[House Hearing, 111 Congress]
[From the U.S. Government Publishing Office]



 
                   CREDIT DEFAULT SWAPS ON GOVERNMENT

                      DEBT: POTENTIAL IMPLICATIONS

                        OF THE GREEK DEBT CRISIS

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


                                HEARING

                               BEFORE THE

                    SUBCOMMITTEE ON CAPITAL MARKETS,

                       INSURANCE, AND GOVERNMENT

                         SPONSORED ENTERPRISES

                                 OF THE

                    COMMITTEE ON FINANCIAL SERVICES

                     U.S. HOUSE OF REPRESENTATIVES

                     ONE HUNDRED ELEVENTH CONGRESS

                             SECOND SESSION

                               __________

                             APRIL 29, 2010

                               __________

       Printed for the use of the Committee on Financial Services

                           Serial No. 111-130



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                 HOUSE COMMITTEE ON FINANCIAL SERVICES

                 BARNEY FRANK, Massachusetts, Chairman

PAUL E. KANJORSKI, Pennsylvania      SPENCER BACHUS, Alabama
MAXINE WATERS, California            MICHAEL N. CASTLE, Delaware
CAROLYN B. MALONEY, New York         PETER T. KING, New York
LUIS V. GUTIERREZ, Illinois          EDWARD R. ROYCE, California
NYDIA M. VELAZQUEZ, New York         FRANK D. LUCAS, Oklahoma
MELVIN L. WATT, North Carolina       RON PAUL, Texas
GARY L. ACKERMAN, New York           DONALD A. MANZULLO, Illinois
BRAD SHERMAN, California             WALTER B. JONES, Jr., North 
GREGORY W. MEEKS, New York               Carolina
DENNIS MOORE, Kansas                 JUDY BIGGERT, Illinois
MICHAEL E. CAPUANO, Massachusetts    GARY G. MILLER, California
RUBEN HINOJOSA, Texas                SHELLEY MOORE CAPITO, West 
WM. LACY CLAY, Missouri                  Virginia
CAROLYN McCARTHY, New York           JEB HENSARLING, Texas
JOE BACA, California                 SCOTT GARRETT, New Jersey
STEPHEN F. LYNCH, Massachusetts      J. GRESHAM BARRETT, South Carolina
BRAD MILLER, North Carolina          JIM GERLACH, Pennsylvania
DAVID SCOTT, Georgia                 RANDY NEUGEBAUER, Texas
AL GREEN, Texas                      TOM PRICE, Georgia
EMANUEL CLEAVER, Missouri            PATRICK T. McHENRY, North Carolina
MELISSA L. BEAN, Illinois            JOHN CAMPBELL, California
GWEN MOORE, Wisconsin                ADAM PUTNAM, Florida
PAUL W. HODES, New Hampshire         MICHELE BACHMANN, Minnesota
KEITH ELLISON, Minnesota             KENNY MARCHANT, Texas
RON KLEIN, Florida                   THADDEUS G. McCOTTER, Michigan
CHARLES A. WILSON, Ohio              KEVIN McCARTHY, California
ED PERLMUTTER, Colorado              BILL POSEY, Florida
JOE DONNELLY, Indiana                LYNN JENKINS, Kansas
BILL FOSTER, Illinois                CHRISTOPHER LEE, New York
ANDRE CARSON, Indiana                ERIK PAULSEN, Minnesota
JACKIE SPEIER, California            LEONARD LANCE, New Jersey
TRAVIS CHILDERS, Mississippi
WALT MINNICK, Idaho
JOHN ADLER, New Jersey
MARY JO KILROY, Ohio
STEVE DRIEHAUS, Ohio
SUZANNE KOSMAS, Florida
ALAN GRAYSON, Florida
JIM HIMES, Connecticut
GARY PETERS, Michigan
DAN MAFFEI, New York

        Jeanne M. Roslanowick, Staff Director and Chief Counsel
 Subcommittee on Capital Markets, Insurance, and Government Sponsored 
                              Enterprises

               PAUL E. KANJORSKI, Pennsylvania, Chairman

GARY L. ACKERMAN, New York           SCOTT GARRETT, New Jersey
BRAD SHERMAN, California             TOM PRICE, Georgia
MICHAEL E. CAPUANO, Massachusetts    MICHAEL N. CASTLE, Delaware
RUBEN HINOJOSA, Texas                PETER T. KING, New York
CAROLYN McCARTHY, New York           FRANK D. LUCAS, Oklahoma
JOE BACA, California                 DONALD A. MANZULLO, Illinois
STEPHEN F. LYNCH, Massachusetts      EDWARD R. ROYCE, California
BRAD MILLER, North Carolina          JUDY BIGGERT, Illinois
DAVID SCOTT, Georgia                 SHELLEY MOORE CAPITO, West 
NYDIA M. VELAZQUEZ, New York             Virginia
CAROLYN B. MALONEY, New York         JEB HENSARLING, Texas
MELISSA L. BEAN, Illinois            ADAM PUTNAM, Florida
GWEN MOORE, Wisconsin                J. GRESHAM BARRETT, South Carolina
PAUL W. HODES, New Hampshire         JIM GERLACH, Pennsylvania
RON KLEIN, Florida                   JOHN CAMPBELL, California
ED PERLMUTTER, Colorado              MICHELE BACHMANN, Minnesota
JOE DONNELLY, Indiana                THADDEUS G. McCOTTER, Michigan
ANDRE CARSON, Indiana                RANDY NEUGEBAUER, Texas
JACKIE SPEIER, California            KEVIN McCARTHY, California
TRAVIS CHILDERS, Mississippi         BILL POSEY, Florida
CHARLES A. WILSON, Ohio              LYNN JENKINS, Kansas
BILL FOSTER, Illinois
WALT MINNICK, Idaho
JOHN ADLER, New Jersey
MARY JO KILROY, Ohio
SUZANNE KOSMAS, Florida
ALAN GRAYSON, Florida
JIM HIMES, Connecticut
GARY PETERS, Michigan

                            C O N T E N T S

                              ----------                              
                                                                   Page
Hearing held on:
    April 29, 2010...............................................     1
Appendix:
    April 29, 2010...............................................    47

                               WITNESSES
                        Thursday, April 29, 2010

Duffie, Darrell, Professor of Finance, Graduate School of 
  Business, Stanford University..................................    14
Johnson, Robert, Director of Global Finance, Roosevelt Institute.     9
Mason, Joseph R., Louisiana Bankers Association Professor of 
  Finance, Louisiana State University............................    17
Pickel, Robert, Executive Vice Chairman, International Swaps and 
  Derivatives Association, Inc...................................    12
Sanders, Anthony B., Distinguished Professor of Finance, George 
  Mason University...............................................    15

                                APPENDIX

Prepared statements:
    Kanjorski, Hon. Paul E.......................................    48
    Duffie, Darrell..............................................    50
    Johnson, Robert..............................................    64
    Mason, Joseph R..............................................    81
    Pickel, Robert...............................................    94
    Sanders, Anthony B...........................................   103


