Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce
Issue 21 - Evidence - April 25, 2007
OTTAWA, Wednesday, April 25, 2007
The Standing Senate Committee on Banking, Trade and Commerce met this day at 4:15 p.m. to examine and report upon the present state of the domestic and international financial system. Topic: Study on hedge funds.
Senator Jerahmiel S. Grafstein (Chairman) in the chair.
[English]
The Chairman: Ladies and gentlemen, I see a quorum. I want to welcome committee members, our witnesses and our audiences, who will see the continuation of our hearings from coast to coast to coast.
Mr. Sprott, you will be seen on television, live to air, coast to coast to coast, as well as around the globe on the Internet. Your words will reverberate around the globe.
The Standing Senate Committee on Banking, Trade and Commerce, as members will recall, visited New York last October, to discuss a number of issues with respect to the committee's mandate, which is to examine the question of hedge funds. During our discussion with U.S. regulators and representatives of the financial services sector, hedge funds emerged as a key issue. At that time, the sector was valued at $1.1 trillion; the latest estimate — Mr. Sprott, you could help us with this — is $1.7 trillion in assets globally. Canadian hedge funds assets were estimated at $26.6 billion as of June 2004; obviously, they have grown since then.
We also heard about hedge funds during our recent study of consumer issues in the financial services sector. In our report on that topic, we recommended the appointment of an eminent person to review appropriate regulatory oversight of hedge funds. We are open on this question, but we thought we needed some more important and independent work to be done. Nevertheless, a key question remains regarding the extent to which and how these types of financial products, hedge funds, should be regulated or supervised, in order to protect consumers as well as the stability of domestic and global financial markets.
We are delighted to welcome as our next witness in our continuing inquiry Mr. Eric Sprott, who president of Sprott Asset Management.
Before I ask you to begin, Mr. Sprott, I shall introduce my colleagues. My distinguished vice-chairman is Senator Angus, who is from Quebec. Also with us is Senator Tkachuk, from Saskatchewan, Senator Goldstein, from Quebec, Senator Ringuette, who is from New Brunswick, and Senator Moore, who is from Nova Scotia.
Please proceed with your opening statement, Mr. Sprott.
Eric Sprott, Chief Executive Officer, Sprott Asset Management Inc.: Thank you, Mr. Chairman. It is a pleasure to meet you all. I hope I can be helpful to your committee.
By way of background, I am with Sprott Asset Management. We run mutual funds, hedge funds and individual accounts. We have assets in excess of $5 billion, of which $1.3 billion are in hedge funds.
I am a B.Com. CA. I worked for Sprott Securities, a brokerage company I founded, from 1980 to 2002. I have a background in the securities business and obviously some experience in the mutual fund and hedge fund businesses as well.
Whenever I look at hedge funds and read comments about them, I think of the terms as being a great misnomer. Hedge funds go back to 1946, I believe. When they were first discovered, they were believed to represent a conservative investment, because you could be both long a stock and short a stock at the same time — which would be described as a market-neutral investment.
We started our hedge funds to protect our clients from the bear market that we foresaw coming in 2001-02. We were trying to protect them from being in a long-only situation — where, in a bad stock market, stocks went down, making it difficult to make a return for our clients in a down stock market. Hence, we thought we should start hedge funds and at least have shorts on the other side to offset the longs. It has proven to be quite rewarding. I also believe it is a very, very conservative approach.
You might find it surprising that I have not recommended our Canadian long-only equity fund for the last six or seven years, even though it has turned out to be the best performing fund in Canada, because I have always had this fear of imminent decline in the stock market. That is why I have always recommended that people have hedge funds. That, to me, is the purpose of a hedge fund — it is a defensive purpose. If used in the proper method, it should provide a conservative approach to things.
What this committee is discussing is what I call leveraged finance; that is really what we are discussing. If we were just discussing hedge funds, like our hedge fund, I do not think anyone would have any concern.
Leveraged finance is where a company with a small amount of capital takes on huge liabilities. The classic example is Long-Term Capital Managment, which had $4 billion in capital and ended up with $130 billion of investments — in other words, $126 billion of liabilities. When you are leveraged like that, you take great risks.
Historically, we have examples of people being overleveraged. There is the 1929 crash, when you could invest in securities by putting 10 per cent down. Once they started going down, mayhem followed. There is the more recent example, a U.S. company, Amaranth Advisors, which took a position in gas. All of a sudden the position went against them. They were overleveraged and essentially they had to be bailed out. Needless to say, it happened quickly.
A leveraged system makes you think of how quickly a situation can unravel.
We also have examples in Canada — Portus Alternative Asset Management Inc. and Northbridge. I do not think they defaulted necessarily for leverage reasons, but perhaps for malinvestment.
I think the discussion really should be on leverage finance. When I think of leverage finance, I think of who lends the money. In my mind, the people who lend the money are all regulated institutions. The banking business and the brokerage business are the greatest sources of funds, and they are already regulated.
For example, the lenders to Long-Term Capital Management were the largest lenders in the world. There was a litany of the 15 largest financial organizations in the United States — Merrill Lynch, Citigroup, JPMorgan, among others. Those were the creditors. Obviously, they did not seem to have in place safeguards to protect themselves. I think that is what this committee should look into.
As an offset to the existing leverage, I want you to think about the derivative position outstanding today. We have about $350 trillion of notional value of outstanding derivatives. Notional value means the underlying value of an asset. It could be a bond worth $1 billion but the derivative might only cost 10 or $20 million, but you are really, in essence, trying to protect $10 billion.
The notional value is about $350 trillion. U.S. GDP is $12 trillion. Canadian GDP is $1.5 trillion, just to give you some sense of what proportion we are dealing with.
That derivative position is increasing by over 30 per cent a year. In fact, a recent article claims that the credit default swap market has been increasing at a 100 per cent per year for the last three years. If this rate continues, we will have more credit default swaps outstanding than we have bonds outstanding. We have more notional value derivatives outstanding than we have outstanding securities in the world today, which always makes me wonder why there are so many securities outstanding. Is this some great trading room in the sky where everyone is trading with themselves?
I use the theory that most people mark their securities to model the model, the model that the computer accepts. Therefore, if you can imagine the volatility that could go on in all markets — and there is volatility in all markets. However, let us imagine that each market moves 1 per cent in a day. The derivative position would go down $3.4 trillion. Mankind has never made $3.4 trillion in its cumulative life history — but you could lose that. Someone could make it on the other side, but nonetheless you would think that these kinds of losses showing up that quickly would have a very dramatic impact on the people on the wrong side of the trade.
My recommendation is that the history of hedge funds, whether it is Amaranth, which was six months ago, or Portus or Northbridge, suggests there should be some oversight. We are in the situation where we are already regulated because we happen to be an IDA member — and it has not bothered us to be regulated. However, I see no reason when people are taking vast amounts of money, albeit they might say from sophisticated investors, a little bit of oversight might be appropriate.
