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U.S. House of Representatives,
Subcommittee on Capital Markets, Securities
and Government Sponsored Enterprises,
Committee on Banking and Financial Services,
Washington, D.C.

    The subcommittee met, pursuant to call, at 10:00 a.m., in room 2128, Rayburn House Office Building, Hon. Richard H. Baker, [chairman of the subcommittee], presiding.

    Present: Chairman Baker; Representatives Toomey, Roukema, Kanjorski, Bentsen, J. Maloney of Connecticut, and C. Maloney of New York.

    Chairman BAKER. I would like to call this hearing to order.

    The focus of our hearing today is to hear the recommendations of the Counterparty Risk Management Policy Group, which is a group consisting of twelve major commercial and investment banks formed in January of this year after the near collapse of Long-Term Capital Management. The ultimate mission was to redevelop standards for strengthening risk management practices at the banks, securities firms and other dealers to avoid similar difficulties in the future. I understand the recommendations were publicly released on Monday, June 21, and we are here this morning to review those findings and recommendations.
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    I am particularly pleased this morning to have two individuals representing the significant principals in the group who co-chaired the group, Mr. Gerald Corrigan, who is Managing Director of the Goldman Sachs Corporation, and Mr. Stephen Thieke, who is the Managing Director with J.P. Morgan & Company.

    At the appropriate time I will recognize each gentleman for their remarks. I would like to first ask Members if they have any opening statements that they would like to make at this time.

    Mrs. Roukema.

    Mrs. ROUKEMA. Thank you, Mr. Chairman. I appreciate your holding these hearings. In fact, we have combined a number of hearings on this issue, your subcommittee as well as mine, and I am most appreciative of it. It is absolutely essential that we get on with this issue. By the way, Mr. Chairman, as normal procedure, I do want the full text of my opening statement included, but I will shorten it to make a couple of observations. So often we here in Congress, not you and I, you understand, have a short attention span. We immediately have lots of hearings and discussions on major issues, and then never follow through on some of the reforms.

    I am hopeful that we are going to really learn something substantive that can be applied to avoid another Long-Term Capital Management problem. That problem was clearly a wake-up call for us. I am very aware through our other hearings—which examined all parts of the LTCM issues—that we cannot have a knee-jerk reaction. There are, however, some substantive things that can be done on this issue because we are talking about systemic risk, and safety and soundness. That is really what we are talking about from our legislative point of view. But the fact is that many have alerted us to the potential problem of forcing these hedge funds overseas and offshore. We have that concern as well. So it is important for Congress to not have a knee-jerk reaction.
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    However, I don't want to be sitting here, as I know you do not want, Mr. Chairman, without taking a legitimate and prudent action from our point of view, based on all of the best minds that have appeared before us. We have here today representatives of the Counterparty Risk Management Policy Group. We are going to be hearing from the private sector. I know that they will address the concerns that we have raised. We have heard all kinds of recommendations about what regulators should be doing, but I want to also hear how the private sector views its role in relation to the regulators. I must say that there is a part of me that is somewhat skeptical about the concerns of pushing these firms offshore.

    I don't think that the fear of forcing hedge funds offshore should prohibit us from addressing the legitimate safety and soundness risks that are obvious from the Long-Term Capital Management problem. We couldn't have two better representatives of the private sector than we have here today. I thank you for your leadership on this.

    Chairman BAKER. Thank you very much, Chairwoman Roukema. I certainly do appreciate your continuing significant interest in this whole matter and the cooperative work that we have been able to do so far has been very productive.

    Mr. Kanjorski.

    Mr. KANJORSKI. Thank you very much, Mr. Chairman. I want to congratulate you for calling this hearing today. Certainly, the systemic risk that Mrs. Roukema discussed is something that is important to our economy, the subcommittee, the Congress, and most of all, to the American people.
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    Perhaps we are all suffering from compression. In the computer age, things are happening so quickly that the limitations of time distort models that have been drafted over normal past practices. Today, with computers, the Web, and the Internet, we have factors that cause ripples, explosions, and sometimes nuclear events in the economy of the world. Perhaps we are ill-prepared, not only for the prevention of these aberrations, but even to understand them.

    So, I look forward to the testimony of the witnesses today. Hopefully, it will help us determine what we can do to lessen the economic exposure to the economy as a whole through hedge funds that may or may not be mismanaged, may or may not be overleveraged, and may or may not be in need of some regulation or disclosure. Certainly the reports indicate that there are things that we can do that would encourage the stability of the market and that is what we are all about.

    Thank you, Mr. Chairman.

    Chairman BAKER. Thank you, Mr. Kanjorski.

    Mr. Toomey, did you have a statement?

    Mr. TOOMEY. Thank you, Mr. Chairman. Just very briefly, I would commend you for holding this hearing and I also would say that I am very much looking forward to the recommendations that these gentlemen will discuss today. It is my hope that these recommendations will not only help to avert a potential crisis down the road, but also help to avoid the creation of any unnecessary or perhaps even counterproductive new regulations. I look forward to hearing what you have to say.
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    Chairman BAKER. Thank you very much, Mr. Toomey.

    Our first witness this morning will be Mr. Gerald Corrigan. Welcome.


    Mr. CORRIGAN. Thank you, very much, Mr. Chairman. And let me join your colleagues in congratulating you for having this timely hearing. The report was just issued this past Monday.

    In the interest of time, Mr. Chairman, I will make a few broad introductory remarks and then my colleague, Mr. Thieke, will talk more specifically about the report itself. I will conclude with a couple of remarks, and then we will look forward to answering your questions and receiving your comments.

    It goes without saying, Mr. Chairman, that we welcome the opportunity to again appear before the subcommittee on this occasion to discuss with you the recently completed and issued report of our group. You will recall, I am sure, and I think you just paraphrased this yourself, that we appeared before your subcommittee on March 3 of this year. We said that the objective of our study group was to develop flexible standards for strengthening risk management practices at banks, securities firms, and other major market players. We believe that our report meets and indeed exceeds that objective that we stated back in March.
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    Certainly as you will hear, the scope of the recommendations in the specific area of risk management are powerful in their own right, but in addition and beyond those areas, the report also includes a series of recommendations for strengthened market practices and conventions in such areas as documentation, netting procedures, and closeout procedures.

    In addition, it proposes a voluntary framework for enhanced reporting to authorities of both qualitative and quantitative information. We also believe, Mr. Chairman, that the report represents a powerful illustration of the constructive role that the private sector can play in helping to better ensure that the universal goals of greater efficiency and greater stability in financial markets and financial institutions can be achieved.

    As I said before, Mr. Thieke will go into a little bit of the philosophy and the content of the report in a few minutes. Let me just make four quick general observations about the report.

    First, the three key individual words which I think describe the report fairly aptly are ''comprehensive,'' which I think it surely is, ''integrated,'' which it surely is, and ''rigorous.''

    With regard to the term ''rigorous,'' some who have read the report from cover to cover, perhaps some of you and your staffs, have described it as dense, and I would be the first to admit, and I think Mr. Thieke would join me in admitting that it is not easy reading, but that is not a flaw of the draftsman, which was Mr. Thieke, to his credit, but is a reflection of the nature of the beast.
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    The second point I would want to emphasize is that the report is very much a report by practitioners for practitioners, but it also serves the universal goals of promoting market discipline and, over time, reducing systemic risk, something you all have mentioned.

    Third, we believe very strongly that the report and its recommendations are very, very much complementary to official efforts here and abroad, including the recently released report of the President's Working Group on Financial Markets.

    Finally, recognizing of course that markets and practices and risk management will continue to evolve at a rapid pace, the report is not the last word on this subject, but it does represent in our view a very giant step in the direction of still stronger risk management practices and stronger market practices and conventions.

    Before turning to Mr. Thieke, let me make one other general observation, Mr. Chairman, about risk management. As I mentioned before, the subject matter is indeed very complex, but the essence of risk management frankly is not all that complex. I have always believed that the essence of risk management reduces fundamentally to getting the right information to the right people at the right time so that the right questions will be asked and the most informed decisions possible will be made.

