices at unprecedented levels. In the last 3 
months the agricultural staples of wheat, corn, soybeans, rice, 
and oats have hit all-time highs. We've also witnessed record 
prices in crude oil, gasoline, and other related energy 
products. Broadly speaking, the falling dollar, strong demand 
from the emerging world economies, global political unrest, 
detrimental weather, and ethanol mandates have driven up 
commodity futures prices across the board.
    On top of these trends, the emergence of the subprime 
crisis last summer led investors to increasingly seek portfolio 
exposure in commodity futures. As the Federal regulator of 
these products, the CFTC is closely monitoring these growing 
markets to ensure they are working properly for farmers, 
investors, and consumers.
    To date, CFTC staff analysis indicates that the current 
higher futures prices generally are not a result of 
manipulative forces. That said, we continue to probe, 
investigate, and gather information from the entire marketplace 
and welcome outside analysis and perspectives so that we can 
ensure that we have an accurate and full view.
    For example, the agency convened an industry agricultural 
forum 2 weeks ago to have a full public airing of views as to 
the driving forces in these markets. The comment period for 
that event ends today and we hope to announce in the near 
future agency initiatives to address the concerns we heard at 
that forum.
    The CFTC also recently announced the creation of an energy 
markets advisory committee and scheduled its first meeting for 
June 10 to review the functioning of the energy markets.
    Despite this tumultuous time in our markets, the agency 
continues to make advancements on important policy initiatives. 
Last fall, the Commission delivered an extensive report to 
Congress recommending additional authorities for the agency in 
overseeing exempt energy trading. Through bipartisan efforts, 
these recommendations became a part of the CFTC reauthorization 
bill, which is contained in the farm bill conference report. 
The enactment of that legislation will improve our oversight of 
the energy markets with the addition of new authorities at the 
agency. The President's fiscal year 2009 budget does not take 
into account these new powers.
    The U.S. futures and options markets of today bear little 
resemblance to the industry of 1976, the Commission's first 
year of operation, in terms of complexity, globalization, 
volume, and economic importance. Yet, staff resources and 
operating funds over time have not kept pace.
    Figure 1 on the monitor shows the growth in trading volume 
on the U.S. futures exchanges from 1996 to present. Trading 
volume has increased sixfold during the last decade, while at 
the same time Commission staffing levels have fallen to 447 
full-time employees. That's 50 fewer staff today than the 
agency had 30 years ago.
    Figure 2 lists many of the different components of the 
futures industry. As you can see from the chart, the growth of 
these categories from 1976 to present is stunning. For 
instance, total contract volume has increased more than 8,000 
percent in 30 years, compared to CFTC's staffing and overhead 
expenses, which have decreased 12 percent and 5 percent 
respectively.
    On behalf of the entire Commission, I would like to express 
my appreciation for the support provided to the CFTC in the 
fiscal year 2008 budget. The $111 million appropriated by 
Congress for the current calendar year is already being put to 
good use to address critical needs in two major areas: 
personnel and technology. That focus will continue with the 
fiscal year 2009 budget.
    The Commission employs highly trained individuals who work 
within three program divisions: market oversight; clearing and 
intermediary oversight; and enforcement. The Division of Market 
Oversight ensures that the markets are operating efficiently 
and free from manipulation and fraud. The Commission's staff 
economists utilize the Commission's Large Trader Reporting 
System and one of the Commission's main technology systems, the 
Integrated Surveillance System (ISS), to detect and deter 
market manipulation. As you can see in figure 3, the current 
atmosphere of rising futures prices across a wide range of 
products makes these anti-manipulation efforts ever the more 
important.
    The Division of Clearing and Intermediary Oversight ensures 
the financial integrity of the futures industry as a whole. The 
amount of funds handled by clearinghouses has increased 
significantly of late. During this time, all exchanges have 
experienced record settlements, including one day in January 
2008 in which the Chicago Mercantile Exchange cleared and 
settled more than $12 billion worth of transactions in 1 day, 
nearly six times its normal load. Despite these spikes in cash 
flow, the clearing system has worked well.
    When a manipulation or fraud occurs in the futures markets, 
it is the job of the Enforcement Division to prosecute the 
offenders. Since the collapse of Enron, CFTC has brought 39 
cases involving energy markets and charged 64 entities or 
persons with manipulation, attempted manipulation, and false 
reporting. The collective civil monetary penalties levied in 
these energy market enforcement cases has exceeded $444 
million.
    Unfortunately, these programs have felt the effects of 
turnover at the agency. The Commission lost 58 experienced 
employees in fiscal year 2006, 49 in 2007, and 15 in 2008. 
Replenishing these losses is critical if this agency is to 
continue to meet its responsibilities in overseeing the futures 
markets.
    The fiscal year 2009 President's budget request, as seen in 
figure 5, is an appropriation of $130 million and 475 full-time 
staff, an increase of approximately $18.7 million and 10 staff 
over the fiscal year 2008 appropriation. Key changes in the 
fiscal year 2009 budget are: $3.2 million to provide increased 
compensation and benefits for current employees; $1.9 million 
to provide for salary and expenses of 10 additional full-time 
employees. This increase, although modest, will allow us to 
build on current key hiring efforts. And $13.6 million to 
provide for increased operating costs for technology 
modernization, office space, and all other services.
    In fiscal year 2009, the requested increased funding will 
continue to target technology upgrades and staffing increases. 
It would permit the Commission to improve existing critical 
technology systems, such as the ISS and E-Law systems. The 
funds requested would also permit the development of the new 
Trade Surveillance System, or TSS. Soon, with these 
investments, we will have the capability to more quickly 
monitor and analyze traders' intraday trading activity.
    In conclusion, I am very proud of the agency and our highly 
skilled staff. Every day they carry out the agency's mission of 
protecting the public and market users from manipulation, 
fraud, and abusive practices. If the futures markets fail to 
work properly, all Americans are impacted. Accordingly, it is 
critical that the CFTC have sufficient resources to hire and 
maintain skilled talent as well as to provide a steady stream 
of technology investment commensurate with the agency's 
expanding and evolving global mission.

                           PREPARED STATEMENT

    Thank you for this opportunity to appear today and I 
welcome any questions.
    [The statement follows:]
                 Prepared Statement of Walter L. Lukken
    Thank you, Mr. Chairman and members of the subcommittee. I am 
pleased to be here to testify before you on behalf of the Commodity 
Futures Trading Commission.
                  background and current market events
    The CFTC is the agency charged with overseeing and regulating the 
U.S. commodity futures and options markets. These markets play a 
critical role in the U.S. economy by providing risk management tools 
that producers, distributors, and commercial users of commodities use 
to protect themselves from unpredictable price changes. The futures 
markets also play a price discovery role as participants in related 
cash and over-the-counter markets look to futures markets to discover 
prices that accurately reflect information on supply, demand, and other 
factors.
    As you are well aware, these are extraordinary times for our 
markets with commodity futures prices at unprecedented levels. In the 
last 3 months, the agricultural staples of wheat, corn, soybeans, rice, 
and oats have hit all-time highs. We have also witnessed record prices 
in crude oil, gasoline and other related energy products. Both macro-
economic factors as well as micro fundamentals for specific markets are 
at play in these prices. Broadly speaking, the falling dollar, strong 
demand from the emerging world economies, Mideast political unrest, 
detrimental weather and ethanol mandates have driven up commodity 
futures prices across-the-board.
    On top of these trends, the emergence of the sub-prime crisis last 
summer led investors to increasingly seek portfolio exposure in 
commodity futures. As the Federal regulator of these products, the CFTC 
is monitoring these growing markets to ensure they are working properly 
for farmers, investors, and consumers. To date, CFTC staff analysis 
indicates that the current higher futures prices are generally not a 
result of manipulative forces. That said, we continue to gather 
information from the entire marketplace--and welcome outside analysis 
and perspectives--so that we can ensure that we have an accurate and 
full view.
    For example, the agency recently convened an agriculture forum 2 
weeks ago in which we brought together a diverse group of market 
participants to have a full airing of views and opinions as to the 
driving forces in these markets. The comment period for that event ends 
today and we hope to announce in the near future agency initiatives to 
address the concerns we heard at the forum. The CFTC also recently 
announced the creation of an Energy Markets Advisory Committee and 
named the public members of the Committee just last week. Our first 
meeting is scheduled for June 10th to look at issues related to the 
energy markets and the CFTC's role in these markets under the Commodity 
Exchange Act. I am confident that these public forums will benefit our 
ability to make informed decisions as we strive to improve our 
oversight of these important markets.
    Despite this tumultuous time in our markets, the agency continues 
to make advancements on several important policy initiatives. Last 
September, the Commission held a public hearing on the regulation of 
exempt markets, resulting in an extensive Report to Congress 
recommending additional authorities for the agency in overseeing this 
type of trading. Through bipartisan efforts, these recommendations 
became a part of the CFTC's reauthorization legislation, which is 
contained in the Farm Bill conference report now being debated. The 
enactment of that legislation will mean increased responsibilities for 
the agency--and accordingly, will mean a need for additional CFTC staff 
to carry out the new authorities. The President's fiscal year 2009 
budget for the $130 million funding level does not take into account 
the new authorities included in the Farm Bill. The legislation would 
also raise penalties for market manipulation violations and close a 
legal loophole that has developed due to adverse court decisions that 
are hindering the CFTC's efforts to combat retail off-exchange foreign 
currency fraud.
    The CFTC has also worked to strengthen its relationship with the 
Securities and Exchange Commission (SEC) over the last year, given our 
shared responsibilities over certain products that affect the 
regulatory interests of both agencies. In March, our respective 
agencies entered into a memorandum of understanding (MOU) that will 
help the agencies share information as well as coordinate our review of 
novel derivative products that have attributes of both securities and 
futures. Two Chicago exchanges, the Chicago Board Options Exchange and 
OneChicago, are the first beneficiaries of this new framework as both 
seek to list for trading derivative products based on gold ETF 
products.
    Last year was busy on the enforcement front as well with the agency 
assessing record penalties against those seeking to manipulate the 
markets and defraud the public, culminating in the CFTC and Department 
of Justice reaching a record settlement against British Petroleum for 
manipulating the propane market. I am confident that the CFTC's 
dedicated staff will continue this productive effort in the coming 
year.
                        evolution of the markets
    Congress created the CFTC in 1974 as an independent agency. The 
CFTC's primary mission under our governing statute, the Commodity 
Exchange Act, is to ensure that the commodity futures and options 
markets operate in an open and competitive manner, free of price 
distortions. In December 2000, Congress reauthorized the Commission 
with passage of the Commodity Futures Modernization Act of 2000 (CFMA). 
This landmark legislation established a flexible, principles-based 
regulatory regime. Today, the CFTC is the only U.S. principles-based 
financial regulator. This flexible approach has allowed the regulated 
futures industry to flourish. The same flexibility also allows alert 
and responsive oversight by the CFTC to fulfill the agency's mission.
    The U.S. futures and options markets of today bear little 
resemblance to the industry of 1976 in terms of complexity, 
globalization, volume, and economic importance--and these differences 
will continue in fiscal year 2009. Yet, staff resources and operating 
funds over time have not kept pace.
    For example, Figure 1 shows the growth in trading volume on U.S. 
futures exchanges from 1996 to present. Trading volume has increased 
six-fold during the last decade, while at the same time, Commission 
staffing levels have fallen to 447 full-time employees. That's 50 fewer 
staff today than the agency had 30 years ago in 1976--the Commission's 
first year of operation.



  Figure 1.--Growth in Volume of Futures & Option Contracts Traded & 
                                 FTEs.

    Figure 2 lists the many different components of the futures 
industry, including the number of contracts traded, the volume of 
trading, the number of futures industry participants, the number of 
exchanges and other trading facilities, and the overall notional value 
of these markets.

    ----------------------------------------------------------------

----------------------------------------------------------------------------------------------------------------
                            Indicator                                  1976            2007       Percent change
----------------------------------------------------------------------------------------------------------------
CFTC Staff......................................................             497             437             -12
Overhead Expenses as a Percentage of Budget.....................              34              29              -5
Total Contract Volume...........................................             37M          3.085B          +8,238
Types of Contracts Traded.......................................              66           1,365          +1,968
Commodity Trading Advisors......................................             447           2,601            +482
Commodity Pool Operators........................................             544           1,416            +160
Floor Brokers...................................................           2,591           8,038            +210
Associated Persons (Sales Persons)..............................          25,579          53,844            +110
CFTC--Regulated Exchanges.......................................              10              12             +20
CFTC--Registered Clearing Organizations.........................  ..............              11         ( \1\ )
Exempt Boards of Trade..........................................  ..............               9         ( \1\ )
Exempt Commercial Markets.......................................  ..............              20         ( \1\ )
Notional Value of Contracts Traded (Per Day)....................             $4B      \2\ $4.78T         119,400
Customer Funds in FCM Accounts..................................           $577M           $155B         26,763
----------------------------------------------------------------------------------------------------------------
\1\ Not available.
\2\ Estimate.


    ----------------------------------------------------------------

               Figure 2.--Indicators of Industry Growth.

    As you can see from the chart, the growth in these categories from 
1976 to present is stunning--with percentage increases in the triple, 
quadruple, and quintuple digits. For instance, total contract volume 
has increased more than 8,000 percent in 30 years. Contrast that with 
the CFTC staffing and overhead expenses over time, which have decreased 
-12 percent and -5 percent, respectively. Looking at the growth in all 
sectors, it's clear that CFTC is doing a lot more with a lot less.
                        fiscal year 2008 budget
    On behalf of the entire Commission, I would like to express my 
appreciation for the support provided to the CFTC in the fiscal year 
2008 budget. The $111 million appropriated by Congress for the current 
calendar year was the first substantial increase for the Commission in 
recent years and is already being put to good use. It is important to 
explain how the CFTC is using the fiscal year 2008 funding to address 
critical needs in two major areas--experienced professionals and a 
modern technology infrastructure--because the fiscal year 2009 funding 
will build on that foundation.
Additional Staff Hires
    The Commission is implementing an intensive hiring program for the 
first time since October 2005. This program seeks to fill the loss of 
experienced, long-time Commission employees, as well as address new 
skill sets required by the rapidly evolving industry we regulate. The 
Commission employs highly-trained, expert staff who works within three 
major program divisions--Market Oversight, Clearing and Intermediary 
Oversight, and Enforcement. These divisions are complemented and 
supported by the Offices of the Executive Director, General Counsel, 
Chief Economist, International Affairs, and External Affairs.
    The Division of Market Oversight ensures that the markets are 
operating efficiently and without manipulation and fraud. One of the 
keys to Market Oversight is market surveillance. The Commission's staff 
economists utilize the Commission's large trader reporting system and 
one of the Commission's main technology systems, the Integrated 
Surveillance System (ISS), to detect and deter market manipulation and 
disruption. As you can see in Figure 3, the current atmosphere of 
rising futures prices across a wide range of products makes these anti-
manipulation efforts all the more important.



      Figure 3.--Recent Commodity Price Changes by Percent Change.

    The Division of Clearing and Intermediary Oversight ensures the 
financial integrity of the futures industry as a whole. Futures and 
options trading on U.S. contract markets increased by approximately 27 
percent in 2007 over the prior year and remains at consistently high 
levels. Not only has the volume of trading increased and the futures 
prices of some commodities increased to record levels, the amount of 
funds handled by the clearing houses has increased as well. In this 
regard, all exchanges have experienced record settlements during this 
time period, including one day in January 2008 in which the Chicago 
Mercantile Exchange cleared and settled more than $12 billion of 
transactions--nearly six times its normal load. Despite these spikes in 
cash flow, the clearing system has worked extraordinarily well. 
Nevertheless, with the rising need for risk management by businesses 
and the rising importance of futures markets to the Nation's economy, 
the Commission's financial integrity programs must be continually 
strengthened. A key component of the Commission's financial integrity 
program is the required segregation of all customer funds from those 
funds of Futures Commission Merchants (FCM). As shown in Figure 4, the 
level of required segregated customer funds has more than doubled since 
the end of 2000.



                 Figure 4.--Segregated Funds Required.

    When a manipulation or fraud occurs in the marketplace, it is the 
job of the Enforcement Division to gather information, build a case and 
prosecute the offenders. In the foreign currency or FOREX markets, the 
CFTC has filed 98 cases involving 374 entities or persons with more 
than $562 million in civil monetary penalties levied and more than $453 
million in restitution awarded. Since the collapse of Enron, CFTC has 
brought 39 cases involving energy markets and charged 64 entities or 
persons with manipulation, attempted manipulation, and/or false price 
reporting. The collective civil monetary penalties levied in these 
energy market enforcement actions exceed $444 million.
    As our financial markets become more complex, global, and 
interwoven, the Commission is increasingly called upon to co-ordinate 
and co-operate with other agencies domestically and world wide. 
Internationally, these activities involve the Commission's 
participation in multilateral bodies, such as the International 
Organization of Securities Commissions (IOSCO), as we strive to raise 
global regulatory standards. This is complemented with specific 
bilateral information sharing arrangements with other nations as we try 
to coordinate our enforcement and oversight efforts. Domestically, the 
Commission staff works with several Federal and State agencies, 
including USDA, FERC, and DOJ, to harmonize our mutual regulatory 
efforts. The Commission recently signed an MOU with the SEC to further 
co-ordinate our efforts, given the additional convergence of the 
futures and equities markets. In addition, our agency has an 
information sharing MOU with FERC to enhance cooperation in the 
policing of the energy markets.
    All of these important responsibilities and priorities require 
qualified personnel in their execution. Unfortunately, recent turnover 
at the agency has been significant. Throughout the agency and its 
divisions, the Commission lost 58 experienced employees in fiscal year 
2006, 49 in fiscal year 2007 and 15 to date in fiscal year 2008. The 
Commission currently has 447 full-time employees onboard and with the 
recent increased funding, we are actively recruiting toward a target of 
465 FTEs for fiscal year 2008. Such personnel additions are critical if 
this agency is to continue to meet its responsibilities in overseeing 
the futures markets.
Technology Investments
    The other focus of the fiscal year 2008 budget allocation is 
technology. The CFTC primarily uses technology in the surveillance of 
the markets and the monitoring of the financial integrity of the 
clearing organizations and firms. The Commission's fiscal year 2008 
appropriation enables the agency to undertake a long-delayed 
modernization of capital investments in Information Technology (IT) 
software and hardware, such as computers, servers, routers, switches 
and other critical communications components. The modernization of our 
surveillance systems will pay off with enhanced transparency and 
detection tools for the oversight of our markets.
    The CFTC receives and analyzes millions of data points everyday 
that come in from the exchanges and firms, which allow us to monitor 
the marketplace. Once aggregate position levels are determined, CFTC 
staff not only monitors daily positions of all large traders, but also 
has the ability to analyze the minute-by-minute trades of these market 
participants, including hedge funds and other speculators, during times 
when there is a heightened risk of manipulation. To do this job, the 
CFTC's market surveillance staff uses its ISS system to organize and 
group the information into meaningful categories.
    With the exponential growth of these global electronic markets, the 
CFTC must continue to devote significant portions of its budget to 
technology in order to stay on top of this sector. This year the agency 
will increase its technology budget by almost 37 percent with the hope 
of almost doubling the overall technology budget by fiscal year 2009. 
These resources will be primarily used to enhance the agency's 
surveillance tools--making these programs faster, more functional and 
better able to detect wrongful activities across markets and 
jurisdictional borders.
    Clearly, technology and personnel investments are keys to the 
agency's success and the fiscal year 2009 budget builds on the 
foundation that has been enhanced this year. I am grateful for the 
administration's and appropriators' recognition of the need for 
increased funding for our agency in these two key areas.
                        fiscal year 2009 budget
    The fiscal year 2009 President's budget request, as seen in Figure 
5, is for an appropriation of $130 million and 475 full-time staff, an 
increase of approximately $18.7 million and 10 staff over the fiscal 
year 2008 appropriation.




Figure 5.--Fiscal Year 2009 Budget Request Provides for an Increase of 
                 $18.7 Million and Additional 10 FTEs.

    Compared to the fiscal year 2008 appropriation, key changes in the 
fiscal year 2009 budget are:
    --$3.2 million to provide for increased compensation and benefit 
        costs for a staff of 465 full-time employees;
    --$1.9 million to provide for salary and expenses of 10 additional 
        full-time employees. This portion of the budget also includes 
        $200,000 to establish a student loan program that is designed 
        to help with retention and recruitment of young, qualified 
        professionals. The agency has not had the resources in previous 
        years to be able to support this program and we're pleased to 
        have this program planned for in our budget.
    --$13.6 million to provide for increased operating costs for 
        information technology modernization, lease of office space, 
        and all other services.
    This funding increase provides the Commission with the financial 
wherewithal to build on the fiscal year 2008 investments by continuing 
to hire additional staff and make critical investments in technology.
Additional Staff Hires
    For fiscal year 2009 the Commission is requesting ten additional 
positions. This increase--although modest compared to industry growth--
will allow us to build on the hiring we are undertaking as a result of 
the fiscal year 2008 appropriation. The ten positions requested for 
fiscal year 2009 are spread throughout the Commission because our needs 
cut across all of our responsibilities. For example, in the Division of 
Market Oversight, we will allocate an additional surveillance economist 
to focus principally on the complex issues and changing practices in 
the energy cash and derivatives market. In the Division of Clearing and 
Intermediary Oversight, we will allocate two additional staff to 
enhance the expanding financial and risk surveillance functions. In the 
Enforcement program, two additional staff will focus mainly on 
allegations of manipulation, trade practice violations, and false 
reporting, but the additional staff will also enhance our ability to 
address a wide range of violations of Federal commodities law. One 
additional staff is planned for the Office of the Chief Economist to 
conduct market research and analysis commensurate with the growth in 
new types of exchanges, new trading execution methods, and the role of 
speculators in our markets. For the Office of Proceedings, we are 
requesting one addition position to fill the long vacant directorship. 
For the Office of General Counsel, we are seeking one additional 
position to replace a loss in expertise among senior staff in areas 
such as bankruptcy and anti-trust law. Finally, in the Office of 
Information Technology, we are requesting two additional positions to 
enhance in-house expertise to assist the major program Divisions in 
monitoring, auditing, and investigating increasingly sophisticated 
technologically driven markets.
Technology Investments
    In fiscal year 2009, additional funding would permit the Commission 
to upgrade telecommunications systems and to expand and improve 
existing critical systems, such as the Integrated Surveillance System 
and eLaw. Also in fiscal year 2009, funds requested would permit 
continued development of the new Trade Surveillance System (TSS), which 
will be used for trade practice surveillance on all exchanges, 
including new and emerging electronic exchanges. TSS will use state-of-
the-art, commercially available software to enhance both intra-exchange 
and inter-exchange trade practice surveillance. We can now obtain and 
analyze the trading activity of our large traders in a mere fraction of 
the time it used to take--minutes instead of days. Soon, with these 
investments, we will have the capability to monitor and analyze even 
more quickly and efficiently a trader's intraday trading activity.
    The Commission's ability to fulfill its mission depends on the 
collection, analysis, communication and presentation of information in 
forms useful to Commission employees, the regulated industry, other 
Federal, State, and international agencies, the Congress, and the 
American public. The resources allocated in fiscal year 2008 and fiscal 
year 2009 to Information Technology will permit a secure modern 
information technology infrastructure and the development of a Document 
Management System to modernize, centralize and automate the management 
of the Commission's information resources. These comprehensive 
enhancements will enable the Commission to serve these stakeholders 
effectively.
    The fiscal year 2009 budget, if approved, will largely enable 
completion of the CFTC's technology modernization initiative--barring 
unforeseen industry developments or new statutory requirements. The 
Commission is making a concerted effort to use commercial best 
practices in developing and maintaining its IT systems and ensuring 
that our IT staff is focused on increasing efficiency and controlling 
costs.
    All of the technology improvements have one commonality; they help 
increase the availability of one of our most critical resources--time. 
That is, technology allows our growing staff to become more productive 
by spending additional time on qualitative analysis rather than 
quantitative processing and compilation.
                               conclusion
    I am very proud of the agency and our highly-skilled staff. 
Everyday, they carry out the agency's mission of protecting the public 
and market users from manipulation, fraud, and abusive practices and 
promoting open, competitive and financially sound markets. If the 
futures markets fail to work properly, all Americans are impacted.
    When looking at the increased volume of activity across all areas 
of the CFTC mission and the scope of the industry changes, the 
resulting increase in specialized workload is demonstrable. 
Accordingly, it is critical that the CFTC have sufficient resources to 
hire and maintain skilled talent, as well as provide a steady stream of 
technology investment commensurate with the agency's expanding and 
evolving global mission.
    Thank you for the opportunity to appear before you today on behalf 
of the CFTC. I would be happy to answer any questions you may have.

               ADEQUATE STAFFING TO MEET VOLUME INCREASES

    Senator Durbin. Chairman Lukken, your graphs tell the story 
about a dramatic increase in trading that you are responsible 
to oversee. As I understand it, if you're able to replace 
employees that have left, the President's new budget request 
will give you an additional 10 employees over the 465 that 
you're targeting. I can't imagine that gets close to matching 
the volume increase that this agency faces in terms of the 
markets that you supervise. Does it?
    Mr. Lukken. Well, our fighting weight as an agency 
historically has been in the mid-500s, and we're trying to 
build up over a series, a period of years, to get to those 
levels, and we're hopeful to reach that. I think the 10 that 
we've requested in 2009 is the minimum we need to ensure our 
responsibilities at the agency. The technology is very 
important in ensuring that we're productive in those 10 
individuals.
    So we're looking over a long-term horizon to make sure that 
we get to where we need to be, but we think 10 is a good start 
in that venture.

                  SPECULATION IMPACT ON ENERGY FUTURES

    Senator Durbin. So let me try to be more specific in the 
next question about another issue. As I understand your 
testimony and your agency's responsibility, you look for 
illegal conduct, market manipulation, evidence of corruption, 
and obviously do your best to keep transparency and 
credibility, integrity in the marketplace, and that is an 
important part of your role.
    But you've also initiated several discussions that relate 
to the overall market and the role it has in our economy as it 
relates to specific commodities. Now being more specific, when 
it comes to energy contracts, that's one that's in the news. 
And there are a lot of people, including some of my colleagues 
that I respect very much, who think that the speculation and 
trading in energy futures has driven up the price of oil, for 
example. One of my colleagues today said he thought that of the 
$120 a barrel, maybe $30 of it or more was attributable just to 
speculators driving up the price of the commodity.
    There's also a question about margin requirements when it 
comes to these energy futures.
    Let me throw in the third element, of course: global 
competition. In London, ICE is selling many of these same 
contracts or contracts similar to them.
    That's as soft a pitch as I could throw you on this, but 
I'd like your feedback on the speculation on this issue.
    Mr. Lukken. Well, certainly we closely follow the market 
participants and track what speculators may be doing in our 
markets. As I mentioned, we receive every day the trade 
positions of all traders in our markets above a certain 
threshold. That ensures that we can see what sort of 
controlling positions they may have as traders on a given 
market.
    Our economists also closely follow fundamentals of those 
markets to ensure that those types of traders aren't using 
their positions in order to manipulate or cause some sort of 
illegal behavior in our markets. So we closely follow that. 
Like I said, every day we're looking at who the large traders 
might be and whether they're either themselves or colluding 
with others to try to manipulate the markets.
    Senator Durbin. Do you think that that's happening now? Do 
you think that the observation that $20 or $30 on a barrel of 
oil can be attributed to speculation is a valid observation?
    Mr. Lukken. Well, I think as far as illegal behavior, where 
an individual or a set of individuals are trying to manipulate 
the market, I can say with a high degree of confidence that we 
are not seeing that. With regard to speculation, we also have 
controls in place for speculators. Each month as the contract 
is about to expire, they have to get down to certain positions 
in agricultural markets and other, energy contracts so that 
there's a less chance that they may be able to manipulate the 
markets, and those controls are currently in place.
    So between seeing the transparency of the reporting that we 
receive, plus the controls, the position limits we have in 
place, we have a high degree of confidence that people are not 
manipulating the markets.

                          MARGIN REQUIREMENTS

    Senator Durbin. And what are the margin requirements on 
these energy contracts?
    Mr. Lukken. The margin requirements--as you know, in the 
futures industry, margin is set based on a risk modeling that 
the exchanges perform, and this is meant to cover a 1-day price 
move, so that the losers can pay the winners every day, and the 
markets mark to market at least twice a day. This wrings the 
risk, credit default risk, out of the marketplace, so that 
losses can't accumulate over a period of days. So every day 
everybody starts afresh.
    So this has worked very well to----
    Senator Durbin. Is there a margin requirement?
    Mr. Lukken. For?
    Senator Durbin. Energy futures.
    Mr. Lukken. Yes, there is. There is to cover a potential 1-
day price move. Again, this is based on statistical, historical 
and statistical evidence of what that might be.
    Senator Durbin. How does that compare with other 
commodities, the actual margin requirement?
    Mr. Lukken. It's based on volatility. I'll have to ask our 
staff whether we can get you figures on percentages. But oil, I 
think, is sort of middle of the pack as far as volatility 
compared to some of the other commodities. But we can give you 
specific numbers.
    Senator Durbin. The last question--I'm sorry to go over a 
minute, but I didn't get my entire opening statement, so I can 
have an extra minute here. So if we passed a law calling on you 
to substantially increase the margin requirements on energy 
futures, particularly as they relate to crude oil, what impact 
would that have in your estimation on migration to another 
marketplace, like ICE in London, as an alternative market to 
pursue the same type of future?
    Mr. Lukken. I think there would be migration off exchanges. 
It would be a tax on a type of trader. These traders--I know 
that there's a lot of people who have disparaging remarks about 
speculators, but they do provide liquidity for a lot of these 
markets and have for years, and that's necessary to make sure 
that the commercial participants in the markets, the producers, 
the farmers, and everybody, has a buyer for every seller and a 
seller for every buyer.
    Senator Durbin. What percentage of those who trade, for 
example, in these energy commodities actually take possession?
    Mr. Lukken. Very few. Very few actually ever deliver. The 
vast majority of the contracts never deliver the physical 
commodity. The futures markets are not a marketing tool for 
product. It is a risk management tool and people utilize it as 
a risk management tool. There has to be delivery as part of the 
mechanism to ensure that the cash price and the futures price 
eventually converge, but the truth is that most people get out 
of these contracts way before delivery ever occurs.
    Senator Durbin. Senator Brownback.
    Senator Brownback. Thank you, Mr. Chairman.

                     MONITORING MARKET FUNDAMENTALS

    Years ago when I was a farm broadcaster, I thought I was 
really smart on these markets, so I speculated a little bit, 
lost my shirt. My dad would not listen to anything I ever said 
again from that point. He farms and he said: All right, we're 
just going to keep it in the bin now; I'm not listening to you 
any more.
    So I know those things move on you. I was long in the wheat 
futures when the Soviets invaded Afghanistan, if anybody 
remembers that period, and we lock-limited down the markets for 
3 days. I'll never forget it. It was quite an experience for a 
young man.
    You mentioned, though, earlier, Chairman, that your 
economists track the fundamentals and what the market should 
be. What should the price of oil be now, according to what your 
economists are saying?
    Mr. Lukken. Well, we make sure that the markets are 
reflecting as best they can and they are functioning 
efficiently and performing. We can't predict what prices may 
be. That's the function of a free market.
    Senator Brownback. Do you do a range? Do you do a range and 
say, on these fundamentals, this supply, this demand, there is 
a range that this price should in normal circumstances trade 
in? Do you do any historical view of that?
    Mr. Lukken. We do not.
    Senator Brownback. There's been a number of articles out 
lately thinking that these markets are being driven heavily.
    Mr. Lukken. We do closely follow what the Department of 
Energy and the U.S. Department of Agriculture, the numbers that 
they're putting out, looking at a holistic approach to make 
sure the fundamentals are supporting the general prices that 
are being put out by the markets. And if we see----
    Senator Brownback. Well then, answer that question: Do the 
fundamentals support the general prices being put out by this 
oil market?
    Mr. Lukken. I think, based on supply and demand that we're 
seeing--and a lot of people in the markets agree--that yes, the 
fundamentals do support largely what the prices are at today.
    Senator Brownback. So you disagree with what the chairman 
said, that there's as much as $30 in these markets that's based 
on speculation?
    Mr. Lukken. Well, I have not seen that study, so we'd have 
to look at that. But we have not seen that speculators again 
are driving--are a major factor in setting these prices.
    Senator Brownback. You're familiar, and I'll enter into the 
record, there's a Barron's article that cites that they believe 
that they are.
    [The information follows:]

                [From Barron's, Monday, March 31, 2008]

                  Commodities: Who's Behind the Boom?
                           (By Gene Epstein)
    China, as everyone knows, is a big force in the extraordinary boom 
in commodities. Its voracious appetite for everything from corn and 
wheat to copper and oil has helped push up U.S. commodities prices by 
some 50 percent over the past 12 months.
    But China is by no means the whole story. Speculators--including 
small investors--are also playing a huge role. Thanks to the 
proliferation of mutual funds and exchange-traded funds tied to 
commodities indexes, speculative buying has gone way beyond anything 
the domestic commodities markets have ever seen. By one estimate, index 
funds right now account for 40 percent of all bullish bets on 
commodities. The speculative juices are even more plentiful--nearly 60 
percent of bullish positions--if you count the bets placed by 
traditional commodity ``pools.''
    Here's the problem: The speculators' bullishness may be way 
overdone, in the process lifting prices far above fair value. If the 
speculators were to follow the commercial players--the farmers, the 
food processors, the energy producers and others who trade daily in the 
physical commodities--they'd be heading for the exits. For right now, 
the commercial players are betting on price declines more heavily than 
ever before, says independent analyst Steve Briese.
    For example, in the 17 commodities that make up the Continuous 
Commodity Index, net short positions by the commercials have been 
running more than 30 percent higher than their previous net-short 
record, in March 2004.
    Briese, author of the recent book The Commitments of Traders Bible 
and editor of the Website CommitmentsOfTraders.org, was one of the 
first to recognize that information on the bets made by the commercials 
could provide rare insights into how the ``smart money'' views the 
price outlook. These days, the data suggest, the smart money clearly 
believes that the market's exuberance has turned irrational.
    Indeed, the great commodities bubble started springing its first 
leaks two weeks ago: Oil, gold and other major commodities posted their 
steepest weekly drop in half a century. Though prices have since 
firmed, they could eventually drop 30 percent as speculators retreat. 
The only real question is when.
    It's not easy to size up the influence of the index funds. But 
based on their known cash commitments in certain commodities, and the 
commodity indexes their prospectuses say they track, it is possible to 
estimate the size of their commitments in all commodities they buy. 
Using this method, analyst Briese (pronounced ``breezy'') estimates 
that the index funds hold about $211 billion worth of bets on the buy 
side in U.S. markets.
    Applying a similar method, but with slightly different assumptions 
for indexes tracked, Bianco Research analyst Greg Blaha puts that 
figure at $194 billion. Either figure is enough to turn the index funds 
into the behemoths of the commodity pits, where total bullish positions 
now stand at $568 billion.
    Commodities index funds, which arrived on the scene in the late 
1990s, have come into their own in the past several years. The biggest 
index fund, Pimco Real Return (ticker: PRTNX), has seen its assets 
swell to $14.3 billion from $8 million since its inception in January 
1997.
    Index funds offer investors an easy, inexpensive way to gain 
exposure to a segment of the commodities markets or a broad-based 
basket of commodities. Result: The funds have drawn many private 
investors who have never ventured into futures, along with pension 
funds and other institutional players looking to diversify. But for all 
the virtues that the funds hold as a way of spreading bets across 
commodity markets, they take only long, or bullish, positions, avoiding 
short-selling. In other words, they trade on the naive and potentially 
fatal assumption that commodities have the same tendency as stocks to 
rise over the long run.
    That this large, bullishly oriented group of funds is flourishing 
is partly a result of a regulatory anomaly. In recognition of the fact 
that the commodity markets are too small to absorb an excess of 
speculative dollars, the Commodity Futures Trading Commission, in 
conjunction with exchanges, imposes position limits on speculators. But 
the agency has effectively exempted the index funds from position 
limits.
    The dislocations caused by allowing so much money into markets that 
have limited liquidity is now causing alarm in the trading pits. That, 
in turn, is prompting the CFTC to call for an industry gathering April 
22 at its Washington headquarters ``to hear firsthand from participants 
to ensure that the exchanges are functioning properly.'' On this and 
related issues, CFTC Acting Chairman Walter Lukken declined to comment 
to Barron's.



