SPEAKERS CONTENTS INSERTS
Page 1 TOP OF DOC
THE PRESIDENT'S WORKING GROUP STUDY ON HEDGE FUNDS
THURSDAY, MAY 6, 1999
U.S. House of Representatives,
Committee on Banking and Financial Services,
Washington, DC.
The committee met, pursuant to call, at 10:00 a.m., in room 2128, Rayburn House Office Building, Hon. James A. Leach, [chairman of the committee], presiding.
Present: Chairman Leach; Representatives Roukema, Baker, Bachus, Ryan, Ose, Biggert, Green, LaFalce, Vento, Waters, C. Maloney of New York, Bentsen, J. Maloney of Connecticut, Sherman, Sandlin, Inslee, Moore, S. Jones of Ohio and Capuano.
Chairman LEACH. The hearing will come to order.
Last fall I asked Secretary Rubin, in his capacity as Chairman of the President's Working Group on Financial Markets, to conduct a study of hedge funds, drawing on the lessons learned from the fiasco of Long-Term Capital Management. An extraordinary intervention by the Federal Reserve Bank of New York and a 14-bank consortium was required to keep that fund solvent and avert jeopardy to the financial system. This morning we will review the Working Group's Report.
Hedge funds have proliferated in recent years. There are now about 3,000 of these unregulated entities, managing about $300 billion in investment capital, about a third of which is highly leveraged. They operate largely in confidentiality or secrecy. According to their proponents, hedge funds help keep markets liquid, efficient and stable. Their social purpose, however, is not always self-evident, but this circumstance alone represents an insufficient rationale to interfere in their operations.
Page 2 PREV PAGE TOP OF DOC
Congress and the Executive Branch, however, have a duty to understand the systemic risks that may develop with hedge fund activities and the risks to which they expose the taxpayer. This is particularly the case because much of the money hedge funds use for leveraging assets comes from federally-insured institutions, and because large hedge funds spread their bets all over the world and so have the power both to apply constructive discipline to markets or destabilizing disorder to the financial system in certain kinds of circumstances. Long-Term Capital's near bankruptcy is a case in point.
The Working Group's Report contains the first authoritative, if still incomplete, account of Long-Term Capital's operations, an explanation that was, and continues to be, frustrated by the persistent refusal of the Long-Term Capital principals to provide a public accounting to this committee of their trading practices and risks. The committee and the public need such an accounting so that they can properly judge whether the Fed's intrusion into our market economy was justified. The Fed's intervention, though it involved no public money, was the first time the too-big-to-fail doctrine has ever been applied beyond insured depository institutions. Indeed, it is still unclear whether the Fed action represents a ''too-big-to-unwind-too-quickly'' corollary or ''too-intertwined-to-do-anything-except-intertwine-further'' approach.
The Working Group's recommendations are thoughtful and appropriately moderate. They strike a sensible balance between governmental oversight to protect the public from systemic risk and an understanding that even if justified, the Government lacks capabilities to control or, at the nuance level, understand private markets of this nature. In this circumstance, I am particularly interested in reviewing the Group's call for greater public disclosure by hedge funds and modestly enhanced supervision of unregulated affiliates. I am also pleased to note that yesterday the House passed, in the bankruptcy reform measure, the netting provisions of the bill Representative LaFalce and I introduced.
Page 3 PREV PAGE TOP OF DOC
The Working Group's conclusions also parallel in many ways the recommendations of a 900-page report I issued five years ago on financial derivatives. Included in the 30 recommendations for regulatory action to constrain systemic risk in a market that was described as ''the new wild card in international finance'', regulators were urged to ''examine the need for regulations to protect against systemic risk'' and to ''conform the netting provisions contained in the Bankruptcy Code to a single standard.'' The Report also suggested that ''unregulated market participants'' be ''supervised by the SEC or the Secretary of the Treasury'' and called for ''prudential standards for management of the risks that are involved in derivatives activities.'' The Fed and the Treasury were asked to ''pursue international discussions to achieve harmonization of international standards.''
Many of the details in the Working Group's recommendations remain to be filled in. As the saying goes, the devil is usually in the details, and I look forward to suggestions from our distinguished panel of Government and private sector witnesses today. It should be stressed, however, that above all, the Working Group realistically relies on the private sector, with only modest public help to police itself. The profit motive is understood to be the most powerful disciplinarian that is likely to be applied to these markets.
Chairman LEACH. Mr. LaFalce.
Mr. LAFALCE. Thank you very much, Mr. Chairman, most especially for scheduling such a timely hearing on this extremely important issue, since the Report of the Working Group was issued just last week. My compliments also to the Working Group.
Page 4 PREV PAGE TOP OF DOC
In our hearings on Long-Term Capital Management in October of 1998, I voiced concern that there was a seeming lack of cooperation within the group. I think that was true at that time. However, this Report alleviates those concerns, especially since its recommendations were unanimous in nearly all respects. The only thing I saw was a very diplomatic declination by note by Chairman Greenspan with respect to an endorsement of the recommendation for expanding risk assessment for the unregulated affiliates of broker-dealers and futures commission merchants while simultaneously deferring to the primary regulators. That is the only minor deviation I saw in a very united front of recommendations.
Even more important, though, the recommendations that you have made are quite significant. A number will require legislation by the Congress. Others can be undertaken administratively and I hope will be quick.
Additionally, the recommendations involve changes at the international level. In short, your proposals are far above the lip service level and do involve substantial, and I think needed, policy change. I am going to withhold any official endorsement on the whole range of recommendations of anyone in particular, although I am certainly inclined strongly in that direction, but I don't think we can make firm judgments on alterations in hedge funds until the Working Group's report on derivatives becomes available.
Innovations in hedge fund characteristics cannot be separated from innovations in the usages of derivatives, since derivatives instruments play such a prominent role in the evolution of hedge fund operations and strategies.
In short, hedge funds must be analyzed in the light of the experiences of the Derivatives Policy Group, which was formed by six major Wall Street firms in August of 1994, and the Counterparty Risk Management Policy Group, which was formed by twelve major and internationally active commercial and investment banks in January of this year. Further, the International Swaps and Derivatives Association Collateral Review, which became available in March of this year, will also have a role to play. Moreover, the January 1999 Basle Committee on Banking Supervision report on highly leveraged institutions will have to be fit into the emerging picture.
Page 5 PREV PAGE TOP OF DOC
The financial stability forum of the G–7 will also soon contribute to our knowledge of the dynamics of hedge funds in the arena of international financial stability, including their part in the currency instabilities through which the international markets have just passed. Perhaps, finally, the Treasury too must finish its work on offshore tax issues affecting hedge funds and matters related to the treatment of total return equity swaps. An understanding of the complex interactions of tax law and hedge funds, many of which are partnerships and not corporations, is simply an imperative predicate to understanding the total scene. So I urge Treasury to expedite its work in this field.
Our committee does not have jurisdiction over tax matters, but it would be very difficult, it seems, for us to take a responsible public policy position until the tax factors are accounted for. It would be beneficial for Congress to have a larger panoply of facts before undertaking any of the statutory changes covered or suggested in today's document.
