Mr. Chairman, I am most appreciative for this opportunity to express my concerns of potential systemic risk in this hearing. It is clear that others will follow my testimony who are far more competent to discuss in detail areas for the committee to turn its attention. In my humble capacity as Chairman of the Subcommittee on Capital Markets, I have strongly held opinions about three principle activities that I believe warrant some review.
Given these obvious concerns, what are the principle areas in which we should direct our attention? Based on recommendations of the President's Working Group and concerns of the Department of the Treasury, I believe there are three principle areas in which we should explore and if warranted, take legislative action. These areas are: OTC derivatives, hedge funds, and agency securities.
I commend you, Mr. Chairman, for your continuing leadership in all areas of financial reform. On this occasion you have demonstrated leadership with your own legislation, HR 4203, with regard to swaps and OTC derivatives products, with your interest in HR 2924, legislation to enhance transparency of the large, and in some cases highly leveraged, hedge funds, and your cosponsorship of HR 3703 relative to agency debt.
First, what are the public policy concerns relating to systemic risk? Why should we care about counterparty obligations in a transaction involving an Italian currency swap? Or whether some well heeled investor in a fancy hedge fund loses money?
The answer to both of these questions is, in most cases, the Congress should not. Only in relatively rare circumstances, when the result of the potential loss would trigger events far beyond the scope of the multimillionaire's portfolio, should regulators or the Congress take note. When the potential exists for innocent third parties to be impacted by the resulting turmoil that would reach far beyond the principals of the transactionto other lending institutions, or even my mothers pension fundthe picture becomes more serious.
Governor Laurence Meyer, speaking in New York on June 14, 1999, observed, " The growing size and complexity of banking organizations make the supervisor's job of protecting bank safety and soundness increasingly difficult. Size, scope, and complexity simply make it more difficult for supervisors to understand and evaluate bank positions and operations." If the Federal Reserve has difficulty in keeping pace with the rate of change, how difficult must it be for the rest of us to understand the real risks which are inherent in the current market structure?
The Presidents Working Group has identified two key risks which unnerve our capital markets and pose a systemic risk. The report on OTC Derivatives identifies legal uncertainty; the Hedge Funds report concerns excessive leverage.
Over the years there have been various studies regarding OTC derivatives recommending modifications to the rules governing the OTC derivatives markets. The most significant to us, however, are the most recent recommendations of the President's Working Group in their report of November 1999, which constitute a sound platform to begin this discussion.
The recommendations contained in H.R. 4203, legislation sponsored by Chairman Leach, represents a forward-thinking legal framework for the dynamically growing derivatives industry. The nature of this industry has changed dramatically over the decade. Historically, commodity futures contracts helped to provide stability primarily in the agricultural commodities market. During my four years on the House Agriculture Committee, I came to an early understanding that today, OTC derivatives are largely centered in interest rate and foreign exchange contracts. This amounts to 98% of all transactions, with tangible commodity transactions accounting for less than a fraction of a percent. In other words, this market isnt just about pork bellies.
To state the importance of this industry to the overall economy, at year end of 1998, the total estimated notional amount of outstanding OTC derivative contracts was $80 trillion, reflecting an increase in activity of 11% during the last six months of the year, alone. Needless to say, we should insure, as best we can, that this market does not experience a general breakdown.
But there is a problem. Legal uncertainty exists as to whether some of these contracts are subject to the Commodity Exchange Act, and therefore under the supervisory jurisdiction of the CFTC. Other instruments operate under an exemption to the CEA with no guarantee the exemption will not be withdrawn. By using new technology, some contracts move jurisdictions again. If this is confusing to you, thats because it is confusing. Congress attempted to clarify this legal uncertainty in 1992, but the uncertainty persists.
Chairman Leach's proposal remedies these uncertainties, with the establishment of multilateral clearing organizations, and clarifies that an over-the-counter derivative instrument contract with a financial institution cannot be held unenforceable solely based on the regulatory status of or the regulatory jurisdiction of the product. The bill allows electronic trading of OTC derivatives by a broad range of financial institutions as defined in the Gramm, Leach, Bliley Act. This means that electronically traded instruments that are outside the reach of the CEA do not fall under its jurisdiction simply because of the manner in which they were traded. Accordingly, this will provide markets assurance of the appropriate regulatory treatment of the products and remove significant concerns as to the certainty executing these contracts.
Stated another way, this proposal, in my view, will insure that markets can operate as efficiently as possible. Given the scope and reliance of financial markets on these instruments, this is a critical step in mitigating systemic risk caused by markets determining that such agreements were unenforceable.