    Now, since that in our view is the essence of risk management, it should be self-evident that risk management is much, much more an art than it is a science. Indeed, despite all of the models and the mathematics, effective risk management still comes down to informed judgments made by dispassionate, disciplined, and experienced managers and executives. And that is very much the spirit of our report which Mr. Thieke will now speak to in somewhat more detail and I will come back in a moment. Steve.
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    Chairman BAKER. Let me just comment on your observation about the report being somewhat dense. We found a bit of irony, in fact, that a study of transparency turned out to be opaque.

    Mr. Thieke, I welcome your participation here. And I have been informed that there may be a near-term retirement in your plans, and I certainly extend my best in your future endeavors.


    Mr. THIEKE. Thank you, Mr. Chairman. It is a pleasure to be here. My role is to give you a feel for how to understand the framework in which the recommendations are presented in the report, to elaborate briefly on how we view the issue of leverage which many have suggested is central to the issues raised in the marketplace last year, and then offer some observations about how implementation might be approached both by participants in the marketplace as well as others.

    The report does provide a very comprehensive set of no fewer than twenty specific recommendations and many which have multiple sub-parts to them. They should be viewed in their totality as representing an integrated framework, rather than a series of stand-alone initiatives. As we highlight on page 3 of the summary of the report, the twenty specific recommendations should, we believe, be viewed as linked together around six key interconnected building blocks, and I think it is worth taking a minute to highlight those building blocks.
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    The first is a framework for enhanced private information sharing among counterparties, including arrangements to preserve the confidentiality of that information.

    The second is an integrated analytical framework for evaluating the effects of leverage on market and liquidity risk.

    The third is a series of steps to improve counterparty credit risk estimation techniques.

    The fourth is a set of strong emerging credit risk management practices which are focused on improving limit setting, collateral margin practices, exposure of management and valuation techniques.

    The fifth is a set of proposals for improving internal risk transparency both for the senior management and boards of directors of firms in the marketplace, as well as for the regulators.

    The last is a comprehensive set of proposals for stronger and more harmonized market conventions or contract closeout valuation practices and other key credit documentation provisions.

    Now, we believe in isolation no one or even a few of the recommendations would be sufficient to bring about the desired degree of strengthening of risk management practices. But taken together, we believe that they address the full spectrum of issues and challenges which the events in the markets last year presented. For example, the improved information sharing will facilitate the application of the more comprehensive, analytical framework we are suggesting for evaluating the effects of leverage. That analysis in turn will highlight ways to improve credit risk estimation techniques, with particular focus on the impact that sudden market liquidations can have on your exposure. That in turn will feed into a much more robust approach for margin and credit limit risk setting within individual institutions. It will also provide the basis for greatly improved internal analyses of concentrations of risk and for highlighting those risks appropriately at senior levels in the firm.
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    Finally, we address the importance of ensuring that the markets have contract closeout arrangements which are capable of producing commercially reasonable valuations even in distressed market conditions, valuations in which the providers would have a high degree of legal certainty. Before commenting on implementation, let me elaborate briefly on how we approach the issue of how people should understand and evaluate leverage, since many have concluded that that was the central issue raised by events last year.

    In short, we believe it is much more useful to focus on the effects of leverage in terms of its potential impact on market risk, on funding liquidity risk, and on asset liquidity risk, rather than to dwell on imperfect and often misleading measures of leverage, particularly when viewed in isolation. There are at least three distinct aspects to leverage.

    One is a notional or balance sheet aspect when assets are funded by third-party liabilities.

    The second is a market-dependent cash flow aspect. For example, when an asset holder is exposed to loss in excess of their initial cash investment, typically taking the form of the purchase of securities or derivatives based upon initial margin.

    The third may be thought of as a market risk aspect when an asset has exposure to market volatility in excess of the volatility of the market as a whole. For example, when buying an asset in the form of a structured or leveraged note or other instrument with embedded leverage.

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    Now, no single definition of leverage can capture all of these aspects of leverage, and simplistic balance sheet measures or more complete measures that include off-balance sheet instruments say very little, if anything, about the three elements of risk which really matter. And that is the degree of market risk, the degree of asset liquidity risk, and the degree of funding liquidity risk.

    However, by developing and applying an integrated framework analyzing the effect of leverage upon these elements of risk, we believe it is possible to reach well-informed judgments about whether the degree of leverage being employed is prudently managed, and that we believe is a central message of our report.

    Before turning it back to Jerry, let me offer four brief observations on implementation. First, many of the 20 specific recommendations build on strong practice changes already being initiated by leading firms in the market, and to that extent I think you can say that implementation efforts are in fact already well underway.

    Second, a number of the recommendations represent new ideas for further practice enhancements which grew directly out of the creative interaction of the many skilled professionals who participated in our various working groups. It is wise to keep in mind that conceptualization of change is easier than implementation, especially when the changes require internal systems changes which need to be balanced against Y2K and other internal resource needs.

    Third, many of the documentation practice changes that we have recommended will require a concerted and cooperative follow-up effort on the part of a number of key industry trade associations. That effort will take time, but we believe it is very important that it begin immediately.
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    And lastly, the recommendations designed to improve information availability for the regulators will obviously require their review and evaluation. Those recommendations, as Jerry mentioned, contain two important elements. First, there are opportunities for improving the qualitative exchange of information on risk developments and market practices. And second, a set of voluntary large counterparty exposure reports which would cover four comprehensive interrelated dimensions of exposure. These reports, we believe, should be based on the improved internal senior management reporting which we are recommending. They should be provided by firms through a single regulator on a consolidated group basis. They should be viewed as a starting point for discussion rather than the last word on the firm's counterparty risk profile, and they should provide scope for contextual information to limit the potential for misinterpretation. The firms in the policy group are keen to work with the regulators on these ideas as well as other proposals that have been advanced related to public disclosure.

    In closing let me emphasize, decisions on whether and how to implement these recommendations are best made by the senior management of individual firms in the context of their own evolving risk management practices and policies. While we welcome positive support from the regulators for our recommendations, we would hope that they would also take a flexible approach in their evaluations.

    Thank you, Mr. Chairman.

    Mr. CORRIGAN. Let me conclude, Mr. Chairman, by proposing, if I may, and answering three questions which I think go to the heart of some of the issues that we have dealt with and some that have been mentioned by you and your colleagues.
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    The first question is: will the full implementation of the report's recommendations ensure that we will not encounter serious bouts of financial instability in the future? The answer to that question, in our judgment, is that obviously there can be no such assurances. However, we strongly believe that the full implementation of the recommendations will work in the direction of reducing the likelihood of such events and, as importantly, making such events easier to manage and deal with when they occur.

    The second question is, had all of the recommendations been in place last year, would the trauma associated with Long-Term Capital have been avoided?

    Our answer to that question is that while it is difficult to be definitive on that question, we are highly confident in saying that it is very unlikely that the Long-Term Capital situation would have ever reached the proportions that it did, were all of these recommendations in place well in advance of last August and September.

    But having said that, I want to emphasize that it is important for all of us to understand and appreciate that the global financial markets would have experienced considerable stress and volatility last year even if Long-Term Capital never existed, and that point of perspective I think is important.

    Finally, the third question is whether the report is merely an exercise in fighting the last war. Our answer to that question is absolutely not. As we see it, the thrust of the report in its framework, its analytics, and its recommendations are distinctly forward-looking in nature and are designed to provide enhancements in risk management and related practices that will indeed work to strengthen the very fabric of financial institutions and financial markets.
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    In closing, Mr. Chairman, we would be remiss if we did not acknowledge in your presence the extraordinary cooperation and extraordinary effort that we received from all twelve of the institutions and from a number of other institutions we brought into our various working groups in making this comprehensive and, yes, admittedly dense report available to you in the very short time that has elapsed since we commenced this effort late in January.

    Thank you, Mr. Chairman.

    Chairman BAKER. Thank you, gentlemen. We certainly appreciate your willingness to be here to give us your perspective to the subcommittee this morning. I certainly agree and concur, Mr. Corrigan, that if all of the recommended procedures had been properly implemented, that damage control would have been much more easy to implement.