Having said that, though, I still have certain fundamental conclusions that I have been able to reach, limited in scope. First, hedge funds can no longer be popularly framed as exotic investment vehicles for the well-to-do and corporations. They have become key parts of the fabric of domestic and international finance. Their problems become public problems, since they can have systemic impacts.
The message of LTCM is not so much that the Federal Reserve set the stage for extricating very big and sophisticated principals and their lenders from a tight situation. The real message is that we can no longer doubt that we have a new powerful kind of financial institution in our midst, the hedge fund, and that we know very little about them.
Page 6 PREV PAGE TOP OF DOC
Second, the legal and economic construction of these entities is very fluid. These are not like banks, brokers, underwriters or mutual funds. Those entities have recognizable and fairly stable forms. On the other hand, hedge fund entities can change their contours with great speed, and what you might be analyzing one moment is not necessarily what you would be analyzing the very next moment.
I don't say that to be critical of what these hedge funds transform from or into. A strong case can be made for the validity and desirability of their existence. However, I am saying that our charges, the commercial banks, their holding companies, their affiliates, are intimately involved with hedge funds as lenders and counterparties in a vast number of subtle and not so subtly different transactions, and we must respond to this involvement, not merely observe it.
Your Report, your administrative actions and your counsel, the counsel of the Working Group can and will help us immensely. I thank you very much. I welcome the entire panel, particularly those of you who might be testifying for the first time. I think Mr. Gensler is testifying before Congress for the first time. We welcome you. Ms. Nazareth, are you too, and Mr. Parkinson? Oh, you are an old hat. This is your second time. And Ms. Born, you are our veteran. Welcome back. Thank you.
Chairman LEACH. Mrs. Roukema.
Mrs. ROUKEMA. Thank you, Mr. Chairman. I appreciate this opportunity, and I do want to express my appreciation for the way you and the Ranking Member have outlined some of the issues involved here. These are very critical issues. As the Chairwoman of the Financial Institutions Subcommittee, I have an intense interest in this subject and also some intense questions regarding the jurisdiction of the subcommittee on the issues that have been raised.
Page 7 PREV PAGE TOP OF DOC
The hedge fund question certainly is an issue of safety and soundness and systemic risk. The Long-Term Capital Management rescue of last September certainly spelled that out and it was obviously a wake-up call for all of us, for the regulators and the policymakers and those of us on this committee.
Chairman Greenspan and President McDonough testified that there was a systemic risk posed by the failure of LTCM that we clearly know, therefore, we have to be concerned about what has happened and work diligently and, if necessary, go beyond the recommendations. I am keeping an open mind on that, in terms of legislation. We have to be as objective as possible about this.
You may remember that last March I held a hearing on the bank regulatory response to the LTCM situation. The Basle Committee, which is the international organization of bank regulators, issued two reports and the Federal Reserve and the Office of the Comptroller of Currency have issued new supervisory guidance. While the guidance from the OCC and the Fed appears to be well thought out, and certainly they are responsible groups, the question still remains as to whether or not it will be effective enough. Some observers have said the problem wasn't a lack of guidance by the regulators or general industry practices; rather, the problem was that the existing guidance and accepted industry practices weren't followed. Who knows whether it was four-star quality or other reasons, but standard bank underwriting and due diligence procedures were not followed.
My concern is that we recognize this wake-up call and that we use it as a way of avoiding other systemic risk situations. Now, the Working Group's Report is certainly a great contribution to this debate, and while it is quite detailed and makes several regulatory and legislative recommendations, designed to avoid systemic risk problems, I believe that the Report is a good start, but we have to objectively determine whether or not it goes far enough.
Page 8 PREV PAGE TOP OF DOC
As outlined by Chairman Leach, we did deal with the financial contract netting legislation in the bankruptcy bill yesterday; Chairman Leach has gone over that particular point. But my concern goes much beyond that concerning other reporting requirements regarding large hedge funds and recommended quarterly reporting.
First of all, what is a large hedge fund, and should it be required to file quarterly reports? That is an essential question. It is central certainly. I hope that our witnesses today will address with some specificity that question of what the definition is and how we can get to those reporting requirements. I don't think the Report is specific enough.
The third point, of course, is the leverage question. My question is whether hedge funds which employ a significant amount of leverage should be required to file quarterly public reports. The question is whether or not legislation should be required that goes beyond what is recommended in the Report. Is the amount of leveraging defined enough? I don't know. I don't think it is. And the reporting requirements, I don't think they are defined enough. So I would like to have more specificity with regard to that and how we can implement the recommendations.
Finally, the question I have relates to the ability of regulators to recognize systemic risks. I don't know exactly how we deal with that question, but it is central. The Report suggests several ways to improve transparency, but I believe we need to consider setting up a formal mechanism for the banking and securities regulators to share information. I don't think that is precise enough in this Report. The information that should be used between the regulated entities, banks, securities firms and other large market participants, and how they deal with the communication and the precise information that has to be shared there.
Page 9 PREV PAGE TOP OF DOC
Finally, there are some other issues, particularly the question of whether or not other legislation is needed. Should the CFTC—I mean particularly in this case, should the CFTC have shared the LTCM financial statement with other regulators? It evidently was not done. Why it was not shared we are not quite sure, but we should consider, in my opinion, whether the CEA needs to be amended to require the sharing of such information. I am not sure that the Report is precise enough on that. The open question is whether or not legislation needs to be considered there.
As noted by Mr. LaFalce, he referenced the question of banks and security regulators regularly share hedge funds and the derivatives exposures that Mr. LaFalce referenced, I would concur with him that we need a more precise explanation of how that fits into your recommendations.
We dodged the bullet this time. The LTCM situation has to be recognized as a wake-up call. There are systemic risks. The Fed may not come in at the right time or private entities to come in at the right time and the right place. The resulting cost of such failures would fall on the American taxpayers in one form or another.
So I am anxious to hear from you today, and look forward to your testimony, and I am hopeful that this is going to be a giant step in a very firm direction.
Thank you, Mr. Chairman.
Chairman LEACH. Thank you.
Page 10 PREV PAGE TOP OF DOC
Mr. Vento.
Mr. VENTO. Well, thanks, Mr. Chairman. I appreciate the gathering and the hearing today and the work of the President's Working Group on Financial Markets. Clearly we need to adjust our oversight and regulatory authority to deal with the dynamics and the evolution of the marketplace, especially I think with regard to those regulated aspects and those that ought to be regulated. Clearly the goal here with hedge funds and many other instruments is to enhance the liquidity and to minimize the risks. The question, of course, with hedge funds, good hedges and bad hedges, as one of the salesmen once described before the committee—quite a successful one, as a matter of fact—is whether or not they will put up with the volatility that exists, whether in fact these can be isolated from the overall health of the financial institution or the entity. I think most of us have some serious questions about that.
Obviously, the tradeoff here between capital and the hedges is one that would obviously vitiate whatever the value is or the instance of the hedge. So the question is to regulate, to monitor, to have the transparency to avoid the risk falling back on the taxpayers and, more importantly probably, on undercutting substantially the health of the economy, the overall economy, which of course was the goal of the Fed intervention or involvement with the Long-Term Capital Management episode, is what we are really about here today.
So we obviously appreciate the work that has been done, and we hope that we can craft a public policy and give direction to the regulators and build in the type of safeguards that are necessary without necessarily thwarting the entire evolution of this particular market instrument.