Another area of dramatic growth, and of market innovation, is the hedge fund industry, a subject of recent analysis by the President's Working Group. The Working Group has recommended several steps for legislative consideration. Although hedge funds secure their capital from high income individuals and invest in sophisticated markets, we are concerned with the scope of their activities, particularly where there is potential for undisclosed, high levels of leverage. Such activity has the potential to bring harm to third parties when high leverage, market position, and lack of disclosure result in the unfortunate events like those of September and October, 1998 when LTCM had its problems.
To consider the Working Groups report, I start with a certain bias. Since I am an advocate of free markets, I believe that markets can best regulate themselves. Nothing moves faster than an investor who is losing moneyregulators may look fossilized in comparison. As the Federal Reserve observes for the regulated banking industry in Staff Study Number 173:
Greater reliance on market discipline supported by efforts to improve disclosure should be viewed as part of a comprehensive approach to supervising and regulating large banking organizations. Another potential benefit from more effective market discipline through improved transparency is greater accuracy of market assessments of risk and value.
While hedge funds are very different from banks, and do not need similar regulation, it is even more critical that the capital markets be encouraged to constrain hedge fund risk and excessive leverage.
H.R. 2924 does nothing more than make financial statements of the large, unregulated hedge funds available to the markets on a quarterly reporting basis. Keep in mind too that I want to insure a fair disclosure of such informationno proprietary information should be released. In fact, there is clear, specific language which prevents the disclosure of proprietary information in H.R. 2924. In my bill, I hope to create a fair and unbiased disclosure similar to the disclosure regimes of large banks, securities firms, and commodity pool operators. And where the affiliates of these entities are subject to existing disclosure and regulation, I support exempting them too from the scope of this legislation. The President's Working Group recommended the provisions of H.R. 2924 as a first step, with the recommendation that further action to directly regulate the hedge fund industry could be taken at a later time should market conditions warrant.
In fact, I am in receipt of a letter from the Honorable Howard Davies, chair of the Financial Stability Forum, which is an organization comprised of the principal financial regulator from each of the G-10 countries, which states as follows:
Our [the Financial Stability Forum working group] report identified measures to enhance the transparency of highly leveraged institutions (including large, leveraged hedge funds) as a crucial condition for the enhancement of market discipline. The working group therefore strongly supports efforts to require disclosure by large hedge funds Both the working group, and the Forum as a whole, is therefore strongly supportive of the leadership you have shown in introducing H.R. 2924. I hope that other members of Congress share your view that this is a vital measure to reduce risks to the global financial system.
Let me make this very clear: I do not support regulating hedge funds. And, I do not want to take any action that would result in the relocation of this industry to an unregulated offshore domicile. This industry provides a valid and important role in our economy and it would be a significant loss if hedge funds left our capital markets. But the message of the Financial Stability Forum cannot be ignored. The provisions of H.R. 2924 provide for the minimal levels of enhanced transparency that should be taken to preserve the integrity of the international financial system and to mitigate systemic risk.
Recently, something profound occurred in the hedge fund industry which demonstrates the integrity of these markets. Just last week, Mr. Julian Robertson, General Partner of Tiger Management, announced his intention to liquidate his partners portfolio. For twenty years Mr. Robertson was viewed as an icon of the industry. With initial capitalization of $8.8 million in 1980, the fund grew to $21 billion, an increase of 259,000%. The compounded annual rate of return, after expenses was 31.7%. But, as he articulates, something significant in the broader markets has occurred.
I quote from the letter of Mr. Robertson dated March 30, 2000, to his partners, "As you have heard me say on many occasions, the key to Tiger's success over the years has been a steady commitment to buying the best stocks and shorting the worst. In a rational environment, this strategy functions well. But in an irrational market, where earnings and price considerations take a back seat to mouse clicks and momentum, such logic, as we have learned, does not count for much."
Mr. Robertson chose to close his fund rather than change his investment strategy. What if he had pursued another strategy? What if Mr. Robertson had abandoned his commitment to this investment strategy given the obvious market pressures, and simply enhanced his leverage, pursued a different and risky strategy, without disclosing to the market his reasons? Given its size, we would not wish to know if his speculative strategy would have failed. Fortunately, Mr. Robertson's principled business judgement has resulted in a responsible conclusion to a terrific business enterprise. Ideally, that's the way markets should work. But as we all know, that's not the way it happens every time.
