CREDIT DEFAULT SWAPS ON GOVERNMENT

DEBT: POTENTIAL IMPLICATIONS
OF THE GREEK DEBT CRISIS

HEARING
BEFORE THE

SUBCOMMITTEE ON CAPITAL MARKETS,
INSURANCE, AND GOVERNMENT
SPONSORED ENTERPRISES
OF THE

COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED ELEVENTH CONGRESS
SECOND SESSION

APRIL 29, 2010

Printed for the use of the Committee on Financial Services

Serial No. 111–130

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HOUSE COMMITTEE ON FINANCIAL SERVICES
BARNEY FRANK, Massachusetts, Chairman
PAUL E. KANJORSKI, Pennsylvania
MAXINE WATERS, California
CAROLYN B. MALONEY, New York
LUIS V. GUTIERREZ, Illinois
´ ZQUEZ, New York
NYDIA M. VELA
MELVIN L. WATT, North Carolina
GARY L. ACKERMAN, New York
BRAD SHERMAN, California
GREGORY W. MEEKS, New York
DENNIS MOORE, Kansas
MICHAEL E. CAPUANO, Massachusetts
´ N HINOJOSA, Texas
RUBE
WM. LACY CLAY, Missouri
CAROLYN MCCARTHY, New York
JOE BACA, California
STEPHEN F. LYNCH, Massachusetts
BRAD MILLER, North Carolina
DAVID SCOTT, Georgia
AL GREEN, Texas
EMANUEL CLEAVER, Missouri
MELISSA L. BEAN, Illinois
GWEN MOORE, Wisconsin
PAUL W. HODES, New Hampshire
KEITH ELLISON, Minnesota
RON KLEIN, Florida
CHARLES A. WILSON, Ohio
ED PERLMUTTER, Colorado
JOE DONNELLY, Indiana
BILL FOSTER, Illinois
´ CARSON, Indiana
ANDRE
JACKIE SPEIER, California
TRAVIS CHILDERS, Mississippi
WALT MINNICK, Idaho
JOHN ADLER, New Jersey
MARY JO KILROY, Ohio
STEVE DRIEHAUS, Ohio
SUZANNE KOSMAS, Florida
ALAN GRAYSON, Florida
JIM HIMES, Connecticut
GARY PETERS, Michigan
DAN MAFFEI, New York

SPENCER BACHUS, Alabama
MICHAEL N. CASTLE, Delaware
PETER T. KING, New York
EDWARD R. ROYCE, California
FRANK D. LUCAS, Oklahoma
RON PAUL, Texas
DONALD A. MANZULLO, Illinois
WALTER B. JONES, JR., North Carolina
JUDY BIGGERT, Illinois
GARY G. MILLER, California
SHELLEY MOORE CAPITO, West Virginia
JEB HENSARLING, Texas
SCOTT GARRETT, New Jersey
J. GRESHAM BARRETT, South Carolina
JIM GERLACH, Pennsylvania
RANDY NEUGEBAUER, Texas
TOM PRICE, Georgia
PATRICK T. MCHENRY, North Carolina
JOHN CAMPBELL, California
ADAM PUTNAM, Florida
MICHELE BACHMANN, Minnesota
KENNY MARCHANT, Texas
THADDEUS G. McCOTTER, Michigan
KEVIN McCARTHY, California
BILL POSEY, Florida
LYNN JENKINS, Kansas
CHRISTOPHER LEE, New York
ERIK PAULSEN, Minnesota
LEONARD LANCE, New Jersey

JEANNE M. ROSLANOWICK, Staff Director and Chief Counsel

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SUBCOMMITTEE

ON

CAPITAL MARKETS, INSURANCE,
ENTERPRISES

AND

GOVERNMENT SPONSORED

PAUL E. KANJORSKI, Pennsylvania, Chairman
GARY L. ACKERMAN, New York
BRAD SHERMAN, California
MICHAEL E. CAPUANO, Massachusetts
´ N HINOJOSA, Texas
RUBE
CAROLYN MCCARTHY, New York
JOE BACA, California
STEPHEN F. LYNCH, Massachusetts
BRAD MILLER, North Carolina
DAVID SCOTT, Georgia
´ ZQUEZ, New York
NYDIA M. VELA
CAROLYN B. MALONEY, New York
MELISSA L. BEAN, Illinois
GWEN MOORE, Wisconsin
PAUL W. HODES, New Hampshire
RON KLEIN, Florida
ED PERLMUTTER, Colorado
JOE DONNELLY, Indiana
´ CARSON, Indiana
ANDRE
JACKIE SPEIER, California
TRAVIS CHILDERS, Mississippi
CHARLES A. WILSON, Ohio
BILL FOSTER, Illinois
WALT MINNICK, Idaho
JOHN ADLER, New Jersey
MARY JO KILROY, Ohio
SUZANNE KOSMAS, Florida
ALAN GRAYSON, Florida
JIM HIMES, Connecticut
GARY PETERS, Michigan

SCOTT GARRETT, New Jersey
TOM PRICE, Georgia
MICHAEL N. CASTLE, Delaware
PETER T. KING, New York
FRANK D. LUCAS, Oklahoma
DONALD A. MANZULLO, Illinois
EDWARD R. ROYCE, California
JUDY BIGGERT, Illinois
SHELLEY MOORE CAPITO, West Virginia
JEB HENSARLING, Texas
ADAM PUTNAM, Florida
J. GRESHAM BARRETT, South Carolina
JIM GERLACH, Pennsylvania
JOHN CAMPBELL, California
MICHELE BACHMANN, Minnesota
THADDEUS G. McCOTTER, Michigan
RANDY NEUGEBAUER, Texas
KEVIN McCARTHY, California
BILL POSEY, Florida
LYNN JENKINS, Kansas

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CONTENTS
Page

Hearing held on:
April 29, 2010 ...................................................................................................
Appendix:
April 29, 2010 ...................................................................................................

1
47

WITNESSES
THURSDAY, APRIL 29, 2010
Duffie, Darrell, Professor of Finance, Graduate School of Business, Stanford
University .............................................................................................................
Johnson, Robert, Director of Global Finance, Roosevelt Institute .......................
Mason, Joseph R., Louisiana Bankers Association Professor of Finance, Louisiana State University ........................................................................................
Pickel, Robert, Executive Vice Chairman, International Swaps and Derivatives Association, Inc. ..........................................................................................
Sanders, Anthony B., Distinguished Professor of Finance, George Mason University ...................................................................................................................

14
9
17
12
15

APPENDIX
Prepared statements:
Kanjorski, Hon. Paul E. ...................................................................................
Duffie, Darrell ...................................................................................................
Johnson, Robert ................................................................................................
Mason, Joseph R. ..............................................................................................
Pickel, Robert ....................................................................................................
Sanders, Anthony B. ........................................................................................

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CREDIT DEFAULT SWAPS ON GOVERNMENT
DEBT: POTENTIAL IMPLICATIONS
OF THE GREEK DEBT CRISIS
Thursday, April 29, 2010

U.S. HOUSE OF REPRESENTATIVES,
SUBCOMMITTEE ON CAPITAL MARKETS,
INSURANCE, AND GOVERNMENT
SPONSORED ENTERPRISES,
COMMITTEE ON FINANCIAL SERVICES,
Washington, D.C.
The subcommittee met, pursuant to notice, at 10:05 a.m., in room
2128, Rayburn House Office Building, Hon. Paul E. Kanjorski
[chairman of the subcommittee] presiding.
Members present: Representatives Kanjorski, Sherman, Lynch,
Maloney, Perlmutter, Donnelly, Carson, Foster, Minnick, Adler,
Himes; Garrett, Manzullo, Hensarling, Neugebauer, and Jenkins.
Ex officio present: Representative Bachus.
Chairman KANJORSKI. This hearing of the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises
will come to order.
Pursuant to committee rules, each side will have 15 minutes for
opening statements. Without objection, all members’ opening statements will be made a part of the record.
Good morning. At the request of our colleague, Congresswoman
Maloney, we gather today to examine important policy questions
that have arisen from the Greek debt crisis. The crisis, which
quietly evolved over a number of years, has demonstrated that innovative Wall Street bankers, acting alone or in concert with their
clients, have the potential to destabilize not only a single country
but an entire economic region, especially if transactions they concoct distort transparency or heighten speculation.
Among other things, this hearing will allow us to explore whether the titans of Wall Street act as traders of government debt by
underwriting bonds, or traitors of governments by using credit default swaps to gamble that sovereign debt will fail. Those who bet
on and seek to cause the default of a government are as bad as
Benedict Arnold.
When used for genuine hedging purposes, credit default swaps
are an appropriate financial tool. But when these instruments are
used for speculation, they have the potential to become a Trojan
horse that will insidiously infect our markets. Some very smart and
sophisticated investors have characterized naked credit default
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swaps as ‘‘weapons of mass destruction’’ that can create imaginary
value out of thin air.
The tragic situation in Greece underscores the urgent need for
Wall Street reform at home. Some recent news reports suggest that
bankers crafted derivatives to hide Greek debt, and other stories
note that the U.S. market for credit default swaps on municipal
debt is growing.
Congress must respond by creating more transparency in our derivatives markets, as provided for in the House-passed bill. The derivatives bill recently approved by the Senate Agriculture Committee similarly advances the goal of greater disclosure.
Additionally, the response of the markets to the Greek debt crisis
raises more questions about the utility of rating agencies. As we all
know, the rating agencies greatly contributed to our recent financial crisis by failing to appropriately rate collateralized debt obligations and other structured debt. The growth in the issuance of
these faulty financial instruments, which the rating agencies
blessed, contributed to the explosion of the credit default swap
market.
While some have raised concerns, other experts have concluded
that a large and liquid market for credit default swaps, including
naked positions, leads the cash bond market in price discovery and
predicting adverse credit events. If this is true, then I question why
the rating agencies waited so long to downgrade Greece’s debt.
After all, the costs for purchasing credit default swaps on Greek
debt has soared for many months, but Moody’s and Standard &
Poor’s have only downgraded the country’s bonds in recent days.
The reform bill already passed in the House takes strong steps
to impose a liability standard on rating agencies and reduce conflicts of interest and market reliance on them. As we proceed today,
I look forward to understanding whether naked credit default
swaps do indeed promote efficient price discovery and whether we
should do more to reform rating agencies.
The Greek debt crisis also parallels a problem in our financial
markets: the problem of ‘‘too-big-to-fail.’’ Greece’s problems have
placed an enormous strain on the European debt markets and the
European Monetary Union. In fact, the European Central Bank
president has said that a Greek default is out of the question.
With respect to our financial markets, the demise of Lehman
Brothers, American International Group, and Washington Mutual,
among many others, have shown that Congress must act to mitigate systemic risk. That is why the House-passed legislation and
the pending Senate bill include provisions to end the era of ‘‘toobig-to-fail,’’ like my amendment directing regulators to break up financial firms that have become too big, too interconnected, too concentrated, or too risky.
In sum, today’s hearing continues to build a case for financial
services regulatory reform. More than 2 years have passed since
the financial crisis began, and the Senate must take swift action
on its bill so that we can finally end Wall Street’s narcissistic pursuit of profit and change the way our financial markets operate.
I would like to recognize Ranking Member Garrett for 4 minutes.
Mr. Garrett?

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Mr. GARRETT. And I thank you. I thank the chairman. I thank
the witnesses who are about to testify.
Today’s hearing is entitled, ‘‘Credit Default Swaps on Government Debt: Potential Implications of the Greek Debt Crisis.’’ There
are really a number of roads our discussion this morning could go
down, given that very long title.
Now, there have been some suggestions, for instance, that CDS
is to blame for the problem Greece finds itself in today. But frankly, I have not been shown any evidence to really support that
claim. In fact, a good argument can be made that rather than causing the Greek debt crisis, CDS actually alerted investors to the uncertainty being felt by some in the marketplace, and to help provide greater transparency about the stated Greek fiscal affairs before the country’s conditions even got worse.
Now, alternatives of CDS for providing transparency about the
creditworthiness of a company or a sovereign entity, of course, are
the credit rating agencies. But when you think about it, I don’t
think anyone would suggest, given their recent track record, that
the sole reliance on credit rating agencies would be the optimal
strategy for policymakers now to pursue.
It has also been noted that if investors can’t hedge their risk
through CDS purchases, what will they do? They will be less willing and less likely to invest in the underlying debt itself. So any
steps that we take to ban sovereign debt CDS, as some European
governments have now proposed, actually can make it even more
difficult and more costly for countries like Greece to sell their
bonds and basically exacerbate the debt crisis.
Another issue in today’s hearing is the parallel between Greece’s
poor financial condition and the financial condition here in the
United States. During the discussion over financial services regulatory reform over the last year or so, there has been a lot of talk
about systemic risk and so-called ‘‘too-big-to-fail’’ institutions.
But, the ultimate ‘‘too-big-to-fail’’ entity is the United States Government. And the most obvious systemic risk is the one posed by
our ever-increasing Federal budget deficit and the accumulated
debt here in this country.
And we have to ask, what will it take for policymakers to get serious about cutting this unsustainable spending here in Washington? Just this past week, Federal Reserve Chairman Bernanke
stated, ‘‘The Federal budget appears set to remain on an
unsustainable path. Moreover, as debt and deficits grow, so will the
associated interest payments, an obligation that in turn further increases projected deficits. Unfortunately, we cannot grow out way
out of this problem.’’
But despite these warnings, we can’t get our Democrat colleagues
here in the House to propose a budget, let alone one that will begin
to put us on a sustainable path to fiscal health. And what makes
our current situation even worse? As large as our official national
debt currently is, it is not even truly stating what the real problem
magnitude is because, like Greece and many financial institutions
that have become easy targets for reform-minded policymakers, the
U.S. Government is engaging in off-balance-sheet accounting that
hides the enormity of our problem.