The other significant thing, and particularly when I look at the Canadian failures, is that we should have a select list of auditors to choose from if you are going to be in this business. I think in the case of those two organizations, the audit was not from a select panel, but I would certainly recommend that that be the case.
As well, when you are looking at leverage finance, do not just look at the hedge funds. It is hardly just the hedge funds. In fact, I believe that something like 80 per cent of the notional amount of derivatives outstanding is held by three banks in the world. They are all American banks. To imagine the leverage they must be taking on — if the system ever had a bit of a hiccup, it is hard to imagine what could happen.
That concludes my comments. If you have any questions, I would be happy to try to answer them.
Senator Angus: Mr. Sprott, welcome to the committee. It is good to have you here — all the way from Toronto. Your reputation precedes you. We are delighted to have your wisdom on a subject that is gaining more and more profile in the international markets and in the media. The financial media seems to have cottoned on to these leveraged finances that you are talking about.
First, before I get into that domain, could you tell us more about your own hedge fund, how it is structured, the order of magnitude and type of investors?
Mr. Sprott: Most of the investors in our Canadian funds are individuals. Most of our investors in our U.S. funds are financial institutions, fund of funds, very sophisticated, wealthy investors. When we started our funds, I was trying to find an offset to being in what we regarded as a weak market. Our structure is that, for every dollar of capital, we have a maximum long investment of one dollar and a maximum short investment of one dollar.
Some people would call that 2:1 leverage. Some people would also call it market neutral. If the market were to fall 20 per cent, perhaps that structure would survive that decline. That is really why we are in the hedge fund business, to try to mitigate a decline in the stock market. We are trying to mitigate a decline because we are from the bear side of the camp, if you will, and we do have worries about the derivative picture. We have worries about the lending mania. Everyone knows there was a lending mania taking place in the U.S. People were being allowed to buy homes and take equity out of their homes, people who were not going to be in a position of repay. We now have the fallout from that. Sixty-five mortgage brokers have collapsed, gone bankrupt, in the last four months.
Senator Angus: That is the below prime mortgage market, subprime; correct?
Mr. Sprott: They call it subprime, but there is recent data, particularly from California, that suggests that the difficulties are to no extent confined to subprime, that they are actually up into the prime side as well.
Senator Angus: You said your fund is made up of individuals. They are all, I think you said, wealthy, sophisticated investors. They would qualify under the IDA definition of an accredited investor, I assume.
Mr. Sprott: Yes.
Senator Angus: How big is your Canadian fund?
Mr. Sprott: Our total funds are $1.3 billion. Our biggest Canadian fund, which closed a number of years ago, was $500 million; we have another one with $200 million and another one with $100 million.
Senator Angus: In any day of trading, do you have traders that trade all that money? How does it work?
Mr. Sprott: We are not like other hedge funds, I am sorry to say; we truly are not. I know lots of people trade aggressively, try to scrape nickels together. If you are leveraged and you make nickels, it adds up to a buck if you are leveraged 20:1, and that is how they make money. We are not of that persuasion. We tend to be long-term investors, so we do not have a lot of turnover of our portfolios. In the sense of what you are trying to guard against, I do not think we fall into the category, because that is not the way we are made up. I do know that many other hedge funds are levered and busy and active in the market all the time. I have read reports where some hedge fund does 2 or 3 per cent of all the NYSE trade in a day. We are not of that style.
Senator Angus: The portfolio in any one of your funds is prudent, long-term investments. However, what makes it different from a mutual fund or some other vehicle? I gather the return on your funds is high, over 20 per cent; am I correct?
Mr. Sprott: Right. However, there is one ingredient that we have not put on the table. I was trying to protect against the stock market going down. In my foresight, I would have thought that our equity fund, which is essentially the long side of our portfolio, would have gone down in that environment. I would think that. If I were looking forward and saying the market will go down 15 per cent in 2001-02, I would imagine my equity fund would go down. As it turns out, it did not go down. They had some of their best years ever. That is why I am a little sheepish about the fact that I did not recommend this long-only fund for these six or seven years when it has had this stellar performance.
In our hedge funds, cumulatively, we probably did not lose anything on the short side and we probably made a lot on the long side. That is the reality of the matter. The way I structure it, I am always worried about a serious fallout happening quickly because of the leverage in the system.
Senator Angus: Is that the system outside your particular fund?
Mr. Sprott: Exactly.
Senator Angus: Your leverage is only either neutral or 2:1, depending on how you interpret it, is it?
Mr. Sprott: Some say it is 2:1 when you have a dollar on each side of the market. I tend to call it neutral. I think it is a better position to have than just being long only, today anyway.
Senator Angus: Would you have more than one counterparty in your operations?
Mr. Sprott: Our counterparty typically is the broker that does the short side of the business, so it could be, in our case, Royal Bank, or in some cases the former Sprott Securities. I would not think they would be concerned about our leverage because we are not really leveraged in that sense.
The example you might want to look at is Amaranth. With three months, the price of a commodity going the wrong way, they lost all their capital. Those are the situations this committee and other committees around the world should be aware of, that when you use leverage things can happen quickly.
Senator Angus: You said what we really should be looking at is not the boutique hedge fund, if you want, or the privately managed one like your own, and we have had some other people that would be, I suppose, competitors. There are other good money managers, Canadians, who are using this particular vehicle to get very significant returns, and it gets peoples' attention, obviously. Our concern started when we found that some less than sophisticated-type people were getting into this and starting with principal protected notes, which we read in the paper today has suddenly got the Minister of Finance's attention, and so on.
Could you comment on that? This is where it gets to be something of our concern. We think the sophisticated investors became accredited for a good reason. They can look after themselves; they are big boys. When we find that your retail investors are getting into this area, it gets scary.
Mr. Sprott: As I suggested, when I look at the two difficult situations we had in Canada and how they could be prevented, first, there needs to be some kind of regulator and some kind of recommended auditor from a panel, just as we do with our banking institutions and our brokers. We have to select from a certain panel of auditors. Obviously, those things were not done. It is highly inappropriate that those organizations could raise the kind of money they did and then all of a sudden the money disappears. We have to try to prevent that. It is not good for the business that those things happen.
Senator Goldstein: Mr. Sprott, we had the advantage of being able to look at your corporate profile before you spoke, and it is impressive indeed. I have to acknowledge a mistake of mine right off, and that is that I never invested with you, which was clearly a big mistake, on the basis of the returns you are showing.
We have been concerned about three or four aspects, which I would like to discuss with you. Clearly, you are not as highly leveraged as some of the other people we have had the advantage of hearing, and certainly not as highly leveraged as some of the very aggressive funds, the ones that we read about in the newspaper.