    Unless regulators clamp down, the index funds could become an even 
bigger force in the markets. In the midst of the recent sell-off, 
commodity bull Jim Rogers made that very point in an interview with 
Bloomberg News. Referring to the ``over 70,000 mutual funds in the 
world'' compared with the ``fewer than 50'' that now invest in 
commodities, he held out the prospect of a speculative bubble that 
could last for years.
    In Rogers' view, the bull market is in the ``fourth inning'' of a 
``nine-inning baseball game.'' To which commodity bear Steve Briese 
counter-quips, ``Maybe, but can't the game be called for a year or two, 
on account of rain?''
    In the organized commodity markets, trading is in futures and 
options, which are essentially two-way bets on the outlook for prices. 
For every buyer (a ``long'') of a future or options contract betting on 
a price rise, there is a seller (a ``short''), taking the other side of 
the contract by betting on a price decline. Since speculators and 
commercials as a group can be either short or long, the charts (see the 
last page) track the net position--longs minus shorts--held by either 
group. Courtesy of Briese, the charts track net long or short positions 
in dollars, based on the dollar value of the commodity each futures or 
options contract covers.
    The speculators, now so bullish, are mainly the index funds. To see 
how their influence on the market has become outsized, just look at how 
they operate. Nearly $9 out of every $10 of index-fund money is not 
traded directly on the commodity exchanges, but instead goes through 
dealers that belong to the International Swaps and Derivatives 
Association (ISDA). These swaps dealers lay off their speculative risk 
on the organized commodity markets, while effectively serving as market 
makers for the index funds. By using the ISDA as a conduit, the index 
funds get an exemption from position limits that are normally imposed 
on any other speculator, including the $1 in every $10 of index-fund 
money that does not go through the swaps dealers.
    The purpose of position limits on speculators, which date back to 
1936, is clearly stated in the rules: It's to protect these relatively 
small markets from price distortions. An exemption is offered only to 
``bona fide hedgers'' (not to be confused with ``hedge funds''), who 
take offsetting positions in the physical commodity.
    The basic argument put forward by the CFTC for exempting swaps 
dealers is that they, too, are offsetting other positions--those taken 
with the index funds.
    Position limits on speculators, in some commodities specified by 
CFTC rules and in others by the exchanges, are generally quite liberal. 
For example, the position limit on wheat traded on the Chicago Board of 
Trade is set at 6,500 contracts. At an approximate value of $60,000 
worth of wheat per contract, a speculator could command as much as $390 
million of wheat and still not exceed the limit.
    But at least one index fund that does trade the organized commodity 
markets directly and must therefore abide by the rules--PowerShares DB 
Multi-Sector Commodity Trust (DBA)--recently informed investors that it 
was bumping up against position limits and therefore would change its 
strategy.
    No such information is available from individual swaps dealers. But 
based on CFTC data on their total position in a commodity like wheat, 
together with the fact that only four dealers account for 70 percent of 
all the trading from the ISDA, it is quite clear that if the exemption 
were ever rescinded, the dealers' trading in these markets would no 
longer be viable.
    Speculators also use the older commodity pools, whose position is 
likewise tracked on the charts. The pools, open to sophisticated 
investors, are flexible enough to sell short as well as buy long and 
are subject to position limits. But since they are generally trend-
followers, they will almost always go long in bull markets. Through 
most of the recent period, then, the pools have been adding to the 
price distortions caused by the index funds. Add the pools' bets to 
those of the index funds, and speculative money forms 58 percent of all 
bullish positions.
    To get a further idea of the impact of these speculative bets, 
Barron's asked Briese to measure them against production in the 
underlying markets. He calculates that in soybeans, the index funds 
have effectively bought 36.6 percent of the domestic 2007 crop, and 
that if you add the commodity pools, the figure climbs to 59.1 percent. 
In wheat, the figures are even higher--62.3 percent for the index funds 
alone, and the figure jumps to a whopping 83.6 percent if you add the 
pools. Betting against them as never before are the commercials, who 
deal in the physical commodity.
    The CFTC provides these figures on index trading for only 10 
commodities. Why are such major commodities as crude oil, gold, and 
copper excluded? The agency's rationale, which even certain insiders 
question, is that it would be hard to get reliable information on these 
other commodities from the swaps dealers.
    What might finally trigger the bursting of the commodities bubble?
    One possible trigger was cited in a Barron's interview with Carl 
Weinberg of High Frequency Economics, published last week. Weinberg 
anticipated a break ``some time this year'' in industrial commodities, 
including crude oil, copper and natural gas once there is news of 
``even the slightest slowdown in the Chinese economy,'' the country 
whose insatiable demand, together with that of India, has been a 
rallying cry of the bullish speculators. When industrial commodities 
prove vulnerable, speculative money could start fleeing agricultural 
commodities, also.
    Societe Generale analyst Albert Edwards goes much further. Based on 
his view that the ``Commodity bubble is nonsense on stilts,'' Edwards 
holds the ``very strong conviction that before the end of this year, 
commodity prices . . . will be unraveling.'' He believes the triggering 
events will be the ``unfolding U.S. consumer recession'' and likelihood 
of ``negative CPI [consumer price index] inflation rates.''
    A sudden turnaround in the dollar could be another trigger, notes 
Briese. By making dollar-denominated commodities ever cheaper in terms 
of other currencies, the collapsing dollar has been a legitimate 
bullish factor. ``But the buck won't go down forever,'' Briese argues. 
``The same cycles that coincided with the dollar's major bottom in 1992 
are due to make a low later this year. A rebounding dollar would pinch 
demand for dollar-denominated commodities.''
    Alternatively, to borrow a quip from the late humorist Art 
Buchwald--who once explained that his candidate lost the election owing 
to ``not enough votes''--the bubble could burst from not enough buying. 
Brokerage houses have been advising their clients to allocate part of 
their portfolios to commodities, compared with allocations of zero 
several years ago. Even a shift of five percentage points would have 
been more than enough to account for the dollars that have fueled the 
``nonsense on stilts.''
    But what if the U.S. economy proves more resilient than currently 
thought, doesn't fall into recession, and instead starts growing again? 
The resulting rally in the stock market could send the allocation share 
back to zero and the bubble could burst, not with a bang, but with a 
whimper.
    The CFTC could also prick the bubble by enforcing its own rules. If 
the agency were to rescind the exemption on position limits given to 
the index funds (say, on a phased basis, so that the funds could make 
an orderly retreat), prices would probably fall back to reflect their 
true supply-demand fundamentals.
    Briese's analysis of commercial hedger positions leads him to 
believe that commodities in general were fully valued in terms of the 
fundamentals as of early September 2007. Based on the 24-commodity S&P 
Goldman Sachs Commodity Index, that would mean about a 30 percent 
collapse from present levels. But, he adds, ``Given the tendency for 
prices to overshoot, commodity values could be cut in half before they 
stabilize.''
    Maybe it's time to start listening to the smart money.

                     LIMITATIONS ON OPEN POSITIONS

    Senator Brownback. I would ask you as well: You have 
limitations on what one individual can control as far as the 
number of open positions in a commodity; is that correct?
    Mr. Lukken. That is correct.
    Senator Brownback. Does that same limitation apply to a 
hedge fund?
    Mr. Lukken. It does.
    Senator Brownback. To an index fund? To a hedge fund?
    Mr. Lukken. Well, a hedge fund is in our terms somebody who 
is a speculative trader. An index fund is somebody like Goldman 
Sachs or AIG, which is a fund that brings in passive long-only 
investments into our markets. We typically call speculators 
those that are buying and selling over a short-term horizon. 
These are long-term investments in which pension funds such as 
CALPERS or retirement funds and endowment funds come into our 
markets in a buy and hold type strategy.
    Senator Brownback. And there is no limitation on the amount 
of open positions they can maintain?
    Mr. Lukken. They receive an exemption from us for those 
position limits.
    Senator Brownback. Now, in one article that I read--only 
long position?
    Mr. Lukken. Only long.
    Senator Brownback. But in one of the articles I read, that 
they were holding as much as 40 percent of some of the near-
term long positions in these index funds.
    Mr. Lukken. Well, they normally never get into the spot 
month. They roll before the spot month occurs. So they again 
are seeking long-term exposure.
    But in our analysis--and this is something that was 
discussed quite a bit at the agricultural forum we held 2 weeks 
ago--we've seen evidence where the largest percentage of index 
fund trading is in live cattle right now, about 45 percent of 
the market, and yet live cattle is down 6 percent, 8 percent on 
the year. So we have not seen high levels of correlation. In 
fact, Minneapolis wheat contract has no index fund trading----

                       INDEX FUNDS IN OIL MARKETS

    Senator Brownback. What about oil?
    Mr. Lukken. Unfortunately, because of the way that index 
funds enter into the oil markets, we're not able to pull out 
that data separately. But it's something we're looking into 
trying to drill down to find out how the index funds enter into 
those markets.
    Senator Brownback. It sure seems like that's one you really 
ought to be, as you say, no pun intended, drilling down into.
    Mr. Lukken. Well, it's something we want to look into 
further, how we can do it. It's a resource question because 
many of these index funds do a variety of types of trading. 
They don't separate the two, and so for us to try to find out 
that type of data, it would be very resource-intensive. But 
it's something we're interested in finding out.
    Senator Brownback. Why wouldn't you want to limit the 
number of open positions, open long positions, that an index 
fund could maintain? I mean, it seems to me, and maybe I'm 
looking at this too simply, but that people are parking money 
in these areas, which is fine, but you're taking a bunch of 
product off the market then and you're letting one entity 
control it, which you would not let an individual do. But an 
individual runs this fund and so you've got an individual 
sitting on top of a big hedge fund that's controlling a lot of 
positions.
    Mr. Lukken. Yes.
    Senator Brownback. I think back to when somebody was trying 
to capture the silver market two or three decades ago. It seems 
like you could get very much in the same spot, just only now 
the name's an index fund rather than an individual, but it's 
still a person that controls it.
    Mr. Lukken. Our markets are risk management markets. 
Financial institutions who are selling these products to 
pension funds and others have a risk. They have risks that 
they're trying to offlay in the futures markets. They are 
exposed to a long or short position when they do sell these 
products. Our markets try to help them to offset that risk.
    That's why I think there's been some discussion of whether 
we should call them a hedger, such that a producer or a grain 
elevator is a hedger. But they are hedging some type of 
financial risk, and it's been the position of the Commission 
for 20-plus years to allow them to have that type of an 
exemption.
    But I think this is something that came out in this ag 
forum and something that we're closely looking at to make sure 
that we're categorizing them correctly.
    I would point out that, even though they are not subject to 
these position limits, we still see all the positions. We see 
who they are. The transparency is complete for us. So we're 
able, if we think they have a position that's going to 
manipulate the markets, we as regulators can see that. They 
just don't have hard limits as they do maybe with the position 
limits. But we certainly can see and exercise judgment on 
whether they're trying to control the marketplace.
    Senator Brownback. It seems to me that you could see where 
this could happen, where they could drive the market up just by 
having a big quantity of open positions on long positions. I 
mean, it just seems, on its face, something that really we 
ought to be deeply concerned about. I hope you do look at the 
amount of positions you let them hold, long positions in those 
months.
    Mr. Chairman, thank you for being generous with my time.
    Senator Durbin. Senator Allard.
    Senator Allard. Thank you, Mr. Chairman. I do have a 
statement I'd like to put in the record, with unanimous consent 
to do that.
    Senator Durbin. Without objection.
    [The statement follows:]
               Prepared Statement of Senator Wayne Allard
    I would like to thank Chairman Durbin and Ranking Member Brownback 
for holding this hearing to examine the fiscal year 2009 budget 
requests of the Commodities Futures Trading Commission (CFTC) and the 
Securities and Exchange Commission (SEC). I appreciate the opportunity 
to more closely examine the regulation of our securities and futures 
markets.
    American capital markets are predicated on openness and fairness, 
and that fairness is only assured though careful, prudent, consistent 
regulation. The SEC and CFTC are at the heart of the effort to protect 
market participants and investors and to ensure market integrity.
    The financial markets have seen a great deal of growth and 
evolution during recent years. Regulation is becoming all the more 
challenging as the agencies must not only adapt to changing times, but 
try to anticipate future trends. The SEC and CFTC budget requests for 
fiscal year 2009 are an important part of helping the agencies meet 
those challenges.
    I place a strong emphasis on outcomes, particularly in the area of 
budgeting. Budgets are not, or at least should not, be simply a sign of 
how much we like a particular program. Rather, it should be tied to 
need and the results that are being achieved with past funding.
    I am concerned that neither budget before us today strikes the 
right balance. The CFTC is requesting a very large funding increase, 
yet according to the PART assessment is demonstrating no results. By 
contrast, the SEC, at least in some of its programs, has been shown to 
be effective. We have also heard repeated testimony in the authorizing 
committee about the need for a stronger SEC presence, yet, this budget 
actually proposes reduced staffing levels.
    I will be eager to hear from the chairmen to see how they square 
their budget requests with the facts on the table.
    Thank you, Mr. Chairman.

    Senator Allard. Just for the record of this subcommittee, I 
think if we were ever to look at a place where there is some 
market control it would be the OPEC countries. Obviously, we're 
not going to be able to control them, but you know, they 
produce oil, I'm told, in Iran for $15 to $17 a barrel. In 
Saudi Arabia they produce it out of the ground for $1 to $3 a 
barrel. We're paying $115 a barrel.
    I think that has more to do with the OPEC cartel and what 
they're doing, their markup. I think that's where the real 
problem is. So I just wanted to make that point for the record.

                       PROGRAM ASSESSMENT RATING

    One thing that you're doing that does concern me in a big 
way, and that is that I don't see you having a satisfactory 
score on the PART program. If you refer to the PART program, 
you understand which program I'm referring to? Well, you need 
to know about it. The PART program is where the administration 
measures objectives and results.
    You are scored as not making any effort--your score on that 
is that you haven't done anything to measure results and 
outcomes. Many of the agencies have. The SEC, which we'll be 
hearing from, has a good PART score. You have ``no results 
demonstrated.''
    Why is that?
    Mr. Lukken. I have to admit, Senator, this is something--I 
just got handed a note. This is dealing with the enforcement 
program?
    Senator Allard. Well, it's ``CFTC.'' That's the way it's 
listed, I think, on the PART program. How is it listed?
    Mr. Lukken. ``CFTC?''
    Senator Allard. It's listed as ``CFTC'' in general, a line 
item, ``CFTC.''
    Your evaluation comes from the Office of Management and 
Budget (OMB). As a policymaker, we look at that to see whether 
the taxpayer dollars or the fees that you're collecting are 
being put into an efficient and effective program. If we look 
at yours, where ``no results demonstrated,'' what is this? I 
mean, it's the CFTC; they're supposed to be a good business. 
They're not even practicing good business. Most good-managed 
businesses use management by objectives. That's what we're 
talking about.
    I see from ``no results demonstrated,'' which tells me 
you're not even bothering to set goals and objectives and 
trying to reach those. Those are measurable goals and 
objectives.
    If you go onto the Internet on expectmore.gov, enforcement 
of commodity futures and options, your rating is ``not 
performing, results not demonstrated; the program lacks 
performance measures that illustrate whether the program meets 
its overall objectives. The program demonstrates through the 
existing performance measures that it brings substantive cases 
in a timely manner. The program is well-designed to meet its 
objectives and examine the use''--those are the three 
classifications.
    You're classified as ``results not demonstrated.'' So a 
question I have is, why aren't you doing this?
    Mr. Lukken. Well, that's something I'll commit to you to 
look further into. I just got handed a note that we rated 80 
out of 100. But this is something----
    Senator Allard. Well, it's not showing up on 
expectmore.gov.
    Mr. Lukken. It's my understanding that we did score, and on 
the enforcement program I know there was something we were 
trying to get a line item in the budget on so we can try to 
find measurable outcomes for the enforcement program. It's 
something I know we want to look into, but I commit to you 
today that this is something we'll try to improve on.
    Senator Allard. I've pulled into the second page. It's 
commodity futures trading--it's ``Enforcement of commodity 
futures and options markets,'' and that's where the ``results 
not demonstrated'' is. That's the way it comes up on the 
report.
    Mr. Lukken. Well, we'll make this a priority.
    Senator Allard. You know, I think it's important. You know, 
if you can't demonstrate results and effectiveness, maybe you 
ought to be combined with the SEC, where they know how to do 
that. I served on the Agriculture Committee and I know you 
don't want to hear that suggestion. But I've tried to say 
something that catches your attention.
    Mr. Lukken. I understand.
    Senator Allard. I think things need to change there and 
it's something that I watch very closely. Whenever you show 
up--you've never had an opportunity to show up before me, but 
whenever you show up before me you can always expect me to have 
looked at your PART score to see what you're doing, because 
it's something I think that's quite helpful as policymakers for 
us to review.
    I served on the Agriculture Committee. I've been pretty 
impressed actually with your programs, and I understand why you 
have speculators there and how important they are. I understand 
that most of your dealings that you have on commodities futures 
and trading are, they're hedging. They're buying and selling in 
a timely way so that they reduce their risk. And I think you 
serve a good and valuable function in that way and you help our 
markets a lot.
    You want to increase your fees. Have you looked at how a 
fee increase might impact your global marketing?
    Mr. Lukken. A fee increase has been suggested by OMB to try 
to help us with raising money. This is not something, a 
position that the Commission has taken, whether it's in support 
or not in support of a fee. I think we believe, and different 
Commissioners can talk about this, their own personal view, 
that this is something that Congress and OMB should have a 
discussion about, how to raise the money.
    From my point of view, I'm here to describe how we spend 
the money, the types of programs we need to ensure illegal 
activity is not occurring on the marketplace.
    Senator Allard. You're the only regulatory agency that 
doesn't collect a fee.
    Mr. Lukken. That's my understanding, we're the only agency 
that does not have a fee.
    Senator Allard. And I think your input is important. I 
wouldn't just leave it up to the OMB and Congress, because we 
don't understand the world markets. You're out there dealing in 
the world markets. You're dealing with other exchanges 
throughout the world and you understand, I think, the impact, 
how the impact would be on your customers and whether you 
continue to do business in a competitive way. So I hope you 
don't back away on that.
    Thank you, Mr. Chairman.
    Senator Durbin. Senator Allard, I'm going to pass down this 
performance and accountability report. I had not seen it 
before, but the staff shared it with me. And we'll let you take 
a look at it. It may address some of your earlier questions, 
and see if it does.
    Senator Allard. We just pulled this off the Internet before 
I came here to the subcommittee meeting. So maybe it's not 
updated there.
    Senator Durbin. Okay. Thank you.
    Senator Allard. It's probably the same as what we've got in 
here.

             IMPACT OF BIOFUELS MANDATE ON PRICE INCREASES

    Senator Durbin. Chairman Lukken, last month you had a 
roundtable at CFTC to talk about changes in the marketplace. 
I'm glad you did it. In your opening remarks you said: ``During 
the last year the price of rice has increased 118 percent, 
wheat 95 percent, soybeans 88 percent, corn 66 percent, cotton 
and oats by 47 percent. These price levels, combined with 
record energy costs, have put a strain on consumers as well as 
many producers and commercial participants that utilize the 
futures market to manage risk and discover prices.''
    Now, the big question we're facing is the impact of the 
biofuels mandate on this phenomenon. I wonder if you could tell 
me whether or not you considered that element and have an 
opinion as to whether this biofuels mandate can be linked to 
any of these price increases?
    Mr. Lukken. I think the economists that follow those 
markets very closely, our agricultural markets, believe ethanol 
is a factor that is affecting the price of not only corn, but 
other commodities around that may substitute acreage from corn. 
So this is something that we closely--I can't comment on the 
mandate itself, but certainly when nearly one-third of corn 
production is going now for biofuels, that's going to have an 
impact on corn, on wheat, on soybeans and others that may be 
involved or be interrelated to the price of corn.
    Senator Durbin. Have you considered--I'm told that there's 
still more American corn exported than converted to ethanol. 
Have you considered why that element is still there if in fact 
we have a short domestic market in corn?
    Mr. Lukken. I'm not sure if that's something we've studied 
intensively or not. But it's something we can get back to you 
on later.
    Senator Durbin. Would you, please.
    Mr. Lukken. Yes.
    [The information follows:]

    
    
                         CFTC-SEC COORDINATION

    Senator Durbin. The last question I have relates to the 
next panel and that is the memorandum of understanding (MOU) 
that I understand that you and SEC Chairman Cox have worked on. 
Could you comment on that and how you are trying to coordinate 
the activities of your two agencies?
    Mr. Lukken. I think both Chairman Cox and I recognize how 
our agencies have to collaborate more as our markets become 
more intertwined. So this was the fruits of that labor, to sign 
an MOU that allows for information-sharing and for us to 
discuss the possibility of allowing novel derivative products 
to get to market quickly.
    So we've taken it out for a test ride. There's a couple of 
Chicago exchanges, in fact, that have submitted products to us 
that we are--that are out for comment, on ETF gold products. We 
hope that those are finalized in the coming months. But we also 
hope to tackle other big issues, such as portfolio margining. 
To allow more efficient use of margin between the two 
marketplaces I think would be enormously helpful, and allowing 
more product choices to consumers.
    Senator Durbin. Have you run into any conflicts with the 
SEC trying to figure out where a new product coming to market 
should be regulated?
    Mr. Lukken. Well, certainly we have differing missions. 
Theirs is capital formation. They have insider trading 
provisions that they have to think about. Ours are risk 
management markets. So we come at this from different angles. 
Certainly we have to discuss our mandates and make sure that we 
can align those mandates properly.
    Certainly we have differences of opinion, but we try to 
work through them, and understanding that collaboration is the 
way forward for both of our agencies.
    Senator Durbin. Thank you.
    Senator Brownback.
    Senator Brownback. Thank you.

                   LONG CONTRACTS HELD BY INDEX FUNDS

    What percentage of open long contracts are held by index 
funds? Do you have that number?
    Mr. Lukken. I think it's about 30 percent across, 30 
percent across the agricultural sector.
    Senator Brownback. Do you know about it in other sectors as 
well?
    Mr. Lukken. Again, we only break this out for agricultural 
products at the moment. We're looking into whether we can do 
that, given resources, for energy complex.
    Senator Brownback. I really want to urge you to do that in 
the energy complex. But it's 30 percent of the positions across 
agriculture. Does that vary substantially based on what it is 
in--corn or wheat or beef?
    Mr. Lukken. We do have a graph that we can give to your 
staff, but it ranges anywhere from about 45 percent in live 
cattle, which again I mentioned actually was in negative 
territory this year, down to around 15 percent in other 
commodities.
    But they typically are somewhere in the range of 25 to 30 
percent in the agricultural commodities.
    Senator Brownback. And what were they several years ago, if 
you'd know? Do you know any of those historic numbers?
    Mr. Lukken. I think when we started tracking this they were 
about 27 percent, 27 to 28 percent. So they've grown slightly 
over the last couple years, but not significantly. We haven't 
seen a huge uptick in growth since we started tracking this in 
the agricultural area.

                      ETHANOL IMPACT ON GAS PRICES

    Senator Brownback. You've noted that you think the price of 
corn is being impacted by ethanol, and certainly the ethanol 
consumption of corn would have an impact on corn prices. I 
don't know if you've tracked the impact of ethanol on gasoline 
prices. Do you track that at all?
    Mr. Lukken. I'm not sure this is something--no, I don't 
think so.
    Senator Brownback. Just for the record, I would put this 
out, and I've got a couple of charts and articles, Mr. 
Chairman, I would like to put in the record.
    Senator Durbin. Without objection.
    [The information follows:]

    
                                 ______
                                 

             [From The Wall Street Journal, Mar. 24, 2008]

As Biofuels Catch on, Next Task is to Deal With Environmental, Economic 
                                 Impact
                           (By Patrick Barta)
    The world's economy is acquiring a new energy addiction: biofuels.
    Crop-based fuels such as ethanol and biodiesel are quietly becoming 
a crucial component of the global energy supply, despite growing 
concerns about their impact on the environment and world food prices.
    Biofuels production is rising rapidly, while other fuel sources are 
failing to keep pace with demand. As a result, biofuels are making up a 
larger portion of the world's energy-supply gap than many analysts 
expected. That means the debate over biofuels probably will shift from 
whether they are good or bad to the more difficult question of how to 
make sure their production keeps growing--without wreaking economic and 
environmental havoc.
    Global production of biofuels is rising annually by the equivalent 
of about 300,000 barrels of oil a day. That goes a long way toward 
meeting the growing demand for oil, which last year rose by about 
900,000 barrels a day.
    Without biofuels, which can be refined to produce fuels much like 
the ones made from petroleum, oil prices would be even higher. Merrill 
Lynch commodity strategist Francisco Blanch says that oil and gasoline 
prices would be about 15 percent higher if biofuel producers weren't 
increasing their output. That would put oil at more than $115 a barrel, 
instead of the current price of around $102. U.S. gasoline prices would 
have surged to more than $3.70 a gallon, compared with an average of a 
little more than $3.25 today.
    Biofuels are playing ``a critical role'' in satisfying world 
demand, says Fatih Birol, chief economist of the Paris-based 
International Energy Agency. Without them, ``it would be much more 
difficult to balance global oil markets,'' he said.
    The implications are huge. After an initial burst of enthusiasm in 
2005 and 2006, environmentalists and some economists now blame biofuels 
for a host of global problems. These include a sharp jump in the price 
of corn and other biofuel crops, which has triggered a rise in global 
inflation and protests in poor nations.
    Many environmentalists now believe biofuels contribute 
substantially to greenhouse gases--those responsible for global 
warming--instead of reducing them, as was previously believed, in part 
because farmers clear forest land to grow biofuel crops. Scientists say 
deforestation causes a large, quick release of carbon into the 
atmosphere when existing plant life is destroyed.
    International agencies, including the Food and Agriculture 
Organization of the United Nations, have called on governments to deal 
with problems caused by biofuels, and some countries have started to 
rethink their support for the fuels. But cutting back on them won't be 
easy. Just as developing nations continue to gobble up coal, despite 
the high environmental cost, Western consumers seem to want whatever it 
takes to ensure enough fuel for their cars.
    As global energy consumption grows, ``there will be pressure to 
continue relying on these sources regardless'' of their negative 
impacts, says Jeff Brown, a Singapore-based economist at consulting 
firm FACTS Global Energy Group. ``The only other choice is higher [oil] 
prices.''
    It's possible newer biofuels will be developed that pose fewer 
problems. In India and Africa, farmers are expanding production of 
jatropha, an inedible shrub that is grown on marginal land and requires 
relatively little water. There also is rising interest in miscanthus, a 
perennial grass grown in Britain and elsewhere that can be used to 
generate energy without driving up the cost of crops needed for human 
consumption.
    Still, most farmers prefer to grow biofuel crops they are familiar 
with, such as corn. And most ``second-generation'' biofuels are coming 
on more slowly than many experts had hoped, meaning it might be several 
years, if ever, before they are viable on a large scale.
    It is also possible that ``first-generation'' biofuels like palm 
oil-derived biodiesel will run into constraints that would make it 
difficult to boost their production. The cost of raw materials like 
palm oil has shot up over the past year, cutting into profits for 
biofuel producers and forcing some to idle refineries or cancel new 
ones. It is also unclear whether there is enough land or water left to 
keep boosting biofuels' production at their current rate of increase.
    But a slowdown in biofuel production would only tighten world 
energy markets--and further highlight the world's dependence on the 
fuels, especially as producers of traditional crude oil struggle to 
crank up their supply.



    Earlier this month, Exxon Mobil Corp. said it planned to boost 
capital spending by several billion dollars in 2008 to roughly $25 
billion, and yet production levels will likely stay about the same this 
year. Mr. Blanch at Merrill Lynch says he expects new oil from 
producers outside the Organization of Petroleum Exporting Countries to 
taper off to as little as 300,000 barrels a day by 2011--about the 
equivalent of today's annual increase in biofuels production.
    Production from OPEC is tougher to forecast, in part because of the 
unpredictable political forces that shape the group's decisions. Last 
year, however, the cartel's output, including that of new members 
Angola and Ecuador, declined by about 400,000 barrels a day, according 
to the IEA. OPEC has lately decided to hold production at its current 
levels despite oil prices in excess of $100 a barrel.
    All of that can only mean one thing: With so many challenges ahead 
for increasing oil supplies, the world will have to get used to relying 
on biofuels--or find yet another alternative, at a time when there 
aren't many.
                                 ______
                                 
   The Relative Impact of Corn and Energy Prices in the Grocery Aisle
         (John M. Urbanchuk, Director, LECG LLC, June 14, 2007)
    Retail food prices measured by the Consumer Price Index (CPI) for 
food have begun to accelerate and are beginning to approach rates of 
increase last seen in mid-2004. Critics of renewable fuels are blaming 
the recent increases on high prices for corn caused by increasing 
ethanol production. They fail to point out that corn prices are only 
one of many factors that determine the CPI for food, and in fact, 
directly affect a small share of retail food prices. Increases in 
energy prices for example exert a greater impact on food prices than 
does the price of corn. A 33 percent increase in crude oil prices--
which translates into a $1.00 per gallon increase in the price of 
conventional regular gasoline--results in a 0.6 percent to 0.9 percent 
increase in the CPI for food while an equivalent increase in corn 
prices ($1.00 per bushel) would cause the CPI for food to increase only 
0.3 percent.
    The purpose of this study is to examine and compare the impact on 
consumer food prices resulting from increases in petroleum and corn 
prices.
Background
    The ethanol and corn industries are under attack by a wide range of 
critics for causing everything from sharply higher food prices for 
American consumers to shortages of and high prices for Mexican 
tortillas and even potentially higher tequila prices. Expansion of the 
ethanol industry to meet clean air standards and reduce dependence on 
imported petroleum has boosted demand for corn, the primary feedstock 
for U.S. ethanol. This increased demand has caused corn prices to rise 
to their highest levels since the drought of 1995. Critics contend that 
the recent increase in retail food prices measured by the CPI for food 
is the direct result of higher corn prices caused by ethanol demand and 
that an even larger increase in food prices is in store for American 
consumers.
    The actual record on the relationship between ethanol, corn, and 
retail food prices is less clear. Over the past 5 years, ethanol 
production has more than doubled, increasing from 2.14 billion gallons 
in 2002 to 4.86 billion gallons in 2006. Over this same period, the 
demand for corn to produce ethanol has grown from 996 million bushels 
to 2.2 billion bushels. Over most of this period, cash market corn 
prices were relatively stable. From January 2002 through September 
2006, corn prices averaged $2.18 per bushel. However, between September 
2006 and May 2007, corn prices jumped 61 percent to $3.56 per bushel in 
May 2007.
    During this same period, the CPI for food averaged a year-over-year 
increase of 2.4 percent. In fact, the inflation rate for food declined 
from a 5-year peak of 4.1 percent in May 2004 to a 2.5 percent year-
over-year rate in September 2006. However, since September 2006 the CPI 
for food has accelerated to a year-over-year rate of 3.7 percent in 
April 2007, an increase of 1.2 percent. During this same period, cash 
market corn prices increased $1.15 per bushel. While it is tempting to 
blame the entire increase in food price inflation over the past 8 
months on higher corn prices, most of the increase in food prices was 
the result of foods not impacted by corn such as fish, fruits and 
vegetables, sugar and sweeteners, and food away from home. Meat, 
poultry, eggs, and dairy products--the foods where corn is a major 
input and are most affected by rising corn prices--accounted for about 
0.2 percent of the 1.2 percent acceleration in food price inflation 
between September 2006 and April 2007. Rising energy prices had a more 
significant impact on food prices than did corn.
    Year-over-year increases in the CPI for all items, CPI for food and 
selected components are shown in Table 1.

                                                               TABLE 1.--CPI URBAN WORKERS
                                                            [Percent change, year-over-year]
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                               Cereals and     Meat,
                                      All items     All food      bakery      poultry,     Beef and       Pork       Poultry        Eggs        Dairy
                                                                 products       fish         veal
--------------------------------------------------------------------------------------------------------------------------------------------------------
2002...............................          1.6          1.8          2.2          0.5          0.1         -0.4          1.3          1.3          0.6
2003...............................          2.3          2.2          2.4          4.0          9.0          1.9          1.3         13.8         -0.1
2004...............................          2.7          3.4          1.6          7.4         11.5          5.6          7.5          6.2          7.3
2005...............................          3.4          2.4          1.5          2.4          2.6          2.0          2.0        -13.7          1.2
2006...............................          3.2          2.4          1.8          0.8          0.8         -0.2         -1.8          4.9         -0.5
                                    --------------------------------------------------------------------------------------------------------------------
January 2007.......................          2.1          2.4          2.7          1.7          0.2          1.4          0.2         11.8         -0.1
February 2007......................          2.4          3.1          4.1          1.7          1.4          0.5          1.0         29.1          0.2
March 2007.........................          2.8          3.3          3.6          2.8          2.3          2.2          2.1         20.8          1.5
April 2007.........................          2.6          3.7          4.5          3.7          4.7          0.7          4.6         18.6          2.5
--------------------------------------------------------------------------------------------------------------------------------------------------------

    Annual average and recent monthly average market prices for corn, 
soybean meal, Distiller's grains, and regular gasoline are shown in 
Table 2. The shift in corn prices that occurred in late 2006 is clearly 
evident and has been mirrored by soybean meal and Distiller's grains. 
During this same period energy price also accelerated rapidly. For 
example, the national average price of conventional regular gasoline 
increased 89 cents per gallon (39 percent) between October 2006 and May 
2007.