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The obligations of Fannie Mae and Freddie Mac, the housing giants that are recipients, by far, of the largest of recent taxpayer
bailouts are not accounted for in our budget. Some of you heard the
verbal gymnastics, for example, that Secretary Geithner had to go
through in this committee as he tried to explain how the government fully intends to stand behind these entities, but at the same
time, their obligations, he said, shouldn’t be considered foreign debt
or sovereign debt.
I have a bill that would put Fannie’s and Freddie’s debt on the
balance sheet. And to me, this really isn’t a partisan issue. It is
about being transparent. As a matter of fact, the record shows I
have 52 co-sponsors of that bill, but unfortunately, there is only
one solitary Democrat who has joined me in that effort so far. But
I do remain optimistic that others will sign on.
And finally, as for the people in Greece who are finding out now
that the fiscal health of one’s nation, when push comes to shove,
can greatly impact its citizens’ standard of living, I know that everyone in this Congress wants to leave our children and our grandchildren with a country in better shape than we have inherited.
But to do that, we can’t keep kicking that can down the road on
the tough decisions. And we certainly shouldn’t be solely blaming
CDS or credit rating agencies, some of which have been recently
suggested that the U.S. AAA rating could be imperiled for the problems brought on by policymakers who need to come to terms with
our precarious fiscal condition, and so do something now before it
is too late.
And with that, I yield back.
Chairman KANJORSKI. Thank you, Mr. Garrett.
The gentleman from Massachusetts, Mr. Lynch, is recognized for
2 minutes.
Mr. LYNCH. Thank you, Mr. Chairman. I thank you for holding
this hearing today, and I thank Ranking Member Garrett, as well.
The relationship between the government and debt and complex
derivatives is one that I have been particularly interested in since
the financial crisis began. I think we have an opportunity today to
learn some valuable lessons from the way Goldman Sachs and others conducted themselves during Greece’s current situation. The
role of complex derivatives in concealing and disguising sovereign
debt in a very opaque market is one that needs to be closely examined.
As my colleagues from California know better than most, credit
default swaps and other sophisticated financial instruments were
used to manage public money. I believe these instruments to be
dangerous in some cases, when they are unregulated, and should
not be used when managing pension funds, public bonds, monies
from municipalities, or any other type of public money unless the
underwriter and the marketers and the traders agree to assume a
direct fiduciary responsibility.
I have heard, in the defense of these instruments, that credit default swaps can be used to hedge certain risks. But I think what
we have learned from this crisis is that what we thought was
hedged was really just a complex instrument that was very poorly
understood.

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While it is certainly a huge step forward, I am not completely
convinced that the derivatives title included in the House regulatory reform bill, H.R. 4173, the Wall Street Reform and Consumer Protection Act, goes far enough to protect public funds and
pension funds and municipalities from being manipulated again in
the future. In addition to Greece, cities and towns all over the
country are struggling with the ramifications of using complex derivatives.
I look forward to our witnesses’ testimony today to examine further these issues, and I thank them for their willingness to come
before this committee and help us with our work. And I yield back.
Thank you, Mr. Chairman.
Chairman KANJORSKI. Thank you very much, Mr. Lynch.
Now we will hear from Mr. Bachus from Alabama for 3 minutes.
Mr. BACHUS. I thank you, Mr. Chairman, for convening this
morning’s hearing, and I thank the witnesses for your attendance.
The ongoing Greek debt crisis, while tragic, is the result of decades of reckless spending, and that is something we are quite familiar with here in the United States. Without real spending cuts
and GSE reform, the bailouts will not stop, the housing market will
not find its footing, and the American economy will not recover.
But so far, the response has been to pledge unlimited bailout aid.
In fact, the GSE debt alone has already cost American taxpayers
more than $127 billion, and puts them at risk for another $5 trillion in guarantees.
The events of 2008 demonstrated there is a need for legislation
to address shortcomings in the regulation of derivatives. But demonizing credit default swaps is not the answer. Used responsibly,
derivatives are a critical tool for managing risk, including the risk
of sovereign debt default. Thousands of U.S. companies use derivatives to hedge against unforeseen events and risk inherent in their
business.
With the current sovereign debt crisis in many European nations, while it is instructive about the growth in impact that sovereign CDS can have on the capital markets, Congress should not
unnecessarily impair the important benefits that credit derivatives
can provide.
All of us agree derivative markets need more transparency and
disclosure. We recognize the Federal Reserve discount window was
not intended as a source of funds for banks to speculate with derivatives for their own account.
However, restrictions on credit default swap contracts limit the
ability of investors to appropriately calculate risk, as CDS spreads
are often a more accurate reflection of credit risk than credit ratings. We have found that the credit rating agencies have not always been reliable measures of creditworthiness.
That being the case, investors should not have alternative and effective risk management tools, such as credit default swaps, arbitrarily removed from their risk management arsenal. The growth
of the CDS market is a reminder that market solutions are capable
of supplying information investors need to make informed decisions. Arbitrary bans of certain derivative products would only
force derivative dealers out of the marketplace, and ultimately increase, not mitigate, systemic risk.

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Let me close by saying in The Republic, the Greek philosopher
Plato stated, ‘‘We can easily forgive a child who is afraid of the
dark. The real tragedy of life is when men are afraid of the light.’’
Mr. Chairman, when will the Administration see the light and
realize we can no longer keep GSEs’ debts in the shadows and continue down our current path of fiscal irresponsibility? Unless we
change course, I fear America will soon experience its own Greek
tragedy.
Thank you, and I yield back the balance of my time.
Chairman KANJORSKI. Thank you very much, Mr. Bachus.
And now, we will hear from the gentlelady from New York, Mrs.
Maloney, for 5 minutes.
Mrs. MALONEY. Thank you, Chairman Kanjorski, for holding this
hearing, and welcome to the witnesses.
This is truly a critical hearing, both because of the international
conditions concerning sovereign debt, but also because of what we
are working on in Congress. Financial regulatory reform will mean
significant changes to the overall functioning of the derivatives
market.
We are shining a light on over-the-counter derivatives, the financial instruments that have been at the heart of the debate of economic and financial news at home and abroad since the global economic crisis began. These complicated financial instruments can be
used for hedging or insuring against risk, which is good. But the
lack of transparency in their use, together with the lack of regulation of the market, can combine to give them the potential to catalyze economic havoc.
Warren Buffett has called derivatives, ‘‘financial weapons of
mass destruction,’’ and many have argued that these instruments
were responsible for the economic crisis in the United States. Our
goal today is to better understand derivatives so we can ensure
that they do more good than harm in today’s global economy.
We have experienced the impact of unregulated derivatives in
housing in the United States, and are still recovering from it. AIG
was unable to pay out on insurance on residential-backed mortgage
securities, and the effects on counterparties was massive. This
brought our country to the brink of collapse, and the lack of transparency was a major factor.
We are now watching the risk of derivatives play out when it
comes to sovereign debt. As this chart on the left shows, the net
notional amount of CDS on Greek debt, which represents the bets
on Greeks’ ability to pay, is well over $8 billion, which is quite
large compared to the $300 billion of outstanding debt in Greece.
In contrast, the CDS on U.S. debt, debt which is in the trillions,
is only one-quarter of the size.
Today there are $1.2 trillion in outstanding CDSs. Sovereign
credit default swaps make up 16 percent of $200 billion of that
total, and European Union CDSs represent two-thirds, $131 billion
of all sovereign CDSS. Greek CDS make up 6.3 percent, or $8.3 billion, of all European sovereign CDSs.
The use of derivatives on sovereign debt has exploded over the
last decade. Two different types of derivatives have been used by
countries looking to gain entry to the European Union. They were

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used in some instances to improve the appearance of their debt-toGDP ratio.
In currency swaps, the infusion of cash based on outstanding
debt in different currencies that fluctuates, the cash infusion is
really just a loan to pay current expenses that is paid back over
time with other resources.
Credit default swaps can be used as a form of insurance on sovereign debt, but they also act as instruments that just allow a bet
to be placed that a country will default on its debt obligations.
While the use of over-the-counter derivatives has exploded, regulation of these instruments remains nonexistent. There is a need
for regulation and transparency. This market has been almost completely unregulated because most of the deals are between counterparties, and there is no reporting requirement.
These transactions also do not have to be cleared by an independent third party or traded on a national exchange. For these
reasons, investors are largely uninformed about the extent of financial entities exposed to risk and about the CDSs that have been
taken out on any asset-backed security.
Regulatory reform will bring needed transparency into the market. It would protect investors from exposure to undisclosed and excessive overleveraging. And investors can still make bets, but they
will have a better idea of the real odds.
The Greek debt crisis is just a single example of the use of complex derivatives, but this hits as close to home as New York. In
Greece, investors must now pay $711,000 to insure $10 million in
Greek government bonds. This is up from $250,000 in the beginning of the year, almost threefold.
Concern has also been expressed at the State level about CDSs
on State debt, specifically in California.
And the question is, how do we regulate over-the-counter derivatives such as sovereign debt, CDSs, so that they can be used for
legitimate purposes without spreading financial contamination to
other countries and other financial institutions?
Thank you, Mr. Chairman. I ask permission to put all of my
statement in the record. My time has expired. Thank you.
Chairman KANJORSKI. Without objection, it is so ordered.
Now we will hear from the gentleman from Texas, Mr. Hensarling, for 4 minutes.
Mr. HENSARLING. Thank you, Mr. Chairman, and certainly thank
you for calling this hearing. When I look at the title of the hearing,
‘‘Credit Default Swaps’’ in the first part and ‘‘Greek Debt Crisis’’
at the end, I think it would behoove Congress to spend a lot more
time focusing on the debt crisis in credit default swaps.
I somehow feel to some extent, as I listen to some of the opening
statements, that there is an element of, let’s shoot the messenger,
the credit default swap market. Let’s to some extent say that they
have exacerbated the Greek debt crisis.
The lesson here for us—and I might add, to amplify a comment
of our ranking member—the market acted more efficiently than the
rating agencies. And theoretically, Greece had a deficit-to-GDP
ratio and a debt-to-GDP ratio that didn’t qualify under E.U. standards. And yet they were still allowed to remain as a member of the
E.U.

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And so the early warning signals in many cases actually came
from the credit default swap market. We need to be very cautious
on how we approach any type of new regulatory scheme that might
harm the ability of essentially this early warning system. And it
is certainly an early warning system to the United States of America.
As we know, I believe Greece is now having to restate their deficit-to-GDP ratio up to about 12 percent. Right now, we have a deficit-to-GDP ratio of 10 percent. We know also at the end of the
President’s 10-year budget window, according to estimates by the
Congressional Budget Office and the General Accountability Office,
we are looking at a debt-to-GDP ratio of 90 percent. All economists
will tell you that is when the needle enters the red zone.
Press reports indicated that members of Chancellor Merkel’s
party in Germany have called upon Greece to sell its sovereign territory in order to deal with its debt crisis. Sell sovereign territory.
I hope and pray that the United States is not on the path to becoming Greece without the Aegean Sea and the Parthenon.
But there are lessons to be learned here for us. There are also
press reports that indicated that when Argentina defaulted on its
debt—and I don’t believe the United States would ever default on
our debt—but when Argentina defaulted on its debt 7 or 8 years
ago, creditors actually tried to put a lien on their navy, their naval
vessels.
Here we are probably facing the most predictable crisis in the
history of America, and yet almost each and every day, this Congress makes it worse. And when we talk about accounting being
opaque, again to amplify comments of the ranking member, how
can we have our Secretary of Treasury come here and say, the debt
of the GSEs are not sovereign debt, but we are going to back each
and every dollar?
And somehow, again, we know that one of the causes of the financial crisis was essentially these off-balance-sheet vehicles, and
yet we have Uncle Sam engaged in the worst. There are 127 billion
reasons why the GSEs ought to be reformed, and yet the bill that
is going through Congress now is stone-cold silent on the root cause
of the problem. These are the true lessons we ought to be learning
from Greece.
Thank you, Mr. Chairman. I yield back the balance of my time.
Chairman KANJORSKI. Thank you very much, Mr. Hensarling.
And now we will hear from our final presenter, Mr. Perlmutter, for
3 minutes.
Mr. PERLMUTTER. Thank you, Mr. Chairman, and thank you,
panelists, for being here today. I look forward to hearing your testimony today to find out what lessons you would have us learn. I
think that the country, our country, has learned the lessons of tax
cuts for the wealthiest and prosecute two wars, and then absolutely
stand by and do nothing while major financial institutions like
Lehman Brothers go by the wayside under the Bush approach and
the Republican approach, is financial disaster.
And we saw that financial disaster in the fall of 2008. And this
country can’t afford to go that approach any longer, and I am glad
that Democrats are now in control to try to pick up the pieces after

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the mess that was left by the Republican Administration and the
Republican Congress.
And my friends on the Republican side of the aisle love to talk
about Fannie Mae and Freddie Mac, and they should have been reformed earlier. And I like to remind them of what the former chairman of this committee, Mr. Oxley, had to say when he and Mr.
Frank tried to do reform of Fannie Mae and Freddie Mac. Mr.
Oxley is quoted in the article from the Financial Times dated September 9, 2008.
Mr. Oxley fumes about the criticism of his House colleagues: ‘‘All
the hand-wringing and bed-wetting is going on without remembering how the House stepped up on this,’’ he says. ‘‘What did we
get from the White House? We got a one-finger salute.’’
This is the kind of situation where your testimony today is going
to be helpful in deciding how much regulation really needs to go
on with these kinds of derivative bets—how often they need to be
cleared, how much margin needs to be put down, and what is the
effect on a nation like Greece when its debt becomes overwhelming.
This country is taking steps to get people back to work and to
rein in the debt and institute uniform and consistent regulation on
its financial markets, unlike under the prior Administration. And
we hope that your testimony today will provide us with further insights.
And with that, Mr. Chairman, I would yield back.
Chairman KANJORSKI. Thank you very much, Mr. Perlmutter.
And now, I have 1 minute from the gentleman from Indiana, Mr.
Donnelly.
Mr. DONNELLY. Thank you, Mr. Chairman.
The American people have lost confidence in CDSs, CDOs, synthetic CDOs, and their aftermath. They have lost confidence in the
word and in the trustworthiness of the institutions creating these
instruments, and whether there is really any purpose behind these
instruments other than gambling and other than opportunities to
try to take advantage of someone else or some other organization
or some other country.
Transparency and trustworthiness are needed. They are a big
part of the effort being made by this committee. And I look forward
to this hearing. Thank you, Mr. Chairman.
Chairman KANJORSKI. Thank you very much, Mr. Donnelly.
Now we will hear from our first panelist, Mr. Robert Johnson, director of global finance, Roosevelt Institute.
Mr. Johnson?
STATEMENT OF ROBERT JOHNSON, DIRECTOR OF GLOBAL
FINANCE, ROOSEVELT INSTITUTE

Mr. JOHNSON. Good morning. Chairman Kanjorski, Ranking
Member Garrett, and members of the subcommittee. I thank you
for the opportunity to address the issues related to credit default
swaps and their implications for government debt.
As the Congress considers legislation on financial reform, I applaud your efforts to explore the implications of financial practices,
financial innovation, and particularly the practice in the areas of
derivative securities. It is my view that the explosive growth of de-

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rivatives and the immaturity of those market systems is at the core
of the financial dangers that we face moving forward.
I have stated elsewhere, and continue to believe, that the overthe-counter derivatives market is the San Andreas Fault of our financial system. The interconnection of balance sheets of the socalled ‘‘too-big-to-fail’’ firms and the OTC derivatives are a cocktail
that may force taxpayers to drink from disaster again in the future.
Repair of the system to reduce complexity and opacity will allow
the markets to function better when adversely shocked, as they
were by the housing price downturn, and as they will surely be
shocked again.
Strong, transparent markets are well-fortified with capital buffers, supervised and examined thoroughly, and they are a means to
help us reach our social goals. Market systems that are structured
according to the profit imperatives of a few concentrated firms,
firms that are supported by the backing of taxpayers, are very dangerous to the financial health of our Nation.
The structural designs that encourage a private appetite for risk
that exceeds the social benefits of that risk-taking are unhealthy.
Markets are a public good, and their structure has to attain and
maintain integrity, despite the formidable pressures that individuals, in particular big business interests, will bring to bear to refract that design for their private benefit, while being unmindful of
the harm that they could impose on society.
Today, our concern is with the impact of the CDS derivatives
market on government debt. I want to emphasize the history of
government debt growth, as many of you have commented, across
many nations and many times, suggests that war and financial crisis are the greatest causes of extreme and rapid increase of public
indebtedness.
Some analysts of the budget in Washington have estimated the
financial crisis of 2008 will result in a doubling of a U.S. debt-toGDP ratio. Therefore, the concerns about our public finances must
be concerns about financial reform. Said another way, one cannot
credibly claim to be a deficit hawk unless one is also a financial
reform hawk.
The credit default swap market has grown tremendously in recent years. The instruments played a large role in the financial crisis after the failure of Lehman Brothers, particularly with respect
to the AIG bailout. AIG provided mirage capital and mirage protection to financial firms, and it evaporated in the crisis. It was picked
up by the taxpayer.
At times, innovation is worshiped as a goddess of progress, even
when we don’t have the ability to measure the value of that innovation. It is an article of faith, but it does not appear to be the case
that financial innovation inspires our faith any longer.
Faith in the financial practices and wisdom of unfettered markets has been shattered. At the same time, faith in regulators and
government action in the aftermath of the bailouts is also absent,
and experts in financial theory now lack credibility in light of the
scale of the crisis due to their inattention to the risks associated
with innovation. Praying at the altar of liquidity and innovation
rings hollow without a clear acknowledgment of the damage that
immature market structures can influence on society.