Mr. Robertsons decision highlights market discipline in its proper context and function. What is the governments role in facilitating this efficient function of the market? I submit that the appropriate role of the government is not to impose regulations that will eliminate risk. Only markets can determine what is too large, too volatile, too highly leveraged, too risky and ultimately what is excessive. This is what Mr. Robertson did, and this is what the market does on a daily basis.
However, what allows the market to make these decisions on a daily basis? I believe it is access to accurate and timely information. Without information, the market simply cannot function. If there is a role for the government, and again I will state it should be limited, the government should act to insure the distribution of information in order to enhance the markets ability to discipline itself. The hedge fund report is very careful to refrain from advocating direct government regulation. But the report is crystal clear in its findings that poor information and lack of minimal disclosure to investors prevents our capital markets from functioning properly. I refer once again to comments by Howard Davies. Mr. Davies wrote, "The Forum supported the use of market discipline as the primary means to reduce systemic risk posed by [highly leveraged institutions]. However, it also agreed that more interventionist measures, such as direct regulation of hedge funds, might have to be considered if the [Financial Stability Forum] reports recommendations to enhance market discipline were not adequately implemented."
The government cannot create a perfect market based on perfect information, but the government can encourage the market to operate as efficiently as possible. In the case of hedge funds, the Committee can enhance the markets ability to self-regulate by allowing investors to have access to information so that market participants have the ability to determine when a highly leveraged institution becomes an "excessively leveraged" one. By enacting H.R. 2924, Congress will not regulate hedge funds, but we will enhance the markets ability to do so.
Apart from hedge funds, particularly large and highly leveraged ones, does the Committee have a reason to examine systemic risk in other vital sectors of our capital markets? A brief glance into our nations financial system would suggest so even to the most casual observer. It is naive to believe that systemic risk only exists in and is limited to institutions like hedge funds that invest heavily in OTC derivatives or other complex instruments.
The Working Group suggests that the Committee focus on investment instruments about which there is legal uncertainty. We have an obligation to search for such instruments. The Working Group cites excessive leverage as a cause of systemic risk. The Committee should focus on other large financial enterprises or institutions that are highly leveraged. The Working Group identified systemic risk in the markets when particular participants hold large, consolidated positions with a high number of counterparties and whether these institutions hold sufficient capital. Again, based on the hedge fund report, we have an obligation to ask how to constrain excessive risk in other large, highly leveraged institutions.
And, finally, as I have stated before, the Committee has an obligation to insure that the market has sufficient information about risk so that the market can be an effective regulator. This enhanced market discipline will lessen the chances that anyone of us will be here ten or fifteen years from now making decisions because one institution failed, and it had a dramatic impact on our financial system.
Over the past year I have been asking these questions of a prestigious group of highly qualified individuals from the Congressional Research Service, the General Accounting Office and the Congressional Budget Office. I have come to the realization that the growth in the size of the housing government-sponsored enterprises has been significant. Allow me to put this in perspective and discuss my findings that, when examined in light of the Working Groups findings and recommendations, demonstrate that the variables identified by the Working Group, high leverage, wide scope, and adequate risk management, may be present in the GSEs.
GSEs now control a dominant position in the mortgage market. According to the Treasury Department, Fannie Mae and Freddie Mac have about $850 billion of mortgages and mortgage-backed securities in portfolio, plus $80 billion in non-mortgage securities. The Federal Home Loan Banks have around $400 billion in outstanding advances and $170 billion in investments. Fannie Mae and Freddie Mac have purchased and retained or guaranteed over 70% of all the conventional, conforming mortgages outstanding. Furthermore, estimates are that they will have more than $3 trillion in residential mortgages by the end of 2003, or almost 48% of all home mortgages in the U. S.
GSEs now have a significant share of the U. S. debt market. GSE debt of $1.4 trillion combined with GSE-guaranteed mortgage-backed securities of $1.2 trillion nearly total the $2.7 trillion of outstanding privately held marketable Treasury debt. The Treasury Department forecasts that GSE debt may double to $3 trillion by 2005 and surpass Treasury debt in the next three years.
These facts alone may not be cause for concern, but some review of their implications is warranted. LTCMs investments were heavily concentrated as well. When those markets failed, LTCM was unable to raise capital to cover losses and defend its positions. Should the housing market encounter problems, investors may turn elsewhere than GSE debt as a safe haven, raising questions about the ability of the GSEs to raise capital to defend their positions should dramatic losses ever be incurred.