We are concerned about issues of transparency. We are not concerned about regulation for regulation's sake, but we are concerned about regulation to the extent that that is necessary for the protection of the public and the market. We are very concerned about the potential effect of these mammoth-like, hugely leveraged organizations on the market as a whole. We are told that, far from limiting liquidity in the market, they enhance liquidity in the market, which is difficult for some of us to understand.
In terms of transparency, regulation, liquidity, we understand that the parties who are supplying the leveraged money, the dollars, the loans, are themselves regulated. They are looked at, and they are responsible and disciplined people. They make mistakes like everyone else does, but they are not likely to do things that are reckless in terms of their lending.
What kind of regulation, if any, would enhance transparency and reduce risk? What kind of regulation would be appropriate if, in fact, as we know, a number of these funds, a very significant proportion, are situated in the Cayman Islands and a variety of other places where Canadian regulation is irrelevant? My third question deals with your suggestion that these funds be called upon to take auditors from a list of auditors. In fact, our Canadian banks, as I understand it, need to have two auditing firms from a list of auditors, just to play safe. We have a pretty solid banking system here. However, if they are situated in the Cayman Islands or an equivalent area — and I am not in any way denigrating the Cayman Islands; I would not intend to do that — what use would anything we would try to do be in terms of protecting the market and individuals?
Mr. Sprott: Those questions encompass almost everything we are dealing with here. Yes, people make the comment that there is improved liquidity. Of course, there is improved liquidity, but there is also improved leverage. You are dealing with the question of leverage, by the way. I do not think we are necessarily dealing with the question of liquidity.
To your point that all these people who are making these investments are prudent, I simply go back to 1998 and the case of Long-Term Capital Management, when the largest financiers in the world got hauled into the Federal Reserve Bank in Washington to look for a solution because Long-Term Capital Management was going down. It happened real fast; it did not take long. August 1998 was a very long month in the investment business. That is when Long-Term was not quite under the radar but it was going on. I might dispute the fact that just because you are sophisticated means you are going to deal with things properly.
I will use another recent example, the lending mania. It is happening right now. We have comments from major banks and major lenders in the U.S., not Canada so much, that are now admitting that maybe their standards were a little loose. So, yes, they were sophisticated, but sophisticated people can act in a very unsophisticated way when certain ambitions come on to the playing field. Generating earnings, returns to your shareholders and getting your stock price up are sometimes ambitions that make people do inappropriate things.
Personally, I think the issue goes beyond hedge funds. It does go beyond hedge funds. It goes to the people who lend to hedge funds. Unfortunately, the hedge fund business, to a financial institution, is tremendously profitable. The money that is made lending securities to a hedge fund is gargantuan, and it seems like free money. There is a great temptation to be a lender, keep lending to this guy, and stretch it out. We are making this great return while paying nothing to depositors and can get such and such from this hedge fund — let us push on.
The biggest fear is that the institutions are not that prudent. That is the biggest fear. If they were prudent, we would not have problems with hedge funds. If the major financial institutions are prudent, we will not have a problem with hedge funds in my mind. I believe this then throws it back to the major institutions.
In response to your question about the Cayman Islands, yes, it is hard to enforce something in the Cayman Islands because immediately the money in most cases goes to the Cayman Islands. With our country, however, we should have regulations. We know the assets are disappearing, but if we could at least ensure that people are not just doing ridiculously silly things. In the two examples we had, someone must have been doing ridiculously simple things wrong. It would have been interesting to see what would happen if you had some oversight, notwithstanding the fact that the assets seemingly are outside the country.
I do not know if I have answered all your questions. I have tried to.
Senator Goldstein: I am content for this round.
Senator Massicotte: Thank you, Mr. Sprott, for being with us. In response to the answer you just gave — I missed part of your presentation and maybe it was answered. What should be our interests? What should be our concern? The examples you used earlier vis-à-vis the U.S. were such that the damage was so significant that the economic system, the monetary system, was put in jeopardy. Are you suggesting we should be equally concerned to protect the investors from themselves, especially sophisticated ones? What should our objectives be?
Mr. Sprott: When I look at the leverage in the financial system and some of the events that have gone on in the financial system recently in the U.S., the rapidity with which certain organizations fall apart, for example, it is obvious that there is a laxness out there that is totally inappropriate, in my view. Therefore, what I am really saying is I think we have a very leveraged financial system. That is why we have all this liquidity. We can put layer on layer, particularly in the fixed income area, where someone has a theorem that I will buy the low grade credit and get 8 per cent. I will borrow my money at 5, I am making 3, and will lever it up 20 times and make a huge return. By making that return, I, as the manager — because in the hedge fund business you get 20 per cent of whatever you do over zero — will make a big return. The system can run amuck here.
Senator Massicotte: Let us make the presumption in that example, that the integrity of the economic system or monetary system was not put into question. In other words, the materiality of those issues would not put in jeopardy the confidence of our economic system. Are you suggesting that we should irrespectively do something to protect those sophisticated investors from themselves, irrespective of the fact they want to do those transactions?
Mr. Sprott: I think a form of oversight is needed. We have had sophisticated investors in Canada who have lost money with two of our hedge funds, as defined. I think some oversight would have improved that situation.
Senator Massicotte: One could argue, so what? They are probably smarter than most regulators and decided to do it anyways. They have confidence in you and they lost money. One would say, so what? What would you want the government to do?
Mr. Sprott: I would want them just as we are. For example, we know we have an audit every year because we are an Investment Dealers Association of Canada member. They are pretty thorough in their investigations, and if those same regulators were regulating those Canadian organizations, perhaps the red flags would have been up much sooner than they were.
Senator Goldstein: Mr. Sprott, I want to go to the Long-Term Capital situation. You indicated earlier that, with respect to Long-Term Capital, the Federal Reserve Bank got together a bunch of large institutions, probably every significant institution in the United States, and pointed out there was a real threat to the system and requested, indeed demanded, if one is to read what resulted in those meetings, that each of those institutions assume a burden in order to make sure that the financial market did not collapse.
Has anything changed systemically since the Long-Term Capital issue? I do not see any change. I may be wrong, but I should like to know if there has been a change. If there has not been a change, what is to prevent another Long-Term Capital situation from arising?
Mr. Sprott: I do not intend to be an expert on U.S. securities law, but I will try to answer your question. I do not think anything has changed. There is no more regulation. I would say that margining, the ability to borrow large amounts of money, is probably even more liberal today than it was then. When I go back to the derivatives situation — I almost find it comical that in two and a half to three years we will have a $1 quadrillion — a number most of us have never used in our lives — of derivatives. In a $15-trillion economy, $1 quadrillion of derivatives almost seems impossible. What are we deriving here?