                   CREDIT DEFAULT SWAPS ON GOVERNMENT


                      DEBT: POTENTIAL IMPLICATIONS


                        OF THE GREEK DEBT CRISIS

                              ----------                              


                        Thursday, April 29, 2010

             U.S. House of Representatives,
                   Subcommittee on Capital Markets,
                          Insurance, and Government
                             Sponsored Enterprises,
                           Committee on Financial Services,
                                                   Washington, D.C.
    The subcommittee met, pursuant to notice, at 10:05 a.m., in 
room 2128, Rayburn House Office Building, Hon. Paul E. 
Kanjorski [chairman of the subcommittee] presiding.
    Members present: Representatives Kanjorski, Sherman, Lynch, 
Maloney, Perlmutter, Donnelly, Carson, Foster, Minnick, Adler, 
Himes; Garrett, Manzullo, Hensarling, Neugebauer, and Jenkins.
    Ex officio present: Representative Bachus.
    Chairman Kanjorski. This hearing of the Subcommittee on 
Capital Markets, Insurance, and Government Sponsored 
Enterprises will come to order.
    Pursuant to committee rules, each side will have 15 minutes 
for opening statements. Without objection, all members' opening 
statements will be made a part of the record.
    Good morning. At the request of our colleague, 
Congresswoman Maloney, we gather today to examine important 
policy questions that have arisen from the Greek debt crisis. 
The crisis, which quietly evolved over a number of years, has 
demonstrated that innovative Wall Street bankers, acting alone 
or in concert with their clients, have the potential to 
destabilize not only a single country but an entire economic 
region, especially if transactions they concoct distort 
transparency or heighten speculation.
    Among other things, this hearing will allow us to explore 
whether the titans of Wall Street act as traders of government 
debt by underwriting bonds, or traitors of governments by using 
credit default swaps to gamble that sovereign debt will fail. 
Those who bet on and seek to cause the default of a government 
are as bad as Benedict Arnold.
    When used for genuine hedging purposes, credit default 
swaps are an appropriate financial tool. But when these 
instruments are used for speculation, they have the potential 
to become a Trojan horse that will insidiously infect our 
markets. Some very smart and sophisticated investors have 
characterized naked credit default swaps as ``weapons of mass 
destruction'' that can create imaginary value out of thin air.
    The tragic situation in Greece underscores the urgent need 
for Wall Street reform at home. Some recent news reports 
suggest that bankers crafted derivatives to hide Greek debt, 
and other stories note that the U.S. market for credit default 
swaps on municipal debt is growing.
    Congress must respond by creating more transparency in our 
derivatives markets, as provided for in the House-passed bill. 
The derivatives bill recently approved by the Senate 
Agriculture Committee similarly advances the goal of greater 
disclosure.
    Additionally, the response of the markets to the Greek debt 
crisis raises more questions about the utility of rating 
agencies. As we all know, the rating agencies greatly 
contributed to our recent financial crisis by failing to 
appropriately rate collateralized debt obligations and other 
structured debt. The growth in the issuance of these faulty 
financial instruments, which the rating agencies blessed, 
contributed to the explosion of the credit default swap market.
    While some have raised concerns, other experts have 
concluded that a large and liquid market for credit default 
swaps, including naked positions, leads the cash bond market in 
price discovery and predicting adverse credit events. If this 
is true, then I question why the rating agencies waited so long 
to downgrade Greece's debt. After all, the costs for purchasing 
credit default swaps on Greek debt has soared for many months, 
but Moody's and Standard & Poor's have only downgraded the 
country's bonds in recent days.
    The reform bill already passed in the House takes strong 
steps to impose a liability standard on rating agencies and 
reduce conflicts of interest and market reliance on them. As we 
proceed today, I look forward to understanding whether naked 
credit default swaps do indeed promote efficient price 
discovery and whether we should do more to reform rating 
agencies.
    The Greek debt crisis also parallels a problem in our 
financial markets: the problem of ``too-big-to-fail.'' Greece's 
problems have placed an enormous strain on the European debt 
markets and the European Monetary Union. In fact, the European 
Central Bank president has said that a Greek default is out of 
the question.
    With respect to our financial markets, the demise of Lehman 
Brothers, American International Group, and Washington Mutual, 
among many others, have shown that Congress must act to 
mitigate systemic risk. That is why the House-passed 
legislation and the pending Senate bill include provisions to 
end the era of ``too-big-to-fail,'' like my amendment directing 
regulators to break up financial firms that have become too 
big, too interconnected, too concentrated, or too risky.
    In sum, today's hearing continues to build a case for 
financial services regulatory reform. More than 2 years have 
passed since the financial crisis began, and the Senate must 
take swift action on its bill so that we can finally end Wall 
Street's narcissistic pursuit of profit and change the way our 
financial markets operate.
    I would like to recognize Ranking Member Garrett for 4 
minutes. Mr. Garrett?
    Mr. Garrett. And I thank you. I thank the chairman. I thank 
the witnesses who are about to testify.
    Today's hearing is entitled, ``Credit Default Swaps on 
Government Debt: Potential Implications of the Greek Debt 
Crisis.'' There are really a number of roads our discussion 
this morning could go down, given that very long title.
    Now, there have been some suggestions, for instance, that 
CDS is to blame for the problem Greece finds itself in today. 
But frankly, I have not been shown any evidence to really 
support that claim. In fact, a good argument can be made that 
rather than causing the Greek debt crisis, CDS actually alerted 
investors to the uncertainty being felt by some in the 
marketplace, and to help provide greater transparency about the 
stated Greek fiscal affairs before the country's conditions 
even got worse.
    Now, alternatives of CDS for providing transparency about 
the creditworthiness of a company or a sovereign entity, of 
course, are the credit rating agencies. But when you think 
about it, I don't think anyone would suggest, given their 
recent track record, that the sole reliance on credit rating 
agencies would be the optimal strategy for policymakers now to 
pursue.
    It has also been noted that if investors can't hedge their 
risk through CDS purchases, what will they do? They will be 
less willing and less likely to invest in the underlying debt 
itself. So any steps that we take to ban sovereign debt CDS, as 
some European governments have now proposed, actually can make 
it even more difficult and more costly for countries like 
Greece to sell their bonds and basically exacerbate the debt 
crisis.
    Another issue in today's hearing is the parallel between 
Greece's poor financial condition and the financial condition 
here in the United States. During the discussion over financial 
services regulatory reform over the last year or so, there has 
been a lot of talk about systemic risk and so-called ``too-big-
to-fail'' institutions.
    But, the ultimate ``too-big-to-fail'' entity is the United 
States Government. And the most obvious systemic risk is the 
one posed by our ever-increasing Federal budget deficit and the 
accumulated debt here in this country.
    And we have to ask, what will it take for policymakers to 
get serious about cutting this unsustainable spending here in 
Washington? Just this past week, Federal Reserve Chairman 
Bernanke stated, ``The Federal budget appears set to remain on 
an unsustainable path. Moreover, as debt and deficits grow, so 
will the associated interest payments, an obligation that in 
turn further increases projected deficits. Unfortunately, we 
cannot grow out way out of this problem.''
    But despite these warnings, we can't get our Democrat 
colleagues here in the House to propose a budget, let alone one 
that will begin to put us on a sustainable path to fiscal 
health. And what makes our current situation even worse? As 
large as our official national debt currently is, it is not 
even truly stating what the real problem magnitude is because, 
like Greece and many financial institutions that have become 
easy targets for reform-minded policymakers, the U.S. 
Government is engaging in off-balance-sheet accounting that 
hides the enormity of our problem.
    The obligations of Fannie Mae and Freddie Mac, the housing 
giants that are recipients, by far, of the largest of recent 
taxpayer bailouts are not accounted for in our budget. Some of 
you heard the verbal gymnastics, for example, that Secretary 
Geithner had to go through in this committee as he tried to 
explain how the government fully intends to stand behind these 
entities, but at the same time, their obligations, he said, 
shouldn't be considered foreign debt or sovereign debt.
    I have a bill that would put Fannie's and Freddie's debt on 
the balance sheet. And to me, this really isn't a partisan 
issue. It is about being transparent. As a matter of fact, the 
record shows I have 52 co-sponsors of that bill, but 
unfortunately, there is only one solitary Democrat who has 
joined me in that effort so far. But I do remain optimistic 
that others will sign on.
    And finally, as for the people in Greece who are finding 
out now that the fiscal health of one's nation, when push comes 
to shove, can greatly impact its citizens' standard of living, 
I know that everyone in this Congress wants to leave our 
children and our grandchildren with a country in better shape 
than we have inherited.
    But to do that, we can't keep kicking that can down the 
road on the tough decisions. And we certainly shouldn't be 
solely blaming CDS or credit rating agencies, some of which 
have been recently suggested that the U.S. AAA rating could be 
imperiled for the problems brought on by policymakers who need 
to come to terms with our precarious fiscal condition, and so 
do something now before it is too late.
    And with that, I yield back.
    Chairman Kanjorski. Thank you, Mr. Garrett.
    The gentleman from Massachusetts, Mr. Lynch, is recognized 
for 2 minutes.
    Mr. Lynch. Thank you, Mr. Chairman. I thank you for holding 
this hearing today, and I thank Ranking Member Garrett, as 
well.
    The relationship between the government and debt and 
complex derivatives is one that I have been particularly 
interested in since the financial crisis began. I think we have 
an opportunity today to learn some valuable lessons from the 
way Goldman Sachs and others conducted themselves during 
Greece's current situation. The role of complex derivatives in 
concealing and disguising sovereign debt in a very opaque 
market is one that needs to be closely examined.
    As my colleagues from California know better than most, 
credit default swaps and other sophisticated financial 
instruments were used to manage public money. I believe these 
instruments to be dangerous in some cases, when they are 
unregulated, and should not be used when managing pension 
funds, public bonds, monies from municipalities, or any other 
type of public money unless the underwriter and the marketers 
and the traders agree to assume a direct fiduciary 
responsibility.
    I have heard, in the defense of these instruments, that 
credit default swaps can be used to hedge certain risks. But I 
think what we have learned from this crisis is that what we 
thought was hedged was really just a complex instrument that 
was very poorly understood.
    While it is certainly a huge step forward, I am not 
completely convinced that the derivatives title included in the 
House regulatory reform bill, H.R. 4173, the Wall Street Reform 
and Consumer Protection Act, goes far enough to protect public 
funds and pension funds and municipalities from being 
manipulated again in the future. In addition to Greece, cities 
and towns all over the country are struggling with the 
ramifications of using complex derivatives.
    I look forward to our witnesses' testimony today to examine 
further these issues, and I thank them for their willingness to 
come before this committee and help us with our work. And I 
yield back.
    Thank you, Mr. Chairman.
    Chairman Kanjorski. Thank you very much, Mr. Lynch.
    Now we will hear from Mr. Bachus from Alabama for 3 
minutes.
    Mr. Bachus. I thank you, Mr. Chairman, for convening this 
morning's hearing, and I thank the witnesses for your 
attendance.
    The ongoing Greek debt crisis, while tragic, is the result 
of decades of reckless spending, and that is something we are 
quite familiar with here in the United States. Without real 
spending cuts and GSE reform, the bailouts will not stop, the 
housing market will not find its footing, and the American 
economy will not recover.
    But so far, the response has been to pledge unlimited 
bailout aid. In fact, the GSE debt alone has already cost 
American taxpayers more than $127 billion, and puts them at 
risk for another $5 trillion in guarantees.
    The events of 2008 demonstrated there is a need for 
legislation to address shortcomings in the regulation of 
derivatives. But demonizing credit default swaps is not the 
answer. Used responsibly, derivatives are a critical tool for 
managing risk, including the risk of sovereign debt default. 
Thousands of U.S. companies use derivatives to hedge against 
unforeseen events and risk inherent in their business.
    With the current sovereign debt crisis in many European 
nations, while it is instructive about the growth in impact 
that sovereign CDS can have on the capital markets, Congress 
should not unnecessarily impair the important benefits that 
credit derivatives can provide.
    All of us agree derivative markets need more transparency 
and disclosure. We recognize the Federal Reserve discount 
window was not intended as a source of funds for banks to 
speculate with derivatives for their own account.
    However, restrictions on credit default swap contracts 
limit the ability of investors to appropriately calculate risk, 
as CDS spreads are often a more accurate reflection of credit 
risk than credit ratings. We have found that the credit rating 
agencies have not always been reliable measures of 
creditworthiness.
    That being the case, investors should not have alternative 
and effective risk management tools, such as credit default 
swaps, arbitrarily removed from their risk management arsenal. 
The growth of the CDS market is a reminder that market 
solutions are capable of supplying information investors need 
to make informed decisions. Arbitrary bans of certain 
derivative products would only force derivative dealers out of 
the marketplace, and ultimately increase, not mitigate, 
systemic risk.
    Let me close by saying in The Republic, the Greek 
philosopher Plato stated, ``We can easily forgive a child who 
is afraid of the dark. The real tragedy of life is when men are 
afraid of the light.''
    Mr. Chairman, when will the Administration see the light 
and realize we can no longer keep GSEs' debts in the shadows 
and continue down our current path of fiscal irresponsibility? 
Unless we change course, I fear America will soon experience 
its own Greek tragedy.
    Thank you, and I yield back the balance of my time.
    Chairman Kanjorski. Thank you very much, Mr. Bachus.
    And now, we will hear from the gentlelady from New York, 
Mrs. Maloney, for 5 minutes.
    Mrs. Maloney. Thank you, Chairman Kanjorski, for holding 
this hearing, and welcome to the witnesses.
    This is truly a critical hearing, both because of the 
international conditions concerning sovereign debt, but also 
because of what we are working on in Congress. Financial 
regulatory reform will mean significant changes to the overall 
functioning of the derivatives market.
    We are shining a light on over-the-counter derivatives, the 
financial instruments that have been at the heart of the debate 
of economic and financial news at home and abroad since the 
global economic crisis began. These complicated financial 
instruments can be used for hedging or insuring against risk, 
which is good. But the lack of transparency in their use, 
together with the lack of regulation of the market, can combine 
to give them the potential to catalyze economic havoc.
    Warren Buffett has called derivatives, ``financial weapons 
of mass destruction,'' and many have argued that these 
instruments were responsible for the economic crisis in the 
United States. Our goal today is to better understand 
derivatives so we can ensure that they do more good than harm 
in today's global economy.
    We have experienced the impact of unregulated derivatives 
in housing in the United States, and are still recovering from 
it. AIG was unable to pay out on insurance on residential-
backed mortgage securities, and the effects on counterparties 
was massive. This brought our country to the brink of collapse, 
and the lack of transparency was a major factor.
    We are now watching the risk of derivatives play out when 
it comes to sovereign debt. As this chart on the left shows, 
the net notional amount of CDS on Greek debt, which represents 
the bets on Greeks' ability to pay, is well over $8 billion, 
which is quite large compared to the $300 billion of 
outstanding debt in Greece. In contrast, the CDS on U.S. debt, 
debt which is in the trillions, is only one-quarter of the 
size.
    Today there are $1.2 trillion in outstanding CDSs. 
Sovereign credit default swaps make up 16 percent of $200 
billion of that total, and European Union CDSs represent two-
thirds, $131 billion of all sovereign CDSS. Greek CDS make up 
6.3 percent, or $8.3 billion, of all European sovereign CDSs.
    The use of derivatives on sovereign debt has exploded over 
the last decade. Two different types of derivatives have been 
used by countries looking to gain entry to the European Union. 
They were used in some instances to improve the appearance of 
their debt-to-GDP ratio.
    In currency swaps, the infusion of cash based on 
outstanding debt in different currencies that fluctuates, the 
cash infusion is really just a loan to pay current expenses 
that is paid back over time with other resources.
    Credit default swaps can be used as a form of insurance on 
sovereign debt, but they also act as instruments that just 
allow a bet to be placed that a country will default on its 
debt obligations.
    While the use of over-the-counter derivatives has exploded, 
regulation of these instruments remains nonexistent. There is a 
need for regulation and transparency. This market has been 
almost completely unregulated because most of the deals are 
between counterparties, and there is no reporting requirement.
    These transactions also do not have to be cleared by an 
independent third party or traded on a national exchange. For 
these reasons, investors are largely uninformed about the 
extent of financial entities exposed to risk and about the CDSs 
that have been taken out on any asset-backed security.
    Regulatory reform will bring needed transparency into the 
market. It would protect investors from exposure to undisclosed 
and excessive overleveraging. And investors can still make 
bets, but they will have a better idea of the real odds.
    The Greek debt crisis is just a single example of the use 
of complex derivatives, but this hits as close to home as New 
York. In Greece, investors must now pay $711,000 to insure $10 
million in Greek government bonds. This is up from $250,000 in 
the beginning of the year, almost threefold.
    Concern has also been expressed at the State level about 
CDSs on State debt, specifically in California.
    And the question is, how do we regulate over-the-counter 
derivatives such as sovereign debt, CDSs, so that they can be 
used for legitimate purposes without spreading financial 
contamination to other countries and other financial 
institutions?
    Thank you, Mr. Chairman. I ask permission to put all of my 
statement in the record. My time has expired. Thank you.
    Chairman Kanjorski. Without objection, it is so ordered.
    Now we will hear from the gentleman from Texas, Mr. 
Hensarling, for 4 minutes.
    Mr. Hensarling. Thank you, Mr. Chairman, and certainly 
thank you for calling this hearing. When I look at the title of 
the hearing, ``Credit Default Swaps'' in the first part and 
``Greek Debt Crisis'' at the end, I think it would behoove 
Congress to spend a lot more time focusing on the debt crisis 
in credit default swaps.
    I somehow feel to some extent, as I listen to some of the 
opening statements, that there is an element of, let's shoot 
the messenger, the credit default swap market. Let's to some 
extent say that they have exacerbated the Greek debt crisis.
    The lesson here for us--and I might add, to amplify a 
comment of our ranking member--the market acted more 
efficiently than the rating agencies. And theoretically, Greece 
had a deficit-to-GDP ratio and a debt-to-GDP ratio that didn't 
qualify under E.U. standards. And yet they were still allowed 
to remain as a member of the E.U.
    And so the early warning signals in many cases actually 
came from the credit default swap market. We need to be very 
cautious on how we approach any type of new regulatory scheme 
that might harm the ability of essentially this early warning 
system. And it is certainly an early warning system to the 
United States of America.
    As we know, I believe Greece is now having to restate their 
deficit-to-GDP ratio up to about 12 percent. Right now, we have 
a deficit-to-GDP ratio of 10 percent. We know also at the end 
of the President's 10-year budget window, according to 
estimates by the Congressional Budget Office and the General 
Accountability Office, we are looking at a debt-to-GDP ratio of 
90 percent. All economists will tell you that is when the 
needle enters the red zone.
    Press reports indicated that members of Chancellor Merkel's 
party in Germany have called upon Greece to sell its sovereign 
territory in order to deal with its debt crisis. Sell sovereign 
territory. I hope and pray that the United States is not on the 
path to becoming Greece without the Aegean Sea and the 
Parthenon.
    But there are lessons to be learned here for us. There are 
also press reports that indicated that when Argentina defaulted 
on its debt--and I don't believe the United States would ever 
default on our debt--but when Argentina defaulted on its debt 7 
or 8 years ago, creditors actually tried to put a lien on their 
navy, their naval vessels.
    Here we are probably facing the most predictable crisis in 
the history of America, and yet almost each and every day, this 
Congress makes it worse. And when we talk about accounting 
being opaque, again to amplify comments of the ranking member, 
how can we have our Secretary of Treasury come here and say, 
the debt of the GSEs are not sovereign debt, but we are going 
to back each and every dollar?
    And somehow, again, we know that one of the causes of the 
financial crisis was essentially these off-balance-sheet 
vehicles, and yet we have Uncle Sam engaged in the worst. There 
are 127 billion reasons why the GSEs ought to be reformed, and 
yet the bill that is going through Congress now is stone-cold 
silent on the root cause of the problem. These are the true 
lessons we ought to be learning from Greece.
    Thank you, Mr. Chairman. I yield back the balance of my 
time.
    Chairman Kanjorski. Thank you very much, Mr. Hensarling. 
And now we will hear from our final presenter, Mr. Perlmutter, 
for 3 minutes.
    Mr. Perlmutter. Thank you, Mr. Chairman, and thank you, 
panelists, for being here today. I look forward to hearing your 
testimony today to find out what lessons you would have us 
learn. I think that the country, our country, has learned the 
lessons of tax cuts for the wealthiest and prosecute two wars, 
and then absolutely stand by and do nothing while major 
financial institutions like Lehman Brothers go by the wayside 
under the Bush approach and the Republican approach, is 
financial disaster.
    And we saw that financial disaster in the fall of 2008. And 
this country can't afford to go that approach any longer, and I 
am glad that Democrats are now in control to try to pick up the 
pieces after the mess that was left by the Republican 
Administration and the Republican Congress.
    And my friends on the Republican side of the aisle love to 
talk about Fannie Mae and Freddie Mac, and they should have 
been reformed earlier. And I like to remind them of what the 
former chairman of this committee, Mr. Oxley, had to say when 
he and Mr. Frank tried to do reform of Fannie Mae and Freddie 
Mac. Mr. Oxley is quoted in the article from the Financial 
Times dated September 9, 2008.
    Mr. Oxley fumes about the criticism of his House 
colleagues: ``All the hand-wringing and bed-wetting is going on 
without remembering how the House stepped up on this,'' he 
says. ``What did we get from the White House? We got a one-
finger salute.''
    This is the kind of situation where your testimony today is 
going to be helpful in deciding how much regulation really 
needs to go on with these kinds of derivative bets--how often 
they need to be cleared, how much margin needs to be put down, 
and what is the effect on a nation like Greece when its debt 
becomes overwhelming.
    This country is taking steps to get people back to work and 
to rein in the debt and institute uniform and consistent 
regulation on its financial markets, unlike under the prior 
Administration. And we hope that your testimony today will 
provide us with further insights.
    And with that, Mr. Chairman, I would yield back.
    Chairman Kanjorski. Thank you very much, Mr. Perlmutter.
    And now, I have 1 minute from the gentleman from Indiana, 
Mr. Donnelly.
    Mr. Donnelly. Thank you, Mr. Chairman.
    The American people have lost confidence in CDSs, CDOs, 
synthetic CDOs, and their aftermath. They have lost confidence 
in the word and in the trustworthiness of the institutions 
creating these instruments, and whether there is really any 
purpose behind these instruments other than gambling and other 
than opportunities to try to take advantage of someone else or 
some other organization or some other country.
    Transparency and trustworthiness are needed. They are a big 
part of the effort being made by this committee. And I look 
forward to this hearing. Thank you, Mr. Chairman.
    Chairman Kanjorski. Thank you very much, Mr. Donnelly.
    Now we will hear from our first panelist, Mr. Robert 
Johnson, director of global finance, Roosevelt Institute.
    Mr. Johnson?