There is a second area where some attention should be focused. GSE debt has become a very significant part of the assets of the banking system. Banks held over $210 billion in housing GSE debt at mid-year 1999. This represented over one-third of total bank capital. Over 41% of commercial banks and savings banks have invested 100% or more of their total capital in housing GSE and other GSE securities. Credit unions have invested $48 billion, which is more than the industrys total capital, in housing GSE and Ginnie Mae securities. The housing GSEs are, of course, private sector companies with uninsured liabilities and there are no limits on the exposure of insured depository institutions to GSE debt obligations.
National banks may invest no more than 10% of their capital in the corporate bonds of one issuer and may not lend more than 15% of their capital to any one borrower. However, bank investments in GSE debt securities are not limited. Does this fact indicate there should be cause for concern? No, but it is certainly reason to ask if such concentration of investments is prudent. Imagine what the repercussions might be if one of the GSEs happens to stumble in difficult market circumstances and what the potential impact on the FDIC and NCUSIF could be?
I also raise the adequacy of risk measurement in these markets: The current ratings of agency securities are, in large part, influenced by the belief that the full faith and credit of the United States stands behind these instruments. We have confirmed this given the market reactions. In recent testimony before the Capital Markets Subcommittee, Undersecretary Gensler stated the Treasury Departments position in response to my question: "Can you tell me this morning that the United States Government does not extend its full faith and credit to GSE debt?" Undersecretary Gensler responded: "I think that Congress has actually stated that GSE debt is not guaranteed by the U. S. Government and such statement is actually contained in the prospectus and on the face of the debentures of all GSE debt."
He went on to say: "These are private sector firms and we look at this consistent with other financial institutions."
On the same day, following the Undersecretarys statement, the markets reacted rather abruptly. Only when assured that Treasurys position on the treatment of agency debt had not changed, did the markets resume historical practices. Treasurys clarification was essentially "our treatment of agency debt has not changed and the testimony is consistent with past practices." The markets interpreted this to mean that the debt may continue to be backed by the full faith and credit of the US government, not recognizing the repeated admonition that agency debt is secured only by the strength of the GSE.
I am concerned that the market is not basing their valuation on the underlying financials alone, but essentially on the premise that these instruments are backed by the full faith and credit of the taxpayer. As I stated earlier, I believe that market discipline, coupled with prudent supervision, is the best formula for mitigating systemic risk. However, in this instance, market discipline has become warped, resulting in analysis that does not accurately reflect the true economic picture.
Does this fact, by itself, justify concern about market stability? No, but again it is an area where further inquiry is warranted.
H. R. 3703 does much more than clarify the relationship of GSEs to taxpayer lines of credit. It establishes a regulatory system similar in authority and scope to the regulation applicable to every other financial institution in this country. I continue to express the concern that the measurement tool needed to determine the risk-based capital adequacy of Fannie Mae and Freddie Macthe Risk-Based Capital Ruleis not yet approved, much less implemented, although eight years have elapsed since Congress mandated this standard. Fannie Mae and Freddie Mac are today, without question, functioning in a sound and profitable manner. However, the application of the stress test is to verify the capital adequacy of these agencies when economic times are not as good and lucrative. The principal financial regulator is not yet in a position to give absolute assurances about capital adequacy in difficult times. Is this by itself reason for concern? Perhaps not to some, but I believe the establishment of improved regulatory oversight is a prudent step to take.
How can the market, let alone this Committee, know if appropriate risk-based models are being employed? LTCM, while it used sophisticated risk-based models, was not able to gauge risk in a volatile market. Risk models did not take into account severe market conditions that were thought not to be possible. In the late 1970s, no economist believed that unemployment and inflation could rise rapidly at the same time, yet this happened. This "impossible" occurrence created market conditions in the early 1980s that actually caused Fannie Mae, because of an interest rate mismatch, to operate insolvent on a mark-to-market basis for quite some time.
In other words, there is lack of transparency in this market. The GSEs reputation, skewed by investor belief that they are government backed, could mean that investors are not exercising due diligence. I could not help drawing these comparisons when I re-read the LTCM report. LTCM released information that did not provide the markets with the tools to adequately assess risk. LTCMs reputation was such that investors did not feel the need to perform due diligence. The concentration of GSE debt and securities held by financial institutions indicates a lack of diversity due to a lack of stringent risk assessment, which seems similar to the behavior of LTCM investors. H.R. 3703 promotes greater transparency by requiring the GSEs to publicly disclose financial information (while withholding proprietary information) and by providing annually for two private credit ratings of the GSEs taking into account that they are not government backed.
