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55–533 CC

MARCH 3, 1999

Printed for the use of the Committee on Banking and Financial Services
Serial No. 106–6


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U.S. House of Representatives,
Subcommittee on Capital Markets, Securities,
and Government Sponsored Enterprises,
Committee on Banking and Financial Services,
Washington, DC.

    The subcommittee met, pursuant to notice, at 10:10 a.m., in room 2128, Rayburn House Office Building, Hon. Richard H. Baker, [chairman of the subcommittee], presiding.

    Present: Chairman Baker; Representatives Lucas, B. Jones of North Carolina, Sweeney, Biggert, Toomey, Roukema, Kanjorski, C. Maloney of New York, Hooley, and S. Jones of Ohio.

    Also Present: Representative Leach.

    Chairman BAKER. I would like to call the Capital Markets Subcommittee hearing to order, and I certainly wish to extend a welcome to all those who are to participate this morning.

    Our hearing today I hope will help give better explanation as to the circumstances following the failure of Long-Term Capital Management and the potential for broad market losses, perhaps, systemic risks.

    The event prompted intercession by the New York Fed and a subsequent $3.6 billion capital injection by a consortia of United States banks. In the aftermath, it is clear that the events could have been dramatically worse had the resolution not been agreed to.
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    How did we come to this circumstance? Did the regulators have the ability to adequately assess the risks, particularly risks that could have been of a systemic nature? How did the regulators even come to learn of potential failure? Is there any need for any further regulation or congressional action to ensure that these conditions are not repeated, or worse, beyond market losses, even the requirement of taxpayer funding to support an institution whose credit was involved in a hedge fund?

    Recently, I have had occasion to work with the committee staff of jurisdiction in the Senate on this very question, and it is clear that there is broad interest in finding answers to these questions. In a lengthy briefing yesterday by Long-Term Capital Management, Members of the subcommittee gained great appreciation for volatility of the markets, and then the impact of how very large trading positions can place others in grave risk. It is our hope not necessarily to lead to new regulation of hedge funds, or to in any way inject ourselves into what is really a private investment matter, but to ensure that the regulators have the capacity to properly judge market risk and have the ability to respond very quickly.

    In the course of a 24-hour trading day, literally hundreds of millions of dollars were lost by one market participant. The scope and potential for loss was really beyond comprehension and so it was with grave reservation that we suggested that further regulatory levels of assessment are required, but we recognize the potential for loss and feel an obligation for taxpayers to ask the questions that need to be answered.

    I thank everyone for their participation this morning. I am told that we will have additional Members joining us momentarily. Would Members care to make any opening statements?
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    Mr. Jones.

    Mr. JONES OF NORTH CAROLINA. Mr. Chairman, thank you very much.

    In the Third District of North Carolina, which I represent, we have many farmers who are financially in pretty bad shape; many are on the verge of bankruptcy. No friendly regulator has called in to banks that have loans to those farmers and suggested to them that they need to buy a stake in the farms instead of foreclosing on their loans. No bank regulator has worried about the overall risk to the economy of Eastern North Carolina if those farms fail. Unlike the case with Long-Term Capital Management, it has apparently been decided that if the farmers fail, so be it. When times are good, everyone involved makes money; when times are bad, Mr. Chairman, they lose money. Mr. Chairman, you can not have it both ways.

    If hedge funds do not pose an overall risk to the economy, then the regulators should stay out of it. Just like my farmers, they should be allowed to make millions of dollars, and they should be allowed to fail. On the other hand, if they do not pose a risk to the economy, then the public should be protected by congressional action, not by backroom deals with regulators in New York City.

    Mr. Chairman, I thank you for holding this important hearing. I look forward to the testimony of the witnesses. Thank you, Mr. Chairman.

    Chairman BAKER. Thank you, Mr. Jones.
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    Mr. Toomey.

    Mr. TOOMEY. Thank you, Mr. Chairman. I am looking forward to learning about a couple of things specifically: first of all, why did the Fed really feel the need to get involved in the bailout? I think it is vital that we know what was the magnitude and the nature of the risk posed to the banking system. I think it is vital that we understand this fully and accurately, because there are voices in Congress to take strong measures to get involved in what could be inappropriate regulation, and if we don't understand this fully, I am concerned that we will go down the wrong path.

    Chairman BAKER. Thank you, Mr. Toomey.

    Mrs. Roukema, Chairwoman of the Financial Institutions Subcommittee.

    Mrs. ROUKEMA. Thank you, Mr. Chairman.

    I hate to start out an opening statement by giving apologies, but I must apologize for not being able to attend the full hearing. I have a conflict with a markup in the Education Workforce Committee that is very important. However, you may be sure I will have a full report and will carefully go over the testimony today as I indicated to Mr. McDonough earlier.

    I do have questions, as you well know, particularly, in the the wake of the Full Committee hearing that was held last October on the Long-Term Capital Management problem. While recognizing what our colleague from the agricultural industry has just indicated, I do believe that the right thing was done to avoid a failure. That the contagion of such a failure and its effect throughout the economy is being discussed here today.
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    But there are still many, many questions raised by Long-Term Capital. Speaking as the Chairwoman of the Financial Institutions Subcommittee, I regret that Mr. Baker and I could not come to agreement to have a joint hearing on this subject. There is so much interlocking and overlapping jurisdiction in this area. I will try to work together with the Chairman. I would note that the Financial Institutions Subcommittee will be having a hearing on March 17 to review the Basle Committee Report, which I think is quite constructive, and also to carefully look at what the OCC and the Fed have done already in terms of revising their oversight.

    I remain deeply troubled by the Long-Term Capital rescue. Despite the Basle Committee Report, and Fed and OCC guidance, all the answers are not out there yet. We have to take a good hard look at the problem. We must protect the public and the taxpayer in the future, as well as the financial system, on architecture, which is what I think we are calling it these days.

    Mr. Chairman, I can assure that I look forward to working with you and conferring with you as we work through this complicated and extremely important subject.

    Chairman BAKER. I thank the gentlelady for her interest and for her continued work in this matter. I know the two subcommittees will work together to try to find the appropriate answers.

    Chairman Leach.

    Mr. LEACH. Well, thank you, Mr. Chairman. I am certainly pleased that you are holding this hearing and that Mrs. Roukema has a complementary hearing in several weeks, and I am particularly honored that Mr. McDonough, the distinguished Chairman of the New York Fed, is with us. He has become the architect of a new economic doctrine, and that is the corollary to the ''too-big-to-fail'' doctrine, the ''too-big-to-liquidate-too-quickly'' doctrine which is forever now going to be the McDonough doctrine I think.
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    Let me just say, a lot of us have some doubts about certain circumstances and respect for certain dilemmas, but it strikes me when dealing with the hedge fund industry that if we are going to not have intrusive regulation, there have to be some opinions of philosophy, and one is that this kind of industry should not be the subject of public bailouts. The second should be that there be no collusion, and, as you know, Mr. Chairman, I have grave doubts about the anti-trust circumstance surrounding the Long-Term Capital Management solution. And the third is—and that relates to banking regulation in a way—that the industry not have advantages in the cost of funds related to publicly-insured deposits, and the obvious corollary to that is that there be security to the public about those funds; that the lending arrangements be prudential.

    In any regard, I think this is a very timely hearing, and we are very respectful of our witnesses. Thank you, Mr. Chairman.

    Chairman BAKER. Thank you, Mr. Chairman. I certainly appreciate your participation in the hearing today.

    I guess of all the developments surrounding this matter, one of the most with the most interest is the corporations or individuals who refused to come here today to talk about this matter. Although I certainly appreciate Long-Term Capital Management's willingness to brief the subcommittee yesterday, I am in receipt of their letter this morning, which will be made part of the record, which basically indicates, although they will make information available to the subcommittee on a briefing basis, they clearly are not yet willing to testify on the record.

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    [The information can be found on page 119 in the appendix.]

    Chairman BAKER. I am also advised that the financials for Long-Term Capital Management for Fiscal Year 1998 will be made available to the subcommittee, which is a public document and required for disclosure to the CFTC, and we are waiting on receipt of that document.

    There are a number of the financial institutions who were investors or lenders in the matter who also have chosen not to testify here this morning. So, we will certainly continue forward with our effort to get all of the pertinent information surrounding the facts leading to these losses, and I, again, want to express my appreciation to those who have chosen to participate this morning on what is a significant matter of public policy.

    Our first panel this morning is the President of the Federal Reserve Bank of New York, Mr. William McDonough. He Chairs the group of central bankers who produced the Basle study on the proper relationship of banks with highly leveraged institutions, and, as well, was instrumental in working out the resolution that averted significant losses, and we certainly appreciate your participation, Mr. McDonough.


    Mr. MCDONOUGH. You are welcome. Thank you, Mr. Chairman, Chairman Leach, Chairman Baker, Members of the subcommittee.

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    When I appeared before the Full Committee in October, I spoke about the near collapse of Long-Term Capital Management and the events leading up to the private sector recapitalization of its fund, Long-Term Capital Portfolio. At that time, I promised you that we would take a hard look at the issues growing out of that experience, particularly as they affect our responsibilities as bank supervisors. I am pleased and honored to appear before you today to report on the lessons we have learned and the actions we have taken to reduce the possibility that such an episode could repeat itself in the future.

    As I indicated last fall, three issues require particular attention by banks and their supervisors in the wake of LTCM. These are, first, the adequacy of banks' credit analysis processes; second, the effectiveness of exposure measurement; and, third, the role of stress testing of counterparty exposure. In my remarks today, I will detail the substantial progress that has been made, both domestically and internationally, to address each of these supervisory concerns.

    But before I get into the details, let me say that I believe that the LTCM episode, and the supervisory response to it, is fundamentally about two things: leverage and good judgment. Leverage is a fact of life in our financial world and is a key part of the risk-taking necessary for the creation of wealth, for the creation of jobs. But sometimes banks go too far in extending credit to their customers and counterparties; that is where good judgment comes in. I know, I have been there. I was a commercial banker for 22 years before becoming President of the New York Fed, and I can tell you that the most important decisions a banker makes are how to lend and to whom. Those decisions are not easy and often involve many shades of gray. One of our aims as supervisors should be to see that banks are using the right tools to make those judgments.

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    The importance of these issues extends beyond banks and their supervisors. Sound credit policies and procedures are essential not only for the stability of individual banks but also, and more importantly, for the health of the financial system and the economy as a whole. This is because banks play a pivotal role in our economy as providers of credit. If banks make poor credit decisions with respect to a borrower, including a hedge fund like LTCM, the financial system and our economy will suffer.

    As you know and has been mentioned, I Chair the Basle Committee on Banking Supervision, comprised of bank supervisors from the G–10 countries who coordinate supervisory policy for internationally active banks. While the committee does not have formal legal enforcement powers, its conclusions and recommendations are widely implemented, both in G–10 countries and many others.

    In late January, the committee issued a report dealing with the relationship between banks and highly leveraged institutions, or HLIs. The committee's report provides a framework for addressing the broader issues raised by the LTCM episode, the policy responses of supervisors, and some key risk management challenges for the banking industry going forward.

    In the United States, the Federal Reserve System, the New York State Banking Department, and the Office of the Comptroller of the Currency have conducted target reviews of a number of large banks dealing with hedge funds. These reviews contributed to the committee's work, the Federal Reserve System's issuance on February 1st of new guidance to financial examiners and banks, and to similar guidance from the Comptroller of the Currency issued in January. These new standards emphasize the need for improvements in the credit risk management processes at banks. The new standards will likely be complemented by a study of the implications of the LTCM episode by the President's Working Group on Financial Markets.
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    Because the Basle Committee's jurisdiction is limited to matters of banking supervision and regulation, its primary emphasis has been on ensuring that major banks prudently manage their risk exposures to HLIs. The best way to achieve this is through the adoption of sound practices by the industry, perhaps supplemented by incentives created through capital requirements. While it is primarily the responsibility of each banking organization to manage its risks, sound practice standards gives banks and supervisors a tool to measure industry progress. If banks themselves do not follow sound practices, then supervisors must step in and take the necessary action.

    The committee's report revealed a number of deficiencies. In particular, the committee observed an imbalance among the key elements of the credit risk management process, with too strong a reliance upon collateral. This undue emphasis, in turn, caused many banks to neglect other critical elements of effective credit risk management, including in-depth credit analysis of counterparties, effective exposure measurement and management techniques, and the use of stress testing.

    For a bank to make sound lending decisions, it needs to obtain sufficient information about the borrower. Supervisors routinely stress the need for banks to have an effective credit approval process consisting of formal policies and procedures, accompanied by documentation of actual credit decisions. When dealing with an HLI, a bank also must obtain comprehensive and timely financial information about the HLI's risk profile and credit quality, and it must engage in an ongoing credit analysis of that HLI. In addition, a bank must have a clear understanding of an HLI's operations and risk management capabilities. The committee observed weaknesses in each of those areas.
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    Let me give a few examples. The committee found that banks did not obtain sufficient financial information to allow for a full assessment of how much and what types of risk had been assumed by large HLIs. In particular, banks did not obtain the information needed to measure leverage. They also did not have sufficient information to understand HLIs' concentrations in particular markets and particular risk categories or their exposure to broad trading strategies. Similarly, banks generally did not sufficiently understand the ability of HLIs to manage their risks. Because risk profiles can change from one day to the next or even from moment to moment, it is necessary for a bank to be sure that the HLI can effectively manage its business operations and its risks on an ongoing basis. In general, we did not find sufficient reviews of HLIs' risk management systems and their underlying assumptions, back office systems used to manage daily operations such as collateral and liquidity, and the major accounting and valuation policies.

