    [Senate Hearing 111-799]
    [From the U.S. Government Publishing Office]

                                                            S. Hrg. 111-799

                            REFORMING U.S. FINANCIAL
                               MARKET REGULATION

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

                                    HEARING

                                   before the

                           COMMITTEE ON AGRICULTURE,
                            NUTRITION, AND FORESTRY

                              UNITED STATES SENATE

                         ONE HUNDRED ELEVENTH CONGRESS

                                 FIRST SESSION

                                   __________

                               NOVEMBER 18, 2009

                                   __________

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

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

                                      ______

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               COMMITTEE ON AGRICULTURE, NUTRITION, AND FORESTRY

                     BLANCHE L. LINCOLN, Arkansas, Chairman

    PATRICK J. LEAHY, Vermont            SAXBY CHAMBLISS, Georgia
    TOM HARKIN, Iowa                     RICHARD G. LUGAR, Indiana
    KENT CONRAD, North Dakota            THAD COCHRAN, Mississippi
    MAX BAUCUS, Montana                  MITCH MCCONNELL, Kentucky
    DEBBIE STABENOW, Michigan            PAT ROBERTS, Kansas
    E. BENJAMIN NELSON, Nebraska         MIKE JOHANNS, Nebraska
    SHERROD BROWN, Ohio                  CHARLES GRASSLEY, Iowa
    ROBERT CASEY, Jr., Pennsylvania      JOHN THUNE, South Dakota
    AMY KLOBUCHAR, Minnesota             JOHN CORNYN, Texas
    MICHAEL BENNET, Colorado
    KIRSTEN GILLIBRAND, New York

                   Robert Holifield, Majority Staff Director

                        Jessica L. Williams, Chief Clerk

                Martha Scott Poindexter, Minority Staff Director

                    Anne C. Hazlett, Minority Chief Counsel

                                      (ii)

                                C O N T E N T S

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                                                                       Page

    Hearing(s):

    Reforming U.S. Financial Market Regulation.......................     1

                                  ----------

                          Wednesday, November 18, 2009
                        STATEMENTS PRESENTED BY SENATORS

    Lincoln, Hon. Blanche L., U.S. Senator from the State of
      Arkansas, Chairman, Committee on Agriculture, Nutrition, and
      Forestry.......................................................     1
    Chambliss, Hon. Saxby, U.S. Senator from the State of Georgia....     3

                                    Panel I

    Gensler, Hon. Gary, Chairman, Commodity Futures Trading
      Commission, Washington, DC.....................................     5

                                    Panel II

    Billings, Jeff, Manager of Risk Management, Municipal Gas
      Authority of Georgia, on behalf of the American Public Gas
      Association, Kennesaw, Georgia.................................    35
    Boling, Mark, Executive Vice President and General Counsel,
      Southwestern Energy Company, Houston, Texas....................    32
    English, Glenn, Chief Executive Officer, National Rural Electric
      Cooperatives Association, Arlington, Virginia..................    28
    Johnson, Robert A., Director of Economic Policy, The Roosevelt
      Institute, on behalf of Americans for Financial Reform, New
      York, New York.................................................    36
    Schloss, Neil M., Vice President And Treasurer, Ford Motor
      Company, Dearborn, Michigan....................................    30
                                  ----------

                                    APPENDIX

    Prepared Statements:
        Nelson, Hon. E. Benjamin.....................................    52
        Billings, Jeff...............................................    54
        Boling, Mark (with attachments)..............................    65
        English, Glenn...............................................    75
        Gensler, Hon. Gary...........................................    79
        Johnson, Robert A............................................    90
        Schloss, Neil M..............................................   122
    Document(s) Submitted for the Record:
        Joint Association Statement on Proposed Reform of Over-The-
          Counter Derivatives Markets................................   128
    Question and Answer:
    Lincoln, Hon. Blanche L.:
        Written questions for and responses from Jeff Billings.......   134
        Written questions for and responses from Mark Boling.........   136
        Written questions for and responses from Glenn English.......   142
        Written questions for and responses from Gary Gensler........   144
        Written questions for and responses from Neil M. Schloss.....   152
    Conrad, Hon. Kent:
        Written questions for and responses from Gary Gensler........   147
    Klobuchar, Hon. Amy:
        Written questions for and responses from Gary Gensler........   150
    Stabenow, Hon. Debbie:
        Written questions for and responses from Gary Gensler........   148
        Written questions for and responses from Neil M. Schloss.....   152

                            REFORMING U.S. FINANCIAL
                               MARKET REGULATION

                                  ----------

                          Wednesday, November 18, 2009

                                  United States Senate,
             Committee on Agriculture, Nutrition, and Forestry,
                                                         Washington, DC
        The committee met, pursuant to notice, at 9:36 a.m., in
    Room 106 Dirksen Senate Office Building, Hon. Blanche Lincoln,
    Chairman of the committee, presiding.
        Present or submitting a statement: Senators Lincoln,
    Conrad, Stabenow, Nelson, Casey, Gillibrand, Chambliss, Lugar,
    Cochran, Johanns, Grassley, and Thune.

      STATEMENT OF HON. BLANCHE L. LINCOLN, U.S. SENATOR FROM THE
        STATE OF ARKANSAS, CHAIRMAN, COMMITTEE ON AGRICULTURE,
                        NUTRITION, AND FORESTRY

        Chairman Lincoln. The Senate Committee on Agriculture,
    Nutrition, and Forestry will now come to order.
        I want to thank Senator Chambliss and fellow members of the
    committee for being here today as we address one of the more
    important issues facing our nation and particularly our
    economy. I cannot overstate the significance of the subject
    matter of our hearing today. Financial market oversight reform
    is, quite simply, the single most important factor in our long-
    term economic recovery. It will be the foundation for our
    nation's financial future, and reform is essential to reaffirm
    the integrity and the soundness of our financial system and to
    maintain our nation's preeminence as a global leader in
    worldwide financial markets. Perhaps most importantly, we need
    financial reform to give comfort to our consumers and the
    businesses so that they can trust our markets to determine fair
    prices and to help manage risk.
        Over the last decade, we have seen deregulation sweep over
    America in a way that has simply devastated our economy. From
    the tragedy of the Enron bankruptcy in 2002 to the massive
    failures of Bear Stearns and AIG in 2008, a steady stream of
    market calamities has exposed fatal flaws in our regulatory
    system. These flaws have cost America dearly.
        And given this reality, business as usual is simply not
    acceptable. Fundamental financial market oversight reforms must
    pass. It is important to remember that while we must correct
    mistakes of the past, we do not want to overreact or veer too
    far in the other direction. We have a very difficult needle to
    thread here, but we are certainly all very capable of it. We
    have no desire to, nor will we, act in a way that will prevent
    legitimate business activity or stifle innovation.
        But the word ``innovation'' cannot be a code word for
    unacceptable practices. Smoke-and-mirrors accounting schemes,
    massively leveraged by under- or non-capitalized transactions,
    or house-of-cards entities posing as investment vehicles are
    not the kind of innovation that prudent financial market
    oversight should foster. We can do better and we will.
        The task that is set before us is considerable, but it is
    not impossible. It is difficult, but it is not unattainable. It
    will be at times confusing, but the answers really are not
    impenetrable. We will get it done.
        Senator Chambliss and I intend to work together to produce
    legislation that will bring much-needed transparency and
    accountability to the over-the-counter derivatives market. In
    our legislation, I am looking to address issues such as
    prudential regulation related to enhanced capital and margin
    requirements, clearing of over-the-counter transactions, as
    well as a host of other matters, including forex trading and
    foreign boards of trade. The list is long, but we will get
    there.
        And I look forward to hearing from all of the interested
    participants, getting their views and cultivating a healthy
    debate on this topic. Today, we will focus specifically on
    three areas: End user margin and clearing, the definition of
    major swap participants, and mandatory clearing of standardized
    products.
        I particularly look forward to today's testimony from end
    users. Knowing the importance of cash flow and working capital
    to businesses, I will be paying great attention to what they
    say about clearing requirements and margin as I will to how we
    address systemic risk.
        On December 2, we plan to hold a second hearing, at which
    Treasury Secretary Geithner will testify, and we will further
    analyze these and other issues. I look forward to hearing views
    from all sides on these very important matters to all
    Americans.
        Lastly, I want to commend Senator Dodd for the draft
    legislation he released last week and its comprehensive view of
    the nation's banking oversight system. There are areas of
    mutual interest in financial market oversight, and I look
    forward to working cooperatively with him and his committee as
    we move forward.
        There is a lot of work to be done, but I know that we will
    pass reform legislation that truly does build something better.
    We owe that to America's consumers and businesses, and they
    deserve no less than our very best efforts to ensure that the
    U.S. financial oversight system promotes and fosters the most
    honest, open, and reliable financial markets in the world. It
    is our responsibility as Americans to be leaders in this
    direction.
        Thank you all for your time today. I look forward to
    hearing from our witnesses and from my colleagues as we move
    forward to reach this goal. And as I said before, it may not be
    easy, but we can do it and we will.
        So thank you all for being here today. I will turn to my
    friend and colleague, Senator Chambliss, for his opening
    statements and then we will return to our witness.

    STATEMENT OF HON. SAXBY CHAMBLISS, U.S. SENATOR FROM THE STATE
                               OF GEORGIA

        Senator Chambliss. Well, thank you, Madam Chairman, first
    of all, for your leadership on this issue and in particular for
    holding this hearing today.
        As you and I have discussed previously, we both strongly
    believe that the Senate Agriculture Committee and the Commodity
    Futures Trading Commission must be engaged in the development
    of any legislation addressing financial regulatory reform. This
    committee also has a responsibility to ensure that the CFTC
    continues to be able to effectively carry out its duties, and
    that is why I am really pleased that we have once again
    Chairman Gensler back with us to talk about not only the
    complexities of the issues, but the practicalities of where we
    need to go with respect to regulatory reform.
        While this issue is complicated, we cannot let the
    complexity of futures and swaps be an excuse for ignoring good
    public policy and ensuring that our markets are both safe and
    functional.
        In the past couple of years, a lot of people have become
    acquainted with one particular type of derivative known as a
    credit default swap, or CDS, which permits one party to
    transfer the credit risk of bonds or syndicated bank loans to
    another party. Since AIG was heavily involved in CDS, it seems
    simple enough to just blame swaps in general for the current
    financial crisis. However, that would be inaccurate, because
    the real situation is much more complicated.
        We need to distinguish between credit default swaps and the
    actual underlying securities represented by these swaps. Before
    we make a big policy change, like an outright ban on all over-
    the-counter derivatives or a requirement that these products
    only trade on an exchange, we need to ask ourselves whether
    this will even address the underlying problem. Why take a
    chance in these uncertain times to make legislative and
    regulatory changes that could possibly make things worse,
    potentially dry up more capital and force the cost of doing
    business higher?
        This does not mean that there isn't room for improvement. I
    think the volatility that we have seen over the past year in
    some markets warrants extensive analysis and some regulatory
    changes. And while I may have concerns with some of the
    proposals that have been discussed to date, I am absolutely
    convinced that the market volatility and financial meltdown of
    the recent past make the case for more market transparency.
        How can we in Congress be sure of the outcome of sweeping
    reforms without first properly identifying the cause of these
    problems? And how can we identify the cause of the problem
    without authorizing and requiring more transparency through the
    collection of necessary data? Beyond requiring more
    transparency, I also believe this committee should explore how
    most effectively to regulate swaps, some of which are
    statutorily excluded from CFTC regulation and oversight. And we
    need to determine how best to encourage the clearing of certain
    derivative products without jeopardizing either the use of
    these risk management tools or the sustainability of our
    clearinghouses.
        If Congress is truly interested in addressing the problem
    as opposed to politicizing a solution, we can no longer ignore
    the complexities of these markets. We must devote time to
    understanding these instruments and their applications. We must
    seek to understand the legitimate purposes that these complex
    instruments serve for large and small businesses in each of our
    States. That is why this hearing is so critically important.
        I want to raise one final concern about financial
    regulatory reform. I would hope that as this legislation
    progresses through Congress, we will take whatever steps are
    necessary to ensure that it does not conflict with the Farm
    Credit Act and that it does not inadvertently hamstring the
    Farm Credit Administration and the entities that it regulates,
    the Farm Credit System and Farmer Mac. We know that the Farm
    Credit System and Farmer Mac did not cause or contribute to
    last year's financial crisis and that they have done a good job
    fulfilling their Congressionally mandated mission of providing
    competitive credit to farmers, ranchers, and rural America.
        We can thank our colleagues on this committee and the House
    Agriculture Committee for their insight and leadership years
    ago in establishing these entities and providing for a strong
    regulatory system through the Farm Credit Administration. I
    look forward to working with the Chairman and all of our
    colleagues on the Banking Committee to make sure the financial
    regulatory package does not negatively effect the Farm Credit
    Administration.
        Again, to my friend, the Chairman, thanks for holding this
    hearing. I know that it is a beginning of a process that
    recognizes the role of the Senate Agriculture Committee in
    broader financial regulatory reform efforts and I look forward,
    as always, to working side-by-side with you. Thank you very
    much.
        Chairman Lincoln. Thank you, Senator Chambliss, and I, as
    always, look forward to working with you. I think we have got a
    great opportunity to find a good outcome and really be
    productive for the people of this country and certainly the
    marketplace, which we want them to have greater confidence in,
    and we can do that from here.
        I would also like to echo the comments of my colleague,
    Senator Chambliss, on the Farm Credit Administration and the
    importance of recognizing that there is not a necessity here in
    any way or shape or form to try to put them into a position
    where they are hamstrung or not able to continue to do the good
    work that they have done, so I appreciate his comments there.
        We would now like to welcome Chairman Gary Gensler to the
    committee. Chairman Gensler, welcome once again to the
    committee. We are proud that you are here and looking forward
    to working with you on this tremendously important issue as we
    move forward and working through the details of how we put our
    markets and our economy back on track. I know you have got a
    great insight into this in your work from multiple different
    areas where you come. And I am also usually relieved because I
    know that when the day has ended, that you usually get your
    marching orders from four lovely ladies at home.
        So we appreciate how you are grounded and, more
    importantly, how you are working hard to make sure that we get
    this right. So we look forward to your testimony today, and
    welcome to the committee.

