[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
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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
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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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