Financial Markets in Crisis: The Waxman Hearings; TARP Update

November 19, 2008

The Gibson, Dunn & Crutcher Financial Markets Crisis Group is tracking closely government responses to the turmoil that has catalyzed dramatic and rapid reshaping of our capital and credit markets.

We are providing updates on key regulatory and legislative issues, as well as information on legal issues that we believe could prove useful as firms and other entities navigate these challenging times.

This update focuses on a series of hearings which are being conducted by Congressman Henry Waxman, chair of the House Committee on Oversight and Government Reform, and, in particular, the recent hearing on hedge funds’ role in the financial crisis.


On Thursday, October 2, 2008, Representative Waxman announced that the House Committee on Oversight and Government Reform would hold a series of hearings to examine the events that led to the current financial crisis.  These hearings have included:

  • The Causes and Effects of the Lehman Brothers Bankruptcy, October 6, 2008: Representative Waxman called Richard Fuld, Chairman and CEO of Lehman Brothers Holding, before the Committee to explain why Lehman Brothers entered bankruptcy, as well as a panel of experts to discuss their perspectives on the event.
  • The Causes and Effects of the AIG Bailout, October 7, 2008: Former AIG CEOs Robert Willumstad and Martin Sullivan testified about credit default swaps and other matters.
  • The Breakdown of Credit Rating Agencies, October 22, 2008: The Committee heard testimony from the nation’s three largest credit rating agencies to investigate why the markets’ "gatekeepers" did not warn investors of the markets’ fundamental unsoundness.
  • The Role of Federal Regulators, October 23, 2008: Former Federal Reserve Chairman Alan Greenspan, former Treasury Secretary John Snow, and current SEC Chairman Christopher Cox came before the Committee to testify about their role as federal regulators in creating the crisis.  They identified subprime mortgage lenders, the market’s lack of transparency, and credit default swaps as three of the major problems that caused the meltdown.
  • The Regulation of Hedge Funds, November 13, 2008: The Committee heard testimony from academics who have studied hedge funds and hedge fund managers to determine their role, if any, in the crisis, as discussed below.
  • The Collapse of Fannie Mae and Freddie Mac, December 9, 2008: Representative Waxman has announced that the Committee will hold a hearing on December 9, 2008, to hear testimony from former CEOs of Freddie Mac, Leland Brendsel and Richard Syron, and former CEOS of Fannie Mae, Daniel Mudd and Franklin Raines.

The Hedge Fund Hearing

On November 13th, Representative Waxman held the latest hearing in this series.  The hearing focused on hedge funds and their role, if any, in causing the financial crisis.  The committee heard two panels of witnesses. 

The first panel was comprised of the following academic witnesses:

  • Professor David Ruder, Northwestern University School of Law and Former SEC Chairman, called for increased regulation of hedge funds, arguing that their illiquidity and opacity poses a risk to the financial system.  He argued that the SEC should be given oversight authority over the hedge funds.
  • Professor Andrew Lo, Director, MIT Laboratory for Financial Engineering, also called for increased oversight of the hedge funds, but suggested that the Federal Reserve be tasked with this responsibility.
  • Professor Joseph Bankman, Stanford University Law School, a tax expert, argued that the "carried interest" (typically set at 20 percent of profits) that hedge and private equity fund managers receive should be taxed at ordinary income – not long term capital gains – rates.  He agreed with Representative Cummings that the current tax treatment of carried interest is "unfair" when compared to the tax treatment of average working Americans.
  • Mr. Houman Shadab, Senior Research Fellow, Mercatus Center, George Mason University, argued against overregulation of the financial markets and suggested that the government should make it easier for hedge funds to invest in banks, which would reduce the need for government assistance. 

