[House Hearing, 110 Congress]
[From the U.S. Government Publishing Office]
HEDGE FUNDS AND SYSTEMIC
RISK IN THE FINANCIAL MARKETS
=======================================================================
HEARING
BEFORE THE
COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED TENTH CONGRESS
FIRST SESSION
__________
MARCH 13, 2007
__________
Printed for the use of the Committee on Financial Services
Serial No. 110-13
______
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35-405 WASHINGTON : 2007
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HOUSE COMMITTEE ON FINANCIAL SERVICES
BARNEY FRANK, Massachusetts, Chairman
PAUL E. KANJORSKI, Pennsylvania SPENCER BACHUS, Alabama
MAXINE WATERS, California RICHARD H. BAKER, Louisiana
CAROLYN B. MALONEY, New York DEBORAH PRYCE, Ohio
LUIS V. GUTIERREZ, Illinois MICHAEL N. CASTLE, Delaware
NYDIA M. VELAZQUEZ, New York PETER T. KING, New York
MELVIN L. WATT, North Carolina EDWARD R. ROYCE, California
GARY L. ACKERMAN, New York FRANK D. LUCAS, Oklahoma
JULIA CARSON, Indiana RON PAUL, Texas
BRAD SHERMAN, California PAUL E. GILLMOR, Ohio
GREGORY W. MEEKS, New York STEVEN C. LaTOURETTE, Ohio
DENNIS MOORE, Kansas DONALD A. MANZULLO, Illinois
MICHAEL E. CAPUANO, Massachusetts WALTER B. JONES, Jr., North
RUBEN HINOJOSA, Texas Carolina
WM. LACY CLAY, Missouri JUDY BIGGERT, Illinois
CAROLYN McCARTHY, New York CHRISTOPHER SHAYS, Connecticut
JOE BACA, California GARY G. MILLER, California
STEPHEN F. LYNCH, Massachusetts SHELLEY MOORE CAPITO, West
BRAD MILLER, North Carolina Virginia
DAVID SCOTT, Georgia TOM FEENEY, Florida
AL GREEN, Texas JEB HENSARLING, Texas
EMANUEL CLEAVER, Missouri SCOTT GARRETT, New Jersey
MELISSA L. BEAN, Illinois GINNY BROWN-WAITE, Florida
GWEN MOORE, Wisconsin, J. GRESHAM BARRETT, South Carolina
LINCOLN DAVIS, Tennessee RICK RENZI, Arizona
ALBIO SIRES, New Jersey JIM GERLACH, Pennsylvania
PAUL W. HODES, New Hampshire STEVAN PEARCE, New Mexico
KEITH ELLISON, Minnesota RANDY NEUGEBAUER, Texas
RON KLEIN, Florida TOM PRICE, Georgia
TIM MAHONEY, Florida GEOFF DAVIS, Kentucky
CHARLES WILSON, Ohio PATRICK T. McHENRY, North Carolina
ED PERLMUTTER, Colorado JOHN CAMPBELL, California
CHRISTOPHER S. MURPHY, Connecticut ADAM PUTNAM, Florida
JOE DONNELLY, Indiana MICHELE BACHMANN, Minnesota
ROBERT WEXLER, Florida PETER J. ROSKAM, Illinois
JIM MARSHALL, Georgia KENNY MARCHANT, Texas
DAN BOREN, Oklahoma THADDEUS G. McCOTTER, Michigan
Jeanne M. Roslanowick, Staff Director and Chief Counsel
C O N T E N T S
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Page
Hearing held on:
March 13, 2007............................................... 1
Appendix:
March 13, 2007............................................... 49
WITNESSES
Tuesday, March 13, 2007
Brody, Kenneth D., Co-Founder and Principal, Taconic Capital
Advisors, LLC, and Chairman, Investment Committee, University
of Maryland.................................................... 9
Brown, Stephen J., David S. Loeb Professor of Finance, Stern
School of Business, New York University........................ 18
Chanos, James, Founder and President, Kynikos Associates, LP, on
behalf of The Coalition of Private Investment Companies........ 10
Corrigan, E. Gerald, Managing Director, Goldman Sachs & Company;
Former President of the Federal Reserve Bank of New York....... 7
Golden, Andrew K., President, Princeton University Investment
Company........................................................ 16
Hall, George, Founder and CEO, Clinton Group, on behalf of The
Managed Funds Association...................................... 13
Matthews, Jeffrey L., General Partner, Ram Partners, LP.......... 14
APPENDIX
Prepared statements:
Bachus, Hon. Spencer......................................... 50
Castle, Hon. Michael N....................................... 52
Waters, Hon. Maxine.......................................... 54
Brody, Kenneth D............................................. 57
Brown, Stephen J............................................. 71
Chanos, James................................................ 73
Corrigan, E. Gerald.......................................... 97
Golden, Andrew K............................................. 111
Hall, George................................................. 119
Matthews, Jeffrey L.......................................... 135
HEDGE FUNDS AND SYSTEMIC
RISK IN THE FINANCIAL MARKETS
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Tuesday, March 13, 2007
U.S. House of Representatives,
Committee on Financial Services,
Washington, D.C.
The committee met, pursuant to notice, at 10 a.m., in room
2128, Rayburn House Office Building, Hon. Barney Frank
[chairman of the committee] presiding.
Present: Representatives Frank, Maloney, Watt, Moore of
Kansas, Capuano, Clay, Lynch, Scott, Green, Cleaver, Sires,
Ellison, Klein, Murphy, Wexler, Marshall; Bachus, Baker, Pryce,
Lucas, Gillmor, Manzullo, Jones, Shays, Feeney, Hensarling,
Garrett, Neugebauer, Davis of Kentucky, Campbell, Bachmann, and
Roskam.
The Chairman. This hearing of the Committee on Financial
Services will come to order.
This is the first in a series of hearings we will be having
on hedge funds and systemic risks in the financial markets. I
do want to make a point that may encounter some skepticism, but
it will not be the first time I have encountered skepticism.
Sometimes congressional committees have hearings because they
want to find things out, but I acknowledge that is not the
normal reason for having hearings. Usually, we have hearings to
make a point, to embarrass somebody, or to reinforce a
position, but there are times when there is a genuine
acknowledgment on our part that we need to know more about
things.
We are now going to have a series of hearings on the linked
topics of hedge funds, private equity, and the role of
derivatives. Those are conceptually separate things; they get
merged. One of the things I hope we will do as a result of
these hearings is to help people to understand that these
topics are not all the same thing, and we will unbundle
conceptually some issues.
We will have two hearings with people from the private
sector. The last hearing we are currently scheduled to have
will be with the members of the Presidential Working Group. We
thought it made sense, they having made their report, to then
have some discussion of that, and then have them come back and
respond to the conversation. We will at that point, too, be
talking to some of the regulators, particularly in the bank
area, who are given certain responsibilities under the approach
of the President's Working Group.
I just have some preliminary comments to make here. First,
I believe there is strong support on the committee--it may not
be unanimous and people can obviously speak for themselves--for
the efforts the SEC has recently made in the area of investor
protection. Among things we want to sort out is the question of
investor protection versus the question of systemic risk. This
hearing is called, ``Hedge Funds and Systemic Risks,'' not
because we are assuming that there is a systemic risk, but
because that is the question we intend to look at. This series
of hearings is not going to be primarily about investor
protection. The SEC has moved in that direction, I think, with
some appropriateness.
There is one sub-set of the investor protection issue,
though, that we do plan to look at and that is the interaction
between pension funds and the hedge funds. That one is not
entirely within our jurisdiction, in fact, that became an issue
last year when the pension bill was being voted on and that
bill, of course, did not come to our committee at all, I
believe, certainly not in any major way. There is interest in
that in the Education and Labor Committee, which has
jurisdiction over ERISA, and the Ways and Means Committee.
Now, I will confess, and I have asked people to be looking
into this, one of the concerns I have is the extent to which
public pension funds get involved in hedge funds. It was not
clear to any of us who exactly had jurisdiction over public
pension funds. That may become an issue now because you have
some of the States concerned about their GASB requirements
regarding the accounting but there is some concern about public
pension funds and hedge funds. Once you have that concern, of
course even if you had it, it is not clear if you are going to
put any protections in there, restrictions, on whom do they go?
Do they go on the fund which receives the investment? Do they
go on their investor? These are all questions that we will be
examining.
I will say from the systemic risk standpoint, it does seem
to me that the form in which investments are made is less
important by far than the type of investments. In particular, I
think it is time for us to look into the question of
derivatives.
Now, I said that sometimes Members of Congress have
hearings to try to find things out and not because there is a
strong position. I am very proud of the level of the discussion
that goes on in this committee. In fact, I think if people had
been at the mark-up we recently had on the question of how to
respond to the hurricane, they would have been very impressed
with the degree of knowledge. I am not prepared to argue that
if we got into a serious discussion of derivatives, that we
would dazzle anybody with the depth of our knowledge and
understanding. I have previously expressed the view,
particularly with regard to accounting for derivatives when
that has become an issue from time to time with Fannie Mae or
elsewhere, that the current state of that appeared to me to be
somewhere between alchemy and astrology. I undoubtedly do a lot
of people an injustice when I say that, and I am prepared to be
further educated.
I just want to stress again that these are hearings that we
are going to have because there is a new development in the
American financial world to some extent, in the hedge funds,
and there is also private equity. I should have added, I ask
for just 30 more seconds. With regard to private equity, the
concern here is not so much systemic risk as what the social
implications are. In fact, our colleague from Florida, Mr.
Feeney, commented the other day when we were having the
executive compensation hearing that he worries about people
going private because constituents that he represents could
lose the opportunity to make good investments. That was an
issue that the gentleman from Florida raised in terms of the
implications of private equity.
Many of us are also very concerned about the implications
for private equity on the workers, and on employers. If you
have in fact an increase in debt and the takeover of companies,
what is the impact, short term and long term? Those are the
questions that we want to look at. And, as I said, I personally
have no pre-conceptions about this. Indeed, to be honest, in
some cases I barely have conceptions much less pre-conceptions.
It is a very important set of questions and it is the job of
this committee to help I think both ourselves and our
colleagues in Congress, and indeed many in the country to
understand it.
The gentleman from Alabama is now recognized for 5 minutes.
Mr. Bachus. I thank the chairman. And let me reiterate what
the chairman said: the purpose of this hearing is
informational; the purpose of the hearing is not to legislate.
I think it speaks well that in reading your testimony, it seems
that all of the witnesses are pretty much in agreement,
although I noticed that two of them want a greater level of
maybe more disclosure and transparency and that is even a
controversial subject. In executive compensation, one of the
reasons I believe that executive compensation has grown as fast
as it has is the SEC requirement that you disclose CEO pay.
Warren Buffett, speaking last night, said that it was not
greed that was driving executive compensation, it was envy.
They see what each other makes and that actually that
disclosure, which everybody thought was a good thing, may
actually be the cause of a lot of the growth in executive
compensation.
One reason it is very important for the committee to
understand the hedge fund industry and other alternative
investment vehicles like private equity and venture capital is
because of the tremendous growth we have seen in hedge funds
and these other alternatives. There are over 9,000 hedge funds
today. That is an explosive growth. They manage over 400
percent more assets than they did in just 1999--$1.4 trillion
of assets under management, 60 percent of that is just in the
100 largest hedge funds.
They also are generating an increased amount of trading
volume. Some experts have represented that up to 50 percent of
the trading in our markets in certain circumstances is hedge
funds. The strategies employed by hedge funds vary
significantly, although most of them hedge against down-turns
in markets, which I think is good.
The primary goal of many hedge funds is to reduce
volatility and risk and simultaneously provide liquidity,
preserve capital and deliver positive returns under all market
conditions. We found that during our hurricanes in the past few
years that it was hedge funds that actually provided the
liquidity for insurance, property insurance coverage, a very
positive benefit of our hedge funds.
We all know hedge funds use complex, sophisticated
strategies to achieve their investment goals. I suppose the
first time most Americans heard of hedge funds, and many
Members of Congress as well, was with the implosion of long-
term capital management in 1998. And you will recall that
resulted in a bail out orchestrated by the Federal Reserve and
the Treasury Department and other regulatory bodies, although
it was a private bail out. And since that time the subject of
systemic risks posed by the operation of large hedge funds has
been a concern of financial regulators and members of this
committee, and rightly so.
Systemic risk is not theoretical, and if not properly
contained and managed, it can threaten the stability and
soundness of our financial markets. There is always the
potential for a single event, such as a massive loss at a large
complex financial institution to trigger a cascading effect
that could impact the broader financial markets and ultimately
the global economy.
For this reason, and I think this is the right approach and
I know that the witnesses have said this, last month's
announcement by the President's Working Group on Financial
Markets of the Principles and Guidelines of Private Pools of
Capital is a welcome development. The President's Working Group
appropriately focused on systemic risks to investor protection.
Private pools of capital are a sophisticated investment used by
sophisticated market participants. I am confident that these
market participants, hedge funds and others, understand they
must engage in constant due diligence and ongoing evaluation of
market exposure and risks created by their relationship with
hedge funds.
I applaud Secretary Paulson, Chairman Cox, and other
regulators who developed this guidance, and I am glad to hear
the chairman also say that he thinks that this is the way to
approach this, and that relies on market discipline and sound
risk management techniques rather than the heavy hand of
government regulation to achieve the desired objective.
This is how I will sum up. The bottom line is that I
believe an overly prescriptive rules-based approach to
regulating these private pools of capital could stifle
innovation and drive hedge funds and their capital offshore.
Such an approach would not benefit the competitive standing of
our capital markets, something we are very concerned about.
So I thank you, Mr. Chairman.
The Chairman. I thank the gentleman. I would just like to
make it clear that in regard to hedge funds, I have come to no
conclusion. My mind is pretty open on this.
Next, we will hear from the gentlewoman from Ohio for 2
minutes.
Ms. Pryce. Thank you very much, Mr. Chairman, for holding
this hearing today and for the promise of continued hearings on
private pools of capital.
I want to take a moment to thank the panel, also. This is
very important information for us. These are very complicated
issues that you can help shed some light on as we start today
and continue down this series of hearings. There is really no
doubt that the hedge funds provide significant economic
benefits to the market and the Federal Reserve Chairman has
cautioned against any heavy-handed regulation of the $1
trillion industry. We all know that the President's proactive
Working Group recently took steps to issue guidelines for hedge
fund participants. I agree with the Working Group that the
regulators' continued role must be to promote market discipline
on hedge funds and to ensure that proper risk management is
being followed.
I think in this committee it is important that we closely
examine why hedge funds do fail on occasion and why some
failures are different than others. Why was the collapse last
September of Amaranth advisors, which lost $6 billion in a
matter of weeks, different from the failure of long term
capital management in 1998 that sent shockwaves through the
system? Is there systemic risk posed to our economic system
today? And, if so, what are those risks? Are the protections
that are in place adequate to provide market actors and
regulators with the information needed to make informed
decisions? Should we be doing more to protect unsophisticated
investors? All are important questions that I hope we will
begin to answer today and in future hearings.
Just once again, Mr. Chairman, and our ranking member, Mr.
Bachus, thank you for holding these hearings, I will look
forward to all of the testimony, and I yield back.