Page 11 PREV PAGE TOP OF DOC
But I think the increasing goal to equate more liquidity in terms of credit and within these institutions is obviously what is at the heart of this issue, without putting aside or setting aside capital, a thinner and thinner amount of capital and trying to then, as it were, shift that risk to other entities in this process is one where—and it is a global phenomena and we obviously need to deal with it through the international markets—to come to a common understanding of that in order for our economy, and our economies on an international basis, to function.
So I look forward to the work and the complexity of the task. We are all students of this and hope that you can help us find some common path of policy that will be appropriate in this instance. I especially appreciate the Chairman's work and the regulators have made a valiant effort in this short time to do it.
Thank you, Mr. Chairman.
Chairman LEACH. Thank you, Mr. Vento.
Mr. Baker.
Mr. BAKER. Thank you, Mr. Chairman. I wish to express my appreciation to you for bringing this matter to the full committee's attention at the hearing today. As the subcommittee Chairman of jurisdiction in this area, we have spent considerable time with our own analysis and reporting mechanisms and have had the benefit of a briefing by Mr. Gensler, as well as many hours with staff, trying to get our arms around what this business is all about.
Page 12 PREV PAGE TOP OF DOC
If I may use a very simple explanation for a complicated subject, Mr. Chairman, it all reminds me of a childhood experience, regrettably. If you think of a bicycle for a moment as a hedge fund, a multi-seat bicycle, the guy who is driving it is the management of the bicycle. He is going to decide where the group is going to go. Well, it is a pretty good bicycle and he wants a little excitement. He gets tired of driving on flat ground and goes down a steep incline.
If you remember that experience, everybody said, ''Gee, that was fun, let's do it again.'' Word got out, and more people wanted to get on the bicycle; these are the investors. So they kept throwing more speed to the bike, cash in this case. As the bike picked up speed, management wanted to do something a little different and started taking steeper inclines. I call that leverage. The leverage provided the opportunity for greater excitement, and perhaps what we call profit.
What soon became inevitable, more people wanted in because it was such a great ride, everybody was hearing about it all over town, so they started throwing deals at the driver that he just couldn't turn down. As they picked up speed down even steeper inclines to increase the thrill of the ride, more leverage. They soon came to a spot in the road where their brakes, their capital, wasn't sufficient to keep from having the inevitable happen. They broke through the turn, had a wreck. The first thing everybody did who was riding on the bike was get up and blame the driver, because they were throwing everything they could at him to tell him to go to take steeper inclines, more leverage, to get a higher rate of return. In the meanwhile, moms were at their kitchen windows looking out, and they saw something strange going on, but nobody really went over there and said, ''What are you all up to?'' That would be, in my case, the regulators.
Page 13 PREV PAGE TOP OF DOC
At the end of the day, we are now going to have some people who say what the appropriate Government response should be is to just outlaw bicycles because they are inherently evil. Others would simply want to redefine them so that they can only go down certain inclines at a certain speed, direct regulation.
I, on the other hand, think that the more appropriate matter to pursue would be just to let everybody know what risk you are going to take when you get on the bicycle and nobody have any secrets about where this guy who is driving it might take you. And if you don't know where you are going, and you can't accept the risk, don't get on the bike. But I think Government intervention to any significant degree in this marketplace would have far more disruptive consequences than letting a few kids get a bicycle and have a good time.
Thank you, Mr. Chairman.
Chairman LEACH. Well, that was an interesting trip.
Mr. BAKER. Just don't get on the bike unless you know what you are on, Mr. Chairman.
Chairman LEACH. Well, I wouldn't want to be in a two-seater.
Mrs. Maloney.
Mrs. MALONEY. I will just be associated with the comments of all of the previous speakers. I look forward to hearing what the panel has to say.
Page 14 PREV PAGE TOP OF DOC
Chairman LEACH. Mr. Bachus, you are challenged.
Mr. BACHUS. Thank you, Mr. Chairman. I was changing my opening statement to include an analogy to an electric train whizzing around the track.
I think this Report is a good starting point when we look at the threat that excessively leveraged hedge funds have on our financial system. And not only that, but also just when we see reckless lending practices, which I think you saw in this case.
I would like to commend the four agencies who make up the Working Group. I think the Report is well balanced; it is informative, and it is thorough. And I appreciate that. I have made three or four observations concerning the Report, and one is that all the agencies agree that direct regulation of hedge funds is not appropriate. I would tend to agree with that, and that these hedge funds will just go to countries where there is less regulation. I don't think that is appropriate.
Second, is all supported increased disclosure, and increased not only in the type of information to be disclosed, but also in the detail and in the frequency of the information that will be shared with investors, creditors and regulators, and I think that obviously is a key.
A third thing is that I thought it was very appropriate that you pointed out that creditors, investors and regulators should improve their own risk management techniques. They have responsibilities to better oversee the risks they are taking.
Page 15 PREV PAGE TOP OF DOC
Long-Term Capital lost nearly $4 billion and it threatened its creditors with potential losses of $3 billion to $6 billion. But what is more important, I think, to us on this committee and to you is that it resulted in a severe shock to the entire financial system. And that alone necessitates, I think, us to review this and to try to come up with proposals which will minimize the risk going forward that over-leveraged hedge funds might have on our financial system.
Finally, Mr. Chairman, one thing that continues to trouble me is that Wall Street continued to pump money into Long-Term Capital even after they got into severe financial trouble. Perhaps the banks and the financial institutions, the creditors were hypnotized by the Nobel Prizes or the connections or the academic accolades on the resumes of Long-Term Capital's management. But regardless of why they do that, any time Wall Street decides to becomes inebriated by reputations and forgets to do due diligence, you are going to have disasters of this type.
I would just say that I hope that this—and I think it already has had some positive effects on Long-Term Capital failure in that banks are looking at their lending practices. They are demanding more information, and hopefully, they are tightening their credit terms for these highly leveraged funds.
With that in mind, I look forward to the hearing. One of your proposals which I think is going to carry some cost to the banks, but proposals to align the capital requirements more closely to the actual risk, I think that obviously is something that will minimize risk in the future, but also, that doesn't come without a cost. But I would say to you that I agree with that proposal. Thank you.
Page 16 PREV PAGE TOP OF DOC
Chairman LEACH. Does anyone else wish to make an opening statement?
If not, we will turn to our panel. Let me particularly welcome you back, Mrs. Born. For first appearances, Mr. Gensler and Ms. Nazareth, and a second appearance, Mr. Parkinson. Why don't we begin with Under Secretary Gensler. Please proceed.
By the way, I would ask unanimous consent that all of your full statements be placed in the record, as well as statements of any other Member of the committee, modified statements of any Member of the committee. Without objection, so ordered.
Please proceed, Mr. Gensler.
STATEMENT OF HON. GARY GENSLER, UNDER SECRETARY FOR DOMESTIC FINANCE, DEPARTMENT OF THE TREASURY
Mr. GENSLER. Thank you, Mr. Chairman, Ranking Member LaFalce, Members of the committee. I will just summarize orally and briefly my written statement.
It is an honor to be here before you today to discuss our Report on Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management. It is also an honor to be here, as I was recently sworn in as Under Secretary, and I look forward to working with this committee and its staff on many matters related to banking and finance.