    The committee also thought that banks need to develop better measures for determining the credit exposure resulting from different types of trading activities. In particular, banks must develop more effective measures of what is called potential future exposure. Potential future exposure measures the credit exposure between a counterparty and a bank, and how this exposure could change in the future as market prices fluctuate. As we have seen, such price movements can be substantial during periods of market stress. The ability of banks to measure potential future exposure is crucial when dealing with highly leveraged institutions.

    Unfortunately, methods for calculating potential future exposure have not kept pace with the growth and complexity of HLIs. Banks' potential future exposure measures have been particularly ineffective in measuring exposures not covered by collateral. For example, under highly volatile market conditions a bank's potential future exposure can grow beyond the value of any collateral. We expect the industry to develop more effective ways to measure and limit potential future exposures, and supervisors will closely monitor progress to ensure that that occurs.
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    The committee's report also shows that banks must develop measures that better account for credit risk under highly volatile market conditions. This can be achieved through what we call stress tests, where a bank conducts ''what if'' analyses of how credit exposures to a single counterparty could grow under extreme market conditions. These might include a large rise or fall in interest rates, a major change in an exchange rate or a flight to quality by investors. In the case of LTCM, stress testing could have given banks at least some warning of the types of exposures that they could have faced last fall. The critical importance of stress testing is noted very explicitly in our new supervisory guidance.

    The sound practices document accompanying the Basle Report presents an important set of standards that will guide both banks and their supervisors. It appears that banks generally have tightened the credit risk management standards for their HLI exposures since the near-collapse of LTCM. However, it is important that supervisors try to ensure that progress continues. Memories tend to be short, and we want to make sure that as markets calm down, as they have in the past months, banks do not return to the old ways of doing business.

    The adoption and rigorous enforcement of enhanced risk management practices should contribute substantially to limiting excessive risk-taking and leverage at HLIs. This is the case because HLIs cannot trade without access to financing and liquidity from banks and securities firms. If each counterparty manages its risks appropriately, the chance of contagion to other institutions and the financial markets more broadly would be reduced substantially. It is this risk of contagion and financial market instability that is the principal concern of central banks and supervisors.

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    Now, along with other Federal banking supervisors, the Federal Reserve has moved quickly to implement the recommendations of the Basle Committee's Report. As I mentioned earlier, we recently issued guidance to the institutions we supervise detailing sound risk management practices for the credit risk management of trading and derivatives activities. This document identifies the areas that our examiners will review during their examination of trading activities. It is important to note that the Federal Reserve's guidance to banks and examiners covers not only HLI and hedge fund counterparties, but all other counterparty relationships. We want to ensure that banks carry forward the lessons of the LTCM experience to all potentially high risk trading activities.

    In this regard, our examiners will devote particular attention to the risks associated with rapidly growing, highly profitable, and potentially high-risk activities and product lines. They will assess the adequacy of banks' reviews of counterparty creditworthiness, exposure measurement and monitoring techniques, stress testing, limit setting, and the appropriate use of collateral and other credit enhancements. Our examiners will also look at internal policies and the degree to which behavior conforms to stated policies. We have already conducted meetings with the major banks to reinforce these messages, and our examiners will conduct follow-up reviews in the course of this year.

    Over the past few months, there has been significant debate about other measures that could be taken to limit the potential risks to the financial system arising from the activities of large, highly leveraged, unregulated financial institutions. The Basle Committee carefully considered all the ideas that have surfaced. Our report discusses a variety of options beyond the implementation of sound practice standards. One possibility is to require higher capital charges for banks' exposures to HLIs. Indeed, a primary objective of our current review of the Basle Capital Accord is to determine how to align regulatory capital charges better with the economic risks of different classes of counterparties.
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    We also recognize the critical need to enhance market transparency for the activity of HLIs and other major market participants. The committee already is working to enhance accounting and disclosure practices at banking institutions worldwide. Extending these efforts to all global players that have the potential to destabilize the financial system, including HLIs, is of particular importance. An international group of central bankers is now studying various approaches to strengthening disclosure in this area.

    The committee also considered the advantages and disadvantages of imposing direct regulation on the HLI industry. There are a number of critical obstacles that would have to be overcome before a direct regulatory approach could be implemented. To be effective, any regulation would have to extend to jurisdictions around the world where HLIs are chartered, some of which have more highly developed and more stringent supervisory structures than others. This would require a high level of coordination involving the political, legislative, and judicial bodies of many countries. There is also the difficulty of establishing a regulatory regime for HLIs that is not easily circumvented. For these reasons, I believe the most practical approach is to focus on financial institutions' lending activities, because such an approach offers a near-term and cost effective remedy to the systemic risks posed by HLIs.

    I strongly believe that both the official and private sectors have important roles to play in addressing the challenges arising from the increasingly complex and dynamic financial services industry. First and foremost, we hold banks accountable for ensuring that sound credit risk management standards are upheld and that these keep pace with financial market innovation. If competitive pressures lead to bad practices in one bank or the industry as a whole, our job as supervisors is to raise standards and ensure that sound practices are restored.
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    In my remarks today, Mr. Chairman, I highlighted a number of areas where progress has been made. Of course, there is more work to be done by banks and supervisors. High on the agenda should be the development of more meaningful measurements of risk exposure and the implementation of effective stress testing techniques. Another important area that requires further industry attention is the measurement of leverage. Finally, I believe that the industry should devote more thought to the appropriate valuation of positions during periods of market stress and illiquidity, which is particularly relevant to the use of collateral to protect against credit risk.

    These are just some of the broader issues arising from the LTCM experience and the market turbulence last fall, but I believe that we are meeting the challenge and have made quick and significant short-term progress. I look forward to your questions, Mr. Chairman.

    [The prepared statement of William J. McDonough can be found on page 48 in the appendix.]

    Chairman BAKER. Thank you, Mr. McDonough. Do you think this will happen again?

    Mr. MCDONOUGH. I think, Mr. Chairman, that important efforts have been made by the banking supervisors and soon, I believe, will be made by the security supervisors. IOSCO, which is the international security supervisors' equivalent of the Basle Committee on Banking Supervision, has a task force working on this issue. My understanding from them is that they are basically in agreement with the evaluation of the issue that the Basle Committee made. Their best practices paper might be somewhat different, because the securities industry is a bit different than the banking industry.
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    But I think that between what the banking supervisors have done and the securities supervisors are about to do, we have significantly lessened the risk. We cannot guarantee that it will never happen again. We will make every effort possible to make it very considerably less likely, but it really isn't possible in our world, basically, of free markets to make it absolutely certain it couldn't happen again. We are making every effort that it won't, but I can't guarantee you that it won't.

    Chairman BAKER. It is my understanding that if the resolution that was successfully implemented had not been successfully implemented, that we were, perhaps, hours away from LTCM's failure to respond to margin calls. If that scenario had actually occurred, what would have been the market implications beyond the losses that were attributable to LTCM's partners directly?

    Mr. MCDONOUGH. Mr. Chairman, as I described last October 1st, we thought that the loss of LTCM completely, had its shareholders lost everything and had its more important counterparties lost probably in the neighborhood of $3 billion to $5 billion, would have been entirely manageable, had the world financial markets not been in considerable turmoil at the time. Had financial markets been behaving normally, there is no question in my mind that I would not have called a group of private sector institutions to the boardroom of the New York Fed to give them an opportunity to have a private sector solution to a private sector problem. There would have been a very important and expensive lesson learned of how dangerous excessive leverage can be.

    What we were concerned about was the tremendous fragility of financial markets at the time. You will recall that the spreads in financial markets were at levels that had never been seen before. There was a 50 basis point spread between the on-the-run 30-year Treasury and the one issued six months earlier, something that simply made no sense. I mean, you can't say that the U.S. Treasury for 30 years is such a good bet that you need 50 basis points higher yield than if it matures in 29.5 years. So, it was a reflection of the incredible illiquidity in markets and the very dangerous nature of them.
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    We were concerned that had LTCM failed, and had the decision not been made to recapitalize it on that particular Wednesday, that it would have failed the next day, and its enormous positions would have been dumped on an already very fragile market.

    Now, what the effect of that would be, nobody really knows for sure, but since I was in the position of the field general having to make the call, my concern was that the dumping of those positions on already fragile markets could well have had a very serious effect on the real economy of the United States; that is, that financial markets would stop functioning. If financial markets don't function, the economy doesn't work very well, and, as a result, the American people would have suffered.

    No one will ever know whether that judgment was valid. Nobody will ever know, because LTCM didn't collapse, whether the damage would have been so severe as to adversely affect the real economy or not. I think the danger was sufficiently great that the step was taken not to use public sector funds but rather to use the good offices, the honest broker traditional role of the New York Fed, to get people to look at the situation; to get into the same room to decide that it was in their interest to recapitalize the firm. It is a decision I will probably spend the rest of my life wondering if I did right. I am pretty sure I did, and I would do it again if the circumstances were the same today, but you never are sure; that is the nature of a judgment call.

    Chairman BAKER. I have one more question before I go to the next person. One of the elements of recommendation is that banks should enhance their stress test capacity and better analyze potential future exposures. Let me say it in congressional terms. What you are really telling me is the bank lending division or bank management must look at the hedge fund philosophy; get a snapshot with the balance sheet of their current risk, and make a judgment of whether these folks, when we give them our money, are going to be successful.
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    Mr. MCDONOUGH. Right.

    Chairman BAKER. They ought to be in the hedge business. I mean, that really is what you are saying, to outguess the traders with the extension of the credit. Everything I have heard and read about LTCM, these folks were very bright. They had record profits for four years; people were banging on their door to get in. Nobody knew they didn't accurately predict the future, and we are going to say that our resolution of this problem in the future is to require the banks to know better than the trader?

    Mr. MCDONOUGH. I think, Mr. Chairman, that what we are asking is that the banks understand more completely than they clearly did in the case of LTCM, what are the whole strategy and risk-taking and risk-control capabilities of the firms that they are dealing with. If the firm says, ''I don't want to give you that information'' or doesn't give it in a way that is fully understandable, the only correct credit judgment is to say ''We will not extend credit to you.'' That is the only possible answer.

    Chairman BAKER. Let me make my point a different way. If you took the financials and the day-to-day trade positions of LTCM for the three-and-a-half years, up until the first time they had back-to-back two day losses, the only time that that occurred, any prudent banker looking at that record, unless he was sitting in the room watching the trades occur, how could he possibly predict future losses given that track record when everybody in the market—I am told that banks made extremely advantageous terms available for borrowers. That was on the basis that these guys know what they are doing, and not only do we want to make loans—not only domestic banks, but some foreign banks even took equity positions.
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    All of this was based on the premise that they knew better than we did how to take this formula and apply it to underpriced commodities in the market. I guess, if we are saying that we are going to try to outsmart these guys and continue at this level of leveraging with borrowed funds, I think you are absolutely correct, we cannot guarantee this is not going to happen again. In fact, it is likely to happen again.

    And then it begs the question, what role should the Federal Government have, and is it only a matter that if we had not acted, our fear is that they were so inextricably tied to markets beyond their direct positions, that we could have drug the whole economy down is a frightening prospect, and I am just troubled that we can't get around this thing and either say there is a better way for us to know in real time the risk they are assuming—because you can't take a quarterly call report or even a weekly report. They were running $200 million to $500 million losses in 24-hour periods. That is not a timely response. It is like being in the front part of the house, and the back three rooms are on fire, and you don't know about it, because you don't have a smoke detector. When did you know about it? If you didn't get it from your regulatory system, you got it from the market, and the house was on fire, and we couldn't even smell the smoke. That is the problem, and I don't know how we avert it in the future.

    Mr. MCDONOUGH. Mr. Chairman, I think that if you and I and the rest of the Members of the committee had been the credit committee of Bank X and we had all the information that we now say that a bank should have—and I think by hindsight, one could say that they should have had then, about the activities of Long-Term Capital Management—what is it that we would have spotted that would have said to us, this is potentially very risky? And the answer is that it was too heavily leveraged. It had just gotten too big, and its leverage on its capital base was simply larger than it should have been. It's hindsight now, but I think that in the practices that we are recommending to the banks and insisting that they follow, what they should be looking for is the total leverage of the firm, and that would have flashed lots of not only yellow lights, but I think red lights as well.
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    Chairman BAKER. I did see—and this is my last response, and I want to recognize Chairman Leach next—in the presentation yesterday by Long-Term, they cast their leveraging position against similar hedge funds against domestic Bank X and others. But they would argue that their leveraging was not excessive in light of their capitalization and when you net out the long and the short, if you are looking just at notional amounts; if you are looking at a particular instrument, but if you—and, perhaps, their problem was the fact that they didn't pair; that they took the high price in the market for the long and for the short, and when it came time to dispose of that position, you didn't have a paired asset that could be easily sold. That is the conclusion that they were coming to as opposed to the level of leveraging.

    But let me recognize Chairman Leach. Mr. Chairman.

    Mr. LEACH. Well, as a footnote, looking at their September 30th balance sheet which shows $121 billion in liabilities, if you subtracted $3.6 billion that was infused, partner capital would have been $200 million. So, that would have been $200 million versus $120 billion to $130 billion which would have meant, assuming this is a valid statistic, leveraging of unprecedented historical dimensions.