My personal view is that there is far more risk in the system today than there was then.
Senator Goldstein: That fits into my second question. You said, when responding to Senator Massicotte a few moments ago, that there is laxness out there. What do you mean by ``laxness out there,'' and what do you think could be done to tighten up that laxness?
Mr. Sprott: When I use the term ``laxness,'' I am looking at, for example, the lending mania that we just witnessed. It went up and down every financial institution in the United States. I am not dealing with Canada because I do not think we went through that mania, but down there a lending mania took place. There is so much proof of things that were awry.
For example, in the real estate business, I am sure you will see, in time, appraisers being sued for giving false appraisals. There were notifications in the Wall Street Journal in 2004 — appraisers are being forced to raise their appraisals because the bank wants to lend the money, so please boost the appraisal. The system wanted laxness; the system got laxness. I look at what happened in housing, in lending to housing, in the negative savings rate of people, and yet we all seem to survive financially somehow. I am referring for the most part to the U.S. here. In fact, most of what I look at is U.S. In looking at all of that, I see a certain laxness in the whole system — it looks systemic to me.
The Chairman: Senator Angus and I are trying to wrap our minds upon the size of the possible systemic risk. You have talked about trillions of dollars here, so take us through it a little more carefully for a moment.
We know the size of the hedge fund business is growing rapidly. When we last heard, it had gone from $1.1 trillion to $1.7 trillion, and today you have given us another number. Give us your best information on the size of the hedge fund business, as we speak, for Canada, the U.S. and Europe, because they are interrelated.
Mr. Sprott: Mr. Chairman, you are making reference to the hedge fund business, but I keep referring to the leverage finance business, which I define as something different.
The Chairman: Let us deal with your topic, which is the leverage finance business.
Mr. Sprott: I will try to deal with the $1.7 trillion that you referenced. That amount is the capital of the hedge fund business; it does not indicate the amount of the investments in the hedge fund business. That could increase, depending on where someone is investing, by a factor of 10 or 20. In the case of Long-Term Capital, it was a factor of 30. Even if it were a factor of 10, we are talking about $17 trillion, which is not a small amount of money in a $12-trillion economy. It is a great deal of money.
The Chairman: For the benefit of our audience and committee members, let us assume the size of the asset management is $2 trillion, give or take $100 billion. You are saying that the exposure for these pools of capital is many times more than the asset value based on leverage. You are suggesting that it could be five or six or more times greater.
Mr. Sprott: Yes, it could easily be so. Certainly, in the fixed income area, there are tremendous amounts of leverage, because you are borrowing at one level, lending at another, and squeezing out whatever the return might be.
The Chairman: To make this analysis relatively clear, you are saying that the size of the leveraged investments, which are in the $10-trillion-plus range, compares to the Canada-U.S. total economy of roughly $15 trillion.
Mr. Sprott: Yes.
The Chairman: That is important to clarify, because the Governor of the Bank of Canada has appeared before the committee, and will appear again. We have heard as well from the regulators who oversee Canada's banking system. Our concern is systemic risks, on the one hand, to the economy, and these numbers are much grander in scope and size and, therefore, riskier than we have heard before.
Senator Goldstein: You have made one concrete proposal, Mr. Sprott, which is to establish a list of chartered accountants and cause leverage houses to be audited by someone on that list, so as to have, presumably, the best possible quality of audit. Would you have any other suggestions of that nature to make?
Mr. Sprott: There are not too many things you can do to monitor people; however, having auditors in place is one and having a regulator is another. Those are about the only two that you can have for that purpose. I suggest there be some oversight, but how that interprets itself I leave open to others. Oversight is good, in particular when dealing with leveraged investments. Of course, having appropriate auditors is important. In the two cases in Canada, I do not think they would have been amongst a panel of auditors permitted to audit a bank. That created more risk.
Perhaps I could go back to Senator Grafstein's comments about the size of hedge fund business being many times greater than $1.7 trillion. I return then to the size of the entire derivatives business, which is so out of proportion to anything that you could possibly imagine anyone deriving. I honestly do not know what they are deriving.
The Chairman: You are saying that a derivative is a misplaced metaphor for a piece of business.
Mr. Sprott: I do not know what everyone is doing.
The Chairman: To make your point, Mr. Sprott, when they talk about derivatives there is a sense that it follows from an investment of a certain size. You are saying that the derivatives inflate the size of the investment, so ``derivatives'' is a misleading term, in some manner of speaking.
Mr. Sprott: You can buy a derivative with a small down payment; therefore, it is a levered investment. It is so substantial that one should have a fear of it. As well, it is highly concentrated in the U.S., where about 80 per cent of the derivatives have been issued by three banks.
The Chairman: Which banks are they?
Mr. Sprott: Two of them are JPMorgan and Bank of America. I hesitate to guess the name of the third one — but it might be Citibank.
The Chairman: We will ask that question.
Mr. Sprott: It worries me, and it is growing so fast. Something at $400 trillion growing at 30 per cent per year, we have another $120 trillion in derivatives to put on the books. I am left to wonder what we are deriving. We already have everything derived a couple of times over, so I do not know why it keeps growing. You have to think that the risk must be increasing with that growth.
Often, the answer one gets is that it is simply a zero-sum game, in that what is won on one side is lost on the other side. If that is so, then why are we all doing it? Someone is doing it to make a profit, so I do not believe it is a zero-sum game. People are taking a side of things and profiting by it.
As you know, Warren Buffet had an insurance company — I am not sure of the name of the company — and they wanted to unravel their derivative position.
The Chairman: That issue flowed from the losses of Lloyds, in London, and the unsecured position many of the insurers had. It had a ripple effect right through economies.
Mr. Sprott: He specifically talked of his derivatives book. He said that it is so complicated, that is has had taken so long to unwind, it ended up costing money. Fanny Mae and Freddie Mac in the U.S., both of whom have not issued financial statements for two or three years, are still trying to unravel their derivatives.
The Chairman: What are the names of the corporations?
Mr. Sprott: These are two government-sponsored mortgage lenders called Fanny Mae and Freddie Mac.
The Chairman: Do they not have a requirement to file financials annually.
Mr. Sprott: They are required to do so, but they do not comply, because they have been given a free pass. There are huge derivative issues there. They have had to hire thousands of people to try to answer their situation.
Senator Eyton: Along that line, I accept your concern that we should be looking at leveraged finance and not what I would call ``unleveraged.'' We are looking at the extreme leveraged situations of 10:1 or 20:1, and that may be a concern. It occurs to me that ``hedge fund'' is an emotive term. People get excited when they hear those words. However, they are carrying on activity that is historic, has gone on for centuries. People have been hedging, although it was never called that. Who invented the term ``hedging''? Surely, it is just another appellation for an activity that has gone on forever.