The Chairman. I thank the gentlewoman again, working off
the list that the ranking member gave me, the gentleman from
Delaware is recognized for 2 minutes. Is he here? Well, the
gentleman was not recognized. Someone was posing as him. The
gentleman from Connecticut is recognized for 2 minutes.
Mr. Shays. Thank you very much, Mr. Chairman, for holding
this hearing. I also thank my ranking member. I live in a
district, in the greater New York area--we say that about 60
percent of the hedge funds exist and in my district there is a
claim that one-fourth to one-third of all assets under
management are in actually the district I represent. I tell
people that if you are from Iowa, you want to get on the
Agriculture Committee, and if you are from Fairfield,
Connecticut, you want to get on the Financial Services
Committee.
I would like to welcome all of our witnesses, but in
particular a personal friend, Jeff Matthews, and also his wife
is here, Nancy. Nancy is the chancellor of the diocese of
Bridgeport. They are quite a force. Jeff is an accomplished
hedge fund manager. He is an active member of his community,
having served in Fairfield, Connecticut, not the county, on the
board of finance and on the board of education. I love him for
his good nature, his sharp, insightful mind, his candor, and
his honesty. He is just a very welcome guest on this panel.
Jeff, thank you for being here.
Thank you, Mr. Chairman.
The Chairman. I thank the gentleman. Next, the gentleman
from New Jersey, Mr. Garrett, is recognized for 1 minute.
Mr. Garrett. Thank you, Mr. Chairman, and thank you for
holding this hearing. Thank you to the witnesses for being with
us today. For those I have met previously, good to see you
again. Also, I would like to thank my colleague who is not
here, the gentleman, Congressman Castle, for his work and focus
on this issue in the past term as well. Hedge funds, as you all
know, are now at $1.2 trillion, truly a high stakes, high-risk
investment. It originally started out for, I guess, the super
wealthy or the very wealthy and have now extended to the
pension funds, as the chairman says, both public and private.
And it is for that reason that it is important, it impacts more
on the middle class, millions of middle class Americans as
well, that we have this involvement here today.
I also would like to point out, just as a more personal
point of view from us coming from New Jersey. My friend from
the other side of the aisle and I, Albio and I, represent
districts that have a strong nexus to the financial markets and
so just as the gentleman behind us from Connecticut has that
connection, I know we do as well and take this from both
perspectives of our constituents here at home and across
America as well. And, as the ranking member had indicated, I
think it is important that we are able to have the benefit of
the President's Working Group on this, that goes all the way
back I guess to 1987, the stock market crash when that was
created to try to take a look at the financial markets and try
to gather up all the information that they can. And since that
time, obviously I don't think you were talking about hedge
funds that much back in 1987 but now we have, and they have
grown in importance. And like the chairman, I am still trying
to get my mind around all the issues involved, so I very much
appreciate the testimony at this hearing today. Thank you, and
I yield back.
The Chairman. I thank the gentleman and now I will ask
unanimous consent since 10 minutes has been consumed on the
minority side to extend the time for opening statements for an
additional 3 minutes. Is there any objection? Hearing none, we
will go forward. And the final recognition is for the gentleman
from Louisiana, Mr. Baker, for 3 minutes.
Mr. Baker. Thank you, Mr. Chairman, for the courtesy. I
think it important to recognize why we are actually here. Few
people would trouble themselves if really wealthy people lose
or make money, and so as long as this phenomena was relegated
to a handful of sophisticated Wall Street types, there was no
need for the Congress to be involved in this discussion.
However, that has changed. As innovation has caused your
reach of scope, economically and otherwise, to broaden, we are
now concerned about the inadvertent consequence of a systemic-
like event which causes pensioners, who have no idea their
manager has invested in a derivatives currency arbitrage, to
lose money as a result of a Russian currency crisis. I think it
is not quite clear to me what really constitutes a hedge fund.
Is that necessarily to the exclusion of private equity or
venture capital or does it go more to the aggregation of large
sums of capital, which are deployed in a sophisticated manner,
which is not subject to the same rules as a public operating
company, for which there could be adverse financial systemic
consequences. So, one, I think we have to define who is it we
are trying to constrain, why are we trying to do it, or what is
it we are trying to find out about them.
In reading through testimony, it became clear there are
certain best practices that each of you may have suggested
would be appropriate, and I think that is highly desirable as
opposed to a governmentally-driven remedy for the industry to
come to some conclusion as to how we should define those who
are engaging in this practice in a professional manner.
Beyond that, I think the valuation issue that has been
referenced and how do we know from an investor perspective that
there is consistency between Fund A and Fund B and the values
associated with your position in that particular exposure, that
is not clear to me either.
Finally, the manner in which the disclosure occurs cannot
be paper-based because by the time you get it on a piece of
paper, it is out of date. There has to be some net-based
disclosure, electronic disclosure, of the essentials that are
determined by the industry to the regulator of importance and
not public disclosure and certainly nothing proprietary.
I only make these comments because as the chairman was
talking about having reached no resolution thereon, this
Congress will come to resolution thereon if there is an adverse
event that drives a number of pensioners into bankruptcy
because a hedge fund guy was fast and loose with his investment
protocol. You will then get a ``Sarb-Ox'' like response,
applicable to whatever is defined as the hedge fund industry,
and you do not want us to do that. I think this is a window in
which there is great opportunity for the industry to coalesce,
to produce a document which is defensible, and give the
appropriate regulator the insightful information you know he
should have to help throw the circuit breaker when things go
bad. Absent that, we are going to get into a policy arena that
I think will be very difficult for the industry and not helpful
to our world economy.
Thank you.
The Chairman. I thank the gentleman, and we will now begin
with the witnesses. And our first, just in the order in which
somebody sat them, is Gerald Corrigan, formerly a very
distinguished leader of the Federal Reserve system and someone
who has been working closely on this issue. He is now managing
director at Goldman Sachs. Mr. Corrigan, please.
Let me say that without objection, the written statements
of all of the witnesses will be included in the record. Mr.
Corrigan, please go ahead.
STATEMENT OF E. GERALD CORRIGAN, MANAGING DIRECTOR, GOLDMAN
SACHS & COMPANY, AND FORMER PRESIDENT OF THE FEDERAL RESERVE
BANK OF NEW YORK
Mr. Corrigan. Mr. Chairman and members of the committee, I,
and I think all of us, appreciate your calling this hearing and
the timeliness with which you have done it. My statement, as
the others, will be accepted into the record.
In the interest of time, let me just highlight several of
the major points that I tried to make in my written statement.
The first part of the statement essentially tries to quickly
trace and highlight the evolution of the hedge fund industry
since long term capital in 1998, and I think that is quite
straightforward. The only thing I would want to emphasize, Mr.
Chairman, is that I think it is entirely fair to say, as I do
in my statement, that over recent years there have been very
substantial improvements in business practices in the hedge
fund industry in such areas as corporate governance, risk
management, disclosures to investors, and operational
infrastructure improvements. And in many cases, certainly not
all, but in many cases, I think the capabilities in those areas
within segments of the hedge fund community now has much in
common with best practices across the financial system as a
whole.
The statement also does a little idle speculation about the
future evolution of the hedge fund industry, which I will not
go into except to say that, at least in my judgment, there is
some prospect that the forces of competition probably will
induce over time some further pressures on fees and therefore
in my judgment the prospect of some further consolidation in
the industry over time.
I think it is very important for the committee to recognize
that as the premium on performance intensifies what I will call
the orderly attrition of under-performing funds may accelerate
and inevitably a few funds will encounter serious financial
problems. Such developments, as I see them, are a natural and
healthy market-driven phenomenon, which need not have material
adverse consequences for the stability of the financial system.
The second part of my statement traces the relationship
between hedge funds and large integrated financial
intermediaries. The substance of that discussion, while
obviously summarized, I think is indeed very important to this
whole question about systemic risk. And what I try to
illustrate is that the relationship between large financial
intermediaries, which are typically major banks and securities
firms, all of whom are subject to some form of consolidated
supervision, it involves two separate but related phenomena,
the first is the so-called prime brokerage phenomenon and that
essentially involves a whole range of services, including
providing credit by prime brokers to their hedge fund clients.
And I do make the point that a well-managed framework within
which prime brokers provide credit to hedge funds that is
secured, following the procedures that I have outlined in my
statement, is a relatively, I emphasize relatively, low-risk
activity.
The second class of activities that characterize the
relationships between hedge funds and major financial
institutions is the totality of what I call their counter-party
relationships and those counter-party relationships are very,
very complex and involve a whole range of activities and risk
taking on both the part of the intermediary and the hedge fund.
I take that discussion into a little sidebar discussion about
risk management. And I think the fundamental point that I want
to stress in terms of risk management, whether it is at a major
intermediary or at a hedge fund, is that the foundation for
effective risk management rests on what I like to call a
``culture'' of sound corporate governance, collective analysis
and decisionmaking, and above all, sound judgments by
experienced business leaders. And it is in this sense, Mr.
Chairman, that I believe that risk management is much more an
art than it is a science. And I go on to illustrate in my
statement some of the reasons why I think that is true.
The next part of my statement talks about systemic risk.
And I think that what I have tried to do here is in a very
summary fashion try to help ensure that the committee
realistically understands what systemic risk is and what it is
not. And the characterization that I have used for years and
years to describe systemic risk of a financial nature is to
call it a financial shock that brings with it the reality or
the clear and present danger of inflicting significant damage
on the financial system and the real economy. And I draw a
sharp distinction, as I have for years, between what I call
``financial shocks'' and ``financial disturbances,'' the latter
of which occur with some regularity.
I stress the point when I began the work of the Counter-
Party Risk Management Policy Group a year-and-a-half ago, that
the whole effort was shaped around three threshold conclusions
about systemic financial risk. The first was that over time the
already low statistical probabilities of the occurrence of
systemic financial shocks had declined further but they were
still well short of zero. The second, and this is the one that
worries me, is that while the probabilities of shocks are
lower, the potential damage that could result from such shocks
is greater due to the increased speed, complexity, and tighter
linkages to characterized a global financial system.
And then finally, that our collective capacity to
anticipate the specific timing and triggers of future financial
shocks is extremely low, if not nil. Indeed, I argue that if we
could anticipate these things, they would not happen.
Now in those circumstances--
The Chairman. Mr. Corrigan, we need you to get to a
conclusion.
Mr. Corrigan. The last thought, Mr. Chairman, that I have
put emphasis on, strengthening what I call the shock absorbers
of the system, and I do think that the President's Working
Group exercise on hedge funds and private pools of capital is a
very constructive move in that direction.
Thank you, Mr. Chairman.
[The prepared statement of Mr. Corrigan can be found on
page 97 of the appendix.]
The Chairman. Thank you. Our next witness is one who has
appeared before us in other capacities when he was the head of
the Export-Import Bank, over which this committee has
jurisdiction, and he is now with Taconic Capital Advisors, Mr.
Kenneth Brody.
STATEMENT OF KENNETH D. BRODY, CO-FOUNDER AND PRINCIPAL,
TACONIC CAPITAL ADVISORS, LLC, AND CHAIRMAN, INVESTMENT
COMMITTEE, UNIVERSITY OF MARYLAND
Mr. Brody. I thank Chairman Frank and Ranking Member Bachus
for the opportunity to testify. In my former life as a public
servant, under the jurisdiction of this committee and Chairman
Frank, I have learned to be brief, to the point, and succinct,
so let's go. I wish to address two issues, systemic risk and
investor protection. The President's Working Group and
virtually all knowledgeable professionals agree that systemic
risk is best controlled by regulators overseeing the providers
of credit. These providers of credit are primarily the large
financial institutions, commercial banks and investment banks.
Turning to investor protection, I believe it is another
story. I am going to take a very unusual view for an industry
participant. I believe that mandatory registration is good
policy. It provides for better investor protection, and I think
it should come about because the nature of the investors have
changed. It is not just wealthy individuals but it is
institutions of all stripes, including pension funds, who are
getting more and more into investing in hedge funds. And with
pension funds, the ultimate beneficiaries are regular working
people.
What registration primarily provides is a self-discipline
and a self-policing because that comes with the threat of SEC
examination. In my testimony, I have included many of the
elements of such protections that are provided by registration
with the SEC. Having said that, a better way to do registration
is to introduce a principles approach instead of a ``tick the
box'' regime. A principle approach will provide better investor
protection and with greater efficiency.
We are registered and a substantial number of hedge fund
managers are registered. We think it is good policy for all. I
thank you again for the opportunity to testify, and I welcome
the opportunity to answer any questions.
[The prepared statement of Mr. Brody can be found on page
57 of the appendix.]
The Chairman. Thank you very much, Mr. Brody, for your
testimony and your example of how to testify.
[Laughter]
The Chairman. Next, we have James Chanos, who is chairman
of the Coalition of Private Investment Companies. And, Mr.
Chanos, please proceed.
STATEMENT OF JAMES CHANOS, FOUNDER AND PRESIDENT, KYNIKOS
ASSOCIATES, LP, ON BEHALF OF THE COALITION OF PRIVATE
INVESTMENT COMPANIES
Mr. Chanos. Chairman Frank, Ranking Member Bachus, and
members of the committee, my name is Jim Chanos, and I am
president of Kynikos Associates, an SEC-registered New York
private investment management company I founded in 1985. I am
appearing today on behalf of the Coalition of Private
Investment Companies, whose members and associate managers
advise more than $60 billion in assets. I would like to thank
the chairman and ranking member for inviting us to participate
today.
The Coalition welcomes the attention of this committee on
our industry. Rapid growth in all alternative investment funds,
whether they call themselves hedge funds, private equity, or
venture capital, has brought significant rewards to investors
and the financial markets. But to paraphrase the great Stan
Lee, ``With great growth comes great responsibility.'' This
responsibility derives from the industry's more prominent roles
in various parts of the financial markets and perhaps most
importantly the trust placed on our managers to properly invest
the assets of pension funds and endowments, institutions whose
ultimate beneficiaries are not themselves wealth individuals.
Consequently, hearings such as this present a unique
opportunity for our industry to explain the way it works,
dispel some of the myths and misconceptions that surround it,
and make clear our commitment to work with policymakers in the
Congress and in the financial regulatory agencies in order to
improve those areas where the system of oversight may not be
keeping pace with the growth of the sector.
The Coalition would like to suggest a few ideas that may be
useful in thinking about the issues associated with private
pooled investment vehicles. First, almost all private
investment pools, whether a hedge fund, a venture capital fund,
or private equity fund, share many common characteristics in
terms of their disclosures to their investors and counter-
parties without detailed government mandates. Consequently, we
would suggest that policymakers, instead of creating
distinctions between these types of entities, treat all private
pool investment vehicles similarly, regardless of their
underlying investment strategies. Even though we may all use
the term ``hedge fund'' in the context of today's hearing, the
most accurate phrase is not ``hedge fund'' but ``private
investment company.
Second, in terms of investment activity, the buying or
selling of securities or commodities or derivatives, hedge
funds are but one type of many market participants engaged in
the same activity. Again, in order to gain the most complete
understanding of the subprime mortgage market, to use a recent
example, one should not focus solely on a single segment of the
market but should look at all participants engaged in that
activity. Looking at mortgage securitizations solely through
the prism of hedge funds without looking at banks, investment
banks, insurance companies, and other types of dealers and
investors will create a distorted picture of how and why that
market operates as it does.