The second panel of witnesses was comprised of hedge fund managers.  Prior to the hearing, Representative Waxman asked the witnesses to be prepared to testify about whether hedge funds pose a systemic risk to the markets, whether they should come under federal regulation, whether hedge funds’ executive compensation encourages inappropriate risk-taking behavior, and whether capital gains tax treatment of carried interest is warranted.  The following witnesses testified:

  • George Soros, Chairman, Soros Fund Management LLC, testified about the inherent weaknesses of the financial markets, contending that financial markets occasionally stray from "so-called equilibrium" and thereby produce bubbles.  His testimony included several proposals including new regulations to more accurately measure margin requirements and capital ratios of banks.
  • Philip A. Falcone, Senior Managing Director, Harbinger Capital Partners, drew attention to the recent criticism of short-selling, arguing that short-selling actually stabilizes markets by providing investors with information about the hedge funds’ assessments of various companies.  He argued that poor management, not short selling, has caused the financial problems we are currently seeing.
  • James Simons, Director, Renaissance Technologies LLC, testified that credit rating agencies are the most culpable cause of the financial crisis.
  • Kenneth C. Griffin, Chief Executive Officer and President, Citadel Investment Group, emphasized the need for a central clearinghouse for derivative products, and, in particular, credit default swaps. 
  • Mr. John Alfred Paulson, President, Paulson & Co., Inc., along with the other witnesses, praised Treasury Secretary Paulson for changing the TARP’s course to focus on injecting equity directly into the markets rather than purchasing illiquid assets.  He also testified that the program’s structure is overly generous to the recipients and that the United States should get a greater return for its investments.

Many of the questions posed to this panel suggested that hedge funds contributed to the financial crisis.  The witnesses generally disagreed but allowed that some new regulation could be warranted provided that it did not discourage investment and did not require public disclosure of investment plans.  The panelists also generally agree that overleveraging contributed to the crisis and that the derivative industry was both overleveraged and opaque, making products like credit default swaps risky to the markets and investors. 

In his closing remarks, Representative Waxman signaled that additional regulation of hedge funds is warranted but stopped short of calling for any specific regulation or for a change in the tax treatment of carried interest.

TARP Update

A number of developments over the past week bear mention.

First, the Treasury Department issued a new transaction report listing all "completed transactions" under the Capital Purchase Program.  Treasury has pledged to disclose on its website all transactions within two days of their completion.  Note that the most recent transaction report (dated November 17, 2008) includes roughly $160 billion in preferred stock purchases.  We understand, however, that the Treasury has agreed to more than $200 billion of preferred stock purchases, though some portion of them are not yet "completed."

Second, Treasury issued term sheets that set forth requirements for private and thinly traded institutions to participate in the CPP.  According to Treasury, the terms are "economically equivalent" to those applicable to public corporations seeking to participate in the CPP.  As a general matter, while public companies are required to provide warrants to purchase their common stock, private company warrants are for preferred stock, which are to pay dividends at a rate of 9 percent per year.  In addition, a private sector institution that receives an investment of $50 million or less and is certified as a Community Development Financial Institution is not required to provide warrants.

Third, both the Administration and Congress moved to fill positions created by the Emergency Economic Stabilization Act ("EESA"), signed into law six weeks ago.  President Bush nominated Neil Barofsky, a federal prosecutor in New York and chief of his district’s mortgage fraud unit, as the special inspector general created by the rescue bill.

Democratic leaders appointed three of the five members of a Congressional panel, also created by the EESA, that will oversee Treasury rescue efforts and explore potential regulatory changes.

House Speaker Pelosi picked Richard H. Neiman, the New York state bank superintendent, while Senate Majority Leader Reid chose Elizabeth Warren of Harvard Law School.  Pelosi and Reid jointly appointed Damon Silvers, associate general counsel of the AFL-CIO.  