   STATEMENT OF ROBERT JOHNSON, DIRECTOR OF GLOBAL FINANCE, 
                      ROOSEVELT INSTITUTE

    Mr. Johnson. Good morning. Chairman Kanjorski, Ranking 
Member Garrett, and members of the subcommittee. I thank you 
for the opportunity to address the issues related to credit 
default swaps and their implications for government debt.
    As the Congress considers legislation on financial reform, 
I applaud your efforts to explore the implications of financial 
practices, financial innovation, and particularly the practice 
in the areas of derivative securities. It is my view that the 
explosive growth of derivatives and the immaturity of those 
market systems is at the core of the financial dangers that we 
face moving forward.
    I have stated elsewhere, and continue to believe, that the 
over-the-counter derivatives market is the San Andreas Fault of 
our financial system. The interconnection of balance sheets of 
the so-called ``too-big-to-fail'' firms and the OTC derivatives 
are a cocktail that may force taxpayers to drink from disaster 
again in the future.
    Repair of the system to reduce complexity and opacity will 
allow the markets to function better when adversely shocked, as 
they were by the housing price downturn, and as they will 
surely be shocked again.
    Strong, transparent markets are well-fortified with capital 
buffers, supervised and examined thoroughly, and they are a 
means to help us reach our social goals. Market systems that 
are structured according to the profit imperatives of a few 
concentrated firms, firms that are supported by the backing of 
taxpayers, are very dangerous to the financial health of our 
Nation.
    The structural designs that encourage a private appetite 
for risk that exceeds the social benefits of that risk-taking 
are unhealthy. Markets are a public good, and their structure 
has to attain and maintain integrity, despite the formidable 
pressures that individuals, in particular big business 
interests, will bring to bear to refract that design for their 
private benefit, while being unmindful of the harm that they 
could impose on society.
    Today, our concern is with the impact of the CDS 
derivatives market on government debt. I want to emphasize the 
history of government debt growth, as many of you have 
commented, across many nations and many times, suggests that 
war and financial crisis are the greatest causes of extreme and 
rapid increase of public indebtedness.
    Some analysts of the budget in Washington have estimated 
the financial crisis of 2008 will result in a doubling of a 
U.S. debt-to-GDP ratio. Therefore, the concerns about our 
public finances must be concerns about financial reform. Said 
another way, one cannot credibly claim to be a deficit hawk 
unless one is also a financial reform hawk.
    The credit default swap market has grown tremendously in 
recent years. The instruments played a large role in the 
financial crisis after the failure of Lehman Brothers, 
particularly with respect to the AIG bailout. AIG provided 
mirage capital and mirage protection to financial firms, and it 
evaporated in the crisis. It was picked up by the taxpayer.
    At times, innovation is worshiped as a goddess of progress, 
even when we don't have the ability to measure the value of 
that innovation. It is an article of faith, but it does not 
appear to be the case that financial innovation inspires our 
faith any longer.
    Faith in the financial practices and wisdom of unfettered 
markets has been shattered. At the same time, faith in 
regulators and government action in the aftermath of the 
bailouts is also absent, and experts in financial theory now 
lack credibility in light of the scale of the crisis due to 
their inattention to the risks associated with innovation. 
Praying at the altar of liquidity and innovation rings hollow 
without a clear acknowledgment of the damage that immature 
market structures can influence on society.
    In the market for credit default swaps, some have been 
tempted to ban the instrument altogether. It is clear, in light 
of recent revelations about financial practice and tremendous 
social losses that can be caused, that a profound shift in 
sentiment has taken place.
    At the same time, I would argue that there is a sound logic 
that underpins construction of these instruments that isolate 
and transfer credit risk to where it is most able to be borne. 
Properly structured, transparent CDS markets that are well-
capitalized and regulated can contribute to our well-being.
    In these controversial times, it is important to keep in 
mind that markets are a useful tool, but a tool that must be 
managed and administered when constructing a balance between 
the social costs and benefits of a market for credit insurance.
    Theories that depend upon the vision of the market 
possessing a high quality of information as a maintained 
hypothesis may not always be a good guide to the behavior of 
credit default instruments.
    The standard, fundamental theory of pricing operates from 
the premise that a market knows what the probability of default 
is after a period of discovery, and it reflects that knowledge. 
Attempts to buy credit default risk increase the price and are 
met with a supply from those that know when the price is too 
high. The price represents the truth, and deviations from the 
truth are arbitraged away.
    The alternative perspective envisions a market filled with 
uncertainty and imperfect information. In this perspective, 
buyers of large amounts of CDS transmit a market signal that 
inspires others to believe that they know something that risk 
has risen.
    Drawing inference from price, market participants then sell 
bonds and stock in the belief that default risk is greater. The 
higher funding costs in turn depresses earnings and validate 
that projection of greater risk. The causation runs from price 
to fundamental outcome.
    Examples of market manipulation contained in the appendix 
suggest there is cause for concern regarding credit default 
swaps. Issues related to incentives for restructuring for 
impaired companies and countries potentially are also 
complicated by the presence of credit protection in effecting 
incentives.
    Government and municipal services are essential, and 
manipulative market methods may put them at risk. The hierarchy 
of human needs for basic elements of social function implies 
that this inquiry that you are holding today is a valid concern 
of public officials.
    The appendix that follows contains my remarks. I will just 
speak regarding the Greek crisis, and I will echo many of your 
introductory remarks. The Greek crisis in sovereign debt is not 
fundamentally caused by credit default swaps. One of you spoke 
about the messenger. I don't even think it is a big enough 
messenger to shoot at in this case. The outstanding amount of 
credit default swaps in Greece was very small.
    Thank you. May I submit the balance of my remarks for the 
record?
    [The prepared statement of Mr. Johnson can be found on page 
64 of the appendix.]
    Chairman Kanjorski. Thank you very much, Mr. Johnson.
    Let me make a point--I failed to do that--that we will make 
the entire statements of the witnesses a part of the record. 
And we request that we hold ourselves to 5 minutes. We will 
give you a little leeway, though, because we are interested in 
what you are saying and we appreciate your testimony.
    We will now hear from Mr. Robert Pickel, executive vice 
chairman, International Swaps and Derivatives Association, 
Incorporated. You must be a popular man this week, Mr. Pickel.

     STATEMENT OF ROBERT PICKEL, EXECUTIVE VICE CHAIRMAN, 
     INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION, INC.

    Mr. Pickel. I would like to think so.
    Thank you, Mr. Chairman, Ranking Member Garrett, and 
members of the committee. Thank you again for the opportunity 
to testify before this committee. I have testified at least on 
one other occasion before this committee. And this time I look 
forward to discussing credit default swaps and government debt.
    I have submitted my statement for the record, so let me 
just summarize some of the key points I have raised in that. I 
will talk a little bit about the varied purposes and 
motivations for parties who utilize credit default swaps. I 
will talk about the important information and signaling 
function that they can provide.
    I will briefly highlight the many industry efforts that are 
going on as it relates to credit default swaps, but also 
derivatives generally, in the areas of systemic risk, 
transparency, and infrastructure. And then we'll talk a little 
bit about manipulation, focusing on the unique nature of these 
products and why that nature in fact provides significant 
protections against the ability to manipulate through credit 
default swaps.
    The classic use of a credit default swap is to hedge credit 
risks that a company might have, typically a bank which has 
lent money or a company that owns the bonds of an institution. 
That is the traditional hedging purpose of a credit default 
swap, buying protection.
    But there are many other purposes for using credit default 
swaps beyond that traditional hedging function. Investors in 
the debt or equity of companies in a specific country may use 
sovereign CDS as a proxy hedge against potential shocks to the 
economy of that jurisdiction. Investors with real estate or 
other corporate holdings or other investments in a country may 
similarly use sovereign CDS to protect against their 
investments in those countries.
    Portfolio managers may use sovereign CDS to hedge against 
country, liquidity, and market risk. Large banks, who typically 
do not, with highly rated sovereigns, post collateral or 
receive collateral from those sovereigns, may use CDS to 
provide some element of credit protection against that 
uncollateralized exposure.
    And then, of course, anyone who sells protection to anyone 
who is buying protection by definition is taking on credit 
risk, and therefore may wish to use credit default swaps to 
hedge some of the exposure that it has. Even banking 
supervisors in central banks can use the price signals provided 
by the CDS market to assess default risks in their system. So 
there are many different purposes for utilizing credit default 
swaps.
    They do provide, as I think has been alluded to by a number 
of the opening statements, important information to the 
marketplace, information that 5 or 10 years ago did not exist. 
We are not suggesting that credit default swap information 
should replace the other information that exists out there, 
whether that be credit rating agencies, an investor's own due 
diligence, but we think it is important additional information.
    And in fact, we know, from talking to treasurers or 
companies, that they are watching their credit default swap 
spreads as closely as they watch their stock price. It is a 
regular assessment by the marketplace of how the company is 
doing.
    So more information is certainly better information, and I 
think finance ministers of countries can utilize the credit 
default swaps on their sovereign CDS similarly to get an 
assessment of the marketplace's assessment of the running of 
their economy.
    We have, as an industry, undertaken a number of different 
initiatives relating to credit default swaps and derivatives 
generally. We have focused on reducing systemic risk and the 
interconnectedness risk that we saw in 2008. That is primarily 
through establishing central counterparties, clearinghouses, 
and utilizing a process of compression to reduce the 
outstanding number of obligations outstanding.
    We have also increased transparency by establishing trade 
repositories, and the information that is on the chart over 
here is drawn from that trade information warehouse that has 
been established and up and running for the last 3 or 4 years, 
sponsored by the Depository Trust Clearing Corporation. So that 
information is readily available and is extensively used as 
parties look at the exposure that is outstanding on any 
particular company or country.
    Then finally, I wanted to just briefly respond to 
suggestions about manipulation through credit default swaps. 
And to look at this, we need to understand the fundamental 
nature of these products, these bilateral transactions. It is 
two parties who are entering into this transaction. Anytime one 
is going short in a transaction implicitly, by definition, 
another party is going long, taking the--selling the protection 
position.
    So that is a natural tension that exists in the bilateral 
relationship. And it is very hard in a series of bilateral 
relationships, bilateral contracts, to have the type of 
manipulative effect that has been suggested for credit default 
swaps.
    And the fact of the matter is that there are other 
mitigating factors relating to potential allegations of 
manipulation. Mr. Johnson referred to the fact that the amount 
outstanding of credit default swaps as it relates to sovereign 
debt is very small, certainly in the Greece situation as well 
as other situations. Also, the majority of sovereign CDS 
investors are likely hedging legitimate economic risks, even if 
they don't hold the actual bond.
    And then finally, sovereign CDS may actually serve to 
moderate downward pressure on troubled countries because if the 
CDS market did not exist, the only alternative would be to sell 
the bonds or not take on the debt exposure to begin with.
    So those are the main points that I have raised in my 
testimony, and I look forward to the questions of the 
committee. Thank you, Mr. Chairman.
    [The prepared statement of Mr. Pickel can be found on page 
94 of the appendix.]
    Chairman Kanjorski. Thank you very much, Mr. Pickel.
    And we will now hear from Mr. Darrell Duffie, professor of 
finance, Graduate School of Business, Stanford University.
    Mr. Duffie?

  STATEMENT OF DARRELL DUFFIE, PROFESSOR OF FINANCE, GRADUATE 
            SCHOOL OF BUSINESS, STANFORD UNIVERSITY

    Mr. Duffie. Thank you, Chairman Kanjorski, and Ranking 
Member Garrett.
    As several committee members have mentioned in their 
opening remarks, concerns have been raised that speculation in 
credit default swaps has been responsible for raising the 
borrowing costs of Greece, California, and other government 
borrowers.
    My written testimony contains empirical evidence, charts, 
and statistical evidence, with Professor Zhipeng Zhang of 
Boston College, showing that there is no evidence that 
speculators have been responsible for raising these borrowing 
costs.
    First, as has been mentioned by Mr. Johnson and Mr. Pickel, 
the amounts of credit default swaps that have been used to 
either hedge or speculate against Greece is relatively small 
compared to the amount of Greek bonds outstanding. It is under 
3 or so percent. Similarly, the amount of credit default swaps 
on California is under 2 percent of the amount of debt 
outstanding.
    Second, there is no evidence of large swings in the amount 
of protection that has been brought. Charts in my testimony 
show that the changes from week to week of credit default swap 
protection is rather small.
    Third, changes in the amount of credit default swaps 
written on these government borrowers and other weaker European 
sovereign borrowers are not related to the credit default swap 
rates demanded by investors in this market. In other words, 
this sort of speculation, if it is speculation, or hedging, is 
actually not related to changes in Greek borrowing costs or the 
borrowing costs of these other sovereigns or California.
    And finally, as several of you--Chairman Kanjorski and 
Ranking Member Garrett--have suggested, the credit default swap 
rates have actually risen in advance of information that has 
been revealed about the true indebtedness of Greece.
    And as that information has come into the market, we have 
learned that Greece is likely to be unable to pay back its debt 
on its own, and it is this fact that has raised its borrowing 
costs. It is quite hard to imagine how speculation by credit 
default swap investors has caused Greece to borrow more than it 
can pay back.
    Also, I would like to say that the external support that 
has been provided to Greece does not, however, imply that 
Greece will avoid default. The CDS rate for Greece, which is a 
close proxy to its borrowing rates, has gone to 10 percent in 
the last few days, indicating a significant chance of default.
    The debt crisis faced by Greece has profound implications 
for other Eurozone countries right now. Eurozone governments 
issue debt in a common currency. If one of them is unable to 
pay its own debt, other Eurozone countries have an incentive to 
come to the rescue and to protect the stability of the Euro on 
which they commonly depend.
    In the long run, however, there can be an erosion of the 
incentives of fiscally stronger Eurozone countries to support 
fiscally weaker Eurozone countries. Economists call this a free 
rider problem. Each time a Eurozone country spends more than it 
can pay back, the fabric of the Eurozone is weakened. This is 
important to the interests of the United States because the 
stability of the Euro contributes to global economic growth and 
security.
    Regulations that severely restrict speculation in credit 
default swap markets could have the unintended consequences of 
reducing market liquidity, which raises trading execution costs 
for investors who are not speculating, and of lowering the 
quality of information provided by credit default swap rates 
regarding the credit qualities of these issuers.
    Regulations that severely restrict speculation in credit 
default swap markets could, as a result, increase sovereign 
borrowing costs somewhat. In any case, speculation could 
continue via short selling of the underlying sovereign bonds to 
the extent the bond market is liquid.
    Proposed reforms of the over-the-counter markets for credit 
default swaps and other over-the-counter derivatives will 
improve the safety and soundness of these markets. Data 
repositories will eventually give regulators the opportunity to 
police those who would manipulate these markets or would take 
positions whose risks are too large with respect to the capital 
backing them.
    Central clearing, if done effectively, will also bring 
needed stability to this market. Transactions price reporting 
will add additional transparency and improve market efficiency.
    Thank you for the opportunity to present my views.
    [The prepared statement of Professor Duffie can be found on 
page 50 of the appendix.]
    Chairman Kanjorski. Thank you very much, Mr. Duffie.
    And now, we will hear from Dr. Anthony B. Sanders, 
distinguished professor of finance, George Mason University.
    Dr. Sanders?