This is not to say that hedge funds should not be included
at all in such a distinction, quite to the contrary, we are an
important part of the equation. But hedge funds are not nearly
so significant in and of themselves that they should be the
focus of attention to the exclusion of other market
participants doing the same thing. A focus on the activity, not
the actor, is more likely to yield the information desired by
policymakers in assessing the appropriate level of oversight
and regulation.
Third, the phrase, ``lightly regulated,'' which typically
is applied to hedge funds and other alternative investment
vehicles, is somewhat misleading as it really only applies to
governmental regulation of the relationship between the fund
and its investors. In this area, sophisticated or institutional
investors are deemed by the government to have the capacity and
equal footing to obtain the requisite information from fund
managers on their own instead of relying on standardized
government-mandated disclosures. In almost all other aspects of
the U.S. financial system, hedge funds are subject to the same
web of statutory and regulatory requirements as all other
institutional market participants engaged in the same activity.
And even with the interaction of the fund, the manager and
the fund investors, despite lack of regulation, does not yield
a lack of transparency, either to investors or to the counter-
parties providing credit and other financial support. In the
case of my funds, for example, investors or their financial
managers generally require us to provide answers to detailed
questions regarding our background, strategies and research,
personnel, returns, compliance programs, risk profile, and
accounting and valuation practices. Prospective investors also
review terms such as liquidity restrictions, management
performance fees, and any applicable lock-up periods for their
capital. Depending upon the nature of the investor, a person
may meet an institution's portfolio managers or compliance
officers.
Some investors also ask to speak to our lawyers, auditors,
and prime brokers for references. The process usually also
includes any number of on-site visits by the potential investor
or their representatives. The right to on-site visits continues
after the investment is made as well as continued oral and
written communication on a regular basis so that the investor
can assure himself or herself that the representations that we
made at the outset are being followed.
Fourth, much of the secrecy surrounding hedge funds is
frequently a consequence of both the proprietary nature of the
investment strategies employed and of the mandates of the SEC
itself. The Commission's restrictions on general solicitation
and public offerings, under which all hedge funds operate,
prohibit fund managers from discussing their strategies and
performance in any venue or in any way that could be construed
as a solicitation or investment from the general public.
Certainly, it means that fund managers must limit the content
of or access to their Web site and limit public interviews
about their funds and investment strategies that could be
viewed as designed to attract the interest of the general
public to invest in the funds. Accordingly, most fund managers
prefer to err on the side of less public discussion rather than
risk running afoul of the SEC.
Fifth, if there are gaps in the system of regulatory
oversight, then there should be ways to address them consistent
with the principles and guidelines recently issued by the
President's Working Group. Such deficiencies are best addressed
without trying to shoe-horn the institutional business and the
statutes that were designed primarily for the interaction of
investment professionals and the general public. In this
regard, we have some suggestions for consideration that may
provide some commonsense approaches to answering at least some
of these concerns without re-engaging in the unproductive
debate from 2 years ago surrounding mandatory registration
requirements.
Mr. Chairman, do I have another minute to give that
suggestion?
The Chairman. Yes.
Mr. Chanos. As an example, the SEC in proposing the Hedge
Fund Advisor Registration Rule hoped to gather census
information about hedge funds. The SEC could, however, without
mandatory registration obtain much of the information it seeks
by amending Form D, a basic document used by issuers of private
placement of securities to acquire some additional information
if the issuer is a pooled investment vehicle. The form could
include a variety of basic information that I set out further
in my written testimony. The SEC could also require that the
form be kept current or updated annually. With this kind of
information, the Commission, and policymakers generally, would
be in a better position to answer the question, ``Who is out
there?''
With respect to best practices, we believe that most
investors already demand practices of their funds that are
equal to or exceed the requirements of the Investment Advisors
Act. Fundamentally, we believe the institutional investors
operate on a fairly equal footing with hedge funds and by
simply taking steps to protect their own assets and investments
produce the desired effect. However, if there is a belief that
certain practices are so commonsense, such as third-party
custodianship of client funds or annual outside audits, that
they deserve the added strength of SEC authority behind them,
we believe the Commission could consider using its anti-fraud
authority under the Advisors Act to require certain measures to
be taken by both registered and unregistered votes in order to
protect fraud.
And with that, I will make the rest of my comments in the
written testimony.
[The prepared statement of Mr. Chanos can be found on page
73 of the appendix.]
The Chairman. Thank you, Mr. Chanos. We have that and of
course, there will be questions from the members.
Next, we have Mr. George Hall, who is testifying on behalf
of the Managed Fund Association. Mr. Hall?
STATEMENT OF GEORGE HALL, FOUNDER AND CEO, CLINTON GROUP, ON
BEHALF OF THE MANAGED FUNDS ASSOCIATION
Mr. Hall. Mr. Chairman, and members of the committee, thank
you for the opportunity to testify here today. I am here on
behalf of the Managed Funds Association, the largest U.S.-based
association representing the hedge fund industry with more than
1,300 members in the United States and around the world. In
addition to being a director of MFA, I am the founder and chief
investment officer of Clinton Group, an investment advisor for
a diverse group of institutional and high net worth individual
investors. We greatly appreciate the interest of this committee
in considering public policy issues relevant to our industry
and the opportunity to share our views with the committee.
Hedge funds have been closely monitored and reviewed by
Congress and Federal regulators in the recent years. This
intense review has led to a clear recognition that hedge funds
play a critical role in the success story of the U.S. capital
markets. Hedge funds have helped to disburse risks, enhance
market liquidity and resilience, and increase overall financial
stability. With this vital market role comes important
responsibilities. We agree with the President's Working Group
on Financial Markets that the hedge fund industry and other
market participants, along with financial regulators, have a
shared responsibility for maintaining the vitality, stability,
and integrity of our capital markets.
I would like to briefly address four points. First, the
President's Working Group on Financial Markets. MFA fully
supports the recent agreement of the President's Working Group
issued in late February. The Working Group addressed both
systemic risk and investor protection concerns in its agreement
and concluded that, and I quote, ``Market discipline most
effectively addresses systemic risks posed by private pools of
capital.'' The agreement stated that a combination of market
discipline and regulatory policies that limit direct investment
in private pools of capital to more sophisticated investors
would be the most effective way to address this issue.
MFA not only agrees with the Working Group's conclusions,
but has been working with its members to address these issues
for a number of years. We are committed to working closely with
regulators, counter-parties, investors, and our own industry to
do our part to remain ever vigilant.
Second, systemic risk. MFA has worked proactively with its
members to develop very specific risk management and internal
control guidance set forth in Sound Practices for Hedge Fund
Managers first published in 2000. Our sound practice guidance
has been revised and enhanced to take into account market
developments and is currently undergoing its third revision to
be issued later this year. The President's Working Group
principles will be a guiding blueprint for this effort. MFA
members have also worked extensively with the major derivatives
dealer firms and Federal Reserve Bank of New York to improve
market practices for credit derivatives and other derivatives
in order to reduce systemic risk concerns.
Third, investor protection. MFA supports increasing the
accredited standard. We applaud the SEC for considering this
issue and for its recent proposed rule. Based on all available
data, hedge funds remain chiefly an investment vehicle for
institutional investors and high net worth individuals. We
support a significant increase in the financial thresholds for
entry into hedge funds.
Finally, pension plans. MFA endorses efforts to increase
the understanding of hedge funds among pension plan fiduciaries
and trustees and is committed to helping promote investor
financial literacy through the development of due diligence
materials.
In conclusion, hedge funds have proven to be attractive
investment vehicles for institutional investors seeking to
diversify risk and enhance portfolio strength. They also play a
key role in our capital markets. To assure that these benefits
continue, and that any associated risks are fully addressed,
MFA believes that the proactive efforts of its members to
enhance market practices are vital. MFA pledges to continue
these efforts and to work with all market participants,
financial regulators and Congress.
Thank you.
[The prepared statement of Mr. Hall can be found on page
119 of the appendix.]
The Chairman. Thank you.
Next we have Jeffrey Matthews, previously introduced by the
gentleman from Connecticut. Mr. Matthews is general partner at
Ram Partners.
STATEMENT OF JEFFREY L. MATTHEWS, GENERAL PARTNER, RAM
PARTNERS, LP
Mr. Matthews. Mr. Chairman and members of the committee,
good morning, and thank you for inviting me to speak. My name
is Jeff Matthews, and I am general partner of Ram Partners, a
hedge fund I formed in 1994 after working at another hedge fund
for 4 years and starting my career at Merrill Lynch in 1979. My
fund is small relative to the others represented here and
rather old-fashioned. We buy stocks for the long term, we hedge
against short term market fluctuations, and we do not do any
derivatives. Nevertheless, 18 years in the hedge fund world
does make me something of an old timer, and I do have views on
the issues that you have raised.
To understand the growth in hedge funds you might ask, why
do people start them in the first place? The answer is quite
simple: Hedge funds are private partnerships whose investors
are wealthy individuals and large institutions. That private
structure and more sophisticated investor base gives us
flexibility to pursue alternative investments, take greater
risks, and reap greater rewards than a more strictly regulated
mutual fund. Furthermore, as a private partnership, hedge fund
managers can charge what their investors are willing to pay,
including a share of the profits the business generates.
So a successful multi-billion dollar hedge fund manager can
earn hundreds of millions of dollars while her mutual fund
counterpart could not. And that is why people start hedge funds
and that is why this industry has exploded. In fact, the single
biggest change I have witnessed since I started is size. In
1994, the biggest hedge fund I knew about had $6 billion in
assets; $6 billion today would not rank in the top 50 hedge
funds, and the three largest U.S. hedge funds now have over $30
billion each.
Along with that explosive growth has come diversity. Hedge
funds no longer focus mainly on stocks, bonds, and currencies
but have branched into subprime debt, distressed securities,
real estate, uranium ore, and even grain silos. In fact, there
are hedge funds that do nothing but invest in other hedge
funds.
The flood of money has also caused many so-called hedge
funds to no longer actively hedge against market declines
because hedging has been a drag on returns during the bull
market. It has been like paying a premium for an insurance
policy you never needed.
However, the most significant change I have witnessed in 18
years in this business is the increased use of leverage,
meaning borrowed money to start new hedge funds. A $400 million
hedge fund today, for example, might actually have only $100
million of equity. The rest, the other $300 million, might come
from a bank that sells a preferred class of equity that looks,
acts, and smells like debt. That structure works fine if the
value of the whole thing goes up, everyone makes money, and the
bank gets paid back. But if it goes down, that equity gets
wiped out, much like a house bought with no money down.
What type of risks might this pose? Could the graded
leverage cause another long term capital type catastrophe that
brings the markets? Well, we had just such a catastrophe last
year. Amaranth was a $10 billion hedge fund with sophisticated
investors, run by intelligent people using computerized trading
systems, and it collapsed in just 20 days after a huge complex
bet on natural gas went wrong.
What does that tell us? Number one, that hedge fund
managers can do stupid things just like any money manager only
in much bigger size.
Number two, even sophisticated investors do not necessarily
mind this kind of risk taking until it goes wrong and when it
does, they pull the plug very quickly. Number three, the more
exotic the investments, the harder it is for any outsider to
know what is going on inside a hedge fund. After all, if
Amaranth's general partner did not realize his business was at
risk, how would the Fed or SEC have seen what was coming and
act to stop it?
There is, however, a fourth and more positive lesson from
Amaranth, which was not foreseen by many observers at the time,
it is this, a $10 billion fund could evaporate in a matter of
months and yet aside from a couple of wild weeks in the natural
gas pits, the system did not blink. Unlike long term capital in
1998, which had to be bailed out by the Fed, other hedge funds
stepped in, bought Amaranth's positions at a deep discount and
the firm was liquidated. It is true that Amaranth's investors
included public sector pension funds, and they lost a great
deal of money, but the people who manage those funds should
have known the risks they were taking.
As I said, I run a smaller, old-fashioned fund, we do not
do derivatives, and I am not defending my own business model
generally represented here but these are my real-world
observations, nor am I acting as a cheerleader for all hedge
funds. There will be failures again, and they could get ugly.
However, the presence of so many large hedge funds today,
specializing in so many aspects of the world markets, means in
my view that the systemic risk of broad failure is probably
much lower than I have ever seen it in the last 18 years. I was
there when long term capital blew up, I was there when Amaranth
blew up, and luckily for us Amaranth turned out to be no long
term capital.
Thank you for inviting me to speak.
[The prepared statement of Mr. Matthews can be found on
page 135 of the appendix.]
The Chairman. Thank you, Mr. Matthews.
Next, we have Andrew Golden, who is president of the
Princeton University Investment Company.
STATEMENT OF ANDREW K. GOLDEN, PRESIDENT, PRINCETON UNIVERSITY
INVESTMENT COMPANY
Mr. Golden. Chairman Frank, Ranking Member Bachus, and
members of the committee, thank you for the opportunity to
share my perspective today as someone who has been an
institutional investor in hedge funds for almost 2 decades. For
the past 12 years, I have been the president of Princeton
University Investment Company, the university office that has
responsibility for investing Princeton's $14 billion endowment.
With a staff of 25, we develop asset allocation plans, and
select and monitor a roster of 140 external managers. We
essentially act as a large fund of funds.
Princeton's hedge fund investment approach illustrates that
taken by a number of sensible investors for whom hedge funds
need not entail great risk. Indeed, for us hedge funds can be
an important tool for reducing risk. Princeton has enjoyed
success as an investor with annual returns during the past 10
fiscal years of 15.7 percent versus 8.3 percent for the S&P
500.
We have enjoyed particular success as an investor in hedge
funds, but before going any further, let me say that all my
comments today are complicated by the fact that hedge funds do
not represent a distinctive asset class like real estate or
venture capital. Rather, hedge funds are a relationship format
defined by the nature of the contractual arrangement between an
investment manager and his or her clients. At Princeton, we use
the hedge fund format to pursue a broad variety of strategies
across a spectrum of markets. Roughly 45 percent of the
endowment is invested via the hedge fund format. One-third of
that amount is invested in 14 funds that pursue traditional,
unleveraged, long-only investment strategies. These funds tend
to walk and quack like mutual funds, albeit ones managed very,
very, very well with superior track records.
The hedge fund format entails a higher fee schedule than
that of traditional institutional accounts, yet it better
aligns the manager's interest with their own, creating an
environment for superior returns net of fees. Notably,
Princeton's hedge fund managers are dis-incentivized from
taking inappropriate risks as all have a significant share,
typically the vast majority of their personal net worth,
invested side by side with us.
Approximately 30 percent of the endowment is invested in 16
hedge funds that do pursue less traditional strategies,
including for example selling short and investing in bankrupt
companies. We categorize these managers as independent return
managers. They seek returns that are equity-like but with
correlation to most broad market moves. This low correlation
means that our independent return program has been particularly
effective at reducing the endowment's total risk. We do not
invest with managers pursuing inherently opaque strategies. Our
managers do not employ significant leverage, yet our low octane
independent return program has generated a very strong 16.4
percent 10 year annualized return with half the volatility of
the stock market.
While we have some natural advantages of the hedge fund
investor, our success largely reflects hard work. We spend at
least 400 person hours in our due diligence process before
investing in a hedge fund. Post-hire we spend for each manager
70 person hours per year monitoring activities.