    One of the concerns that I think needs to be raised, however, is that all of these recommendations are certainly voluntary, based upon senior management judgment. I have no doubt that the twelve affected institutions having come near, let's simply say, an impressionable circumstance, would be likely to walk away from the situation, even shareholder liability.

    What I am concerned about is the broader market and these are voluntary. There does already appear in the national media—I have been given an article that was printed June 18 by Reuters relative to the Bank of England's concern that there is evidence that hedge fund activity in global markets is showing a renewed interest in willingness of banks to extend credit to highly leveraged speculators. This is not something that we are making up. It appears that the lessons of last fall are already beginning to dim somewhat in importance.
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    How do you respond to the point that if the recommendations are sound, that they should be more than just simply a voluntary framework?

    Mr. CORRIGAN. Let me take that at several levels and Mr. Thieke, I am sure, will add to what I have to say.

    First of all, obviously I believe—and I think we all believe—that whatever the risks of a dimming of memories might have been or might be, I think the mere presence of this report kind of works the other way, because while there may be some who may differ with this recommendation or these tools or those analytics, I don't think anybody can seriously question the proposition that this is sweeping and tough. I think that helps a little bit.

    The second point that I would make is that obviously it is not for us to say the extent to which these standards and practices should be applied more broadly. All we can say, and we can speak for our colleagues and the other firms as well, is that all of us will undertake a rigorous effort to implement these recommendations within our respective institutions. Again, I think that itself works in the right direction because while the twelve of us hardly comprise the world, we are not incidental institutions as a group.

    As to your third comment regarding the Bank of England, I am not familiar with that specific comment. One thing I would say is that I don't think from what I can tell that the extent of leverage and markets in general is anything like it was late last summer and last fall, but that is not to say that it may not have come back from the extraordinary low levels of activity that characterized the last two or three months of last year and perhaps even the first month or two of this year.
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    Steve, if you have any comments.

    Mr. THIEKE. I do think that there was such an extreme contraction of credit availability, not only to the investor community but to other segments of the market in the immediate aftermath of events last year, that some increase from that level is probably to be expected and could certainly be within the bounds of being prudent.

    Second, it is as important to understand what the terms and conditions are for which credit is made available and not simply the amount of credit available. So what is important is whether credit is being offered on terms which represent more prudent credit evaluations, more prudent limit setting practices and more prudent collateral and margin setting considerations.

    Certainly the Bank of England's observations need to be taken to heart by market participants. While we have stressed the importance of these recommendations being viewed as voluntary, and we have emphasized the importance of the regulators being flexible, we are not at all naive about the fact that most of the institutions in question are in fact supervised and regulated institutions, and it is entirely appropriate for their supervisors to make evaluations of how they have reviewed and changed their own practices in light of their experience of last year, including their evaluation of the recommendations from this group.

    Chairman BAKER. My last question, or other large principal concern, is the distinct differences between the President's Working Group's recommendations and your recommendations.
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    The two principal ones I think of obvious significance are the Working Group recommended a quarterly disclosure of financial statements. You did not take that position.

    Second, that all public companies, including the hedge funds, should publicly disclose their direct material financial exposures to significantly leveraged institutions. Also a step that you did not recommend.

    Can you address those two discrepancies between yours and the Working Group's?

    Mr. CORRIGAN. We will reverse the batting order.

    Mr. THIEKE. First, Mr. Chairman, what we are focusing on particularly is how to improve the exchange of information on a private basis. Which is not to preclude the possibility of additional public disclosure, but I think it is important to stress that when credit is made available in private markets, and by that I mean other than in the form of publicly traded securities, a credit provider is not limited only to information that is publicly disclosed, but can in fact have arrangements with the user for an exchange of a much more detailed set of information on a much more systematic and regular basis than what would be associated with public disclosure.

    What we are suggesting is that particularly for evaluating this type of credit, you would not want to limit yourself just to access to information through publicly disclosed channels, even if those channels were enhanced. So in that sense, I don't think that we are in conflict with the recommendations of the Working Group, but I think we are more complementary in focusing on where greater levels of information availability can be made to the credit providers insofar as there can be assurances that that information would be treated with appropriate levels of confidentiality within the receiving organization.
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    Mr. CORRIGAN. The only thing I would add, Mr. Chairman, I think we have made it clear that we are prepared to try to work with the regulatory community to sort our way through some of these issues. I would just make the observation that if you take, for example, the large exposure report that we have suggested as part of this voluntary framework of enhanced reporting to regulators, in putting together this report we had a collection of some of the best and the most experienced people you can find, trying to sort our way through a sensible approach to that framework of enhanced reporting.

    And without being at all defensive or without being at all unwilling to try to find the right way to do this, we found it very difficult to get it right, which is just another way of saying this is not as easy as it looks in terms of the conceptualization of appropriate frameworks necessary to achieve high standards in regulatory reporting.

    So I would not confuse our effective silence, not quite effective silence on that issue, again as Mr. Thieke said, as an indication we do not think that it is important, but we do think that it is very difficult, though we are more than prepared to work with the appropriate authorities to help sort our way through it.

    Chairman BAKER. If I can restate the position, make sure that I am properly understanding it, your recommendations are more aimed toward internal risk management purposes on a day-to-day investment basis.

    Mr. CORRIGAN. That is correct.

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    Chairman BAKER. As opposed to a regulatory oversight which may be more generic, broad-based data that gives regulators broad market perspectives as opposed to insight into individual investment strategies? And you do not necessarily see the Working Group's recommendations as counterproductive or necessarily even in contrast with yours; they raise points which need to be further examined?

    Mr. CORRIGAN. I think that is fair.

    Mr. THIEKE. That is a fair assessment, Mr. Chairman.

    Chairman BAKER. Thank you very much.

    Mr. Kanjorski.

    Mr. KANJORSKI. Relative to last summer, what significant change do you see? Is there as much risk occurring today as occurred last summer or is it significantly less?

    Mr. CORRIGAN. I think we both touched on this a bit, and Steve can elaborate perhaps a little further on the point he was making, which I think is very important, and that is it is not just the amount of credit in the system, it is the terms and conditions under which it is being extended.

    But the general answer I would give, recognizing that no one can be 100 percent precise here, would be that looking at the marketplace as a whole, there is less leverage in the system today than there was in the early part of last summer, but more understandably more, and perhaps appropriately more, especially with the comments that Steve will make in a moment, than there was at the depths of the collapse of markets last September and October.
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    We don't want to go back to last May or June, but we don't want to go back to last September or October either.

    Mr. THIEKE. I would generally agree. I think overall the markets are better balanced now than they were in the period leading into the crisis events; and further that the terms and conditions on which credit is made available I think are also more balanced relative to issues of risk and availability. That is to some extent reflected in the fact that credit spreads generally, while they have come in from the crisis levels, and gladly so, have not reached the levels that were perhaps excessively tight levels that characterized market conditions before the turmoil in late summer, early fall.

    It is, I think, a little bit dangerous to make overly general observations about the level of risk and asset valuations across all asset classes in all markets around the world and some of us still marvel at some of the heights that have been reached in some of those markets, so I would not want to suggest that we are operating in a riskless system, but I do think that overall the system is in better balance at this stage, particularly as it relates to credit-sensitive decisions.

    Mr. KANJORSKI. It seems to me that hedge funds are truly the closest thing to pure capitalism that we can get. I am not sure that the Congress has an interest in restricting people from investing their own capital. I think we only come into this situation on the credit side, particularly if the institutions which are providing that credit are federally-insured.

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    The impression that I got from the disaster of last summer was that there was, at least, the appearance of a conflict of interest. When you looked at all of the parties and where the funds were being put together, they were ultimately drawing on a large part of the insured funds of institutions. I cannot see how that will not continue to happen unless we find a way to separate where the credit comes from.

    I am not certain why we should have direct credit to hedge funds from insured institutions. If individuals want to participate and be players or if they want to individually provide the assets to support a line of credit for themselves and then take those funds and apply them to hedge funds, I think that is a reasonable thing to do.