Lets review the facts: The GSEs continue to grow in market presence, insured depository institutions have enormous holdings of GSE debt, and, despite the best efforts of the Administration, the markets still view GSE debt instruments as government backed. The bigger the GSEs become in the mortgage and capital markets and the larger the exposure of financial institutions to GSEs, the greater the concern we should have about systemic risk in other words, the more potential for problems at a GSE causing instability in the financial markets and banking system. This concern is heightened by the fact that the housing GSEs are not only large and growing, but also are highly leveraged.
Undersecretary Gensler in his recent testimony highlighted the relative degree of leverage by various market participants. He said GSEs operate with less equity capital per dollar of debt than other financial institutions. Specifically, Fannie Mae and Freddie Mac have roughly $32 of debt for each dollar of capital; the Federal Home Loan Banks have $19 of debt per dollar of capital. In contrast, per dollar of capital, large banks have about $11.50 of debt, thrifts have $12.50 of debt, and the five largest securities firms have $25 of debt.
Before drawing any conclusion about the significance of these numbers, lets return to the Presidents Working Group review of the circumstances surrounding the demise of LTCM. Their report stated:
The central public policy issue raised by the LTCM episode is how to constrain excessive leverage more effectively. As events in the summer and fall of 1998 demonstrated, the amount of leverage in the financial system, combined with aggressive risk taking, can greatly magnify the negative effects of any event or series of events. By increasing the chance that problems at one financial institution could be transmitted to other institutions, leverage can increase the likelihood of a general breakdown in the functioning of financial markets."
It was not the underlying business strategy that created the potential for systemic risk. It was the fact that LTCM achieved remarkable size in the market and was also highly leveraged. Irrational exuberance caused capital to chase investment opportunity based on perceptions of success and rate of return.
It might seem unfair that I compare LTCM to housing GSEs. I do not believe that a GSE is soon to fail. Quite the opposite, they are healthy, which makes this discussion particularly relevant. Again, the hedge fund report encouraged me to make this connection. The report states that excessive leverage and systemic risk is not isolated to hedge funds. In fact the report states, "Although LTCM is a hedge fund, this issue is not limited to hedge funds. Other financial institutions, including some banks and securities firms, are larger, and generally more highly leveraged, than hedge funds."
Two charts graphically illustrates the relative degree of leverage currently used by various market participants and LTCM. In terms of an assets-to-capital leverage ratio, Fannie Mae is more highly leveraged than not only the biggest bank and biggest securities firm in this country but also than LTCM was at its height. Is this degree of leverage by the biggest housing GSE reason for alarm? Probably not. But it does present another issue for the Committee to consider.
This Committee concluded in 1992 that, despite the high leverage, the ratio should serve as a floor. But, only while a regulator has measured risk and encouraged these entities to hold sufficient capital. However, LTCM showed that high leverage can become excessive leverage when capital is insufficient to support asset risk.
What about the future of the GSEs? There is nothing wrong with the GSEs growing, taking risk, and making profits, so long as they stay on mission. However, to maintain their level of profitability, the GSEs will have to grow even larger and take on considerably more risk. This is why we must begin to mitigate systemic risk by promoting market discipline, transparency, and improved supervision and regulation on all three of our housing GSEs.
To ignore the potential impact of a misstep by a GSE on our housing market and financial system is to flirt with potential disaster. While economic times are so prosperous, the GSEs are enjoying impressive earnings. Lets prepare for the days to come when the only thing standing between losses of a GSE and your constituents wallet is your good judgment.
I do not expect this Committee to act on my proposal without a full discussion of all ramifications. However, we must ask the questions I have raised before reaching any conclusions.
I do feel that the Committee should advocate market-based solutions to mitigate systemic risk in the financial system. These solutions would include enhanced private sector risk management practices, improved transparency in the financial system, and risk-sensitive approaches to capital adequacy. Congress should do its part to facilitate this market discipline.
Mr. Chairman, I appreciate your tolerance in allowing me to participate in this important hearing and to identify efforts to mitigate systemic risk in our financial markets. Your leadership on these important issues relating to systemic risk are indeed very important to not only every taxpayer in the country, but to every retiree, every homeowner, every investor, and ultimately to the orderly functioning of our economic system. I am prepared to provide for the record any information the committee may need, or to answer any questions. Thank you Mr. Chairman for your leadership in mitigating systemic risk in our US capital markets.