                                  TABLE 2.--MARKET PRICES FOR FEED AND GASOLINE
----------------------------------------------------------------------------------------------------------------
                                                               Corn No. 2
                                                                 Yellow      SBM High                  Regular
                        Calendar year                           central    Pro decatur   DDG L'burg    gasoline
                                                              Illinois ($/    ($/cwt)     ($/cwt)     ($/gallon)
                                                                bushel)
----------------------------------------------------------------------------------------------------------------
2002........................................................        $2.17      $167.36       $81.55        $1.38
2003........................................................         2.29       200.00        91.66         1.60
2004........................................................         2.39       237.01       105.18         1.89
2005........................................................         1.90       188.08        75.71         2.31
2006........................................................         2.41       175.85        89.01         2.62
                                                             ---------------------------------------------------
January 2007................................................         3.66       190.56       118.00         2.29
February 2007...............................................         3.90       208.81       129.00         2.32
March 2007..................................................         3.76       205.26       130.88         2.61
April 2007..................................................         3.36  ...........  ...........         2.89
May 2007....................................................         3.56  ...........  ...........         3.19
----------------------------------------------------------------------------------------------------------------

    Livestock and poultry producers are beginning to respond to higher 
feed costs by slowing the growth in animal numbers and market prices 
are reflecting these changes. However, corn prices are only one of 
several factors that impact livestock and meat production.
  --Heavy cow and calf slaughter and early placement of feeder cattle 
        in feedlots have combined with poor fall and winter pasture 
        conditions and higher grain prices to set the stage for slower 
        growth in cattle numbers through early 2008. This will in turn 
        slow growth in beef production in 2008 and support higher beef 
        prices.
  --Growth in hog inventories are expected to be constrained by higher 
        feed costs. However, this will be offset by growth in domestic 
        demand supported by a stronger consumer economy and increases 
        in exports as China turns to the U.S. to offset sharply reduced 
        domestic pork production.
  --Higher feed costs will dampen broiler producer's zest to sharply 
        expand production. However, producers will respond to higher 
        prices for red meat and growth in real disposable income that 
        will support demand growth. This will moderate any potential 
        sharp increases in broiler prices in 2008.
    Recent data for beef, pork, and broiler production and market 
prices are summarized in Table 3.

                                              TABLE 3.--SELECTED LIVESTOCK, POULTRY PRODUCTION, AND PRICES
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                 Beef and                                                                      Broiler
                                                   Cattle on       veal     Steer price      Pork     Barrows and  Hog and pig    Broiler     price 12-
                                                      feed      production     Omaha      production     gilts      inventory    production      city
                                                   (thousands   (millions    direct ($/   (millions     national    (thousands   (millions   average  ($/
                                                    of head)    of pounds)      cwt)      of pounds)      base       of head)    of pounds)      cwt)
--------------------------------------------------------------------------------------------------------------------------------------------------------
2002............................................        9,910       27,090       $67.04       19,664       $34.91       59,722       32,240       $55.52
2003............................................        9,124       26,238        84.69       19,945        39.45       59,554       32,749        62.00
2004............................................       11,253       24,547        84.75       20,511        52.48       60,444       34,063        74.10
2005............................................       11,299       24,682        87.28       20,685        50.01       60,975       35,365        70.80
2006............................................       11,726       26,071        85.41       20,999        47.28       61,449       35,752        64.30
                                                 -------------------------------------------------------------------------------------------------------
January 2007....................................       11,974        2,178        86.75        1,898        44.04       62,149        3,015        70.43
February 2007...................................       11,726        1,965        88.68        1,636        48.60  ...........        2,656        75.89
March 2007......................................       11,599        2,131        96.39        1,861        46.00  ...........        2,903        78.66
April 2007......................................       11,644        2,027        98.04        1,711        48.43  ...........        2,905        78.63
May 2007........................................  ...........        2,279        95.90        1,759        54.00  ...........        3,259        80.50
--------------------------------------------------------------------------------------------------------------------------------------------------------

Analysis
    Retail food prices are not likely to accelerate significantly in 
2008 and beyond, even as ethanol production continues to expand. In 
fact, consumers will be more severely affected by rising gasoline and 
energy prices than by increases in corn prices.
    Increasing petroleum prices have about twice the impact on consumer 
food prices as equivalent increases in corn prices. A 33 percent 
increase in crude oil prices--the equivalent of $1.00 per gallon over 
current levels of retail gasoline prices--would increase retail food 
prices measured by the CPI for food by 0.6 to 0.9 percent. An 
equivalent increase in corn prices--about $1.00 per bushel over current 
levels--would increase consumer food prices only 0.3 percent.
    The reason for the larger impact on food prices from petroleum and 
energy prices stems from the relative importance of energy in food 
production, packaging, and distribution compared to that of a single 
ingredient. While petroleum and energy prices affect virtually all 
aspects of agricultural raw material transportation, processing, and 
distribution of all finished consumer food products, corn prices affect 
only a segment of consumer foods--livestock, poultry, and dairy. Corn 
is an important feed ingredient for livestock and poultry producers and 
changes in corn prices can have significant impacts on profitability 
and production. However, meat, poultry, fish, eggs, and dairy products 
account for only one-fifth of the CPI for food which, in turn, is only 
15 percent of the overall CPI.
    Crude oil and refined petroleum prices have increased sharply over 
the past several years and have put considerable pressure on consumers. 
Energy plays a significant role in the production of raw agricultural 
commodities, transportation and processing, and distribution of 
finished consumer food products. Several studies have looked at the 
impact of increased energy prices on food prices.
  --Reed, Hanson, Elitzak and Schluter utilized three different model 
        structures to examine the impact of a doubling of crude oil 
        prices on the CPI for food.\1\ They conclude that the short run 
        impact of a doubling (e.g., 100 percent increase) in crude oil 
        prices would cause a 1.82 percent rise in average food prices 
        in the short run and 0.27 percent in the long run.
---------------------------------------------------------------------------
    \1\ A.J. Reed, Kenneth Hanson, Howard Elitzak, and Gerald Schluter. 
``Changing Consumer Food Prices: A User's Guide to ERS Analyses''. USDA 
Economic Research Service. Technical Bulletin 1862. June 1997.
---------------------------------------------------------------------------
  --A more recent analysis published by Chinkook Lee examined the 
        impact of energy price increases as an intermediate input for 
        food processing and concluded that a 10 percent increase in 
        energy prices results in a 0.2709 percent increase in the 
        purchase (consumer) price of food and kindred products 
        prices.\2\
---------------------------------------------------------------------------
    \2\ Lee, Chinkook. ``The Impact of Intermediate Input Price Changes 
on Food Prices: An Analysis of ``From-the-Ground-Up'' Effects.'' 
Journal of Agribusiness 20, 1 (Spring 2002).
---------------------------------------------------------------------------
    As pointed out, earlier corn prices also have increased 
significantly over the past year as the markets have recognized the 
impact of increasing ethanol production on corn demand. The price of 
No. 2 Yellow corn at Central Illinois averaged $3.56 per bushel in May 
2007, nearly 60 percent higher than year ago levels. The USDA and many 
private sector forecasters project ethanol production to exceed 15 
billion gallons by 2017, utilizing more than 4 billion bushels of corn 
and maintaining corn prices well above $3.00 per bushel for most of the 
decade.
    We evaluated the impact of an increase in petroleum prices on 
consumer prices food prices by applying the impact elasticities 
summarized above to an assumed 33 percent increase in crude oil (the 
equivalent of a $1.00 increase in retail gasoline prices from current 
levels). To determine the impact of an increase in corn prices on 
livestock, poultry, dairy and consumer food prices we imposed a 33 
percent increase in corn prices (about $1.00 per bushel from current 
levels) on the current LECG agricultural sector baseline forecast over 
the 5-year period 2007 through 2012. This is consistent with the 
increase in corn prices that has occurred over the past year.
    The analyses by Reed and Lee indicate that a 33 percent increase in 
oil/energy prices would increase retail food prices by 0.6 percent and 
0.9 percent. Reed indicates that a 100 percent increase in crude oil 
prices results in a short-term increase of 1.82 percent in consumer 
food prices while Lee reports that a 10 percent increase in energy 
prices provides a 0.2709 percent increase in retail food prices. 
Restating these on an equivalent 33 percent basis (1.82 percent times 
.33 and 0.2709 times 3.3) provides the 0.6 to 0.9 percent range.
    As shown in Table 4, the equivalent 33 percent increase in corn 
prices over the 5-year period is expected to reduce beef, pork, and 
broiler production by 2.6 percent between 2008 and 2012 and increase 
prices by 2.4 percent. Combined with higher turkey, egg, and dairy 
prices, the CPI for food is projected to increase an additional 0.3 
percent. This result is consistent with the 0.2 percent contribution to 
food price inflation between September 2006 and April 2007 from meat, 
poultry, fish, and dairy and the $1.15 per bushel increase in cash 
market corn prices.

         TABLE 4.--IMPACT OF A $1.00 CORN PRICE INCREASE ON LIVESTOCK, POULTRY, AND CONSUMER FOOD PRICES
                                               [Average 2008-2012]
----------------------------------------------------------------------------------------------------------------
                                                                                                    Percentage
                                                                     Baseline        Scenario         change
----------------------------------------------------------------------------------------------------------------
Corn Price, Average Farm ($/bu).................................           $3.10           $4.10            33.0
Beef and Veal Production (millions of pounds)...................          25,778          25,749            -0.1
Pork Production (millions of pounds)............................          21,057          20,696            -1.7
Broiler Production (millions of pounds).........................          35,530          33,740            -5.0
Steer Price, Omaha Direct ($/cwt)...............................          $98.41          $98.59             0.2
Barrows and Gilts, Market ($/cwt)...............................          $49.95          $50.99             2.1
Broilers, 12-City Average (cents/lb)............................          $77.90          $82.09             5.4
CPI, Food (percent).............................................             2.3             2.6             0.3
CPI, Food at Home (percent).....................................             1.9             2.2             0.3
CPI, Meats, Poultry, Eggs (percent).............................             1.4             2.1             0.7
----------------------------------------------------------------------------------------------------------------

Conclusion
    The days of cheap corn are more likely than not over. Livestock and 
poultry producers who enjoyed low and relatively stable corn (and other 
feed) prices over most of the past decade are now faced with the 
challenge of adjusting to an environment of higher feed prices. The new 
reality is that corn prices are likely to remain nearer to the $3.00 
per bushel than the $2.00 per bushel mark for an extended period. The 
good news is that prices may be more stable as corn production expands 
to meet ethanol requirements and new ethanol feedstocks and 
technologies emerge. Livestock and poultry producers also will have an 
incentive to increase use of the ethanol coproduct Distiller's grains 
in order to control feed costs. This medium protein feed component can 
be used in place of corn in a substantial portion of the feed ration. 
As ethanol production expands, so will production of Distiller's grains 
and thus putting downward pressure on prices.
    Corn and energy prices both affect consumer food prices. However, 
since increases in corn prices are limited to a relatively small 
portion of the overall CPI for food, an increase in corn prices 
resulting from higher ethanol demand or a supply disruption such as a 
major drought is expected to have about half the impact of the same 
percentage increase in petroleum and energy prices.

                                                                            APPENDIX TABLE 1.--CPI ALL URBAN WORKERS
                                                                               [Percent change from previous year]
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                          Cereals and
                                                                 All items     All food      bakery        Beef         Pork       Poultry        Eggs        Dairy      Fruits and   Fats, oils
                                                                                            products                                                         products    vegetables
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
January 2004..................................................          1.9          3.5          2.1         20.4          5.4          5.5         30.5          3.6          2.3          3.1
February 2004.................................................          1.7          3.3          1.3         16.1          3.6          4.1         31.2          2.9          2.9          2.3
March 2004....................................................          1.7          3.2          1.3         12.8          5.5          6.1         33.2          2.9          2.9          5.5
April 2004....................................................          2.3          3.4          1.8         13.2          4.8          5.9         26.4          4.9          3.2          6.5
May 2004......................................................          3.1          4.1          1.5         15.9          6.6          9.5         19.0         12.4          2.4          7.5
June 2004.....................................................          3.3          3.7          1.5         16.0          6.3          8.9         10.1         15.2         -0.3          9.5
July 2004.....................................................          3.0          4.0          1.3         15.4          7.0          9.5          6.3         14.0         -0.9         10.0
August 2004...................................................          2.7          3.5          1.3         14.2          7.4         10.5         -1.0         10.4         -0.4          7.6
September 2004................................................          2.5          3.3          1.4         12.2          6.2          9.8         -9.6          6.6          0.7          8.1
October 2004..................................................          3.2          3.4          1.9          7.4          5.3          8.3        -12.4          6.0          6.1          6.6
November 2004.................................................          3.5          3.2          2.1          0.6          5.2          6.3        -21.1          5.7          9.1          6.7
December 2004.................................................          3.3          2.7          1.7         -0.9          4.7          5.1        -19.9          4.1          7.9          6.2
                                                               ---------------------------------------------------------------------------------------------------------------------------------
January 2005..................................................          3.0          2.9          1.8          1.5          5.5          5.3        -23.0          6.3          4.5          6.0
February 2005.................................................          3.0          2.6          2.0          3.5          6.3          4.5        -21.5          5.6          2.2          4.3
March 2005....................................................          3.1          2.5          1.8          6.0          4.5          4.0        -27.0          5.5          1.6          0.5
April 2005....................................................          3.5          3.1          1.8          5.3          7.0          3.4        -25.9          4.7          5.2          1.9
May 2005......................................................          2.8          2.4          1.7          5.0          2.8          1.2        -18.6         -1.4          5.6         -0.9
June 2005.....................................................          2.5          2.2          1.3          3.3          1.8          1.3        -17.3         -4.1          5.2         -4.0
July 2005.....................................................          3.2          2.1          1.1          0.8          0.1          0.5        -11.9         -3.2          7.0         -2.7
August 2005...................................................          3.6          2.2          1.4          0.8         -0.7          0.1        -12.2         -1.1          5.6         -1.2
September 2005................................................          4.7          2.5          0.9          0.5         -1.0          1.3          1.4          0.1          6.5         -0.6
October 2005..................................................          4.3          2.2          1.2          1.4         -0.8         -0.2         -0.6          0.3          2.4         -0.9
November 2005.................................................          3.5          2.2          1.1          1.2         -0.2          2.3          5.3          1.4         -0.8         -1.0
December 2005.................................................          3.4          2.3          1.0          2.2         -0.1          0.3          1.4          1.7          0.6         -1.3
                                                               ---------------------------------------------------------------------------------------------------------------------------------
January 2006..................................................          4.0          2.6          1.4          2.8         -1.7         -1.3          8.3          0.2          6.4         -0.3
February 2006.................................................          3.6          2.8          0.9          1.3         -1.7         -0.3         -3.1          0.9          7.9          0.6
March 2006....................................................          3.4          2.6          1.2          1.2         -1.0         -1.6          5.5          0.9          6.3          0.9
April 2006....................................................          3.5          1.8          0.9          0.7         -1.9         -2.0          8.7         -0.5          2.7         -2.6
May 2006......................................................          4.2          1.9          1.0         -1.7         -0.8         -2.0          2.4         -1.3          1.3          0.5
June 2006.....................................................          4.3          2.2          1.6         -1.9         -1.0         -1.4          8.9         -0.8          4.0          1.7
July 2006.....................................................          4.1          2.2          2.5         -0.5          0.2         -2.7          0.5         -0.4          3.7         -0.2
August 2006...................................................          3.8          2.4          2.1          1.4          1.1         -1.7          6.0         -1.6          5.3         -0.1
September 2006................................................          2.1          2.5          2.5          1.6          1.3         -2.6         -0.8         -1.0          7.2         -0.9
October 2006..................................................          1.3          2.6          2.5          2.0          1.6         -1.9          1.5         -0.3          6.5          0.3
November 2006.................................................          2.0          2.3          2.6          2.4          0.1         -3.1          6.6         -1.6          4.2          1.1
December 2006.................................................          2.5          2.1          3.1          0.5          0.7         -0.7         14.1         -1.2          1.9          0.9
                                                               ---------------------------------------------------------------------------------------------------------------------------------
January 2007..................................................          2.1          2.4          2.7          0.2          1.4          0.2         11.8         -0.1          1.7          0.2
February 2007.................................................          2.4          3.1          4.1          1.4          0.5          1.0         29.1          0.2          6.0          0.8
March 2007....................................................          2.8          3.3          3.6          2.3          2.2          2.1         20.8          1.5          6.2          1.4
April 2007....................................................          2.6          3.7          4.5          4.7          0.7          4.6         18.6          2.5          6.2          2.9
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

                                 ______
                                 
 The Impact of Ethanol Production on U.S. and Regional Gasoline Prices 
       and on the Profitability of the U.S. Oil Refinery Industry
                                abstract
    Using pooled regional time-series data and panel data estimation, 
we quantify the impact of monthly ethanol production on monthly retail 
regular gasoline prices. This analysis suggests that the growth in 
ethanol production has caused retail gasoline prices to be $0.29 to 
$0.40 per gallon lower than would otherwise have been the case. The 
analysis shows that the negative impact of ethanol on gasoline prices 
varies considerably across regions. The Midwest region has the biggest 
impact, at $0.39/gallon, while the Rocky Mountain region had the 
smallest impact, at $0.17/gallon. The results also indicate that 
ethanol production has significantly reduced the profit margin of the 
oil refinery industry. The results are robust with respect to 
alternative model specifications.
    Keywords: crack spread, crude oil prices, ethanol, gasoline prices.
Introduction
    Fuel ethanol production in the United States increased from 1.63 
billion gallons in 2000 to 7.22 billion gallons in 2007 (RFA). In 
comparison, the United States consumed approximately 146 billion 
gallons of petroleum in 2007 (EIA). The purpose of this paper is to 
estimate the impact of this increase in ethanol supply on the U.S. 
gasoline market.
    Ethanol is blended with gasoline to improve octane and performance 
in about 50 percent of the Nation's gasoline supply. Typically, a 
gallon of ethanol blend will have 10 percent ethanol and 90 percent 
gasoline. This gallon of ethanol blend will contain approximately 97 
percent of the energy of a gallon of gasoline (Tokgoz et al. 2007) and 
will use approximately one-tenth as much fuel energy to produce as it 
contains (Wang et al. 2007). Therefore, ethanol has essentially added 
to U.S. gasoline supplies by utilizing solar energy to grow the crop, 
coupled with energy from natural gas and coal to manufacture the farm 
equipment and fertilizer used in crop production.
    In order to identify the separate impact of ethanol on gasoline 
prices, we need to separate the impact of ethanol from the other forces 
driving gasoline prices. We do so by examining the price of gasoline 
relative to the price of crude oil. We also estimate the impact of 
ethanol on the profits made by refiners. Both estimates are calculated 
for the United States as a whole and for each of five regions within 
the United States. The motivation for conducting the regional analysis 
is that if ethanol is affecting gasoline prices, then we hypothesize 
that this impact will be largest in the Midwest where regional ethanol 
production and utilization is at its maximum.
    The paper proceeds as follows. First, background information 
regarding previous work, relative gasoline prices, and the use of the 
crack spread as a measure of industry profitability are introduced. We 
then describe the five regional ``Petroleum Administration for Defense 
Districts'' (PADDs) that are the basis for the analysis. Next, we 
present a detailed description of and motivation for the explanatory 
variables. We also provide a description of and motivation for the 
three estimation methods that are used. The last section summarizes the 
results.
Previous Work
    Quantitative analysis of the effect of ethanol on gasoline prices 
and on the profitability of the refinery industry has been largely 
neglected in the literature. Eidman (2005) points out that ethanol 
largely acts as a fuel extender. He also shows that there has been a 
strong positive correlation between ethanol and gasoline prices. 
Employing an international ethanol model consisting of behavioral 
equations for production, consumption, and trade, Tokgoz and Elobeid 
(2007) analyze the price linkage between ethanol and gasoline markets. 
They conclude that ethanol is mainly used as an additive to gasoline 
and that the complementary effect of ethanol dominates the substitution 
effect on gasoline prices. Szklo, Schaeffer, and Delgado (2007) 
conclude that by replacing methyl tertiary butyl ether (MTBE), which is 
a traditional additive used as an oxygenate to raise the octane number, 
ethanol blending will not reduce gasoline use until flexible fuel 
vehicles become widely available. Vedenov et al. (2006) apply a 
continuous-time option pricing method to calculate the decision 
threshold of switching to ethanol. Their empirical analysis suggests 
that blending ethanol into gasoline would generate lower gasoline price 
volatility and that switching from conventional gasoline to an ethanol 
blend is an economically sound decision.
    The ``3:2:1 crack spread'' is used as one of the significant 
indicators of refinery profitability. It is a term used in the oil 
industry and futures trading as a proxy for the profitability of 
refineries. Although there is some qualitative description of its 
determinants, formal quantitative analysis is limited in the 
literature. Asche, Gjolberg, and Volker (2003) examine the price 
relationships among crude oil and refined products. They find that the 
crude oil price is weakly exogenous and that the spread is constant 
among some of the prices. Girma and Paulson (1998) examine the crack 
spread of daily futures prices of crude oil and heating oil. Girma and 
Paulson (1999) investigate the long-run relationship among crude oil, 
gasoline, and heating oil futures prices and find the prices are co-
integrated. They also find a stationary relation between crude oil and 
its end products.
    In the literature on mergers in the refinery industry, several 
studies rely on analysis of the price margin, which is defined as 
wholesale prices of gasoline less crude oil prices. The Government 
Accounting Office (GAO 2004) models the price margin as a function of 
the crude oil price, inventory ratio, utilization rate, and dummy 
variables representing a merger and acquisition event. Geweke (2003) 
provides a comprehensive survey on this subject.
    The degree of market concentration has been long recognized and 
analyzed in the literature seeking to explain price changes and 
adjustment in the wholesale gasoline market. Focusing on Gulf Coast, 
Los Angeles, and New York whole spot gasoline markets, Oladunjoye 
(2007) investigates the effects of market structure on the pattern of 
price adjustment and finds that market concentration has a significant 
asymmetric effect on gasoline price changes responding to crude price 
shocks. The GAO (2004) concludes that mergers and increased market 
concentration generally led to higher wholesale gasoline prices in the 
United States from the mid-1990s through 2000. Examining wholesale 
price responses in 188 gasoline markets in the United States, 
Borenstein and Shepard (2002) find that refinery firms with market 
power generally choose a different adjustment rate and adjust prices 
more slowly than do competitive firms.
Background
    The 3:2:1 crack spread is defined as

    
    

where PG, PH, and PO are the prices of regular gasoline, no. 2 heating 
oil, and crude oil, respectively.
    The 3:2:1 crack spread has been institutionalized over the years as 
a way to measure the refinery margin. The use of the 3:2:1 crack spread 
is justified by the fact that among all finished products converted 
from crude oil in the refinery process, gasoline and distillate fuel 
oil are the two primary product classes. The relative proportion of 
these two products is approximately two barrels of gasoline to one 
barrel of distillate fuel. Together, gasoline and distillate fuel 
comprise about 80 percent of the refinery yield. The average refinery 
yield of finished motor gasoline is about 46 percent and has been 
stable over the 1993-2007 sample period (DOE).
    The West Texas Intermediate (WTI) crude oil price, which is priced 
at Cushing, Oklahoma, is chosen to represent the crude oil price in 
this study. The reason is that WTI-Cushing is one of the most widely 
traded and price-transparent crude oils in the U.S. crude oil market.
    We use the Petroleum Administration for Defense Districts (PADDs) 
to define refinery product markets. This market definition was formed 
during World War II for the purpose of administering oil allocation. 
The PADDs are still used by the Department of Transportation (DOT) and 
Energy Information Administration (EIA) for statistical and reporting 
purposes. The five regions are East Coast (PADD I), Midwest (PADD II), 
Gulf Coast (PADD III), Rocky Mountain (PADD IV), and West Coast (PADD 
V). These five geographically distinct regions are also very different 
in terms of their economic conditions, oil and petroleum 
characteristics, oil-related pipeline infrastructure, and local product 
supply and demand conditions.
    Because of its high population density, the East Coast PADD I has 
the highest demand for refined products in the country, but it has very 
limited refinery capacity. Its regional demand is largely satisfied by 
the Gulf Coast and by foreign imports. The Midwest PADD II is distinct 
in its coexistence of a highly industrialized section and a rural 
agricultural section. It also leads the Nation in ethanol production, 
mainly because of its leading role in corn production, the primary 
feedstock for ethanol production. For example, Iowa had 30 ethanol 
plants in operation by the end of 2007 and produces nearly 2.1 billion 
gallons of ethanol annually. Much of the crude oil used in the Midwest 
is piped in from the Gulf Coast and Canada. One place worth mentioning 
in this region is Cushing, Oklahoma, which is the major crude oil 
transportation hub for the Midwest.
    The Gulf Coast region, including Texas, Louisiana, New Mexico, 
Arkansas, Alabama, and Mississippi, produces over 50 percent of the 
Nation's crude oil and 47 percent of its final refined products. This 
region also serves as a national hub for crude oil and is the center of 
the pipeline system. The Rocky Mountain region, or PADD IV, has the 
smallest and fastest-growing oil market in the United States, with only 
3 percent of national petroleum product consumption. The West Coast 
region, PADD V, is the largest oil-producing and consuming region. This 
region's oil supply is independent of
    other regions since it is geographically separated by the Rocky 
Mountains. In addition, the refinery market of this region is highly 
concentrated.
Data
    The gasoline price relative to that of crude oil is used as a 
dependent variable to measure ethanol's possible substitution effect on 
the gasoline price, while the 3:2:1 crack spread is employed as a 
dependant variable to quantify the effect of ethanol on the refinery 
profit margin. Figure 1 presents the relative gasoline to crude oil 
price over the 1995-2007 period. Figure 2 is for the 3:2:1 crack spread 
deflated by Producer Price Index (PPI) for crude energy material for 
five PADD regions over the same sample period. The PPI data are 
obtained from the U.S. Bureau of Labor Statistics.





    The relative gasoline price is similar to crack spread in the sense 
that both are measurements of profitability of the refinery industry. 
The difference is that relative gasoline prices only account for the 
contribution of gasoline to the profit margin. It is employed in this 
study to quantify the substitution effect of ethanol production on 
gasoline prices. Relative gasoline prices and the refinery profit 
margin are mainly determined by similar explanatory variables. The 
explanatory variables included in this study are market demand and 
supply conditions, refinery capacity and utilization rate, market 
concentration and structure, unexpected supply disruptions, gasoline 
imports, seasonality, and ethanol production. Each of these chosen 
variables and its relationship with the relative gasoline price and 
refinery profitability is discussed in greater detail in this section.
            Crude and Product Market Conditions
    The gasoline price and refinery profitability are affected by the 
supply and demand balances of the crude market and product market. When 
the crude oil market has ample stocks, refinery profit should increase 
because of lower crude oil prices. Alternatively, when there are large 
stocks of gasoline and other refinery products, refinery profits should 
fall because of lower product prices. A tight product market will 
generate upward pressure on product prices even when there is an ample 
supply of crude oil. That is, product prices are bid up by more than 
any underlying cost increases. This upward movement relative to crude 
oil prices will be seen as an increase in the relative price and crack 
spread. We use monthly crude oil inventory and gasoline inventory data 
collected by the EIA to represent the conditions in these two markets. 
The gasoline stock and crude oil stock data for the East Coast region 
from 1995 to 2007 are shown in Figures 3 and 4, respectively.





            Refinery Capacity and Capacity Utilization Rate
    Refinery capacity is a critical factor influencing the 
profitability of the refinery industry. Figure 5 presents the operable 
crude oil distillation capacity in the five PADD regions from 1995 to 
2007. In this figure, refinery capacity is represented by monthly data 
of atmospheric crude oil distillation units (barrels per calendar day). 
Total refinery capacity increased by 13 percent over the past 12 years, 
with PADD III, the Gulf Coast, having the highest growth of 19 percent. 
The lowest increase in capacity occurred in the Midwest, with a 4 
percent growth over the same period.




    The monthly percent refinery capacity utilization rates for 1995 to 
2007 for PADDs II, III, and V are shown in Figure 6. Here, refinery 
capacity utilization is based on gross input to atmospheric crude oil 
distillation units divided by the refinery operable distillation 
capacity. The average rate over five regions is 92 percent, which means 
that capacity utilization has increased significantly and refineries 
are running at high rates of utilization. Refinery capacity and its 
utilization rate are variables that will affect gasoline price and 
refinery profits via higher prices for products and possible increases 
in marginal costs.




Market Concentration
    Mergers and acquisitions among refinery firms may potentially 
further reduce the competition in the refinery market, thus possibly 
leading to a higher refinery margin. To measure the level of market 
concentration, the Herfindahl-Hirschman Index (HHI) is commonly applied 
in the literature. The HHI of a market is calculated by summing the 
squares of the percentage market shares held by the respective firms as




where Sit is the market share of a specific firm in the corresponding 
production market with total firms of Nt at year t. A market with an 
HHI less than 1,000 is considered to be a competitive market; 1,000-
1,800 to be a moderately concentrated market, and greater than 1,800 to 
be a highly concentrated market.
    We constructed an HHI for the five PADD regions over the period 
1995 to 2007, and we present this information in Figure 7. The HHI for 
the refinery market in PADD I increased from 1,558 to 2,335 from 1995 
to 2007 and changed from a moderately concentrated to a highly 
concentrated market using Department of Justice definitions. Since much 
of this region's refinery product supply is from other regions, the 
impact of this increased concentration may be small. The refinery 
market in PADD II, the Midwest, suggests that this is a competitive 
market, although its HHI increased to 960 in 2007. Similar to the 
Midwest region, PADD III, the Gulf Coast, also has a competitive 
refinery market as of the end of 2007. The HHI for PADD IV, the Rocky 
Mountain region, decreased from 1,025 to 930, which suggests that its 
refinery market became less concentrated than before. The HHI for the 
PADD V, the West Coast region, increased from 914 to 1,155, and this 
refinery market changed its definition to a moderately concentrated 
market by 2007.




            Unexpected Supply Disruptions
    On August 29, 2005, Hurricane Katrina hit the U.S. Gulf Coast at 
New Orleans. On September 24, 2005, Hurricane Rita hit at the border 
between Texas and Louisiana. Both were category four storms when they 
did significant damage to the refineries' facilities and pipeline in 
the Gulf Coast region. Refinery operations were reduced by 1.8 million 
barrel/day in September and October 2005. Retail gasoline prices jumped 
by $0.50 to over $3.00 per gallon on a national average basis after 
Hurricane Rita. Prices were distinctly higher than before. In order to 
control for the effect of this event on the gasoline and refinery 
profit margin, we include dummy variables for September and October in 
2005, when the disruptions were most severe.
            Gasoline Imports
    A significant share of total gasoline demand in the United States 
is met by imports. The net import share of total gasoline consumption 
in 2007 is 14 percent. Figure 8 presents U.S. finished motor gasoline 
imports from all countries over the period 1995 to 2007. Imports 
reached their highest level in October 2005, the month after Hurricanes 
Katrina and Rita. Major sources of gasoline imports include Canada, 
Europe, and the Virgin Islands. A structural surplus in gasoline 
production in Europe means that gasoline production costs are lower 
when derived from foreign sources than they would be if the United 
States built and operated additional refinery capacity domestically. 
Growth in imports is expected to be tempered because of the increased 
use of domestically produced ethanol. Also, with increases in imported 
gasoline, refinery profitability is expected to be negatively affected.




            Ethanol Production
    Figure 9 presents the monthly ethanol production over the 1995-2007 
period. There are 68 ethanol plants under construction or expanding. 
Iowa leads the Nation with about 2 billion gallons of ethanol 
production capacity. Our hypothesis is that this additional production 
has had a negative impact on gasoline prices and on the margins of 
crude oil refiners.




