[House Hearing, 110 Congress]
[From the U.S. Government Printing Office]




                               before the

                         COMMITTEE ON OVERSIGHT
                         AND GOVERNMENT REFORM

                        HOUSE OF REPRESENTATIVES

                       ONE HUNDRED TENTH CONGRESS

                             SECOND SESSION


                           NOVEMBER 13, 2008


                           Serial No. 110-210


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                 HENRY A. WAXMAN, California, Chairman
EDOLPHUS TOWNS, New York             TOM DAVIS, Virginia
PAUL E. KANJORSKI, Pennsylvania      DAN BURTON, Indiana
ELIJAH E. CUMMINGS, Maryland         JOHN M. McHUGH, New York
DENNIS J. KUCINICH, Ohio             JOHN L. MICA, Florida
DANNY K. DAVIS, Illinois             MARK E. SOUDER, Indiana
JOHN F. TIERNEY, Massachusetts       TODD RUSSELL PLATTS, Pennsylvania
WM. LACY CLAY, Missouri              CHRIS CANNON, Utah
DIANE E. WATSON, California          JOHN J. DUNCAN, Jr., Tennessee
STEPHEN F. LYNCH, Massachusetts      MICHAEL R. TURNER, Ohio
BRIAN HIGGINS, New York              DARRELL E. ISSA, California
JOHN A. YARMUTH, Kentucky            KENNY MARCHANT, Texas
BRUCE L. BRALEY, Iowa                LYNN A. WESTMORELAND, Georgia
    Columbia                         VIRGINIA FOXX, North Carolina
BETTY McCOLLUM, Minnesota            BRIAN P. BILBRAY, California
JIM COOPER, Tennessee                BILL SALI, Idaho
CHRIS VAN HOLLEN, Maryland           JIM JORDAN, Ohio
PAUL W. HODES, New Hampshire

                      Phil Barnett, Staff Director
                       Earley Green, Chief Clerk
               Lawrence Halloran, Minority Staff Director

                            C O N T E N T S

Hearing held on November 13, 2008................................     1
Statement of:
    Ruder, Professor David, Northwestern University School of 
      Law, former chairman U.S. Securities and Exchange 
      Commission; Professor Andrew Lo, director, Laboratory for 
      Financial Engineering, Massachusetts Institute of 
      Technology, Sloan School of Management; Professor Joseph 
      Bankman, Stanford University Law School; and Houman Shadab, 
      senior research fellow, Mercatus Center, George Mason 
      University.................................................    12
        Bankman, Joseph..........................................    61
        Lo, Andrew...............................................    25
        Ruder, David.............................................    12
        Shadab, Houman...........................................    69
    Soros, George, chairman, Soros Fund Management, LLC; John 
      Alfred Paulson, president, Paulson & Co., Inc.; James 
      Simons, president, Renaissance Technologies, LLC; Philip A. 
      Falcone, senior managing partner, Harbinger Capital 
      Partners; and Kenneth C. Griffin, chief executive officer 
      and president, Citadel Investment Group, LLC...............   114
        Falcone, Philip A........................................   157
        Griffin, Kenneth C.......................................   166
        Paulson, John Alfred.....................................   141
        Simons, James............................................   128
        Soros, George............................................   114
Letters, statements, etc., submitted for the record by:
    Bankman, Professor Joseph, Stanford University Law School, 
      prepared statement of......................................    63
    Davis, Hon. Tom, a Representative in Congress from the State 
      of Virginia, prepared statement of.........................    10
    Falcone, Philip A., senior managing partner, Harbinger 
      Capital Partners, prepared statement of....................   160
    Griffin, Kenneth C., chief executive officer and president, 
      Citadel Investment Group, LLC, prepared statement of.......   168
    Lo, Professor Andrew, director, Laboratory for Financial 
      Engineering, Massachusetts Institute of Technology, Sloan 
      School of Management, prepared statement of................    27
    Paulson, John Alfred, president, Paulson & Co., Inc., 
      prepared statement of......................................   143
    Ruder, Professor David, Northwestern University School of 
      Law, former chairman U.S. Securities and Exchange 
      Commission, prepared statement of..........................    15
    Shadab, Houman, senior research fellow, Mercatus Center, 
      George Mason University, prepared statement of.............    71
    Simons, James, president, Renaissance Technologies, LLC, 
      prepared statement of......................................   131
    Soros, George, chairman, Soros Fund Management, LLC, prepared 
      statement of...............................................   117
    Towns, Hon. Edolphus, a Representative in Congress from the 
      State of New York, prepared statement of...................   197
    Waxman, Hon. Henry A., a Representative in Congress from the 
      State of California, prepared statement of.................     3



                      THURSDAY, NOVEMBER 13, 2008

                          House of Representatives,
              Committee on Oversight and Government Reform,
                                                    Washington, DC.
    The committee met, pursuant to notice, at 10:06 a.m., in 
room 2154, Rayburn House Office Building, Hon. Henry A. Waxman 
(chairman of the committee) presiding.
    Present: Representatives Waxman, Towns, Maloney, Cummings, 
Tierney, Lynch, Yarmuth, Norton, Cooper, Van Hollen, Sarbanes, 
Davis of Virginia, Souder, and Issa.
    Staff present: Phil Barnett, staff director and chief 
counsel; Kristin Amerling, general counsel; Stacia Cardille and 
Erik Jones, counsels; Theodore Chuang and John Williams, deputy 
chief investigative counsels; Roger Sherman, deputy chief 
counsel; Michael Gordon, senior investigative counsel; Karen 
Lightfoot, communications director and senior policy advisor; 
Caren Auchman, communications associate; Zhongrui Deng, chief 
information officer; Mitch Smiley and Alvin Banks, staff 
assistants; Jennifer Owens, special assistant; Brian Cohen, 
senior investigator and policy advisor; Earley Green, chief 
clerk; Jennifer Berenholz, assistant clerk; Leneal Scott, 
information systems manager; Lawrence Halloran, minority staff 
director; Jennifer Safavian, minority chief counsel for 
oversight and investigations; Ellen Brown, minority senior 
policy counsel; Jim Moore, minority counsel; Christopher 
Bright, minority senior professional staff member; Brien 
Beattie, Molly Boyl, and Adam Fromm, minority professional 
staff members; John Cuaderes and Larry Brady, minority senior 
investigators and policy advisors; Patrick Lyden, 
parliamentarian and Member services coordinator; Brian 
McNicoll, minority communications director; and John Ohly, 
minority staff assistant.
    Chairman Waxman. The committee will come to order. The 
focus of our committee today is the hedge fund industry. Our 
four previous hearings have looked at failure. Our first two 
hearings examined the collapse of Lehman Brothers and AIG. We 
learned that these companies took on massive risk. When the 
bottom fell out, senior management walked away with millions of 
dollars, while shareholders and taxpayers lost billions. Our 
third hearing focused on the role of the credit rating 
agencies. At that hearing, we learned about the colossal 
failures of these gatekeepers of the financial markets. As one 
internal document said, ``We sold our soul to the devil for 
    At our fourth hearing, we examined the role of financial 
regulators. Former Federal Reserve Chairman Alan Greenspan told 
us that he had identified a flaw in the deregulatory ideology 
he had championed. Today's hearing has a different focus. The 
five hedge fund managers who will testify today have had 
unimaginable success in the financial markets. Although there 
is a variation on how much they made individually, on average 
our witnesses made over $1 billion a year. That is on average 
$1 billion a year.
    There are two reasons we have invited these hedge fund 
managers to testify. First, these are some of the most 
successful and knowledgeable investors in our financial 
markets. They each have valuable perspectives to share about 
what has gone wrong and what steps we need to restore our 
financial system. Second, their testimony and the testimony of 
the independent experts on our first panel will help the 
committee to examine three important issues. What role have 
hedge funds played in our current financial crisis? Do hedge 
funds pose a systemic risk to our financial system? And what 
level of government oversight and regulation is appropriate?
    Currently, hedge funds are virtually unregulated. They are 
not required to report information on their holdings, their 
leverage, or their strategies. Regulators aren't even certain 
how many hedge funds exist and how much money they control. We 
do know, however, that hedge funds are growing rapidly and 
becoming increasingly important players in the financial 
markets. Over the last decade, their holdings reportedly have 
increased over five-fold, to more than $2 trillion. We also 
know that some hedge funds are highly leveraged. They invest in 
assets that are illiquid and difficult to price, and sell 
    And we know from our hearing into Lehman and AIG, combining 
these factors can cause financial institutions to blow up. And 
we will hear today some experts worry that the failure of large 
hedge funds could pose a significant systemic risk to our 
financial system. We also know that hedge funds can receive 
special tax breaks. The five witnesses we will hear from today 
earned on average of a billion dollars last year, yet the tax 
law allows them to treat the vast majority of their earnings as 
capital gains. That means that at least some portion of their 
earnings could be taxed at rates as low as 15 percent. That is 
a lower tax rate than many school teachers, firefighters, or 
even plumbers pay. In our prior hearings, we have focused on 
what went wrong in the past. Today's hearing lets us ask what 
could go wrong in the future so we can prevent damage before it 
occurs. Both types of hearings are essential. We need to 
understand both what happened and what could happen in order to 
solve the immense economic problems we are facing.
    I want to thank all of our witnesses for appearing today. 
Some of the witnesses readjusted their schedules to testify. 
They all responded to our requests for documents. And I 
appreciate their cooperation, and look forward to their 
testimony. I want to now call on ranking member, Tom Davis for 
an opening statement.
    [The prepared statement of Hon. Henry A. Waxman follows:]
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    Mr. Davis of Virginia. Thank you, Mr. Chairman. Thank you 
for calling the hearing today. Hedge fund losses, and in some 
cases, complete liquidations are an effect of the current 
financial crisis. It is unlikely they are the cause. The real 
origin of this market contraction is the continuing collapse of 
the U.S. housing market, triggered and fueled by preposterously 
lax lending standards, loose management, aggressive lobbying, 
and lavish perks, some at the quasi-governmental giants that 
dominated the market, Fannie Mae and Freddie Mac. They helped 
to create and enhance the ravenous hunger for mortgage-backed 
securities, credit default swaps, and other highly 
sophisticated byproducts of the housing boom that drew hedge 
funds into the abyss. As a result, hedge fund redemptions of 
stocks and others assets will continue to put downward pressure 
on the market.
    It wasn't supposed to be this way. Billed as purely private 
gambles by sophisticated investors, hedge funds now pose very 
public peril when the bets go bad. Designed as a strategy to 
reduce investment risk, hedge funds now compound risk when 
complex deals start to unravel and throw off unintended 
consequences. Empowered by sophisticated computer models, hedge 
fund trading was meant to capitalize on, not cause, global 
market shifts. But now, due to their size and speed, hedge 
funds often accelerate wild market fluctuations. So when these 
unregulated private funds become a public problem, many see a 
need for greater transparency in their operations and tighter 
regulation on some hedge fund activities. Greater 
standardization, registration, disclosure, and some regulatory 
limitations could help the industry mature and survive. 
Remember the automobile started out as a purely private, wholly 
unregulated mode of transportation. But when widespread use of 
the new and powerful machines began to pose public safety 
issues, it became necessary to decide as a matter of public 
policy who was qualified to operate a motor vehicle, how fast 
they could go, where they could go.
    We seem to be at the same crossroads for hedge funds. With 
as many as 8,000 funds managing up to $1.5 trillion, hedge 
funds are said to account for 20 to 30 percent of trading 
volume in the United States in U.S. stocks. They may handle 
even higher levels of transactions involving more specialized 
instruments, such as convertible bonds and credit derivatives. 
Their trades can move markets.
    So this isn't just about sophisticated high stakes 
investors any more. Institutional funds and public pensions now 
have a huge stake in hedge funds' promises of steady above-
market returns. That means public employees and middle income 
senior citizens, not just Tom Wolfe's masters of the universe, 
lose money when hedge funds decline or collapse altogether. 
Brittle complexity, huge transactions on computerized 
autopilot, and other structural inadequacies make hedge funds 
particularly, sometimes spectacularly vulnerable to financial 
contagion, the downward spiral of lost value, margin calls, and 
redemptions in the desperate search for cash. It is clear 
investors and regulators need to know more about fund 
investment strategies, leverage levels, and redemption terms to 
reduce their systematic risk posed by hedge funds. The hedge 
fund business model may become a casualty of the downturn or it 
will adopt to new global realities. Going forward, hedge funds 
will have to take account of a reduced tolerance by investors 
and governments for an unregulated parallel financial universe 
of exotic derivatives run by faceless quants that exerts 
unpredictable gravitational forces on the open marketplace.
    But again, we need to remember in the larger implosion of 
the housing market, hedge funds are collateral damage. We 
should avoid Congress's natural tendency to overreact and 
bayonet the wounded. Today's witnesses bring extensive 
expertise and experience to our discussion of hedge funds in 
the current financial crisis. We appreciate their testimony.
    [The prepared statement of Hon. Tom Davis follows:]
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    Chairman Waxman. Thank you very much, Mr. Davis. I would 
like to introduce the four members of our first panel. 
Professor David Ruder is a professor at Northwestern University 
School of Law, and served as chairman of the SEC under 
President Reagan from 1987 to 1989. Professor Andrew Lo is 
director of the Laboratory for Financial Engineering at the 
Massachusetts Institute of Technology's Sloan School of 
Management. Professor Joseph Bankman is the Ralph M. Parsons 
professor of law and business at Stanford Law School. And Mr. 
Houman Shadab is a senior research fellow from the Mercatus 
Center at George Mason University. I thank each of you for 
being here.
    It is the practice of this committee that all witnesses 
testify under oath. So I would like to ask if you would please 
stand and raise your right hands.
    [Witnesses sworn.]
    Chairman Waxman. The record will indicate that each of the 
witnesses answered in the affirmative. You had prepared 
statements, and we will insert your complete statements in the 
record. What we would like to ask each of you to do is to try 
to limit the oral presentation to around 5 minutes. We won't 
bang you out of order after 5 minutes, but there is a clock 
that will be green for 4 minutes, orange for the last 1 minute, 
and then it will turn red. And when you see that it is red, we 
would like you to then consider wrapping up the presentation to 
us. Professor Ruder, there is a button on the base of the mic. 
I ask you to press it in and pull it close enough to you so 
that it will pick up everything you have to say. We are pleased 
to hear from you first.


                    STATEMENT OF DAVID RUDER

    Mr. Ruder. Chairman Waxman, Congressman Davis and committee 
members, I am pleased to be here today. Hedge funds are risk 
takers. They seek greater than market returns by identifying 
pricing anomalies, by engaging in hedging strategies, by using 
leverage, and by investing in derivative instruments. Hedge 
fund investments and hedging activities make positive 
contributions to capital formation, market liquidity, price 
discovery, and market efficiency. Hedge funds, however, may 
pose risks to investors and to the financial markets. They pose 
risks to their investors because they may suffer substantial 
losses, may not be able to repay investors in times of stress, 
or may simply dissolve without returning any moneys to their 
    Dishonest hedge funds may injure investors by making 
misrepresentations when they sell fund securities, falsifying 
operating and valuation results, or by stealing fund assets. 
Hedge funds can create negative results to the financial system 
when their losses cause them to liquidate market positions, 
resulting in downward pressures on the asset classes they are 
selling. Their defaults may cause losses to their 
    This danger was dramatically illustrated in 1998 at the 
time of the collapse of Long Term Capital Management, when the 
implosion of one major hedge fund caused tremendous disruption 
in the financial markets. Although hedge funds have been active 
participants in the derivative and stock markets, they do not 
seem to have played a major causal role in the events 
precipitating the credit market crisis. Nevertheless, hedge 
funds that have suffered major losses have contributed to 
declines in stock and asset prices by liquidating assets in 
order to meet other obligations and in order to pay investors 
seeking to withdraw funds. Some hedge fund advisers are 
registered with the Securities and Exchange Commission under 
the Investment Advisers Act of 1940. Under that act, the 
Commission has power to inspect hedge fund advisers for 
compliance with Federal securities laws. In 2004, the SEC 
sought the power to inspect all hedge fund advisers, but lost a 
court case overturning the rule it adopted. Following that 
decision, the SEC adopted a rule giving it strong powers to 
bring enforcement actions against hedge fund advisers, whether 
registered or unregistered, who defraud investors. 
Nevertheless, the SEC still does not have the power to inspect 
unregistered hedge fund advisers.
    A primary problem identified in the credit crisis has been 
the loss of confidence among market participants regarding the 
ability of counterparties to honor contractual obligations and 
to repay their debts. The main reason for this lack of 
confidence is lack of information. Despite the fact that hedge 
funds were not the primary actors in causing the credit crisis, 
I believe that the Securities and Exchange Commission should be 
given power to register and inspect all hedge funds. It should 
have power to require hedge fund advisers to disclose the size 
and nature of hedge fund risk positions and the identities of 
their counterparties. It should have the power to monitor and 
assess the effectiveness of hedge fund risk management systems.
    Information the SEC receives should be shared on a 
confidential basis with the Federal Reserve Board as the 
Federal agency with primary responsibility for systemic risk 
regulation. Although these new regulatory powers are important, 
it is not desirable to impose regulation on hedge fund risk 
activities, including use of leverage and derivative 
instruments. Hedge funds should not be regulated in a manner 
that stifles their innovative financial market activities. The 
SEC is the proper entity to obtain hedge fund risk information 
and to monitor and assess the effectiveness of hedge fund risk 
management systems. The SEC understands the financial markets 
and the need to allow innovative risk taking.
    If the SEC is charged with increased inspection, risk 
monitoring, and risk assessment responsibilities, it will need 
substantial additional funding. These new responsibilities 
would require increased numbers of SEC staff who can understand 
and evaluate the complicated hedge fund environment. Hedge 
funds are major users of non-exchange traded derivative 
instruments. A tremendous void exists regarding the specific 
characteristics of many of these instruments, the amounts at 
risks, and the identity of counterparties. The terms of these 
instruments are often unique and complicated. As a second 
method of addressing the opacity and impact of derivative 
instruments in our financial markets, I believe that the swaps 
exclusion included in the Commodity Futures Modernization Act 
of 2000 should be repealed so that trading in these non-
exchange derivative instruments can be regulated. Some of the 
current uncertainties relating to derivative instruments can be 
overcome by standardizing terms and causing the instruments to 
be traded and settled on futures or options exchanges. I 
understand that efforts are currently underway to provide a 
platform for settling these instruments. Thank you for the 
opportunity to express my views on these important matters.
    Mrs. Maloney [presiding]. Thank you very much.
    [The prepared statement of Mr. Ruder follows:]
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    Mrs. Maloney. Professor Lo.

                     STATEMENT OF ANDREW LO

    Mr. Lo. Chairman Waxman, Ranking Minority Member Davis, and 
other members of the House Oversight Committee, thank you for 
inviting me to testify today at this hearing on hedge funds. In 
the interests of full disclosure, I would like to inform the 
committee that in addition to my faculty position at MIT, I am 
also affiliated with an asset management company that manages 
several hedge funds and mutual funds. I realize that the 
committee has a number of questions for the panel, so I will 
keep my introductory remarks brief. Over the past 10 years, 
much of my research at MIT has been focused on hedge fund and 
hedge fund industry. Part of that research has been devoted 
    Mr. Lynch. Madam Chair, could we have the witness either--I 
am not sure if your mic is on or you are not close enough to 
    Mr. Lo. Sorry.
    Mr. Lynch. No problem. Thank you very much.
    Mr. Lo. Thank you. It used to be the case that systemic 
risk was the exclusive domain of central bankers, 
macroeconomists, regulators; and finance professors had little 
to do with the subject. But the events of August 1998, the 
collapse of LTCM and other hedge funds that year showed pretty 
clearly that the hedge fund industry does have an impact on 
what we think of as systemic risk. Since then, the hedge fund 
industry has grown even bigger, and it has become even more 
important to the growth and operations of the global economy. 
And that is no exaggeration. Hedge funds control approximately 
$1\1/2\ trillion of capital, but which is more like $3 trillion 
with leverage.
    Now that has come down quite a bit from just a year ago, 
when it was $2 trillion of assets and $5.5 trillion with 
leverage. And this decline is likely to imply several thousand 
hedge funds going under between the years of 2007 to 2009. 
Hedge funds are now involved in virtually every aspect of 
economic activity, investing in every kind of market and asset, 
making loans for all purposes, including mortgages, engaging in 
market making activity, financing bridges, highways, tunnels 
and other infrastructure in many countries, and even providing 
insurance. It is the hedge funds' ubiquity, size, leverage, 
illiquidity and lack of transparency that creates systemic risk 
for the financial system.
    Hedge funds now provide many of the same services as banks, 
but unlike banks, hedge funds are not regulated. They are 
outside the Federal Reserve system, which you may recall was 
originally set up to deal with systemic risk in the banking 
industry. Like banks, hedge funds provide liquidity. But unlike 
banks, they can withdraw that liquidity from the marketplace at 
a moment's notice. Like banks, hedge funds use leverage. But 
unlike banks, they face no limits, other than those imposed by 
their prime brokers and counterparties, nor do they face any 
capital adequacy requirements, which means that hedge funds can 
get wiped out completely. But of course, investors are prepared 
for that. And when hedge funds were a cottage industry 
consisting of small boutiques, that wasn't a problem.
    In fact, that was very positive for the economy because 
there are some risks that only hedge funds are willing to bear. 
But when hedge funds become too big to fail, that poses a 
problem for the financial system. As the hedge fund industry 
has grown, so too has its contribution to systemic risk. And as 
early as 2004, my co-authors and I uncovered indirect evidence 
for increasing levels of systemic risk in the industry due to 
apparent increases in assets under management, leverage, 
illiquidity, and correlations among hedge funds in commercially 
available data bases.
    And I realize that this hearing is about hedge funds, so 
that has been the focus of my comments and my written 
testimony, but in the interests of fairness I should point out 
that while hedge funds have taken on many of the same functions 
as banks over the last decade, thanks to the repeal of the 
Glass-Steagall Act in 1999, many banks have become more like 
hedge funds. And over the past decade, commercial banks, 
investment banks, and hedge funds have been locked in heated 
competition with each other, all fueled by investors, including 
pension funds, sovereign wealth funds, and government-sponsored 
enterprises, seeking that extra bit of yield in a frustratingly 
low yield environment. This economic free-for-all between 
banks, hedge funds, government-sponsored entities, and Wall 
Street is one of the main reasons for the magnitude of the 
current financial crisis.
    In my written testimony I provide several concrete 
proposals for addressing these issues, but let me mention two 
that pertain specifically to hedge funds. While I have written 
about the possibility of systemic shocks emanating from the 
hedge fund industry, the fact is that we cannot come to any 
firm conclusions because we simply don't have the data. Hedge 
funds don't have to report their monthly returns to any 
regulatory authority, much less details about their risk 
    So my first proposal is to require all hedge funds or their 
prime brokers to provide certain risk measures to regulators 
periodically and on a confidential basis. And I give examples 
in my written testimony of the types of risk measures that 
would be most useful from the systemic perspective. My second 
proposal is to create an investigative office like the National 
Transportation Safety Board to examine every single financial 
blowup, not just the headline grabbers, and to produce publicly 
accessible reports on what happened, how it happened, why it 
happened, who caused it to happen, and how to keep it from 
happening again. With greater transparency into the hedge fund 
industry and a better understanding of blowups that contribute 
most to systemic risk, both the public and the private sectors 
will be much better prepared to handle any financial crisis now 
or in the future. Thank you.
    [The prepared statement of Mr. Lo follows:]
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    Mrs. Maloney. Thank you very, very much. Professor Bankman.


