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HEDGE FUNDS AND SYSTEMIC RISK:
PERSPECTIVES OF THE PRESIDENT’S
WORKING GROUP ON FINANCIAL MARKETS

HEARING
BEFORE THE

COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED TENTH CONGRESS
FIRST SESSION

JULY 11, 2007

Printed for the use of the Committee on Financial Services

Serial No. 110–48

(

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2007

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HOUSE COMMITTEE ON FINANCIAL SERVICES
BARNEY FRANK, Massachusetts, Chairman
PAUL E. KANJORSKI, Pennsylvania
MAXINE WATERS, California
CAROLYN B. MALONEY, New York
LUIS V. GUTIERREZ, Illinois
´
NYDIA M. VELAZQUEZ, New York
MELVIN L. WATT, North Carolina
GARY L. ACKERMAN, New York
JULIA CARSON, Indiana
BRAD SHERMAN, California
GREGORY W. MEEKS, New York
DENNIS MOORE, Kansas
MICHAEL E. CAPUANO, Massachusetts
´
RUBEN HINOJOSA, Texas
WM. LACY CLAY, Missouri
CAROLYN MCCARTHY, New York
JOE BACA, California
STEPHEN F. LYNCH, Massachusetts
BRAD MILLER, North Carolina
DAVID SCOTT, Georgia
AL GREEN, Texas
EMANUEL CLEAVER, Missouri
MELISSA L. BEAN, Illinois
GWEN MOORE, Wisconsin,
LINCOLN DAVIS, Tennessee
ALBIO SIRES, New Jersey
PAUL W. HODES, New Hampshire
KEITH ELLISON, Minnesota
RON KLEIN, Florida
TIM MAHONEY, Florida
CHARLES WILSON, Ohio
ED PERLMUTTER, Colorado
CHRISTOPHER S. MURPHY, Connecticut
JOE DONNELLY, Indiana
ROBERT WEXLER, Florida
JIM MARSHALL, Georgia
DAN BOREN, Oklahoma

SPENCER BACHUS, Alabama
RICHARD H. BAKER, Louisiana
DEBORAH PRYCE, Ohio
MICHAEL N. CASTLE, Delaware
PETER T. KING, New York
EDWARD R. ROYCE, California
FRANK D. LUCAS, Oklahoma
RON PAUL, Texas
PAUL E. GILLMOR, Ohio
STEVEN C. LATOURETTE, Ohio
DONALD A. MANZULLO, Illinois
WALTER B. JONES, JR., North Carolina
JUDY BIGGERT, Illinois
CHRISTOPHER SHAYS, Connecticut
GARY G. MILLER, California
SHELLEY MOORE CAPITO, West Virginia
TOM FEENEY, Florida
JEB HENSARLING, Texas
SCOTT GARRETT, New Jersey
GINNY BROWN-WAITE, Florida
J. GRESHAM BARRETT, South Carolina
JIM GERLACH, Pennsylvania
STEVAN PEARCE, New Mexico
RANDY NEUGEBAUER, Texas
TOM PRICE, Georgia
GEOFF DAVIS, Kentucky
PATRICK T. MCHENRY, North Carolina
JOHN CAMPBELL, California
ADAM PUTNAM, Florida
MICHELE BACHMANN, Minnesota
PETER J. ROSKAM, Illinois
KENNY MARCHANT, Texas
THADDEUS G. McCOTTER, Michigan

JEANNE M. ROSLANOWICK, Staff Director and Chief Counsel

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CONTENTS
Page

Hearing held on:
July 11, 2007 .....................................................................................................
Appendix:
July 11, 2007 .....................................................................................................

1
41

WITNESSES
WEDNESDAY, JULY 11, 2007
Overdahl, James A., Chief Economist, U.S. Commodity Futures Trading Commission ..................................................................................................................
Sirri, Erik R., Director, Division of Market Regulation, U.S. Securities and
Exchange Commission .........................................................................................
Steel, Hon. Robert K., Under Secretary for Domestic Finance, U.S. Department of the Treasury ...........................................................................................
Warsh, Hon. Kevin M., Member, Board of Governors of the Federal Reserve
System ...................................................................................................................

15
17
12
14

APPENDIX
Prepared statements:
Overdahl, James A. ..........................................................................................
Sirri, Erik R. .....................................................................................................
Steel, Hon. Robert K. .......................................................................................
Warsh, Hon. Kevin M. ......................................................................................
ADDITIONAL MATERIAL SUBMITTED

FOR THE

42
49
61
67

RECORD

Frank, Hon. Barney:
Financial Times article, dated July 10, 2007 .................................................
Article from Moody’s Investors Service ...........................................................
Bean, Hon. Melissa:
Responses to questions submitted to Erik Sirri .............................................
Responses to questions submitted to Hon. Robert K. Steel ..........................
Responses to questions submitted to Hon. Kevin M. Warsh ........................
Responses to questions submitted to James A. Overdahl .............................

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HEDGE FUNDS AND SYSTEMIC RISK:
PERSPECTIVES OF THE PRESIDENT’S
WORKING GROUP ON FINANCIAL MARKETS
Wednesday, July 11, 2007

U.S. HOUSE OF REPRESENTATIVES,
COMMITTEE ON FINANCIAL SERVICES,
Washington, D.C.
The committee met, pursuant to notice, at 10:04 a.m., in room
2128, Rayburn House Office Building, Hon. Barney Frank [chairman of the committee] presiding.
Members present: Representatives Frank, Kanjorski, Waters,
Maloney, Watt, Meeks, Capuano, Clay, McCarthy, Baca, Lynch,
Scott, Green, Cleaver, Sires, Hodes, Klein, Mahoney, Boren; Bachus, Baker, Pryce, Castle, Royce, Shays, Capito, Feeney, Hensarling,
Garrett,
Brown-Waite,
Neugebauer,
McHenry,
Campbell,
Bachmann, and Marchant.
The CHAIRMAN. The hearing will begin. This is a hearing of the
Financial Services Committee with the members of the President’s
Working Group, which I guess is about 20 years old. And it is part
of a series of hearings we are having on the issue of hedge funds
and private equity, the increase in the amount of financial activity
that goes through.
We had a hearing earlier with some of the representatives of
hedge funds themselves. We will continue to deal with this and we
are pleased to have the President’s Working Group before us.
I think, as I read the testimony, we have a kind of uneasy consensus that there is a potential problem here that we wish we were
more sure about how to approach. I, for instance, read with great
interest the speech by Assistant Secretary Ryan of the Treasury a
couple of weeks ago. I don’t think anybody can be confident that
all is entirely well here, but neither is there any obvious thing we
ought to be doing.
This is a matter for concern. It is an interesting issue in that it’s
a challenge to our regulatory system both within the United States
and internationally. I mean the fact that we have a wide range of
entities here, we have two quasi-independent commissions, and we
have the Treasury and the Federal Reserve all with pieces of this.
We have obviously a very important interface with the international community, and I know that people don’t generally believe
this, but it is the case that sometimes, not often, I acknowledge,
but sometimes, congressional committees have hearings because
they want to know things. That’s not the norm, but it is true today.
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2
This is a subject of great importance and considerable uncertainty. There is obvious value to the activity of these entities. The
market is not irrational. People profit because they are doing
things that are ultimately beneficial, but there are also potential
dangers.
In particular from this community standpoint I think, not all of
us but most of us, is the potential for systemic risk. We are not
here largely in an investor protection capacity. Particularly after
what the SEC has done, we are not talking about small investors.
There is one exception to that. There is a great deal of concern
about the potential for pension funds to get involved beyond what
they should be doing. And I’ve talked to the chairman of the Committee on Education and Labor, Mr. Miller, who has jurisdiction
there. We are going to be working at—one of the things we have
to address is whether or not there should be some special rules regarding pension funds.
But beyond that, the question is systemic risk. The question is
whether, given the proliferation of forms of investment that have
high leverage, whether or not if there is a rapid change in the basic
financial environment, people will be able to deal with the consequences. So far, there have been some good signs.
The Amaranth situation was a problem for people for whom it
should have been a problem but it did not have broader systemic
problems. It does not appear so now, but we’ll be interested in people’s sense of whether the Bear Stearns issue is going to be something that causes broader problems. But those have happened
within a stable financial context.
The question, I guess, is what happens if the current financial
context regarding international liquidity and interest rates were to
change. And I don’t think anyone thinks that’s going to remain forever in both contexts. So what we are talking about is, are we now
ready to deal with a potential problem, and if so, what should we
be able to do about it and how do we get ready to do that without
causing some damage?
So as I said, I regard this as a study that’s ongoing, and I’m glad
to say that it has been a collaborative one between the Congress
and the various regulators and it’s good to see them working together on this. And as I said, we are here to learn some things and
to talk about things in general, and this is part of a continuing inquiry into this problem which is we have quantitatively, and as
Marx said, ‘‘Changes in quantity can become changes in quality.’’
We have what could be a qualitative change in the extent to which
investment is carried on.
Our question is, does that pose potential problems, and is the
regulatory structure adequate to this new set of issues. That’s what
we will be dealing with. I’ll now recognize for 5 minutes the ranking member of the committee, the gentleman from Alabama.
Mr. BACHUS. I thank the chairman. I thank you for holding this
hearing.
This is the third hearing we’ve held on the rapid growth of private pools of capital including hedge funds and private equity
funds. I’d also like to associate myself with the remarks of the
chairman when he said that we’re unsure about what to do, and
we’re not confident about any action that we may take at this time.

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So that is, as he said, a clear indication that we ought to be listening, we ought to be learning, but we should not be taking legislative action. What we are doing, I think, is very appropriate. We’re
talking with each of you, your agencies, and we’re confident that
the regulators appreciate the problems and we’re also confident
that you know more about it than we do.
We’re really fortunate to have with us our four witnesses today.
They are distinguished representatives of the Presidential Working
Group on Financial Markets.
And the President’s Working Group, as you all know, but the audience may not know, was formed in the wake of the 1987 stock
market crash. It is chaired by the Treasury Secretary, and it is
made up of the Chairmen of the Federal Reserve, the Securities
and Exchange Commission, and the Commodity Futures Trading
Commission. It was formed to promote integrity, efficiency, orderliness, and competitiveness in our financial markets.
Since then, it has issued periodic reports on these issues affecting the U.S. markets including the 1999 report on Long Term Capital Management.
Earlier this year the President’s Working Group endorsed an approach to hedge fund regulation that relies primarily on market
pressures and incentives to contain risks. The group concluded, correctly in my opinion, that market discipline together with statutory
limits restricting access to hedge funds to wealthy investors can
sufficiently mitigate industry risk.
By emphasizing the importance of free market forces, rather
than the hand of excessive government regulation, I believe that
the President’s Working Group struck the right balance in regulating and overseeing the activities of these highly innovative investment vehicles.
Hedge funds and private equity funds have in recent days, as we
all know, become convenient targets for those favoring higher taxes
and more government intervention in our capital markets. While
this is certainly a debate worth having, I hope that it will be an
informed debate, informed by the appreciation for the vital role
that these private pools of capital play in an efficiently functioning
market and their importance in maintaining America’s competitive
standing in the global economy.
Hedge funds actively pursue arbitrage opportunities across markets, and in the process often reduce or eliminate mispricing of financial assets. That actually can bring stability to a market.
As former Federal Reserve Chairman Alan Greenspan said,
‘‘Their willingness to take short positions can act as an antidote to
the sometimes excessive enthusiasm of long-term investors. Perhaps more importantly, they often provide valuable liquidity to financial markets both in normal market conditions and especially
during periods of stress.
‘‘They can ordinarily perform these functions more effectively
than other types of financial intermedia because their investors
often have a greater appreciation for risk and because they are
largely free from regulatory constraints on investment strategies.’’
Private equity funds offer tools for providing capital and expertise to underperforming companies and companies struggling with
the tremendous pressure of the public markets to meet quarterly