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In the market for credit default swaps, some have been tempted
to ban the instrument altogether. It is clear, in light of recent revelations about financial practice and tremendous social losses that
can be caused, that a profound shift in sentiment has taken place.
At the same time, I would argue that there is a sound logic that
underpins construction of these instruments that isolate and transfer credit risk to where it is most able to be borne. Properly structured, transparent CDS markets that are well-capitalized and regulated can contribute to our well-being.
In these controversial times, it is important to keep in mind that
markets are a useful tool, but a tool that must be managed and administered when constructing a balance between the social costs
and benefits of a market for credit insurance.
Theories that depend upon the vision of the market possessing
a high quality of information as a maintained hypothesis may not
always be a good guide to the behavior of credit default instruments.
The standard, fundamental theory of pricing operates from the
premise that a market knows what the probability of default is
after a period of discovery, and it reflects that knowledge. Attempts
to buy credit default risk increase the price and are met with a
supply from those that know when the price is too high. The price
represents the truth, and deviations from the truth are arbitraged
away.
The alternative perspective envisions a market filled with uncertainty and imperfect information. In this perspective, buyers of
large amounts of CDS transmit a market signal that inspires others to believe that they know something that risk has risen.
Drawing inference from price, market participants then sell
bonds and stock in the belief that default risk is greater. The higher funding costs in turn depresses earnings and validate that projection of greater risk. The causation runs from price to fundamental outcome.
Examples of market manipulation contained in the appendix suggest there is cause for concern regarding credit default swaps.
Issues related to incentives for restructuring for impaired companies and countries potentially are also complicated by the presence
of credit protection in effecting incentives.
Government and municipal services are essential, and manipulative market methods may put them at risk. The hierarchy of
human needs for basic elements of social function implies that this
inquiry that you are holding today is a valid concern of public officials.
The appendix that follows contains my remarks. I will just speak
regarding the Greek crisis, and I will echo many of your introductory remarks. The Greek crisis in sovereign debt is not fundamentally caused by credit default swaps. One of you spoke about the
messenger. I don’t even think it is a big enough messenger to shoot
at in this case. The outstanding amount of credit default swaps in
Greece was very small.
Thank you. May I submit the balance of my remarks for the
record?
[The prepared statement of Mr. Johnson can be found on page
64 of the appendix.]

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Chairman KANJORSKI. Thank you very much, Mr. Johnson.
Let me make a point—I failed to do that—that we will make the
entire statements of the witnesses a part of the record. And we request that we hold ourselves to 5 minutes. We will give you a little
leeway, though, because we are interested in what you are saying
and we appreciate your testimony.
We will now hear from Mr. Robert Pickel, executive vice chairman, International Swaps and Derivatives Association, Incorporated. You must be a popular man this week, Mr. Pickel.
STATEMENT OF ROBERT PICKEL, EXECUTIVE VICE CHAIRMAN, INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION, INC.

Mr. PICKEL. I would like to think so.
Thank you, Mr. Chairman, Ranking Member Garrett, and members of the committee. Thank you again for the opportunity to testify before this committee. I have testified at least on one other occasion before this committee. And this time I look forward to discussing credit default swaps and government debt.
I have submitted my statement for the record, so let me just
summarize some of the key points I have raised in that. I will talk
a little bit about the varied purposes and motivations for parties
who utilize credit default swaps. I will talk about the important information and signaling function that they can provide.
I will briefly highlight the many industry efforts that are going
on as it relates to credit default swaps, but also derivatives generally, in the areas of systemic risk, transparency, and infrastructure. And then we’ll talk a little bit about manipulation, focusing
on the unique nature of these products and why that nature in fact
provides significant protections against the ability to manipulate
through credit default swaps.
The classic use of a credit default swap is to hedge credit risks
that a company might have, typically a bank which has lent money
or a company that owns the bonds of an institution. That is the
traditional hedging purpose of a credit default swap, buying protection.
But there are many other purposes for using credit default swaps
beyond that traditional hedging function. Investors in the debt or
equity of companies in a specific country may use sovereign CDS
as a proxy hedge against potential shocks to the economy of that
jurisdiction. Investors with real estate or other corporate holdings
or other investments in a country may similarly use sovereign CDS
to protect against their investments in those countries.
Portfolio managers may use sovereign CDS to hedge against
country, liquidity, and market risk. Large banks, who typically do
not, with highly rated sovereigns, post collateral or receive collateral from those sovereigns, may use CDS to provide some element
of credit protection against that uncollateralized exposure.
And then, of course, anyone who sells protection to anyone who
is buying protection by definition is taking on credit risk, and
therefore may wish to use credit default swaps to hedge some of
the exposure that it has. Even banking supervisors in central
banks can use the price signals provided by the CDS market to as-

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sess default risks in their system. So there are many different purposes for utilizing credit default swaps.
They do provide, as I think has been alluded to by a number of
the opening statements, important information to the marketplace,
information that 5 or 10 years ago did not exist. We are not suggesting that credit default swap information should replace the
other information that exists out there, whether that be credit rating agencies, an investor’s own due diligence, but we think it is important additional information.
And in fact, we know, from talking to treasurers or companies,
that they are watching their credit default swap spreads as closely
as they watch their stock price. It is a regular assessment by the
marketplace of how the company is doing.
So more information is certainly better information, and I think
finance ministers of countries can utilize the credit default swaps
on their sovereign CDS similarly to get an assessment of the marketplace’s assessment of the running of their economy.
We have, as an industry, undertaken a number of different initiatives relating to credit default swaps and derivatives generally.
We have focused on reducing systemic risk and the interconnectedness risk that we saw in 2008. That is primarily through establishing central counterparties, clearinghouses, and utilizing a process of compression to reduce the outstanding number of obligations
outstanding.
We have also increased transparency by establishing trade repositories, and the information that is on the chart over here is
drawn from that trade information warehouse that has been established and up and running for the last 3 or 4 years, sponsored by
the Depository Trust Clearing Corporation. So that information is
readily available and is extensively used as parties look at the exposure that is outstanding on any particular company or country.
Then finally, I wanted to just briefly respond to suggestions
about manipulation through credit default swaps. And to look at
this, we need to understand the fundamental nature of these products, these bilateral transactions. It is two parties who are entering
into this transaction. Anytime one is going short in a transaction
implicitly, by definition, another party is going long, taking the—
selling the protection position.
So that is a natural tension that exists in the bilateral relationship. And it is very hard in a series of bilateral relationships, bilateral contracts, to have the type of manipulative effect that has been
suggested for credit default swaps.
And the fact of the matter is that there are other mitigating factors relating to potential allegations of manipulation. Mr. Johnson
referred to the fact that the amount outstanding of credit default
swaps as it relates to sovereign debt is very small, certainly in the
Greece situation as well as other situations. Also, the majority of
sovereign CDS investors are likely hedging legitimate economic
risks, even if they don’t hold the actual bond.
And then finally, sovereign CDS may actually serve to moderate
downward pressure on troubled countries because if the CDS market did not exist, the only alternative would be to sell the bonds
or not take on the debt exposure to begin with.

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So those are the main points that I have raised in my testimony,
and I look forward to the questions of the committee. Thank you,
Mr. Chairman.
[The prepared statement of Mr. Pickel can be found on page 94
of the appendix.]
Chairman KANJORSKI. Thank you very much, Mr. Pickel.
And we will now hear from Mr. Darrell Duffie, professor of finance, Graduate School of Business, Stanford University.
Mr. Duffie?
STATEMENT OF DARRELL DUFFIE, PROFESSOR OF FINANCE,
GRADUATE SCHOOL OF BUSINESS, STANFORD UNIVERSITY

Mr. DUFFIE. Thank you, Chairman Kanjorski, and Ranking
Member Garrett.
As several committee members have mentioned in their opening
remarks, concerns have been raised that speculation in credit default swaps has been responsible for raising the borrowing costs of
Greece, California, and other government borrowers.
My written testimony contains empirical evidence, charts, and
statistical evidence, with Professor Zhipeng Zhang of Boston College, showing that there is no evidence that speculators have been
responsible for raising these borrowing costs.
First, as has been mentioned by Mr. Johnson and Mr. Pickel, the
amounts of credit default swaps that have been used to either
hedge or speculate against Greece is relatively small compared to
the amount of Greek bonds outstanding. It is under 3 or so percent.
Similarly, the amount of credit default swaps on California is
under 2 percent of the amount of debt outstanding.
Second, there is no evidence of large swings in the amount of
protection that has been brought. Charts in my testimony show
that the changes from week to week of credit default swap protection is rather small.
Third, changes in the amount of credit default swaps written on
these government borrowers and other weaker European sovereign
borrowers are not related to the credit default swap rates demanded by investors in this market. In other words, this sort of
speculation, if it is speculation, or hedging, is actually not related
to changes in Greek borrowing costs or the borrowing costs of these
other sovereigns or California.
And finally, as several of you—Chairman Kanjorski and Ranking
Member Garrett—have suggested, the credit default swap rates
have actually risen in advance of information that has been revealed about the true indebtedness of Greece.
And as that information has come into the market, we have
learned that Greece is likely to be unable to pay back its debt on
its own, and it is this fact that has raised its borrowing costs. It
is quite hard to imagine how speculation by credit default swap investors has caused Greece to borrow more than it can pay back.
Also, I would like to say that the external support that has been
provided to Greece does not, however, imply that Greece will avoid
default. The CDS rate for Greece, which is a close proxy to its borrowing rates, has gone to 10 percent in the last few days, indicating a significant chance of default.

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The debt crisis faced by Greece has profound implications for
other Eurozone countries right now. Eurozone governments issue
debt in a common currency. If one of them is unable to pay its own
debt, other Eurozone countries have an incentive to come to the
rescue and to protect the stability of the Euro on which they commonly depend.
In the long run, however, there can be an erosion of the incentives of fiscally stronger Eurozone countries to support fiscally
weaker Eurozone countries. Economists call this a free rider problem. Each time a Eurozone country spends more than it can pay
back, the fabric of the Eurozone is weakened. This is important to
the interests of the United States because the stability of the Euro
contributes to global economic growth and security.
Regulations that severely restrict speculation in credit default
swap markets could have the unintended consequences of reducing
market liquidity, which raises trading execution costs for investors
who are not speculating, and of lowering the quality of information
provided by credit default swap rates regarding the credit qualities
of these issuers.
Regulations that severely restrict speculation in credit default
swap markets could, as a result, increase sovereign borrowing costs
somewhat. In any case, speculation could continue via short selling
of the underlying sovereign bonds to the extent the bond market
is liquid.
Proposed reforms of the over-the-counter markets for credit default swaps and other over-the-counter derivatives will improve the
safety and soundness of these markets. Data repositories will eventually give regulators the opportunity to police those who would
manipulate these markets or would take positions whose risks are
too large with respect to the capital backing them.
Central clearing, if done effectively, will also bring needed stability to this market. Transactions price reporting will add additional transparency and improve market efficiency.
Thank you for the opportunity to present my views.
[The prepared statement of Professor Duffie can be found on
page 50 of the appendix.]
Chairman KANJORSKI. Thank you very much, Mr. Duffie.
And now, we will hear from Dr. Anthony B. Sanders, distinguished professor of finance, George Mason University.
Dr. Sanders?
STATEMENT OF ANTHONY B. SANDERS, DISTINGUISHED
PROFESSOR OF FINANCE, GEORGE MASON UNIVERSITY

Mr. SANDERS. Mr. Chairman and distinguished members of the
committee, on November 5, 2009, Reuters published a story entitled, ‘‘Greek Debt Reached 120.8 Percent of GDP in 2010.’’ Everyone around the global is aware of how Greece’s excessive debt fiasco had led to a meltdown of the European economy, potential
meltdown, at only 120 percent of GDP. Things became even more
critical when Greece discovered it had overlooked $40 billion more
of debt. Markets do not like surprises.
These stories about the Greek economy beg the following question: Was the cause of the fiscal collapse of Greece perpetrated by
credit default swaps, or was it out-of-control spending and bor-