    Mr. Bankman. Chair Waxman, Ranking Member Davis, members of 
the committee, thank you very much for asking me to come here 
to testify. The views I express are my own, and are not 
necessarily shared by Stanford University. I have been asked to 
provide an overview of hedge fund taxation, focusing on some of 
the benefits of hedge fund managers. My testimony, however, 
will also include private equity fund compensation agreements 
and tax benefits, since they are quite similar. Managers in 
both these fields receive a management fee, typically set at 2 
percent of the amount under management. They also receive a 
profits interest, typically set at 20 percent of the fund's 
profits. The profits interest is sometimes called the carried 
interest, or simply a carry. The management fee is taxed as 
ordinary income. The profits interest is taxed as capital gain 
if and to the extent the fund itself is recognizing capital 
gains. If it is long-term capital gain, that is at a tax rate 
of 15 percent, as opposed to the 35 percent maximum tax rate on 
ordinary income.
    In addition, carry is exempt from payroll tax. The benefits 
of this treatment have been estimated at over $30 billion over 
the next 10 years. However, as I note in my written testimony, 
most of the benefits treatment probably accrue to the private 
equity side of the ledger rather than the hedge fund side of 
the ledger. That said, the hedge fund and private equity 
industries to some extent overlap. Hedge fund managers do 
benefit from this preference, and change in trading strategies 
might make this preference even more important in the future. 
In my written testimony, I express my belief, and I believe the 
belief of an overwhelming majority of my colleagues and tax 
scholars, that this preference is misguided. The way to think 
about it is to think of the choice our sons and daughters face 
when they decide upon a career. If they are smart and 
ambitious, they might become doctors or scientists or lawyers. 
These occupations and countless other occupations are going to 
produce income that is taxed at ordinary income rates. 
Alternatively, they could go into the fund industry and 
recognize some, and in some cases most of their income at 
capital gain rates. That is simply unfair. It violates a common 
sense maxim that if you have two people earning the same 
amount, you ought to tax them at the same rate. It is also 
inefficient. It reduces the size of our economic pie by 
distorting the career choice our sons and daughters are going 
to make.
    It is sometimes argued that hedge fund managers ought to 
be--and private equity managers--ought to be compared to 
entrepreneurs. As I mention in my written testimony, I don't 
think that comparison is apt. Hedge fund managers are more 
similar, I think, to investment bankers or to executives at 
public companies, all of whom recognize income at ordinary 
income rates. There are other arguments made in defense of the 
current tax treatment. It is said, for example, that this is 
recompense for the risk fund managers take, that it is a good 
way to favor certain industries, or to subsidize investment in 
    As I note in my written testimony, I believe all those 
arguments are incorrect. And I would be happy to discuss that 
with the Members in question period. The capital gain 
preference isn't the only tax preference hedge fund managers 
receive. They have been able to defer recognition of gain, 
defer tax on their management fees simply by leaving those fees 
in the fund. And they have also been able to defer tax on the 
income those fees have generated. Tax applies only when the 
managers have decided, at their election, to withdraw the money 
from the fund. The value of this benefit has been estimated at 
about $20 billion over 10 years. This last benefit, the 
deferral of fees, might be of interest for the committee in 
discussing the relevant benefits and burdens of government 
regulations and tax on the industry. It is not, however, 
something of current interest in terms of legislation, since 
under the Economic Stabilization Act it is scheduled to end at 
the end of this year. However, the tax benefits of carry still 
remain. The House has voted in June to tax all carry at 
ordinary income rates. That was a measure I supported. 
Unfortunately, it died in the Senate. I am hopeful that the 
Members here and the House in general will again reenact that 
    In my written testimony, I suggest that the drafters look 
at the remarks of the New York State Bar Association as to how 
to draft that provision. And hopefully this time it will make 
it through the Senate and become law. Thank you.
    Mrs. Maloney. Thank you very much for your testimony.
    [The prepared statement of Mr. Bankman follows:]
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    Mrs. Maloney. Mr. Shadab.