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earnings expectations in order to improve corporate performance.
Private equity funds recruit top managers and directly tie compensation to long-term performance and growth. They develop strategic business plans and implement operational improvements to
revitalize these companies in a manner that can only be achieved
when the firm’s owners are directly and actively engaged in its
management.
Let me conclude by saying that hearings like the one we’re having today are important because they allow Members of Congress
to better understand the industries and markets we oversee. If
Congress attempts to regulate or tax any specific sector of the financial services industry without a thorough understanding of the
role it plays in our financial system the risk of unintended, unnecessary, burdensome and harmful regulation is real. The last thing
we want to do is drive investment—whether it’s hedge funds or private equity funds—and their capital offshore.
So I again commend Chairman Frank for his attention to this
issue, and I welcome our distinguished guests.
The CHAIRMAN. Next, the gentleman from Louisiana, Mr. Baker,
is recognized for 4 minutes.
Mr. BAKER. Thank you, Mr. Chairman, and thank you, Ranking
Member Bachus, for the time. I have some significant questions
about where we stand with this matter.
From the President’s Working Group recommendations of April
1999, there were at that point in financial history some observations I think worthy of reviewing. The Working Group recommendations at that moment emphasize the promotion of sound
risk management practices by all market participants and to allow
individual market participants therefore to make more informed investment and credit decisions.
So the message in 1999 was to the market, get your act together
so people can make informed decisions. I think some assessment of
what has taken place from 1999 until now on the market side of
the fence might be instructive for the committee to hear in light
of the fact of market factors that have changed rather dramatically
since 1999.
There was legislation that was filed pursuant to the 1999 report,
H.R. 2924, implementing the Working Group recommendations, requiring, interestingly enough, the largest unregulated funds to disclose certain public information which was nonproprietary, including a new meaningful measurement of risk.
I also note that the internationally generally accepted FSA regime does require the larger funds to make such disclosure of nonproprietary information to enable governmental regulators to assess not only leverage, but the potential for systemic risk events.
Consistent with the 1999 Working Group, H.R. 2924 did not call—
and I can’t make this any more clear—for direct regulation, but instead provides for enhanced public disclosure by only those funds
that, if large enough, if one were to fail, that failure could potentially pose systemic risks to those innocent third parties.
That set of findings and comments were made by Mr. Sachs, who
was then the Assistant Secretary for Financial Markets for the Department of the Treasury. Mr. Patrick Parkinson’s comments, who
was an Associate Director, Division of Research, for the Federal Re-

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5
serve, went on to say that there was strong support for the 1999
Working Group recommendations and that the very largest funds
should be required to publicly disclose information about their financial activities.
The only modification to H.R. 2924 suggested by the Fed at that
time was that the disclosure should be made to the SEC rather
than the Federal Reserve Board because of the SEC’s broader responsibilities in the field of public disclosure.
My point is that from 1999 until now, it is not only the explosive
growth in the number of funds, but the enormity of growth in individual’s funds. The advent of the fund of funds, which enables the
$25,000 investor to take on risks that were intended for sophisticated, qualified investors and that pension funds now, as a matter
of practice, routinely invest in funds for which I do not believe fund
managers necessarily are adequately equipped to assess the risk
for which the third parties they represent are undertaken.
I foresee a circumstance in which an Amaranth matter might
lead to significant upheaval in State pension funds of some region.
I can think of several in my own State that have displayed significant inadequate governance capabilities that would then lead to a
school teacher or a fireman or a policeman to find their reserves
for retirement dissipated because the fund manager did not fully
understand the counterparty risk that the hedge fund investment
really represented.
I don’t have a remedy for this problem, but I have an observation
about what the recommendations may mean if not fully heeded by
the market, if the 2007 Working Group recommendations and that
message is not fully received. And I have concerns because the
message was sent in 1999, and I don’t know that market discipline
has yielded any regulatory constraints in market practice. Should
we have one of those undesirable events I read from the 1999
Working Group report, page 26, ‘‘Generally government regulation
becomes necessary because of a market failure or the failure of
pricing mechanisms to account for all social costs. Government regulation of markets is largely achieved by regulating financial intermediaries who have access to the Federal safety net, the banks,
that play a central dealer role or that raise funds from the general
public. Any resort to governmental regulation should have a clear
purpose and be carefully evaluated in order to avoid unintended
consequences.’’
I think here my cautionary note is if self-regulation in the market does not work, and we have an untoward event, the resulting
actions of this Congress will be very unhelpful to the market at
large. This is no casual warning. This is a plea for the market to
act, and if they do not, the consequences are very undesirable.
Thank you, Mr. Chairman.
The CHAIRMAN. The gentleman from Pennsylvania is recognized
for such time as he consumes.
Mr. KANJORSKI. Thank you very much, Mr. Chairman.
First of all, let me thank the chairman and ranking member for
commissioning this hearing. It is certainly a topic in which all of
us are interested, and I think that we have labored in the forest
together with Mr. Baker over the years to get some information
and enlightenment.

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From my perspective, I look forward to hearing a real definition
of a hedge fund. I understand that you all have defined it today
so that I will be able to clearly understand the entity with which
we are dealing.
But in all seriousness, the difficulty lies in defining what a hedge
fund is and the import of how it operates in the marketplace; I myself am not worried about protecting individuals of high net worth
or constricting their right to invest and participate in helping the
marketplace to level the field and provide the liquidity that is necessary out there.
On another point, I am disturbed about potential systemic risk
and particularly about the great deal of financing that comes out
of federally insured institutions. This leveraging could cause risk to
the government or systemic risks to the system. I think we are
going to rely on the testimony of this group today to see where we
are headed and what the Congress should do in response to some
of the existing problems out there.
But, I would also agree with Mr. Baker: We hope self-regulation
can be the order of the day. However, if it fails, I hope we do not
hear the cry that we have over-regulated because the Congress will
be called upon to move in very swiftly and very deeply into a control situation. We hope that is not necessary.
I look forward to the Working Group’s report to the Congress
today, and I look forward to working with them in the future.
Thank you, Mr. Chairman.
The CHAIRMAN. The gentleman from Delaware is recognized for
2 minutes.
Mr. CASTLE. Thank you, Mr. Chairman. I thank you and the
ranking member for holding this hearing, and I agree with your
comments, those of the ranking member and everybody else who
has spoken, particularly Mr. Baker, with respect to pension funds
and their investments.
This Working Group has already indicated the tremendous influence hedge funds have on our markets. The hedge funds have more
than doubled in the past 5 years, growing to over 9,000 hedge
funds. Since your last study in 1999, the industry has grown by
more than 400 percent, now totaling nearly $2 trillion. And the
combined assets of the 100 largest hedge funds represent about 65
percent of the total industry.
Secretary Steel further explained the vast amount of trading volume hedge funds are generating. It is speculated that they may
represent up to 50 percent of trading in particular instances, which
is something to think about. The group also discussed how institutional investors like pension funds constitute more than half of the
investments in hedge funds.
With pension funds placing more of their money in hedge funds,
American workers, retirees, and other average investors may unknowingly be exposed to hedge fund losses. The President’s Working Group recommended that investors in hedge funds gather necessary information regarding the fund’s strategies, terms, conditions and risk management to make informed investment decisions
and perform due diligence, yet hedge funds are not required to disclose this information.

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I am concerned with this lack of transparency because the manager of a pension fund cannot fulfill their fiduciary duty and may
not understand the risk to their investments to perform due diligence before committing funds. The lack of transparency in the industry may also pose systemic risk. The long-term capital management incident showed how overexposure of counterparties had the
potential to cause systemwide damage to financial markets.
After LTCM, the Working Group recommended the very largest
hedge funds be required to disclose information about their financial activities, including meaningful and comprehensive measures
of market risk. The Working Group now concludes that no government agency needs any information about hedge fund activities and
that we can rely on hedge fund investors themselves to protect the
markets from systemic risk.
It is unclear to me why the Treasury now appears a lot less cautious than they were in 1999 since the industry has grown considerably. More recently the New York Federal Reserve has repeatedly warned that hedge funds pose the largest risk since the LTCM
crisis and Treasury officials have forewarned financial institutions
about hedge fund vulnerability.
There are many instances of pension fund involvement now. And
the bottom line is that while I don’t know the answers either, as
the chairman and ranking member indicated, I do think we need
to be looking very carefully at what we are doing here. I yield back
the balance of my time.
The CHAIRMAN. The gentlewoman from California for 2 minutes,
or as much time as she consumes.
Ms. WATERS. Thank you very much, Mr. Chairman and members. I want to thank Chairman Frank and Ranking Member Bachus for holding the second in a series of hearings on the issue of
hedge funds.
These hearings are designed to examine the emerging role of
hedge funds and private equity pools in the United States and global markets. Indeed, this is a timely hearing because I have become
somewhat fascinated by hedge funds and their dramatic growth
over the last several years.
The estimate suggests that hedge funds have grown in number
to more than 9,000—double what they were just 5 years ago. The
assets have also grown by some 400 percent to $1.4 trillion.
The primary purpose of hedge funds is to reduce volatility and
risk while attempting to preserve capital and deliver positive returns under all market conditions.
Have the funds grown because they are the most flexible investment tool in today’s volatile financial system? I ask this question
because in the past few months it has been revealed that a number
of hedge funds are heavily invested in mortgage backed securities
related to subprime loans.
According to the New York Times, the Bear Stearns Company,
an investment bank, pledged up to $3.2 billion in loans to bail out
one of the hedge funds that was collapsing because of bad bets on
subprime mortgages. It is the biggest rescue of a hedge fund since
1998 when more than a dozen lenders provided $3.6 billion to save
Longterm Capital Management.

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Unfortunately, it is precisely this type of investment activity that
raises concerns in the marketplace. I’m sure that we have just seen
the tip of the iceberg as it relates to subprime lending, 2.2 million
defaults, according to some estimates, by next year.
Interestingly, some hedge fund strategies are designed to capitalize on these negative conditions in the market. So what are the
cost benefits associated with hedge fund activity in the United
States and in the global economy?
I thank you and I look forward to hearing our witnesses today.
I yield back the balance of my time.
The CHAIRMAN. The gentleman from California, Mr. Royce, is
recognized for 3 minutes.
Mr. ROYCE. Thank you very much, Mr. Chairman.
The CHAIRMAN. Before the gentleman begins, let me just say to
the people here that we have a limited number of opening statements. We have about 10 more minutes of opening statements, so
I do want to reassure people that we will get to you.
The gentleman from California.
Mr. ROYCE. Thank you, Mr. Chairman, and thank you for holding this hearing on hedge funds and the effect on our capital markets that they have. I’d also like to commend the members of the
President’s Working Group for their work on this issue.
The role of hedge funds clearly continues to evolve, and as you’ve
mentioned, the hedge funds have experienced incredible growth—
the numbers I’ve seen, from $50 billion in assets in 1988, to today
totaling over $1 trillion. While both the size and scope of these private pools of capital have changed over the years, their unique ability to bring significant benefits to the financial markets still remain.
The varying strategies utilized by hedge funds, which results in
additional liquidity, has helped the U.S. financial markets become
the deepest and most liquid markets in the world today. The ability
of hedge funds to target price inefficiencies between markets has
also proven to be a useful tool that has resulted also in more efficient markets.
Furthermore, their ability to transfer and distribute risk allows
market participants to more easily manage the level of risk held
on their portfolio. While the broader financial system has gained
from the presence of hedge funds, an inherent risk will always accompany those private pools of capital that we call hedge funds.
Banks and other depository institutions that choose to extend
credit or choose to be counterparties to hedge funds must make
well-informed, sound business decisions. Regulators with authority
over banking systems should focus their attention on preventing
the institutions which they oversee from taking on excessive risk.
If market discipline and prudent risk management is practiced, the
likelihood of a systemic shock will be greatly reduced.
Again, Mr. Chairman, I would like to thank you for exploring
this issue today, and I look forward to hearing from our distinguished witnesses.
The CHAIRMAN. The gentlewoman from New York, for 3 minutes.
Mrs. MALONEY. Thank you, Mr. Chairman, and Ranking Member
Bachus, for holding this incredibly important hearing. I welcome