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rowing by the Greek government that led to Greece being, in popular parlance, broke?
Credit default swaps play two important roles in the market for
credit. First, they facilitate liquidity by allowing investors to hedge
against negative outcomes—for example, defaults—and second,
CDS provide vital information to other market participants about
the risk of a particular investment.
This price or spread conveys information to potential investors,
communicating the level of risk involved in an investment, and
helping them to make a more informed and prudent investment decision. Restricting either of these roles makes credit less widely
available and markets less transparent.
CDS is the current villain du jour in the Greek debt fiasco. The
Greek crisis is the result, again, of massive government spending
and debt issuance to fund that spending. In fact, CDS in Greek
sovereign debt actually served a positive role: It alerted everyone
around the globe that Greece was in fact in a death spiral from
credit.
CDS is often misunderstood. Essentially, it allows investors to
hedge their positions in debt, in this case, default of Greek sovereign debt. An investor may hold Greek sovereign debt long and
may want to partially or fully insure against that default on debt.
By limiting or abolishing CDS, you not only decrease liquidity for
investors, which is a terrible idea, but you actually decrease liquidity in the underlying asset, in this case Greek sovereign debt.
As can be seen in Exhibit 1 in my report, CDS spread started
to widen in October and November of 2009. By December 2009,
CDS spreads widened even more dramatically. That is when the
120 percent GDP story came out.
Now, consider further the Greeks’ surprise when on April 2,
2010, a story revealed that Greece had another $40 billion of unknown debt, and CDS widens. For a country that is already deep
in trouble making its debt payments, the discovery of another $40
billion came as a rude surprise. I also show that in my exhibits,
how devastating this is.
So focusing on the instrument as the cause of the problem, in
this case CDS, misses the real culprit, the behavior of the underlying asset. With Greece, CDS reacted to the behavior of the underlying asset, the debt. Just as in the housing crisis, CDS has been
blamed for exacerbating the crisis, but really, it was the behavior
of the underlying asset, housing prices and mortgages, that was the
issue.
If you are looking to place blame, don’t blame the instrument.
Blame the behavior of the underlying asset. Greece hid its debts.
Markets found out and reacted appropriately. This is a lesson we
learned well for the United States. Our own sovereign debt has a
Greek surprise component, too. It is called GSE and agency debt.
As Secretary Geithner tried to emphasize in a recent House hearing that I was involved in, the Federal Government’s support of
Fannie Mae and Freddie Mac does not change the legal status. In
addition, he said, the corporate debt of the GSEs is not the same
as U.S. Treasury debt.
Secretary Geithner went on to say he wanted to eliminate this
ambiguity. I completely agree with Secretary Geithner. But to end

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that ambiguity, we need to at least recognize the GSE corporate
debt on the Federal budget along with projected guarantee book
losses.
An argument can be made against requiring that the guarantee
books be brought on balance sheet, and an argument can be made
to bring them on balance sheet. As I had mentioned before, the
CBO has projected that these losses will be about $400 billion over
10 years, which could be higher or lower depending on future economic conditions, interest rate, and tax rates. These guarantees are
supported by cash flows from borrowers, so it’s less critical to bring
them on the Federal balance sheet, although the losses that are expected should be recognized.
Lastly, I would err on the side of fiscal conservatism by raising
the projected guarantee charges for $400 billion to a higher number
based on stress tests by the CBO in the same way that Fannie and
Freddie run stress tests and alternative scenarios. FHFA has the
stress test results, and we should prepare for the possibility of a
double dip in housing prices in a few of the recessions, which is
going to drive those losses much higher.
Thank you for allowing me to share my thoughts with you today.
[The prepared statement of Dr. Sanders can be found on page
103 of the appendix.]
Chairman KANJORSKI. Thank you very much, Dr. Sanders.
And finally, we will hear from Mr. Joseph R. Mason, Louisiana
Bankers Association professor of finance at the Louisiana State
University.
Mr. Mason?
STATEMENT OF JOSEPH R. MASON, LOUISIANA BANKERS ASSOCIATION PROFESSOR OF FINANCE, LOUISIANA STATE
UNIVERSITY

Mr. MASON. Thank you, Chairman Kanjorski, Ranking Member
Garrett, and members of the subcommittee for inviting me to testify today on this important and timely topic.
While it is widely held that unprecedented monetary and fiscal
policy responses of countries worldwide have been successful at
preventing a worst-case scenario repeat of the Great Depression,
the combination of rising fiscal deficits and continued monetary
policy accommodation has raised concerns about the sustainability
of public finances and fears of inflation. As a result, the recent uproar about Greece’s fiscal woes and possible debt default are viewed
by many as merely a canary in a coal mine.
It is hard to argue that Greece is not to blame for its difficulties.
As of December 2009, Greece had the highest fiscal account imbalance, as a percent of GDP, in all the Euro area countries and Britain at negative 7.7 percent, and its projected 2009, 2010, and 2011
balances were second only to Ireland.
With a long history of fiscal stress and four previous defaults in
modern history, investors are right to be suspicious. As of this
hearing, Spain, Ireland, Italy, and Portugal are being pressured for
similar good reasons, not mere contagion.
Defaults are nothing new, even for sovereign entities and municipalities. There exists a long history of defaults throughout the
world as well as U.S. history. The definitive guide to the history

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of U.S. State and municipal defaults shows that even in the Great
Depression, States with serious default problems took on far more
debt in the decade than States that had no defaults. Hence, even
historically, default is not a threat without a substantial debt load.
More recently, S&P reports that the 5-year transition rate for
AAA-rated local and municipal debt over the period 1975 to 2009
was 27.4 percent, with 10.9 percent of that resulting from ratings
that were withdrawn and 16.4 percent resulting from ratings that
were downgraded. S&P reports that the sovereign speculativegrade-rated 15-year default rate over the same period was 29.66
percent. The point is, sovereign defaults happen.
A real problem in the sovereign CDS market, however, arises because of the concentration in counterparty risk. Whether that concentration is at a central counterparty or a small group of market
participants, the risk remains. Recently, the IMF has opined that
the magnitude of risk to be assumed at the proposed CCP on behalf
of unmargined market participants is of an order of magnitude in
the neighborhood of some $200 billion, and is rising daily with further exemptions. That estimate should not be dismissed or the
amount will surely precipitate a future crisis.
Some have pointed to CDS as creating problems for sovereign
debt financing. It is hard, however, to see the case. While CDS provide transparency by aggregating market views of the probability
of default and recovery, CDS in and of themselves do not create additional volatility to those views.
The view of CDS as creating volatility comes from observations
that CDS spreads can widen quickly before a credit event, reflecting demand from CDS protection buyers. Some of the furor arises
because CDS markets may be dominated by fast-moving hedge
funds, while cash bond markets are dominated by buy-and-hold
real money investors.
While it can seem that the signals from the two markets may be
at odds during distress, the apparent divergence has been shown
to be bounded by some fundamental institutional and value distinctions between CDS and the underlying debt contracts.
CDS do contribute greater information to markets than credit
ratings, but no degree of rating agency liability, not even that
greater than the PSLRA that would make them responsible for
even Goldman Sachs’ alleged fraud, will change that relationship.
Overall, the danger that a CDS buyer may deliberately trigger
a credit event remains theoretical. There are no known cases of adverse behavior that have directly impacted debt borrowers because
those borrowers are known to be struggling financially anyway.
In sum, therefore, I am not convinced that sovereign CDS deserves its current negative press, and fear that a ban or restriction
on trading could easily backfire. Bans on trading activity tend
largely to reduce liquidity, forcing a reversion to a world where
sudden and unhedgeable price jumps occur when information about
underlying fundamentals is occasionally priced into an illiquid
market, that is, when someone finally trades.
Sovereign CDS provides an efficient way to trade and to hedge
credit exposures to governments, as well as a more continuous way
for governments to poll their fiscal decisions more continuously in

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the marketplace. If governments do not like that transparency, it
seems they doth protest too much.
Thank you.
[The prepared statement of Professor Mason can be found on
page 81 of the appendix.]
Chairman KANJORSKI. Thank you very much, Mr. Mason. I thank
the entire panel for their testimony, and now we will move to the
questions. I will take the first 5 minutes, and at the conclusion of
my 5 minutes, I will ask Mrs. Maloney to take the chair.
I am not sure what I am supposed to gather from the testimony
of all five witnesses other than that CDSs obviously are not the
problem, but we have a big problem out there. Is that true, relatively speaking? We just have not done a postmortem to determine what really constitutes the problem, and how it can be solved.
Is that reasonable?
And the reason I ask you that is over the last 3 or 4 weeks when
the Greece problem was called to international attention, it started
at $45 billion, a need for a $45 billion underwriting or infusion
from the European Union, and now it is up to $120 billion and
climbing. And somebody today stated that there is no way that
they can work a rescue here without a restructuring.
I would like your reaction to that opinion, if any of you have one.
Is that a correct or a likely conclusion?
Mr. DUFFIE. Mr. Chairman, could I address that?
Chairman KANJORSKI. Surely.
Mr. DUFFIE. You are correct. The estimates of how much will
have to be loaned to Greece have gone up—tripled in the last few
days. And again, relying on the CDS markets, as we have said,
there seems to be a perception that Greek sovereign debt has a significant probability of defaulting anyway.
One of the reasons for that is that these monies coming from the
IMF and the Eurozone countries are not donations to Greece. They
are loans. They have to be paid back. So they will actually increase
Greece’s indebtedness, although the terms of the loans are rather
generous.
The other issue is that some of these loans to Greece in external
support may actually come in ahead of Greek sovereign debt in
terms of who gets paid first. And that actually causes concerns to
some Greek sovereign debt holders. If the IMF, for example, gets
paid before them, maybe there won’t be enough left for them.
So in summary, I think it is not at all clear that Greece will
avoid a restructuring of its debt or an outright default, and only
time will tell.
Mr. SANDERS. Chairman Kanjorski, I would like to first of all
agree completely with my esteemed colleague, Professor Duffie. But
I would also like to point out that it is just not Greece; it is also
Portugal—Spain is about to blow up; Ireland; Iceland. Great Britain is on the brink, too.
So we are talking about a substantial amount of—some of those
are non-Euro countries, but that Europe in general is having a severe meltdown due to, again, excessive spending. And it is biting
them really hard right now.
Chairman KANJORSKI. What sort of potential—obviously, we do
not have jurisdiction to intrude into the European Union. But I am

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dealing with them on financial matters on a regular basis now because we are trying to do our regulatory reform consistently, with
the E.U. and the United States being on an equal footing.
This is rather shocking, though, that suddenly someone can discover $75 billion of new debt that was really unrealized just 3 or
4 weeks ago. And it is true, when you talk about Spain, Portugal,
Italy, and Ireland, if you throw them all in, the one commonality
they seem to have is that they have violated the rule for entry into
the Euro Union in that they went—they are all over 60 percent in
debt, as opposed to the other countries that were far more stable
and were in the union originally. I guess it proves that whoever set
that formula up knew what they were thinking or talking about.
But like anything that can be contagious, and we saw that recently in the credit crisis in the United States when things started
to tumble, suddenly what are reasonable assets become valueless
or almost valueless. And that obviously, probably, is happening to
some extent in these countries.
How do we put a stopgap in there, and how do we prevent that
constant rolling motion that would take everything down, eventually the entire European Union? Is there some thinking on that?
And maybe somebody wants to grab it and run with it?
Mr. MASON. If I may, one substantial element that was left out
of the European Union construct was a way to address individual
country difficulties through some type of central bank action. In
fact, that is why we designed the U.S. Federal Reserve System as
a system of central banks able to address regional needs, even if
the entire Nation did not need a stimulus.
That is a fundamental flaw, and that is what creates the risk of
being unable to address specifically Greece, Italy, and Spain while
leaving, for instance, Germany and France relatively untouched.
But you are exactly correct that the E.U. entry rules set the
stage for off-balance-sheet finance. By arbitraging this rule, by
keeping funding off-balance-sheet, they could stay within the debt
limits, at least based upon the formula, but not in any real economic way.
And that is a very, very important lesson that I want to point
out here that happened in the United States with securitization in
commercial banks. And I really would like to stress to the committee to see how that application is very robust to a number of
different rules, even some rules that may be considered today in financial reform.
Chairman KANJORSKI. Thank you very much.
Yes, Mr. Johnson?
Mr. JOHNSON. Characteristically, when officials are doing a workout, the rule of thumb is to do too much rather than too little, in
other words, to get ahead of the curve and do something so profound in restructuring that you essentially what you might call
stop all of the emotion that leads to contagion in its tracks. You
stop people from drawing inference about propagation.
What is particularly difficult about this situation once it has
taken place, and Professor Duffie mentioned this, is the free rider
problem, which is at this point Greece knows that it is not just its
own fate that is in its hands. Greece knows that it can take Italy,
Portugal, and possibly the whole Euro structure down with it. And

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their incentives in bargaining now reflect more than their own fate.
They think they have more leverage than if it was just an isolated
country.
So at some level, doing something that would, how should I say,
not call Greece’s bluff, but would acknowledge that they are going
to perceive those side effects require a bigger offering from the
other side of the table. Right now, Germany doesn’t want to offer
that. And they have a traditional concern about inflation in their
past, and they don’t want to do that right before an election when
their population is not necessarily that fond of the Euro anyway.
But the basic concept is you have to do more than you think is
necessary in order to quell those anxieties once it takes place.
Mr. PICKEL. Mr. Chairman, if I could just return to your first
question. I think it’s important to understand the nature of these
contracts as they are sovereign CDS versus corporate CDS.
In a corporate CDS, the triggering events for a settlement are
typically bankruptcy and failure to pay. For a sovereign CDS, the
relevant events that would trigger a settlement of the credit default swap would typically be restructuring or a moratorium or repudiation of debt.
And so, it is certainly true that participants in the credit default
swap market are watching the current discussions very closely to
see what the nature of the support from the IMF of the Euro might
be because it could in fact be those events that might trigger a
credit event under the contract.
Because countries don’t go bankrupt. Countries always have the
ability to tax. But they may restructure their debt or they may
miss a payment, and that would trigger a settlement.
Chairman KANJORSKI. Thank you, Mr. Pickel.
I am now going to recognize the gentleman from New Jersey, Mr.
Garrett, for 5 minutes. And may I request Mrs. Maloney to take
the chair?
Mr. GARRETT. I thank the Chair, and again thank the witnesses.
And I guess my opening thoughts and comments were that this
committee and this title, ‘‘Credit Default Swaps and Government
Debt,’’ could involve itself into a bunch of different areas.
I guess the first takeaway from this is, taking the lead from the
chairman and also from Mr. Johnson’s opening testimony, and everybody else right down the row, is that CDS were not the underlying cause of the problem that we see in Greece right now. So
from that, then we can sort of explore and say, well, what should
we learn from this experience?
Mr. Johnson, I know in your testimony you conclude, ‘‘The Greek
crisis in sovereign debt—sort of saying what I just said—is not fundamentally caused by CDS. It is caused by a profile of spending
and tax revenue, and a dynamic of government debt accumulation
that is fundamentally unsustainable.’’ And I mentioned in my remarks what Chairman Bernanke said, that here in this country we
are not going to be able to grow our way out of it, which is some
people’s suggestion as to how we solve our problem.
So I would just be curious for your take on our problems here
in this country is in order to avoid the situation that Greece sees
themselves in. Is it like a lot of the experts who testify over in the
budget committee hearing, that our first and fundamental area

