[House Hearing, 111 Congress]
[From the U.S. Government Publishing Office]
REGULATORY PERSPECTIVES ON THE
OBAMA ADMINISTRATION'S FINANCIAL
REGULATORY REFORM PROPOSALS, PART I
=======================================================================
HEARING
BEFORE THE
COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED ELEVENTH CONGRESS
FIRST SESSION
__________
JULY 22, 2009
__________
Printed for the use of the Committee on Financial Services
Serial No. 111-66
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HOUSE COMMITTEE ON FINANCIAL SERVICES
BARNEY FRANK, Massachusetts, Chairman
PAUL E. KANJORSKI, Pennsylvania SPENCER BACHUS, Alabama
MAXINE WATERS, California MICHAEL N. CASTLE, Delaware
CAROLYN B. MALONEY, New York PETER T. KING, New York
LUIS V. GUTIERREZ, Illinois EDWARD R. ROYCE, California
NYDIA M. VELAZQUEZ, New York FRANK D. LUCAS, Oklahoma
MELVIN L. WATT, North Carolina RON PAUL, Texas
GARY L. ACKERMAN, New York DONALD A. MANZULLO, Illinois
BRAD SHERMAN, California WALTER B. JONES, Jr., North
GREGORY W. MEEKS, New York Carolina
DENNIS MOORE, Kansas JUDY BIGGERT, Illinois
MICHAEL E. CAPUANO, Massachusetts GARY G. MILLER, California
RUBEN HINOJOSA, Texas SHELLEY MOORE CAPITO, West
WM. LACY CLAY, Missouri Virginia
CAROLYN McCARTHY, New York JEB HENSARLING, Texas
JOE BACA, California SCOTT GARRETT, New Jersey
STEPHEN F. LYNCH, Massachusetts J. GRESHAM BARRETT, South Carolina
BRAD MILLER, North Carolina JIM GERLACH, Pennsylvania
DAVID SCOTT, Georgia RANDY NEUGEBAUER, Texas
AL GREEN, Texas TOM PRICE, Georgia
EMANUEL CLEAVER, Missouri PATRICK T. McHENRY, North Carolina
MELISSA L. BEAN, Illinois JOHN CAMPBELL, California
GWEN MOORE, Wisconsin ADAM PUTNAM, Florida
PAUL W. HODES, New Hampshire MICHELE BACHMANN, Minnesota
KEITH ELLISON, Minnesota KENNY MARCHANT, Texas
RON KLEIN, Florida THADDEUS G. McCOTTER, Michigan
CHARLES A. WILSON, Ohio KEVIN McCARTHY, California
ED PERLMUTTER, Colorado BILL POSEY, Florida
JOE DONNELLY, Indiana LYNN JENKINS, Kansas
BILL FOSTER, Illinois CHRISTOPHER LEE, New York
ANDRE CARSON, Indiana ERIK PAULSEN, Minnesota
JACKIE SPEIER, California LEONARD LANCE, New Jersey
TRAVIS CHILDERS, Mississippi
WALT MINNICK, Idaho
JOHN ADLER, New Jersey
MARY JO KILROY, Ohio
STEVE DRIEHAUS, Ohio
SUZANNE KOSMAS, Florida
ALAN GRAYSON, Florida
JIM HIMES, Connecticut
GARY PETERS, Michigan
DAN MAFFEI, New York
Jeanne M. Roslanowick, Staff Director and Chief Counsel
C O N T E N T S
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Page
Hearing held on:
July 22, 2009................................................ 1
Appendix:
July 22, 2009................................................ 39
WITNESSES
Wednesday, July 22, 2009
Gensler, Hon. Gary, Chairman, Commodity Futures Trading
Commission (CFTC).............................................. 10
Schapiro, Hon. Mary L., Chairman, U.S. Securities and Exchange
Commission (SEC)............................................... 8
APPENDIX
Prepared statements:
Garrett, Hon. Scott.......................................... 40
McCarthy, Hon. Carolyn....................................... 42
Gensler, Hon. Gary........................................... 43
Schapiro, Hon. Mary L........................................ 58
Additional Material Submitted for the Record
Schapiro, Hon. Mary L.:
Written responses to questions from Representative Royce..... 69
REGULATORY PERSPECTIVES ON THE
OBAMA ADMINISTRATION'S FINANCIAL
REGULATORY REFORM PROPOSALS, PART I
----------
Wednesday, July 22, 2009
U.S. House of Representatives,
Committee on Financial Services,
Washington, D.C.
The committee met, pursuant to notice, at 10 a.m., in room
2128, Rayburn House Office Building, Hon. Barney Frank
[chairman of the committee] presiding.
Members present: Representatives Frank, Kanjorski, Maloney,
Watt, Sherman, Moore of Kansas, Capuano, Baca, Lynch, Miller of
North Carolina, Green, Cleaver, Moore of Wisconsin, Klein,
Wilson, Perlmutter, Foster, Carson, Speier, Minnick, Driehaus,
Kosmas, Himes; Bachus, Castle, Royce, Lucas, Biggert, Miller of
California, Capito, Hensarling, Garrett, Neugebauer, McHenry,
Posey, Jenkins, Lee, Paulsen, and Lance.
The Chairman. The hearing will begin. We are very happy
today to have before us two Presidential appointees who head
important agencies: the Chair of the SEC, Mary Schapiro; and
the Chair of the Commodity Futures Trading Commission, Gary
Gensler. I want to begin by saying I am very happy that both
agency heads are here. I strongly believe that if we were
starting from scratch, we would not have two separate agencies,
with the extent to which they share a mission. But we do have
the two separate agencies. There is no point in wasting energy
in trying to consolidate them when there would be no chance of
that happening. I am encouraged by the fact that the two Chairs
here today have, from the beginning of their appointment,
worked closely together to try and avoid friction.
I have to say that in my view, jurisdictional fights--
whether between congressional committees or among congressional
committees or between or among Federal agencies--represent
Washington at our worst, because the job getting done well
ought to be the issue. And people who insist that--people's
egos get too tied up with their positions. We are working hard
to avoid that. I have also been working closely with Chairman
Peterson of the Agriculture Committee because there is a shared
jurisdiction here. And we have come to a very good agreement on
substance. We had the hearing a week ago with the Secretary of
the Treasury an unusual hearing with two major full committees.
We intend to keep doing this. There will be some disagreements
I believe at the edges--I am reluctant to say margins here
because it will get too doubly interpreted--but at the edges,
there may be some disagreements.
They clearly are outweighed by the substantial agreement
that we have. So one of the questions will be on derivatives.
Another will be in our jurisdiction which, we should be clear,
is primarily the SEC. I appreciate the fact that Mr. Gensler is
here. This committee is not the committee of jurisdiction for
him.
Mr. Peterson, in the spirit of cooperation, understands
that. If Mr. Peterson would ask Chair Schapiro to appear before
Agriculture, I don't know if you have yet, but we would
encourage that as well, because we don't want these
jurisdictional issues to be there. With regard to derivatives,
I will tell you the conceptual approach that Mr. Peterson and I
have taken, Mr. Peterson's committee has the jurisdiction over
those for whom hedging is a part of their business. That is,
the Agriculture Committee are more the end users of this who
have a product to sell and who hedge because they want to deal
with price volatility. Our jurisdiction is more over the people
who do some of the hedging and are in the financial area.
The concept, it seems to me, we ought to be guided by here
is what we ought to be thinking about with the financial
institution in general. Their role is to be intermediaries, not
to be ends in and of themselves. When there is a breakdown in
the financial sector, we call it disintermediation. Their job
is to be a very important, I was going to say bridge, but
bridge understates the creativity involved. There is nothing
passive about their role, but their job is to link up
essentially people in the end of the economy who are producing
goods and services of value and the people with money to invest
in them. Their job is to help us in this society agglomerate
investment funds so that they are made available to the end
users.
Obviously, people aren't going to do that unless they make
a profit off it. That is a very important and sometimes complex
business. People aren't going to make their money available
unless they make a profit. But I do think that over the past
couple of decades, there are some examples in the financial
sector of the means becoming the ends. We have had people tell
us that we should not restrict or regulate this or that because
then certain entities would not be able to make money. Yes, it
is important that they make money as a by-product of the
intermediation function they perform. The fact that a given
institution won't make money is, in itself, no reason to be
opposed to this. And, in fact, activities whose major
justification is that they make a profit for some entity
unconnected to that intermediation function are not going to be
well received by us.
I will now add, finally, this is not just about
derivatives, we have other issues, this committee has been very
interested in the whole question of mark-to-market. The
gentleman from Pennsylvania has played a major role there. And
there is also continued interest in the question of short sale
and corporate governance. I will say that two of our members,
the gentleman from California, Mr. Campbell, and the gentleman
from Michigan, Mr. Peters, in a bipartisan way, have a great
interest in corporate governance issues. And I expect the
committee will turn to them this fall after we have done some
of the major regulatory stuff. But both of those issues are,
particularly the short sale and the mark-to-market, are going
to be before us today. The gentleman from New Jersey is
recognized for 3 minutes.
Mr. Garrett. Thank you, Mr. Chairman, and thank you,
members of the panel. Today's hearing is on the President's
financial regulatory reform proposals. You know, your agencies
oversee some of the most transparent, efficient, and complex
markets in the world that are also responsible for ensuring
that our capital markets promote price discovery, capital
formation, and investor protection.
Now, the Administration's reform proposals task the SEC and
the CFTC with developing a regulatory infrastructure for over-
the-counter derivatives and reporting to Congress by September
30th on how the agencies will harmonize two very disparate
regulatory approaches. So I look forward to hearing from you to
see how well those are coming together and where some of your
sticking points are going to be, if there are some, I think
there will, and whether you will be able to meet that deadline.
You know, with regard to the Administration's proposals, I
agree with some of them. I think it is evenhanded and certainly
less radical than other ideas that have been proposed so far in
Congress.
Still, there are some aspects of the Administration's
proposals that trouble me. And I am worried that in the name of
systemic risk reduction, requirements that would force more OTC
transactions into central clearinghouses or onto exchanges, as
well as strident new margin requirements for both centrally
cleared and noncentrally cleared transactions will make hedging
just too expensive for many end users of derivatives throughout
the broader economy. The perverse outcome, therefore, of
efforts to reduce systemic risk in these markets can actually
increase risk for many companies if they are no longer able to
cost effectively engage in a comprehensive risk management
practice.
So if you take a step back for a moment, perhaps an even
more fundamental question should be asked here: Were
standardized derivatives significantly related to the recent
meltdown of our financial markets, and if not, why are we
prescribing cures for a nonexistent ailment? You know, the
failed oversight of one large dealer directly related to
broader regulatory failures in the housing finance markets
should not cause us to pursue radical fixes for the broader OTC
derivative markets and their nondealers participants that had
little or really nothing to do with the recent crisis.
What we do need is comprehensive regulatory reform, but it
needs to be sensible and we need to make sure that we are
addressing actual problems in the way that we are doing it and
not causing more harm than good. The risk of mobile capital
migrating elsewhere as we overshoot the mark in regulatory
reform, I think, is a real one and we should take the time to
carefully evaluate the proposals presented to us before we move
ahead with legislation.
So once again, thank you both for coming to the panel
today, thanks to the people who have been here numerous times
in the past as well. Thank you.
The Chairman. Let me just, to balance, because we have the
time, I call on the gentleman from Texas for 1 minute, Mr.
Neugebauer.
Mr. Neugebauer. Thank you, Mr. Chairman. I appreciate the
witnesses providing us with their views on the Administration's
regulatory proposals as well as an update on their efforts to
find more harmonization between futures and securities
regulation. While there are differences in the products in
marketplaces, there is quite a bit of overlap in regulation.
One concern I have heard from those with products that fall
under both regulators is the length of time it takes to get new
products approved in the process for determining whether the
product falls under the CFTC or the SEC. We all want our proper
transparency and disclosure but we also need the regulatory
process to be effective. I am also interested in hearing from
Chairman Gensler about the upcoming hearings at the CFTC
regarding hedge exemptions and positional limits in energy
futures. We have had quite a bit of discussion on this issue in
the Agriculture Committee over the past couple of years and
added new authorities for the CFTC in the 2008 farm bill.