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9
the members of the President’s Working Group, and I very much
look forward to your testimony.
I hope that I hear in your testimony answers to some of the concerns that my colleagues and I have about hedge funds. There has
been a tremendous amount of media coverage of the potential that
a fire sale of CDOs triggered by Bear Stearns hedge funds could
have upon the entire financial system.
At the heart of these concerns appears to be a fear that such a
public sale of CDOs would clearly set market prices that are way
below the value at which many pension funds and endowments and
banks are carrying these products on their books.
I specifically hope to hear what steps the President’s Working
Group is taking to ensure that there are best practices for evaluation of these types of securities and products across all types of institutions. I specifically want to hear, did any of the agencies comprising the President’s Working Group weigh in with the creditors
of the Bear Stearns fund to encourage them to forebear on selling
off the collateral until such time as Bear could decide to back the
funds with their own capital.
I share the concerns of my colleagues of the impact this has on
pension funds invested in hedge funds. I am deeply concerned and
hope you will address what, if any, concerns you have with the size
and complexity of collateralized debt obligations, these CDOs, especially the difficulty investors have in adequately understanding and
identifying the true value of these securities.
And given the difficulty in having a day-to-day value on
collateralized debt obligations and given the sheer size of these
CDOs, what concerns do you have about the systemic risk of these
securities?
I was really surprised and startled to learn from the head of the
SEC, Chairman Cox, that he is investigating 12 separate investigations in this particular area, which raises a concern that he must
have, and I want to know, do you share that concern, and what
best practices and advice do you give us today? I thank you for
your work and for your time.
The CHAIRMAN. The gentleman from Texas, Mr. Hensarling, for
2 minutes.
Mr. HENSARLING. Thank you, Mr. Chairman. I too look forward
to this hearing.
As of yet, I haven’t seen evidence of a level of systemic risk that
warrants direct Federal regulation but I certainly have an open
mind so I look forward to hearing from the witnesses.
I have noted in previous statements of our former Fed Chairman
and our present Fed Chairman that have cautioned us about the
risk involved in direct regulation of the hedge fund industry. And
although it has been many years, and I hold myself as no expert,
there was a time when I was employed at a hedge fund. And at
that point I saw a level of expertise from the investors, endowments, pension funds, and charitable foundations that led me to believe that certainly private market discipline was alive and well
and that properly informed sophisticated investors provide that
level of discipline which is needed.
We all know that there has been a certain amount of negative
press recently regarding hedge funds and I hope we all remember

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in this committee the role that they play in helping create jobs and
our economy, helping our investors receive superior returns, and
keeping the economy growing.
And as the gentleman, the ranking member from Alabama well
noted, capital can move overseas. So the area of regulation is one
that we need to approach, I believe, with some trepidation.
Although this hearing is focusing on systemic risk, I am too disturbed, as the ranking member noted, by a flurry of proposals to
do everything from increasing taxation on carried interest to penalizing tax exempt organizations that invest in hedge funds. And potentially these proposals may pose even a greater risk to our economy, and so I believe that should be duly noted.
And I trust any of these proposals that come around will be thoroughly vetted and debated at some length. With that, I thank
again, Mr. Chairman, for holding this hearing. I yield back the balance of my time.
The CHAIRMAN. The gentleman from Georgia.
Mr. SCOTT. Thank you, Mr. Chairman. This is indeed a very important hearing, but I think we have to look at the facts and be
able to make some very objective decisions.
Hedge funds are playing a very important and significant economic role in our economy. The whole private equity transactions
in the United States last year totaled over $400 billion, and between 1991 and 2006, created more than $30 billion in profit for
our investors.
The funds hold unmatched sway over our markets. They are responsible for more than a third of our stock trades, control more
than $2 trillion worth of assets, and each of the top hedge fund
managers earned more than $1 billion in 2006. So this is a very
serious and impactful area.
My major concern is, taking the example of Bear Stearns, which
recently admitted it would need to add some $1.6 billion to prevent
the fund from a total collapse—now granted, many bankers and
regulators consider this process to be one of the great advances in
finance over the past 5 years, however the trouble, as Bear Stearns
points out and shows that this system may not be as crash-proof
as we once thought.
How dependent has our system now become on hedge funds, for
example? Are these trades becoming more risky? Should more of
these funds begin to unravel? Who absorbs the losses and at what
costs to all who are involved?
What I’m really concerned about is that no one really knows, including the funds’ lenders, what its exotic portfolio or risk mortgage derivatives is really worth.
And finally, as hedge funds are purchasing all sorts of illiquid,
hard-to-value assets, are we worried about or do we even care to
know what these assets are really worth, and are we worried that
hedge funds’ managers are coming up with suspicious valuations
using financial models that aren’t necessarily based on what the
assets would fetch in the open market?
These are very serious questions. No decision has been made
whether we—and what type of regulation, but it is very, very incumbent upon us to ask the serious, in-depth, clear, incise ques-

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tions when you look at the extraordinary economic impact that
hedge funds have in our investment community.
Thank you, Mr. Chairman. I yield back the balance of my time.
The CHAIRMAN. I thank the gentleman.
As we proceed to the testimony, several of us have talked about
the international aspect. We have, I am pleased to acknowledge,
recognition of that because observing the hearing is Duzana
Vavrova, who is the administrator in the directorate general on internal policies of the Committee on Economic and Monetary Affairs
of the European Parliament, presumably our counterpart. So we
welcome this.
Several of us have been meeting with our European counterparts. Indeed, a delegation from this committee, members and
staff, bipartisan staff met in both London and Brussels with EU
and British regulators because of the importance of this.
Secondly, I’m going to ask unanimous consent to introduce into
the record two items. First, an item which is related, not specifically to hedge funds, but a very interesting and sobering comment
from Moody’s Investors Service, a special comment of July 2007 on
rating private equity transactions expressing some concerns about
their ability to do that and about the risks that are increasing.
And second, an article from yesterday’s Financial Times by
Mohamed El-Erian, who runs the Harvard Firm, entitled, ‘‘How to
Reduce Risk in the Financial System,’’ expressing concern that
some of the investors in these funds are themselves regulated by
entities that are not up to the job of regulating instruments of this
degree of complexity. None of you here, you’re off the hook. But
they are talking about some of the buyers, and it relates to pension
funds, insurance industry.
As we know, one of the things that this committee will be looking
at is the structure of the insurance industry because uniquely in
America you have this very important financial industry, the insurance industry, particularly in the life side but in general that’s entirely State-regulated. And what that means is to the extent that
insurance companies are big players here, and pension funds to a
great extent, none of you have the kind of supervisory role that
you’ll have over banks and other counterparties.
And that is one of the issues that will deserve some attention,
so I ask that these two articles be put into the record. There being
no objection, they will be put in.
And we will begin our testimony, and we will begin with an introduction. Our colleague from Connecticut, he’s very busy when
we deal with hedge funds because half the time he’s introducing
the people who run hedge funds, and live in his district, and then
the other half he’s introducing the people who regulate the hedge
funds who live in his district.
So if we just—we could probably move the whole thing to Greenwich and save a lot of travel time on witness fees. But the gentleman from Connecticut is recognized.
Mr. SHAYS. Thank you, Mr. Chairman. I feel a little guilty, because last time I didn’t introduce this individual, and I did introduce someone else, so I would like to welcome all our of witnesses,
but in particular, Under Secretary Robert Steel, who hails from

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Connecticut’s 4th District, and you nailed Greenwich pretty well,
Mr. Chairman.
The Under Secretary leads the Treasury Department’s activities
with respect to the domestic financial system, fiscal policy and operations, government assets and liabilities, and related economic
and financial matters. I have appreciated the chance to get to know
Secretary Steel, who has extensive experience in the private sector
as well as academia. Bob Steel is straightforward, sharp, and someone whose perspectives and recommendations I appreciate and respect a great deal, and I welcome him.
The CHAIRMAN. Thank you. Mr. Steel, with that, why don’t you
begin with you, and we’ll down the list after that.
STATEMENT OF THE HONORABLE ROBERT K. STEEL, UNDER
SECRETARY FOR DOMESTIC FINANCE, U.S. DEPARTMENT OF
THE TREASURY

Mr. STEEL. Good morning, Chairman Frank, Ranking Member
Bachus, and members of the committee. It’s a privilege to be with
you today. Thank you for holding this hearing and inviting the
Treasury Department to present our perspective on the important
topic of hedge funds and systemic risk.
Today I am representing both the Treasury Department and
more specifically, Secretary Paulson, in his capacity as the Chairman of the President’s Working Group on Financial Markets. Fostering financial preparedness is part of the core mission of the
Treasury Department.
Under Secretary Paulson’s leadership, the four members of the
President’s Working Group, along with the Office of the Comptroller of the Currency and the Federal Reserve Bank of New York,
have issued a call to action directing all market participants to undertake efforts that mitigate the likelihood and impact of a systemic risk event caused by private pools of capital.
Private pools of capital, which include hedge funds as well as private equity and venture capital funds, exemplify the innovation
that make our capital markets the strongest in the world. These
investment vehicles bring many benefits to our markets, including
liquidity, price discovery, and risk dispersion. Yet the rapid growth
in size and scope of private pools of capital has brought challenges
to our markets, particularly in areas of investor protection, market
integrity, and the potential for systemic risk.
To address these challenges, the President’s Working Group released principles and guidelines for private pools of capital in February. These ten principles and the clarifying guidelines do not represent an endorsement of the status quo, but instead reflects, we
hope, the uniform view of all relevant regulators that heightened
vigilance is necessary and appropriate.
While it is not our current expectation, we should remain vigilant to the possibility that significant losses by a highly leveraged
hedge fund could present systemic challenges to the broader financial system. Therefore, the principles and guidelines make a number of very specific suggestions for improved vigilance in market
discipline so as to mitigate systemic risk.
Hedge funds’ clientele, originally wealthy investors, has shifted
to become one that is comprised more of institutional investors, in

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many cases representing individual investors who may be less sophisticated. Investment fiduciaries, such as pension funds, do have
a responsibility to perform due diligence to ensure that their investment decisions on behalf of these beneficiaries and clients are
prudent.
These principles also emphasize the responsibility of managers to
provide accurate and timely information so that investors can make
informed decisions. Additionally, supervisors must work within the
existing regulatory framework, utilizing their broad anti-fraud and
anti-manipulation authority to address these issues of investor protection.
Our next step is to ensure that all four groups of the market participants—the regulators and supervisors, the counterparties, and
the creditors, the actual managers of the private pools of capital
themselves, and the pool investors—adopt and use these principles
and guidelines. We are very encouraged by the initial response, as
much good progress is currently underway.
Additionally, these principles and guidelines have been very well
received by policymakers, regulators, industry leaders, and the general public, both in the United States and overseas.
Regulators and supervisors are already involved in a range of important initiatives. Supervisors are engaged in ongoing reviews of
creditors’ and counterparties’ practices. These efforts are aimed at
improving the sophistication of stress-testing practice, counterparty
credit risk management and over-the-counter derivatives, structured credit, hedge funds, and the post-trade processing infrastructure of the over-the-counter derivatives market.
Consistent with my representation that we are not standing still,
just 2 weeks ago, Secretary Paulson announced that we, at the
President’s Working Group, will work with the private sector to develop and adopt industry best practices for both investors and the
asset managers of hedge funds.
The President’s Working Group is facilitating the establishment
of two separate yet complementary private sector groups, one comprised of hedge fund managers, and the other comprised of hedge
fund investors. These two groups will develop best practices for
their respective stakeholder groups that address investor protection, enhanced market discipline, and also help to mitigate systemic risk.
The President’s Working Group will serve as an ongoing
facilitator for these groups. We are engaging a broad spectrum of
market participants to develop high quality best practices. The nature of a competitive marketplace is such that when leaders adopt
best practices, others in the industry feel pressure to do the same.
All market participants must be accountable to help ensure the integrity of our capital markets.
While substantial progress has already been made, there is still
much work to be done. Building upon efforts to date, all stakeholders must continue to do more. We look forward to the development and implementation of coherent best practices for the investors and hedge fund managers.
Our system works well when market participants recognize the
benefits, mitigate the risks, and choose to be diligent. We look for-

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14
ward to a continued dialogue with this committee on these important issues.
Thank you, sir, and I look forward to your questions.
[The prepared statement of Under Secretary Steel can be found
on page 61 of the appendix.]
The CHAIRMAN. Next we’ll hear from Kevin Warsh, who is a
member of the Board of Governors of the Federal Reserve System.
STATEMENT OF THE HONORABLE KEVIN M. WARSH, MEMBER,
BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