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that we need to address is the entitlement spending in this country, and somehow or other we have to rein that in, and that is our
Greek problem, if you will?
Mr. JOHNSON. You are calling me back to the days when I was
a staffer on the Republican Senate Budget Committee under Pete
Domenici, so I will have to dust off those memories.
What I would say is that there are many tools that reflect social
priorities, and that the United States, after this financial crisis and
definitely if we had a recurrence, would be reaching what Congressman Hensarling talked about, the red zone, which Ken Rogoff
and Carmen Reinhart talk about as a debt-to-GDP ratio approaching 90 percent.
I do think that structural reforms have to be made. Whether
those structural reforms take the form of further health care legislation that reduces the price of care, or whether it involves entitlement reform in terms of the extent or quality of care, whether it
involves taxation, or whether it involves the military budget, any
of those things logistically fit into the what you call menu, theoretical menu, of tradeoffs that one could invoke.
It is really a question of social preferences as to how you get
there. And I do believe that we face that challenge. We have to define those preferences.
Mr. GARRETT. And then turning to Mr. Duffie, I noted your one
comment, and then there was like a pregnant pause after it, and
I don’t know if it was intended or not, saying that speculation did
not force the excessive borrowing, or spending first and then borrowing by Greece.
Do you have any other comment to follow up, after your pregnant
pause?
Mr. DUFFIE. I would like to address the issue of whether speculation has any benefits at all. And one of the ones that has been
mentioned by all of the panelists, I believe, which is that it provides an early warning system to the market. I think that has been
quite helpful in this case. It has caused people to dig into the true
financial condition of Greece, as Professor Mason suggested.
Another benefit of speculation is that when someone needs to lay
off some risk, they have to find someone to take it on, and speculators will usually do that in return for an expected profit. If we
didn’t allow them to participate in this market, it would be harder
for investors to either exit their positions or hedge their positions.
So I would encourage regulators generally not to clamp down on
speculation, but to clamp down on manipulation, which is a different aspect.
Mr. GARRETT. One last question. My time is coming up here. Mr.
Sanders and others alluded to the fact that a lot of this that happened in Greece, the triggering was the finding of new information,
the $40 billion, or what-have-you. I have legislation in to say that
we want to make sure that all of our information in this country
is clear and transparent, and to say that all of our debt should be
apparent to the public.
I would think it is apparent, but I think the clearer way is to
put it on the budget. Is there any reason why that would not be
a legitimate avenue for Congress to go down and say, all of our

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GSE debt, if it is really sovereign debt or whatever the Treasury
Secretary says it is, should not be transparent and on our budget?
Mr. DUFFIE. I think that is correct. I think Supreme Court Justice Brandeis at one point said, ‘‘Sunlight is the best disinfectant.’’
And I think that is exactly what is needed, as much transparency
as possible.
Mr. GARRETT. Let’s flip it around. Does anybody disagree with
that?
Mr. SANDERS. I agree completely with that statement. I think it
really should be brought on it because we do want to avoid another
Greek surprise. And if we leave it off, it just begs for another surprise in the market that is a negative.
Mr. GARRETT. And Mr. Mason, it looks like you—
Mr. MASON. I also agree that we need to be clear about our own
off-balance-sheet exposures, so to speak. But we also need to pay
attention to the resolution of the consumer problems in today’s
marketplace in terms of what we have talked about in restructuring in the Greek context.
If you think about a restructuring for today’s consumers, by offering the modification and therefore taking a loss on the secured
debt, while leaving the unsecured debt of the consumer intact, we
have actually violated an absolute priority rule in the restructuring
of the consumer in a way that has confused and shocked markets.
And in the restructuring, we do need to be very careful to communicate directly to investors, previous investors, what they are
liable to get even after loans from the outside come in to bail out
the—
Mr. GARRETT. And just so I understand what you just said, that
means that all the work that we do as far as restructuring on the
secured debt, which is mortgages and all those programs, we have
to be careful of the implications on what that does as far as the
unsecured debt and going forward as far as whether lenders want
to engage themselves in that activity?
Mr. MASON. We have seen that directly by modifying first lien
mortgages before second lien mortgages, and of course the second
lien holder was able to avoid a loss where they would have otherwise, according to the rules of the game, taken a loss. It has been
confused.
Mr. GARRETT. Right. Thanks. I appreciate the clarification.
Mrs. MALONEY. [presiding] Thank you. The Chair recognizes herself for 5 minutes.
The first time CDSs came to national spotlight and attention was
during the AIG crisis. And I would like to ask the panelists, starting with Mr. Johnson and going down, if anyone would like to comment on it.
What would have been necessary to avoid the AIG bailout in
terms of CDS reform?
Mr. JOHNSON. Would you like me to start?
Mrs. MALONEY. Yes. You start, and then Mr. Pickel and Mr.
Duffie, if you would like to comment.
Mr. JOHNSON. I think there are a couple of things that come to
mind, the first of which is the way in which premium income is
booked by those who wrote CDS during that period, allowed them
to book it as income and not have set-aside or loss provisioning,

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whereby—how do I say it—they built a war chest or a contingency
fund in the event that they had to pay out.
But I want to be a little bit careful about that. CDS is an unusual contract. It is not as if there is a stream of payments that
when the event is triggered, the insurer just assumes a stream of
payments. They actually have to deliver on the whole loss for the
outstanding bond.
And you go from collecting a premium, which is a flow each year,
to having a huge liquidity demand on as the writer. And obviously,
when we had a giant storm like that, it is not clear to me that even
a well-provisioned system would have withstood that shock.
The second dimension, I think, is that a systemic risk regulator
needs to understand the distribution of exposures, ex ante, and
they need to have a very clear sense of that pattern of exposures
because when they are called upon to resolve any impaired institution, they may be triggering an event that is not necessarily emanating from the balance sheet of that institution.
If one bank fails, two other banks may have transferred risk on
the CDS on the failing bank. And unless there is a unified awareness of that exposure map, by taking action, putting the failing
bank into receivership, you may drag somebody else over the wall
with you and lead to contagion.
Understanding those consequences will make it much easier for
the resolution authorities. So that information system, I think, is
very important.
Mrs. MALONEY. Mr. Pickel, would you—
Mr. PICKEL. I think it is important to understand the differences
between the nature of the transactions done by AIG and the transactions that are the focus of this hearing, the sovereign CDS or
even the corporate CDS. Those credit default swaps were written
on super-senior tranches of CDOs which had exposure to underlying real estate risk.
And in fact, those were—there is all this discussion about naked
credit default swaps or situations where you actually have the underlying risk. The people who bought that protection from AIG actually had the underlying risk. So those would be—even if you
wanted to ban naked credit default swaps, those could still be done.
I think it is also a function of the fact that the AIG individuals
who were involved in these transactions didn’t have a full understanding of the nature of the risks. They were looking at the potential for them to have to pay out. They did not take into account the
mark-to-market risks that they had.
It was compounded by a reliance on AAA ratings and refusing to
provide collateral. Collateral is a very important tool in the OTC
business, widely used, and it provides not just credit protection, but
provides indications as to the exposure that you have under your
underlying positions that you can adjust to. They compounded that
by agreeing to downgrade provisions so that at the very worst time,
when they lost their AAA rating, they had to come out with massive amounts of collateral because of the mark-to-market exposures.
So I think you need to have the information that Mr. Johnson
refers to. Clearing wouldn’t help in that situation, but greater utilization of collateral in those transactions would be quite helpful.

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Mrs. MALONEY. Would anyone else like to comment? Mr. Duffie
and Mr. Mason, and then my time is up.
Mr. DUFFIE. Briefly, there are four measures in the legislation
that your committee has proposed to reform the financial system
that address this.
First of all, the supervision by the Federal Reserve of systemically important financial institutions would include a firm like
AIG. Hopefully, they would do a much better job than the Office
of Thrift Supervision actually did at the time.
Second, the legislation proposes a new method for resolution of
systemically important financial institutions, and that would allow
AIG to be taken apart without necessarily a lot of collateral damage.
Third, data repositories are in the new derivatives legislation.
This would provide regulators with the opportunity to see how
much credit default swaps AIG would have held.
And then finally, as Mr. Pickel said, the new legislation will require substantial amounts of additional collateral, and that will
also improve the situation.
Mrs. MALONEY. And Mr. Mason, and then my time is up.
Mr. MASON. Thank you. I would like to emphasize Mr. Johnson’s
remark about information, but also take it a slightly different direction. The information that we needed to understand AIG’s exposures was there. DTCC had it. We just needed to think to ask
them.
After my own experience in the bank regulatory agencies, it has
been amazing to me that bank regulators would not ask outside of
banks for additional market information or even information about
direct bank exposures, whether it is CDS or off-balance-sheet
securitized entities.
To me, that is the important element that can be solved fairly
simply in financial reform. Instead, financial reform, as currently
drafted, is asking for the entire trading book of every systemically
important institution, which is information overload. Any attorney
knows if you want to fight off an attack, you either withhold information or you give them too much to digest.
That would be far too much to digest, and I think the best starting point is to allow bank regulators and other Federal regulators
access to information sources, common on Wall Street, that they
cannot afford right now, and sometimes even, because they are not
a qualified institutional buyer, cannot even legally access. That
would give the greatest bang for the buck, so to speak, of the legislation. Thank you.
Mrs. MALONEY. Thank you. Mr. Bachus is recognized for 5 minutes.
Mr. BACHUS. Thank you. First, I want to say that your testimony, which arrived yesterday afternoon, our staff reads that, and
they refer that to us—not always; they will recommend that we
read it or not. And we then will review some of it or look at it or
use it.
And I want to say the staff and I both want to compliment you
on your testimony. We found that it was very insightful in all
cases, and did what it is supposed to do. So if you had a Member
who stepped out during your testimony, he probably read it or will

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read it, and he certainly had a staffer that highlighted certain
things to him. So I commend you on that.
Mr. Duffie, let me start with you. Credit default swap spreads,
I think, are a reflection of Greece’s economic condition. I know the
Greek government’s difficulty refinancing its debt is a direct result
of not the CDS—sovereign CDS market, but of legitimate concerns
about its financial health.
Would those concerns—or let me say this: Is it correct to say that
the sovereign CDS market alerted us to the problem the Greeks
had, as opposed to contributed to it? Many people have blamed it
on the sovereign CDS market, or part of that. But what is your
view?
Mr. DUFFIE. Based on the statistical evidence, that is certainly
my conclusion, Mr. Bachus.
Mr. BACHUS. That—
Mr. DUFFIE. That the CDS market, rather than causing Greece
to have borrowed too much money or to be currently in a debt crisis, it actually alerted investors that Greece would have borrowing
problems.
Mr. BACHUS. Right. And it served a very useful purpose in that
I think it caused people to confront the problem.
Mr. DUFFIE. Yes. It provided both an early warning system, and
of course, for those who needed to get rid of some of their risk, it
provided a way for them to transfer it to others.
Mr. BACHUS. Right. I appreciate that.
Mr. Sanders, the Federal debt stands at $8 trillion, and GSE
debt stands at an additional $8 trillion. That represents 110 percent of our GDP. What are the implications of an unsustainable
debt load? And actually, Chairman Bernanke said that our debt
projected was unsustainable.
Mr. SANDERS. Actually, the Federal debt load is over $12 trillion.
It is just that $8 trillion of it is public debt. And of the GSEs, the
guarantees are a large part of that $8 trillion. There is a lesser
amount, which is a little less than 50 percent, is the GSE corporate
debt. But it still amounts to a large chunk of GDP, and this is before all the real massive entitlement programs, etc., kick in.
And then once we hit that, I think the unfunded liabilities, depending on the source of it, can be upwards of $110 trillion and
growing. We are at $8 trillion plus GSE debt plus, remember, my
good friend Joe has always talked about the off-balance-sheet issue.
I wrote a paper a few ago called, ‘‘Banks: The Next Enron,’’ warning that off-balance-sheet financing is devastating unless you put
it on the balance sheet.
And for the government, it is especially true. We have pension
programs which are currently off balance sheet that, like Wall
Street, are only recognized if there is a loss. And really, we have
to end that. We have to bring it all on balance sheet so, as Professor Duffie—according to Justice Brandeis, sunlight is a great
thing. We should have all this stuff visible because it is
unsustainable.
And as I quoted in my paper, presentation, I said that 2 percent
of United States households have $250,000 or more of income. But
if they are bearing the brunt of all these entitlement programs and
war spending—let’s just say all spending—and we add these up,

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that ends up being that each household that makes $250,000 or
more is responsible for $47 million per household.
Now, I would call that unsustainable. And it also scares the living heck out of me, too.
Mr. BACHUS. I appreciate that. I also appreciate that Chairman
Frank and Congresswoman Maloney and Subcommittee Chairman
Kanjorski selected our witnesses. They did a good job this time.
Thank you.
Mrs. MALONEY. Mr. Sherman?
Mr. SHERMAN. Thank you. Mr. Sanders, just a comment, and
that is you seem to be focusing on income taxpayers rather than
Social Security taxpayers. People earning much less than $250,000
are paying the bulk of that Social Security tax. And if you are talking about who is going to pay for the entitlements, it is chiefly
those who are paying Social Security tax.
One could design a society where the greatest rewards went to
science and engineering. But we pay the largest salaries to those
who study under Mr. Duffie and go into Wall Street. And that is
justified on the theory that capital allocation is very important.
But the question is whether Wall Street is engaged in capital allocation or just naked betting. Gambling is usually thought to serve
no particular social purpose, and if anything, imposes social costs.
George Soros a couple of days ago, in commenting on synthetic
CDOs, but this also applies to naked CDSs, said that they serve
no social purpose and build up the amount of debt, thus creating
a larger crash when the crash occurs.
What social benefit, Mr. Johnson, occurs from those who bet on
Greek currency for no good reason, nothing to do with their regular
business, just because they think they are smarter than the market
and they can guess whether it is going to go up or down?
Mr. JOHNSON. I have to refer to the distant past in my resume
before answering you, just to be very clear. I used to be—
Mr. SHERMAN. I have limited time. Please answer my question.
I will learn about your resume later.
Mr. JOHNSON. I used to be George Soros’s partner and a currency
speculator in the early 1990’s, and I just want to preface with that.
I believe that there are times when price systems get out of balance. You referred to the excessive incentive to allocate our best
talent to Wall Street, probably because we had a lot of embedded
subsidies in the system that blew up a year or so ago that made
Wall Street firms excessively profitable, and they could pass their
risk off onto the taxpayers.
That is being corrected now, and I don’t expect Wall Street to
draw quite as much talent as in the past. I don’t think that gambling on currencies for its own sake, as an action, has much redeeming quality. But I would say that when a price system reequilibrates, a society gets back on track sooner.
Greece right now is—how do we say—harming future generations, and the price pressure coming to a head, and violent, may
represent those future generations.
Mr. SHERMAN. Reclaiming my time, one issue that comes before
us is whether we should impose any fees or taxes on the casinos
on Wall Street. I would point out that every other town in America
where they have a casino, there is a tax. And at least then, there