As the CFTC weighs options, we must maintain efficient
price discovery and open market and keep the United States
competitive. As we continue to work through these issues, we
must remember that government regulations can't substitute for
the due diligence for investors and other market participants.
The Chairman. The gentleman from Pennsylvania, the Chair of
the Subcommittee on Capital Markets, Mr. Kanjorski, for 3
minutes.
Mr. Kanjorski. Thank you very much, Mr. Chairman. Among
other matters this morning we will address the need for
effective regulatory oversight of the over-the-counter
derivatives market estimated at $500 trillion in notional
value. These reforms are long overdue. Fifteen years ago, I
first advocated for increased regulation of our derivatives
market. When I helped to introduce the Derivative Safety and
Soundness Supervision Act, we sought to enhance the supervision
of derivatives activities of financial institutions. Since
then, I have endorsed other legislation aimed at improving
transparency in and enhancing the oversight of our derivatives
markets. Our witnesses today, SEC Chairman Mary Schapiro and
CFTC Chairman Gary Gensler, have an important task before them.
They must reposition their agencies to better respond to the
crises of today and the problems of tomorrow.
Fortunately, both of these leaders come equipped with
extensive experience and a commitment to effective regulation.
While this crisis also seems to me the ideal time to merge
these two agencies, political judgments have led us down a
different path. Thankfully, however, the two seem determined to
work together constructively rather than battle over
jurisdictional turf. These two Chairmen are working within the
Obama Administration which will soon release legislative
language on derivatives reform and with Congress can help to
create a more transparent, safer, and less risky over-the-
counter derivatives market. To increase investor protection and
market confidence, we must make this reform effort a top
priority.
Most fair-minded observers have acknowledged that
unregulated derivatives, such as the credit default swaps,
played a significant role in contributing to our present
financial crisis. AIG's disastrous abuse of these potentially
explosive financial instruments represents the most glaring
example of the dangers to our system posed by derivatives. By
moving forward, we should remain sensitive to the highly varied
nature of derivatives products. Derivatives that consist of
highly accustomed contracts which thousands of nonfinancial
businesses, both large and small, employed to managed risk
simply do not easily fit within the mandatory clearing and
exchange trading regime. By mandating the collection of certain
data on such contracts in a repository even where they cannot
be cleared, we can achieve transparency and access for
regulators in the hope that we can detect warning signs of
systemically risky transactions. And by requiring increased
capital reserves for those who enter into unique derivatives
contracts, we can also provide incentives for markets to
standardize these complex financial products going forward.
In closing, Chairman Schapiro and Chairman Gensler can help
Congress to sensibly regulate this dark corner of our financial
markets. I look forward to their testimony.
The Chairman. The gentleman from Delaware, Mr. Castle--
Mr. Castle. Thank you, Mr. Chairman.
The Chairman. --for 1 minute.
Mr. Castle. I appreciate this opportunity to further
explore the Administration's regulatory reform proposal,
particularly looking at securities and futures related reforms
in particular. A lot has been said about derivatives; currency
derivatives, interest rate derivatives, and the like. And I
will be interested to hear what the witnesses have to say about
the over-the-counter trades and cleared and exchanged trades of
derivatives. All of these are issues before this committee and
the organizations our witnesses represent. Although I believe
registering hedge funds and reforming credit ratings are
integral pieces of financial reform, I maintain that we must
fully vet the consequences of the entire proposed regulatory
reform plan. I hope to hear from the witnesses today about
their views on the reform proposal and areas that may need some
improvement.
In particular, I am curious to know if you believe that
there will still be gaps in regulation between agencies, if
investors will be protected as expected, and whether the SEC
and the CFTC will have the resources necessary to carry out the
requirements proposed under these reforms. Thank you. I yield
back, Mr. Chairman.
The Chairman. The gentleman from California, Mr. Royce, for
1 minute.
Mr. Royce. Thank you, Mr. Chairman. Why has the SEC in the
course of the past dozen years experienced catastrophic
failures in every one of its four core competencies: rule
making; filing review; enforcement; and examinations? This was
the question raised by former SEC Commissioner Paul Atkins
recently. And I think it is a tough question that needs
answering prior to giving additional authority to the SEC. Mr.
Atkins goes on to note that Enron's corporate filings were not
reviewed for years in the late 1990's, enforcement examinations
tips were not pursued on Bernie Madoff, and again, potentially
in the Allen Stanford fraud case.
In rule making, the Commission proposed in December of
1997, and again in April of 2005, regulations regarding credit
rating agencies, but never adopted any of those. According to
former SEC Chairman Harvey Pitt, the enforcement examination
failures in the Bernie Madoff case may have been the result of
the SEC developing a blind spot because it is overlawyered and
lacked the necessary traders, managers, and veterans of the
market. This is certainly also the view of Harry Markopolos
who, for years, tried to bring this Ponzi scheme to the
attention of the SEC. Before increasing the SEC's regulatory
authority, I hope we can get to the bottom of these series of
failures. Thank you, Mr. Chairman.
The Chairman. The gentleman from California, Mr. Sherman,
for 1\1/2\ minutes.
Mr. Sherman. Mr. Chairman, thank you for holding this
series of hearings on the Obama Administration's White Paper.
At yesterday's hearing, I relied on secondary sources to agree
with a witness that the resolution authority set forth in the
White Paper involved a permanent unlimited bailout authority.
In fact, page 77, paragraph 2, of the White Paper, does support
that witness' conclusion in large part because the Treasury has
been so bold in interpreting whatever statutory authority we
give them. Secretary Paulson boasted that he went far beyond
any authority.
And of course, the bill has been used to bail out auto
companies and to recycle funds, both real stretches of the
statute. So the onus is on us to draft a statute that cannot be
stretched or manipulated by any Treasury no matter how bold.
And it is especially, the onus is on us to make sure that any
bill we pass does not provide a permanent bailout authority.
Whether that is a fair reading of what the Obama Administration
wants or not, it is certainly not what the people of this
country expect us to do. So I look forward to revisiting the
Chairman's statements that sometimes duplication is better than
ambiguity, and in this case, I may argue for triplication. I
yield back.
The Chairman. If the gentleman will yield, we will be glad
to do that at a hearing at which that is the subject, which is
not today. The gentlewoman from Illinois is recognized for 2
minutes.
Mrs. Biggert. Thank you, Mr. Chairman. Thank you for
holding today's hearing. And welcome, Chairman Schapiro and
Chairman Gensler. I am very interested in the Administration's
evolving ideas regarding regulatory reform. I am interested in
hearing from you all today about the discussions with the
Administration about OTC derivatives clearing and reporting.
How will the Administration define standardized and customized
OTC derivatives? Will new rules include trigger mechanisms that
will mandate that OTC products be electronically traded,
cleared or reported to a central database for review. Which
firms or trading will fall into these three buckets?
I think I want to hear your views on the recently House-
passed cap and trade bill, which includes a transaction tax.
Taxing transactions to raise Federal revenues for more spending
or creating an unnecessary burdensome regulatory environment
may force U.S. businesses and jobs to move overseas. Our
economy can't afford it. I also look forward to you addressing
concerns about the SEC-CFTC regulatory harmonization,
specifically concerns about the inefficiencies of the SEC's
rule-based approach to regulation.
My fear, which I think is shared by many in Chicago, is
that an effort to harmonize regulations between the SEC and the
CFTC may slow down market innovations and give international
competitors an unfair advantage. It is crucial that we strike
the right balance, not overreact and fashion sound regulation
to address the deficiencies in the current regulatory
environment. With that, I yield back.
The Chairman. The gentleman from California, Mr. Miller,
for 1 minute.
Mr. Miller of California. Thank you, Mr. Chairman. In
recent months, it has become increasingly clear that accounting
policy has tremendous impacts on the credit markets which are
experiencing recovery efforts by the financial stability plan.
Specifically, the issue of mark-to-market has not been
adequately addressed. In fact, private market activities,
lending and investing, as well as recovery efforts, remain
hamstrung by pricing challenges while the accounting
policymakers have been willing to or are unable to offer the
necessary guidance.
The TALF program is an example. Under TALF, assets that
investors owned that were placed as collateral are held in non-
mark-to-market accounts to shield the investors from the
exposure. To me, this indicates the problem with the current
pricing regime and accounting policymakers' ability to address
the issues in a meaningful manner. More recently, FAS has made
changes to the accounting standards that will have a tremendous
impact on securitization known as FAS 166 and 167. These
enormous changes are occurring at the same time that the
Administration is trying to restart the securitized credit
markets to facilitate private lending.
It is our understanding that the Federal Reserve has
serious concerns with the policy shift that will derail efforts
to stabilize financial institutions and get credit flowing. Why
is there a disconnect between policymakers who own significant
issues at a time when we are experiencing extraordinary
economic circumstances. There is tremendous challenge facing
the $6 billion--okay, I guess my time is over. Thank you, Mr.
Chairman.
The Chairman. The gentleman from Massachusetts is
recognized for 1\1/2\ minutes.
Mr. Lynch. Thank you, Mr. Chairman. I want to thank our
panelists. I appreciate the frequency of these hearings to try
to get a sense of the Administration's White Paper on
regulatory reform. I would like to hear from the panelists
during their testimony about the issue of these complex
derivatives being traded over-the-counter. I still believe, in
spite of the Administration's position, we have a big payday
problem with the major banks, so I think a lot of money is
going to gravitate to the OTC version of these things. There is
no exchange, so we don't have a consistent valuing mechanism in
place. And I just think that the complexity here is
incentivized under the President's proposal.
I raised these issues with Secretary Geithner in the
meetings that the chairman has arranged, but I still don't
think the protections are there. So I would like to hear the
answer to that in your testimony. And I yield back the balance
of my time. Thank you.
The Chairman. The gentleman from Texas for 1 minute.
Mr. Hensarling. Thank you, Mr. Chairman. I am disappointed
in the Administration's regulatory reform plan for a number of
reasons, one of which is it doesn't seem to make sense of our
current existing regulatory structure as much as simply adding
new regulatory structure on top of it. Again, the premise is
wrong that we suffered from a lack of regulation. It wasn't
lack of regulation, it was regulators making a mistake, and
frankly, some dumb regulation. I know that one of the members
brought up the AIG matter. I would have all my colleagues
recall that the regulators said, do you know what, we had the
expertise, we had the regulatory authority, we had the
manpower, we just missed it. And so maybe there are things we
can do to help make regulators smarter. I am not sure that
necessarily argues for more regulation. I continue to be
concerned that if you hamper or customize OTC derivative
contracts, firms will find it more challenging to hedge their
risk, that means less credit, which means less job
opportunities in an economy that has the highest unemployment
in 25 years. We must do better.
The Chairman. We will now begin with our statements. And we
will start with Chairman Schapiro.
STATEMENT OF THE HONORABLE MARY L. SCHAPIRO, CHAIRMAN, U.S.
SECURITIES AND EXCHANGE COMMISSION (SEC)
Ms. Schapiro. Thank you very much. Chairman Frank, Ranking
Member Bachus, members of the committee, thank you for the
opportunity to testify today on behalf of the Securities and
Exchange Commission. I am especially pleased to be here with my
colleague Gary Gensler. I am committed to a long and successful
collaboration. President Obama recently unveiled a plan for a
stronger and safer financial system. I believe the plan makes
real progress in filling gaps in our regulatory landscape that
became apparent in the wake of the financial crisis. In
particular, it calls for improved regulation, oversight, and
transparency for over-the-counter derivatives, more consumer
investor focus by financial regulators, and improved
macroprudential oversight so that regulators can identify and
minimize risks that flow across the financial system.
I believe this plan will strengthen the SEC, build on our
internal efforts and, in the process, improve investor
protection and help us to begin to restore confidence in our
financial system. The most critical regulatory gap we must fill
involves the enormous over-the-counter derivatives market.