Mr. WARSH. Thank you very much, Chairman Frank, Ranking
Member Bachus, and other members of the committee here today.
I appreciate the opportunity to appear on behalf of the Board of
Governors of the Federal Reserve System to discuss the systemic
risk implications of hedge funds.
The Board believes that the increased scale and scope of hedge
funds has brought significant net benefits to financial markets. Indeed, hedge funds, as many of you have mentioned in your opening
statements, have the potential to reduce systemic risk by disbursing risks more broadly and by serving as a large pool of opportunistic capital that can stabilize financial markets in the event of
disturbance.
At the same time, the recent growth of hedge funds presents
some formidable challenges to the achievement of key public policy
objectives, including significant risk management challenges to
market participants. Of course, if market participants prove unwilling or unable to meet these challenges, losses in the hedge fund
sector could pose significant risks to financial stability.
The Board believes that the principles and guidelines regarding
private pools of capital issued by the President’s Working Group on
Financial Markets, just in February, provide a sound framework
for addressing these challenges associated with hedge funds, including the subject of today’s hearing, the potential for systemic
risk.
The Board shares the considered judgment of the PWG: The most
effective mechanism for limiting systemic risks from hedge funds
is market discipline. And the most important providers of market
discipline are the large global, commercial, and investment banks
that are their principal creditors and counterparties.
This emphasis on market discipline neither endorses the status
quo nor implies a passive role for government. In recent years, the
global banks have significantly strengthened their practices and
procedures for managing risk exposures. But further progress on
this front is needed, in no small part because of the increasing complexity of structured credit products such as collateralized debt obligations.
The Board believes that even those banks with the most sophisticated risk management practices must further strengthen their enterprise-wide systems to put the PWG principles fully into practice.
As these principles rightly emphasize, supervisors of global banks
are responsible for promoting market discipline by monitoring and
evaluating banks’ management of their exposure to hedge funds.
As the umbrella supervisor of U.S. bank holding companies, the
Fed continues to pay keen attention to hedge fund exposures and

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15
is working to ensure stronger risk management practices. In addition, through the Reserve Bank of New York, the Fed is actively
facilitating collaboration and coordination among domestic and
international supervisors of these global banks that are key
counterparties and key creditors.
This area of significant focus targeting management of exposure
to hedge funds is part of a broader, comprehensive set of supervisory initiatives that seeks to ensure that banks’ risk management
practices and market infrastructures are sufficiently robust to cope
with stresses that may accompany a deterioration in market conditions.
To this end, the Federal Reserve has been focusing on five key
supervisory initiatives: First, comprehensive review of firms’ stresstesting practices; second, a multilateral supervisory assessment of
the leading banks’ current practices for managing their exposures
to hedge funds; third, a review of the risks associated with the
rapid growth of leveraged lending; fourth, a new assessment of
practices to manage liquidity risk; and fifth, continued efforts to reduce risks associated with weaknesses in the clearing and settlement of credit derivatives and other over-the-counter derivatives.
Indeed, this committee should be assured that the Federal Reserve has taken on these initiatives with great purpose and resolve.
The initiatives are fully consistent with the founding purpose assigned to the Fed by Congress to help mitigate the risks to the financial system and the broader economy caused by periodic bouts
of instability and financial stress.
Thank you again, Mr. Chairman. I’d be happy to respond to your
questions.
[The prepared statement of Governor Warsh can be found on
page 67 of the appendix.]
The CHAIRMAN. Next, Mr. Jim Overdahl, who is the Chief Economist at the Commodity Futures Trading Commission. We welcome
you in your rare appearance away from the Agriculture Committee
here, where you really belong.
[Laughter]
STATEMENT OF JAMES A. OVERDAHL, CHIEF ECONOMIST, U.S.
COMMODITY FUTURES TRADING COMMISSION

Mr. OVERDAHL. Thank you, Mr. Chairman, Congressman Bachus,
and members of the committee. I am pleased to have this opportunity to testify on behalf of the CFTC regarding hedge funds and
systemic risk.
The Chairman of the CFTC is a member of the President’s Working Group on Financial Markets, and he participated in the deliberations that resulted in the agreement announced by the PWG in
February, setting out principles and guidelines regarding private
pools of capital, including hedge funds.
I will focus my remarks today on how hedge funds intersect with
the CFTC’s responsibilities under its governing statute, the Commodity Exchange Act, or CEA. At the outset, I should emphasize
that the CFTC does not regulate hedge funds per se. However, the
CFTC encounters hedge funds as it performs two of its critical missions under the CEA—promoting market integrity and protecting
the public from fraud in the sale of futures and commodity options.

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Hedge funds are on the CFTC’s market surveillance radar when
they trade in regulated futures and commodity options markets regardless of whether their operators and advisors are registered or
not. With respect to investor protection, if a collective investment
vehicle such as hedge fund trades futures or commodity options,
the fund is a commodity pool, and its operator and advisor may be
required to register with the CFTC and meet certain disclosure, reporting, and recordkeeping requirements.
Futures markets serve an important role in our economy by providing a means of transferring risk from those who do not want it
to those who are willing to accept it, for a price. In order for businesses to hedge the risk they face in their day-to-day commercial
activities, they need to trade with someone willing to accept the
risk the hedger is trying to shed. Data from the CFTC’s larger
trader reporting system are consistent with the notion that hedge
funds and other professionally managed funds often are the ones
absorbing the risks hedgers are trying to shed.
Hedge funds also play a vital role in keeping the prices of related
futures contracts in proper alignment with one another. In addition, hedge funds add to overall trading volume, which contributes
to the formation of liquid and well functioning markets. Over the
past decade, the average number of funds participating in futures
markets has grown across nearly all market segments. Also it appears that funds, on average, hold positions in more markets today
than they did a decade ago.
One notable development over the past 5 years has been the increased participation by hedge funds and other institutional investors in futures markets for physical commodities. These institutions have allocated a portion of the investment portfolios they
manage into commodity-linked investment products. A significant
portion of this investment finds its way into futures markets, either through the direct participation of those whose commodity investments are benchmarked to a commodity index, or through the
participation of commodity index swap dealers who use futures
markets to hedge the risk associated with their dealing activities.
The CFTC relies on a program of market surveillance to ensure
that markets under CFTC jurisdiction are operating in an open
and competitive manner. The heart of the CFTC’s market surveillance program is its large trader reporting system. For surveillance
purposes, the larger trader reporting requirements for hedge funds
are the same as for any other larger trader. In addition to regular
market surveillance, the CFTC conducts an aggressive enforcement
program that deters would-be violators by sending a clear message
that improper conduct will not be tolerated.
The financial distress of any large futures trader poses potential
risks to other futures market participants. With respect to commodity pools operating as hedge funds, the CFTC addresses these
risks through its oversight of futures clearinghouses and the clearing member firms of each clearinghouse. This oversight regime is
designed to ensure that the financial distress of any single market
participant, whether or not that participant is a hedge fund, does
not have a disproportionate effect on the overall market. It is
through this oversight regime that the CFTC does its part in helping to mitigate systemic risk.

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In closing, the CFTC will remain vigilant in utilizing the tools
provided in the CEA: Market surveillance; disclosure; reporting;
recordkeeping; and enforcement authority, to fulfill its statutory responsibilities as hedge fund participation in futures markets continues to expand.
This concludes my remarks, and I look forward to your questions.
[The prepared statement of Mr. Overdahl can be found on page
42 of the appendix.]
The CHAIRMAN. Next, Dr. Erik Sirri, who is the Director of the
Division of Market Regulation at the SEC.
STATEMENT OF ERIK R. SIRRI, DIRECTOR, DIVISION OF MARKET REGULATION, U.S. SECURITIES AND EXCHANGE COMMISSION

Mr. Sirri. Chairman Frank, Ranking Member Bachus, and members of the committee, on behalf of the Securities and Exchange
Commission, I appreciate the opportunity to speak to you today regarding recent initiatives being taken by the Commission with respect to hedge funds.
As you know, the President’s Working Group released principles
and guidelines regarding private pools of capital. These principles
complement and inform the regulatory and supervisory work of
each of the PWG agencies with respect to investors, fiduciaries,
creditors, and counterparties.
Even as the Commission believes that private pools of capital
such as hedge funds bring significant benefits to financial markets,
the Commission is also working diligently to protect hedge fund investors and other market participants against fraud, and to ameliorate, through its oversight of internationally active securities firms,
the broader systemic risks such funds potential pose to our financial system.
The Commission’s work in this area includes vigorous enforcement activities related to the Federal securities laws, the Commission’s Consolidated Supervised Entity Program, and as appropriate,
regulatory improvement.
I will focus my oral remarks today on the oversight function. At
present the Commission supervises five securities firms on a consolidated or groupwide basis. These include Bear Stearns, Goldman
Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley.
These firms are known as the CSEs. For such firms, the Commission oversees not only the registered broker-dealer but also the consolidated entity; that is, the holding company, which may include
regulated entities, such as foreign-registered broker-dealers and
banks, as well as unregulated entities, such as derivatives dealers
and the holding company itself.
The Commission’s CSE program is designed to provide holding
company supervision in a manner that is broadly consistent with
the oversight provided to bank holding companies by the Federal
Reserve. The aim of this program is to diminish the likelihood that
weakness in the holding company itself or any of the unregulated
entities places a regulated entity, such as a bank or a broker-dealer, or the broader financial system, at risk.
The CSEs are subject to a number of requirements under the
program, including monthly computation of a capital adequacy

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18
measure consistent with the Basel II Standard, maintenance of
substantial amounts of liquidity at the holding company level, and
documentation of a comprehensive system of internal controls that
are subject to Commission inspection.
The primary concern of the CSE program with regard to hedge
funds revolves around the risks they potentially pose to CSE firms
specifically, and through CSEs to the financial system.
The Commission’s CSE program monitors and assesses these
risks in several ways.
First, the Commission staff meets at least monthly with senior
risk managers at the CSEs to review market and credit risk exposures, including those to hedge funds. The process provides information not only concerning the potential risk to CSEs, but also a
broader window into the relationship with hedge funds, and those
hedge funds’ potential impact on the broader financial markets.
Second, Commission staff has recently engaged in targeted discussions with the CSEs about the challenges of measuring credit
exposures to hedge funds.
And finally, the Commission’s staff has embarked on a joint
project with the Federal Reserve and the UK’s Financial Services
Authority to understand current in Street practices of banks and
broker-dealers in managing their exposures to hedge funds. The
agencies have identified a number of issues related to the extension
of credit to hedge funds and are now addressing those issues in a
second phase which entails more detailed work by the principal
regulator of each firm.
Taken together, these efforts allow us to identify some trends
that we and our supervisory colleagues, as well as the risk managers at the large banks and securities firms, will follow more
closely. The demise of Amaranth and the issues associated with the
Bear Stearns managed hedge funds also provide some interesting
datapoints to consider.
First, some of the largest and most systemically important hedge
funds are beginning to look more and more like mature financial
institutions, diversifying their portfolios beyond leveraged equity
and fixed-income strategies, and diversifying beyond their activities
in proprietary trading.
Second, hedge funds generally have become more sophisticated
about risk management, in part by negotiating more flexible credit
terms with dealer banks.
Third, in some markets, hedge funds are the major providers of
liquidity. The impact that the Bear Stearns’ hedge funds losses is
having on the subprime market illustrates this point.
Finally, leverage can be achieved in a myriad of ways. The ability to engineer economic leverage through structured products is almost infinite, and that can be seen in the CDO markets.
The supervisory focus on excessive leverage, we believe, is the
right one. It is far from simple in today’s innovative financial markets. While these trends will continue to challenge the regulated
institutions and their supervisors, the focus in recent years on
counterparty credit risk management has clearly been good for financial institutions and the financial system as a whole.
After the failure of long-term capital management in 1998, the
Counterparty Risk Management Policy Group brought together

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senior policy managers from the major commercial and investment
banks—excuse me, senior risk managers—to consider the lessons of
that event. The report addressed systemic risk concerns by articulating best practices in counterparty risk management appropriate
to such regulated entities such as banks and securities firms.
The Counterparty Risk Management Policy Group also issued a
second report in July of 2005 that dealt with developments since
the initial report, including the proliferation of products with embedded leverage and securitization. More work remains to be done
in these areas, and we must not in fact become complacent here.
In conclusion there is no guarantee that the favorable conditions
that allowed for the orderly unwinding of Amaranth, and thus far
Bear Stearns managed hedge funds will persist. We must assume,
in fact, that they will not. The supervisory community must continue to engage with systemically important banks and securities
firms and encourage additional efforts to expand their risk management capabilities.
We will continue to work with our PWG colleagues and other
market participants, hopefully including some of the larger hedge
funds, to further this agenda.
I thank you for the opportunity to testify today, and I’d be happy
to take any of your questions.
[The prepared statement of Mr. Sirri can be found on page 49 of
the appendix.]
The CHAIRMAN. Thank you. I’m going to begin with a very specific question. It would be aimed to probably the SEC. When we
had the hedge fund managers, a panel of them before us, one issue
that came up was that they noted that many of them are already
required to register with somebody or another. Ms. Robinal mentioned many of them do that.
One suggestion that somebody made, I forget who, but they all
seemed to agree with was this: There is a potential for insider trading here because of the kind of integrated degree of activity. There
was a proposed suggestion that all of them agreed to that over and
above any other form of regulation or registration, there be a document retention requirement so that if allegations came up of inappropriate practices, that could be done.
You mentioned, Dr. Sirri, that you’re working on enforcement.
What would your response be to a document retention requirement
for those entities that did not otherwise have one because they
were required to register for some other reason?
Mr. SIRRI. Well, I think it’s important to consider the Commission’s authority over hedge funds. You quite correctly make the distinction that there are two groups of hedge funds. There are those
that are registered—there are about 2,000 of those—and then there
are those that are unregistered.
But it’s important to realize that with respect to either of those,
the Commission maintains anti-fraud authority—
The CHAIRMAN. Well, I understand that. But what some people
suggested was that the ones that are unregistered don’t have a document retention requirement. And the suggestion was simply to
give a document retention requirement to those so that was there
if you needed enforcement.