            Seasonality
    The gasoline market is highly seasonal due to stronger demand in 
spring and summer. Gasoline price tends to gradually rise before and 
after summer. Demand for distillate fuel including heating oil and 
diesel fuel typically peaks in winter and thus has a counter-cyclical 
price pattern from gasoline. We include a set of monthly dummies to 
account for the seasonal pattern.
Estimation Method
    The regression model is specified as follows:

    
    

where pit it is the price of gasoline divided by the price of crude oil 
or the 3:2:1 crack spread of region i at month t, and Xit is the K-
dimensional vector of explanatory variables described earlier.
    There are several options for estimating equation (1), including 
pooled OLS regression and panel data models. The pooled OLS regression 
simply pools together data series for all PADD regions and applies the 
ordinary least squares method. The OLS estimates of the standard errors 
may be highly inaccurate if the data exhibits heteroskedasticity and/or 
cross-sectional and serial correlation. The panel data models increase 
precision of estimates and allow us to control for an unobservable 
individual region's heterogeneity and temporal effects without 
aggregation bias.
    The Hausman test for misspecification (Greene 2003, p. 301) is 
employed to help us select from two principal types of panel data 
models: the fixed effect model and the random effect model. Under the 
null hypothesis, the random effects estimator is consistent and 
efficient, while under the alternative, it is inconsistent. The random 
effect model is chosen if we fail to reject the null hypothesis. In the 
case of relative gasoline price (3:2:1 crack spread), the x\2\ test 
statistic was calculated at 26.92 (48.99) and significant at the 5 
percent (1 percent) significance level. This suggests that the fixed 
effect estimator is consistent and asymptotically efficient in both 
cases.
    Different specification tests are applied on the data set to better 
specify the panel data model. Applying the Wooldridge test for 
autocorrelation in panel data for the relative gasoline price (or crack 
spread) (Wooldridge 2002, p. 282), we get an F-test statistic of 917 
(1,708), which is highly significant, and the null hypothesis of no 
first-order autocorrelation is rejected. Tests developed by Pesaran 
(2004) and Frees (1995) of cross-sectional independence are applied and 
both null hypotheses are rejected; this confirms the existence of 
cross-sectional correlation across regions.
    Based on these diagnostic results, we used a fixed effect panel 
data model with correction for first-order serial correlation. We also 
estimated a feasible generalized least squares (FGLS) model with 
generalized error structure to allow for the presence of AR(1) 
autocorrelation within panels, as well as for heteroskedasticity and 
cross-sectional correlation across panels. By using three alternative 
model specifications we hope to provide information on the robustness 
of the results.
    The fixed effect model is specified as

    
    

where ai represents the individual regional effect. The fixed effect 
model is typically estimated by the least squares dummy variable (LSDV) 
method (Greene 2003, p. 287).
    The FGLS estimation method takes into account heteroskedasticity, 
and cross-sectional and serial correlation. The error terms can be 
written as




    An FGLS panel data model is also called the Parks-Kmenta method 
(Kmenta 1986). This method consists of the following steps. Estimate 
equation (1) by regular OLS. Then use the estimation residuals to 
estimate assumed error AR(1) serial correlation coefficient r. Use this 
coefficient to transform the model to eliminate error serial 
correlation. Substitute V for V using estimated r and s\2\ then obtain 
the FGLS estimator of b as




Analysis of Estimation Results
    Using the relative gasoline price as the dependent variable, we get 
estimation results for the pooled OLS regression, a fixed effect panel 
data model, and a panel FGLS method; these are shown in Table 1. The 
corresponding estimation results for 3:2:1 crack spread are shown in 
Table 2.
    In the case of the relative gasoline price, three estimation 
methods generate similar results. The only difference is that standard 
errors of coefficient estimates get bigger after taking into account 
cross-sectional and temporal autocorrelation, which in turn lead to a 
comparatively lower significance level for corresponding variables. 
Crude oil and gasoline inventories, refinery capacity, short-run supply 
disruption, and dummy variables for some summer months all 
significantly influence the relative gasoline price. Ethanol production 
has a considerably negative impact on the gasoline price, which is 
highly significant at the 1 percent level in all three estimation 
results. This indicates that over the sample period, ethanol has a 
significant substitution effect on gasoline. Evaluating at the sample 
mean, we find that the gasoline price is lowered by 39.50 cents, 
28.70 cents, and 34.10 cents per gallon because of the substitution 
effect of ethanol.
    For the 3:2:1 crack spread, the estimation results of the fixed 
effect and panel FGLS models are quite different from that of the 
pooled OLS regression. In addition, the pooled OLS regression model 
generates highly significant estimates for all explanatory variables 
except the dummy variables for January, February, and November. As 
previously mentioned, ignoring cross-sectional and serial correlation 
as well as individual heterogeneity typically leads to highly 
inaccurate standard error estimation; i.e., the significance estimation 
results are not reliable. Hence, we focus on the fixed effect and panel 
FGLS estimation results.
    From these two sets of estimates, all the explanatory variables 
have intuitively correct signs. First, the profitability represented by 
the 3:2:1 crack spread presents a strong seasonal pattern. This is 
reflected by the fact that the dummy variables for months in the second 
and third quarters are all significant at the 1 percent significance 
level in the panel FGLS model and at the 5 percent level in the fixed 
effect model. Second, crude oil and refinery product market conditions, 
refinery capacity, ethanol production, and unexpected supply disruption 
significantly affect profit margins. For all five PADD regions, 
unexpected supply disruption, measured by dummies for Hurricanes 
Katrina and Rita, considerably increased profits in the months right 
after the occurrence. Gasoline imports and the HHI are found not to 
have statistically significant effects on crack spread nationally. 
Finally, we find that ethanol production generates negative pressure on 
crack spread over the sample period. For the fixed effect and panel 
FGLS models, the marginal effect of ethanol production on the crack 
spread is estimated to be -0.000073 and -0.000077, respectively.
Regional Analysis
    Pooling cross-sectional and time-series information provides more 
accurate estimation results. However, it is instructive to analyze the 
time-series data of each region individually. Each PADD region has 
unique supply and demand conditions of crude oil and refinery products, 
different market structures, and different ethanol production and 
usage. The effects of explanatory variables may differ considerably 
because of region-specific factors.
    We apply regular OLS regression on individual region's monthly data 
series over the period 1995 to 2007. The estimation results for the 
relative gasoline price and 3:2:1 crack spread are summarized in Tables 
3 and 4, respectively.
    From the estimation results for the relative gasoline price, 
ethanol production has a significant negative effect on gasoline prices 
in all regions. And the magnitude of the effect varies with PADD 
regions, ranging from -0.000041 to -0.000095. As expected, in PADD II, 
the Midwest region, ethanol production has the largest impact on the 
gasoline price with a coefficient of -0.000095. The substitution effect 
is highly significant and reduces the gasoline price by 39.5 cents on 
average over the sample period. The West Coast and East Coast 
experience similar negative ethanol impacts with estimates of 
-0.000056, which means that the corresponding gasoline price is lowered 
by 23.3 cents. The Gulf Coast region, PADD III, has a slightly higher 
coefficient estimate of -0.000059, or, equivalently, a 24.6 cents 
reduction in gasoline prices. The Rocky Mountain region, or PADD IV, 
experienced the smallest downward gasoline price change, at 17.1 cents, 
probably because of its comparatively low total gasoline consumption. 
These results tell us what would have happened had we removed the 
entire ethanol industry at the mean of the data set, and they are not 
marginal effects of removing one unit of ethanol capacity in each 
region.
    From the estimation results of the profit margin for individual 
regions, effects of some explanatory variables differ considerably 
across regions. In PADD regions III and V, the HHI has a significant 
positive effect on refinery profit. This result suggests that higher 
market concentration in these two regional markets results in refinery 
profits. We did not find this pattern in our panel data model. 
Similarly, gasoline imports have a significant negative effect on the 
profit margin in both East Coast and Midwest regions, possibly because 
these two regions are more heavily dependent on imported refinery 
products to meet their regional demand. Ethanol production has a 
significant negative effect on the refiner's profit margin in all five 
PADD regions.
Conclusions
    We employ pooled OLS regression, a fixed effect panel data model, 
and a panel FGLS estimation method to quantify the possible impact of 
ethanol on regular gasoline in the United States as a whole and in five 
regions of the United States. The models control for gasoline imports, 
refinery capacity, capacity utilization rate, hurricanes, market 
concentration in the refinery industry, stocks, and seasonality.
    Estimation results show that over the period 1995 to 2007, ethanol 
production had a significant negative effect of $0.29 to $0.40 per 
gallon on retail gasoline prices. The results suggest that this 
reduction in gasoline prices came at the expense of refiners' profits. 
These results are statistically significant across a range of model 
specifications and across all regions.
    Results for individual U.S. regions indicate that the largest 
impact of ethanol on gasoline is found in the Midwest region where 
gasoline prices were reduced by 39.5 cents per gallon. The Gulf Coast 
region is found to have experienced a 24.6 cents reduction in the 
retail gasoline price, while for the West Coast and East Coast, the 
average price drop is about 23.3 cents. The smallest impact, a 
17.1 cents reduction, is found in the Rocky Mountain region, mainly 
because of its comparatively low gasoline consumption.
    These reductions in retail gasoline prices are surprisingly large, 
especially when one considers that they are calculated at their mean 
values over the sample period. The availability of ethanol essentially 
increased the ``capacity'' of the U.S. refinery industry and in so 
doing prevented some of the dramatic price increases often associated 
with an industry operating at close to capacity. Because these results 
are based on capacity, it would be wrong to extrapolate the results to 
today's markets. Had we not had ethanol, it seems likely that the crude 
oil refining industry would be slightly larger today than it actually 
is, and in the absence of this additional crude oil refining capacity 
the impact of eliminating ethanol would be extreme. In addition, the 
impact of the first billion gallons of ethanol on this capacity 
constraint would intuitively be greater than the billions of gallons 
that came later. We did try a quadratic term to pick up this effect, 
and it was not significant.
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               TABLE 1.--REGRESSION RESULTS FOR POOLED OLS, THE FIXED EFFECT MODEL, AND THE PANEL FGLS METHOD ON RELATIVE GASOLINE PRICES
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                          Pooled OLS Regression         Fixed effect model with AR(1)           Panel FGLS method
                     Variable                      -----------------------------------------------------------------------------------------------------
                                                        Estimate      Standard error      Estimate      Standard error      Estimate      Standard error
--------------------------------------------------------------------------------------------------------------------------------------------------------
Oil stock.........................................     \1\ 3.88e-6          8.42e-7      \2\ 1.97e-6          9.28e-7      \1\ 5.71e-7          2.19e-7
Gasoline stock....................................    \1\ -5.03e-6          1.11e-6      \1\ 0.000010         2.70e-6      \2\ 1.03e-6          5.24e-7
Refinery capacity.................................    \1\ -0.000099         0.000029    \2\ -0.00038          0.00019     \3\ -0.00040          8.94e-6
Utilization rate..................................        -0.0019           0.0028           0.00095          0.0015           0.00048          0.00041
Ethanol production................................    \1\ -0.000095         3.96e-6     \1\ -0.000069         0.000012    \1\ -0.000082         0.000012
Supply disruption.................................     \1\ 0.32             0.11         \1\ 0.20             0.055        \2\ 0.20             0.099
Gasoline import...................................    \1\ -0.000037         3.89e-6      \1\ 7.37e-6          2.75e-6          6.22e-6          4.78e-6
HHI...............................................     \1\ 0.00028          0.000062        -0.00019          0.00019         -0.000037         0.000025
January...........................................        -0.030            0.054       \2\ -0.047            0.022            0.015            0.035
February..........................................        -0.083            0.054       \2\ -0.058            0.028            0.00061          0.046
March.............................................         0.013            0.055           -0.0079           0.031            0.031            0.053
April.............................................     \2\ 0.12             0.055            0.055            0.035            0.069            0.058
May...............................................     \1\ 0.19             0.056        \2\ 0.089            0.036        \3\ 0.099            0.060
June..............................................     \1\ 0.17             0.055        \1\ 0.10             0.037        \3\ 0.10             0.060
July..............................................     \2\ 0.11             0.055            0.046            0.036            0.020            0.059
August............................................         0.046            0.055            0.029            0.034           -0.0084           0.056
September.........................................        -0.0077           0.054           -0.012            0.031           -0.060            0.052
October...........................................        -0.014            0.054           -0.014            0.026           -0.069            0.046
November..........................................        -0.032            0.053           -0.0063           0.019           -0.05             0.034
Constant..........................................     \1\ 3.12             0.29         \1\ 3.20             0.076        \1\ 2.46             0.12
R \2\.............................................         0.6014    ...............     r = 0.87      ...............  ...............  ...............
Adjusted R \2\....................................         0.5914    ...............    F test                9.42      ...............  ...............
--------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ 1 percent significance.
\2\ 5 percent significance.
\3\ 10 percent significance level.


              TABLE 2.--REGRESSION RESULTS FOR THE POOLED OLS, THE FIXED EFFECT MODEL, AND THE PANEL FGLS METHOD ON THE 3:2:1 CRACK SPREAD
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                          Pooled OLS Regression         Fixed effect model with AR(1)           Panel FGLS method
                     Variable                      -----------------------------------------------------------------------------------------------------
                                                        Estimate      Standard error      Estimate      Standard error      Estimate      Standard error
--------------------------------------------------------------------------------------------------------------------------------------------------------
Oil stock.........................................     \1\ 4.61e-6          9.53e-7      \1\ 7.27e-7          3.19e-7          1.7e-6           1.18e-6
Gasoline stock....................................    \1\ -4.56e-6          1.26e-6          1.13e-6          7.55e-7      \1\ 0.000011         3.48e-6
Refinery capacity.................................    \1\ -0.000015         0.000032    \1\ -0.000063         0.000012    \3\ -0.00039          0.00022
Utilization rate..................................    \1\ -0.015            0.00032         -0.000066         0.00073         -0.00087          0.0019
Ethanol production................................    \1\ -0.000091         4.49e-6     \1\ -0.000073         0.000011    \1\ -0.000077         0.000014
Supply disruption.................................     \1\ 0.32             0.12         \3\ 0.23             0.13         \3\ 0.13             0.071
Gasoline import...................................    \1\ -0.000062         4.41e-6         -3.3e-6           6.0e-6           5.19e-6          3.53e-6
HHI...............................................     \1\ 0.00026          0.000069        -0.000027         0.000036         0.000079         0.00024
January...........................................        -0.058            0.06             0.00099          0.046       \1\ -0.075            0.028
February..........................................        -0.075            0.06             0.022            0.059           -0.036            0.036
March.............................................     \2\ 0.13             0.062        \2\ 0.14             0.067        \2\ 0.095            0.039
April.............................................     \1\ 0.30             0.063        \1\ 0.22             0.072        \1\ 0.18             0.044
May...............................................     \1\ 0.39             0.063        \1\ 0.23             0.07         \1\ 0.19             0.046
June..............................................     \1\ 0.36             0.063        \1\ 0.24             0.074        \1\ 0.20             0.046
July..............................................     \1\ 0.31             0.062        \2\ 0.17             0.073        \1\ 0.15             0.045
August............................................     \1\ 0.28             0.062        \2\ 0.16             0.07         \1\ 0.18             0.043
September.........................................     \1\ 0.23             0.061        \3\ 0.12             0.066        \1\ 0.18             0.039
October...........................................     \1\ 0.19             0.061        \3\ 0.099            0.059        \1\ 0.18             0.034
November..........................................         0.0022           0.060           -0.03             0.044            0.02             0.025
Constant..........................................     \1\ 4.04             0.33         \1\ 2.06             0.13         \1\ 2.53             0.10
R \2\.............................................         0.6196    ...............     r = 0.87      ...............  ...............  ...............
Adjusted R \2\....................................         0.6101    ...............    F test                3.98      ...............  ...............
--------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ 1 percent significance.
\2\ 5 percent significance.
\3\ 10 percent significance level.


                                               TABLE 3.--RESULTS FOR OLS REGRESSION ON RELATIVE GASOLINE PRICE WITH INDIVIDUAL PADD REGIONAL DATA
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                         PADD I                    PADD II                  PADD III                   PADD IV                   PADD V
                                                               ---------------------------------------------------------------------------------------------------------------------------------
                           Variable                                            Standard                  Standard                  Standard                  Standard                  Standard
                                                                  Estimate      error       Estimate      error       Estimate      error       Estimate      error       Estimate      error
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Oil stock.....................................................  \3\ .000025      .000015  \1\ .000012      2.11e-6  \1\ 3.89e-6     9.38e-7     -7.88e-6       .000018     2.84e-6      5.62e-6
Gasoline stock................................................  \1\ .000031     6.48e-6       .000011      8.16e-6  \1\ .000024     7.36e-6   \1\ .00015       .000055      .000029      .000019
Refinery capacity.............................................     0.0048       0.00032       .00054        .00047     -.00012       .00021   \1\ -.0062       .0023    \1\ -.0032       .00074
Utilization rate..............................................     0.0051       0.0046       -.012          .0073   \3\ .010         .0056       -.010         .0086        .0037        .011
Ethanol production............................................  \1\ -.00005      .000014  \1\ -.00009      8.45e-6  \1\ -.00005      .000014  \1\ -.00004      .000020  \1\ -.00005      .000015
                                                                   6                         5                         9                         1                         6
Supply disruption.............................................  \2\ .47          .20          .19           .19     \1\ .54          .20          .23          .26         -.069         .29
Gasoline import...............................................  \1\ -.00004     7.58e-6      -.000012      9.59e-6    -5.07e-6      8.18e-6      -.000013      .000014    -9.37e-6       .000014
                                                                   4
HHI...........................................................  \3\ -.00029     0.00017      -.00029        .00037      .00037      -.0030        .00051       .00053   \1\ .0019        .00046
January.......................................................     -.10          .097        -.047          .10        -.0057        .0084       -.14          .13         -.067         .15
February......................................................     -.11          .098        -.11           .10        -.024         .088        -.17          .13         -.0060        .15
March.........................................................      .0079        .099        -.12           .11        -.006         .079        -.063         .12          .12          .14
April.........................................................      .060         .10         -.013          .10        -.0044        .080         .15          .13          .22          .14
May...........................................................      .023         .11          .11           .11         .019         .080     \3\ .26          .13          .22          .14
June..........................................................      .000052      .10          .17           .11         .0097        .078     \2\ .35          .14          .22          .14
July..........................................................      .018         .10          .065          .10        -.0013        .078     \2\ .33          .15          .16          .14
August........................................................      .072         .10          .093          .10         .017         .079     \2\ .32          .15          .11          .15
September.....................................................     -.037         .10          .053          .098       -.047         .076         .23          .14          .074         .14
October.......................................................      .035         .10         -.012          .099       -.056         .077         .18          .13          .096         .14
November......................................................     -.029         .097        -.025          .096       -.052         .075         .09          .12          .046         .14
Constant......................................................  \1\ 0.17         .67          .31          1.79         .048        1.20      \1\ 5.56        1.49      \1\ 8.87        2.79
R \2\.........................................................      .7109    ...........      .7119    ...........      .8229    ...........      .6610    ...........      .6415    ...........
Adjusted R \2\................................................      .6705    ...........      .6717    ...........      .7981    ...........      .6136    ...........      .5915    ...........
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ 1 percent significance.
\2\ 5 percent significance.
\3\ 10 percent significance level.


                                                  TABLE 4.--RESULTS FOR OLS REGRESSION ON 3:2:1 CRACK SPREAD WITH INDIVIDUAL PADD REGIONAL DATA
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                         PADD I                    PADD II                  PADD III                   PADD IV                   PADD V
                                                               ---------------------------------------------------------------------------------------------------------------------------------
                           Variable                                            Standard                  Standard                  Standard                  Standard                  Standard
                                                                  Estimate      error       Estimate      error       Estimate      error       Estimate      error       Estimate      error
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Oil stock.....................................................      .000012      .000018      .000014      2.3e-6   \1\ 4.9e-6      1.0e-6        .000017      .000019  \3\ .000012     6.2e-6
Gasoline stock................................................  \1\ .000038     7.8e-6    \3\ .000015      8.7e-6   \1\ .000029     7.9e-6    \1\ .000023      .000058      .000025      .000021
Refinery capacity.............................................    -0.000079     0.000038     -.00017        .00050     -.00028       .00023   \1\ -.012        .0025    \1\ -.0029       .000082
Utilization rate..............................................  \2\ -.01         .0055    \1\ -.031         .0078   \3\ -.012        .0063       -.013         .0091       -.0065        .012
Ethanol production............................................  \1\ -.00005      .000017  \1\ -.00009      9.e-6    \2\ -.00003      .000016    -4.2e-6        .000021  \1\ -.00004      .000016
                                                                   1                                                   9                                                   7
Supply disruption.............................................  \2\ .59          .24          .23           .21         .10          .21          .079         .27         -.24          .32
Gasoline import...............................................  \1\ -.00006     9.1e-6    \1\ -.00002       .00001  \2\ -.00001     8.8e-6       -.000023      .000015     -.000019      .000016
                                                                   5                         9                         9
HHI...........................................................     -.00033       .24         -.00042        .00039  \1\ -.0023       .000078      .00033       .00056   \1\ .0016        .00050
January.......................................................     -.098         .12         -.053          .11        -.13          .090        -.19          .13         -.11          .16
February......................................................     -.023         .12         -.098          .11        -.12          .10         -.17          .14         -.025         .16
March.........................................................      .16          .12         -.069          .11         .05          .085         .044         .14          .22          .16
April.........................................................  \3\ .22          .12          .16           .11         .14          .086     \2\ .34          .14      \2\ .41          .16
May...........................................................      .17          .13      \1\ .33           .12     \3\ .16          .086     \1\ .46          .14      \2\ .36          .16
June..........................................................      .11          .12      \1\ .41           .11     \3\ .15          .084     \1\ .59          .15      \2\ .36          .16
July..........................................................      .16          .13      \2\ .28           .11     \3\ .15          .084     \1\ .62          .16      \2\ .36          .16
August........................................................  \2\ .25          .12      \1\ .37           .11     \2\ .21          .085     \1\ .68          .16      \2\ .38          .16
September.....................................................      .14          .12      \1\ .32           .10     \3\ .14          .081     \1\ .63          .15      \2\ .40          .16
October.......................................................      .20          .12      \3\ .18           .10         .065         .083     \1\ .53          .14      \2\ .34          .16
November......................................................      .01          .12          .017          .10        -.053         .081         .21          .13          .068         .15
Constant......................................................  \1\ 2.10         .81      \1\ 3.76         1.91     \1\ 3.52        1.29      \1\ 7.22        1.58      \1\ 8.04        3.07
R \2\.........................................................      .7017    ...........      .7419    ...........      .8299    ...........      .7216    ...........      .6592    ...........
Adjusted R \2\................................................      .6600    ...........      .7058    ...........      .8061    ...........      .6827    ...........      .6116    ...........
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ 1 percent significance.
\2\ 5 percent significance.
\3\ 10 percent significance level.

                                 ______
                                 
                                                     November 2007.
     Analysis of Potential Causes of Consumer Food Price Inflation
              prepared for: the renewable fuels foundation
        prepared by: informa economics, an agra informa company
                          i. executive summary
A. Introduction
    Since fall 2006, public debate has intensified over the extent to 
which the expansion of the ethanol industry has resulted in higher 
agricultural commodity prices and, more importantly, whether and to 
what extent there has been an impact on consumer food prices. To date, 
this debate has been fueled mainly by anecdotal information. Given that 
this issue has bearing on major policy decisions with respect to 
agriculture and renewable energy, it is imperative that an objective, 
fact-based assessment be available to public policymakers. The 
Renewable Fuels Foundation (RFF) commissioned Informa Economics, Inc. 
(Informa) to conduct such an assessment, and the results are contained 
in this report.
B. Key findings
    The ``farm value'' of commodity raw materials used in foods 
accounts for 19 percent of total U.S. food costs, a proportion that has 
declined significantly from 37 percent in 1973. For food products where 
corn is only one of several farm-produced inputs, the proportion of the 
total product cost attributable to the cost of corn is even less than 
19 percent. The remaining portion of total retail food costs is known 
as the marketing bill. The marketing bill includes the costs of labor, 
packaging, transportation, energy, profits, advertising, depreciation, 
rent, interest, repairs, business taxes, and other costs not 
attributable to basic agricultural commodities. The marketing bill has 
a higher correlation with the consumer price index (CPI) for food than 
does corn, although there is a notable long-term upward trend to both 
the marketing bill and the food CPI. Within the overall marketing bill, 
the costs of energy and transportation have increased considerably over 
the last several years, with crude oil prices surging from just under 
$60 per barrel in fall 2006 to nearly $100 per barrel in November 2007, 
the same period during which corn prices have increased.
    An analysis was performed to quantify the historical price 
relationships between corn prices and livestock, poultry, egg, and milk 
prices, and the results showed weak correlations. With these low 
correlations, it is statistically unsupported to suggest that high and/
or rising corn prices are the causative reason behind high and rising 
retail meat, egg, and milk product prices. Moreover, the upward trend 
in cattle, hog, and poultry prices began in the late 1990s, well before 
the corn price began to increase significantly. Notably, dairy and egg 
prices have been driven higher mainly by strong export demand.
    More generally, there has historically been very little 
relationship between corn prices and consumer food prices. Statistical 
relationships are weak even when corn price data are lagged to allow 
time for them to work their way through the food supply chain. The corn 
price would be considered a statistically insignificant variable in 
determining what drives the food CPI.
    To provide context to an analysis of consumer food prices, it is 
useful to consider the role of food expenditures in the average 
American's budget. The proportion of the average American's disposable 
income that is spent on food has declined steadily over the last half-
century, from 21 percent of disposable income in 1950 to below 10 
percent in 2006. Additionally, the share of total food expenditures 
accounted for by at-home food consumption has been declining relative 
to away-from-home consumption. In 1950, 83 percent of total food 
expenditures were for at-home consumption, but by 2006 this share had 
declined to 58 percent.
    Consumer food prices have been increasing at a relatively steady 
pace over the last two decades. The annual increase in the food CPI has 
averaged 2.96 percent since 1985, with food price inflation peaking at 
5.84 percent in 1989 and falling to 1.2 percent in 1992. Since 1992, 
the rate of increase in the food CPI has averaged a slightly lower 2.57 
percent. By comparison, the annualized growth rate during the first 
three-quarters of 2007 has been 3.40 percent. While growth rates in the 
CPI sub-index for food consumed away from home have been slowly 
trending upward since about 1994, the CPI for food consumed at home is 
significantly more volatile and is currently growing more rapidly than 
away-from-home food prices.
    The United States harvested a record corn crop of 11.8 billion 
bushels in 2004, but production fell to 11.1 billion bushels in 2005 
and dropped further to 10.5 billion bushels in 2006. Over the same time 
period, encompassing crop-marketing years 2004-2005 through 2006-2007, 
the usage of corn in ethanol production expanded to 2.1 billion bushels 
from 1.3 billion bushels. Yet, the ethanol industry was not the only 
source of additional demand for corn. U.S. corn exports, which were 1.8 
billion bushels in 2004-2005, rose to 2.1 billion bushels in both 2005-
2006 and 2006-2007--a level that was at the top of the range 
experienced over the previous decade. Thus, the combination of a 
reduction in supply and an increase in demand from both the ethanol 
industry and the export market led to corn prices moving higher 
starting in fall 2006.
    Sub-indices of the food CPI are reported for the major food product 
categories. It was investigated whether the price of corn has a greater 
influence on these sub-indices than the overall food CPI. However, 
similar to the case with the overall food CPI, the relationship with 
the product sub-indices is generally weak.
    Given the weak correlation between corn prices and consumer food 
prices, it can be hypothesized that a considerable proportion of the 
impact of corn price changes is absorbed by participants in the value 
chains for meats, poultry, and other corn-based food products. This 
does not necessarily mean that margins within the value chain are low 
or negative, but rather that they are lower than they would be in the 
absence of higher corn prices.
    In summary, the statistical evidence does not support a conclusion 
that the growth in the ethanol industry is driving consumer food prices 
higher. This is demonstrated by the fact that the R-squared statistic 
between nearby corn futures prices on the Chicago Board of Trade (CBOT) 
and the food CPI is only 0.04, which means that only 4 percent of the 
change in the food CPI is ``explained'' by fluctuations in nearby corn 
futures prices. Even when the corn price is lagged to allow for the 
effects to work their way through the food supply chain, the 
statistical results do not improve. It can be concluded that no single 
factor is the driver of consumer food prices over time--or the 
moderately higher-than-average inflation during the first three 
quarters of 2007--but rather there is a complex and interrelated set of 
factors that contribute to food prices.
                            ii. introduction
    Since fall 2006, public debate has intensified over the extent to 
which the expansion of the ethanol industry has resulted in higher 
agricultural commodity prices and, more importantly, whether and to 
what extent there has been an impact on consumer food prices. To date, 
this debate has been fueled mainly by anecdotal information. Given that 
this issue has bearing on major policy decisions with respect to 
agriculture and renewable energy, it is imperative that an objective, 
fact-based assessment be available to public policymakers. The RFF 
commissioned Informa to conduct such an assessment, and the results are 
contained in this report.
    As a result of the confluence of several factors that are explained 
in Section VIII of this report, corn prices received by farmers 
increased to an average of $3.03 per bushel during the crop-marketing 
year that began in September 2006 and ended in August 2007, which was a 
substantial increase from the $2.09 per bushel that farmers received in 
August 2006, just before the start of the 2006-2007 crop year. 
Similarly, it was considerably higher than the $2.00 per bushel average 
experienced during the 2005-2006 crop year. However, other costs 
incurred in the production and distribution of food products were 
moving higher as well.
    The price of crude oil (West Texas Intermediate) hovered just below 
$60 per barrel in fall 2006, then increased to the $60-$70 per barrel 
range in the spring and early summer of 2007 and further to the $70-$80 
per barrel range in the late summer and early fall of 2007; in November 
2007, the price surged to near $100 per barrel. Additionally, 
transportation costs have been surging in recent years, propelled 
higher partly by increasing fuel prices and partly by capacity 
tightness relative to strengthening demand for transportation services.
    As will be shown in this report, no single factor is the driver of 
consumer food prices over time--or the moderately higher-than-average 
inflation during the first three quarters of 2007--but rather there is 
a complex and interrelated set of factors that contribute to food price 
inflation. In addition to the analysis contained in this report, 
Appendix A provides background on media coverage of the ``food versus 
fuel'' debate and on other studies that have looked into whether 
ethanol industry growth and changes in corn prices are contributing to 
food price inflation.
                        ii. consumer food prices
    Consumer food prices have been increasing at a relatively steady 
pace over the last two decades. Specifically, the annual increase in 
the food CPI has averaged 2.96 percent since 1985, with food price 
inflation peaking at 5.84 percent in 1989 and falling to 1.2 percent in 
1992 (see Figure 1). Since 1992, the rate of increase in the food CPI 
has averaged a slightly lower 2.57 percent. In comparison, the 
annualized growth rate during the first three-quarters of 2007 
(January-September) has been 3.40 percent--a rate of growth that was 
matched only one other time in the last 15 years (in 2004).




    The ``core CPI,'' which excludes food and energy prices, is viewed 
as a more accurate reflection of underlying inflationary pressures in 
the general economy than the overall CPI (at least in the short term), 
since the core CPI excludes food and energy prices, which tend to be 
significantly more volatile from month-to-month than other sectors of 
the economy. Over the 1985-2007 time period, the average annual 
inflation rate of the core CPI has been 3.09 percent, which is very 
close to the 2.96 percent average food CPI growth rate (see Figure 2). 
Whether inflation in the core CPI or the food CPI is higher varies 
almost from year to year.




    If only the period since 1992 is considered, core CPI inflation has 
on average been 0.17 percent below food CPI inflation. Essentially, 
this again indicates food CPI inflation has been similar to the core 
inflation rate over the long run. During this time period, the greatest 
differential between the two CPI inflation rates was in 2004, when food 
CPI inflation was higher than core CPI inflation by 1.69 percent. 
Similarly, from January to September 2007, the food CPI inflation rate 
has been running 1.32 percent above the core CPI inflation rate.
    Not only is the overall CPI composed of major expenditure 
categories such as food and energy, but the food CPI is composed of two 
main sub-indices: food consumed at home and food consumed away from 
home. While growth rates in the away-from-home food CPI have been 
slowly trending upward since about 1994, the at-home food CPI is 
significantly more volatile and is currently growing more rapidly than 
away-from-home food prices (see Figure 3). However, both are currently 
growing at rates exceeding the core CPI.




    Importantly, the USDA's Economic Research Service (ERS) and the 
Bureau of Labor Statistics (BLS) have noted that the at-home food CPI 
statistic likely overestimates actual inflation in prices consumers pay 
for food. This is due in part to the impact of emerging ``big-box 
stores'' (e.g., Wal-Mart and Costco) on the food at-home CPI. Data from 
previous studies have shown that food prices from these ``big-box 
stores'' are, on average, 7 percent to 8 percent lower than those found 
in large supermarket chains. The problem is that such stores might not 
be fully represented in the sample of stores surveyed for price data. 
Furthermore, when a ``big-box store'' acquires a store that is included 
in the surveyed group, the BLS has an aligning procedure which assumes 
that quality-adjusted prices at these stores are equal to the prices at 
the large supermarket chains. In essence, this procedure equates the 
prices of these alternative food retailers. A study by Hausman and 
Leibtag \1\ concluded that this phenomenon confers an upward bias of 
0.32 percent to 0.42 percent in the at-home food CPI.
---------------------------------------------------------------------------
    \1\ Hausman, J. and E. Leibtag. 2004. ``CPI Bias from Supercenters: 
Does the BLS Know that Wal-Mart Exists?'' NBER Working Paper #20712 
(Aug). National Bureau of Economic Research, Cambridge, MA.
---------------------------------------------------------------------------
    The at-home food CPI is further categorized into additional sub-
indices, broken down into product categories with increasing levels of 
specificity. An evaluation of relevant first-level product categories 
further demonstrates which categories are largely responsible for 
changes in the overall food CPI. Among products that have a direct or 
indirect linkage to corn as an input, egg prices have recently been 
exhibiting the strongest inflation, while other livestock, dairy, and 
poultry markets exhibit similar, but much milder, trends (see Figure 
4). In contrast, the CPI for cereals and bakery products has avoided 
the large, volatile swings that have occurred in the egg market. In 
general, the more value added in the manufacture of the product, the 
more consolidated the market, and the more price elastic the demand 
(i.e., costs cannot be passed along to consumers without lowering 
demand), the less volatile end-product prices will be.



             iv. perspective on consumer food expenditures
    In providing context to the food-versus-fuel debate, in addition to 
examining how the CPI has changed over time it is also useful to 
consider the role of food expenditures in the average American's 
budget. To start with, the proportion of the average American's 
disposable income that is spent on food has declined steadily over the 
last half-century. In 1950, approximately 21 percent of disposable 
income was spent on food; by 2006, the share had broken below 10 
percent (see Figure 5).



    Interestingly, the proportion of disposable income spent on food 
away from home has remained relatively stable over time. Away-from-home 
food consumption has remained in the range of 4.0 percent to 4.3 
percent of total disposable income since 1976. Given the increase in 
consumers' disposable income over time, this means that in nominal 
terms the total amount spent on food away-from-home has increased 
substantially. In fact, per capita away-from-home food expenditures 
have increased 44 percent between 2000 and 2006, increasing from an 
average $971 to $1,402.
    Another trend within food expenditures is that the share accounted 
for by at-home food consumption has been declining relative to away-
from-home consumption. Again, this is the share of food expenditures, 
whereas the previous paragraph addressed the share of disposable 
income. In 1950, 83 percent of total food expenditures were for at-home 
food consumption (see Figure 6). By 2006, this share had declined to 58 
percent, and according to the USDA, it is predicted to fall to 51 
percent by 2016.




    Increases in food prices in 2007 have been showing up more in the 
at-home food CPI than the away-from-home food CPI, which is to be 
expected since at-home food prices historically have been more volatile 
than away-from-home food prices (refer back to Figure 3). However, 
given that the at-home food category has been a declining component of 
total food expenditures, and that food expenditures have accounted for 
a declining proportion of consumer incomes, the effect of any increase 
in at-home food prices on the average American's financial condition 
will be considerably muted relative to what it would have been in the 
past.
    In the Center for Agricultural and Rural Development (CARD) study 
referenced in the appendix to this study, long-run general food prices 
were predicted to increase by as much as 1.8 percent above the ``no 
ethanol'' scenario. This was the most extreme scenario of the reviewed 
research publications, as the USDA forecasts long-run food price 
inflation equal to or less than the general inflation rate, the AFBF 
found no short- or long-term relationship, and the consulting firm AES 
only reported inflationary increases for individual products. However, 
even though the inflation rates estimated by AES were only examined for 
individual products, for most product categories the rates were less 
than those estimated by the CARD study. Therefore, it can be said that 
this average retail food price inflation estimation of 1.8 percent 
above the ``no ethanol'' control is the highest inflation rate 
estimation of those referenced.
    What would the scenario of 1.8 percent higher food price inflation 
mean for consumers? In 2006, the average disposable income was $32,114, 
with 9.9 percent of this being spent on food. This would mean that a 
1.8 percent increase in the price food would increase the total annual 
food expenditures of an average household by about $57 a year. With 58 
percent of this being spent on at-home food expenditures, this means 
that the average American household can be expected to spend an extra 
$34 a year on their groceries.
    However, to understand the net impact on consumers' financial 
condition, changes in expenditures on not only food but also fuel would 
have to be considered. Specifically, if more abundant supplies of 
ethanol were to result in a measurable reduction in retail fuel prices, 
this would have to be compared to any food price increase in 
determining the net impact to consumers. The effect of ethanol on 
retail fuel prices is not addressed in this study.
v. relationship between corn prices and other agricultural commodities 
                                 prices
    This section analyzes the relationships among the prices of corn, 
other commodities and consumer food prices. It examines whether there 
is a sufficient relationship between corn prices and other commodity 
and food prices to substantiate whether an increase in corn prices--
regardless of the reason for the increase in corn prices--would cause 
an increase in the prices consumers pay for food.
A. Historical relationships among corn and other commodity prices
            1. Grain and oilseed prices
    Grain and oilseed prices have always been highly volatile. In 
Figure 7, historical monthly nearby futures averages are shown for 
corn, soybeans, and wheat, the three major row crops grown in the 
United States.\2\ Until recently, domestic demand for these commodities 
generally grew at a relatively steady rate, while changes in supply 
(usually due to weather) have been the main determinants of price 
volatility.
---------------------------------------------------------------------------
    \2\ ``Nearby'' futures refer to the futures contract closest to 
expiration. For example, March futures would serve as the nearby corn 
contract during January and February of any given year, since contracts 
are not traded with delivery during those months.