    But how do we justify, one, using insured institutions' funds for credit to these risk areas? And, two, how do we avoid the misuse of information that flows between newly-allied institutions? Obviously, some institutions are able to find out what the hedge fund is doing and play a side game, if you will, getting information that may cause them to change their credit to institutions that they have invested with. I am not sure that we should not look at it, back off, and say, ''Let it be a private market operation.'' No insured institutions can provide that credit.

    If Goldman Sachs wants to put up its assets to be a player, that is OK. I do not think that we should even be having a hearing on that. Our primary interest is to protect the full faith and credit of the Government in bailing out the systems and protecting insured institutions. Then, the unholy alliance that may occur may be addressed. It seems to me that credit was extended by very large institutions into this one fund, and that most corporations and medium-sized businesses could never have had that amount of credit extended to them at those positive rates except for the fact that there was some simpatico going on between the determiners of the lendability and the credit requesters. That is what frightens me. It makes it look like this is really an inside operation: A limited number of people and organizations got together and found a way to use insured funds to be rather speculative. It is no different than extending favorable loans to average citizens so that they may go to Las Vegas or Atlantic City. We know that would not happen.
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    Mr. THIEKE. First, I don't believe that one should regard all leveraged investors as posing equal risk. There are varying degrees of risk associated with the different strategies which hopefully are reflected in the individual evaluations. Nor do I think you want to presume that they as a group pose inherently different or unacceptable risks than other customers of financial institutions, be they corporations or others that might also be evaluated from a credit perspective as below investment grade, which is certainly the general credit evaluation associated with leveraged investors. Certainly in the past, Congress has been reluctant to prescribe what purposes would be considered appropriate and inappropriate in terms of the provision of credit by financial institutions and has tended to prefer the approach of supervision of those institutions to determine whether the credit is being extended on prudent terms and is being properly managed, because you can be much more sensitive to that.

    Lastly, given how financial institutions in the marketplace are becoming increasingly more integrated, distinctions between institutions that have a bank, perhaps with other activities alongside it and institutions that have a broker-dealer with other activities alongside it, are increasingly less helpful in terms of drawing these distinctions, and I don't think it would be a particularly useful debate to get into whether customers of a major broker-dealer are any less sensitive to the risk of that broker-dealer providing financing to a leveraged investor than would customers of a bank be relative to that bank.

    Mr. KANJORSKI. No, they are incurred. I am talking about the Government.

    Mr. THIEKE. But there are also insurance arrangements associated with the broker-dealer community as well. And there is ample evidence of the public sector being concerned about their health and vitality of large broker-dealers.
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    Mr. KANJORSKI. But that is private insurance. We are talking about allowing these institutions to make incredibly large-sized loans. If they fail, it is the people who pick up the loss.

    Mr. THIEKE. Even in the case of Long-Term Capital where the risk appeared oversized in the extreme, very few if any of the financial institutions, banks or broker-dealers which were creditors of that institution would have had their viability seriously at risk as a result of even a disorderly liquidation of that fund. That was not an event that we wanted to encourage, but I think you were dealing with institutions that were well within their capacity to absorb that risk. I think there are a lot of safeguards that you can employ short of banning the availability of credit from certain financial institutions to certain customers to address the concerns that were raised by your questions.

    Chairman BAKER. Thank you, Mr. Kanjorski.

    Mr. Toomey.

    Mr. TOOMEY. Thank you, Mr. Chairman.

    Gentlemen, virtually every major, certainly global financial institution engages on their trading floors in the very same kind of strategies that Long-Term Capital engaged in. They have sophisticated arbitrage trading operations. They have a very extensive understanding of leverage and liquidity, the various kinds of market risks. They are aware that stress tests and various scenarios have to be routinely run in order to quantify their risks.
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    Given that is an institutional knowledge on the trading floor, are you surprised that that knowledge somehow at these institutions seems to have not made it to the credit decision floor, as evidenced by the fact that you are recommending a more extensive rigorous risk management system? Why would that knowledge not permeate the institution and provide for a system of risk management that wouldn't require these recommendations?

    Mr. CORRIGAN. Let me take a stab at that for starters.

    Again, I think there are several dimensions to the situation and your question. It is true for starters that we must appreciate and recognize that market practices and therefore risk management and all of the things that go with it are in a constant state of change and evolution, and we must also recognize that the character of particularly global financial markets are also in a very rapid state of change and evolution.

    So that risk management practices and, for that matter, supervisory practices as well, are continually in the mode of keeping pace with this rapidly changing environment.

    I think it is true, to respond directly to your question, that there probably was a more or less accepted view that the precise combination of events that took place last summer and last fall was so far out of the range of expectations that it wasn't something that perhaps got the amount of attention in advance that it should have.

    Were that the case, I don't think that we would have twenty or more recommendations aimed at that type of situation. But having said that, I think you also have to recognize that the world as it pertains to risk management wasn't standing still and still isn't standing still. I think also, and perhaps most importantly, that the totality of the recommendations that are contained in our report really do go a considerable distance, not eliminating, but reducing the risk that even these very, very severe outlier situations will occur and, if they do occur, as I said earlier, toward helping us to manage them better.
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    But I think you have to look at those issues in that broad context. Again, no one would deny that there were aspects of the situation which frankly did catch people off-guard.

    Mr. THIEKE. I would add two observations. One, skill integration across different disciplines in a multifaceted organization is not as simple to achieve as in principle it ought to be. And that is particularly so in a world where because of the increased complexity of markets and instruments, there is greater emphasis on the start on specialization rather than generalization.

    Second, the so-called arbitrage risk-takers that you referred to in the market areas of these firms, did not presume that they were all-knowing and all-anticipatory of these events. They were as much taken by surprise in terms of the impact that these events had on their own positions as were their colleagues in the credit areas. So they too learned some lessons.

    I think your question is a good one, and that the nature of the changes that we are seeing in markets increasingly require an appreciation of the integration between market and credit risk and the need to bring what were historically two separate disciplines within the firm together so you can have a cohesive view of the risk.

    Mr. TOOMEY. Having traded derivatives during much of the 1980's, we had an understanding of these kinds of risks, and whether we quantified them adequately and took the necessary precautions was another matter, but there certainly was an understanding that they were out there, and that was quite some time ago. So it just surprises me a little bit that perhaps integration of that knowledge and skill didn't make it to the credit departments as well as it should have.
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    On a separate note, is there any effort underway to get financial institutions to publicly pledge to adopt the recommendations to provide some pressure for voluntary compliance with this so the world knows who is in compliance and who is not without requiring regulatory mandates?

    Mr. CORRIGAN. As I said before, Congressman, the twelve firms that make up the policy group in effect have all committed to precisely what you are suggesting.

    There is no formal mechanism that I know of, certainly at this early date, to try to achieve that broader sense of purpose and commitment. As I said earlier, obviously there is only so much that we can do to produce that result.

    Chairman BAKER. Thank you, Mr. Toomey.

    Mr. Bentsen.

    Mr. BENTSEN. Thank you, Mr. Chairman.

    The President's Working Group on this issue testified last month, I think it was, before the committee, before another subcommittee. In their proposal, they broadly outlined a proposal requiring enhanced documentation to the extent of quarterly public reports. I would assume that this group is opposed to that requirement?

    Mr. THIEKE. Congressman, I think what we were suggesting in the conclusion of our report is that the issues associated with how to frame public disclosure proposals in this area are very complex. We in fact confronted that complexity when trying to organize proposals for voluntary private regulatory reporting. And as generally set out in the President's Working Group Report, in terms of the desire to see more disclosure, there would be, I think, a lot to be said for some very informal and extensive cooperation and coordination between private market practitioners who understand the complexity of what might be behind the information that is being proposed to be disclosed, and those in the public sector who are developing further some of the ideas behind the general proposals in the Working Group report.
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    We also want to stress that there are limits to what you can accomplish with public disclosure because of the less frequent nature of it, and, by definition, the higher level of aggregation of information, and that we should not be reliant only on public disclosure to improve information availability leading to better informed credit decisions.

    Mr. BENTSEN. The way that I read the summaries of your report, there is a great deal of internal disclosure, standardization of documentation, enhanced standardization of documentation, I guess, and I to some extent agree with you on the idea of this quarterly public disclosure. In fact, I was looking over the transcript from the previous hearing and I still think that certain members of that other panel were on the verge of proposing registration or something getting close to registration. In fact, I think the outgoing chair of the CFTC sort of danced around that issue.