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Mr. SIRRI. Sure. And on the registered end, books and records requirements are in place. For the unregistered entities, we would
have no authority to require that. That may be—
The CHAIRMAN. Well, I understand that. But you’re not before a
court now. You’re before the Congress. We make the laws, sometimes. Sometimes we don’t. My question to you, I’m sorry if it
wasn’t clearer, is what would you think about our passing a law
that would enhance your authority to require document retention
among the unregistered?
Mr. SIRRI. I think we’d have to be very careful of the tradeoff
there. The potential benefit of something like that has to do with
fraud in the markets and the example that you gave. The potential
cost of something like that is to cause those hedge funds to leave
the United States and perhaps locate overseas.
The CHAIRMAN. But I will say, none of them raised that when we
asked them. They all—or maybe we had an unusually quiescent
group. I don’t think we tried to find that.
Let me just ask you, with regard to registration, Mr. Overdahl,
you mentioned that some are registered with you. Now you say
2,000 are registered with the SEC. Are there funds that register
with the CFTC that don’t register with the SEC?
Mr. OVERDAHL. We do not register funds per se. We register advisors and operators.
The CHAIRMAN. Right.
Mr. OVERDAHL. And there will often times be overlap between—
The CHAIRMAN. Are there some that register with you, though,
that don’t have to register with the SEC?
Mr. OVERDAHL. Absolutely. There are some funds or operators of
funds that are operating pools that are exclusively futures pools
that will be registered with us as opposed to the SEC.
The CHAIRMAN. Is that at all a problem that jurisdiction, should
you share information about them? How does that work? We have
entities that many of us would think are doing very similar things,
and some of them aren’t registered at all, and some are registered
with the SEC, and some are registered with the CFTC. My sense
is that was due to nobody’s plan, but that just was a result of other
decisions. Is that something we ought to be trying to rationalize?
Let me ask Mr. Steel, what’s your sense of how that breaks out?
In terms of the split between those that register at the CFTC,
those that register at the SEC, and those that aren’t registered—
is that a rational distribution now, do you believe?
Mr. STEEL. No. I think that consistent with things that we’ve
talked about at Treasury, this has developed in a patchwork basis,
and there isn’t an overarching strategy, that people have chosen a
regulator or chosen not to be regulated, and that’s the reality of the
situation today.
The CHAIRMAN. Should we change that if we could work together
on a collaborative way to do that?
Mr. STEEL. Well, I think that there’s no question. Just a week
or two ago, Secretary Paulson announced that one of the goals he
had was to look at this on a holistic basis, and I would think that
as part of that examination, with the goal of writing a blueprint
of what regulations should look like—
The CHAIRMAN. Very good.

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Mr. STEEL.—that this would be part of that.
The CHAIRMAN. Well, I appreciate it. So in other words, when we
talk about the regulation, which includes banking and other things,
I think that’s—I mean, whatever one thinks about what degree of
registration or whether there should be or shouldn’t be, it ought to
be the result of conscious decisions by people, not just random.
Let me say in closing, and I understand we’re not rushing to register and regulate, but regulation shouldn’t be a bad word. As we
look at the subprime crisis, it strikes me that there are two groups
of entities that have made loans to people in the subprime category: regulated entities, i.e., depository institutions regulated by
the banks; and unregulated entities, brokers and others, who are
subject to no such regulation.
I think it’s fairly clear. If only regulated entities had made
subprime loans, we wouldn’t have a crisis. The overwhelming number of loans that have caused problems were made by unregulated
entities. And it does seem to me an argument for the sensible kind
of regulation that I believe we have with regard to depository institutions. So I would hope that people would not automatically assume that regulation has to be a bad thing. If we would have had
more regulation of lenders in the subprime area, we would have
had less of a subprime crisis.
The gentleman from Alabama.
Mr. BACHUS. Thank you, Mr. Chairman. Mr. Chairman, first I’d
like to acknowledge our former staff director of the committee, Bob
Foster. Bob, if you’d stand up, we welcome you back to the committee. You did a very professional job here, and I think you will
do the same at the Treasury Department.
The CHAIRMAN. You haven’t mentioned his new position. You just
had him stand up. You didn’t mention his new job.
Mr. BACHUS. He is—Under Secretary Steel, is he—
Mr. STEEL. He’s working in Legislative Affairs as a Deputy Assistant Secretary, and we welcome him to Treasury with his good
wisdom.
Mr. BACHUS. Thank you.
The CHAIRMAN. And he comes with a due respect for congressional prerogative.
[Laughter]
Mr. BACHUS. Or disrespect. Let me start by saying, I don’t think
anyone on the Republican side discounts the existence of risk. In
fact, you know, risk is inherent in the market and probably—the
markets, so there’s a high degree of risk in the markets at this
time. I think the President’s Working Group has acknowledged
that some of these sophisticated investments, although they diminish risk in many respects, there is the potential for systemic risk.
I think what many of us, Mr. Hensarling and I particularly discussed in our opening statements, what we discount is the ability
of Congress to intervene constructively at this point. In other
words, as the chairman said, pass a law.
I’m not sure that that—I don’t see that bringing stability to the
market. In fact, especially some calls recently to increase taxation
on capital, I don’t in any way see how that could bring stability or
have a positive effect on the market. So, in fact, I see them having
a very detrimental effect at this particular time.

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Some of the members in their opening statements also mentioned
transparency and disclosure. You know, we talk about those terms
almost as ‘‘mom’’ and ‘‘apple pie.’’
But—Secretary Steel, you made a speech to the Manhattan Institute when you talked about one potential problem with further regulation, and that’s that investors begin to take comfort in, you
know, the—almost like a stamp of approval. The government is
regulating these. Would you like to comment on that?
And before you do, Dr. Sirri pointed out something else. Yes, you
know, we could require or regulators could require more disclosure,
more transparency, but, you know, we run into two things, two
problems there that I see. One is that a lot of this is proprietary.
These are proprietary methods. There are strategies that they engage in, and I’m not sure that would not have a chilling effect, and
I’m not sure even some constitutional limitations we may have on
asking people to give out their proprietary—you know, their actually property right.
But as Dr. Sirri pointed out, they have an option to disclose.
They have an option to paying greater taxes, and that option is
taking that capital to China or India or South America or offshore.
And I can tell you, if anything that I do believe this morning, withdrawing capital out of the United States, I do know that would
have a destabilizing effect on our economy and our market, and
just the last thing we need at this time is taxation or regulation
that would cause a flight of capital out of the United States.
So with that, let me ask Secretary Steel, would you comment
again on your remarks at the Manhattan Institute, which I believe
are very valid?
Mr. STEEL. I think if I could frame this through the lens, as you
said, of the important issues of transparency and disclosure, and
then I think you asked me to comment further on the issue of
moral hazard, I think that you’re correct. Transparency and disclosure are important issues, but I would want to frame it with to
whom and for what end.
Basically, we believe the key aspects of transparency and disclosure in the President’s Working Group, that we’ve tried to codify
in the principles and guidelines, really relate to two specific
areas—very good transparency and disclosure from the fund manager to the regulated entities that are providing the capital and
loaning them money, and the disclosure there should be quite good.
In our guidelines, we’ve written about this and tried to give very
specific examples of the type of transparency and disclosure that’s
appropriate. And if you don’t have that type of very, very high
transparency and disclosure, it should be reflected in margin and
the terms of credit. And that should be the Governor on that issue
to provide the protection, the best protection that we could, for
mitigation of systemic risk.
The second key issue of disclosure really is between the investor
and the fund manager. And once again, in our guidelines and principles, we tried to give very specific examples of what one should
expect so as to invest. And hopefully raising that standard, and we
intend to raise the standard further with specificity with the committees that I described, then we think that’s the key issues of disclosure and transparency.

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With regard to the more specific issue about the talk that I made
on moral hazard, I think there’s a clear issue. These are investments of a certain type. They’re less liquid. They’re private partnerships, and they’re different than buying and selling a security
that offers instant liquidity. And so there are very specific requirements for investors to meet which the SEC has outlined historically
and is now in the process of adjusting.
And, therefore, the idea that approval or regulation or registration provides a comfort, it would be a false comfort that might
not—has the potential to be a false comfort—that does not recognize the distinct characteristics of the private pools of capital.
Mr. BACHUS. And Governor Warsh, both you and Secretary Steel
have talked about that you all have made recommendations, principles which you have asked all the stakeholders to put into practice. How do you assure that they do this? How do you assure that
they do move towards market discipline?
Mr. WARSH. Thank you. I would say that one thing that is certain, which is by virtue of the oversight that this committee and
others can bring to bear, by virtue of the discussions that Under
Secretary Steel and I have, is that there is a laser-like focus in the
markets on trying to ensure that all of the stakeholders around
hedge funds really need to continue the progress that has been
made in recent years on subjects of due diligence and valuation,
and making sure that stakeholder community is fully vested and
fully understands what is going on.
This is, I think, an important opportunity for them to step up to
the challenge put before them by the principles outlined by the
President’s Working Group.
Moreover, I would say for these hedge funds, the group that has
the most skin in the game—the most responsibility, the most focus
on ensuring that they have the right collateral—are these very
counterparties and creditors that we’re talking about. They are the
life blood for hedge funds, maybe equal to importance of the investors themselves.
And when we talk about market discipline, we say that they
really need to make sure that they’re putting their money where
their mouth is, and we are very encouraged by the discussions that
have commenced that they’re going to adopt these principles and
put them into action. And, obviously, those of us here at the table
will do our best to make sure of that.
Mr. BACHUS. You know, when you have somebody who is both a
creditor and investor and a counterparty at the same time, it does
become very difficult to do that. But I would like to commend all
of you. I believe that you are very active on the job. You appreciate
the danger that you are working with the stakeholders and market
participants, and I commend you for what you’ve done.
Mr. KANJORSKI. [presiding] Thank you, Mr. Bachus. In the absence of our chairman, I will take my questioning period now, if I
can.
I am really interested more in the process of what the Working
Group represents and whether or not they have created certain authorities and where these authorities, whatever authority that they
use, emanate from. One of the important questions that I have
raised up here on the Hill is that so often now, we fail to provide