Mr. Sprott: I read the name of the person who, I believe, invented hedging in 1946, but I do not remember it. I apologize to the committee for not having the name. The individual developed a formula, whereby if an investor wanted to mitigate risk, being long and being short at the same time is one way to do that. It is a logical methodology and is a very safe way of investing.
However, once you begin to lever it up — for example, where you lever your longs by 5:1 and your liabilities by 5:1, then you have serious possibilities of a quick demise.
Senator Eyton: Sophisticated people and sophisticated managers have done that for a very long time.
Mr. Sprott: Yes.
Senator Eyton: I have been involved with a number of companies where a hotshot CFO would have some hedging program and he would cover off counterparty risk, political risk, currency risk, commodity risk and supply risk. All of that is hedging. We did not have a special name for it, but it was a very important part of ordinary activity.
Bringing it back to the subject, and it is all the same subject, to what extent have the hedge funds and their activity displaced the old timers that one way or another were in that kind of marketplace doing that same kind of function?
Mr. Sprott: That is a tough question. One thing that is so true about the hedge fund business, which even Mr. Trichet was talking to, is that no one knows anything. No one knows the answers to these questions. We do not know. How could we know when we do not regulate them? We cannot even get the data. No one has the right to get data. Therefore how can we know?
I cannot tell you that I know the answer, because I do not possibly know the answer, even though I might read everything I could possibly read about systemic risks — and I try to read everything about systemic risk because I worry about it. However, I do not know the answer to the question. I believe no one, including all the federal reserve governors in the world, has ideas as to the risk.
Senator Eyton: To what extent, then, do you think the growth of hedge funds represents a kind of exodus of capital from the old time industries, but ones that are more transparent, where there are more reporting requirements or that are regulated? In effect, they can hide the leverage that might have been fairly typical in the business one way or another and go off and invest capital in a hedge fund, so-called. Would part of the transit be because of lack of regulation and lesser transparency?
Mr. Sprott: I can tell you that some of the largest hedge funds in the world are headed up by people who worked at major financial institutions who left and saw even the ability of the financial institutions to do well. You have to appreciate that, in the last 20 or 30 years, the stake in the economy that is controlled by financial institutions has risen remarkably, and the stake that belongs to people who are non-financial has decreased markedly. Somehow, there is a great business there, whatever it is, but it has increased way beyond the norm of the economy.
Senator Eyton: I guess the driver would be, first, greater opportunity, because it is leveraged, in good markets that is certainly so; and the other compelling thing are the fees, and the fees drive a lot of activity.
Mr. Sprott: Yes.
Senator Eyton: Going on to a more relevant concern, to what extent do you think our Canadian hedge funds are isolated from global events or international events? By that, I recognize that there is some supervision. They have to deal with banks and the banks are themselves regulated. They deal with other brokers and investment bankers, and they are regulated.
We have a kind of Canadian view of Canadian hedging. On the other hand, we can be impacted, as we know well, by things that happen beyond our borders. To what extent do you think we can claim some sort of isolation from those events?
Mr. Sprott: Again, I do not profess to be an expert because the leverage in hedge funds is normally in the fixed income side and I happen to be from the equity side of the business. I get the view that we do not take on the same degree of leverage that others might do in various centres around the world.
To me, the bigger risk is the global risk that we all should be looking at. I realize that we are here in Canada trying to deal with the Canadian part of it, but I do not think we can close our eyes to a possible global systemic risk, which, as you are undoubtedly aware, the Europeans seem to be taking more seriously, that something could affect them if there is an unravelling here.
Anyone who realizes the leverage in the system realizes that everyone will be involved — there is no way to escape it, if there is a problem. If there had been a problem with Long-Term Capital and we had just let things implode, then confidence would have disappeared, and if confidence disappears it is over for everyone. If confidence in the financial system ever disappeared, it would be very difficult everywhere. That is why Long-Term Capital was not allowed to unravel as it might have.
That is perhaps why Fannie Mae has not really been taken to task, because if we found out how bad Fannie Mae was, it might start a chain reaction. I do not profess to know, but I know no one else knows. We do know some things. We know they have lost a lot of money in derivatives. That they have admitted to, but they do not know how much yet.
Senator Eyton: To what extent do you think that the hedge fund industry, for example, would come together, à la Long-Term Capital, where, in fact, they were summoned to Washington and worked out a solution and got over a crisis? My own sense is that purely in the hedge fund business, if someone gets in trouble, the guys around may taste blood in the water and it may be an opportunity to make money rather than help their wounded compatriot.
Mr. Sprott: We have seen that in the Amaranth situation. That is my own observation. I think certain people knew Amaranth was in trouble and they all pressed the bet and made the demise of Amaranth happen that much faster.
Senator Eyton: It is not very reassuring to have the industry looking and saying together we are all right.
Mr. Sprott: I do not think you would ever get the industry to coalesce on issues like this. I can understand the chairman of the Federal Reserve saying to the people he regulates, ``You guys get into this room because we have to talk about this,'' but I am not so sure that the hedge fund industry could be forced into the same room.
Senator Eyton: What you are describing then is the ultimate hedge, where basically, if things go wrong, they can walk out of the room and leave the pieces for someone else to fix up.
Mr. Sprott: In some of the great banking crises of all time — there was one in 1906 — they brought the bankers into a room and told them they were not leaving until the problem was solved. I am sure the same was true with Long-Term Capital: ``You are not leaving until the problem is solved, because we have to solve it.'' That is fine when you have 10 or 15 people and they are the dominant.
Senator Eyton: The senior regulated people.
Mr. Sprott: Yes, regulated people, too.
Senator Moore: This has been very interesting. The numbers are incomprehensible for the average citizen, including me — $350 trillion of notional value of derivatives outstanding today, versus a GDP in Canada of $1.5 trillion. What is behind that $350 trillion?
Mr. Sprott: Someone has placed a bet on a commodity, oil or gold — credit default swap —
Senator Moore: That it is going to go up?
Mr. Sprott: Up or down, either way. Someone is on either side the transaction, and it gets bigger all the time. I just wonder whether there are enough assets in the world that we need to derive that much. I would argue that we do not have that many assets in the world, which really means that ultimately someone is trading with someone for the sake of trading. That is what I happen to believe.
Senator Moore: They are grinding out the fees — the brokers.
Mr. Sprott: Someone believes it is in their best interests.
What it tells us is that there is a lot of leverage around. There has to be leverage for that.
Senator Moore: Not liquidity, but leverage.
Mr. Sprott: It has created liquidity, too. Someone could buy a credit default swap and then go out and buy a low- quality credit, because he has this credit default swap that he can present to someone and tell them that he made the bet that this guy would not pay his interest and principal and now you have to pay me. That is an example of a derivative. One of my big fears is that he has to go down to the Cayman Islands to collect payment.