    While these three commodities have only limited substitutability 
for each other, conditions in one market can influence the prices in 
another--often caused by the common denominator of weather. Recent 
increases in corn prices are no exception. While a record corn crop is 
being harvested in the fall of 2007, there is concern that increased 
demand will bring soybean supplies down to low levels by the end of the 
crop year, and weather problems in Australia and other wheat-growing 
nations have caused wheat prices to reach record levels. As a result, 
corn prices have not been able to fall as would have been expected 
given the size of the crop. This section provides a brief overview of 
the complex historical relationships among these three markets.
    The Corn Price.--Over the historical time period extending from 
January 1985 to August 2007, the average nearby corn futures price has 
averaged $2.46/bu. Weather had a substantial impact on corn futures 
prices in the 1988-1989 crop year, when poor crops resulted in high 
prices. (The crop year for corn begins in September, when harvest gears 
up on a large scale, and ends in August of the following calendar 
year.) In 1995-1996 record high corn prices were reached when a drop in 
production coincided with very strong export demand, resulting in 
record corn futures prices as high as $5.00/bu.
    Following record corn production in the 2004-2005 crop year of 11.8 
billion bushels and another crop over 11 billion bushels in 2005-2006, 
corn futures prices declined to $2.23/bu in the 2005-2006 crop year. 
However, driven by a significant decrease in corn acreage harvested in 
2006, corn production fell to 10.5 billion bushels, while corn usage in 
ethanol production increased and exports rebounded strongly to the top 
end of the range experienced during the prior decade; as a result, 
nearby corn futures in 2006-2007 increased to an average $3.56/bu, with 
spring prices approaching the $4.50/bu range.
    A fundamental driver of the price of corn is the level of 
inventories at the end of the crop-marketing year. Ending stocks are 
viewed by the industry as the ``cushion'' or ``buffer'' stocks 
available to incorporate increases in demand or reductions in supply in 
the following crop year. The larger the level of ending stocks, the 
more comfortable the market will be with a given level of demand. In 
particular, the ratio of year-end stocks to total consumption during 
the year is a key price determinant. Corn prices tend to weaken when 
supplies are plentiful relative to usage, whereas they strengthen when 
stocks are drawn down compared to demand. The level of stocks is market 
driven, as the U.S. Government no longer carries large stocks as part 
of its corn support programs.
    Price Relationships Among Corn, Wheat, and Soybeans.--As was shown 
above in Figure 7, a general price relationship exists among these 
three crops. In 1995, the early frost that affected corn production 
also led to spikes in soybean and wheat prices. Just as the corn price 
increases were compounded by strong export demand, the wheat price 
increase was also compounded by other factors. These included low 
stocks that year and world supply issues, as production and export 
subsidies in the United States and EU were curtailed under the Uruguay 
Round of the General Agreement on Tariffs and Trade (now called the 
World Trade Organization, WTO).
    However, a weather problem for one crop does not necessarily always 
mean a supply problem for the other. A prime example of this is the 
drought of 2003, which affected the soybean crop but left the other two 
crops relatively unscathed. While weather plays a key role in 
explaining the relationship between these three commodities, it is not 
the only factor. Each market has its own set of supply and demand 
factors that can either exacerbate the problems in another market or 
help to mitigate potential price increases.
    Higher corn prices can influence wheat prices, but typically the 
reverse has not been true. This is because as corn prices move higher, 
wheat prices will be pulled higher to keep wheat from being used as a 
feed. However, the record wheat prices of 2007 are very much a result 
of supply-side issues. U.S. wheat supplies were reduced by adverse 
weather, including a spring freeze and unseasonably heavy rainfall 
around harvest. To add to the global supply problems, Australia's wheat 
production has fallen significantly due to drought. Eastern Europe, 
Ukraine, and to some extent Canada--all of which are large-scale wheat 
producers--have also been having supply issues.
    In general, the demand bases for wheat and corn are quite different 
since the crops' end-product uses are generally different, with corn 
mainly used as a feed grain and wheat mainly used as a food grain. 
Usually, the global wheat supply has a modest impact on corn exports, 
although for countries where wheat and barley are the primary feed 
grains, a weather problem can necessitate increased usage of other feed 
grains, including imported corn. Although there can be some linkage 
between the wheat and corn markets in such a case, corn futures prices 
are remaining at high levels in fall 2007 in order for corn to 
``compete'' against high-priced soybeans for acres to be planted in 
spring 2008; this competition is mainly with soybeans as opposed to 
wheat, since wheat is typically grown in areas that are not necessarily 
best suited for corn.
    This competition between corn and soybean acres has affected the 
price relationship between these two commodities over the last couple 
of years. In the spring of 2006, futures prices provided a net revenue 
premium to grow soybeans compared to corn, and soybean acres expanded 
at the expense of corn. In 2007, the reverse was true, and corn acreage 
increased substantially. After the 2007 crop was made, the market 
realized that the pace of usage would bring soybean inventories to low 
levels at the end of the 2007-2008 crop year, and if a larger soybean 
crop were not realized next year, the inventory situation would become 
particularly acute by the end of the 2008-2009 crop year. This has led 
to inflation in the corn price over what it would have been had it not 
had to compete with soybean acreage.
    While part of the increase in soybean prices can be attributed to 
the shift of some soybean acres to corn in 2007, it can be argued that 
the price of soybeans would not have gone quite so high had it not been 
for the price of crude oil (petroleum), which has driven soybean oil 
prices higher due to the growth of the biodiesel industry.
            2. Livestock, poultry, egg, and milk prices
    Figure 8 provides a visual indication that there is not a strong 
correlation between corn prices and livestock or poultry prices. It is 
also evident that the upward trend in cattle, hog, and poultry prices 
began in the late 1990s, well before the corn price began to increase 
significantly in 2005-2006.




    Cattle prices have been on an upswing since the mid-to-late 1990s, 
resulting from declining cattle supplies and increasing demand. Cattle 
inventories declined from 103.5 million head in 1996 (January 1 
inventories) to just under 95 million head by 2004, and there has been 
only a modest 2-million-head rebound since then. In conjunction with 
declining cattle inventories was an increase in beef demand that became 
evident in the late 1990s. Consumer preferences began to take a 
detectable turn; the previously held belief that beef was a health 
detriment began to moderate as consumers adopted diets that placed more 
emphasis on protein and less on carbohydrates. These shifts in supply 
and demand have been the main driving forces behind the increasing 
cattle prices, which have been rising at an average annual growth rate 
of about 3.6 percent since 1998. Previous (1985-1998) cattle price 
increases averaged just less than 1 percent.
    In contrast to the strong growth in cattle prices, the growth in 
hog and poultry prices has been more moderate, although there have 
still been increases. Similar to cattle prices, an upward trend in hog 
prices can be detected beginning near the turn of the millennium. In 
recent years, annual productivity gains have continued at trend levels, 
even as industry structure has matured. The breeding herd has held 
relatively steady, at or slightly above 6 million head since 2000, with 
minor deviations from year to year. From the demand side, pork demand 
at the wholesale level has remained stagnant in the United States, 
while export demand has increased dramatically. In general, there 
appears to be very little relation between corn prices and hog prices, 
with the possible exception being in the 1996-1997 crop year when hog 
prices spiked following the large corn price spike in 1995-1996. While 
most of this increase is attributed to constrained supplies of pork 
that year, the large increase in corn prices the previous year 
(exceeding the recent corn price spike in 2006-2007) may have partially 
motivated these supply reductions.
    Poultry prices remained relatively flat across the 1985-1986 to 
1999-2000 time period, averaging $54.50/cwt. Since then, poultry prices 
have been trending upward at an average annual growth rate of 4 percent 
(averaging $67.86/cwt). Such price increases can be largely explained 
by increasing per capita poultry consumption. Further demand increases 
have been seen following the Avian Influenza found within Asia and 
Europe in 2003. Such demand increases, along with tight supplies, 
resulted in the record-high prices recorded during the 2003-2004 crop 
year. Then in 2005-2006, prices dropped back down as exports backed off 
as a result of the record prices.
    Egg prices, on the other hand, have been relatively more responsive 
to corn prices. There are several reasons for this tighter 
relationship. First, while the egg industry supply chain is not as 
concentrated as the broiler industry, it is still relatively integrated 
and consolidated. These larger, integrated operations are able to make 
supply decisions and respond more quickly to changing input prices than 
small, independent laying operations. Second, demand for eggs is 
relatively inelastic, as they are a cheaper source of protein than 
meats or other livestock products and are used in a range of processed 
food products. This enables price changes to be passed on to consumers 
without affecting overall consumption severely.
    Egg values have been extremely high in 2007. With production 
margins extremely poor during 2005 and into 2006, producers cut their 
laying flocks considerably. Consequently, egg production has fallen. 
The total number of eggs produced up to this point in 2007 is about 1.5 
percent fewer than the number of eggs produced during the same time 
period in 2006.
    Along with a diminished U.S. egg supply, export trade of both eggs 
and egg products has risen strongly during 2007 (see Table 1). There 
has been a significant increase in exports of both shell eggs and egg 
products during the first 9 months of 2007 compared to recent years. 
Even though exports of shell eggs still account for less than 2 percent 
of all U.S. egg production, the increase in exports combined with 
diminished egg production was enough to skim necessary supplies from an 
already tight domestic market for eggs and has been a contributing 
factor to higher egg prices in 2007.
    Similarly, inelastic demand for milk leads to a moderately tighter 
relationship between corn and milk prices than with other livestock and 
poultry prices (see Figure 9). That being said, recent milk price 
increases have been driven primarily by substantial increases in world 
dairy product demand and tight world supplies that resulted from major 
droughts in leading milk-producing countries, such as Australia (see 
Figure 10).

               TABLE 1.--U.S. EXPORTS OF SHELL EGGS AND EGG PRODUCTS, JANUARY-SEPTEMBER, 2003-2007
----------------------------------------------------------------------------------------------------------------
                                                                                                      All egg
                                                                                                     products,
                              Year                                  Table eggs      Shell eggs        liquid
                                                                   (1,000 dozen)   (1,000 dozen)    equivalent
                                                                                                    (1,000 lbs)
----------------------------------------------------------------------------------------------------------------
2003 (January-September)........................................          33,523          68,816          70,603
2004 (January-September)........................................          36,123          73,157          61,195
2005 (January-September)........................................          47,216          82,250         110,308
2006 (January-September)........................................          37,838          75,478         114,536
2007 (January-September)........................................          62,170         107,057         125,603
----------------------------------------------------------------------------------------------------------------
Note: Since only January-September data are available for 2007, data for the same time periods in previous years
  are shown for purposes of comparison.



  
  
            Correlation analysis
    An analysis was performed to quantify the historical price 
relationships between corn prices and livestock, poultry, egg, and milk 
prices, and the results showed rather weak correlations. With these low 
correlations, it is statistically unsupported to suggest that high and/
or rising corn prices are the causative reason behind high and rising 
retail meat, egg, and milk product prices.
    Quarterly average nearby corn futures prices were analyzed relative 
to quarterly average nearby cattle and nearby hog prices and quarterly 
cash price averages for broilers, milk, and eggs (January 1985-
September 2007). Direct quarter to quarter correlations were calculated 
as were lagged correlations for one, two, three, and four quarters to 
identify if there was a lagged impact from corn prices on meat, egg, 
and milk prices. The results are presented below.
                Cattle and beef
    In the cattle-and-beef sector, the correlation coefficients were 
weak over short periods of time and even negative over longer periods 
of time, which indicates that there is no discernible strong 
relationship between corn prices and cattle prices (see Table 2). Based 
on this analysis, it can be concluded that high corn costs do not 
automatically result in higher cattle prices, either in the short term 
or over a 12-16 month period. The higher costs of producing beef result 
in a negative impact on cattle feeders' margins, and this ultimately 
would have a negative impact on feeder cattle prices (i.e., the prices 
paid animals entering feedlots). Irrespective of the price of corn, the 
price of fed cattle and beef might be higher or lower, with such prices 
determined by the supply/demand conditions in the beef market.

          TABLE 2.--CORN/CATTLE PRICE CORRELATION COEFFICIENTS
------------------------------------------------------------------------
                                                            Correlation
------------------------------------------------------------------------
Current.................................................           +0.18
One quarter lag.........................................           +0.15
Two quarter lag.........................................           +0.06
Three quarter lag.......................................           -0.06
Four quarter lag........................................           -0.21
------------------------------------------------------------------------

    The cattle and beef industry has a rather complex supply chain, as 
numerous independent entities participate in the production of cattle 
as they progress from the core cow-calf production operation through 
backgrounding activities and then on through commercial cattle-feeding 
activities. In the production process for grain-fed beef, it can take 
anywhere from 16 to 24 months for an animal to move from birth to 
slaughter. Multiple buy/sell transactions occur in this process, as 
young calves are typically sold to operations that put these animals on 
forage programs and then eventually sell the animals to feedlot 
operations that feed out the animals to slaughter weights. The 
complexity of this process has a tendency of disrupting the supply 
response to changing cattle prices and changes in feed costs, which is 
likely reflected in the weak correlations between cattle and corn 
prices.
                Hogs and pork
    Within a single quarter there is virtually no correlation between 
corn prices and hog prices, as measured by nearby futures prices. Given 
the length of the breeding and production process (10-12 months), a lag 
of at least four quarters between high feed costs and any possible 
impact on hog prices would be anticipated. Historically, producers 
endured losses for at least two quarters prior to adjusting breeding 
inventories; if that behavior pattern still holds, there would 
theoretically be a relationship between corn prices lagged five or six 
quarters and hog prices. However, the correlations between corn prices 
and hog prices for all lagged time periods are very weak (see Table 3).

            TABLE 3.--CORN/HOG PRICE CORRELATION COEFFICIENTS
------------------------------------------------------------------------
                                                            Correlation
------------------------------------------------------------------------
Current.................................................           +0.15
One quarter lag.........................................           +0.19
Two quarter lag.........................................           +0.18
Three quarter lag.......................................           +0.17
Four quarter lag........................................           +0.22
Five quarter lag........................................           +0.19
Six quarter lag.........................................           +0.06
Seven quarter lag.......................................           -0.01
------------------------------------------------------------------------

    Even with a four-quarter lag on corn prices, the correlation of 
+0.22 is so weak that it cannot be concluded that higher corn prices 
result in higher hog prices. Once again, if higher corn prices were 
going to have an impact on pork supply and prices, such impacts would 
be expected at least a year from when corn prices rise. However, when 
further lags are considered (five, six, and seven quarters), the 
correlation actually begins to decline.
                Broilers
    In the broiler (chicken) sector, there does appear to be a slightly 
higher degree of linkage between broiler prices and corn prices. Still, 
correlation coefficients below 0.75 (actually, between -0.75 and 0.75) 
are considered tenuous at best, and the highest correlation coefficient 
between corn and the Georgia dock broiler price is only 0.3 (see Table 
4).

          TABLE 4.--CORN/BROILER PRICE CORRELATION COEFFICIENTS
------------------------------------------------------------------------
                                                            Correlation
------------------------------------------------------------------------
Current.................................................           +0.25
One quarter lag.........................................           +0.31
Two quarter lag.........................................           +0.23
Three quarter lag.......................................           +0.12
Four quarter lag........................................           +0.03
------------------------------------------------------------------------

    The coefficient of 0.25 within a single quarter indicates a weak 
relationship between corn and broiler prices. The fact that the 
coefficient with a one-quarter lag is a little higher does suggest that 
there is a very weak price relationship; however, over time the 
correlation coefficients get smaller (weaker), which indicates that 
there is little relationship between the cost of corn and the price of 
broilers.
                Eggs
    While correlations between corn and egg prices were the strongest 
observed for any of the livestock/poultry markets, the correlation 
coefficients would still be considered statistically weak. Again, a 
correlation between -0.75 and 0.75 is generally considered 
statistically insufficient to be used in modeling or predictions (for 
an equation with a single explanatory variable). Within a single 
quarter, or with up to a two-quarter lag in corn prices, the 
correlation coefficient between corn and eggs is gravitates around 0.5 
(see Table 5). When a further lag in corn prices is considered, the 
correlations worsen.

            TABLE 5.--CORN/EGG PRICE CORRELATION COEFFICIENTS
------------------------------------------------------------------------
                                                            Correlation
------------------------------------------------------------------------
Current.................................................           +0.51
One quarter lag.........................................           +0.49
Two quarter lag.........................................           +0.51
Three quarter lag.......................................           +0.39
Four quarter lag........................................           +0.13
------------------------------------------------------------------------

    Egg producers have the capability of adjusting short-term 
production volumes, which in turn can have fairly immediate impacts on 
egg prices. If corn prices were the driver of either ``high'' or 
``low'' egg prices, the correlation coefficients would be substantially 
higher than those found and presented above. It would appear that other 
factors besides corn prices contribute to egg price changes. For 
example, egg-product exports have increased to 126 million pounds 
during the first 9 months of 2007, compared to 115 million pounds 
during the same period in 2006, which has resulted in high egg prices; 
the role of high corn prices appears to have been, at most, a secondary 
contributor.
                Dairy and milk
    Again, there is only a moderate degree of correlation between corn 
prices and milk prices (stronger than the broiler market but weaker 
than the egg market). The correlation coefficients for nearby corn 
futures prices and milk prices are shown in Table 6.

           TABLE 6.--CORN/MILK PRICE CORRELATION COEFFICIENTS
------------------------------------------------------------------------
                                                            Correlation
------------------------------------------------------------------------
Current.................................................           +0.27
One quarter lag.........................................           +0.41
Two quarter lag.........................................           +0.44
Three quarter lag.......................................           +0.31
Four quarter lag........................................           +0.13
------------------------------------------------------------------------

     vi. relationship between corn prices and consumer food prices
A. Historical relationship between corn prices and consumer food prices
    The first question to be asked in determining whether statements 
that higher corn prices are causing higher consumer food prices is: 
Have corn prices shown a strong relationship with consumer food prices 
in the past? In fact, this section shows there has historically been 
very little relationship between corn prices and consumer food prices. 
This is not surprising, given the results of the last section--if 
correlations between corn prices and livestock, poultry, egg, and milk 
prices at the wholesale level are weak, than correlations to further 
processed products at the retail level should be at least as weak.
    Relationships between corn prices and consumer food prices were 
evaluated by running a simple regression of corn prices against food 
CPI index values. Crop year averages since 1985-1986 were utilized. The 
resulting R-squared \3\ value was only 0.04, indicating that variations 
in the corn price ``explain'' only 4 percent of the variations in the 
food CPI index (see Figure 11). Thus, the corn price would be 
considered a statistically insignificant variable in determining what 
drives the food CPI.
---------------------------------------------------------------------------
    \3\ The R-squared value represents the proportion of the total 
variation in the food CPI (the ``y'' variable) that can be explained by 
the corn price (the ``x'' variable).




    In reality, it would be expected that a change in the corn price 
would take time to work its way through the value chain before the food 
CPI is affected, so that the impact might not be instantaneous. 
However, the R-squared values do not improve when quarterly prices are 
used and the corn price is lagged by as many as four quarters (see 
Table 7).

         TABLE 7.--FOOD CPI AS A FUNCTION OF LAGGED CORN PRICES
------------------------------------------------------------------------
                                                             R-squared
               Corn price                   Correlation        value
------------------------------------------------------------------------
Current.................................          0.2010          0.0404
One quarter lag.........................          0.1749          0.0306
Two quarter lag.........................          0.1351          0.0183
Three quarter lag.......................          0.0558          0.0031
Four quarter lag........................         -0.0078          0.0001
------------------------------------------------------------------------

    Given that a general upward trend in the food CPI is prevalent, 
another regression was run using crop-year changes in corn prices 
against the crop-year changes in the food CPI. Again, very little of 
the food CPI inflation rate can be directly explained by year-to-year 
movements in the corn price, as reflected in an R-squared of 0.002 (see 
Figure 12). The corn price variable is statistically insignificant in 
the regression equation.




    While movements in the overall food CPI are not explained well by 
the price of corn, it was investigated whether the price of corn has a 
greater influence on sub-categories within the food CPI. Similar to the 
case with the overall food CPI, the relationship with the product sub-
indices is generally weak, with only eggs having an R-squared over 0.1 
(see Table 8 and Table 9). This is true even if lagged corn prices are 
used.

                TABLE 8.--CORRELATION BETWEEN FOOD CPI SUB-INDICES AND CURRENT/LAGGED CORN PRICES
----------------------------------------------------------------------------------------------------------------
                                                                                        Dairy and    Cereals and
         Corn prices            Beef and      Pork CPI     Poultry CPI    Eggs CPI       related       bakery
                                veal CPI                                              products CPI  products CPI
----------------------------------------------------------------------------------------------------------------
Current.....................        0.1968        0.1701        0.2164        0.4163        0.1413        0.2186
One quarter lag.............        0.1534        0.1830        0.2286        0.0064        0.1435        0.2006
Two quarter lag.............        0.0947        0.1689        0.2078        0.3782        0.1243        0.1660
Three quarter lag...........       -0.0068        0.0939        0.1243        0.2936        0.0491        0.0919
Four quarter lag............       -0.0798        0.0370        0.0427        0.1427       -0.0186        0.0321
----------------------------------------------------------------------------------------------------------------


      TABLE 9.--R-SQUARED VALUES FOR FOOD CPI SUB-INDICES REGRESSED AGAINST CURRENT AND LAGGED CORN PRICES
----------------------------------------------------------------------------------------------------------------
                                                                                        Dairy and    Cereals and
         Corn prices            Beef and      Pork CPI     Poultry CPI    Eggs CPI       related       bakery
                                veal CPI                                              products CPI  products CPI
----------------------------------------------------------------------------------------------------------------
Current.....................        0.0387        0.0289        0.0468        0.1733        0.0200        0.0478
One quarter lag.............        0.0235        0.0335        0.0523  ............        0.0206        0.0402
Two quarter lag.............        0.0090        0.0285        0.0432        0.1431        0.0154        0.0276
Three quarter lag...........  ............        0.0088        0.0155        0.0862        0.0024        0.0084
Four quarter lag............        0.0064        0.0014        0.0018        0.0204        0.0003        0.0010
----------------------------------------------------------------------------------------------------------------

    The value chain for eggs is relatively more consolidated than other 
product value chains, as there are fewer handlers; eggs also generally 
have less value added than other food categories, and their price 
elasticity of demand is highly inelastic. These are all potential 
reasons to explain the slight but notable correlation between the eggs 
CPI and the corn price. Still, this relationship is too weak to be 
statistically significant. Despite the fact that milk is also 
considered to be a highly price-inelastic product, a very weak 
correlation with corn prices (lagged or current) is exhibited.
    Considering that there are trends in some food CPI sub-indices, an 
attempt was again made to determine whether there would be a more 
notable relationship between the annual crop-year percent change in the 
corn price and the annual crop-year percent change in the food CPI sub-
indices. Again, the eggs CPI had the strongest correlation with corn 
prices, but the R-squared value was only 0.30; the corn price variable 
was statistically significant at the 5 percent level (the first 
regression where this was the case), but it still suggests that only 30 
percent of the yearly movements in the eggs CPI can be attributed to 
yearly corn price changes (see Table 10). Other correlation and 
regression results indicate very weak price relationships--in some 
cases negative.

TABLE 10.--RELATIONSHIP BETWEEN ANNUAL CROP-YEAR CHANGES IN FOOD CPI SUB-
                     INDICES AND CORN PRICE CHANGES
------------------------------------------------------------------------
                                            Correlation      R-squared
------------------------------------------------------------------------
Annual crop year percentage change in            -0.1078          0.0116
 meats (beef and pork) CPI..............
Annual crop year percentage change in            -0.0228          0.0005
 beef and veal CPI......................
Annual crop year percentage change in            -0.1901          0.0361
 pork CPI...............................
Annual crop year percentage change in             0.0835          0.0070
 poultry CPI............................
Annual crop year percentage change in             0.5505          0.3031
 eggs CPI...............................
Annual crop year percentage change in             0.2756          0.0760
 cereals and bakery products CPI........
------------------------------------------------------------------------

B. Price spreads among different levels of the value chain
    There are several segments in the value chain between the farm and 
the consumer. For grains and oilseeds, there are grain elevators, bulk 
processors (e.g., flour millers and soybean crushers), further 
processors (e.g., packaged food manufacturers), wholesale distributors, 
and retail grocery and foodservice establishments that take basic 
commodities, transform them and deliver them to the consumer. For 
livestock and poultry, there are slaughterhouses and sometimes separate 
first-stage and further processors that produce in-tray meat cuts/
poultry and packaged food products containing meats/poultry; 
distributors and retailers bring these products to consumers, while 
foodservice establishments prepare the meats/poultry before they are 
served.
    There are various economic factors (supply/demand and costs) and 
industry structure issues that determine the margins at each of these 
value-chain segments and the degree to which they can pass along cost 
increases. The historical price spreads from farm to wholesale and from 
wholesale to retail are shown in Figure 13 to Figure 15.




C. Role of margins as shock absorbers
    Given the weak correlation between corn prices and livestock, 
poultry, egg, and milk prices (at the farm level), it can be 
hypothesized that a considerable proportion of the impact of corn price 
changes is being absorbed in the value chain in the form of reduced 
margins to livestock producers. Importantly, this does not necessarily 
mean margins for livestock producers are low or negative, but rather 
that they are lower than they would be in the absence of higher corn 
prices. This section will look at the historical relationships between 
corn prices and production margins, as well as evaluate the impact of 
recent corn price changes.
            1. Beef cattle
                Cow-calf and cattle-feeding margins
    Calf-crop levels have been declining steadily since about 1996, 
dropping from a level of 40.3 million head to 37.6 million head in 
2007. During this same time period, a string of profitable years has 
been achieved in the cow-calf sector. Such strong profitability has not 
been experienced in the cattle feeding sector, where imputed margins 
have been negative since early 2004 (see Figure 16). This followed 
uncharacteristically high margins in 2003, which resulted mainly from 
the large increase in cattle prices during the last half of that 
year.\4\ In fact, over the long term from January 1985 to August 2007, 
average cattle feeding margins were negative, by an amount of -$15.42/
head. However, this does not necessarily mean that cattle feeders have 
experienced sustained losses over the time period, since there are many 
cost markups associated with feedlot operations that are already 
included in their margin calculations.
---------------------------------------------------------------------------
    \4\ Trade disruptions in the aftermath of the first domestic case 
of BSE in Canadian cattle helped boost United States fed cattle prices 
to record levels in the fall of 2003.




    While total feed costs are undeniably affected by changes in the 
corn price, overall margins are not mirror-reflections of corn price 
changes. For one, there is often a lagged affect. The corn purchased in 
one period does not directly affect the profitability of the feeder 
steers being sold that period, but rather those that are being fed to 
be sold at a later date. Furthermore, cattle feeders anticipating 
higher corn prices will make operational adjustments. They will 
purchase fewer feeder cattle or only buy them at reduced prices; they 
can make ration adjustments to a degree; and/or they can decrease the 
number of days each animal is on feed (reducing total yardage costs and 
perhaps total feed consumption). The latter option is achieved by 
placing heavier-weight feeder cattle into the feedlot, or selling 
fattened cattle at a lower finished weight. There are also many other 
factors, such as beef demand, that affect the sales price of finished 
cattle but have nothing to do with the corn price.
    Another mitigating factor has been the ability of feedlots to 
incorporate distillers grains into their feed rations. For each bushel 
of corn ground to make ethanol, almost one-third of the material ends 
up as distillers grains, and according to industry sources, 
approximately 42 percent of the distillers grains consumed in the 
United States in 2006 were used in beef cattle rations. Distillers 
grains are a high-energy, high-protein feed source that can be used as 
a feed substitute for corn. In fact, many recent feeding trials suggest 
that feeding wet distillers grains with solubles actually increases 
feed efficiency relative to corn.
    Table 11 provides cost and revenue data for the U.S. cattle-feeding 
industry based on a proprietary feedlot production cost model developed 
by Informa. Annual data for calendar years 2004, 2005, and 2006 are 
presented. The key assumptions made are that feeder cattle are 
purchased and enter the feedlot at 750 pounds and are fed to a 
marketing weight of 1,200 pounds live, equivalent to 756 pounds carcass 
weight. The cost per head for feeder cattle entering the feedlot over 
this 3-year timeframe ranged from $774 in 2004 to $841 in 2006, with 
the 2005 cost very similar to 2006.

                                TABLE 11.--INFORMA FEEDLOT PRODUCTION COST MODEL
                                    [Feedlot production cost model ($/head)]
----------------------------------------------------------------------------------------------------------------
                                      Market                           Total      Market
                                     cost on                Total     cost of    value of                Steer
          Marketing year              750 lb   Feed cost   costs in   1,200 lb   1,200 lb  Difference   carcass
                                      feeder               feedlot     feeder     feeder                 weight
                                      steer                            steer      steer
----------------------------------------------------------------------------------------------------------------
2004..............................     774.40     167.92     270.00   1,044.40   1,012.97      -31.43        807
2005..............................     838.98     135.77     247.16   1,086.14   1,054.46      -31.68        816
2006..............................     840.99     150.92     268.72   1,109.71   1,035.62      -74.09        833
                                               1,200 lb liveweight fed steer yields an average carcass weight of
                                                                            756 lbs
----------------------------------------------------------------------------------------------------------------
Source: Informa Economics, Inc.

    Feed costs per head for 450 pounds of gain vary primarily with the 
cost of corn. Feed costs per head were about $168 in 2004, dropped to 
$136 in 2005 as corn prices declined, and then rebounded to about $151/
head in 2006 as corn prices turned higher. Total costs per animal 
during the feeding period are also provided; most changes are directly 
related to the cost of corn. For the 3 years analyzed, the feed cost as 
a percent of total costs ranged from a low of 54.9 percent in 2005 to a 
high of 62.2 percent in 2004.
    For information purposes, a calculation of the total cost of a 
1,200 pound fed steer is provided along with the average market value 
for that same animal. As can be seen, margins for feeding these animals 
were negative in each year under study, with 2004 and 2005 losses 
amounting to just over $31/head while 2006 losses were more than double 
that at an estimated $74/head. Of note is the fact that even with a 
$32/head lower feed cost per head in 2005 relative to 2004, per-head 
production losses were the same in both years which, once again 
reflects the disconnect that exists between the cost of corn and the 
price of cattle.
                Packer margins
    Packers have been experiencing the largest sustained losses of any 
of the beef supply chain participants. This has been a result of excess 
capacity chasing relatively tight supplies. Declining margins in the 
early 1990s forced plant shutdowns, and while margins improved in the 
mid-1990s, they have declined to historically low levels within the 
last 2 years. Figure 17 shows net packer margins since 2002.



            2. Hogs
    The hog industry has a much more integrated production system than 
the cattle industry, and as a result, pork production growth tends to 
be relatively stable, increasing at an average pace of 2 percent 
annually since 2000. Unlike cattle, hogs can not utilize forages, thus 
feed costs tend to account for a relatively large percentage of 
variable input costs.
    Hog production margins remained high but volatile throughout most 
of the 1990s. However, in the late 1990s, producers expanded rapidly at 
the same time as the packing industry was reducing capacity, resulting 
in a huge price collapse in late 1998 and poor production margins for 
the next year. Production margins recovered in 2000 and 2001 only to 
turn negative during much of 2002 and 2003, as per capita pork supplies 
increased to burdensome levels once again (see Figure 18).




    Beginning in late 2003, the U.S. pork industry began to experience 
an unprecedented boom in exports, which helped drive demand for pork 
and propel prices and margins to much higher levels. Since then, hog 
margins have remained mostly in the $20 to $30/head range, peaking 
periodically into the $40/head range and dropping down into the teens 
in early 2006. The run of profitability since 2004 has been the best on 
record. Then, starting in early 2007, as corn prices had begun to 
increase significantly, hog margins took a slight decrease down into 
the $5-$25/head range, as the higher cost of gain offset hog prices, 
which remained favorable up through the summer of 2007. In the fall of 
2007, on large production increases, hog production margins finally 
began to turn negative, ending the longest uninterrupted run of profits 
on record for the industry.
    In Table 12, the total production cost per hog is calculated and 
converted to a total cost per cwt lean; it then is compared to the 
annual average market value per cwt lean to give an indication of 
production margins. The 2004-2006 time period was the best ever in 
terms of profitability for the hog production sector. Given that the 
long-term average margin for producers would fall somewhere in the $7-
$8/cwt lean range, the United States industry headed into 2007 with a 
strong equity and financial condition fully able to withstand potential 
margin pressures arising from higher corn costs.

                                      TABLE 12.--HOG PRODUCTION COST MODEL
                                   [Farrow to finish cost of production model]
----------------------------------------------------------------------------------------------------------------
                                                                      Total    Market
                                                     Feed    Total     cost    value    Margin
                                                   cost $/  cost $/   per $/   per $/  per cwt    Live   Carcass
                                                     head     head     cwt      cwt      lean    weight   weight
                                                                       lean     lean
----------------------------------------------------------------------------------------------------------------
2004.............................................    49.00   114.00    57.41    71.74    14.33   262.00   199.30
2005.............................................    37.00   103.00    51.09    68.28    17.19   264.00   200.70
2006.............................................    40.00   105.00    52.03    64.41    12.38   265.00   201.10
                                                                            Butcher hog fed to 265 pounds
----------------------------------------------------------------------------------------------------------------
Source: Informa Economics, Inc.

            3. Poultry: broilers and eggs
                Broilers
    The broiler industry is a highly integrated and concentrated 
industry with the top 25 production operations accounting for a large 
percentage of industry output. Since the decision making at the 
production level is consolidated into few hands, the broiler industry 
has the capability of making rather quick and meaningful production 
adjustment decisions.
    There appears to be very little correlation between historical 
poultry margins and the price of corn (see Figure 19). In fact, when 
corn prices were at their lowest in early 2006, poultry margins were 
negative, and as corn prices began to take off, poultry margins climbed 
(although they took a brief dip when corn prices peaked in early 2007). 
In early 2003, poultry margins took a swing from negative to positive, 
despite relatively stagnant corn prices. This was a direct result from 
a cutback in production taken after the margin losses in 2002 and 2003. 
This cutback in production along with record high prices in late 2003 
and early 2004 led to record high margins by mid-2004. Then, as exports 
dropped off due to the high poultry prices, margins began to decline. 
Corn prices throughout all of this have had relatively little effect. 
In fact, the record-high margins in mid-2004 directly followed a corn 
price spike in the preceding months.