The single most important factor behind our success,
however, has been that we have always been guided by a simple
over-arching rule: we will not invest in something we do not
understand. Princeton requires that our hedge funds provide
substantial transparency. No one has ever been forced to invest
in any particular hedge fund. I do not believe that
sophisticated investors who willingly invest in anything
without assuring that they have adequate information and
understanding deserve any sympathy, let alone any additional
regulatory safeguards. Indeed, I believe that fiduciaries who
fail to assure their own understanding of investments may
deserve to be sued or prosecuted.
Understanding investment, however, does not guarantee happy
results. It is a certainty that at least some investors will
suffer significant losses in their hedge fund investments.
However, for perspective, it should be remembered that when the
tech bubble burst, U.S. stock investors collectively lost
almost $7 trillion. Among the losers were sophisticated and
unsophisticated investors. The losses were suffered through the
entire spectrum of relationship formats including mutual funds.
The $7 trillion losses give interesting context to worries
about the hedge fund industry, to which we have all been
estimating total investor exposure is between $1- and $2
trillion.
I suspect that there are some hedge funds using imprudent
leverage with likely unpleasant consequences for their
investors at some point in the future. However, when I think
about the important systemic risk facing markets today, hedge
fund leverage is less of a concern than say mortgage or Federal
debt levels. The markets for institutional client money
provides some discipline with regard to what a particular hedge
fund manager will flourish but then again not so much to
prevent an Amaranth. However, as others have noted today, the
resolution of Amaranth was quite orderly.
The Chair asked that I comment on current levels of risks
in the markets, and actually could I have one more minute to
deal with that?
The Chairman. Yes.
Mr. Golden. And I think you cannot refer to risk without
referring to price. If prices are high, likely investors are
not getting compensated for the risk present today but who
knows if the resolution of that will be a sharp down draft or
more prolonged periods of mediocre results?
I was also asked to comment on market practices since the
issuance of the CRMPG II report, and I can echo others'
comments that market practices have matured with much greater
discipline in trade documentation.
Finally, let me give my views on the appropriate role of
government with regard to hedge funds, their activities and
markets. And, basically, the bottom line there is I think the
President's Working Group essentially has it right. I would
wonder whether or not the minimum wealth test should be set
even higher than what has been anticipated.
With respect to the regulation of hedge fund activity in
the markets, I think the PWG again has it right, to assure fair
markets and control systemic risks, it makes most sense to
focus regulatory and private oversight bandwidth on large
financial institutions that act as counter-parties and lenders.
Perhaps we should accept guidance from the bank--and direct our
activities to where they keep the money.
Thank you.
[The prepared statement of Mr. Golden can be found on page
111 of the appendix.]
The Chairman. Thank you.
Our final witness is Stephen J. Brown, who is a David S.
Loeb professor of finance at the NYU Stern School of Business.
We have appropriately thanked all the donors here, the
Loebs and the Sterns. They all have their names in it.
Please go ahead, Mr. Brown.
By the way, the business schools practice what they preach.
Most medical schools and law schools are not named for people.
Every business school is. They do understand marketing and put
it into practice.
[Laughter]
STATEMENT OF STEPHEN J. BROWN, DAVID S. LOEB PROFESSOR OF
FINANCE, STERN SCHOOL OF BUSINESS, NEW YORK UNIVERSITY
Mr. Brown. Absolutely. I agree 100 percent.
It is a very distinct honor to be invited to testify before
this committee, and I really thank Chairman Frank and Ranking
Member Bachus for this honor.
The President's Working Group on Financial Markets tells us
that private pools of capital bring significant benefits to the
financial markets.
What are these benefits? Some would tell us that their only
objective is to enrich themselves and their rich clients.
The industry needs to show that these benefits outweigh any
problems they might cause. A premise of the PWG is that hedge
funds do not pose a systemic risk for the financial markets.
What is a ``hedge fund?'' The term actually comes from
Carol Loomis, a Fortune journalist writing in 1966 about the
strategy of AW Jones who invested in under valued companies
financed in part by short positions in companies he felt were
over valued. In this sense, the investment was ``hedged''
against general market movements.
The term ``hedge fund'' was a stretch even for AW Jones, as
his short positions never equalled in size or economic
significance of his long positions. Subsequent funds adopted
the regulatory form of AW Jones but not his investment
philosophy. Indeed, the term ``hedge fund'' belies their
considerable risk.
Sophisticated investors ought to be allowed to do as they
please, provided they not hurt innocent bystanders.
Unfortunately, the industry interprets the general solicitation
ban as limiting all kinds of public disclosure. Indeed, some
view the lack of transparency as part of the business model the
very reason for their success.
I argue that it is this lack of information, this lack of
transparency, at an industry level, that is of greatest
concern. Absent industry-wide disclosure, the only reliable
information we have is a purely voluntary disclosure to data
vendors, such as Lipper TASS.
According to their numbers, U.S. domiciled funds have grown
from close to $20 billion under management in December 1995 to
$131 billion today, although the growth has leveled off
recently.
I should add that the trillion dollar number that people
cite includes both domestic and foreign funds.
The data show remarkable diversity of styles of management
under the ``hedge fund'' banner. The AW Jones long/short
strategy captures about 30 to 40 percent of the business.
The style mix has been fairly stable, although there has
been a dramatic rise in assets managed by funds of funds. These
diversified portfolios of hedge funds are attractive to an ever
increasing institutional clientele, which a decade ago did not
exist, but now is about 52 percent of the total.
Event driven funds focusing on private equity, mergers and
acquisitions and such, have risen in market share from 19 to 25
percent over the past decade, while the global macro style
popularized by Soros has actually fallen from 19 to 3 percent.
There is a concern of the committee about the role of hedge
funds in the credit derivatives and CDO markets. How big is
this issue? We do not know since the industry is not required
to tell us, but based on TASS, fixed income arbitrage, which
involves these kinds of strategies, is just 4 percent of the
business.
I think the industry should make the case that entering
this market, their ``rich clients'' are taking on significant
risk, which would otherwise fall on the banking system. They
are thus reducing systemic risk, not increasing it.
What about leverage? According to TASS, the fraction of
funds that use leverage has fallen from 69 percent in 2002 to
57 percent today. In addition, there are vast differences in
degree of leverage across funds. Strategies that report the
highest degree of leverage have quite small market share.
More information would certainly help. Does this detract
from due diligence of sophisticated investors? With colleagues,
I studied the recent controversial and ultimately unsuccessful
SEC attempt to increase hedge fund disclosure.
We examined disclosures filed by many hedge funds in
February 2006. Leverage and ownership structures as of the
previous December suggest that lenders and hedge fund equity
investors were already aware of hedge fund operational risk
revealed in these forms.
However, operational risk does not mediate the naive
tendency of investors to chase past returns. Investors either
lack this information or regard it as immaterial.
What is the role of government? Perhaps Congress needs to
re-visit the 1940 Act. The ``sophisticated investor'' exemption
seems quaint these days.
Industry argues that the ban on direct solicitation
inhibits disclosure, and perhaps it does. However, Congress can
mandate any level of selective disclosure necessary for 3C1 or
3C7 exemption. There is no need to know proprietary trading
information.
However, by being just a little bit more forthcoming, the
industry could allay public concern about systemic risk and
operational risk.
Thank you, Mr. Chairman.
[The prepared statement of Mr. Brown can be found on page
71 of the appendix.]
The Chairman. Thank you. I thank all the witnesses. I think
many of us will be reading in detail particularly what you have
submitted.
Let me begin with Mr. Corrigan. Obviously, our job is to
think about whether or not there is any public policy
implications.
You talked about the need or the desirability of increasing
the shock absorbers. What would they be and would we have any
role in trying to do that? That would seem to me to be what we
ought to be focusing on to the extent that there was something
for us to do.
Mr. Corrigan. Certainly, to answer your last question
first, I think your oversight role is very important. As to the
shock absorber concept that I have used, I have tended to put
my favorite shock absorbers, if you will, into basically six
categories.
One is corporate governance. I cannot begin to underscore
how important the details of what corporate governance really
means is for this purpose. It is a lot more than having a few
independent directors. The second is risk management and risk
monitoring. The third is what I call financial infrastructure,
and these are some of the problems that we encounter with
backlogs of derivatives and so on and so forth. The fourth is
better understanding in managing these highly complex products.
The fifth is a multiple four legged table of enhanced
disclosure, and the sixth is what I like to call reputational
risk management.
The Chairman. Let me go to the one that may potentially
involve us, number five, the disclosure. Would you change the
disclosure regime that we now have?
Mr. Corrigan. Most of the time when we talk about
disclosure, we are thinking about public disclosure. One of the
issues that I raised in my statement in terms of suggesting
some enhancements to the President's Working Group approach is
to better recognize that in the context of financial stability
issues.
Disclosure is a four legged table. The first has to do with
disclosure of a bilateral confidential nature say between a
hedge fund and its prime broker.
The second has to do with disclosures that are made by
hedge funds or private equity funds to their investors or
prospective investors.
The third has to do, and this is very important, with what
I like to call voluntary informal exchanges of largely
confidential information between hedge funds or private equity
funds and regulated institutions with the regulatory community.
The last is public disclosure.
I firmly believe, Mr. Chairman, that again, in the context
of shock absorbers and financial stability, there is more pay
dirt in those first three legs than there is the last, in part
because public disclosure is suffering from a very chronic
information overload problem.
The Chairman. I accept that. Is there a role for the
government? Again, I ask this without any preconception.
``Public'' can mean two things. It can mean public in that
it is to some extent compelled by public agencies, and it can
also mean that the actual information is made public.
Is there a role for the government in increasing the flow
of information in the first three categories?
Mr. Corrigan. Yes, there is. Again, one of the suggestions
in my statement, Mr. Chairman, was that in the context of the
so-called systemic risk principles of the President's Working
Group, I suggest in my statement that one thing I would like to
see happen would be an effort to quickly develop best
practices, make them public, so that we have benchmarks,
including in this area of transparency--
The Chairman. Would you recommend that any public agency
have the responsibility to monitor whether or not the best
practices were being followed?
Mr. Corrigan. I would expect in this context that the
supervisory authorities would indeed do that. I believe, if I
take as a point of reference the recommendations of our risk
management policy group, that has happened.
The Chairman. That would be the supervising authorities
obviously for the depository institutions. Would that also mean
by anybody for the hedge funds themselves? I understand on the
counterparties.
Would you recommend there be any governmental
responsibility to monitor whether best practices were being
followed by the investment entities themselves?
Mr. Corrigan. I think that it is in the best interest of
the hedge funds themselves to put themselves in a position in
which they voluntarily make their practices public.
The Chairman. I understand. Every time people tell me
something would be good if it was done voluntarily--if
everybody did everything voluntarily, I would be out of a job.
Maybe that would be a good thing. We are in the involuntary
part of this.
If people do not do it, should somebody at least be
checking to see who does and who does not do it voluntarily?
Mr. Corrigan. I think that will happen; yes.
The Chairman. Thank you. Mr. Bachus.
Mr. Bachus. Thank you. Let me ask all the panelists. We
have talked about the President's Working Group and they are
going to come up with some recommendations.
Would your advice to us be to wait on their final
recommendations before we considered any action?
I will start with Mr. Corrigan.
Mr. Corrigan. Yes. I would suggest, and I don't think that
is going to take all that long. I think there is enough in the
pipeline right now that the committee, in my judgment, should
continue to exercise its oversight function as it is doing
today.
I do not see the need for anything beyond the continued
effective exercise of that oversight function.
Mr. Bachus. Mr. Brody?
Mr. Brody. I guess it would depend upon how long it takes.
If it is done in a sensible and timely way, I think it is
absolutely appropriate for the committee to wait.
If it takes an extensive period of time, then it is
probably proper to move without it.
Mr. Bachus. All right. Mr. Chanos?
Mr. Chanos. I would echo Mr. Brody's comments on that. I
think if we are looking at a long process, I think it would
behoove the committee to keep moving at all due speed. I
suspect the report will be out relatively soon.
Mr. Bachus. Is 6 months a reasonable amount of time?
Mr. Chanos. If there are no financial hiccups, I would say
yes, 6 months seems reasonable.
Mr. Bachus. We probably would not know until after the
hiccup, I guess. By ``hiccup,'' you do not mean a failure of a
hedge fund. You mean?
Mr. Chanos. A broader market problem that would include but
not be exclusive to hedge funds, that would move things
quicker.
Mr. Bachus. Some of the things that have been advised still
would not prevent that, would it?
Mr. Chanos. Absolutely not. I am a realist as well as an
idealist. I understand, as one of the members said earlier,
that the industry will come under greater scrutiny should there
be such a hiccup.
Mr. Bachus. Mr. Hall?
Mr. Hall. I would agree with that, that the committee
should wait for the President's Working Group. We believe they
are on the right track. They have identified what we think are
the important issues, and they have also identified what the
potential failures could be of aggressive regulation.
I think, as Mr. Baker pointed out, overreaction based on a
hiccup is in the long run not going to serve the industry or
the economy as well either. We need to be very careful and
hopefully they will move quickly and get it taken care of.
Mr. Bachus. Mr. Matthews?
Mr. Matthews. I agree with my colleagues.
Mr. Bachus. To wait?
Mr. Matthews. Yes.
Mr. Bachus. A reasonable amount of time?
Mr. Matthews. Yes.
Mr. Bachus. Mr. Golden?
Mr. Golden. There is a downside to being on this end of the
table. It's all been said before.
Mr. Brown. I agree also.
Mr. Bachus. Thank you. Mr. Brody, you mentioned
registration with the SEC. What does that mean? In your mind,
what is registration with the SEC?
Mr. Brody. It gives oversight by the SEC. Let me just tick
off some of the things that are required in registration,
realizing that I would have the SEC go to a principles-based
approach.
Some of the things they do now is they require a chief
compliance officer. They require a set of written compliance
policies and procedures. They require a code of ethics. They
require a filing of a public information form. They require
independent custodian requirements, which leads to a financial
audit, and they do on-site inspections and examinations, and
they require retention of books and records.
There are obviously more things, but those are key elements
of registration that give protection to the more
unsophisticated investors.
Mr. Bachus. Some of you mentioned the traditional hedge
fund and then the ones that are private equity, and then the
ones that are leveraged that are borrowing a lot of their money
from financial institutions.
One thing that should be happening right now at the Federal
Reserve, Mr. Corrigan, you were on it, is that the Federal
Reserve should be looking at our financial institutions and
seeing their investments. In that regard, that is already a
regulated part of the process, is it not?
Mr. Corrigan. It is. That is correct.
One of the very constructive things that has happened just
in the recent past that I might add is consistent with this
whole notion of principles based oversight is that the Federal
Reserve, in cooperation with the SEC, and interestingly with
the U.K. FSA, went through an exercise, again, in a largely
principles-based approach.
They spent a very substantial amount of time with each of
the major banks and securities firms that have prime brokerage
activities, in an effort to systematically review and
understand the nature of those relationships, out of which they
will be developing a statement of best practices to be used
prospectively in order for them to be able to better judge how
individual institutions perform this function.
This, to me, is a terrific example of adapting the approach
to prudential oversight to the real world in which we live, and
I think it is enormously constructive. I think it provides a
framework for the future that can be applied in other areas as
well.
Mr. Bachus. My final question, if I can, Fortress
Investment Group, which is the first IPO of a hedge fund, at
the New York Stock Exchange, that is an example of a hedge fund
that is being basically offered to anyone.