  STATEMENT OF ANTHONY B. SANDERS, DISTINGUISHED PROFESSOR OF 
                FINANCE, GEORGE MASON UNIVERSITY

    Mr. Sanders. Mr. Chairman and distinguished members of the 
committee, on November 5, 2009, Reuters published a story 
entitled, ``Greek Debt Reached 120.8 Percent of GDP in 2010.'' 
Everyone around the global is aware of how Greece's excessive 
debt fiasco had led to a meltdown of the European economy, 
potential meltdown, at only 120 percent of GDP. Things became 
even more critical when Greece discovered it had overlooked $40 
billion more of debt. Markets do not like surprises.
    These stories about the Greek economy beg the following 
question: Was the cause of the fiscal collapse of Greece 
perpetrated by credit default swaps, or was it out-of-control 
spending and borrowing by the Greek government that led to 
Greece being, in popular parlance, broke?
    Credit default swaps play two important roles in the market 
for credit. First, they facilitate liquidity by allowing 
investors to hedge against negative outcomes--for example, 
defaults--and second, CDS provide vital information to other 
market participants about the risk of a particular investment.
    This price or spread conveys information to potential 
investors, communicating the level of risk involved in an 
investment, and helping them to make a more informed and 
prudent investment decision. Restricting either of these roles 
makes credit less widely available and markets less 
transparent.
    CDS is the current villain du jour in the Greek debt 
fiasco. The Greek crisis is the result, again, of massive 
government spending and debt issuance to fund that spending. In 
fact, CDS in Greek sovereign debt actually served a positive 
role: It alerted everyone around the globe that Greece was in 
fact in a death spiral from credit.
    CDS is often misunderstood. Essentially, it allows 
investors to hedge their positions in debt, in this case, 
default of Greek sovereign debt. An investor may hold Greek 
sovereign debt long and may want to partially or fully insure 
against that default on debt. By limiting or abolishing CDS, 
you not only decrease liquidity for investors, which is a 
terrible idea, but you actually decrease liquidity in the 
underlying asset, in this case Greek sovereign debt.
    As can be seen in Exhibit 1 in my report, CDS spread 
started to widen in October and November of 2009. By December 
2009, CDS spreads widened even more dramatically. That is when 
the 120 percent GDP story came out.
    Now, consider further the Greeks' surprise when on April 2, 
2010, a story revealed that Greece had another $40 billion of 
unknown debt, and CDS widens. For a country that is already 
deep in trouble making its debt payments, the discovery of 
another $40 billion came as a rude surprise. I also show that 
in my exhibits, how devastating this is.
    So focusing on the instrument as the cause of the problem, 
in this case CDS, misses the real culprit, the behavior of the 
underlying asset. With Greece, CDS reacted to the behavior of 
the underlying asset, the debt. Just as in the housing crisis, 
CDS has been blamed for exacerbating the crisis, but really, it 
was the behavior of the underlying asset, housing prices and 
mortgages, that was the issue.
    If you are looking to place blame, don't blame the 
instrument. Blame the behavior of the underlying asset. Greece 
hid its debts. Markets found out and reacted appropriately. 
This is a lesson we learned well for the United States. Our own 
sovereign debt has a Greek surprise component, too. It is 
called GSE and agency debt.
    As Secretary Geithner tried to emphasize in a recent House 
hearing that I was involved in, the Federal Government's 
support of Fannie Mae and Freddie Mac does not change the legal 
status. In addition, he said, the corporate debt of the GSEs is 
not the same as U.S. Treasury debt.
    Secretary Geithner went on to say he wanted to eliminate 
this ambiguity. I completely agree with Secretary Geithner. But 
to end that ambiguity, we need to at least recognize the GSE 
corporate debt on the Federal budget along with projected 
guarantee book losses.
    An argument can be made against requiring that the 
guarantee books be brought on balance sheet, and an argument 
can be made to bring them on balance sheet. As I had mentioned 
before, the CBO has projected that these losses will be about 
$400 billion over 10 years, which could be higher or lower 
depending on future economic conditions, interest rate, and tax 
rates. These guarantees are supported by cash flows from 
borrowers, so it's less critical to bring them on the Federal 
balance sheet, although the losses that are expected should be 
recognized.
    Lastly, I would err on the side of fiscal conservatism by 
raising the projected guarantee charges for $400 billion to a 
higher number based on stress tests by the CBO in the same way 
that Fannie and Freddie run stress tests and alternative 
scenarios. FHFA has the stress test results, and we should 
prepare for the possibility of a double dip in housing prices 
in a few of the recessions, which is going to drive those 
losses much higher.
    Thank you for allowing me to share my thoughts with you 
today.
    [The prepared statement of Dr. Sanders can be found on page 
103 of the appendix.]
    Chairman Kanjorski. Thank you very much, Dr. Sanders.
    And finally, we will hear from Mr. Joseph R. Mason, 
Louisiana Bankers Association professor of finance at the 
Louisiana State University.
    Mr. Mason?