    But I am wondering whether or not you all in your report in your committee propose a number of new standards, what would be new industry standards. The President's Working Group proposes a number of new standards, some which would require legislation, some which could be done through the regulatory structure, and some of which would just be industry agreements.

    And I am wondering, and I would like to have your comment, as to whether or not we are moving toward the situation where we may want to take ISDA or some like entity and establish another MSRB and self-regulatory body with congressional approval, rather than move all of the way toward some registration and greater regulatory oversight?

    Mr. CORRIGAN. Let me take an initial stab at that.
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    We have tried to make it clear both in our report and in our comments before your subcommittee here this morning that we do very much want to be able to work with the official community in trying to find mutually acceptable and sensible ways to deal with these issues, both as they pertain to regulatory reporting in particular, but also to the public disclosure question.

    Frankly, I believe that there is a real opportunity here to do just that, in part because I think the work that we have done in this report can be characterized in many respects as groundbreaking. This is not a report that is at the height of 50,000 feet, this is right down there on the battlefields, so to speak.

    Now, that said, and again just to pick up on one of your specific points about ISDA, again we make it clear in the report and in Mr. Thieke's opening comments this morning that we feel very strongly that there is a need for concerted action involving organizations like ISDA and others to get on with this task of enhancing and altering and changing and standardizing many of these so-called standards for industry practice in regard to critical issues such as closeout proceedings. And I am hopeful that that is going to happen in any event, even though I want to emphasize that is not an easy task.

    But I also want to say something on this disclosure question, and I probably will regret saying it, but I am going to say it anyway, and that is we have to be balanced about disclosure. There is no question that greater disclosure and greater transparency are good things. No one can dispute that.

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    But I think, frankly, there is a little danger that taken to the extreme, disclosure and transparency may promise more than they can deliver. I think there is, therefore, a subtle danger in suggesting that if we only fix those specific problems, the world is going to be safe again. I don't think that is proper. Again, I will ask Mr. Thieke to comment on that.

    One of the strengths, I believe, of our report is the fact that it is an integrated package. It doesn't look at just one or two of these pieces, it looks at a whole family of them. It is the framework, the building blocks that Mr. Thieke was talking about, and I think that is the way to go.

    Mr. THIEKE. Mr. Congressman, some forms of regulation are directed at financial institutions. For example, regulations that are directed at trying to protect safety and soundness or to help protect the interest of small depositors and other creditors who might not otherwise be able to protect their own interests.

    Other forms of financial regulation are directed at markets, typically to protect the interests of investors and other participants. Very few forms of regulation are directed literally at instruments. There are some examples, for example margin loans; they tend to be the most micro-forms of regulation.

    And before you would jump to the most micro-form of regulation, should you have a form of regulation or self-regulation—you used the term ISDA, which is the International Swap Dealers Association—over the activities in the swap markets, you want to ask yourself first whether in their existing forms the institutions and markets are capable of providing the level of protection from a public policy perspective that is appropriate. Whether it is then a form of self-regulation or formal regulation, it still ultimately is regulation. The self-regulators are hopefully more knowledgeable and responsive than the regulators who do not employ self-regulatory techniques, but it ultimately rests on a statutory basis for formal regulation.
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    Mr. BENTSEN. Just to clarify this point, with the Chairman's indulgence, I understand the point you are making, and what I am saying is that rather than end up with more regulation than you want, which could constrict the market in the derivatives market, at some point it might be worthwhile to consider a more formalized self-regulatory structure. We have done that; our predecessors have done that in the municipal securities market, for instance, which dealt with an individual type of security, although I would assume the intent was not the security itself, but was the market that is affected by the security, both the providers and the users or investors in that market.

    I think the same is true here. We are not so much concerned about the instrument itself as we are the impact on safety and soundness, and the Treasury as it relates to that as well, as the impact on shareholders of the institutions who are engaged in this activity and ultimately can be harmed as well as the end users of this.

    So my point is to say ISDA, I think and your group, I think, is doing good work on this, and I have tried to take a very cautious approach to this for lack of understanding if nothing else, but in making sure that we don't overregulate and snuff out a market that otherwise I think is very beneficial. But I think it is something that the industry ought to think about. I am not concerned that the Goldmans or the J.P.s are not going to follow this, I feel pretty confident that they will. You all know, and Mr. Corrigan knows from his prior experience, that while the big boys can occasionally err and get in trouble, the fringe players of the market can also be problematic, and not everybody always plays by the same rules or the gentleman's agreements that are out there.

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    Thank you, Mr. Chairman.

    Chairman BAKER. Thank you.

    Mrs. Roukema.

    Mrs. ROUKEMA. Thank you, Mr. Chairman. I am a little at a loss as to how to present my question.

    The Chairman has presented my original question particularly with respect to, as he put it, the voluntary proposals that you have outlined. I thought I was going to understand better your position with your presentation, but I am afraid I didn't do my homework well enough in terms of reading the entirety of the report.

    I will go back to what Mr. Kanjorski asked. You have answered Mr. Bentsen, saying you oppose a self-regulatory body. I am really perplexed, because I thought when Mr. Corrigan started out with enhanced reporting and risk management practices and the essence of risk, that is the right information to the right people at the right time, I thought perhaps we were going to come to some understanding as to how we can have this information for proper regulation without being intrusive. But I don't see anything fitting together here. I really don't. I am very disturbed, because I think if we keep going down this road, we may end up with another taxpayer bailout or a systemic risk problem which is the other side of what Mr. Kanjorski was talking about.

    You addressed the taxpayer risk and the question of insured institutions. There are also potential systemic problems here that will end up with taxpayers or the economy paying for all of this.
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    Now, I don't know how I get to my point, but let me play devil's advocate here.

    I don't believe that the ''you are on your honor'' approach is satisfactory from a policy perspective. Maybe I would agree if I had not lived through the savings and loan debacle, because philosophically I understand what you are getting at. But it certainly seems to me that there are not enough regulatory requirements here. I think you are telling me that the regulators should not be doing any of this. Is that what you are saying?

    And I don't know who this disclosure is going to, the disclosure that you are talking about. And if you say leverage is central, and I guess I am here again referencing some of your testimony, but who should know about the leverage? Shouldn't the regulators know about the amount of leverage and maybe have some statutory authority to intervene if you are not going to have a self-regulatory body?

    Can you clear up a couple of these things, because I don't think that we can keep saying ''none of the above.''

    Mr. CORRIGAN. Let me try, Congresswoman.

    I perceive your frustration, if I may respectfully characterize it.

    Mrs. ROUKEMA. That is correct. I am very frustrated.

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    Mr. CORRIGAN. Part of your frustration stems from the fact that we don't say in point-blank bold terms, and perhaps we should, that we do not believe that further de novo regulation, but especially legislation, is needed in this area. We do recognize on the legislative side that there may be a case to be made in certain technical areas having to do with bankruptcy laws and things like that. But we do not believe, and this may add to your frustrations, we do not believe that additional legislation is needed in this area.

    On the regulation/voluntary question that you and others have raised, as I think we have tried to say, we obviously cannot speak to this issue since we obviously don't have the authority to do so. We do believe, however, that the framework of enhanced communication between these institutions and their primary regulators is an important part of our recommendations. Indeed, I would submit to you that if you look at our recommendations as a whole, you can I believe think of them not as a three-legged stool, but a four-legged table. One of the four legs is this enhanced framework for interaction and reporting with regulators which has both.

    Mrs. ROUKEMA. Excuse me, please, this is an important issue. It sounds as though you would say then that the President's Working Group recommendation for quarterly disclosures and the direct disclosure regarding leveraged institutions, that should not be contradictory. When you answered an earlier question, it sounded as if you were strictly opposed to those recommendations.