    Mr. Shadab. Chairman, Ranking Member Davis, and 
distinguished members of the committee, it is an honor to 
testify in this forum today about the relationship between 
hedge funds and the financial crisis. I am privileged to join 
such a distinguished panel. My name is Houman Shadab, and I am 
a senior research fellow at the Mercatus Center, and a 
participating scholar in the center's financial markets working 
group. The Mercatus Center is a university-based education 
outreach and research organization affiliated with George Mason 
University. My own research focus is on financial regulation. I 
was asked to testify today on certain aspects of the role of 
hedge funds in the financial crisis. I also have submitted 
written testimony which provides more detail and background. 
There are three important findings that I would like to share 
with the committee. First, hedge funds did not cause the 
financial crisis. And they are, in fact, helping to reduce its 
damage and save taxpayers money. This may seem surprising, but 
in fact, hedge funds have historically made markets more 
stable, and have helped their investors conserve wealth in 
times of economic stress. In other words, hedge funds are often 
less risky than mutual funds. A typical hedge fund strategy 
seeks to achieve higher risk-adjusted returns, but not 
necessarily higher returns in other investment vehicles. And in 
fact, throughout this crisis hedge funds have conserved wealth 
much better than mutual funds have.
    Second, short selling by hedge funds has helped draw 
attention to the poor investment choices made by financial 
companies in recent years, but did not cause them to collapse. 
When hedge funds short-sell stocks of unhealthy companies, they 
help to divert capital from companies that are fundamentally 
unstable. This not only prevents stock market bubbles from 
becoming worse, but it helps to ensure that companies that are 
making good decisions are rewarded and are better able to 
provide stable, long-terms jobs for their employees. Third, 
existing laws and regulations should be strictly enforced 
against hedge funds and their managers. And these include laws 
prohibiting fraud, insider trading, abusive short selling, and 
other types of market manipulation. But changing how hedge 
funds are regulated could actually undermine the interests of 
investors and heighten economic instability. While it may be 
easy to lump hedge funds together with the financial 
institutions that were directly involved with this crisis, we 
must be very careful to make the appropriate distinctions to 
ensure that policy responses to the crisis do not undermine the 
ability of the economy to recover.
    So what is a hedge fund? A hedge fund is a private 
investment company that makes frequent trades in stocks and 
other financial instruments, and compensates its manager in 
part with an annual performance-based fee, typically 20 percent 
of profits. Hedge fund managers also typically invest in the 
funds they manage. This compensation agreement leads hedge fund 
managers to strike a relatively healthy balance between risk 
taking and risk management, and as empirical research has 
found, to make the survival of the hedge fund a greater 
priority than earning performance fees. Now, it may come as a 
surprise to some, but hedge funds are not even actually a part 
of corporate America. Hedge funds often take aggressive action 
against company executives they think are paid too much or are 
not properly running their companies.
    Importantly, when hedge funds get other companies to more 
properly manage their businesses, hedge funds help those other 
companies provide more stable jobs for their employees. Now, 
the financial crisis is the result of distortions in the 
mortgage and banking sectors, and would have happened even if 
hedge funds had never existed. Indeed, hedge funds were never 
the major purchasers of mortgage-related securities. The major 
purchasers were banks, insurance companies, pensions, and 
mutual funds. The most meaningful role hedge funds have played 
during the financial crisis has actually been to dampen its 
cost to the economy. Large numbers of hedge funds, worth a 
total of approximately $100 billion, have increasingly been 
purchasing poorly performing assets, such as mortgage-backed 
securities, and are helping to reduce the need for economic 
bailouts funded by taxpayers.
    Indeed, just yesterday the Treasury Department announced 
that it may start requiring companies that receive government 
funds to first raise private capital. Many hedge funds may be 
poised to provide such capital, as a recent estimate found that 
hedge funds are currently holding about $400 billion in cash. 
Given the massive losses that have resulted from the financial 
crisis, our system of financial regulation certainly needs 
rethinking. Yet based upon the empirical evidence, changing the 
already substantial body of law applicable to hedge funds will 
not stop this crisis or prevent another one from happening. 
Instead, lawmakers and regulators should focus on two things.
    First, economic recovery may take place more quickly if 
lawmakers make it easier for hedge funds and other private 
investment funds to invest in banks. Second, lawmakers and 
regulators may want to take a look at making it easier for 
ordinary investors to have access to the investment strategies 
offered by hedge funds. For example, reducing the restrictions 
on mutual funds' investment activities may be a way for all 
investors to benefit from the protection that hedge funds 
provide, and not just the rich ones. Thank you very much for 
the opportunity to share my research with the committee.
    [The prepared statement of Mr. Shadab follows:]
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    Mrs. Maloney. Thank all the panelists for your testimony. 
The Chair recognizes herself for 5 minutes. The current 
financial crisis started over a year ago, with the collapse of 
the subprime market. Through our hearings, we have learned 
about the roles of lenders, bankers, brokers, and credit rating 
agencies. One question that I have is how hedge funds may have 
affected and contributed to this crisis. Since September, hedge 
funds have faced a massive increase in withdrawals from their 
investors. According to one report, they have faced redemptions 
of over $50 billion.
    As a result, many have been forced to sell assets to raise 
cash. The hedge funds are selling into a down market, and this 
further drives down stock prices. Bloomberg News described the 
cycle recently as, ``downdraft of market declines, client 
redemptions, demands from lenders for more collateral, and 
forced asset sales.''
    Professor Ruder, in your testimony you stated that hedge 
funds have contributed to the decline in stock and asset prices 
by liquidating stocks and other assets in order to meet other 
obligations and in order to pay investors seeking to withdraw 
funds. Is it your view that these hedge fund withdrawals are 
affecting the broader market?
    Mr. Ruder. Indeed, they are. The hedge funds, at least by 
all reports, are selling massive amounts into the stock 
markets, causing the stock markets to--assisting in the stock 
market decline. We don't know how much they have contributed to 
declines in other assets. But surely they are engaged in sales 
of those assets as well. I know it is happening. I regard that 
aspect of it to be a rather natural effect coming from the 
credit crisis itself.
    Mrs. Maloney. And Professor Lo, what is your view?
    Mr. Lo. I agree with Professor Ruder that there is 
certainly an effect of hedge funds unwinding their positions on 
the marketplace. However, those effects are the unavoidable 
aspects of a free capital market, and something that while we 
need to be aware of and we need to prepare for, it may not 
require any direct oversight.
    Mrs. Maloney. OK. Market analyst Jeff Bagley has estimated 
that hedge funds might be forced to sell half a trillion 
dollars worth of assets as a result of this financial crisis. 
And Professor Lo or Professor Ruder, what would be the impact 
of forced sales like this?
    Mr. Ruder. Well, it is clear that forced sales will affect 
the markets. What we need to know in advance is what are these 
positions so that the financial regulators can have some way of 
attacking the problem of the massive amounts of moneys that are 
held by hedge funds.
    Mrs. Maloney. So there is a definite need for more 
    Mr. Ruder. I certainly agree with that.
    Mrs. Maloney. And Professor Lo, a recent report by the 
Organization for Economic Cooperation and Development found 
that hedge funds had purchased over 70 percent of the riskiest 
tranches of collateralized debt obligations, the financial 
instruments used to sell the subprime mortgages to investors 
that are at the root of this crisis before us. What impacts did 
these investments have on the financial crisis? And did hedge 
funds facilitate the growth of the market for the sale of these 
toxic CDOs?
    Mr. Lo. Certainly I think they did facilitate the growth of 
these markets by taking on the capacity for holding these so-
called toxic waste tranches. However, that again has both a 
positive and a negative. The positive is that there are few 
other investors in the economy that are willing to take such 
risks, and so hedge funds provide a valuable service. However, 
on the down side, when these particular risky assets end up 
losing great sums of money, hedge funds are put under great 
stress. And the unwinding of these portfolios can create 
significant market dislocation.
    Mrs. Maloney. Long Term Capital Management hedge fund 
failed in 1998, and the Federal Reserve was so concerned about 
market turmoil that they organized investment bankers to come 
in and to really be supportive and to put them back on a sound 
financial footing. What concerns me now is there are no 
investment banks left to buy up hedge funds if they fail and 
are causing systemic risk in our financial markets. And would 
anyone like to comment on that? Yes, Professor Lo?
    Mr. Lo. Yes, I agree that this is a significant issue, 
which is one of the reasons that in my written testimony, I 
call for further transparency into the so-called shadow banking 
system. It is not at all clear that we need more regulation. I 
think it is clear that we need more effective regulation. But 
it is difficult for us to propose what that effective 
regulation looks like unless we have more transparency into the 
hedge fund industry. With that additional transparency we can 
develop a sense of what exactly is needed.
    Mrs. Maloney. Thank you very much. And I recognize Ranking 
Member Davis for 5 minutes.
    Mr. Davis of Virginia. Well, thank you very much, Ms. 
Maloney. Do all of you believe that hedge funds are adequately 
regulated? And could you also comment on the adequacy of the 
disclosure requirements for these entities? I know you touched 
on it in your statements, but I just----
    Mr. Ruder. I would be pleased to expand on that, 
Congressman Davis. There ought to be some way in which the 
aggregate risk positions of the hedge funds and the risk 
positions of their counterparties are revealed to a central 
regulator. I don't really know what the central regulator will 
do, but it is impossible for that central regulator to take 
adequate steps to forestall calamities without having that 
information. So the first step has to be an inspection system, 
an assessment system. And as my prepared testimony says, I 
think that the SEC should--or someone like the SEC should have 
an opportunity to look at the risk management systems of the 
hedge funds in order to see that they are not engaged in steps 
which are going to create the kinds of calamities we have had.
    Mr. Davis of Virginia. Professor Lo.
    Mr. Lo. Well, Congressman Davis, I think that the 
possibility of legislating losses away is obviously impossible 
and unwise. Dislocation comes not from losing money, but from 
the wrong investors losing money. And if we provide greater 
transparency to the marketplace, I believe that a great deal of 
the problems that we have been facing will take care of 
themselves to a large degree. However, there is no mechanism 
currently for that information to be provided to the public or 
to regulators. So I agree with Professor Ruder that we do need 
to have a mechanism for providing that level of transparency. 
Beyond that, I think it is very premature to be able to say 
what kind of regulations should be imposed.
    Mr. Davis of Virginia. Thank you. Professor Bankman.
    Mr. Bankman. Yes.
    Mr. Davis of Virginia. You want to answer?
    Mr. Bankman. No, I am just a tax expert. You don't want my 
opinion on that.
    Mr. Davis of Virginia. OK. Mr. Shadab.
    Mr. Shadab. I think one of the underlying assumptions is 
that somehow all of these risks are out there in the economy 
and are known by some parties, and the only issue is simply 
gathering them in a centralized source and then making 
decisions on that basis. The problem with that perspective is 
that the risks that hedge funds and their counterparties pose 
to the economy are A, very highly complex, and B, constantly 
    And in fact, in 2006, Federal Reserve Chairman Ben Bernanke 
rejected a proposal to create a centralized data base of hedge 
fund positions for a couple reasons, one of which being that 
type of information, in order to be gathered, would be required 
to be gathered from all financial participants in the economy, 
not just hedge funds, but also banks, their lenders, their 
counterparties, and even investors and creditors to some 
extent, too. Second of all, when that type of information is 
created by regulators, it creates a false sense of security 
among market participants that these risks are adequately being 
monitored and managed.
    And in fact, to a large extent the reason the investment 
banks took on so much leverage and collapsed was because market 
participants were under the false assumption that the 
Securities and Exchange Commission, through their Consolidated 
Supervised Entities Program, was monitoring the risks of 
investment banks to their investors and to the economy, but it 
was not doing so. By contrast, hedge funds, it is widely known 
by market participants, have no oversight by any central 
authority, and we can rely upon the market discipline of their 
counterparties. And it is for that reason that losses from 
hedge funds typically do not spread to the entire economy. This 
idea of systemic risk is an idea, but it is really just a 
hypothetical. It has not come to fruition and practice.
    A much more instructive example of large hedge funds 
collapsing is not Long Term Capital Management in 1998, but 
actually Amaranth Advisors, which happened in 2006. That hedge 
fund was much larger by at least $2 billion than Long Term 
Capital Management. It disappeared almost virtually overnight, 
or at least within 1 week, and the markets didn't even notice. 
Why? Because Amaranth and its counterparties were engaging in 
proper risk management, and it is true that investment banks 
are no longer there to provide capital to purchase failed hedge 
funds, but other hedge funds are there to purchase each 
other's. And in fact, as we speak right now, new hedge funds 
are being launched, which really displays and reflects the 
vitality of that industry compared to, for example, the banking 
sector. And I haven't heard many banks being created in recent 
times. Thank you.
    Mr. Davis of Virginia. Thanks. Let me continue. Mr. Shadab, 
the briefing memorandum that was produced by the majority 
implies that hedge funds were major drivers of the subprime 
housing market through the large investments in collateralized 
debt obligations backed by subprime mortgages. They cite 
figures from the OECD estimating that hedge funds purchased 46 
percent of all CDOs and over 70 percent of the most risky 
portions of these investment vehicles. But in your testimony 
you estimate that the hedge funds never had more than 29 
percent of the CDO market, and probably less. I guess my 
question isn't debating what the facts are, but were hedge 
funds significant contributors to the growth of the subprime 
mortgage market or weren't they?
    Mr. Shadab. No, they were not. And this is not just based 
upon the numbers. We take a step back and think what is the 
purpose of a structured investment vehicle, a special purpose 
vehicle that is going to put together a collateralized debt 
obligation? The purpose of that vehicle is to provide higher 
interest rates paid out by investment grade securities for 
institutional investors such as pension funds and insurance 
companies to be able to invest under a certain class of 
security that has a certain safety rating, but nonetheless 
gives them a higher grade.
    Hedge funds have no genuine interest in purchasing CDOs, 
because the CDO is to some extent another private investment 
fund. If hedge funds want exposures to those types of risks 
they can buy the underlying bonds or what have you. And in 
fact, the reason hedge funds concentrated their investments in 
the riskiest tranche was because first of all, it is an equity 
tranche, which pays out a much higher interest rate because it 
is more risky, and it is important to know that those equity 
CDO tranches were five to less percent of a typical equity CDO 
deal, which is primarily based upon, again, to get those 
investment grade ratings.
    Mrs. Maloney. Thank you. The Chair recognizes Congressman 
Cummings for 5 minutes.
    Mr. Cummings. Thank you all for your testimony. Let me make 
sure I got this right, Professor Bankman. I would like to ask 
you about your testimony that some hedge fund managers may 
currently pay taxes at a lower rate than Americans who make 
less money. If I understand your testimony correctly, the 
earnings of hedge fund managers are called carried interest. Is 
that correct?
    Mr. Bankman. That is right.
    Mr. Cummings. And to the extent that these earnings can be 
tied to long-term gains, the tax rate is just 15 percent. Is 
that right?
    Mr. Bankman. That is right.
    Mr. Cummings. I just want to make sure, because I thought I 
was hearing something different. And I want to compare that 15 
percent tax rate to the tax rates of some other working 
Americans, very hardworking Americans. The Bureau of Labor 
Statistics has calculated the median earnings for various 
occupations in the American work force. The median earnings for 
American school teachers were $43,000, Professor Bankman, to 
$49,000 per year. What is the tax rate for a school teacher 
with that income?
    Mr. Bankman. Well, it depends on their marital status. But 
if they are single, the 25 percent rate would start at about 
$32,000, I believe. So they would be paying tax at 25 percent 
on that income, and there would be payroll tax they would be 
paying, too. So it would be a 40 percent higher rate, that is 
25 as compared to 15.
    Mr. Cummings. Jesus Christ. The median earnings for a 
firefighter was 41,190. His or her tax rate would also I think 
be around that 25 percent range that you just talked about. Is 
that right?
    Mr. Bankman. That is right.
    Mr. Cummings. Now, the median hourly earnings for a 
plumber, we have been talking about plumbers here a lot lately, 
were $20.65 per hour. And that is about $41,000 per year. That 
is also taxed about at the 25 percent rate. Is that right?
    Mr. Bankman. That would be right. Of course, there may be 
deductions from that, too. So we may be slightly overstating 
the rate on some of those cases.
    Mr. Cummings. Let me get this, let me ask it this way. So 
Joe the plumber is being taxed at a higher rate than Joe the 
investment banker. Is that right? Is that a fair statement?
    Mr. Bankman. That would be true if it were Joe the fund 
manager. The investment bankers actually don't get that break.
    Mr. Cummings. OK. So the fund manager.
    Mr. Bankman. Yes.
    Mr. Cummings. All right. Now Professor Bankman, does this 
seem fair to you?
    Mr. Bankman. No.
    Mr. Cummings. On the average, the witnesses on the next 
panel made over $1 billion, $1 billion in 2007, yet at least 
some portion of their earnings is being taxed at just a 15 
percent rate. Is that fair?
    Mr. Bankman. No, I don't believe that is either fair or 
    Mr. Cummings. And why do you say that? Let's concentrate on 
the word efficient. Why do you say it is not efficient?
    Mr. Bankman. Well, a fundamental goal of tax policy is to 
try to tax everything at the same rate. Otherwise the tax 
system interferes with the flow of labor, the flow of 
resources. So it is inefficient to give a tax break to one 
occupation as opposed to another. We ought to start them off at 
the same rate. And we can all debate what that appropriate rate 
is, but nobody has ever offered a reason why this one slice of 
highly paid professionals should be taxed at a lower rate than 
other slices of either highly paid or less highly paid 
    Mr. Cummings. Is there something that makes these guys so 
special that they get this 15 percent rate? I mean because I am 
sure people like Joe the plumber and others would like to try 
get into that category. I mean is there something special about 
these guys and ladies?
    Mr. Bankman. Well, the rate has a long historical 
explanation to it, which doesn't make hedge fund managers that 
benefit from the rate special, but does give a little bit of an 
explanation how we to some extent slipped into a situation 
where so many of our most highly paid members are getting 
preferential tax treatment.
    Mr. Cummings. Let me just say this: This Congress, the 
House twice voted to close this loophole, and it would have 
generated more than $30 billion in tax savings according to the 
Congressional Budget Office. Unfortunately, this provision has 
not been passed by the Senate, and it was opposed, opposed by 
the Bush administration. I hope we can correct this injustice 
once and for all next year. Would you agree?
    Mr. Bankman. Yes.
    Mr. Cummings. All right. I see my time is about up. I yield 
    Mrs. Maloney. Thank you very much. Congressman Issa.
    Mr. Issa. Thank you, Madam Chair. Welcome all of you to the 
Ways and Means Committee. It is very clear we have moved onto 
tax policy. And I am actually glad we are, because I think it 
reveals what we are in for in this Congress and the next 
Congress. I am a Member of Congress who has my capital gains 
treatment under the old tax law when I sold my business and 
came to Congress. So I didn't get the 15 percent, and I did pay 
10 percent or so to the State of California in addition. But 
let me go through a couple of assumptions here since we are 
playing tax policy. Professor Bankman, you lump together the 
LBO firms, like the one that bought out my company, and the 
hedge funds. Now, isn't it true that a leveraged buyout firm in 
fact is a classic--I mean, these types of firms buy a company. 
They put skin in it.
    And over a long period of time, or sometimes short, they 
hope to get a capital gains. Isn't capital gains over a hold of 
more than 1 year by definition, yes or no, the existing tax 
    Mr. Bankman. Yes.
    Mr. Issa. OK. So we will just assume that you didn't really 
mean to say people who buy whole companies should be somehow 
not entitled to this. That is not the loophole that I think Mr. 
Cummings was going to close.
    Let me go through another question. You talk about a 
doctor. Isn't it true that if a doctor forms a medical practice 
and builds it up and then sells it, he gets capital gains 
treatment on that?
    Mr. Bankman. That's right.
    Mr. Issa. OK. So the doctor really does have the same 
opportunity, he just has to avail himself of it. If he works 
for a hospital, and he doesn't own a piece of the clinic or 
hospital, then he doesn't avail himself. If he does invest in 
some sort of partnership, he gets that ability when it is sold; 
isn't that true?
    Mr. Bankman. That's right. But I think there is a 
distinction when the doctor's regular income, which is taxed at 
ordinary income rates, and the very occasional capital gain he 
    Mr. Issa. And I appreciate your feeling on that. And, look, 
I am one of those people that thinks we should look at hedge 
fund income, including profit sharing, and ask whether or not 
that should be long term or short. I have no problem at looking 
at it, but of course I am not on the Ways and Means Committee 
normally, so I don't get that opportunity.
    Let's go through a couple of other things--and by the way, 
Professor Bankman, thank you for supporting the flat tax. I 
appreciate that we should all be taxed at the same rate and we 
shouldn't use tax policy to manipulate the economy. 
Unfortunately, the Congress historically has not agreed with 
that and they have micro-managed it in the other Ways and Means 
    Professor Ruder, you sort of alluded to the problems of 
lack of regulation, the SEC not getting authority. I just have 
a brief question.
    Would you agree that a size for SEC filing and regulating 
of hedge funds so as to take the small firm--let's say you have 
two clients, and no matter how much money, it is just two 
clients that you are investing on behalf of--that those 
wouldn't be sensible for a hedge fund or any fund to have to 
report to the SEC, but if you had 2,000 you probably would fit. 
Would you say that there are numbers, let's say a dozen or more 
clients and more than $100 million under management, that would 
trigger a SEC requirement?
    Mr. Ruder. It is possible to arrange regulation in that 
way. The Investment Advisers Act today, the legislation----
    Mr. Issa. I believe it S. 17.
    Mr. Ruder. Well, I am not talking about numbers of people, 
but there is an inspection split between the States and the SEC 
at $25 million. If there is less than $25 million under 
management, it is not regulated by the SEC. And I would support 
that kind of distinction. It is just a matter of deciding what 
the number is. Is it $25 million? Is it $100 million? One has 
to come to some conclusion about that.
    Mr. Issa. I appreciate that. And I think you are right, if 
we regulate we do have to recognize that we can't regulate 
every entity.
    Mr. Shadab, I have a couple of questions that you are 
probably very equipped to answer. First of all, this whole 
question of hedge funds, isn't it true that hedge funds 
normally hedge both, if you will, long and short, and as a 
result when they unwind they tend to unwind more neutral than 
other long-only investments?
    Mr. Shadab. That is fair to say, that is correct.
    Mr. Issa. And isn't it true that some of the biggest 
investors in hedge funds are union pension plans and even State 
plans, that they will have a percentage, usually 5 percent or 
less, but a percentage they are putting in hedge funds?
    Mr. Shadab. Increasingly so, yes.
    Mr. Issa. And isn't it true that the inefficiency in the 
market is partially because we have built up a strategy of most 
mutual funds not being able to go to all cash, not being able 
to essentially leave a certain paradigm that they are in and, 
to a great extent, if you want to limit risk and you are in a 
fund that is 100 percent invested in small caps, or whatever, 
that a hedge fund is often the way, if you are a big investor 
like a union pension plan, that you hedge against your other 
investments which are 100 percent long?
    Mr. Shadab. Correct. Hedge funds are more flexible.
    Mr. Issa. Thank you. Thank you, Madam Chair.
    Mrs. Maloney. Congressman Tierney.
    Mr. Tierney. I want to thank the witnesses here today. But 
Professor Lo, I want to ask you something about what you said 
in your testimony. You talked about the fact that we had not 
yet seen the full impact of the unraveling and the deleveraging 
of the hedge fund industry. And I think you predicted that we 
could see thousands more of additional entities go under. So I 
guess about 9,000 different hedge funds out there, estimates, 
and you are talking about a good healthy percentage of them are 
going under. What would be the potential impacts of the 
collapse of that many hedge funds?
    Mr. Lo. Well, it is hard to say because, as I mention in my 
testimony, we don't have a lot of information about their 
holdings, their leverage, the counterparties, or other aspects 
of their exposures. I suspect that a large number of them will 
be taken over by larger financial institutions, so the impact 
for those may be relatively minimal. But there may be a small 
number of very large hedge funds that have a variety of 
different counterparty relationships that could cause some 
market dislocation. And that is really the purpose of 
transparency is to be able to tell whether or not we are 
looking at a significant event or not.
    Mr. Tierney. I think the general perception of the public 
with respect to these hedge funds is that, if they go under, so 
what? They are super rich people who understand the risk, are 
somewhat sophisticated, what do we care? But I have heard 
discussed here through some of your testimony that increasingly 
State and local and private pension funds are invested in them. 
So we really have a concern here about ordinary people involved 
in this, whether they know it or not, retirees, students, it 
could be millions of other citizens that are getting affected 
by that. So tell me what the impact is, if they go under, how 
does it affect Main Street?
    Mr. Lo. Well, clearly there are going to be losses faced by 
individual investors because one of the largest amount of 
assets that have come into the hedge fund industry over the 
last 5 years is pension funds. So there will be an impact 
there. The question though is really whether or not that impact 
is anticipated or not.
    I mentioned earlier that dislocation happens not when 
losses occur, but when losses by individuals that are not 
prepared for those losses occur. The hedge funds that invest in 
the worst risk tranches, they are prepared for losses; but when 
money market funds, pension funds, mutual funds invest in AAA 
securities that then lose substantial value, that is really the 
cause for dislocation.
    Mr. Tierney. And that is where the transparency aspect 
comes in, I suspect. But the transparency you are talking about 
is disclosure to the SEC in sort of a confidential way.
    Mr. Lo. That's right.
    Mr. Tierney. What transparency is there to investors from 
these hedge funds? My understanding is that you could invest in 
this hedge fund and have no particular rights to be able to get 
information as to just what the investments are and what the 
circumstances are; is that correct?
    Mr. Lo. That's right. Let the buyer or let the investor 
    Mr. Tierney. So here you have a pension fund investing in a 
hedge fund. Not only is whoever is managing the pension fund 
unaware, but certainly the investors--the pensioners, or 
whatever--are totally unaware. Do you think if that continues 
to hold is a good policy, or do you think that there ought to 
be more transparency to the investors from the manager of these 
hedge funds?
    Mr. Lo. Well, for the most part, investors would probably 
not be able to make use of the kind of transparency that I am 
proposing to the regulators. Most investors delegate their 
decisions, particularly involving sophisticated and highly 
risky investments like hedge funds, to professional managers. 
So the managers and the ultimate institutional investors I 
think would have the responsibility to monitor those kinds of 
risks, and of course the regulators would be focused on a 
different issue, which is the risk to the entire financial 
    Mr. Tierney. Is it too late for transparency to help 
individuals who belong to a retirement fund that is invested in 
hedge funds that may go under at this stage?
    Mr. Lo. I don't think it is ever too late. I think that 
additional transparency even now will provide some sense of 
what we are likely to expect to see over the next year or two, 
and that could help investors with their own planning for 
financial market dislocations yet to come.
    Mr. Tierney. Does anybody on the panel recommend any 
stronger intervention on behalf of these pensioners or the 
State, local or private pension funds that are being invested 
in hedge funds and that may stand the prospect of losing 
significant amounts of money if as large a portion of the hedge 
funds go under as some have predicted?
    Mr. Shadab. I would just like to say that it is very 
atypical, in fact unheard of, for hedge funds not to make 
substantial disclosures to their investors, especially when 
they are institutions like pension funds. Hedge fund investors 
typically demand quite a bit of information from the fund and 
funds in order to compete for investor wealth will make 
substantial disclosures, and in fact more disclosures and in 
fact higher quality and more easily understandable disclosures 
than mutual funds make to their investors. It is actually much 
easier to be able to contact and have a discussion with a hedge 
fund manager about your investments in the hedge fund as 
opposed to a mutual fund manager.
    Mr. Tierney. That is interesting, Mr. Shadab, because some 
of the information we looked at from the second panel on their 
funds disclosed very little information. Professor Lo, would 
you agree with that? I mean, it is not like they give out very 
specific detailed information to their investors.
    Mr. Lo. Well, that is right. I think it depends on the 
hedge fund. But by and large, hedge funds are not obligated to 
provide transparency to investors, and in many cases that is 
one of the reasons managers decide to launch hedge funds as 
opposed to mutual funds, to protect their proprietary 
information that they are using to make money for their 
    I wanted to add one more comment to Congressman Tierney's 
question about pension funds, which is that one issue that we 
haven't talked about today is the impact of potential hedge 
fund failures on the PBGC's ability to make good on pension 
fund claims. The PBGC recently has faced significant losses 
because of their internal investment policies. That might 
actually hamper their abilities to make good on these 
guarantees, and that is an issue that I think we need to 
    Mrs. Maloney. Congressman Souder.
    Mr. Souder. I would like to continue to followup a little 
bit with Professor Lo, because you have in your written 
statement an extended discussion on risk, and it seems to me 
that is one of the fundamental questions here.
    In a general way, other than temporary aberrations, do you 
know of any where the yield was disconnected from the risk? In 
other words, has the market accurately reflected that wherever 
you got a higher yield, you took more risk?
    Mr. Lo. That has typically been the case, yes.
    Mr. Souder. And wouldn't it also be true that the more you 
invested in economies that were kind of away from established 
economies, you would assume there would be higher risk?
    Mr. Lo. That's right.
    Mr. Souder. And wouldn't you assume that the less 
transparency there was there would be higher risk?
    Mr. Lo. That's right.
    Mr. Souder. In other words, if you are a doctor or a lawyer 
and you are investing in a fund that isn't very transparent, I 
would think that you would assume in any logical way that you 
were taking more risk.
    Mr. Lo. You should, that's correct.
    Mr. Souder. Now, what becomes fundamental here, and what a 
lot of people--and understand that I voted for both versions of 
the rescue package, but there is a lot of bitterness in my 
district of Indiana, which is relatively conservative, and as 
we see other parts of the country struggling, where they got 
great rewards and now are getting penalized and expect the rest 
of us to pick up some of their risk because they don't want to 
assume the risk. Now, in your written comments, you more or 
less compare that. You say people have a propensity to 
irresponsible behavior, more or less comparing drunks, people 
who drink too much and go out and drive, to some of the people 
here who weren't paying attention to the risk part. But then 
those of us who don't get drunk and go out and drive are now 
expected to bail them out. And this is why there is so much 
anger at the grass roots level because there seems to be a 
disconnection from reward and risk because in fact not 
everybody took those kinds of risks, not everybody invests in 
the higher risk parts.
    In this risk, as we look at the debate over hedge funds and 
other things, how much do you believe this risk was a question 
of the mortgage market than being the core of all the other 
    Mr. Lo. Well, I think that certainly the mortgage market 
was the epicenter for this series of losses, and there is a 
fundamental issue about how those markets grew so quickly over 
time without the proper infrastructure to be able to support 
that. And the idea behind regulation is to try to correct those 
kinds of market failures.
    Mr. Souder. Do you believe that the securitization of the 
credit card market is starting to look like what happened in 
the mortgage market?
    Mr. Lo. It does have the same elements, yes.
    Mr. Souder. And part of the question here is because, in 
your discussion of risk and what you just said in response to 
Mr. Tierney, is that part of the problem here is people who 
really weren't thinking they were getting risk in their ability 
to absorb risk suddenly found risk. The question there is is, 
where were the pension managers? In other words, part of the 
debate here is how much does government provide the regulation? 
And I have a business degree and a management degree, and the 
more we have these hearings, the more I am thinking is did 
people pay any attention in class? Did any of them really know 
what being a manager means? That maybe an individual goes out 
and gets drunk and drives, maybe somebody does irresponsible 
behavior, but that is why you hire pension managers. Where were 
    Mr. Lo. Well, part of the problem that I mentioned in my 
written testimony is that we didn't have enough expertise in 
financial markets to properly assess these risks.
    Mr. Souder. Let me interrupt a minute. You said--this is 
basic stuff--that risk was correlated with return, that where 
you put your money was related, that the housing market, 
anybody could see it was going bananas out of doubling in 
growth, that anybody in elementary could see that as you extend 
it to six paths and different tranches, you are getting farther 
and farther out, which normal basic management would say, go 
check your base, the farther out you go, go check your base; 
normal management would say that as you are doing more overseas 
risky investment, you should do that. The pension fund 
managers, while I understand that it wasn't perfect 
information, that in a sense was a warning too, the less 
information you have.
    I am trying to come back here. Some of this has to be 
blamed on incompetence of management, and yet nobody will take 
the blame, no individual manager will take blame, no government 
agency will take blame, and I would argue that in fact many 
people got out of these markets, some funds didn't get into 
these markets because in fact they saw it.
    Mr. Lo. Well, as Warren Buffett said, ``a rising tide lifts 
all boats.'' And during periods of great prosperity there is a 
complacency that is induced by this kind of success that blinds 
people to risks. And that is one of the purposes for better 
transparency and, frankly, for regulation.
    Mrs. Maloney. Thank you very much.
    Congressman Lynch.
    Mr. Lynch. Thank you, Madam Chair, for holding this 
hearing, and I want to thank the panelists as well for their 
thoughtful advice for the committee.
    Just a quick comment. I know we are trying to make 
comparisons to the Amaranth situation, the Amaranth collapse, 
as well as Long Term Capital Management, and it is difficult to 
make a broad projection from just a couple of examples. But I 
do want to note that the Amaranth collapse was simplified in 
some degree by the fact that it was largely an effort to corner 
the market on one commodity, natural gas. And fortunately it 
was a good time in the market. And you are right, Mr. Shadab, 
that they were able to dump other higher quality corporate 
equities into the market. And it was a good time to sell, so 
they were able to cushion some of their losses.