  STATEMENT OF JOSEPH R. MASON, LOUISIANA BANKERS ASSOCIATION 
        PROFESSOR OF FINANCE, LOUISIANA STATE UNIVERSITY

    Mr. Mason. Thank you, Chairman Kanjorski, Ranking Member 
Garrett, and members of the subcommittee for inviting me to 
testify today on this important and timely topic.
    While it is widely held that unprecedented monetary and 
fiscal policy responses of countries worldwide have been 
successful at preventing a worst-case scenario repeat of the 
Great Depression, the combination of rising fiscal deficits and 
continued monetary policy accommodation has raised concerns 
about the sustainability of public finances and fears of 
inflation. As a result, the recent uproar about Greece's fiscal 
woes and possible debt default are viewed by many as merely a 
canary in a coal mine.
    It is hard to argue that Greece is not to blame for its 
difficulties. As of December 2009, Greece had the highest 
fiscal account imbalance, as a percent of GDP, in all the Euro 
area countries and Britain at negative 7.7 percent, and its 
projected 2009, 2010, and 2011 balances were second only to 
Ireland.
    With a long history of fiscal stress and four previous 
defaults in modern history, investors are right to be 
suspicious. As of this hearing, Spain, Ireland, Italy, and 
Portugal are being pressured for similar good reasons, not mere 
contagion.
    Defaults are nothing new, even for sovereign entities and 
municipalities. There exists a long history of defaults 
throughout the world as well as U.S. history. The definitive 
guide to the history of U.S. State and municipal defaults shows 
that even in the Great Depression, States with serious default 
problems took on far more debt in the decade than States that 
had no defaults. Hence, even historically, default is not a 
threat without a substantial debt load.
    More recently, S&P reports that the 5-year transition rate 
for AAA-rated local and municipal debt over the period 1975 to 
2009 was 27.4 percent, with 10.9 percent of that resulting from 
ratings that were withdrawn and 16.4 percent resulting from 
ratings that were downgraded. S&P reports that the sovereign 
speculative-grade-rated 15-year default rate over the same 
period was 29.66 percent. The point is, sovereign defaults 
happen.
    A real problem in the sovereign CDS market, however, arises 
because of the concentration in counterparty risk. Whether that 
concentration is at a central counterparty or a small group of 
market participants, the risk remains. Recently, the IMF has 
opined that the magnitude of risk to be assumed at the proposed 
CCP on behalf of unmargined market participants is of an order 
of magnitude in the neighborhood of some $200 billion, and is 
rising daily with further exemptions. That estimate should not 
be dismissed or the amount will surely precipitate a future 
crisis.
    Some have pointed to CDS as creating problems for sovereign 
debt financing. It is hard, however, to see the case. While CDS 
provide transparency by aggregating market views of the 
probability of default and recovery, CDS in and of themselves 
do not create additional volatility to those views.
    The view of CDS as creating volatility comes from 
observations that CDS spreads can widen quickly before a credit 
event, reflecting demand from CDS protection buyers. Some of 
the furor arises because CDS markets may be dominated by fast-
moving hedge funds, while cash bond markets are dominated by 
buy-and-hold real money investors.
    While it can seem that the signals from the two markets may 
be at odds during distress, the apparent divergence has been 
shown to be bounded by some fundamental institutional and value 
distinctions between CDS and the underlying debt contracts.
    CDS do contribute greater information to markets than 
credit ratings, but no degree of rating agency liability, not 
even that greater than the PSLRA that would make them 
responsible for even Goldman Sachs' alleged fraud, will change 
that relationship.
    Overall, the danger that a CDS buyer may deliberately 
trigger a credit event remains theoretical. There are no known 
cases of adverse behavior that have directly impacted debt 
borrowers because those borrowers are known to be struggling 
financially anyway.
    In sum, therefore, I am not convinced that sovereign CDS 
deserves its current negative press, and fear that a ban or 
restriction on trading could easily backfire. Bans on trading 
activity tend largely to reduce liquidity, forcing a reversion 
to a world where sudden and unhedgeable price jumps occur when 
information about underlying fundamentals is occasionally 
priced into an illiquid market, that is, when someone finally 
trades.
    Sovereign CDS provides an efficient way to trade and to 
hedge credit exposures to governments, as well as a more 
continuous way for governments to poll their fiscal decisions 
more continuously in the marketplace. If governments do not 
like that transparency, it seems they doth protest too much.
    Thank you.
    [The prepared statement of Professor Mason can be found on 
page 81 of the appendix.]
    Chairman Kanjorski. Thank you very much, Mr. Mason. I thank 
the entire panel for their testimony, and now we will move to 
the questions. I will take the first 5 minutes, and at the 
conclusion of my 5 minutes, I will ask Mrs. Maloney to take the 
chair.
    I am not sure what I am supposed to gather from the 
testimony of all five witnesses other than that CDSs obviously 
are not the problem, but we have a big problem out there. Is 
that true, relatively speaking? We just have not done a 
postmortem to determine what really constitutes the problem, 
and how it can be solved. Is that reasonable?
    And the reason I ask you that is over the last 3 or 4 weeks 
when the Greece problem was called to international attention, 
it started at $45 billion, a need for a $45 billion 
underwriting or infusion from the European Union, and now it is 
up to $120 billion and climbing. And somebody today stated that 
there is no way that they can work a rescue here without a 
restructuring.
    I would like your reaction to that opinion, if any of you 
have one. Is that a correct or a likely conclusion?
    Mr. Duffie. Mr. Chairman, could I address that?
    Chairman Kanjorski. Surely.
    Mr. Duffie. You are correct. The estimates of how much will 
have to be loaned to Greece have gone up--tripled in the last 
few days. And again, relying on the CDS markets, as we have 
said, there seems to be a perception that Greek sovereign debt 
has a significant probability of defaulting anyway.
    One of the reasons for that is that these monies coming 
from the IMF and the Eurozone countries are not donations to 
Greece. They are loans. They have to be paid back. So they will 
actually increase Greece's indebtedness, although the terms of 
the loans are rather generous.
    The other issue is that some of these loans to Greece in 
external support may actually come in ahead of Greek sovereign 
debt in terms of who gets paid first. And that actually causes 
concerns to some Greek sovereign debt holders. If the IMF, for 
example, gets paid before them, maybe there won't be enough 
left for them.
    So in summary, I think it is not at all clear that Greece 
will avoid a restructuring of its debt or an outright default, 
and only time will tell.
    Mr. Sanders. Chairman Kanjorski, I would like to first of 
all agree completely with my esteemed colleague, Professor 
Duffie. But I would also like to point out that it is just not 
Greece; it is also Portugal--Spain is about to blow up; 
Ireland; Iceland. Great Britain is on the brink, too.
    So we are talking about a substantial amount of--some of 
those are non-Euro countries, but that Europe in general is 
having a severe meltdown due to, again, excessive spending. And 
it is biting them really hard right now.
    Chairman Kanjorski. What sort of potential--obviously, we 
do not have jurisdiction to intrude into the European Union. 
But I am dealing with them on financial matters on a regular 
basis now because we are trying to do our regulatory reform 
consistently, with the E.U. and the United States being on an 
equal footing.
    This is rather shocking, though, that suddenly someone can 
discover $75 billion of new debt that was really unrealized 
just 3 or 4 weeks ago. And it is true, when you talk about 
Spain, Portugal, Italy, and Ireland, if you throw them all in, 
the one commonality they seem to have is that they have 
violated the rule for entry into the Euro Union in that they 
went--they are all over 60 percent in debt, as opposed to the 
other countries that were far more stable and were in the union 
originally. I guess it proves that whoever set that formula up 
knew what they were thinking or talking about.
    But like anything that can be contagious, and we saw that 
recently in the credit crisis in the United States when things 
started to tumble, suddenly what are reasonable assets become 
valueless or almost valueless. And that obviously, probably, is 
happening to some extent in these countries.
    How do we put a stopgap in there, and how do we prevent 
that constant rolling motion that would take everything down, 
eventually the entire European Union? Is there some thinking on 
that? And maybe somebody wants to grab it and run with it?
    Mr. Mason. If I may, one substantial element that was left 
out of the European Union construct was a way to address 
individual country difficulties through some type of central 
bank action. In fact, that is why we designed the U.S. Federal 
Reserve System as a system of central banks able to address 
regional needs, even if the entire Nation did not need a 
stimulus.
    That is a fundamental flaw, and that is what creates the 
risk of being unable to address specifically Greece, Italy, and 
Spain while leaving, for instance, Germany and France 
relatively untouched.
    But you are exactly correct that the E.U. entry rules set 
the stage for off-balance-sheet finance. By arbitraging this 
rule, by keeping funding off-balance-sheet, they could stay 
within the debt limits, at least based upon the formula, but 
not in any real economic way.
    And that is a very, very important lesson that I want to 
point out here that happened in the United States with 
securitization in commercial banks. And I really would like to 
stress to the committee to see how that application is very 
robust to a number of different rules, even some rules that may 
be considered today in financial reform.
    Chairman Kanjorski. Thank you very much.
    Yes, Mr. Johnson?
    Mr. Johnson. Characteristically, when officials are doing a 
workout, the rule of thumb is to do too much rather than too 
little, in other words, to get ahead of the curve and do 
something so profound in restructuring that you essentially 
what you might call stop all of the emotion that leads to 
contagion in its tracks. You stop people from drawing inference 
about propagation.
    What is particularly difficult about this situation once it 
has taken place, and Professor Duffie mentioned this, is the 
free rider problem, which is at this point Greece knows that it 
is not just its own fate that is in its hands. Greece knows 
that it can take Italy, Portugal, and possibly the whole Euro 
structure down with it. And their incentives in bargaining now 
reflect more than their own fate. They think they have more 
leverage than if it was just an isolated country.
    So at some level, doing something that would, how should I 
say, not call Greece's bluff, but would acknowledge that they 
are going to perceive those side effects require a bigger 
offering from the other side of the table. Right now, Germany 
doesn't want to offer that. And they have a traditional concern 
about inflation in their past, and they don't want to do that 
right before an election when their population is not 
necessarily that fond of the Euro anyway.
    But the basic concept is you have to do more than you think 
is necessary in order to quell those anxieties once it takes 
place.
    Mr. Pickel. Mr. Chairman, if I could just return to your 
first question. I think it's important to understand the nature 
of these contracts as they are sovereign CDS versus corporate 
CDS.
    In a corporate CDS, the triggering events for a settlement 
are typically bankruptcy and failure to pay. For a sovereign 
CDS, the relevant events that would trigger a settlement of the 
credit default swap would typically be restructuring or a 
moratorium or repudiation of debt.
    And so, it is certainly true that participants in the 
credit default swap market are watching the current discussions 
very closely to see what the nature of the support from the IMF 
of the Euro might be because it could in fact be those events 
that might trigger a credit event under the contract.
    Because countries don't go bankrupt. Countries always have 
the ability to tax. But they may restructure their debt or they 
may miss a payment, and that would trigger a settlement.
    Chairman Kanjorski. Thank you, Mr. Pickel.
    I am now going to recognize the gentleman from New Jersey, 
Mr. Garrett, for 5 minutes. And may I request Mrs. Maloney to 
take the chair?
    Mr. Garrett. I thank the Chair, and again thank the 
witnesses. And I guess my opening thoughts and comments were 
that this committee and this title, ``Credit Default Swaps and 
Government Debt,'' could involve itself into a bunch of 
different areas.
    I guess the first takeaway from this is, taking the lead 
from the chairman and also from Mr. Johnson's opening 
testimony, and everybody else right down the row, is that CDS 
were not the underlying cause of the problem that we see in 
Greece right now. So from that, then we can sort of explore and 
say, well, what should we learn from this experience?
    Mr. Johnson, I know in your testimony you conclude, ``The 
Greek crisis in sovereign debt--sort of saying what I just 
said--is not fundamentally caused by CDS. It is caused by a 
profile of spending and tax revenue, and a dynamic of 
government debt accumulation that is fundamentally 
unsustainable.'' And I mentioned in my remarks what Chairman 
Bernanke said, that here in this country we are not going to be 
able to grow our way out of it, which is some people's 
suggestion as to how we solve our problem.
    So I would just be curious for your take on our problems 
here in this country is in order to avoid the situation that 
Greece sees themselves in. Is it like a lot of the experts who 
testify over in the budget committee hearing, that our first 
and fundamental area that we need to address is the entitlement 
spending in this country, and somehow or other we have to rein 
that in, and that is our Greek problem, if you will?
    Mr. Johnson. You are calling me back to the days when I was 
a staffer on the Republican Senate Budget Committee under Pete 
Domenici, so I will have to dust off those memories.
    What I would say is that there are many tools that reflect 
social priorities, and that the United States, after this 
financial crisis and definitely if we had a recurrence, would 
be reaching what Congressman Hensarling talked about, the red 
zone, which Ken Rogoff and Carmen Reinhart talk about as a 
debt-to-GDP ratio approaching 90 percent.
    I do think that structural reforms have to be made. Whether 
those structural reforms take the form of further health care 
legislation that reduces the price of care, or whether it 
involves entitlement reform in terms of the extent or quality 
of care, whether it involves taxation, or whether it involves 
the military budget, any of those things logistically fit into 
the what you call menu, theoretical menu, of tradeoffs that one 
could invoke.
    It is really a question of social preferences as to how you 
get there. And I do believe that we face that challenge. We 
have to define those preferences.
    Mr. Garrett. And then turning to Mr. Duffie, I noted your 
one comment, and then there was like a pregnant pause after it, 
and I don't know if it was intended or not, saying that 
speculation did not force the excessive borrowing, or spending 
first and then borrowing by Greece.
    Do you have any other comment to follow up, after your 
pregnant pause?
    Mr. Duffie. I would like to address the issue of whether 
speculation has any benefits at all. And one of the ones that 
has been mentioned by all of the panelists, I believe, which is 
that it provides an early warning system to the market. I think 
that has been quite helpful in this case. It has caused people 
to dig into the true financial condition of Greece, as 
Professor Mason suggested.
    Another benefit of speculation is that when someone needs 
to lay off some risk, they have to find someone to take it on, 
and speculators will usually do that in return for an expected 
profit. If we didn't allow them to participate in this market, 
it would be harder for investors to either exit their positions 
or hedge their positions.
    So I would encourage regulators generally not to clamp down 
on speculation, but to clamp down on manipulation, which is a 
different aspect.
    Mr. Garrett. One last question. My time is coming up here. 
Mr. Sanders and others alluded to the fact that a lot of this 
that happened in Greece, the triggering was the finding of new 
information, the $40 billion, or what-have-you. I have 
legislation in to say that we want to make sure that all of our 
information in this country is clear and transparent, and to 
say that all of our debt should be apparent to the public.
    I would think it is apparent, but I think the clearer way 
is to put it on the budget. Is there any reason why that would 
not be a legitimate avenue for Congress to go down and say, all 
of our GSE debt, if it is really sovereign debt or whatever the 
Treasury Secretary says it is, should not be transparent and on 
our budget?
    Mr. Duffie. I think that is correct. I think Supreme Court 
Justice Brandeis at one point said, ``Sunlight is the best 
disinfectant.'' And I think that is exactly what is needed, as 
much transparency as possible.
    Mr. Garrett. Let's flip it around. Does anybody disagree 
with that?
    Mr. Sanders. I agree completely with that statement. I 
think it really should be brought on it because we do want to 
avoid another Greek surprise. And if we leave it off, it just 
begs for another surprise in the market that is a negative.
    Mr. Garrett. And Mr. Mason, it looks like you--
    Mr. Mason. I also agree that we need to be clear about our 
own off-balance-sheet exposures, so to speak. But we also need 
to pay attention to the resolution of the consumer problems in 
today's marketplace in terms of what we have talked about in 
restructuring in the Greek context.
    If you think about a restructuring for today's consumers, 
by offering the modification and therefore taking a loss on the 
secured debt, while leaving the unsecured debt of the consumer 
intact, we have actually violated an absolute priority rule in 
the restructuring of the consumer in a way that has confused 
and shocked markets.
    And in the restructuring, we do need to be very careful to 
communicate directly to investors, previous investors, what 
they are liable to get even after loans from the outside come 
in to bail out the--
    Mr. Garrett. And just so I understand what you just said, 
that means that all the work that we do as far as restructuring 
on the secured debt, which is mortgages and all those programs, 
we have to be careful of the implications on what that does as 
far as the unsecured debt and going forward as far as whether 
lenders want to engage themselves in that activity?
    Mr. Mason. We have seen that directly by modifying first 
lien mortgages before second lien mortgages, and of course the 
second lien holder was able to avoid a loss where they would 
have otherwise, according to the rules of the game, taken a 
loss. It has been confused.
    Mr. Garrett. Right. Thanks. I appreciate the clarification.
    Mrs. Maloney. [presiding] Thank you. The Chair recognizes 
herself for 5 minutes.
    The first time CDSs came to national spotlight and 
attention was during the AIG crisis. And I would like to ask 
the panelists, starting with Mr. Johnson and going down, if 
anyone would like to comment on it.
    What would have been necessary to avoid the AIG bailout in 
terms of CDS reform?
    Mr. Johnson. Would you like me to start?
    Mrs. Maloney. Yes. You start, and then Mr. Pickel and Mr. 
Duffie, if you would like to comment.
    Mr. Johnson. I think there are a couple of things that come 
to mind, the first of which is the way in which premium income 
is booked by those who wrote CDS during that period, allowed 
them to book it as income and not have set-aside or loss 
provisioning, whereby--how do I say it--they built a war chest 
or a contingency fund in the event that they had to pay out.
    But I want to be a little bit careful about that. CDS is an 
unusual contract. It is not as if there is a stream of payments 
that when the event is triggered, the insurer just assumes a 
stream of payments. They actually have to deliver on the whole 
loss for the outstanding bond.
    And you go from collecting a premium, which is a flow each 
year, to having a huge liquidity demand on as the writer. And 
obviously, when we had a giant storm like that, it is not clear 
to me that even a well-provisioned system would have withstood 
that shock.
    The second dimension, I think, is that a systemic risk 
regulator needs to understand the distribution of exposures, ex 
ante, and they need to have a very clear sense of that pattern 
of exposures because when they are called upon to resolve any 
impaired institution, they may be triggering an event that is 
not necessarily emanating from the balance sheet of that 
institution.
