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Hedge Funds and the Financial Crisis

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Hedge Funds and the Financial Crisis STENOGRAPIIIC MINUTES Unrevised and Unedited Not for Quotation or Duplication HEDGE FUNDS AND THE FINANCIAL MARKET Thursday, November 13, 2008 House of Representatives, Committee on Oversight and Government Reform, V/ashington, D.C. Committee Hearings of the IJ.S. HOUSE OF REPRESENTATIVES OFFICE OF THE CLERK OfIice of Official Reporters HGO318.000 PAGE 1 1 RPTS .JOHNSON 2 DCMN ROSEN 3 HEDGE FUNDS A}TD THE FINA}ICIAL MARKET 4 Thursday, November t3, 2008 5 House of Representatives, 6 Committee orf Oversight and 7 Government Reform, 8 üüashington, D. C. 9 The committee met, pursuant to call, ât 10:06 a.m., in 10 Room 2154, Rayburn House Office Building, Hon. Henry A. 11_ ülaxman [chairman of the commíttee] presiding. 1,2 Present: Representatives ülaxman, Towns, Maloney, 1_3 Cummings, Tierney, Lynch, Yarmuth, Norton, Cooper,. Van L4 Hollen, Sarbanes, Davis of Virginia, Souder, and Issa. 1_5 Staff Present: Phil Barnett, Staff Director and Chief L6 Counsel; Kristin Amerling, General Counsel; Stacia Cardi11e, l7 Counsel; Erik .Jones, Counsel; Theo Chuang, Deputy Chief LB Investigative Counsel; ilohn ü'Ii11iams, Deputy Chief t9 Investigative Counsel; Roger Sherman, Deputy Chief Counsel; 20 Michael- Gordon, Senior Investigative Counsel; Karen HGO3l-8.000 PAGE 23. Lightfoot, Communications Director and Senior Policy Adrrisor; 22 Caren Auchman, Communications Associate; Zhongrui Deng, Chief 23 Information Officer; Mitch Smiley, Staff Assistant; Jennifer 24 Owens, Special- Assistant; Brian Cohen, Senior Investigator 25 and Policy Advisor; Earley Green, Chief Clerk; .fennifer 26 Berenholz, Assistant Clerk; Leneal Scott, Information Systems 27 Manager,' Alvin Banks, Staff Assistant; Lawrence Ha1loran, 28 Minority Staff Director; ,fennifer Safavian, Minority Chief 29 Counsel for Oversight and Investigations; El1en Brown, 30 Minoríty Senior Po1icy Counsel; .fim Moore, Minority Counsel; 3l_ Christopher Bright, Minority Senior Professional Staff 32 Member,' Brien Beattie, Minority Professional Staff Member; 33 Mo11y Boy1, Minority Professional Staff Member; ,John 34 Cuaderes, Minority Senior Investigator and Policy Advisori 35 Adam Fromm, Minority Professional Staff Member; Patrick 36 Lyden, Parliamentarian and Member Services Coordinator; Larry 37 Brady, Minority Senior Investigator and Po1icy Advisor; Brian 38 McNicoll, Minority Communications Director; and ,John Ohly, 39 Minority Staff Assistant. HGO3l_8.000 PAGE 40 Chairman WAXIvIAN. The comrnittee will come to order. The 41, focus of our Committee today is the hedge fund industry. Our 42 four previous hearings have looked at failure. Our first two 43 hearings examined the collapse of Lehman Brothers and AIG. 44 t'le l-earned that these companies took on massive risk. lrlhen 45 the bottom feII out, senior management walked away with 46 mil-lions of do11ars, while shareholders and taxpayers lost 47 billions. Our third hearing focused on the role of the 48 credit rating agencies. At that hearing, wo learned about 49 the colossal fail-ures of these gatekeepers of the financial 50 markets. As one internal document said, rtWe sold our soul to 51_ the devil for revenue. rt 52 At our fourth hearing, we examined the role of financial 53 regulators. Former. Federal Reserve Chairman Alan Greenspan 54 told us that he had identified a flaw in the deregulatory 55 ideology he had championed. Today's hearing has a different 56 focus. The five hedge fund managers who will testify today 57 have had unimagÍnable success in the financial markets. 58 Although there is a variation on how much they made 59 individually, on average our witnesses made over $1 billion a 60 year. That is on average $1 biltion a year. 6t There are two reasons we have invited these hedge fund 62 managers to testify. First, these are sorne of the most 63 successful and knowledgeable investors in our financial- 64 markets. They each have valuable perspectives to share about HGO318.000 65 \^rhat has gone wrong and what steps we need to restore our 66 financial system. second, theír testimony and the testímony 67 of the independent experts on our first panel wil-l- help the 68 committee to examine three important issues. lrrhat role have 69 hedge funds played in our current financial crisis? Do hedge 70 funds pose a systemic risk to our financial system? And what 7t level of government oversight and regulation is appropriate? 72 Currently, hedge funds are virtually unregulated. They 73 are not required to report information on their holdings, 74 their leverage, or their strategies. Regulators aren,t even 75 certain how many hedge funds exist and how much money they 76 control. We do know, however, that hedge funds are growing 77 rapidly and becoming increasingly important players in the 78 financial markets. Over the last decade, their holdings 79 reportedly have increased over five-fold, to more than $2 80 trillion. T¡üe also know that some hedge funds are highly 8l_ leveraged. They invest in assets that are illiquid and 82 difficult to price, and sel-l rapidly. 