      STATEMENT OF HON. GARY GENSLER, CHAIRMAN, COMMODITY FUTURES
                   TRADING COMMISSION, WASHINGTON, DC

        Mr. Gensler. I thank you, Chairman Lincoln. I will mention
    to my three daughters your hello. And Ranking Member Chambliss
    and members of this committee, thank you for inviting me to
    testify on behalf of the full Commission today regarding
    regulation of over-the-counter derivatives markets and, if I am
    allowed, I am going to say a comment or two at the end about
    our joint efforts with the SEC on some harmonization efforts.
        But before I begin, I would really like to congratulate the
    new Chairman, Chairman Lincoln. I think this is the first time
    I am testifying before you as Chair. I want to thank Senator
    Harkin for his leadership of this committee and I look forward
    to working with all of you going forward.
        I would like to address regulation of the over-the- counter
    derivatives market in the context of two principal goals that I
    think there is a broad consensus around. One is promoting
    transparency of the markets, and two, lowering risk of these
    markets to the American public.
        In terms of transparency, the administration proposed and I
    fully support the following priorities. First, that all
    standardized derivative transactions should be moved onto
    regulated exchanges or transparent trade execution facilities,
    similar to what we have in the securities or futures markets.
    Increasing transparency for the standardized derivatives should
    enable both large and small end users to obtain better pricing
    on their derivative products. Just as transactions are on the
    securities markets and the futures markets available and you
    can see trade by trade what occurs there, and every corporate
    treasurer, assistant treasurer, or municipal government can see
    the transactions, we believe that same transparency will help
    benefit growth in America and promote market efficiency in
    America.
        If Congress were to exempt some end users--and I know you
    have a panel of end users you are going to be chatting with--
    exempt end user transactions from a clearing requirement, I
    think that--and I believe that those transactions could still
    be required to be brought onto the trading platform--a trade is
    where buyers and sellers meet-- and still exempt them and
    separate out from the clearing requirement where there is this
    issue of posting margin that I know you will be talking about.
        Second, I believe all non-cleared transactions--these are
    the customized transactions which should still be allowed--
    should be reported to a trade repository so that the regulators
    can at least see those transactions.
        Third, data on the transactions themselves should be
    aggregated and made available to the public in an aggregate
    form, for both the customized and the standardized products.
        And fourth, stringent recordkeeping and reporting
    requirements should be required for the swap dealers with an
    audit trail so that we can effectively look into these markets
    even after the fact.
        The administration has proposed, and at the CFTC we support
    lowering risk for American public. Again, I will talk about
    four principal components. First, standard over-the-counter
    derivatives transactions should be required to be cleared on a
    robustly regulated central clearinghouse. By guaranteeing the
    performance of these contracts submitted for clearing, clearing
    significantly reduces systemic risk. Clearinghouses
    significantly reduce systemic risk by removing the
    interconnectedness in this marketplace.
        I believe that all clearable transactions should be
    required to be brought into clearinghouses regardless of the
    end user, but if Congress were to decide to exempt transactions
    for certain end users, I would hope that would be narrowed to
    the corporate end users and it wouldn't exempt transactions,
    for instance, with hedge funds and other financial investment
    funds. I think there is a difference in the needs of those.
    Also, I would hope we would still bring them into the trading
    requirement and exempt them from the margin or the clearing
    requirement.
        Second, swap dealers and major swap participants would be
    explicitly regulated for capital, so they have a cushion
    against risk.
        Third, the dealers would be required to post margin
    themselves. This would be the dealers posting margin, not the
    end users in this case.
        And fourth, the CFTC and SEC should be authorized to
    mandate robust business conduct standards to protect the
    marketplace against fraud, manipulation, and even aggregation
    position limits for the commodity space in this marketplace.
        If I might just take a moment to say, we have been working
    with the SEC to harmonize some of our rules. We are different
    agencies. We have different missions, but we have a lot of
    overlap. We have actually put together a report the President
    requested with 20 recommendations, 11 of which will require
    legislative assistance from this committee and the rest of
    Congress. Some of them are in the administration proposal we
    have already sent up. I just wanted to highlight in my 15
    seconds left two, really quickly.
        One is I do believe with the significant risks that are in
    these clearinghouses, both futures clearinghouses, and new swap
    clearinghouses, that it is appropriate to look back to our
    oversight, the CFTC's oversight, of clearinghouses, bring some
    of the core principles that have worked well to international
    standards, and ensure that in certain circumstances that the
    CFTC has a little bit more authority to write rules. This was
    included in the administration's proposal and we have been
    working with the exchanges directly on some of that language.
        Second, we have found that our ability to enforce the
    markets and protect them against manipulations can be enhanced,
    and we have legislative language that we will be sharing with
    this committee on specific disruptive trading practices that we
    think it would be appropriate to try to enhance our ability to
    police these markets for manipulation.
        Again, we will be working with this committee on the other
    nine recommendations that need legislative assistance and I
    have included that in my written testimony. I look forward to
    working with this committee and Congress to bring this much-
    needed reform to the over-the-counter derivatives marketplace.
        [The prepared statement of Mr. Gensler can be found on page
    79 in the appendix.]
        Chairman Lincoln. Thank you, Chairman Gensler. I appreciate
    your comments here today and am looking forward to working with
    you.
        I will start with my questions and then turn to my
    colleague, Senator Chambliss, and then we will go in the order
    that people arrived to the hearing.
        Chairman Gensler, it's my understanding that the more
    standardized a product is, the easier it should be or would be
    to clear and exchange trade, and that clearing and exchange
    trading are in some ways gold standard of risk management in
    the derivatives world. Given that, I do believe that moving as
    many of these contracts as we can through a clearinghouse or
    onto that regulated exchange is important. But I also believe
    there is a place for tailored contracts and some over-the-
    counter market transactions.
        My question is really who should make the determination as
    to what is standardized and should be cleared? Should it be the
    clearinghouse or should it be the regulator? If it is the
    clearinghouse, in my opinion, that does look to be somewhat of
    a--I don't know. There is some concern there. My question to
    you is if, in fact, the clearinghouse was asked to do the
    clearing determination, what safeguards would need to be there
    and what is your position on who should make that
    determination?
        Mr. Gensler. I----
        Chairman Lincoln. Maybe you could also mention some of your
    response to Chairman Frank. I know that there was a back-and-
    forth on that, as well.
        Mr. Gensler. Sure. I recall the first time I was in this
    committee room on February 25 for my confirmation hearing. This
    very question came up with then-Chairman Harkin. I believe that
    the regulators, the SEC and the CFTC, should have clear
    authority to determine that contracts are standard enough to be
    cleared. I believe we should also be able to rely on market
    mechanisms, that there is some presumption that if a
    clearinghouse were to accept it for clearing, that we should be
    able to hopefully rely on that, and the presumption is to get
    as many transactions and as many contracts to be cleared, and
    hopefully on these transparent trading venues.
        So to answer your question, I think the regulators should
    have clear authority to make the determination, but also be
    able to rely on some market mechanisms that the clearinghouses
    might, in fact, determine something is clearable, but we could
    add to that list and we would have to approve--to have a
    safeguard against the clearinghouse, we should also approve
    which transactions are clearable, hopefully by class of
    transaction just for efficiency. But in certain circumstances,
    we would do it contract by contract.
        Chairman Lincoln. But to make sure I understand what you
    are saying, you are saying that should be predetermined?
        Mr. Gensler. I think that it should be transparent. The
    marketplace should clearly know if they are entering a
    transaction--if an end user is entering into a transaction,
    they should know, is this one that has already been designated
    by the regulators and the clearinghouse to be, quote,
    ``standard'' or clearable, and I do believe, thus, it should be
    transparent, and as you say, predetermined, and that the
    clearinghouses have a role to play, but the regulators should
    have clear authority to make a determination.
        Chairman Lincoln. Thank you.
        A major swap participant is defined in the Treasury
    proposal as a non-dealer who maintains a substantial net
    position in outstanding swaps for the purpose other than to
    create and maintain an effective hedge, under the GAAP
    standards. I understand that some of the players want a limited
    definition of the MSP so as to not to kind of get pulled into
    that category, perhaps. Maybe there is reason for that for
    some, and for some, maybe there is not.
        Are you comfortable with the Treasury's definition of major
    swap participant? Are the GAAP standards the appropriate
    standard to determine hedging, and if not, what is? Is a
    substantial net position standard workable and is it going to
    capture all the institutions that pose the kind of systemic
    risk that we are trying to get at?
        Mr. Gensler. What we are trying to do in the legislation is
    ensure that there are two complementary regimes, that the
    dealers are regulated, they have to register and be regulated,
    have capital and business conduct standards, and then that the
    markets themselves have these clearing and trading
    requirements.
        Major swap participant is a term that nine months ago none
    of us knew. It was just created in the legislative language.
    But what it is really trying to address is the next AIG or the
    near-dealer, something that is not quite a financial
    institution, but it holds itself out to the public, as a
    substantial net swaps business. There are many counterparties
    that would be at risk if it failed. I don't know its broad
    category. It is not meant to pick up the thousands of end users
    or even the hundreds of end users. But I believe it should be a
    category that is included, that we not just bring this
    regulation to the five or six large financial institutions.
    They are sort of the next AIG or the next swap dealer category.
        Chairman Lincoln. Well, depending on what standards are
    going to be used to determine that, as an alternative, I mean,
    when you are looking for Congress to be helpful, could Congress
    use a gross notional exposure standard to determine who is
    going to register as a major swap participant, and if a gross
    notional exposure test is appropriate, what should the level
    be?
        Mr. Gensler. I would want to work with you and the
    committee to see if that would be appropriate. I think, most
    importantly, is that the full registration and regulation would
    be of swap dealers and the next, I don't know if it is several
    dozen, but the next several that really hold themselves out to
    the public as almost like a swap dealer and have a significant
    book of business with a lot of counterparties. And so I think
    it is more with regard to do they have other end users as
    counterparties as contrasted to are they just doing their
    business with Wall Street, would be the best test.
        And again, that is separate and apart from these issues of
    whether end users post margin or whether end user transactions
    are brought to trading venues. We should try to bring as many
    of these end user transactions into transparency.
        Chairman Lincoln. Well, I mean, obviously, if we are
    working toward something that is going to provide more
    oversight and regulation, then standardization and what we use
    to standardize is going to be a key question. So we look
    forward to working with you on that as I definitely think that
    is going to be important, to have something more definitive
    about what that standard is going to be.
        And I have gone over my time, so I am going to wait for my
    second round and I will defer to my colleague, Senator
    Chambliss.
        Senator Chambliss. Mr. Chairman, I guess if we could write
    down on paper very clearly what is standard and what is not
    standard, it would make our job a lot easier, and certainly
    that is something we are going to continue to wrestle with and
    work with you on.
        I want to, first of all, ask you a very practical question.
    We have got a very valued member of this committee who is here
    who also happens to be Chairman of the Budget Committee. As he
    moves forward next year, irrespective of what we do, we have
    got to have a clear picture of what it is going to cost. Part
    of the cost obviously is increasing the resources to CFTC to
    make sure that the new challenges that we give you, you are
    obviously capable of carrying out.
        CBO indicated that the House legislation would require an
    additional 235 employees by 2011 for CFTC--that is a 40 percent
    increase--resulting in an increased cost of $291 million over
    the next five years. Your agency's total appropriation for
    fiscal year 2009 was only $146 million. How will you implement
    these changes that are set forth in the House bill, for
    example, if you do not get the necessary increases in
    appropriations?
        Mr. Gensler. Well, I thank you, Senator. I think our
    agency, unfortunately, has been sorely under-resourced for a
    number of years. With Congress's help, we are just now back to
    the same staffing we were at in 1999, and that is even though
    the markets have grown at least four-fold and we have not yet
    even taken on this new authority, over what is nearly a $300
    trillion market. The swaps market is roughly, in notional
    amount, 20 times our economy. So that means every time you buy
    a tank of gas, you can think of about $1,000 of derivatives
    behind that $50 tank of gas, somewhere, on average, in the
    economy.
        So in staffing, we do believe that we would need probably
    in the order of magnitude, 235 people to add to the approximate
    2010 staffing level of about 650 people.
        Senator Chambliss. Okay. Many end users of derivatives have
    informed us that they do not believe that the benefit of
    clearing is worth the expense of posting margin at a
    clearinghouse, and we have talked through this time and time
    again. You have proposed that clearing members of a
    clearinghouse, such as financial institutions, could post
    margin to the clearinghouse for their end user counterparties
    who would then meet collateral requirements through credit
    arrangements involving non-cash collateral.
        I want you to help us think through this and help us
    understand how this would work with respect to daily margin
    settlement. What sort of expense do you believe these end users
    would incur in the form of fees or variation margin charges if,
    as you have proposed, their dealers were posting margin to the
    clearinghouse on their behalf?
        Mr. Gensler. The goal, I think, is to lower risk in the
    system and to move as much of these transactions off the books
    of the financial institutions once they have arranged them, and
    that is where the clearinghouse comes into place because it is
    safer than the financial institutions. No matter what we do in
    financial reform, financial institutions still, I believe, are
    going to be very large, complex, and they will house risk. That
    is their business.
        So if we can move these transactions in the clearinghouse,
    allow end users, just as they do now, to have individual credit
    arrangements, maybe unsecured or secured arrangements with the
    banks and have the banks move them to the clearinghouse and
    post the margin. Today, they are charged a credit arrangement.
    These swaps do have a credit fee in them.
        End users have raised their concern it might still raise
    their costs. They recognize there is a credit arrangement
    already, but it might raise their costs, and I recognize
    Congress might decide to exempt them. I hope we would keep any
    exemptions narrow, just to the corporate end users, hopefully
    not to the financial end users like hedge funds that do have
    liquidity and could post margin.
        Senator Chambliss. One practical aspect of that that I have
    a problem with is, for example, Delta Airlines, who is a big
    user of this type of transaction, having to put up an airplane,
    a 777, for each transaction, or any other company taking part
    of their non-cash collateral that they normally would post for
    a line of credit and having to put it up as collateral of some
    sort for one of these type transactions. Again, I am not sure
    how we resolve that to make sure that we do lower that risk you
    are talking about, but don't hamstring these companies from not
    having the ability to post those non-cash collateral assets for
    lines of credit that they have got to have.
        Mr. Gensler. Well, actually, Senator, today, many large
    institutions--I am not familiar enough with Delta's own
    finances, but many large corporations have credit arrangements
    with the large Wall Street firms that say if we hedge a
    transaction and there is an exposure that develops six months
    or a year later, that they do have some arrangement. They might
    not be securing it with an airplane, but in some way, they are
    being charged for that credit arrangement. Even today, there is
    no free lunch there. There is a charge for the credit
    arrangement. It is just that they are not posting cash, and I
    don't think they need to post cash in the future.
        Senator Chambliss. Let me go to one other area that we have
    talked about before, and you know my concern regarding, making
    sure that we don't take any action from a legislative
    standpoint going forward that handicaps U.S. markets as
    competitors from the standpoint of individuals utilizing
    foreign markets to carry out the same type of transaction that
    they are doing today on U.S. markets, and that we don't
    overregulate them.
        In your testimony and in previous discussions, we have
    talked about the fact that you want to make sure that any U.S.
    company that trades on foreign markets still provides CFTC with
    information regarding those transactions so that we can have
    total transparency, and I understand why that is absolutely
    necessary. If you have got somebody trading on a U.S. market
    and a foreign market, if we are going to be able to let the
    general public know the financial condition, obviously, you
    need to be aware of both those transactions, whether it is on
    foreign or U.S. market.
        Give us your thoughts about your impressions on the, number
    one, ability of foreign markets to give you the right kind of
    information, and secondly, on the receptiveness that you have
    seen from foreign regulators regarding providing information to
    U.S. regulators, both SEC and CFTC.
        Mr. Gensler. I think that the crisis was so severe, both in
    Europe and in the United States and in Asia, that we do have a
    very good consensus. I am optimistic. I have worked in Europe,
    I have been over there and I have talked to the regulators
    almost on a weekly basis. They put out a paper about a month
    ago that said that they are going to be mandating that the
    standardized contracts be brought into transparent trading
    venues, just as we are considering here, mandating that the
    standard contracts be brought into central clearing, and they
    have also said that for the non- standard contract, they would
    be requiring the banks to hold higher capital. They actually
    used the word, I think, ``significantly'' higher capital.
        Now, their legislative process is different. They will take
    this to the European Parliament next summer. So they are really
    watching very closely what the Senate and the House do here.
    But I am very optimistic that though different cultures,
    different political systems, we will come out about the same on
    this with Europe, and between Europe and the United States,
    that is over 80 percent of these markets, and I think Canada,
    Mexico, and Japan are likely to work with this, as well, along
    the way.
        So I think you are absolutely right, Senator, but I am
    optimistic that we will be able to achieve consistent
    approaches.
        On information sharing, we have been very clear. We just
    wouldn't want bank secrecy laws in another country to hold back
    that information.
        Senator Chambliss. Today, on certain oil contracts that are
    traded on the London Exchange, the London Exchange provides
    CFTC with certain information to help with that transparency.
    Is the information that you are getting today from the London
    Exchange on those contracts, for example, adequate to allow you
    to feel that there is total transparency with those customers?
        Mr. Gensler. It is the futures market, not swaps, but they
    have been very helpful. First, a year ago, they agreed to give
    us positions, and then two months ago, we negotiated further.
    Now they are giving us transaction data, as well.
        Senator Chambliss. And is that the type of cooperative
    effort that it is going to take from all foreign markets?
        Mr. Gensler. I believe it will, and as I said, I think I am
    optimistic that we will be able to see into their trading and
    trade repositories and vice-versa.
        Senator Chambliss. Thanks, Madam Chairman.
        Chairman Lincoln. Senator Stabenow?
        Senator Stabenow. Thank you, Madam Chairman, and welcome,
    Chairman Gensler. It is great to see you again. Madam Chairman,
    I also want to thank you for inviting Neil Schloss, the
    Treasurer of Ford Motor Company, a great Michigan company, to
    testify on a very important part of the discussion about end
    users. We welcome all of the others on the second panel, as
    well.
        To follow up on what Senator Chambliss was talking about in
    terms of the international cooperation, it sounds like you
    believe that we can develop a system for regulating the futures
    markets internationally, that what is happening--am I hearing
    you right--is something that you believe will allow us to do
    that? One of my concerns is that without having an
    international regulatory regime for energy commodity futures
    and derivatives tradings and so on, that we are going to see
    companies that use derivatives to hedge legitimate business
    risks being placed at a competitive disadvantage, potentially,
    if we are not confident that we can do that.
        So am I hearing you say that you are confident, and what
    else would you need from us to be able to support your effort
    to be able to make sure there is an international agreement
    that is good for our businesses?
        Mr. Gensler. I am optimistic. When the President met with
    20 heads of State in Pittsburgh, I think now we are about two
    months ago, he was successful in negotiating these core
    principles right in the G-20 statement to ensure that we
    brought the standard part of the markets onto clearing and onto
    trading venues. It was at that high a level, at the G-20
    included. And then the European Commission, as I said, followed
    up.
        So I am confident. It won't be exactly the same. It is two
    different cultures and two different political systems. But I
    am confident, and I agree with you, Senator, that we need that.
        I think it is important in the statutory language you pass
    here, if successful, that there be some recognition explicit
    authority for the Commodity Futures Trading Commission to
    register some foreign boards of trade. We have been using what
    is called a ``no action'' process, and I think that could be
    enhanced in statute. But I am confident overall that we will
    come close, maybe not exactly the same.
        Senator Stabenow. All right. Thank you. You and I have
    talked about concerns about end users and the impact of
    whatever we do, and we know that 92 percent of the largest
    American companies and over 50 percent of mid-size companies
    use derivatives to hedge business risk. So whether it is
    hedging the business risks associated with oil prices, as has
    already been talked about, or currency exchanges, the ability
    to provide financial certainty to companies' balance sheets is
    absolutely critical for them and for us in terms of jobs and so
    on.
        So I appreciate your comments and your efforts to protect
    end users from diverting needed capital by providing the option
    to post non-cash collateral to meet the clearing requirements.
    However, we are in a situation where we have many companies
    that can't use their non-cash collateral, such as a
    manufacturer who has a mortgage on a building because the