    However, if you look at the Long Term Capital Management 
example, there was less than $3 billion in the fund, but they 
had by leverage built that up to about $100 billion and 
actually, by the use of complex derivatives, had a notional 
value of over a trillion dollars; a trillion dollars notional 
value, they had $3 billion in the fund. So that really spells 
the possibility for systemic risk, at least to me.
    Let me just go back. You all have said, to some degree, 
with the exception of Mr. Bankman, I think, that hedge funds 
didn't cause this collapse, they didn't cause it. And I agree 
with that statement. However, I want to ask you, do you think 
that the structure and the opacity--and let's remember now, 
hedge funds have purchased the vast majority of these complex 
derivatives and CDOs, they are the major purchasers here. Have 
they amplified the negative impact of this economic downturn? 
If they have not caused it, has their structure and the lack of 
transparency and the concentration in those complex derivatives 
and CDOs, has that amplified the impact of the crisis? I would 
like you all to comment.
    Mr. Ruder. I would like to take the first crack at that if 
you don't mind. I think that is the case. I think that the 
participation in the complex derivative markets by hedge funds 
in large quantities have contributed to the complexity of the 
market and to the risks that are there in the markets. And that 
is why I think we should have some system for having the hedge 
fund positions be known to a central regulator so that 
regulator could look at all risk positions across the markets 
and see where the systemic risk problems are. It might also be 
able to identify the Long Term Capital Management twin in which 
there is a single hedge fund participant who may itself bring 
down the market.
    Mr. Lynch. Professor Lo.
    Mr. Lo. The short answer to Congressman Lynch's question 
is, I don't know. I don't think anybody knows because we don't 
have that kind of transparency to be able to say for sure 
whether hedge funds have exacerbated or possibly ameliorated 
the kind of market gyrations that have gone on in this 
particular area. That is one of the reasons we need 
transparency. However, it is the case that hedge funds, because 
they take on these extraordinary risks, provide a valuable 
service, but when those risks end up causing great losses, the 
opposite side of that same coin is that they can provide great 
    Mr. Lynch. Mr. Shadab.
    Mr. Shadab. A couple of things. The real core of this 
crisis is that banking institutions, commercial banks and 
investment banks, had these CDOs and other mortgage-related 
securities on their assets. So to the extent that hedge funds 
had purchased them from the banking institutions and other 
investors, that purchase has been taken away from banks, they 
have ameliorated the crisis to that extent. If these banks had 
gotten all the bad assets off of their books, we wouldn't have 
that core epicenter of a crisis happening from a banking 
sector, which is so important for the entire economy happening 
in the way we did right now.
    In addition, it is important to distinguish between credit 
default swaps, which are derivatives, and collateralized debt 
obligations, which are actually securities. Now, hedge funds 
were very large traders, but not the largest, it was banks, of 
CDSs, credit default swaps. And their trading of those 
instruments, along with banks' trading of those instruments, 
have really brought liquidity and some price discovery and 
transparency into the risks that are associated with their 
underlying credit obligations. And, in fact, the fall of any 
institution in relation to their----
    Mr. Lynch. I am sorry, Mr. Shadab, you are burning my time. 
Do you think it has amplified the impact, or no? And I 
appreciate it, and I don't mean to cut you short, it is just 
that with this structure we have very little opportunity.
    Mr. Shadab. It is hard to be sure. I don't think so though.
    Mr. Lynch. That is fair enough.
    Professor Lo, just with the last few seconds I have, you 
did mention the idea about this NTSB type organization to be 
able to come in. The only problem I have with that is that the 
NTSB usually comes and does accident reconstruction. They are 
not very good proactively, but they are excellent in 
forensically telling us what actually happened. I am out of 
time, but at some point I would like to hear your thoughts on 
how that would actually operate because I think that is 
actually what we need.
    And I thank all of the witnesses for your testimony today.
    Mrs. Maloney. Thank you, Congressman Lynch. And if 
Professor Lo would like to respond to your question.
    Mr. Lo. Thank you, Congressman Lynch. I believe that the 
National Transportation Safety Board is an incredibly valuable 
tool for developing deeper understanding into a variety of 
different failures and blowups. And while you are right that 
the NTSB does not have any oversight responsibilities, the FAA 
obviously controls issues regarding airline safety, the fact is 
that by publishing a publicly available report that describes 
the details of various accidents, the public learns an enormous 
amount of what happened and how to prevent it from happening in 
the future. And I think this is the most sensible starting 
point for thinking about new regulations in this industry.
    Mrs. Maloney. Thank you very much.
    Mr. Lynch. Thank you. Thank you, Madam Chair.
    Mrs. Maloney. Congressman Yarmuth.
    Mr. Yarmuth. Mr. Shadab, I am going to start with you. We 
are going to have on the next panel several people who are very 
wealthy and who have been involved in these types of 
activities. From a practical perspective, is there any 
difference between what any one of these next panel of 
witnesses can do and what a hedge fund can do; they can do as 
individuals what a hedge fund can do?
    Mr. Shadab. Do you mean a distinction between their own 
    Mr. Yarmuth. Yes. I mean, you have George Soros, with a net 
worth of billions of dollars, you have a Warren Buffett--not on 
the panel--but you have a Warren Buffett with billions of 
dollars, you have a Michael Bloomberg with billions of dollars. 
Is there anything that prevents them from doing what a hedge 
fund does?
    Mr. Shadab. With their own personal wealth, I don't think 
there is anything that prevents them from doing the same thing.
    Mr. Yarmuth. So in your testimony, when you say that there 
is a danger in regulating hedge funds because they would lose 
their unique benefits, why does it present a unique benefit 
when any individual with a lot of money can do the same thing?
    Mr. Shadab. Because it allows an investment manager not to 
use their own personal wealth, but to pool it from others. 
Sure, there are exceptions when you have hedge fund managers 
who over time accumulate their own large personal wealth and 
can basically run their own hedge funds without having to go to 
investors. But typically a hedge fund manager, in order to 
implement their trading, will need wealth from other investors.
    Mr. Yarmuth. So the hedge fund manager who is putting these 
deals together, when you mentioned the societal benefits of 
hedge fund managers, that is really not what the hedge fund 
manager is interested in, he or she is not interested in 
necessarily highlighting the deficient management style of a 
    Mr. Shadab. They don't need to be to create those benefits.
    Mr. Yarmuth. But that is not their motivation?
    Mr. Shadab. I would say unlikely that is the case, correct.
    Mr. Yarmuth. So if we are worried about the impact, whether 
or not, as Professor Ruder described, we can definitively 
describe what the systemic risk is, we similarly cannot 
describe the systemic benefit of hedge funds, it seems to me 
either, can we, Professor Ruder?
    Mr. Ruder. We could, by aggregating information, know where 
the hedge funds as a group are headed and be able to find out 
where they are hedging and what they are doing. I don't think 
that would be the purpose of the aggregation of risk 
information, but a regulator gathering information from all 
sources would be able to reach some conclusions and take some 
action, and may also even be able to issue some public 
statements which would help the public to know what is going 
    Mr. Yarmuth. I mean, I have a little hard time grasping 
this philosophically because, again, if all we are talking 
about is a group of individuals, let's say the members of our 
next panel all got together and they say we are just going to 
do our own hedge fund, we are going to sit together in a living 
room and embark upon these strategies, there would clearly be 
no governmental interest that I could define except maybe some 
kind of a conspiracy to disrupt the market. So is that really 
what we are talking about, is a distinction without a 
    Mr. Ruder. I think you are talking about the aggregation of 
assets by the hedge funds in ways that will far surpass the 
billions of dollars that these individual investors have. And 
that is the reason that we are concerned about it.
    Mr. Yarmuth. So this is a question of size. This is the 
whole argument about being too big to fail that we have dealt 
with with AIG and some of the other entities that we are 
talking about.
    Mr. Ruder. Well, I am not talking about too big to fail in 
the sense that when we find a hedge fund that is going to fail 
that we run to bail it out. I think we need to know what the 
effects of that failure will be on our system and, if 
necessary, take some preventative steps.
    Mr. Yarmuth. I tend to agree with you, that is why I am 
trying to ask this series of questions. Because when I read 
that in some cases that all the trades on the New York Stock 
Exchange, 5 percent of all the trades were controlled by one 
trader in a particular session, that is very disturbing because 
that is an unbelievable amount of market power.
    I want to ask one question of Professor Bankman, also. I 
have a friend who is a person I call upon to discuss these 
things. He is a master of the universe, he will remain 
nameless. And when I talked about carried interest with him 
several months ago, he said the problem with doing anything 
with carried interest is that all the hedge funds will do is 
restructure their organizations so that they will convert 
everything into pure capital gains. They will take equity 
interest in the entity and then take capital gains, in which 
case the revenue to the Federal Government will actually be 
delayed--it will not increase it, it will be delayed because 
they will just hold the investments longer. Do you have a 
response to that argument?
    Mr. Bankman. Yeah. I don't think that is going to happen. 
Whenever you pass a tax measure, it is always imperfect and 
there is always ways to get around it. And so you are always 
trying to come up with a compromise that is going to get 
revenue and hopefully not make the law too complicated and 
improve efficiency and equity, and there will always be ways 
around it. I have read the arguments that the industry is going 
to reorganize. And you know, the two and twenty and present 
form of industry organization have been around for a long time 
even when, by the way, capital gain was not a factor as it is 
not with respect to certain hedge funds. And I think experience 
shows that reorganizing industries and changing the way people 
do business is very costly and it doesn't happen very easily.
    So while I think that is something to watch, I amnot 
convinced that is the concern that some people think.
    Mrs. Maloney. Thank you very much.
    Chairwoman Norton.
    Ms. Norton. Thank you, Madam Chair.
    I am interested in a subject that is raised time and time 
again during this crisis, and that is the notion of regulation. 
It appears that we may have moved out of the mode we have been 
in in a kind of to be or not to be--to regulate or not to 
regulate, that is--to something we don't hear a lot of 
discussion about, if you want to regulate, who is going to do 
it, who is going to do it? Not a lot of meat on those bones. 
Indeed, there may be a contest among various agencies. So I 
looked at your testimony.
    Let's start with you, Professor Lo. You raised the idea, 
and it is interesting, you say that one would have to expand 
the scope--of course one would, one doesn't think of the 
Federal Reserve as such a regulatory agency--but you raise the 
notion of the Federal Reserve as the direct oversight agency 
for these largest of these funds. Why do you think the Federal 
Reserve is the best of the agencies to do such regulation?
    Mr. Lo. Well, primarily because the main issue regarding 
hedge funds and systemic risk is their impact on the liquidity 
of markets. And as we know, the Federal Reserve is the lender 
of last resort, they are the manager of market liquidity. So if 
it is a liquidity issue that threatens the global financial 
system through the hedge fund industry, the Federal Reserve 
would be the natural regulatory agency to focus on that.
    Ms. Norton. Chairman Ruder, in your testimony you suggest 
the agency you chaired, the SEC, to essentially have hedge 
funds register with the SEC. How do you think a rule to 
register with the SEC would improve its ability to monitor 
and--think this crisis now--would help to reduce the systemic 
risks we have seen?
    Mr. Ruder. Well, first of all, I think that the 
registration provisions ought to extend to hedge funds, as they 
do not under the current law. Second, the registration would 
allow the SEC to engage in inspection activities. But currently 
they do not have the power, even in the inspection of 
investment advisers, to seek risk management information. And I 
would expand that inspection power so that they would be able 
to go into a hedge fund adviser and find out what are the risk 
management systems that are being used; what are the nature and 
extents of the risks, and who are the counterparties. And that 
would help the SEC, first of all, to make some judgments about 
whether the risk management systems are good and, second, to 
pass information on to a central regulator, such as the Federal 
Reserve Board, to aggregate that information and come to some 
decisions about how to manage the liquidity risk on the 
    Ms. Norton. I wish you would tell me the difference between 
what you are proposing now and the rule apparently in 2004 that 
the SEC actually passed. The hedge fund sector, however, 
heavily lobbied against the rule, and it was ultimately 
overturned by the courts. Chairman Cox from the SEC did not 
seek to appeal it and did not come to Congress for new 
authority. So the SEC, I take it, has no authority now, not 
even the authority under that rule. What is the difference 
between that rule and the rule, if any, that you have in mind?
    Mr. Ruder. Well, the Goldstein case overruled the SEC's 
attempt to have inspection rights over hedge fund advisers, and 
the Commission did not appeal that ruling.
    Ms. Norton. Did you support that rule?
    Mr. Ruder. Yes. I support the fact that they should have 
inspection right over all hedge fund advisers. And as I said, I 
think that is going to take congressional action. And I think 
the inspection power ought to be increased so that they are 
able to get the kind of risk management information that is 
needed to protect society.
    Ms. Norton. Well, Professor Lo, do you see this kind of 
marriage between the SEC and the Federal Reserve that could 
come out of, listening to both of you, that the information 
would be passed on to the Federal Reserve and then you would 
have a regulatory setup that we could have confidence in?
    Mr. Lo. Well, no, I don't, Congressman Norton. I feel that 
there is a different--there is a different purpose for 
registration under the 1940 act, which is investor protection. 
Investor protection is a separate issue from systemic risk. And 
I believe that even now, if you ask all hedge funds to register 
under the Investment Advisers Act, they will not provide the 
kind of information that we need in order to get transparency.
    Ms. Norton. So transparency is not enough, you need 
somebody to be a regulator; and you think that should be the 
Federal Reserve?
    Mr. Lo. That's right.
    Mr. Ruder. Could I just comment? What I am saying is you 
need to have an expansion of the inspection power. The Federal 
Reserve already can receive information from the banking 
sector. And the Federal Reserve's administration of the banking 
sector has different objectives than the SEC's regulation of 
the securities sector. Banking regulators are concerned about 
safety and soundness of banks; the SEC is concerned about the 
capital markets and the matter of risk-based activities. I 
think we need two regulators sharing information rather than a 
single regulator.
    Ms. Norton. Professor Lo, would you like to respond to 
    Mr. Lo. It is always dangerous to disagree with a former 
chairman of the SEC, but let me say that I think the 
information regarding systemic risk is different from the 
information under the Investment Advisers Act. And with regard 
to garnering information about systemic risk, it is possible to 
obtain that, not necessarily directly from hedge funds, but 
from the prime brokers that have all of the positions, all the 
leverage and all of the counterparties among the hedge funds. 
So it is now possible to obtain that information very 
efficiently from a very small number of prime brokers.
    Ms. Norton. Thank you very much, Madam Chair.
    Mrs. Maloney. Mr. Cooper is recognized for 5 minutes.
    Mr. Cooper. Investors need to know how to swim, but we have 
also got to keep the sharks out of the pool. When you have 
large pension funds investing in hedge funds, shouldn't there 
be truth in advertising so that they know whether it is a true 
hedge fund or whether it is not hedging at all, but in fact 
speculating heavily? And shouldn't, perhaps, the speculative 
funds be called speculative funds? But the current situation 
with trade secrets, a black box surrounding the true investment 
strategy, pension managers don't really know whether they are 
getting hedging or speculation.
    Professor Lo.
    Mr. Lo. What I would argue is that it is always a good idea 
to have truth in advertising, and certainly that applies to the 
hedge fund industry as well as any other. Another example of 
truth in advertising is money market funds that have the one 
dollar NAV, but in fact don't have that kind of guarantee for 
that one dollar and they break the buck. That is another 
example of less than truth in advertising.
    Mr. Cooper. What about volatility-only strategies? The 
roller coasters we see in the market, 500 point swings in a 
day, that is neither long or short. Is that productive 
behavior? When Joseph Schumpeter said capitalism is the process 
of creative destruction, he really didn't endorse the roller 
coaster at the same time, did he?
    Mr. Lo. Well, in a way I think Schumpeter did because his 
argument is that free flowing capitalism is going to require 
occasional blowups just like what we are going through now, and 
out of the ashes a much stronger capitalistic system should 
    Mr. Cooper. Well, why not 1,000 point swings in a day, or 
2,000 point swings; wouldn't that be even more productive?
    Mr. Lo. Not necessarily. It depends upon whether the 
underlying economics justifies it. But as I said, if you have 
the proper disclosure for investors, if they are prepared for 
those kinds of swings, then that would be fine.
    Mr. Cooper. ``If'' can be the longest word in the English 
language. What about want-to-be hedge fund managers, not just 
rogue traders for folks inside perhaps large commercial banks 
who get enough leeway to pretend they are hedge fund managers, 
how significant a sector would this be and how dangerous are 
    Mr. Lo. Well, clearly that does pose a danger, but 
hopefully over time those managers ultimately get weeded out. 
And the process of hedge funds closing and new hedge funds 
rising I think really underscores that kind of birth and death 
    Mr. Cooper. Well, these wouldn't necessarily be authorized, 
the push for yield is so great. Sometimes you can look the 
other way and these operations are so vast you don't 
necessarily know what in fact is being done.
    Mr. Lo. I agree.
    Mr. Cooper. Is there a way to measure the size or 
significance of a want-to-be hedge fund?
    Mr. Lo. Currently, no, there is no way because we don't 
have that level of transparency. That is one of the reasons 
that I think all of us are calling for that.
    Mr. Cooper. I think the key area is going to be the 
interaction between hedge funds and derivatives. As I 
understand derivatives, it is possible to buy derivative 
products with embedded leverage. So when you, in your excellent 
testimony, cited relatively low leverage ratios, especially 
recently, you have to really look at the combined measure of 
leverage, don't you? And still the committee is without 
information on that, the true leverage that is in fact 
    Mr. Lo. That's right. That is another area where I think 
greater transparency is necessary. Leverage by itself is not 
necessarily a bad thing, but undisclosed it can be.
    Mr. Cooper. Should there be capital requirements for 
    Mr. Lo. I agree with Mr. Ruder that we need to have 
organized exchanges, standardized contracts, and a clearing 
corporation for certain OTC derivatives like credit default 
    Mr. Cooper. How are these hedge funds going to operate 
without investment banks now that all the major investment 
banks have converted into bank holding companies? And I guess 
the real question is, how are they going to operate without the 
deep capital markets that they were accustomed to?
    Mr. Lo. Well, hedge funds are nothing if not adaptive. And 
my sense is that they will certainly adapt to this new economic 
reality very quickly; in fact, I believe that they already 
have. And new hedge funds are being started to take advantage 
of the kind of opportunities that are presented by current 
market conditions.
    Mr. Cooper. I see that my time is expiring.
    Chairman Waxman. Mr. Sarbanes.
    Mr. Sarbanes. Thank you, Madam Chair. I thank you all for 
your testimony.
    I wanted to get to this concept of the sophisticated 
investor a little bit more because it is sort of the 
underpinning of the original exemptions from the statutes that 
are quite old now, and must have been based on premises and a 
rationale that is obsolete in many ways. And as I listen to 
this discussion, the exemptions are designed for people who are 
sophisticated, for institutional investors and so forth. But it 
seems like the standard for exemption ought not to be so much 
the sophistication, although I would like you to tell me if you 
think, Professor Bankman, for example, whether anyone can be 
sophisticated enough these days to warrant an exemption? But 
the standard maybe ought to be not how ``sophisticated'' you 
are, but what kind of investments you are holding, who is 
giving you their money to invest and how much damage can you do 
with it.
    So speak to that, because I think that is going to--
reassessing this concept of the sophisticated investor may be 
the foundation for the overall redesign of the regulatory 
framework in this particular arena. So maybe you can talk to 
    Mr. Bankman. Well, you probably don't want the tax guy on 
the panel. So I think I should throw that to my colleagues here 
    Mr. Ruder. Well, the Securities and Exchange Commission has 
recognized the need for higher dollar limits to create a 
threshold for accredited investors. And it has a proposal it 
has made but not adopted saying that you have to have $5 
million in investable assets in order to become a sophisticated 
investor and be able to invest in a pool of vehicles. That is a 
very good step in the right direction. The problem is, as we 
begin to say who is sophisticated and who is not sophisticated, 
it is not always that dollar levels are going to be the 
determining amount.
    We have already been wondering how some of the pension 
funds got involved in the hedge fund area, and there all I can 
say is that we have to draw a line someplace and say we are 
going to put the responsibilities on the stewards of other 
people's money to make proper investigations. We can't proceed 
by bright line dollar numbers in every case to make 
distinctions because at some point by putting bright dollar 
levels at the high, high levels we are going to prevent the 
kind of investment we have had.
    So I think the Commission is on the right track going 
toward a $5 million assets under investment as a bright line.
    Mr. Sarbanes. Professor Lo, do you want to talk about this 
sophistication concept?
    Mr. Lo. Sure. You know, in financial markets there is a 
common risk of confusing your W-2 with your IQ. Just because 
you are wealthy does not necessarily make you sophisticated. So 
I have always thought that the sophisticated investor threshold 
was really more about the ability to withstand losses. But I 
think when it comes to institutional investors where there is a 
fiduciary responsibility, for example, pension plan sponsors, 
it may make sense to actually impose some kind of an 
educational minimum so that we can be assured that a pension 
plan sponsor that has fiduciary responsibilities to pension 
plan participants would be investing wisely.
    Mr. Sarbanes. I guess what I am struggling with is you are 
looking at this in terms of what the burden is on the investor 
to demonstrate their sophistication and I am thinking about it 
in terms of the arena into which that investor goes and whether 
that arena is regulated. The concept seems to be that once a 
group of people are determined to be sophisticated then you are 
going to let them into a ring that is completely unregulated 
because they are sophisticated. But you may be letting them 
into a ring where they can do a lot of damage, where they can 
run over a lot of innocent bystanders and so forth. So that 
standard ought to be operating more than it has in terms of 
deciding whether to regulate that area.
    Mr. Lo. Well, I would agree with that wholeheartedly, but I 
would also add that, in defense of pension plan sponsors that 
have put money in hedge funds, first of all, by and large their 
amount of investments that they have put into hedge funds is 
fairly low, probably less than 5 percent of pension assets in 
the aggregate.
    Second, if you look at the performance of hedge funds as a 
category, as a broad group for 2008, hedge funds are probably 
down on average 10 percent to 15 percent for the year, where as 
the S&P is down about 30 to 35 percent for the year. And so the 
idea behind hedge funds being able to take short positions and 
benefit from down markets, that is something that pension plans 
have benefited from. However, there are blowups that occur, and 
that is one of the reasons I have argued that we need to 
examine those blowups to make sure that other investors, 
including pension plan sponsors, are fully aware and fully 
prepared for those eventualities.
    Mr. Sarbanes. And of course, as we discussed with Chairman 
Greenspan, when blowups occur the people that get hurt are not 
just the ones that are driving the train or driving the car, or 
whatever, it is this group of bystanders that gets pulled in as 
    Thank you.
    Chairman Waxman [presiding]. Thank you, Mr. Sarbanes.
    Mr. Van Hollen.
    Mr. Van Hollen. Thank you, Mr. Chairman. And I thank all of 
you gentlemen for your testimony.
    Professor Ruder and Professor Lo, I have some questions 
related to your proposal to require greater transparency. I 
think we have talked a little bit about the history of efforts 
to provide greater transparency and reporting requirements, for 
example, putting hedge funds under some of the reporting 
requirements and jurisdiction of the SEC, both to protect 
investors, including, as we have heard, lots of pension funds, 
as well as to address the potential for systemic risk and have 
an early warning system to detect that.
    Let me just take that one step further. Assuming we change 
the law and provide for greater transparency and allow the SEC 
to get this information--I understand you are suggesting on a 
confidential basis--what powers would you suggest the SEC have 
when it looks at that information and says that either the 
investors are at risk or you face a systemic risk? Would you be 
proposing the SEC also have additional powers, for example, 
changing leverage requirements with respect to a particular 
hedge fund if, based on the information they collect, they say 
hey, we have a real problem here? What additional powers would 
you give to the SEC if they reveal, through their 
investigation, a serious threat either to the investors or a 
systemic risk?
    Mr. Ruder. I am not suggesting that the SEC be given that 
kind of power. I think the SEC should learn what the management 
systems are, inspect those management systems, risk management 
systems, and criticize the way they are operating.
    With regard to the broad information about leverage, about 
risk positions, I think that should go to a regulator such as 
the Federal Reserve Board, which would then be able to 
aggregate that information and take some steps regarding the 
entire economy. I think it would be wrong for the result of 
this regulatory reform that we are going through to have some 
government agency try to tell investors what their leverage 
should be. The exception of that, of course, is in the banking 
area, where the banking credential regulators do impose 
leverage requirements. But I think for the high-risk 
individuals, including the hedge funds, we should not be doing 
    Mr. Lo. Well, at this point, I think it would be premature 
for me to propose any kind of additional powers to be granted 
to the SEC or any agency since there is so little that we know 
about the sector. But as a hypothetical, if the kind of 
information that Professor Ruder and I propose to be disclosed 
shows a very large and isolated risk for one or two too-big-to-
fail organizations, at that point it may be the case that the 
Federal Reserve would be called in to impose either capital 
adequacy requirements or maximum leverage constraints on that 
too-big-to-fail institution. But that is still very much a 
    Mr. Van Hollen. Let me just followup a little bit on that 
point. I mean, the Federal Reserve today would have the power 
to go and do that now, so let me make sure I understand both 
your testimony. You, Professor Ruder, wouldn't give that to the 
SEC. And I understand, Professor Lo, you would say that if the 
SEC found something that would be a big problem for the 
economy, they would then go to the Federal Reserve. But let me 
just make sure I understand. Would that require that Congress 
provide the Federal Reserve with additional authorities with 
respect to hedge funds in this area to take action?
    Mr. Lo. I believe so.
    Mr. Ruder. I believe so, too. It probably should be the 
Federal Reserve, but you have the Treasury blueprint talking 
about a market stability regulator, somebody that might play 
that function. I happen to think that the Federal Reserve is 
the right agency to do that.
    Mr. Van Hollen. If I could just ask you a quick question on 
the short positions. There is a lot of discussion about the 
role of hedge funds and naked short selling. Of course the SEC 
took action. Do you think that hedge funds should be required 
to disclose their short positions on an ongoing basis?
    Mr. Lo. Well, I believe that under certain conditions it 
may be advisable for hedge funds to disclose, but not 
necessarily publicly. Hedge funds spend a lot of time and 
effort developing models and information about over-valued 
companies. That information is extraordinarily important to get 
into the capital markets. If we eliminate the incentives for 
them to do so, we will hurt the informational efficiency of 
markets. But there are certain situations that may call for 
kind of a 13-F filing for short positions, but not necessarily 
to be made public, but to be given to regulators.
    Mr. Van Hollen. But let me just ask you; would you, on a 
confidential basis to the regulator, would you have that on an 
ongoing basis, the short selling disclosed?
    Mr. Lo. Yes.
    Mr. Van Hollen. Professor Ruder.
    Mr. Ruder. I agree with that. He refers to 13-F. That is 
the kind of filing that is required when the numbers get fairly 
high. So that we wouldn't be just asking for all short sale 
positions to be revealed, but only the very large ones.
    Mr. Van Hollen. Thank you, Mr. Chairman.
    Chairman Waxman. Mr. Shays.
    Mr. Shays. Let me ask you this basic question: What is the 
greatest value--I realize you can't repeal the law of gravity, 
so I am not looking to get rid of hedge funds. But tell me the 
greatest advantage or value to society of hedge funds and the 
greatest disadvantage of hedge funds. I would like to go down 
the line.
    Mr. Ruder. Well, the hedge funds provide liquidity to the 
system because they invest and they sell short. They provide 
price discovery by choosing the way they invest. They provide 
the additional benefits of being large participants in the 
    Mr. Shays. Would anyone add any additional advantage to a 
hedge fund? Yes, sir.
    Mr. Shadab. One additional social benefit that hedge funds 
have created is disciplining corporate managers with whom they 
invest. Not a large percentage of hedge funds are devoted to 
being corporate activists, but the ones that are corporate 
activists actually do very well at disciplining management. For 
example, a recent study has shown that if a hedge fund takes a 
corporate activist position in a company, CEO compensation 
would typically decrease by, let's say, a million dollars, and 
an overall long-term value is created for the other company 
    Mr. Shays. Any other advantage?
    Tell me the greatest disadvantage or greatest risk of hedge 
    Mr. Ruder. Well, the hedge funds do take positions, 
particularly in the derivatives market and particularly at 
using leverage, which create tremendous risks. And it may be 
that one hedge fund would be in a position to create calamity 
in the market, or it may be the aggregation of a number of 
hedge fund positions might cause problems.
    Mr. Shays. Anybody want to add something to that?
    Mr. Ruder. I would add one more. When they begin to sell in 
times of stress, they do cause dislocations in the market in 
terms of asset sales and stock sales.
    Mr. Shays. I represent--at least until the end of next 
month--the largest concentration of hedge funds I think in the 
world in the Fairfield County/New York area. In other words, 
they either sleep in the district and work in New York or they 
actually work in the district as well. And their argument to me 
constantly was, you know, these folks know what they are doing, 
they have the money to risk and they know what they are doing, 
they are wise investors and they would suggest large, you know, 
universities and so on who know the risks. And never then was 
it discussed that, in a sense, Wall Street could bring down 
Main Street.
    Was it obvious to all of you in the last 5 or 6 years that 
we were going to encounter what we are encountering now? I 
would like to ask each of you. And let me start backward.
    Mr. Shadab.
    Mr. Shadab. Yes, because housing prices could not keep 
going up forever.
    Mr. Shays. But this was obvious to you, that we would be 
dealing with the kind of mess we are in right now?
    Mr. Shadab. Not necessarily the extent of it, no.
    Mr. Bankman. Well, I am just a tax guy. So I am going to 
pass to Professor Lo.
    Mr. Shays. You are just a coward.
    Mr. Lo. Well, I may not use the word ``obvious,'' but 
starting in 2004 I published a series of papers highlighting 
the fact that there was growing indirect evidence that a 
dislocation in the hedge fund industry was building, and so 
certainly the indirect evidence seemed to show that was the 
    Mr. Ruder. In 1998, I testified before the House Banking 
Committee suggesting that there be the kind of information 
disclosure I suggested today, so that 10 years ago I was 
concerned about this problem of opacity in this market.
    Mr. Shays. Well, part of my question for asking is--good 
for you. And, you know, sometimes we don't notice the people 
who were out in front years ago attempting to make this point 
    The head of Lehman Brothers, Dick Fuld, in a hearing before 
this committee, laid a large deal of blame for Lehman's 
collapse on hedge funds shorting the stock. Would any of you 
care to comment on that?
    Mr. Shadab. I think that is sort of reversing the cause and 
effect. A prominent hedge fund manager, David Einhorn, back in 
March of this year, he called out Lehman Brothers' financial 
statements and saying, wait a second, you are not fully 
disclosing all of your risks with investors. He sold the stock 
short. So the problem was Lehman Brothers, not the short 
sellers. They attracted the short sellers because of their 
financial mismanagement.
    Mr. Shays. So the bottom line is you don't agree?
    Mr. Shadab. Correct.
    Mr. Lo. I would say don't kill the messenger.
    Mr. Ruder. And I don't, no.
    Mr. Shays. Don't kill the messenger. Who is the messenger?
    Mr. Lo. The messenger in the sense are the short sellers 
that are trying to get the message across that a company is 
    Mr. Shays. Is it necessary to increase regulation on hedge 
funds, or would creating an exchange for derivatives trading be 
    Mr. Ruder. I think the creation of standardized derivative 
contracts and this clearing and settlement and exchange trading 
would be a very fine step in the right direction. We are having 
today steps toward creating a clearance and settlement platform 
for derivative contracts. I think that is a very good step in 
the right direction to overcome the opacity and counterparty 
risk problems we have.
    Mr. Lo. I agree, but I don't think that we know whether or 
not it would be sufficient.
    Mr. Shadab. I think that goes too far to push all 
derivatives onto a centralized exchange. I think the only 
problems that we have had with the credit default swaps is with 
either involvement with insurance companies and model line 
insurers, not a typical derivatives trader.
    Mr. Shays. Thank you, Mr. Chairman.
    Chairman Waxman. All Members having asked questions, I want 
to thank this panel for your testimony. It has been very 
helpful to us, and we appreciate you being here.
    We are going to take a 5-minute recess while we seat the 
next panel. So we will reconvene in 5 minutes.
    Chairman Waxman. The committee will please come back to 
    Our second panel consists of five of the most successful 
hedge fund managers of 2007. George Soros is the chairman of 
Soros Fund Management. James Simons is the president of 
Renaissance Technologies. John Paulson is the president of 
Paulson & Co. Philip Falcone is the senior managing partner of 
Harbinger Capital Partners. And Kenneth Griffin is the 
president and chief executive officer of Citadel Investment 
    And we are pleased to welcome all of you to our hearing 
    I appreciate your being here and cooperating with our 
committee. I understand Mr. Falcone had to reschedule an 
overseas business trip to join us today, and I particularly 
appreciate the fact that he is here.
    It is the practice of this committee that all witnesses 
that testify before us do so under oath. So I would like to ask 
each of you before you even begin giving your testimony that 
you stand and raise your right hands.
    [Witnesses sworn.]
    Chairman Waxman. Thank you.
    The record will indicate that each of the witnesses 
answered in the affirmative.
    Your prepared statements will be in the record in full. 
What we'd like to ask each of you to do is to make a 
presentation to us, mindful of the fact that we will have a 
clock that will be green for 4 minutes, orange for 1 minute and 
then red at the end of 5 minutes. And at that point, if you see 
that it is red, we would like to ask you to conclude your oral 
presentation to us. We are going to want to leave enough time 
for questions by the Members of the panel.
    Mr. Soros, we'd like to start with you. There is a button 
on the base of the mic, be sure it is pressed in. Proceed as 
you see fit.