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is some social benefit that accrues from allowing the gambling activity to occur.
My next question relates to why California is facing a valuation
of its debt below that is Kazakhstan, Croatia, Brazil, Bulgaria, and
even Thailand—at least, I haven’t checked Thailand recently; they
have some problems there—where you have to pay 200 basis points
for insurance. That is only 3 times what you pay on Greece.
My reason is not just that the California economy is many score,
or at least 20 times, that of Greece—at least many times that of
Greece. The debt in California is considerably less. But also, as a
matter of law, if California doesn’t pay, courts will step in and divert revenue streams of California to pay the bondholders.
In contrast, when a sovereign, a true sovereign, goes bankrupt,
an independent country, they can simply disclaim their debt, declare it void, and there is—100 years ago, we would send in the
Marines to Haiti and collect their revenue and give it to the creditors. But since those days, it seems to be in the interest, the shortterm interest of Greece, at least, to repudiate its debt. They make
$300 billion in one day.
So why is the cost of insuring Greek debt, where the Greeks can
make over $100,000 per family of 4 in 1 day with no court able to
enforce the debt—why is that in the same ballpark, even, as the
cost of insuring California debt, where if California doesn’t pay, a
court comes in, takes our income tax and sales tax revenue, and
makes sure that large chunks of it go to the debt holders? I am
looking for—Mr. Pickel, do you have an answer?
Mr. PICKEL. Yes. I will try to respond to that.
You are right that repudiation is certainly an option for a sovereign, and that would trigger the settlement of the credit default
swaps. That is an event that would trigger for Greece or a country.
Mr. SHERMAN. And what would Greece lose if it renounced its
debt? We see what it gains. It gains $300 billion. It loses the ability
to borrow.
Mr. PICKEL. Right.
Mr. SHERMAN. But on a cash flow basis, if your debt service exceeds your borrowing—first of all, I don’t know anybody other than
the IMF and the European Union who is going to loan any money
to Greece.
Mr. PICKEL. Right.
Mr. SHERMAN. But even if they could, they are going to borrow
less than their debt service. So why isn’t Greece defaulting? It is
a $300 billion payday.
Mr. PICKEL. I will maybe defer to some of the economists on the
panel. But I think that there is that reputational issue of being
able at some time in the future ever to get back into the capital
markets to borrow in the future. So that is certainly a concern.
Mr. SHERMAN. Let me turn to one of the economists quickly. If
Greece honors its debt, nobody is going to want to lend them
money for 2 or 3 years anyway. And if they dishonor their debt,
in a decade, people will be loaning them money again. So, Mr.
Duffie, why don’t they just renounce?
Mr. DUFFIE. I think there is—
Mrs. MALONEY. The gentleman’s time is up.
Mr. SHERMAN. I will ask you to answer the question, please.

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Mrs. MALONEY. Answer the question.
Mr. DUFFIE. I think there is a significant probability that Greece
will default on its debt for exactly the reasons that you suggested,
although, as Mr. Pickel suggested, it is costly to do that because
in the future, Greece may need to borrow again.
Mrs. MALONEY. Thank you. Mr. Neugebauer?
Mr. NEUGEBAUER. Thank you, Madam Chairwoman.
I would like to kind of continue down that same line of the discussion because—and I think it was Mr. Johnson who said that the
whole European Union is somewhat in a fragile position right now.
And I referred to it yesterday as kind of a house of cards, and that
two or three of these cards fall and it puts an extreme amount of
pressure on the E.U.
Probably the United States is the beneficiary of that right now
because people are—that is probably what is giving the Treasury
Secretary the ability to keep borrowing money and dollars to support these huge deficits.
But I think the question I have for the panel is if this begins to
happen in Europe and we have some defaults—Japan is not in just
the best of shape itself. A lot of people don’t—that is not on their
radar scope. The Chinese have said on a number of occasions that
they are kind of like my banker back home. They are getting a little nervous.
So what is the implication of us continuing these deficits, and
then we have some fairly major defaults, or potential defaults, in
the E.U., and what does that do to the United States? I would get
concerned at some point in time here we are going to have an auction or two fail here just because, one, there may not be enough
money in the economy to sustain all of these credit needs; but secondly, just the nervousness of when countries start to default, what
that does—how people are looking at our debt as well.
So Mr. Johnson, do you want to start? And just go down the—
Mr. JOHNSON. I think currency and international investing is always the business of assessing the lesser of relative evils. And at
this point, the acute anxiety and the new information that pertains
to Europe is actually encouraging funds to so-called flight to quality to the United States.
The dollar is likely to strengthen. Given our trade deficit, the import-competing industries and export industries will receive a negative incentive in terms of the expansion they would like to undertake.
In the longer term, I think you point to a heightened anxiety
about sovereign debt and what we might call a renewed scrutiny
or skepticism, and people will be very concerned about our debt dynamics, though as a snapshot at the moment, I think the first effect, the lesser of evils, is the dominant influence. In the medium
term, it may make it more difficult to sustain deficit spending.
Mr. NEUGEBAUER. Thank you. Mr. Pickel?
Mr. PICKEL. Yes. I think there are those two effects that Mr.
Johnson refers to, the ‘‘beneficial one’’ of a flight to quality and
lower rates on U.S. debt and a stronger dollar. But that, of course,
has implications for the economy longer term competing against a
weaker Europe.
Mr. NEUGEBAUER. Mr. Duffie?

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Mr. DUFFIE. The United States depends heavily on the ability to
export to these countries. And even though there is a flight to quality effect that temporarily benefits our currency and our bond markets, and even though our bonds are very, very, very strong and
the United States has, despite its heavy debt load, extremely large
abilities to borrow more, it can’t help the United States to have our
neighbor countries in Europe and Japan become economically
weaker or even default. That is definitely bad for us.
Mr. SANDERS. One thing we haven’t discussed so far is that
Greece may default. But they also may become a zombie state, in
which they have the IMF and other countries loaning them money
just to perpetuate them. They will have no incentive to actually cut
spending. They will just exist on the dole from the international
market.
The problem is that we can probably do that for one country. But
then as they all start to fall, it is going to get incredibly more expensive around the globe to keep propping up zombie states. Japan
already is in that state. Their banks are—our top banks are almost
zombie banks at this point.
We have a lot of problems because we are not letting anyone go
to bankruptcy, whether it is on a corporate level. Even countries
can actually find out they have—I wouldn’t call it extortion rights,
but they can threaten to collapse the market and get more IMF
money or more money and not ever do anything. So it is an outcome that might occur.
Mr. MASON. I would like to add—just make a separation between
fundamentals and contagion here. There is not a lot of evidence for
pure contagion in economics, where just I happen to fail, but I have
no linkages with Mr. Sanders here, but because I fail, he fails.
There are linkages there.
Now, economics is amoral, and markets are amoral, and they will
root out those linkages. And that is one of the social benefits of secondary market trading. Primary market trading is about allocating
capital. Secondary market trading is about rooting out inefficiencies, and secondary market traders will find those inefficiencies.
Countries that default will resume. Resumption is costly. The
only country that hasn’t resumed in anything near modern history
that wasn’t invaded was the Soviet Union, which still has—that is,
not the Soviet Union, pre-Soviet Russia, I am sorry—which still
has debt outstanding that trades at a half a cent on the dollar or
so. But it does trade.
But really, the more important aspect that we have to deal with,
not only with the U.S. sovereign situation but also with financial
reform and consumer policy, is we have made a concerted effort to
centralize losses from this credit crisis, from this bubble in real estate—which was a bubble, and it is not coming back, we don’t want
it back—and we have made a conscious decision to centralize those
losses up to the sovereign entity.
And this kind of gets to where we started out today talking about
CDS markets. Sovereign CDS markets are especially concentrated,
and that concentration creates the systemic risk, the biggest risk
out there.

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So Greece has a lot of losses concentrated in its sovereign debt,
particularly, mind you, through its overly generous pension allocations, which are far too—just far too—
Mrs. MALONEY. Would the gentleman sum up? The time has expired.
Mr. MASON. The point is, the GAO in 2006 already suggested a
significant number of U.S. pensions are underfunded. Markets lost
40 percent since then, or more. We know the United States is in
a similar situation. Let’s see the linkages for what they are.
Mrs. MALONEY. Congressman Lynch?
Mr. LYNCH. Thank you, Madam Chairwoman, and I want to
thank the witnesses. This has been very helpful.
Now, Mr. Johnson, I appreciate your statement that in the Greek
cases, credit default swaps is probably just a smaller portion of the
problem, and that Wall Street didn’t create their crisis. However,
in some ways I think we may have—Wall Street may have exacerbated it.
But now I am wondering about not just the credit default swaps
that Goldman and others might have sold to the Greek government. I am also worried about what they sold to Spain, what they
sold to Portugal, what they sold to Ireland, because as others have
pointed out, the E.U. as a group is our largest trading partner. And
if we start seeing defaults here, that will have a tremendous impact on our economy from an import/export standpoint.
And also, we sort of talk like the IMF, like they have their own
money. But we are a major contributor to the IMF. So that is—the
IMF is us, is the American taxpayer as well.
And I guess one of the most troubling aspects of the credit default swap practice in Europe, and even with our own municipalities and pension funds, is the concealment aspect of this, and that
these deals, off balance sheet, allowed Greece to conceal debt that
was there. It allowed them to conceal the fact that certain major
aspects in their country were encumbered.
Airports: They actually pledged future revenues from their airport to cover the collateral on the debt to Goldman. And also, they
pledged—they have a national lottery. They took their lottery proceeds from the next 10 or 12 years, or 20 years, and pledged that
as well. But an innocent person coming in would not know about
that. It was all hidden.
And let me get to my question. Is there not a greater obligation
here, when this is sovereign debt or when you are dealing with a
municipality, where behind that deal stands the full faith and credit of the taxpayer? We are picking up the tab, just like a lot of this
debt in Greece—all of it, all the sovereign debt—is really being put
on the taxpayer. But they are completely ignorant of what is going
on here.
It is the same with the debt associated with the pension funds
and municipalities. Those pensioners, those current and future retirees, are completely ignorant of what is going on here. And the
same thing with deals entered into by municipalities. These are
being made without the knowledge of the townspeople, the residents, the taxpayers, who are standing behind these deals.
I just wonder, is there not an obligation for us, when parties
enter into these deals and the taxpayer is behind them, should we

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not require the parties, the people who assemble the credit default
swaps, the people who market them, the people who trade them,
to all—and the people who underwrite them—to all assume a fiduciary responsibility to the people who are standing behind that
debt?
It just seems that at least in the public dimension, it is something we should require. We could talk about private parties later
on. But I think there is a special exposure here that we haven’t
really acknowledged.
And I just wonder, should we require a greater obligation, this
fiduciary duty, for these parties that are dealing with public debt?
Mr. Johnson?
Mr. JOHNSON. You raise a whole series of issues. One thing I
want to clarify is, I don’t think it was the credit default swap that
created the deception about Greece’s indebtedness or deficit which
allowed them to get into the European Union. But it was a derivative transaction—
Mr. LYNCH. Right. It was a currency—they fashioned it as a loan,
so it went off balance sheet. But it was a structure—
Mr. JOHNSON. I just want to clarify that because we are talking
about CDS today along with this problem.
Mr. LYNCH. Right.
Mr. JOHNSON. But it was a different dimension. I believe every
aspect of the capital market, whether it is municipal, sovereign, or
corporate depends upon accounting standards and disclosure standards so that we can properly value things. And in every dimension
of that process, more integrity, more transparency, is imperative.
I alluded in my testimony that when you are talking about the
needs of communities, when you are talking about basic services in
life, which sometimes are financed by municipalities or State or
Federal Government, it is very important to have those things, that
integrity, in place.
One thing that concerns me a great deal now, as I am listening
today, I can see coming over the horizon a tremendous concern
about our Federal finances.
And I am concerned in the current legislation on derivatives
about so-called end-user exemptions because when I have informally polled CFOs about why they are so attracted to playing in
these OTC dark markets, some of what I pick up—I am not saying
I have a smoking gun—is their earnings management and their
ability to manage tax liabilities, not unlike the Greek government
did with Goldman Sachs, is a risk in terms of the revenue-based
tax collection and the future of our national finances.
Mr. LYNCH. I agree.
Mr. PICKEL. Mr. Lynch, if I could just comment on the fiduciary
duty, these transactions—and I mention this in my remarks—are
bilateral transactions. So if I am dealing with a government entity
and I am paying them fixed, they are paying me floating, say, on
an interest rate swap, we are in those transactions are principals.
I am acting as a principal on the swap. They are acting as their
principal on the swap.
They may be well-advised to get some advice as to whether that
is a good transaction for them. But in that particular transaction,
it is two parties interacting and making their own decisions as to

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whether the transaction makes sense or not. That is the fundamental nature of these transactions.
There is a role for advice, and an advisor would have a fiduciary
capacity. But in that particular transaction, it is I buy, you sell. I
go long, you go short. I pay fixed, you pay floating.
Mr. LYNCH. Thank you. Thank you, Madam Chairwoman.
Mrs. MALONEY. Mr. Manzullo?
Mr. MANZULLO. Thank you, Madam Chairwoman.
I am sorry I came late. I have read through a good part of the
testimony. One of the uses of derivatives in the credit default
swaps occurs when a giant U.S. manufacturer such as John
Deere—and their VP for finance testified here several months
ago—that in exporting to a market, they will get involved in the
CDS for the purpose of protecting the price of their machinery
when it is sold.
Could somebody comment on that? First of all, do you agree with
me on that?
Mr. DUFFIE. I will address that.
Mr. MANZULLO. Thank you.
Mr. DUFFIE. Yes, Mr. Manzullo. That is one of the primary uses
of derivatives, for a corporation such as John Deere to lay off risks,
such as currency risks or interest rate risks or commodity risks.
They are very useful for that purpose.
Mr. MANZULLO. Could you walk us through? The reason I ask
that is I spend most of my time on manufacturing, and I am from
northern Illinois so it is a heavy industrial area. Most people in the
country really do not understand the connection between manufacturers who export and the credit default swaps.
Could you walk us through a transaction of, say, John Deere selling a giant piece of equipment to Greece? How would they do to
protect their price?
Mr. DUFFIE. Okay. So in this case, John Deere would be receiving Euros in return for its tractors. But it might not get them until
next—the Euros might not come until next year.
So, being concerned about that, John Deere might enter, for example, with Morgan Stanley or Credit Suisse, an over-the-counter
derivative security by which it would effectively sell the Euros now
to that bank when they arrive next year at a price to be agreed
now so that it wouldn’t suffer the risk that those Euros would decline in value in the meantime.
Mr. MANZULLO. Why would they not get payment until next
year?
Mr. DUFFIE. For example, they may have just signed a contract
to deliver 1,000 tractors in return for 10 million Euros next year.
Mr. MANZULLO. Next year would be the date of the delivery?
Mr. DUFFIE. Correct.
Mr. MANZULLO. Okay. Mr. Pickel?
Mr. PICKEL. I was just going to add, from a credit default swap
perspective, John Deere may have sold to, say, a Greek company
those thousand tractors, and they may be concerned about the
creditworthiness of that company a year down the road.
If it existed, if there was a credit default swap on that company,
the most efficient way for them to hedge that credit exposure that
they have would be to buy protection on that name.

