purpose of regulation should be to focus on@@@@@ @ @ @ @ @ @ @ h as i was saying before, there are certain class of instruments that you really cannot risk manage. we were talking about an airline that wants to put together a complex customized swap for fuel. there is no problem with that. everybody knows what the price of fuel is today. you do the work, and you can figure out what it is worth. the trouble comes if you look at the sub-prime complex structure of the acid market a few years ago. we had everybody in agreements on the model being the definition of a value for this class of instruments. one day a number of people on the buy side started to question that assumption. they started backing away from

the securities, so did the dealers. so at in point -- it's hard to say win -- the consensus about value for that class of assets broke down. and that's where we are today. the buy side custom still does not want to know. so i question really how effective risk management can be where we don't have a completely separate, independent reference point for value. >> thank you. senator bunning. >> mr. griffin, whalen and pickel, should parties to derivative contracts be required to post cash collateral or is other collateral acceptable? and is there any reason not to require segregation of customer collateral? >> senator, i believe that one of the hallmarks of mature market is a well functioning margin paradigm where custom

assets are egg segregated. in over 100 yours through wars and the great depression has never had a loss that needed to be neutralized because of the appropriate margin requirements. what should be posted as collateral? you can post cash, you can post treasuries, variety of liquid, well understood assets and that's the right paradigm in my opinion. >> as far as the types of collateral, i think similarly cash and liquid instruments would be appropriate. there have been discussions about other types of securities that might be taken as chat a recall but you have to have significant haircut to apply to those to consider them, 50% or more to take them in as far as segregation of customer collateral, in the otc, talking about the customized peelings of the business -- the use of margin is extensive in that

business, and i think that one of the reasons it is used so effectively is that there is an ability to rehypothecate or pass on collateral and use it for your own positions. i think there's room for greater exploration of segregation of collateral so the customers can have the confidence that when something like a lehman brothers situation should happen they can get ahold of their collateral. so there's a lot of focus on that going forward. >> mr. whalen. >> i agree with in other speakers. segregation of collateral is something we need. the dealers mansion themselves tend to rely on overarching agreements and treaties to deal with collateral and exposure back and forth. if you mo of an exchange model everybody it treated the same and you have different tiers of collateral requirements but the point is there's a third party who holds the money.

you don't have the dealer holding the collateral. you have the clearinghouse or a trust company that is separate from the dealer. and i think that's an important distinction. >> this is for anybody. what economic value outweighs the social cost of somebody being able to buy insurance in the form of swaps for asset that it do not own? turn it oven, please. >> ranking member bunning, this is really very interesting, this issue, in terms of credit default swaps and the incentives so that the state insurance people have argued, well, gee, you should not be able to buy credit default swaps unless you have an insurance interest. all right? well, interestingly, the problems may be more difficult

if you have insurable interests. met explain. whenup think about owning a bond or owning a loan, traditionally you have economic rights, various affirmative covenants into loan agreement, and you have various right given to you under bankruptcy law, securities law, and other laws, and sometimes you have obligations, too. ... he thinks the creditor would like to see it survive. in today's world, what if the creditor has lent $100 million

and conjure up a really extreme example. but buys to lead to an dollars of credit default swaps. in that circumstance, this is an extreme version of an empty creditor. this is an extreme version. it does not happen very much. you would have a creditor who rather than wanting to work to avoid a volatile bankruptcy, he would make sure the person goes into bankruptcy. even if he did not have that extreme example, if you have a creditor who actually lent money, that creditor has much weaker incentives to work to avoid bankruptcy. if the borrower is not aware the creditor has bought credit default swaps, he does not understand that he is trying to

negotiate with the creditor which is really happening. if the power goes into bankruptcy, there are all kinds of complications within bankruptcy. in terms of whether this is real or not, really happens are not, i wrote an op-ed in the "wall street journal". there was a really curious incident. in september, as you recall, aig -- lehman brothers had collapsed. the fed felt compelled to intervene to prevent asd from collapsing. that september 16, goldman sachs said, its exposure to aig was not material. that is fine.

middle march, it turns out that of the initial $85 billion of a federal bailout money, about $7 billion went to goldman sachs. how do you reconcile that? sachs. well how do you reconcile? this goldman receiving 7 billion had no exposure to a aig. goldman was an empty creditor. goldman bought credit to default swaps from aig from, quote, large financial constitution's so care terribly much what happens to aig and it indeed was quite aggressive in terms of calling for collateral from aig. >> but it didn't work. >> what was interesting is it did work for goldman but it

illustrates this issue, social issue. >> we are still wondering where the bottom is on aig. islamic and using this to illustrate the concerns you have is as a public policy matter we should be concerned about these creditors who used to care about ensuring our worst stay out of bankruptcy. that they have much less incentive to do that and that in today's world -- >> we better corrected. >> we might want to consider correcting that. >> thank you very much mr. chair. >> i would like to add if that is okay for a moment. >> please do. >> it's important we think about the reasons why a company might want to use credits the fall swaps or a bank for that matter.