                   STATEMENT OF GEORGE SOROS

    Mr. Soros. Thank you, Mr. Chairman.
    We are in the midst of the worst financial crisis since the 
1930's. The salient feature of the crisis is that it was not 
caused by some external shock, like OPEC raising the price of 
oil. It was generated by the financial system itself.
    This fact, that the defect was inherent in the system, 
contradicts the generally accepted theory about financial 
markets. The prevailing paradigm is that markets tend toward 
equilibrium. Deviations from the equilibrium either occur in a 
random fashion or are caused by some sudden external event to 
which markets have difficulty in adjusting.
    The current approach to market regulation has been based on 
this theory. But the severity and amplitude of the crisis 
proves convincingly that there is something fundamentally wrong 
with it.
    I have developed an alternative paradigm that differs from 
the current one in two important respects: First, financial 
markets don't reflect the underlying conditions accurately. 
They provide a picture that is always biased or distorted in 
some way or another.
    Second, the distorted views held by market participants and 
expressed in market prices can under certain circumstances 
affect the so-called fundamentals that market prices are 
supposed to reflect. I call this two-way circle of connection 
between market prices and the underlying reality 
``reflexivity.'' I contend that financial markets are always 
reflexive, and on occasion, they can be quite far away from the 
so-called equilibrium. In other words, it is an inherent 
characteristic of financial markets that they are prone to 
produce bubbles.
    I originally proposed this theory in 1987, and I brought it 
up to date in my latest book, ``The New Paradigm for Financial 
Markets: The Credit Crisis of 2008 and What It Means.'' I have 
summarized my argument in the written testimony I have 
submitted. Let me recall briefly the main implications of the 
new paradigm for the regulation of financial markets.
    The first and foremost point is that the regulators must 
accept responsibility for controlling asset bubbles. Until now, 
they have explicitly rejected that responsibility.
    Second, to control asset bubbles it is not enough to 
control the money supply. It is also necessary to control 
credit because the two don't go in lock step.
    Third, controlling credit requires reactivating policy 
instruments which have fallen into disuse, notably margin 
requirements and minimum capital requirements for banks. When I 
say reactivate them, I mean that the ratios need to be changed 
from time to time to counteract the prevailing mood of the 
markets because markets do have moods.
    Fourth, new regulations are needed to ensure that margin 
requirements and the capital ratios of banks can be accurately 
measured. The alphabet soup of synthetic financial instruments, 
CDOs, CDSs EDSs and the like, have made risk less apparent and 
harder to measure. These new products will have to be 
registered and approved before they can be used and their 
clearing mechanism has to be regulated in order to minimize 
counterpart risk.
    Fifth, since financial marketings are global, regulations 
must also be international in scope.
    Sixth, since the quantitative risk management models 
currently in use ignore the uncertainties inherent in 
reflexivity, limits on credit and leverage will have to be set 
substantially lower than those that have been incorporated in 
the Basel Accords on bank regulation. Basel 2, which delegated 
authority for calculating risk to the financial institutions 
themselves, was an aberration and has to be abandoned. It needs 
to be replaced by a Basel 3 which will be based on the new 
    How do these principles apply to hedge funds? Clearly hedge 
funds use leverage and they contribute to market instability in 
times like the present when we're experiencing wholesale and 
disorderly de-leveraging. Therefore, the systemic risks need to 
be recognized and more closely monitored than they have been 
until now. The entire regulatory framework needs to be 
reconsidered, and hedge funds need to be regulated within that 
framework. But we must be aware of going overboard with 
    Excessive deregulation is at the root of the current 
crisis, and there is a real danger that the pendulum will swing 
too far the other way. That would be unfortunate because 
regulations are liable to be even more deficient than the 
market mechanism itself. That's because regulators are not only 
human but also bureaucratic and susceptible to political 
    It has to be recognized that hedge funds were an integral 
part of the bubble which has now burst, but the bubble has now 
burst, and hedge funds will be decimated. I will guess that the 
amount of money that they manage will shrink between 50 and 75 
percent. It would be a grave mistake to add to the forced 
liquidation currently depressing markets by ill-considered or 
punitive regulations. I'd be happy to expand on these points in 
greater detail in answering your questions.
    [The prepared statement of Mr. Soros follows:]
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    Chairman Waxman. Thank you very much, Mr. Soros.
    Mr. Simons.

                   STATEMENT OF JAMES SIMONS

    Mr. Simons. OK. Well, good morning.
    Chairman Waxman. There is a button at the base of the mic 
you have to press----
    Mr. Simons. I think it's on.
    Chairman Waxman. OK. Good.
    Mr. Simons. Good morning, again Chairman Waxman and Ranking 
Member Davis. Members of the committee, I'm James Simons. I'm 
chairman of Renaissance Technologies, and in my opinion, this 
series of hearings is quite important. And I appreciate your 
interest in trying to understand what this is all about.
    Now, in my view, this crisis has a number of causes: The 
regulators who took a hands-off position on investment bank 
leverage and credit default swaps; everybody along the 
mortgage-backed securities chain who should have blown a 
whistle rather than passing the problem on; and in my opinion 
the most culpable, the rating agencies, which in effect allowed 
sows' ears to be sold as silk purses.
    Before addressing the committee's questions, I would like 
to say a little bit about myself and my company because 
Renaissance is a somewhat atypical investment management firm. 
Our approach is driven by my background as a mathematician. We 
manage funds whose trading is determined by mathematical 
formulas. We operate only in highly liquid publicly traded 
securities, meaning we don't trade in credit default swaps or 
collateralized debt obligations or some of those alphabet soup 
things that George was referring to. Our trading models 
actually tend to be contrarian buying stocks recently out of 
favor and selling those recently in favor.
    We manage three funds. Our flagship fund, Medallion, 
accounts for nearly all of our income and is almost entirely 
owned by Renaissance employees. We charge ourselves fees, which 
has the effect of shifting income away from the largest owners 
of the firm, like me, to the rest of the employees. Our two new 
funds designed for institutional investors are both lightly 
leveraged and charge fees roughly half of those charged by most 
hedge funds.
    I will now turn briefly to the questions that the committee 
asked. Do hedge funds cause systemic risk? In my view, hedge 
funds were not a major contributor to the recent crisis, and 
generally, hedge funds have increased liquidity and reduced 
volatility in the markets. Moreover, because of their 
remarkably diverse strategies, hedge funds as a class are 
unlikely to create systemic risk, although it is not out of the 
question that they could.
    Hedge funds do use leverage, and--but here is an important 
point--each hedge fund's leverage is controlled by its lenders 
which is far more than one could say for investment banks.
    Will hedge funds require further regulation? I do think 
additional regulation focused on market integrity and stability 
will be useful, and I will get back to that.
    Should hedge funds be registered with the SEC? Well, we 
have always been registered, at least for 10 years, and we are 
certainly not opposed to an appropriate registration 
    Should hedge funds be more transparent? Well, transparency 
to appropriate regulators can be helpful. And as Professor 
Ruder said very well--described a procedure which was also in 
my written testimony--you may wish to consider requiring all 
market participants to report their positions to an appropriate 
regulator and then allowing the New York Fed to have access to 
aggregate position information and to recommend action if 
    This is pretty much what Ruder said. I'll say it again. I 
stress, however, that the fund-specific information should not 
be released publicly, which could do more harm than good.
    Does the compensation structure of hedge funds lead to 
excessive risk taking? This question doesn't really apply to us 
as almost all of our income is based on profits on our own 
capital, but generally speaking, I think not. The statistics 
bear this out to some extent. Compare the 7 percent annual 
volatility of the hedge fund index to the 15 percent annual 
volatility of the S&P over the last 10 years. Thus hedge funds 
appear to be at least on the cautious side. Moreover--obviously 
there are exceptions. Moreover, typically a manager's largest 
investment is in his own fund.
    Is special tax treatment for hedge fund managers warranted? 
Well, I would only say that, if Congress decides that it is 
good policy to alter the tax treatment of carried interest, 
that change should apply to all partnerships, private equity, 
oil and gas, real estate, etc., all of which are based on that 
same principle, not just hedge funds. And I personally would 
have no objection whatsoever to such a change.
    Before concluding I would like to reflect on how we could 
help get out of this hole and make proposal to prevent us 
getting back in.
    So I think that in the near term the most important thing 
we can do is keep people in their homes, even if their 
mortgages are in default. This would help millions of families 
already coping with a tough economy and would maintain higher 
home values than would foreclosure. This would also mitigate 
losses on the securities collateralized by these mortgages. 
Now, there have been a number of proposals on how to do this, 
and I won't opine on which is best.
    Now, Mr. Chairman, you mentioned you had a hearing on the 
failure of the credit rating agencies. And I particularly 
appreciate your attention to that issue. I propose a new rating 
agency. Historically the bond rating agencies were paid by the 
bond buyers, which was natural because it was they whom they 
were supposed to be serving. But in the 70's, the agencies 
began to be paid by the bonds issuers. Now, despite the obvious 
conflict of interest, the new model worked OK with conventional 
type bonds, but until the advent of financially engineered 
    Now even though I don't trade these products, I believe in 
their value. I think they are good. But the organizations 
rating them must owe their allegiance to buyers, not to 
    I, therefore, encourage the major holders of these bonds 
such as CalPERS, TIAA, PIMCO, etc., to sponsor a new nonprofit 
rating agency focused on derivative securities. Congress might 
consider chartering such an organization, having board 
representation from appropriate regulators. Revenues could come 
from buyer-paid fees on each transaction, which I think would 
be minuscule. These complex instruments would then be subject 
to proper analysis and rating. The interests of buyers and 
raters would be aligned, and the likelihood of again seeing a 
problem like this one would be dramatically reduced.
    Thank you, and I look forward to your questions.
    [The prepared statement of Mr. Simons follows:]
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    Chairman Waxman. Thank you very much, Mr. Simons.
    Mr. Paulson.


    Mr. Paulson. Chairman Waxman, Ranking Member Davis, and 
members of the committee, thank you for inviting me to appear 
    Paulson & Co. is an investment advisory firm that was 
founded in 1994. We currently manage assets of approximately 
$36 billion using event driven strategies. We are based in New 
York and also have offices in London and Hong Kong. We have 
approximately 70 employees.
    Chairman Waxman. There is a question whether your mic is 
on. Is the button pressed?
    Mr. Paulson. All of the investment funds we manage are open 
only to qualified purchasers, those with a minimum $5 million 
in investable assets if they are individuals and $25 million in 
investable assets if they are institutions. Our investors 
include pension funds, endowments and foundations.
    These investors look to us to protect their capital and to 
show positive returns in both good and bad markets. We do this 
by going long securities that we think will rise in value and 
by going short securities that we think will decline in value.
    We have been able to operate profitably in 14 out of the 
last 15 years, including this year when the S&P is down over 40 
    We believe that our ability to protect our investors' 
capital and generate positive returns over the long term is the 
reason we have grown to be one of the largest hedge funds in 
the world.
    Regarding compensation, we share profits with our investors 
on an 80/20 basis, where 80 percent of the profits go to the 
investors and 20 percent remains with us. We only earn 
performance allocations if our investors are profitable. All of 
our funds have a high water mark, which means that if we lose 
money for our investors, we have to earn it back before we 
share in future profits. Some of our funds also have a claw-
back provision which requires us to return profits earned in 
prior periods if we lose money in subsequent periods. In 
addition, we invest or own money alongside that of our clients, 
so we share investment loss along with gains.
    We are a private company and have no public shareholders. 
We receive no taxpayer subsidies. All of our investors invest 
with us on a voluntary basis. We also use very little leverage. 
Over the past 5 years, for over half the time, our base 
portfolios were not funded with any borrowed money, and our 
maximum borrowing over the last 5 years as a percentage of 
equity capital was only 33 percent.
    In February 2004, we voluntarily registered with the SEC as 
an investment advisor. As a Registered Investment Advisor we 
are subject to periodic inspections, focused reviews, and ad 
hoc requests for information. We are also subject to stringent 
recordkeeping requirements and have to file information 
regularly with the SEC.
    We comply with all rules and regulations, not only in the 
United States but in each of the over 15 countries where we 
    As Americans, we are proud of the leadership position the 
United States occupies in this industry, the jobs our industry 
has created, the export earnings we have produced our country, 
and the taxes that we generate for the Treasury. For example, 
over the last 5 years, our firm has increased our employee 
count by 10 times, creating numerous high-paying jobs for 
    In addition, 80 percent of our assets under management come 
from foreign investors. The revenues we receive from foreign 
investors allow us to contribute to the U.S. economy like an 
exporter of goods bringing in money from abroad.
    In 2005, our firm became very concerned about weak credit 
underwriting standards, excessive leverage amongst financial 
institutions, and a fundamental mis-pricing of credit risk. To 
protect our investors against the risk in the financial 
markets, we purchased protection through credit default swaps 
on debt securities we thought would decline in value. As credit 
spreads widened and the value of these securities fell, we 
realized substantial gains for our investors.
    We have offered suggestions on the causes of the credit 
crisis and what the U.S. Government can do to help the 
situation. I also have some recommendations on how future 
purchases of preferred stock under the TARP can be structured 
both to protect taxpayers better and to provide greater 
stability to financial institutions, and I would be pleased to 
share those thoughts with you.
    Again, thank you for the opportunity to address this 
    [The prepared statement of Mr. Paulson follows:]
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    Chairman Waxman. Thank you very much, Mr. Paulson.
    Mr. Falcone.


    Mr. Falcone. Thank you, Chairman Waxman, Ranking Member 
Davis, and other members of the committee.
    My name is Philip Falcone. I am the senior managing 
director and cofounder of the Harbinger Capital Partnership 
fund. I'm extremely proud of the work that we have done at 
Harbinger. Year in, year out, we have generated substantial 
returns for our investors, which include pension funds 
endowments and charitable foundations. We have achieved our 
success for our investors by doing things the right way. 
Through our investments we have also provided much-needed 
Capitol to American companies, supporting them as they pursue 
their business plans and giving them a second chance to reach 
their potential.
    I appreciate the committee holding today's hearing in order 
to learn more about hedge funds and their positive role in the 
financial markets. I am hopeful that this committee can take 
four points away from today's testimony.
    No. 1, compensation in the hedge fund industry is 
performance based. I think that is the right way to do business 
because it creates incentive for hard work and innovation.
    No. 2, hedge funds use a variety of investment strategies, 
including traditional approaches. Investors, especially large 
institutions, want a broad array of strategies and disciplines 
so they can diversify their portfolios.
    No. 3, short selling is a valuable longstanding feature of 
our markets. It isn't short selling that puts companies out of 
business but rather over-leveraged balance sheets, poor 
management decisions, and flawed business plans.
    No. 4, I support greater transparency and better reporting 
in the hedge fund sector.
    I would like to take a moment to tell you a little bit 
about myself. I currently reside in New York City with my wife 
of 11 years and two children. By way of background, I was born 
in Chisholm, MN, population 5,000 on the Iron Range of northern 
Minnesota. I was the youngest of nine kids who grew up in a 
three-bedroom home in a working class neighborhood. My father 
was a utility superintendent and never made more than $15,000 
per year, while my mother worked in the local shirt factory.
    The point of all this is I take great pride in my 
upbringing, and it is important for the committee and the 
public to know that not everyone who runs a hedge fund was born 
on Fifth Avenue. That is the beauty of America and the beauty 
of the potential in our industry.
    Through hard work and perhaps a little bit of luck, 
Harbinger Capital Partners has been able to generate 
substantial returns for our investors since 2001. Our 
investment philosophy is very simple: We study, often for 
months, the fundamentals of companies to identify those that 
are undervalued or overvalued, and we act decisively when 
opportunities present themselves. We are not momentum traders 
nor are we day traders. We are investors. It is not magic. My 
analysts perform thorough due diligence rather than relying on 
rating agencies or other research reports, like many of the 
reports that improperly valued securitized mortgage products 
over the past few years.
    My compensation is based upon the returns that we generate 
for our investors, which have far exceeded the performance of 
the overall market. There is no doubt that as result of the 
success of Harbinger Funds, I have done extremely well 
financially. But this is not the case where management takes 
huge bonuses or stock options while the company is failing. My 
success is tied to that of my investors, and I have reinvested 
a substantial portion of my compensation over the years back 
into the funds alongside my investors who are fully aware of 
the compensation formula when deciding whether to place their 
money with us.
    Because of the events of the past few months, the American 
public, including my investors, have justifiable concerns about 
our financial markets and the economy. The important thing to 
remember, however, is that we must keep things in perspective 
and not overreact, misperceive or misrepresent what has 
happened. We are a resilient society. We must focus on the 
positives and continue taking the positive steps forward, 
rather than backward.
    Hedge funds play an important role in the economy by 
providing needed capital and encouraging creativity and 
outside-the-box thinking. Many viable companies struggling 
under a huge debt load or poor cash-flow have not only survived 
but flourished through an infusion of hedge fund capital, 
saving thousands of jobs. I am proud of Harbinger's track 
record of helping these types of companies emerge from 
bankruptcy and helping others avoid filing in the first place.
    Finally, I would like to offer a thought or two on how 
Congress and the hedge fund industry can work together to 
increase public confidence not only in our industry but in the 
financial markets as a whole.
    I support some additional government regulation requiring 
more public disclosure and transparency for hedge funds as well 
as for public companies. All investors, whether individual or 
sophisticated institutions, have a right to know what assets 
companies have an interest in, whether on or off their balance 
sheets, and what those assets are really worth.
    I also support the creation of a public exchange or 
clearing house for derivatives trading, especially credit 
default swaps. An open and transparent market for these 
transactions would reduce confusion and improve understanding 
as well as help with valuation issues.
    In summary, while I was growing up, my family may have 
lacked money, but one thing we didn't lack was integrity and 
pride in what we did and how we did it. It was a cornerstone 
then, and it remains the cornerstone of my family and my 
business today. In 1990, one of my investors once told me 
something that continues to resonate with me today. He said, I 
can't guarantee that if you work hard, you will be successful; 
but I can guarantee that if you don't work hard, you won't be 
successful. We should never lose sight of that.
    Needless to say, I love this country, and I am grateful for 
the opportunity that I have been provided. That being said, we 
are living in difficult times now. Consequently, I hope that 
this committee and indeed the entire Nation will look the at 
hedge fund industry as part of the solution to our economic 
    Given the tightening of credit markets, access to capital 
is more important than ever, and I believe that hedge funds can 
and should be a source for this capital. Thank you for 
permitting me the opportunity to make this statement, and I 
would be happy to answer any questions that you may have.
    [The prepared statement of Mr. Falcone follows:]
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    Chairman Waxman. Thank you, Mr. Falcone.
    Mr. Griffin.