    mortgage agreement is preventing them from using it. I would
    dare say that anything right now that is viewed as non-cash
    collateral is taken, I would guess, for many, many of our
    manufacturers.
        So that still raises a great concern to me. I know you
    spoke a moment ago about arrangements that already exist, but
    this is very serious for our manufacturers and I wonder if you
    might speak to how you would handle that situation.
        Mr. Gensler. Well, I think that every manufacturer in your
    State and in all of the States suffered gravely when AIG went
    asunder and $180 billion of our taxpayer money, I mean, roughly
    $3.5 billion per State. I think in Michigan, it would be bigger
    because per person----
        Senator Stabenow. Right.
        Mr. Gensler. You could do the calculation. And so that is
    the risk we are trying to protect again, that large financial
    institutions aren't so interconnected with the economy at large
    and that we try to move these transactions over to these well-
    regulated clearinghouses.
        I do think that there is a competing public policy interest
    that you just raised about the posting of margin, and that is
    what Congress is debating, these two public policy interests.
    One is lowering the risk of these financial institutions, and
    two is the interface with the end users.
        And that is why I truly believe we can also lower the cost
    to these end users by having every treasurer, every assistant
    treasurer being able to see on a screen where the transactions
    have traded. And so a manufacturer in Michigan would be able to
    see where a manufacturer in New York last traded and price and
    volume of the transactions. Even if Congress decides to exempt
    it from the clearing requirement, I think that would be just an
    unfettered good for manufacturers, to see the prices and the
    volumes of these transactions and have them--just as we do in
    securities markets.
        Senator Stabenow. Mr. Chairman, I agree with you on
    transparency, that is critical, and we are working through how
    we balance minimizing the risk to businesses, to consumers, to
    all of us in our economy and at the same time not creating a
    situation where we are diverting working capital that is so
    critically needed right now for so many of our businesses. And
    so I look forward to working with you as we work our way
    through to find the right balance.
        Thank you, Madam Chairman.
        Chairman Lincoln. Senator Gillibrand.
        Senator Gillibrand. Thank you, Madam Chairwoman.
        Today, we are going to hear from a number of our corporate
    end users on derivatives, and these companies obviously, as we
    have discussed already this morning, use derivatives on a daily
    basis to hedge risks that are an integral part of their daily
    risk and of their businesses.
        As we look at the regulation of derivatives going forward,
    my question is, do you see a difference in the various sources
    of derivatives and their ultimate uses, and I will give you
    some examples. For example, would you see a difference in a
    futures contract for copper that might be used to hedge the
    future costs of a manufacturing company's basic materials,
    which is sort of what Senator Stabenow is concerned about,
    than, say, an instrument like a credit default swap, which
    might have a less obvious benefit and has recently shown to
    have a greater potential detriment to the financial system?
        And just to boil that down a little bit, in the credit
    default swap market, we have two kinds. We have naked and we
    have covered. Naked means there is no underlying ownership of
    the assets that you are talking about. Covered is much more
    like an insurance policy. It is quite ironic that we heavily
    regulate gambling, which is like the naked variety, and we
    heavily regulate insurance, which is like the covered variety,
    but we don't regulate at all if it is called a credit default
    swap, which I think is what goes to your point, Mr. Gensler,
    about some of your concerns.
        So if there is greater risk associated with a specific
    derivative class, should they be regulated in a different
    manner with significantly higher safeguards associated with
    that regulation? For example, if you are going to be in the CDS
    market, do you want higher capital requirements so it doesn't
    undermine what Senator Stabenow is trying to say for a
    manufacturer that is trying to offset the price of copper
    because that is an input for their business, vis-a-vis another
    financial firm that may be using CDSs because it is a great way
    to create capital or a great way to hedge risk in a different
    respect?
        Mr. Gensler. I think, Senator, you raise an excellent
    point. I believe the draft administration bill allows this, but
    if it doesn't, it would be a worthy enhancement, to make sure
    that business conduct standards, capital charges, and the like
    could be set by different class--in terms of capital, it would
    be the bank regulators largely setting capital, but that they
    might be able to set capital different by class of contract.
    Credit default swaps are event contracts. One day, you think it
    is only this, and the next day, it gaps out and has a far
    different value because of the default. So it might be worthy
    to have different capital charges as an event contract, as you
    say. So I do believe there may be differences.
        On business conduct standards, the administration bill, I
    think, has a robust set of charges to the SEC and CFTC to write
    business conduct standards. Credit default swaps also have a
    very real interplay to the securities markets, with individual
    stocks and protecting against insider trading and manipulation.
    I believe it is there already, but we would look forward to
    working with you if you think there is more that needs to be in
    the administration proposal on business conduct standards.
        Senator Gillibrand. Well, I was mostly just interested in
    your opinion, if you think that this is an important issue to
    analyze fully and make recommendations on or not.
        Mr. Gensler. I do think that there are unique qualities of
    each category of swaps. Interest rate and rate swaps are very
    different than energy swaps, for instance.
        Senator Gillibrand. Right.
        Mr. Gensler. We have asked for authorities to set aggregate
    position limits across markets where they perform a significant
    price discovery function. I think that is important in the
    commodity space. It is not really applicable to interest rate,
    for instance.
        Senator Gillibrand. Right.
        Mr. Gensler. Credit default swaps, I do think have unique
    circumstances, particularly the interplay that you mentioned to
    the securities market and to issuers.
        Senator Gillibrand. Okay. Second area of inquiry: Has the
    CFTC examined the impacts of the reform proposals on small
    businesses and farmers who may not directly participate in the
    swaps market but may indirectly be utilizing derivative
    contracts through an intermediary? And an example of this is a
    greenhouse farmer may enter an agreement to receive natural gas
    at a certain rate through an intermediary, who in turn would
    then use a derivative contract with a supplier to lock in a
    fixed price for that gas. So my concern is what impact would
    these small businesses and farmers see from the proposals that
    are currently before Congress?
        Mr. Gensler. I believe, Senator, they would have a very
    real benefit. Right now, for many small businesses or small
    municipalities and nonprofits, when they use a derivative, they
    might just do one every two or three years. They often have to
    go out and hire a financial advisor, maybe pay $50,000 or
    $100,000 just for that advisor to give them advice. What do
    they do on this hedge, this important hedge for their business
    or hospital?
        I think if we bring transparency all the treasurers and
    assistant treasurers can see the pricing, we are going to see
    that small businesses actually are benefited. That is where the
    biggest information deficit is, is small and medium-sized
    businesses.
        Senator Gillibrand. Thank you. Thank you, Madam Chairwoman.
        Chairman Lincoln. Senator Conrad.
        Senator Conrad. Thank you, Chairman Lincoln, and thank you
    and welcome to the Chairmanship of the committee. We are
    delighted to have you as our leader and have great confidence
    in the skills that you will bring to this committee. We
    especially appreciated the leadership you provided in the last
    farm bill discussion, along with the Ranking Member, the
    current Ranking Member. We had a good team and we have got a
    lot of challenges ahead.
        I think this is one of the most important hearings of the
    year. I remember very well, Senator, several years ago, Warren
    Buffet called derivatives a nuclear time bomb, and we saw the
    bomb go off. I will never forget as long as I live being called
    after one of our Group of Ten meetings, Senator Chambliss,
    being called to the Leader's office, and I got there and there
    were the leaders, Republican and Democrat, of Congress and the
    Chairman of the Federal Reserve and the Secretary of Treasury
    and they were telling us they were taking over AIG the next
    day. They weren't there to ask us, they were there to inform
    us. And they told us in no uncertain terms they believed if it
    was not done, there would be a global financial collapse. That
    is about as stark as anything can be.
        So already, just on the AIG debacle, we have seen taxpayers
    saddled with $180 billion of debt. We must act to prevent that
    from ever happening again. I believe the administration
    proposals are important and balanced and a good beginning.
        I do want to register skepticism about a super- regulator.
    After having served on this committee for 23 years, I am
    concerned that CFTC would be down the end of a long dark
    hallway at the SEC, and I don't think that is appropriate. I
    would be very concerned about them not having the knowledge of
    the commodities that CFTC oversees that have been in CFTC's
    jurisdiction and domain and, frankly, in the domain and
    jurisdiction of this committee. So I do want to register
    skepticism on the notion of a super-regulator, but that is not
    what I want to ask you about, Chairman Gensler.
        We have heard from several end users who will be testifying
    on the second panel that if they are forced to come up with
    additional capital to meet the clearing costs, the additional
    capital required of clearing costs, that would put them in a
    difficult situation. One thing I would like to understand is
    how much are we talking about in terms of clearing costs? Can
    you put in perspective what we would be talking about in terms
    of margin requirements in a clearing situation?
        Mr. Gensler. Senator, I first want to thank you for your
    comment and support for the Commodity Futures Trading
    Commission. I, too, have found great expertise in the building,
    great staff that knows the derivatives market. As you look to
    the broader financial reform and councils and powers that are
    possibly considered for other regulators, I think it is
    important that market regulators, the SEC, as well, stay as
    independent, vigorous protectors of the markets and investors.
        In terms of the cost. You are correct. There is potentially
    a cost of the extension of credit. If somebody wants to hedge a
    risk, maybe they are hedging $100 million, a big risk, $100
    million of oil delivery, on the first day, the prices haven't
    moved. But a month later, the prices have moved and the
    question is, do they have to post something for that valuation
    difference.
        In the futures markets, one does that already. That is how
    futures have been regulated for 70-some years. In the swaps
    markets, it is all individually negotiated, and that is why I
    have used the same words--I have said, leave it individually
    negotiated between those end users and Wall Street. Allow them
    to do what they wish. Currently, there is some pricing in that
    credit arrangement. The end users have said they are concerned
    that if we require it, it might go up, and it is very hard to
    tell whether that is correct, whether that is one basis point
    in that example of $100 million.
        In natural gas, I am told, a lot of these current swaps
    will charge as much as five cents a million cubic foot for the
    credit arrangement. We don't have transparency in these markets
    right now, so I don't have good statistics.
        Senator Conrad. All right. My time has expired, but I would
    just say to you, I think you will find a lot of allies on both
    sides of the aisle on this committee with respect to CFTC
    jurisdiction. It is critically important to commodities, and
    many of us represent commodity States, that the regulator
    understand commodities. So I think you will find strong allies
    on this committee.
        Mr. Gensler. I thank you.
        Chairman Lincoln. Thank you, Senator Conrad, and I don't
    know that I need to echo that, but I will, that this committee
    does, or at least many of us do believe that.
        Senator Lugar.
        Senator Lugar. Chairman Gensler, a bipartisan financial
    crisis inquiry commission has been established to look at the
    whole crisis and derivatives. It is my understanding that they
    are to report their findings by December of 2010. Now, I
    remember a hearing in this committee held a year ago October by
    Senator Harkin, and we had excellent witnesses. They described
    at that point, and this is a year or more ago, that mortgages
    had been issued by local bankers and they sold them on to
    higher levels. They sold them on, packaging and packaging.
    Finally, they got pretty big packages at certain levels in the
    financial community and they sought firms like AIG, as it was
    mentioned prominently in that hearing, to get insurance. They
    were describing the derivative process as one of trying to
    obtain insurance for whatever risk there might be in those
    large packages.
        But then one witness intrigued us by saying that you could
    buy not only insurance, but you could also express opinions
    through derivatives. So we said, what is this, a public opinion
    poll? They said, not exactly, but nevertheless, if you still
    felt that you were not quite secure, you might bet on, for
    example, the failure of the banking system of Iceland, or
    Pakistan, or something of this variety. Some of these
    situations or opinions might come home and balance out your
    risks some more.
        Now, this was startling to all of us, but nevertheless,
    whether opinions are being expressed in such extravagant ways
    in derivatives, the mortgage thing did catch people's
    attention. I have read reports, and maybe you could confirm
    this, that as many as 25 million mortgages were issued that
    were subprime quality or worse. There was large encouragement
    by the United States Government for much of this. Some of it
    came really through some of our government firms. Private firms
    were encouraged, and banks, likewise, to do the same thing.
    This may not be the entirety of the world crisis, but it is a
    very large part of it, and that is why this inquiry by this
    commission is important. They need to identify really what it
    is that we are looking at here.
        At the end of the day, whether it was extravagance in terms
    of idealism by our government that everyone should own a house,
    even if they could not pay for it, and everyone ought to have a
    mortgage, and people tried to keep insuring this through
    various derivative instruments, it was a catastrophe. How do we
    prevent these kinds of excessive public sentiments? Is the
    transparency that might come through the legislation now, or
    with amendments that might be suggested by you, likely to
    solidify unwise decisions with regard to things like prime or
    subprime mortgages or other unusual loans or transactions? And
    what is meant when people called about the dark passages or the
    ideas that somehow there are sort of blacked out areas that
    those of us who are unsophisticated really don't know about and
    should not know about? Are all of these going to be uncovered?
    Will the transparency bring to light good transactions, and
    bad, transactions?
        Can you make a general comment about how we avoid the
    crisis again and how we identify correctly what happened this
    time so at least we might correct through public policy some of
    those areas?
        Mr. Gensler. Senator, I think there are many causes of the
    crisis, but I think we could all agree that the over- the-
    counter derivatives marketplace was one of the factors--not the
    only factor. And in the marketplace, it is currently not
    regulated in Europe or here, or in Asia, so there is not
    transparency. But at the size that it is, and a notional amount
    nearly 20 times our economy, just to give it a whole size,
    there are many important and fundamental things it does--
    hedging, corporations hedging their risk, interest rate, oil
    risks, and so forth. But there are, as you said, some event
    contracts, expressions of opinion, as you say.
        I do think that transparency in this marketplace, if we
    could bring as much as possible onto regulated exchanges, would
    help market participants foremost, that they would see the
    pricing. As Senator Chambliss earlier said, it was to determine
    the fair prices and hedge risk. I think moving transactions
    will allow end users to do that, but also that regulators could
    see the pricing.
        I think that we need to make sure that dealers have
    sufficient capital and that there are business conduct
    standards, and real rules of the road. It used to be, well,
    this is an institutional market. We don't need rules of the
    road because it is all big women and big men dealing with each
    other. And we are really saying, no, we need some business
    conduct standards here, as well.
        Senator Lugar. Well, I strongly favor the transparency that
    you are talking about. Likewise, I am cognizant of the costs
    that come with people who are using these markets. I think we
    must be thoughtful about this. The results of this catastrophe
    are really unparalleled, and the long term costs of this are
    going to be borne by our grandchildren. This is not just simply
    a business transaction proposition.
        Now, I am hopeful that transparency, at least inclusion of
    as much of this, leads to better decision making, both by
    businesses and government. My fundamental question is this.
    Even after we know the score, how do we prevent mistakes? Is
    the transparency likely to bring these things to the fore?
        Mr. Gensler. I think it is a big component. It is not the
    only component, and that is why we, I believe, need to also
    lower risk in the four ways that I mentioned in my testimony,
    getting as many transactions into the clearinghouse, away from
    these concentrated financial institutions. I mean, we only have
    five, six, seven that are really large in this industry right
    now here in the United States, and the same number overseas. So
    they are, in a sense, too big and too interconnected to fail.
    So we move the transactions away and make sure they have
    sufficient capital, as well.
        Senator Lugar. And hopefully give you sufficient capital to
    be able to enforce whatever the situation is.
        Mr. Gensler. Well, yes, because our $147 million this past
    year is small compared to any one department--any one swaps
    department of a large Wall Street firm. It is billions of
    dollars of revenue and costs.
        Senator Lugar. Thank you. Thank you, Madam Chairman.
        Chairman Lincoln. Thank you, Senator Lugar.
        Senator Cochran.
        Senator Cochran. Madam Chairman, thank you.
        One thing occurs to me, and that is what is the practical
    consequence of the changes the Obama administration is
    recommending that we make? What are the practical consequences?
    I know we have another panel that will come along and tell
    about how they use the markets to transact their business and
    to market what they sell and finance the transactions that they
    have to make to be successful in the marketplace. From your
    standpoint, though, are they wrong when they say that the Obama
    administration's proposals are going to cost more? Isn't that
    going to be passed on to consumers, like people who borrow
    money to buy cars or whatever, or businesses who use airplanes?
    Are the operational costs going to go up? What is your
    reaction?
        Mr. Gensler. I think the practical effect of the
    administration proposal, which I do fully support, is to lower
    the risk to the American public. Now, lowering the risk of
    these large financial institutions, which I think in some
    regards were mispricing liquidity, mispricing their capital,
    and had too little capital, could well take some leverage out
    of the system, some risk out of the system. And when you do
    that, they may well pass on costs. But I don't believe there is
    any free lunch, that the financial firms did get too highly
    leveraged and too much debt and through derivatives were
    possibly extending too easy credit, so to speak.
        So I do believe that the end users would be able to hedge
    their risk. They would be able to tailor products. We are fully
    supportive that they could customize products. I do believe
    they would get lower execution costs by the transparency
    initiative, and where the real sort of rubber meets the road is
    whether they are included in this clearing requirement, which
    it may well be that Congress decides not to require that, and
    that is the balancing act that Congress is looking at.
        Senator Cochran. Thank you. Thanks, Madam Chair.
        Chairman Lincoln. Senator Johanns.
        Senator Johanns. Madam Chairman, thank you.
        Mr. Chairman, it is good to see you. I want to start out
    and tell you how much I appreciate you taking the time to get
    around and stop by our offices. I think that is a very decent
    thing to do and very, very helpful in kind of thinking through
    some of these issues.
        I think you have a committee here that kind of approaches
    this and recognizes the obvious need to do some things here,
    but I think we also recognize that, done wrong, this has some
    very, very serious consequences even for farmers in North
    Dakota or Nebraska in terms of how they manage their risk and a
    whole host of other people, not to just mention the agriculture
    community.
        And I have some concerns here, I must admit. There is never
    time to go into all the concerns, so I am going to try to jump
    into a couple of things that just kind of jump out at me every
    time I think about this.
        The first concern is, to be very candid with you, this
    reminds me a little bit of the climate change legislation. In
    theory, we can all agree about its merits and what it might be
    doing, but in reality, if you don't get the world on board, you
    are not going to get very far.
        Now, if I were a small country out there, recognizing that
    just by its nature derivative trading is an international
    phenomena--I mean, we are trading in oil and commodities that
    sell in the international marketplace and hedging risk, et
    cetera--just by its nature, if I were a president of a small
    country out there, I would wait for the rest of the world to
    pressure down the regulatory atmosphere for the business
    community, and then I would find the sweet spots and I would do
    something different and I would gather all the business. What
    is going to stop that from happening?
        Mr. Gensler. Well, I think, Senator, that you are right
    that capital and risk know no geographic boundary or border.
    But I am optimistic, having worked closely with the Europeans
    and some of the other North American regulators, that we are
    going to come out with a consistent framework. There is still a
    lot in front of us, in front of this Congress, in front of the
    European Parliament. And I think these are the major centers of
    capital. So if we regulate our derivative dealers and the
    Europeans regulate theirs and we ensure through legislation
    that they can only have access to U.S. customers if they are
    comparably regulated, consistently and comparably regulated, I
    think that goes a far way.
        That hypothetical that you mentioned always gnaws at us and
    we have to find ways to close that. But that small country that
    you mentioned wouldn't have the capital, wouldn't have the end
    users in that country.
        Senator Johanns. But it might be able to attract it through
    its sympathetic regulatory atmosphere. I appreciate today it
    may not be much of a player, but it may be sophisticated enough
    to recognize. And you are--well, let me get to this, without
    bantering too much about this. You are never going to be able
    to assure us of that, are you? I mean, that is always going to
    be a risk and possibility if this legislation passes.
        Mr. Gensler. But I could ensure you this. If we don't do
    this in the United States, others won't do it. We have to show
    the leadership and, I think, rise to the occasion to bring
    regulation here. And the President was successful in Pittsburgh
    to get 20 heads of state to sign on. It was a brief statement,
    but an important statement about this. I think it is very
    encouraging.
        Senator Johanns. That is what we are being told about
    climate change, too.
        The second thing I wanted to ask about--two things relative
    to the margin requirements. Again, I would love to have an hour
    with you to delve into that deep, but let me delve into----
        Mr. Gensler. Tell me when you want to schedule it.
        Senator Johanns. Okay, great. We might do that. We will do
    that.
        Here is what worries me about the margin requirements.
    Number one, if I take this bank of money to put it into
    bringing down risk by posting, in effect, a cash bond of sorts,
    because that is basically how it works, I have taken that money
    out of the economy and it is now on the sidelines. Now, I have
    probably brought some risk down. In fact, in the no-risk