Should there be maybe a different rule for that, or would
you depend on the New York Stock Exchange?
Mr. Corrigan. Others, I am sure, will want to comment. It
is important to keep in mind that in the Fortress case where
there is an IPO, by definition, as part of the IPO process.
Fortress and the new public entity is subject to a whole
further raft of regulations that apply to listed companies in
general.
Not only do they have the regulations that others talked
about earlier, but in addition, they now are subject to all of
those regulatory requirements as well.
Mr. Bachus. Mr. Brody?
Mr. Brody. There is an important distinction to make
between a public offering of the fund and the public offering
of the management company. In the Fortress case, it was a
public offering of the management company. That is the entity
that is responsible for advising the funds.
I think, so far in the United States, we have not had
significant, or even any, public offerings of hedge funds. In
Europe, there have been.
Mr. Bachus. This was the management company, not the
participating hedge fund.
Mrs. Maloney. [presiding] The gentleman's time has expired.
Thank you, and I thank all of the witnesses. Coming from New
York, I certainly appreciate the significant role that hedge
funds have come to play in our markets and our economy.
I want to thank the chairman for holding this hearing to
review the growth in hedge fund activity and whether that
growth needs additional transparency or constraints.
Certainly, hedge funds operate in a regulatory scheme that
has not been adjusted much to reflect their new activity. Many
of you testified to the tremendous growth in hedge funds, the
change in leverage, and this may well be out of date.
The SEC is taking a few small steps to tweak the rules,
such as raising the threshold for individual investors, but
such investors are only a very small part of the hedge fund
market, so these are very minor adjustments.
I would like to go back to Mr. Brody's statement and
support of requiring all hedge funds to register as investment
advisors. I would like to go down the panel and see if you
support this idea, yes or no.
Would you support that, having Mr. Brody's strong statement
in support of having them registered as investment advisors?
Mr. Corrigan, would you support that or not?
Mr. Corrigan. I would not. At this juncture, I would not.
Mrs. Maloney. You would not. Why would you not support
that?
Mr. Corrigan. Because I think that the central thrust of
the approach suggested by the President's Working Group can
achieve what we really need to achieve.
Many of the witnesses have suggested this idea that hedge
funds are unregulated, and it is a bit misguided. There is a
lot of regulation.
I do not see any need at this point to go that distance,
and I would emphasize, Congresswoman Maloney, that I have
debated this thing with myself for years. What always stops me
from going there is the so-called moral hazard problem, the
danger that by going to that place, we effectively encourage
people to believe that the government will protect these
organizations, even in very dire circumstances.
Philosophically, I am just not ready.
Mrs. Maloney. Thank you. Mr. Chanos, yes or no?
Mr. Chanos. No. I believe that through--
Mrs. Maloney. Thank you. Mr. Hall, yes or no?
Mr. Hall. No.
Mrs. Maloney. Mr. Matthews, yes or no?
Mr. Matthews. I think if you take public pension money, you
should. If you do not, why should you. You are no different
than a partnership that invests in a shopping mall, and those
are not regulated.
Mrs. Maloney. Thank you. Mr. Golden?
Mr. Golden. No, I would say no. I would note that we do the
same extensive due diligence on registered advisors as non-
registered's. It gives no real protection.
Mrs. Maloney. Mr. Brown?
Mr. Brown. I would say no in the current way the
registration works because my research shows that sophisticated
investors already understand what is in those forms.
Unsophisticated investors either did not know or did not care.
Mrs. Maloney. Thank you. I would like to ask anyone on the
panel, starting with Mr. Brody, about the credit derivatives,
the credit default swaps. They have been criticized as unduly
risky and have raised issues of systemic risk, which regulators
worked to resolve in the 2005 Novation Protocol.
Maybe these credit default swaps are the canaries in the
mine of the subprime lending which we are reading about in the
Tsunami Daily as it unravels.
A few months ago, the ABX Index that tracks the credit
default swaps suggested that the subprime market was headed for
a fall and now we have seen that is now taking place.
Do you think the CDS investments can soften the impact on
the markets of events such as the subprime challenge or crisis
that we are seeing today, or do they inherently aggravate
market swings, or are they neutral in their impact?
Mr. Brody. Let me first make a comment on derivatives, CDS'
and hedge funds. The reality is that these instruments are used
throughout the investment community. They are used
substantially by investment banks. They are used substantially
by commercial banks. In general, these instruments serve the
laudable purpose of dispersing risk, putting risk in many
hands.
However, that dispersion of risk does not prevent failure.
We are seeing right now in the subprime market some degree of
failure.
Mrs. Maloney. Anyone else?
Mr. Hall. I would be happy to comment. I agree their
purpose is to disperse risk. I think they are really no more
risky than the underlying investment. If you can buy the
underlying investment, the derivative is a more efficient way
to take advantage of that.
It can be used as a hedging instrument and as you pointed
out with the ABX Index, it can lead to price discovery that
might not as readily be seen in the underlying prices of
illiquid bonds.
I think they are an important risk mitigator in the system.
Mrs. Maloney. Would anyone else like to comment?
Mr. Brown. The hedge funds are actually taking the risk
away from the financial system. They are giving it to the high
net worth individuals who are in the best position of society
to afford that risk.
The other thing is that they are such a small part of this
business. There is a real problem, I think, in the public
perception of seeing all the hedge funds as the same, that the
danger is that the sins of the few will be visited upon the
many, and if there is a problem in that little section of the
market, it may affect public perception of the whole market.
No. The whole purpose is to take risk away from them.
Mrs. Maloney. Mr. Chanos?
Mr. Chanos. I would like to make two points on that. The
derivative swap market, which has grown dramatically, has not
only dispersed risk but it has given us new informational
content.
Over and over again, we see the credit default swap market
show us prices ahead of the rating agencies, pointing out risks
that the market may not have completely understood.
I would also point out that hedge funds themselves, through
their effort of shorting the ABX market, were sending an
important signal back in the fall that the subprime market was
headed for problems.
Again, this was more information, not less, for those who
wanted to look at it and draw the proper conclusions.
Thank you.
Mrs. Maloney. Thank you. Yes, sir?
Mr. Corrigan. One thing I would want to emphasize is that
there have been several comments earlier about leverage. Most
of those comments deal with what I think I would consider to be
balance sheet leverage, equity to asset ratio's and things like
that.
Credit default swaps are in the family of what I would
consider to be fairly complex financial instruments. One of the
reasons why they are complex is that depending upon market
conditions, they can have the characteristics of what I like to
call ``embedded leverage.'' Embedded leverage is different than
balance sheet leverage because it is a measure of how a given
instrument, like a credit default swap, can change in value
based on a shock.
When we talk about these complex instruments, we have to
recognize the distinction between balance sheet leverage on the
one hand and so-called embedded leverage on the other.
Having said that, I want to emphasize credit default swaps
have been a tremendously constructive innovation for the
financial markets generally.
The Chairman. The gentleman from Louisiana.
Mr. Baker. Thank you, Mr. Chairman.
Mr. Hall, I am going to address my sort of series of
questions to you, since you are representing an association.
Generally, what happens within a fund, and I am not even
going to call it a ``hedge,'' I am just going to say a private
investment opportunity company, is of no concern to anyone as
long as it is operating in an expected and anticipated way.
We are dealing with a circumstance where there is an
unanticipated loss that brings about consequences that are
adverse financially to other parties. That is the focus of what
we are about.
If you limit those who participate in that activity, that
is one way to stem the scope of adverse consequences. It has
been mentioned by several that the current definition of
sophisticated or qualified investors does seem inadequate.
My observation is that a dollar figure does not necessarily
equal sophistication, as in a young person who is the
beneficiary of a substantial trust. They will be relying upon a
third party to make investment decisions on their behalf,
whether hedge fund or otherwise.
The suitability of that person in conducting that financial
or fiduciary responsibility is pivotal in this case. That goes
to the pension fund question and whether the school bus driver
ought to be exposed to some derivative transaction with
embedded leverage.
Beyond the question of who gets in, it is the elements that
constitute the organizational activity of that fund itself,
going to the question of leverage defined broadly.
Someone in a sophisticated regulatory position needs to
understand that leverage position so we do not have an LTCM
like event, and I do not mean that somebody loses money.
I mean when people showed up in the work out room,
everybody was surprised by who was at the table, that there is
some sense of systemic scope of what that hedge fund is engaged
in, and that gets you to the counterparty risk.
Although there is a counterparty risk management policy
group that Chairman Bernanke referenced in recent testimony,
and generally speaking, if we are going to constrain the hedge
fund activities by limiting their access to capital, which is
not true equity, then we really begin to sit heavily around the
neck of these operations and potentially minimize the systemic
risk potential that everyone seems to express concern about.
Is there anything inconsistent with your view of market
function about those areas of focus? Who gets in a regulatory
responsibility to understand leverage, embedded or otherwise,
and counterparty risk management tools to watch?
In my judgment, registration does not work. All that does
is just say you have a label on your door and you can still be
a bad actor.
Mr. Hall. I appreciate your comments and I thank you for
addressing the question to me. I am happy to discuss this.
I think you have isolated two very important points.
Effectively, what is it that lawmakers have to worry about? You
pointed out investor protection, who loses the money, and is it
okay if it is wealthy people or retail investors.
You make a very good point. An example that I use many
times is that finance professors probably would not be able to
pass the net worth test, even though they are qualified to
invest in these instruments.
Mr. Baker. For some folks, you could move their Bentley and
they would not be able to find it.
Mr. Hall. That is true. There are other wealthy people who
should not be investing.
I think ultimately the link between sophistication and
wealth is really not the basis for this, even though many times
people say that.
The real link is who can afford to lose it. If you have a
Bentley, you probably also have a Rolls Royce. If you lose the
Bentley, you are still going to be okay.
It is not the best system for determining who is
sophisticated enough, but it is really the best we have to
prevent things from coming across your desk that you need to
worry about.
The second issue, aside from investor protection, is the
systemic risk. I firmly believe the President's Working Group
believes is best handled at the counterparty level, through the
banking system, the brokerage system.
Mr. Baker. Excuse me for interrupting. Does that not
necessitate a more standardized methodology of disclosure and a
disclosure of values to that counterparty for them to be able
to make appropriate judgments about risk?
Mr. Hall. I think that already happens. I think the
relationship between hedge funds or private investment pools
and their prime brokers, if they are borrowing money, the prime
brokers and the counterparties demand an enormous amount of
information and transparency.
Mr. Baker. What I am getting to is that methodology for
oversight will vary from practitioner to practitioner. There is
not some kind of standard boilerplate. If I am at Bank ``X''
which is generally viewed as a good management team, but their
practices are a little weak in this arena, is there any
advisability, not in Congress but in a regulatory overview of
the consistency of those practices?
That is what bothers me, not just from hedge fund to hedge
fund, but from bank to bank. How capable are those folks in
asking the right questions?
Mr. Hall. My own experience is it is relatively consistent
across the sophisticated brokerage firms and banks. The most
important shock absorber, I think, for the system is capital.
The capital charge against these types of loans that banks and
brokers would make is in the regulations, and ultimately they
will evaluate whether making a loan gets them the appropriate
return on capital.
I think there is a reasonably consistent methodology that
has been put in place by the capital charges.
Long term capital comes up a lot. Prior to Amaranth, that
was the last big blow up in a hedge fund. We have had more blow
up's in the stock market since then.
The President's Working Group of 1999 pointed out that long
term capital had enormous amounts of leverage relative to their
peer group. They were on a plateau of their own in terms of
their ability to get leverage, and frankly, I think the message
is that even the banking and brokerage community overextended
themselves to long term capital.
Mr. Baker. My point exactly. Thank you.
Mr. Hall. If I have answered your question, I am finished.
Thank you.
Mr. Baker. Thank you.
The Chairman. The gentleman from North Carolina.
Mr. Watt. Thank you, Mr. Chairman.
Let me focus, if I can, on two areas. One of the witnesses
raised the question of whether the Working Group's proposal
about who qualifies as an accredited investor is or is not the
appropriate definition. I cannot remember which witness it was.
Maybe Mr. Brown, Dr. Brown.
I wanted to follow up on Mr. Baker's question and be a
little bit more pointed on that issue. Is that the appropriate
level or should it be a different level?
Dr. Brown, was it you who made that point?
Mr. Brown. I made it, as well as another gentleman.
Mr. Watt. Let's start with you and get the perspective of
the other gentlemen on the panel.
Mr. Brown. When I teach, I often have aggressive students
who say, you know, if you are so smart, why are you not rich.
The temptation is always to say well, how do you know I am not
rich.
Another possible response is you know, if you are so rich,
why are you so stupid. Wealth and intelligence, particularly in
investment matters, is not at all related.
I can point to many anecdotes and many cases.
Mr. Watt. I think I did accept the proposition that the
monetary figure is appropriate as opposed to--how are you ever
going to evaluate somebody's sophistication and evaluate their
financial well being or worth or ability to lose.
Mr. Brown. That is right. You have exactly the point.
Mr. Watt. It is the monetary figure that I am zeroing in on
more than the sophistication issue that Mr. Baker was zeroing
in on.
Is the net worth figure an appropriate figure?
Mr. Brown. I have various thoughts about this. For a high
net worth individual, they know what they are doing and there
is no real business for us to be too concerned about what they
do.
I must confess to some concern about the level of
involvement of pension funds and the ability of the pension
benefit guarantee corporation and absorbing any potential
losses that come through investing in these vehicles.
The issue is really to look at risk, I think, and to
understand what the financial resources are of the sponsoring
organization of the pension, any defined benefit pension plans.
I am concerned about that.
Mr. Watt. Let's start with Mr. Golden and go all the way
down. What do you say in response to the question I asked, and
to Dr. Brown's comments?
Mr. Golden. I commented earlier that I think the capital
test should be raised. I do not know how high they should go.
That is something that I think could be derived through a lot
of conversations with the participants.
I do wonder about this issue of assuring that people can
afford to lose money in this. I am not convinced that any
particular hedge fund investment is any more risky than a
single stock investment in a single company. We do not have the
same kind of concerns about people losing money in those
particular investments.
Mr. Watt. You are not advocating to lower the threshold?
Mr. Golden. Absolutely not. I think it should be raised.
The fact of the matter is people--we need to make the bite size
with which they invest to be small enough that they can weather
the storm. The diversified portfolio is a really important
measure of protection.
Mr. Watt. You all may need to speed up your responses if I
am going to get all the way down the panel.
Mr. Matthews, Mr. Hall, Mr. Chanos.
Mr. Matthews. Personally, my feeling is that the question
is, can you afford to lose it? That is the question that should
be asked. I do not know what that means in terms of the level
you set.
Mr. Hall. That is correct. It is an issue of net worth. It
is an issue of income. It is an issue of investing experience.
I think actually some of my colleagues at the MFA have done
some work and we would be happy to present you with some more
definitive information on our recommendations.
Mr. Watt. That is consistent with the Working Group or
different from the Working Group?
Mr. Hall. Consistent with the Working Group.
Mr. Chanos. I would echo most of these comments with the
one exception that we do have members in our Coalition who make
the very good point that, for example, the people who were made
very wealthy by a man named Warren Buffett, who ran his
partnership as a hedge fund for 20 years, would not have been
accredited investors under the standard.