Page 17 PREV PAGE TOP OF DOC
The Working Group has recommended measures in two broad areas: in disclosure and better risk management practices, as well as a number of other important matters. Legislation will be required in three of these areas, and I will note those as I quickly summarize the recommendations.
The central policy issue raised by the near collapse of Long-Term Capital Management is how to constrain excessive leverage more effectively. To constrain leverage in a market-based economy relies heavily on the discipline provided by creditors, counterparties and investors. I think the Working Group believes that is the best way to constrain leverage. However, if one looks at the history of financial markets, it is also true that market-based constraints can break down in good times, and we certainly saw that last fall.
Risk management practices broke down at both Long-Term Capital and its creditors and counterparties. The Working Group also found that although Long-Term Capital is a hedge fund, the issues that were presented, or the lessons that we took away, are not unique to Long-Term Capital or unique to hedge funds.
Let me just quickly review some of the proposals. The two recommendations that we made with regard to public disclosure: One, we would look forward to working with Congress on legislation, and that is that hedge funds themselves publicly disclose financial information. This we propose would be on a quarterly basis, and the information that they disclose right now, as noted to the CFTC, is confidential and it is only once a year, and what we are proposing is on a more regular basis and that all but the smallest of hedge funds would be disclosed publicly. We think that this would enhance behavior and that the entire public would be aware of these large pools of financial risk.
Page 18 PREV PAGE TOP OF DOC
Second, we think that all public companies, including financial institutions, should publicly disclose a summary of their direct material exposures to other financial institutions. While this does not necessitate legislation, the SEC would move forward and promulgate rules that would require public companies to disclose these exposures. We think that that would help the public markets work again to address leverage in the system.
There are a number of risk management breakdowns that we observed, and while the Report details those, there are three categories of recommendations that we suggest to enhance risk management practices of financial institutions. First, regulators should promote the development of more risk-sensitive, but prudent approaches to capital adequacy. Thus, we believe that the Basle Committee on Banking Supervision should update their Capital Accord to the financial markets of 1999. As many of you know, they were first adopted in the 1980's, and much has changed in those past ten to fifteen years.
Second, regulators have issued supervisory guidance to address some of the risk management weaknesses that have been identified. The examiners will be looking to see that financial institutions actually adopt those practices.
Third, the Report outlines a number of practices that the private sector itself should adopt through a number of private sector initiatives to publish sets of sound practices, and a number of Members in their opening statements already referred to a number of those, and those are encouraging developments.
We also have a number of other recommendations. We believe that regulators need a greater window into the unregulated affiliates of broker-dealers and futures commission merchants. While the SEC currently regulates broker-dealers, securities firms are placing a significant and growing share of their trading positions, leverage and activity in unregulated affiliates. This measure would require legislation and it would allow the regulators, and with regard to broker-dealers the SEC specifically, to have a better window, but it is a modest recommendation; it is not envisioning full consolidated supervision or capital requirements for those affiliates.
Page 19 PREV PAGE TOP OF DOC
With regard to bankruptcy, we studied closely what might have happened if Long-Term went bankrupt. Two specific proposals, which legislation is in front of Congress and as mentioned has been incorporated in the bankruptcy bill moving in the House, relate to cross-netting and relate to clarification of bankruptcy law. As it was, Long-Term Capital had affiliations in the Cayman Islands, could have filed for bankruptcy in the Cayman Islands and could have created a great deal of systemic risks, as the court sorted out whether U.S. law was applicable on this vast amount of leverage that was here in this market.
Lastly, we think that it is important in this world of mobile capital that the Working Group work to internationalize these recommendations. We have already been working closely with our G–7 colleagues, but beyond that, we think it is important to continue to encourage offshore financial centers, what some people refer to as tax havens, to adopt and comply with internationally agreed upon standards.
The Working Group did consider a number of additional potential measures, and while the Working Group is not currently recommending any of these measures, the Report suggests that they could be given further consideration. The three that I would like to mention are direct regulation of hedge funds, and as I earlier said, consolidated supervision of entire securities firms. A third one, direct regulation of derivatives dealers, we think is best taken up in the derivatives study that we will take up later this year. So while we are not currently recommending it, we will be coming back to that in our further study.
In conclusion, we believe that the Report contains a thoughtful, well balanced set of recommendations, and we look forward to working with Congress on these important matters.
Page 20 PREV PAGE TOP OF DOC
I would also like to add a comment. The Secretary of the Treasury wishes also to extend his appreciation to all of the members of the Working Group and their staffs for their close cooperation and hard work as we compiled this Report and recommendations. Thank you.
Chairman LEACH. Thank you, Mr. Gensler.
Ms. Born.
STATEMENT OF HON. BROOKSLEY BORN, CHAIRPERSON, COMMODITY FUTURES TRADING COMMISSION
Ms. BORN. Thank you, Mr. Chairman and Members of the committee. I very much appreciate the opportunity to testify concerning the study of the President's Working Group on Financial Markets entitled, ''Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management,'' which was transmitted to the Speaker of the House of Representatives last week.
As a member of the President's Working Group, I am very pleased to endorse its study on hedge funds. The President's Working Group and the staff of its members worked very cooperatively on the study and reached a consensus on the recommendations. The study identifies as a central issue excessive leverage in the financial system and the lack of available information about it. The study provides important recommendations about each of the four main issues raised by the near insolvency of Long-Term Capital Management, the need for increased transparency, the need to eliminate excessive leverage, the need for better prudential controls, and the need for enhanced international cooperation and harmonization of regulations.
Page 21 PREV PAGE TOP OF DOC
The study recognizes the critical importance of heightened transparency in the markets by recommending greater disclosure and reporting by hedge funds. It calls for all hedge funds to report detailed financial information, including information about their exposure to market risk, on a quarterly basis. This information would be provided not only to regulators, but also to the public. It would thus be available to hedge fund investors, counterparties and creditors to assess the creditworthiness of the hedge fund. It would also be available to regulators and market participants to help assess market integrity and financial stability. In addition, the study recommends that all public companies should be required to report publicly their exposure to highly leveraged financial institutions.
The study also emphasizes the need for enhanced risk management efforts by regulated entities and enhanced oversight of those efforts by their regulators. It endorses the view that prudential supervisors and regulators should promote the development of more risk-sensitive approaches to capital adequacy. In addition, the study recommend that regulators should have expanded risk assessment powers related to the unregulated affiliates of securities broker-dealers and futures commission merchants. Finally, it reaffirms support for the President's Working Group's legislative proposal on financial contract netting upon insolvency.
The Report recognizes the need for international cooperation among regulators to encourage the adoption and implementation of international standards governing hedge funds and credit exposure to them.
The President's Working Group also agreed that if these measures prove to be inadequate, serious consideration should be given to the direct regulation of hedge funds and other highly leveraged institutions, including such measures as capital requirements. In addition, direct regulation of derivatives dealers should be considered and indeed is currently being studied by the President's Working Group in the context of its ongoing study on the over-the-counter derivatives market.
Page 22 PREV PAGE TOP OF DOC
These recommendations, in my view, represent a significant contribution to the effort to reduce the dangerous risks to the financial markets and the economy demonstrated by Long-Term Capital Management. The Commodity Futures Trading Commission and the other agencies represented on the President's Working Group will be taking steps promptly to implement the recommendations to the extent that they can do so without legislation. To the extent that congressional implementation of the recommendations is necessary, I commend them to this committee and to the Congress.