    transaction, we would require 100 percent and then there
    wouldn't be a risk. But that is not how a free economy works.
    So that is the number one concern, and I see I have just run
    out of time, but the second concern is this.
        The little guy out there, the small, medium-sized risk
    hedger, whoever that is, is going to be very limited in how
    much margin they can put up, how much capital they have access
    to in reality, and so I just worry that what you are really
    doing here, if you pound down on these margin requirements, is
    you have just set a course where bigger gets bigger and we
    exacerbate the problem of too big to fail. And I will guarantee
    you, sitting on the Agriculture Committee and the Banking
    Committee, it is a very bipartisan frustration that we are
    dealing with, too big to fail.
        Mr. Gensler. I share that frustration and that is what
    animates me. On the other side, is I think that the large
    financial houses are keeping a great deal of risk on their
    books. The largest financial houses often have between ten and
    20 percent of their balance sheet extending credit. Credit is
    being extended in these derivative contracts. They are central
    counterparties. They are not well regulated for it. They are
    also in the underwriting business and proprietary trading
    business and the leasing businesses and so forth.
        So that is why, as a public policy matter, and Congress
    will weigh trying to move as much of this into central
    clearinghouses but also weigh the concerns of these end users
    about posting margin. If they are exempted, I think the next
    panel, I am hoping you will hear, is fine and, in fact, it is a
    huge benefit for small and medium-sized companies to see the
    transactions trade by trade on trading platforms.
        Senator Johanns. Yes. I will just wrap up with this, before
    my microphone gets shut off. Transparency is good. I like
    transparency. I have tried to emphasize transparency is a good
    thing. How you execute that, again, I think it can send you
    down a pathway of just encouraging bigger and bigger and bigger
    to meet the requirements that we impose upon the private
    sector. Thank you.
        Chairman Lincoln. Senator Thune.
        Senator Thune. Thank you, Madam Chair.
        Mr. Chairman, I think the whole focus of this debate has
    got to be how do we figure out the right way, the balanced way
    to constrain some of the risk that led to this massive collapse
    and meltdown that we saw last fall. And I think a lot of this
    debate, too, comes down to some definitions, who is in, who is
    out, who is covered, who is not.
        And one of the questions I guess I would ask of you,
    because you stated earlier that the regulator should be the
    appropriate entity to determine what is a standardized
    contract, and I guess I would ask you, in light of that, how
    would you define a standardized contract?
        Mr. Gensler. I think--a very good question. I think there
    should be a presumption that if it can be cleared, a
    clearinghouse accepts it, it would be a presumption that it
    would be clearable. If it had a volume of transactions and had
    a pricing, clear pricing--one of the things about
    clearinghouses, they need to know what the pricing is of these
    transactions.
        I remember in February, actually, in front of the committee
    when then-Chairman Harkin asked me the question, I provided in
    writing, and I would be glad to get it to you, Senator, five
    different factors that could be. But it was related to a
    presumption that if it is accepted for clearing, then it would
    be standardized, if the clearinghouse took it. If there was
    such volume in the contract. If it was so similar, there was
    just one feature that was different, as if somebody was trying
    to evade the standardization, that would be a factor, for
    instance.
        Senator Thune. Okay. Do all derivative end users, in your
    opinion, create systemic risk to the financial markets?
        Mr. Gensler. I think that the greatest systemic risk is
    housed within the large financial entities. And though
    individual transactions don't, or even sometimes collection of
    transactions don't pose that type of risk, that when you go
    across, if we exempt a whole class of transactions, it is a
    significant part of the market. Again, there is not much
    transparency here. But the end user transactions are
    significant in dollar amount and even a larger number of the
    individual transactions, because usually end users have smaller
    transactions.
        Senator Thune. Right. Do you think that all end users ought
    to be subject to the same level of Federal oversight?
        Mr. Gensler. I am glad you asked the question. I am not for
    the end users having oversight. I am for the swap dealers
    having oversight and that the requirement would be on the swap
    dealer to bring the transaction into a trading venue, and that
    would benefit the end user. If Congress were to say that the
    transaction was brought into the clearinghouse, it would be the
    responsibility of the swap dealer to bring it in. But the end
    user wouldn't have oversight, if I can----
        Senator Thune. Okay. If you have a derivative end user
    like, say, for example, a rural electric cooperative who relies
    on standard over-the-counter contracts, should they be forced
    onto exchanges or central clearinghouses if it is a legitimate
    hedging transaction, something that they are simply doing to
    manage risk?
        Mr. Gensler. I think they should be able to manage risk
    however they wish to manage risk. If it is a customized or
    tailored transaction, then I would say no. But if a trading
    venue actually listed it for trading, it was so standard, it is
    a one-year contract for natural gas and it was similar to many
    of the transactions currently listed on the exempt commercial
    markets that we know of and talk about, ICE Atlanta, then the
    swap dealer would be required to bring it and make sure that
    small rural electric cooperative would be able to see the
    transactions of similar electric cooperatives in other States.
    They would never see the name, but they would see the price and
    volume. I think that would benefit them.
        Senator Thune. Okay. Thank you, Madam Chair. Thank you, Mr.
    Chairman.
        Chairman Lincoln. I think----
        Senator Conrad. Madam Chair?
        Chairman Lincoln. Sure?
        Senator Conrad. Might I just make a quick observation that
    in that meeting that I described where we were told government
    was going to take over AIG because there would be a global
    financial collapse if it was not done, what became clear is
    that AIG had written insurance contracts and they didn't have
    the capital to back up the commitment. And somehow, we have got
    an absolute obligation to make sure that can't happen again,
    and I don't know how you do that without some margin
    requirement. It would be unthinkable that we were to permit
    that same circumstance to occur again.
        Chairman Lincoln. I think we have got a few questions left,
    but we would like to do maybe one quick round, because we do
    have another panel and we do have a nomination hearing, so I am
    going to defer to my colleague, Senator Chambliss. I know he
    has got to step out for a few moments.
        Senator Chambliss. Thank you, Madam Chairman.
        Picking up where Senator Conrad left off there, you talked
    about some of these institutions being too big to fail and the
    sophisticated institutions that were dealing in this--that do
    deal in this market, and that those are the regular players, so
    to speak, in the market, versus the small businessman who might
    kind of almost inadvertently get involved in this.
        If we had total transparency, if AIG had been required to
    report to you or to the CFTC the nature and the details of all
    of their transactions, would not that have put not only CFTC in
    a better position, but the potential buyers of AIG products or
    investors in AIG products in a much better position to look at
    them and say, wow. They have got all these transactions out
    there and all these obligations out there, but they don't have
    the capital. And aren't these sophisticated traders just that?
    They are so sophisticated that they would have known that AIG
    was not capable of delivering on the products that they were
    selling, or that their capital was so low that there was no way
    they could meet those commitments and they wouldn't have made
    the investment if there had been total transparency at that
    time. Is my thinking right there?
        Mr. Gensler. Senator, I think that the markets need more
    than that. Transparency is critical----
        Senator Chambliss. I understand that----
        Mr. Gensler. --but as Senator Conrad said, I think the need
    to have the authority to effectively say an AIG or the next AIG
    has to have capital, has to have cushions really built in, and
    even business conduct standards and so forth, are critical, as
    well.
        Senator Chambliss. I understand that, and that is why we
    have got to look at the other portion of that. But from a
    transparency standpoint, isn't that correct, that investors
    would have been so sophisticated that they would not have made
    additional investments in AIG?
        Mr. Gensler. Though I would like to agree with you, as I
    would like to agree with every Senator, I think that the crisis
    showed that many sophisticated actors made whopping big
    mistakes. And AIG--I think we can't just rely on sophisticated
    actors making the choices. I think we need to regulate the big
    swap houses and make sure they have the capital and the
    business conduct standards right there.
        Senator Chambliss. I guess my point is, I don't disagree
    with what you are saying, but I agree that there has got to be
    transparency, and I think we have all said that today. There
    will be some additional issues relative to the margin
    requirements, position limits, whatever, but my point is that
    if we don't put in legislative language a requirement that
    there be total transparency and that transparency would lead an
    investor to shy away from somebody who is undercapitalized,
    then I think we have failed. So I want to make sure that we are
    talking along the lines of putting in legislative language the
    capability of an investor to be assured that the seller of a
    product does have the capital to back up that product.
        Mr. Gensler. I think such transparency would be a positive
    and a net benefit to the markets and I think it sounds like we
    are in agreement, but we need other factors, as well, in this--
    --
        Senator Chambliss. I don't disagree with that, but yes.
    Okay. Thank you.
        Chairman Lincoln. Just quickly, in the last farm bill, we
    passed some reforms that granted CFTC the authority to regulate
    contracts with a significant price discovery function. I would
    just like to hear from you how those reforms are working.
    Specifically, how many of the SPDC reviews have you undertaken
    since you have been given the authority to do so and how do you
    plan to use this authority in the future?
        Mr. Gensler. I thank you. The authority really was looking
    at trading venues called exempt commercial markets and trying
    to bring greater regulation to those where the contracts were
    similar or look-alike, as the documents had significant price
    discovery. We went through rule writing in the spring, and then
    subsequent to the rule writing have put out the determination,
    I think it is 43 individual contracts. Because----
        Chairman Lincoln. That is more than predicted, I believe.
        Mr. Gensler. More than was predicted, that is correct. But
    subject to the rules, there are four factors to be considered.
    We have put them out. One has actually been determined to be--
    because it was the first one we put out, the other 42 are still
    getting public comment and so forth-- one has been determined.
    It is the natural gas contract on ICE, and then ICE Atlanta
    then had to put in place the self- regulatory functions that
    this committee and Congress required of them, and we are
    getting now the reporting and so forth. And we are going to
    sort through--we are in a determination phase now, but we are
    going to sort through the other contracts. Most of them are in
    the--in fact, I think all of them are in the energy space.
        Chairman Lincoln. Thank you.
        Senator Conrad?
        Senator Conrad. Thank you, Madam Chairman.
        I want to go back to this question that was kind of ping-
    ponging back and forth with Senator Chambliss, because I think
    it is very important we get this right. A couple of years ago,
    I was at a charity dinner and had seated next to me a man who
    was in charge of all derivatives trading worldwide for a major
    financial institution that no longer exists. They were brought
    down by this derivatives disaster. And during the course of
    this dinner, we talked about derivatives.
        I raised with him--because just a few weeks before, I had
    asked my staff to bring me a formula that is used to measure
    the risks of a derivative deal. I wanted to see if I could
    understand it, because I have a Master's in business and I
    would have had that training about the time most of the people
    running these companies would have had their training. So I
    just wanted to see, would I be able to understand it. They
    brought me a formula. I couldn't make heads nor tails out of
    it.
        I said to this man, again, who was in charge of all
    derivatives trading for this major firm worldwide, I said, how
    many of the top executives of your firm do you think understand
    these formulas that determine, supposedly measure the risk of a
    deal? He said, ``I don't think any of them understand it.'' He
    said, ``I don't understand it.''
        And I tell you, I remember my feeling when he told me that.
    My God, this is the guy that is in charge of derivatives
    trading worldwide for a major company and he doesn't understand
    the formulas. And I understood, because, you know, I am pretty
    good in math. I couldn't understand it. And I will bet you a
    lot of money these guys would go to board meetings. Nobody
    wanted to be embarrassed and ask the question, what does this
    really mean?
        And in AIG's case, the vast majority of that company was
    sound. They were doing strong business worldwide. What brought
    them down was a 500-member outfit that engaged in these
    derivative deals, and they never--they couldn't conceivably
    back up the insurance products that they were selling. And they
    almost brought this whole thing to its needs.
        So for this member, transparency, absolutely. And to the
    point Senator Chambliss was raising, I do think it would make a
    difference if people were able to see, because, I mean, this
    gentlemen told me nobody knew how many derivatives deals were
    out there because there was no place it was reported. That has
    got to be.
        But then we have got to go another step. We have got to
    make certain that folks have the capital to back up the
    promises that we are making. Is that your position?
        Mr. Gensler. It is, Senator. I think that one of the
    critical functions of the regulatory group--and financial
    regulation failed the American public. I mean, there is no
    doubt about that. But the financial system also failed, and it
    wasn't just AIG. It is to make sure that these financial
    institutions, and they are more highly concentrated today than
    they were ten years ago--it is not uncommon, it happened in the
    airline industry, it happened in the drug industry--but in this
    industry, it is so consequential because they are intertwined
    in the fabric of every company, all the end users you will hear
    from and so forth, that they have enough capital, that their
    business conduct is such that it lowers risk, not heightens
    risk, and in my recommendation that we move what we can off the
    books into these central clearinghouses.
        They operate as a fiduciary duty, with a profit motive, as
    they should. They are for-profit companies. That means they
    want to make as much profit on as little capital and survive.
    They don't want to go under. But that is different than the
    responsibility to the taxpayers that I feel in my job every
    day, is to make sure that there is enough capital that this
    crisis can't happen again.
        Chairman Lincoln. Senator Lugar, anything else? Senator
    Cochran, Senator Johanns?
        Senator Johanns. I hope you don't take my asking hard
    questions as feeling one way or the other about this. I just
    think we have to ask hard questions. I once had a law school
    professor tell me--and anybody who has gone through law school
    has probably heard this--hard cases make bad law, this law
    professor said, and it is true. The most difficult AIG kind of
    cases can sometimes lead to terrible results if we are not
    paying attention.
        So let me just ask you on this margin phenomena, could AIG
    borrow money to make the margin call? I mean, they have access
    to great--or did have access to great capital at one time.
    Could a company go out under the administration proposal and
    meet the margin requirements by borrowing money?
        Mr. Gensler. They could. They could. But importantly, the
    large financial houses, like an AIG in the future, would be
    less interconnected because these transactions would have to be
    moved off of their books into these clearinghouses. What
    happened in AIG, they had about a $450 billion credit default
    swap book and their counterparties were not asking for margin
    to be posted. They said, well, they are fine, you know. And one
    day in September of last year, they were downgraded by the
    rating agencies and all of a sudden they had to post $30
    billion, and you know the rest of the story. The taxpayers put
    it up.
        Senator Johanns. It is just, you look at AIG and you wonder
    how people got paid so much to make such poor decisions, to be
    very blunt about it. And it is not just AIG. There were a lot
    of very, very bad things going on.
        To follow up on this question of capital to cover risk
    exposure, I mean, all of our economy is working with risk
    exposures. I buy a million-dollar life insurance policy,
    hypothetically. They are banking that they get to use my
    premiums long enough before they have to pay out on that. And
    in the world, some risk is--a situation in life insurance,
    well, some die sooner than expected, others don't, and on and
    on. But if you had a phenomena, say, in the casualty industry
    where you had a massive hurricane event, for example, yes, the
    claim problems can be absolutely overwhelming. They do not have
    oftentimes enough money sitting there to cover all of the
    claims, right? And isn't that the balance we are trying to
    strike here?
        Mr. Gensler. It certainly is, but I think this was more
    than just, if I can say it, an analogy of the 50-year flood or
    the 100-year flood. I think that the financial system had--and
    the regulatory system had real gaps and this over-the-counter
    derivatives marketplace is a real gap.
        We do have regulated securities markets. We have regulated
    futures markets.
        Senator Johanns. Sure.
        Mr. Gensler. This market is larger than the futures markets
    by orders of magnitude. I think we need to bring similar
    discipline to it.
        Senator Johanns. And again, I am going to work with you to
    try to get there. I just want to make sure that in this hard
    case, we don't make bad law. That is why I ask these questions.
    I think it is just important that we try to get a sense of what
    we are doing here, so thank you, Mr. Chairman.
        Mr. Gensler. I appreciate the hard ones and even the easy
    ones.
        Senator Johanns. Great. Thanks.
        Chairman Lincoln. Senator Grassley, we are finishing up the
    second round. If you have got anything for the Chairman, we
    would ask it now and we will then move to our second round.
        Senator Grassley. Thank you. We have questions from end
    user witnesses after you and they are going to testify that
    exemptions for bona fide hedgers and legitimate end users
    should be granted from regulated exchange requirements because
    it will, in short, break the bank. CAn you elaborate on what
    specific threats these users pose to financial stability?
        Mr. Gensler. Good to see you again, Senator. I believe that
    it is the large financial institutions that pose the greatest
    risk. But at the end of every financial institution, there are
    thousands of end users. So it is not any individual end user,
    but what we are really trying to do is lower the risk to the
    American public and promote transparency.
        Exchanges that you mentioned are actually a benefit to end
    users, and I think most end users would like to have
    transparency. What they are worried about is posting margin on
    something called a clearinghouse. A clearinghouse happens after
    the transaction, and while it is related to an exchange, I
    think that is what they are most worried about, is the cost of
    possibly posting margin. But the real risk is the large
    financial institutions being so interconnected.
        Senator Grassley. Your testimony includes support for a
    trade repository that would assist regulators. Could you expand
    on who and how this repository would be administered and how
    will this be kept independent from market players?
        Mr. Gensler. I think it is important that trade
    repositories and clearinghouses, which will serve in some way
    the public, broad public, be robustly regulated by the market
    regulators for governance, that the governance is an open
    governance and not sort of controlled by sort of a club deal
    amongst dealers. And the trade repositories are a place where
    all the regulators should be able to see the transactions. That
    is a regulatory transparency. And that our trade repositories
    and the European trade repositories, I believe, should be open
    and available that we can see as regulators that information.
        Senator Grassley. Okay. Probably all the witnesses at the
    hearing will agree with you that greater transparency and more
    information for both market participants and consumers will be
    beneficial. One recommendation is to aggregate data on the OTC
    trades and make them available to the public. Could you explain
    how you would make this available to the public but at the same
    time safeguard information that could be used to manipulate the
    markets?
        Mr. Gensler. As we do it, the CFTC, we put out a weekly
    report right now on the futures market and we aggregate data
    around large traders and we put that out every Friday. I think,
    similarly, we should promote aggregate data of customized and
    standardized product out to the marketplace. I do think market
    participants also benefit if individual trades are transparent,
    if they are standard enough to be listed on execution
    facilities. And that is really one of the best ways to protect
    against manipulation.
        But I also hope to work with this committee and you,
    Senator. I think we need to enhance the CFTC's authority to
    police the markets against manipulation and we do have some
    statutory language to address specific disruptive practices.
        Senator Grassley. Thank you, Madam Chairman.
        Chairman Lincoln. Thank you, Senator Grassley.
        Chairman Gensler, thank you again. You have been most
    gracious with your time. We appreciate that. We look forward to
    continuing to work with you as we move forward to find the kind
    of solutions that will really put our economy back on track and
    provide that kind of confidence in the consumer and the
    marketplace that we all know that we need, and more
    importantly, that we can provide, so----
        Mr. Gensler. Madam Chairman, members of the committee, I
    thank you and I look forward to working with all of you and
    making our staff and me available to any questions you have.
        Chairman Lincoln. Great. Thank you for joining us today.
        We would like to now call the second panel, if we could.
    First of all, we have got Glenn English, who became the fourth
    executive officer of the National Rural Electric Cooperative,
    chief spokesman for the nation's consumer-owned cooperative
    electric utilities. He represents the national interest of
    electric cooperatives and their consumers before
        the United States Congress and executive branch, the
    Federal agencies.
        We are also being joined by Mr. Neil Schloss, Treasurer for
    Ford Motor Company, a position to which he was elected in March
    of 2007. He joined the Ford Motor Company in 1982 as a
    financial analyst in the comptroller's office. From there, he
    has progressed through a series of finance positions at Ford
    Aerospace before transferring to Ford in 1990.
        We would also like to welcome Mark Boling, who is an
    Executive Vice President and General Counsel of Southwestern
    Energy Company. Prior to joining Southwestern in January of
    2002, he was in private practice in Houston, specializing in
    oil and gas transactional work.
        We are also being joined by Jeff Billings of the Municipal
    Gas Authority of Georgia, Manager of Risk Management. Jeff is
    responsible for the development and the execution of hedging
    strategies for the Gas Authority's hedging program. He also
    works closely with the members and partners of the Gas
    Authority to develop and implement hedging plans.
        And we are also joined by Dr. Robert Johnson. Dr. Johnson
    is an international investor and consultant to investment funds
    on issues of portfolio strategy. He currently serves on the
    United Nations Commission of Experts on International Monetary
    Reform under the Chairmanship of Joseph Stiglitz. Dr. Johnson
    is also the Director of Economic Policy for the Franklin-
    Eleanor Roosevelt Institute in New York, and we are pleased to
    be joined by him as well.
        Thank you, gentlemen, for coming to work with the committee
    on such a critical issue and we look forward to your testimony
    and then are, again, grateful for your being able to stay and
    answer our questions, as well.
        Congressman English.