It is a good point. We have to understand that these
numbers are arbitrarily policy driven numbers, not economic
numbers. The industry and the proper authorities have to
coalesce around figures that broadly represent the ability of
investors to shoulder the risk, as my colleague said.
Mr. Watt. Mr. Brody?
Mr. Brody. It is probably not a bad number. It is hard to
determine what it should be. I think nobody has great wisdom on
this score. The number serves as an imperfect proxy for
understanding, and the reality, as has been mentioned earlier,
is hedge funds in general are not riskier than most other
investments.
Mr. Watt. Mr. Corrigan?
Mr. Corrigan. I would raise the limit to at least what is
being contemplated by the SEC's current proposals. These
standards are not perfect, but they are easy to understand. We
have standards like that in a lot of places. That is probably
the best we can do.
Mr. Watt. Thank you, Mr. Chairman.
The Chairman. I thank the gentleman. I do have to interject
for 30 seconds, as we talk about the level at which we protect
people.
I am going to propose with regard to the bill that we
passed last year that prevents anybody from betting on
blackjack, that maybe if you can invest in a hedge fund, we
will at least let you gamble. This committee decided that we
would protect people from gambling at all; maybe we can link
the two.
The gentleman from Texas.
Mr. Hensarling. Thank you, Mr. Chairman. I certainly
appreciate you calling this hearing. It is an important
hearing. Clearly, I think the committee has identified several
areas of legitimate concern.
First, are investors possibly being misled? Do we have the
proper level of transparency? Second, is there a legitimate
issue of systemic risk? Third, as the gentleman from Louisiana
has pointed out, we certainly have a concern about the
institutional investor represented by pensions, and what could
happen to individual pensioners, much less the American
taxpayer who might have to bail out the PBCG.
Having said all of that, although I am not a physician, I
am reminded of the Hippocratic Oath; first, do no harm. It
should also apply to Members of Congress.
I recently came across a couple of statements of our
present and former Fed Chairman, and apparently Chairman
Greenspan said it would be counterproductive to directly
regulate hedge funds.
I know that Chairman Bernanke has been quoted as saying
that direct regulation of hedge funds would impose costs in the
form of moral hazard and the likely loss of private market
discipline, and possible limits on funds' ability to provide
market liquidity.
My first question, which is kind of tossing the ball up in
the air for anybody who wants to take a strike at it, is if we
do not get the regulation right, what harm might we do, and
particularly if you could comment on Chairman Bernanke's
statement about possible moral hazard.
Dr. Brown, it looked like you were reaching for the button
first.
Mr. Brown. There is an issue with the tendency of the
industry to be more expanded overseas than it is here. I have
different views on this.
I do not hold with the view that industry is going to
disappear any time soon. The plain fact is that other
jurisdictions have a much more significant regulatory
environment than we do here. I do not think there is any danger
of this industry going anywhere very soon.
Mr. Hensarling. Anybody else care to comment?
Mr. Hall. The one thing to be cognizant of is if there is
regulation that keeps hedge funds from doing their business,
which is out of the ordinary.
One of the great things about what I think private pools of
capital do is they do things that are out of the mainstream,
like investing in insurance risk after the hurricanes.
If there is regulation and it is inappropriate regulation
or if it overly restricts the ability to make these types of
one off investments or out of the mainstream investments, then
the economy will overall suffer from that.
Mr. Hensarling. The investment capital represented by the
hedge fund industry, just how fluid is it? Some of us have been
concerned about certain provisions of Sarbanes-Oxley that might
be helping drive capital to overseas markets, the number of
IPOs that have taken place on domestic markets versus
international markets.
Just how easy is it to locate these investment vehicles
overseas and if it is easy, is that something that Congress
should be concerned about?
Mr. Chanos?
Mr. Chanos. I can speak personally to that, because I set
up an operation in London a few years ago to complement our New
York office.
There is a lot of concern about capital moving overseas. We
hear about this. Capital can move overseas at the flick of a
button and does so all day long all around the world. Capital
moves around. The bigger issue, I believe, and have told my New
York political friends this, is the human capital that moves.
When I set up an office in London, I am now paying people
overseas. All of those effects of economy are benefitting the
U.K. directly and not the United States.
I am more worried about that and losing our competitiveness
of keeping good people and keeping our financial primacy in the
United States from the human side and the organizational side
than the capital side. Capital flows very freely across borders
all day long, 365 days a year.
Mr. Hensarling. If I could hit the risk issue again. I
certainly hold myself up to be no expert, but for a couple of
years in the early 1990's, I was actually an officer in a hedge
fund.
It basically ran a very classic AW Jones kind of operation,
classic stock pickers, long, short, they levered it up 2:1.
I was able to invest in the fund as an officer, and during
the time I was there, I discovered that our investment fund,
number one, gave a greater rate of return to my family than my
alternative investments at a low correlation to the market and
had less volatility.
I am kind of asking the question, what is wrong with this
picture? Is there anything inherently risky, since I think it
was Mr. Golden who said that hedge funds are not a distinctive
asset class, it is more of a structure, is there anything about
the structure of having a private investment vehicle that has a
performance fee that leads these investments to be more risky
than alternative investments that might be found in the mutual
fund industry?
Mr. Matthews?
Mr. Matthews. Absolutely. It is the 20 percent performance
fee. If you can make 20 percent on $50 million that you earned
for your investors, that is pretty good. If you can make 20
percent on $50 billion, that is even way better.
The inclination is to take on more investors, more
leverage, and greater risk to try to hit the jackpot. That is
why hedge funds occasionally do fail, and mutual funds never
fail. Mutual funds do not take the leverage but a hedge fund
does.
Mr. Corrigan. We get a little bit bogged down here because
we use this term ``hedge fund.'' There is an enormous
dispersion in terms of the behavioral characteristics of hedge
funds, and in particular, the extent to which individual hedge
funds take more risk, have higher risk profiles than other
hedge funds.
I think it is fair to say that if you look at the universe
as a whole, the characterizations that have been made by
several of the other witnesses are correct. It is not so true
that to the extent one or more individual hedge funds are
reaching for extraordinary returns, by definition, they have to
be taking extraordinary risk.
That is where the dilemma lies. How do you square the
circle in terms of performance in general with outliers?
I want to add, if I could, very quickly, Mr. Chairman, a
point about Amaranth. Several people have noted that Amaranth
worked itself out in a very, very successful fashion, and it
did. I, like others, take a lot of comfort from that.
In my statement, I have identified several factors
associated with the Amaranth event which I think warrant a
fairly high degree of caution as to how one should judge the
Amaranth episode in a vacuum compared to a similar type of
episode under different circumstances in the future.
The Chairman. We will go to the gentleman from
Massachusetts.
Mr. Lynch. Thank you, Mr. Chairman. First of all, I want to
thank you and the ranking member for having this hearing, and
also thank the panelists for helping us with our work.
To begin with, I think that we all take the position that
the best regulation is self-regulation. As the chairman
indicated before, it actually allows us to focus on some other
things.
Given the size of these hedge funds and the possibility
that at least in the currency exchanges, there is a possibility
of hedge funds working in concert, not necessarily
deliberately, but their impact could be multiplied, and the
sort of mercenary strategy, it could be good mercenaries, but
it is definitely geared strictly to the investor, and the OPIC
nature of these hedge funds, the secretive way in which they
operate, it does raise some concerns in a number of areas.
The chairman mentioned in his opening remarks the situation
with our pension funds, and while the Amaranth work out might
have been suitable for some, I am not sure that the pensioners
who were affected would come to the same conclusion.
I know that Mr. Matthews raised the possibility that it
might be good to look at some limits, not necessarily on hedge
funds, but on pension funds that would invest in a hedge fund,
and maybe put some limits on either a percentage or based on
their unfunded liabilities, their exposure. We might do that.
The other area I am concerned about, and this goes to the
mortgage issue and somewhat the subprime market, but in the
area of mortgage backed securities held by hedge funds and what
could happen if a hedge fund dumps those securities back into
the market, putting downward pressure on those securities, what
could happen to the distribution of capital available for
housing.
That is an essential good in terms of affordable housing,
that I am concerned about.
The last dimension of this that concerns me is I also wear
another hat sort of ancillary to my work on this committee, and
that is as the chairman of the Taskforce on Anti-Terrorist
Financing. I work a lot with Treasury. I work a lot with FinCen
and a number of our counterterrorist organizations.
They say that it is very difficult to track and to
scrutinize these hedge funds to make sure that the proper anti-
money laundering and anti-terrorist financing protocols are in
place.
That concerns me greatly, given the amount of money that is
flowing here. I will just let the panelists take a crack at
what might we do, with your cooperation, rather than acting
upon the hedge fund industry, what can you give us? We would
rather have the suggestions come from you as to ways to address
these concerns rather than us trying to do it from whole cloth
from this side of the table.
Mr. Brown?
Mr. Brown. I think first of all, you have to understand the
international nature of this business. This body cannot even in
principle examine the very important issues you raise about
terrorist financing through vehicles of this kind because the
international business is far greater than the national
business, the U.S. domiciled business--
Mr. Lynch. I am not talking about just us. We are working
with the Egmont Group, which is made up of FIUs from all over
the globe, 94 countries. I would not suggest us doing it alone;
we would work with our international counterparts.
Mr. Brown. Okay, great. I am also a little concerned about
the anecdotal evidence on systemic risk that you referred to.
My own research, for example, for the most obvious example
is the Asia currency crisis in 1997, and the allegation that
Mahathir Mohamad, the Prime Minister from Malaysia, made that
George Soros had engineered the whole affair for his benefit.
I looked at the numbers, and it turned out that the hedge
funds actually were very risk adverse during that period and
had pulled out of the markets, and in fact, George Soros had
lost 10 percent, hemorrhaging 10 percent right through that
period.
The anecdotal evidence of massive systemic risk, I would
argue, is just not there. Yet, a lot of central banks, in
particular, the Australian Central Bank, were trying to get
actively involved.
Mr. Lynch. I appreciate that remark. If you could focus on
the question, the pension funds. Two, mortgage backed
securities. Three, anti-money laundering protocols that are not
in place right now with hedge funds. If you could just address
that question.
Mr. Brown. I am sorry. The pension funds, I do agree there
is an issue there and we have to examine the amount or the at-
risk status of pension funds with regard to any kind of high-
risk investment, in particular, hedge funds, and we may have to
look at ERISA to do that.
On mortgage backed securities, I am less concerned because
that is not a huge amount of this business. The hedge funds are
only involved in about 4 percent of that business. It is not a
big thing.
That is about all I have to say.
Mr. Hall. If I may.
Mr. Lynch. Sure, Mr. Hall.
Mr. Hall. In this hearing, we have talked about Amaranth in
2007, and long term capital in 1998, two high profile blow up's
that were terrible for a lot of investors.
We really have not talked at all about the fundamental risk
of the stock market. If you look at the 2001 crash of the stock
market, and you look at the fact that it was only recently that
the S&P actually recovered all the losses over the last 6
years, ultimately, it has not made much money in the last 5 or
6 years, whereas hedge funds have actually generated positive
returns, with much less volatility than the stock market.
In terms of investments in hedge funds, if we look at the
pension market, which you asked about, no one disagrees, or
very few disagree, that pension funds should not be investing
in common equities.
Unfortunately, I think the reality is--I should not say
unfortunately--I think the reality is that common equities in
most cases may be more risky than the overall hedge fund
market.
The Chairman. We are going to have to wrap this up.
Mr. Hall. In terms of the housing issue, I will address it
quickly. I think it will probably be if a hedge fund blows out,
as you point out, of securities, it will be another hedge fund.
It has the flexibility to enhance their leverage and buy these
assets and provide that shock absorber for any liquidations
that will occur.
The Chairman. Thank you. Mr. Shays of Connecticut.
Mr. Shays. Thank you very much, Mr. Chairman. Again, thank
you for holding this hearing, and I thank the ranking member,
as well.
Long term capital and Amaranth were both from the Fourth
Congressional District, one from Greenwich and one from
Westport.
I wrestle with memories of savings and loans, and I wrestle
with memories of when we changed the tax laws, what happened to
real estate, and it kind of stared us in the face, and we all
kind of knew it was going to happen. I think all of us are just
trying to look for assurances that you will not just see
another day like that.
What I wrestle with is long term capital basically was
dealt with with a proactive--as you point out, Mr. Matthews--
effort on the part of the Fed.
How did Amaranth resolve itself, Mr. Matthews? What took
place and why would I feel comfortable that would happen again?
In other words, that people would buy a lesser position? What
happened?
Mr. Matthews. The prime broker for Amaranth, J.P. Morgan,
the prime creditor, that had the most at stake, took over the
natural gas portfolio and re-sold it. They made a low ball bid
that Amaranth was forced to take because Amaranth needed to
liquidate and pay back other creditors.
J.P. Morgan turned around and re-sold the same positions to
other hedge funds. Those other hedge funds provided the
liquidity that caused it to not spread.
Mr. Shays. The question I have, and I would ask all of you,
is when that happens again, and it will happen again because
there will be foolish mistakes done by foolish people or very
smart people who do foolish mistakes, which model is most
likely to occur, the long capital or Amaranth? Tell me what
model is likely to occur in the future.
Mr. Corrigan. I will take a stab at that. The answer is we
do not know. I think one can argue about probabilities, but we
do not know.
As I said before, if you look at Amaranth and you contrast
it with long term capital, the world of long term capital does
not exist any more, in terms of the way that fund was run and
the mesmerizing effect--
Mr. Shays. Then let me ask you this. What is the likelihood
then, instead of one company going under, and evidently, I
guess they both were from Greenwich, not Westport, but what is
the likelihood that instead of one, you would have three, four,
or five?
What would be the kind of circumstance that would create it
happening for more than one company?
Mr. Corrigan. Let's look at the characteristics of Amaranth
for a minute in terms of why that worked out as well as it did.
There are a couple of things that I think are very
important. One, the instruments that were used to construct
those natural gas trades, by today's standards, were relatively
simple and straightforward.
Mr. Shays. I need you to give me as short an answer as you
can, because I have another question.
Mr. Corrigan. The short answer is I cannot tell you the
probability--low, but not zero.
Mr. Shays. Let me ask you this. Are any of you concerned
that you could have three or four companies go down at the same
time and then would we still see the Amaranth model working out
or would the Fed or someone else have to step in, if you had
two or three companies go down at once?
Mr. Brown. I think the important thing you have to note is
the incredible diversity of the fund business. I think the
industry is not doing itself a service in really explaining
this to the world, and the fact that we have so focused on
Amaranth and long term capital management and assume this is
the whole industry--
Mr. Shays. One answer is just diversity?
Mr. Brown. Diversity. Incredible diversity of this business
is a great protection, I think.
Mr. Shays. Can anyone else give another reason or diversity
would be the biggest?
Mr. Matthews. Diversity and size of capital. As I point out
in my testimony, there are three hedge funds in the United
States alone with $30 billion or more in assets. That did not
exist in Amaranth and long term capital's day. It just did not
exist.
Mr. Shays. One of my friends owns a hedge fund and they had
three partners. They bought out one because one partner wanted
to keep expanding and they were happy making millions and
millions of dollars, but they did not want to keep adding
because they did not think they could service their clients as
well.
I frankly thought it was remarkable. Obviously, he makes
about $10 million a year, each of them do. It is not like they
are suffering.