    Having said that, as the Chairman knows, I believe the solution may in many ways be worse than the problem, given, in particular, that there was another private sector offer on the table, one of $4 billion instead of $3.6 billion. And so that makes the governmental intervention, in my judgment, frail to say the least, and that what you have done is create a de facto anti-trust umbrage that the United States Government is implicit in creating and in defending. And I would like to stress this—both the Fed and the Treasury were involved in the decision to go forth. Both the Fed and the Treasury have defended the action subsequently, but what you have set up is a company that is above market forces and—I want to underline this—above and beyond prudential regulation, and let me give meaning to this. You are above market forces because even though people have tried to set up as non-collusive an arm's length arrangement between the new owners of the 14 largest investment and commercial banks in the world and the largest hedge fund, when they agree to keep their money in, that is a de facto, collusive decision that sets this company now above the market in terms of regulation.
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    The current regulatory circumstance, as I understand the numbers of Long-Term Capital, maintain better than 25-to-1 leveraging, and, as I have suggested to the Fed, that if the average commercial or investment bank had 5 percent core capital and lent to an institution that leverages 25-to-1, that is the equivalent of 500-to-1 leveraging, and when the banks, themselves, are part owners of this, that makes the collusive dimension of this overextension of credit remarkable.

    And it is astonishing to me that the Federal Reserve Board of the United States, as the prudential bank regulator, and the OCC as the prudential bank regulator, have not objected strenuously to this arrangement. I am respectful that you have moved at certain degrees with regard to the BIS, but it strikes me as self-evident that you have not moved in certain other degrees, and it is my view that if you are going to avoid again this governmental intervention that is a potential, you have got to ensure for hedge funds, you have got to ensure that there is no one above market forces, that there are no public bailouts, and that there is no advantage in publicly-ensured deposits going into these institutions. And the model that you have set up is precisely the opposite on all three of those points. And so I am concerned.

    Now, there is another aspect of this—that there also has been a lack of public transparency. It was committed to me, Mr. Chairman, by a senior official of Long-Term Capital Management, when I asked him to a hearing last year, last fall, that they wouldn't come, but they would come this year. Long-Term Capital Management's management has decided to break that commitment, and that is something this subcommittee takes very seriously.

    Second, there has been a lack of transparency, none of us know who the losers were in investment. There are rumors rife, for example, that central banks, not commercial banks alone, but that certain central banks invested in Long-Term Capital Management. Can you shed any light on that subject?
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    Mr. MCDONOUGH. I can't shed light, Chairman Leach, on anything other than newspaper stories which I have also read that there was at least one European central bank which had lost money, but I don't have independent verification of that.

    Mr. LEACH. Well, the Federal Reserve Board is responsible for a solution and then apparently has made a point of staying above knowledge so it doesn't get involved in that knowledge, and it is analogous to certain things that I have seen in public life before that I am not altogether appreciative of. But I stress that, to my knowledge, the BIS has not come down with any recommendation that central banks should or should not invest in hedge funds. I would think that the answer to that is not a difficult one. Central banks should not invest in hedge funds, and the BIS ought to spell that out, and the United States Federal Reserve Board ought to affirm it.

    So, let me ask you the question: From the perspective of the Federal Reserve Board of the United States, do you think central banks should invest in hedge funds, and should this be a matter of concern?

    Mr. MCDONOUGH. I can assure you that if I have anything to do with it, and I am sure that I speak for everybody connected with the Federal Reserve, you need not be concerned about the Federal Reserve investing in hedge funds.

    Mr. LEACH. I would be confident of that.

    Mr. MCDONOUGH. Whether the Basle Committee——
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    Mr. LEACH. We are the world's largest hedge fund.

    Mr. MCDONOUGH. Right—excuse me.


    Whether the Basle Committee as a group of banking supervisors should have advised central banks around the world that they shouldn't invest in hedge funds, to be very honest we really didn't think of the issue. To me, it is so obvious that central banks shouldn't invest in things like hedge funds that coming out and saying it, to be very frank, I just never thought about it. It does not imply that I think that it is a good idea.

    Mr. LEACH. Well, coming back to the obvious—and my time is expired—but, I mean, are you willing to affirm what I think is the very most obvious that BIS avoided? Do you want to affirm that there should never be a Government intervention to defend the hedge fund?

    Mr. MCDONOUGH. I think that we have a mild difference of opinion on what Government intervention in this case did. The Federal Reserve Bank of New York, under, I think, every president that it has ever had, has played the role of honest broker. The most recent example before the Long-Term Capital Management situation was inviting banks from around the world into the New York Fed boardroom in Christmas week of 1997 to give them the opportunity to see that it was in their interest to reschedule Korea's debt. We don't make them do it, but we give them an opportunity to get together and see what is in their collective interest. That is really what we did in the LTCM case. Would you have preferred that there be a capability in the private sector to call such a meeting, that somebody had the prestige that J.P. Morgan did after the Knickerbocker Trust collapse in 1907? Yes, but there really isn't any such institution or such person, so the New York Fed winds up being the body that invites people to get together and see if they have a solution.
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    Much as I thought that the collapse at LTCM was dangerous for the American economy, I would not have dreamed of recommending that we use public funds for it.

    Mr. LEACH. Well, I appreciate that. My time has expired, but I am compelled as a regionalist to note that a meeting was called in the Midwest in Omaha to solve the LTCM issue, and that an alternative bid of a Midwestern dimension was on the table that the coastal parochialists objected to.


    I yield back.

    Chairman BAKER. Thank you, Mr. Chairman.

    Mr. MCDONOUGH. Being a Midwesterner—can I comment? Being a Midwesterner, I think that was a great remark.


    Chairman BAKER. Being a Southerner, it was all irrelevant to me.


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    I would like to next recognize Mr. Toomey, and, Ms. Hooley, we will recognize you next.

    Mr. Toomey.

    Mr. TOOMEY. Thank you, Mr. Chairman. I noted with some curiosity your reference toward the close of your comments about one of the central problems being that LTCM was too leveraged, as you put it. It struck me that in the traditional sense of assets as a multiple of capital that leverage wasn't necessarily the thing we should have been looking at here; that leverage and collateral both, perhaps, in this sense are not a good measure or proxy of the risk of institutions that are engaged primarily in proprietary trading of financial instruments, and, instead, the real meaningful risks are the nature of the activity.

    And I don't think it is necessary for the banks to be better at it than the hedge funds, but they need to understand the magnitude of potential future risk and, particularly in the context here, the magnitude that arises in extremely illiquid markets where, particularly, derivatives and other instruments can reach economically irrational pricing, because they are driven by large flows in illiquid markets.

    Do you think those are the things that should be focused on rather than the traditional measures of—the balance sheet strikes me as almost meaningless in many respects. The collateral is a—there is a bare minimum there, but beyond that, it is not of much value. Would you agree that those are the more important things?

    Mr. MCDONOUGH. Yes, I agree that you have to look at the totality which is, I think, Congressman Toomey, your clear point—that you have got to look at the whole way that they run their businesses, and if you just look at leverage you wouldn't be looking at enough. I think leverage is a useful tool still. It is very, very difficult to know—as I am sure you understand from your comments—just what the leverage is. There are enough things going on off the balance sheet that the old way of saying ''here is the capital, here is the size of the balance sheet, you divide one by the other, and that is the leverage,'' doesn't work anymore. So, all we know is that whatever the balance sheet leverage was, the real leverage was a lot bigger. That was a warning sign, but it wasn't—it isn't enough analysis. You have to really get into how they run the business.
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    Mr. TOOMEY. And this is the curious part for me, because you mentioned that there was not enough understanding of this potential risk, the stress test—the sensitivity analysis, as we used to call them—but yet the banks that were involved in the bailout in the end are all banks that very well understand these risks. They understand the nature of these risks; they understand the potential magnitudes, because they are engaged in these kinds of activities on their trading floors every single day. Most of them I believe are quite good at engaging in this risk, managing it, and profiting from it. So, it strikes me as curious that this technique has not been transferred to the credit department that analyzes this activity in another institution. Could you comment on that?

    Mr. MCDONOUGH. The banks, by hindsight, were far too dependent on collateral, thinking that if they had enough collateral they were OK. They certainly learned the hard way that collateral was not adequate and that if markets really begin to move quickly, there is no way that you can get enough collateral in place to protect you.

    As I mentioned, there clearly was a lapse, not so much in the existence of credit procedures, but in the following of the credit procedures. It was being done too much on the trading desk with what appears to be inadequate involvement of the credit department. Thus, I think what we need to do, and what we are pushing for, is a combination exercise within the banks to help the traders understand how these organizations work and how they think. You also want to retrain the old crusty credit guy who is saying, ''I don't care about all that stuff. All I know is that as I look at this credit, there is an excessive likelihood of our losing money on it, and, therefore, I don't approve the credit.'' That is what we want to see happen.

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    Mr. TOOMEY. Thank you.

    Chairman BAKER. Thank you, Mr. Toomey.

    Ms. Hooley.

    Ms. HOOLEY. Thank you, Mr. Chairman.

    I am sorry I missed a good deal of your testimony, but, just glancing through it, I noticed in your testimony that you touched on the difficulty of Government regulations for international hedge funds activities. However, you then said that your bank was looking at standards for lending to highly leveraged organizations. So, my question is, do you see any role for the Federal regulators to set and enforce such standards? And, then, would the Government—if you see that as a role, would the Government be able to achieve this in a flexible manner to allow for the free flow of capital and still protect their banking system?

    Mr. MCDONOUGH. I think that adequate powers are available to the banking and securities regulators to insist that these regulated institutions have and follow credit procedures that will make the likelihood of another LTCM very low; not impossible, but very low. Therefore, I think that the public sector has that responsibility, has the capability, has the power to exercise that responsibility, and should be doing so. And that is why I think that it is important that in the case of the banking regulators—I being one of those—that the Office of the Comptroller of the Currency and the Federal Reserve have both gotten busy, gotten out into the firms to see what the weaknesses were, telling them what they need to do to run their businesses better, and that we will continue to follow up on it. The securities regulators will be coming along quite soon, I am sure.
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    Ms. HOOLEY. OK, thank you.

    Chairman BAKER. Ms. Biggert.

    Ms. BIGGERT. Thank you, Mr. Chairman.

    Could you talk a little bit about leverage and if you think that there is some need there for more regulation, and how would that come about?

    Mr. MCDONOUGH. The single greatest risk in looking at financial markets is leverage; that is, if you just don't have enough capital base to withstand the losses that are likely to take place, both in the case of the customer to which banks and securities firms are making credit available and then, obviously, in the case of the banks and securities firms, themselves. In defining leverage in these very sophisticated, modern financial markets, it is very difficult to define exactly what leverage is because of all the derivatives activities.

    Now, I think derivatives activities generally have contributed to better functioning of financial markets, better distribution of risk, but the markets are now so sophisticated that it is very difficult to use the old tools. Leverage, I think, is still the one tool that you want to use as a major warning signal if it gets too big. We are working very closely with the industry on new and more accurate ways of defining and measuring leverage, which I think is very important to do, and it is an important part of the public sector-private sector dialogue that is taking place.

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    As you know, on your third panel, you have private sector firms being represented, and they are making a very important effort themselves. We are working very closely with them in kind of a joint effort to protect society which is the public sector responsibility, and, in the case of the firms, to protect themselves, which is their responsibility. Those two interests are not always the same, but I think in this case, clearly, the firms are better off if the markets function better; the public sector is better off as well. So, in that sense, cooperation between the public and private sectors is, I think, very appropriate and commendable.

    Ms. BIGGERT. If there is cooperation, do you think that the private firms are able to, not really regulate, but to police themselves as far as the risk of that concept?

    Mr. MCDONOUGH. By and large, yes, but my experience of 22 years as a private banker is that the one thing one has to worry about is the length of memory. Usually, if financial institutions make a mistake, they very fully remember that mistake until the people who made the mistake are either transferred or retired and move on, and then if the markets get very benign, there is a tendency for the institutions to make the same mistake over again. Usually, the mistake is not made by the same people, but the same institution, which, from our regulatory perspective, and your responsibility is what is important, not the individual. Therefore, I think that what the public sector can do, what the supervisors can do, is to help that memory bank, to say, ''Remember, this happened in year X. It looks very much as if from our observation your credit standards are not as tight as they should be. Let us tighten up that credit activity. Let us tighten up the approach.'' I think we can help them police themselves.

    Ms. BIGGERT. OK, thank you. Thank you, Mr. Chairman.
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    Chairman BAKER. Thank you, Ms. Biggert.

    Mr. McDonough, by way of sort of background for this question, the subcommittee invited Bank of America, Chase, and Deutsche Bank, and they either said, ''We will think about it'' or ''yes,'' and then later got second advice and changed their mind. D.E. Shaw was in a similar position. If Tiger or D.E. Shaw were to request a loan from Bank America, Chase or Deutsche with the intended purpose of using it for investment in the market, what would occur differently today than occurred prior to the failure of LTCM?

    Mr. MCDONOUGH. The credit process which would be used to evaluate that request for credit, if they are following the guidance that we have given—and our visits to the institutions say that they are doing that—the investigation of the credit, and the analysis of the credit, would be considerably more detailed along the lines that I have described, and, therefore, the credit judgment, in my view, would be a more informed one.

    Chairman BAKER. In the event that the credit extension was made, the institutions were not using the better informed credit analysis or stress test which you think is appropriate, and let us assume both funds would get into significant difficulty, would it again be your position, hearing concerns of some Members of the subcommittee this morning, that the Fed should intercede based solely on the systemic risk concern?

    Mr. MCDONOUGH. The background is very, very different now. Although the credit spreads have not returned to whatever normal is—and nobody is quite sure what that is—but certainly the financial markets are functioning very well; companies of various qualities can issue bonds or get bank loans, so that the systemic risk potential background is very, very much different from the one that existed last fall. Consequently, if an institution were to have a problem, I would have a very different view from the one I had last fall. Last fall, as I mentioned both this morning and October 1st, has to be understood in the background of the extremely dangerously disturbed financial markets; that is no longer the case.
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    Chairman BAKER. So that, to put a fine point on it, given the international instabilities, the illiquidity of the markets, the economic irrationally priced market, the scope of the transactional relationships, all of those elements urged you toward this resolution. Were it not for that and a similarly sized LTCM with the same partners were engaged in transactions and lost it all, as they did, would not in itself warrant intersession by the Fed?