     STATEMENT OF GLENN ENGLISH, CHIEF EXECUTIVE OFFICER, NATIONAL
      RURAL ELECTRIC COOPERATIVES ASSOCIATION, ARLINGTON, VIRGINIA

        Mr. English. Thank you very much, Madam Chairman. I, too,
    want to join others in congratulating you on your new position.
    We certainly are enthusiastic about the kind of leadership that
    we know that you will provide to this committee and to rural
    America in general, so congratulations once again.
        Chairman Lincoln. Thank you very much.
        Mr. English. Thank you. I think most of the members of this
    committee, certainly those that are present, are very familiar
    with electric cooperatives. I don't need to really go into the
    background about there being not-for- profit, consumer-owned,
    930 cooperatives in 47 States all across this country.
        But certainly we have a great interest in the subject at
    hand. We want to commend the committee and certainly encourage
    transparency, encourage any action that you can take that will
    deal with any market manipulation that may be taking place and
    any abuses that we may have seen in the past.
        I recall some 20 years ago--goodness, it doesn't seem that
    long, but 20 years ago when I served as Chairman of the
    subcommittee in the other body dealing with this very same
    issue, wrestling with some of the very same questions that I
    heard asked this morning. So this is one that has been with us
    and I commend you for continuing to work to get it right and to
    get it focused.
        I certainly appreciate and understand also that much of the
    discussion this morning is with regard to some of the larger
    participants in the derivatives market and the impact that they
    have had recently on our economy and some of the shortcomings
    that we have seen in that marketplace.
        I am here to represent some of the smallest of the
    participants in this particular market, but we have just as
    great an interest in a functioning market and legislation could
    have just as great an impact with regard to electric bills for
    those 21 million people who are represented on the Agriculture
    Committee through the cooperatives that you have in your
    particular States. And in this particular case, we find that we
    are concerned about one thing, and that is affordability.
        It is important for us to be able to hedge. It is important
    for us to be able to reduce risk. And certainly that has helped
    in keeping electric bills reasonable and affordable for our
    membership, and we need to continue to do that in the future. I
    think that a lot of the members of the committee fully
    understand how volatile fuels can be and the impact that can
    have on the electric bills of your constituents. Certainly,
    anything that we can do to bring stability in that area is
    certainly beneficial. So we want everyone to understand where
    we are coming from there.
        Interest rates swaps are also very important to us and can
    have a very big impact. As you know, we don't have a lot of
    cash on hand. Much of our cash has to go into that
    infrastructure. The 42 percent of the distribution lines of
    this country that are owned by electric cooperatives must be
    maintained by electric cooperatives. So we have a huge amount
    of infrastructure that has to be dealt with and a lot of the
    resources that we have go into that particular region.
        Not having money on hand puts us in the difficult position
    that the more volatility that is brought into constructing our
    plants and financing our infrastructure obviously means we have
    to go into the marketplace and borrow more money, and in some
    cases we have to borrow a lot of money. If we have one other
    element added, namely the volatility of fuels if we can't hedge
    without clearing, if we can't deal with swings in the
    marketplace, because it means we have to borrow a great amount
    of money for margin that is going to impact those electric
    bills each and every month.
        As the Chairman just recently discussed in response to a
    question from this committee, there is no question that the
    margin call issue is a big issue for us. It is a big concern
    for us. If, in fact, we are suddenly hit with the need for a
    margin call to go out and borrow a lot of money to be able to
    meet that margin call, that can have a huge impact as far as
    the electric bills of some local electric cooperatives. So
    where we are coming from and what we are focused on is dealing
    with this particular issue.
        Of the legislative proposals that we have seen put forth,
    both from Treasury and from others here within the Congress, we
    have been working with the various committees and trying to
    find out if there isn't some way that the smallest of those who
    use these markets, not for speculative purposes but for
    purposes of legitimate hedging, if there isn't some way in
    which we can assist the committee in this issue of providing a
    great deal more transparency while dealing with manipulation,
    but at the same time not impacting those electric bills of the
    folks back home, in trying to keep this thing at a manageable
    degree.
        Now, attempts have been made. Certainly, the Treasury
    Department has made that attempt, and one of the proposals here
    in Congress is to use GAAP. The difficulty that we have with
    using GAAP is that while it does through its exclusion provide
    a way in which you can deal with the margin issue, the question
    is whether we can qualify on any particular trade for GAAP. So
    it brings more uncertainty in, and uncertainty itself provides
    us with difficulty.
        So as the committee wrestles with this issue, as you look
    at how we can provide more transparency, if you look at how we
    might deal with any manipulation that might be taking place, I
    would simply urge the committee to do everything that they can
    to also keep affordability for some of the small users that are
    using it for legitimate hedging purposes in mind, as well.
        I thank the committee and I appreciate it very much.
        [The prepared statement of Mr. English can be found on page
    75 in the appendix.]
        Senator Conrad. [Presiding.] Thank you, Mr. English.
        We will go next to Mr. Schloss, the Treasurer of Ford
    Motor. Welcome.