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legislative leadership as to where we should go: We hold a hearing
such as this one where we invite up a working group about which
I am not at all sure. Maybe I will ask: Who wants to represent the
role of chairman here? Where do you come from? I mean, can you
name your parents? Does anybody want to answer? You know, it
is a simple question, and it is an honest question.
Mr. STEEL. Let me start, sir, and I’ll invite my colleagues to comment. The establishment of the President’s Working Group in 1988
was born out of an issue which was basically understanding and
learning from the market dislocation of 1987.
Mr. KANJORSKI. Right.
Mr. STEEL. And President Reagan had the idea that you needed
to have this multi-headed group look at these issues, because they
crossed borders, crossed markets, and crossed different jurisdictions, and that was the idea.
And in my brief period, I think that this is the appropriate way
to consider them, and Secretary Paulson has convened the President’s Working Group actively and with all of the principals of the
President’s Working Group in, as Governor Warsh said, in a laserlike way, to use his word, focused on these issues. And so the idea
of financial preparedness, which really is the link-up to systemic
risk, has been the focus, one of the key focuses of the President’s
Working Group.
Mr. KANJORSKI. Obviously, the Working Group is a continuing
body. As I understand, it emanates from a former White House executive order in 1988. Has that order been enlarged upon or drafted subsequent to 1988 to include more authority?
Mr. STEEL. Not that I know of. But I would comment that the
Secretary doesn’t view our lens on these issues as being limited or
circumscribed—needing any additional scope or aperture.
Mr. KANJORSKI. Now, under normal circumstances, I would agree
with you. But, now you are really propounding regulations or
guidelines. I think you call them guidelines. That is very interesting. They are not legislatively constructed guidelines. They are
from the Working Group.
Mr. STEEL. Yes, sir.
Mr. KANJORSKI. And, of course, they come out of the Working
Group’s office downtown?
Mr. STEEL. They come—Treasury is the convener, as I said.
Mr. KANJORSKI. I was being facetious. If I try to locate the Working Group’s office, where would I go?
Mr. STEEL. You can call mine, I guess. But the Secretary of the
Treasury is the convener.
Mr. KANJORSKI. I understand, and as an initial study group, it
worked well. But why have you not all felt that perhaps there was
a time since 1988—that is 19 years ago—to come to the Congress
to get some legitimate legislative authority to pursue formal activity? If you really analyze what you’re doing, your whole sense of
controlling or influencing industry and the participants is the
threat of your capacity to regulate. That is a pretty dangerous way
of operating within our system.
You call in the people that you regulate, and you say we are
going to construct guidelines for you. We have no legislative authority to do that. There is no law allowing us to do that, just an

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executive order. But, we anticipate that you are going to participate and follow those guidelines.
You don’t seem to ask why, and I’m just asking the question now:
Why would they follow your guidelines? Other than the fact that
they have the fear of God that if they do not, they have four massive regulators that are going to come down on them in some way?
Is that a good principle to get things done?
The other area I wanted to ask you about is who is your
counterparty in the Legislative Branch of Government? Who do you
talk to up here on the Hill?
Mr. STEEL. Well, the other regulators or people—members can
speak for themselves, but from the Treasury Department, we’re in
constant communication and regular communication with the leadership on the Hill and describing what we’re doing both, as I said
when I began, I appear here today as a representative of the Treasury Department and also Secretary Paulson as Chairman of the
President’s Working Group.
And so the regular dialogue that the Secretary has with leaders
in Congress includes that same duality of responsibility. And I can
comment from having been in meetings that both of those perspectives are discussed and considered.
Mr. KANJORSKI. I just want to break into that response because
of a side question that I had. There is a rule in this Administration
that no group or representative of the Administration comes to the
Congress and makes a speech without having their remarks vetted
by the Office of Management and Budget. Mr. Steel, were your remarks vetted today by the Office of Management and Budget?
Mr. STEEL. Not that I’m aware of, sir.
Mr. KANJORSKI. Was anybody else’s here?
Mr. WARSH. No, sir.
Mr. KANJORSKI. So you have no vetting responsibility any more
in this Administration? I mean, that is great if you do not. But I
understood that you just don’t make—
Mr. STEEL. Testimony is run by our colleagues and counterparts
in other offices.
Mr. KANJORSKI. Who do you vet with?
Mr. STEEL. Within Treasury and discuss with other people.
Mr. KANJORSKI. Who were those other people?
Mr. STEEL. In Treasury, different divisions and different parts.
Mr. KANJORSKI. In Treasury? Nobody outside of the Department?
Mr. STEEL. Well, we would also discuss with people at the NEC
and other areas where we work on economic issues continually. I
think the idea of having a flat organization and getting the benefit
of other people’s perspective, but the idea of vetting, which was
your choice of words, would not describe the situation at all.
Mr. KANJORSKI. Do you vet your material with these other agencies, like your speech?
Mr. STEEL. Vet with? With these—my colleagues here?
Mr. KANJORSKI. No. I mean, with the other agency. You mentioned the National Economic Council?
Mr. STEEL. They—we shared our perspective with them and have
the benefit of ongoing discussions on economic policy continually.
Mr. KANJORSKI. You have on occasion, as a Working Group, sent
material to the Congress to consider for legislation, have you not?

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Mr. STEEL. Not that I’m aware of.
Mr. KANJORSKI. Nothing over the 20 years that you’ve sent up?
Mr. STEEL. Not that I’m aware of.
Mr. KANJORSKI. It has never dawned on anyone that it may be
wise to codify guidelines that are going to be worked with?
Mr. BACHUS. Would the chairman yield?
Mr. KANJORSKI. Oh, surely.
Mr. BACHUS. Actually, I think the President’s Working Group,
after Long Term Capital and 9/11, submitted requests to Congress.
That’s my recollection, but—
Mr. WARSH. Congressman, at the request of Congress, as you
know, the President’s Working Group as its constituent members,
have responded to questions and queries that have come up. We’ve
certainly provided technical assistance. I think the point worth reiterating is that none of us, at least speaking on behalf of the Federal Reserve, cede any of the authorities which Congress has granted to us, to members of the PWG. That is, the PWG has consulted—
Mr. KANJORSKI. Do not call it that. It so disturbs me to have
those initials used. Call it the President’s Working Group. I hate
the initials in Washington. It really illegitimizes your organization,
if you know what I mean.
Mr. WARSH. So the point I was trying to make, Congressman,
only is that each of us have authority. Certainly the Federal Reserve has authorities granted to us by Congress. We’re overseen by
this committee in the House.
Mr. KANJORSKI. No, but you understand why I am getting a little
disturbed here. I heard in earlier testimony that you are creating
two more working groups. You are having babies. A new generation
is being born here, and I am trying to figure out when your marriage was held. Where do you think you have the right to form
other groups that will exist out there interminably and be exercising leadership by virtue of the coerciveness of regulation?
I mean, does that not disturb anybody at the table?
Mr. STEEL. I’ll try to describe it, sir, in a way that’s not disturbing, but I view it as encouraging. And basically, what we’re
trying to do, as we’ve described in the guidelines and principles, is
to get people together to share the very best practices—
Mr. KANJORSKI. Admirable.
Mr. STEEL. Excuse me.
Mr. KANJORSKI. I do not disagree with that, Mr. Steel. I am saying that what it is a sort of ethereal structure.
Mr. STEEL. Excuse me?
Mr. KANJORSKI. There is no body to it. There is nothing we can
identify, you know, who is leading it and what rights it has. We
do not know how big you are. We do not know how many people
you have. You probably have the combined number of employees
that exist in every one of your respective organizations and other
people that you can get to participate in government. You start to
become a very large umbrella operation, and probably find little
need to go through the legislative process.
And then finally, one of the questions I am asking is: What do
we have as a countervailing weight to you up here in the Legislative Branch of Government? You know, if I want to get tremendous

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expertise, I do not have the Congress Working Group filled with experts of huge abilities. They are not around. How many people do
we have, Mr. Chairman, on the committee? We have eight people.
The CHAIRMAN. Seventy.
Mr. KANJORSKI. Seventy on the full committee, but in terms of
securities staff and things like this, what do we have, eight or ten
people? But you have literally hundreds or thousands, and yet I
thought under our structure we are supposed to be creating and
passing the laws that implement you, that give you the authorities
you will exercise. I am going to try and find your address downtown so that I can either come down and meet with you there at
the President’s Working Group headquarters, wherever that may
be.
Mr. Chairman.
The CHAIRMAN. The gentleman from Louisiana, Mr. Baker.
Mr. BAKER. Thank you, Mr. Chairman. Dr. Sirri, I don’t have a
question, just an observation. In reading over your rather distinguished resume, I noted your expertise in extra-planetary exploration, and at first wondered how someone with that suitability
would be a hedge fund expert. But then when I started thinking
about it, anybody who could talk about the details of exploration
of Pluto probably has a pretty good grasp of what’s going on in a
hedge fund. So, I welcome you to the hearing with that acknowledgement.
Mr. SIRRI. Thank you.
Mr. BAKER. Mr. Overdahl, I was curious. In looking at the 1999
President’s Working Group report, there was a recommendation
relative to CPO filings. What is the Commodity Pool Operator filings? Can you tell me what the current frequency of reporting is
today? Is it still annual, or is it quarterly?
Mr. OVERDAHL. I’ll have to get back to you on that.
Mr. BAKER. Well, my reason for asking is it was annual. The report suggested that they at least move to quarterly, and the reason
for that suggested modification was to provide additional transparency to market participants.
Mr. OVERDAHL. Right.
Mr. BAKER. That brings to the fore my generalized observation
about this problem. We can’t really describe who it is that we
would like to subject to whatever regulatory regime, be it self-regulation or government regulation, who should report. We don’t know
what it is they should report if we could identify who they are.
But the most troubling aspect of it all is the frequency of reporting is so insufficient in light of the trading strategies, that all you
would be able to do is get the license tag number of the truck that
just ran over you. You wouldn’t really get anything that could be
instructive before the untoward event were to occur.
That all leads me to wonder if we couldn’t have some set of triggering devices. For example, those commodity pool operators have
some set of requirements which they must report to you. But not
all hedge funds are registered CPOs. So you have people outside
your regulatory regime, and not all CPOs are hedge funds. So we
seem to have some regulatory arbitrage that would lead a smart
business practitioner to figure out where the radar is weakest, and
that’s where I make my border crossing.

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If, on the other hand, we had a multi-regulatory team agree that
under certain triggering circumstances—and Mr. Steel, I’m going to
jump to you after I hear Mr. Overdahl’s response—if under certain
circumstances, for example, high concentration in one economic activity, subprime lending, where it represents some agreed-upon
percentage of business activity that would be generally viewed as
aberrant.
In bank terms, we have limits on loans to one borrower. As a,
for example, parallel, where that individual firm is engaged in a
counterparty relationship where the counterparties from a regulatory perspective might not be as strong financially as we would
like, where that fund has an excessive investment from certain protected classes; for example, a high degree of reliance on pension
fund monies, where that fund has changed its profile within a certain period of time from its routine practice.
Now, all of that said, those are parameters you all should decide.
But under those circumstances, what would be wrong when we
identify that kind of aberrant actor from making a nonpublic disclosure to the appropriate Federal regulator for the purpose solely
of insulating as best we can from a systemic risk shock? Do you
have a view? Well, either one.
Mr. OVERDAHL. The way we’ve handled that at the CFTC, that
is a delegated responsibility of the National Futures Association.
My understanding is that these are annual disclosures. And beyond
that, we do see the operators of the pools, when they’re operating
within our markets through our large trader reporting system, and
that’s going to be there whether they’re registered, whether they’re
filing reports or not. And that’s going to be true with—
Mr. BAKER. Well, because my time is about to expire, and I
apologize for curtailing it. But I’m just saying a certain set of factors that would lead one to identify a fund practice as perhaps aberrant with market practice, shouldn’t those folks be subject to
some sort of required disclosure in that event? Mr. Steel?
Mr. STEEL. I agree with you completely that the issue of transparency to the funding so as to understand these types of challenges is exactly a good question. I think that the way we’ve
thought about this is I’m going to defer to Governor Warsh, who
can describe to you how they’re convening all of the regulators to
talk about best practices and sharing expertise to exactly accomplish what you’re describing.
Mr. WARSH. Congressman Baker, as you know, these are issues
that cross agency lines. What we’ve tried to do is to really have a
supervisory review that does the same. Working with the SEC, the
OCC and others, domestically and internationally, we at the Federal Reserve have tried to track what these risks are and to compare best practices.
Mr. BAKER. Well, it is possible, depending on the funding source,
where a fund could be fairly large and not be subject to anybody’s
direct regulation at the table?
Mr. WARSH. Absolutely. I think—
Mr. BAKER. Or even reporting? I hate to say ‘‘regulation.’’ I’m
just talking about a private reporting regime so you can act on our
social benefit behalf.