    Mr. MCDONOUGH. Yes, Chairman Baker, I think the best way I could answer that is that had markets been anywhere near normal, never mind perfectly normal, last October, I would not have encouraged people to come to the Federal Reserve Bank of New York to discuss the recapitalization of LTCM.

    Chairman BAKER. So that those who are in the market this morning, who are hearing a message from you today should understand that the likelihood of assistance in the face of financial difficulty is at best remote.

    Mr. MCDONOUGH. We are making every effort to make it as remote as one can conceivably imagine.

    Chairman BAKER. Thank you very much. I certainly do appreciate—if no other Member has a comment—I certainly do appreciate your appearance here this morning. Thank you, Mr. McDonough.

    Mr. MCDONOUGH. Thank you.

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    Chairman BAKER. Good morning, and welcome to both of you. I certainly appreciate your willingness to participate in our hearing this morning. Our next witness is Brooksley Born who is Chair of the Commodity Futures Trading Commission and certainly no stranger to the subcommittee. Welcome.


    Ms. BORN. Thank you very much, Mr. Chairman and Members of the subcommittee. I would like to thank you for inviting me to testify here today concerning regulatory issues relating to Long-Term Capital Management L.P., or LTCM, and other highly leveraged institutions. I would request that my written testimony on behalf of the Commission be included in the record.

    Chairman BAKER. Without objection.

    Ms. BORN. Thank you.

    The events surrounding the financial difficulties of LTCM raise a number of important issues relating to hedge funds and to the increasing use of OTC derivatives by those funds and by other institutions in the world financial markets.

    The LTCM episode demonstrates the unknown risks that the OTC derivatives market may pose to the U.S. economy and to financial stability around the world. It also highlights the need to address regulatory issues in the OTC derivatives market, including whether there are dangerous regulatory gaps relating to trading by hedge funds and other large OTC derivatives market participants. These important regulatory questions relating to hedge funds and the OTC derivatives market include lack of transparency, excessive leverage, and insufficient prudential controls.
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    The Commodity Futures Trading Commission welcomes the heightened awareness of these issues that the LTCM matter has engendered and believes it is critically important for U.S. financial regulators and foreign regulators to work together closely and cooperatively on them. The Commission is working diligently as part of the President's Working Group on Financial Markets and the International Organization of Securities Commissions, or IOSCO, to study these and other regulatory issues relating to hedge funds and the OTC derivatives market.

    A consensus has developed both domestically and internationally that the LTCM episode demonstrated shortcomings in the internal controls among the commercial and investment banks that were LTCM's major creditors and counterparties and the need for enhancements to the prudential supervision of those institutions. The Basle Committee on Banking Supervision and our own domestic banking supervisors are taking important steps to ensure improvements in bank practices and supervision.

    Although these steps are very beneficial, we should not overlook the fact that many participants in the OTC derivatives market, including many hedge funds and other highly leveraged institutions, are not subject to Government oversight and that the market itself is extremely opaque. While the CFTC and the U.S. Futures Exchanges have detailed daily information about LTCM's reportable exchange traded futures positions through the CFTC's required large trader position reports, no Federal regulator received detailed and timely reports from LTCM on its OTC derivatives positions and exposures. Notably, no reporting requirements are imposed on most OTC derivatives market participants. This lack of basic information about the positions held by OTC derivatives market participants, the nature of their investment strategies, and the extent of their risk exposures potentially allows them to take positions that may threaten the regulated markets without the knowledge of any Federal regulatory authority.
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    In my personal view, more transparency is needed in the OTC derivatives market. Congress and Federal financial regulators should consider requiring hedge funds to provide their investors, counterparties, and creditors with disclosure documents and periodic reports concerning their OTC derivatives positions, exposures, and investment strategies. In addition, consideration should be given to requiring OTC derivatives market participants to file large trader position reports with one or more Federal agencies charged with oversight of the OTC derivatives market.

    Certainly, the regulated derivatives exchanges are vulnerable to the unknown activities in the OTC derivatives market ranging from financial risks resulting from the default of a large player such as LTCM to manipulative activities. For example, Sumitomo Corporation of Japan manipulated the price of copper in U.S. cash and futures markets through a combination of transactions on the London Metal Exchange and the OTC market. Last year, the CFTC settled its manipulation case against Sumitomo Corporation with the largest civil monetary penalty the U.S. Government has ever imposed, $125 million plus $25 million as restitution for private parties.

    As a result of the Sumitomo experience, the London Metal Exchange has recently proposed new rules requiring periodic reports by exchange traders on their OTC activities. Because of the impact such activities may have on the integrity of regulated exchanges, the Commission has long supported the ability of market regulators to obtain such information.

    In addition, serious consideration should be given to other mechanisms that would curtail the risk of default by highly leveraged institutions, such as LTCM. For example, the establishment of OTC clearing operations, margin and mark-to-market requirements, and capital and audit requirements should be considered.
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    Thank you very much, and I would be pleased to answer any questions Members of the subcommittee may have.

    [The prepared statement of Hon. Brooksley Born can be found on page 59 in the appendix.]

    Chairman BAKER. Thank you, Ms. Born. We appreciate your testimony.

    Our next witness is the Deputy Assistant Secretary for Government Financial Policy at the Treasury, Mr. Lee Sachs. Welcome, Mr. Sachs.


    Mr. SACHS. Thank you, Mr. Chairman and Members of the subcommittee. I am pleased to testify today on behalf of the Treasury Department. I would like to provide you with a brief summary of a written statement, which I also would ask be submitted for the record.

    Chairman BAKER. Certainly, without objection.

    Mr. SACHS. Thank you.
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    As you know, following the Long-Term Capital Management episode, Secretary Rubin called for a study of the potential implications of the operations of firms such as Long-Term and their relationships with their creditors. In this study, we have focused on excessive leverage in complex financial institutions in general, and, importantly, how it relates to systemic risk. At the outset, I would like to emphasize that the Working Group has not yet completed its study, and neither the Treasury nor the Working Group is prepared to present final recommendations at this time. However, all the members of the Working Group look forward to sharing this study and its conclusions with you in the near future.

    Hedge funds are most commonly organized as limited partnerships or limited liability corporations and are often engaged in active trading of securities, commodities, currencies, and related derivatives. Although the hedge fund sector has grown significantly over the past two decades, the industry remains relatively small when compared to other sectors of financial markets, such as mutual funds and pension funds, and most hedge funds, themselves, are small with the majority controlling less than $100 million in investor capital. Despite their relatively small size, however, both individually and as an industry, the impact of hedge funds is greatly magnified by their highly active trading strategies and by the leverage obtained through their use of repurchase agreements and derivative contracts.

    While the LTCM episode should not necessarily indict an entire industry, it does demand that both market participants and financial regulators, both here and abroad, understand how one firm became so highly leveraged, for it is excessive leverage of this nature and the practices which allowed the accumulation of such leverage that have the potential to lead or contribute to systemic risk.
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    The Working Group, therefore, is focused on evaluating the costs and benefits of potential policy options related to leverage. These include relying on market discipline enhanced by greater regulatory scrutiny of guidance for regulated suppliers of credit; resorting to more direct forms of regulation, such as expanded use of margin requirements, and, finally, imposing direct regulation on some currently unregulated market participants. Although we have not come to any conclusions, we are carefully studying the potential impact of various proposals in this area.

    I should point out that in recent months, as we have been conducting this study, renewed market discipline has begun to have a positive effect in at least temporarily reducing excessive leverage. Importantly, there is some evidence that banks and other suppliers of credit to highly leveraged financial institutions are demanding more collateral or requiring more margin on their derivative transactions and repurchase agreements. While it is encouraging to see these developments, the Working Group must continue to study what further steps may be necessary.

    A related issue and a key concern of the Working Group is the adequacy of transparency and disclosure. There is a broad consensus among Working Group members that creditors must demand and borrowers must provide more relevant and up-to-date information than they have in the past. It is equally important for these creditors to report and disclose the extent of their exposures to such highly leverage financial institutions.

    The Working Group is examining a number of proposals aimed at enhancing disclosure and transparency, including both ways to encourage increased voluntary disclosure and the possibility of increasing certain regulatory disclosure requirements and is carefully weighing the costs and benefits of all such proposals.
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    Again, while we have been studying the various options, there have been positive developments in the marketplace. Many banks and other suppliers of credit to highly leveraged institutions are requesting and receiving more detailed and more relevant information for making credit judgments and, importantly, are more strenuously attempting to understand the nature of the risks their clients are taking.

    This raises the third area of concern being examined by the Working Group which is the sufficiency of risk management practices at both the lending institutions and the hedge funds themselves. While further steps may be necessary, this is an area in which members of the Working Group have already taken action. The Comptroller of the Currency and the Federal Reserve have been updating their supervisory guidance to banks and bank examiners concerning exposures to highly leveraged entities, such as hedge funds and are effectively putting banks on notice that they expect to see further improvements in this area.

    Additionally, many market participants share these concerns and are also beginning to take steps to address them. For example, twelve major banks and investment banks have formed the Counterparty Risk Management Policy Group with the purpose of developing industry standards for strengthened risk management practices, and I understand you will be hearing from representatives of this group later today.

    Finally, in addition to working with market participants and a variety of regulatory bodies here in the United States, members of the Group are working closely with our major international colleagues, including the G–7, the Basle Committee, and the International Organization of Securities Commissions, or IOSCO, to address systemic risk issues raised by highly leveraged institutions. This international coordination is essential since—as Chairman Leach and others have pointed out—hedge funds and other highly leveraged institutions can easily move from the United States to other jurisdictions, thus, diluting some of the positive effects of any regulatory adjustments the U.S. might consider.
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    As the Working Group addresses the key issues of leverage, risk management, and disclosure and transparency, we are considering a broad universe of possible responses in order to arrive at the most effective recommendations. As enhanced market discipline may or may not be adequate to address these issues, we must carefully weigh the costs and benefits of adopting some additional regulatory constraints in an effort to further mitigate systemic risks.

    I appreciate the opportunity to appear here today. We at the Treasury Department, along with the other members of the Working Group, look forward to presenting you with our conclusions and recommendations and to working with you to address these important matters. I would be happy to answer any questions that you may have. Thank you, Mr. Chairman.

    [The prepared statement of Lee Sachs can be found on page 65 in the appendix.]

    Chairman BAKER. Thank you, Mr. Sachs. We do appreciate your testimony and your appearance here today.

    In your observations, you indicated that the amount of leveraging was of extreme concern. Based on the information I received as of yesterday from Long-Term, they operated in a leveraging ratio of between 20 to 30, typically, 24, 25 as sort of a working daily average. There were a couple of dividends paid out of significance that made that ratio appear to be higher, because as capital went out, the ratio, accordingly, was adjusted. Press reports indicated they were customarily operating at 50 to 100 times in leveraging ratio which, looking at the presentation by Long-Term, does not appear to be a factual representation. What occurred in the closing weeks of the debacle when investors withdrew, is there was involuntary leveraging ratio increase. It wasn't a result of Long-Term investing or enhancing their market positions. They stood still as capital left the investment organization. Therefore, leveraging ratios did reach 50 to 100 times depending on the trading day.
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    It would appear to me that there are other firms operating this morning that would probably operate in that 20 to 30 range as a customary scope of leveraging. Tell me, what is your view of a highly leveraged institution, and what trading ranges are we concerned about as bankers extending credit to these firms where it would become a problem if everything else was OK?

    Mr. SACHS. Sure. Those are some of the central questions on which the Working Group is focused, and, as Mr. McDonough indicated this morning, leverage can be measured any number of ways, and the most easy to identify is obviously the gross leverage ratios which we have all read about. There is no perfect measure of leverage, and I would agree with your assessment that there are other entities out there that are operating with similar leverage ratios that you had mentioned that Long-Term reported to have had. The primary focus of the Working Group is this issue of leverage—how do you measure leverage? What are the most efficient ways to constrain that excessive leverage? And we are evaluating options both to address it directly in the form of——

    Chairman BAKER. Let me rephrase that and make it either a little more difficult or a little easier, I don't know which.

    Mr. SACHS. OK.

    Chairman BAKER. Mr. McDonough made it clear that the amount of leveraging was at the heart of his concern. If the amount of leveraging is, in fact, at the heart of the concern, and there are others engaging in similar businesses practices with the similar leveraging that occurred in LTCM, should we be worried?
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    Mr. SACHS. That is one of the greatest concerns that came out of the LTCM episode, certainly, and it is——

    Chairman BAKER. That is not the answer I was hoping to hear, thank you—meaning, that you do have concerns.

    Mr. SACHS. We have concerns about excessive leverage, sure, and we are addressing—this is why we are focused on excessive leverage in highly leveraged financial institutions in general and not just specifically focused on hedge funds.

    Chairman BAKER. Ms. Born and the CFTC has indicated—this is still directed to you, Mr. Sachs—that if the CFTC had more regulatory authority in this matter that it would have inhibited, prevented, lessened, and in some manner or measure affected the scope of loss that LTCM finally piled up. Do you have a view that additional regulatory oversight in the specific case of the LTCM matter would have made any difference?

    Mr. Sachs.

    Mr. SACHS. I am sorry, I thought you were addressing the question to——

    Chairman BAKER. No, that was a trick question.

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    I was asking you whether you thought the CFTC's regulatory oversight of this enhanced regulatory oversight would have made any significant difference in the outcomes? My reason for the question, when you look at the trading base and you look at the scope of losses and you look at the volatility of the market, unless you are in the trading room making the decisions with the investor, how can you regulate against this type of loss?