Senator Moore: You mentioned that 80 per cent of the leverage financing is held by three banks in the world, all U.S.
Mr. Sprott: Eighty per cent of the outstanding derivatives issued by banks are held by three banks.
Senator Moore: Is that the $350 trillion?
Mr. Sprott: No. It is a smaller amount. Let us say it is $140 trillion.
Senator Moore: What is the sum of the derivatives in Canada? Is that also held, that notional value, by our banks? If so, which ones? Do we have a breakdown?
Mr. Sprott: I do not have the answer to that question. I know they are involved in the market.
Senator Moore: What would be the amount be?
Mr. Sprott: I do not know what the amount is.
Senator Moore: There is no regulation.
Mr. Sprott: There is no data.
Senator Moore: When you said no one has the right number, does that mean no one knows because there is no reporting?
Mr. Sprott: There is reporting. Some institute reports the total notional value of all derivatives outstanding. Perhaps I can find the name — the derivatives association of the United States, or something.
I am more of a student of the U.S. than Canada. You always have to worry about what will happen there more than what will happen here. What happens there will happen here, so you better study there.
We get data from, I presume, the Federal Reserve or some other banking organization about the notional value of derivatives that the banks have contracted to. It comes out every quarter. I have never seen that number here.
Senator Moore: We do not have that same sort of reporting or assembling of data in Canada.
Mr. Sprott: We may have; I do not know. I personally would not study it anyway. I am more interested in the bigger issue. You, obviously, are more concerned about the Canadian issue than I am. I am trying to analyze what could happen to the dog that wags the tail.
Senator Moore: My head is spinning with these numbers. I have been reading about Fanny Mae and Freddie Mac. I think you are probably right, that is, that it is probably so big that, in order not to cause a lessening of the confidence in the market, they have been called in, sat down, and told that we are just going to tough this out.
Mr. Sprott: It is odd. To say the least, it is odd. Can you imagine a situation in Canada where a major bank did not issue an audited statement for two years? These are big lenders, the biggest lenders in the world.
Senator Tkachuk: Thank you, Mr. Sprott. I appreciate the information you have been providing. I am like Senator Moore — I get a little confused when we move into the trillions. I get confused in the billions, let alone the trillions.
We cannot do much about the United States except provide leadership. I cannot do much and the government cannot do much about people who want to take risks to make more money. This is why they go into hedge funds and buy the kinds of securities that you are talking about.
Our concern is not so much the investment; our concern is that money disappears. People think money is real, and it is, but they do not realize that it just disappears. We do not want a Japan situation to happen here, where so much money disappeared that it stalled their economy for 10 years.
What can we do to mitigate a threat to the financial system? That is our concern. Our concern is not so much that Joe Blow lost $500,000 or $5 million or $10 million but that the instruments and the institutions, their debts, liabilities, and leverage, become so large that they threaten the viability of the financial institutions — which now affects savings of ordinary Canadians, pension plans, all the things that, we, as politicians and regulators, care about.
With the limited amount of information that I have absorbed from your discussion and from past discussions here, what can we do to protect the financial institutions from committing suicide? Banks are regulated by how much money they can lend — based on their deposits. However, with respect to other funds, can we limit the amount, the multiples, that they can play with? Can we say five times or ten times? Can governments do that kind of thing? Can the industry self-regulate itself?
What concrete things can we do that would make sense — that would not impinge the creativity of the marketplace, which I like — that would come some way toward ensuring that the financial system itself does not become threatened.
Mr. Sprott: Thank you for the question. I think there are a couple of answers. I find your comments about Japan very instructive. I would guess that the Japanese banking system was broke whatever number of years ago — which means that these prudent people were not that prudent.
To answer the question about whether prudent people can still make mistakes — of course, they can make mistakes, so much so that in Japan they had to destroy the return to their citizenry for the last 20 years so that their banks could get re-liquefied and become profitable and not have negative equity. That is the way I look at it. They do not say it that way, but that is what I happen to believe.
How do you protect the financial system? To me, it is all margin. I am a stockbroker, so how much margin can you lend on something and what is practical here? Vis-à-vis margin, even in my short stint in the brokerage business, it used to be that you could borrow 50 cents on the dollar. Now, in most cases, you can borrow 75 cents on the dollar, so we are allowing more margin.
Whenever I think of margin, I think of the NASDAQ bust, when all the stocks were trading at multiples that were so out of character. Why did we not raise margins? We did not want to kill the golden goose — but it was going to kill itself anyway. It seems to me that that would have been the most logical thing to do at the time. You have to raise margin to stop speculation.
As I look as what is happening in the Chinese market today — it went up 100 per cent in the last little while. Last week, they opened up 240,000 brokerage accounts in the week. It is unbelievable.
Senator Angus: What city is your Chinese office in?
Mr. Sprott: It should be in all the cities.
It is worrisome that these things can get frothy in time. There are issues over there that are oversubscribed by hundreds of times. It makes you sit back and wonder what you can do to mitigate overzealousness.
I think margin is obviously the answer that is the easiest to use. If you just raise margin requirements, that slows everyone down. I cannot remember the last time we saw a margin increase; it has been a long time. We have seen margin decreases, though. As well, we see instruments created that essentially are allowing more margin, if you will, more leverage, lots of instruments that give you more leverage.
Senator Ringuette: I must say that I am very naive regarding these issues of grandeur. From your comments, I do understand your major concern in regard to what is happening with the lending mania in the U.S. and our economy being so tied to it — and what happens in the event of a hiccup.
You said that 80 per cent of the outstanding derivatives is with three U.S. banks. You said also that a lot of the lending is in the housing market. Is there another sector that we should be looking at for indications?
Mr. Sprott: In essence, with the outstanding derivatives being as large as they are, and the liquidity being as big as it is — you create liquidity by increasing your leverage. I cannot say that there is another area that is abused.
Having studied the real estate market and the evolution of the real estate market in the U.S., you could see that there were many issues, and, unfortunately, it got down to the guy in the street, who was convinced to do things he never should have been convinced to do.
I read story after story about an individual saying that he or she did not understand the adjustable rate mortgage, and they did not. It was probably not well explained to them, that two years from now the rates are going down and we as a lender think your house value is going up so we are not worried. The minute the house value did not go up, the lender got worried.
I do not know where else I would point the finger. There is lots of leverage in the system, whether it is lending to hedge funds or lending to private equity now. You see these gargantuan transactions taking place, which obviously require lending. These people do not have $25 billion sitting around in their bank account.
However, I cannot point a finger at any specific area.
Senator Ringuette: Where do you see the U.S. military industry in this scenario?
Mr. Sprott: I do not make any connection between the U.S. military industry and what we are discussing. I may be totally wrong, but I do not see a connection there.