    If one bank fails, two other banks may have transferred 
risk on the CDS on the failing bank. And unless there is a 
unified awareness of that exposure map, by taking action, 
putting the failing bank into receivership, you may drag 
somebody else over the wall with you and lead to contagion.
    Understanding those consequences will make it much easier 
for the resolution authorities. So that information system, I 
think, is very important.
    Mrs. Maloney. Mr. Pickel, would you--
    Mr. Pickel. I think it is important to understand the 
differences between the nature of the transactions done by AIG 
and the transactions that are the focus of this hearing, the 
sovereign CDS or even the corporate CDS. Those credit default 
swaps were written on super-senior tranches of CDOs which had 
exposure to underlying real estate risk.
    And in fact, those were--there is all this discussion about 
naked credit default swaps or situations where you actually 
have the underlying risk. The people who bought that protection 
from AIG actually had the underlying risk. So those would be--
even if you wanted to ban naked credit default swaps, those 
could still be done.
    I think it is also a function of the fact that the AIG 
individuals who were involved in these transactions didn't have 
a full understanding of the nature of the risks. They were 
looking at the potential for them to have to pay out. They did 
not take into account the mark-to-market risks that they had.
    It was compounded by a reliance on AAA ratings and refusing 
to provide collateral. Collateral is a very important tool in 
the OTC business, widely used, and it provides not just credit 
protection, but provides indications as to the exposure that 
you have under your underlying positions that you can adjust 
to. They compounded that by agreeing to downgrade provisions so 
that at the very worst time, when they lost their AAA rating, 
they had to come out with massive amounts of collateral because 
of the mark-to-market exposures.
    So I think you need to have the information that Mr. 
Johnson refers to. Clearing wouldn't help in that situation, 
but greater utilization of collateral in those transactions 
would be quite helpful.
    Mrs. Maloney. Would anyone else like to comment? Mr. Duffie 
and Mr. Mason, and then my time is up.
    Mr. Duffie. Briefly, there are four measures in the 
legislation that your committee has proposed to reform the 
financial system that address this.
    First of all, the supervision by the Federal Reserve of 
systemically important financial institutions would include a 
firm like AIG. Hopefully, they would do a much better job than 
the Office of Thrift Supervision actually did at the time.
    Second, the legislation proposes a new method for 
resolution of systemically important financial institutions, 
and that would allow AIG to be taken apart without necessarily 
a lot of collateral damage.
    Third, data repositories are in the new derivatives 
legislation. This would provide regulators with the opportunity 
to see how much credit default swaps AIG would have held.
    And then finally, as Mr. Pickel said, the new legislation 
will require substantial amounts of additional collateral, and 
that will also improve the situation.
    Mrs. Maloney. And Mr. Mason, and then my time is up.
    Mr. Mason. Thank you. I would like to emphasize Mr. 
Johnson's remark about information, but also take it a slightly 
different direction. The information that we needed to 
understand AIG's exposures was there. DTCC had it. We just 
needed to think to ask them.
    After my own experience in the bank regulatory agencies, it 
has been amazing to me that bank regulators would not ask 
outside of banks for additional market information or even 
information about direct bank exposures, whether it is CDS or 
off-balance-sheet securitized entities.
    To me, that is the important element that can be solved 
fairly simply in financial reform. Instead, financial reform, 
as currently drafted, is asking for the entire trading book of 
every systemically important institution, which is information 
overload. Any attorney knows if you want to fight off an 
attack, you either withhold information or you give them too 
much to digest.
    That would be far too much to digest, and I think the best 
starting point is to allow bank regulators and other Federal 
regulators access to information sources, common on Wall 
Street, that they cannot afford right now, and sometimes even, 
because they are not a qualified institutional buyer, cannot 
even legally access. That would give the greatest bang for the 
buck, so to speak, of the legislation. Thank you.
    Mrs. Maloney. Thank you. Mr. Bachus is recognized for 5 
minutes.
    Mr. Bachus. Thank you. First, I want to say that your 
testimony, which arrived yesterday afternoon, our staff reads 
that, and they refer that to us--not always; they will 
recommend that we read it or not. And we then will review some 
of it or look at it or use it.
    And I want to say the staff and I both want to compliment 
you on your testimony. We found that it was very insightful in 
all cases, and did what it is supposed to do. So if you had a 
Member who stepped out during your testimony, he probably read 
it or will read it, and he certainly had a staffer that 
highlighted certain things to him. So I commend you on that.
    Mr. Duffie, let me start with you. Credit default swap 
spreads, I think, are a reflection of Greece's economic 
condition. I know the Greek government's difficulty refinancing 
its debt is a direct result of not the CDS--sovereign CDS 
market, but of legitimate concerns about its financial health.
    Would those concerns--or let me say this: Is it correct to 
say that the sovereign CDS market alerted us to the problem the 
Greeks had, as opposed to contributed to it? Many people have 
blamed it on the sovereign CDS market, or part of that. But 
what is your view?
    Mr. Duffie. Based on the statistical evidence, that is 
certainly my conclusion, Mr. Bachus.
    Mr. Bachus. That--
    Mr. Duffie. That the CDS market, rather than causing Greece 
to have borrowed too much money or to be currently in a debt 
crisis, it actually alerted investors that Greece would have 
borrowing problems.
    Mr. Bachus. Right. And it served a very useful purpose in 
that I think it caused people to confront the problem.
    Mr. Duffie. Yes. It provided both an early warning system, 
and of course, for those who needed to get rid of some of their 
risk, it provided a way for them to transfer it to others.
    Mr. Bachus. Right. I appreciate that.
    Mr. Sanders, the Federal debt stands at $8 trillion, and 
GSE debt stands at an additional $8 trillion. That represents 
110 percent of our GDP. What are the implications of an 
unsustainable debt load? And actually, Chairman Bernanke said 
that our debt projected was unsustainable.
    Mr. Sanders. Actually, the Federal debt load is over $12 
trillion. It is just that $8 trillion of it is public debt. And 
of the GSEs, the guarantees are a large part of that $8 
trillion. There is a lesser amount, which is a little less than 
50 percent, is the GSE corporate debt. But it still amounts to 
a large chunk of GDP, and this is before all the real massive 
entitlement programs, etc., kick in.
    And then once we hit that, I think the unfunded 
liabilities, depending on the source of it, can be upwards of 
$110 trillion and growing. We are at $8 trillion plus GSE debt 
plus, remember, my good friend Joe has always talked about the 
off-balance-sheet issue. I wrote a paper a few ago called, 
``Banks: The Next Enron,'' warning that off-balance-sheet 
financing is devastating unless you put it on the balance 
sheet.
    And for the government, it is especially true. We have 
pension programs which are currently off balance sheet that, 
like Wall Street, are only recognized if there is a loss. And 
really, we have to end that. We have to bring it all on balance 
sheet so, as Professor Duffie--according to Justice Brandeis, 
sunlight is a great thing. We should have all this stuff 
visible because it is unsustainable.
    And as I quoted in my paper, presentation, I said that 2 
percent of United States households have $250,000 or more of 
income. But if they are bearing the brunt of all these 
entitlement programs and war spending--let's just say all 
spending--and we add these up, that ends up being that each 
household that makes $250,000 or more is responsible for $47 
million per household.
    Now, I would call that unsustainable. And it also scares 
the living heck out of me, too.
    Mr. Bachus. I appreciate that. I also appreciate that 
Chairman Frank and Congresswoman Maloney and Subcommittee 
Chairman Kanjorski selected our witnesses. They did a good job 
this time. Thank you.
    Mrs. Maloney. Mr. Sherman?
    Mr. Sherman. Thank you. Mr. Sanders, just a comment, and 
that is you seem to be focusing on income taxpayers rather than 
Social Security taxpayers. People earning much less than 
$250,000 are paying the bulk of that Social Security tax. And 
if you are talking about who is going to pay for the 
entitlements, it is chiefly those who are paying Social 
Security tax.
    One could design a society where the greatest rewards went 
to science and engineering. But we pay the largest salaries to 
those who study under Mr. Duffie and go into Wall Street. And 
that is justified on the theory that capital allocation is very 
important.
    But the question is whether Wall Street is engaged in 
capital allocation or just naked betting. Gambling is usually 
thought to serve no particular social purpose, and if anything, 
imposes social costs. George Soros a couple of days ago, in 
commenting on synthetic CDOs, but this also applies to naked 
CDSs, said that they serve no social purpose and build up the 
amount of debt, thus creating a larger crash when the crash 
occurs.
    What social benefit, Mr. Johnson, occurs from those who bet 
on Greek currency for no good reason, nothing to do with their 
regular business, just because they think they are smarter than 
the market and they can guess whether it is going to go up or 
down?
    Mr. Johnson. I have to refer to the distant past in my 
resume before answering you, just to be very clear. I used to 
be--
    Mr. Sherman. I have limited time. Please answer my 
question. I will learn about your resume later.
    Mr. Johnson. I used to be George Soros's partner and a 
currency speculator in the early 1990's, and I just want to 
preface with that.
    I believe that there are times when price systems get out 
of balance. You referred to the excessive incentive to allocate 
our best talent to Wall Street, probably because we had a lot 
of embedded subsidies in the system that blew up a year or so 
ago that made Wall Street firms excessively profitable, and 
they could pass their risk off onto the taxpayers.
    That is being corrected now, and I don't expect Wall Street 
to draw quite as much talent as in the past. I don't think that 
gambling on currencies for its own sake, as an action, has much 
redeeming quality. But I would say that when a price system re-
equilibrates, a society gets back on track sooner.
    Greece right now is--how do we say--harming future 
generations, and the price pressure coming to a head, and 
violent, may represent those future generations.
    Mr. Sherman. Reclaiming my time, one issue that comes 
before us is whether we should impose any fees or taxes on the 
casinos on Wall Street. I would point out that every other town 
in America where they have a casino, there is a tax. And at 
least then, there is some social benefit that accrues from 
allowing the gambling activity to occur.
    My next question relates to why California is facing a 
valuation of its debt below that is Kazakhstan, Croatia, 
Brazil, Bulgaria, and even Thailand--at least, I haven't 
checked Thailand recently; they have some problems there--where 
you have to pay 200 basis points for insurance. That is only 3 
times what you pay on Greece.
    My reason is not just that the California economy is many 
score, or at least 20 times, that of Greece--at least many 
times that of Greece. The debt in California is considerably 
less. But also, as a matter of law, if California doesn't pay, 
courts will step in and divert revenue streams of California to 
pay the bondholders.
    In contrast, when a sovereign, a true sovereign, goes 
bankrupt, an independent country, they can simply disclaim 
their debt, declare it void, and there is--100 years ago, we 
would send in the Marines to Haiti and collect their revenue 
and give it to the creditors. But since those days, it seems to 
be in the interest, the short-term interest of Greece, at 
least, to repudiate its debt. They make $300 billion in one 
day.
    So why is the cost of insuring Greek debt, where the Greeks 
can make over $100,000 per family of 4 in 1 day with no court 
able to enforce the debt--why is that in the same ballpark, 
even, as the cost of insuring California debt, where if 
California doesn't pay, a court comes in, takes our income tax 
and sales tax revenue, and makes sure that large chunks of it 
go to the debt holders? I am looking for--Mr. Pickel, do you 
have an answer?
    Mr. Pickel. Yes. I will try to respond to that.
    You are right that repudiation is certainly an option for a 
sovereign, and that would trigger the settlement of the credit 
default swaps. That is an event that would trigger for Greece 
or a country.
    Mr. Sherman. And what would Greece lose if it renounced its 
debt? We see what it gains. It gains $300 billion. It loses the 
ability to borrow.
    Mr. Pickel. Right.
    Mr. Sherman. But on a cash flow basis, if your debt service 
exceeds your borrowing--first of all, I don't know anybody 
other than the IMF and the European Union who is going to loan 
any money to Greece.
    Mr. Pickel. Right.
    Mr. Sherman. But even if they could, they are going to 
borrow less than their debt service. So why isn't Greece 
defaulting? It is a $300 billion payday.
    Mr. Pickel. I will maybe defer to some of the economists on 
the panel. But I think that there is that reputational issue of 
being able at some time in the future ever to get back into the 
capital markets to borrow in the future. So that is certainly a 
concern.
    Mr. Sherman. Let me turn to one of the economists quickly. 
If Greece honors its debt, nobody is going to want to lend them 
money for 2 or 3 years anyway. And if they dishonor their debt, 
in a decade, people will be loaning them money again. So, Mr. 
Duffie, why don't they just renounce?
    Mr. Duffie. I think there is--
    Mrs. Maloney. The gentleman's time is up.
    Mr. Sherman. I will ask you to answer the question, please.
    Mrs. Maloney. Answer the question.
    Mr. Duffie. I think there is a significant probability that 
Greece will default on its debt for exactly the reasons that 
you suggested, although, as Mr. Pickel suggested, it is costly 
to do that because in the future, Greece may need to borrow 
again.
    Mrs. Maloney. Thank you. Mr. Neugebauer?
    Mr. Neugebauer. Thank you, Madam Chairwoman.
    I would like to kind of continue down that same line of the 
discussion because--and I think it was Mr. Johnson who said 
that the whole European Union is somewhat in a fragile position 
right now. And I referred to it yesterday as kind of a house of 
cards, and that two or three of these cards fall and it puts an 
extreme amount of pressure on the E.U.
    Probably the United States is the beneficiary of that right 
now because people are--that is probably what is giving the 
Treasury Secretary the ability to keep borrowing money and 
dollars to support these huge deficits.
    But I think the question I have for the panel is if this 
begins to happen in Europe and we have some defaults--Japan is 
not in just the best of shape itself. A lot of people don't--
that is not on their radar scope. The Chinese have said on a 
number of occasions that they are kind of like my banker back 
home. They are getting a little nervous.
    So what is the implication of us continuing these deficits, 
and then we have some fairly major defaults, or potential 
defaults, in the E.U., and what does that do to the United 
States? I would get concerned at some point in time here we are 
going to have an auction or two fail here just because, one, 
there may not be enough money in the economy to sustain all of 
these credit needs; but secondly, just the nervousness of when 
countries start to default, what that does--how people are 
looking at our debt as well.
    So Mr. Johnson, do you want to start? And just go down 
the--
    Mr. Johnson. I think currency and international investing 
is always the business of assessing the lesser of relative 
evils. And at this point, the acute anxiety and the new 
information that pertains to Europe is actually encouraging 
funds to so-called flight to quality to the United States.
    The dollar is likely to strengthen. Given our trade 
deficit, the import-competing industries and export industries 
will receive a negative incentive in terms of the expansion 
they would like to undertake.
    In the longer term, I think you point to a heightened 
anxiety about sovereign debt and what we might call a renewed 
scrutiny or skepticism, and people will be very concerned about 
our debt dynamics, though as a snapshot at the moment, I think 
the first effect, the lesser of evils, is the dominant 
influence. In the medium term, it may make it more difficult to 
sustain deficit spending.
    Mr. Neugebauer. Thank you. Mr. Pickel?
    Mr. Pickel. Yes. I think there are those two effects that 
Mr. Johnson refers to, the ``beneficial one'' of a flight to 
quality and lower rates on U.S. debt and a stronger dollar. But 
that, of course, has implications for the economy longer term 
competing against a weaker Europe.
    Mr. Neugebauer. Mr. Duffie?
    Mr. Duffie. The United States depends heavily on the 
ability to export to these countries. And even though there is 
a flight to quality effect that temporarily benefits our 
currency and our bond markets, and even though our bonds are 
very, very, very strong and the United States has, despite its 
heavy debt load, extremely large abilities to borrow more, it 
can't help the United States to have our neighbor countries in 
Europe and Japan become economically weaker or even default. 
That is definitely bad for us.
    Mr. Sanders. One thing we haven't discussed so far is that 
Greece may default. But they also may become a zombie state, in 
which they have the IMF and other countries loaning them money 
just to perpetuate them. They will have no incentive to 
actually cut spending. They will just exist on the dole from 
the international market.
    The problem is that we can probably do that for one 
country. But then as they all start to fall, it is going to get 
incredibly more expensive around the globe to keep propping up 
zombie states. Japan already is in that state. Their banks 
are--our top banks are almost zombie banks at this point.
    We have a lot of problems because we are not letting anyone 
go to bankruptcy, whether it is on a corporate level. Even 
countries can actually find out they have--I wouldn't call it 
extortion rights, but they can threaten to collapse the market 
and get more IMF money or more money and not ever do anything. 
So it is an outcome that might occur.
    Mr. Mason. I would like to add--just make a separation 
between fundamentals and contagion here. There is not a lot of 
evidence for pure contagion in economics, where just I happen 
to fail, but I have no linkages with Mr. Sanders here, but 
because I fail, he fails. There are linkages there.
    Now, economics is amoral, and markets are amoral, and they 
will root out those linkages. And that is one of the social 
benefits of secondary market trading. Primary market trading is 
about allocating capital. Secondary market trading is about 
rooting out inefficiencies, and secondary market traders will 
find those inefficiencies.
    Countries that default will resume. Resumption is costly. 
The only country that hasn't resumed in anything near modern 
history that wasn't invaded was the Soviet Union, which still 
has--that is, not the Soviet Union, pre-Soviet Russia, I am 
sorry--which still has debt outstanding that trades at a half a 
cent on the dollar or so. But it does trade.
    But really, the more important aspect that we have to deal 
with, not only with the U.S. sovereign situation but also with 
financial reform and consumer policy, is we have made a 
concerted effort to centralize losses from this credit crisis, 
from this bubble in real estate--which was a bubble, and it is 
not coming back, we don't want it back--and we have made a 
conscious decision to centralize those losses up to the 
sovereign entity.
    And this kind of gets to where we started out today talking 
about CDS markets. Sovereign CDS markets are especially 
concentrated, and that concentration creates the systemic risk, 
the biggest risk out there.
    So Greece has a lot of losses concentrated in its sovereign 
debt, particularly, mind you, through its overly generous 
pension allocations, which are far too--just far too--
    Mrs. Maloney. Would the gentleman sum up? The time has 
expired.
    Mr. Mason. The point is, the GAO in 2006 already suggested 
a significant number of U.S. pensions are underfunded. Markets 
lost 40 percent since then, or more. We know the United States 
is in a similar situation. Let's see the linkages for what they 
are.
    Mrs. Maloney. Congressman Lynch?
    Mr. Lynch. Thank you, Madam Chairwoman, and I want to thank 
the witnesses. This has been very helpful.
    Now, Mr. Johnson, I appreciate your statement that in the 
Greek cases, credit default swaps is probably just a smaller 