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But very likely—and I am not sure there are many Greek companies that you can buy protection on, so they might actually buy
protection on Greek sovereign debt as a proxy for the fact that if
there is a problem in Greece, it is going to affect the ability of that
company to pay on that obligation, and therefore it is a proxy for
that exposure that they have.
Mr. MANZULLO. Does anybody there have an idea as to the percentage of CDS that would be reflected by the manufacturers engaging in that activity? One percent, 10 percent of the total value?
Anything?
Mr. PICKEL. It is a relatively small amount at this point.
Mr. MANZULLO. A small amount?
Mr. PICKEL. One percent is probably close. It certainly wouldn’t
be any more than 5 percent, I think. The CDS is largely, in the financial world, in terms of dealer kind of parties, hedge funds, asset
managers, and others.
Mr. MANZULLO. Private companies. So what could John Deere
do? The OPIC, Overseas Private Investment Corporation, I don’t
think guarantees against a currency collapse. It would by a seizure
by coup or something like that. What would John Deere do in the—
if they couldn’t guarantee that they would get payment, if they
couldn’t use a derivative?
Mr. DUFFIE. They would have to take the risk. They would expose their shareholders to that risk. And the shareholders might
themselves try to hedge it, but it would not be as efficient as having John Deere hedge it.
Mr. MANZULLO. We had a company back home, now out of business, that sold paper machines, paper-making machines to Indonesia several years ago. And their economy collapsed, and the
American company went bankrupt.
What would the proposed restrictions on derivatives—how would
that impact a company such as John Deere?
Mr. DUFFIE. I will take that briefly. Some of the proposed restrictions are to allow hedging but to eliminate speculation. The unfortunate issue is that if John Deere were to look for a hedging opportunity, most likely it would be provided by a speculator who would
be willing to take that risk. So by eliminating speculation, you actually make it much harder to hedge.
Mr. MANZULLO. Anybody else?
Mr. JOHNSON. I think the—I would guess that all of us on the
panel believe that there is a very important use for derivatives in
this insurance-like feature, where the currencies, interest rates,
and the full spectrum of market possibilities should be offered to
someone like John Deere.
The question is more in what context should the market-making
systems—how do you say—be set or structured because they do
have collateral influences on the integrity of the financial system,
propagation of financial disturbances, and impact on the taxpayer
to the extent that the—
Mrs. MALONEY. The gentleman’s time has expired. If you would
wind up, Mr. Johnson. Are you—the gentleman’s time is expired.
Mr. Perlmutter? Mr. Foster?
Mr. FOSTER. Thank you, and I would like to thank the witnesses
for their excellent testimony. And I share their conclusions that the

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CDS on Greek debts, amounting to less than 2 percent of their outstanding debt, cannot be a major contributor to Greece’s woes.
I also share with my colleagues on the right their sincere regret
that we did not leave in place the fiscally responsible policies prior
to the Bush Administration which, as we all know, would have paid
down the debt essentially to zero at this point had we left them in
place.
I am happy also to see them embrace the concept that we cannot
grow out way out of this since this was, after all, the philosophy
that they used to justify the fiscally irresponsible policies that got
us into this mess. Perhaps, given the $17.5 trillion of household net
worth destroyed in the last 18 months of the previous Administration, they believe that we can shrink our way out of this crisis. But
I digress.
What I would like to raise is the limits to the concept of an insurable interest, as we have chosen not to apply it to derivatives
markets. As you all know, we do not allow people to take out fire
insurance on their neighbor’s house, at least in part because that
provides an incentive to firebomb their neighbor’s house. And we
have chosen not to apply that principle to derivatives markets.
And so my question: Do you see any role at all for the principle
of insurable interest in the derivatives markets? And I will open
up to anyone that—
Mr. PICKEL. I think I will start off there. As I highlighted in my
testimony, there are a lot of different risks or reasons for entering
into credit default swaps beyond that actually holding the underlying bond at a loan. Sellers of protection may in turn want to
hedge their exposure. You may have investors who have exposure
to that particular country in the sovereign situation.
So I think the notion of what is an interest that might be insurable is a very broad concept. And certainly if you were to go down
that path, you would have to recognize the diversity of those interests.
I think, as Mr. Duffie said, there is a role for speculators here.
It provides liquidity to the market so that when somebody does
need to hedge, they know that they have a deep, liquid market that
they can turn to. I think those are some of the principal reasons
for that.
I think it is also important to keep in mind that in a derivative
situation, the exposures are mark-to-market. So if I have bought
protection at a low price because the perception was that the credit—the reference entity was creditworthy, and they go down in
their credit rating, I am going to see the price increase.
I will be in the money as the buyer of that protection. You will
be out of the money as the seller of that protection. And we will
typically exchange collateral—footnote: AIG didn’t do that; that
was one of the big problems—but in most of the situations, there
would be collateral moving back and forth to protect that exposure.
And if either party defaulted, whether that is the buyer of protection or the seller of protection, they would have to make the other
party whole for that fluctuation, unlike in insurance, where if I
don’t pay my premium, I just can’t get the protection when I need
it.

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Mr. DUFFIE. Could I add to that? Ironically, there is a reverse
concern on my part. If I, for example, were to lend money to Mr.
Sanders and was responsible for making sure that he pays me
back, I would need to monitor him and take care that he is going
to pay me back.
If I were to turn to Mr. Johnson and buy protection from him on
this loan so that I was no longer concerned about Mr. Sanders paying me back, there is a moral hazard. First, I won’t be doing my
job properly in monitoring Mr. Sanders’ ability to pay me back.
And secondly, poor Mr. Johnson is going to be bearing the risk that
I won’t be doing my job.
So it can be the case that exactly when I have an insurable interest, that the use of credit default swaps can lead to a problem. Disclosure is the way to deal with that problem. It should be disclosed
to Mr. Johnson that I do have a loan to Mr. Sanders.
Mr. MASON. And I would like to follow up that the 2009 Fitch
Global Derivatives Survey produced results that suggested most
market participants are really not concerned with that type of misuse. It seems to be overblown outside the financial world.
I think the key is observability. And I think this gets back to an
earlier issue of fiduciary responsibility. I think the appropriate fiduciary responsibility is to make sure that enough information is
reported so that good decisions can be made.
Consider, maybe, I am a leader of a country. I am arming my
army, getting ready to invade next door. And I want to take out
a lot of CDS coverage on that, just like firebombing my neighbor’s
house. In the case of insurable interests in the standard kind of life
insurance or fire insurance example, that would not be known to
the outside world. That would not be known to the other side that
is providing the contract that I am aggregating this coverage.
In the credit derivatives market that we envision developing and
that is developing, we have significant reporting such that the information is available to the other side that has to provide the insurance on the contract. Once we see an aggregation of exposure,
that risk can be priced in even if we don’t know specifically what
risk is there.
Mr. SANDERS. Mr. Foster—
Mrs. MALONEY. The gentleman’s time has expired.
Mr. Perlmutter, and we have been called for two votes, gentlemen, so we will have to adjourn in a moment.
Mr. PERLMUTTER. Do you want me to go ahead?
Mrs. MALONEY. Yes. Go ahead.
Mr. PERLMUTTER. Somebody was going to finish the answer. So
please, go ahead and finish.
Mr. SANDERS. Oh, well, thank you very much. I was just going
to remark to Mr. Foster, I hear your point about the firebombing.
I have been asked that numerous times. Bear in mind those are
felonies and—
Mr. FOSTER. As is market manipulation.
Mr. SANDERS. Wait a minute—but again, that is one of the purposes of regulation, is to prevent felony-type transactions and to
monitor and to look for those things, not necessarily to tie it up in
knots. But that would be covered by proper regulation if it was oc-

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curring in financial markets. But we don’t really have any evidence
that it happened with Greece.
Mr. PERLMUTTER. My question—and I appreciate the gentlemen
from Illinois, Mr. Manzullo and Mr. Foster, sort of zeroing in on
something—but mine is so much more basic, and it applies to a response.
What is the difference between hedging and speculating?
Mr. DUFFIE. Hedging means you are getting rid of risk. Speculating means you are taking on risk in order to make a profit.
Mr. PERLMUTTER. But you have to have—it is like you were saying, somebody is going long, somebody is going short; somebody is
buying, somebody is selling. If you are going to hedge, you have to
speculate. Right?
Mr. DUFFIE. In some cases, you can get lucky and the person who
is hedging can find someone else who needs the hedge in the other
direction. But that is somewhat unusual.
Mr. PERLMUTTER. One of you mentioned you might want to
hedge against the Greek company from going broke next year, as
opposed to hedging against some currency. But you are hedging
against the Greek company going broke. I am not sure which one
of you—
Mr. PICKEL. I think that was me, yes.
Mr. PERLMUTTER. And so in hedging against the Greek company
going broke, John Deere goes and finds somebody who says, okay.
We are going to do our due diligence, and we think this company
is an upstanding company, and the chances are slim that it is
going to go broke. Sure. We will provide you some insurance. Is
that how that works?
Mr. PICKEL. Yes. They would go typically to a dealer, one of the
large banks, and ask them to sell protection to John Deere to hedge
that exposure.
Mr. PERLMUTTER. But, the bank supposedly does some due diligence, I would assume—
Mr. PICKEL. Yes.
Mr. PERLMUTTER. —to figure out how much insurance they are
going to provide and at what cost.
Mr. PICKEL. Yes. The bank, if it is a global bank, may have relationships with that company in Greece. They may have exposure
to Greece. So they are monitoring credit generally.
Mr. PERLMUTTER. Let’s narrow it down even further. I am just
trying to figure out how far the insurance extends. Let’s say you
are worried about the head of the company. He really is the guy
who runs the show. Am I, in effect, buying—I am John Deere. I am
worried about my distributor in Greece. Am I buying key man insurance on him? Can I go to Bank of America and buy insurance
on the guy who is the head of the company? He might die next
year?
Mr. PICKEL. No. I don’t think that would be permissible. And I
don’t know what the insurance laws would be as to whether you
would have a sufficient insurable interest in the CEO of major customer to purchase insurance on that person.
Mr. JOHNSON. Usually, that kind of key man clause is in a bilateral contract you make with the company, so if the CEO departs,
the contract has to be adjusted or voided.

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Mr. PERLMUTTER. When we start getting into this subject of derivatives and swaps, and who is covering whom and why, and what
the risk is, and who is analyzing the risk, so long as there is somebody posting some margin or keeping some reserve someplace that
I can find, or that every so often you see if the insurance is still
good, then I am less concerned about it.
The AIG situation kept posting insurance, insurance, insurance,
insurance, but never could cover. How do I find out if Bank of
America has enough—what should I be looking for to make sure
that the swap can be covered?
Mr. PICKEL. I think in these markets, in the OTC markets, it is
collateral that is the significant portion. For the more liquid products, the more standardized products, clearing could provide a significant risk reduction. But in a situation like the AIG transactions, those were not capable of being cleared, weren’t then and
aren’t now because of the customized nature of them.
But there it is even more important to have collateral so that as
the exposure, the mark-to-market exposure, fluctuates, collateral is
moving back and forth. And keep in mind, it could move from the
buyer of protection to the seller of protection, or the seller to the
buyer, depending on where that price—where that contract was
struck, what the price was, and what the current market price is.
Mr. JOHNSON. There is a dimension to this that is fascinating
that you raise, which is when you buy insurance from one company
on the other company, you are getting rid of counterparty risk visa-vis the company you bought insurance on, and you are incurring
it from the provider of insurance. So you do have to understand the
financial integrity of the insurance provider in order to weigh the
balance of those two risks.
Mrs. MALONEY. Congressman Himes?
Mr. HIMES. Thank you, Madam Chairwoman, and thank you to
the witnesses for your excellent presentation today. I have a couple
of questions.
First, you have spoken—basically sung from the same hymnbook
with respect to whether, in fact, CDS contributed to Greece. Hypothetical, though.
What about—and this I offer to anybody, and just ask that it be
answered quickly—what about situations that we saw, for example,
in the subprime market, where you had CDS activity that in many
instances was multiples of the value of the underlying asset?
Would you encourage us to think differently in that situation than
you have encouraged us to think with respect to this case?
Mr. PICKEL. I think the situation of multiples was typically the
gross notional, which is the total amount of protection. What I
think is relevant and I think what the chart here highlights is the
net notional.
So in an active market, you have a lot of buyers and sellers, and
overall, that market will reflect either a net short position or a net
long position. And it is that—really, it is that number that should
be focused on.
So I think if you focus in the subprime market or if you focus
in the corporate market on net notional versus debt outstanding,
you don’t see those multiples to the same extent.