      STATEMENT OF NEIL M. SCHLOSS, VICE PRESIDENT AND TREASURER,
                 FORD MOTOR COMPANY, DEARBORN, MICHIGAN

        Mr. Schloss. Thanks very much, and good morning.
        Senator Conrad. Please proceed.
        Mr. Schloss. Madam Chairman, Ranking Member Chambliss, and
    members of the committee, my name is Neil Schloss and I am the
    Treasurer of Ford Motor Company. I want to thank the committee
    for inviting me to testify and share the views of Ford Motor
    Company on a very important issue regarding financial
    derivatives and their regulation. The views that I express
    today are those of Ford Motor Company and their subsidiaries.
        Derivatives are an integral part of Ford's business of
    manufacturing, sale, and financing of vehicles worldwide. Ford
    employs derivatives to manage business risk so we can achieve
    stable cash flow and profitability in an increasing volatile
    global economy. We do not use derivatives to speculate or bet
    on potential changes in the economy or the financial markets.
    Our use of derivatives are focused on mitigating risks arising
    from our normal business operations.
        We fully support the legislation to increase transparency
    and oversight of the over-the-counter markets and participant
    activities. As an end user of derivatives, Ford would benefit
    from strengthening the derivative market and bank
    counterparties. We agree with general intent of most of the
    draft legislation that focuses on swap dealers and major swap
    participants and to exclude end users such as Ford and its
    affiliates from clearing, margin, and capital requirements.
        Like other end user manufacturers with captive finance
    companies, we are concerned that margin requirements would
    significantly increase our costs and liquidity requirements and
    could provide a disincentive to hedging our business risks.
    Most corporations do not have immediate and low-cost access to
    liquidity, such as the Federal Reserve discount window or FDIC-
    insured deposits. An end user raising capital requires lead
    time and is often very expensive.
        Ford's use of derivatives shows why the regulations are
    critically important to all end users. As of September 30, the
    net fair value of our derivatives was about $800 million, and
    this is the amount that the bank counterparties would have to
    pay us to terminate existing transactions. Our total derivative
    notional outstanding is about $108 billion, which includes $93
    billion of hedging interest rates, $14 billion hedging foreign
    exchange, and about a billion hedging commodity price risks.
    The automotive derivative book is just over $7 billion, and
    that is small compared to historical levels, and especially
    small compared to our financial services book, which is about
    $101 billion. But as the markets change and as our business
    grows, that could change significantly.
        Although we see the merits of credit default swaps, or CDS,
    in facilitating risk management and access to capital, we do
    not buy or sell CDS derivatives ourselves.
        In the automotive business, Ford uses derivatives to hedge
    currencies and commodities in order to lock in near- term
    certainty for our revenue and costs for global vehicle
    production. We are a capital-intensive business with various
    manufacturing facilities producing and selling cars around the
    world. For example, we use over-the-counter derivatives to
    hedge currency exposure resulting from our F- series production
    here in America in U.S. dollars and some of the sales being
    sold in Canada and Mexico in Canadian dollars and pesos.
    Similar exposures and trade flows exist all over Ford's
    worldwide operations on finished products, components, and raw
    material.
        We also use over-the-counter derivatives to hedge
    commodities, such as aluminum and copper, and we opt to long-
    term supply agreements to hedge those commodities that do not
    have a deep or liquid derivative market.
        Many of the product and sourcing decisions are made years
    in advance of when the product actually reaches the customer.
    Without hedging, we would be exposing ourselves and our
    customers to high volatility and price risk.
        One of the biggest concerns relating to the derivative
    market reform is the potential disruption that would have on a
    pretty fragile asset-backed securitization market. Mandatory
    clearing and margin requirements for securitization
    derivatives, which as you all know makes up a significant part
    of Ford Credit's funding today, would cause major structural
    changes on our existing transactions and future transactions in
    what is still a fragile market, despite TALF's success.
        During the credit crisis, many financial institutions
    curtailed credit capacity, but Ford consistently supported most
    of its 3,000-plus dealers and Ford Credit's portfolio of more
    than three million active retail accounts. It is vital in that
    recovery that the securitization market continue so we can
    continue to support our dealers and our customers.
        In our view, securitization trusts should qualify for end
    user exemption, as well, because securitization derivatives are
    uniquely structured and only protect the investor. In absence
    of end user exemption, we would strongly advocate that
    securitization derivatives be allowed an exemption similar to
    that which is being widely distributed for foreign exchange
    swaps and forwards in various Senate and House proposals.
        So in summary, we appreciate that Congress recognizes that
    end users such as Ford use derivatives to mitigate risk. As
    legislation is crafted, the distinction between pure risk
    mitigation and speculation is important to maintain. End users
    represent only a small fraction of the estimated $600 trillion
    outstanding in the over-the-counter market. All our derivatives
    are used to risk mitigate, and credit risk that is entailed
    within them are priced and fully paid up front when the
    transaction begins.
        We thank this committee for giving derivative market reform
    the serious attention it deserves and inviting us to share our
    views with you, and at the end of the panel, I welcome your
    questions. Thank you.
        [The prepared statement of Mr. Schloss can be found on page
    122 in the appendix.]
        Senator Conrad. Thank you, Mr. Schloss.
        Mr. Boling.

    STATEMENT OF MARK BOLING, EXECUTIVE VICE PRESIDENT AND GENERAL
          COUNSEL, SOUTHWESTERN ENERGY COMPANY, HOUSTON, TEXAS

        Mr. Boling. Thank you. My name is Mark Boling and I am
    Executive Vice President and General Counsel of Southwestern
    Energy Company, an independent energy company primarily engaged
    in natural gas exploration and production within the United
    States. I appreciate the opportunity to appear before you today
    and provide testimony regarding the very important legislative
    effort to reform the over-the- counter derivatives market.
        One of the biggest challenges in enacting legislative
    reforms for the over-the-counter derivatives market is that the
    term ``over-the-counter market'' covers a vast array of
    products across a number of markets, thereby making it
    extremely difficult to implement an effective one-size-fits-
    all solution. In this regard, it is important to note that
    energy derivatives did not cause the financial crisis of 2008.
    Credit default swaps and subprime mortgages did. It is also
    important to note that while we have witnessed the greatest
    economic crisis in 80 years and perhaps the most volatile
    commodity markets Southwestern ever experienced, over-the-
    counter derivatives in the energy markets performed well, did
    not create systemic risks, and, in fact, helped many end users
    manage and hedge their risks during this very difficult time of
    extreme volatility.
        We support all legislative efforts to improve the
    transparency and stability of the over-the-counter derivatives
    markets and to ensure market integrity by preventing excessive
    speculation, manipulation, and other abusive practices.
    However, we believe that any such legislation must recognize
    the significant differences between the various derivative
    markets and make a clear distinction between those market
    participants that engage in hedging transactions with a goal of
    managing the price risk inherent in their business and those
    market participants that engage in speculative transactions
    with the goal of achieving profits through the successful
    anticipation of price movements.
        My testimony today will focus on four things: Why over-the-
    counter swaps are so important to independent energy companies
    like Southwestern; the impact on Southwestern and other
    independent energy producers if they are required to clear or
    post cash margin for their hedging transactions; Southwestern's
    recommendation for the treatment of hedging transactions; and
    Southwestern's support of market transparency and reporting.
        Southwestern Energy Company is a growing independent energy
    company. Since 2005, Southwestern invested over $6.5 billion in
    its operations, all of which are located in the United States.
    These investments have resulted in substantial domestic job
    creation, increased direct and indirect business expansion, and
    significant Federal, State, and local tax revenues. Within our
    company alone, we have increased our employee base from 248
    employees at year-end 2004 to approximately 1,500 employees
    today, an increase of over 600 percent.
        Our ability to make over $6.5 billion of capital
    investments and create thousands of job opportunities during
    this period was primarily due to our ability to generate a
    reliable cash flow from the sale of our natural gas production
    and to gain access to additional funds borrowed under our bank
    revolving credit facility. The ability to generate our reliable
    cash flow was due in large part to our use of over-the-counter
    derivatives to lock in natural gas prices. Southwestern uses
    these derivatives as a risk management tool for our natural
    gas, a commodity that we produce, own, possess, and market. We
    do not use derivatives for speculative purposes.
        Southwestern regularly hedges its natural gas price
    exposure by entering into over-the-counter swap transactions
    with multiple counterparties with S&P credit ratings ranging
    from triple-B-plus to double-A. Southwestern has typically
    hedged 60 to 80 percent of its expected natural gas production
    volumes for the following year. Southwestern does not post
    collateral with any swap counterparty for a very good reason.
    Natural gas swaps lower Southwestern's business risk and makes
    it a much more stable company. Like all commodity producers,
    Southwestern is naturally long in commodity, and hence
    naturally subjected to the risk of falling commodity prices.
    Southwestern's swap counterparties understand that Southwestern
    is reducing its business risk when transacting over-the-counter
    swaps, and therefore the credit risk to the swap dealer is
    greatly diminished, thereby eliminating the need for
    Southwestern to post collateral.
        Increasing hedging costs by forcing all standardized
    derivative trades onto a clearinghouse will result in fewer
    market participants, more price volatility, and less price
    discovery. Because of the increased cost, fewer market
    participants will be able to hedge, or the ones that can hedge
    will hedge a lower volume. With fewer transactions and fewer
    participants in the marketplace, there will be more price
    volatility and less price discovery. By driving out the bona
    fide hedgers, the market share of speculators will increase,
    which does not create a healthy functioning environment. A
    healthy market requires a balance between bona fide hedgers and
    speculators.
        Finally, if the independent energy producers are forced to
    post cash collateral for natural gas hedging activities, they
    will be unable to fully invest in their business, the
    exploration and production of natural gas. The additional cost
    from posting cash collateral will be substantial and
    necessarily require that independent energy producers reduce
    their capital investments, resulting in a dramatic reduction in
    drilling activity, fewer jobs, and a significant decrease in
    domestic natural gas production.
        After analyzing the potential costs of posting cash
    collateral, Southwestern determined that during 2009, without
    hedging, Southwestern would have drilled 240 fewer wells in its
    Fayetteville Shale Project, resulting in the loss of 1,500 jobs
    and a total economic impact to the State of Arkansas of $1.6
    billion. In addition, fewer wells drilled in the United States
    means less domestic gas is produced, and less gas produced
    unfortunately means higher prices for consumers. There is a
    real world effect to a mandatory clearing requirement for all
    standardized over- the-counter derivatives.
        Southwestern believes the solution to these problems would
    be to provide an exemption from the clearing and margining
    requirements for bona fide hedging transactions where at least
    one party involved is a company that produces, owns, and sells
    the commodity and the transaction is directly related to
    managing commodity pricing risk inherent to that company's
    operating activities.
        In conclusion, a clearing requirement for over-the- counter
    derivatives, when applied appropriately, can play an important
    role in mitigating operational and counterparty risk for large
    segments of the over-the-counter derivatives market. However,
    we believe the broad application of a clearing requirement for
    all over-the-counter derivatives will hurt many American
    companies, particularly in the energy sector, by effectively
    taking away the most powerful tool for managing price-related
    risk.
        It is our hope that the concerns we have raised are
    addressed so that any proposed legislation does not
    significantly impair our ability to use derivatives to
    prudently hedge the risks we face in our day-to-day operations
    or to ensure our continued access to the credit sources we rely
    upon to grow our business. Ultimately, what matters most is
    that American companies continue to be allowed to cost
    effectively manage risk in a manner that enhances market
    stability and contributes to both the overall health of the
    economy and our country's goal of achieving energy
    independence.
        Madam Chair and members of the committee, this concludes my
    testimony. I would be happy to answer any questions.
        [The prepared statement of Mr. Boling can be found on page
    65 in the appendix.]
        Chairman Lincoln. [Presiding.] Thank you.
        Mr. Billings.

        STATEMENT OF JEFF BILLINGS, MANAGER OF RISK MANAGEMENT,
     MUNICIPAL GAS AUTHORITY OF GEORGIA, ON BEHALF OF THE AMERICAN
               PUBLIC GAS ASSOCIATION, KENNESAW, GEORGIA

        Mr. Billings. Thank you. Madam Chairman Lincoln, Ranking
    Member Chambliss, members of the committee, I appreciate this
    opportunity to testify before you today. My name is Jeff
    Billings and I am the Risk Manager for the Gas Authority of
    Georgia. The Municipal Gas Authority of Georgia is the largest
    nonprofit natural gas joint action agency in the United States.
    We have 76 public gas system members in five States, including
    Georgia, Florida, Alabama, Pennsylvania, and Tennessee.
    Together, these systems meet the gas needs of approximately
    243,000 customers.
        I testify today on behalf of the American Public Gas
    Association. APGA is the national association for publicly-
    owned not-for-profit natural gas retail distribution systems.
    There are approximately 1,000 public gas systems in 36 States.
        APGA's number one priority is the safe and reliable
    delivery of affordable natural gas. If we are to fully utilize
    natural gas at long-term affordable prices, we ultimately need
    to increase the supply of natural gas. However, equally
    critical is to restore public confidence in the pricing of
    natural gas. This requires a level of transparency in natural
    gas markets which assures consumers that market prices are a
    result of fundamental supply and demand forces and not the
    result of manipulation or other market abuses.
        Public gas systems depend upon both the physical commodity
    markets as well as the over-the-counter derivatives markets to
    meet the natural gas needs of our consumers. Both markets play
    a critical role in public utilities securities natural gas
    supplies at stable prices.
        Since 2005, APGA has been a strong supporter of increasing
    market transparency, limiting excessive speculating, and
    providing the CFTC with the resources it needs to protect
    consumers. APGA believes that provisions relating to the
    unregulated energy trading platforms contained in the CFTC
    Reauthorization Act passed last Congress was and is a
    critically important step in addressing our concerns.
        We commend this committee for its work on the
    Reauthorization Act. However, APGA believes that significant
    regulatory gaps still exist with respect to the over-the-
    counter markets. Congress should provide the CFTC with
    additional statutory authorities to enhance transparency, limit
    excessively large speculative positions, and help prevent
    market abuses.
        As this committee considers reforms to OTC markets, we are
    extremely concerned about the cost impacts of proposals that
    would require all standardized OTC transactions to be cleared.
    Mandatory clearing would significantly impair the ability of
    public gas systems to engage in the gas supply strategies that
    we have historically utilized.
        Under current practices in the OTC markets, many public gas
    systems, based upon their very high creditworthiness, are not
    required to post collateral as long as their exposure stays
    below a predetermined threshold. In contrast, the mandated
    clearing of all OTC transactions would require public gas
    systems to post initial margin for all transactions and to meet
    maintenance margin calls whenever required and on little
    notice. This would constitute a significant financial and
    operational burden on public systems that would be borne 100
    percent by consumers.
        In the case of the Municipal Gas Authority of Georgia,
    mandated clearing would require, based upon our current hedge
    positions, the posting of initial margin in the range of $163
    to $243 million. In addition to the initial capital
    requirements, we would also be responsible for additional
    capital contributions based on mark-to-market calculations.
        It has been suggested that the clearing requirements would
    be less burdensome if some end users are given the option of
    posting non-cash collateral. Unfortunately, the alternative of
    using non-cash collateral would not provide any relief to
    public gas systems. Non-cash collateral would entail the
    deposit of liquid assets and public gas systems simply do not
    maintain liquid assets in the quantity necessary to meet the
    requirements associated with clearing.
        APGA understands that proposals to require clearing of all
    OTC transactions are intended to address issues related to
    systemic risk and prevent future bailouts. However, the hedging
    of natural gas supply purchases by public gas systems using
    non-cleared bilateral OTC derivatives do not prevent systemic
    risks to the market.
        In addition, the proposed mandate to clear all standardized
    OTC derivative transactions would increase costs for public gas
    systems and their municipalities, an increase which, again,
    would be borne 100 percent by consumers. This increase in
    consumer cost comes without any benefits. In essence, we feel
    it would be punishing the victims.
        We look forward to working with the committee towards the
    passage of legislation that strikes an appropriate balance that
    allows end users, such as public gas systems, to continue to
    use the over-the-counter markets without incurring additional
    costs to hedge risk while enacting reforms that would protect
    our financial system. Thank you.
        [The prepared statement of Mr. Billings can be found on
    page 54 in the appendix.]
        Chairman Lincoln. Thank you.
        Dr. Johnson.