Given the breadth of this market and the importance and
interconnectedness of institutions participating in it, the
Administration has proposed a comprehensive framework for
regulating OTC derivatives with four broad objectives:
preventing activities that pose risk to the financial system;
promoting efficiency and transparency; preventing market
manipulation and other abuses; and ensuring that these products
are not marketed inappropriately to unsophisticated parties.
The SEC, the CFTC, and the Treasury Department have been
working closely and have general agreement on the pressing need
for a comprehensive regulatory framework. There is agreement on
the need for recordkeeping and reporting requirements,
significant transparency, robust margin requirements, clearing
systems that monitor and manage risk, comprehensive dealer
regulation, business conduct and disclosure standards, and
vigorous enforcement.
In fashioning a regulatory framework for OTC derivatives,
it is crucial to recognize the close relationship between the
regulated securities markets and the now mostly unregulated
markets for OTC derivatives. For example, when an OTC
derivative references a security, it can be used to establish
synthetic long or short positions regarding that underlying
security. In this way, market participants can replicate the
economics of either a purchase or sale of securities without
actually purchasing or selling any securities. Because market
participants can use unregulated OTC derivatives to service
synthetic substitutes for securities, these securities-based
derivatives are closely interconnected with the regulated
securities markets. This creates significant regulatory
arbitrage opportunities, that is, moving products away from
traditionally regulated transparent markets to customized
unregulated and opaque bilateral contracts. In deciding how to
fill this regulatory gap, it is important that similar products
be regulated similarly so that market participants cannot use
size and leverage to work around the system.
Accordingly, we believe securities-based swaps should be
subject to the Federal securities laws. This approach would
incorporate the securities related OTC derivatives market into
an existing unified securities regulatory regime. As such, it
would be relatively straightforward to implement because these
products would be placed under the same umbrella of oversight
as the underlying securities. This approach also would
establish a clear delineation of primary regulatory
responsibility which would help avoid regulatory gaps.
And finally, it provides a workable framework for bringing
transparency, clearing, and exchange trading to this market in
the near term without creating undue dislocation. In addition
to OTC derivatives, the SEC and the CFTC have been working
closely together to identify differences between our two
regulatory frameworks that might be harmonized. While the
cultures and missions of our agencies are, in some ways
different, we share many of the same public policy objectives.
While I focus largely on my remarks on derivatives, there are
many aspects of the Administration's plan as well as
complementary proposals that have a direct bearing on the SEC's
oversight capabilities. Very briefly, the plan seeks to require
that advisers to hedge funds and other private investment pools
register with the SEC. Currently, exemptions in the laws have
placed hedge funds and many of their advisers outside the
purview of regulation.
First, through registration and resulting oversight, we can
enable investors, regulators in the marketplace to have more
complete and meaningful information about private fund
investors, the funds they manage and the impact of their
activities on the broader markets. Second, the SEC and the
Administration also appreciate that many investors do not
realize that they may be treated differently depending on
whether they seek investment advice from a broker-dealer or an
investment adviser. I fully support the view that financial
professionals who provide similar services should be subject to
the same standard of care, namely, that they act solely in the
interest of their customers or clients and that they be subject
to comparable regulatory requirements.
Third, I support the Administration's proposals to
strengthen SEC enforcement by giving it expanded authority to
compensate whistleblowers who bring significant enforcement
information to our attention, to pursue expanded sanctions
against wrongdoers, and to increase the potential grounds for
seeking sanctions.
Fourth, I agree with the need to do more to address
conflicts of interest in the credit ratings process. To that
end, I believe the Administration's legislative proposals are a
valuable step forward and will help to better align the
interest of credit rating agencies with investors who rely on
them. Already, the SEC is taking steps to heighten regulation
of rating agencies, including establishing a branch of
examiners dedicated specifically to rating agencies.
Finally, I believe there is a need for a systemic risk
regulator as well as a strong and robust financial stability
oversight council. Such a council would help assess emerging
systemic risk by setting standards for liquidity, capital, and
risk management practices. There is clearly much to do, but I
believe the steps the Administration, the SEC, and the Congress
are taking will help restore investor confidence. Thank you,
Mr. Chairman.
[The prepared statement of Chairman Schapiro can be found
on page 58 of the appendix.]
The Chairman. Chairman Gensler.
STATEMENT OF THE HONORABLE GARY GENSLER, CHAIRMAN, COMMODITY
FUTURES TRADING COMMISSION (CFTC)
Mr. Gensler. Good morning, Chairman Frank, Ranking Member
Bachus, and members of the committee. It is good to be back
with you again after 8 years since I was last before this
committee. Thank you for inviting me to discuss the White Paper
on Regulatory Reform on behalf of the full CFTC. Financial
regulatory reform is critical for the health of our economy. As
President Obama outlined last month, we must urgently move to
enact broad reforms in our financial regulatory structure in
order to rebuild and restore confidence in our financial
system.
I would like to start by discussing reforms most relevant
to the CFTC. First and foremost, this is with regard to
bringing broad regulatory reform for the derivatives
marketplace. This will require two complementary regimes: One
regime that oversees the derivative dealers themselves; and
another regime that oversees the market functions. I think it
is only with those two complementary regimes that we are able
to capture the reforms that are necessary.
For the dealers, we should set capital standards and margin
requirements to help lower risk. We should set business conduct
standards to guard against fraud, manipulation, and other
market abuses. We should also mandate recordkeeping and
reporting with an audit trail to promote transparency. The
dealer regulation will cover all OTC derivatives, standardized
as well as customized derivatives. This, I believe, won't go
far enough, though, and we also need to try to lower risk
further by mandating that standard contracts be on central
clearing and that standard contracts also be on exchanges
whether they be fully regulated exchanges or regulated
electronic trading systems which promotes transparency.
Requiring clearing and trading on exchanges or regulated
transparent electronic trading systems will further promote
transparency, and will further lower risk in addition to the
dealer regime that I talked about. To fully achieve the
objectives, we must enact both of these complementary regimes.
President Obama last month also called for recommendations
to change the statutes and regulations that would harmonize the
regulation of the futures and securities markets, and I believe
this is essential. Specifically, I would just mention three
areas where the CFTC and SEC harmonization process, I think,
would benefit the American public. First, as we saw last year,
there are gaps in our regulatory structure right now. The heart
of this hearing today is filling one of the major gaps; over-
the-counter derivatives.
Second, I think there are places where we may overlap in
regulation. And while in certain circumstances that is
appropriate, we look to identify those overlaps and seek to
work with this committee and Congress where we can help clarify
those overlaps for the marketplace and for all participants.
And third, there are places where we regulate similar
products or similar market events or exchanges where we might
have inconsistent rules, and we look forward to working
together to identify those inconsistencies and try to harmonize
them.
Chairman Schapiro and I are committed to doing this and
seeking public comment. And in fact, we are looking to have
joint hearings between the SEC and the CFTC in August and
September to help inform the Commissions on these views as we
seek to inform the rest of the Administration and you on our
views on these matters. As we work with Congress to apply these
regulations to over-the-counter derivatives, I think it is a
real opportunity actually to start with harmonization right
here on over-the-counter derivatives.
And whether the SEC has jurisdiction or the CFTC, we need
to have similar fraud standards and manipulation standards,
that the electronic trading systems that we oversee have
similar standards and that we embed in statute, the over-the-
counter derivative statute, that we have strong vigorous
standards with this regard. I would also like to just briefly
touch upon hedge funds where the Administration is called to
require hedge funds to register and other investment funds with
the SEC, which I fully endorse. But I think as we go forward to
do that, we have to ensure that the CFTC still can make sure
that anyone participating in the futures markets and those
markets that we oversee that we are able to have our full
ability to police those markets and get ready access to
information from the SEC from these hedge funds.
Lastly, I just want to say how fortunate I believe to have
a partner in this effort, SEC Chair Mary Schapiro. She brings
invaluable expertise which gives me great confidence that we
will be able to provide Congress with sound recommendations on
comprehensive oversight of OTC derivatives in the markets as a
whole. I look forward to your questions, and I am glad to
testify in front of you at any time, Mr. Chairman.
[The prepared statement of Chairman Gensler can be found on
page 43 of the appendix.]
The Chairman. Thank you. Ms. Schapiro, one of the issues
that you know people have concern about here that is clearly in
your jurisdiction is the short sale question. Could you give us
the state of play now before the Commission, what are you
thinking about, what is pending, what do you think is going to
be happening?
Ms. Schapiro. I would be happy to, Mr. Chairman. As I have
told the committee before, that has been the number one issue
on which I receive comments and letters from both the public,
the industry, and Congress as well. The SEC proposed a rule a
couple of months ago and the comment period closed on June
19th, multiple approaches to dealing with short selling in the
marketplace. Those approaches broke down roughly to two
categories: a set of proposals that would operate as a market-
wide mechanism to slow the descent of stocks during a declining
market; and the other set akin to the old uptick rule or a bid
test.
The first set of proposals were triggered off of a circuit
breaker concept so that if the price of a particular stock
declined by more than, say, 10 percent in one day, then a
circuit breaker would kick in and no more short selling of that
stock would be possible for some period of time. As I said, the
comment period closed on June 19th on the multiple proposals.
We received 4,000 comment letters. We are working our way
through those comment letters. In addition, we held a
roundtable to solicit views.
The Chairman. What is your timetable for a decision?
Ms. Schapiro. I am hopeful that we will do some interim
steps very quickly with respect to fails to deliver and a
number of other rules that were also in play. And I am hopeful
that over the next several weeks or next 2 months we will be
able to come to closure and, assuming the votes on the
Commission, an appropriate response.
The Chairman. Thank you. I know members may still have some
further questions about that. On the registration of hedge
funds, let me ask both of you, I think there is a fairly broad
consensus among some on our side of the committee that hedge
funds should register, but the question is how. That is, hedge
funds are not mutual funds. And I know when you are a lawyer
and you have to choose, well, we will take this model or that
model, A or B or C, but we can make it A-plus or C-minus or ice
cream. So we can do whatever we want in terms of the form. When
we come to the drafting on registration of hedge funds, should
we pick one of the existing models, etc., or would you
recommend that we draft a registration for hedge funds that
might vary from some of the existing forms taking into account
their particular nature? Ms. Schapiro?
Ms. Schapiro. I think, Mr. Chairman, there are obviously,
as you suggest, lots of ways to do this. You can register the
funds themselves as investment companies and then try to exempt
them from a lot of the requirements. You can register the
adviser to the hedge fund which is what the SEC has proposed
doing which would get us I think virtually everything we need
to effectively regulate hedge funds in terms of registration,
inspection ability.
The Chairman. Let me just say, because again, we have the
power to write the law, requiring to register and then
exempting from some of the requirements of what we register
doesn't make a lot of sense, right? We ought to just write it
right the first time.
Ms. Schapiro. I don't disagree with that. And I think the
concern would be that trying to stuff a hedge fund into the
model of an investment company isn't really the most rational
way to go. But registering the investment adviser gets us
access to really everything we need as a regulator of these
instruments with the exception of the ability to impose on the
fund itself capital requirements, diversification requirements
that nobody is envisioning, at this time any event, needing to
do. So we think adviser registration works.
The Chairman. I figured that, and depending on how it
works, that could conceivably be something that a systemic risk
regulator, however it is constructed, might be taking a look
at.
Let me ask the last point on derivatives. One of the
questions that has come up was mentioned today in one of the
publications. What is your view on--well, let's put it this
way. What is the function that is served, and there may well be
one, when someone who does not own an asset buys insurance
against a drop at its value, people buying credit default swaps
who don't have an economic interest, in particular, on the item
for which they bought the credit default swap. Is that an
economically important function? Should we, in any way, try to
change that? Mr. Gensler?
Mr. Gensler. I think that the function of using a
derivative to hedge a risk, first and foremost, is generally a
risk that is in that commercial enterprise. But there are some
times that you are hedging a risk that is similar to a risk you
have. So it may be that a commercial bank wants to hedge a
portfolio of loans and enters into a credit default swap which
is on a portfolio, again, of listed securities that have some
correlation or relationship to it. So there are--
The Chairman. Let me ask you, and finish in writing, is
there a third category, that is, you might decide to buy one
because you are taking a good guess that something is going to
go bad and you will make some money if it does, and is that
something that is good or bad or indifferent? Well, let me get
that in writing because we don't have time. We have a lot of
members who want to ask questions. The gentleman from New
Jersey.