    As of November 2007, nearby CBOT corn futures were about $4/bushel, 
while soybean meal has been averaging near $220/ton. Based on these 
feed input prices, the feed cost per pound of broiler meat produced has 
risen to 25 cents compared to an average of 20.6 cents in 2006. This 
appreciation in feed costs has raised total production costs to nearly 
56 cents per pound. Even with this advance in feed costs, sales values 
for both whole birds and broiler parts are providing a weighted 
industry return of nearly 14 cents per pound (see Table 13).
    With financial returns of this magnitude, odds favor the industry 
increasing production rather than maintaining the slight reductions 
that started last fall and lasted through the first quarter of 2007. 
The industry did initiate a production rollback in the fall of 2006 due 
to poor margins; the weak margin situation was due to weak product 
prices in combination with rising feed costs. The production declines 
were large enough to raise product prices, and now that sales values 
have recovered so too have margins.

                                           TABLE 13.--BROILER PRODUCTION COSTS AND IMPACT OF HIGHER CORN PRICE
                                                                     [U.S. broilers]
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                                                Weighted
                                                                                                                                                  net
                                                                                                                                                returns
                                                                                                                             Whole    Cutout      (80
                                                                                  Average      Feed      Other     Total    broiler     net     percent
                                                                      Average   eviscerated  cost per  cost per  cost per     net     returns   cutout,
                                                                    liveweight     weight       RTC       RTC       RTC     returns   per RTC      20
                                                                                               pound     pound     pound    per RTC    pound    percent
                                                                                                                             pound               whole
                                                                                                                                               broilers)
                                                                                                                                                per RTC
--------------------------------------------------------------------------------------------------------------------------------------------------------
2004..............................................................       5.27         3.82      22.58     30.84     53.43     21.24     16.45      17.41
2005..............................................................       5.38         3.90      19.52     30.84     50.36     22.46     10.21      12.66
2006..............................................................       5.47         3.96      20.60     30.84     51.45     16.80      0.00       3.36
2007 ($4.00/bu corn)..............................................       5.45         3.95      25.00     30.84     55.85     18.30     12.92      13.99
2007 ($4.50/bu corn)..............................................       5.41         3.92      27.49     30.84     58.33      7.06     -4.05      -1.83
--------------------------------------------------------------------------------------------------------------------------------------------------------

                Eggs
    Table 14 provides estimates of shell egg production costs. The feed 
cost per dozen eggs produced has varied from a low of 23.95 cents per 
dozen in 2005 to a high of 27.54 cents in 2004. Costs in 2006 for the 
feed component of production costs averaged 25.49 cents per dozen. 
Based on shell egg selling prices in the past 3 years, margins have 
been rather variable. In 2004, margins averaged over 18 cents per dozen 
even though feed costs were high, helped by very firm egg prices. Lower 
feed costs in 2005 were accompanied by weak egg prices and margins 
slipped to 5.41 cents before recovering to 10 cents per dozen in 2006. 
As with other livestock sectors, changes in feed costs have not been 
correlated with producer margins.

                                     TABLE 14.--EGG COST OF PRODUCTION MODEL
                                      [Table egg cost of production model]
----------------------------------------------------------------------------------------------------------------
                                                                                                  Urner Barry MW
                                                   Feed cost per  Total cost per    Margin per       shell egg
                                                       dozen           dozen           dozen           price
----------------------------------------------------------------------------------------------------------------
2004............................................          $27.54          $49.80          $18.04          $86.54
2005............................................           23.95           45.72            5.41           68.80
2006............................................           25.49           47.37           10.00           75.44
$4.00 corn......................................           32.61           55.25           20.90           92.71
$4.50 corn......................................           34.75           57.75           18.40           92.71
----------------------------------------------------------------------------------------------------------------

    Despite the highest feed costs in over 10 years, margins for the 
industry are the best in many years due to very strong egg prices. With 
average shell egg prices projected to be near 93 cents per dozen, 
production margins are very strong and this suggests the potential for 
expanding production rather than production declines.
            4. Milk
    Estimated milk production margins have averaged $9.35/cwt over the 
time period from January 2000 to September 2007. Milk margins declined 
in 2002-2003 when corn prices increased, but margins climbed as corn 
prices spiked in 2003-2004 (see Figure 20). Both corn prices and milk 
margins declined during the latter part of 2004 and most of 2005. 
Despite current corn prices taking off, beginning in early 2007, milk 
margins have climbed to record high levels. This suggests that corn 
prices are a very minor determinant of milk production margins and are 
not a primary driver of milk prices.




    Milk margins have been strong the past year largely as a result of 
rising milk prices, which have been driven by demand increases. U.S. 
milk consumption is increasing, and world dairy demand is also 
increasing. This world demand increase follows strong economic growth 
in many developing countries, and it is compounded by the fact that 
many major milk-producing countries, such as Australia, have been 
experiencing drought, thus tightening world milk and dairy supplies. 
Due to this strong global demand, U.S. exports of dairy products have 
increased significantly, and this has supported domestic price 
increases of milk and milk products.
                  vii. drivers of food price inflation
    Given that historical data shows little relationship between corn 
prices and consumer food prices, the question arises: What does drive 
consumer food prices? This section will explore various factors 
affecting consumer food price inflation. In summary, food price 
inflation is caused by a complex set of factors.
A. Summary of usda models of the food CPI
    USDA-ERS periodically forecasts the food CPI, and it is frequently 
asked to evaluate the impact of input price changes. The agency has 
three different models it uses to analyze the food CPI, with the choice 
of model depending on whether or not the objective calls for an 
analysis of short-run or long-run impacts. The ERS price-spread model 
and input-output model are used to analyze short-run impacts, while the 
variable proportions model is used in long-run analyses.
    The price-spread model uses a weighted sum of percent changes in 
input prices from 16 food industries to estimate input price change 
effects on at-home food prices, where each input change is weighted by 
its respective cost share. It is assumed that each firm in each of the 
16 food industries produces a single end-product; accordingly, the 
model combines a farm commodity with a set of non-farm inputs in fixed 
proportions.
    Alternatively, the input-output model, while similar to the price-
spread model, considers the indirect effects of changing input costs. 
For example, an increase in energy will not only affect the cost of 
producing the food item, but it will also impact the costs of producing 
other food production inputs. This model uses a system of equations 
from 50 food industries and 430 nonfood industries. Both of the short-
run models assume that consumers do not respond to retail price changes 
and that food producers do not alter their input proportions.\5\
---------------------------------------------------------------------------
    \5\ This may be a rather strong assumption, especially for certain 
food products in which demand is elastic, there are multiple substitute 
products available to consumers, or for which there are substitute 
products available within the production process.
---------------------------------------------------------------------------
    However, the long-run model, the variable proportions model, 
relaxes these short-run restrictions. This eight-market food model uses 
a system-of-equations approach: (1) the first equation relates the 
industry's retail price to the price of one marketing or non-farm 
input, the exogenous farm supply, and the shift in consumer demand; and 
(2) the second equation relates the industry's farm price with the same 
three variables. Analyses using the variable proportions model have 
shown that changes in input prices do not always lead to food price 
increases. This effect is mitigated by firms altering their input 
proportions and by changing consumer demand.\6\
---------------------------------------------------------------------------
    \6\ Reed, A.J., K. Hanson, H. Elitzak, and G. Schluter. 1997. 
``Changing Consumer Food Prices: A User's Guide to ERS Analyses.'' 
Technical Bulletin #1862. Economic Research Service, Washington, DC.
---------------------------------------------------------------------------
    The ERS lists four key factors as influencing how input cost 
increases affect food prices.\7\ The first is the share of total costs 
accounted for by the input (this is discussed in detail below). The 
second is whether or not the input has adequate substitutes in the 
production process. the third is whether or not consumers have good 
substitutes for the food product. Last is the time period considered. 
In the short run, producers and consumers might not be able to adjust 
to price changes. If the price change is permanent, such adjustments 
can be made, but on the other hand, this might cause some firms to go 
out of business, causing the price increase to be greater in the long 
run.
---------------------------------------------------------------------------
    \7\ Economic Research Service. 2007. ``Food CPI, Prices, and 
Expenditures: How Changes in Input Costs Affect Food Prices.'' 
Retrieved from www.ers.usda.gov/Briefing/CPIFoodAndExpenditures/
howchangesininputcostsaffectf.
---------------------------------------------------------------------------
B. Food marketing costs
            1. Composition of the retail food dollar
    The share of the final food product price accounted for by the cost 
of commodities purchased from producers has declined over the years. 
According to consumer expenditure data collected by the BLS and 
reported by the USDA, the ``farm value'' accounts for 19 percent of 
total food costs. This proportion has declined significantly from 37.2 
percent in 1973 (see Figure 21).
    The remaining portion of total retail food costs (i.e., in addition 
to the farm value) is known as the marketing bill. The marketing bill 
includes labor, packaging, transportation, energy, profits, 
advertising, depreciation, rent, interest, repairs, business taxes, and 
other costs.
    With the decrease in the share of the food dollar accounted for by 
the farm value of raw materials, corn price changes have a declining 
impact on the overall food retail price. Furthermore, within many food 
items, corn constitutes only a portion of the farm value. Thus, in 
items where corn is only one of several farm inputs, total food costs 
attributable to the cost of corn will be on average even less than 19 
percent.
    While 19 percent represents the average share of farm value in the 
retail food dollar, this percentage varies considerably among food 
items. Table 15 provides the most current annual average data available 
for food categories for which the USDA estimates the farm value share 
of the retail food price.\8\
---------------------------------------------------------------------------
    \8\ The most recent annual average data available for cereals and 
bakery products, fats and oils, and dairy were for 2005. Annual 
averages were available for 2006 for meat product data.




    TABLE 15.--FARM VALUE SHARE OF RETAIL FOOD PRICE BY FOOD CATEGORY
------------------------------------------------------------------------
                                                           Farm value as
                  Food product category                    percentage of
                                                           retail price
------------------------------------------------------------------------
Cereals and bakery items................................               6
Beef....................................................              47
Pork....................................................              30
Chicken.................................................              36
Dairy products..........................................              36
Fats and oils...........................................              17
------------------------------------------------------------------------

    The farm value share of the food dollar is provided for specific 
food products rather than categories in Table 16. The product examples 
that were selected for the table either are derived from corn or are 
commodities affected by the corn market (e.g., livestock, poultry, 
wheat, and soybeans). Again, total farm-based input costs are shown, 
not only the cost of corn.

          TABLE 16.--EXAMPLES: COST OF FARM INPUTS AS A SHARE OF PRICES OF SELECT RETAIL FOOD PRODUCTS
----------------------------------------------------------------------------------------------------------------
                                                                                                      Cost of
                                                                    Farm value    Example retail     input(s)
                          Food product                               share of      prices (price  purchased from
                                                                   retail price     per pound)      farm (price
                                                                   (percentage)                     per pound)
----------------------------------------------------------------------------------------------------------------
Milk, \1/2\ gal.................................................              34           $3.84           $1.31
Flour, wheat, 5 lbs.............................................              19            0.36            0.07
Bread, 1 lb.....................................................               5            1.21            0.06
Margarine, 1 lb.................................................              15            1.26            0.19
Corn flakes, 18 oz. box.........................................               4            1.65            0.07
Corn syrup, 16 oz. bottle.......................................               3            1.57            0.05
Ground beef, 1 lb...............................................              47            2.37            1.11
Bacon, sliced...................................................              28            3.78            1.06
Chicken, fresh whole............................................              47            1.14            0.54
----------------------------------------------------------------------------------------------------------------
Sources: USDA, ERS (utilizing most current data available for each food product category, as of October 2007)

             viii. perspective on commodity price inflation
    Although it has been shown in the preceding sections of this report 
that corn price changes have, at most, a weak correlation with changes 
in the food CPI, additional context can be provided to this report by 
examining not only the higher corn prices that have occurred since fall 
2006 but also the environment of general commodity price inflation in 
which this has been occurring.
A. Corn prices
    The ``conventional wisdom'' expressed in the media is that a 
dramatic increase in the use of corn in ethanol production caused corn 
prices to increase substantially, particularly since the fall of 2006. 
However, even the reason for the increase in corn prices is more 
complex than indicated by the media.
    Fueled by a record yield, the United States harvested a record corn 
crop of 11.8 billion bushels in 2004. In 2005, acreage remained steady, 
but a more historically consistent yield led production to fall to 11.1 
billion bushels. Then, in the spring of 2006, price signals in the 
futures markets gave farmers the incentive to plant more soybeans, and 
the acreage planted to corn fell by 3.5 million acres. Combined with 
relatively flat yields, corn production fell for the second year in a 
row, to 10.5 billion bushels.
    Thus, corn production fell by 1.3 billion bushels over 2 years, 
even though the usage of corn in ethanol production expanded from 1.3 
billion bushels in 2004-2005 to 2.1 billion bushels in 2006-2007 (see 
Figure 22). Yet, the ethanol industry was not the only source of 
additional demand. U.S. corn exports, which were 1.8 billion bushels in 
2004-2005, rose to 2.1 billion bushels in both 2005-2006 and 2006-
2007--a level that was at the top of the range experienced over the 
previous decade. So, it was basic supply and demand--a reduction in 
supply and an increase in demand from both ethanol and exports--that 
led to prices moving higher in the fall of 2006.




    Then, in 2007, U.S. farmers proved that they could respond to the 
market's need for more corn. In the 1996 and 2002 Farm bills, producers 
had been relieved of the base-acre and set-aside systems that had 
previously restricted what they could plant, and they now had ``freedom 
to farm''--the ability to allocate their crop acreage as they saw fit, 
with few remaining constraints. With this freedom and corn prices that 
provided a significant net revenue premium per acre over soybeans, 
farmers planted 93.6 million acres of corn in 2007--the highest level 
since the 1940s. As of November 2007, the USDA estimates the crop at a 
record 13.2 billion bushels (see Table 17).
    As was mentioned earlier in this report, the level of corn stocks 
at the end of the crop year relative to the volume of corn consumed 
during the year is a key factor in the pricing of corn. At the end of 
2004-2005, when the previous record crop was harvested, the stocks-to-
use ratio was nearly 20 percent, which is plentiful by recent 
historical standards. However, with lower production and rising ethanol 
usage and exports, the stocks-to-use ratio was cut almost in half, to 
just under 12 percent, in 2006-2007. This was reflected in 
substantially higher prices.
    Despite Informa's projections of an almost 800-million-bushel 
increase in the corn grind for ethanol and an additional 250 million 
bushels of exports, the record crop of 2007 is forecast to allow stocks 
to build to over 2.1 billion bushels by the end of the crop year, 
allowing the stocks-to-use ratio to rebound to 17.1 percent. Normally, 
this would be expected to allow prices to ease significantly. However, 
soybean oil prices have been lifted by rising crude oil (petroleum) 
prices, and as a result the pace of soybean consumption is expected to 
bring stocks to meager levels by the end of the 2007-2008 crop year, 
and if there is not a rebound in soybean acres planted in 2008 stocks 
could reach unsustainably low levels. This has led to upward pressure 
on soybean prices, and in order for corn acreage not to fall too far in 
the face of continued ethanol industry expansion--and likely continued 
strength in exports given weakness in the U.S. Dollar--the market has 
maintained relatively high corn futures prices.
    Based on futures prices as of November 2007, farmers would be 
expected to plant nearly 89 million acres of corn in 2008. If this were 
to occur, Informa's forecast of the stocks-to-use ratio for 2008-2009 
would be 16.5 percent, which is ample but not burdensome. The national 
average farm price for corn, which Informa forecasts to be $3.25/bu in 
2007-2008 would be forecast to fall to $2.85/bu in 2008-2009 under this 
scenario.
    However, absent a very favorable soybean yield in 2008, such a high 
level of corn plantings would likely not allow soybean production to be 
sufficient to prevent stocks from falling to an unsustainable level, 
and prices would have to rise even further to ration demand. 
Accordingly, it is expected that by the spring of 2008 the market will 
anticipate this imbalance, and corn acres will be reduced further, with 
balance perhaps occurring at roughly 86 million acres of corn. In this 
case, even with no change in the demand forecast, the stocks-to-use 
ratio for corn would be forecast to recede to 12.7 percent in 2008-
2009, which would be sufficient and would allow corn prices to come 
down.

                                                           TABLE 17.--U.S. CORN BALANCE SHEET
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                               97/98    98/99    99/00    00/01    01/02    02/03    03/04    04/05    05/06    06/07    07/08    08/09
--------------------------------------------------------------------------------------------------------------------------------------------------------
Planted acres...............................     79.5     80.2     77.4     79.6     75.7     78.9     78.6     80.9     81.8     78.3     93.6     88.9
Harvested acres.............................     72.7     72.6     70.5     72.4     68.8     69.3     70.9     73.6     75.1     70.6     86.1     81.8
Yield.......................................    126.7    134.4    133.8    136.9    138.2    129.3    142.2    160.4    148.0    149.1    153.0    160.0
                                             ===========================================================================================================
Beginning inventories (September 1).........      883    1,308    1,787    1,718    1,899    1,596    1,087      958    2,114    1,967    1,304    2,117
Production..................................    9,207    9,759    9,431    9,915    9,503    8,967   10,089   11,807   11,114   10,535   13,168   13,083
Imports.....................................        9       19       15        7       10       14       14       11        9       12       10       10
                                             -----------------------------------------------------------------------------------------------------------
      Total supply..........................   10,099   11,085   11,232   11,639   11,412   10,578   11,190   12,776   13,237   12,514   14,482   15,209
                                             ===========================================================================================================
Feed and residual...........................    5,479    5,469    5,665    5,842    5,864    5,563    5,795    6,158    6,155    5,598    5,700    5,400
Food/seed/industrial........................    1,805    1,846    1,913    1,957    2,047    2,340    2,537    2,686    2,981    3,488    4,290    5,500
    Of which: ethanol for fuel..............      481      526      566      628      706      996    1,168    1,323    1,603    2,117    2,900    4,100
                                             ===========================================================================================================
    Domestic use............................    7,284    7,316    7,578    7,799    7,911    7,903    8,332    8,844    9,136    9,086    9,990   10,900
Exports.....................................    1,507    1,983    1,937    1,941    1,905    1,588    1,900    1,818    2,134    2,124    2,375    2,150
                                             -----------------------------------------------------------------------------------------------------------
      Total use.............................    8,791    9,298    9,515    9,740    9,815    9,491   10,232   10,662   11,270   11,210   12,365   13,050
                                             ===========================================================================================================
Ending inventories (August 31)..............    1,308    1,787    1,718    1,899    1,596    1,087      958    2,114    1,967    1,304    2,117    2,159
                                             ===========================================================================================================
Stocks/use (percent)........................     14.9     19.2     18.1     19.5     16.3     11.4      9.4     19.8     17.5     11.6     17.1     16.5
                                             ===========================================================================================================
Futures price ($/bu)........................     2.57     2.16     2.10     2.09     2.15     2.37     2.64     2.12     2.23     3.54     3.55     3.25
Farm price ($/bu)...........................     2.43     1.94     1.82     1.85     1.97     2.32     2.42     2.06     2.00     3.03     3.25     2.85
--------------------------------------------------------------------------------------------------------------------------------------------------------
Sources: USDA, CBOT (History); Informa Economics.

    Thus, producers have demonstrated their ability to respond swiftly 
to market conditions in making their acreage decisions. Assuming normal 
weather, this ability and willingness to shift acres is expected to 
mitigate any further inflationary pressures on corn prices through at 
least the 2008-2009 crop year, despite expectations for continued rapid 
growth in the ethanol industry. As a final note, there is evidence that 
the biotech corn traits that were first introduced in the United States 
in 1996 and have been gaining broader adoption in recent years have led 
to the potential for above-trend yields to be achieved; to the extent 
that this occurs or technology developments accelerate, this would 
further mitigate any upward pressure on corn prices.
B. General commodity and macroeconomic inflation
    The increase in corn prices since the fall of 2006 is not occurring 
in a vacuum, and in fact the Reuters/Jeffries CRB index, an index of 
commodity prices, has more than doubled since 2001 (see Figure 23). The 
index is a weighted average of the prices of 19 commodities in three 
categories: energy, agriculture, and metals.




    Crude oil, heating oil, and unleaded gasoline carry one-third of 
the overall weighting of the index. Therefore, it is not surprising 
that the index has been on a prolonged run as crude oil prices have 
surged from around $20/barrel in November 2001 to almost $100/barrel in 
November 2007 (see Figure 24).




    However, the weighting of energy commodities in the index masks the 
fact that the prices of metals and, more recently, agricultural 
commodities have been increasing. There is some interrelation of the 
price increases, as the demand for basic materials that has been 
generated by the strong economic growth in developing countries, 
especially China and India, encompasses not only energy but also 
metals. Higher energy prices have been a contributor to higher 
agricultural commodity prices as well, since they have fostered higher 
prices for ethanol and biodiesel and the expansion of those industries. 
Moreover, the depreciation of the U.S. Dollar, which has been 
particularly acute in the fall of 2007, has affected the prices of 
multiple commodities, making U.S. corn more affordable and thereby 
increasing export demand, and contributing to the rise in oil prices 
(see Figure 25).




    In summary, corn has been one of several commodities that have 
experienced upward price pressure in recent years. Historically, rising 
prices for commodities in general--not corn in isolation--have 
contributed to overall macroeconomic inflation (see Figure 26). This 
was particularly the case during and after the oil price shocks of the 
1970s. However, as the U.S. economy has become more service oriented 
and the manufacturing sector has accounted for a declining share of 
gross domestic product, there has been less of a direct impact of 
higher commodity prices on general inflation. Productivity gains have 
also helped dampen inflation.




                            ix. conclusions
    While there have been a number of stories in the media over the 
last year indicating that consumer food prices are being driven higher 
by an ethanol-induced increase in corn prices, there is little evidence 
of such a simplistic cause-and-effect linkage. In reality, a complex 
set of factors drives the food CPI. In fact, the marketing bill, 
defined as the portion of the food dollar that is not related to the 
farm value of raw materials, has a stronger relationship with the food 
CPI than does the cost of corn. While an increase in corn prices will 
affect certain industries--for example, causing livestock and poultry 
feeding margins to be lower than they otherwise would have been--the 
statistical evidence does not support a conclusion that there is a 
strict ``food-versus-fuel'' tradeoff that is automatically driving 
consumer food prices higher.
         appendix a: background on the ``food vs. fuel'' debate
A. Media coverage
    There has been no shortage of media attention given to the food-
versus-fuel debate since late 2006. Major news sources such as The 
Washington Post, Los Angeles Times, CBS News, U.S. News & World Report, 
and The Wall Street Journal have run stories indicating that rising 
corn demand is causing an increase in consumer food prices. The 
following quotes are representative of stories and editorials that have 
been carried by the media:
  --``Corn prices in America have spiked. And since corn is also a 
        prime ingredient for animal feeds and sweeteners, prices 
        likewise are rising for poultry, beef and everything from soft 
        drinks to candy.'' (The Washington Post; June 30, 2007)
  --``While we worry about gas prices, the cost of milk, meat, and 
        fresh produce silently skyrockets. So like the end of cheap 
        energy, is the era of cheap food also finally over?'' 
        (Washington Times; June 30, 2007)
  --``. . . rising food prices are threatening the ability of aid 
        organizations to help the world's hungriest people . . .'' 
        (Christian Science Monitor, quoted by CBS News; July 29, 2007)
  --``Food prices were up 3.9 percent in April over a year ago. The 
        overall inflation rate in the same period: 2.6 percent. Over 
        the past 5 years, food prices have risen 12.2 percent 
        nationwide. . . . Fuel costs and rising demand for corn are 
        helping to drive the higher prices, experts said. Corn, for 
        instance is in growing demand to make ethanol. Because it's 
        used so much in cattle feed, that's pushing up prices for meat, 
        milk, and eggs.'' (Chicago Sun Times; June 6, 2007)
  --``Ethanol already consumes so much corn that signs of strain on the 
        food supply and prices are rippling across the marketplace.'' 
        (U.S. News & World Report; February 4, 2007)
  --``Further, there's only so much farmland to go around. To meet the 
        Senate's 2022 renewable-fuels mandate of 35 billion gallons 
        using corn would take 96 million acres. Last year, the entire 
        corn crop, most of which went to food, was grown on 80 million 
        acres. The only source of unused farmland is 37 million acres 
        in the Federal Conservation Reserve Program, under which the 
        Government rents cropland from farmers for wetlands and 
        wildlife.'' (L.A. Times; August 20, 2007)
    However, not all mainstream media reports have drawn a simplistic 
link between ethanol production and food prices. Bad weather, 
increasing export demand for certain food products, and high 
transportation costs resulting from rising fuel prices also have been 
cited as being additional drivers of recent food price increases. 
Additionally, the declining cost of corn as a proportion of total food 
prices has been used as a counter-argument, particularly regarding the 
prices of higher value-added products. Recently, the U.S. Department of 
Agriculture (USDA) acting Secretary Chuck Conner was noted as saying, 
``Ethanol fuel is getting too much of the blame for what's happening in 
grocery store aisles'' (Food and Fuel America; October 5, 2007).
    While the statements made in the mainstream media are what reach 
the general public, there is not necessarily much analytic rigor behind 
them. Given all the claims and counter-arguments in the media, and 
given the importance of the policy debate occurring regarding renewable 
fuels, it is useful to look at more in-depth, analytically oriented 
research on whether there is a connection between ethanol production 
and consumer food prices.
B. Research publications
    Despite the considerable amount of attention given to this topic by 
the media, relatively few studies have been conducted to provide 
evidence supporting one side or the other on this issue.
            1. Center for Agricultural and Rural Development
    A study entitled ``Emerging Biofuels: Outlook of Effects on U.S. 
Grain, Oilseed, and Livestock Markets'' (May 2007) was conducted by the 
Center for Agricultural and Rural Development (CARD) at Iowa State 
University. This study utilized a multi-product, multi-country, 
deterministic partial-equilibrium model to evaluate the impacts of 
ethanol production on planted acreage, crop prices, livestock 
production and prices, trade, and retail food costs. The analysis 
assumes current tax credits and trade policies are maintained. 
Essentially, the study authors customized the modeling system of the 
Food and Agricultural Policy Research Institute (FAPRI), which models 
supply and demand for all important temperate-climate agricultural 
products. This model was then utilized to analyze long-run equilibrium 
prices under several ethanol outlook scenarios.
    The CARD study concluded that ethanol expansion will cause long-run 
crop, livestock, and retail food price increases. The study predicted 
that in the long run, general food prices (food at home and food away 
from home) will increase 0.7 percent to 1.8 percent more than they 
otherwise would have.
    There were two basic ethanol scenarios considered. Under the 
baseline oil-price assumption, model results indicate a 0.7 percent 
increase in food prices due to ethanol production. If oil prices were 
$10/barrel higher than the baseline assumption, the ethanol impact on 
food prices increases to 1.8 percent. The highest increases are 
predicted for at-home food prices (0.9 percent-2.2 percent), whereas 
away-from-home food-price increases are slightly more modest (0.6 
percent-1.5 percent).
    The study then deconstructs the predicted increase in prices of 
food consumed at home into more specific food item categories, 
predicting that the greatest inflationary pressure will be evident in 
the eggs market. The range in consumer egg price inflation as a result 
of ethanol production is estimated between 5.4 percent and 13.5 
percent. Additional consumer price inflation is estimated to range 
between 2.5 percent and 6.3 percent for meats, between 1.4 percent and 
3.5 percent for dairy, and 0.5 percent to 1.2 percent for cereal and 
bakery products.
            2. National Corn Growers Association/Advanced Economics 
                    Solutions
    The National Corn Growers Association (NCGA) released a report in 
March 2007 addressing the impact of higher corn prices on consumer food 
prices. They compiled the analyses/reports of the USDA, the Bureau of 
Labor Statistics (BLS), and Advanced Economics Solutions (AES, a 
consulting firm commissioned by the NCGA to analyze the impact of 
increased corn prices on retail food prices). Given USDA estimates of 
food input costs as a percentage of retail food prices and hypothetical 
corn prices of $3.50 to $4.00 per bushel (bu), AES estimated that 
retail prices for meat, poultry, fish, and eggs would be 4 percent to 
11 percent higher than they otherwise would have been during the 2007-
2009 period. As for consumer dairy prices, increases in the range of 
4.3 to 8.3 percent were predicted. The study predicts a much lower 
increase in price inflation levels for cereal/bakery items of 0.67 
percent to 1 percent annually. However, an important assumption behind 
the study is that while food-processing margins might be compressed in 
the short run due to higher corn prices, in the long run all of the 
increase in corn prices will be passed on to consumers.
            3. U.S. Department of Agriculture
    The publication ``USDA Agricultural Projections'' (February 2007), 
which was also incorporated into the NCGA report, projected market 
impacts related to ethanol supply; corn production, prices, and usage; 
other crop production and prices; livestock production and prices 
(including the impact of distiller's grains); and farmland values. The 
study concluded:
  --Consumer price inflation rates for red meats, poultry, and eggs 
        will exceed the general inflation rate between 2008 and 2010, 
        raising the inflation rate of food prices (all food) above the 
        general inflation rate by as much as about 0.5 percent;
  --Despite this initial period of higher food price inflation, on 
        average, retail food prices will increase less than the general 
        inflation rate over the next 10 years (the food-price inflation 
        rate is predicted to fall below the general inflation rate 
        after 2010); and
  --Highly processed foods, such as cereals and bakery products, will 
        rise at a rate near the general inflation rate.\9\
---------------------------------------------------------------------------
    \9\ Since the USDA projections were released in February 2007, some 
of the assumptions are now out of date. For instance, study authors did 
not foresee 93 million acres planted to corn in 2007, or wheat supply 
issues that have caused a spike in wheat prices.
---------------------------------------------------------------------------
            4. American Farm Bureau Federation
    The American Farm Bureau Federation published an article (July 
2007) in which it indicated that while meat and dairy consumer price 
indices (CPI) have increased more than the ``core CPI'' (i.e., the 
average rate of inflation in the general economy, excluding food and 
energy prices), these increases are not related to corn prices. The 
analysis illustrates that recent corn price increases are not related 
to meat and dairy prices (on-farm). The point is made in the article 
that meat prices were increasing long before corn prices started to 
increase. It concludes that with little relationship between corn 
prices and meat and dairy prices, very little of the increase in food 
costs--particularly for meat and dairy products--can statistically be 
attributed to increased corn prices.

    Senator Brownback. The figure that I've seen is that it 
reduces the price 15 percent; the gasoline price in the country 
would be 15 percent higher if not for ethanol. So I think we've 
got to look at this thing as an overarching supply and demand 
situation. While you take corn out of the market to make 
ethanol, it doesn't go in the trash can; it goes in the gas 
tank; and that there's a supply and demand there that has a 
positive impact.
    Plus, I was looking at the prices. In this country we don't 
eat that much corn directly. We do some, but mostly it's fed to 
livestock. So it has an indirect impact on the overall food 
prices in this country. You can escalate corn prices 40 percent 
with having minimal, less than 1 percent, impact on overall 
food prices in the country.
    Do you chart that number or look at that number?
    Mr. Lukken. Yes, we look at all sorts of fundamental 
numbers like that, yes.
    Senator Brownback. I hope you can supply that one to us as 
well.
    Thank you, Mr. Chairman.
    [The information follows:]
    
    

    Senator Durbin. Chairman Lukken, thank you very much. We 
appreciate your testimony today. We look forward to sending you 
some questions in writing, myself and other members of the 
subcommittee, and hope you can give us some timely answers.
    Mr. Lukken. Thank you for allowing me to testify.
    Senator Durbin. You bet.
                   SECURITIES AND EXCHANGE COMMISSION

STATEMENT OF HON. CHRISTOPHER COX, CHAIRMAN
    Senator Durbin. Chairman Cox, welcome to the subcommittee. 
Senator Brownback and I are minimizing our opening statements 
so that we'll have a few more moments to ask questions and not 
take too much of your own time. If you would like to summarize 
your opening statement, the entire written statement will be 
made part of the record.