    Mr. Griffin. Mr. Chairman, Congressman Davis, and 
distinguished members of the committee, my name is Kenneth 
Griffin, and I am the founder and CEO of Citadel Investment 
Group. Thank you for the opportunity to address this committee.
    Today, our Nation is working through the worst financial 
crisis since the 1930's. It is imperative that we as a Nation 
continue to take actions to mitigate the impact of the credit 
crisis on our broader economy in the hopes of keeping Americans 
employed and productive. I appreciate your leadership on this 
important undertaking.
    I am proud that in the 18 years since I founded Citadel, it 
has grown into a financial institution of great strength and 
capability. With a team of over 1,400 talented individuals, 
Citadel manages approximately $15 billion of investment capital 
for a broad array of institutional investors, high net-worth 
individuals, and Citadel's employees.
    Citadel's Capital Markets Division plays an important role 
in our Nation's market. Our broker dealer is the largest market 
maker in options in the United States, executing approximately 
30 percent of all equity option trades daily. In addition, 
Citadel accounts for nearly 10 percent of the daily trading 
volume of U.S. equities.
    All businesses take risks. In some industries we refer to 
risk-taking as research and development. At financial 
institutions, we often take risks by investing in securities. 
Failure to understand and manage risk can be severe, as we have 
seen far too often in recent weeks. Although the financial 
crisis has affected virtually every participant in the 
financial markets, including Citadel, I believe that Citadel's 
constant and consistent focus on risk management has been a key 
asset in successfully navigating this financial crisis and will 
continue to serve us well in the years to come.
    In this crisis, the concept of ``too interconnected to 
fail'' has replaced the concept of ``too big to fail.'' The 
rapid growth in the use of derivatives has created an opaque 
market whose outstanding notional value is measured in the 
hundreds of trillions of dollars. As a result, there is great 
concern about the systemic effects of the failure of any one 
financial institution.
    In the area of credit default swaps, for example, there is 
an estimated $55 trillion of outstanding notional contracts 
between market participants. This number is almost four times 
the GDP of our Nation.
    The creation of central clearinghouses to act as 
intermediaries and guarantors of financial derivatives such as 
credit default swaps represents a straight-forward solution to 
the issues inherent in today's opaque over-the-counter market. 
Of greatest importance, such a clearinghouse will dramatically 
reduce systemic risk, allowing us to step away from the ``too 
interconnected to fail'' paradigm. Numerous other benefits will 
accrue to our economy. Regulators, for example, will have far 
greater transparency into this vast and important market.
    In recent months, Citadel and the CME Group have partnered 
in building such a clearinghouse for credit default swaps. Our 
solution is an example of how industry in cooperation with 
regulators can solve complex market problems.
    I believe and have said before that our financial markets 
work best when they are competitive, fair, and transparent. 
Proper regulation is critical, but the best regulation is 
created with an eye toward unleashing opportunities, not 
limiting possibilities. To achieve this, Congress, regulators 
and industry must all work together. Our markets are complex, 
and they must be well understood if they are to be well 
    We must solve the serious issues we face but not in a way 
that stifles the best innovative qualities of our great capital 
    I thank the committee for holding this hearing today, and I 
look forward to answering your questions, thank you.
    [The prepared statement of Mr. Griffin follows:]
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    Chairman Waxman. Thank you very much, Mr. Griffin.
    We are now going to proceed to questions by Members of the 
panel, who will each have 5 minutes each.
    I want to remind the Members that the hearing today is 
about hedge funds and the financial markets, and questions 
about other topics are not relevant to the hearing. The Chair 
won't bar any Member from asking any particular question or a 
witness from answering a particular question, but witnesses 
will not be required to answer questions unrelated to the topic 
of today's hearing. So I urge Members and witnesses to keep 
their questions and answers focused on the topic of today's 
    I'm going to start with myself. Let me start off by asking 
about systemic risk. In 1998, Long Term Capital Management was 
one of the Nation's largest hedge funds. It had about $5 
billion in capital and was leveraged at a ratio of 30 to 1. It 
had made investments worth about $150 billion, and when those 
investments went bad, its capital was quickly wiped out.
    The Federal Reserve became so concerned about the broader 
impacts of this collapse that it organized a multibillion 
dollar bailout. That was in 1998 when only about 3,000 hedge 
funds managed approximately $2 billion in assets. Current 
estimates suggest that there may be 9,000 hedge funds managing 
assets worth more than $2 trillion. Some say hedge funds have 
become a shadow banking system.
    So I'd like to ask each of you two questions: Do you 
believe that the collapse of large hedge funds could pose 
systemic risks to the economy? And if so, do you believe this 
justifies greater Federal regulation?
    Mr. Soros, why don't we start with you and go straight down 
the line?
    Mr. Soros. Yes, I think that some hedge funds do pose 
systemic risk. And I think particularly leveraged capital was 
built on a false conception--I talked about the false paradigm 
on which our financial system has been built. And that was 
actually embodied in leveraged capital, which was very--which 
basically assumed that deviations from--are random.
    Chairman Waxman. Do you believe this justifies greater 
Federal regulation?
    Mr. Soros. Pardon?
    Chairman Waxman. Do you believe this justifies greater 
Federal regulation?
    Mr. Soros. Yes, it does.
    Chairman Waxman. Thank you.
    Mr. Simons.
    Mr. Simons. Yeah, well, certainly----
    Chairman Waxman. Is your mic on?
    Mr. Simons. Certainly the possibility exists that an 
individual hedge fund or hedge funds in aggregate could be a 
cause of systemic risk. And I think that regulation in the form 
of reporting up to the SEC, for example, in a more detailed 
manner than is presently done with those things aggregated--
that information aggregated, passed on to the Federal Reserve 
or some such would be a good approach. So, yes.
    Chairman Waxman. Thank you.
    Mr. Paulson.
    Mr. Paulson. I think the risk--I think the systemic risk in 
the financial system, and that includes hedge funds as well as 
banks and other financial institutions, is due to too much 
leverage; that when banks or hedge funds use too much leverage, 
you only need a small decline in the value of the assets before 
the equity is wiped out and the debt is impaired. I do think 
there is a need for more stringent leverage requirements on 
banks, financial institutions and, where, necessary on hedge 
    The amount of common equity that institutions are operating 
with is simply too thin to support their balance sheets. The 
primary reasons why financial firms have run into trouble, 
whether Lehman Brothers, Bear Stearns or AIG, is they have way 
too much leverage. Lehman Brothers, as an example, had over 40 
times the assets compared to their tangible common equity. They 
just didn't have enough equity. Every hedge fund that has had a 
problem, whether it was the Carlisle funds, the Bear Stearns 
funds or Long Term Capital before, was because of the use of 
too much leverage.
    Chairman Waxman. Do you think, therefore, that there ought 
to be more government regulation of the hedge funds and 
particularly on leverage?
    Mr. Paulson. Yes, I think the equity requirements of 
financial institutions need to be raised, and the margin 
requirements, the amount capital institutions or investors have 
to hold to support individual securities, should also be 
raised. And by doing that, that would reduce the risk in the 
    I may add just one point is that in all the trillions of 
government support globally to try and stem this financial 
disaster, not $1 yet has been used to support a hedge fund. So 
the problems have been with our investment banks with other 
financial institutions. And although Long Term Capital was 
large, a $4 billion hedge fund, that problem was also solved 
privately without any government intervention. And the problems 
of Long Term Capital, which today was the largest hedge fund to 
experience a problem, are minuscule compared to the $150 
billion that was required to bail out AIG, the $700 billion 
billion in the TARP program, or the $139 billion that was just 
advanced to GE in the form of guarantees.
    Chairman Waxman. Good point. Thank you.
    Mr. Falcone.
    Mr. Falcone. Yes, I think that any institution that has a 
pool of capital at its availability and uses reckless leverages 
indeed poses a systemic, potential systemic risk to the 
marketplace. I think that when you look the at hedge fund 
industry with the trillion or trillion and a half dollars 
outstanding, that the leverage aspect of it is a bit isolated. 
And there are certain institutions that may pose risks, but I 
would suspect that for the most part the industry in general is 
not nearly as leveraged as some of the banking institutions 
that we were dealing with over the past 4 or 5 months.
    And I do support additional regulation as it relates to 
that, because I don't think it's in anybody's best interest to 
see these institutions unravel and create a domino effect.
    Chairman Waxman. Thank you.
    Mr. Griffin.
    Mr. Griffin. Mr. Chairman, as you referred to Long Term 
Capital's consortium bailout in 1998, it is important to 
remember, it was a private market solution to a very 
challenging problem. Just a few years ago, Citadel and JP 
Morgan created a private market solution to the challenges 
faced by Amaranth and its shareholders when they incurred even 
greater losses in the natural gas market. Private market 
solutions can address crises. And we should keep in the center 
of our mind that we want to foster private market solutions as 
the way to handle crises first and foremost.
    Of second point, hedge funds are already regulated 
indirectly by the fact that the banking system is regulated and 
the banking system is the primary extender of credit to hedge 
funds. And last but not least, I think it's important that we 
keep in mind, it's very convenient to say we should simply have 
more equity in the system, but equity is very expensive, and if 
we wish to reduce the cost of loans to consumers and loans to 
homeowners, we need to think of capital structures that have 
the right mix of equity to debt.
    Thank you.
    Chairman Waxman. Well, the private market solution was 
organized by the Fed. So it wasn't without some public 
intervention. Is it your conclusion that we do need some 
greater Federal regulation because of the systemic risks?
    Mr. Griffin. No, it is not my belief that we need greater 
government regulation of hedge funds with respect to the 
systemic risks they create. And to be very direct, we have gone 
through a financial tsunami in the last few weeks, and if we 
look at where the failure stress points have been in the 
system, they have been in the regulated institutions; whether 
it is AIG, an insurance company, Fannie or Freddie, the banking 
system. We have not seen hedge funds as a focal point of 
carnage in this recent financial tsunami.
    Chairman Waxman. Well, our expert witness in the first 
panel testified they believe hedge funds do pose systemic risk.
    Former SEC Chairman David Ruder said this: Highly leveraged 
hedge funds that borrow large sums and engage in complex 
transactions using exotic derivative instruments may severely 
disrupt the financial markets if they are unable to meet 
counterparty obligations or must sell assets in order to repay 
    And Professor Andrew Lo gave similar testimony.
    My concern is that our regulatory system has not recognized 
these potential risks. The hedge fund industry is getting 
bigger. The systemic risks are growing larger, and yet Federal 
regulators have virtually no oversight of your industry, and 
that is a potentially dangerous situation. So I appreciated 
hearing each of your views on that subject.
    Mr. Davis.
    Mr. Davis of Virginia. Thank you, Mr. Chairman.
    I would ask, let me just amplify your question, and they 
can answer the question you just posed. Because our first panel 
of witnesses did propose requiring hedge funds to divulge 
comprehensive risk to regulators. But I have heard some concern 
here and elsewhere that you need to keep such data in an 
aggregated and confidential format. And so I would ask, along 
with Mr. Waxman's question, is there a danger of too much 
transparency in the hedge fund industry, and what is that?
    Mr. Griffin, I will start with you. I think you have some 
limits on regulation and ask you to address that, and then I 
will move right down.
    Mr. Griffin. On the issue of disclosure of positions or 
aggregate risk factors, we at Citadel would not be adverse to 
that so long as the information was maintained confidential and 
in the hands of the regulators. To ask us to disclose our 
positions to the open market would parallel asking Coca-Cola to 
disclose their secret formula to the world.
    Mr. Falcone. I agree. I think that it is important to 
disclose the information to the appropriate regulatory 
agencies. We work long and hard in developing our ideas, and to 
make them public I don't think is the right thing to do. And 
the public would not necessarily use them in the same way, 
shape, or form that we would use our ideas.
    Mr. Davis of Virginia. Mr. Paulson.
    Mr. Paulson. Yes, as you know, we voluntarily registered 
with the SEC in 2004. We believe, to the extent, having a 
regulatory oversight over the policies of hedge funds, to the 
extent it provides greater comfort to the public sector and to 
private investors is a beneficial thing.
    Mr. Simons. I don't have much to add. I have already said 
that reporting up to the regulators is a good idea, more so 
than is now reported. I agree with the others that it should 
stay with the regulators or with the Federal Reserve. It should 
not be reported in the New York Times.
    Mr. Soros. As I have said, I think the regulators need to 
monitor positions more closely than they have done until now. 
But disclosing it to the public can be very harmful in many 
ways. And I think that the publication of short positions, for 
instance, practically endangers the business model of long-
short equity investors--it is not our business, it is the other 
hedge funds that do that--because of the reaction of the 
companies whose shares they were selling short.
    Mr. Davis of Virginia. Let me ask this. I asked Mr. Waxman, 
and he is comfortable with me asking this. Do you have any 
opinions on what the Treasury Department is doing now with the 
Troubled Asset Recovery Plan? How they can deploy that maybe 
better than they are doing? In light of the fact that the $700 
billion is not actually being used to buy up troubled assets 
but to purchase equity stakes in financial firms, Secretary 
Paulson has indicated that Treasury may start purchasing stakes 
in nonbank financial firms. And do you think any hedge funds 
might take advantage of such an offer? Anybody want to opine an 
opinion on that?
    Mr. Griffin, I will start with you.
    Mr. Griffin. Congressman Davis, I believe that the decision 
to focus on injecting equity or preferred equity into the 
banking system versus buying assets will create a larger effect 
for all of us and is a good decision on a relative basis. So, 
in other words, I applaud the Secretary of Treasury for making 
the decision to increase the equity capital base of the banking 
system at this moment in time.
    Of course, we have a difficult decision to make ahead of 
us: Do we expand TARP to include the nonbanking sector? And if 
we do so, where do we draw the line? I think that is a very 
difficult decision that we have to make in the weeks and months 
ahead. Obviously, the economy as a whole is slowing down, and 
we need to keep Americans employed. And I believe that we are 
going to need more stimulus packages to keep our economy as 
close to full potential as possible.
    Mr. Falcone. I have been in favor of TARP to a certain 
extent considering that it could be a safety net for isolated 
incidents. I don't believe, however, that the money should be 
used for random purchases of assets because of the lack of 
clarity as it relates to what the institutions will do with 
that capital and what benefits it will do for the individual 
consumer. And I furthermore do not think that it should go 
above and beyond the financial institutions.
    Mr. Paulson. Congressman Davis, I do think it was a 
tremendous improvement shifting the focus of TARP from buying 
assets, which has very little impact on recapitalizing banks, 
to directly buying equity. I think the problem in the financial 
sector is one of solvency. Financial firms don't have enough 
equity. And injecting equity is the solution to the problem.
    I also think the list of recipients needs to be expanded to 
include other types of financial firms whose failure could pose 
systemic risk. That may include auto finance companies other 
finance companies, and insurance companies.
    However, I do think the structure of TARP investments can 
be improved. I think the current terms are overly generous to 
the recipients, and I will give you some examples. When 
Berkshire Hathaway bought preferred stock in one of the 
investment banks, they received a 10 percent dividend and 
warrants equal to 100 percent of the value of the investment. 
Under the TARP program, the yield was only 5 percent and 
warrants equal to only 15 percent.
    In the U.K. And Switzerland, when they invested preferred 
knock their financial companies, they got a 12 percent yield, 
also substantial equity stakes.
    By investing proceeds at less than market rates and less 
than other governments are doing, it's in effect an indirect 
transfer of wealth from the taxpayers to these financial 
    In addition, in the U.K., Switzerland and all other 
governments, when government money was required to help out 
financial institutions, there were restrictions on common 
dividends and on executive compensation. In the U.K. And in 
Switzerland, as long as government money is inside these 
companies, there are prohibitions on the payment of common 
dividends and caps on executive compensation. And this is 
essential in order to increase the retained earnings and common 
equities of the banks. It doesn't seem to make sense to me that 
the banks are short of capital, the government puts in capital, 
and then that capital comes out the other door in the forms of 
dividends and compensation.
    I would make two suggestions that I think should be 
required of any financial firms that receive preferred stock 
investments or any form of guarantee from the Federal 
Government on their debt or other securities. One would be, 
while that guarantee is outstanding or while the preferred 
investment is made, that cash common dividends be eliminated 
and any dividends be restricted to dividends in additional 
shares of common stock.
    Second, as other governments have required, there should be 
restrictions on cash compensation, and any bonuses or payments 
above that amount should be paid in common stock. By making 
those three adjustments, first increasing the terms of the 
preferred in terms of yield and equity to benefit the taxpayer; 
second, eliminating cash dividends; and third capping executive 
compensation, that would both protect taxpayers and restore the 
badly needed equity capital to these institutions.
    Mr. Simons. OK. Well, it was generally agreed that the 
original goal of TARP to buy some of this paper was perhaps not 
the best idea and more leverage would be created by 
capitalizing the banks and so on. On the other hand--and I more 
or less agree with that--but nonetheless, something has to be 
done about this paper. No one knows what much of it is worth, 
and it's in weak hands. People don't know how to, you know, 
appraise the balance sheets of the companies that are holding 
it and so on. So it is a problem, and it is a big problem.
    I had suggested to Bob Steel when he was Under Secretary of 
the Treasury that rather than buy this stuff, they organize an 
auction, a two-sided auction dividing the paper up into various 
categories and so on and conducting auctions that people could 
buy and sell. And hopefully buyers would come in, and sellers 
would put up, and the market would kind of get cleared.
    It is a pretty good idea, but it is a dangerous one because 
the prices might not make some folks very happy, people who 
maybe aren't selling but all of a sudden their balance sheets 
get whacked way down. But sooner or later we have to face the 
question what is this stuff worth and how do we get it out of 
weak hands, where much of it is, and into strong hands? And 
because only with the paper being in strong hands can the 
issues, some of these issues be dealt with. If a mortgage is 
chopped up into a million pieces and owned, fractions of its 
cash-flow is owned by all kinds of people, it is very hard to 
deal with that homeowner and renegotiate the terms. But if you 
have bought this mortgage at, OK, a discount, then you can go 
to the fellow, and I am of course projecting this on a much 
wider scale, and say, OK, you can't make your monthly payments, 
but could you make it half? And can we make a deal here? And 
because he or she bought this paper at a substantial discount, 
everyone can make out OK in a reduced way. Somehow or other 
that paper has to be dealt with. And that is all I have to say.
    Mr. Davis of Virginia. Mr. Soros.
    Mr. Soros. I am on record being very critical of the 
original TARP proposal. And I would like to go on record saying 
that while it is a great improvement that it is not used for 
removing toxic securities, but for equity injection, the way it 
is done is not an adequate or acceptable way, that if it were 
properly done then $700 billion would be more than sufficient 
to replenish the gaping hole in the banking system and to 
encourage the banks to start lending again. And the way that 
this should be done would be to ask the examiners to determine 
how much capital each bank needs to bring it up to the required 
8 percent. Then the banks would be free to raise that capital 
or go to TARP and get an offer. But TARP should only underwrite 
the issue, and not actually take it on. But underwrite it on 
terms that the shareholders would be likely to take it on. And 
only if the shareholders don't take it would TARP take it on. 
Then you would have replenished the banking system, you would 
then reduce the minimum lending requirements from 8 percent, 
let's say, to 6 percent--the minimum capital requirements--and 
the banks would be very anxious to put that very expensive 
capital, because equity capital is expensive, to good use to 
get a good return on it by actually lending.
    So that would solve that problem. And as far as the toxic 
securities are concerned, I think the first thing is to 
renegotiate the mortgages so that people would actually stay in 
their houses, and you remove the pressure of foreclosures, 
which are liable to push down the value of mortgage securities 
way below that. That is an undone business that has to be 
urgently attended to.
    Mr. Davis of Virginia. Thank you all.
    Mr. Towns [presiding]. Let me tell my colleague he has no 
time to yield back. Let me just ask the question and just go 
right down the line and get an answer from each of you.
    All of you have successfully navigated the recent problems 
in the economy which appears to have blind-sided the people on 
Wall Street, and of course the people here in Washington. I 
don't think we can pass up this opportunity to explore what it 
is that you knew that allowed you to get so far ahead of 
everyone else when it came to predicting what would happen in 
the markets.
    I would like to go right down the line. Right down the 
line. We will start with you, Mr. Griffin, go right down the 
    Mr. Griffin. Sir, the last 8 weeks have been a challenging 
8 weeks for Citadel. We have had a very successful 18 years 
holistically, but we have had a tough time in the last 8 weeks 
as the banking system around the world came close to the verge 
of collapsing. I think what is very important to note is what 
has happened in the last 8 weeks looks like nothing that any of 
the traditional risk management metrics would have shown as a 
realistic possibility.
    I think it is very important for everyone to keep in mind 
in terms of policy decisions on a going forward basis we had a 
panic in the money market system, we had a panic in the banking 
system, and we have had very negative consequences as a result 
of that in the entire Western world's financial system.
    I think if we look at the firms that have done well over 
the last 8 weeks, they came into this position with portfolios 
of both credit risk and equity market risk that could tolerate 
extreme moves, which we have witnessed. And they have come into 
this crisis with very solid financing lines, which have been 
important in terms of weathering the storm that we have just 
gone through.
    Mr. Towns. Mr. Falcone.
    Mr. Falcone. I think in looking at what has happened over 
the past 8 weeks versus what has happened over the previous 
history in the financial markets is a very unique point in 
time. The markets are very irrational right now. And I have 
always said you could be right fundamentally and wrong 
technically. And the technical situation in the marketplace is 
putting a lot of pressure on a lot of institutions.
    How we have weathered the storm and how we have done over 
the past has really been a function of our diligence. And I 
think in looking at where we have been successful, we have 
taken our time and been methodical and really thought things 
through. And we were very involved in the mortgage market over 
the past couple years. And it has been to a point--it was to a 
point where it took me about 8 to 12 months of some pretty 
substantial analysis before we put that trade on, or trades 
like that on.
    So I would say that over the past couple of months it again 
has been very irrational, and been very difficult to avoid, no 
matter what type of institution you are, to avoid the pitfalls 
of what has been taking place. And I think in order to succeed 
going forward, the proper liquidity and the proper lines with 
the right institutions are a very critical and very important 
    Mr. Towns. All right. Mr. Paulson.
    Mr. Paulson. Mr. Chairman, we conduct a lot of detailed 
analysis independent of the rating agencies.
    Mr. Shays. Lower your mic just a bit.
    Mr. Paulson. Yes. Our firm conducts a lot of detailed 
independent research that is independent of what the rating 
agencies do. And we determined late in 2005 and early in 2006 
there was a complete mispricing of risk of mortgage securities. 
We found Moody's and S&P rating various securities investment 
grade, including as high as triple A, that we thought would 
become worthless. The reason we had this opinion was we looked 
at the underlying collateral of these securities. The subprime 
securities were comprised of mortgages that were made with 100 
percent financing and no down payment. They were made to 
borrowers that had a history of poor credit. There was no 
income verification. And the mortgage value was based on an 
appraisal that was typically inflated. We felt this was very 
poor underwriting quality, that the default rates in these 