    Mr. SACHS. Regulating against this type of loss would be very difficult. The information that—if I understand your question—if the CFTC had more information, would that have made any difference? And the whole question of information—what information you would have; how frequently it would be reported—is one of the central questions with which we are wrestling. It is unclear as to whether or not more frequent reporting to an entity, such as the CFTC or another Government entity, would have the desire to——

    Chairman BAKER. Well, doesn't that make it equally difficult for the extender of credit? How can we then expect the bank lender to have better judgment and insight than the regulator? If we are going to get information from call reports and annual statements and capital adequacy and a statement from the hedge fund managers saying, ''Oh, this is what we are going to do, and we are going to make a bunch of money,'' if that is the pile of information from which the banker is going to make this judgment about extension of credit, how can we hold them to a higher standard of conduct than we hold the regulator?

    Mr. SACHS. The banks and other lenders to highly leveraged institutions are on the front lines of our—they are on the front lines of the situation. The regulators cannot be in the front lines; they are a secondary defense, and the purpose of the regulators is to make sure that the banks and other financial institutions that are lenders are asking the right questions and are getting the relevant information on a timely basis but are not in place, I don't believe, to be making the immediate credit judgments.
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    Chairman BAKER. Thank you, sir.

    Ms. Born, would you care to respond to how you view the CFTC's role as a regulator with enhanced authority or greater transparency would have enabled the agency to at least minimize, if not altogether mitigate, against a loss like LTCM?

    Ms. BORN. Well, it would have required more than mere enhanced transparency, because the CFTC does not currently have any prudential responsibilities with respect to commodity pools or even commodity pool operators. We regulate commodity pool operators in order to ensure that they are not defrauding investors in the pool by stealing the funds or misrepresenting the trading strategies, and, for that reason our statute requires registration of the operator, disclosure statements to the investors, and annual reports of audited financial statements to us. But because these entities are engaging in inherently speculative and highly risky transactions on the futures exchanges, which is why they become commodity pools and why their operators are commodity pool operators, there is no provision to interpose the Government to prevent significant losses.

    There are significant losses inherent in trading on the futures exchanges, because it is a zero sum game. For any dollar that one entity makes, another entity loses a dollar. So, there is no Government insurance, nor have we been given prudential responsibilities. What the Commission and the President's Working Group is looking at is whether there is a need for some, first of all, transparency so that creditors and counterparties and investors are familiar with the positions of these hedge funds and other highly leveraged institutions, and, second, whether there is a need to go further than that and have some kind of prudential oversight over these institutions, for example, net capital or audit requirements and other reporting requirements, margin requirements, and so forth.
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    Chairman BAKER. Let me follow up this way: if I am understanding most regulators properly, it would be the view that we let big-time players lose big-time money as long as it doesn't affect the market to such a great extent that it presents a systemic risk concern, and, yet, at the same time, we do not wish to inject ourselves into what is apparently ultimate free enterprise gain. Does that mean that we should at least look at an upper limit on size. If ''too-big-to-fail'' is at the root of the concern here, how big is ''too-big-to-fail,'' and should we draw a circle around it? Stay the heck out of the market, but, ultimately, limit the scope with which this international, multi-billion fund who could lose $200 to $500 million a day may have been over that line?

    Ms. BORN. I don't know that we want to impose limits, but I do think that transparency, that is providing someone, some regulatory agency, with information about very large positions in these very opaque markets, would be a step forward. Right now, the Commission, daily, gets reports on the futures and option positions of traders on exchanges, our regulated exchanges, where the positions are above what we define as the large trader reporting level, and our economists look at these to examine, first of all, whether there is systemic exposure because of large positions, and, second, to see if the players in the market may be engaging in incipient manipulation of prices or other price distortions. Something similar to that, I think, for the very opaque OTC derivatives market.

    Chairman BAKER. But even if you had the total transparency which you seek, how would that have helped you in the case of Long-Term's circumstance given the extraordinary volatility, the quick timing of profit to loss, and the extent of losses in a 24-hour period? The only thing we would know then was how big is the train wreck going to be; we wouldn't be able to avoid the wreck.
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    Ms. BORN. Well, that may well be right. You might get some advanced notice if you had not only information on the positions themselves, but on the investment strategies and the risk exposures, and there might be an opportunity to step in before things got to the state that they did with Long-Term Capital Management.

    Chairman BAKER. Thank you. Oh, I have lost Ms. Hooley.

    Ms. Biggert.

    Ms. BIGGERT. Thank you, Mr. Chairman. If there were restrictions on leverage, let us say through an amendment to the Investment Company Act, that would treat hedge funds like regular mutual funds—I must say, I am not—I believe in the free market, and I think that the creativity that has been very much a part of our American scene has worked well, so I am not advocating this or not; I am just asking the question—or to increase regulation of derivative markets, what would be the economic cost to that if there was this regulation?

    Ms. BORN. Well, I think it would depend on what kind of regulation you had. For example, right now, the Commission has before it a petition from the London Clearinghouse to permit a clearing operation for OTC derivatives dealers to clear their OTC derivatives transactions. That might be a step toward increased transparency, taking care of credit exposures, and allowing margin requirements that dealers in the market might voluntarily choose because of the safety it gives them, and they might feel that the benefits in that situation outweighed any cost of participating in the clearing operation. This would not be something mandated for people to participate. What the Commission is currently considering is whether we should amend our regulations or give an exemption from our regulations so that OTC derivatives can be cleared. Right now, our swaps exemption doesn't permit that.
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    Ms. BIGGERT. Would this mean, now, that these investors would seek other avenues? Would they go abroad to other areas where there was not regulation?

    Ms. BORN. One of the arguments that has been made against any kind of regulation of highly leveraged institutions that are currently not regulated is that they will escape offshore. I think there are a couple of answers to that. One is that certainly our jurisdiction today is over any hedge fund that trades on futures markets and accepts money from U.S. investors. The SEC has similar broad jurisdiction over people who trade on our markets or people who seek investments from our citizens so that, to some extent, the legitimate scope of U.S. jurisdiction can be quite extensive.

    Also, as our written testimony says, IOSCO, which is the organization of all the securities commissions around the world, is currently considering these issues. They have recently begun to come out with best practice standards of how to regulate various markets. We just entered into best practice standards on how to regulate derivatives exchanges that all the members have said they will aspire to and try to adhere to. I think international coordination like that can go a long way toward eliminating that risk of hedge funds going to unregulated environments.

    Ms. BIGGERT. But you have to have that international coordination and cooperation.

    Ms. BORN. I think it is extremely important.

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    Ms. BIGGERT. OK. Would another way to look at this—I know that coming from Illinois, we have the Board of Trade and the Mercantile Association, which really started out as being self-regulated, and the process that they set up was for really to regulate themselves, and then it was sort of taken over and put into a statute. Wouldn't it be better to have self-regulation of the hedge fund investors as well and maybe to free up some of the regulation on the other markets?

    Ms. BORN. Well, I think that self-regulation is a very important aspect of regulation. Without the self-regulation that our exchanges and commodity professionals do, we certainly could not, with our budget or staff, do an adequate job of regulating the futures markets. I welcome any efforts by private participants in these markets to improve their own practices. I think that is very important. Whether that is adequate is, I think, a question, and the President's Working Group is looking at that. Exchanges, for example, have to have anti-trust exemption, and they have statutory self-regulatory responsibilities which, of course, isn't true in the over-the-counter derivatives market.

    Ms. BIGGERT. How would these investment groups—about how long are they in existence? I mean, this isn't something that is a firm that lasts for twenty years or anything. On the average, isn't usually a couple of years the life of such an organization?

    Ms. BORN. I think a number of them have been around for quite awhile. George Soros has some very big funds that have been around for at least a decade. I think the Tiger funds have been around for a long time. I think hedge funds go back to the 1950's or even 1940's when they were first developed. They have proliferated in recent years, and I think a lot more money is being managed by them today. A number of them do go out of business on a regular basis. Certainly, we have commodity pools that become insolvent fairly frequently.
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    Ms. BIGGERT. Is it just because they become insolvent or is it because they just make enough money where they want to avoid more stress factor?

    Ms. BORN. I think it is usually that they have made significant losses even if they are not insolvent, and, therefore, there isn't much incentive to invest in them.

    Ms. BIGGERT. OK. I guess what you said earlier is that their ability to make an impact on the market by getting into it with such amounts of money. Is it much more significant than, let us say, a pension fund moving into a market that would have the ability to affect that market as much?

    Ms. BORN. Well, there are some very big pension funds as well, but Long-Term Capital Management had about $1.25 trillion in notional value of derivatives, both on exchange and over-the-counter, and that is an extremely large position.

    Ms. BIGGERT. A little. Thank you very much.

    Thank you, Mr. Chairman.

    Chairman BAKER. Chairman Leach, did you care to ask questions at this time?

    Mr. LEACH. Well, thank you.
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    I apologize, I have missed some of the hearing. Just one area of interest that has always struck of great interest to me is the growing role of offshore enterprises, and Long-Term Capital Management is symbolic of this; that is, it is a company that is incorporated in Delaware, as I understand it; located in Greenwich; but its' funds are organized offshore. And there are presumably two reasons for this: less regulation as well as less taxes, any taxes, and it strikes me from a regulatory perspective, there is an awkwardness to that, and it also struck me that there are problems in the system that you end up with some extra legal risk issues that come into play. This is an issue that certainly regulators ought to be concerned with, for example, for extensions in bank lending. But I am wondering if either would like to opine on the problem of the offshore dimension of circumstances of this nature?

    Ms. BORN. Well, we have certainly given some thought to that, because there is nothing in our statute that requires that pools be domestic. We regulate operators as long as they seek funds from U.S. investors and invest some of those funds in either U.S. or foreign futures exchanges, and our statute extends the jurisdiction of the United States to those operators wherever they may be located as long as they either trade on our markets, on our regulated markets, or seek money from U.S. investors. Obviously, it is harder to enforce our jurisdiction against entities that are located offshore even if we have it. I think the SEC has similar jurisdiction over entities that are offshore that deal in the securities markets or seek U.S. investment.

    I think that it is extremely important because of the existence of offshore havens for international regulators to get together and agree on regulatory principles and agree on cooperating with one another. IOSCO has a new task force on this issue where we are looking specifically at the regulatory haven issue, and, of course, if all the developed countries and some of the larger emerging markets took our position, the U.S. position that they wouldn't permit these funds to seek investments from their citizens unless they subjected themselves to regulation, we would go a long way toward solving the offshore regulatory haven issue.
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    Mr. LEACH. Well, let me just say, I think if there is any sense of the Congress it is for, in the first instance, regulatory coordination here at home, but also greater regulatory coordination abroad, and your emphasis on IOSCO, I think, is something that this Congress would certainly want to encourage. Philosophically, as bizarre as it might seem, it would appear that the United States Government moved to assist in the rescue of a Cayman Islands organization. Last fall, I asked the Chairman of the Fed whether, of course, he consulted in advance the monetary authorities on the Caymen Islands before this ruling; he acknowledged he didn't. May I ask, did Chairman McDonough consult you in advance?

    Ms. BORN. Not in advance. We were informed about the whole situation on the morning of the 23rd of September, which was the day that the infusion of capital was agreed on by the Treasury Department because of a concern that if an arrangement wasn't entered into, there would be significant defaults that day which would impact on our regulated futures exchanges and regulated futures exchanges in several foreign countries.

    Mr. LEACH. Thank you.

    Chairman BAKER. Thank you, Mr. Chairman.

    Mr. Sachs, just one further question. I understand prior to your role at Treasury, you did have a relationship with Bear Stearns. One of the observations made generally in the market is that if this thing had melted down little would have happened to the major participants. Despite the fact that Bear Stearns did not participate financially in the workout, basically, using the argument ''We gave at the office,'' had not the workout plan been successfully negotiated, isn't a fairly good assumption that Bear Stearns would have very deep financial difficulties?
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    Mr. SACHS. I am not sure, to tell you the truth. I did work with Bear Stearns before I came to Treasury last summer. I am not sure what the implications of a Long-Term Capital failure would have had on Bear Stearns. The area that dealt with Long-Term, the clearance, which I believe you are referring to, was, for very good reasons, separate from the areas in which I was.

    Chairman BAKER. I just made the observation that since they refused to participate in the workout, either inability or the fact that losses were already so deep, the collapse certainly could not have improved their circumstance, so I was trying to get to the point that it could have had significant implications for them.

    But I thank both of you for your appearance here this morning. Thank you very much, and I call our next panel. Thank you very much.

    Mr. SACHS. Thank you.

    Ms. BORN. Thank you, Mr. Chairman.

    Chairman BAKER. I thank each of you for your participation, and I would like to introduce all members of the panel at this time.

    Our panel includes E. Gerald Corrigan, the Managing Director at Goldman Sachs and Mr. Steven Thieke, Managing Director at J.P. Morgan, and I understand that they both appear here in their capacity as co-chairmen of the recently formed Counterparty Risk Management Policy Group, not necessarily for the institutions with which they are associated.
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    We also have Mr. Leon Metzger, the President of the Paloma Patners Hedge Fund. A particular thanks to you, Mr. Metzger, for your willingness to appear here today. You apparently have a great deal of courage as the only hedge fund representative in our hearing today, and I would note that you have a further burden of clarity and accuracy in your testimony today since both of your parents, I understand, are also here with you, and so you have a very high standard of conduct to meet to satisfy all the observing participants; thanks to both of you for coming.

    And, finally, Mr. Ernest Patrikis, who, really, an introduction is not needed. He has appeared in this Banking Committee room many times as a senior Federal Reserve official. Now, as the special advisor to the Chairman of the American International Group, and we certainly appreciate your willingness to appear this morning. Thank you, sir.