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Mr. WARSH. As you and others have rightly pointed out, the regime of regulating hedge funds, for example, within the borders of
the United States, is a difficult exercise. This capital is remarkably
nimble, and as a result, we’re finding ourselves increasingly working with our counterparts overseas to accomplish many of those
same objectives.
I think the principles set out by the President’s Working Group
have been echoed in substantial respects by many of those regulators, so I have some degree of confidence that progress is being
made across these jurisdictional lines.
The CHAIRMAN. Thank you. Let me just announce, we have votes
in 15 minutes, so I’ll ask the indulgence of the panel. We will have
Ms. Waters’ questions, and we will then adjourn to vote. We should
be back in less than 40 minutes from the voting, and the committee
will resume as soon as the people have gotten a chance to vote on
the fourth vote.
The gentlewoman from California.
Ms. WATERS. Thank you very much, Mr. Chairman, and I’d like
to thank the members of the President’s Working Group for being
here today. I am focused on what has happened in the subprime
market. And I’m very much aware of the foreclosures that are devastating communities across this country. I’ve been in communities
and cities such as Cleveland, Ohio, and now in Atlanta, and other
places where whole blocks are boarded up. You know, people are
losing their homes, and we all know why. We know that they were
offered exotic products that they could not afford.
And what we did not know and what we did not understand was
Wall Street’s role in these loans that were being extended and afforded to people, many of whom certainly could not repay them. We
are learning about products such as no verification of income, of
course, the interest only, and on and on and on.
My question is—well, and also understanding and knowing Bear
Stearns’ exposure to the subprime loans recently required the firm
to bail out two of its hedge funds. Bear Stearns put up $3.2 billion
to rescue the two funds. What can you tell me about other hedge
funds that might be in trouble because of exposure to subprime
loans? And can we expect, as some are predicting, a collapse in the
financial markets as a result of the subprime crisis? And recent
loan performance in the subprime market appears to support the
premise that the crisis certainly is not over, particularly with huge
numbers of adjustable rate mortgages setting as we speak here
today.
Again, what do you know about this and other hedge funds that
may be in trouble? Why didn’t you see this coming? And how are
we going to correct this?
Mr. SIRRI. Congresswoman, the question about hedge funds and
what we know about hedge funds, let me address that first, because your question raised many issues. With regard to—and I
don’t want to focus too much on any one event such as Bear
Stearns. But let me explain to you a bit about the funding situation
there.
You raised the point about $3 billion being used to bail out the
funds managed by Bear Stearns. The way that funding is done is
on a secured basis, by which I mean funds are lent against actual

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securities themselves. So in that sense, capital was provided to
support that fund, so it was actually only to one of the two Bear
Stearns funds as far as we know, and we think that number was
a little less than $3 billion. We think it was slightly over $1 billion
at the point.
But moving beyond to the general point of your question, how
would we know whether more of this is coming, our main window—
and some of the other questioners asked questions that were related to this—our main window into this is indirect. It’s through
the providers of capital into the financial systems. The regulated
banks and the regulated securities firms are the primary providers
of capital to hedge funds, who in turn purchase securities or instruments linked to subprime mortgages.
When we go in to inspect those providers of capital, in the case
of the SEC, we’re going to look at prime brokers, the Bear Stearns,
the Morgan Stanleys and such, we look very carefully at their practices for funding those instruments. We look at their ability to
manage those risks. We look at the valuation practices that they
have.
We look at all of those things holistically and make sure, as best
we can, that they are not impairing the financial health of the regulated entity itself or of the holding company. In that sense, by
doing that, we believe that we’re appropriately minimizing the risk
and managing the risk that a failure of a large, systemically important firm, such as big investment bank, would in fact bring risk to
the financial system.
Ms. WATERS. Would anyone else like to comment?
Mr. WARSH. Thank you, Congresswoman. Let me speak principally on the subject of the financial markets, which I think you
raised. Certainly the tumult that you’ve described and that is no
doubt happening, particularly in certain communities, is very real
and is generating very real losses in the financial markets.
From the Federal Reserve’s perspective, I think our overall view
is that there are certainly concerns that we might not be at the
bottom of this tumult. But these losses don’t appear to be raising,
to this point, systemic risk issues. That in no way would suggest
that the very real problems that some of your constituents and others are having aren’t real. And, obviously, the Federal Reserve,
working with other regulators, is doing its best to try to address
those issues.
But the financial markets are certainly repricing risk in this environment in the housing markets and more broadly. The losses
that have been felt by hedge funds and other financial intermediaries are certainly forcing them to go back to first principles,
revisit their exposures. And what we’re trying to do in our supervisory capacity is ensure that they still have adequate cushions,
that they still have sufficient capital so that they can operate
robustly in these markets. From the perspective of the institutions
we oversee, we don’t see any immediate systemic risk issues that
are brought to bear.
Ms. WATERS. Thank you very much, Mr. Chairman. I yield back
the balance of my time.
The CHAIRMAN. We’ll recess and return in 35 minutes or so, as
quickly as we can. I thank the panel.

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[Recess]
The CHAIRMAN. The hearing will reconvene. That means the two
people over there talking will please take seats. Sorry that we are
late, but I do not want to inflict any more time constraints. Let’s
get those doors closed, please.
And in a very easy choice, I now recognize the gentleman from
Delaware.
Mr. CASTLE. Thank you, Mr. Chairman. I am glad to be an easy
choice.
Dr. Sirri, I think this question should be addressed to you. In
just reading Business Week in the last week or two, the magazine,
there are all kinds of questions about hedge funds, etc. One of the
ones that caught my attention was in the last couple of weeks. It
says, ‘‘The Street’s Next Big Scandal,’’ and it goes on to talk about
traders and hedge funds colluding to profit from privileged information. I will not go into a lot of details on this, you can sort of
figure out where it is going.
They believe, this particular author believes, that the next big
scandal will most likely involve brokerage activities and proprietary trading which long ago surpassed investment banking to become Wall Street’s chief profit center, that is, trading on their own
accounts in a variety of ways.
At the heart of the new collusion is the practice of frontrunning,
essentially trading ahead of big buy and sell orders to profit unfairly from the resulting ups and downs in prices. The concern is
that prime brokers are not only tipping off their own traders about
big mutual fund orders on deck, but also giving the heads up to
their hedge fund clients. The banks’ rewards are two-fold, etc., as
you can imagine profits on commissions and profits on the trades.
Meanwhile, mutual funds unwittingly subsidize this scheme by
buying stocks at higher prices or selling at lower ones than they
otherwise would. It’s a slippery, slimy slope, lamented a mutual
fund manager, adding that all these leaks make pure beating returns harder to achieve.
And then it says, ‘‘Regulators have been slow to crack down on
what has quickly become an open secret. The U.S. Attorney’s Office
and the SEC have accused brokers from various companies of allowing clients to listen into their internal speaker systems.’’ A series of things.
I mean the probably—I share very much what the chairman said,
and what the ranking member said, and that is, it is hard for us
to get our arms around exactly what the problems with hedge
funds may be. But I know one thing. When you get a big money
operation like this, people are trying to make money on it and, obviously, if brokers can take advantage of this, they may do that.
There is just a lot of things we have to do.
And again, like the chairman, and the ranking member, and all
of you, to a degree, I am not sure what we should be doing. I do
not want to over-regulate. I happen to believe that there is tremendous equity advantage in hedge funds and private equity capital in
terms of our markets and I think, frankly, all of you do a good job.
It is just that this is sort of new to everybody. And I am going
to get into pension funds here in a moment, but I am concerned
about those allegations. And I am concerned about what we are

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doing that might prevent that from happening in the future without really judging whether it is really happening now or not and
what perhaps, if anything, the SEC is doing in that particular area
of this whole business of collusion and people just simply take advantage of information and knowledge.
Mr. SIRRI. Sure. Let me address that question. First let me say
it is a very important question. It is one that runs to the heart of
the SEC’s mission of providing fair capital markets and investor
protection. So there are two things that you put together that at
times I think make sense in this context.
One is the behavior of a broker dealer protecting customer information and the other is, as you pointed out, the concentration of
wealth and hedge funds and the fact that they are large entities
that, that like they are big clients of the brokers.
We should be very clear about one thing. The broker dealers
have an obligation to protect the proprietary nature of customer’s
order flow. To not do so would violate the securities laws.
Regardless of whether it is a single entity that is a person who
is being tipped or a large hedge fund that is being tipped, the
broker dealer must protect the confidential nature of that order
flow and not leak it out to people for their own benefit or for the
benefit of their clients. That is a violation of the securities’ law. We
have adequate authority to go after that. And, as you have noted,
we have gone after such behavior. We have brought cases out in
that way.
With regard to what you specifically mentioned with hedge funds
having access to such things, our Office of Compliance, Inspections,
and Examinations, has actually publicly said that we are looking
exactly for that.
We have gone and requested out of a large number of broker
dealers information, data, actual detailed trading data and we are
trying to piece together and look for exactly, the footprint of exactly
what you are citing. That is, a tip or a trade coming and then or
an order coming and other trades front-running the eventual consummation of that trade benefitting some other parties who were
actually in process or looking for that.
So I would say that it is probably, you know, the article may
have characterized the idea that we are running behind there, but
I think we are very much aware of that. The difficulty, of course,
is detecting, but we are looking with all our tools to detect that.
I think we are crystal clear that violates Federal securities laws.
Mr. CASTLE. And I didn’t read the entire article to you obviously,
but you may have read it yourself. But it goes on to say how difficult it is to prove all these things. It is hard to get cooperative
witnesses, etc. So your work is cut out for you and we appreciate
what you are doing on that.
Mr. SIRRI. Thank you.
Mr. CASTLE. Secretary Steel, let me turn to an area that concerns
me that I mentioned. You have talked about the principles and the
guidelines which were revealed earlier this year and the discussion
of the industry’s best practices.
My concern—and I’m not that concerned about the extremely
wealthy investors in hedge funds, but I am becoming increasingly
concerned about the institutional investor, particularly pension

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funds. There are many individuals who are not wealthy who may
receiving a payment or will receive a payment from that pension
fund, the fiduciary which decides to get into a hedge fund. And I
am not sure what knowledge they actually have.
I do not know—in some of the due diligence you have spoken
about, in some of the best practices you have adopted in your principles and guidelines are—is this information which is available to
the individuals who are going to be actually getting involved in
that investment or is it just to you as regulators?
I mean I want to make sure these people who are representing
more middle America, if you will, actually know what the heck they
are getting into. I cannot judge whether they are good investors or
not. But at least they would have full knowledge. Is it moving in
that direction?
Mr. STEEL. Congressman, you ask an important question. And in
my opening comments I chose or tried to highlight this, that we at
Treasury and the President’s Working Group think this is a crucial
issue.
As I said, when hedge funds began, it was the province of
wealthy individuals and then it spread to foundations and endowments. But today it is basically pulling others into the area where
they are affected and in particular through pension funds and
things of that ilk.
When we wrote the principles and guidelines, we dedicated one
of the principles to this specific issue. Principal Number 5 basically
talks about the importance of this trend and that the key front-line
defender has to be the fiduciary. And the fiduciaries representing
these people should be a very demanding investor.
We give specific examples of what they should want to understand, the importance of diversification as they construct the proper portfolio for that pension plan.
Next, I’m quite comfortable that the way we’re going and the forward-leaning perspective with our declaration that we are not confirming the status quo. Instead when we convene the group of people to help us think about the investors and the best practice for
investors, our plan is to include as key members of that group the
very best people from the pension world to help set standards and
rules that can be a signpost for people who want to understand
best practices as fiduciaries as they consider allocating part of the
assets of a pension fund to alternative asset products.
Mr. CASTLE. My time is up. If I could just ask one very brief—
I cannot.
The CHAIRMAN. If you want to make a statement?
Mr. CASTLE. Well, the only statement I was going to make, Mr.
Chairman, is—and I did not get a chance to say this per se—I understand the fiduciary’s responsibility, but ultimately I think it is
very important to make sure that the fiduciary has the information
to be able to make that decision.
I am not 100 percent comfortable with that now although perhaps I can be persuaded with a little more attention to it.
The CHAIRMAN. I think that is right, that is the fiduciary after
all is a fiduciary for other people. We have some obligation to make
sure that if the fiduciary screws up, it is not only the fiduciary who
suffers. So, it is not enough to say, ‘‘Well, it was the fiduciary’s