    Mr. CORRIGAN. There may be a bit of a problem here with semantics. There are two aspects to this issue. Well, there are three. The first is the one that Mr. Thieke emphasized, and that is the information exchanged between suppliers and users of credit. That, in effect, is the first of our four legs.
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    The fourth leg, the one that I was starting to speak to before, has to do with information that is provided by supervised institutions to their primary regulators. We do, I think, have robust recommendations in the report on that issue. The issue of public disclosure, as distinct from regulatory reporting, is different; and it is true that we are silent on specific recommendations regarding public disclosure, but what we try to do in the report is thrash out the issues that are relevant to what we think are the best ways to approach that question, and we make it, I think, very clear that we are prepared to work with the authorities in that regard.

    So again, we are acknowledging, I think very forcefully and with a robust set of recommendations, that we as supervised and regulated institutions are prepared on a voluntary basis to expand the information that we would provide to our primary regulators. For banks, that would be the Federal Reserve. For we at Goldman Sachs, it would be the SEC. And, of course, we have foreign banks on our group as well, and they would be thinking of this in the context of their primary regulators in the U.K. Or Germany or Switzerland or wherever.

    So again we are not silent on the issue. We are saying in effect that we do not think that legislation is needed, except as I said, possibly in some technical areas having to do with bankruptcy. But we certainly are not saying that there are not opportunities to enhance the interaction between our institutions and the regulatory authorities. Quite to the contrary.

    Mrs. ROUKEMA. You are not saying that?

    Mr. CORRIGAN. No.

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    Mrs. ROUKEMA. We will have to go over that again because that is the heart of my concern.

    Mr. THIEKE. We want to make this as clear as we can. As a general proposition, we think the best way from a public sector point of view to be sensitive to the developments and the risks associated with the activities in the market such as we saw last year, is to use the channels that they already have for regulation and supervision of the main providers of credit to those markets, and with very few exceptions all of those institutions are already regulated and supervised.

    All we are suggesting in terms of these improvements and practices is, first, that the management of the firms should evaluate them and make their own judgments about how best to implement them. To the extent that they are regulated and supervised institutions, we fully anticipate that their regulator and supervisor will take a look at not only whether they have implemented recommendations like this, and if not, why not. But further, whether they are prudently managing what they are doing.

    That is the most productive approach from a regulatory and supervisory standpoint to ensure that you have adequate protections and safeguards.

    Mrs. ROUKEMA. This has been helpful, but I think there is going to be a continuing dialogue here with more specifics.

    Thank you very much, Mr. Chairman.

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    Chairman BAKER. Thank you, Mrs. Roukema.

    Mr. CORRIGAN. I should say, we will be happy for your staff to visit with some of our experts on these questions.

    Chairman BAKER. Thank you very much. We have a couple of Members that had to depart, and so we will go to a second round for a few moments.

    I want to return to the basic subject raised by the Bank of England article, and maybe ask a question to make me feel a little better about your ability to have a handle on market developments.

    Assume for the moment that there is a hedge fund that is unwinding its positions, say, heavily in European fixed incomes, and you don't have direct investment in your portfolio. So therefore you would not have immediate direct information about the liquidation.

    What is it that would enable you to assess the impact of that activity on your own trading positions and to allow you to react properly before there would be significant market deterioration?

    Tell me how the system works. What is it that your report would enable you to do that you could not do if your recommendations were not implemented? In other words, this is just sort of a real fantasy, a real-world example, and I am trying to understand what your recommendations do to help preclude those unexpected losses.

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    Mr. THIEKE. Let me make a start at this, Mr. Chairman, and Jerry might want to add some comments.

    Among the themes that we emphasize in the report is that when thinking about credit exposure that you have, you must think about that not only in terms of the size of the exposure based upon current observed market prices, but also in terms of what could happen to that exposure if there were a sudden large liquidation in the market that were relevant to where your credit exposures were, not just to where your own market risk positions are, and to think about, in systematic terms, what could happen to the size of that exposure.

    In addition, we suggest that when you think about whether you have an undue concentration of risk to a particular development in the markets, you think about that not only in terms of whether that risk would show up in your counterparty credit exposures, but whether it might also show up through your own market risk positions. So that while you cannot anticipate entirely in advance when or where there might be a large liquidation in any given financial asset market, you can anticipate in advance what the impact of that liquidation might be on your risk positions, both credit and market. And we have very specific recommendations in the report on the desirability of doing that kind of analysis for your largest counterparty exposures.

    Chairman BAKER. That is my concern; not so much your own market risk positions, but that of a counterparty who may have a position in the European fixed incomes. But what is their obligation in the current structure to inform you that they may have their financial ability impaired because of their market risk positions? When do you know these things?

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    Mr. THIEKE. Again, in institutional markets there is no specific obligation for one institution to inform another regarding what it is planning to do, obviously. But if you have a credit relationship with that institution, the amount of information that you have available to you to support your credit decisions would include not only information about what particular credit exposures you have to them, but information on the broader risk associated with their activities, so that you can place your risk exposures to them in the broader context of understanding what portfolio of risk they have.

    Now, in order to get that better information from them, you have to provide them with reasonable assurances that you will respect the confidentiality of that information and that you, as a receiver of it, would not allow that information to be misused within your own organization, let alone in the marketplace generally.

    We are suggesting a framework for providing those adequate assurances, one that would reinforce the likelihood that you would have enough information not only to judge your direct exposure to them, but to understand what else they are exposed to as well.

    Chairman BAKER. I just feel that there is a need for more disclosure between participants in the market, which is distinctly different in its scope and purpose than a public disclosure. Public disclosure, in my mind, is far too late to do anything other than to decide how big the train wreck is. The day-to-day risk management information that is proprietary and can be dangerous to a particular institution's success or failure in the market ought to be on a need-to-know, proprietary, nondisclosure basis. But in fairness, that ought to go all of the way up the stream, back to the notification to the regulator, when in the judgment of all of the parties what is about to happen is going to be a bad thing. That is not a fixed target. That does not mean X number of shares or dollars. I don't think that we can even throw that net around it. I think, as Mr. Corrigan said earlier, management of risk is an art, not a science.
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    I don't sense today, if we start with that counterparty who has exposure in the European fixed income, that the obligation to disclose, either to you if they happen to be your counterparty, or further to disclose to that regulator in a timely manner, is an obligation that necessarily carries much weight with it.

    I think your voluntary recommendations go a long way in that direction, but I am not sure that we are quite there. I think that is what many Members of the subcommittee are saying. Try one more time to make us feel more secure that we have done as policymakers all that we can do to avert a repetition of last fall.

    Mr. THIEKE. First, Mr. Chairman, I think your comments properly suggest an appreciation for the hierarchy, if you will, of how information exchanges can help inform better risk decisions. And that is, at the very first level of the hierarchy there are more frequent, more robust, more intense exchanges of information privately between counterparties and credit providers, and that between them the sharing of information can be more frequent, more specific, and more customized.

    The next level of information sharing is digesting that information and reporting the main features to the senior management of the organization itself, so at the top levels they have a better appreciation.

    The next level is better information sharing with the regulators, and the final level is better public disclosure. What we are suggesting are significant steps for enhancing the first three of those levels, which is much more robust, much more frequent, much more useful information sharing within confidentiality parameters, improvements in senior management reporting, and we think significant enhancements to regulatory reporting operating at the first three levels of hierarchy, so to speak, and we simply are observing that there is a lot of complexity associated with the fourth one, which is public disclosure.
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    Chairman BAKER. I think I am getting to this point that I certainly understand internal risk management. Nobody wants to lose money. As business people and as managers of the public trust, we all want to see success. These tools are management tools to help you enhance your probability of making wise investments, and to some extent mitigate loss which is ultimately inevitable. That is still a distinctly different set of parameters than those of us who are sitting on the outside looking in, not speaking to you gentlemen at all, or either institution. But when somebody knew and did not disclose, there is a shareholder liability on your side of the fence, perhaps; but what we are concerned about is if the parties knew and did not let regulators know, and that failure to disclose led to broader market losses, that is a real problem.

    I don't sense that there is a way for us to get a handle on that particular set of circumstances. Professional individuals are going to conduct their activities in an appropriate manner. But, as Mr. Bentsen pointed out earlier, not everybody in the market is going to agree with your perspectives on how to run their business. How do you get to that element without unduly interfering with normal business practice that is being conducted in a responsible fashion?