I would be very happy to answer any questions you may have. Thank you.
Chairman LEACH. Thank you, Ms. Born.
Ms. Nazareth.
STATEMENT OF ANNETTE L. NAZARETH, DIRECTOR, DIVISION OF MARKET REGULATION, SECURITIES AND EXCHANGE COMMISSION
Ms. NAZARETH. Good morning, Chairman Leach.
Chairman LEACH. If I could interrupt you. If you could pull the mike a little closer, I think it would be helpful.
Ms. NAZARETH. Good morning, Chairman Leach, Ranking Member LaFalce and Members of the committee. I am pleased to appear today to testify on behalf of the Securities and Exchange Commission concerning the Working Group's findings on hedge funds and leverage in the wake of the near collapse of Long-Term Capital Management.
Page 23 PREV PAGE TOP OF DOC
First, I want to commend my colleagues on the Working Group. Although I only recently became the Director of the SEC's Division of Market Regulation, I can already appreciate the high level of professionalism and cooperation of the Working Group members, and I look forward to working with them and with this committee throughout my tenure.
The SEC supports the Working Group's recommendations. I believe that the recommendations in the Report represent a balanced approach that addresses the problems highlighted by LTCM without running the risk of driving hedge funds offshore. After careful study, the Working Group concluded that the lessons to be learned from LTCM should focus on the risks posed by the use of excessive leverage, not just by hedge funds, but by all large, significantly leveraged financial institutions.
As a preliminary matter, it is worth noting that some broker-dealers use significant leverage in carrying out their investment strategies. Unlike hedge funds, however, broker-dealers are required to maintain a capital cushion to help ensure that they have adequate resources to meet their obligations as they come due. Throughout the LTCM crisis, this cushion proved to be more than adequate to safeguard U.S. broker-dealers.
I would like now to briefly discuss the Working Group proposals that directly impact the SEC. Earlier in this hearing, you heard about the breakdown in market discipline among financial institutions that extended credit to hedge funds. While no securities firm was at risk of failing, securities firms did not consistently adhere to prudent standards, and at times, to their own written policies in their dealings with hedge funds. Moreover, some securities firms did not adequately stress test their exposures to hedge funds, leading them to underestimate their level of risk exposure. During the third quarter of 1998, statistical measurements of potential exposure became less relevant as market volatility increased beyond the historical levels incorporated into the risk models.
Page 24 PREV PAGE TOP OF DOC
In the wake of LTCM's difficulties, the major securities firms are attempting to improve their risk models and procedures and we have conducted examinations of the largest firms and intend to issue reports to each firm, recommending further improvements that we believe are necessary. But more can and should be done. At Chairman Levitt's request, several large firms formed the Counterparty Risk Management Policy Group to develop a set of best practices to guide firms in formulating their risk management procedures. As you know, the Working Group recommended a number of improvements to firms' risk management procedures. We will be working with individual firms directly and with industry groups such as the Policy Group to encourage financial institutions to make these important improvements to their procedures and to make them part of their corporate cultures.
From the SEC's perspective, the second key issue highlighted by the LTCM crisis was the need for better information on the activity of unregulated holding companies and affiliates of broker-dealers with hedge funds. Although we received comprehensive information about broker-dealers' direct exposures to hedge funds, the data we received about the exposures to their unregulated affiliates is more limited. As responsible regulators, we should have available more comprehensive information about the potential risks that may be incurred by the firms we regulate. For this reason, the SEC, Treasury, and the CFTC recommended that Congress enact legislation that would provide the agencies with expanded risk assessment authority to obtain more information about the affiliates of broker-dealers.
For example, the information we hope to obtain from this new authority should help us determine whether turmoil in a particular market or sector is likely to have a negative impact on an individual firm or group of firms. The proposal would also give the SEC the examination authority that is necessary to ensure the information reported is both accurate and complete.
Page 25 PREV PAGE TOP OF DOC
We also learned from LTCM that more public information about hedge funds and other highly leveraged entities, including public companies' exposures to these entities, should be made available. As a result, the Working Group proposed that all public companies, including financial institutions, be required to publicly disclose a summary of their direct material exposures to significantly leveraged institutions, including hedge funds. This disclosure, which would be included in the periodic reports, public companies that already file with the SEC should help impose private market discipline on those companies. This, in turn, could indirectly curb potentially risky exposures of unregulated entities such as hedge funds that borrow from or trade with those companies.
Finally, the Working Group recommended that Congress enact legislation to require hedge funds to disclose certain financial information to regulators and to the public. This information could be provided quarterly and could include more meaningful and comprehensive measures of market risk such as value at risk or stress test results. It would not, however, include proprietary information on strategies or positions.
I have heard this proposal called ''top-down disclosure'' because it would not require hedge funds to tell the public the details of their trading activities. Rather, it would require them to disclose how much risk they are assuming in their strategies.
In sum, I believe the Working Group's proposals are a measured, reasonable response to the issues raised by the LTCM episode. Thank you.
Chairman LEACH. Thank you very much, Ms. Nazareth.
Page 26 PREV PAGE TOP OF DOC
Mr. Parkinson.
STATEMENT OF PATRICK M. PARKINSON, ASSOCIATE DIRECTOR, DIVISION OF RESEARCH AND STATISTICS, BOARD OF GOVERNORS, FEDERAL RESERVE SYSTEM
Mr. PARKINSON. Thank you, Mr. Chairman. I am pleased to appear before this committee to discuss the Working Group's Report. Under Secretary Gensler has made a comprehensive presentation of the Report's conclusions and recommendations. Chairman Greenspan participated actively in the Working Group's discussions and supports the contents of the Report. My remarks this morning will be limited to highlighting a few key findings.
The Working Group has concluded that the central public policy issue raised by the LTCM episode is excessive leverage. Well, LTCM is a hedge fund. Excessive leverage is neither characteristic of, nor necessarily limited to, hedge funds. Available data indicate that no other hedge fund was or is as large as LTCM and no other large hedge fund was or is so highly leveraged.
Many financial institutions, including some banks and securities firms, are far larger than LTCM, and are significantly leveraged, although, to be sure, none proved nearly so vulnerable as LTCM to the extraordinary market conditions that emerged last August.
In our market-based economy, the discipline provided by creditors and counterparties is the primary mechanism that regulates firms' leverage. If a firm seeks to achieve greater leverage, its creditors and counterparties will ordinarily respond by increasing the cost or reducing the availability of credit to the firm. The rising cost or reduced availability of funds provides a powerful economic incentive for firms to restrain their risk-taking.
Page 27 PREV PAGE TOP OF DOC
The Working Group's recommendations are intended to make market discipline more effective by improving risk management practices and by increasing the availability of information on the risk profiles of hedge funds and their creditors. The Working Group has not recommended steps such as direct Government regulation of hedge funds that might risk significantly weakening market discipline by creating or exacerbating moral hazard.
The primary responsibility for addressing the weaknesses in risk management practices that were evident in the LTCM episode rests with the private financial institutions whose credit and clearing services are critical to the establishment of leveraged trading positions. Nonetheless, prudential supervisors and regulators have a responsibility to help to ensure that the processes that banks and securities firms utilize to manage risk are commensurate with the size and complexity of their portfolios and responsive to changes in financial market conditions.