Mr. Garrett. Thank you, Mr. Chairman. Taking a page out of
Mr. Royce's comment, and as I said the last time, we have sort
of been here before with regard to having a problem and then
coming back to reform it, and we went through a litany of
problems in the past of the SEC. Just yesterday, we had a
panel, and the idea was we were going to give more authority to
the Fed. And I went through a litany of problems where they
missed on capital requirements, they missed on regulation, they
missed on monetary policy, and yet it is the thought right now
in Congress we are going to give even more authority there to
the Fed. So in a sentence, why should the American public be
watching the hearing today and be sanguine to think that we
should be at this point giving more authority to the SEC?
Ms. Schapiro. Congressman, I think it is fair to say that
every regulator over the last several years has had episodic
failures and missed many of the issues that gave rise to the
financial crisis, the SEC included, but certainly not only the
SEC. But at the end of the day, there is an enormous amount of
work that happens at the SEC that benefits the American
investor and taxpayer on a daily basis. Whether it is the
review of corporate filings to ensure that they are honest and
transparent or ensuring that mutual funds are actually
operating as they have extremely effectively over the last
several years.
Mr. Garrett. I appreciate it. They do some good, but
obviously, the failures in the past, present company excepted
because you were not there at the time, is something that just
raises that question. I don't have much time, so let me go on
to the next point, because I know you are going to sing the
praises of things that have been done well. A lot of people
could have a disparate opinion as to what brought us here. Some
people would say it is GSEs and their leveraging issues, other
people would say it is the credit rating agencies and they have
problems; other people would say it was the regulators or the
OTS and what have you that simply missed things and what have
you. A lot of people can point out different things. We have
not come to a conclusion as to what the problem ultimately was
that brought us here. Can you point to one example where it was
standardized derivative products that was ultimately part of
the cause that brought us here?
Mr. Gensler. I think that the unregulated derivative
dealers, the affiliates at Lehman Brothers and Bear Stearns
and, for that matter, even that which was in the back allowed
for a great deal extra leverage in the system.
Mr. Garrett. Okay. That is the--
Mr. Gensler. And even the standardized product.
Mr. Garrett. That is the entities. How about the product
themselves? What we are talking about here is regulating the
product and putting constrictions around the product itself,
and its a standardized product as opposed to, because there is
a whole host of other proposals out there as far as regulating
the brokers and investment advisers, can we point to where it
was--
Mr. Gensler. I am of the firm belief that bringing
standardized products onto central exchanges and onto central
clearing will lower risk and enhance transparency. Tens of
thousands of end users will benefit by that.
Mr. Garrett. I appreciate we can lower risk, but can we
give one example so I can go home and say this was part of the
problem that caused it and here is a specific example.
Mr. Gensler. I think that AIG is Exhibit 1--$180 billion of
American taxpayer money for standardized and maximized
products.
Mr. Garrett. Excellent point. AIG, would they be products
that would therefore go through and be considered a
standardized product that would go through a clearinghouse?
Mr. Gensler. Many of their products would. Some of them
were so customized they couldn't. But all of them would be
regulated for capital and margin. All of them would be
regulated as a derivative deal.
Mr. Garrett. Wasn't most of the problem with the AIG
situation with their credit default swaps which were based upon
the subprime problem and the mortgage problem? They would not
be standardized product.
Mr. Gensler. Also, there was no effective Federal
regulation for capital or margin. So last September, Congress
was put in a terrible position we should never put Congress in
to have to think about the TARP bill and then the Federal
Reserve and the Treasury loan, you know, this $180 billion of
the Fed specifically. We want to avoid that in the future. And
that is for standardized products as well as customized
products. We need capital and margin requirements to do that.
Mr. Garrett. Well, I have never heard anyone say that the
problems over at AIG were with their standardized product.
Mr. Gensler. It was actually both. The customized product
get a lot more publicity obviously because they are so exotic.
But it was also the standard. It is the amount of leverage that
you can put in the system, how much debt you can put on a very
small basic capital.
Mr. Garrett. Very quickly, I have heard a lot of people
from the business community say even with the nonstandardized
products which would raise the capital requirements or the
marginal requirements that this would basically make it
impossible for them to use them and hedge their businesses. You
only have 30 seconds.
Mr. Gensler. I think that it is a very good question, but
they could absolutely--end users could use the products. We are
saying there should be customized products. I think that by
bringing transparency to the standard part it would actually
lower costs because they should see where the spreads are and
they could price off the standard product.
Mr. Garrett. Thank you.
The Chairman. I recognize the gentleman from Pennsylvania
and take 15 seconds to say, Mr. Gensler, when you said that the
AIG thing put Congress in a terrible position, yes, but only as
spectators. I do want to emphasize. We voted on the TARP, but
the Administration came to us, the Secretary of the Treasury
and the Chairman of the Federal Reserve last September, and
informed us that they decided to advance money to AIG. There
was never any congressional input into that. A few jaws dropped
but no votes were taken. The gentleman from Pennsylvania.
Mr. Kanjorski. Thank you, Mr. Chairman. And should we add
that there was a different President at that time?
The Chairman. Yes.
Mr. Garrett. We don't want to get partisan, do we?
Mr. Kanjorski. No, no. Just timeframe. First of all, the
relationship between the two of you is something we should
compliment, and I do. And I anticipate that because of this
good relationship we are going to have very positive things. I
understand because of prior meetings and other testimony that
you have made that you have worked out and harmonized a great
deal of the conflict between the two agencies but that you have
not resolved all of those conflicts. And you are down to what
really I would like to ask, what are the remaining
disagreements between the SEC and the CFTC that have not yet
been harmonized and are still open in the air, and do you have
a suggestion where they are going to come down and are they
resolvable at a given time?
Ms. Schapiro. Let me take the first crack at that and then
ask Gary obviously to fill in. I think you point out correctly
that we have tremendous agreement around most issues. There is
a very narrow area where we are not in full accord, and that is
with respect to whether broad-based indices, OTC derivatives or
swaps on broad-based indices should be regulated by the SEC or
the CFTC. Our view is that securities-related derivatives ought
to be under the SEC's jurisdiction.
The Commodity Futures Modernization Act, while exempting
these products broadly from regulation, did retain with the SEC
antifraud authority over anything securities based. As Gary
will point out, under the Shad-Johnson Accord reached quite a
few years ago, there was a drawing line between narrow-based
and broad-based indices. Broad-based went to the CFTC and
narrow-based went to the SEC for the purposes of options and
futures. I would say that is the one area that we still are
trying to work through. As we go through our harmonization
process, and as Gary said, we are going to hold joint hearings
to get public input on this, we will discover there are lots of
areas where our rules approach things differently.
And on those I don't even know that we will have particular
disagreement. Some won't be able to be harmonized because the
nature of the markets and the products is quite different. But
that is what we are working through right now.
Mr. Gensler. I would agree with that. I think that we are
in agreement. And the products, the interest rate, currency,
and commodity products, the CFTC would take the lead on. On the
narrow-based, the SEC would take the lead. This is broad-based
product area. Currently, there are over 150 broad-based futures
contracts. There are five or six that trade actively that are
regulated by the CFTC. There are about 60 options on those
futures, again, regulated by us. So broad-based implicate
those. But there is a second category that I should mention. I
do think we can go in and harmonize for the trading platforms.
And working with Congress and working together we can do that,
but we haven't yet, between our agencies, been able to get to
that level of detail. But I think that would be important.
Mr. Kanjorski. I did hear, though, in Chairman Schapiro's
testimony, that there is a concession that there will be some
areas that cannot be harmonized and will take some other
action. And that is consistent with other things that I have
seen in the last week or so where regulators have not been able
to agree as to where a problem should lie in terms of who has
the responsibility of solving or moving in. I am particularly
referring to the CIT. There seemed to be three Federal
regulating entities that were not quite in agreement as to who
had the responsibility to take action if any.
As a result of that, and the fact that we have a
concession, you cannot harmonize, have you thought of the
possibility of our creating an Uber-regulator so that there is
a final resolver of conflict of disagreement in the regulatory
community of the United States if the problem gets--rather than
just waiting around for months and having the Congress enact
some special features because of a disaster. Can we close it
down as if there is an actual decider and a peak and have you
given any consideration to that?
Ms. Schapiro. I think it is certainly worth exploring. And
I do think, to the extent Congress might move forward with some
sort of financial stability oversight council, whether as the
systemic risk regulator or as a body over the systemic risk
regulator as we would propose that might be a forum for broader
discussion of the differences with other regulators. It might
help us achieve some kind of a consensus on how to go forward.
The Chairman. The gentleman from Alabama.
Mr. Bachus. Thank you. I noticed that both of you, in your
opening statements, said that you were working together as
colleagues and in partnership and I think that is going to be
critical and I was glad to hear that. I think the key in doing
this, we are going to continue to have two separate agencies,
that is apparent. We are the only country in the world that
really has that dual set of securities and futures, and you
know they are regulated quite differently.
So I think there is obviously a need for harmonization. I
think the key is going to be the leadership of you two. I think
that will really set the tone and will determine how successful
we are. So I applaud you for your opening statements. I also
want to focus on something, and I agree that Chairman Schapiro
said, she said I want to emphasize to the committee that the
SEC and other financial regulatory agencies have been making
solid progress using our existing authority to address the
financial regulatory problems that face this country.
You do have a lot of existing authority, and I think it is
important that we as a Congress realize that. And actually, in
all this regulatory reform, my concern has been that we are
telling you what to do as opposed to you looking at your
authority you have, looking at the problems that we now all
realize, and they are very complex problems, and saying to us
this is what we need, you know this is how we are going to
discharge that authority or we need additional statutory
authority. As opposed to, particularly with some of the banking
regulators, saying we are going to totally change our approach
to regulation and some good, but maybe not so good ways.
I am going to ask one question and one question only.
Having to do this by September 30th is to me an overwhelming
and unrealistic goal. Now, I know that the problems are there,
but you have already taken steps. And other regulators have
already taken steps, I think, to minimize a recurrence of what
we saw last year.
I don't think in the current climate that businesses are
going to take that kind of risk, number one, or that regulators
are allowing that kind of risk. But tell me, I will ask both of
you, how realistic is that? And will you not hesitate to ask
for more time?
Mr. Gensler. We certainly will not hesitate to ask for more
time, but what we are trying to do--and I think why the
President and Secretary Geithner asked for that time--is to
help inform Congress as they are embarking upon legislative
process. So we are going to have joint public hearings to hear
from the public. We are doing what I will call a ``gap
analysis'' to see where the gaps are right now. And then we are
going to try to have as many meetings as we can fit into our
schedule to try to resolve those and make recommendations. But
again, we might have an interim step on September 30th, and
then have more to report, but to help you in your legislative
process as well.
Mr. Bachus. Chairman?
Ms. Schapiro. I would agree with that completely. We are
really committed to getting as much done as we can by September
30th. And if we need more time, we will ask for more time. It
is very important that we get this right. These are, as many of
you have pointed out, massively important markets, and we want
to be sure we are thoughtful about it.
Mr. Bachus. And I endorse this idea of trying to get at
least an interim report, but I would caution you as well as you
cautioned, I think, in your statements, how complex these
matters are and that you want to get it right because these
have tremendous implications for our economy if they are not
done right.
So I thank you and look forward to what I hope will be an
interim report September 30th.
But I would caution you also, you are going to be asked to
speak to all sorts of forums and all sorts of public addresses.
You need to limit some of that. You need to set your priorities
because there is a lot of hard work back at the agencies. And I
hope that the public and the Congress will realize that the
agencies are going to have to do a lot of hard work, a lot of
concentration, and a lot of study in a very short period of
time.
Mr. Gensler. Thank you.
The Chairman. I just would say, I think the gentleman from
Alabama has just shared with you the advice he probably gets
from his scheduler, as we all do: Don't speak at every forum of
your priorities. So you are getting passed on what every one of
us hears every day.