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fault.’’ Because we have to protect the people who are the fiduciaries’ presumed beneficiaries.
Mr. CASTLE. Yes, sir.
The CHAIRMAN. Let me just say, Mr. Secretary, I think you kind
of summed up the message. I hope people have taken this which
is the fact that there have not been any new proposals for increased regulation, etc., is not an endorsement to the status quo.
I think that is the important lesson for people to take. That there
is a recognition that this is an ongoing issue. The absence of any
specific new regulatory scheme right now is not an endorsement of
the status quo. I appreciate your putting it that way.
The gentleman from Texas.
Mr. GREEN. Thank you, Mr. Chairman.
I thank the witnesses for appearing today. I also thank the ranking member, in his absence, and I would like to pick up where the
chairperson left off with the responsibility of the fiduciary. But let
us start with the notion and premise that historically hedge funds
have been available to sophisticated investors. Sophisticated investors are not sophisticated by virtue of their knowledge. Knowledge
alone does not make one a sophisticated investor.
Unfortunately or fortunately as the case may be, to become a sophisticated investor, one has to have a certain amount of assets.
Does anyone differ with that premise? That you have to have a
combination of assets and knowledge to be a sophisticated investor
for the purpose of investing in a hedge fund traditionally as we define sophisticated investor.
Mr. SIRRI. The Federal securities laws provide for various tests:
Income levels, in some instances investments, and in other instances assets
Mr. GREEN. Okay. So the assets are important to this process.
And my concern, and it is a serious concern, is the problem that
we have when we commingle sophisticated funds with what Mr.
Steel calls less sophisticated and some others may have utilized
this terminology, I use the term ‘‘unsophisticated’’ funds.
When you have these funds commingled, then we have a problem
because no matter how much knowledge the people acquire who
are part of a pension fund, they will not become a sophisticated investor. The knowledge alone will not make them sophisticated investors.
Traditionally the reason we have had these sophisticated investors in hedge funds is because they could suffer the loss. If they
suffered a loss, we had an individual or family that lost money and
as bad as that is, it would not have the kind of impact that we can
have on a market that the system itself, the people who happen to
be a part of society because if a pension fund takes a serious hit,
then we have a lot of people that we have to concern ourselves with
as opposed to a family, as opposed to an individual who has an inordinate amount of money and God bless the person who has it. I
think everybody ought to be a millionaire in a country where 1 out
of every 110 persons is a millionaire.
In fact, in this country, it is almost unhealthy not to be a millionaire, so everybody ought to want to try to become a millionaire in
America. This is the richest country in the world, a country where
we can spend $353 million a day on a war and still do well.

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So my question and my concern have to do with having these
persons who have their pensions who are not sophisticated even if
they have Ph.Ds in economics, they are still not sophisticated investors.
And when this, if something goes belly up and the stock market
of 1929 would never have gone belly up, should not have gone belly
up, but it did. Enron should not have failed, but it did. We have
had other instances where institutions, long term capital should
not have failed, but it did. And nothing fails until it does. And
when it does, then we have problems and taxpayers pick up a large
portion of the tab because people eventually who are pensioners
will go to the public trough in the form of public assistance and
they need assistance and they ought to receive it by the way.
So I do concern myself with this notion of a fiduciary being able
to shoulder all of the burden for what can happen when those
funds are intermingled and we have a loss. That is a real concern
for me. And I don’t know that I have heard anything that addresses this concern to the extent that I feel comfortable with this, the
continuation of this as it is currently.
Perhaps there is a way to do this and my chairman is very enlightened and I am sure that he will help me through it as well
as others, but maybe there is a way to do this and not create the
consternation that we are going to—that I have and maybe it is
just me but that I have on behalf, I think, of the working people
in this country who are finding more and more of their money
going into the sophisticated market. This is a sophisticated market.
And people who engage in this ought to have a better understanding and the capital to back up the losses that they may suffer.
Is that my time, Mr. Chairman?
The CHAIRMAN. You still have about 30 seconds.
Mr. GREEN. Thirty seconds. The question would be this. Explain
to me how we can allay the concern that I called to your attention
with reference to the sophisticated and unsophisticated or non-sophisticated or less sophisticated monies being commingled.
Mr. SIRRI. Congressman, let me see if I can shed some light on
this. You are quite correct in how you have characterized sophistication. The Federal securities laws provide that you have to be—
have some little wealth, income or assets to buy a hedge fund as
an individual and that is as you have stated.
You bring up the issue of the fiduciary. One of the reasons—and
you are noting that there seems to be something that does not
match because unsophisticated people find themselves invested in
investments that are normally held by sophisticated entities.
I think there are two things. One, the first, is what you observed,
the fiduciary. That person has a heightened responsibility to invest
for those people. But the other is the amount of investment that
is made.
A fiduciary, if acting properly for say a pension fund, would
never plunge 50 or 80 percent of their assets into one or more
hedge funds. They would prudently place a small amount of assets
in a hedge fund.
When you turn to an individual, one of the reasons why we have
wealth and income standards is there is a chance that an individual investor might place half of their wealth in a hedge fund,

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and that is dangerous. That is why we have the high wealth standards.
What I am about to point out is that when a fiduciary is acting,
and they are investing a pool of say, pension fund monies, it is not
going to be the case that 30, 50, or 90 percent of that pool is in
hedge funds.
It is going to be the case that hopefully a prudent amount is in
hedge funds and it depends on the purpose. And so the exact quantity will serve to protect you.
Mr. GREEN. Just a quick response, Mr. Chairman, and then I
yield back my time.
But there is nothing that thwarts a fiduciary from doing the opposite, the antithesis of what you just said.
Mr. SIRRI. Well, the fiduciary has an obligation to invest prudently and what you are pointing out is that fiduciary would not
have the best interests of their beneficiaries in mind.
If that is the case—I am not saying that could not happen. But
if that is the case, that fiduciary could have just as well put 100
percent of their investments in tech stocks in the late 1990’s.
The CHAIRMAN. Would the gentleman yield to me?
Let me say this because I think he is on a very important point
and it is really related to what the gentleman from Louisiana had
said and the gentleman from Delaware. Yes, it is the fiduciary’s responsibility, but if we are talking about an individual investor, if
an individual mis-invests several million dollars of her own money
that is too bad for her. With a fiduciary, it is other people.
And I think the point is this: You are right. That has always
been a problem. The problem is that hedge funds appear to many
of us to be a new and more enticing opportunity for the unwary fiduciary. And the problem we think is not just the one who does not
have his or her client’s interests at heart or beneficiaries, but who
does not have the smarts to do it.
And that is why we think this increased set of very complex opportunities promising a very high rate of return create a new potential problem that particularly with regard to fiduciaries that we
may have to do some new things.
The gentlewoman from New York has arrived and is now recognized to ask some more questions.
Mrs. MALONEY. Thank you very much.
Going back to my original questions, my concern about the Bear
Stearns funds is not whether the funds themselves go under, or
even if a major firm loses money, my main concern is what effect
a sale of CDOs assets would have had on all institutions holding
similar securities. And do each of you believe that the institutions
that you oversee are valuing those assets properly? Are the credit
rating agencies acting with appropriate speed to downgrade assets
that no longer warrant their investment grade?
And what about the customers such as pension funds, endowments, and so forth to whom these securities are sold, the CDOs,
other mortgage derivatives. What about them? Are they valuing
them properly?
And what is the systemic consequences of a broad downgrade or
significant deterioration of those types of securities’ values?

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So I would like everyone to respond on whether you feel they are
valued. Is there a bubble there? And what is the systemic, the systemic effect really on the markets with properly valuing them?
Mr. WARSH. Thank you, Congresswoman. Perhaps I will go first,
but I will defer on the specific matter of Bear Stearns that you referenced to my colleague from the SEC who has oversight over
them.
Let me talk a little bit more broadly—
Mrs. MALONEY. I want to make it clear. I am not asking about
Bear Stearns. I am not talking about a major firm losing money,
but what effect it has on the value of the CDOs and the systemic
problem it could have on the markets and on the proper valuing
of the CDOs.
Mr. WARSH. As you heard from us at the outset, market discipline is going to have a critically important role to play here.
Market discipline is tough medicine and I think, Congresswoman,
to your point, losses will no doubt be held by some individuals and
institutions that own collateralized debt obligations and other securities as the markets turn against them.
And it is these losses which force all institutions to go back to
first principles, revisit their valuations, revisit the ratings that
have put on these securities to make sure they know where their
risks are. The Federal Reserve, as regulators and supervisors of
U.S. bank holding companies, is keenly focused on ensuring that
the risks held by these institutions are manageable.
We are not in the business of trying to ensure that there are not
losses but only to ensure that there are capital cushions, risk management processes, and proper oversight to ensure that those losses
do not become systemic.
Mrs. MALONEY. But do you believe that these, that they are
being valued—are these assets being valued properly? The credit
agencies are still giving them 100 percent rating. Some analysts
are saying they are really worth 20 percent. This is problematic.
Do you believe they are being valued appropriately?
Mr. WARSH. I would expect that—
Mrs. MALONEY. Is there a bubble out there?
Mr. WARSH. I would expect that the valuations of these securities
are at the crux of what regulated institutions are reviewing as we
speak. The valuations that have been put on securities that tend
to be more complex, that tend to be less liquid, is both art and
science. And I think that those institutions that rely wholly on
models, that rely wholly on history of the last 4 or 5 years, are
learning market lessons. That is, many of these new products—
though they have been tested to some degree in recent months—
may not have been subjected to the most adverse stress test.
Speaking for the Federal Reserve, that is part and parcel of one
of our priorities to ensure that the stress test work that we have
done with our regulatees is taken to the next level to ensure that
there are not risks that should be brought to bear.
Mrs. MALONEY. Some analysts have said that they believe there
should be broad downgrades. What is the systemic consequence of
broad downgrades on these assets? And I would like to go to someone else on the panel.

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Mr. WARSH. Would you like me to briefly answer that and then
I will defer to—
Mrs. MALONEY. I would like to let someone else speak.
Mr. STEEL. Thank you. You asked an important question and I
think my response would be in line with Governor Warsh’s, that
the key issues here are current pricing which you keep poking at
and the issue of cushions or liquidity margin against them.
And I think that right now the market is adjusting and seems
to be settling at new prices. And right now there is stress in the
subprime market. It does not seem to be a systemic issue which
you have asked repeatedly and that would be the representation
we would make. But it is going through an adjustment process.
And so that will happen as the market develops and it seems as
though it is happening in an orderly way.
We have the largest residential financial market for housing in
the world. It is $10 trillion, and it is a terribly important asset to
the economy and to the housing market.
It is now going through a process of revaluing certain parts of
it, but I would not describe it in any alarming way other than it
is going to go through the process of resetting prices, people readjusting their margin as the market adjusts and as Governor Warsh
said, the harsh medicine of market conditions and the truth of the
marketplace.
The CHAIRMAN. Thank you. Actually I would say to Governor
Warsh that I think people are very happy that the Fed is dealing
with stress test. The fear is that they will do a little stress reality
with interest rates. That will be the—stick with the tests.
The gentleman from Texas is now recognized for one last question and then the hearing will adjourn.
Mr. GREEN. Thank you, Mr. Chairman.
This will be to Dr. Sirri. Sir, would you oppose a codification of
what you expressed in terms of a judicious prudent manager surrogate, if you will, having to invest not more than a certain percentage of a certain pension in a hedge fund?
Mr. SIRRI. I do not, you know—
Mr. GREEN. The fiduciary.
Mr. SIRRI. Sure. I think it is very difficult to place that kind of
a structure. I understand what you are getting at and let me tell
you why. A hedge fund could be in fact a long only equity fund and
be a perfect substitute for a common mutual fund that you find
today. And some hedge funds do exactly that.
Other hedge funds as we have been talking about invest in exotic
instruments. So it is actually the job of the fiduciary to see through
all of that and to find in fact a prudent packaging of instruments
for the beneficial owners.
It is really—it is very, very difficult to take the fiduciary off the
hook in my view here. That is really where the rubber meets the
road. And it extends to the point where a diligent fiduciary in
many ways—for example, a fiduciary looking to invest for people’s
retirement who didn’t select a small portion of say alternative investments may not always be acting in the best interest of investors.
Mr. GREEN. I yield back. Thank you, sir.

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The CHAIRMAN. I thank you for returning. The hearing is adjourned. I must say that I think this has been very useful, and I
hope that people will pay serious attention. We have, I think, a
pretty good consensus that this is an issue that we have to remain
seriously on top of. We have to be considering it and the final chapter has not been written. I think people should have some assurance, though, that there is an awareness of the problems and the
risks and serious people are attuned to it.
[Whereupon, at 12:45 p.m., the hearing was adjourned.]

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July 11, 2007

(41)

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