Gibson, Dunn & Crutcher LLP

Gibson Dunn has assembled a team of experts who are prepared to meet client needs as they arise in conjunction with the issues discussed above.  Please contact Michael Bopp (202-955-8256, [email protected]) in the firm’s Washington, D.C. office or any of the following members of the Financial Markets Crisis Group:

Public Policy Expertise
Mel Levine – Century City (310-557-8098, [email protected])
John F. Olson – Washington, D.C. (202-955-8522, [email protected])
Amy L. Goodman
– Washington, D.C. (202-955-8653, [email protected])
Alan Platt – Washington, D.C. (202- 887-3660, [email protected])
Michael Bopp – Washington, D.C. (202-955-8256, [email protected])

Securities Law and Corporate Governance Expertise
Ronald O. Mueller
– Washington, D.C. (202-955-8671, [email protected])
K. Susan Grafton – Washington, D.C. (202- 887-3554, [email protected])
Brian Lane – Washington, D.C. (202-887-3646, [email protected])
Lewis Ferguson – Washington, D.C. (202- 955-8249, [email protected])
Barry Goldsmith – Washington, D.C. (202- 955-8580, [email protected])
John H. Sturc
– Washington, D.C. (202-955-8243, [email protected])
Alan Bannister – New York (212-351-2310, [email protected])
Adam H. Offenhartz – New York (212-351-3808, [email protected])
Mark K. Schonfeld – New York (212-351-2433, [email protected])

Financial Institutions Law Expertise
Chuck Muckenfuss – Washington, D.C. (202- 955-8514, [email protected])
Christopher Bellini – Washington, D.C. (202- 887-3693, [email protected])
Amy Rudnick – Washington, D.C. (202-955-8210, [email protected])

Corporate Expertise
Howard Adler – Washington, D.C. (202- 955-8589, [email protected])
Richard Russo – Denver (303- 298-5715, [email protected])
Dennis Friedman – New York (212- 351-3900, [email protected])
Stephanie Tsacoumis – Washington, D.C. (202-955-8277, [email protected])
Robert Cunningham – New York (212-351-2308, [email protected])
Joerg Esdorn – New York (212-351-3851, [email protected])
Stewart McDowell – San Francisco (415-393-8322, [email protected])
C. William Thomas, Jr.
– Washington, D.C. (202-887-3735, [email protected])

Private Equity Expertise
E. Michael Greaney – New York (212-351-4065, [email protected])

Private Investment Funds Expertise
Edward Sopher – New York (212-351-3918, [email protected])

Real Estate Expertise
Jesse Sharf – Century City (310-552-8512, [email protected])
Alan Samson – London (+44 20 7071 4222, [email protected])
Andrew Levy – New York (212-351-4037, [email protected])
Fred Pillon – San Francisco (415-393-8241, [email protected])
Dennis Arnold – Los Angeles (213-229-7864, [email protected])
Andrew Lance – New York (212-351-3871, [email protected])
Eric M. Feuerstein – New York (212-351-2323, [email protected])
David J. Furman – New York (212-351-3992, [email protected])

Crisis Management Expertise
Theodore J. Boutrous, Jr. – Los Angeles (213-229-7804, [email protected])

Bankruptcy Law Expertise
Michael Rosenthal – New York (212-351-3969, [email protected])
Oscar Garza – Orange County (949-451-3849, [email protected])
Craig H. Millet – Orange County (949-451-3986, [email protected])
Janet M. Weiss – New York (212-351-3988, [email protected])

Tax Law Expertise
Arthur D. Pasternak – Washington, D.C. (202-955-8582, [email protected])
Paul Issler – Los Angeles (213-229-7763, [email protected])

Executive and Incentive Compensation Expertise
Stephen W. Fackler – Palo Alto (650-849-5385, [email protected])
Charles F. Feldman – New York (212-351-3908, [email protected])
Michael J. Collins – Washington, D.C. (202-887-3551, [email protected])
Sean C. Feller – Los Angeles (213-229-7579, [email protected])
Amber Busuttil Mullen – Los Angeles (213-229-7023, [email protected]

© 2008 Gibson, Dunn & Crutcher LLP

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