    Mr. CORRIGAN. Let me first come back a little bit to the interaction, and Mr. Thieke's answer in terms of the hierarchy is a good way to think about it. I would like to emphasize that within that hierarchy, the kinds of things that we are talking about in this report are the tools and the analytics that firms should be using and making the kinds of judgments that you are both talking about. We did not design these things for sunny days. We designed them in a way for stormy days.
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    Just to give you one or two examples, there is a recommendation in the report that says as a general matter when credit is extended to institutions that are heavily dependent upon a portfolio of risky assets, that as a general matter it should always be done with initial margin present.

    To take another example, there is a recommendation and a very detailed discussion in one of the appendices in the report on credit that says, for example, that the day-to-day practice of risk monitoring should be enhanced by bringing into play estimates of liquidation values of positions or hypothetical positions.

    There is a series of recommendations that potentially at least would take what I will call the state-of-the-art of stress testing, including with emphasis on liquidation values, to new heights.

    So it is not as if in this case the second leg of the hierarchy that Steve was talking about is, to come back to my table analogy, it is a robust leg. So I don't think that we want to leave you with the impression that the kind of infrastructure that goes with this package of things that we were suggesting is wimpy. It is not.

    Now, to get to the form of the question that you asked last, we cannot sit here and say to you with a straight face there is never going to be, to use your term, another train wreck.

    We can say to you that we believe that the totality of the things that we are recommending work in the direction of both reducing the frequency of train wrecks and the damage associated with them. It is, however, only a framework, and it is a framework that depends upon four sturdy legs.
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    What we can't do is provide the absolute assurances, to go back to Mr. Bentsen's comment that there is not some fringe player out there somewhere who is going to get messed up, but we can say to you that the framework that we are talking about really does go some very considerable distance in ensuring if that happens, it need not and more likely will not produce the kind of systemic threat that understandably all of you are concerned about.

    So again, there is no perfect way of ensuring that somebody is not going to mess up. We have got this case now which is just totally unrelated, but it is quite sensational, about this fellow that apparently disappeared from his mansion up in Greenwich, Connecticut, and that is not a happy thing. But I cannot prevent that and you can't prevent that. Ultimately what we can do is to try to ensure that the system will not be jeopardized by outliers, and we think that this report goes a considerable distance in that direction.

    Chairman BAKER. Perhaps our questions might engender a little more enthusiasm about voluntary participation.

    Mr. Bentsen, do you have any questions?

    Mr. BENTSEN. Thank you, Mr. Chairman. Just a few questions.

    First of all, I understand your point. And we have also seen some large players every once in awhile get in trouble. I don't want to mention any names, but I think we all know.

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    I am not trying to belittle what your report did. From what I have looked at, and I have not read the report, I have just read a summary of it, but what I have seen, I think you do try to address a number of things. Maybe I am just being the devil's advocate here.

    I also understand that the industry is not out seeking new regulation. That would be counterintuitive of the industry, and I understand that. But there are a couple of things that I raise. One is while you can't guarantee that anybody would not follow the recommendations that are in there, and that is understandable, you also I think would then have no body of law or regulatory law that would apply to those who fail to follow it. You could have, I believe, civil action where shareholders could bring civil action and I am not an attorney, maybe the Government could, but certainly no criminal action that could be brought for failing to meet what are the standards. You could go to build a civil case I think against it.

    The other issue that I want to raise is something that you all should think about, I believe. In the quest to increase—and let me say first-off, I am not endorsing the Administration or the President's Working Group. I think it is the Administration's position on this idea of quarterly reports. I think there are real problems with that and I think there is a lot of information that is unnecessarily disclosed by it. But in internal disclosure of proprietary information amongst dealers, with the understanding that if there is a problem then it is disclosed to regulators, very well could bring up the charge that there is some collusion or some violation of trust within the market. And it might not apply to the question of affecting the safety and soundness of the system as much as the impact on shareholders, because again we must be concerned with a problem in the marketplace and the impact it has on your shareholders, including Goldman Sachs now.

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    And so I think that is something that you all should consider; and something that we have to consider as well, that we create a new trust exemption, or do you set yourself up for a trust violation? Let me ask two other questions.

    One, you don't get into the question of leverage in your report, or you don't get into it by specifically stating what are the accepted rules related to leverage, but do you feel, in your opinion, that you adequately address the potential risk of leverage by increasing the amount of risk, stress test analysis and risk modeling and disclosure to ensure that there is not excess leverage?

    And the second would be your group included primarily the participants in this. There was no one from the rating agency community which is also engaged in this type of activity. Is that something you all considered? Is that something that you would consider in the future? Is it conceivable, does it make sense that perhaps the industry look to bring third parties in to providing analysis to a greater extent than they may already be doing?

    Mr. THIEKE. Congressman, first, regarding potential collusion or violations of trust, we were highly sensitive in doing our work to the fact that, while we are a group of market institutions cooperating to bring forward ideas on how to improve risk management, it would be entirely inappropriate for us to converse with one another on the details of the terms and conditions under which we would offer credit because we thought that was strictly out of bounds.

    Second, we believe that there is a lot of prior experience in the financial community in terms of how to address issues within an organization regarding proper treatment of confidential information and the management of potential conflicts. Those experiences arise not only from the provision of services like brokerage services and futures brokerage services, and prime brokerage services, but also are inherent in both commercial credit relationships and it is inherent in terms of how you conduct your activities as an M&A adviser.
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    What we are saying is that people need to apply those same disciplines in how they manage the information they get as part of improved credit decisionmaking in their dealings with their financial counterparties, and there is no suggestion that that information would be shared with other market participants. Indeed, it is suggested that it is not even shared broadly within the organization itself.

    Mr. BENTSEN. A lot of those rules now related to M&A activity are either regulatory or statutory rules; is that correct?

    Mr. THIEKE. With regard to activities that might lead to public offerings of securities, certainly that is the case. But not all forms of advisory work are targeted toward leading to public offerings of securities or changes of a public nature that would effect securities. But you still have a very strong obligation to preserve and protect the confidentiality of that advisory work. So we are suggesting building on those frameworks which are very sensitive to avoiding both the appearance, as well as any actual misuses of information or conflicts that might arise from the possession of that information.

    And suggested exchanges of information with the regulators are very bilateral; that is to say, between the regulated institution and the regulator and not involving sharing that information with other regulated institutions. So I think we are trying to be extremely sensitive to the points that are behind your earlier observations dealing with how to guard against misuse, mistrust or collusion.

    Mr. CORRIGAN. The second set of your questions, you asked about the possibility of involving what you described as third parties, including rating agencies in the process.
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    First of all, just so we don't lose sight of it, when we put together for purposes of this report the various working groups that did all the hard work, we actually went to great lengths to involve what I think would fit the description of third parties in your question, in that a number of the very, very large hedge funds participated in the working groups, as did a number of legal firms and other financial and financially related institutions.

    In fact, I think we drafted—if my memory is right—ten or twelve institutions whose interests and expertise we thought might contribute in a significant way to our work to participate in the exercise. I might add that they all did so with great enthusiasm and with considerable contribution. So we share that view.

    I would have, I have to confess, a little bit of uneasiness on the rating agency question. That raises some fairly delicate issues. I don't think that I would want to opine upon that one right now.

    Your other comment and question got back to the leverage issue. All I want to say in response to that comment is don't get us wrong. We certainly are not saying that leverage may not be and cannot be very, very, very important. We are saying that you have to look at it in a framework. But just to take things one step further, we are not saying, for example, that minimal capital standards imposed and required by regulatory institutions are a bad idea. Quite to the contrary, I think all of us would say that they are a damn good idea.

    So again, it is a question of balance and perspective, but certainly our report should not be construed as to suggesting that we are even remotely indifferent to the question of leverage.
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    Mr. BENTSEN. You may have misunderstood my question which was: Do you believe that your report, while not specifically stating leverage, encompasses leverage through the modeling and stress tests?

    Mr. CORRIGAN. Absolutely. As a matter of fact, again, back to my earlier comment, this is the densest of the dense, and there is a very, very detailed appendix to the report that I think is a terrific piece of analysis that really gets into how to look at this question in the context of other issues, with particular emphasis on liquidity, not just on the liability side of an institution's balance sheet, but on the asset side as well.