Since the LTCM episode, both private financial institutions and prudential supervisors and regulators have taken steps to strengthen risk management practices. Banks and securities firms have demanded more information and tightened their credit terms, especially vis-a-vis highly leveraged institutions. Supervisors and regulators have sought to lock in this progress by issuing guidance on sound practices.
That said, further improvements in risk management practices can and should be made, and, as was demonstrated so clearly by the Group of Thirty's 1993 work on risk management, shared private sector initiatives can be extremely effective in fostering progress. The International Swaps and Derivatives Association already, in the wake of LTCM, has issued a review of collateral management practices that sets out recommendations for improvements. And in January, twelve major internationally active banks and securities firms formed the Counterparty Risk Management Policy Group, with the broader objective of promoting enhanced best practices, not only in collateral, but in counterparty credit and in market risk management generally.
Page 28 PREV PAGE TOP OF DOC
Supervisors and regulators undoubtedly will study these reports carefully and, where appropriate, incorporate their findings and supervisory guidance, as they did with the findings of the Group of Thirty's earlier report.
Improving the quality of information on the risk profiles of hedge funds and other highly leveraged institutions is particularly challenging because the liquidity of markets allows them to alter their risk profiles significantly within days or even hours. One of the most difficult or important issues to be addressed by the Counterparty Risk Management Group involves the exchange of information between creditors and their counterparties. The challenge is to develop meaningful measures of risk that could be exchanged frequently, perhaps weekly or even daily, without revealing proprietary information on strategies or positions. The need for timely information for rapidly changing risk profiles means that counterparties cannot expect to rely on public disclosure mechanisms to meet their requirements. Nonetheless, new public exposure requirements for both hedge funds and public companies could also contribute to the goal of strengthening market discipline.
With respect to hedge funds, the Working Group has recommended that more frequent and more meaningful information be made public. So hedge funds, as you know, already are required to report certain financial information to the CFTC. Quarterly release to the public of enhanced information on a broader group of hedge funds, not limited to those that trade futures, would help form public opinion about the role of hedge funds in our financial system. It would also make clear that public disclosure, not prudential oversight, is the objective of any reporting requirements.
Page 29 PREV PAGE TOP OF DOC
In the case of public companies, including financial institutions, the Working Group recommends that they publicly disclose additional information about their material financial exposures to significantly leveraged institutions. The precise nature of any new disclosure requirements would be determined by the SEC, taking into account public comments through the normal rulemaking process, and we certainly intend to support and assist in that process.
Thank you. I would be pleased to answer any questions you might have.
Chairman LEACH. Thank you very much, Mr. Parkinson. Let me say as Chair I have a large number of questions, but I would like to stick today very precisely to the five-minute rule, and we may have a second round.
I want to begin with three questions. First, I was very surprised that in the Working Group Report that there was no strong assertion that public bailouts are unacceptable and that taxpayer resources should not be used ever in bailing out hedge funds, and that public monies shouldn't be used to protect speculators from losing wagers.
Second, I will tell you I have a great deal of concern at the notion of a so-called ''emergency circumstance'' being used as a rationale for creating an antitrust outreach. Isn't it true that putting fourteen of the biggest commercial investment banks together to own the largest hedge fund is an antitrust collusion that the Department of Justice must review? And frankly, hasn't it created a worse situation than existed just prior to the bailout, a much more difficult situation in a competitive sense?
Page 30 PREV PAGE TOP OF DOC
Third, I am very worried about a precedent that has gotten almost no review, and that is that this Fed-led, Treasury-endorsed bailout of Long-Term Capital Management had the effect of putting the United States Government in collusion with a group of private parties against a private party alternative bid, and that is the only rationalization for Government action, was that there was no private alternative on the table. But there was, and a very credible one and one that was every bit as secure as the one that was put together by the Government.
So what you have is a circumstance in which the Government has intervened against private market forces and has chosen sides. That is something that I think all of us should be very concerned about.
Well, let me just begin first with the issue of the question of shouldn't there ever be taxpayer bailouts of hedge funds.
Mr. Parkinson, what does the Fed think?
Mr. PARKINSON. First, we think it is important to remember that there was no Government bailout of LTCM, that as President McDonough testified before your committee in October, there were no Federal funds put at risk, no promises were made by the Federal Reserve, and no individual firms were pressured to participate.
Chairman LEACH. But do you want to make a commitment on this in the future?
Page 31 PREV PAGE TOP OF DOC
Mr. PARKINSON. Well, I think we would want to remind you that under current law and regulation, the Federal Reserve is already quite constrained in terms of potential lending to nondepository institutions. For the Federal Reserve to make such a loan, the Board would have to determine, first, that there were unusual and exigent circumstances; second, that credit is not available elsewhere; and third, that a failure to lend would hurt the economy. Moreover, unless the loan is collateralized by Treasury and agency securities, and it is doubtful a market participant in those circumstances would have any such left for liquidity, the Federal Reserve Act requires the affirmative vote of at least five members of the Board of Governors. This authority in fact has not been used since the 1930's. And it is our view that this law creates some very high hurdles that would have to be cleared before the Federal Reserve.
Chairman LEACH. So you are giving a high hurdle, but not a ''never'' response.
With regard to the antitrust issue, let me turn to Ms. Born as an attorney at the table. Does this strike you as something the antitrust authorities should be looking at?
Ms. BORN. I think it is appropriate for the Antitrust Division or the Federal Trade Commission to look at the issues. I don't want to opine on them because I, number one, am no antitrust expert; and second, have not examined the consortium from that point of view because that is not part of our statutory mandate.
Chairman LEACH. Finally, let me just ask all of you at the table, do you find anything troubling about the United States Government taking sides in an ownership circumstance? Does that trouble you, Mr. Parkinson?
Page 32 PREV PAGE TOP OF DOC
Well, let me turn to Mr. Gensler. The Treasury ought to be a part of this, since you were part of it. Does that trouble you, sir?
Mr. GENSLER. I think, Chairman Leach, as Pat Parkinson and the Fed have said, that there were no public monies involved here, and while the events of the fall have receded somewhat from memory, it was a very challenging time in the markets. And what the New York Fed facilitated in bringing those fourteen groups together, if I can use a phrase, it was like a prepackaged bankruptcy, I think that there would have been absolutely no tears shed if Long-Term Capital Management went out of business or lost money.
Chairman LEACH. But there was exact, in fact a slightly stronger financial package presented by Warren Buffett for which the Fed and the Treasury had the—effectively speaking, work with a counter package on. Does that trouble you?
Mr. GENSLER. Mr. Chairman, actually, I think that we all learned afterwards more about that. Certainly at Treasury, we learned more about that after that week. At the time we didn't participate directly in those, the dialogue and the conversations, and it was a focus on the systemic risk at the time.
Chairman LEACH. Very briefly, Mr. Parkinson, would you want to respond?
Mr. PARKINSON. I think our view is we certainly should not take sides, but we do not feel we did so in that matter. My recollection of the chronology of events on the day in question is that when the group of firms that were at the New York Fed became aware of the Buffett offer, their meeting was adjourned. It was only reconvened when Mr. Meriwether informed the group that he did not have the legal authority to accept the Buffett deal, so the Buffett deal was then effectively off the table.