for example i could be in the supply chain of an industry and worry the company to whom i supply goods or services may not actually perform and might go into default. the ability to buy credit-default swaps against that company makes it much more economically attractive for me to enter into a long-term sales agreement to provide goods and services to that company. i don't own the bonds but i do have a position over time as being a creditor of the company as a supplier to them. another ex sable, and this one strikes home because we lend money to a variety of companies around a world in the united states, companies to the biggest fortune 500. there is often no market for credit to default swaps for midsized companies. if i want to be a significant lender to a portion of the economy where i observed a substantial amount of industry

risk for the airlines let's say i want to lend money to a regional carrier, i can't buy a credit default swap on the regional carrier blight can buy a credit defaults flops on american airlines, delta and others. it would help me manage the industry specific risk that i have and most importantly that reduces the cost of capital for the midsize company visa fi the large companies of credit defaults will play a very important role allowing pension plans and other lenders to midsize companies in america, to allow them to reduce industry specific risk and reduce the cost of capital of companies in america that have created the most jobs over the last 30 years. >> mr. pickel, i think for buddy -- >> he deserves a good answer. as briefly as possible. >> i would say in the derivative

space for 25 years the developments were on market risks, interest rates, currency, equity, commodities where you are managing risk. credit risk is a relatively new derivative and i would say we are still understanding some implications of that and i think that professor hu's work has been interesting in that regard. i would say regarding that empty creditor issue, the fact is every time somebody is going into the market and buying protection which is what he's suggesting someone is doing he's sending signals your business plan isn't working, the yellow light is getting brighter and brighter and so when it comes to the end and somebody says time is up, i am not going to continue to lend to you i think that's a natural evolution but it's certainly understand that. i would also mention the credit stifel swaps are becoming embedded in various ways. if they are being used for pricing loans. it was done with the rollback of

scotland extension of credit by the u.k. government and today in "the wall street journal" it was mentioned s&p has developed additional means of providing information on credit exposure to the marketplace that incorporates credit defaults slops so we see continuing evolution and about to be encouraged. >> jury quickly senator joe hans deserves his round and at the end of we have time we will -- >> i'm not worried about to people on one side or another of the market so if somebody wants to buy and sell -- you've heard but symbols of the utility of the credit devolve swaps. the concern i have is the small airline, the small company doesn't have it treated market that we can use to price these contracts. so, again we have the lawyer poker scenario which is you have a trader firm on one side and they've decided the implied spread on the debt of this company is a good way to price

redefault contract. the trouble is most people on wall street trade these instruments like options. the use them for delta hedging, various expose sirs and these are great examples, they have wonderful utility but the problem is i suspect the pricing is wrong in other words it's not priced like insurance so when that contract goes into default and the provider of protection has to come up with the money you've got to ask yourself going back to the question about the supervision of dealers, is that person doing the work so they are actually cognizant what the cost of the fault is this is the spread on the bond. lehman brothers, you could have bought protection of lehman brothers before it failed at 7%. the next week you had to come up with 97% of cash. so it is a pricing issue that i >> i am hoping somebody can

answer this question. at this whole bank of business, in our full term, in this entire business agreement, what percentage would be of that classification that is not easily valued? >> i think most of the over-the- counter contracts to not have a problem in that regard. it up about the energy currency, what ever it is. there is a vigorous trade in cap market. it is easy to come up with derivatives. when you are talking about liquid corporate bonds, if you are talking about a complex structured asset with three levels of packaging away from the reference asset that it is supposed to be derived from, it creates some questions in terms of pricing. there are very few firms on the street that did the have the

people resources to do that wor. the resources and money to do the work. let me give you an example -- >> doesn't that get to the point i was raising on the previous questioning? you know, you've now got a whole regulatory scheme. you've got somebody that's going to regulate and they are hired and paid -- and they are probably going to take the safe route and say i am not sure understand this. i am not sure it can be valued. it's 100 million-dollar contract. we want capital. >> and that's appropriate. >> okay, so isn't that just another way -- how will capital be posted in a circumstance like this if you have the capitol you probably either alone or not alone and it's a bad deal you wouldn't want it. but anyway, what i am getting to is this, doesn't that basically put that segment of this arena

out of business? >> it may and i am not sure that wouldn't be inappropriate and i assure my colleagues will disagree that most people on wall street are competent to be a rating agency. and if you are talking about calculating probability of the fault of the company or security, that is not a trivial exercise. it takes a lot of work and i don't think most people will st. dewitt. they look at the bloomberg terminal and by consensus the have all agreed to split on the bloomberg terminal is the price you're going to deal with three is right or not. >> you know i would say to you, mr. whalen, listening to your testimony from a sterile standpoint and saying if it's that kind of risk maybe it should that's probably okay

unless that's the only regional airline in town. and when that one goes away, guess what? air transportation for western nebraska goes away. >> i don't know any airlines that can't hedge their fuel costs -- >> i'm not talking about fuel costs but you know what i'm getting at here. there are always unintended consequences and i just want to understand. if we are going to put a lot of little guys out of business tell me that. >> here's the thing i want your little guy to have the same facility of pricing a contract as the dealer. how do we do that? that goes to transparency but if i have transparency of an instrument that's still opaque even after of legislated transparency than i have a problem. >> and the tools that we have been given i think in the end is when to be the capitol requirement. that's the alternate protection, and we, when you talk about what