    Going back to an earlier question, we should not forget that one of the points that we made in the statement that we delivered to you back in March was that when we look at these financial surprises, not just last year's, but others we have experienced, there is kind of a common denominator there; and that is, as Mr. Thieke said earlier, that when we get knocked off the tracks, which rarely by the way is an outgrowth of a problem with a single institution, there are three things that seem to happen. The first one is the distinction between credit risk and market risk gets blurred or evaporates, and much of the report is aimed at trying to create a framework and the tools and analysis to better understand that.

    The second thing that happens is once that distinction between credit risk and market risk evaporates, then liquidity dries up. One of the main characteristics, especially of the events of last year, was the extent to which liquidity dried up. It was quite astonishing.

    The third thing that happens is that what once seemed to be very generous elements of margin and collateral all of a sudden are not very generous because asset prices are changing by 10, 15, 20, or 25 percent. It is that dynamic which was not limited to last year, we have seen it on other occasions, and it is in the context of that dynamic that the analysis that is here about how to look at leverage in the context of market risk and liquidity and credit risk I think is so important.
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    Chairman BAKER. Mr. Bentsen, I want to recognize Mrs. Maloney before we go for the vote.

    Mrs. MALONEY. Welcome to two great institutions from the great City and State of New York.

    I would like to comment that there is something terribly wrong with a system where someone can be highly leveraged, take tremendous risks, and when they work out, make great profits; but when they fail, then turn to other fine institutions to basically bail them out. In my own observation, I believe it would have been better if they were not bailed out. It seems to me that a lot of good businesses that were regulated put in a great deal of money, took the pain, and Long-Term Capital basically wasn't hurt that much. I think it is terribly unfair.

    Back to the leverage point, as I understand from your recommendations, you are not requiring them to be mandatory, but to me it seems that stockholders and other individuals would want to know how much a transaction is leveraged. Most transactions and hedge funds are leveraged at 5 to 15 percent, but Long-Term Capital was at 20 or 30 percent.

    And I talked to one banker who told me it was like a race. Long-Term Capital was making so much money you were afraid to ask any questions, you were putting your money in to be part of the game and eventually it all blew up.

    What is wrong with requiring the information, not to regulate or limit what an individual wants to do, but as a stockholder I would want to know, in whatever company or bank, I would like to know what type of risk they are taking, and I think that information should be available to the shareholders. I personally believe that if the investors had to report to their shareholders the degree of risk, they never would have done it. It would have been a built-in deterrent to highly leveraged risky operations.
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    We have been called to a vote. Personally investment banks securities are regulated, investment banks are regulated, and our banks are regulated. And we have the finest banking and financial services industry in the world, and it runs primarily not on capital, but on trust and belief in the institutions, and the regulation is part of the institutions.

    Personally, you are regulated. Why shouldn't these hedge funds be regulated? To the extent that the information at least is shared with the regulators and shared with the stockholders, I think that would be a built-in risk reducer. I would like your comments on that.

    Also, I don't want to get into spilled milk, but would it have been better, yes or no, to just let Long-Term Capital fail?

    Mr. CORRIGAN. I will answer that. In the circumstances that prevailed last September——

    Mrs. MALONEY. Yes or no? I have to go vote.

    Mr. CORRIGAN. In the circumstances that prevailed last September, no.

    Mrs. MALONEY. Pardon me?

    Mr. CORRIGAN. No. Recapitalizing it with private institutions and private money was a better alternative than letting it fail.
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    Mrs. MALONEY. It seemed to me that Goldman took a big hit and Long-Term Capital walked away. That is ancient history.

    On the risk question, how would you answer; requiring disclosure, not regulating it, but disclosure to your shareholders of what type of risk that you are taking with their money?

    Mr. THIEKE. The leverage funds themselves are private investment funds. Their shareholders are, by definition, sophisticated private investors. There is nothing that prevents those investors from expecting, requiring, and perhaps even demanding as a condition for providing the investment, sufficient information for them to judge the riskiness of their investment.

    Mrs. MALONEY. My understanding is that it was not given. The banks that were investing in these hedge funds were not told what the risk factor was.

    Mr. THIEKE. I think you want to distinguish between investors and creditors. As far as the investors in Long-Term Capital were people who put equity into Long-Term Capital, who had their equity wiped out to the extent of preserving, at best, 10 cents on the dollar. The creditors, we have very specific recommendations for the kind of information that they should expect to receive in order to make better informed credit decisions.

    Mrs. MALONEY. Would you mandate it?

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    Mr. THIEKE. What we are suggesting is that as market participants, their own self-interest would be highly consistent with them wanting to have highly informed decisions, and to the extent that they are regulated and supervised, you have a built-in opportunity for the regulator to judge whether they are following those practices in a reasonable and prudent way.

    The only hesitation that we come back to against mandating, we point out in the report, in 1993 when what was then considered a state-of-the-art review of risk management, done by the Group of 30, identified what was then regarded as best practices, and at least five or six of those were shown to be insufficient in the markets of last year. The practice changes are going to be continuous and the only danger in mandating is simply that you lock people in on what was then the best idea, one that may have been overtaken by events and innovations.

    We are not suggesting that there is not a need for constant oversight of this discipline, but we guard against the risk of locking people into what was once thought to be best practice, but is no longer sufficient to keep pace with the innovations that we are constantly and appropriately encouraging in our markets.

    Mrs. MALONEY. You recommend closer relationships between lenders and regulators, yet you do not encourage financial institutions to provide more information to the principal regulator.

    Mr. THIEKE. I am sorry; we do in fact not only suggest, but as institutions we are volunteering to provide what we consider to be better, more frequent information to our regulators.
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    Mrs. MALONEY. But you just want it on a voluntary basis; you do not want it mandated?

    Mr. THIEKE. The regulator is always free to decide that voluntary is not good enough, but we are not in a position to mandate. We are certainly in a position to volunteer.

    Mrs. MALONEY. Do you think that the Government had enough information to avert the Long-Term Capital crisis?

    Mr. CORRIGAN. I think the thrust of our recommendations with regard to large exposure reporting speaks for itself. Probably not. We can't be sure, since we were not there, but it seems to me that the answer to your question is probably not.

    Mrs. MALONEY. What would have happened if we just let them fail? In retrospect, I don't think that it would have had any impact on our markets. The Asian crisis everyone thought was going to hurt the American economy, it was not even a ripple. If we had let them fail, I don't think that it would have had a major impact on our markets, do you?

    Mr. CORRIGAN. Yes, I do. Not only do I think it would have had a major impact on our markets, but I think the damage could have gone beyond markets.

    I, as I think you know, Congresswoman Maloney, have been around a long time, including 25 years in the Federal Reserve, and I have seen a lot. I have pretty thick skin about these types of events and episodes. All I can tell you is that from my personal perspective, the tenor of events as they emerged beginning on the 17th of August of last summer through the early part of October, were as threatening as I have ever seen.
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    And the threat isn't measured simply in terms of a question of whether J.P. Morgan or Goldman Sachs may have lost a lot of money; both of us did anyway. The threat and question is: Is there clear and even remotely present danger that circumstances could begin to unwind upon a large and generalized scale whose spillover effects could begin to affect the real economy?

    Chairman BAKER. Mr. Corrigan, we are down to three or four minutes on the vote.

    Mr. CORRIGAN. I think we were there, is how I would finish.

    Chairman BAKER. I would echo your concerns and say that had there not been a voluntary workout agreement achieved, the potential consequences, I think, were rather significant.

    I do believe that there are other issues that we would like to explore with you. However, given the time of the day, I would suggest that I, as well as other Members, may forward further written inquiry to you for your thoughtful response.

    And I want to say I do appreciate the effort the group has put forward. I think your recommendations are constructive, and I know that the subcommittee will work closely with those knowledgeable individuals to try to even perhaps assist further on the public policy side as well.

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    Thank you for your participation. Our hearing stands adjourned.

    [Whereupon, at 11:55 a.m., the hearing was adjourned.]

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