Page 33 PREV PAGE TOP OF DOC
Chairman LEACH. Fair enough. Did the Fed look at this as a serious statement of Mr. Meriwether? I mean the notion that a head of an institution can accept one offer, but not another, wouldn't you call that bluffing?
Mr. PARKINSON. Well, I think the problem was that——
Chairman LEACH. That he preferred the one offer because he had maintained ownership in the new structure and he would have lost ownership in the other structure, and the United States Government chose sides. My time has expired.
Mr. LaFalce.
Mr. LAFALCE. Thank you, Mr. Chairman.
To what extent have hedge funds emerged as a new type of investment vehicle? Do we have any trends? Do we have any data? To what extent are more and more ordinary citizens able to participate in hedge funds as opposed to super millionaires?
Mr. GENSLER. I would say that they are more prominent in the 1990's, but they have their antecedent back to the early 1950's when the first hedge funds were founded.
Mr. LAFALCE. Give me a sense of the magnitude of their growth perhaps within the past half-dozen years or so. Anybody?
Page 34 PREV PAGE TOP OF DOC
Mr. PARKINSON. I think other than to say it has been very rapid indeed, I don't think——
Mr. LAFALCE. OK. Well, see if you can flush that out in writing for me. I would appreciate that.
Mr. LAFALCE. Congressman Neal of Massachusetts has introduced a bill to curtail the ability of hedge funds to convert ordinary income and short-term capital gains into long-term capital gains. Does Treasury have a position on that? Do the others have a position on that?
Mr. GENSLER. Congressman LaFalce, I don't know that I am familiar with that particular legislation, but the Administration did provide in their proposals earlier this year and in the Taxes Green Book, as it is called, proposals to address the attempt through derivatives to take short-term gains and turn it into long-term gains, and that proposal we think is worthy for consideration of Congress in moving forward on.
Mr. LAFALCE. Do any of the others wish to comment on that issue? No. We will go on.
Do any of you have any comments as to who should be able to own hedge funds? The Securities Investment Promotion Act of 1996 increased the potential number of partners in the hedge funds by creating two categories of possible partners. There used to be a limit to 99 persons, and now with the creation of not only a qualified, but a super qualified investor, it is virtually, as I understand it, limitless. This can mean a pretty big membership. With the increase in the capitalization of the markets, you have an awful lot of individuals who could become eligible. We might develop a parallel banking system.
Page 35 PREV PAGE TOP OF DOC
Any thoughts on this?
Ms. BORN. Well, to the extent that a hedge fund invests in futures contracts or option contracts on a futures exchange, they do become commodity pools under our statute, and investors, even though they are very wealthy, are entitled under our rules to certain investor protections. Fraud is forbidden, as is stealing the investor's money, and we have a lot of cases involving fraud by commodity pool operators and conversion of investor funds. We require risk disclosure statements to be provided to investors and potential investors, including the history of a performance of the fund. We require audited financial statements and quarterly assets, and I think that is very useful.
Mr. LAFALCE. Thank you. We know that the five largest commercial bank holding companies have an average leverage ratio of nearly 14–to–1; the five largest investment banks average leverage ratio, 27–to–1; and LTCM's was 28–to–1 at the end of 1997.
On a scale of one to three, one being the most serious, taking into consideration not just the leverage but the magnitude of the funds, what should we be most concerned about—the hedge funds, the investment banks, or these largest commercial bank holding companies?
Ms. BORN. Well, the commercial banks are rather closely supervised, I believe. The hedge funds are not, and aspects of investment banks that have the highest leverage and pose the greatest risk are frequently not regulated. I am worried about any large financial services entity in the markets with extremely high leverage, extremely high positions, and particularly about those with extremely high over-the-counter derivatives positions, which LTCM of course had.
Page 36 PREV PAGE TOP OF DOC
Mr. LAFALCE. Ms. Nazareth, you have some responsibility for these investment banks, especially the five that have an average leverage 27–to–1 ratio. To what extent are they involved in derivatives and to what extent that they give you concerns that might be similar to the concerns we should have had before the difficulties of LTCM?
Ms. NAZARETH. Well, certainly it is true that the derivatives activities of these investment banks are primarily conducted in offshore derivatives subsidiaries. The activity is not conducted in the registered broker-dealer. We do, as you know, get some voluntary reporting through the Derivatives Policy Group, but with the Working Group——
Mr. LAFALCE. Only voluntary, you do not have the legal capacity to require that?
Ms. NAZARETH. Only voluntary, that is correct, that is right. Obviously what the Working Group's proposals here would do would be to really enhance our ability to see, to basically get a window into what the risk is throughout the enterprise, including what the credit risks are, a better idea of what the credit risks are with respect to the derivatives activities through the enhanced risk assessment that is called for in this Report.
Mr. LAFALCE. What is the magnitude of the notional amount of hedge funds that have an average 28–to–1 in comparison say with the five investment banks which are 27–to–1?
Ms. NAZARETH. I don't know how to compare those two numbers. I think when you look at the—it is important to note that when you look at the 27–to–1 numbers that are cited with respect to the broker-dealers, that is a very different analysis, because the broker-dealers are highly regulated, they are subject to—there are very strict net capital rules and the high leverage in the broker-dealer entities is primarily through a different kind of leverage. It is because of things like matched book repurchase transactions.
Page 37 PREV PAGE TOP OF DOC
Mr. LAFALCE. So you have nothing to compare the 27 to 28? Is it apples and oranges?
Ms. NAZARETH. It is a bit of apples and oranges.
Mr. LAFALCE. I think it is imperative that you flesh that out for us in considerable detail. That would be not only helpful, but necessary. Thank you. My time has expired.
Chairman LEACH. Thank you. We have a vote on the floor, and I think maybe at this point it would be wise to recess. So the hearing will be in recess pending the vote.
[Recess.]
Chairman LEACH. The hearing will reconvene.
Mr. Baker.
Mr. BAKER. Thank you, Mr. Chairman.
Mr. Parkinson, I was interested in your comments with regard to the institutions referenced on page 29 of the Report, particularly those investment banks, which indicate they have leverage ratios similar to that of LTCM, asset size exceedingly larger than LTCM, and your observation that circumstances surrounding their practices would appear to separate them from the likely direction of an LTCM cataclysm.
Page 38 PREV PAGE TOP OF DOC
Is it your view that you can assure the committee today that from your observations of the actions of these particular institutions, that there is little risk of failure?
Mr. PARKINSON. I would be happy to address the question of commercial banks, but I think Ms. Nazareth ought to address the other part.
Ms. NAZARETH. Yes. As I was saying earlier, I think that a large part of that leverage, that high leverage number for investment banks is indicative of certain activities that have the impact of ballooning their balance sheets, and therefore, resulting in a higher leverage number, but it is not activity that you need to worry about from the standpoint of——
Mr. BAKER. Let me interrupt if I may, since we are running a narrow time slot today. I think, and this is my observation, the excessive concentration on leverage questions really are missing the primary issue. You can be extraordinarily well leveraged, as long as the risk distribution is appropriate for the activities you are engaged in.