                           SUMMARY STATEMENT

    Mr. Cox. Thank you very much, Mr. Chairman, Senator 
Brownback, and members of the subcommittee. Thank you for the 
opportunity to testify today about the President's fiscal year 
2009 budget request for the SEC.
    I'll begin by saying that, in return for the SEC's not 
quite $1 billion budget, the taxpaying public is getting 
significant value. The SEC oversees the nearly $44 trillion in 
securities trading annually on U.S. equity markets, the 
disclosures of about 13,000 public companies, and the 
activities of about 11,000 investment advisers, 1,000 fund 
complexes, and 5,700 broker-dealers.
    The Commission is active on a number of fronts working to 
protect investors, promote capital formation, and foster 
healthy markets. The failure of Bear Stearns has brought to the 
fore the regulatory gap in the supervision of investment banks. 
Although Federal law provides for supervision of commercial 
banks, no such scheme exists for the largest investment banks. 
The Commission created the voluntary Consolidated Supervised 
Entities (CSE) Program to partly fill this gap. Without this 
voluntary program, there would have not been any consolidated 
information available to regulators, including the New York 
Fed, when Bear Stearns precipitously lost liquidity in mid-
March 2008.
    While the CSE program is at present voluntary and receives 
no dedicated funding from the Congress, we understand that 
Congress may be acting to fill this gap. I strongly support 
this because of the fact that even today the SEC has no 
explicit statutory mandate to supervise the Nation's investment 
banks on a consolidated basis. It is a statutory no-man's-land 
that should not be tolerated indefinitely.
    For the meantime, I have prepared information for the 
subcommittee concerning the SEC's proposed increases to the 
staffing in the CSE Program that I have submitted along with my 
testimony.
    In addition to the important work of investment bank 
supervision, the Congress recently gave the Commission 
significant new statutory authority over credit rating 
agencies. That has permitted us to register credit rating 
agencies with the SEC beginning last fall. As of the end of 
September 2007, seven credit rating agencies, including those 
that are most active in rating subprime securities, became 
subject to the Commission's new oversight authority.
    In the 6\1/2\ months since the Commission's authority over 
these credit rating agencies went into effect, two additional 
ratings agencies have registered with the Commission, so that 
now there are nine nationally recognized statistical rating 
organizations registered with the SEC and in competition in the 
marketplace.
    We have aggressively used our new examination authority 
under the new law to evaluate whether credit rating agencies 
are adhering to their published methodologies for determining 
ratings and managing conflicts of interest. We will shortly 
publish the findings of these examinations, which have focused 
on the three largest firms most active in rating subprime-
related securities, and we will soon propose significant new 
rules governing credit rating agencies that build on the 
lessons learned from the recent subprime market turmoil.
    Through the SEC's broader inspection and examination 
program, the SEC is focusing on securities firms and the 
adequacy of their controls over valuation, their controls to 
prevent insider trading, the level of protection they provide 
to seniors in our markets, and the adequacy of their compliance 
programs to prevent, detect, and correct violations of the 
securities laws.
    The SEC is also working closely with our fellow regulators 
to promote the fairness and stability of the markets. Under the 
recently concluded MOU with the CFTC to which you just 
referred, Mr. Chairman, and Mr. Chairman Lukken has just talked 
to you about, we have established what we hope will be a 
durable process to better regulate today's increasingly 
interconnected markets.
    To better anticipate future problems across all areas of 
the securities markets, we are more than doubling the size of 
the SEC's Office of Risk Assessment. The newly expanded office 
will help throughout the Commission to look around the corners 
and over the horizon in order to identify potentially dangerous 
practices before they impact large numbers of investors and the 
economy as a whole.
    From both a budget and a policy standpoint, the SEC is 
first and foremost a law enforcement agency. The budget 
submission for fiscal 2009 would represent the largest amount 
of money ever devoted by the agency to pursuing wrongdoers in 
all corners of the securities markets. To lever the 
effectiveness of that investment, we are using new technology, 
including a new agency-wide enforcement database called the 
Hub, along with improved management of resources to focus our 
enforcement efforts on the areas of greatest risk for 
investors.
    The Enforcement Division is aggressively investigating 
possible fraud, market manipulation, and breaches of fiduciary 
duty in the subprime area through our subprime working group. 
It's also pursuing significant investigations of insider 
trading, wrongdoing in the municipal bond market, Internet and 
microcap fraud, and scams against seniors. We've taken 
additional steps to safeguard investors and protect the 
integrity of the markets by redoubling our efforts to stamp out 
abusive naked short selling, including recently proposing a 
rule that would explicitly target naked short selling as fraud.
    The SEC is also building upon its growing success in 
returning funds to harmed investors. Since the agency first 
received authority from Congress under the Sarbanes-Oxley Act 
to use FAIR funds, we have returned a total of more than $3.7 
billion to harmed investors. We expect to distribute another 
three-quarters of $1 billion in the next 6 months alone, aided 
by the establishment of a dedicated Office of Distributions and 
Collections and a new computer tracking system for investor 
funds from penalties and other sources called Phoenix.
    The SEC's efforts in the international arena have by 
necessity been a key focus of my chairmanship. The world's 
regulatory and enforcement authorities are finding that we have 
to collaborate if we are to protect our own investors. 
Accordingly, the SEC is working closely with our international 
counterparts to monitor the markets and pursue fraudsters 
wherever they run.
    We're also exploring the idea of mutual recognition among a 
very few high standards countries with robust regulatory and 
enforcement regimes in order to strengthen our level of 
cooperation.
    In recognition of the interconnectedness of global markets, 
the SEC is continuing to expand our own expertise in 
international financial reporting standards and to explore 
additional ways that U.S. investors might benefit from the 
increased comparability of investments in the marketplace that 
would result from using a truly global high-quality standard.
    This year, after years of experience through the SEC's 
voluntary interactive data pilot program, the Commission will 
consider beginning to migrate public company filing with the 
SEC to interactive data. That would allow investors to have far 
easier access to information from the paper forms and financial 
statements that companies have filed since the 1930s. In 
addition, they would be able to use computers to easily and 
instantly compare information about the companies and funds in 
which they invest.
    There are other investor-friendly improvements in store for 
mutual fund disclosure. In the coming months the SEC will 
consider allowing investors to have access to a summary 
prospectus for mutual funds that would succinctly present key 
facts about their funds up front and, with progressively more 
detailed information available in layers, give them an 
opportunity to exploit the Internet's easy search capabilities.

                           PREPARED STATEMENT

    Mr. Chairman, these are only some of the highlights of what 
the agency has recently been focused on and what we have 
planned for the coming year. The SEC's mandate is as broad as 
it is important to America's investors and to our markets. On 
behalf of the agency, let me thank you for the support that you 
and this subcommittee have so well provided for these vital 
efforts. I want to thank you for this opportunity to discuss 
the SEC's appropriation for fiscal 2009, and I look forward to 
working with you to meet the needs of our Nation's investors. 
I'll be happy to answer your questions.
    [The statement follows:]
                 Prepared Statement of Christopher Cox
    Chairman Durbin, Ranking Member Brownback, and members of the 
subcommittee: Thank you for the opportunity to testify today about the 
President's fiscal year 2009 budget request for the Securities and 
Exchange Commission.
    As you know, until this year the Congress had not increased the 
SEC's budget for 3 years. If the President's budget request for another 
increase next year is approved, then after years of flat budgets, the 
SEC will have received a roughly four percent increase over 2 years. 
After taking inflation and pay increases into account, this budget for 
fiscal year 2009 would permit the SEC to keep staffing on par with 
levels in fiscal year 2007--at about 3,470 full-time equivalents.
    In return for the SEC's not-quite $1 billion budget, the tax-paying 
public gets significant value. The SEC oversees the nearly $44 trillion 
in securities trading annually on U.S. equity markets; the disclosures 
of almost 13,000 public companies; and the activities of about 11,000 
investment advisers, nearly 1,000 fund complexes, and 5,700 broker-
dealers. By way of illustration, let me outline some of what the agency 
achieved during fiscal year 2007.
                       review of fiscal year 2007
    For the SEC's Enforcement Division, which polices the markets and 
helps keep investors' money safe, fiscal year 2007 was truly a notable 
year. The Division's results are impressive both in the number of cases 
filed--the second highest in Commission history--and in their 
substance, covering a range of topics of critical importance to 
investors.
    Among many highlights, the Commission brought one of the most 
significant insider trading cases in 20 years. We filed options 
backdating cases against executives at companies in a range of 
industries, to stamp out that notorious abuse. Even non-investors 
benefited from the Commission's efforts: our anti-spam initiative was 
credited with a 30 percent reduction in the volume of stock market spam 
emails in an independent industry review. In all, the SEC forced 
wrongdoers to give up more than $1 billion in illegal profits and pay 
more than $500 million in financial penalties. In the 17 years since 
the Congress gave the SEC authority to collect penalties against 
companies, this is the fifth highest penalties and disgorgement total 
ever, and $1 billion above the pre-Enron average of the 1990s.
    The SEC also continued to aggressively combat scams targeting the 
retirement savings of America's senior citizens. In fiscal year 2007, 
the Enforcement Division brought 30 enforcement actions involving 
investment fraud, abusive sales practices, and other schemes aimed 
against seniors. In addition, our examination and investor education 
programs joined with other regulators, law enforcement agencies, the 
Financial Industry Regulatory Authority, and others to conduct 
examination sweeps and sponsor events to educate seniors across the 
country.
    The Commission also reached an important new agreement to share 
enforcement and examination information with the Financial Crimes 
Enforcement Network (FINCEN), to assist in the identification, 
deterrence, and interdiction of terrorist financing and money 
laundering. The agreement will help ensure that SEC-regulated firms 
have robust anti-money laundering programs and identify financial 
institutions that are in violation of the Bank Secrecy Act.
    The SEC's examination program also worked to identify compliance 
issues at brokerage firms and investment advisers and correct such 
problems before they could harm investors. In fiscal year 2007, the SEC 
conducted more than 2,400 examinations of investment advisers and 
investment companies, broker-dealers, transfer agents, and self-
regulatory organizations. Overall, 75 percent of investment adviser and 
investment company examinations and almost 82 percent of broker-dealer 
examinations revealed some type of deficiency or control weakness. 
Importantly, most examinations resulted in improvements in the firms' 
compliance programs. Where appropriate, inspection results were 
referred for enforcement action.
    In fiscal year 2007, we also initiated a new program for broker-
dealer chief compliance officers that seeks to help them improve their 
compliance programs, called the CCOutreach BD program. This program has 
been a great success, involving hundreds of participants.
    On the regulatory front, the Commission reformed the implementation 
of Section 404 of the Sarbanes-Oxley Act, to fulfill the congressional 
intent that the law's objectives be achieved without waste and 
inefficiency. These reforms included Commission approval of a new 
auditing standard to ensure that 404 audits are conducted in a more 
cost-effective way, and that they focus on areas that truly matter to 
investors. The Commission also adopted Section 404 guidance for 
management, who previously had to rely on the rules intended for 
auditors. Currently, the staff is undertaking a study to determine 
whether as a result of these reforms Section 404 is in fact being 
implemented in a manner that is efficient and that will be cost-
effective for smaller reporting companies. The study will be completed 
before small companies are required to have their first audit under 
Section 404. In addition, during 2007 the Commission approved a series 
of reforms to help smaller companies gain faster and easier access to 
the financial markets when they need it.
    One of the most significant disclosure initiatives in the 
Commission's history was our new comprehensive disclosure regime for 
executive compensation, which took effect in 2007. These new rules 
require every public company to provide a single number stating total 
compensation for their top officers. For the first time, all forms of 
compensation are in one place for investors to analyze, and companies 
are required to provide plain English statements of their compensation 
policies. The complete and readily accessible information about 
executive pay that this initiative has opened up to investors has 
provided a valuable new insight into corporate governance in the 
Nation's public companies.
    Also in 2007, the SEC broke an 8-year logjam by publishing final 
rules to implement the Gramm-Leach-Bliley Act's bank-broker provisions. 
This will benefit investors who utilize banks as well as brokers to 
help achieve their financial objectives. And we approved the merger of 
the NYSE and NASD's regulatory arms, with the goal of creating a single 
set of rules and eliminating the regulatory gaps between markets that 
often made enforcement difficult.
    The Commission also significantly intensified its contacts with its 
counterparts across the globe. As Chairman, I executed agreements with 
the College of Euronext Regulators, the German Federal Financial 
Supervisory Authority, and the UK's Financial Services Authority and 
Financial Reporting Council, all aimed towards enhancing information-
sharing on enforcement and supervisory matters. The Commission also 
approved the merger of the New York Stock Exchange and Euronext; 
streamlined the deregistration requirements for foreign private 
issuers, removing a significant deterrent to listing on U.S. exchanges; 
and authorized foreign firms to use IFRS as published by the 
International Accounting Standards Board in preparing their disclosures 
in the United States. These important steps have helped facilitate 
cross-border capital formation and helped our market better integrate 
with the rest of the world.
    Administratively, we undertook major reforms to improve the 
effectiveness of the SEC's operations. In 2007, the SEC significantly 
augmented its investor education and advocacy functions. To 
reinvigorate the agency's emphasis on the needs of retail investors, we 
created the Office of Policy and Investor Outreach which will assess 
the views of individual investors and help inform the agency's 
policymaking. The new Office of Investor Education is focused 
exclusively on promoting financial literacy and helping investors gain 
the tools they need to make informed investment decisions.
    In 2007, the SEC took major steps to foster the widespread use of 
interactive data in corporate disclosures. Interactive data will 
empower investors to obtain and compare information about their 
investments far more easily than ever before. This initiative will 
completely remake financial disclosure. Instead of an electronic filing 
cabinet for 1930s-style forms, which was the SEC's EDGAR system, every 
item within an income statement or a balance sheet will be individually 
searchable and downloadable. Investors and the entire marketplace will 
be able to compare any information they choose for thousands of 
companies in an instant. RSS feeds will send the latest SEC filings to 
investors' desktops or handhelds, without their even having to know a 
form was filed.
    Overall in fiscal year 2007, the SEC had one of the most productive 
years in its history, aggressively pursuing wrongdoing and tackling 
fundamental reforms in the securities markets, all on behalf of 
America's investors.
                        fiscal year 2008 to date
    Already in fiscal year 2008, the Commission has been active on a 
number of fronts working to protect investors, promote capital 
formation, and foster healthy markets. And our agenda in the coming 
months is no less ambitious.
Oversight of the Markets
    The failure of Bear Stearns has brought to the fore the regulatory 
gap in the supervision of investment banks. Although Federal law 
provides for supervision of commercial banking by bank regulatory 
agencies, no such scheme exists for the largest investment banks. 
Because the law fails to provide for supervision of even the largest 
globally active firms on a consolidated basis, the Commission created 
the Consolidated Supervised Entities (CSE) program to fill this gap, 
beginning in 2004. Without this voluntary program there would not have 
been any consolidated information available to regulators, including 
the Federal Reserve Bank of New York, when Bear Stearns precipitously 
lost liquidity in mid-March 2008. This program, which is necessary to 
monitor for, and act quickly in response to, any financial or 
operational weaknesses that might place regulated entities or the 
broader financial system at risk, is providing the basis for 
significant new collaboration with the Federal Reserve.
    Building on the new statutory authority from Congress that enabled 
the SEC to register and examine credit rating agencies, as nationally 
recognized statistical rating organizations, beginning in late 
September 2007, the SEC has launched a new program to oversee credit 
rating agencies. This is also a vitally important topic in light of 
recent market events. Under this new authority, the Commission is 
conducting inspections of rating agencies to evaluate whether they are 
adhering to their published methodologies for determining ratings and 
managing conflicts of interest. Given the recent problems in the 
subprime market, the SEC has been particularly interested in whether 
the rating agencies' involvement in bringing mortgage-backed securities 
to market impaired their ability to be impartial in their ratings. We 
will shortly propose additional rules building on the lessons learned 
from the subprime market turmoil. These proposals may include, among 
other things, requiring better disclosure of past ratings, so as to 
facilitate competitive comparisons of rating accuracy; enhancing 
investor understanding of the differences in ratings among different 
types of securities; regulating and limiting conflicts of interest; 
reducing reliance on ratings per se, as opposed to the underlying 
criteria that ratings are thought to represent; and disclosing the role 
of third-party due diligence in assigning ratings. This will continue 
to be an area of emphasis for the Commission in the coming fiscal year.
    Currently neither the CSE nor the credit rating agency programs 
receive dedicated funding from the Congress. We understand that 
Congress may be acting to fill this gap, and I believe such a move 
would help formalize and strengthen these two critical programs. We 
have prepared some information about this proposal that I have 
submitted along with my testimony.
    The SEC is also working closely with our fellow regulators to 
promote the fairness and stability of the markets. Under a recently 
concluded Memorandum of Understanding with the Commodity Futures 
Trading Commission, we have established a durable process to better 
address the regulatory issues that in today's increasingly 
interconnected markets don't respect regulatory boundaries drawn up 
decades ago. The agreement that I signed with Acting Chairman Lukken 
establishes a permanent regulatory liaison between the two agencies, 
provides for enhanced information sharing, and sets forth several key 
principles guiding their consideration of novel financial products that 
may reflect elements of both securities and commodity futures or 
options.
    To anticipate future problems, I announced in February 2008 a 
program to more than double the size of the SEC's Office of Risk 
Assessment, created under the leadership of my predecessor, Chairman 
Bill Donaldson. With additional staff experts and the right 
surveillance tools, the newly expanded Office will help staff 
throughout the Commission look around the corners and over the horizon 
to identify potentially dangerous practices before they impact large 
numbers of investors and the economy as a whole.
Enforcement
    The SEC is continuing to pursue wrongdoers in all corners of the 
securities markets, while also applying enforcement resources to the 
areas that pose the greatest risks to investors.
    The Enforcement Division's subprime working group is aggressively 
investigating possible fraud, market manipulation, and breaches of 
fiduciary duty. Among the issues we are looking at is whether financial 
firms made proper disclosures about their holdings and their 
valuations, whether insiders used non-public information to gain from 
the recent market volatility, and whether naked short sellers illegally 
manipulated the market.
    The Enforcement Division is also investigating insider trading 
among large institutional traders; wrongdoing in the municipal bond 
market; Internet and microcap fraud; and scams against seniors.
    In fiscal year 2008, the SEC is building upon its growing success 
in returning funds to harmed investors. Since the agency first received 
authority under the Sarbanes-Oxley Act of 2002 to use Fair Funds to 
compensate victims, we have returned a total of more than $3.7 billion 
to wronged investors. We expect to distribute another $750 million in 
the next 6 months alone. To further professionalize the agency's 
execution in this area, I have created the Office of Collections and 
Distributions, which is led by a Director who reports to the Executive 
Director and the Chairman. As part of this initiative, the agency has 
deployed a new computer tracking system, called Phoenix, which with 
additional enhancements this year will help to speed the return of 
investors' money and maintain appropriate internal controls.
    Another major productivity enhancement in the Enforcement Division 
is ``The Hub,'' an agency-wide database that gives all enforcement 
staff access to the entire inventory of investigations. By giving line 
staff a window into this deep knowledge base, and permitting senior 
management to direct the resources of the national enforcement program 
quickly and effectively when necessary, The Hub is significantly 
increasing the effectiveness of our enforcement dollars. Additional 
features being rolled out in the coming months will help Division staff 
more readily access performance information, coordinate more 
effectively with our examination staff, and better manage their 
investigative documents throughout the enforcement lifecycle.
International Enforcement and Regulatory Issues
    The SEC's efforts in the international arena, which have markedly 
increased in recent years, have by necessity been a key focus of my 
Chairmanship. The time is long past when the SEC, or any financial 
regulator, can feel safe that by scrutinizing just the activities 
within its national borders, it can comprehend all the potential 
dangers ahead. In a world where capital flows freely across borders, 
problems or issues in one corner of the globe rarely stay there. The 
world's regulatory and enforcement authorities are finding that we have 
to collaborate if we hope to protect our own investors. Accordingly, 
the SEC is working closely with our international counterparts to 
monitor the markets and pursue fraudsters wherever they may run. We are 
also exploring the idea of mutual recognition among a very few high-
standards countries with robust regulatory and enforcement regimes.
    In recognition of the interconnectedness of global markets, the SEC 
will continue to expand our own expertise in IFRS, and explore 
additional ways that U.S. investors might benefit from increased 
comparability using a high-quality international standard. The 
continued integration of our own domestic accounting standards and IFRS 
will enhance the quality of both, while improving the reliability, 
clarity, and comparability of financial disclosure for American 
investors.
Disclosure
    The SEC is committed to making public company disclosure more 
useful to investors. Under the leadership of the Office of Interactive 
Disclosure, the SEC is building upon our recent successes in 
constructing a foundation for the widespread use of interactive data. 
After years of experience through the SEC's voluntary pilot program, 
the Commission will consider a rule in 2008 that requires the use of 
interactive data by reporting companies, as well as other proposals to 
expand interactive data reporting by mutual funds and other market 
participants. These efforts will be aimed at giving investors the 
ability to easily find and compare key data about the companies and 
funds in which they invest.
    There are other investor-friendly improvements in store for mutual 
fund disclosure. Too many investors today throw away their mutual fund 
disclosures instead of reading them. Too often, the prospectuses are 
laden with legalese that makes them nearly impenetrable for the average 
person. In the coming months, the SEC will consider authorizing mutual 
funds to issue a summary prospectus that will be more user-friendly for 
investors. If adopted, the summary document would succinctly present 
key facts about the fund up front, with more detailed information 
available for investors on the Internet or in paper upon request. The 
agency also is preparing help for investors at the time they buy a 
mutual fund to learn about fees, expenses, and conflicts of interest.
    Another important initiative relates to the $2.5 trillion worth of 
municipal securities currently outstanding, about two-thirds of which 
is owned either directly or indirectly by retail investors. Despite its 
size and importance, this market has many fewer protections for 
investors than exist in the corporate market. For example, investors 
often find it difficult even to get their hands on the disclosure 
documents for the municipal securities they own. To address this 
shortcoming, the Commission is working to authorize the creation of an 
online computer database, which would give investors in municipal 
securities electronic access to disclosures filed in connection with 
their investments. I have also urged our authorizing committees in the 
House and in the Senate to update the SEC's authority in this area.
Investor Protection
    The Commission has very recently taken additional steps to 
safeguard investors and protect the integrity of the markets during 
short selling transactions by proposing a rule that would specify that 
abusive ``naked'' short selling is a fraud. In a naked short sale, the 
seller does not borrow or arrange to borrow the securities in time to 
make delivery to the buyer within the standard 3-day settlement period 
for trades. As a result, the seller fails to deliver stock to the buyer 
when delivery is due. This is known as a ``failure to deliver.'' When 
sellers intentionally fail to deliver securities to the buyer as part 
of a scheme to manipulate the price of a security, or possibly to avoid 
borrowing costs associated with short sales, they should be subject to 
enforcement action by the Commission for violation of the securities 
laws.
    The Commission is also working to protect Americans' pension fund 
investments. In March 2008, the Commission issued a special report 
reminding public pension funds of their responsibilities under the 
Federal securities laws, and warning them that they assume a greater 
risk of running afoul of anti-fraud and other provisions if they do not 
have adequate compliance policies and procedures in place to prevent 
wrongdoing in their money management functions.
    To protect investor privacy and to help prevent and address 
security breaches at the financial institutions the SEC regulates, the 
Commission proposed new rules that provide more detailed standards for 
information security programs. The proposed rules provide more specific 
requirements for safeguarding information and responding to information 
security breaches. The Commission also extended these privacy 
protections to other entities registered with the Commission.
    The Commission has also proposed an expedited process to speed up 
the availability to the investing public of exchange-traded funds 
(ETFs). ETFs are similar to traditional mutual funds, but issue shares 
that trade throughout the day on securities exchanges. The proposed 
rules would eliminate a barrier to entry for new participants in this 
fast-growing market, while preserving investor protections. The 
Commission also proposed enhanced disclosure for ETF investors who 
purchase shares in the secondary markets.
    Mr. Chairman, these are only some of the highlights of what the 
agency has recently been focused on, and what we have planned for the 
coming year. The SEC's mandate is as broad as it is important to 
America's investors and our markets. On behalf of the agency, let me 
thank you for the support that you and this Committee have so well 
provided for these vital efforts.
                               conclusion
    The budget request for fiscal year 2009 will allow the SEC to 
continue to aggressively pursue each of these ongoing initiatives on 
behalf of investors, as well as to address new risk areas as they 
emerge. As I mentioned, the request will allow the SEC to fully 
maintain our current program of strong enforcement, examinations and 
inspections, disclosure review, and regulation.
    The request also will cover merit raises for SEC staff, as the 
agency transitions to a new performance evaluation system. This new 
five-level rating system has been developed in conjunction with the 
National Treasury Employees' Union to provide more individualized 
feedback to staff, based on clear performance criteria. The system has 
been piloted in our Office of Human Resources, and will next be 
extended to the agency's senior managers. The rest of the agency's 
employees are scheduled to transition into the program next year.
    I want to thank you for this opportunity to discuss the SEC's 
appropriation for fiscal year 2009. I look forward to working with you 
to meet the needs of our Nation's investors, and I would be happy to 
answer any questions you may have.

                            STAFFING LEVELS

    Senator Durbin. Thank you very much, Chairman Cox.
    Let me try to reconcile budget request with some of the 
policy statements you've made. If I understand the President's 
budget request for 2009, it calls for 3,409 permanent staff at 
the SEC, which would be a reduction anywhere between 94 and 100 
employees, and over the last 3 or 4 years you've had about an 
11 percent reduction in your enforcement activities. Does that 
sound about right?
    Mr. Cox. All the way up to the 11 percent reduction in 
enforcement activities. We have within our overall budget, 
which is----
    Senator Durbin. Staffing reduction. I'm sorry, staffing 
reduction of 11 percent since 2005.
    Mr. Cox. Yes, we have had budget freezes, as you know, from 
Congress through continuing resolutions in 2006 and 2007. So 
holding at the same dollar figure for two fiscal years in a 
row, combined with the fact that we have a built-in ratchet of 
about 5 percent just standing steady because of cost-of-living 
allowances, merit pay, and promotions within the agency and an 
historically low turnover rate, means that, with two-thirds of 
the total budget going to personnel, it is impossible to 
maintain even the same staffing numbers year to year at higher 
dollar levels.
    But what we have done within the overall budget number is 
to prioritize enforcement and also the Division of Trading and 
Markets and its market supervisory responsibilities, so that in 
the last fiscal year we have brought the second highest number 
of enforcement actions in the agency's 74-year history. 
Likewise, we have the highest number of respondents in actions 
in years by quite a wide margin.

                     OVERSIGHT OF INVESTMENT BANKS

    Senator Durbin. So I want to applaud your efficiencies and 
what you have achieved. But if you continue to reduce the 
number of staff that are working in some of these sections, 
some of these divisions within the SEC, it clearly would have 
an impact on your future activity. One of the things that you 
raise is something that I'm concerned about. You mentioned the 
Bear Stearns situation, in which the head of the Federal 
Reserve as well as the Secretary of the Treasury decided to 
step in and to help Bear Stearns through a rough patch.
    Without judging the wisdom of that decision, and I think it 
was necessary personally, it seems to have opened up a new area 
of concern and responsibility. You talked about the gap in 
enforcement for investment banks. I don't know what the most 
current figure is, but I heard at one time that we have opened 
our discount window to the tune of about $200 billion in 
borrowing by these investment banks.
    The obvious question is, the entities that are borrowing 
the money now from the Federal taxpayers through the discount 
window, what kind of oversight and supervision we have of these 
entities. I think what I heard in your opening statement is the 
suggestion that the SEC may play a role in that or could or 
should play a role in that.
    Reconcile these two things--reducing the number of staffers 
in your budget and expanding your responsibilities to include 
investment banks to make sure that at the end of the day the 
taxpayers of America don't end up holding the bag as investment 
banks use the discount window.
    Mr. Cox. Well, Mr. Chairman, you're absolutely right about 
the importance of that function of overseeing and supervising 
investment banks. In addition, I would add to that, the SEC 
also has been given very recently a significant new function 
related to subprime issues and that is oversight and regulatory 
authority over credit rating agencies. Both of these functions 
are prioritized within the SEC's budget, but something has to 
give. It has to come from some place.
    So, if the SEC's budget were to be frozen on a continued 
basis, we would run out of potential savings. The largest area 
of potential savings I have been able to find thus far is the 
agency's historical function of maintaining a filing and 
information service that was essentially related to the 1930s-
era idea of having paper forms. We had people walk into the SEC 
and inspect documents. With the Internet we didn't need that 
any longer, and so we were able to free up about 100 positions 
within the agency and put those slots to better use.
    But the opportunity to find efficiencies like that is a 
very steep declining curve.
    Senator Durbin. Historically, the SEC has relied on fees 
and collections to defer their costs of operation to some 
extent; is that not the case?
    Mr. Cox. Well, it is partly true, but in a way that 
concerns me some days, not entirely true, because, while we do 
collect a good deal in the way of fees, all of our funds are 
appropriated.
    Senator Durbin. All of your funds----
    Mr. Cox. We cannot live off of the fees we collect.

                        IMPOSITION OF USER FEES

    Senator Durbin. I understand that part. But what I'm 
driving at is, I'm trying to reconcile the earlier question: 
Where will you find some future SEC Chairman, where will they 
find the resources to now keep a close eye on investment banks 
using the discount window, borrowing from American taxpayers? 
It seems that there should be, and it may not exist today, some 
fee collection that would fund that Government responsibility. 
Has that been proposed by the administration or anyone to your 
knowledge?
    Mr. Cox. Well, indeed, were this subcommittee willing to do 
so, taking the existing stream of fees that the SEC already 
collects and dedicating it to SEC operations would provide a 
good deal of consistency to the budget.
    Senator Durbin. But those fees are not collected from 
investment banks currently, are they?
    Mr. Cox. No, they are not, and we could, I suppose--I 
should say, Congress could--fashion a new kind of fee. But in 
any case, the difference between the fees that the SEC's 
responsible for collecting and our appropriation is already 
significant. There's a big delta there.
    Senator Durbin. But it would seem, in fairness, that if 
this branch of our economy is going to be reviewed, there's 
oversight, that the cost of that oversight shouldn't be borne 
by another sector of the economy, collection of fees from some 
other entity. That doesn't seem to track. At least, I don't 
know in this detail, but it would seem that collecting a fee 
from the supervised entity is more reasonable.
    Mr. Cox. Well, I think at least in the SEC's experience we 
have subsisted entirely on the basis of appropriated funds, and 
so there has been no effort with respect to any of the agency's 
programs to match some form of fee collection with our 
function.
    Senator Durbin. Thank you.
    Senator Brownback.
    Senator Brownback. Thank you very much, Mr. Chairman.

                        SUBPRIME MORTGAGE CRISIS

    Welcome, Chairman Cox. I want to look at what led up to the 
subprime debacle that we've had. You can go back after these 
crises are over and look at how did all this occur and you hope 
to learn lessons from that.
    I went and met with my realtors in Kansas and different 
bankers and they said: Oh, yeah, yeah, we knew this was going 
on; we weren't making any of the loans, but people were out 
trolling and originating subprime mortgages to people we had 
never lent to. I even had one banker say to me: Yes, I 
originated one of the loans that I would never have made, but 
then put it into the pool for the subprime fund. And I thought, 
well, at least he admitted it, I guess, but he would never have 
made it, but it got into then the securitized overall fund.
    I want to enter into the record, Mr. Chairman, an article 
in the New York Times magazine from April 27, 1996, Thomas 
Friedman, a New York Times columnist, remarked in the ``News 
Hour with Jim Lehrer'' that: ``There are two superpowers in the 
world, the United States and Moody's bond rating service, and 
it is sometimes unclear which is more powerful.''
    [The information follows:]

               [From The New York Times, April 27, 2008]