The gentlewoman from California.
Ms. Waters. Thank you very much, Mr. Chairman. And I thank
our presenters for being here today.
As you know, I have introduced H.R. 3145, a bill to ban
credit default swaps. And that has caused a lot of conversation
with many saying, well, they should not be banned but we should
have the central exchange and there should be transparency. But
the more I learn about them, the more concerned I am. I just
want to cite this particular situation.
McClatchy Company provides the most recent example of
credit default swaps hindering our lending markets. This
California-based newspaper publisher with large holdings in
North Carolina and Minnesota recently offered bondholders an
above-market price for its outstanding debt. The company made
this offer in order to offset declining advertising revenues
with reduced costs. More than 90 percent of bondholders have
turned down this offer.
According to an industry analyst, the debt offer failed
because many of the bondholders also had substantial credit
default swap positions. These bondholders stood to gain more
from McClatchy's demise than from its continued operation.
While the company still exists today, it carries massive
amounts of debt, thanks to the many empty creditors who stand
to profit from McClatchy's bankruptcy.
Some say we should only be concerned about naked credit
default swaps. I say we should be concerned with all credit
default swaps, particularly when they function as an incentive
to drive a company into bankruptcy.
Ms. Schapiro, if your agency was given authority over
security-based swap agreements, how would you deal with this
very controversial question of credit default swaps? And if you
could, comment on other types of swaps, such as interest rate
and currency swaps.
Ms. Schapiro. Thank you. I will ask Chairman Gensler to
talk about the latter two since those are CFTC-related
products.
You raise a very important question, and you and I have had
a little bit of a chance to discuss this previously. There is
no question but your economic interest, when you are on a
credit default swap, may dictate that you have less incentive
to cooperate with a troubled company entering bankruptcy,
because you are going to be paid when that credit event happens
in any event. And perhaps to make things worse, there may also
be an incentive to even short the stock on top of that.
I think transparency would help tremendously in this
regard. And I think attaching some greater costs, frankly, to
doing credit default swaps via regulatory oversight, which
obviously has a cost to it, the provision of capital and margin
requirements.
I do think that as we explore this issue--and we are
spending a lot of time thinking about it, and whether at a
minimum there ought to be some kind of an insurable interest--
we have to think about the complexities even of just that piece
of it, putting aside whether you would ban the product
entirely.
A bondholder has an underlying economic interest. Yet in
this instance, they were not incented to cooperate in the
bankruptcy. Does an equity holder have an economic underlying
insurable interest? What about a large supplier to the company
who would see their revenues disappear if the company declares
bankruptcy? Might not they want to ensure that revenue stream
through the purchase of a credit default swap? So I think the
complexities are very significant and ones we have to work
through.
I would say that if Congress decides to go down the path of
banning naked credit default swaps, it would be good to think
about doing something like that prospectively, given the size
of the marketplace that already exists and the potential
disruption of unwinding those kinds of positions. But again, I
think these are very difficult questions.
Ms. Waters. Thank you. I still have time.
Would you like to comment on that, please, Mr. Gensler?
Mr. Gensler. Well, I do think that on the credit default
swaps--and this is one of the reasons why we agree--the credit
default swaps on single issuers like McClatchy that you
mentioned, are very related to their stock, are very related to
their bond. And appropriately, all of these interplay on
investor protection and should be regulated, I think, jointly
by the SEC. And just as they are looking very closely at the
short sale roles on equity, there is some similarity of the
short sale or naked sales in credit default swaps.
I think as it relates to interest rate swaps and currency
swaps, what really are far more about broad interest rates or
broad--you know, where currencies are, that there is a role for
both hedgers and speculators. And speculators play an important
role in the marketplace, even if they are naked, so to speak--
if that term is all right--because they provide the other side,
so that hedgers can find somebody that may, in essence, provide
that insurance to them who want to protect themselves in
currency and interest rate markets.
Ms. Waters. Thank you very much.
I yield back the balance of my time.
The Chairman. The gentleman from Texas, Mr. Neugebauer.
Mr. Neugebauer. Thank you, Mr. Chairman.
Chairman Gensler, I understand that the CFTC is going to
have some public hearings regarding hedge exemptions and
position limits in the energy markets. As you are aware, in the
2008 farm bill we had quite a bit of discussion about that, and
we expanded some of the CFTC's authority in that area. There is
a lot of disagreement about the role of speculators in the
marketplace. And my opinion is that they provide liquidity and
price discovery by the fact that they are in the marketplace.
But what do you think might be the impact if you move to
limit, and in some cases prohibit, some institutional investors
from actually being in the energy commodities?
Mr. Gensler. I thank you, and I thank you for the support
in last year's farm bill for the additional authorities.
The CFTC, under a statute that had been in place for some
70 years, sets limits in the agricultural space--corn, wheat,
soy, and so forth--and has the authority, in fact, it says that
we shall set them in other markets.
And so what we have raised as a question is, we do it in
the agricultural stock, we don't do it in the energy markets.
The philosophy really is to protect against the burdens that
may come from excess speculation. Speculators are good, they
provide the other side for hedgers to hedge their transactions.
But conceptually, it is that we have at least a minimum number
of participants in a market place. If there is a diversity, if
you had that 10 percent limit, then you would have at least 10
participants in a marketplace and lower the risk that there are
dislocations. If they have to liquidate those positions, it
actually lowers the risk in clearinghouses that we have been
talking about today.
So we are going to have hearings starting next week--I see
Commissioner Dunn from the CFTC is here also today--and we will
be looking at this over the next several weeks and then trying,
if appropriate, to move on it during the fall.
Mr. Neugebauer. One of the issues, though, that I get
concerned about, when you talk about beneficial interest and
whether someone is hedging or they are speculating, I would
submit to you that in the energy business, everybody in this
room has some beneficial interest when it comes to energy. So
one of the concerns I have is if we move in this direction,
what impact could that potentially have on commercial hedging
if we begin to limit the participants in that? Because, as you
know, it is a fairly large market.
Mr. Gensler. And our mission is to make sure that the
markets are fair and orderly and provide the risk management
for those hedgers. But through position limits, Congress gave
us the authority many years ago to set position limits to
protect those markets, so that they are fair and orderly and
they represent the price discovery that you are so--so I think
we are aligned on that, and it is whether this promotes market
integrity along that front.
Mr. Neugebauer. And then there is the question out there
that there are other places for the investors to go and trade
energy. Obviously, the United States doesn't have a lock on
that. What impacts, if we get two prescriptive, too overly
protective here, could that have on U.S. markets down the road?
Mr. Gensler. It is a very good point. It is why we have
asked Congress and this committee to consider in over-the-
counter derivatives regulation that we also make sure that the
position limit authority for commodities of finite supply, that
we also be able to do that in the over-the-counter market if it
serves a price discovery function back into the other regulated
markets.
Because you are right that you could move from the futures
to the over-the-counter derivatives. And we saw that in a
number of cases in the last several years.
Mr. Neugebauer. Quickly, a question to both of you. You
know, we see in this regulatory proposal that the
Administration is putting out, you have the clearinghouses, you
have the regulators, and you have obviously the investors.
There has been a lot of discussion about bringing more equity
and margin to the marketplace. Do you support a more aggressive
setting of margin requirements from the regulator, or still
leaving that decision to be made by the individual clearers,
and basically with the regulators primarily looking at the
capital structure of the clearing entities?
Mr. Gensler. I think we need to start with having in
statute, mandatory centralized clearing for the standardized
product as contrasted today--it is voluntary--and that there be
rigorous risk management standards and that clearinghouses have
open access to members to be part of that.
Margin could first be set by the clearinghouse, but that
the regulators, the SEC and the CFTC overseeing those
clearinghouses should be able to prescribe through rules those
risk management standards and, where appropriate, if we find
that a clearinghouse--just as we have in the futures clearing
and an options clearing now, the regulators do have authority
to go in and comment on that.
Mr. Neugebauer. Mr. Chairman, could I ask Ms. Schapiro to
quickly answer that? Could I ask unanimous consent to have an
additional 30 seconds?
The Chairman. We have members low down who don't get to ask
questions. If everybody gets an extra 30 or 45 seconds, then
they are not permitted. That is why I would object. People can
answer in writing.
The gentlewoman from New York.
Mrs. Maloney. I first grant 30 seconds to Ms. Schapiro to
answer his question.
Ms. Schapiro. Thank you.
I very much agree. I think that margin levels can be set in
the initial instance at clearinghouses. I think it will be very
important for the regulators to have very robust oversight of
those clearinghouses to ensure that they themselves don't
become systemic risk concerns over time. And that will involve,
obviously, making sure they are stress-testing those marginal
levels and their capital levels, as well as ensuring they have
all the proper systems and backup and books and records and
transparency.
Mrs. Maloney. First, I would like to welcome our
witnesses--particularly Mary Schapiro, a former constituent, a
resident of New York; New Yorkers are very proud of your
service and your current appointment--and to Gary Gensler, the
Chairman, who was part of the Clinton team that brought us the
longest period of economic expansion in our country's history
of balanced budgets and surpluses. I am glad that you are back
on the economic team. And welcome, it is good to see you again.
First of all, I want to say that I truly believe that
reforming the financial markets and system is the most
important issue before our country. And getting it right will
determine our economic growth and expansion for the next--
probably 50 years.
And I want to go on record in support of the many honest
hardworking men and women in the financial services industry.
Many people have made mistakes, and they feel like they are
unjustly being attacked when they are trying very, very hard to
be part of the solution and part of moving our economy forward.
I also want to state how important financial services are
in terms of our exports. Along with Boeing, it is one of the
largest areas that we export goods and services that helps with
our trade deficit. So moving forward in a correct way is
tremendously important.
I for one would like to wait until the report comes back
from the Commission that we have put in place that will tell us
what was really the problem, so that we can make sure we are
addressing what is the thoughtful process of what caused the
crisis. I truly believe the best chapter in government since I
have been in Congress was the 9/11 Commission report that
expertly pointed out what caused the problem, with concrete
recommendations of what should be done. And I would like to see
what this Commission has to say.
But the first road map we saw was AIG. And it clearly
showed markets were out of control. No one knew what was going
on. At the beginning of the week, they said they didn't need
help. By the end of the week, they needed $50 million. By the
end of the weekend, they needed another $30 million, and then
it just continued.
Former Chairman Fuld testified before this committee on the
Lehman disaster and crisis and said if he had one
recommendation, it would be that there would be one central
clearinghouse so that you had control of what your exposure is
internationally and nationally so you understood the exposure.
I don't think you are going to get that with capital
requirements and margin requirements and leverage requirements.
And my question, really to Mr. Gensler is, in these
clearinghouses are you proposing one central clearinghouse,
which is what he suggested, or several clearinghouses? And then
what do you determine is going to be over the counter, what is
going to be in a clearinghouse? But do we have one area where
we are going to be able to track the exposure of investors and
the economy of our country?
Mr. Gensler. I thank you. And I thank you for that warm
welcome. And having met my wife and having my three daughters
born in New York, I feel some closeness, too.
I think that we must bring the standard product into
clearinghouses, but the reason for the regulation of the full
dealers is so we can also regulate the customized as well as
standard--
Mrs. Maloney. Would it be one clearinghouse or many
clearinghouses? How many clearinghouses?
Mr. Gensler. What we would envision is that we would allow
the market--right now there are three or four clearinghouses
sort of, as I say, competing for this. They need not to be
voluntary, but they need to be mandated, and that the
regulators would be able to see them and rigorously oversee
them. If they meet the standards, they would be able to
compete. I believe over time you might see a consolidation and
a concentration in this, but initially the statute would allow
for more than one clearinghouse.
Mrs. Maloney. Very clearly, my time has almost expired.
Brooksley Born fought very hard to keep derivatives,
particularly energy derivatives, on the exchange. I put forward
an amendment that mirrored her recommendation, which failed
primarily because the regulators were opposed to it. Where does
that stand now? Are the energy derivatives back on the
exchange?
The Chairman. Quick answer.