we require, treasurys, to me like you're talking about cash. you're probably not going to take something very risky, right? >> i think the standardized tests to bring those down over time though i really do. >> in the credit to default swap area we have introduced a very high degree of standardization to the first point about which of the contracts would be most standardized and i think in the credit-default swaps base we do have contracts that will be easily to move into the clear environment perhaps more so in two and electronically traded or exchanged treated environment so those things are in place and yes people look to bloomberg screens but it is a collective view of the marketplace and not a rise on wall street. we have active dealers around the world who are expressing views on these contracts and it is that collective reflection of the market judgment that indicates the spread at any

particular point in time. >> i think the question you are opposing about capital and will the regulation of this market increase the amount of capital required in the marketplace the answer is not as clear-cut as one might imagine is in today's market structure if i buy credit protection contract from goldman sachs, i am just as likely to eliminate line economic risk but not my counterpart risk by closing the contract with morgan stanley. i will still be was in march and as a customer to both of the firm's. it's incredibly inefficient. if i had a central clearing house i would open the contract with goldman clearinghouse, morgan stanley to a clearing house and i would have no capital as a customer out the door any longer. i would actually have capital that comes to me. i think it is a very important concept to under the stand when we think of clearing houses this

wouldn't in any way increase the amount of capital demanded of the system as a whole because the tremendous efficiency inherent in netting. the other key concept we should keep in mind is price transparency will most favored the smaller less frequent users of derivatives, citadel, the other world's largest asset managers. we can price of the derivatives we commonly trade with a great degree of precision but we have a tremendous investment infrastructure to do so. for smaller companies that's outside of their range of capabilities. but in exchange, a visible exchange traded price gives the cfo of a small company confidence and part of what we want our capital markets to do is to create confidence and all

americans that the markets are fair. they are transparent and they are just because that reduces the cost of capital for every company in america. >> mr. griffin i will wrap up with this, mr. chairman, i appreciate your patience. nobody is going to disagree with you were last speech. that is about as motherhood and apple pie as we can get. nobody disagrees with that. it's like i said, i just want to know if this is where we are headed what impact is it going to have on the marketplace from the small to the very large. my experience is the very large survive and they get bigger. >> actually, you would be surprised where every analysis on this ends up. today the largest dealers have the defacto monopoly in the business. it's because of their credit rating privilege as credit

intermediaries to almost every contract they durham extraordinary economic profits. where there is a clearinghouse for it simply in the options market, the occ act as a clearinghouse for all listed transactions. you find there is a vibrant, incredibly vibrant market of small trading firms that had a tremendous amount of liquidity to the marketplace. citadel for example the single largest in the united states. we started from scratch seven years ago with zero market presence. our ability to get to number one was because of a lack of barriers to entry. we were allowed to compete on a level playing field with other incumbents. in the credit devolve swap interest markets the barriers are enormous. who would want to take as a counterparty anyone but quote on quote the firm's view today has systemically important or too big to fail.

>> here is again to wrap up the second time here is what i would ask. if there are that many small firms that are going to benefit from this my address is on line, my phone number is online. mr. pickel, you probably represent some big and small people. i hope they overwhelm me with letters over the next 72 hours or e-mails saying mike, this is great. we want this to happen. because of the am worried and concerned and i don't want this in the end to create a situation where literally by our regulatory effort we have damaged and created a very phenomena that this hearing is for and that is the big just got bigger to the point literally we are all scratching out ahead about the too big to fail.

i think if we look back in 20 years and found out that is where we ended up that would be a tragedy. thanks for your patience. i really appreciate that. >> i want to thank you all, gentlemen. if there are additional questions by the colleagues -- live in also, professor hu has been trying to get recognized. can i give you a minute? >> [inaudible] >> all right. put on your microphone. >> i think that these clearinghouse of arrangements we are moving into will reduce systemic risk. they will reduce the profits in the sense now available to the derivative dealers. it will be cheaper for everybody in terms of the standardized products. i think one of the very interesting issue used to think about in connection with these clearinghouse arrangements and

the data that we are going to be requiring of all derivatives in terms of customized derivatives for instance one of the issues is how to solve this informational a senate trade between regulators and regulated so for instance in terms of this general movement to more information being provided to the regulators to what extent should regulators actually ask for modeling information? regulators can't develop them, can't understand how to value these things on like citadel. to what extent should they require this information and if we require this proprietary information how do we maintain safeguards in terms of respecting the proprietary nature and so i think that this is the start of a very long process. >> thank you. you had the last word this evening but not the last word because it is a long process the this testimony has been excellent. some of my colleagues might have

written questions which they would forward within two weeks please respond. all of your written testimony as part of the record and by thank you all for excellent testimony and your presence this afternoon and i will adjourn the hearing. thank [captioning performed by national captioning institute] [captions copyright national cable satellite corp. 2009]

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