     STATEMENT OF ROBERT A. JOHNSON, DIRECTOR OF ECONOMIC POLICY,
     THE ROOSEVELT INSTITUTE, ON BEHALF OF AMERICANS FOR FINANCIAL
                       REFORM, NEW YORK, NEW YORK

        Mr. Johnson. Madam Chairman, Ranking Member Chambliss, and
    members of the committee, I want to thank you for inviting me
    to testify before you here today. I represent on this day
    Americans for Financial Reform, who are a collection of 200
    organizations who are taxpayers, workers, and the end users'
    end user.
        The American people clearly sense that there is something
    deeply flawed in the current structure of our financial
    markets. The financial sector calamity spilled over and did
    great harm to the lives of many Americans and people throughout
    the world. When they are properly designed, financial markets
    play a fundamental role in the resource allocation of our
    society. Financial markets serve to aggregate savings and
    allocate them to productive use and to transfer risk to
    entities that bear it most comfortably. The system we have had
    in place in recent years and the one that is still in place as
    we meet today has revealed itself to be profoundly flawed.
        Efforts to repair these market structures in light of the
    crisis should address and seek to rectify four core problems:
    Excessive leverage, opacity and complexity, the ability to buy
    insurance without an insurable risk, and the misalignment of
    incentives, where the private incentive to take risk exceeds
    the social desire to bear that risk.
        Certain types of derivative structures have contributed to
    all of these problems and it is time for a thorough redesign of
    the market system to fortify the real potential derivative
    instruments and repair the obvious flaws in structure that have
    caused so much harm.
        I must admit that I am very surprised by the intense focus
    on end users of derivative instruments. They are at present, by
    their own claim, a relatively small part of the market, and
    that focus does appear to me to have substantially misdirected
    energy away from the essential task of financial reform that is
    before the United States Congress and that centers on the
    regulation of large-scale financial institutions who threaten
    our economic system.
        This diversion of focus on end users is not independent of
    that quest and it is a dangerous exercise for at least two
    reasons. First, efforts to legislate what type of institutions
    are exempt from restrictions of healthy market practice runs
    the risk of creating loopholes that could be large enough to
    drive a jet aircraft through. End users' exemptions are drawn
    too broadly and they would allow anyone and everyone to claim
    them, especially the large ``too big to fail'' institutions
    that stand next to the public treasury and are the dominant
    actors in the opaque OTC market. That would directly undermine
    the need to bring these markets out of the dark. It would
    enable the largest market participants to remain in the shadow,
    where they earn profits--extraordinary profits--but put society
    and the public treasury in peril.
        In addition, end user exemptions may inadvertently spawn
    large organizations or divisions of the organizations the
    incentive to create Enron-like entities as the risk implicit in
    creating legislation that confers special advantage for special
    types of market participants.
        A second danger is the exemption of certain classes of
    financial products, such as foreign exchange forwards and swaps
    or any products that are traded on foreign platforms and serve
    to drive more activity offshore, perhaps to locations where the
    underpinning market structures are themselves quite unsound.
    Foreign exemptions will also divert creative energy into the
    creation of complex foreign exchange-based products to qualify
    for the exemptions and avoid the scrutiny and structures that
    they require for systemic safety.
        There has been a great deal of recent testimony, and it
    goes into some length to justify end user exemptions. This body
    of testimony tries to illuminate the consequences for end
    users, require them to trade upon exchanges or submit their
    transactions to clearinghouses. While I do agree that some
    increase in cost will be borne by these end users if the
    current structures are replaced by more robust and healthy
    market structures, I believe the magnitudes of the costs they
    report that they would incur pale in comparison to the cost
    this crisis inflicted on society.
        I do agree that the end users were not the primary cause of
    the recent crisis and they are not deserving of any particular
    punishment. Yet punishment is different than the adjustment to
    the removal of unhealthy subsidies. I don't believe their
    arguments should dissuade you from undertaking profound
    institutional reform, even reform that impacts their practices.
        Economists are fond of saying there is no such thing as a
    free lunch, and efforts to hedge market exposures by commercial
    users are primarily a transfer of risk rather than a diminution
    of underlying risk. An oil hedger is not reducing the
    volatility of oil prices, but merely transferring the risk to
    another party who will bear that risk for a price.
        When market structures are weak and unsound, they
    underprice that insurance and encourage the over-use of
    insurance. In the case of OTC derivatives that are largely run
    by the handful of ``too big to fail'' banks, the insurance
    offered to end users is often underpriced because the risk is
    borne in part by the public or the taxpayer who underpin the
    safety net that backstops these banks.
        Removing the back room subsidy and excessive use it
    inspires, something oftentimes referred to as moral hazard,
    would lead to an increase of cost to providing that risk
    insurance. Removing the subsidy would diminish profits for end
    users. That leads to less use of insurance and some greater
    cost for the consumers of those end users' services.
        Where I differ with many of the end users is the claim, I
    believe this would be a good thing--is that I claim this would
    be a good thing for the nation as a whole. Removing subsidies
    to the buyers of insurance does not make the world a more
    dangerous place. It merely redistributes who bears that risk
    away from those who had provided the subsidy.
        The American private sector, be it end users of financial
    products or financial institutions, do not need to clamor for
    subsidies from the taxpayer in order to thrive. That type of
    rent-seeking behavior is demoralizing for society and it is
    unproductive. It weakens the economy in the long term, and
    furthermore, government willingness to abide efforts to exact
    subsidy actually weaken the companies who receive them. The
    dependence on government subsidy allows the private sector's
    creative powers to atrophy. We would all do much better in the
    long term if we were shown tough love, were refused state
    welfare and forced to focus on new product development and
    innovations in the marketplace that would create a strong,
    profitable, productive future in the business sector and for
    the nation.
        Reforming the financial structure of the U.S. marketplace
    is essential to restore confidence in the United States.
    Transparent market structures, proper capitalization,
    regulation, restoration of market discipline to our largest
    financial institutions are the essential ingredients that are
    needed to restore that confidence.
        Finally, if this is done properly, it will also greatly
    diminish the possibility that future financial bailouts will
    reemerge and crowd out the use of our public finances for much-
    needed infrastructure, education spending, health care, and
    other things that make our society stronger and our lives more
    secure.
        I will submit the balance of my remarks for the record. I
    thank you, and I look forward to your questions.
        [The prepared statement of Mr. Johnson can be found on page
    90 in the appendix.]
        Chairman Lincoln. Thank you, Dr. Johnson, and thanks to all
    of you all for joining us today.
        We have heard some testimony today that our financial
    system has been put at risk by certain actors who have been
    over-leveraged and undercapitalized. It is important we find a
    balance to protect markets and consumers, and to that end, I
    just have a couple of questions for all of you and then a
    couple of specific ones for you, Dr. Johnson.
        It has been argued that with wider bid-ask spreads, capital
    charges, and other fees, that using OTC derivatives to hedge
    might be more convenient, but it is not necessarily less
    expensive than exchange trading, even without factoring in the
    possibility of mandated margin costs. To that end, would you
    compare the costs maybe, and you don't have to do this today if
    you don't have it at your fingertips, you could certainly
    submit it for us, which I think would be very helpful, but to
    compare the costs for me of one of your most standard contracts
    conducted over-the-counter versus similar costs of an exchange-
    traded hedge. As I said, if you don't have that breakdown now,
    it is certainly something you can get to us in detailed data
    later, which I think just would be very helpful to members of
    the committee, to really see what that comparison might be.
        And then the other question is to discuss the parameters of
    a possible end user exemption that you or your group members
    might support. Do you believe that the financial end users or
    their affiliates should be permitted to use such an exemption,
    or should we work to exempt smaller end users and if so, where
    would you draw the line between the less and more significant
    players? Or maybe would you suggest some other type of a test
    in terms of what we could put in there.
        So those are the questions I would like to throw out for
    you all and would like you to answer.
        Dr. Johnson, you have heard these end users' arguments
    today, and obviously you have heard them before, but they are
    very concerned about the additional margin requirements of
    mandatory clearing and that those requirements will make
    hedging with futures contracts prohibitively expensive. What do
    you make of their arguments, and if there were to be an
    exemption for end users, what should it look like, in your
    opinion, or are you adamantly opposed to any exemption?
        Also, what are your thoughts on a new resolution regime? I
    think it is very important for us to eliminate the prospect of
    ``too big to fail'' and I understand that we need a resolution
    regime in place that would account for how we very methodically
    deal with those who think they are too big to fail. We must
    make sure that they are not.
        So I am just opening it up to the panel. Yes, Congressman
    English.
        Mr. English. I will take a crack at that. Some of our
    members have formed and gone together, because we are so small,
    with our own entity we have created and we own it that does
    these kinds of hedging for our membership. We did take a look
    at--earlier this year, we had about 18 of our members who were,
    in fact, hedging, and if they had gone to a clearing device
    that they would have to, in order to meet these requirements,
    they would have likely had to come up with about $300 to $400
    million in order to cover what we would anticipate would be the
    margin cost. If you look at that at about five percent, you are
    talking about roughly somewhere in the neighborhood of $15
    million that those 18 entities would have to incur in
    additional expense.
        We do have some of our trades that are on the exchanges, so
    it is not that everything is over-the-counter. Most are, and
    this is the primary reason for it.
        Chairman Lincoln. Thank you.
        Mr. Schloss. I guess I will cover a couple of the questions
    that you asked, because I think the cost comparison one is one
    that, from a transaction-specific base, we all in the case of
    over-the-counter derivatives pay a credit charge up front from
    the standpoint of the unique credit charge. So how would that
    compare to what it would actually cost if you did to go an
    exchange, I think is yet to be seen if you go that way from the
    standpoint of the market development.
        I think for end users, and in our case specifically, the
    margin requirement that would come from a standpoint of not
    only the up-front margin for every transaction, but as you
    heard earlier today, as you go in time, the market value of
    that transaction changes, so the posting of margin changes. And
    going through an exchange will tie up valuable working capital,
    which for us is a tradeoff between margin versus product
    programs. You know, a half-a-billion dollars of margin could be
    a very significant new product from the standpoint of our
    ability to stay competitive, not only domestically, but against
    foreign competition. So I think there is a cost of that capital
    and an alternative use for that capital that is very important
    for us.
        As you get into defining end users, and I recognize the
    problem that you all face, because everybody is going to be
    here talking about why they need exemptions, and end users all
    have a different flavor for why they need it, our--and the
    problem that we all have is that we are a very small piece of
    the market from the standpoint of the overall over- the-counter
    market, and there have been studies that we make up something
    about ten to 15 percent of the overall market.
        The end users from our perspective, or from Ford's
    perspective, clearly will center around who are the market
    makers versus who has the underlying business risk. We use
    over-the-counter derivatives to hedge an underlying business
    risk that is generated from either selling of cars made
    domestically and shipped foreign or vice-versa, interest rate
    hedging from a standpoint of our ability to continue to fund
    our customers and our dealers. So there is an underlying
    business risk that if we aren't able to hedge or aren't able to
    hedge effectively, we are making a risk tradeoff from the
    standpoint of our overall business.
        So I think those are our two points very specific to Ford
    from the standpoint of both end user as well as cost.
        Mr. Boling. To answer your questions in kind of reverse
    order, Southwestern hedges its natural gas price risk using two
    different types of derivative instruments, over-the-counter
    swaps and costless collars. And both of those instruments
    require no initial net investment payment up front to
    Southwestern.
        With respect to what would happen if the clearinghouse
    requirements were in place as has been proposed by some
    legislation, we did our own internal estimates, and if you
    estimated if they were in effect June 30, 2008, if the
    clearinghouse margin requirements had been in place, we would
    have been required to post $740 million in cash margin. But by
    the end of the year, that would have changed because of the
    volatility in prices down to $118 million at year end 2008.
        And just to put these numbers in context, as of December 31
    of 2008, our company's total debt outstanding was $735 million.
    So these clearinghouse requirements and the margin requirements
    would have required us to come up with additional money
    somewhere of $740 million.
        Mr. Billings. On the cost issue, and our hedging is very
    much, as the other gentlemen here have described, we are
    hedging future gas costs for our municipal members and
    ultimately their customers. We deal primarily in the over- the-
    counter market. We also have no collateral arrangements, and so
    not required to post collateral when we hedge.
        As far as the costs go, a couple of things. Chairman, on
    your point about bid-offer spreads, I don't know that I have
    seen anything--it sounds good in practice, but I don't know
    that I have seen anything to convince me, anyway, that we are
    going to see a big change in bid-offer spreads just because we
    force everything to clear. It is possible.
        From a cost standpoint, when we go out to do a hedge-- and
    I am in these markets every day--when we go out and do a hedge,
    I may pay a half-a-cent or a cent per MMBtu over the stated bid
    or offer on the exchange to trade over-the-counter. That is a
    very minor cost for us. We are very comfortable with that cost.
    We have several counterparties we deal with. I can try to work
    that cost down through competition.
        On the other side, now, if I am forced to clear everything,
    we are going to have a large line of credit in place. We don't
    have a large amount of cash on hand. This really is going to
    change what we are doing, and so we are going to have to go out
    and get a big line of credit. Our estimate, we weren't exactly
    sure what standardized meant, so I took a look at if we had to
    clear every swap that we have on our books and had to have
    enough cash on the side for maintenance margins, we estimated
    we could have possibly up to a $500 million line of credit that
    we would have to have. Just having the line of credit, 50 to 75
    basis points. Using it, and then we are talking about, as Mr.
    English said, five percent, those dollars add up quickly. We
    estimated it could be as much as $10 million per year of
    additional cost.
        So for me, it is very simple. The cost of having a line of
    credit far exceeds anything that I could see in improvements in
    the bid-offer spreads.
        And then we also--we are concerned that having to put a big
    additional debt on our balance sheet could impact our credit
    rating, so it could have trickle-down effects in other things
    that we do, if we are trying to do infrastructure updates or
    help a system reach a new customer. Anything where we have to
    issue debt, if the rating of that debt is impacted by this
    large line of credit that we might have to have, there are
    other impacts to our systems that we are very concerned about.
        Chairman Lincoln. Dr. Johnson.
        Mr. Johnson. First of all, let me start by saying that I am
    much less intimately familiar with the individual businesses of
    each of the gentlemen to my right. So I don't think--to dispute
    them regarding the individual costs, I just have no basis for
    that.
        As I say in my written testimony, I do believe that we have
    had a system that has been reliant upon the guarantees of the
    taxpayers via the marketplace that was the ``too big to fail''
    institutions, and we have had underpriced insurance. And as
    each of them discusses, the change to an exchange or to a
    clearinghouse would in all likelihood entail--the process of
    obtaining that insurance would be more costly for each of them.
    It would be more costly in the cash management realm. Some
    would go without insurance and the consequences would likely be
    diminished profits in their sector or at their firms and it
    would also likely be the case that their pricing, they would
    pass through to their customers and they would bear some of
    that burden.
        But philosophically, what I am saying is that is a removal
    of a subsidy, and it might have even been what you might call
    an implicit design, not something that we all sat down and
    said, we want to subsidize this credit. We just have revealed
    in light of episodes that that is the case.
        I would anticipate, if you moved to exchange trading, that
    we would experience a narrowing of bid-ask spreads, more
    transparency of market prices, and an integrity of the system,
    which would also diminish the contingency of a big wipe-out-
    like crisis that we just had, and that indirectly should be
    factored into their costs. The collapse of demand, the layoffs,
    and all of the other things that all of our firms and our
    society are adjusting to right now, in my opinion, dwarf the
    kind of calculations that we are talking about today, however
    real they happen to be.
        Chairman Lincoln. Thank you.
        I have to apologize. I have gone way over my time and I
    need to defer to my colleague, Senator Chambliss, to move on.
    Thank you.
        Senator Chambliss. All of you have heard the previous
    discussion we have had about transparency and moving towards a
    different form of reporting requirement. Whether it is a
    clearinghouse for all transactions or not obviously is still
    going to be up for debate. But from the standpoint of each of
    you four, if we required full transparency of all transactions,
    irrespective of whether you have an exemption or not, is there
    any issue with doing that? I mean, are all of you willing to be
    fully transparent about the swaps and derivatives that you
    enter into? Glenn?
        Mr. English. Yes.
        Mr. Schloss. Absolutely.
        Mr. Boling. Yes.
        Mr. Billings. Yes, without question. We have been in favor
    of more transparency for many years.
        Senator Chambliss. All right. The question that I was
    getting to with Chairman Gensler, I think I finally understood
    his answer, and that is as each of you deal with the respective
    financial institutions or sellers of products or whatever it
    may be, if you have the benefit of the full transparency of all
    of their transactions prior to your engaging them in a swap or
    a derivative, would the information that you could glean as a
    result of knowing their financial position and their capital
    position affect your ability to make a decision on whether or
    not it would be a prudent investment for you to engage with