Mr. Gensler. We believe that energy derivatives need to be
brought onto the exchange if they are standardized. With the
exempt commercial markets through the farm bill, we have more
authorities than we used to have.
The Chairman. The gentleman from Delaware. And remember,
our witnesses are encouraged to respond in writing in greater
detail, and we will have plenty of time this summer to read it
before we get to any legislative activity.
The gentleman from Delaware.
Mr. Castle. Chairman Schapiro, you and others--even us up
here--expressed some concern with the revolving-door issue of
employees at the SEC. Actually, I don't see employees of the
SEC. I see you or your predecessors, or whatever. But as you
know, the concern has always been that people go to work at the
SEC, they are relatively young, they are relatively
inexperienced, and they may then be looking for offers from
Wall Street, so that may taint what they are doing--not to
suggest there is anything wrong with what they have been doing,
but it may taint their thinking on it. And the thinking was--
and you stated--that we need more experienced people.
Is that starting to happen with the economy and with your
desire to change that? Can you give us a brief answer on that
subject?
Ms. Schapiro. Yes, very much so, Congressman. We have been
able to take advantage of some of Wall Street's woes by
bringing on board tremendously experienced people with a broad
range of skill sets.
I am sorry Congressman Royce isn't still here, but we
aren't just hiring lawyers and accountants, we are actually
bringing in financial analysts, forensic accountants, people
with expertise in trading and derivatives, in a wide range of
areas, and we are very much the beneficiaries of Wall Street's
woes in that regard right now. And that is very much by design
that we are bringing in those skill sets.
Mr. Castle. Thank you. Let me jump to another subject. When
you talk about hedge funds--and I think there are other private
pools of capital you were talking about--you indicated they
should be registered. And I couldn't find it in your written
testimony, but in your oral testimony you suggested that
registration would lead to other oversight of those particular
entities.
Can you elaborate on that a little bit? I mean, I can
understand and I am all for the registration--I am probably for
the oversight as well--but does that automatically lead to
other regulatory supervision of these entities?
Ms. Schapiro. Not automatically, but I think there is an
expectation on the part of the public that if an entity would
be registered with us, we would have some regulatory oversight,
including reporting to the SEC and, ultimately, if there is a
systemic risk regulator, to the systemic risk regulator about
trading activity.
We would expect to have the ability to examine the books
and records of a hedge fund, potentially to write rules that
might require the provision of certain kinds of information to
their investors or to counterparties.
But our commitment is also, though, not to try to force
hedge funds, PE firms, venture capital firms, into a model that
doesn't fit for them. We recognize these are different types of
investment vehicles, but I think we need to bring them under
the umbrella of regulation.
Mr. Castle. And if you could share with us what is
happening with respect to credit-rating agencies, without going
through all the details of that. We all know that there have
been some concerns about the ratings of various products that
ended up falling flat on their faces, etc. And should we be
doing more with transparency registration of some of the
credit-rating agencies? Where does that stand right now from
the SEC?
Ms. Schapiro. Well, as you know, since the agency got
authority under the 2006 Act, it has engaged in no less than
five rulemakings to try to put some structure around the
regulatory regime for rating agencies. And many of those rules
are new and we are seeing how they work.
But I will say that we are going to go forward later this
summer with some additional rules that we think will be very
useful. One would propose to require issuers to disclose
preliminary ratings they have received as a way to get at this
issue, which I find really pernicious, of ratings shopping.
Another would require disclosure of the underlying data in
structured products that are being rated to all other rating
agencies so they can perform an unsolicited rating as a check
on the conflicts that exist in the issuer-pays business model.
We are going to look at sources of revenue disclosure,
again, to get at the conflicts issue. More performance history,
how the ratings have performed over 1-, 5-, and 10-year periods
of time. And we are beginning a road map to explore how the SEC
and its own rules can lessen reliance on ratings as a way to
hopefully get investors to do additional due diligence on their
own as well.
So we have quite a lot in the works. And of course the
Administration has a new proposal that came out yesterday to
require mandatory registration and a number of other things.
Mr. Castle. Well, thank you. I believe there are a lot of
legitimate concerns with credit-rating agencies, and we should
be trying to help with that as well.
I thank you for your testimony and yield back.
Mr. Kanjorski. [presiding] We will now hear from Mr. Watt
of North Carolina.
Mr. Watt. Thank you, Mr. Chairman.
Let me go back to a question that was raised earlier by Mr.
Kanjorski. A lot of people have said that if we were starting
from scratch, we would have only one agency. And I understand
the political realities of two existing agencies, the history
that exists there.
And you addressed the process that the two of you engaged
in cooperatively to define what turf should be in the SEC and
what turf should be in the CFTC. You said you have come to
fairly good understandings about existing products.
I guess the question I want to ask is, with respect to a
new product and the possibility--probability--that at some
point in the future the two administrators of these agencies
won't be as nice and kind and cooperative with each other as
the two of you are, how should we be assuring in this
legislation that there is not the potential for future conflict
and legislating a way to resolve that conflict if in fact it
does occur?
Ms. Schapiro. I am happy to take the first shot at that.
I think you have identified a real issue for sure. And we
have this concern now. We have products that are not clearly on
the futures side or the securities side, and it takes the
agencies a very long time--really in some ways an unacceptably
long time--to resolve where these products will trade and under
which regulatory regime. And we disadvantage commercial
entities who are trying to propose these new instruments.
I think we are of good will here. I think we will try and
we will be more successful in working those issues out.
Mr. Watt. I have the utmost confidence in the two of you,
as I said, but I am not sure that I have the utmost confidence
in the future. And we are trying to draw a process that will
last, as this process did until the meltdown, for 75 years or
more.
Ms. Schapiro. I think short of merging the agencies--which
is also not in the cards--that one option would be to use
something like the Financial Stability Oversight Council that
has been proposed by the Administration as a mechanism or a
forum for the resolution of these kinds of issues.
Mr. Watt. And we can write that into this legislation.
What is your opinion on it?
Mr. Gensler. I think if we limit the differences, if we
harmonize going in, Congress writes clear, statutory guidelines
on the clearinghouses and on the exchanges, it sort of limits a
little bit more whether a product is under one set of
Presidentially appointed people and career staff and another
set of Presidentially appointed people and career staff--I
mean, to the extent that we harmonize going in. And so that is,
I believe, a challenge for all of us.
Mr. Watt. But you acknowledge that we need to address that
probably in this legislation; do both of you agree on that?
Mr. Gensler. Yes.
Mr. Watt. Mr. Gensler, you actually led to the next
question I want to try and get some further clarification on,
because I am not clear in my own mind. You have referred to
clearinghouses, and I think you also referred to electronic
platforms. I want to get a clearer understanding of the
difference between those two as you see it. Just give us a
little education here so the members of the committee,
including myself, fully understand.
Mr. Gensler. I thank you. Both are very important. They
serve different functions, though. Both, I think, should be
regulated by the market regulators. The exchange is where
buyers and sellers meet, and there is transparency on the
transactions themselves. And what we are proposing is that
after any transaction in a sort of real-time basis, just like
we have in the corporate bond market now and the equity markets
and the futures markets, those trades are reported, so there is
transparency between buyers and sellers, and then that the
trades are announced.
Clearinghouses have lower risk because it is where, after
the trade, after the transaction had happened--and some of
these transactions will go on for 30 years if it is a 30-year
interest rate swap--that we can lower risk because the
transaction has to do with a lot of things like marking it to
market, posting collateral, to make sure that the transaction
can live those 30 years regardless of market events.
Mr. Watt. My time has expired. If you would just give me
some more written information about that distinction, because I
am still a little unclear--electronic platforms,
clearinghouses, electronic exchanges. I would like to kind of--
Mr. Gensler. And I would also be glad to come and see you
in your office anytime you want us to come by.
Mr. Watt. Thank you, Mr. Chairman. I yield back.
Mr. Kanjorski. The Chair recognizes Mr. Royce of
California.
Mr. Royce. Thank you, Mr. Chairman.
Ms. Schapiro, Allen Stanford, who has been accused of being
a mini-made office, has been in the headlines for the last few
weeks as people have been trying to get a handle on exactly
what happened to $8 billion and the full extent of the damage
of his actions. And recently an alleged Stanford whistleblower,
Layla Wydler, was interviewed on the matter. And she detailed
her initial concerns with the Stanford firm, her termination--
which was allegedly tied to her unwillingness to sell their
offshore certificate of deposits coming out of Antigua, which
she had had concerns about--and her attempts to bring what she
believed was a Ponzi scheme to the attention of NESB, now FINRA
and the SEC. This was some 5 years ago.
According to a complaint filed by the SEC in February of
this year, the Stanford bank allegedly touted ``improbable if
not impossible returns'' while selling $8 billion in those very
same, apparently cryptic, CDs to investors for more than a
decade.
On going to the SEC in 2004, Ms. Wydler said, ``I had a
list of everything, all my concerns. I wrote down the document,
and I sent it to them and told them these are my concerns; this
is what happened, look into it. This might save people's
savings in the future because we can stop this.'' And it was
just sent to them, and that's it.
Now, I understand there is a criminal investigation going
on. But what can you tell us about this allegation? Are you
aware of any evidence legitimizing Ms. Wydler's claim that she
did, in fact, approach the SEC 5 years ago raising concerns
over this Ponzi scheme, laying out how they were doing it, with
respect to Allen Stanford's firm?
Ms. Schapiro. Congressman, I am happy to address it.
I don't know about her specific claim, so let me be clear
about that. But I will tell you that prior to the SEC opening
its formal investigation in 2005 into Stanford, the Agency had
looked into tips that had come its way. But at the time, my
understanding is that the staff believed that these were
largely foreign investors investing in foreign certificates of
deposit issued by a foreign bank.
So those jurisdictional issues presented significant
hurdles, offshore CDs issued by a foreign bank. And those
jurisdictional issues, we now understand, were significantly
complicated by the fact that the Antiguan securities regulator,
who had jurisdiction and authority over Stanford International
Bank, was on the payroll of Mr. Stanford, and has been sued by
the SEC, but was clearly subverting the SEC's investigation
into this matter.
There is also a period of time of significant coordination
with other Federal agencies, which also took time--undoubtedly
longer than it should have. But as soon as it became clear to
the SEC that there was adequate information for us to go
forward and that we could overcome those jurisdictional
hurdles, the case was brought. Nine people and entities have
been sued, and, as I said, including the CEO of the Antiguan
Financial Services Regulatory Commission.
Mr. Royce. Well, I would like to ask you if you could then
address the questions raised by Mr. Atkins, which I raised in
my opening statements; specifically, why do you think the SEC,
in the course of the past 12 years, experienced, in his words,
``catastrophic failures in every one of its four core
competencies.'' He started with rulemaking, filing review,
enforcement, and examinations.
Ms. Schapiro. I would be happy to do that. I would also be
happy to come and talk with you directly about these. Needless
to say, I don't agree with Commissioner Atkin's
characterization of the SEC's failures over the last number of
years during that period he was a Commissioner of the Agency.
I do think all of the Federal financial regulators missed
issues related to the economic crisis in the last several
years, but I also think that an enormous amount of positive
work and important things have happened also under those same
years.
Mr. Royce. Let's do it this way, then. For the benefit of
members, you can do it in writing.
Ms. Schapiro. I would be happy to.
Mr. Royce. And I would add two more questions in writing,
if you could submit. I think going forward it would help the
committee members. What led to failures in financial
institutions to recognize the inadequacy of their own risk
management systems and strategy in time to avert a collapse?
And second, how did many investors get lulled into complacency
and not adequately do their own due diligence as well?
You probably will have some perspectives at the SEC on
those two questions, and I think a better understanding of the
failure on that front as well.
Ms. Schapiro. I would be very happy to do that.
Mr. Royce. Thank you.
Mr. Kanjorski. The gentleman from California, Mr. Sherman.