    Our first participant would be Mr. Corrigan. Welcome, Mr. Corrigan.


    Mr. CORRIGAN. Thank you, Mr. Chairman. I would like just to make a very, very brief comment and then to turn to Mr. Thieke who will summarize our joint testimony. The comment I would make is one that is aimed at perspective and, frankly, reflects some of my own biases accumulated over 25 years of service in the Federal Reserve.

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    I think I want, basically, to reduce this to three quick points. First, the pattern of market disruptions and firms' specific problems that we have seen over recent years, I want to emphasize, are not unique to the United States and are not unique to unregulated financial institutions. Indeed, having said that, I would quickly add that in looking around the room, if anything, the problems here in the U.S., even including the problems with the S&L industry in the 1980's, have been relatively modest in cost and duration relative to what we have seen in at least some other major industrial countries, to say nothing of so-called emerging market countries.

    I think it is also important, Mr. Chairman, to note that at this juncture, the major U.S. financial institutions, by and large, including banks, investment banks, and insurance companies, are again widely recognized as world leaders; something that, perhaps, could not be said with as much conviction ten or fifteen years ago, and that is not something that we should take lightly.

    The second general point, which Steve will touch on I think in a little bit greater detail, is sort of keep in mind that as a matter of respect, the events of financial disruption and so on that we have seen in recent years are very much, but not exclusively, but very much driven by the closely related phenomena of the application of very sophisticated technology to banking and finance and the associated and related problem of the globalization of finance and economics as well, and those phenomena really do have a major bearing on a lot of what we have seen.

    I think it is also important to note that as with any technological revolution—and that is what we are talking about here—growing pains are inevitable, and we have seen more than a few. But I think it is also important to recognize that while those growing pains are inevitable, the phenomenon that we are describing is a very clear net plus for the United States and the world at large even if those growing pains do crop up from time to time. I think it is important also that we recognize these forces have not remotely run their course, and, as such, it is not conceivable to structure failsafe systems of practices, regulation or law that will leave us certain that problems of this nature will not occur. Indeed, I think we must assume that, at least for the foreseeable future, volatility and periodic bouts of financial instability are likely to remain a part of the landscape.
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    What we can do, however, is to seek to further bolster efforts to improve the stability of the financial system, both here in the United States and around the world. I think it is important to recognize that that process has been working, and, indeed, whether you look at the process of supervision and regulation on the official side or the process of management and risk management on the private side, we have, in fact, come a long distance in recent years. And what we in the Working Group and the Policy Group, as Mr. Thieke will describe to you in a moment, are seeking to do is to contribute further to that effort.

    But with that brief introduction, I would like to ask Mr. Thieke to summarize our joint statement. Thank you, Mr. Chairman.

    Chairman BAKER. Thank you, Mr. Corrigan.

    Mr. Thieke.


    Mr. THIEKE. Thank you, Mr. Chairman. With your permission, we will just review a summary of the presentation. We do welcome the opportunity to be here today to discuss the initiative that we are co-leading. Before reviewing some of the specifics of the project, we would like to provide some perspective.

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    Over the years, we have witnessed a number of very significant disruptions in global financial markets. While each of these has distinguishing characteristics, there are some common features. Failures in macro-economic policies have almost always been present as have weaknesses in domestic banking and financial systems. Moreover, the scale and mobility of pools of risk capital, made possible by the very technological advances that have increased the efficiency of our financial markets, have manifested both stronger and faster linkages across those markets.

    To some degree, all these factors were at work in the buildup to the market events of last year which were at the outer edge of our prior experiences in terms of size, speed, and reach of market moves. In mid-1998, there were roughly twenty countries that were experiencing moderately serious to very serious economic problems. Although these problems varied greatly, in many cases they spawned major adjustments in exchange rates, local interest rates, equity valuations, and credit conditions. Yet despite this, the U.S. markets had remained a relative oasis of calm.

    It was in this context that Russia's announcement of unilateral debt moratorium sparked a sea change in market psychology in the direction of extreme risk aversion. Over the ensuing four to six week timeframe, we witnessed a drying up of risk capital availability as part of a self-reinforcing deleveraging process. This spawned dramatic increases in risk premiums and market volatility as well as breakdowns of normal relationships between financial asset prices. As investors pulled back from credit sensitive asset markets, this accentuated the illiquidity and contributed to even more volatility. In this sense, the Long-Term Capital situation was only a part of a much larger and more complex story.

    When considering the disruptions that we have seen, a general pattern emerges in which major shocks quickly alter the behavior of market participants typically with extreme short-term consequences. When it occurs, several developments seem to follow. First, the distinction between market and credit risks blurs, and that is changes in market factors such as exchange rates, interest rates, equity prices, and credit spreads, become key determinants of how much a firm would lose if a default occurs as well as changing the likelihood of default. In earlier times, market and credit risk were managed more or less separately, but the credit intermediation function is shifting in the degree such that buy-and-hold lending activity at traditional banks is increasingly becoming a more actively managed credit markets activity. As such, financial firms face the challenge of integrating the management of their market and credit risk.
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    Second, market liquidity is sharply reduced in these cases, most recently, by a shift of some hedge funds and others from being significant providers to absorbers of liquidity. Once market liquidity is reduced, the amplitude and predictability of financial asset price changes becomes much more uncertain, thus increasing the sense of risk.

    Third, what were seemingly adequate amounts of collateral are quickly called into question, thus highlighting the challenges that firms face, both in their risk measurement and collateral management processes.

    Now, it is important to recognize that the trends which have tightened the connections across these markets cannot be reversed or suppressed. As Gerry has already noted, what both market participants and public policy officials must do is recognize this and continuously pursue steps to bolster the stability and liquidity of markets and to improve the discipline of risk management.

    Toward this end, the central banks and the G–7 finance ministers have all stressed the need for these improvements. Some of these are properly the remit of the public sector; others, most notably calls for improvements in market standards and risk management practices, are best shaped by market practitioners. Given both our direct experience as well as the strong economic incentive we have to protect our companies' well-being. It is in this spirit that the Counterparty Risk Management Policy Group was established.

    In early January, twelve globally active commercial and investment banks formed the Policy Group for the purpose of developing flexible standards for strengthening risk management practice. In order to better understand our objectives, I would like to stress a number of points. First, this is an initiative by private practitioners mainly targeted at promoting enhanced best practices in counterparty and market risk management. We aim to do so, however, with the full appreciation that these practices must not be thought of in either static or ''one-size-fits-all'' terms. Rather, they must be regularly adapted to both the particulars of firms and the markets in which they operate. They are also constantly evolving. Indeed, today's best practices can easily become tomorrow's second best, thus pointing to the need for almost continuous improvement. Accordingly, our work should not be viewed as developing a roadmap for regulation or even self-regulation, let alone legislation.
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    Second, while we seek to raise the bar by broadening and reinforcing improvements in risk management practices, we do not, in any way, intend to standardize credit terms and conditions, as these must remain the essence of bilateral counterparty relationships.

    Third, the scope of the Policy Group's work is counterparty credit risk management and market risk management broadly defined. We are not targeting only derivatives or only hedge fund relationships.

    The Group consists of a senior level official from each of the twelve sponsoring organizations, as well as we two as co-chairs. Members have a broad mix of line business, market and credit risk management skills, giving us a full range of experience from both commercial and investment banking with a global, not just U.S., perspective. We have also reached out directly to involve additional firms in our various working groups. Clearly, our intent is for this to have a very broad reach.

    We have organized our work into three areas: internal credit and market risk management practices; shared industry initiatives; and credit and market risk reporting, each of which is the subject of a dedicated working group of practitioners drawn from a broad list of participating firms.

    One group is focused on where improvements in internal risk practices are likely to be most useful, not on defining the base of a sound risk management program. This includes addressing complex issues around improving our understanding of how leverage, liquidity, and concentration issues interrelate and what their implications are for credit terms, collateral arrangements, and improvements in margin practices. It also is looking at the scope for practice improvements in valuation, exposure and risk measurement, stress testing techniques, limit setting, and the internal checks and balances that make up the dynamic between risk management and risk taking.
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    The second working group is focused on enhanced practices for reporting of risk information. There are four distinct dimensions to this: the first involves information exchanges between counterparties and their creditors, along with the confidentiality issues that these relate to; the second involves internal risk management reporting; the third concerns potential for improvements in regulatory reporting, including the nature and frequency of information provided, by whom, and for what purpose; the fourth involves the scope for improvement and public disclosure.

    The final working group is considering a range of industry initiatives that would promote more orderly disciplined management of counterparty credit risk. This includes addressing practical issues which arose concerning industry documentation, practices, the potential for improved standard closeout and netting provisions, alternative approaches to dispute resolution practices, and we are also looking at opportunities for expanding the scope and effectiveness of netting arrangements, as well as both the potential benefits and drawbacks of shared initiatives for improving information on credit concentrations, valuation practices, and market liquidity.

    While it is too early to predict the final conclusions of our work, most of our recommendations are likely to take the form of suggested improvements in internal risk management practices which individual firms can choose to implement and not as an all or none proposition. Some recommendations may require cooperative industry follow-up, while others would require regulatory consideration mainly as it relates to improvements in reporting. Very few are likely to require legislation.

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    In closing, let us stress three points: first, this is a private sector initiative. While we appreciate the encouragement received from the regulatory community, the regulators are not involved in our work. Second, there is no silver bullet here. There is no way to simplify an increasingly complex financial world or to eliminate the volatility and bouts of market instability we experience. This is not simply a matter of better computer models. Indeed, too much focus is made on the sophistication and precision of risk estimation models and not enough on the important managerial and judgmental aspects of a strong risk management program. While improved risk models can undoubtedly help, experience, market knowledge, management culture, internal risk transparency, and the quality of internal controls will remain more important in determining how well financial institutions weather the next storm that will surely come.

    Finally, paraphrasing Chairman Greenspan, the optimal number of financial firm failures is certainly not zero. Our initiative is not aimed at preventing failures of financial institutions or leveraged investors. Rather, we are focused on our ability to manage and control the risk of those failures when they occur.

    Thank you, again, Mr. Chairman, for the opportunity to be here today.

    [The prepared joint statement of E. Gerald Corrigan and Stephen G. Thieke can be found on page 71 in the appendix.]

    Chairman BAKER. Thank you, Mr. Thieke.

    Mr. Metzger, welcome.

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    Mr. METZGER. Mr. Chairman, I represent Paloma Partners Company L.L.C., which is the manager of several private investment funds that primarily employ relative-value strategies. Today, I plan to offer three recommendations in response to proposals that some have suggested in the aftermath of last fall's market turmoil: first, that the Government not undertake any additional regulation of hedge funds; second, that no statutory arbitrary limits be placed on leverage; and, third, that although market self-discipline is the best regulator, Government should continue its practice of providing guidance to business.

    Hedge funds play a positive role in maintaining the smooth operation of the financial markets. Hedge funds enhance market liquidity, helping to absorb economic shocks in times of high volatility, which makes markets more stable. In more liquid markets, high volumes of buying and selling cause less price fluctuation. Hedge funds are the buyers when there are only sellers and the sellers when there are only buyers. Hedge funds search out assets whose prices are temporarily out of line with fundamental values, helping to reestablish the true market value of securities by selling short an overpriced instrument and buying an underpriced one.

    More efficient markets reduce the cost of capital to issuers of securities, as prices more accurately reflect underlying values. Unfortunately, some fail to make the distinction between gambling and what the economist Dr. Aaron Levine has described as the type of speculative activity necessary to keep our markets efficient.

    Today, the term ''hedge fund'' generally is used to describe any private investment fund, whether it employs ''hedging'' strategies or not. There are many categories of hedge funds, and each has different strategies, risks, and potential rewards. Even within one category, funds use a variety of strategies. Therefore, it is difficult to make general statements that would apply to all hedge funds.
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    The recent stereotype of hedge funds has been based on Long-Term Capital Management. In fact, Long-Term Capital is unique in the world of hedge funds. Few hedge funds either use as much leverage, or have as much capital, as Long-Term Capital did. This massive combination of capital and leverage was unprecedented.

    To say that hedge funds are not subject to any regulation is quite misleading. Hedge funds and their affiliates are not only subject to direct Government regulation, but they are members of self-regulatory organizations. Hedge funds can be subject to the rules of the CFTC, SEC, Federal Reserve, NFA, and NASD. Furthermore, last October, Chairman Greenspan testified that hedge funds already are regulated, indirectly, through the financial intermediaries that lend to them.

    Because of the problems that Long-Term Capital faced, there has been a call to regulate hedge funds further. If the Government further regulates hedge funds, it will be regulating the flow of liquidity and, hence, may interfere with the efficiency of the markets.

    The most likely outcome of any significant additional regulation of hedge funds in the U.S. is that they would be driven offshore to countries where that regulation doesn't exist. To be effective, any regulation would have to be coordinated worldwide. Even then, some country inevitably will change its laws to welcome all the business associated with providing an unregulated home.

    Some have said that ''macro'' hedge funds are doing terrible things to the economies of ''good'' countries, for example, destroying the value of currencies. On the contrary, the IMF recently published a study that found that, in general, hedge funds make financial markets more stable, not less. Hedge funds have been the messengers delivering the news that certain countries' currencies were overvalued, but the cause of that overvaluation was the policies of the countries themselves.
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    By propping up overvalued currencies, governments wasted an enormous amount of public money trying to undo the view of the market. In contrast, no public money was used to prevent Long-Term Capital from collapsing. As President McDonough explained last October, as well as today, it was ''a private sector solution to a private sector problem.'' We applaud the efforts of the Fed in providing guidance to the private sector. This was not a ''bailout'' of investors; their interests were reduced to 10-cents-on-the-dollar. If anything, the fund's creditors bailed themselves out of trouble.