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Mr. MASON. I think it is really important in regulation, especially
in reg reform, to get to principles of regulation. And principles of
regulation, especially for systemic risk, have to follow kind of principles of crowd control. You can’t have regulators everywhere to
monitor everything.
So you need to look for either non-fundamental movements or aggregations that would suggest there is something going on here.
Securitization RMBS was one of the fastest-growing sectors in financial services. As a result, you might want to look there for
something going on, including CDS and related technologies.
Similarly, with regard to infrastructure and other kinds of offbalance-sheet funding, if you look at hedge fund activities and you
really talk to hedge fund investors, you find they have been involved in infrastructure deals for a while now. Why? Because it is
a great way to provide secured funding to these undercapitalized
countries, but avoid the country premium because you have the
capital as long as, of course, property rights hold up.
So if you do follow financial markets, they are telling you the information that you need. But again, you can’t be averse to the signals that you find because you may find things you don’t like.
Mr. HIMES. Thank you. I have a question for Professor Sanders.
Professor Sanders, you in your testimony drew an analogy between
the GSE debt and the Greek surprise. You say our own sovereign
debt has a Greek surprise component to it. This is something we
hear talked a lot about lately, and I want to explore this a little
bit.
The situation in Greece—correct me if I am wrong here—this
Greek surprise came because, in fact, financial markets didn’t understand the esoteric, technical, untransparent characteristic of
some debt mechanisms that they had employed. Is that correct?
Mr. SANDERS. Actually, I would state it a little differently. I
would state it that Greece, like many other countries, used heavy
off balance sheet and didn’t bring anything on balance sheet. That
is why we couldn’t observe—
Mr. HIMES. Right. But airport deals and foreign currency swaps
designed to look like debt, this stuff was pretty untransparent.
My question is this: Markets don’t like surprises; I get that. Is
there any uncertainty or lack of transparency with respect to the
amount, the tenor, or the characteristics of GSE debt right now in
the minds of the market players who focus on this stuff?
Mr. SANDERS. First of all, once again, Greece could have solved
the problem by bringing everything on balance sheet and making
it transparent. But in terms of the GSEs, the answer is yes. We
have absolutely no idea in the near future whether housing prices
could take a big second dip and Freddie and Fannie are on the
hook for billions and billions more. We just don’t know. So—
Mr. HIMES. But there are—we don’t know that about any security. We do have some sense, based on market values, what the
value—some sense, with some uncertainty around it, what the
market values are of the debt that the U.S. Government has effectively guaranteed. Okay.
So were we to all of a sudden move the GSE debt on balance
sheet, there would be no incremental new information to the market. So my question to you is, if we took that step—which may or

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may not be a good idea; I haven’t thought a lot about it—but would
you expect, if we simply took the step of moving that information
onto the Federal budget, would you expect any change in the rate
at which the United States Government funds? Would you expect
any change in the willingness of the creditors of the United States
Government to fund as a result, all other things being equal, of
that accounting change?
Mr. SANDERS. Yes, sir, I do.
Mr. HIMES. Why?
Mr. SANDERS. And the reason for that is the same thing Secretary Geithner said at the last hearing I was at with him. Ambiguity is a very dangerous thing. The more ambiguous it is whether
the government is going to bail out Fannie and Freddie or not—
right now they said, it is not sovereign debt, but we are going to
guarantee it.
But remember, go back years, Fannie and Freddie were denying
they even had an implicit guarantee. And suddenly they said, oh,
well, we do have an implicit guarantee.
Mr. HIMES. But now those guarantees—those guarantees are
very explicit now, are they not?
Mr. SANDERS. Then why not bring them on balance sheet?
Mr. HIMES. Right, right, right. But my point is that the market
understands that debt is fully guaranteed by the U.S. Government,
for all practical purposes is, in fact, U.S. Government debt. So what
I hear you arguing is that the simple accounting change of moving
it on budget would somehow impact the market. That just confuses
me.
Mr. SANDERS. Let me rephrase it to help out. I apologize if I
wasn’t clear. It still is ambiguous if it is off balance sheet. The
market is never going to be convinced. How do we know that in 2
years, the Obama Administration or Treasury will not come back
and say, ‘‘No, we have changed our mind. We are not going to guarantee this.’’
We don’t know that. In fact, they have not made any permanent
commitment to a bailout of Fannie and Freddie. So that is ambiguity. Once you bring it on balance sheet, mystery solved. We are
on the hook for it. That is what I mean.
Mr. HIMES. I get it. Okay. I think I understand the distinction.
So you are saying if we just, in a sense, permanently guaranteed
it, which you are saying would be the effect of moving it onto the
balance sheet, that would remove the ambiguity. Yes. I think I am
out of time, but if the chairwoman would—
Mrs. MALONEY. Absolutely. This is an important point. Mr.
Duffie, if you want to add to it?
Mr. DUFFIE. I just wanted to suggest that one could actually
quantify the effect that you are describing. Right now, the United
States Government, at the Treasury, borrows at a lower interest
rate than do Fannie and Freddie.
If, in the event that the Fannie and Freddie debt were explicitly
guaranteed by the government, the cost to the government of borrowing would rise to the blended average interest rate of the Treasury and the agencies, which would be a higher number, that is, our
borrowing costs would go up.

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Mr. HIMES. Are you sure that would happen, though? Because,
then you would do away with the ambiguity. Right? That would become sovereign debt. And you are sure that it would rise to the
blended rate rather than removing the ambiguity and therefore reducing the GSE debt to the U.S. rate?
Mr. DUFFIE. It is not a guarantee. But the United States indebtedness would rise as a result of the explicit guarantee. We know
that because the agencies are borrowing at a higher interest rate.
So it wouldn’t necessarily rise all the way to the current blended
average, but it would rise somewhat.
Mr. HIMES. Great. Thank you. I know I am out of time.
Mr. GARRETT. And through the Chair, since I think this is a
great point that the gentleman just raised, the fact that—I think
you made an interesting point. The fact that there is a difference
right now in the borrowing rate between the Federal Government
and the GSEs tells me that as far as the markets are concerned,
they are still—probably had tuned into this hearing back when
Chairman Bernanke was here, and he says he can’t tell us whether
they are sovereign debt or not. And they probably tuned into the
other hearing when Secretary Geithner says that is an accounting
decision; he really couldn’t tell us, either.
So there must be that ambiguity out there. Otherwise—correct
me if I am wrong—if there was no ambiguity at all, if the market
said, GSEs, you are just like the Federal Government because it is
all guaranteed until 2012, then the rates should be exactly the
same. Right?
Mr. DUFFIE. Correct.
Mr. GARRETT. Okay. And also—one last question—and also, because the Secretary only has this authority until 2012, right, this
unlimited authority, that is the other reason why we have ambiguity. Mr. Johnson, it sounds like you wanted to—
Mrs. MALONEY. The gentleman’s time has expired. We have been
called for a vote, so I would like to ask a question and get a yes
or no answer. And you could write—get more questions in general.
Earlier, Mr. Johnson, you said that if AIG had cleared through
a clearinghouse, it would not have removed the systemic risk or the
challenge of that particular situation. In your opinion, is just having derivatives clear through a clearinghouse enough to remove
systemic risk? Yes or no, would you say?
Mr. JOHNSON. No.
Mrs. MALONEY. No? Mr. Pickel?
Mr. PICKEL. I would say no. It goes a long way, but—
Mrs. MALONEY. Okay. It is a big part of our reform. That is why
I am interested.
Mr. Duffie?
Mr. DUFFIE. It is a very good move, but it doesn’t do it on its
own.
Mrs. MALONEY. Mr. Sanders?
Mr. SANDERS. I agree. Plus, they will find another way to do it.
Mrs. MALONEY. Mr. Mason?
Mr. MASON. I agree. No.
Mrs. MALONEY. No? Okay. Now, if that is not going to remove
systemic risk, how will we deal with the risk of the clearinghouse
itself? Mr. Johnson, and go down the line.

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Mr. JOHNSON. Very quickly, the question of clearinghouse, its
capitalization, its collateral, and its integrity is very important.
And one of the dangers is if you have multiple clearinghouses,
there can be a competition in reducing margin, and it can create
a systemic risk. So we have to be very careful about who defines
and maintains the thresholds of capitalization at the clearinghouses.
Mrs. MALONEY. That is a very important point, and we will have
a series of questions to all of you to respond in writing. Treasury
is at the Senate today, and they likewise said they would respond
in writing to any questions.
There was a lot of—
Mr. HIMES. Would the chairwoman yield for just a second?
Mrs. MALONEY. Yes.
Mr. HIMES. Sorry, just one follow-up question, because I am very
interested in this point.
Quick question: If we, in fact, took the recommendation of some
that we brought the GSE debt on balance sheet, is there agreement—because I sensed agreement—that would cause an uptick in
the cost of financing of the United States Government? Does anybody think the answer is no?
[No response.]
Mr. HIMES. So everybody thinks the answer is yes. If we move
this on balance sheet, the interest paid by the U.S. Government
would rise. Correct?
Mr. JOHNSON. I don’t necessarily agree with that. I don’t think
it would—it would cause a downtick in GSE financing, but—how
would I say—what we are really talking about is the duration of
guarantees. There is a guarantee through 2012. If you extend the
duration of the guarantee, there probably is some minuscule sense
in which—
Mrs. MALONEY. I would ask the gentleman to respond to the gentleman’s question in writing, and I invite all my colleagues to.
I would like to ask, what are the worries you have about manipulation? There have been allegations about manipulation in Greece
and in the American economy, in the sovereign markets and in city
governments and State governments. Is there a concern about manipulation?
Mr. GARRETT. Will the panel be submitting this in writing, too,
or are we going to a second round at this point?
Mrs. MALONEY. My time has expired. Okay.
Mr. GARRETT. It expired a couple of minutes ago.
Mrs. MALONEY. All right. Then submit it in writing. And the gentleman is recognized for 5 minutes. We have 15 minutes to get to
the Floor. Okay? You have questions?
Mr. GARRETT. Then, we will just—I thought we were through the
second round. Just clarification, then, on the differentiation on the
interest rates that you were going to. Does anyone else want to
speak on that as far as putting it online or not, differentiation? No?
Mr. SANDERS. Yes. What I would like to say is on the GSE debt,
by making it unambiguous, meaning that it is on balance sheet,
that might lower the GSE debt, the rate on that debt, to what it
would be on the Federal. That is the good news. The bad news is

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that it reveals that our actual debt loads are much bigger than we
thought, which would then probably raise the cost of borrowing.
Mr. MASON. And the financial way to look at it is we are currently holding an option to take on this debt. And if we exercise
the option, then we realize the value, we lose the option value. So
we could estimate directly the amount.
Mr. GARRETT. Great. Would anyone else like to comment?
Mr. JOHNSON. I would just say the increment in the cost of the
Treasury debt is dependent upon the change in your beliefs when
the option is exercised. If you say for all intents and purposes it
is full faith and credit now, by making it explicit and perpetual and
blending it in the secondary market—and I think the Treasury
market is slightly more liquid—you probably get most of the benefits and not a lot of cost.
But if you believe that there is a significant risk that in 2012
they would reverse course, you would have to say that bringing it
on raises the cost of Treasury debt.
Mr. GARRETT. The bottom line is, I guess, the one thing we can
learn from the Greek situation is no matter whether they are hiding it or not, or intentional or otherwise, I guess the thing the public wants most is to have that transparency, and for someone to
make that decision and to carry forward so we know exactly what
we are dealing with from today to 2012 and going into the future.
Thanks again to the entire panel. I commend the Majority for the
panel selection, as the ranking member did, and I thank you all for
your testimony today. Thanks.
Mrs. MALONEY. If I could go back to my other question, and get
a yes or no answer, and then further follow-up in writing, are you
worried about manipulation in the municipalities in our country
and smaller sovereign markets with the credit default swaps and
derivatives in general? Yes or no? Are you worried about manipulation?
Mr. JOHNSON. Yes.
Mrs. MALONEY. Mr. Pickel?
Mr. PICKEL. No.
Mrs. MALONEY. Mr. Duffie?
Mr. DUFFIE. I think it should be policed, but I don’t see it right
now.
Mrs. MALONEY. Mr. Sanders?
Mr. SANDERS. I am more worried about the manipulation by the
governments themselves not reporting all the debt they have on
balance sheet.
Mrs. MALONEY. Mr. Mason?
Mr. MASON. I am in agreement. I am not explicitly concerned
from the investor side.
Mrs. MALONEY. Thank you. And who are the major sellers of
CDSs in these sovereign, muni, and government credit derivative
markets? Who are the major sellers? Can anyone tell us who they
are?
Mr. JOHNSON. I believe it is primarily financial institutions, large
financial institutions here and abroad.
Mr. PICKEL. Yes. It would be the large financial institutions. You
may have some hedge funds which would sell protections, and that
was true in the Greek situation. In the past, you would have had

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the insurance companies, the monolines a little more active, potentially, in that area, but not now.
Mrs. MALONEY. What is the relationship between the CDS market and the underlying market? Which one leads which?
Mr. DUFFIE. In a large, liquid market, they are very close together. It is hard to tell. But in a market such as Greek debt, the
CDS probably moves slightly first because it is somewhat more liquid and easily obtained.
Mrs. MALONEY. Mr. Johnson?
Mr. JOHNSON. Yes. I agree with that. I think, when we talk
about the price discovery role of CDS, I often scratch my head because I look at bond spreads and I don’t know what incremental
information I get from the CDS.
But in the case of Greece, it is sometimes difficult for people to
borrow in short bonds as speculators. And so the CDS market,
being a lower transaction cost and more liquid medium, will tend
to reflect that information sooner than will a bond that has what
you might call hiccups with shorting.
Mrs. MALONEY. And following up on that, Mr. Johnson, how are
prices set on instruments when the underlying has so few credit
events or defaults?
Mr. JOHNSON. It is set with subjective probability. You are estimating what the likelihoods are. It is not like a deck of cards in
the sense that you know there are 52 cards and you know what
suit and what rank they are. It is a much more what economists
call radical uncertainty, where you are trying to infer prospects
that are unprecedented, or largely unprecedented, events.
Mrs. MALONEY. And Mr. Pickel and Mr. Duffie, how could a CDS
or other credit derivative be used to keep a normal restructuring
from happening for a firm in the real economy? Should we worry
about this happening in the future, hindering the restructuring?
Mr. PICKEL. If I could just also add to that, the market assessment of the price of the CDS is essentially the market’s assessment
of the probability of default of the underlying entity and the recovery rate, potential, if there actually is a default. So those are kind
of the factors in that.
As far as the influence on restructurings, there has been a lot of
discussion. Henry Hu at the SEC has written about this. We think
it is probably worth some additional analysis.
But our feeling—we have written a piece as an organization on
this we can send to you—is that while superficially it suggests that
somebody who has a CDS position may be motivated and
incentivized in a different way when they are engaged in restructuring discussions, that has not really been proven in any particular instance. But it is something I think is worthy of some additional analysis.
Mrs. MALONEY. Thank you. And Mr. Duffie, could you respond to
a statement by Federal Reserve Chairman Ben Bernanke at a recent JEC hearing where he said that the Fed had seen little exposure to Greek debt or CDSs within the financial institutions that
he supervises here in the United States.
However, is it possible that U.S. financial institutions are vulnerable via their exposure to German or French banks, which are believed to have a large exposure to Greek debt and CDSs? I do know

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that in many of our—some of our bailouts, we were bailing out
counterparties in foreign countries. Do you see this as a challenge,
for anybody to comment? My time has expired, and we are being
called to a vote. But your comments?
Mr. DUFFIE. Sure. Some very large European banks are exposed
to Greece significantly. I don’t think there is a contagion effect for
U.S. banks because the sovereigns of those large European banks—
for example, in France and Germany—would protect those large
banks from failing. They are still ‘‘too-big-to-fail.’’
Mrs. MALONEY. I want to thank all of your for your excellent testimony. The panelists have mentioned to me, the Members of Congress, that they have future questions. We will submit them in a
bipartisan way, and hope that you can give us your best thoughts.
The Chair notes that some members may have additional questions for this panel, which they will submit in writing. And without
objection, the hearing record will remain open for 30 days for members to submit their opening statements and questions.
The meeting is adjourned, and we are rushing to a vote. Thank
you so much.
[Whereupon, at 12:27 p.m., the hearing was adjourned.]

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APPENDIX

April 29, 2010

(47)

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