    that company? Glenn?
        Mr. English. Yes.
        Mr. Schloss. I think to the extent that we could get more
    transparency into the credit charges, I think that would be a
    help. The market itself is pretty transparent already. There
    are plenty of market screens from a standpoint of knowing where
    transactions trade. The difficulty will come when you have a
    very specialized trade, in our case, the securitization world,
    which takes on a very unique piece of the asset. Transparency
    in those transactions, even if everything was reported, I am
    not sure would add a whole lot of value.
        Mr. Boling. Our company has a formal commodity risk
    management policy, and as part of that policy, we engage in
    analysis, credit analysis of all the counterparties that we
    use, which at this time is, I believe there are 13 different
    counterparties. So that is an ongoing thing for us because we
    are concerned about their particular credit exposure in making
    sure it is spread across a number of different counterparties,
    as well as making sure of the financial integrity of each
    counterparty. So anything that would allow us to do that job
    more effectively, we would support.
        Mr. Billings. I really agree with Mr. Boling, that anything
    that helps shed light on potential red flags--we talked about
    AIG earlier--anything that would throw off concern that one of
    our counterparties was undercapitalized would certainly help us
    on the front end make decisions about whom we are trading with,
    so very much so.
        Senator Chambliss. Well, Dr. Johnson makes a good point
    about they fact that we need to make sure that there is
    security in the market, and it is like buying an insurance
    policy. I think that is a pretty good analogy that has been
    used several times today.
        But what I am concerned about is the practicalities, having
    been in business myself, the practicalities that each one of
    you have alluded to. In fact, you, Mr. Billings, have indicated
    that there are no liquid assets that your members could put up
    basically to provide for security or non-cash collateral assets
    or cash collateral assets. And even if you had to put up cash,
    it is going to severely hamstring you.
        But when we modernized the CEA in 2000, we thought we were
    doing the right thing, and I think we did do the right thing,
    to put more flexibility in the marketplace. But what we didn't
    anticipate was the ability of the players in the market to
    package CDSs, for example, and do it the way that, say, AIG did
    it. And where I come down on Dr. Johnson's side is just trying
    to make sure that as we move forward with whatever legislation
    we wind up with, that we don't create an opportunity for
    additional CDSs to collapse the market ten years from now. So I
    think that is what we have got to be careful of.
        I am not concerned about any of the full review. You all
    have got folks you have got to answer to and you have got smart
    people doing your business. But the folks who caused this
    collapse were out there getting greedy and making a lot of
    money and trying to make more money, and they weren't going to
    make it off folks like you all, but they are going to make it
    off of some people who are not as savvy or not as sophisticated
    as the four entities we have got here today.
        So I think our job is going to have to be where do we find
    that middle ground without requiring, Mr. Boling, you put up as
    much for a line of credit as you have in total outstanding
    debt. That makes no sense at all. But yet, we need to make sure
    that there is that security in the marketplace for that
    operator down the line who may be third or fourth removed from
    you as an ultimate customer to make sure that there is no
    collapse in the intervening transaction that is taking place.
        That is why this is such a complicated issue and why I am
    really glad that the Chairman has held this hearing today,
    because I think all of you provided valuable information that
    we are going to have to take back and digest and see if we
    can't find that common ground that is going to allow you to
    continue to operate.
        And Glenn, I guess I am more familiar with your folks than
    anybody else because I know your members are all nonprofit and
    they are made up of farmers and ranchers and small business
    people, primarily, who can't afford the kind of cost that is
    going to be put on them from the standpoint of having to secure
    all of these transactions. And since I am a consumer of yours,
    too, I don't want my utility bill going up.
        And the same thing with Mr. Billings there. He is serving
    Georgia.
        But all of you have provided very valuable practical
    information for us to digest and I thank you for being here and
    giving us that testimony today. It is going to help you through
    this period. We look forward to staying in touch and dialoguing
    with you about the issues that we are going to continue to see
    develop as we go through this process. Thank you.
        Chairman Lincoln. Senator Conrad.
        Senator Conrad. Thank you, Madam Chairman.
        First of all, let me say this is an excellent panel, really
    five outstanding witnesses. All of you have contributed to the
    work of this committee in a very positive way and we appreciate
    that.
        What strikes me about this conversation is transparency, as
    I see it, is necessary but not sufficient. In the case of AIG,
    as my memory serves me, one of the big financial houses wanted
    to go from ten-to-one leverage to 30-to-one leverage. They knew
    there was inherent risk in moving to that kind of leverage. If
    everything is going well, you make a lot more money. If things
    are not going well, you lose a lot more money.
        And so they recognized the need for an insurance product
    and they went to AIG and convinced them to write such insurance
    products, and AIG saw a gift horse and said, oh, yes, we can
    make a lot of money on this deal. What they forgot about is
    having the resources to cover against the down-side risk of
    these transactions. And when the down- side risk occurred, here
    we go. Taxpayers were the ultimate funder of the liability.
    That, we cannot permit to happen again.
        Dr. Johnson, thank you for your testimony. I think it was
    very clear and compelling.
        The one thing that strikes me is, as legislators, we have
    got an obligation to differentiate those places that are
    contributors to systemic risk, those that are not, and
    somewhere in between, because if we try to impose a regime on
    everyone and some of them are in a different category, we won't
    get anything done. I would say that to you. That is the trick
    of legislating.
        As I listened to the first four witnesses, I have high
    regard for Congressman English. He was the Chairman of a
    subcommittee in the House Agriculture Committee when I chaired
    the comparable committee on this side. I can tell you, he is
    one of the smartest and tough negotiators I ever dealt with
    around here. No, I said that wrong. I said smartest and
    toughest. Toughest and smartest.
        [Laughter.]
        Senator Conrad. When I listen, he is a smart guy. I don't
    think those kind of transactions contribute much to systemic
    risk.
        Mr. Schloss, as I listen to your description, that does not
    strike me as in the same category at all of what the hedge
    funds were doing or what certainly AIG was doing, which I
    believe was criminal. I believe some of those people ought to
    go to jail.
        Mr. Boling, I thought you were very persuasive. Mr. Boling,
    you used a phrase there on exemptions. You used language there
    about hedging transactions. I would like to go back and have
    you just reread that specific language, where you were
    proposing an exemption. For those who are hedging transactions,
    people who are hedging real business transactions, I think is
    what you were getting at, rather than, you know, speculation.
    Do you have that? Can you----
        Mr. Boling. I believe I can identify--I believe it was
    under the--was it at the beginning of my remarks or at the end
    where we were making recommendations?
        Senator Conrad. You were making recommendations and you
    were proposing where you would draw a line with respect to
    exemptions----
        Mr. Boling. Yes.
        Senator Conrad. and you were describing that. I don't have
    all the words. I wrote down, hedging actual transactions.
        Mr. Boling. Yes. I believe the language is Southwestern
    believes the solution to these problems would be to provide an
    exemption from the clearing and margining requirements for bona
    fide hedging transactions where at least one party involved is
    a company that produces, owns, and sells, or purchases and
    consumes, the commodity, and the transaction is directly
    related to managing commodity pricing risk inherent to that
    company's operating activities. We believe these transactions
    are easily distinguishable from those that are purely
    speculative, which appears to be the primary focus of the
    proposed derivatives legislation.
        Senator Conrad. In a nutshell, to me, you summed it up with
    that statement. And it seems to me that that is something we
    have got to try to capture here, and I would ask Dr. Johnson--
    and Mr. Billings, thank you for your testimony. It was very
    clear. You are in a situation, you don't have a lot of cash.
    Whether it is $500 million or $250 million doesn't make that
    much difference. The point is, you would have to, if you are
    running it through clearing, come up with additional money that
    you would have to finance somehow. Clearly, that would add to
    cost.
        Dr. Johnson's point is, yes, but there is risk in any of
    these, and certainly there is risk. I mean, we have to
    acknowledge that, not nearly the risk in these transactions
    that I see in what I saw hedge funds doing, what I saw AIG
    doing. Would you acknowledge, Dr. Johnson, there is a
    difference between what some of the hedge funds were engaging
    in, what AIG was engaging in, and what these companies have
    been doing?
        Mr. Johnson. Well, first of all, Senator, there clearly is
    a difference, and to echo Chairman Lincoln's comment earlier
    about how to construct an exemption, I was trying in my
    testimony to warn against creating hard and fast rules that
    then we might say lawyers can navigate around and leave us
    where Senator Chambliss talked about with AIG, which was with a
    disaster that was never the intention of the committee in the
    year 2000. So what I would recommend is to see someone like
    Chairman Gensler as the referee, as the arbiter.
        The gentleman sitting to my right, Mr. Billings, talks
    about the various cash flow problems, and no one has any
    intention to drastically impair his business. That is not
    healthy. So the kind of exemption that he would seek is
    something that someone with expertise who could differentiate
    between a hedge fund and his type of risk and his type of
    business structure could make a determination that it was in
    the public interest.
        And while--how would I say--I characteristically am more in
    favor of rules that are clearer than in allowing regulatory
    interpretation, because, as you know, the nature of who is in
    that regulatory chair changes, and that creates a volatility
    that these men probably don't appreciate.
        Senator Conrad. Sure.
        Mr. Johnson. But I think in this instance, because of the
    complexity of derivative markets, I would opt for the exemption
    arbiter, if you will, to be the Chairman of the CFTC.
        Senator Conrad. All right. Thank you. My time has expired.
        Chairman Lincoln. Senator Lugar?
        Senator Lugar. Dr. Johnson, let me go back to the question
    I raised with Chairman Gensler about AIG and the insurance that
    was being sought by the banks that had finally packaged
    together all these residential loans. I gather from your
    testimony, AIG could have charged a higher fee to these banks
    for the insurance they were seeking. If I listened to you
    carefully, AIG was offering a subsidy, of sorts. The subsidy
    ultimately was paid for by the American people in the collapse
    of the system. In other words, by offering these derivatives
    for lower costs than really the type of insurance that was
    required, and AIG not having the resources to pay, should they
    collapse, this huge subsidy, ultimately caused this catastrophe
    that we continue to go through with all of the rescue efforts.
        In this particular situation, how do we require AIG to
    charge the proper amount? In other words, where is the market?
    Is this something up to Mr. Gensler, as the referee, saying you
    are underpricing this derivative. It ought to be much higher,
    or all of us are likely to have systemic risk.
        At the other end of the situation, as you listened to the
    other four on the panel, you said you understand they have cash
    problems, and these are small situations in comparison to what
    we were talking about with AIG. Trying to find an exemption as
    to who comes underneath this--after all, someone at AIG or some
    equivalent company may be clever enough, to sneak underneath
    the tent with those who are being exempted now. You are saying
    perhaps the response we ought to have is not to try to do in
    legislative language the precise exemption, but to have Mr.
    Gensler or somebody like this as a referee, or as an
    arbitrator, who has the expertise, who has the staff, who says,
    ``no, you folks really don't qualify as agriculture
    cooperatives or natural gas firms or so forth. You are
    something else.''
        I am just trying to figure this out, because I like your
    idea that somebody pays ultimately. If we had no exemptions,
    then the small businesses here today could say, ``if we are
    going to hedge on behalf of our customers and so forth, this is
    going to cost money. We don't have a whole lot of cash. It
    ultimately has to be passed on to the customers.'' But if it is
    not passed on to the customers and risks are taken, then the
    customers are getting a subsidy in terms of what they ought to
    be paying to begin with for the natural gas or for whatever
    else they are buying for.
        We are more sympathetic with householders and so forth as
    customers than we are with large entities who are getting the
    subsidies from AIG. I am curious, how do we construct this
    legislation so that the subsidy, if it is there, and is clear,
    how do we extract the subsidy out of it? Because at the end of
    the day, why, none of us really are thinking of subsidy. We are
    thinking now of the bailouts of the stimulus package, and how
    are going to pay for it forever, even if we are very small
    individual consumers given the billions and trillions that we
    are borrowing. That is going to be the ultimate result of this
    if it is not done right to begin with.
        How do you spot the subsidy and how do you make sure it is
    not a part of the process?
        Mr. Johnson. You ask me easy questions.
        [Laughter.]
        Mr. Johnson. I think that in the case of AIG--I will start
    with where you started--what was fundamentally missing was an
    equivalent of a supervisor or a regulator that understood that
    they were providing what I will call mirage capital. They were
    providing assurances through the credit default swap market to
    the other ``too big to fail'' institutions, as well as others,
    but it was a mirage in the sense that they were not setting
    aside the resources to be able to meet those claims contingent
    on an event called a default.
        Senator Lugar. Is this fallibility, then, of the President
    or whoever appoints these regulators? How do we know that the
    person that is appointed is going to be bright enough to
    understand?
        Mr. Johnson. Well, that was the next stage, which is the
    first piece you need is for them to be regulated. We have
    insurance companies that are dealing in these actuarial odds
    regarding property, casualty, life insurance, and other things,
    earthquakes and what have you. You are never sure what the odds
    are. The past is not always prologue, and we had an extreme
    outlier in this episode.
        The second--but at some level, somebody should have been
    there, calling on AIG and saying, how come you are paying out
    bonuses and recording this as income and paying dividends and
    not provisioning for these losses? What was called a credit
    default swap to avoid regulation was actually credit default
    insurance.
        The second thing to diminish that is that I would stop
    uninsurable risks. People shouldn't buy insurance on something
    they don't own. So that is what fomented the speculation there.
        With regard to designing the structure and where the
    subsidy lies, what they call the lemon socialism, the downside
    is ours and the upside is private, it really has been the
    architecture of the banking system and the acknowledgement that
    the spillovers from the banking system can harm the real
    economy that has been the basis for that safety system. So I
    would return to that ``too big to fail'' regime and the design
    of the systemic regulator.
        With regard to your specific task--and what I think is
    really fascinating is that the interaction between derivatives
    and ``too big to fail'' is going to put you into a joint
    venture with the Banking Committee, and keeping the derivatives
    simple, transparent, supervised, and provided for with capital
    and margin will diminish the extent to which they can spill
    onto the banks. And one thing I might recommend in legislation
    is over in the Banking Committee in their ``too big to fail''
    determinations, they are going to speak about tier one
    financial institutions, or systemically significant
    institutions, and I would very much consider-- and I would be
    interested in each of your thoughts on this-- if you go to a
    tier one classification, your legislation could have an
    exemption which says--or have a provision which says no one is
    eligible for an end user exemption in any subsidiary,
    affiliate, branch, or whatever who has been designated a
    systemically significant institution, and that way you would
    avoid this attempt to drive, as I call it, the jet plane
    through the loopholes of language.
        Senator Lugar. Thank you very much.
        Chairman Lincoln. Thanks, Senator Lugar.
        Thanks to all of you all for joining us, and I think,
    actually, Senator Chambliss has one more question.
        Senator Chambliss. Yes. I have one for Mr. Schloss. I want
    to drill down on one particular issue that is important. That
    is, you indicated in your written testimony that your interest
    rate swaps are over-the-counter customized derivatives, and
    some have claimed that interest rate derivatives are an example
    of standardized swaps that can easily be cleared. Could you
    describe why you consider these to be customized as opposed to
    standardized?
        Mr. Schloss. Great question, Senator. There are really
    three pieces, or three types of interest rate derivatives that
    we will use. The biggest one by far is the securitization
    swaps, which are done between the securitization trust and the
    counterparty from the standpoint of protecting the underlying
    investor. And a great example is when we do a retail contract
    to consumers, those are typically done on a fixed-rate interest
    rate. We package hundreds of thousands of those together and
    sell them to investors that are typically floating rate buyers.
    So we have to hedge that interest rate, but they are amortizing
    structures and they are very unique to the underlying asset
    class. So that is probably over half of our interest rate
    derivatives are done in that form.
        The other piece is when we do a long-term debt instrument
    and we try to fund the business longer than our assets, so if
    we do a ten-year bond, our assets are three years, we need to
    match those terms of the bond specifically in order to get FAS
    133 hedging treatment. So those have to be very unique from the
    standpoint of matching the exact same terms of the bonds.
        The other piece of our interest rate hedge are more common
    from the standpoint of taking floating rate to fixed on a more
    standardized basis.
        Senator Chambliss. And again, I am assuming from your
    earlier answer, even if you had an exemption, there is no
    problem with you disclosing all of the financial transactions
    involved in those derivatives----
        Mr. Schloss. No problem whatsoever.
        Senator Chambliss. --to the CFTC. Thank you.
        Chairman Lincoln. Well, thanks again to the panel. You, as
    the members have said, you have been most helpful to us in the
    deliberations. We appreciate your testimony and certainly would
    ask that you not go too far because we would love to be able to
    continue the conversation as we move legislation through the
    committee and have deliberations on how to do a good job
    putting this together.
        I would remind people that we are going to have a second
    hearing on December 2nd, Secretary Geithner will be on our
    first panel there.
        Thank you all for joining us. We appreciate it. We look
    forward to continuing to work with you to solve the problem.
    Take care.
        [Whereupon, at 12:25 p.m., the committee was adjourned.]

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                                A P P E N D I X

                               NOVEMBER 18, 2009

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