portion of the problem, and that Wall Street didn't create 
their crisis. However, in some ways I think we may have--Wall 
Street may have exacerbated it.
    But now I am wondering about not just the credit default 
swaps that Goldman and others might have sold to the Greek 
government. I am also worried about what they sold to Spain, 
what they sold to Portugal, what they sold to Ireland, because 
as others have pointed out, the E.U. as a group is our largest 
trading partner. And if we start seeing defaults here, that 
will have a tremendous impact on our economy from an import/
export standpoint.
    And also, we sort of talk like the IMF, like they have 
their own money. But we are a major contributor to the IMF. So 
that is--the IMF is us, is the American taxpayer as well.
    And I guess one of the most troubling aspects of the credit 
default swap practice in Europe, and even with our own 
municipalities and pension funds, is the concealment aspect of 
this, and that these deals, off balance sheet, allowed Greece 
to conceal debt that was there. It allowed them to conceal the 
fact that certain major aspects in their country were 
encumbered.
    Airports: They actually pledged future revenues from their 
airport to cover the collateral on the debt to Goldman. And 
also, they pledged--they have a national lottery. They took 
their lottery proceeds from the next 10 or 12 years, or 20 
years, and pledged that as well. But an innocent person coming 
in would not know about that. It was all hidden.
    And let me get to my question. Is there not a greater 
obligation here, when this is sovereign debt or when you are 
dealing with a municipality, where behind that deal stands the 
full faith and credit of the taxpayer? We are picking up the 
tab, just like a lot of this debt in Greece--all of it, all the 
sovereign debt--is really being put on the taxpayer. But they 
are completely ignorant of what is going on here.
    It is the same with the debt associated with the pension 
funds and municipalities. Those pensioners, those current and 
future retirees, are completely ignorant of what is going on 
here. And the same thing with deals entered into by 
municipalities. These are being made without the knowledge of 
the townspeople, the residents, the taxpayers, who are standing 
behind these deals.
    I just wonder, is there not an obligation for us, when 
parties enter into these deals and the taxpayer is behind them, 
should we not require the parties, the people who assemble the 
credit default swaps, the people who market them, the people 
who trade them, to all--and the people who underwrite them--to 
all assume a fiduciary responsibility to the people who are 
standing behind that debt?
    It just seems that at least in the public dimension, it is 
something we should require. We could talk about private 
parties later on. But I think there is a special exposure here 
that we haven't really acknowledged.
    And I just wonder, should we require a greater obligation, 
this fiduciary duty, for these parties that are dealing with 
public debt? Mr. Johnson?
    Mr. Johnson. You raise a whole series of issues. One thing 
I want to clarify is, I don't think it was the credit default 
swap that created the deception about Greece's indebtedness or 
deficit which allowed them to get into the European Union. But 
it was a derivative transaction--
    Mr. Lynch. Right. It was a currency--they fashioned it as a 
loan, so it went off balance sheet. But it was a structure--
    Mr. Johnson. I just want to clarify that because we are 
talking about CDS today along with this problem.
    Mr. Lynch. Right.
    Mr. Johnson. But it was a different dimension. I believe 
every aspect of the capital market, whether it is municipal, 
sovereign, or corporate depends upon accounting standards and 
disclosure standards so that we can properly value things. And 
in every dimension of that process, more integrity, more 
transparency, is imperative.
    I alluded in my testimony that when you are talking about 
the needs of communities, when you are talking about basic 
services in life, which sometimes are financed by 
municipalities or State or Federal Government, it is very 
important to have those things, that integrity, in place.
    One thing that concerns me a great deal now, as I am 
listening today, I can see coming over the horizon a tremendous 
concern about our Federal finances.
    And I am concerned in the current legislation on 
derivatives about so-called end-user exemptions because when I 
have informally polled CFOs about why they are so attracted to 
playing in these OTC dark markets, some of what I pick up--I am 
not saying I have a smoking gun--is their earnings management 
and their ability to manage tax liabilities, not unlike the 
Greek government did with Goldman Sachs, is a risk in terms of 
the revenue-based tax collection and the future of our national 
finances.
    Mr. Lynch. I agree.
    Mr. Pickel. Mr. Lynch, if I could just comment on the 
fiduciary duty, these transactions--and I mention this in my 
remarks--are bilateral transactions. So if I am dealing with a 
government entity and I am paying them fixed, they are paying 
me floating, say, on an interest rate swap, we are in those 
transactions are principals. I am acting as a principal on the 
swap. They are acting as their principal on the swap.
    They may be well-advised to get some advice as to whether 
that is a good transaction for them. But in that particular 
transaction, it is two parties interacting and making their own 
decisions as to whether the transaction makes sense or not. 
That is the fundamental nature of these transactions.
    There is a role for advice, and an advisor would have a 
fiduciary capacity. But in that particular transaction, it is I 
buy, you sell. I go long, you go short. I pay fixed, you pay 
floating.
    Mr. Lynch. Thank you. Thank you, Madam Chairwoman.
    Mrs. Maloney. Mr. Manzullo?
    Mr. Manzullo. Thank you, Madam Chairwoman.
    I am sorry I came late. I have read through a good part of 
the testimony. One of the uses of derivatives in the credit 
default swaps occurs when a giant U.S. manufacturer such as 
John Deere--and their VP for finance testified here several 
months ago--that in exporting to a market, they will get 
involved in the CDS for the purpose of protecting the price of 
their machinery when it is sold.
    Could somebody comment on that? First of all, do you agree 
with me on that?
    Mr. Duffie. I will address that.
    Mr. Manzullo. Thank you.
    Mr. Duffie. Yes, Mr. Manzullo. That is one of the primary 
uses of derivatives, for a corporation such as John Deere to 
lay off risks, such as currency risks or interest rate risks or 
commodity risks. They are very useful for that purpose.
    Mr. Manzullo. Could you walk us through? The reason I ask 
that is I spend most of my time on manufacturing, and I am from 
northern Illinois so it is a heavy industrial area. Most people 
in the country really do not understand the connection between 
manufacturers who export and the credit default swaps.
    Could you walk us through a transaction of, say, John Deere 
selling a giant piece of equipment to Greece? How would they do 
to protect their price?
    Mr. Duffie. Okay. So in this case, John Deere would be 
receiving Euros in return for its tractors. But it might not 
get them until next--the Euros might not come until next year.
    So, being concerned about that, John Deere might enter, for 
example, with Morgan Stanley or Credit Suisse, an over-the-
counter derivative security by which it would effectively sell 
the Euros now to that bank when they arrive next year at a 
price to be agreed now so that it wouldn't suffer the risk that 
those Euros would decline in value in the meantime.
    Mr. Manzullo. Why would they not get payment until next 
year?
    Mr. Duffie. For example, they may have just signed a 
contract to deliver 1,000 tractors in return for 10 million 
Euros next year.
    Mr. Manzullo. Next year would be the date of the delivery?
    Mr. Duffie. Correct.
    Mr. Manzullo. Okay. Mr. Pickel?
    Mr. Pickel. I was just going to add, from a credit default 
swap perspective, John Deere may have sold to, say, a Greek 
company those thousand tractors, and they may be concerned 
about the creditworthiness of that company a year down the 
road.
    If it existed, if there was a credit default swap on that 
company, the most efficient way for them to hedge that credit 
exposure that they have would be to buy protection on that 
name.
    But very likely--and I am not sure there are many Greek 
companies that you can buy protection on, so they might 
actually buy protection on Greek sovereign debt as a proxy for 
the fact that if there is a problem in Greece, it is going to 
affect the ability of that company to pay on that obligation, 
and therefore it is a proxy for that exposure that they have.
    Mr. Manzullo. Does anybody there have an idea as to the 
percentage of CDS that would be reflected by the manufacturers 
engaging in that activity? One percent, 10 percent of the total 
value? Anything?
    Mr. Pickel. It is a relatively small amount at this point.
    Mr. Manzullo. A small amount?
    Mr. Pickel. One percent is probably close. It certainly 
wouldn't be any more than 5 percent, I think. The CDS is 
largely, in the financial world, in terms of dealer kind of 
parties, hedge funds, asset managers, and others.
    Mr. Manzullo. Private companies. So what could John Deere 
do? The OPIC, Overseas Private Investment Corporation, I don't 
think guarantees against a currency collapse. It would by a 
seizure by coup or something like that. What would John Deere 
do in the--if they couldn't guarantee that they would get 
payment, if they couldn't use a derivative?
    Mr. Duffie. They would have to take the risk. They would 
expose their shareholders to that risk. And the shareholders 
might themselves try to hedge it, but it would not be as 
efficient as having John Deere hedge it.
    Mr. Manzullo. We had a company back home, now out of 
business, that sold paper machines, paper-making machines to 
Indonesia several years ago. And their economy collapsed, and 
the American company went bankrupt.
    What would the proposed restrictions on derivatives--how 
would that impact a company such as John Deere?
    Mr. Duffie. I will take that briefly. Some of the proposed 
restrictions are to allow hedging but to eliminate speculation. 
The unfortunate issue is that if John Deere were to look for a 
hedging opportunity, most likely it would be provided by a 
speculator who would be willing to take that risk. So by 
eliminating speculation, you actually make it much harder to 
hedge.
    Mr. Manzullo. Anybody else?
    Mr. Johnson. I think the--I would guess that all of us on 
the panel believe that there is a very important use for 
derivatives in this insurance-like feature, where the 
currencies, interest rates, and the full spectrum of market 
possibilities should be offered to someone like John Deere.
    The question is more in what context should the market-
making systems--how do you say--be set or structured because 
they do have collateral influences on the integrity of the 
financial system, propagation of financial disturbances, and 
impact on the taxpayer to the extent that the--
    Mrs. Maloney. The gentleman's time has expired. If you 
would wind up, Mr. Johnson. Are you--the gentleman's time is 
expired.
    Mr. Perlmutter? Mr. Foster?
    Mr. Foster. Thank you, and I would like to thank the 
witnesses for their excellent testimony. And I share their 
conclusions that the CDS on Greek debts, amounting to less than 
2 percent of their outstanding debt, cannot be a major 
contributor to Greece's woes.
    I also share with my colleagues on the right their sincere 
regret that we did not leave in place the fiscally responsible 
policies prior to the Bush Administration which, as we all 
know, would have paid down the debt essentially to zero at this 
point had we left them in place.
    I am happy also to see them embrace the concept that we 
cannot grow out way out of this since this was, after all, the 
philosophy that they used to justify the fiscally irresponsible 
policies that got us into this mess. Perhaps, given the $17.5 
trillion of household net worth destroyed in the last 18 months 
of the previous Administration, they believe that we can shrink 
our way out of this crisis. But I digress.
    What I would like to raise is the limits to the concept of 
an insurable interest, as we have chosen not to apply it to 
derivatives markets. As you all know, we do not allow people to 
take out fire insurance on their neighbor's house, at least in 
part because that provides an incentive to firebomb their 
neighbor's house. And we have chosen not to apply that 
principle to derivatives markets.
    And so my question: Do you see any role at all for the 
principle of insurable interest in the derivatives markets? And 
I will open up to anyone that--
    Mr. Pickel. I think I will start off there. As I 
highlighted in my testimony, there are a lot of different risks 
or reasons for entering into credit default swaps beyond that 
actually holding the underlying bond at a loan. Sellers of 
protection may in turn want to hedge their exposure. You may 
have investors who have exposure to that particular country in 
the sovereign situation.
    So I think the notion of what is an interest that might be 
insurable is a very broad concept. And certainly if you were to 
go down that path, you would have to recognize the diversity of 
those interests.
    I think, as Mr. Duffie said, there is a role for 
speculators here. It provides liquidity to the market so that 
when somebody does need to hedge, they know that they have a 
deep, liquid market that they can turn to. I think those are 
some of the principal reasons for that.
    I think it is also important to keep in mind that in a 
derivative situation, the exposures are mark-to-market. So if I 
have bought protection at a low price because the perception 
was that the credit--the reference entity was creditworthy, and 
they go down in their credit rating, I am going to see the 
price increase.
    I will be in the money as the buyer of that protection. You 
will be out of the money as the seller of that protection. And 
we will typically exchange collateral--footnote: AIG didn't do 
that; that was one of the big problems--but in most of the 
situations, there would be collateral moving back and forth to 
protect that exposure.
    And if either party defaulted, whether that is the buyer of 
protection or the seller of protection, they would have to make 
the other party whole for that fluctuation, unlike in 
insurance, where if I don't pay my premium, I just can't get 
the protection when I need it.
    Mr. Duffie. Could I add to that? Ironically, there is a 
reverse concern on my part. If I, for example, were to lend 
money to Mr. Sanders and was responsible for making sure that 
he pays me back, I would need to monitor him and take care that 
he is going to pay me back.
    If I were to turn to Mr. Johnson and buy protection from 
him on this loan so that I was no longer concerned about Mr. 
Sanders paying me back, there is a moral hazard. First, I won't 
be doing my job properly in monitoring Mr. Sanders' ability to 
pay me back. And secondly, poor Mr. Johnson is going to be 
bearing the risk that I won't be doing my job.
    So it can be the case that exactly when I have an insurable 
interest, that the use of credit default swaps can lead to a 
problem. Disclosure is the way to deal with that problem. It 
should be disclosed to Mr. Johnson that I do have a loan to Mr. 
Sanders.
    Mr. Mason. And I would like to follow up that the 2009 
Fitch Global Derivatives Survey produced results that suggested 
most market participants are really not concerned with that 
type of misuse. It seems to be overblown outside the financial 
world.
    I think the key is observability. And I think this gets 
back to an earlier issue of fiduciary responsibility. I think 
the appropriate fiduciary responsibility is to make sure that 
enough information is reported so that good decisions can be 
made.
    Consider, maybe, I am a leader of a country. I am arming my 
army, getting ready to invade next door. And I want to take out 
a lot of CDS coverage on that, just like firebombing my 
neighbor's house. In the case of insurable interests in the 
standard kind of life insurance or fire insurance example, that 
would not be known to the outside world. That would not be 
known to the other side that is providing the contract that I 
am aggregating this coverage.
    In the credit derivatives market that we envision 
developing and that is developing, we have significant 
reporting such that the information is available to the other 
side that has to provide the insurance on the contract. Once we 
see an aggregation of exposure, that risk can be priced in even 
if we don't know specifically what risk is there.
    Mr. Sanders. Mr. Foster--
    Mrs. Maloney. The gentleman's time has expired.
    Mr. Perlmutter, and we have been called for two votes, 
gentlemen, so we will have to adjourn in a moment.
    Mr. Perlmutter. Do you want me to go ahead?
    Mrs. Maloney. Yes. Go ahead.
    Mr. Perlmutter. Somebody was going to finish the answer. So 
please, go ahead and finish.
    Mr. Sanders. Oh, well, thank you very much. I was just 
going to remark to Mr. Foster, I hear your point about the 
firebombing. I have been asked that numerous times. Bear in 
mind those are felonies and--
    Mr. Foster. As is market manipulation.
    Mr. Sanders. Wait a minute--but again, that is one of the 
purposes of regulation, is to prevent felony-type transactions 
and to monitor and to look for those things, not necessarily to 
tie it up in knots. But that would be covered by proper 
regulation if it was occurring in financial markets. But we 
don't really have any evidence that it happened with Greece.
    Mr. Perlmutter. My question--and I appreciate the gentlemen 
from Illinois, Mr. Manzullo and Mr. Foster, sort of zeroing in 
on something--but mine is so much more basic, and it applies to 
a response.
    What is the difference between hedging and speculating?
    Mr. Duffie. Hedging means you are getting rid of risk. 
Speculating means you are taking on risk in order to make a 
profit.
    Mr. Perlmutter. But you have to have--it is like you were 
saying, somebody is going long, somebody is going short; 
somebody is buying, somebody is selling. If you are going to 
hedge, you have to speculate. Right?
    Mr. Duffie. In some cases, you can get lucky and the person 
who is hedging can find someone else who needs the hedge in the 
other direction. But that is somewhat unusual.
    Mr. Perlmutter. One of you mentioned you might want to 
hedge against the Greek company from going broke next year, as 
opposed to hedging against some currency. But you are hedging 
against the Greek company going broke. I am not sure which one 
of you--
    Mr. Pickel. I think that was me, yes.
    Mr. Perlmutter. And so in hedging against the Greek company 
going broke, John Deere goes and finds somebody who says, okay. 
We are going to do our due diligence, and we think this company 
is an upstanding company, and the chances are slim that it is 
going to go broke. Sure. We will provide you some insurance. Is 
that how that works?
    Mr. Pickel. Yes. They would go typically to a dealer, one 
of the large banks, and ask them to sell protection to John 
Deere to hedge that exposure.
    Mr. Perlmutter. But, the bank supposedly does some due 
diligence, I would assume--
    Mr. Pickel. Yes.
    Mr. Perlmutter. --to figure out how much insurance they are 
going to provide and at what cost.
    Mr. Pickel. Yes. The bank, if it is a global bank, may have 
relationships with that company in Greece. They may have 
exposure to Greece. So they are monitoring credit generally.
    Mr. Perlmutter. Let's narrow it down even further. I am 
just trying to figure out how far the insurance extends. Let's 
say you are worried about the head of the company. He really is 
the guy who runs the show. Am I, in effect, buying--I am John 
Deere. I am worried about my distributor in Greece. Am I buying 
key man insurance on him? Can I go to Bank of America and buy 
insurance on the guy who is the head of the company? He might 
die next year?
    Mr. Pickel. No. I don't think that would be permissible. 
And I don't know what the insurance laws would be as to whether 
you would have a sufficient insurable interest in the CEO of 
major customer to purchase insurance on that person.
    Mr. Johnson. Usually, that kind of key man clause is in a 
bilateral contract you make with the company, so if the CEO 
departs, the contract has to be adjusted or voided.
    Mr. Perlmutter. When we start getting into this subject of 
derivatives and swaps, and who is covering whom and why, and 
what the risk is, and who is analyzing the risk, so long as 
there is somebody posting some margin or keeping some reserve 
someplace that I can find, or that every so often you see if 
the insurance is still good, then I am less concerned about it.
    The AIG situation kept posting insurance, insurance, 
insurance, insurance, but never could cover. How do I find out 
if Bank of America has enough--what should I be looking for to 
make sure that the swap can be covered?
    Mr. Pickel. I think in these markets, in the OTC markets, 
it is collateral that is the significant portion. For the more 
liquid products, the more standardized products, clearing could 
provide a significant risk reduction. But in a situation like 
the AIG transactions, those were not capable of being cleared, 
weren't then and aren't now because of the customized nature of 