Mr. Sherman. Chairman Schapiro, I hope I have time to focus
on the SEC's--what I would hope would be a policy, it is not
your policy now--to surf the Internet, pose as an investor, and
deal with all the unregistered activity. Because too much of
the SEC's attitude seems to be, well, if they don't register
with us, we don't focus on them. And that is especially
necessary because we have relied on State regulation. But now
with the Internet, it is easy to steal half a million dollars
in each of 50 States; whereas in the past, if you were going to
steal several million dollars, you had to do it pretty much in
one area.
But I want to use my time to focus on derivatives.
Derivatives offer the potential to make huge fortunes to those
who are very powerful. And so they are defended because there
is the tiniest argument that they do some good some of the
time. And I refer here to over-the-counter derivatives.
Secretary Geithner reserved the right to use taxpayer funds
to the full extent of the law not only to bail out old
derivatives but to bail out derivatives that are issued
tomorrow. So they operate with that subsidy, or implied
subsidy, that maybe Treasury will figure out a way to bail out
counterparties.
The defense of derivatives is that on rare occasions they
are actually purchased by someone who has a risk they are
trying to hedge; and that on even rarer occasions, they can't
hedge that risk efficiently on an exchange-traded derivative,
so they need the over-the-counter derivative.
I don't know if either of you have done any studies. But
what percent of the over-the-counter derivatives are purchased
by those who really are hedging a risk rather than the more
common case of somebody just placing a casino bet? I mean, I
could wake up today and think pork bellies are going up and
place a bet, and I would love--those who like gambling would
think that is a wonderful idea, but I don't own any pigs. I
will ask either of you.
Do either of you know what percentage of this
multitrillion-dollar industry, conducted in part at the risk of
the U.S. taxpayer, is serving its alleged legitimate, societal
purposes?
Ms. Schapiro. I think because this has been such an opaque
market and it is such a broadly unregulated market, that it is
very hard for regulators to actually--
Mr. Sherman. What if we simply said a derivative was
illegal unless you were really hedging a risk, and we basically
said you can't use over-the-counter derivatives as a casino?
Mr. Gensler. We actually need--and this has been a concept
in our financial markets for many decades, if not over 100
years--for those that want to hedge a risk, you need
speculators on the other side--
Mr. Sherman. One of the two parties has to have a real
risk.
Mr. Gensler. And so the vast majority of end users--and
there are tens of thousands of end users--whether it is a small
municipality, a small hospital, or a large consumer products--
Mr. Sherman. Although the vast majority of those end users
can and do use the exchange-traded derivatives.
Mr. Gensler. And we believe and we share your view that we
have to bring the over-the-counter derivatives market onto
exchanges. And in that regard, I have heard various estimates.
The low estimate is about half, and the high estimate is about
80 percent of the over-the-counter derivatives marketplace
could be considered standardized and on to exchanges. That
would accommodate all end users. They would be able to see in
real-time the pricing of these transactions and to be able to
then decide to use those--
Mr. Sherman. So we could ban over-the-counter derivatives
without major harm to the legitimate users of derivatives?
Mr. Gensler. No, no. I would have to say I think that the
tens of thousands of end users are able to hedge risk in their
day-to-day business--it could be interest rate risk, it could
be risk related to a certain energy product--but we want to
bring transparency and lower the risk by the reforms we are
calling for.
Mr. Sherman. Well, under these reforms, Wall Street will
continue to have trillions of dollars of societally useless
betting, using over-the-counter derivatives, and the taxpayer
may very well be called upon to bail out these derivatives and
their counterparties.
What I am asking is, given the risk to taxpayers, are there
enormous benefits to our economy to have these over-the-counter
derivatives where neither party has an insurable interest?
Chairman Schapiro?
Ms. Schapiro. I think it is a very good question. And it is
very hard to answer when you are trying to balance societal
risk with trading, where neither party has an insurable
interest.
I guess I would go back to what I said to Congresswoman
Waters, that defining insurable risk is a very difficult
question and one we need to think about very carefully.
I do think it is important where a party does have an
insurable risk, that there is some flexibility to have a
customized over-the-counter product, that they not absolutely
be forced onto the exchange.
But I think where there is no insurable risk and it is
merely a matter of two parties speculating, if we don't ban
them--and that is a question for the Congress, obviously--I
think the answer is that there has to be sufficient capital and
dealer regulation and protections in place to ensure that we
don't end up walking down this same path again.
Mr. Sherman. I would think we might ban them, and then we
could open the door later.
Ms. Schapiro. Exemptive authority actually might be a
possible thing for Congress to consider.
Mr. Kanjorski. The gentleman's time has expired.
Now I recognize the gentleman from California, Mr. Miller.
Mr. Miller of California. Thank you very much, Mr.
Chairman.
FASB has made changes to accounting standards that will
have tremendous impacts on securitizations known as FAS 166 and
167, as I said in my opening statement. These changes are
occurring at the same time that the Administration is trying to
restart the securitized credit markets through programs like
TAF to private lending. On the other hand, it is our
understanding that the Federal Reserve has serious concerns
with this policy shift that could derail efforts to stabilize
financial institutions and get credit flowing.
And, I guess, is that accurate; and what are their
concerns?
Ms. Schapiro. Thank you, Congressman. I guess I have a
couple of comments on this.
I would say that FASB walked down the path of reviewing off
balance sheet accounting, really as a result of a concern
expressed by the Fed and the Treasury and the President's
Working Group, that more transparency and improvement to all
balance sheet accounting was absolutely essential; that it had
been the lack of transparency; the ability to push all these
products off balance sheet had, in fact, been a contributor and
perhaps a significant one to the financial crisis.
So I am surprised to learn that the Fed is not comfortable
with where FASB landed with the guidance that it issued in
June. I guess I would also say that these new standards were
actually--the assumptions underlying these new standards were
actually even incorporated into the stress-testing that was
done of the banks. So the Fed has been quite involved and quite
aware of what FASB was doing here and had quite a lot of input
throughout this process.
With respect to what the Fed might do regarding capital
rules, I think that is a question, obviously, best perhaps
directed to Chairman Bernanke.
Mr. Miller of California. That is applying stress tests to
basically the banks with that slice of the market. How do you
plan to apply it to the rest? Basically applying the stress
test to banks is only a slice of the market.
Ms. Schapiro. Yes. I brought that up only to indicate that
the Fed has had active involvement in these discussions.
Mr. Miller of California. Okay. We discussed in Chairman
Bernanke's hearing yesterday about the challenges facing the $6
trillion commercial marketplace that we see coming in the
future. Many of these accounting regulation changes--aimed most
at the residential market--hit the commercial real estate
capital market especially hard, which in turn impacts business
and provides jobs.
Are the accounting policymakers communicating with the
financial regulators who oversee the economy and recovery
efforts? And I guess that would be Chairman Schapiro.
Ms. Schapiro. Very much so. There is very great sensitivity
at FASB--and I will say on the international level, the
International Accounting Standards Board--that while financial
statements are prepared for investors so that they can make
rational decisions about the allocation of capital and where
and how to invest, that there are other constituents that have
interests. And so they have been very open to receiving input
from bank regulators, from the SEC, as well as from investor
groups and others.
Mr. Miller of California. My concern is, if you look at the
situation the banks were in at the beginning of the situation
with the subprime and the residential marketplace, the reserves
were much healthier than they are today and I think they were
in a healthier than they are today.
And if you look at the commercial-backed mortgage
securities, they are starting to hit about the fourth quarter
this year; about $5 billion worth of loans are maturing and
coming due. And then about January, the default rate on the
commercial sector was about one-quarter of 1 percent. It is
about 2 percent today. In the coming days, it is expected to
rise dramatically.
The loans due by about 2012 are about $1 trillion. The
growing expectation is that default rates will be between 12
and 15 percent. How do we realistically handle that when most
of these loans are 30-year loans, 5-year calls and you have
gone from a 7 percent cap rate in 2006 to a 10 percent cap rate
today. Whereby a lender is stuck in a situation where they
might have a $14 million loan on a piece of property that based
on a declining marketplace, as we see in a 10 percent cap rate,
might value at $8 million when they should only get 5 on it,
how are you going to deal with them trying to extend that loan
when you have to apply mark-to-market to it, which would
require a $9 million set-aside?
Ms. Schapiro. I guess I am not exactly the right person to
answer that question. But if I could take a step back and say
that the SEC staff conducted a pretty extensive review of fair
value and mark-to-market accounting last year and published
their report before I arrived at the agency in early January.
And what they found through their efforts is that investors
value greatly fair-value accounting. It is what allows them to
make decisions to invest at all.
Mr. Miller of California. I understand that. But the
situation we are facing is you are hitting a second round of
residential foreclosures that is occurring right now. And that
is the people who have good loans, but have lost their jobs. Or
they are business people who are no longer able to make their
payments who are losing their homes today.
You have about 70 percent of the lending marketplace is
commercial; you have lenders that are not in a situation they
were in 4 years ago as far as liquidity and reserves. I am not
talking about a new loan that somebody wants to make for a
piece of commercial investor property. I am talking about a
current situation that the banking and lending industry is
going be in today when these 5-year calls come due. And based
on accounting standards, you have to apply mark-to-market--I
mean, that is the rule today. And based on that rule alone, the
banking industry is going to be absolutely upside down. I don't
know how they weather this, or the economy weathers this next
round of commercial foreclosures.
And my question is--I am not saying new loans--I am saying
for existing loans that are coming due, how are we going to
deal with them? We can't just say, ``well, mark-to-market
requires.'' We are faced with a financial situation that could
be devastating.
Ms. Schapiro. I guess I don't have a quick answer to your
question. I would be more than happy to come up and maybe bring
our chief accountant with me and spend some time to talk with
you about that.
Mr. Miller of California. I would love to, because this is
a serious situation for the economy that is going to occur very
rapidly, and I don't think banks can handle it.
Ms. Schapiro. I would be very happy to do that.
Mr. Miller of California. I would love to meet with you.
Thank you.
Mr. Kanjorski. Thank you, Mr. Miller.
We will now hear from Mr. Moore of Kansas.
Mr. Moore of Kansas. Thank you, Mr. Chairman.
In light of the Madoff scandal and other Ponzi schemes,
what can and should we do to improve the return of funds for
defrauded investors? Chairman Schapiro, are the SEC's fair
funds fulfilling this mission and should Congress consider
additional steps for helping out defrauded investors?
Ms. Schapiro. I think, Congressman, the fair funds program
has been largely successful. It has returned billions and
billions of dollars to investors. I think it was actually a
brilliant idea on the part of this committee and the Congress
to enable the SEC to get money back to investors through that
mechanism.
That said, I think it takes us sometimes a little bit too
long to get that done. We have a new Director of Enforcement
who has responsibility for fair funds administration, and he is
looking at how we can try to speed that process up to get the
money back as quickly as we possibly can.
Mr. Moore of Kansas. Thank you.
Chairman Gensler, do you have any comments, sir?
Mr. Gensler. Not specifically on the fair funds proposal.
But I do think that in working to harmonize our roles, that we
should look very closely at whether our fraud standard between
the CFTC and the SEC should be the same. We bring about a third
of our fraud cases with the SEC, we do a lot jointly, and I
think it would be helpful.
Mr. Moore of Kansas. Thank you.
Some people have suggested we should require the largest
financial firms to undergo an annual stress test that would
have aggregate information publicly released even in good
times, not just bad times. Is this something Congress should
require, Chairman Gensler? And what about leverage? Any
thoughts on how best to create incentives for firms to maintain
reasonable leverage ratios?
Mr. Gensler. Well, I think that one of the ways with regard
to over-the-counter derivatives is that we be explicit. In the
past, I think this is one of the assumptions that was sorely
tested. We assumed that our overall capital standards would
take into consideration these derivatives. And I think that we
should be explicit in--whether it be the bank regulators or the
SEC overseeing the broker dealers where most of the derivatives
take place, there should be explicit capital standards for
these derivatives. And then beyond that, we lower risk, of
course, with centralized clearing.
Mr. Moore of Kansas. Chairman Schapiro, do you have any
comments?
Ms. Schapiro. I guess I would add that I think stress-
testing is critically important. And one of the failures was
perhaps to include enough low-probability, high-impact events
in stress tests historically. And that would be important for
the regulators to insist upon with respect to clearinghouses,
as well as with respect to dealers and other participants in
the financial markets.