They had a chance of making more, but they honestly could
not service their customers as well the larger they became.
Why is it the larger you become sometimes you cannot get as
good a return? I do not understand that.
Mr. Hall. If I may, the answer to that is an important part
of the distinction between the classic mutual fund long only
business and hedge funds. Hedge funds, because they have an
incentive fee, they look at the opportunity set and they have
no interest in increasing assets under management unless it is
in fact going to yield an appropriate marginal return. When
that marginal return decreases, they have no incentive.
Hedge funds for years and years have been giving back
money, closing, not taking any new money. If you contrast that
to the long only business, frankly, they are asset gatherers,
in my view, and they pretty much take as much money as they can
because as they take new money, it is greater fees, but not
necessarily greater marginal opportunities to invest in.
Mr. Brown. I can address that issue as well. The evidence
does show that there is some economies of scale that hedge
funds face. Interestingly enough, if you look at funds of
funds, there is actually economies of scale, because of the
important due diligence function that they serve in vetting out
the funds under their management, and the funds that have the
greatest amount of assets under management are the ones that
can afford to do the greatest amount of due diligence on behalf
of the institutional clients they serve.
Mr. Shays. Thank you. Thank you, Mr. Chairman.
The Chairman. The gentleman from Georgia.
Mr. Scott. Thank you, Mr. Chairman. This is a fascinating
hearing on the evolving topic of hedge funds.
My understanding of hedge funds, I want to make sure I am
right on this, and if I am not, you all correct me, is that
they are massive unregulated investment pools that are
typically invested in only by institutional investors or
wealthy individuals, that try to hedge the value of assets it
holds and provides returns to investors that are not correlated
to those of traditional stock or bond markets.
Is that a fairly good assessment there?
Mr. Matthews. My only correction would be they are not
necessarily all massive. It is like the retail business. You
have Wal-Mart, Target, and Home Depot, but you also have a lot
of local mom and pop's, like myself.
Mr. Scott. I am very glad that you said that, because that
leads into my question in terms of the retail. As many of the
particularly retail industry giants move closer to departure
from this traditional form of long-standing traditional
industry practices, it has somewhat created an interest and an
apprehension for what is on the horizon for some of these
companies.
Let me give an example of what I am talking about. If we
take Sears, for example, Sears is now being classified as more
of a hedge fund over its traditional role. Granted, Mr.
Lambert, who was the chairman of Sears, has done a great job
for the company as far as investments and the like.
Are you worried that more and more of our Nation's stores,
especially retailers, will turn more to hedge funds and
unrelated investment strategies to survive, and do you believe
that more and more corporations whose sales are hurting will
move in this same direction?
Do you believe we have a worrisome trend here? This is kind
of a lead in to that. Is there a concern that the more
unpredictable ventures like hedge funds may lead to yet other
problematic issues in corporations? Should they stick to what
they were formed to do and work on inventive and further
creative ways of bringing in the customers instead of focusing
more on unrelated investments like hedge funds?
Are they counting more primarily on these hedge fund
investments over store performance, as sales decline, stores
lose customers, and those customers are finding other places
that address their needs or the prices.
This way of doing business is good for shareholders, but
what about retailers? Do you believe this will further become
the ongoing trend, retailers taking their focus off the classic
focus of same store growth, market share, and store spending,
and substantial losses in the long run?
What I am asking is the impact of this trend on some of our
retail giants, like Sears.
Mr. Brody or Mr. Chanos or Mr. Hall?
Mr. Brody. I will give it a quick try. The rationalization
of businesses really has little to do with hedge funds. What we
see over time is that some businesses are successful and some
businesses are not successful. Some retailers are successful
and some retailers are not successful.
When a retailer has ``X'' number of stores and a bunch of
them are not successful, if the retailer is to survive, it
needs to rationalize itself, get out of some stores, and change
its merchandising. We have seen that in the retailing business
and we have seen that in many, many industries in the United
States.
I guess what I would say is that sound management is needed
for all businesses and it has little to do with hedge funds.
Mr. Scott. Do you believe that down the road, some sort of
reform will need to take place to address hedge funds with
respect to their size and scope?
Mr. Brody. Let me just make a comment on size. Many of the
top 10 hedge funds by assets are terrific performers, and I
think it just depends upon hedge fund by hedge fund, their
management, the activities that they invest in, and each, in my
view, in our capital system, should be free to make the
economic choices that they do.
Mr. Scott. Am I being over cautious or overreacting in my
concern that a lack of transparency in the current hedge fund
market could lead to volatility down the road?
Am I seeing something that is not there? Is there anything
to worry about with this move towards hedge funds?
Mr. Brody. I think there are always plenty of things to
worry about, not just with hedge funds, but probably everything
else in life.
Mr. Scott. Is there volatility?
Mr. Brody. The hedge fund world actually has less
volatility in the aggregate than the stock market world does,
and Mr. Corrigan went through a very useful notion of
transparency and transparency to whom, to the regulators, to
the prime brokers, to those who are lending you money, to the
institutions that are investing in you, and to the general
public.
I think the major point is that where the transparency is
needed, it exists.
Mr. Scott. Was it hedge funds that--my final question, my
mind is foggy. Did hedge funds play a role in the situation
regarding Fannie Mae?
Mr. Brody. No.
The Chairman. If the gentleman will yield to me, I think
Fannie Mae got in trouble over their own accounting for
derivatives. It was their own derivative investments and the
dispute over the accounting standard that was the last straw.
The gentleman from Illinois.
Mr. Corrigan. Mr. Chairman, can I just see if I can help a
little bit.
The Chairman. Yes.
Mr. Corrigan. I am one of the world's great worriers. I
worry about those things, too. If you look at the size of hedge
funds, the threat of retailers going amuck via financial
activities, those risks really are very, very small. I
appreciate your concern. There are more important things I
think in this area to worry about than those.
The Chairman. The gentleman from Illinois.
Mr. Roskam. Thank you, Mr. Chairman.
I just wanted to follow up briefly on what Mr. Shays was
bringing up and to put it in a context. I apologize. I went out
for three constituent meetings in the hallway that started with
your testimony, Mr. Corrigan, and I came in, Mr. Brown, as you
were clearing your throat at the end basically. I missed all
your good stuff.
That being said, could you comment--I will just open it up
for anybody who has anything interesting and insightful to
say--could you comment on the characterization of long term
capital management, the environment where the Fed obviously
came in and intervened, the Amaranth situation--which I think
the best phrase today, by the way, was that it worked itself
out. I just thought that was a brilliant nice use of language,
that it sort of worked itself out.
What is different today in terms of the sophistication in
the marketplace so that we do not have to have that sort of
intervention that we saw in the late 1990's?
I think, Mr. Matthews, you mentioned diversification, and
then you also referenced the size of several funds.
Could you go further on that? I did not follow what you
meant by that.
Mr. Matthews. It is those two issues, diversification and
size. Back when long term capital blew up, I think they lost
$4.5 billion. I think that was the number.
There were no other $4.5 billion funds around that either
could or had the ability to or wanted to step in and help. They
could not do it. You needed the Fed to step in.
Today, we have three funds alone that have $30 billion each
in the United States. There is one in London that has $60
billion, I believe.
There is tons of capital around. They do a lot of different
things. They have branched into all kinds and all different
classes of financial instruments and commodities and markets
around the world.
It is simply not at all the kind of environment that long
term capital was. They were the biggest and there was nobody
out there who could rescue them.
Mr. Roskam. The old notion of being too big to fail is
really the marketplace has matured since then, and now there
are others who would be big enough to assume that market share?
Mr. Matthews. It has. There is an issue that gets back to
Mr. Scott's question about are they not too big or can they get
too big.
There is a very Darwinian factor to our business model. The
person who runs the management firm gets 20 percent of the
profits. The investors know this. They are paying that money.
If they are not getting a return on that investment, they are
out of there very quickly.
A fund cannot keep growing forever just for the heck of it.
The investors have to be satisfied or the money will go
elsewhere. It is a very efficient marketplace.
Mr. Roskam. Could someone comment on the failure of hedge
funds? I assume it is the natural thing, right? Some flourish.
Some diminish. They do well and they stumble, like normal, and
we ought not overreact to hedge fund failures?
Mr. Hall. One of the things that I think the President's
Working Group points out is that there is responsibility on the
part of investors themselves.
I think there was clearly a failure in the long term
capital situation on the part of the counterparties, but it was
not a system wide failure. There is clearly long term capital,
I think, arrangements that were extended credit that other
people did not get, so it was not a systemwide problem.
The Amaranth problem is strictly investors losing money. I
do not think there was any threat to the system. Ultimately,
due diligence is important and investors have to focus on due
diligence, and keep in mind that Amaranth advertised and
achieved extraordinarily high returns in the years subsequent
to that.
You get higher returns from taking high risk. Investors
knew that going in, I would assume. If they did not know, then
we really need to focus on the due diligence aspect.
It is really going to be difficult to regulate the due
diligence process, and the MFA is doing the best it can with
creating standardized due diligence forms and processes.
Mr. Roskam. Mr. Chanos?
Mr. Chanos. I would like to point out that hedge funds
actually are very fragile vehicles. I would like to amplify
what Mr. Matthews said; 10 to 20 percent of all hedge funds go
out of business every year. It is a very large number. They do
not because of stupendous losses, but for the very Darwinian
thing that he mentioned, investors are constantly looking for
the best return in this area, even though the evidence is
exactly the opposite, that returns have been relatively high
with less risk in aggregate.
However, investors are shopping for the best returns in a
very high fee world and tend to move very quickly out of
something that is not performing, and therefore, keeping the
market disciplined in that way.
Mr. Roskam. Thank you.
Mr. Brody. I think an important thing is to make sure that
the investors get a fair shake. I think that is what
registration does, it surely does not guarantee investors that
they cannot lose their money.
Mr. Corrigan. Just very quickly on long term capital. We
should not forget the circumstances in which long term capital
happened. Long term capital was horribly mismanaged, the fact
of the matter is that coming off the Asian crisis and the
Russian crisis, that combination of circumstances in 1998 made
long term capital a hell of a lot harder to deal with than it
would have been had it happened in a more tranquil environment.
The Chairman. We should make sure that there are no hedge
funds around when we have a crisis?
[Laughter]
Mr. Corrigan. We are not going to be that lucky.
The Chairman. The gentleman from Texas.
Mr. Green. Thank you, Mr. Chairman. I thank the witnesses
for your testimony. Our friends, it seems to me that every
failsafe system is failsafe until it fails to be safe. And
before long-term capital, there was no long-term capital. And
my suspicion is that there is something else out there that we
cannot prognosticate currently that may manifest itself, and
then that will be the pariah paradigm that we'll have hearings
about and talk about.
So, it seems to me that we do have to concern ourselves
with the taxpayers in this paradigm, because the taxpayers are
at the very foundation of the payout, because we now have the
commingling of sophisticated and unsophisticated capital, and
that occurs through the pension funds.
The sophisticated investor, as Mr. Golden said, is one that
you may have little sympathy for. But I have a great deal of
sympathy for the pension fund that happens to have pensioners
who are unsophisticated investors who happen to be a part of
this system that necessitates sophistication.
And I might add also that sophisticated investors make some
very unsophisticated decisions, and I think we have to be
mindful of this. So, if the--just to take us through it, if the
sophisticated investor puts his money in the hedge fund, that's
great. The pension is in the hedge fund. At some point, the
pension fails. And at this point, the person who receives his
benefits from the pension then relies on the taxpayer, perhaps
through some sort of social program.
So in the final analysis, the taxpayers have a vested
interest in what happens with funds that are supposed to be
entirely supported by sophisticated investors. So the question
for me becomes this, that I'd like to have each of you address.
Do you agree, each of you, that something must be done about
the commingling of sophisticated and unsophisticated funds? And
I'll start with Mr. Brown.
Mr. Brown. Thank you.
Mr. Green. If you could start with a yes or a no. And I say
this only because sometimes when folks finish, I don't know
whether they've said yes or no.
Mr. Brown. I think there is an issue, and I think that
there are a lot of hedge fund salespeople out there who will
tell you about S&P returns and Treasury bill risk and that you
need to be sophisticated in terms of your ability to understand
the markets, although--
Mr. Green. Mr. Brown, if I may, would you then say yes is
the answer, that there should be something done about this
commingling of sophisticated and unsophisticated funds?
Mr. Brown. I'm concerned about it, but I'm not sure what to
do.
Mr. Green. Okay. In a world where something can be done,
would you do something?
Mr. Brown. I think I probably would.
Mr. Green. Okay. Mr. Golden?
Mr. Golden. I'm not entirely sure I understand the
question.
Mr. Green. Well, it gets to the pensions. The pensions. The
guy who happens to be a pipefitter who happens to have his
pension fund invested in the hedge fund, he, by definition, may
not be a sophisticated investor. You could have a Ph.D. and not
be a sophisticated investor. So, he's not a sophisticated
investor. What about him? What about the fact that the taxpayer
eventually picks up the tab if that pension fund loses money
and he then has to have some sort of social benefit that
taxpayers cover?
Mr. Golden. I think the answer is no. I think it's
definitely no at the level of the hedge fund. I think we have
concerns about the safety of pension funds, and we should be
focusing attention on those who manage the pension funds, and
seeing whether or not they are operating in a prudent fashion,
using proper elements of diversification.
Mr. Green. But your answer is that we should not do
anything with reference to the commingling of the sophisticated
and unsophisticated money?
Mr. Golden. I guess I'm not sure that the pension fund
money is unsophisticated, because there is a fiduciary involved
at that point.
Mr. Green. Well, the guy who manages the pension fund,
we're going to assume that he's sophisticated. But the guy who
benefits, the person who receives the pension, I think we all
agree that the overwhelming majority of them would not be
classified as sophisticated investors, correct?
Mr. Golden. Yes.
Mr. Green. All right. So they're the people who lose. And
then the taxpayers pick up the tab. Should we do something to
avoid that type of occurrence? And your position is you'd do it
with the manager as opposed to with the fund itself?
Mr. Golden. Right. Right. I agree with that. The manager of
the San Diego pension fund that invested in Amaranth made a bad
decision. They put too much money in Amaranth. Something people
should be asking--the pipefitter should be asking the pension
fund manager for San Diego why did you do that? And I--
Mr. Green. I agree with you, sir, that the pipefitter
should pose this question, but the problem becomes the
pipefitter still needs the social services. He has a family; he
has children, and they need the social services that we, the
taxpayers, seem to provide. So we still get back to the
taxpayer having a vested interest in what happens to the
pipefitter who had a manager who made an unsophisticated
decision who is a sophisticated investor.
Mr. Golden. So--and I understand completely, and I think
the regulation should--the concern you should have is who is
running these funds? If they're making bad decisions regularly,
that's a real problem. The hedge fund is just doing its job,
and I don't know if you can regulate that.
Mr. Green. Well, tell me this. How would you manage the
managers such that we can do exactly what you're talking about?
Mr. Golden. It's a great question. Off the top of my head,
I don't know.
Mr. Green. Does anybody have an answer? Yes, sir?
Mr. Chanos. Aren't we really talking about an ERISA issue
here?
Mr. Green. Say again?
Mr. Chanos. Aren't we really talking about an ERISA issue
here, which is the way in which pension funds are managed and
how those pension funds are advised? For example, self-directed
pension plans and 401(k)s, which we be more direct to what
you're saying, aren't investing in hedge funds.