Senator Ringuette: Is the 80 per cent derivatives figure totally within the U.S. territory or are we looking at foreign?
Mr. Sprott: I think it would encompass world derivatives.
Senator Angus: Following up on the margin, relaxing the margin requirements, I just want to make sure I understand it. You are saying that because these investors are not getting enough leverage on the traditional type of investment they have been driven into these other areas where there is more leverage and credit available? When you say relaxed, I assume you want to go from 75 to 80; is that it?
Mr. Sprott: If you buy $100 worth of a bank stock today, you can probably borrow $75 of it from any broker —
Senator Angus: You can.
Mr. Sprott: — all on the assumption that stocks do not go down 25 per cent. You probably could have borrowed 75 cents on the dollar against an income trust as well, on the assumption —
Senator Angus: You still can.
Mr. Sprott: — that income trusts could never go down 25 per cent. Anything can happen in life. We saw examples in this country where if a person was leveraged a huge part of their capital was destroyed quickly because of leverage.
Senator Angus: In regard to relaxing the margin, I am thinking you are saying the opposite.
Mr. Sprott: I am not saying to relax the margin, I am saying the opposite, tighten it up.
Senator Angus: That is what I thought, but it came out the other way.
One of the things that has come to our attention — and not only in recent days of hearings; we went to the U.S. to meet some of the players there and got a sense of their take on it — is the common theme of conflicts of interest. We came away with a sense that this is something. The incidence of insider trading and conflicts of interest between lenders and borrowers is so rife that it is uncontrollable. It is equivalent, in my mind, to the rot that you are alluding to, the potential rot.
Could you comment on that? Is it as prevalent as we were told? Someone asked us one night, off-line, what we were doing down there. I said that we are looking into lessons that we can learn from Long-Term Capital and Enron, as well as other situations — insider trading and conflicts of interest. The person's casual attitude to it blew us away.
Mr. Sprott: I do not have a comment on insider trading. If you are suggesting the potential of some financial institution that happens to be the prime broker of some hedge fund tipping them off that something will happen, or vice versa — I have no comment on that; I would never suggest that that is happening because I have no evidence of that.
The other question, what you described as conflict of interest, I would describe as mutual interest — the mutual interest of the lender and the hedge fund.
Senator Angus: That is a very good distinction.
Mr. Sprott: I mentioned that some hedge funds do 2 per cent to 3 per cent of all the trades on the NYSE. There is a tremendous flow of commissions going to the financial community from the hedge funds, plus the money that is made on the lending against the short positions, which is a bit of a no-brainer in terms of generating a return.
Even in Canada, I would say that hedge funds are probably regarded as better clients than other funds, perhaps substantially better clients than other funds, from an economics point of view. I think there is a mutual interest between the lender and the hedge fund because it is economic for both parties.
Senator Angus: Are the usual risk-management practices not followed?
Mr. Sprott: I do not know. I can only tell you that in the case of one, Long-Term Capital, it does not look like they were followed.
Are there other examples? I would guess there might be some examples, where someone might be running pretty lean in terms of his capital versus his commitment. I would think that might be the case.
Senator Angus: We recognize that there are lending sources other than the main banks. However, at the end of the day, Canada's financial system is heavily characterized by our chartered banks, of which there are so few compared to other jurisdictions, particularly in Europe, the U.S. and Japan. Your statistic of the three banks is resounding in this respect. One, maybe two, of our main chartered banks, the Commerce and the Royal, made some pretty hefty settlements. Yet the stocks keep going up, making one wonder how quickly it can happen.
Does the Canadian system have adequate safeguards through OSFI? As you said, you are more focused on the U.S. system because it is the dog that wags the tail. The new head of the Federal Reserve stated as recently as last Friday or Saturday that he does not want to tamper. This could be a case of it being only hedge funds and not leverage finance, between which you made a big distinction. Could you comment? Are we a little close to the line?
Mr. Sprott: There is no question that the entire financial world is interrelated because everyone is everywhere. There was a time 50 years ago where, if there was a problem in a bank in Canada, you simply closed the bank down and merged it with an existing bank — the depositors were not leaving; they stayed in the country. It was a closed system. I do not regard the system as being closed today, because it has become truly global with everyone going everywhere. If a problem occurs today, no matter where, I would venture to say that some of our banks will be involved, whether the biggest or the smallest. How can you guard against it? I do not know the answer to that question. You have to worry about other people having a problem and, depending on what you decide, you could show a little leadership and say what you think is good for us, and perhaps someone will adopt it.
The mention of the head of the Federal Reserve takes me back to a recommendation made by Chairman Greenspan about three or four years ago such that perhaps people should consider adjustable rate mortgages rather than fixed rate mortgages. He made this argument because, over the long run, the cost of adjustable rates has been lower than fixed rates have been.
However, it raises the question: How could you not try to deal with a situation where the rates increase? What if the rates go up? Someone locked into a fixed rate can do his financial planning for 10 or 20 years. With an adjustable rate, you are at the mercy of the system. The head of the Federal Reserve suggested it might be cheaper to do an adjustable rate. Now that they all have their adjustable rates, what has happened? All of them are in a bit of a jam. We have to be cautious about where we seek our best advice, and it is not an easy playing field. Obviously, I am one who assumes things can go bad.
Throughout this time, we have not talked about Enron, which is what you referred to, in that it unwound so fast and had so much leveraged money involved. There are many examples of this happening in the world.
Senator Angus: I was on this committee at the time the Barings Bank went down in a nanosecond. Our committee travelled to Toronto, to the trading rooms of the Toronto-Dominion Bank. This was the early, high-profile days of derivatives. That is what we are talking about today — those risks that were manifested in the Barings case were repeated in the Amaranth case, in the LTC case and in other cases that we do not hear about because the boys belly-up to the bar and prevent the loss of confidence to which you referred. Is that not what is happening?
Mr. Sprott: Certainly, that happened in some of those cases and, in others, such as Enron, they simply let them go down. All of us deal with the fallout later, and it is still happening in the form of outstanding litigation. We talked about prudent people making prudent decisions; I can give you examples of prudent people not making prudent decisions. Senator, you raised Enron, and that is my reference.
In hindsight, it does not seem prudent, and I have the benefit of 20/20 hindsight.
The Chairman: Mr. Sprott, your comments are correct. If you study the history since the 1960s, you will know that there has been a period in every decade when the system underestimated the risks. In the 1960s, we had sovereign loans because they provided fast, easy money. All of a sudden, it shook the banking structure with no warning signs. Then, we had big real estate, and that shook a number of Canadian corporations because everyone wanted to get into real estate. Then there was big oil and then the Internet boom.