    The majority of hedge funds use leverage to a prudent degree. Moreover, since the troubles last fall, many hedge funds have decreased their leverage. Put another way, the market has already addressed the problem, and, therefore, it is unlikely to happen again. It would be unwise to regulate ''leverage,'' as such, any further, because the amount of leverage that is prudent depends on the risk involved in a particular type of trade.

    Market-neutral hedge fund strategies generally have a very low probability of enormous loss and a very high probability of a small gain. These probabilities are similar to those faced by a property or casualty insurance company, or a bank that makes loans. These businesses also have a very high probability of a small profit from premiums or interests and fees and a very low probability of a large loss in case of a catastrophe or major default.

    Risk management systems do not attempt to eliminate risk; they help determine which risks are appropriate to take given the probability of loss. One of the lessons learned from last fall's difficulties is that the risk assessment models of some hedge funds and creditors alike may have failed to place enough weight on the possibility of a low-probability catastrophic event such as last fall's worldwide liquidity crunch. Creditors and hedge funds are constantly working to improve their risk assessment models, for example, through better stress testing. They should ensure that their senior managers are reviewing those stress-testing reports regularly.
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    The Federal Reserve, the OCC, and the Basle Committee are most qualified to assess what additional guidance the creditors need. Although I am not advocating suitability standards for financial intermediaries, I wonder if officials in charge of credit decisions may not have understood all the risks involved in their transactions with hedge funds. Therefore, although it would increase the cost of doing business, lending institutions should add analysts who are familiar with the particular businesses of their borrowers to their credit departments.

    Creditors may not have been able to consider the additional risks involved in lending to funds that had positions similar to their proprietary ones, because of the ''firewall'' between the credit and trading departments. As a result, they may have been forced to bail out Long-Term Capital out of self-interest, for if Long-Term Capital had been forced to liquidate in a fire-sale, the institution's own positions would have dropped significantly in value. I am opposed to credit officials sharing information about a potential borrower's trades with their traders. Preventing a lender's traders from seeing a borrower's position is critical to maintaining the proprietary nature of the strategies of hedge funds. Moreover, it should be a breach of the lender's obligations to its borrower to disclose proprietary information to the borrower's competitor. Instead, the lender's traders should share information about its exposures with its credit officials so that they can consider those exposures when making credit decisions.

    If Congress' goal is to protect investors, there are more significant issues on which to focus. Consider, for example, the inexperienced ''day traders'' of internet stocks, who are leveraging themselves by buying on margin without any grasp of the potential results. Furthermore, The Economist reported that banks' losses from hedge funds were in the tens of millions of dollars, while their losses in emerging market lending, which is regulated, ran in the tens of billions of dollars.
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    In conclusion, I would like to focus again on the self-regulation already occurring in the private sector. Lenders are demanding more transparency from their borrowers, and hedge funds are opening their books to their lenders and investors. Because of the self-discipline imposed by the market, creditors have tightened their lending practices with more thorough due diligence and stricter margin requirements, and hedge funds and other financial institutions are improving their risk assessment procedures to include stress testing for extreme market conditions.

    Market discipline and self-regulation are the best ways to reduce risks to the financial system. Further regulation of this industry only would result in less efficient markets. Furthermore, regulation, which already exists over credit providers, can be supplemented by additional guidance to address areas of concern. The best possible solution, therefore, is for intra-industry discussion and vigilance combined with Government guidance—not further regulation of hedge funds, not arbitrary limits on leverage.

    Thank you for inviting me to share my views with you.

    [The prepared statement of Leon M. Metzger can be found on page 79 in the appendix.]

    Chairman BAKER. Thank you, Mr. Metzger.

    Mr. Patrikis, as you note, bells have gone off for a vote. If your testimony is five or six minutes, we can conclude your testimony, and then I will run over and come back as quickly as I can.
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    Mr. PATRIKIS. Thank you, Chairman Baker. I request that my statement be put in the record. I will try to truncate my truncated statement.


    Basically, coming down to the issue is what is a hedge fund, I think we have heard it today that it is a fund that is unregulated or seeks to be unregulated in terms of doing investments, and there are many, many types of hedge funds.

    I look at it and say, well, what isn't a hedge fund? What shouldn't be a public policy concern to the Congress? As to funds that are unregulated, that limit their participation to sophisticated institutional and individual investors and that do not use leverage, I don't think these types of institutions pose systemic risks. Those funds are vehicles for investing large amounts of money quickly where the investors can take the degree of risk they want to assume and presumably have made a risk-reward judgment that the benefits are worth pursuing.

    For example, at AIG, we organize funds that invest in emerging markets. The proceeds of those funds are being invested in India, Asia, Brazil, and Africa. Investment vehicles of that sort could fall into a broad definition of hedge fund, but I see no need for this subcommittee to follow that path.
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    I think that the Basle Committee on Banking Supervision got it right when it focused on highly leveraged institutions in its two papers. In effect, the Basle Committee was saying to banks, ''You know one when you see one.''

    My prepared statement contains detailed discussion regarding credit risk management, stress testing, and collateral; I won't go into those now. I think the issue is: should highly leveraged hedge funds be regulated? I think there are two answers to this question: either fully regulate highly leveraged hedge funds or only allow market discipline to work its risk-limiting force. Proposals for partial regulation or position reporting to an information clearinghouse will have little tangible effect and far too much moral hazard risk. It will be assumed that the agency acting as the clearinghouse will be able to bring pressure to bear on a hedge fund whose behavior it concludes is questionable. This would have the effect of taking some pressure off of private firms to conduct the necessary in-depth reviews and could well lead market participants to conclude that the Government can be expected to have the situation well in hand. I believe that one of the worst situations an agency can find itself to be in is to have knowledge but not the power.

    From my discussions with my colleagues, I conclude that sensible regulation of highly leveraged hedge funds is beyond the state-of-the-art and practical. Regulatory capital requirements are still mainly balance sheet-oriented, largely ''rule of thumb''-based, aimed at broad categories of risk and designed to be as simple as possible. Hedge funds are pretty much the opposite of a financial firm for which that approach may be suitable. They are sophisticated, idiosyncratic, and highly disparate. Quantifying leverage in a case such as Long-Term Capital Management requires a firm-specific, and, perhaps, time-specific model. That model would neither be simple nor necessarily applicable to another large hedge fund.
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    Supervision, as opposed to regulation, looks at qualitative facts. But I must go on to say I believe that supervision applied directly to hedge funds most certainly would involve similar and, perhaps, greater moral hazard risks as regulation. Instead, public policy concern with hedge fund problems should focus on the potential impact of such problems on the financial system as a whole, which will occur through a hedge fund's counterparties. Such firms almost always will be commercial, and investment banks, which are supervised and regulated institutions.

    The question, then, should not be whether to regulate hedge funds, but whether existing supervision of commercial and investment banks which deal with hedge funds is adequate, and, if not, how should it be improved? As any risk manager knows, correlation matrices break down when market volatilities spike, and the nature and extent of these abnormal market events go far beyond the capacity of anyone to anticipate. Therefore, in such a situation, we must be artists and not scientists. Regulation is not the thing of artists, but risk managers must be artists as well as scientists. I refer to this as the need for managers with grey hair—individuals who managed through crises who have the experience and judgment to deal with the situation. Both the hedge fund and its counterparty creditor must engage in self-regulation in place of official regulation.

    Finally, one press report on the Basle Supervisors' Report stated that the committee's language was harsh and that it was mad at certain banks. While I have expressed some reservations with several parts of those papers, I agree with the vast majority of what they recommend for bank supervisors and supervised banks. Indeed, I would argue that there is little new in those papers. I believe that bank supervisors have all the tools they need to address banks' relationships with highly leveraged hedge funds. Bank supervisors have the power to terminate unsafe and unsound banking practices. To the extent that banks are engaging in such practices with respect to highly leveraged hedge funds, supervisors should use the powerful tools already granted them by Congress.
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    Thank you very much.

    [The prepared statement of Ernest T. Patrikis can be found on page 107 in the appendix.]

    Chairman BAKER. Well done, Mr. Patrikis.

    If we may, we will stand in recess for about fifteen minutes. We have two votes that shouldn't take very long. Thank you very much.


    Chairman BAKER. I would like to reconvene our hearing; I appreciate your patience.

    My first question would be to you, Mr. Patrikis. I was appreciative of your view that the Government either ought to really regulate it and run the market or it ought to leave it the heck alone and leave it to market forces to regulate and self-discipline. Given that, what was your feelings with regard to the Fed's participation in the workout among the voluntary participants?

    Mr. PATRIKIS. Well, that is an interesting question. I would first like to take it up in the context assuming we didn't have this market situation of this nature. What would happen to a firm in trouble like that? One, it would go out and seek new capital, new investors or sell itself off; two, it would call in its creditors—there would be a meeting asking the creditors, ''Would you please restructure? Would you take some equity instead of the debt that you have and work with the firm?''; or, three, to go into bankruptcy. And those are the three choices that Long-Term Capital Management faced.
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    I can't be objective about this; there was an offer on the table by Warren Buffet and Hank Greenberg and Goldman Sachs, and, to me, that was the preferred choice. Why was that the preferred choice? I think it would have shown the market that the market can handle the situation. There wouldn't have been as much negative publicity about hedge funds and positions; it would have said there is value there; there are people who believe that there is an opportunity and that that would be the preferable choice. But even taking it a step further, I just don't know whether or not that creditors' committee meeting would have happened anyway. Would someone have called it together?

    So, I look on what my former colleagues did as, perhaps, accelerating a process that might well have happened anyway, but, again, I am not objective; I think that that offer on the table to inject the $4 billion of capital would have been the best for the financial markets.

    Chairman BAKER. Thank you, sir.

    Mr. Thieke, in Mr. Metzger's testimony, he made reference that LTCM may have had cross-default agreements in place with counterparties which would have helped force creditors to recapitalize LTCM. Do you know whether such cross-default agreements existed? Do you know about them all or did they not exist?

    Mr. THIEKE. Mr. Chairman, cross-default provisions are relatively common in various forms of credit agreements, and they are intended, typically, to provide protection to the creditor in that if a counterparty of theirs defaults on some other obligation, it provides them with certain rights which typically is associated with the ability to accelerate. Realistically, what these are intended to do is to allow one creditor not to be disadvantaged relative to another creditor of equal standing.
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    The technical provisions that are associated with those—and they typically exist in quite a number of agreements, presumably, not just Long-Term Capital—have to be triggered by a formal event of default, and then some notification, and there may, at times, be cure periods associated with that. I don't think those provisions necessarily—they certainly don't prejudge the actions of a creditor once an event has occurred, and, if anything, the experiences with Long-Term Capital are such that they either didn't get triggered early enough or didn't effectively bring the creditors together fast enough to have had a solution in effect that would have preceded the actions of the Fed in terms of calling the creditors together as a group. Because had a default occurred, those kinds of provisions would have accelerated a gathering of the creditors who each would have exercised, or would have attempted to exercise, some of their rights under cross-default practices.

    Chairman BAKER. Saying it a different way, then, you are saying the speed of the technology and the market volatility worked faster than the legally enforceable provisions of the agreement.

    Mr. THIEKE. That is one way of characterizing it, Mr. Chairman, and that is that the speed was a very important factor here; the speed of the losses that occurred at the fund and, quite frankly, the speed of the liquidation that would have occurred had the fund formally defaulted, and one of the things that we, as market practitioners, have to adapt to in terms of our practices, is how do we get our response mechanisms lined up properly to recognize the speed with which these events can take place in the markets that we have today.

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    Chairman BAKER. Mr. Corrigan, it was reported that—I don't know if many is the right description—but at least some lenders to LTCM were unaware of LTCM's exposure to other lenders; that the universe of LTCM's market position was not fully appreciated by all the participants, perhaps, even the investors. Is there a possible way, without impinging upon a responsibly operated hedge fund, for lenders and investors to be fully apprised of the risk that the hedge fund is actually engaging in?

    Mr. CORRIGAN. Well, first, with regard to the premise of your question, I suspect it is reasonably accurate to say that there were lenders and investors that did not fully appreciate all elements of activities at Long-Term Capital that were relevant here. But, on the other hand, I think it is also true that while people didn't have precise point estimates, they probably should have had at least a reasonable idea that this was bigger than a bread basket.

    As to the operational part of your question, are there things that lenders and investors can do? And the answer, I think, is yes. Mr. Thieke, in describing the work of the Policy Group earlier, mentioned that there were specific issues that our people are looking at to try to enhance the exchange of information, for example, between creditors and their counterparties that would at least move in the right direction in trying to deal with this type of issue.

    The other side of the issue, again, Mr. Patrikis touched on, and that is this notion of trying to, on the official side, have a better idea as to what is going on, not directly but through the banks and other creditors. And I think, again, that there may be some room to consider possible enhancements to exposure reporting—not position reporting or that type of thing—exposure reporting on the part of creditors that would permit the authorities to have a little better idea of what the overall picture is.
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    So, yes, I think there are constructive things that can be done here.

    Chairman BAKER. As to the specific trading techniques of LTCM—I am told and do not fully understand, so I will explain to the best of my ability—that when a particular instrument was purchased and was either long or short in the market position, that a pairing would normally occur in many hedge fund practices where you had a unit—one short, one long—that could be easily reconciled, one against the other. Now, somewhere within LTCM's risk assessment models, they were doing it internally, but they were going out into the market and getting the best price for the long, best price for the short, and they were not paired hedges. LTCM's folks tell me that that was one of the difficulties for them, when it came time to liquidate assets to meet their obligations because of the unpaired nature of those hedges. Is that a unique or unusual practice among—and I ask Mr. Metzger the same—but is that a practice that did in fact contribute to the difficulty or is it of no consequence in your judgment?