So really, that pipefitter is getting advice, or should be
under ERISA, getting fiduciary responsible advice from an
advisor, and that's always the case, for example, in our fund.
We never talk to the underlying investor directly. There's
always an advisor. That is where the nexus of this concern
should be, and I think it is a really good question. But I
think we're looking at it from the wrong side of the telescope.
Mr. Green. Do you really think that the majority of people
who are pension investors, they have money in pension plans, do
you really think that the majority of these persons are
receiving the level of advice that they need in terms of what a
sophisticated investor is and how that impacts their
investments?
Mr. Chanos. Well, if they're in a defined benefit plan,
generally, yes, they are. I don't know of any pension, large
pension funds that have failed due to one hedge fund
investment.
Mr. Green. But we're not talking about the ones that have.
We're looking to the future. Eventually we'll have that
discussion. Thank you, Mr. Chairman.
The Chairman. And I would also note, one of our concerns is
the public pension funds, so that you don't have the ERISA
rules, and that is something we'll be looking at. Mr. Campbell?
Mr. Campbell. Thank you, Mr. Chairman. Mr. Matthews and Dr.
Brown, both of you in your presentations talked about leverage
in hedge funds, and I don't mean the leverage in the
investments, Mr. Corrigan, but the actual leverage in the fund
investment itself. Is the degree and amount of that leverage
transparent to the investors?
Mr. Brown. To the informed investor, there's a whole
industry out there for people to investigate and do due
diligence. And if I were investing--I'm not a qualified
investor--if I were investing a substantial portion of my
wealth, I would certainly investigate. And the investor has
every right to demand any kind of information they need to make
an informed decision.
Mr. Campbell. So I guess my question is that's not
information that is readily available to an investor so an
investor could be, I think Mr. Matthews had talked about a
three to one leverage fund.
Mr. Brown. Right.
Mr. Campbell. So someone investing in that might not know--
a sophisticated investor, I realize, or pension fund?
Mr. Brown. My evidence is that sophisticated investors, as
indicated by people who grant the leverage, the counterparties,
they know and they have access to that information already, and
it's evidenced by the fact that if you look at the ADV filings,
and I've looked at 2,270 of them, that the sophisticated
investors lending money already knew of the operational risk
characteristics that were revealed in those forms. So they've
done their homework, and the people who are lending money, and
that's really the systemic risk concern that we have is what
effect this is going to have on the financial system as a
whole.
Mr. Campbell. Does anyone else want to comment? I mean,
just from my perspective, obviously, we're talking about
multiplying the risk--
Mr. Brown. Right.
Mr. Campbell.--dramatically when you take what hedge funds
invest in and add to that degrees of leverage. Yes, Mr. Brody?
Mr. Brody. There's a wide range of sophistication among
investors, and some will have a very good idea of what they're
getting into and what the leverage is, and some will not. My
view on the proper kind of registration is that a principles-
based registration would require the disclosure of the
important items to all investors, and that kind of disclosure
then would benefit the unsophisticated--
Mr. Campbell. Do any of you disagree with that?
Mr. Hall. Well, I'd put that in perspective. I think
``leverage'' is too simple a term to really have a whole lot of
meaning. If you leverage Treasury bills or if you leverage
Internet stocks, you have--or Internet stocks without leverage
can be significantly more risky. So I'd be concerned about
providing rules-based disclosure as opposed to principle-based
regulation that makes people feel comfortable but they're
really not.
Mr. Campbell. Do any of you believe there's a proprietary
issue there? I mean, part of the reasons that hedge funds don't
disclose, as you said, is because they're using oftentimes
proprietary methods. Yes, Mr. Chanos.
Mr. Chanos. I think there's a big proprietary issue at work
here, and we need to make the distinction between disclosure of
leverage and positions to our investors and our counterparties
and our custodians, and disclosure of positions to the general
public.
Mr. Campbell. Right.
Mr. Chanos. And I think that's an important distinction,
and I think that the committee understands, but I want to
emphasize it. But quite frankly, and I know a number of people
in the written testimony have touched upon this, I run a fund
in addition to being an industry person, and our investors all
have on-site inspection ability, and they take advantage of it.
They routinely come in, look at our books, look at our
positions, query us over and over and over again. Talk to our
counterparties, talk to our prime brokers. This type of due
diligence is done all the time and increasingly so both from
high net worth individuals, public and private pension funds.
These people are doing their work. When we have these blow-ups,
they are very much the exception to the rule.
Mr. Campbell. Okay. The second question is about accredited
investor. Do any of you, and anybody, you can answer this.
Should that be changed? Is it right? Do you support the SEC's
proposal to change the threshold? Anybody want to take that?
Mr. Hall. Well, I would support it. On behalf of the MFA,
we would support it.
Mr. Campbell. You support the SEC's proposal?
Mr. Hall. Yes.
Mr. Campbell. Anybody else? I mean, do we have the right
definition of accredited investor, or should it be changed?
Mr. Corrigan. I think the definition is as good as it's
going to get. There's no way to perfectly define these things.
Mr. Campbell. And the threshold is okay?
Mr. Corrigan. The threshold proposed by the SEC is a big
improvement. I actually might go a little bit further, but
that's another story.
Mr. Brown. As one of the members said, it's not an issue of
intelligence about such matters, it's about the degree to which
you can afford any losses that you may incur. And that's the
reason for that standard.
Mr. Campbell. Okay. And then one last question.
Mr. Golden. Can I just add?
Mr. Campbell. Sorry.
Mr. Golden. I'd like to see the threshold raised as high as
is politically feasible, at least as high as the SEC's.
Mr. Campbell. And one last little question for Mr. Chanos.
We talked about this fortress company that went public and you
said it was the management of the hedge fund. I'm just curious.
People access the public markets for capital. Why would a
manager of a hedge fund require capital?
Mr. Chanos. Well, I think that it's not only for requiring
capital but to possibly use their stock as currency for
possible acquisitions, or to incentivize their senior and mid-
level people perhaps through stock options. There are all kinds
of reasons why companies go public that don't necessarily need
the capital, so I think that's sort of a broader issue, perhaps
beyond the purview of this panel.
Mr. Campbell. All right. Thank you. I yield back, Mr.
Chairman.
The Chairman. Thank you. I did just want to add one thing
to Dr. Brown and the very useful and interesting questions Mr.
Campbell is asking about what people know. Did I read you
correctly as basically saying that even if you tell them, they
don't pay any attention, they just chase returns? I mean, is
that an accurate statement?
Mr. Brown. That's an accurate statement.
The Chairman. So that you tell them that, but they don't--
even the sophisticated ones, don't factor into account and
just, as you say, chase returns?
Mr. Brown. That's what the evidence seems to suggest.
Either they don't know the information and they can't have
access to it, which I find rather unusual, or they do have
access to it and it's immaterial.
The Chairman. The gentleman from Missouri.
Mr. Cleaver. Thank you, Mr. Chairman. I just have one
question for the entire panel. Mr. Chanos, you earlier brought
up Warren Buffett and his hedge fund history. He's fond of
using the adage in describing hedge funds if a man with money
proposes a deal to a man with experience, the man with money
ends up with the experience and the man with the experience
ends up with his money.
That's kind of the theme of what's been going on, and Mr.
Buffett has become very critical of the hedge fund fee
arrangements, as you may or may not know, and he calls the
managers the 2 and 20 crowd. And I frankly think that he raises
some very pertinent issues. How would you characterize the
fairness and the accuracy of Mr. Buffett's comments?
Mr. Chanos. Well, I don't want to put words in Mr.
Buffett's mouth, but I--
Mr. Cleaver. No, I'd like to give an exact quote. Hold on
just a second. ``It is a lopsided system whereby 2 percent of
your principal is paid each year to the manager even if he
accomplishes nothing, or for that matter, loses you a bundle
and additionally, 20 percent of your profit is paid to him if
he succeeds, even if his success is due simply to a rising
tide.''
Mr. Chanos. All right. Well, I think those, while factually
accurate, and he's entitled to his opinion, I would point out
Mr. Buffett ran a hedge fund for 20 years, just about.
The Chairman. Well, it takes one to know one.
[Laughter]
Mr. Chanos. So, again, perhaps he's speaking from personal
experience, I don't know. But every hedge fund is different.
Every business is different. Everything should be judged on the
merits of its management team, its performance, and its fee
structure, and to make blanket statements about every single
hedge fund, something like that seems to me to be a bit strong.
It's like saying, well, all of corporate America is not
performing well for its shareholders, or every corporate
executive is making too much money.
I mean, these are individual cases, and I think that while
there's plenty of examples of hedge funds that aren't probably
doing a good job and are charging fees that are too high, as
one of my panelists said here that this market is pretty
Darwinian, and it weeds out those people pretty quickly. If
you're not performing, you don't tend to keep those assets very
long.
Mr. Cleaver. So the 2 and 20 crowd is actually a small
crowd?
Mr. Chanos. It's not a small crowd. In fact, it's a growing
crowd.
Mr. Cleaver. Or is it the in crowd?
Mr. Chanos. But there's a reason it's growing, Mr. Cleaver,
in that there is a reason. No one here has asked the question,
why are we having this--because of the growth of the industry,
obviously something must be happening here where relatively
sophisticated investors want to put more money with these
managers. It's not because simply they're hanging out a shingle
in front of their house. There is good performance being done
with less risk. That's why it's attractive in the aggregate.
But individually and specifically, there will always be, as one
of our members said, the fools and the frauds are going to make
things difficult for most of the good actors.
Mr. Hall. If I may, it's important in my view, a semantic
issue about the 2 percent of the 2 and 20 is on capital. And
that doesn't, if you look at--if someone manages $100 million
and takes a smaller fee, but 90 percent of their fund is
coincident with the index, then they're really--their marginal
benefit is only on a small portion of that $100 million, $100
billion.
So a hedge fund may manage a smaller amount of capital and
charge a higher fee on a smaller amount of capital, then they
also manage leverage, they manage short positions, they manage
hedges. So, you really have to look at the services that one is
providing for that fee, and percentage of fee on capital is not
necessarily what the manager is ultimately getting compensated
for.
Mr. Brown. I need to make one clarification point on the 2
and 20 issue. You only earn the 20 once you've won back any
losses that you've incurred in the past. It's called a high
water mark provision.
It's that high water mark provision that really enforces
the Darwinian aspect of it, and, in fact, hedge funds are like
radioactive substances. They have a half-life of 2\1/2\ years,
typically, because, you know, you lose, you lose, you die in
this world very quickly because you just aren't earning any
returns.
Mr. Cleaver. I yield back my time.
The Chairman. Thank you. Let me just ask two quick
questions. One, we will be talking next time about--we were
talking about how these things should run and do run in
general. There are always aberrations with anything. The
insider trading issue is one of the issues that we will be
looking at next time, the SEC has been involved in.
One of the questions is, record retention for entities that
are otherwise unregulated. Is that an issue? Should we look at
that? That is, over and above everything else, there is an
argument for record retention to be able to help law
enforcement for the aberrant cases. I'd be interested in any
comments.
Would there be objections to some kind of record retention
requirement that for those--and I realize a lot of them already
have them, because they're otherwise regulated. But would there
be any objection to a generalized sort of record retention
requirement for entities that otherwise didn't have them? Mr.
Chanos?
Mr. Chanos. I don't think our members would have--we have
not canvassed them, but I don't think our members would have a
problem with that.
The Chairman. Mr. Hall?
Mr. Hall. I think we would have no objection.
The Chairman. All right. I'm quitting while I'm ahead. The
next question is one of the ones that some of the staff have
suggested, and that is on the counterparty issue, the--who's in
charge of the aggregates? I mean, obviously, you have each
individual counterparty, but is anybody looking at the
aggregate counterparty responsibility, and is that something
that somebody should be looking at? Mr. Corrigan?
Mr. Corrigan. That--the short answer to that is no,
because--
The Chairman. Nobody's looking at it or nobody should look
at it?
Mr. Corrigan. Well, we should look at it, and we are making
efforts through the regulatory process to better look at it
through the regulated institutions, yes. But it's not easy.
The Chairman. Again, would there be objection if there was
a way to do that that did not impinge on proprietary concerns?
Mr. Brown. I would agree with that.
The Chairman. Mr. Chanos? Yes?
Mr. Chanos. Let me just point out. We could look across the
pond to our financial cousins in the United Kingdom who have a
very interesting process through their FSA. Their FSA, it's my
understanding, occasionally canvasses all of its major prime
brokers and then canvasses them separately in relation to their
specific hedge fund exposure and looks for cross--
The Chairman. So that would be a good thing to do?
Mr. Chanos. I think it would be--
The Chairman. Well, good. If the FSA is-- Mr. Corrigan?
Mr. Corrigan.--here, too, right now.
The Chairman. What's that, Mr. Corrigan?
Mr. Corrigan. We do that right now here.
The Chairman. Well, we might want to improve on that. These
days if the FSA is doing it, one of the great passionate love
affairs in the world today is between the American financial
community and the FSA, except where it comes to executive
compensation.
I understand no love affair is perfect, and the lover may
have a blemish. And in fact, McCarthy was here the other day
and said, yes, he is enjoying being the flavor of the month
through the FSA. So both of those are areas I think we would
pursue.
If you'll indulge us, the gentleman from Louisiana had one
last question.
Mr. Baker. I thank you, Mr. Chairman. Mr. Corrigan, I went
back and looked at the written statement relative to Amaranth,
and what I drew from your comments was had Amaranth occurred in
an illiquid market, or where there was a crowded trade going
on, the unwinding of it all may have been less pretty.
Mr. Corrigan. That's correct.
Mr. Baker. And so the cautionary tale was, although we
escaped it, let's not assume our system is functioning exactly
as we would like to that end. I just wanted to do a quick wrap-
up of sort of the elements I've drawn from this. Limitation on
who gets in needs to be reviewed whether it's the individual's
net worth standard, or whether it's pension fund management
capability. And I'm adding one to the list which I don't think
I've heard, and that is limitations more restrained on the fund
of funds, the $25,000 entry fee into that, I think, is highly
inappropriate in today's world.
Then establishing a benchmark of best practices, not only
for the private investment company side, but--and I'm asking
here--but shouldn't we do that as well on the counterparty side
with the broker-dealer community, financials, insurance,
whoever is playing with these guys needs to be required. And
then last would be some sort of formal and/or informal
exchange. For example, I'm not clear today, if I'm the
counterparty and I see something that I think is ill-advised,
when am I obligated to notify my regulator as to the hedge fund
conduct, not my conduct, which I think is a lower standard of
responsibility?
If we were to address those issues, do you feel that is an
appropriate litany of steps to take in light of the relatively
low systemic risk potential we think is likely to be in the
near term?
Mr. Corrigan. I think the list is approximately right, and
so long as we do it in a way that honors this more principles
based as opposed to checking boxes approach, I think that's
right.
Mr. Baker. Thank you. Anybody want to comment? Mr. Hall?
Mr. Hall. I would agree with that.
Mr. Baker. Great. Thank you very much, Mr. Chairman.
The Chairman. I thank you all. This is very useful in
advancing our understanding, and the hearing is adjourned.
[Whereupon, at 12:43 p.m., the hearing was adjourned.]
A P P E N D I X
March 13, 2007
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