                            Triple-A Failure
                         (By Roger Lowenstein)
The Ratings Game
    In 1996, Thomas Friedman, the New York Times columnist, Thomas 
Friedman, the New York Times columnist, remarked on ``The NewsHour With 
Jim Lehrer'' that there were two superpowers in the world--the United 
States and Moody's bond-rating service--and it was sometimes unclear 
which was more powerful. Moody's was then a private company that rated 
corporate bonds, but it was, already, spreading its wings into the 
exotic business of rating securities backed by pools of residential 
mortgages.
    Obscure and dry-seeming as it was, this business offered a certain 
magic. The magic consisted of turning risky mortgages into investments 
that would be suitable for investors who would know nothing about the 
underlying loans. To get why this is impressive, you have to think 
about all that determines whether a mortgage is safe. Who owns the 
property? What is his or her income? Bundle hundreds of mortgages into 
a single security and the questions multiply; no investor could begin 
to answer them. But suppose the security had a rating. If it were rated 
triple-A by a firm like Moody's, then the investor could forget about 
the underlying mortgages. He wouldn't need to know what properties were 
in the pool, only that the pool was triple-A--it was just as safe, in 
theory, as other triple-A securities.
    Over the last decade, Moody's and its two principal competitors, 
Standard & Poor's and Fitch, played this game to perfection--putting 
what amounted to gold seals on mortgage securities that investors swept 
up with increasing elan. For the rating agencies, this business was 
extremely lucrative. Their profits surged, Moody's in particular: it 
went public, saw its stock increase sixfold and its earnings grow by 
900 percent.
    By providing the mortgage industry with an entree to Wall Street, 
the agencies also transformed what had been among the sleepiest corners 
of finance. No longer did mortgage banks have to wait 10 or 20 or 30 
years to get their money back from homeowners. Now they sold their 
loans into securitized pools and--their capital thus replenished--wrote 
new loans at a much quicker pace.
    Mortgage volume surged; in 2006, it topped $2.5 trillion. Also, 
many more mortgages were issued to risky subprime borrowers. Almost all 
of those subprime loans ended up in securitized pools; indeed, the 
reason banks were willing to issue so many risky loans is that they 
could fob them off on Wall Street.
    But who was evaluating these securities? Who was passing judgment 
on the quality of the mortgages, on the equity behind them and on 
myriad other investment considerations? Certainly not the investors. 
They relied on a credit rating.
    Thus the agencies became the de facto watchdog over the mortgage 
industry. In a practical sense, it was Moody's and Standard & Poor's 
that set the credit standards that determined which loans Wall Street 
could repackage and, ultimately, which borrowers would qualify. 
Effectively, they did the job that was expected of banks and government 
regulators. And today, they are a central culprit in the mortgage bust, 
in which the total loss has been projected at $250 billion and possibly 
much more.
    In the wake of the housing collapse, Congress is exploring why the 
industry failed and whether it should be revamped (hearings in the 
Senate Banking Committee were expected to begin April 22). Two key 
questions are whether the credit agencies--which benefit from a unique 
series of government charters--enjoy too much official protection and 
whether their judgment was tainted. Presumably to forestall criticism 
and possible legislation, Moody's and S.&P. have announced reforms. But 
they reject the notion that they should have been more vigilant. 
Instead, they lay the blame on the mortgage holders who turned out to 
be deadbeats, many of whom lied to obtain their loans.
    Arthur Levitt, the former chairman of the Securities and Exchange 
Commission, charges that ``the credit-rating agencies suffer from a 
conflict of interest--perceived and apparent--that may have distorted 
their judgment, especially when it came to complex structured financial 
products.'' Frank Partnoy, a professor at the University of San Diego 
School of Law who has written extensively about the credit-rating 
industry, says that the conflict is a serious problem. Thanks to the 
industry's close relationship with the banks whose securities it rates, 
Partnoy says, the agencies have behaved less like gatekeepers than gate 
openers. Last year, Moody's had to downgrade more than 5,000 mortgage 
securities--a tacit acknowledgment that the mortgage bubble was abetted 
by its overly generous ratings. Mortgage securities rated by Standard & 
Poor's and Fitch have suffered a similar wave of downgrades.
Presto! How 2,393 Subprime Loans Become a High-Grade Investment
    The business of assigning a rating to a mortgage security is a 
complicated affair, and Moody's recently was willing to walk me through 
an actual mortgage-backed security step by step. I was led down a 
carpeted hallway to a well-appointed conference room to meet with three 
specialists in mortgage-backed paper. Moody's was fair-minded in 
choosing an example; the case they showed me, which they masked with 
the name ``Subprime XYZ,'' was a pool of 2,393 mortgages with a total 
face value of $430 million.
    Subprime XYZ typified the exuberance of the age. All the mortgages 
in the pool were subprime--that is, they had been extended to borrowers 
with checkered credit histories. In an earlier era, such people would 
have been restricted from borrowing more than 75 percent or so of the 
value of their homes, but during the great bubble, no such limits 
applied.
    Moody's did not have access to the individual loan files, much less 
did it communicate with the borrowers or try to verify the information 
they provided in their loan applications. ``We aren't loan officers,'' 
Claire Robinson, a 20-year veteran who is in charge of asset-backed 
finance for Moody's, told me. ``Our expertise is as statisticians on an 
aggregate basis. We want to know, of 1,000 individuals, based on 
historical performance, what percent will pay their loans?''
    The loans in Subprime XYZ were issued in early spring 2006--what 
would turn out to be the peak of the boom. They were originated by a 
West Coast company that Moody's identified as a ``nonbank lender.'' 
Traditionally, people have gotten their mortgages from banks, but in 
recent years, new types of lenders peddling sexier products grabbed an 
increasing share of the market. This particular lender took the loans 
it made to a New York investment bank; the bank designed an investment 
vehicle and brought the package to Moody's.
    Moody's assigned an analyst to evaluate the package, subject to 
review by a committee. The investment bank provided an enormous 
spreadsheet chock with data on the borrowers' credit histories and much 
else that might, at very least, have given Moody's pause. Three-
quarters of the borrowers had adjustable-rate mortgages, or ARMs--
``teaser'' loans on which the interest rate could be raised in short 
order. Since subprime borrowers cannot afford higher rates, they would 
need to refinance soon. This is a classic sign of a bubble--lending on 
the belief, or the hope, that new money will bail out the old.
    Moody's learned that almost half of these borrowers--43 percent--
did not provide written verification of their incomes. The data also 
showed that 12 percent of the mortgages were for properties in Southern 
California, including a half-percent in a single ZIP code, in 
Riverside. That suggested a risky degree of concentration.
    On the plus side, Moody's noted, 94 percent of those borrowers with 
adjustable-rate loans said their mortgages were for primary residences. 
``That was a comfort feeling,'' Robinson said. Historically, people 
have been slow to abandon their primary homes. When you get into a 
crunch, she added, ``You'll give up your ski chalet first.''
    Another factor giving Moody's comfort was that all of the ARM loans 
in the pool were first mortgages (as distinct from, say, home-equity 
loans). Nearly half of the borrowers, however, took out a simultaneous 
second loan. Most often, their two loans added up to all of their 
property's presumed resale value, which meant the borrowers had not a 
cent of equity.
    In the frenetic, deal-happy climate of 2006, the Moody's analyst 
had only a single day to process the credit data from the bank. The 
analyst wasn't evaluating the mortgages but, rather, the bonds issued 
by the investment vehicle created to house them. A so-called special-
purpose vehicle--a ghost corporation with no people or furniture and no 
assets either until the deal was struck--would purchase the mortgages. 
Thereafter, monthly payments from the homeowners would go to the S.P.V. 
The S.P.V. would finance itself by selling bonds. The question for 
Moody's was whether the inflow of mortgage checks would cover the 
outgoing payments to bondholders. From the investment bank's point of 
view, the key to the deal was obtaining a triple-A rating--without 
which the deal wouldn't be profitable. That a vehicle backed by 
subprime mortgages could borrow at triple-A rates seems like a trick of 
finance. ``People say, `How can you create triple-A out of B-rated 
paper?' '' notes Arturo Cifuentes, a former Moody's credit analyst who 
now designs credit instruments. It may seem like a scam, but it's not.
    The secret sauce is that the S.P.V. would float 12 classes of 
bonds, from triple-A to a lowly Ba1. The highest-rated bonds would have 
first priority on the cash received from mortgage holders until they 
were fully paid, then the next tier of bonds, then the next and so on. 
The bonds at the bottom of the pile got the highest interest rate, but 
if homeowners defaulted, they would absorb the first losses.
    It was this segregation of payments that protected the bonds at the 
top of the structure and enabled Moody's to classify them as triple-A. 
Imagine a seaside condo beset by flooding: just as the penthouse will 
not get wet until the lower floors are thoroughly soaked, so the 
triple-A bonds would not lose a dime unless the lower credits were 
wiped out.
    Structured finance, of which this deal is typical, is both clever 
and useful; in the housing industry it has greatly expanded the pool of 
credit. But in extreme conditions, it can fail. The old-fashioned 
corner banker used his instincts, as well as his pencil, to apportion 
credit; modern finance is formulaic. However elegant its models, 
forecasting the behavior of 2,393 mortgage holders is an uncertain 
business. ``Everyone assumed the credit agencies knew what they were 
doing,'' says Joseph Mason, a credit expert at Drexel University. ``A 
structural engineer can predict what load a steel support will bear; in 
financial engineering we can't predict as well.''
    Mortgage-backed securities like those in Subprime XYZ were not the 
terminus of the great mortgage machine. They were, in fact, building 
blocks for even more esoteric vehicles known as collateralized debt 
obligations, or C.D.O.'s. C.D.O.'s were financed with similar ladders 
of bonds, from triple-A on down, and the credit-rating agencies' role 
was just as central. The difference is that XYZ was a first-order 
derivative--its assets included real mortgages owned by actual 
homeowners. C.D.O.'s were a step removed--instead of buying mortgages, 
they bought bonds that were backed by mortgages, like the bonds issued 
by Subprime XYZ. (It is painful to consider, but there were also third-
order instruments, known as C.D.O.'s squared, which bought bonds issued 
by other C.D.O.'s.)
    Miscalculations that were damaging at the level of Subprime XYZ 
were devastating at the C.D.O. level. Just as bad weather will cause 
more serious delays to travelers with multiple flights, so, if the 
underlying mortgage bonds were misrated, the trouble was compounded in 
the case of the C.D.O.'s that purchased them.
    Moody's used statistical models to assess C.D.O.'s; it relied on 
historical patterns of default. This assumed that the past would remain 
relevant in an era in which the mortgage industry was morphing into a 
wildly speculative business. The complexity of C.D.O.'s undermined the 
process as well. Jamie Dimon, the chief executive of JPMorgan Chase, 
which recently scooped up the mortally wounded Bear Stearns, says, 
``There was a large failure of common sense'' by rating agencies and 
also by banks like his. ``Very complex securities shouldn't have been 
rated as if they were easy-to-value bonds.''
The Accidental Watchdog
    John Moody, a Wall Street analyst and former errand runner, hit on 
the idea of synthesizing all kinds of credit information into a single 
rating in 1909, when he published the manual ``Moody's Analyses of 
Railroad Investments.'' The idea caught on with investors, who 
subscribed to his service, and by the mid-20s, Moody's faced three 
competitors: Standard Statistics and Poor's Publishing (which later 
merged) and Fitch.
    Then as now, Moody's graded bonds on a scale with 21 steps, from 
Aaa to C. (There are small differences in the agencies' nomenclatures, 
just as a grande latte at Starbucks becomes a ``medium'' at Peet's. At 
Moody's, ratings that start with the letter ``A'' carry minimal to low 
credit risk; those starting with ``B'' carry moderate to high risk; and 
``C'' ratings denote bonds in poor standing or actual default.) The 
ratings are meant to be an estimate of probabilities, not a buy or sell 
recommendation. For instance, Ba bonds default far more often than 
triple-As. But Moody's, as it is wont to remind people, is not in the 
business of advising investors whether to buy Ba's; it merely publishes 
a rating.
    Until the 1970s, its business grew slowly. But several trends 
coalesced to speed it up. The first was the collapse of Penn Central in 
1970--a shattering event that the credit agencies failed to foresee. It 
so unnerved investors that they began to pay more attention to credit 
risk.
    Government responded. The Securities and Exchange Commission, faced 
with the question of how to measure the capital of broker-dealers, 
decided to penalize brokers for holding bonds that were less than 
investment-grade (the term applies to Moody's 10 top grades). This 
prompted a question: investment grade according to whom? The S.E.C. 
opted to create a new category of officially designated rating 
agencies, and grandfathered the big three--S.&P., Moody's and Fitch. In 
effect, the government outsourced its regulatory function to three for-
profit companies.
    Bank regulators issued similar rules for banks. Pension funds, 
mutual funds, insurance regulators followed. Over the 1980s and 1990s, 
a latticework of such rules redefined credit markets. Many classes of 
investors were now forbidden to buy noninvestment-grade bonds at all.
    Issuers thus were forced to seek credit ratings (or else their 
bonds would not be marketable). The agencies--realizing they had a hot 
product and, what's more, a captive market--started charging the very 
organizations whose bonds they were rating. This was an efficient way 
to do business, but it put the agencies in a conflicted position. As 
Partnoy says, rather than selling opinions to investors, the rating 
agencies were now selling ``licenses'' to borrowers. Indeed, whether 
their opinions were accurate no longer mattered so much. Just as a 
police officer stopping a motorist will want to see his license but not 
inquire how well he did on his road test, it was the rating--not its 
accuracy--that mattered to Wall Street.
    The case of Enron is illustrative. Throughout the summer and fall 
of 2001, even though its credit was rapidly deteriorating, the rating 
agencies kept it at investment grade. This was not unusual; the 
agencies typically lag behind the news. On Nov. 28, 2001, S.&P. finally 
dropped Enron's bonds to subinvestment grade. Although its action 
merely validated the market consensus, it caused the stock to collapse. 
To investors, S.&P.'s action was a signal that Enron was locked out of 
credit markets; it had lost its ``license'' to borrow. Four days later 
it filed for bankruptcy.
    Another trend that spurred the agencies' growth was that more 
companies began borrowing in bond markets instead of from banks. 
According to Chris Mahoney, a just-retired Moody's veteran of 22 years, 
``The agencies went from being obscure and unimportant players to 
central ones.''
A Conflict of Interest?
    Nothing sent the agencies into high gear as much as the development 
of structured finance. As Wall Street bankers designed ever more 
securitized products--using mortgages, credit-card debt, car loans, 
corporate debt, every type of paper imaginable--the agencies became 
truly powerful.
    In structured-credit vehicles like Subprime XYZ, the agencies 
played a much more pivotal role than they had with (conventional) 
bonds. According to Lewis Ranieri, the Salomon Brothers banker who was 
a pioneer in mortgage bonds, ``The whole creation of mortgage 
securities was involved with a rating.''
    What the bankers in these deals are really doing is buying a bunch 
of I.O.U.'s and repackaging them in a different form. Something has to 
make the package worth--or seem to be worth--more that the sum of its 
parts, otherwise there would be no point in packaging such securities, 
nor would there be any profits from which to pay the bankers' fees.
    That something is the rating. Credit markets are not continuous; a 
bond that qualifies, though only by a hair, as investment grade is 
worth a lot more than one that just fails. As with a would-be immigrant 
traveling from Mexico, there is a huge incentive to get over the line.
    The challenge to investment banks is to design securities that just 
meet the rating agencies' tests. Risky mortgages serve their purpose; 
since the interest rate on them is higher, more money comes into the 
pool and is available for paying bond interest. But if the mortgages 
are too risky, Moody's will object. Banks are adroit at working the 
system, and pools like Subprime XYZ are intentionally designed to 
include a layer of Baa bonds, or those just over the border. ``Every 
agency has a model available to bankers that allows them to run the 
numbers until they get something they like and send it in for a 
rating,'' a former Moody's expert in securitization says. In other 
words, banks were gaming the system; according to Chris Flanagan, the 
subprime analyst at JPMorgan, ``Gaming is the whole thing.''
    When a bank proposes a rating structure on a pool of debt, the 
rating agency will insist on a cushion of extra capital, known as an 
``enhancement.'' The bank inevitably lobbies for a thin cushion (the 
thinner the capitalization, the fatter the bank's profits). It's up to 
the agency to make sure that the cushion is big enough to safeguard the 
bonds. The process involves extended consultations between the agency 
and its client. In short, obtaining a rating is a collaborative 
process.
    The evidence on whether rating agencies bend to the bankers' will 
is mixed. The agencies do not deny that a conflict exists, but they 
assert that they are keen to the dangers and minimize them. For 
instance, they do not reward analysts on the basis of whether they 
approve deals. No smoking gun, no conspiratorial e-mail message, has 
surfaced to suggest that they are lying. But in structured finance, the 
agencies face pressures that did not exist when John Moody was rating 
railroads. On the traditional side of the business, Moody's has 
thousands of clients (virtually every corporation and municipality that 
sells bonds). No one of them has much clout. But in structured finance, 
a handful of banks return again and again, paying much bigger fees. A 
deal the size of XYZ can bring Moody's $200,000 and more for 
complicated deals. And the banks pay only if Moody's delivers the 
desired rating. Tom McGuire, the Jesuit theologian who ran Moody's 
through the mid-90s, says this arrangement is unhealthy. If Moody's and 
a client bank don't see eye to eye, the bank can either tweak the 
numbers or try its luck with a competitor like S.&P., a process known 
as ``ratings shopping.''
    And it seems to have helped the banks get better ratings. Mason, of 
Drexel University, compared default rates for corporate bonds rated Baa 
with those of similarly rated collateralized debt obligations until 
2005 (before the bubble burst). Mason found that the C.D.O.'s defaulted 
eight times as often. One interpretation of the data is that Moody's 
was far less discerning when the client was a Wall Street securitizer.
    After Enron blew up, Congress ordered the S.E.C. to look at the 
rating industry and possibly reform it. The S.E.C. ducked. Congress 
looked again in 2006 and enacted a law making it easier for competing 
agencies to gain official recognition, but didn't change the industry's 
business model. By then, the mortgage boom was in high gear. From 2002 
to 2006, Moody's profits nearly tripled, mostly thanks to the high 
margins the agencies charged in structured finance. In 2006, Moody's 
reported net income of $750 million. Raymond W. McDaniel Jr., its chief 
executive, gloated in the annual report for that year, ``I firmly 
believe that Moody's business stands on the `right side of history' in 
terms of the alignment of our role and function with advancements in 
global capital markets.''
Using Weather in Antarctica To Forecast Conditions in Hawaii
    Even as McDaniel was crowing, it was clear in some corners of Wall 
Street that the mortgage market was headed for trouble. The housing 
industry was cooling off fast. James Kragenbring, a money manager with 
Advantus Capital Management, complained to the agencies as early as 
2005 that their ratings were too generous. A report from the hedge fund 
of John Paulson proclaimed astonishment at ``the mispricing of these 
securities.'' He started betting that mortgage debt would crash.
    Even Mark Zandi, the very visible economist at Moody's forecasting 
division (which is separate from the ratings side), was worried about 
the chilling crosswinds blowing in credit markets. In a report 
published in May 2006, he noted that consumer borrowing had soared, 
household debt was at a record and a fifth of such debt was classified 
as subprime. At the same time, loan officers were loosening 
underwriting standards and easing rates to offer still more loans. 
Zandi fretted about the ``razor-thin'' level of homeowners' equity, the 
avalanche of teaser mortgages and the $750 billion of mortgages he 
judged to be at risk. Zandi concluded, ``The environment feels 
increasingly ripe for some type of financial event.''
    A month after Zandi's report, Moody's rated Subprime XYZ. The 
analyst on the deal also had concerns. Moody's was aware that mortgage 
standards had been deteriorating, and it had been demanding more of a 
cushion in such pools. Nonetheless, its credit-rating model continued 
to envision rising home values. Largely for that reason, the analyst 
forecast losses for XYZ at only 4.9 percent of the underlying mortgage 
pool. Since even the lowest-rated bonds in XYZ would be covered up to a 
loss level of 7.25 percent, the bonds seemed safe.
    XYZ now became the responsibility of a Moody's team that monitors 
securities and changes the ratings if need be (the analyst moved on to 
rate a new deal). Almost immediately, the team noticed a problem. 
Usually, people who finance a home stay current on their payments for 
at least a while. But a sliver of folks in XYZ fell behind within 90 
days of signing their papers. After six months, an alarming 6 percent 
of the mortgages were seriously delinquent. (Historically, it is rare 
for more than 1 percent of mortgages at that stage to be delinquent.)
    Moody's monitors began to make inquiries with the lender and were 
shocked by what they heard. Some properties lacked sod or landscaping, 
and keys remained in the mailbox; the buyers had never moved in. The 
implication was that people had bought homes on spec: as the housing 
market turned, the buyers walked.
    By the spring of 2007, 13 percent of Subprime XYZ was delinquent--
and it was worsening by the month. XYZ was hardly atypical; the entire 
class of 2006 was performing terribly. (The class of 2007 would turn 
out to be even worse.)
    In April 2007, Moody's announced it was revising the model it used 
to evaluate subprime mortgages. It noted that the model ``was first 
introduced in 2002. Since then, the mortgage market has evolved 
considerably.'' This was a rather stunning admission; its model had 
been based on a world that no longer existed.
    Poring over the data, Moody's discovered that the size of people's 
first mortgages was no longer a good predictor of whether they would 
default; rather, it was the size of their first and second loans--that 
is, their total debt--combined. This was rather intuitive; Moody's 
simply hadn't reckoned on it. Similarly, credit scores, long a mainstay 
of its analyses, had not proved to be a ``strong predictor'' of 
defaults this time. Translation: even people with good credit scores 
were defaulting. Amy Tobey, leader of the team that monitored XYZ, told 
me, ``It seems there was a shift in mentality; people are treating 
homes as investment assets.'' Indeed. And homeowners without equity 
were making what economists call a rational choice; they were 
abandoning properties rather than make payments on them. Homeowners' 
equity had never been as high as believed because appraisals had been 
inflated.
    Over the summer and fall of 2007, Moody's and the other agencies 
repeatedly tightened their methodology for rating mortgage securities, 
but it was too late. They had to downgrade tens of billions of dollars 
of securities. By early this year, when I met with Moody's, an 
astonishing 27 percent of the mortgage holders in Subprime XYZ were 
delinquent. Losses on the pool were now estimated at 14 percent to 16 
percent--three times the original estimate. Seemingly high-quality 
bonds rated A3 by Moody's had been downgraded five notches to Ba2, as 
had the other bonds in the pool aside from its triple-A's.
    The pain didn't stop there. Many of the lower-rated bonds issued by 
XYZ, and by mortgage pools like it, were purchased by C.D.O.'s, the 
second-order mortgage vehicles, which were eager to buy lower-rated 
mortgage paper because it paid a higher yield. As the agencies endowed 
C.D.O. securities with triple-A ratings, demand for them was red hot. 
Much of it was from global investors who knew nothing about the U.S. 
mortgage market. In 2006 and 2007, the banks created more than $200 
billion of C.D.O.'s backed by lower-rated mortgage paper. Moody's 
assigned a different team to rate C.D.O.'s. This team knew far less 
about the underlying mortgages than did the committee that evaluated 
Subprime XYZ. In fact, Moody's rated C.D.O.'s without knowing which 
bonds the pool would buy.
    A C.D.O. operates like a mutual fund; it can buy or sell mortgage 
bonds and frequently does so. Thus, the agencies rate pools with assets 
that are perpetually shifting. They base their ratings on an extensive 
set of guidelines or covenants that limit the C.D.O. manager's 
discretion.
    Late in 2006, Moody's rated a C.D.O. with $750 million worth of 
securities. The covenants, which act as a template, restricted the 
C.D.O. to, at most, an 80 percent exposure to subprime assets, and many 
other such conditions. ``We're structure experts,'' Yuri Yoshizawa, the 
head of Moody's' derivative group, explained. ``We're not underlying-
asset experts.'' They were checking the math, not the mortgages. But no 
C.D.O. can be better than its collateral.
    Moody's rated three-quarters of this C.D.O.'s bonds triple-A. The 
ratings were derived using a mathematical construct known as a Monte 
Carlo simulation--as if each of the underlying bonds would perform like 
cards drawn at random from a deck of mortgage bonds in the past. There 
were two problems with this approach. First, the bonds weren't like 
those in the past; the mortgage market had changed. As Mark Adelson, a 
former managing director in Moody's structured-finance division, 
remarks, it was ``like observing 100 years of weather in Antarctica to 
forecast the weather in Hawaii.'' And second, the bonds weren't random. 
Moody's had underestimated the extent to which underwriting standards 
had weakened everywhere. When one mortgage bond failed, the odds were 
that others would, too.
    Moody's estimated that this C.D.O. could potentially incur losses 
of 2 percent. It has since revised its estimate to 27 percent. The 
bonds it rated have been decimated, their market value having plunged 
by half or more. A triple-A layer of bonds has been downgraded 16 
notches, all the way to B. Hundreds of C.D.O.'s have suffered similar 
fates (most of Wall Street's losses have been on C.D.O.'s). For Moody's 
and the other rating agencies, it has been an extraordinary rout.
Whom Can We Rely On?
    The agencies have blamed the large incidence of fraud, but then 
they could have demanded verification of the mortgage data or refused 
to rate securities where the data were not provided. That was, after 
all, their mandate. This is what they pledge for the future. Moody's, 
S.&P. and Fitch say that they are tightening procedures--they will 
demand more data and more verification and will subject their analysts 
to more outside checks. None of this, however, will remove the conflict 
of interest in the issuer-pays model. Though some have proposed 
requiring that agencies with official recognition charge investors, 
rather than issuers, a more practical reform may be for the government 
to stop certifying agencies altogether.
    Then, if the Fed or other regulators wanted to restrict what sorts 
of bonds could be owned by banks, or by pension funds or by anyone else 
in need of protection, they would have to do it themselves--not farm 
the job out to Moody's. The ratings agencies would still exist, but 
stripped of their official imprimatur, their ratings would lose a 
little of their aura, and investors might trust in them a bit less. 
Moody's itself favors doing away with the official designation, and it, 
like S.&P., embraces the idea that investors should not ``rely'' on 
ratings for buy-and-sell decisions.
    This leaves an awkward question, with respect to insanely complex 
structured securities: What can they rely on? The agencies seem utterly 
too involved to serve as a neutral arbiter, and the banks are sure to 
invent new and equally hard-to-assess vehicles in the future. Vickie 
Tillman, the executive vice president of S.&P., told Congress last fall 
that in addition to the housing slump, ``ahistorical behavorial modes'' 
by homeowners were to blame for the wave of downgrades. She cited 
S.&P.'s data going back to the 1970s, as if consumers were at fault for 
not living up to the past. The real problem is that the agencies' 
mathematical formulas look backward while life is lived forward. That 
is unlikely to change.

    Senator Brownback. It goes through how these rating 
agencies rated these subprime mortgages with an AAA score. I'm 
trying to piece all this together in hindsight. So, people are 
originating these loans that locals would not make because it 
isn't up to their standards. And when you put them all 
together, it somehow magically transforms into an AAA-rated 
bond entity that is cited in this article.
    I go back on it, Chris, and ask: What should we be doing 
differently to keep this from happening again? Obviously, we're 
in a credit crunch and so we're not going to have a lot of 
money flowing at the moment. Are there things we should be 
doing to either oversee or rank the bond raters? Should we 
provide greater oversight on the mortgage originating entities, 
to make sure that data is there and that the loan is worthy? I 
think that this whole system is a series of bad practices, 
trying to get people into loans that they shouldn't have and 
then catching them in the net.
    What's the lesson learned here?
    Mr. Cox. Well, first, yes to both of your questions. These 
are both areas that Congress and regulators should take very 
serious interest in and make big changes in. We are not the 
front-line regulators for the mortgage industry, but I feel 
comfortable as Chairman of the SEC commenting on this because 
of the big impact that it has had in the securities markets, 
and focusing on proper oversight of mortgage origination is of 
vital importance for regulators and for lawmakers.

                  OVERSIGHT OF CREDIT RATING AGENCIES

    With respect to credit rating agencies, the Congress has 
done a very important and wise thing very recently in the 
Credit Rating Agency Act, giving the SEC brand new authority to 
regulate and oversee credit rating agencies that presently we 
are exercising vigorously. Up until a few months ago, until the 
end of September last year, the credit rating agency industry 
was essentially unregulated. Now that is completely changed. We 
are in the midst of a very broad investigation of the three 
largest credit rating agencies that rated most of the subprime-
related securities. We will report publicly our findings from 
that examination very soon. The findings of that examination 
will also inform our ongoing rule-writing that we expect to 
complete this year. We expect to propose very, very soon new 
rules to govern, for example, conflicts of interest in that 
industry, to prohibit certain practices, to make sure that 
there is full disclosure of things like due diligence in 
preparation of these ratings, that there's full understanding 
and disclosure of the various methodologies, and that there's 
healthy competition in that industry.
    None of this existed before. These are big changes and they 
are very, very necessary.

                FINANCIAL SERVICES REGULATORY STRUCTURE

    Senator Brownback. Would you mind commenting on the 
Secretary's comments about the need for changes due to new 
business structures? He's saying we need to consolidate several 
of these agencies and remove blind spots. Just your thoughts on 
that.
    Mr. Cox. Modernization of financial services regulation, 
which is the general topic that was broached by the Treasury 
blueprint, is I think very high on everybody's agenda, in the 
Congress, certainly for all of us at the SEC and for other 
regulatory agencies, but also around the world, and in 
international fora such as the Financial Stability Forum and 
IOSCO.
    The reason is that our regulatory structure is old. It's 
got quite a pedigree, a distinguished one, but the major 
regulatory agencies go back to the first part of the 20th 
century. Our agency is going to turn 75 years old in just a few 
months. This is already the 75th anniversary of the 1933 act.
    So as markets have changed, as the products that Walt 
Lukken and the CFTC regulate have morphed in such dramatic ways 
in the 21st century into competitors for products that the SEC 
regulates, our system has to take that into account. It's very 
hard to do that, I understand, because of both constituencies 
in the marketplace who've become accustomed to the existing 
regulatory structure, because of difficulties in Congress 
related to different jurisdictions and different committees, 
and because of some very difficult substantive choices that 
would have to be made about which model to pick and how to 
integrate it.
    So it's surpassingly difficult. But I think the topic is 
the right one to focus on because we have to do a better job of 
integrating regulatory responsibilities if we're going to keep 
abreast of what's going on, not only in our own country but in 
interconnected ways around the world.
    Senator Brownback. Thank you, Mr. Chairman.

                        BROKER-DEALER RULEMAKING

    Senator Durbin. Mr. Chairman, on March 19, 2007, the SEC 
published a proposed rule on amendments to financial 
responsibility rules for broker-dealers. In the notice the SEC 
asked for comments on changes to the rules on net capital, 
customer protection, books and records, notification rules. I 
understand that some of these proposed amendments have been 
sought by the financial services community for a number of 
years.
    Among the changes proposed are reduction in capital 
charges, haircut for money market mutual funds, and the 
inclusion of certain money market mutual funds as qualified 
securities eligible for deposit in the special reserve account.
    It's my understanding that the comment period closed last 
June, and since it will soon be a full year since the comment 
period on the proposed rule elapsed, what is the current status 
of this rulemaking?
    Mr. Cox. Mr. Chairman, we are very interested in this 
subject. We have taken a fresh look at it in light of all the 
market turmoil to make sure that this is the right time to be 
embarking on these kinds of changes. But the comment that we 
have received has included much favorable comment, and so this 
is very much on the rulemaking agenda of the Commission at this 
time.
    Senator Durbin. Since it's been a year, what is the 
anticipated release date for your final rule?
    Mr. Cox. We don't have a calendar date right now for 
further action on this proposal. But I would be happy, Mr. 
Chairman, to report back to you in real time about what the 
prognosis for that is.
    Senator Durbin. If you would, please.
    Are you soliciting additional comments?
    Mr. Cox. No, I believe the comment period is closed. Let me 
check and make sure that's the case.
    Yes, that is the case.
    Senator Durbin. Is there a plan to reissue a new proposal 
or are you going to stick with the original proposal?
    Mr. Cox. I think that the opportunity to fashion a final 
rule based not only on the proposal but the questions that were 
asked and the comments that were received should be sufficient 
so that it would not be required that we repropose it.
    Senator Durbin. If you'd kind of let me know just in 
general terms when that might happen.

                      SECURITIES LITIGATION REFORM

    Last August, a group of law professors asked your agency to 
convene a series of roundtables on the topic of securities 
litigation reform, and the ``Wall Street Journal'' reported 
that the forums would occur early next year, implying this 
year, 2008. Can you tell me if such roundtables are planned or 
under way?
    Mr. Cox. Mr. Chairman, this was a suggestion in chief from 
academics led by, among others, Professor Langwood at 
Georgetown. It is one that I think for a variety of reasons 
many people agree the Commission should act upon. There are a 
variety of reasons across the ideological spectrum and across 
the markets that people have interest and concerns with this 
general topic.
    My own interest in this topic and experience with it 
suggests to me that it is best taken up in a bipartisan way. We 
have currently a short-handed Commission comprised only of 
Republican commissioners and so I have wanted to wait before we 
had any such roundtable, even though of course we could always 
have a balanced panel, to make sure we also had a balanced 
Commission that can give the public confidence that we're 
handling this very important issue with great care and not in 
any political way.

                         DIVESTMENT DISCLOSURES

    Senator Durbin. Last question I have. Two weeks ago the SEC 
adopted rules requiring a registered investment company 
disclose when it divests from securities of issuers that the 
fund determines conduct or have direct investments in certain 
business operations in Sudan. These rules were mandated under 
the Sudan Accountability Investment Act signed into law on 
December 31 of last year.
    How will the SEC track these particular divestment 
disclosures?
    Mr. Cox. Mr. Chairman, as you know, we acted with great 
alacrity to do what was required by the statute, and we are 
energetically going to implement it as well, through the 
Division of Corporation Finance and our Office of Risk 
Assessment.
    Senator Durbin. So how would an investor be able to quickly 
determine that a particular company has made such a disclosure, 
for example?
    Mr. Cox. I'm sorry?
    Senator Durbin. How would an individual investor be able to 
determine that a particular company has made such a disclosure?
    Mr. Cox. Well, all of these filings will be made public and 
we have taken some very recent measures to provide for full 
text search capability of filings that are available on our 
EDGAR online disclosure system.
    Senator Durbin. Good. Thank you.
    Senator Brownback, any further questions?
    Senator Brownback. No questions.
    Senator Durbin. Chairman Cox, thanks. We appreciate your 
coming by. We're glad you're working with the CFTC on a 
memorandum of understanding and how that you'll continue that 
cooperative arrangement. I asked when they formed this 
subcommittee to bring these two agencies under the 
subcommittee's jurisdiction. There are so many things that you 
do have in common, at least in terms of the integrity of the 
marketplace. I hope that that conversation continues outside 
this room.
    Thank you for being here today.
    Mr. Cox. Thank you very much, Mr. Chairman.

                     ADDITIONAL COMMITTEE QUESTIONS

    Senator Durbin. Any questions for the record will be 
submitted to those who have testified, in the hopes that there 
will be prompt replies so we can complete our work.
    [The following questions were not asked at the hearing, but 
were submitted to the Commission for response subsequent to the 
hearing:]
            Questions Submitted by Senator Richard C. Shelby
                              cra program
    Question. Chairman Cox, in your testimony you indicated that the 
SEC's credit rating agency program's costs are approximately $2.2 
million. Would you please discuss how these funds would be allocated 
within the program? How would having a dedicated funding source for the 
program improve the SEC's ability to administer the program?
    Answer. The SEC created the credit rating agencies program in 
September 2007 as a result of the enactment of the Credit Rating Agency 
Reform Act, to ensure that rating agencies are adhering to their 
published methodologies for determining ratings and managing conflicts 
of interest. The Act also provides the Commission with authority to 
write new regulations in this area and inspect the nationally 
recognized statistical rating organizations for compliance with 
applicable rules and policies. The SEC's proposed budget for fiscal 
year 2009 would increase the number of staff responsible for 
implementing the Credit Rating Agency Reform Act from 7 to 20 positions 
for oversight and inspections of credit rating agencies. This would 
nearly triple the number of staff dedicated to the program. Having 
dedicated funding would give the credit rating agency program more 
legislative structure and formality and ensure that the agency's 
allocation of resources was in line with the intent of Congress.
                              cse program
    Question. Chairman Cox, over the past several months our economy 
has been plague by a liquidity crisis triggered by poorly underwritten 
subprime loans and structured finance products. The investment banks 
the SEC regulates as part of the CSE program were among the most active 
players in both the subprime and structured finance markets. They 
structured and underwrote many of the financial instruments now causing 
so many problems for our economy.
  --If the SEC was properly monitoring the CSE firms, why did it fail 
        to raise the alarm about the decline in underwriting and 
        lending standards?
  --How much responsibility does the SEC bear for the deterioration of 
        lending and underwriting standards by CSE firms and their 
        subsidiaries?
    Answer. The President's Working Group noted in their March report 
to the President that a principal underlying cause of the turmoil in 
financial markets was ``a breakdown in underwriting standards for 
subprime mortgages'' which then rippled through the system as these 
substandard mortgages were securitized. However, the SEC has no 
authority over mortgage underwriting standards. The consolidated 
supervised entities program does not change this reality. Under the 
Commission's new authority to supervise credit rating agencies, the 
Commission has recently proposed new rules designed to increase 
accountability and competition among credit rating agencies, as their 
ratings may have played a significant role in the market acceptance of 
subprime-related securities.
                              enforcement
    Question. Chairman Cox, earlier today at a hearing of the Banking 
Committee, former SEC Chairmen Arthur Levitt stated that the SEC needs 
substantial increases in its enforcement budget and that it does not 
have the manpower to properly enforce our securities laws.
  --How many personnel are presently employed by the Division of 
        Enforcement, and how has that figured changed over the past 10 
        years?
    Answer. In fiscal year 2008, the Enforcement program has over 1,100 
permanent FTE which is more than 30 percent higher than the size of the 
enforcement program since 1998.

                          [Dollars in millions]
------------------------------------------------------------------------
                                                            Enforcement
                                                              Program
                                            Enforcement    Salaries and
                                            Program FTE      Benefits
                                                            Obligations
------------------------------------------------------------------------
1998....................................             852         ( \1\ )
1999....................................             811         ( \1\ )
2000....................................             824         ( \1\ )
2001....................................             904         ( \1\ )
2002....................................             925         ( \1\ )
2003....................................             935         ( \1\ )
2004....................................           1,144          $168.8
2005....................................           1,232           195.4
2006....................................           1,157           200.6
2007....................................           1,111           197.8
2008 (Budget)...........................           1,124           210.0
------------------------------------------------------------------------
\1\ Not available.

    Question. Also, how do the number of SEC enforcement actions and 
the amount disgorgements orders during your tenure compare to the 
levels seen when Chairmen Levitt was at the Commission?
    Answer. In fiscal year 2007, the Commission brought the second 
highest number of cases in the Commission's history including the 
largest number of corporate penalties cases ever. The chart below, 
provides the requested information on the nearly seven full fiscal 
years of Chairman Levitt's tenure and the two full fiscal years of my 
tenure.

                          [Dollars in millions]
------------------------------------------------------------------------
                                                              Average
                                          Average Number   Disgorgements
                                          of Enforcement   and Penalties
                                            Actions Per     Ordered Per
                                               Year            Year
------------------------------------------------------------------------
Arthur Levitt, Chairman, July 1993-Feb.              490            $608
 2001...................................
Christopher Cox, Chairman, August 2005-              615           2,483
 present................................
------------------------------------------------------------------------
Note: Figures for Chairman Levitt are totals for fiscal year 1994-fiscal
  year 2001. Figures for Chairman Cox are totals for fiscal year 2005-
  fiscal year 2007.

    The following table shows the specific figures for each fiscal year 
during Chairman Levitt's and my tenures:

                          [Dollars in millions]
------------------------------------------------------------------------
                                                           Disgorgements
                                            Enforcement    and Penalties
                                              Actions         Ordered
------------------------------------------------------------------------
Under Chairman Levitt:
    1994................................             497            $764
    1995................................             486           1,028
    1996................................             453             392
    1997................................             489             263
    1998................................             477             477
    1999................................             525             841
    2000................................             503             488
Under Chairman Cox:
    2006................................             574           3,365
    2007................................             655           1,601
------------------------------------------------------------------------

                          SUBCOMMITTEE RECESS

    Senator Durbin. This meeting of the subcommittee will stand 
recessed. Thank you.
    [Whereupon, at 4:12 p.m., Wednesday, May 7, the 
subcommittee was recessed, to reconvene subject to the call of 
the Chair.]
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