    Mr. CORRIGAN. Well, again, I think we have to put value in context and perspective. Again, as Mr. Thieke mentioned, when the markets began to come significantly unglued, which we kind of roughly placed with the Russian default—and, again, that was kind of the straw that broke the camel's back—but once the market started to come unglued, well, you begin to get this impairment of liquidity as market participants in a understandably defensive posture start to withdraw. Now, it is true that many of the trades that Long-Term Capital apparently had on its books were of the nature that you suggested, and they implicitly had made the assumption that: a, liquidity was going to be there; and, b, that they all wouldn't go the wrong way at the same time, and because of the combination of events, neither of those assumptions turned out to be particularly valid, and, hence, the drying up of liquidity substantially aggravated the problems of the markets in general, but especially the problems of some institutions such as Long-Term Capital that for obvious reasons was trying to liquidate positions.
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    Chairman BAKER. So, your general view is that the lack of liquidity was the principal factor, but, second, the lack of pairing may or may not have contributed to the difficulty.

    Mr. CORRIGAN. Yes, I think that is a fair statement.

    Chairman BAKER. Mr. Metzger, I don't know the nature of the Paloma Fund, and I am not asking to have great detail, but in LTCM's defense, the pairing issue was one which was raised as a contributor to their difficulty in generating liquidity when the market turned out. Do you have an opinion about that observation?

    Mr. METZGER. There is a compelling argument to make that to have long and short positions with different entities is good because this way the—even if there is supposed to be a firewall in place, in case the firewall gets breached, you don't want your competitors to clone your trades. On the other hand, I want to point out to you that some of these trades where the spreads are so razor thin, you need to have simultaneous execution, and, therefore, to go to two different parties to place the long and the short wouldn't make sense, because if you didn't have simultaneous execution, you might lose money on the trade.

    Chairman BAKER. I want to return to a comment you made earlier about Long-Term's particular and unique position in this matter that they had, quote, ''an extraordinarily large amount of capital as well as an unusually high amount of leverage.'' Can I take from that comment—even though I clearly understand your position about Government's role, regulation, and the market—to mean that if something unusual and aberrant like a Long-Term in structure potentially to exist again, is that something that at least regulators should look at with caution, the structure itself? Because it was so large and because it was so leveraged, are you implicating that that was inherently meaning a problem?
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    Mr. METZGER. I don't think so. I think the financial intermediaries which dealt with Long-Term Capital have received a wake-up phone call, and they are going to be paying attention. It is not the size anymore.

    Chairman BAKER. Nor the leveraging?

    Mr. METZGER. The leveraging may have been higher—you may recall that I testified that you must look at the underlying risk of the trade itself. The leverage just magnifies the potential profit. I think all these things have to be considered. Also, what needs to be considered is just what I will call ''concentration.'' The financial intermediaries need to look at where those trades are, what those positions are, and it is up to the financial intermediaries. If they want to go ahead and extend credit to the hedge funds, they ought to ask for more information. They may want to say, ''OK, we are doing business with you as well as twenty other banks. We want to know what all your positions are, or at least what your exposures are. What countries? What is the nature of the instruments?'' It is up to the banks to ask for that.

    Chairman BAKER. But, again, one of the unique characteristics of LTCM was its apparent stature, its precedent success for three-and-a-half years, its record levels of profits which were returned. Any prudent man looking at the history would have come to the probable conclusion these folks know what they are doing, and it is relatively low risk, because they have never had even two successive days of losses until the end was in sight.

    Mr. METZGER. There is still an issue of concentration; that never goes away. Good risk management takes concentration into account.
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    Chairman BAKER. Well, what I am—I guess, ultimately, if we follow what I have heard is a theme, either Government run it, or Government get out of the way. If we get out of the way, then we should not have a role in workouts. If there is a loss, it ought to be the market's loss, and, somehow, we have to deal with the economic consequences of it as an aftermath or we have to have much more insight in regulatory interference which may impair the efficiency of the market. It doesn't seem—and I will get to you, Mr. Patrikis; I think it was the nature of your comment—either regulate it or leave it alone. I like that, but I am not sure we can afford to leave it alone.

    Do you care to comment, Mr. Metzger?

    Mr. METZGER. Yes, I think one of the issues involved last fall was what I will call the spillover effects. I don't think that—and I think President McDonough has testified—that the issue wasn't bailing out Long-Term Capital; it was the effect that it could have elsewhere on our markets, on our economy, and that is the reason why I believe the Fed intervened. Although, in my view, what the Fed did was provide guidance in light of the fact that no public money was involved.

    Chairman BAKER. Well, you are, again, helping me try to make the point: on the one hand, we say Government should not be involved, but we should be involved if the consequences of letting the markets function in their true, unfettered way is to result in a loss that could trigger systemic risk, then Government gets in. It is, we wait till the wreck—the train is on fire, and the passengers can't get out—then we call the fire department. I am saying there has got to be some train management in here somewhere when the market goes awry.
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    True, Long-Term's circumstances were unique; there was a high degree of illiquidity in the marketplace. No one fully knew the scope of their investments nor their investments strategies, and the investors didn't know. The banks couldn't adequately assess the risk-taking by Long-Term either, coupled with their long-term—or apparent long-term—success since their initial organization.

    And then I get the kind of disconcerting news from Mr. McDonough that there is no way to avert this from happening again. We were hours away from a failure which could have triggered unpredictable systemic losses, and yet there is nothing we can do to make sure that that does not happen again. That is the troubling part of this, and you agree, I guess.

    Mr. METZGER. Yes, I don't see right now a practical solution.

    Chairman BAKER. Thank you.

    Mr. Patrikis.

    Mr. PATRIKIS. I look at the answer in separate ways. We have a firm that is a dealer in derivatives. It did not do business with Long-Term Capital Management. It decided not to do business with Long-Term Capital Management. In terms of Government involvement, for firms that are supervised and regulated, it comes for a commercial bank in the form of their bank examiners. Steve Thieke is a risk manager. The bank examiners who focus on trading risks and market risks will come in and look over Steve's shoulder. They are the ones that should be making the judgment: Did the risk managers or others at the commercial banks do their job? The question for you is, is bank supervision up to the task? Are the bank examiners adequately armed, educated and sophisticated, to be able to evaluate that process enough to know whether to criticize a bank for not following good practices or best practices? So, most of the counterparties of Long-Term Capital Management would be investment banks or commercial banks that are supervised and regulated. It is Government-indirect. The examiners would be saying, ''What do you know about Long-Term Capital Management? What questions have you asked?'' And the industry is still going through improvement in these practices, so the role is for Government to come in and second-guess to make sure that the supervised and regulated institutions are doing what they should be doing.
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    Chairman BAKER. Well, it would seem logical that at the point at which capital begins to flow into the organization would be the appropriate gatekeeper as opposed to the regulator who really is looking at the institution who forwards the capital or, perhaps, as a later point, based on an investor complaint, the CFTC looks at what information the investor was given.

    Mr. PATRIKIS. Well, I agree with you half. At the beginning, it is crucial to make credit judgment. I will wager most firms did that. The issue is in terms of credit risk, because the credit risk that the firm takes, the risk that its counterparty is going to fail, is based on the market value of the transaction we are talking about. That has to be measured over time, so that the risk managers who do credit risk have to talk to the risk managers in the firm who know how to calculate market risk, so that they will constantly be looking at the value of that transaction over time. This is not easy and simple, but that is what must be going on in the firm. So, in commercial banks and the investment banks, the credit risk managers and the market risk managers have to work together over the life of that transaction, because its value can change from day to day.

    Clearly, up front, a key question is: ''Do you understand this firm? Do you know what it is going to do? And, if you don't, walk away.'' I have seen Hank Greenberg on occasion tell people, ''I don't want you to be a hero. Now, don't try to hit home runs; hit singles.'' And that needs to be done up front in the transaction and during the course of the transaction.

    Chairman BAKER. Well, in that regard, was it not a practice, at least reportedly a practice, where the individual investor would place at risk a minimum of $10 million; agree to leave it for three years, and don't call me, we will call you?
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    Mr. PATRIKIS. Those were the investors.

    Chairman BAKER. Correct.

    Mr. PATRIKIS. I could care less about them.

    Chairman BAKER. No, no, I don't care about whether they make money or lose money. What I care about is the aggregation of investors that made Long-Term of the size it was to then leverage bank lending which gets us to systemic risk.

    Mr. PATRIKIS. Well, I would hope that after Long-Term Capital Management, that even investors would start taking a bit more of a look.

    Chairman BAKER. Maybe ask a question.

    Mr. Corrigan.

    Mr. CORRIGAN. Mr. Chairman, I would try to speak briefly to this systemic risk question, because in the years when I was President of the New York Fed and Mr. Thieke and Mr. Patrikis, I have to say, were my partners in crime for some of this, we had to face this issue more than once, and I want to emphasize as strongly as I can that a judgment that has to be made in a particular circumstance, whether it is in the United States, at the Fed or in—countries are making these decisions with great frequency.

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    This is very much an art and not a science. It is a very, very, very tough call, and usually you have to make the call with less than perfect information and less than a lot of time, which is partly what you are saying. I think it is important that we recognize that mistakes on either side are very damaging, because if you do, in effect, make the systemic determination and, therefore, do something on the official side, that kind of creates and intensifies the moral hazard and related problems. But, of course, we can't forget the other side, because if the situation is indeed one that has truly systemic consequences and you fail to recognize that, then the consequences of that decision are going to be very, very dire as well.

    Chairman BAKER. And I don't disagree with you.

    Mr. CORRIGAN. I know you don't, but let me just kind of make sure we have the perspective here. Now, I would argue, Mr. Chairman, that the statistical probabilities of systemic failures actually are less today than they were, say, ten or twenty years ago, much less four years ago. The problem that we have is that because of the changed character of the global financial system, the potential damage associated with a lower-probability systemic event are probably greater because of all these interconnections, and that makes this issue all the more difficult to deal with.

    But to go right to, I think, the heart of your question, the world is not standing still with regard to efforts to better and further reduce both the probabilities of a systemic shock and the amount of damage that can go with it. I mean, when I look at the world today—notwithstanding the fact that we have problems every now and then—when I look at the world today in terms of the ability of the system to withstand shocks, I will tell you, in my judgment, it is a hell of a lot more resilient than it was, again, ten or twenty years ago. You take the events of last fall, just as one example—and Steve appropriately described them as ''on the outer edge.'' Certainly in my experience over thirty years in terms of speed and all the rest of it—one of the interesting things is that, to my knowledge, we did not have one material glitch in either domestic or international payments, clearance, and settlements systems despite the enormous volatility in other things going on at that time. Now, that is not an incidental factor, because these things are kind of the lightening rod to really create problems.
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    So, we are not standing still. You look, for example, at the initiatives that Steve and I and our colleagues are working on right now. These are not throwaways; these are very, very important initiatives that are consistent, I think, with the philosophy that says we don't want, nor do we need, nor would it work to try to solve these problems.

    Chairman BAKER. I think the recommendations are excellent. The only difficulty is they have to be voluntarily implemented, and in times like these—I come from Louisiana and came to Congress in the 1980's, so I understand crisis management, but as history moves away from us, you tend not to be quite as aggressive in your oversight as you were in the middle of the crisis.

    Mr. CORRIGAN. We have all been to that school, and, hopefully, we can do better at that too, but I don't know—Steve, do you want to add something on this systemic thing?

    Mr. THIEKE. I would just say, I wouldn't want to leave you, Mr. Chairman, thinking that nothing either can be done or is being done. I do think that at every level steps are being taken to both reduce the odds of a recurrence and, importantly, reduce the implications if it were to recur. They are being done at the first level by the firms, themselves; they are being done at the next level by the firms pooling their energies and looking for solutions that no one firm can implement, but that can be done collectively to improve market practice. The regulatory authorities have already taken important initiatives to try to reinforce sound practice, and the agencies in the Working Group are looking at some of the broader issues, all of which, I think, move in the direction of an appropriate response mechanism that both lessens the probability of a recurrence and reduces the implications of one should it occur.
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    Chairman BAKER. Well, I thank all the witnesses. I certainly don't want to leave the wrong impression either. I am the last to suggest we need more regulation. I generally have great faith in the markets, but I also have great faith in the resilience of markets, and think that the extraordinary measure of Federal intervention ought to be only in the clear and not misunderstood view that not to intervene would result in trauma to individuals who have no direct involvement in the principal failure. Those are the individuals that I care about in this matter the most, and my frustration is that although I know good faith and well-intentioned people are doing their best to get a rope around the new animal that has been created, I am afraid there will be others engaging in this practice who may not be so well-intentioned, who may take advantage of the new technologies and the speed with which trades can be engaged, leading to significant market losses before responsible regulators or uninformed investors or limited bank lenders in knowledge have a chance to withdraw from that potential exposure. That is a very frightening prospect.

    And let me say that other Members of the subcommittee have asked for the ability to forward written questions to members of all panels at a later time which certainly will have a right to do, as will I. And because of the continual pointing toward the problems of technology and its implication for the future of capital markets, we have already cleared a date for another hearing later in the month on that specific point—technology and movement of capital within the markets given the fact that it is global, instantaneous, and huge. We need to also be better understanding as policymakers what that represents to us in future years and potential market risk.

    And I want to express my appreciation to all of you for having been here and for being so patient. Thank you very much. The hearing is adjourned.
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    [Whereupon, at 1:18 p.m., the hearing was adjourned.]

    [insert offset folios 47 to 141 here]