83 And we know from our hearing into T,ehman and AïG, 84 combining these factors can cause financial institutions to 85 blow up. And we will hear today some experts \^rorry that the 86 failure of large hedge funds could pose a significant 87 systemic risk to our financiar system. I¡tre also know that 88 hedge funds can receive special tax breaks. The fíve B9 witnesses $re wil-l hear from today earned on average of a HGO318.000 PAGE 5' 90 billion dollars last year, yet the tax 1aw allows them to 91, treat the vast majority of their earnings as capital gains. 92 That means that at least some portion of their earnings could 93 be taxed at rates as low as 15 percent. That is a lower tax 94 rate than many school teachers, firefighters, or even 95 plumbers pay. In our prior hearings, w€ have focused on what 96 went wrong in the past. Today's hearing lets us ask what 97 could go wrong in the future so s/e can prevent damage before 98 it occurs. Both types of hearings are essential. I¡le need to 99 understand both what happened and what could happen in order 1_00 to solve the immense economic problems we are facing. l_ 01 I want to thank all of our witnesses for appearing to2 today. some of the witnesses readjusted their schedules to 103 testify. They all responded to our requests for documents. to4 And r appreciate their cooperation, and l-ook forward to their 1-05 testimony. I want to now call on ranking member, Tom Davis 1_06 for an opening statement. to7 . [Prepared statement of Mr. ï¡traxman fo]-lows:l 108 ******** INSERT ]_X ******** HGO3t_8.000 PAGE 109 Mr. DAVIS OF VIRGINfA. Thank you, Mr. Chairman. Thank 110 you for calling the hearing today. Hedge fund losses, and in 1_ t_ 1- some cases, complete liquidations are an effect of the tL2 current financial crisis. rt is untitely they are the cause. 1_1_3 The real origin of this market contraction is the continuing aL4 collapse of the U.S. housing market, triggered and fueled by l_r_5 preposterously 1ax lending standards, loose management, 1_16 aggressive lobbying, and lavish perks, some at the ]-]-7 quasi-governmental giants that dominated the market, Fannie 1_1-8 Mae and Freddie Mac. They helped to create and enhance the 1_l_9 ravenous hunger for mortgage-backed securities, credit L20 default sr^raps, and other highly sophisticated byproducts of t2L the housing boom that drew hedge funds into the abyss. As a t22 result, hedge fund redemptions of stocks and others assets ]-23 will continue to put downward pressure on the market. 1-24 It wasn't supposed to be this way. Billed as purely 1-25 private gambles by sophisticated investors, hedge funds now L26 pose very public peril when the bets go bad. Designed as a 127 strategy to reduce investment risk, hedge funds nor^r compound 128 risk when complex deals start to unravel and throw off 1,29 unintended consequences. Empowered by sophisticated computer 130 models, hedge fund trading was meant to capit a1ize ott, not 13l_ cause, g1obaI market shifts. But noür, due to their size and L32 speed, hedge funds often accelerate wild market fluctuations. 1_3 3 So when these unregulated private funds become a public HGO3l_8 .000 PAGE 434 problem, many see a need for greater transparency in their 1_35 operations and tighter regulation on some hedge fund ]-36 activities. Greater standardization, registration, 1-37 disclosure, and some regulatory limitations could help the 138 industry mature and survive. Remember the automobile started 139 out as a purely private, wholIy unregulated mode of 1,40 transportation. But when widespread use of the new and 1,41, powerful machines began to pose public safety issues, it L42 became necessary to decide as a matter of public policy who t43 r^ras qualified to operate a motor vehicle, how fast they could 1,44 go, where they could go. 145 We seem to be at the same crossroads for hedge funds. r46 Vüith as manyf as 8,000 funds managing up to $1.5 tri11ion, L47 hedge funds are said to accounL -for 20 to 30 percent of 148 trading volume in the United States in U.S. stocks. They may 1,49 handle everf higher levels of transactions involving more 150 specialized instruments, such as convertible bonds and credit 1_51_ derivatíves. ïheir trades can move markets. r52 So this isn't just about sophisticated high stakes 153 investors any more. Institutional funds and public pensions :-54 now have a huge stake in hedge funds' promises of steady 155 above-market returns. That means public employees and middle l_56 income senior citizens, not just Tom lrlolfe's masters of the 1,57 universe, lose money when hedge funds decline or collapse 1_58 altogether.
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