In each decade, there has been a series of seismic meltdowns. The job of this committee, as best we can in terms of the Canadian system, is to look at a few things: first, systemic risks to our economy from the perspective of the financial sector; second, whether government structures within the sector are fair, appropriate and transparent so that people can invest with confidence; and, obviously, consumer protection.
Allow me to relate a couple of suggestions, to see if they meet your concerns. You talked about not keeping track of risk, that, in effect, we are overleveraging the security when a number of these funds hedge on the same risk. One of the suggestions made in the United States, which we tested here, was to establish an international clearing house of risks so that, in effect, there is no double-dipping on the risk. How would you feel about that as a safeguard? Would it work? We had it before; it was the origin of the international banking system when the question of settlements was a problem in the 1920s and 1930s. That resulted in the Bank of International Settlements, which has its head office in Basel, Switzerland, and they felt it was a good way to clear it. Have you looked at this question? What are your comments on that?
Mr. Sprott: Mr. Chairman, I have not looked at that and whether it would work. I cannot imagine all parties agreeing to it because it is almost impractical that all would agree. Unfortunately, the financial system is thriving opportunistically on risk and leverage, which is why they constitute such a very large part of our economic profits today. I cannot imagine that they would buy into it, if you will.
Is it the answer? That is such a complicated question because I do not know how you would limit and who would be the judge that would limit the risk. That is the big problem.
The Chairman: These are exactly the same questions that the international banking community and governments had to grapple with in the 1930s during the Depression. We are trying to examine these suggestions and recommendations to determine whether they have some validity and substance.
Senator Moore: You said that a derivative is a bet.
Mr. Sprott: Yes, it could be a bet, but someone might think it is not a bet because perhaps he is long and buys a credit default swap and thinks he is offsetting risk. However, all financial investments have risk attached.
Senator Moore: What is behind it? There is no tangible asset and no offsetting cash. Everything is leveraged in this game, which is on paper only.
Mr. Sprott: I am sure people in the banking community would answer it quite differently, that they have a loan or a mortgage and are going to write some credit default swap, and they have it, that that is a transaction that is now hedged.
I do not know what the individual who buys a credit default swap has on the other side of the transaction — because he is the one who has just taken on the risk of the mortgage failing. I do not know what he has on the other side to balance that.
I know the banking community seems to believe that it is a zero-sum game but I have a great deal of difficulty with that way of thinking. When you become that big, one little shift in any area can cause a problem.
Senator Moore: When an entity fund wants to unwind its derivative situation, what does it do? Do they go to the people who hold their securities and asking what we owe you?
Mr. Sprott: One of the problems with the derivatives business is that many of us do not know who is behind whom and, therefore, who holds the ultimate derivative. When you attend a trading function, you learn that derivatives are traded here and there and you might find that your credit default swap is owned by an insurance company in Germany, for example. You simply do not know.
Another problem in the derivative business has been settlement of trades. There are still a great many trades outstanding.
Senator Moore: What percentage, or how do you quantify it?
Mr. Sprott: It was so extensive that about 18 months ago a panel was convened to try to resolve outstanding derivative contracts. They have decreased the percentage that are failing, but there is still a substantive number of them.
Senator Moore: Can you put a figure to that? Are we talking about 10 per cent of the $350 trillion?
Mr. Sprott: No, I do not think it would be that big. Rather, the number is more in the range of 5 per cent of trades outstanding for the last 90 days that have not settled.
Senator Moore: Is it because people have not been able to come up with the cash at the very end of this derivatives chain?
Mr. Sprott: They have to determine who the counterparty is so it can be settled, which is a little odd in a way. You would think that in our system of computers we would be able to identify the counterparty in order to settle the trade.
Senator Moore: Deal with the cash.
Mr. Sprott: I do not know why they do not settle; and it is odd. How many stock trades do not settle? They all settle, ultimately.
The Chairman: Going back to my earlier comment about the clearing house, it would come into play at that point of settlement.
Mr. Sprott, I have one last question on executive compensation. Mr. Sprott and I discussed this informally before he gave his evidence today, so this will not come as a surprise to him. This committee, under able former chairmanship of Senator Kolber, who has retired from the Senate, and his then deputy chairman, Senator Tkachuk, released a report in June 2003 entitled Navigating Through ``The Perfect Storm'': Safeguards to Restore Investor Confidence. The report contained recommendations dealing with executive compensation. More recently, on April 20, 2007, the United States Senate and the House of Representatives passed bills to allow shareholders a higher visibility in executive compensation. Obviously, this committee should examine that issue.
In respect of hedge funds, we heard the extraordinary news last week that three hedge fund managers received amounts that dwarfed any other compensation, on an annual basis, that I have heard about in the history of the world. Perhaps some kings did better than they, but that was never measured on the exchanges. Essentially, one hedge fund manager's annual compensation this year was $1.7 billion. Mr. Sprott, you indicated that that amount is greater than the net worth of most Canadian companies. What is your comment on that? Obviously, I will not ask about your compensation or modalities but, even though your success has been extraordinary, I am certain your annual compensation is nowhere near that amount. What is your comment on that?
Mr. Sprott: Perhaps I will answer the question in this way: As a firm, we charge incentive fees, which all hedge funds charge. The Sprott Canadian Equity Fund charges an incentive fee, and if we beat the TSX our compensation is 10 per cent of the amount by which we surpass the TSX. That is what we earn.
The Chairman: If it goes up 10 per cent, you receive 1 per cent.
Mr. Sprott: If it is 10 per cent above the TSX, we would make 1 per cent. I would say that very few people have ever complained to me about the incentive fee they pay to us.
In the hedge fund business, we get paid 20 per cent over zero. Now, I will admit that is a little egregious. It is egregious to receive 20 over zero, but sophisticated people were prepared to go there because these hedge funds delivered an out-sized return. Therefore, those people to whom you refer could charge what we would all agree is an excessive fee.
I believe the particular individual's name is Simon.
The Chairman: I believe the name was publicized and I believe it is James Simon.
Mr. Sprott: He might have had a fee of about 4 per cent up front and 44 per cent of what I make above zero. He could charge that fee because he has experienced some excessive returns. Without excessive returns, no one would pay that kind of fee. Interestingly, he was a professor of mathematics who learned some skills at beating the market, and he has done it for a long time. I have no idea what his returns are but they have been astounding because people agree to his fees. If you were to ask his customers whether they would like Mr. Simon to make $3.4 billion next year, the answer would be yes, they would like him to make $3.4 billion.
The Chairman: On that extraordinary note, Mr. Sprott, we will conclude the hearings for today. I would like to your family — who are sitting here in the hearing: your sister-in-law, Jenny Sprott, your brother, Doug Sprott, and Vizma Sprott, your wife. Mr. Sprott, you provided interesting and compelling evidence that will be beneficial to the committee in its deliberations.
The committee adjourned.