mortgages would be very high, and that securities backed by 
these mortgages would also--would likely also have very high 
defaults. And it was that analysis that allowed us to buy 
protection on these securities, which resulted in large gains 
for our funds.
    Mr. Towns. Thank you. Mr. Simons.
    Mr. Simons. OK. Well, I didn't have that kind of wisdom. 
Happily, the funds that we operate didn't require that kind of 
wisdom. So our principal fund, called Medallion, is long and 
short equal amounts of equity, and is not necessarily affected 
by the rises and falls in the stock market, and in fact has 
done fine through this period.
    A second fund which is designed to be a dollar long, that 
is for outsiders, not employees, obviously has--it is long more 
than it is short, so it is net long a dollar if you invest a 
dollar. That has obviously had some declines with the stock 
market down 40 percent, but considerably less than the declines 
of the market. And our investors in that fund are quite happy, 
because that is what they--that is what we advertised would 
happen, and so that is fine.
    An outside futures fund we have was hurt by the explosion 
of volatility in October. I couldn't have predicted that. Maybe 
I should have. I didn't. It was on the wrong side of a few 
things and suffered some losses in October. But by and large, 
our business is not highly correlated with the stock market. 
And so that is how we have skated along here.
    Mr. Towns. Mr. Soros.
    Mr. Soros. What was your question? I didn't fully 
understand your question. Was it how it affected our----
    Mr. Towns. Yes. How you seemed to have been able to 
anticipate when others were not able to anticipate, especially 
Wall Street and Washington.
    Mr. Soros. I fully anticipated the worst financial crisis 
since the 1930's. But frankly, what has happened in the last 8 
weeks exceeded my expectations. The fact that Lehman Brothers 
was allowed to go declare bankruptcy in a disorderly way really 
caused a meltdown, a genuine meltdown of the financial system, 
a cardiac arrest. And the authorities have been involved since 
then in resuscitating the system. But it has been a tremendous 
shock, the impact of which has not yet been fully felt.
    Now, as far as my own fund is concerned, I came out of 
retirement to preserve my capital, and I have succeeded in 
doing that. So we are flat for the year, because by taking the 
necessary steps I was able to counterbalance the losses that we 
would be suffering otherwise, which would be quite substantial.
    Mr. Towns. Thank you very much. Thank all of you for your 
    The gentleman from Indiana.
    Mr. Souder. Thank you, Mr. Chairman. And I understand this 
is a financial hearing, and I am not going to get into other 
questions, but I just want to say, Mr. Soros, we have had deep 
disagreements over the years on the heroin needles promotions 
and your promotion of different what I believe are back-door 
legalization of marijuana. And I believe while you have done 
humanitarian efforts around the world, your intervention in the 
drug area has been appalling. And I haven't had the chance to 
talk to you directly, and I wanted to say that because I 
believe it has damaged many Americans. And I hope you will 
reevaluate where you put your money.
    But I do have a question directly to you on your question 
on equilibrium, that don't hedge funds provide some of that 
equilibrium by buying long and selling short and going after 
companies that haven't been responsible? And why do you think 
there wasn't more of that in this case?
    Mr. Soros. Well, to some extent hedge funds do. And of 
course we shouldn't put all the hedge funds in one category. 
There are different strategies and they have different effects. 
And definitely selling short is a stabilizing factor, generally 
speaking, in the market. In other words, the markets that allow 
and facilitate short selling tend to be more stable than those 
that prohibit them.
    At the same time, hedge funds do use leverage. And leverage 
by its very nature has the potential of being destabilizing, 
because as the market goes up the value of the collateral 
increases, you can borrow more, and also maybe since you are 
making profits your appetite for borrowing more is increasing. 
So there is greater willingness to lend by the banks.
    So this is the--generally speaking, bubbles always involve 
credit. And since hedge funds use credit, they are contributors 
to the bubbles. It is nothing specific to hedge funds, it 
relates to everyone who uses credit.
    Mr. Souder. Mr. Paulson, you said a little bit ago that you 
felt that the government needed to get more involved in the 
fact that some use too much leverage, and that it is kind of a 
slippery slope because, as Mr. Soros just suggested, that in 
fact hedge funds use some leverage as well, and in fact while 
you serve a function for equilibrium, you often exaggerate the 
extremes of that through selling short or buying long.
    Could you respond some to what Mr. Soros said? How do you 
feel? Do you still feel you shouldn't have additional 
regulation with that? And how do you respond to the fact that 
you do in fact exaggerate some of these trends?
    Mr. Paulson. Well, I think what leverage does is it 
exacerbates any move----
    Mr. Shays. Is your mic on, sir?
    Mr. Paulson. Yeah. The danger of leverage is that 
exacerbates any type of market move. So almost every financial 
firm that has run into problems, not only hedge funds like Long 
Term Capital, but Lehman Brothers, AIG, has because they used 
too much leverage. And a small decline in the value of their 
assets wiped out their equity. So I think that there is a need 
to raise the margin requirements on particular asset classes 
and to require stronger equity positions in banks so that--and 
that would reduce the risk of failure.
    Mr. Souder. Mr. Griffin, you have been the most aggressive 
in saying that there shouldn't be regulation. How would you 
respond to the comments there?
    Mr. Griffin. Let me be very direct on the point of 
regulation. Good regulation is good for every market 
participant. I mean, for example, in the middle of the 
financial crisis we worked hand in hand with the SEC to create 
the necessary exemptions to allow Citadel to continue to make 
markets every day in options to millions of retail investors. 
And every day during this crisis we have provided liquidity in 
the equities markets to millions of retail investors, whether 
they are at Schwab or Fidelity or Ameritrade or E-Trade. I am 
very proud of my firm's commitment to providing liquidity to 
retail investors in America. We have also worked hand in hand 
with the Federal Reserve Bank of New York for creating a 
clearinghouse for credit default swaps.
    I think that as a Nation we need an intelligent dialog 
about the right regulatory frameworks to encourage markets that 
are transparent, that have the appropriate amount of leverage 
in the system, and that create value for society. The point of 
our capital markets is to allocate capital efficiently, to 
allow corporate America to raise equity, to grow, and to allow 
America to be more competitive in the world markets. And any 
regulation that furthers those key goals of our capital markets 
is regulation I would support.
    Mr. Souder. May I ask a brief--if regulation goes too far 
would your funds, because I assume you all have foreign 
investment, would we see this move offshore either to Europe or 
Asia or other places?
    Mr. Griffin. It breaks my heart when I go to Canary Wharf 
and I look at the thousands and thousands of highly paid jobs 
in London in the derivatives markets that belong in America. We 
went through a period of regulatory uncertainty with respect to 
derivatives that pushed thousands of high-paying jobs abroad, 
jobs that belonged in our country.
    Mr. Souder. Thank you.
    Mr. Towns. Thank you very much. The gentlewoman from New 
    Mrs. Maloney. Thank you. Thank you very much. And I would 
like to ask a question about a specific regulatory proposal, 
which is to require hedge funds to disclose information to 
regulators. This is an idea that was proposed in the prior 
panel by both Mr. Ruder and Professor Lo.
    Right now the SEC, the Fed, and other entities have 
virtually no information about hedge funds. As a result, they 
have very limited ability to assess systemic risk. As Professor 
Lo testified, one cannot manage what one cannot measure. He 
said that it is, ``an obvious and indisputable need to require 
financial institutions to provide additional data to 
regulators.'' Chairman Ruder made the same point when he said, 
``I continue to believe that a system should be created 
requiring hedge funds to divulge to regulators information 
regarding the size, nature of their risk positions, and the 
identities of their counterparties.'' And I see you have your 
book with you, Mr. Soros, and in your book you said, ``there 
are systemic risks that need to be managed by the regulatory 
authorities. To be able to do so, they must have adequate 
information. The participants, including hedge funds and 
sovereign wealth funds and other unregulated industries, must 
provide that information even if it is costly and cumbersome. 
The costs pale into insignificance when compared to the costs 
of a breakdown. And we are now experiencing a major 
    And so Mr. Soros, would you support a requirement for hedge 
funds to report financial information to regulators?
    Mr. Soros. Yes.
    Mrs. Maloney. And Mr. Simons, you also in your testimony 
made a similar statement about transparency and appropriate 
regulation. So would you agree also that it is correct to have 
    Mr. Simons. Yep.
    Mrs. Maloney. And also Mr. Paulson, Mr. Falcone, and Mr. 
Griffin, would you support additional information and 
transparency to regulators?
    Mr. Paulson. Congressman Maloney, you make a very good 
argument. I think given the size of the industry and the 
potential for systemic risk----
    Mr. Towns. We are having trouble hearing you.
    Mr. Paulson. Congressman Maloney, I think you make a very 
good argument that given the size of the industry and the 
potential for systemic risk, greater disclosure and 
transparency would be warranted.
    Mrs. Maloney. Mr. Falcone.
    Mr. Falcone. I agree. I think providing information to the 
regulatory agencies is very important. I think, however, it is 
very critical what they do with that information, and that we 
have to make sure that it is properly analyzed. And I think 
that can go a long way, as opposed to providing the information 
and just seeing it filed away.
    Mrs. Maloney. Mr. Griffin.
    Mr. Griffin. I think one of the challenges that we need to 
address before we can get to the goals that you want to get to 
is to have a common language to describe derivatives.
    Mrs. Maloney. That is important.
    Mr. Griffin. Every firm uses a different set of 
terminologies, a different set of representations to describe 
their derivatives portfolios. Until we create central 
clearinghouses for over-the-counter derivatives, any reporting 
that we are likely to create will be inscrutable to regulators.
    Mrs. Maloney. We are moving toward that direction. As you 
have read and know, the Fed is moving in that direction.
    Mr. Paulson, I would like to ask you to comment on an 
article that you wrote for the Wall Street Journal on the TARP 
when it first came out. Along with many of us in Congress, you 
argued that we should not be investing in these--in a toxic 
asset purchase, but to move into an equity injection. And some 
people, including yourself and others, have argued that why are 
we being treated differently as taxpayers in America as opposed 
to Great Britain. We have a 5 percent return, they have a 12 
percent. Switzerland a 12\1/2\ percent. Mr. Buffett got a 10 
    Would you comment further on this and how the TARP possibly 
should be structured in a way that is more beneficial to the 
economy and to the American taxpayer?
    Mr. Paulson. Well, certainly. In terms of----
    Mrs. Maloney. And could you speak up?
    Mr. Paulson. Certainly. In terms of using the TARP money 
for equity instead of buying assets is much more beneficial. 
And the benefit can be described very simply. If you put a 
dollar of equity in a bank and a bank uses 15 to 1 leverage, 
then that dollar would support $15 of new lending. If you 
merely use that dollar to buy a toxic asset from a bank for a 
dollar, it doesn't increase the equity and doesn't provide for 
any new lending besides the dollar of equity provided.
    So the leverage to support the system and provide for 
liquidity and new lending is far more efficient by putting it 
in equity rather than buying assets. So I think the----
    Mrs. Maloney. And could you comment on the difference 
between the equity return to the taxpayer, 5 percent versus 
Great Britain, Switzerland----
    Mr. Paulson. Yes.
    Mrs. Maloney [continuing]. And even Mr. Buffett?
    Mr. Paulson. Yes. So the change in TARP to buy equity 
instead of assets is very beneficial. But second, the terms 
that the Treasury has been providing equity, it seems to be 
very generous to the recipients, that it is way below what 
market terms are, what the firms would have to pay if they 
raised this money privately, and is also considerably below the 
returns that other governments get when they are forced 
involuntarily to support the financial institutions with 
    So I think the three----
    Mrs. Maloney. Thank you. Go ahead.
    Mr. Paulson. The three changes I would recommend is that 
for future equity injections the government should get a higher 
dividend, perhaps around 10 percent, and warrants that equal a 
greater percentage of the investment than they are currently 
    Second, in order to restore the equity in the financial 
firms, I think it is imperative that while that preferred stock 
is outstanding that common--cash dividends on common be 
prohibited. And as an additional means of creating more equity 
that ultimately will allow the company to pay back the 
preferred, that cash compensation be capped and bonuses above 
that amount be paid in additional shares of common stock. That 
will go a long way to restoring the equity in these financial 
    Mrs. Maloney. My time has expired. I wish I could ask many 
more questions. Thank all of you for your very insightful and 
important testimony. I yield back.
    Mr. Towns. Thank you very much. And the gentleman from 
    Mr. Shays. Thank you, Mr. Chairman. I only have 5 minutes, 
so I would love some short answers, and then I am going to just 
focus on one individual, just so I can pursue a little more in 
detail. I would like to ask each of you, and I will just 
preface it when I meet with hedge fund partners and they are in 
a room and I ask them about treating capital gains--income as 
capital gains or as regular income, when they are with their 
colleagues they say we should have capital gains treated the 
way it is. And when they meet with me privately, they put their 
arm around me and say Chris, this is crazy, they should be 
treated as ordinary income. So, you know, the people that I 
respect look me in the eye and say it should be treated as 
regular income. I would like each of you to tell me capital 
gains or regular income? Mr. Soros.
    Mr. Soros. I think earned income should be taxed as earned 
income. If you have a partnership arrangement and you--and that 
allows you to take capital gains and you want to change that, I 
think that would be appropriate. It would be inappropriate to--
    Mr. Shays. Let me just cut you off, Mr. Soros, because you 
have all answered the question. Do you all agree with or 
disagree with----
    Mr. Soros. I am in agreement with it being taxed as earned 
income. But I would take exception if this was only applied to 
hedge funds, and not other forms of partnership.
    Mr. Shays. I am sorry. I thank you for finishing the 
answer. Do any of you disagree with that answer?
    Mr. Falcone. I disagree to a certain extent. I think that 
hedge funds shouldn't be looked at differently. And it is 
really a function of the underlying asset. If you have an asset 
and you hold it for longer than 12 months, then you should be 
subject to capital gains tax like any other individual or real 
estate partnership or any investor.
    Mr. Shays. OK. You have answered the question. I just have 
so little time. I don't mean any disrespect.
    Mr. Falcone. OK.
    Mr. Shays. Mr. Griffin, I am just going to focus in on you 
because I just have to isolate one, and you are the furthest 
away from my district, so if I offend you it won't bother. I am 
told you can only have 99 members as part of a particular hedge 
fund. It is 99 or less. Is that correct?
    Mr. Griffin. The rules have changed over the years. That is 
not necessarily applicable any more.
    Mr. Shays. But it is limited?
    Mr. Griffin. Yes.
    Mr. Shays. What concerns me is that some funds say 20 
percent profit, 1 percent management fee. I am told that you 
don't do 1 percent management fee, you do costs. And that can 
be closer to 8 percent. Is that accurate or not?
    Mr. Griffin. We do pass through costs. Costs as we define 
will include, for example, commissions paid to other firms.
    Mr. Shays. So does it amount to more than 1 percent?
    Mr. Griffin. Yes, it does.
    Mr. Shays. OK. I am also told that some of your funds have 
done well and some haven't. And the accusation was that the 
funds that have done better are the ones you have your own 
money in, your own personal money, and the funds that haven't 
have not. And I want to know if that is accurate.
    Mr. Griffin. That is completely inaccurate. I am the single 
largest investor in our largest funds by a significant margin. 
I am also the largest investor in some of our funds that have 
been very profitable this year.
    Mr. Shays. So would your statement for the record be, and 
under oath, that you have investment in every fund that you 
have or just some of the funds?
    Mr. Griffin. I have a material, several billion dollar 
investment in Wellington and Kensington.
    Mr. Shays. Right.
    Mr. Griffin. And I have an investment in the several 
hundred millions of dollars in our other funds.
    Mr. Shays. And the one that you have the most investment 
in, has that done the best or the worst or somewhere in 
    Mr. Griffin. Regretfully, it has done the worst.
    Mr. Shays. OK. Let me ask all of you then, do you think 
that you should be required to have your funds, your own 
personal funds in every fund that you have? The implication is 
that since you make 20 percent of the profit, that you might 
tend to be more risky with the funds you may not have your own 
money in because you still make 20 percent. And if you lose, if 
the funds lose, you don't lose anything.
    So let me ask you about that. Mr. Soros.
    Mr. Soros. Exactly in order to avoid this kind of conflict 
of interest, I only have one fund and all my assets are in that 
    Mr. Shays. I see. Has that fund done better or worse than 
your other funds?
    Mr. Soros. There is no comparison. It is the only one.
    Mr. Shays. I am sorry, you just have one fund. I am sorry. 
Thank you.
    Mr. Simons. OK. Well, no, I have----
    Mr. Shays. I can't hear you. You are mumbling.
    Mr. Simons. Well, all right. Is that better?
    Mr. Shays. Yeah.
    Mr. Simons. All right. I have substantial amounts of money 
in the three different funds that we manage. I think that 
question is generally asked in due diligence by people 
considering investing in hedge funds. We always do. We invest--
the family invests in many, many hedge funds. And that is the 
first due diligence question, does the fellow have skin in the 
game or whatever? Does he have--so to a large extent I think 
that issue is taken care of by the market.
    Mr. Shays. You have answered the question. Thank you. Mr. 
    Mr. Paulson. Yes, all my assets are invested in the funds 
that we manage. I don't have any outside investments.
    Mr. Falcone. I think it is very important that the manager 
aligns himselves with the investors, and in my situation I am 
the largest investor in both of my funds.
    Mr. Shays. Thank you all. Thank you.
    Mr. Towns. Thank you very much. The gentleman from 
    Mr. Cummings. Thank you very much, Mr. Chairman. Mr. Soros, 
Mr. Souder had some comments about you a little bit earlier, 
and I just want to let you know that I thank you for what you 
all have done for the citizens of Baltimore in my district. It 
has been simply phenomenal, and I thank you and the Open 
Society Institute.
    Let me go to all of you and just to kind of piggyback on 
some of the things that Mr. Shays was just talking about. Each 
of you appearing here, my neighbor on his way to work this 
morning said to me, he said how does it feel to be going before 
five folks who have more money than God? And I am sure you will 
disagree with him. But you are private citizens, and your 
income is not required to be publicly disclosed, so I am going 
to respect your privacy and not disclose your specific 
compensation. But you have provided information about your 
income to the committee, and it shows that although there are 
individual variations, on the average each of you made more 
than $1 billion in 2007. I've got to tell you that is a 
staggering amount of money. And I am not knocking you for it. 
But even though you made enormous sums, you are not taxed like 
ordinary citizens, like the guy that said what I told you. Your 
earnings are not taxed as ordinary income. Instead, the fees 
you receive are called carried interest, which means that they 
are taxed at capital gains rates. There are two capital gains 
rates, a low 15 percent rate for long-term gains, and a higher 
rate for short-term gains. What this means is that to the 
extent your earnings are based on long-term gains, the tax rate 
is just 15 percent.
    My question for you is whether this is fair. A school 
teacher or a plumber or policeman makes on the average of 
$40,000 to $50,000 a year, yet they have to pay 25 percent tax. 
You make $1 billion, yet your rate can be, can be as low as 15 
percent. Is that fair, Mr. Paulson? I want to start with you, 
because I understand that a significant part of your earnings 
can be short-term gain, but not all of it is. And Mr. Paulson, 
press accounts say that you earned over $3 billion in 2007. If 
just 20 percent of your income is long-term gain, that is over 
$600 million in income that is being taxed at a low rate. And 
so I will start with you, and we will just----
    Mr. Paulson. Well, we certainly appreciate----
    Mr. Cummings. I want you to keep your voice up for my 
    Mr. Paulson. Yeah. We certainly appreciate your concern for 
fairness in the Tax Code. But what I will say, I believe our 
tax situation is fair. If your constituents, whether they are a 
plumber or a teacher bought a stock and they owned that stock 
for more than a year, they would pay a long-term capital gains 
rate. So for our investments, to the extent I own investments 
for more than a year, I also pay a long-term capital gains tax. 
If we own an investment for less than a year, we pay short-term 
capital gains, which is taxed as ordinary income. And any fee 
income we receive, such as management fees, for that it is 
strictly ordinary income.
    Mr. Cummings. But this is about money that you are managing 
for other people. It is not your money, right? In other words, 
you said if I hold certain things for someone. But you are 
actually getting paid for what you do, the work that you 
perform. Isn't that right?
    Mr. Paulson. The way partnership accounting works, if the 
partnership owns an asset for more than a year, that asset is 
taxed at long-term capital gains. And that tax is passed along 
to all the partners in the same way. If the asset in the fund, 
in the partnership is a short-term capital gain, then all the 
partners, including the general partner, pay short-term capital 
    Mr. Cummings. Do you have an opinion, Mr. Falcone?
    Mr. Falcone. Yes, I do. I think that the important thing to 
realize is that hedge funds, quite frankly, are not and 
probably should not be treated any differently than any other 
investor. And as the case may be with my particular situation, 
last year approximately 98 percent of my taxable income was 
taxed under ordinary income. But I think it is important not to 
differentiate between hedge funds and the rest of the 
investment community, whether a private equity or real estate, 
or even individuals or the doctor that may own his hospital and 
decide to sell it.
    Mr. Cummings. So would any of you support repealing this 
tax loophole and taxing your income at regular income rates? 
Mr. Soros.
    Mr. Soros. I do.
    Mr. Cummings. I can't hear you.
    Mr. Soros. I agree to it. I have no problem with it.
    Mr. Cummings. Mr. Simons.
    Mr. Simons. Yeah, I said the carried interest portion 
represented by other people's money, if that were raised to 
higher levels that would be OK with me.
    Mr. Cummings. Mr. Falcone. You just stated your position, I 
think, right?
    Mr. Falcone. Yes, I did.
    Mr. Cummings. Mr. Paulson.
    Mr. Paulson. Yeah, I would--I don't think it is a loophole. 
The carried interest merely passes through the nature of the 
income to the partners. If it is short-term capital gain, we 
are taxed at short-term capital gain. If it is long-term 
capital gain, it is taxed at long-term capital gain.
    Mr. Cummings. Mr. Griffin.
    Mr. Griffin. I think tax equity is incredibly important. 
And most of the income, if not all of the income that I 
generate is subject to either ordinary or short-term tax rates, 
the highest marginal rate. But if you and I were to start a 
restaurant together, and I was to be the chef and operator and 
you were to put up the capital, even though my labor goes into 
making that restaurant work every day, if we sell that business 
2 or 3 years down the road I will get long-term capital gains. 
Our society preferences long-term capital gains from a tax 
perspective. And I think what we should seek to have is 
consistency in how we treat long-term capital gains, whether it 
is the hedge fund manager, the private equity manager, or the 
entrepreneur who starts a restaurant together.
    Mr. Cummings. I see my time is up. Thank you.
    Mr. Towns. Thank you very much. Mr. Tierney.
    Mr. Tierney. Thank you. Just to followup on that, Mr. 
Griffin, when you use your analogy about the restaurant, when 
you are the chef the money you earn from being the chef gets 
taxed at a regular income rate.
    Mr. Griffin. That is correct, sir.
    Mr. Tierney. When you are managing other people's money, 
you are in effect the chef of that process, you get taxed for 
those earnings at the regular income tax rate.
    Mr. Griffin. And management fees are taxed as ordinary 
income, sir.
    Mr. Tierney. Well, which way do you determine the 
management fees? The 1 or 2 percent or the 20 percent?
    Mr. Griffin. The management fees are generally taxed as 
ordinary income for most firms.
    Mr. Tierney. What are you referring to as the management 
    Mr. Griffin. The 1 or 2 percent.
    Mr. Tierney. One or 2 percent. Set that aside. You get 20 
percent and the other partners get 80 percent of the earnings, 
    Mr. Griffin. That is correct.
    Mr. Tierney. You get 20 percent for the effort you made in 
managing those funds, making those investments, and doing that 
type of work. That is being the chef, not in terms of selling 
the product. I know what you want to do, you want to wash it 
all through and come out the other end. But the fact of the 
matter is that is compensation for your day-to-day efforts of 
managing those funds, is it not?
    Mr. Griffin. Well, let's go back to the story of the chef. 
The chef in his salary every year is taxed as ordinary income. 
But if the restaurant has capitalizable value----
    Mr. Tierney. But you are not selling anything when you are 
getting compensated for the day-to-day management efforts that 
you make.
    Mr. Griffin. If I make an investment that creates long-term 
capital gains, so I invest in a biotechnology company where the 