Mr. Moore of Kansas. Thanks to our witnesses, Mr. Chairman.
I yield back.
Mr. Kanjorski. Thank you, Mr. Moore.
We will now hear from the gentleman from Florida Mr. Posey.
Mr. Posey. I thank you very much, Mr. Chairman.
Madam Chairwoman, I know we have the IG report that we
should be receiving to give us more information. But I am
curious as to whether or not we can know if anyone has been
fired or even reprimanded over the way the Madoff fiasco was
mishandled?
Ms. Schapiro. Congressman, we are waiting, obviously, for
the release of the Inspector General Report, which has been
quite comprehensive and quite extensive and is due to be
released at the end of the summer. And based upon whatever is
in that report, we will have to make decisions about whether
any kind of personnel actions are appropriate. We do not want
to interfere in any way with the independent review of the
Inspector General.
I will say, though, that I have not wanted to wait for the
Inspector General's Report to make really extensive changes in
the Securities and Exchange Commission, both in how we are
organized--
Mr. Posey. I know we are going to make changes in the
future, hopefully, but I think there should be some
accountability for the people who did not do their jobs. And I
think that we made the illustration before: If you report a
bank robbery to the local police department and the bank
robbery has gone on for 10 years and they never walk over to
the bank to investigate the robbery, somebody ought to lose
their job, somebody ought to be reprimanded.
And it is just incredible that hasn't happened yet and that
we have to wait for a report to take any action against the
negligence that cost people, arguably, $70 billion in losses.
Because your agency would not take any action, even after
Barron's Magazine writes a feature story about this guy. I
mean, it was worldwide news.
The smart hedge fund managers and the money managers know
to stay away from him, but gullible members of the public were
still lured in by this because he was allowed to continue doing
business.
I just would think that there should be some discipline
taken for the employees who allowed that to happen.
Ms. Schapiro. Congressman, I think it is really critical
that we have the full story of exactly what happened, and that
is what the Inspector General has been charged with doing.
There has not been a separate inquiry down to the level of
employee conduct because that investigation is going on. And no
one has wanted, and myself included, to interfere in any way
with that.
But we are not just making changes in the future, we are
making changes right now and have, over the last 6 months, made
extensive changes at the SEC. We have a new Enforcement
Director, a new Deputy, a new head of the New York office. We
have new technology, we have new rules--
Mr. Posey. But the question is, when employees don't do
their job to protect the public, do we have to have an
Inspector General come in there and tell us if it is okay to
fire people? I mean, wouldn't that be a normal management
routine if you have an employee who is incompetent or lazy, or
for whatever other reason doesn't do his job to protect the
public clearly like he should be doing, that we just don't fire
those people? I mean, isn't there a policy in place to do that?
Ms. Schapiro. I believe deeply in holding employees
accountable for their work, but I can't do that until I have
the facts and the details about how they conducted their work
and what the issues were. And that is what needs to wait for
the Inspector General Report.
Mr. Posey. But don't they have supervisors? Isn't there
somebody in the organization that already--I mean, I know in
any business--and I know government doesn't have competition
like a business, but in any business where someone made a
business blunder that big, the whole department would be gone,
the senior manager would be gone. Doesn't that happen anywhere
in government? I mean, doesn't anybody have the authority to
get rid of incompetent employees, people who refuse or for
whatever reason don't do their jobs?
Ms. Schapiro. We do certainly have the ability to get rid
of incompetent employees, but I have to have the evidence that
shows me that employees were incompetent. I can't fire hundreds
of people or tens of people without having a basis for doing
that, and I don't have that basis at this point. That is the
purpose, in part, of the Inspector General's Report, to
understand--as was by my predecessor, Chairman Cox--to
understand what went wrong; what did the SEC do; what did it
fail to do; and where does the responsibility lie? And that is
a necessary precondition, from my perspective, to taking any
kind of personnel action.
Mr. Posey. And with all due respect--and I am not aiming
this at you--but I think the failure to know what went wrong
and who is responsible for things that go wrong is culpable
negligence on the part of management.
Ms. Schapiro. I understand that concern. And there are
things that we do know went wrong. We know that, for example,
the agency receives 1.5 million tips a year and has no
capability to really manage them or manage that process, so we
have attacked that. We know we have gaps.
Mr. Posey. We know twice they blew off Mr. Markopolos, even
after Barrons Magazine did a big feature cover story on this
fraud. I mean, anybody with half a brain in the agency, that
should have been plenty to know right there. I mean, this is
not one of a million tips that got ignored. This guy took a big
file down there, he was a qualified, experienced investigator--
I am talking about Mr. Markopolos--he took it down there and
laid it in their hands, and they did nothing. He went back, and
they did nothing. It was exposed in Barrons; they did nothing.
I mean, I can't imagine any excuse. It is just a matter of
finding out who all had a fingerprint on this thing and getting
rid of them.
Ms. Schapiro. There is no question but that the agency did
not appropriately follow up on the information that he gave
them; I am not defending that at all. And that is why we are in
this process. And that is why we have devoted extraordinary
resources both to the Inspector General's investigation, but
also to filling all the gaps that we can, putting in place all
the processes and procedures, and bringing in many senior new
people to the agency to try to ensure that we can protect
against this ever happening again.
This is a tragedy of epic proportions, I fully appreciate
that. And we are doing everything we can do--
Mr. Posey. When do we expect the IG's report?
Ms. Schapiro. The Inspector General has said that he would
hope to release his report by the end of the summer.
Mr. Kanjorski. By September 30th, Mr. Posey. And as soon as
he does, we anticipate having a special session.
We have five votes on the Floor, and we have another
committee hearing starting at 2 p.m., so I am going to pose the
question to the members, do they wish to return and poll the
panel for an additional hour and then start up, which would
only give us about 40 minutes? Or should we have one more
individual on questions and then recess the hearing until a
further date or some other time? Are there any preferences?
Mr. Baca. Continue, and have the hearing some other time.
Mr. Kanjorski. You are next.
Mr. Baca. That is why I want to continue.
Mr. Kanjorski. I am not suggesting we do not have you. The
question is, after you have had your opportunity, should we
come back in an hour from now after votes? Is there anyone
terribly in favor of that? Mr. McHenry says no.
Mr. McHenry. I am in favor of Mr. Baca getting his time,
though. He is a good pitcher.
Mr. Kanjorski. We follow seniority, so Mr. Baca gets the
next question.
Ms. Moore of Wisconsin. I guess I will write my questions
to them, Mr. Chairman. Whatever you decide, Mr. Chairman.
Mr. Kanjorski. And return in an hour? That is what we will
do. We will hear Mr. Baca, and then take a recess for an hour
and then return. And we will give the opportunity for the
witnesses to have lunch or something in the meantime.
Mr. Baca.
Mr. Baca. Thank you very much, Mr. Chairman. And thank you
for holding this meeting, along with the ranking member. And
thank you, Chairwoman Schapiro and also Chairman Gensler.
My question is to either one of you two, or both of you can
answer this. I have a question regarding both of your agencies'
roles in the Consumer Financial Protection Agency. The bill
states that CFPA will be required to coordinate with both of
your agencies in an effort to promote consistent regulatory
treatment of consumers' investment product and services.
Can you comment on your role in coordinating with CFPA?
That is one question. And how do you envision this taking
place? And what level of interaction would you like to see?
And finally, would you like to see the interactions be
limited solely to derivatives, regulations; or does it expand
beyond that?
Ms. Schapiro. I am happy to start with that.
I think it is going to be critically important for the SEC
to coordinate pretty closely with the CFPA. We both have
investor or consumer protection missions at our core, and there
is a possibility for there to be products or issues that arise
where we will both have an interest. So I think a high level of
pretty continuous coordination will be important.
The President's plan actually calls for, I think, a
quarterly meeting, at a minimum, between the leadership of
those agencies and the FTC and others, to make sure we are
sharing information and that no gaps are able to arise between
our authorities to protect investors.
Mr. Gensler. I would concur with that. And while the CFTC
principle focuses on markets and risk management, there is a
clear consumer piece in protecting against fraud and
manipulation where we would envision coordination.
The second part of your question was about derivatives, and
I am sorry--
Mr. Baca. Would you like to see interaction be limited
solely to derivatives regulation or does it expand beyond that?
Mr. Gensler. I think it really does expand beyond that
probably for both of our agencies because derivatives are a new
product. But whether it be futures, options, or securities,
there is some interplay.
I can even think of it in terms of how foreign currency
transactions that are marketed to the retail public, which is
very much something that we look at and try to protect the
public on. But this consumer agency, as a bank product, might
possibly get involved. So I think we need coordination as well
on other product areas.
Mr. Baca. And the other question I have, I was wondering if
you could speak to the concerns that a quick transaction to
either a mandatory clearing process or a mandatory exchange
process for all derivatives may cause a disruption in the
market? Do you share this concern? And what can be done to
counter this potential problem?
Mr. Gensler. I think that bringing derivatives onto
centralized clearing and exchanges will actually be an enormous
benefit to the market. I think it will promote transparency and
efficiency, and end users will get the benefit of seeing those
prices, where right now they can't. And I think it will lower
risk.
So, though I might not have understood the question, but I
don't see it as a disruption, I see it as an enormous benefit
to markets.
Mr. Baca. Chairman Schapiro?
Ms. Schapiro. I agree.
Mr. Baca. Thank you.
Mr. Gensler, I want to follow up for a question that was
asked by one of my colleagues earlier about the clearinghouses.
Chairman Gensler, you said that you were in favor of having
several different clearinghouses compete. Wouldn't this create
the same problem as credit-rating agencies' experience with
conflict of interest, and how do you safeguard against this?
Mr. Gensler. I think that your analogy is a very apt one.
And how we safeguard against it is it should be mandatory
regulation. Not only do they have to register--which right now
there is voluntary registration of the rating agencies--but we
have to have regulation to manage the risk management. Rating
agencies have very real conflicts of interest.
And I will defer to Chair Schapiro on whether she has the
right authorities. But if she needs more, I would certainly
support that.
But in this case, we should make sure that these
clearinghouses have open access, that any member who can meet
the rigorous risk management standards be able to be there and
we not allow them to be sort of too clubby or controlled by the
dealer community, but that they have to meet the rigorous risk
management standards that we would lay out.
Mr. Baca. Ms. Schapiro, how would you answer that?
Ms. Schapiro. I agree with that.
Mr. Baca. What do you agree with?
Ms. Schapiro. That we have to have rigorous oversight of
the clearing agencies in order to assure that, to the extent
any conflicts of interest arise, that they are fully disclosed
and, to the greatest extent possible, eliminated.
Mr. Baca. How will we monitor the oversight? You said that
we need oversight. How will we monitor that we actually do have
the oversight and that oversight is really occurring right now
and the accountability that needs to be done?
Ms. Schapiro. Both the SEC and the CFTC currently oversee
clearinghouses for other products, for securities at the SEC,
for futures at the CFTC, for options at the SEC. So we have
pretty extensive programs in place to review the governance
models of clearinghouses, the risk management systems, the
technology, because if they have a major technology failure it
can hugely disrupt markets. And so those programs exist. And my
view would be we would expand them to cover any new clearing
platforms or agencies that are created.
Mr. Baca. Thank you very much. I know that my time has
expired. I yield back the balance of my time.
Mr. Kanjorski. The Chair notes that some members may have
additional questions for this panel which they may wish to
submit in writing. Without objection, the hearing record will
remain open for 30 days for members to submit written questions
to these witnesses and to place their responses in the record.
Quite different from what we had originally decided, we decided
not only to give you a lunch break but to give you the
afternoon off to enjoy yourselves on the golf course.
Since we have votes, we are going to recess the meeting at
this point and ask you to return in the future, probably in
September, for the SEC as soon as the Inspector General's
report is out, Ms. Schapiro. And we will annoy you, Gary. We
won't let you feel abandoned. But with no further questions
before the committee, the committee stands adjourned.
[Whereupon, at 12:10 p.m., the hearing was adjourned.]
A P P E N D I X
July 22, 2009
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