them.
    But there it is even more important to have collateral so 
that as the exposure, the mark-to-market exposure, fluctuates, 
collateral is moving back and forth. And keep in mind, it could 
move from the buyer of protection to the seller of protection, 
or the seller to the buyer, depending on where that price--
where that contract was struck, what the price was, and what 
the current market price is.
    Mr. Johnson. There is a dimension to this that is 
fascinating that you raise, which is when you buy insurance 
from one company on the other company, you are getting rid of 
counterparty risk vis-a-vis the company you bought insurance 
on, and you are incurring it from the provider of insurance. So 
you do have to understand the financial integrity of the 
insurance provider in order to weigh the balance of those two 
risks.
    Mrs. Maloney. Congressman Himes?
    Mr. Himes. Thank you, Madam Chairwoman, and thank you to 
the witnesses for your excellent presentation today. I have a 
couple of questions.
    First, you have spoken--basically sung from the same 
hymnbook with respect to whether, in fact, CDS contributed to 
Greece. Hypothetical, though.
    What about--and this I offer to anybody, and just ask that 
it be answered quickly--what about situations that we saw, for 
example, in the subprime market, where you had CDS activity 
that in many instances was multiples of the value of the 
underlying asset? Would you encourage us to think differently 
in that situation than you have encouraged us to think with 
respect to this case?
    Mr. Pickel. I think the situation of multiples was 
typically the gross notional, which is the total amount of 
protection. What I think is relevant and I think what the chart 
here highlights is the net notional.
    So in an active market, you have a lot of buyers and 
sellers, and overall, that market will reflect either a net 
short position or a net long position. And it is that--really, 
it is that number that should be focused on.
    So I think if you focus in the subprime market or if you 
focus in the corporate market on net notional versus debt 
outstanding, you don't see those multiples to the same extent.
    Mr. Mason. I think it is really important in regulation, 
especially in reg reform, to get to principles of regulation. 
And principles of regulation, especially for systemic risk, 
have to follow kind of principles of crowd control. You can't 
have regulators everywhere to monitor everything.
    So you need to look for either non-fundamental movements or 
aggregations that would suggest there is something going on 
here. Securitization RMBS was one of the fastest-growing 
sectors in financial services. As a result, you might want to 
look there for something going on, including CDS and related 
technologies.
    Similarly, with regard to infrastructure and other kinds of 
off-balance-sheet funding, if you look at hedge fund activities 
and you really talk to hedge fund investors, you find they have 
been involved in infrastructure deals for a while now. Why? 
Because it is a great way to provide secured funding to these 
undercapitalized countries, but avoid the country premium 
because you have the capital as long as, of course, property 
rights hold up.
    So if you do follow financial markets, they are telling you 
the information that you need. But again, you can't be averse 
to the signals that you find because you may find things you 
don't like.
    Mr. Himes. Thank you. I have a question for Professor 
Sanders. Professor Sanders, you in your testimony drew an 
analogy between the GSE debt and the Greek surprise. You say 
our own sovereign debt has a Greek surprise component to it. 
This is something we hear talked a lot about lately, and I want 
to explore this a little bit.
    The situation in Greece--correct me if I am wrong here--
this Greek surprise came because, in fact, financial markets 
didn't understand the esoteric, technical, untransparent 
characteristic of some debt mechanisms that they had employed. 
Is that correct?
    Mr. Sanders. Actually, I would state it a little 
differently. I would state it that Greece, like many other 
countries, used heavy off balance sheet and didn't bring 
anything on balance sheet. That is why we couldn't observe--
    Mr. Himes. Right. But airport deals and foreign currency 
swaps designed to look like debt, this stuff was pretty 
untransparent.
    My question is this: Markets don't like surprises; I get 
that. Is there any uncertainty or lack of transparency with 
respect to the amount, the tenor, or the characteristics of GSE 
debt right now in the minds of the market players who focus on 
this stuff?
    Mr. Sanders. First of all, once again, Greece could have 
solved the problem by bringing everything on balance sheet and 
making it transparent. But in terms of the GSEs, the answer is 
yes. We have absolutely no idea in the near future whether 
housing prices could take a big second dip and Freddie and 
Fannie are on the hook for billions and billions more. We just 
don't know. So--
    Mr. Himes. But there are--we don't know that about any 
security. We do have some sense, based on market values, what 
the value--some sense, with some uncertainty around it, what 
the market values are of the debt that the U.S. Government has 
effectively guaranteed. Okay.
    So were we to all of a sudden move the GSE debt on balance 
sheet, there would be no incremental new information to the 
market. So my question to you is, if we took that step--which 
may or may not be a good idea; I haven't thought a lot about 
it--but would you expect, if we simply took the step of moving 
that information onto the Federal budget, would you expect any 
change in the rate at which the United States Government funds? 
Would you expect any change in the willingness of the creditors 
of the United States Government to fund as a result, all other 
things being equal, of that accounting change?
    Mr. Sanders. Yes, sir, I do.
    Mr. Himes. Why?
    Mr. Sanders. And the reason for that is the same thing 
Secretary Geithner said at the last hearing I was at with him. 
Ambiguity is a very dangerous thing. The more ambiguous it is 
whether the government is going to bail out Fannie and Freddie 
or not--right now they said, it is not sovereign debt, but we 
are going to guarantee it.
    But remember, go back years, Fannie and Freddie were 
denying they even had an implicit guarantee. And suddenly they 
said, oh, well, we do have an implicit guarantee.
    Mr. Himes. But now those guarantees--those guarantees are 
very explicit now, are they not?
    Mr. Sanders. Then why not bring them on balance sheet?
    Mr. Himes. Right, right, right. But my point is that the 
market understands that debt is fully guaranteed by the U.S. 
Government, for all practical purposes is, in fact, U.S. 
Government debt. So what I hear you arguing is that the simple 
accounting change of moving it on budget would somehow impact 
the market. That just confuses me.
    Mr. Sanders. Let me rephrase it to help out. I apologize if 
I wasn't clear. It still is ambiguous if it is off balance 
sheet. The market is never going to be convinced. How do we 
know that in 2 years, the Obama Administration or Treasury will 
not come back and say, ``No, we have changed our mind. We are 
not going to guarantee this.''
    We don't know that. In fact, they have not made any 
permanent commitment to a bailout of Fannie and Freddie. So 
that is ambiguity. Once you bring it on balance sheet, mystery 
solved. We are on the hook for it. That is what I mean.
    Mr. Himes. I get it. Okay. I think I understand the 
distinction. So you are saying if we just, in a sense, 
permanently guaranteed it, which you are saying would be the 
effect of moving it onto the balance sheet, that would remove 
the ambiguity. Yes. I think I am out of time, but if the 
chairwoman would--
    Mrs. Maloney. Absolutely. This is an important point. Mr. 
Duffie, if you want to add to it?
    Mr. Duffie. I just wanted to suggest that one could 
actually quantify the effect that you are describing. Right 
now, the United States Government, at the Treasury, borrows at 
a lower interest rate than do Fannie and Freddie.
    If, in the event that the Fannie and Freddie debt were 
explicitly guaranteed by the government, the cost to the 
government of borrowing would rise to the blended average 
interest rate of the Treasury and the agencies, which would be 
a higher number, that is, our borrowing costs would go up.
    Mr. Himes. Are you sure that would happen, though? Because, 
then you would do away with the ambiguity. Right? That would 
become sovereign debt. And you are sure that it would rise to 
the blended rate rather than removing the ambiguity and 
therefore reducing the GSE debt to the U.S. rate?
    Mr. Duffie. It is not a guarantee. But the United States 
indebtedness would rise as a result of the explicit guarantee. 
We know that because the agencies are borrowing at a higher 
interest rate. So it wouldn't necessarily rise all the way to 
the current blended average, but it would rise somewhat.
    Mr. Himes. Great. Thank you. I know I am out of time.
    Mr. Garrett. And through the Chair, since I think this is a 
great point that the gentleman just raised, the fact that--I 
think you made an interesting point. The fact that there is a 
difference right now in the borrowing rate between the Federal 
Government and the GSEs tells me that as far as the markets are 
concerned, they are still--probably had tuned into this hearing 
back when Chairman Bernanke was here, and he says he can't tell 
us whether they are sovereign debt or not. And they probably 
tuned into the other hearing when Secretary Geithner says that 
is an accounting decision; he really couldn't tell us, either.
    So there must be that ambiguity out there. Otherwise--
correct me if I am wrong--if there was no ambiguity at all, if 
the market said, GSEs, you are just like the Federal Government 
because it is all guaranteed until 2012, then the rates should 
be exactly the same. Right?
    Mr. Duffie. Correct.
    Mr. Garrett. Okay. And also--one last question--and also, 
because the Secretary only has this authority until 2012, 
right, this unlimited authority, that is the other reason why 
we have ambiguity. Mr. Johnson, it sounds like you wanted to--
    Mrs. Maloney. The gentleman's time has expired. We have 
been called for a vote, so I would like to ask a question and 
get a yes or no answer. And you could write--get more questions 
in general.
    Earlier, Mr. Johnson, you said that if AIG had cleared 
through a clearinghouse, it would not have removed the systemic 
risk or the challenge of that particular situation. In your 
opinion, is just having derivatives clear through a 
clearinghouse enough to remove systemic risk? Yes or no, would 
you say?
    Mr. Johnson. No.
    Mrs. Maloney. No? Mr. Pickel?
    Mr. Pickel. I would say no. It goes a long way, but--
    Mrs. Maloney. Okay. It is a big part of our reform. That is 
why I am interested.
    Mr. Duffie?
    Mr. Duffie. It is a very good move, but it doesn't do it on 
its own.
    Mrs. Maloney. Mr. Sanders?
    Mr. Sanders. I agree. Plus, they will find another way to 
do it.
    Mrs. Maloney. Mr. Mason?
    Mr. Mason. I agree. No.
    Mrs. Maloney. No? Okay. Now, if that is not going to remove 
systemic risk, how will we deal with the risk of the 
clearinghouse itself? Mr. Johnson, and go down the line.
    Mr. Johnson. Very quickly, the question of clearinghouse, 
its capitalization, its collateral, and its integrity is very 
important. And one of the dangers is if you have multiple 
clearinghouses, there can be a competition in reducing margin, 
and it can create a systemic risk. So we have to be very 
careful about who defines and maintains the thresholds of 
capitalization at the clearinghouses.
    Mrs. Maloney. That is a very important point, and we will 
have a series of questions to all of you to respond in writing. 
Treasury is at the Senate today, and they likewise said they 
would respond in writing to any questions.
    There was a lot of--
    Mr. Himes. Would the chairwoman yield for just a second?
    Mrs. Maloney. Yes.
    Mr. Himes. Sorry, just one follow-up question, because I am 
very interested in this point.
    Quick question: If we, in fact, took the recommendation of 
some that we brought the GSE debt on balance sheet, is there 
agreement--because I sensed agreement--that would cause an 
uptick in the cost of financing of the United States 
Government? Does anybody think the answer is no?
    [No response.]
    Mr. Himes. So everybody thinks the answer is yes. If we 
move this on balance sheet, the interest paid by the U.S. 
Government would rise. Correct?
    Mr. Johnson. I don't necessarily agree with that. I don't 
think it would--it would cause a downtick in GSE financing, 
but--how would I say--what we are really talking about is the 
duration of guarantees. There is a guarantee through 2012. If 
you extend the duration of the guarantee, there probably is 
some minuscule sense in which--
    Mrs. Maloney. I would ask the gentleman to respond to the 
gentleman's question in writing, and I invite all my colleagues 
to.
    I would like to ask, what are the worries you have about 
manipulation? There have been allegations about manipulation in 
Greece and in the American economy, in the sovereign markets 
and in city governments and State governments. Is there a 
concern about manipulation?
    Mr. Garrett. Will the panel be submitting this in writing, 
too, or are we going to a second round at this point?
    Mrs. Maloney. My time has expired. Okay.
    Mr. Garrett. It expired a couple of minutes ago.
    Mrs. Maloney. All right. Then submit it in writing. And the 
gentleman is recognized for 5 minutes. We have 15 minutes to 
get to the Floor. Okay? You have questions?
    Mr. Garrett. Then, we will just--I thought we were through 
the second round. Just clarification, then, on the 
differentiation on the interest rates that you were going to. 
Does anyone else want to speak on that as far as putting it 
online or not, differentiation? No?
    Mr. Sanders. Yes. What I would like to say is on the GSE 
debt, by making it unambiguous, meaning that it is on balance 
sheet, that might lower the GSE debt, the rate on that debt, to 
what it would be on the Federal. That is the good news. The bad 
news is that it reveals that our actual debt loads are much 
bigger than we thought, which would then probably raise the 
cost of borrowing.
    Mr. Mason. And the financial way to look at it is we are 
currently holding an option to take on this debt. And if we 
exercise the option, then we realize the value, we lose the 
option value. So we could estimate directly the amount.
    Mr. Garrett. Great. Would anyone else like to comment?
    Mr. Johnson. I would just say the increment in the cost of 
the Treasury debt is dependent upon the change in your beliefs 
when the option is exercised. If you say for all intents and 
purposes it is full faith and credit now, by making it explicit 
and perpetual and blending it in the secondary market--and I 
think the Treasury market is slightly more liquid--you probably 
get most of the benefits and not a lot of cost.
    But if you believe that there is a significant risk that in 
2012 they would reverse course, you would have to say that 
bringing it on raises the cost of Treasury debt.
    Mr. Garrett. The bottom line is, I guess, the one thing we 
can learn from the Greek situation is no matter whether they 
are hiding it or not, or intentional or otherwise, I guess the 
thing the public wants most is to have that transparency, and 
for someone to make that decision and to carry forward so we 
know exactly what we are dealing with from today to 2012 and 
going into the future.
    Thanks again to the entire panel. I commend the Majority 
for the panel selection, as the ranking member did, and I thank 
you all for your testimony today. Thanks.
    Mrs. Maloney. If I could go back to my other question, and 
get a yes or no answer, and then further follow-up in writing, 
are you worried about manipulation in the municipalities in our 
country and smaller sovereign markets with the credit default 
swaps and derivatives in general? Yes or no? Are you worried 
about manipulation?
    Mr. Johnson. Yes.
    Mrs. Maloney. Mr. Pickel?
    Mr. Pickel. No.
    Mrs. Maloney. Mr. Duffie?
    Mr. Duffie. I think it should be policed, but I don't see 
it right now.
    Mrs. Maloney. Mr. Sanders?
    Mr. Sanders. I am more worried about the manipulation by 
the governments themselves not reporting all the debt they have 
on balance sheet.
    Mrs. Maloney. Mr. Mason?
    Mr. Mason. I am in agreement. I am not explicitly concerned 
from the investor side.
    Mrs. Maloney. Thank you. And who are the major sellers of 
CDSs in these sovereign, muni, and government credit derivative 
markets? Who are the major sellers? Can anyone tell us who they 
are?
    Mr. Johnson. I believe it is primarily financial 
institutions, large financial institutions here and abroad.
    Mr. Pickel. Yes. It would be the large financial 
institutions. You may have some hedge funds which would sell 
protections, and that was true in the Greek situation. In the 
past, you would have had the insurance companies, the monolines 
a little more active, potentially, in that area, but not now.
    Mrs. Maloney. What is the relationship between the CDS 
market and the underlying market? Which one leads which?
    Mr. Duffie. In a large, liquid market, they are very close 
together. It is hard to tell. But in a market such as Greek 
debt, the CDS probably moves slightly first because it is 
somewhat more liquid and easily obtained.
    Mrs. Maloney. Mr. Johnson?
    Mr. Johnson. Yes. I agree with that. I think, when we talk 
about the price discovery role of CDS, I often scratch my head 
because I look at bond spreads and I don't know what 
incremental information I get from the CDS.
    But in the case of Greece, it is sometimes difficult for 
people to borrow in short bonds as speculators. And so the CDS 
market, being a lower transaction cost and more liquid medium, 
will tend to reflect that information sooner than will a bond 
that has what you might call hiccups with shorting.
    Mrs. Maloney. And following up on that, Mr. Johnson, how 
are prices set on instruments when the underlying has so few 
credit events or defaults?
    Mr. Johnson. It is set with subjective probability. You are 
estimating what the likelihoods are. It is not like a deck of 
cards in the sense that you know there are 52 cards and you 
know what suit and what rank they are. It is a much more what 
economists call radical uncertainty, where you are trying to 
infer prospects that are unprecedented, or largely 
unprecedented, events.
    Mrs. Maloney. And Mr. Pickel and Mr. Duffie, how could a 
CDS or other credit derivative be used to keep a normal 
restructuring from happening for a firm in the real economy? 
Should we worry about this happening in the future, hindering 
the restructuring?
    Mr. Pickel. If I could just also add to that, the market 
assessment of the price of the CDS is essentially the market's 
assessment of the probability of default of the underlying 
entity and the recovery rate, potential, if there actually is a 
default. So those are kind of the factors in that.
    As far as the influence on restructurings, there has been a 
lot of discussion. Henry Hu at the SEC has written about this. 
We think it is probably worth some additional analysis.
    But our feeling--we have written a piece as an organization 
on this we can send to you--is that while superficially it 
suggests that somebody who has a CDS position may be motivated 
and incentivized in a different way when they are engaged in 
restructuring discussions, that has not really been proven in 
any particular instance. But it is something I think is worthy 
of some additional analysis.
    Mrs. Maloney. Thank you. And Mr. Duffie, could you respond 
to a statement by Federal Reserve Chairman Ben Bernanke at a 
recent JEC hearing where he said that the Fed had seen little 
exposure to Greek debt or CDSs within the financial 
institutions that he supervises here in the United States.
    However, is it possible that U.S. financial institutions 
are vulnerable via their exposure to German or French banks, 
which are believed to have a large exposure to Greek debt and 
CDSs? I do know that in many of our--some of our bailouts, we 
were bailing out counterparties in foreign countries. Do you 
see this as a challenge, for anybody to comment? My time has 
expired, and we are being called to a vote. But your comments?
    Mr. Duffie. Sure. Some very large European banks are 
exposed to Greece significantly. I don't think there is a 
contagion effect for U.S. banks because the sovereigns of those 
large European banks--for example, in France and Germany--would 
protect those large banks from failing. They are still ``too-
big-to-fail.''
    Mrs. Maloney. I want to thank all of your for your 
excellent testimony. The panelists have mentioned to me, the 
Members of Congress, that they have future questions. We will 
submit them in a bipartisan way, and hope that you can give us 
your best thoughts.
    The Chair notes that some members may have additional 
questions for this panel, which they will submit in writing. 
And without objection, the hearing record will remain open for 
30 days for members to submit their opening statements and 
questions.
    The meeting is adjourned, and we are rushing to a vote. 
Thank you so much.
    [Whereupon, at 12:27 p.m., the hearing was adjourned.]


                            A P P E N D I X



                             April 29, 2010


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