stock appreciates----
    Mr. Tierney. A good portion of that money isn't yours. 
    Mr. Griffin. That is correct.
    Mr. Tierney. So when you get 20 percent, it is for 
investing other people's money as well as your own.
    Mr. Griffin. That is correct.
    Mr. Tierney. And some of that compensation is for your 
efforts in managing and investing those other moneys.
    Mr. Griffin. That is correct.
    Mr. Tierney. Right. And that, my friend, I suggest to you 
is what we are saying ought to be taxed as regular income. You 
can disagree, but I just don't want you to take the chef 
analogy too far on that.
    Mr. Griffin. Just to be very clear, all of my income, or 
virtually all is taxed at the highest marginal rates.
    Mr. Tierney. As it should be.
    Mr. Griffin. All right. So I speak to you from a 
    Mr. Tierney. We don't disagree on that. I don't want you to 
take your chef analogy and confuse people with that.
    Mr. Paulson, except for our disagreement on that particular 
issue, I was thinking that we probably had the wrong Paulson 
handing out the TARP moneys here, because I agree with you in 
essence about us not getting the deal as taxpayers that we 
ought to be getting. And fairly adamant. And I can daresay that 
you can't walk down the street at home in any of our districts 
that people don't make that point, is what the heck are we 
doing giving money to these institutions, and they are out 
there giving bonuses, paying high salaries without being 
capped, and then waltzing around giving dividends. I think that 
is an important point, and I know you have already mentioned 
that twice now, but I think it probably can't be mentioned 
loudly enough and clearly enough while the other Mr. Paulson is 
busy determining what he is going to do.
    What I would like to know is whether the other four 
panelists here agree with our Mr. Paulson here that if we are 
going to have taxpayer money go to any of these institutions, 
we ought to get a better deal, you know, better security on 
that, make sure the compensation isn't excessive, and make sure 
in fact that dividends aren't given out in cash during that 
period of time when we have the guarantee of the investment 
made. Mr. Soros.
    Mr. Soros. I am sorry, I didn't follow the question 
properly. I am sorry.
    Mr. Tierney. In my old business we used to be able to have 
it read back. Do you agree with Mr. Paulson that as long as 
taxpayers' money is being given to these institutions for the 
purposes of thawing out the so-called credit freeze that we 
ought to be getting a better deal for the taxpayers? We ought 
to be getting better security for that investment? We ought to 
be making sure that the banks or the entities are not giving 
excessive compensation with it, bonuses and things of that 
nature, and are not giving cash dividends while the 
stockholders, the taxpayers' money is there?
    Mr. Soros. I am not sure that I would agree with Mr. 
Paulson on that.
    Mr. Tierney. Why not?
    Mr. Soros. I think that if you have a capital increase in 
the banks, then I think that as long as the money is put up by 
the shareholders, there should be no change in the--it is up to 
the shareholders how they compensate.
    Mr. Tierney. But this is taxpayer money, not shareholders' 
money we are talking about.
    Mr. Soros. When it is taxpayers' money, no, that I agree. 
Yes. Yes.
    Mr. Tierney. Thank you.
    Mr. Simons, do you also agree?
    Mr. Simons. Generally speaking I do, although I will make 
the point that when this first round of money was put into 
these banks some of them didn't want to take it. And then 
Paulson said everyone has to take it. And therefore, if you are 
going to--because he didn't want the public to distinguish 
which bank is stronger and which bank is weaker or so on, which 
maybe was a good idea, maybe wasn't. But the result is that 
everyone had to take it. And if you have to take it, well, then 
you can mitigate that a little bit by saying, OK, I won't gouge 
you too much or whatever it would be. So I am not saying the 10 
percent is gouging, by the way, but some of this money was not 
requested by some of these banks. To the extent that it was, I 
think it was quite a sweet deal.
    Mr. Tierney. I think whether you request it or not, you 
ought to have a fair deal, not a lopsided deal on that. But we 
can discuss that later.
    Mr. Falcone.
    Mr. Falcone. I agree. I think that to the extent that the 
capital is infused into some of these companies it should be 
more along the lines of market rates.
    Mr. Tierney. Mr. Griffin.
    Mr. Griffin. I believe that market rates for many of these 
companies would be extremely high. And if one of our goals is 
to reduce the cost of consumer credit, this is in essence an 
indirect subsidy to the banking system that I hope they will 
pass on in some form or another to the ultimate consumers to 
whom they lend to.
    Mr. Tierney. Thank you all for your answers. Thank you, Mr. 
    Mr. Towns. Thank you very much. Mr. Yarmuth.
    Mr. Yarmuth. Thank you, Mr. Chairman. I want to thank the 
panel. The testimony has been, I think, unusually candid and 
thoughtful, and I appreciate that very much. I am going to 
probably cross the line a little bit that Chairman Waxman set 
down, but I am going to try to draw the connection.
    We have had a number of hearings related to the immediate 
financial crisis. And even going back some months we had a 
hearing on corporate compensation and its connection to the 
housing crisis. And we had a panel back then that included the 
former CEO of Time Warner, the former CEO of Merrill Lynch, 
Citigroup, and we had Mr. Mozilo from Countrywide. And one of 
the questions that I asked was when all these corporate 
executive compensation committee meetings met, was there ever a 
discussion of things like employee welfare, the communities 
that the corporation served, so forth, general corporate 
policies, or was there--the discussion always about stock 
price? And with unanimity they said the conversations were 
always about stock price. And one of the things that has become 
a common theme in hearings we have had is that when you tie 
everyone's compensation to stock performance, and relatively 
short-term stock performance, then you have an incentive or 
pressure for maybe riskier behavior that might have contributed 
to a lot of the crisis that we have.
    So I ask you, as people who own significant positions in 
some of these companies, whether you have a concern about the 
corporate governance structure in this country and whether we 
should be doing things, whether it is related to corporate 
compensation generally or general corporate governance laws 
that might ameliorate some of this issue if you think it is a 
problem? Mr. Soros, would you like to start?
    Mr. Soros. I am definitely at a loss because it is not a 
subject that I have really given a lot of thought to.
    Mr. Yarmuth. Chairman Waxman excused you.
    Mr. Simons.
    Mr. Simons. I haven't thought about it a great deal, but 
generally speaking I am more of a fan of profit sharing for 
CEOs than I am of stock options. The latter is very volatile, 
and you never know quite what he is getting.
    Mr. Paulson. In this case I would echo Mr. Simons' 
    Mr. Falcone. I am inclined to agree with Mr. Paulson and 
Mr. Simons that it is important to participate, from a 
compensation perspective as it relates to profit sharing, along 
those lines.
    Mr. Yarmuth. Mr. Griffin.
    Mr. Griffin. I will concur with the other panelists.
    Mr. Yarmuth. In today's Financial Times, Professor Malkiel 
from Princeton suggested that one of the things that might be 
considered is when you have compensation tied to stock options 
and so forth that it involve restricted stock that the CEO 
could not sell until sometime after he or she left the company, 
and therefore the concern would be more in the long-term 
interests of the corporation rather than short-term stock 
performance. Is that something that resonates with any of you 
that you think might be a good idea? You can say you didn't 
think about it.
    Mr. Griffin. I think that would be a terrible idea.
    Mr. Yarmuth. Terrible idea?
    Mr. Griffin. And part of the reason is that we need 
executives in America to take risks. Whether it is to put the 
money down on the line for R&D in drugs or willing to try to 
create new ways to power America, we need executives to take 
risk. And what we find is as executives become more successful, 
they actually become more risk averse often. And so if you have 
their entire net worth tied up in stock options, which are 
inherently risky, and then they cannot monetize any portion of 
that until after they retire, I would be gravely concerned 
about the reduction in risk taking by America's corporate 
leaders. It sounds good on paper. I don't think it will give us 
what we need as a country. We need innovation.
    Mr. Yarmuth. Does anybody else want to address that? I 
don't have any other questions. But if you don't, that is fine. 
Thank you, Mr. Chairman.
    Mr. Towns. Thank you, very much. Thank you. The gentleman 
from Tennessee, Mr. Cooper.
    Mr. Simons. I would like to excuse myself for a moment. I 
will be right back.
    Mr. Towns. Sure.
    Mr. Cooper. Thank you, Mr. Chairman. The headline of this 
hearing is definitely Paulson v. Paulson. As has been 
enumerated, John Paulson accuses Henry Paulson of botching the 
bailout. Because taxpayers do want a good return for their 
money, and they are very worried when we are only getting 5 
percent interest on the preferred stock, and not getting 
sufficient warrant positions. But I think the real purpose of 
this hearing is to understand better the role that hedge funds 
play. And I asked the previous panel, professors largely, if it 
is possible to distinguish between hedge funds that hedge and 
funds that are more speculative. Because Mr. Paulson, for 
example, bet right on the down housing market, but that was not 
necessarily a position--you know, for example, if you had taken 
that position 3 or 4 years ago you wouldn't be as wealthy as 
you are today. The only thing worse than being wrong about the 
market is being right too early. So is it possible to 
distinguish between hedge funds that hedge and those that are 
    Mr. Paulson. Well, let me first say I hope this is not 
Paulson v. Paulson, or that I am accusing a Paulson of botching 
    Mr. Towns. Would you pull that mic? We have a great 
difficulty hearing you, so could you pull the mic closer to you 
or talk a little louder?
    Mr. Paulson. Absolutely. I will be glad to do that, Mr. 
    I in no way want to be critical of Mr. Paulson. He has done 
a tremendous amount for our country, is willing to change his 
position when the circumstances change, and I think he has 
reoriented the TARP program in the right direction.
    The second part of your question--or I really wasn't sure 
what it was again.
    Mr. Cooper. For example, Mr. Simons doesn't purchase credit 
default swaps, he is not leveraged much. Other hedge funds have 
quite different strategies. We will never know because it is a 
black box trade secret. But is it possible for the pension fund 
and other investors to know in advance whether they are buying 
interests in a hedge fund or a speculative fund? I know in the 
private conversations you reveal a little bit more of your 
operations. But most people have no idea whether it is a hedge 
fund that hedges or it is not. It is a question about truth in 
    Mr. Paulson. Congressman Cooper, that is a very good 
question. Investors never have to invest in a hedge fund.
    Mr. Cooper. I know.
    Mr. Paulson. If they don't get the proper transparency----
    Mr. Cooper. They don't, but there is a Wisconsin school 
board that put money in SIVs that got traced all around the 
world. You know, a lot of investors don't necessarily know. So 
right now we have a hedge fund as a category that is not 
defined, and some of which hedge, but many of which do not. And 
people have no advanced notice. So there is no truth in 
    Mr. Paulson. Well, we for one give a lot of transparency to 
our investors. And while we don't disclose them publicly, we do 
disclose a great deal about what we are doing to our investors. 
So I would encourage investors such as pension funds, that they 
invest with managers that give disclosure so the pension funds 
know what they are investing in.
    Mr. Cooper. Do any of the witnesses know? Mr. Soros.
    Mr. Soros. I think that hedge funds, several hedge funds 
have claimed to follow a market neutral strategy exactly 
because institutional investors want to see low volatility, and 
I think that was rather misleading. I don't think it was 
deliberately misleading, but actually because there is this 
false paradigm that has prevailed, that has pervaded the 
thinking on this subject, people thought that they were market 
neutral, and in actual fact when an event occurred that was not 
a random fluctuation or deviation, then it turned out to be 
non-market neutral.
    Mr. Cooper. Thank you. You mentioned that investors usually 
want low volatility. The markets have been unusually volatile 
recently, and some trading strategies depend on volatility. How 
much volatility is enough?
    Mr. Soros. Well, see----
    Mr. Cooper. 200 points a day, 500 points a day, a thousand 
is more better?
    Mr. Soros [continuing]. Basically, what the prevailing 
paradigm has neglected is the uncertainty that is connected 
with this reflexive connection. We have become very adept in 
calculating risk. And by focusing on risk, we have left out 
uncertainty. And that has been our undoing in this particular 
    Mr. Cooper. How about the other panelists? Is a volatility 
only strategy appropriate? And if so, is more volatility always 
    Mr. Soros. Well, you see, I think volatility is an 
indication of uncertainty. And the fact that normal volatility 
is 30, and it shot up to 50 and 70 and 80, it just shows the 
increased uncertainty that is currently pervading the markets.
    Mr. Cooper. Does the government have a role in limiting 
excessive uncertainty?
    Mr. Soros. Well, I think that regulators have to understand 
that there is this uncertainty in markets. And that is why the 
risk management methods used by individual participants who are 
only thinking of their own risk is not appropriate in 
calculating systemic risk. And to protect against systemic 
risk, you have to impose restrictions on the amount of credit 
or leverage market participants can use. That is actually the 
core of my argument that I am putting forward.
    Mr. Griffin. Congressman Cooper, if I may.
    Mr. Cooper. Yes.
    Mr. Griffin. Good regulation, good policy helps to reduce 
volatility in the market. And we are extremely invested in the 
safety and soundness of our financial system.
    Mr. Cooper. But doesn't your firm have a conflict of 
interest in grouping with CME to create clearinghouses and 
other means that might somehow prejudice the market?
    Mr. Griffin. In the sense of?
    Mr. Cooper. Well, if you are partnering with the market 
maker or the clearinghouse, how do people know it is going to 
be a fair market?
    Mr. Griffin. Well, we would clearly have a very sharp 
distinction between our role as a contributor of intellectual 
property and know-how to the CME to expedite the launch of this 
clearinghouse from the day-to-day management of the 
clearinghouse. We will have no involvement in the day-to-day 
management of the clearinghouse. Because the positions of other 
market participants should not be made available to Citadel.
    Mr. Cooper. That makes investors rely on a Chinese Wall 
instead of a greater separation.
    Mr. Griffin. Well, CME will be running the clearinghouse. 
So we are not running it, just to be very clear on the record.
    Mr. Cooper. Thank you, Mr. Chairman. I see my time has 
    Chairman Waxman [presiding]. Thank you, Mr. Cooper.
    Mr. Van Hollen.
    Mr. Van Hollen. Thank you, Mr. Chairman, and thank all of 
you gentlemen for your testimony. We have had a lot of 
discussion about trying to create greater transparency over 
hedge funds. And as I understand all of your testimony, you 
agree with the idea that at least on a confidential basis it 
would be appropriate for some Federal agency, the SEC or some 
other Federal agency, to monitor and obtain that information 
for the purpose of making a determination whether there is 
systemic risk, putting the taxpayer at risk. Am I right about 
    Mr. Soros. Yes.
    Mr. Simons. Yes.
    Mr. Falcone. Yes.
    Mr. Van Hollen. Now, we had just before you a panel of a 
number of professors, including Professor Lo and Professor 
Ruder. And the question I posed was OK, let's say you are the 
SEC or the regulator and you are getting this information and 
data and you see your alarm bells go off. You say look, we 
really do think we have a problem here, whether it is to the 
investors or systemic risk. What authorities should they have 
then with respect to the hedge fund? And the response we got 
was maybe the SEC shouldn't have that authority, but they would 
provide the Federal Reserve with that authority, which 
according to their testimony would require additional 
congressional action.
    So my question of you gentlemen is, is that something you 
think would be necessary? Because the obvious question that 
comes up once you say it is OK to collect the information is 
OK, you got it, now you make a determination that something is 
going wrong, shouldn't we also make sure they have the 
authority to deal with it? Especially in light of the fact that 
what we have learned, at least with respect to the investment 
banks, is that the taxpayer is of course sort of holding the 
risk as a last resort and is going to be asked and has been 
asked anyway to go in? So I would pose that question to you, 
gentlemen, whether you think, whether it is the SEC or the 
Federal Reserve, they should also have additional authorities, 
whether it is leverage requirements or some other powers that 
they can intervene with respect to a particular hedge fund that 
they determine is causing systemic risk?
    Mr. Soros. Well, I would definitely argue that is exactly 
what you need. That is what currently is missing and it needs 
to be introduced. We used to have that kind of authority. In 
earlier years, in my youth I used to be aware of them. They 
have fallen into disuse. And I think they have to be brought 
back, because there is a distinction between money and credit, 
and markets don't tend toward equilibrium, and it is the job of 
the regulators to prevent asset bubbles from developing.
    Mr. Simons. Yes.
    Mr. Paulson. I would agree with that.
    Mr. Falcone. I would agree as well. I'm not so sure it 
should be the SEC or the Federal Reserve or a new regulatory 
agency, but I think it's a very good idea.
    Mr. Griffin. I think what is important in the concept is 
for the hedge funds that are subject to this new paradigm to 
understand the rules of the road. Are we heading toward a Basel 
2 requirement for hedge funds, for example? So long as I know 
what the rules of the road are, I can conduct my business in a 
way to be well within the lines.
    Mr. Simons. That's a very good point, I think.
    Mr. Griffin. And I would like to clarify one previous 
statement. On the issue of clearinghouses for credit default 
swaps, there were two primary solutions proposed over the last 
couple of weeks; one was the dealers in the consortium called 
TCC, the other is a solution by Citadel on the CME. A key 
distinction between these two solutions just a few weeks ago 
was that the CME solution is open to all financial market 
participants, both the buy side and the sell side.
    Whereas the TCC solution, the dealer solution, was to be 
open only to the dealer community. And I believe that all of us 
on the buy side, whether we are Pemco, Black Rock, Citadel, 
Paulson, would want a platform that is open to all. It goes 
back to transparent and fair markets. And we have seen the 
dealer community trying to create doubts as to why the CME 
solution is the best one, this issue of Chinese walls. Let me 
just make it clear; we need a solution to meet the needs of all 
market participants. And I believe that our work with the CME 
to do so is in the best interest of our Nation and the entire 
world's financial system.
    Mr. Van Hollen. Thank you for that. Let me also just say, 
with respect to your answer to the previous question, we 
appreciate it. We may need all of you gentlemen to continue to 
provide that input as we go forward. Because, as you know, just 
the notion of providing greater transparency has been proposed 
in the past, it was proposed after the failure of Long Term 
Capital Management took a case to the Supreme Court that you 
are all very familiar with. And the fact of the matter is, not 
you as individuals, but certainly the industry, fought efforts 
to provide greater transparency, to provide greater oversight 
and some of these things. So as we go through this effort to 
provide reasonable regulation of the financial markets, we 
appreciate your input going forward as well as today.
    Thank you, Mr. Chairman.
    Chairman Waxman. Thank you, Mr. Van Hollen.
    Mr. Issa.
    Mr. Issa. Thank you, Mr. Chairman.
    Mr. Soros, it's good to meet you at last. I'm very 
intrigued at some of your comments, and one of them 
particularly has to do with leverage. Is it enough, or would it 
be at least a good quick beginning if the Congress--obviously 
with the President--were to create a truth in, if you will, 
transparency of leverage, require standards and disclosure as 
to leverage, and of course that means that, derivatively, if 
you leverage something and then you go to resell it, it would 
be standard so that if you leverage a leverage a leverage, then 
that would have to be transparent and flow through. If that 
were one of the items on President Obama's short list of things 
to be done in that first 100 days, would it go at least a long 
way toward preventing the kind of over-leveraging that you're 
speaking of, at least the lack of visibility on over-
    Mr. Soros. Well, certainly the introduction of newfangled 
financial instruments has made it much harder to calculate 
leverage because some of those instruments are leveraged 
instruments. So, given all the derivatives that have been 
introduced, calculating the leverage becomes a very, very 
complicated problem. And especially if you have tailor-made 
instruments, then it becomes even more difficult. So I think 
that it may be necessary to actually--while it is certainly 
necessary for the regulators to understand what they are 
regulating, and if they don't, they should perhaps not allow 
some of those instruments to be used. So I think that the 
instruments themselves would have to be authorized, approved by 
the SEC, or whatever, before they could be used.
    Mr. Issa. Good point.
    Mr. Paulson, first of all, congratulations. I'm not an 
investor with your fund, but I've noticed that you manage to be 
still up about 1 percent at a time in which the walls are 
falling all around most other people. In order to have the kind 
of stellar gauge you've had, including obviously dealing with 
some of what we rename, we call them, you know, caustic and 
corrosive and acidic products, were you able to make sound 
decisions as to the real leverage that you were buying into in 
your investments?
    Mr. Paulson. Absolutely. What we did was primarily buy 
protection on debt securities. And at the time, we bought this 
protection, it's like buying an insurance policy, the premium 
was very, very low, on the order of 1 percent. So if the debt 
security never fell, we would lose the value of that premium. 
But that premium in our base funds was only about 1 to 2 
percent, and that was the extent of loss we would realize if 
our investments didn't pan out.
    Mr. Issa. So to characterize what you've just said, you 
gambled less than those who went routinely long on any 
    Mr. Paulson. I believe that's the case.
    Mr. Issa. So the people who invested with you, including 
the pension funds and so on, were gambling less because of your 
technique--which was available to them and you have a track 
history since 1994--they were gambling less because you told 
them that you had, in fact, hedged outcomes in order to protect 
their investment.
    Mr. Paulson. I prefer not to use the word ``gambling.''
    Mr. Issa. And I didn't use it for you, I used the word 
``hedge'' for obvious reasons. And the term ``gambling,'' and 
just correct me if I'm wrong, most mutual funds, whether 
they're in small cap, mid cap, large cap, foreign, they 
basically tell you they're going to be 100 percent invested or 
they're going to have a ratio. And no matter what happens in 
the market, they don't go to all cash, and many of them refuse 
to go short to market as a matter of it's in the prospectus; 
isn't that right?
    Mr. Paulson. That's correct.
    Mr. Issa. So your technique and the technique of virtually 
all hedge funds is, in fact, to limit risk by stating how you 
will maneuver in a market as it becomes less than one 
directional up; isn't that true?
    Mr. Paulson. That's true. An important goal of our funds is 
to limit risk and reduce volatility.
    Mr. Issa. Last question, if I could, Mr. Chairman.
    There was some talk on the earlier panel about tax 
treatment--and I know this isn't the Ways and Means Committee 
so I want to limit it, but do any of you see a way in which we 
could look at the long term gains that you and your investors 
achieve when you're long for a period of more than a year and 
differentiate between those and any other investor in stocks 
and other equity products or debt products? Do any of you see a 
way in which you could effectively differentiate, because we're 
often talking about hedge funds and saying, well, we've got to 
get rid of their capital gains treatment, the only reason I ask 
is, can any of you--because you're very smart people--think of 
a way that we would separate your category from every other 
mutual fund, if you will, and the capital gains treatment they 
    Mr. Falcone. If I may, if you plan to go down that road, 
there might be one possibility where----
    Mr. Issa. By the way, I don't plan to go down that road.
    Mr. Falcone. Instead of having the horizon be 12 months, 
maybe make it a little bit longer for hedge funds. I would hate 
to see that eliminated in its entirety because there are truly 
individuals in the hedge fund market that are investors, and if 
you extend that timeframe, that could be one way of looking at 
    Mr. Issa. Thank you, Mr. Chairman.
    Chairman Waxman. Thank you, Mr. Issa.
    I want to thank the Members of this panel. The Members, I 
think, have asked very important questions, and you gave very 
thoughtful answers which is very helpful to us. Congress 
usually has trade associations at hearings, and they give the 
predictable responses, which are in what they see their self 
interest. And that's why we wanted to have you testify here 
today to get an unfiltered response, and your comments and 
recommendations were very helpful.
    I believe there has been a consensus or near consensus that 
hedge funds can pose systemic risks. And there has been a 
similar consensus that there should be more disclosure about 
the activities of such hedge funds. Several of you have urged 
more oversight and reasonable restrictions on leverage and 
closing the tax loophole that benefits hedge fund managers. You 
have also provided insightful criticisms of the Federal 
response to the financial crisis.
    We're facing a terrible economy and enormous disruption in 
our financial markets, and I think your testimony is very 
helpful to us in pointing out ways that Congress and Federal 
regulators can help restore our markets. So I thank you very 
much for what you have done today.
    That concludes the business before the committee, and we 
stand adjourned.
    [Whereupon, at 2:03 p.m., the committee was adjourned.]
    [The prepared statement of Hon. Edolphus Towns follows:]
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