Ms. NAZARETH. That is right.
Mr. BAKER. Can you tell me, for example, LTCM was diversified globally, but not diversified with strategy. Do any of these institutions have strategy diversification? Do we know that?
Page 39 PREV PAGE TOP OF DOC
Ms. NAZARETH. Yes. I think we would know for the broker-dealers; we would have a better sense of strategy diversification. Are activities such as oversight of matched book repurchase transactions fully collateralized by U.S. Government securities? We know that, that that is the activity that is contributing to the high number in the broker-dealer entities, and that is not something that we have a——
Mr. BAKER. Is it common practice, or do a significant number of these institutions rely on variation margins to assess credit risk? Do we know that, as LTCM did?
Ms. NAZARETH. No.
Mr. BAKER. Because one of the conclusions of the Report was we need enhanced credit risk management tools, but if we go to page 15, I believe, of the Report, although it is somewhat better outlined—wrong page number—it is better outlined in the recommendations, the general consensus of the Working Group is that private industry uses a variation of credit risk management tools, and we ought to encourage that. There is not really a specific risk management recommendation. There is a disclosure recommendation, there is a contract netting recommendation, there is a bankruptcy recommendation, but there is not a recommendation for a congressionally prescribed risk management assessment. Is that correct?
Ms. NAZARETH. That is right. What we are hoping to get is an expanded risk assessment authority so that we can view what the activities are. We are not specifically prescribing what the risk management policies would be, and we are looking to private sector initiative.
Page 40 PREV PAGE TOP OF DOC
Mr. BAKER. Well, isn't the problem with LTCM in one regard that internal management was really the only control governing decision in risk-taking and that the consequence of that recommendation would be really to rely on private industry to adopt more proficient risk management tools?
Ms. NAZARETH. Yes. Part of it is that there should be greater transparency systemwide with respect to both the public and counterparties and the regulators having a better sense of what the risk is.
Mr. BAKER. Let me return to the earlier question that I directed to Mr. Parkinson.
Given your knowledge of the institutions cited on page 29, are you in a position to say the likelihood of a cataclysmic event is much less lower than that for LTCM, or do you have any concerns about their prospects?
Ms. NAZARETH. I think that we have a sense that they are at far less risk than the LTCM entities.
Mr. BAKER. Mr. Gensler, if I may follow on to that question to you, earlier I asked in another meeting what was your view with regard to the institutions' condition, and your response was not exactly on the same track. Would you again give me your assessment of the financial condition and assure the committee that there is no likelihood of another LTCM on the horizon?
Page 41 PREV PAGE TOP OF DOC
Mr. GENSLER. Congressman, with regard to the major securities firms, their business is more diversified than that of Long-Term Capital. Their funding sources are more diversified than Long-Term Capital. I would also say they benefit from more market and regulatory discipline.
Mr. BAKER. But as the Report indicates, they have higher fixed operating costs and more illiquid assets. That tends to offset some of that advantage, does it not?
Mr. GENSLER. It may offset some of that advantage in the midst of a downturn, but they also have advantages from regulatory structures, some of which are represented at this table, and by creditors and the public, and I think the thrust of the Report is to have more public disclosure of hedge funds which will help put back some pressure on the hedge fund community, as all the major investment banks have from the public markets and from rating agencies.
Mr. BAKER. Thank you.
Mr. Chairman, I have exceeded my time, but I, like you, have a few more later.
Chairman LEACH. Mr. Vento.
Mr. VENTO. Well, thanks, Mr. Chairman. I may just say with regards to your comments, Mr. Chairman, about the role of the Federal Reserve Board, I think that the response was understated of the actual role of the Federal Reserve Board. Because obviously, just by convening that meeting, and I, Mr. Parkinson and the witnesses don't disagree that the Fed should have played a role. I think it is the way you conduct yourself, but to suggest that when you convene this type of gathering and you are dealing with institutions that you regulate and you are one of the principal regulators in the Nation, to suggest that that does not then have some sort of impact, indirect assistance in some way is I think not fully an admission of what the role is.
Page 42 PREV PAGE TOP OF DOC
I don't know that it is wrong. The concern I have is as I look at these particular provisions, and it seems to me that they are pretty timid, and that there is an awful lot of authority that exists with the regulators if they choose to regulate. It always seems to me that we are trying to solve the last problem and not really looking to the future in terms of where these might go. I am like you, I can't foresee what is going to happen. But we do know that there has been a tremendous growth in terms of derivatives, a way of providing more leverage, more liquidity, with a smaller amount of capital.
So the issue here is that banks have become sort of one of the sources, at least we ought to be concerned about that, because they carry the moral hazard, the deposit insurance, and other factors that we regulate. I guess to some extent by even suggesting that we are going to give the authority to the SEC, more authority, which you are seeking here, that then would suggest that we would, in fact, have some greater control over it.
So I mean there is a concern here with regards to the banks, Mr. Gensler, if, in fact, we changed the—as is implied in this Report that there be a capital change, that more capital is required against these types of loans that are made to derivatives, what is that going to do with the banks' role in terms of this lending practice?
Mr. GENSLER. Congressman, the recommendation is that capital standards take into consideration the risk of the loans or the derivatives, and that they not have a bias that encourages activity one way or the other.
Mr. VENTO. Don't you think that the result would be that more capital would be required, that you are going to have to say that in doing your diligence against those particular types of activities, extensions of credit, that there is more uncertainty that you are going to have then? Isn't the end result going to be—I mean you could say a more precise amount of capital, but maybe less? Do you think it will be less capital?
Page 43 PREV PAGE TOP OF DOC
Mr. GENSLER. It may well be that it is more, but as we are in the midst of negotiations with our international colleagues around the Basle Accord, it is not yet clear how those negotiations will come out. I think that the thrust of our Report is that the capital standards shouldn't have in them a bias toward derivatives or toward cash loans if there are identical or similar risks, and that right now there are some instances where there are biases that would encourage one activity over another, and that seems to be inappropriate to the Working Group.
Mr. VENTO. How would you explain the line of credit that is given by financial institutions, financial depository institutions in this country today? Isn't it basically a line of credit in which there is not a static circumstance with regards to the derivatives? How would you explain the existing lending practices today?
Mr. GENSLER. I don't know whether I should defer to the bank regulator.
Mr. VENTO. Well, you can defer to the Fed if you would like. That is fine.
Mr. GENSLER. Just because it is a specific question about the line of credit.
Mr. PARKINSON. Right. Well, I think that banks are quite conscious that when they enter into a derivatives transaction with a counterparty, they are assuming a counterparty exposure, and moreover, that the size of that exposure can increase in the future if the value of that contract moves further into the money, as market rates change. And because one doesn't have a crystal ball with respect to the future, one cannot know with certainty just how large that exposure is going to be.
Page 44 PREV PAGE TOP OF DOC
This raises the whole issue that has gotten a lot of attention, particularly in the Basle Supervisors' report, of estimating potential future credit exposure. In other words, how much into the money these contracts can move.
Mr. VENTO. Well, we have a little bit of familiarity in talking about stress tests and other things here with some of the regulators, but I mean the issue is that it is a very volatile type of circumstance and the end result of this particular recommendation I assume would be whether it goes through Basle or wherever it comes down from, there is going to be more capital that will be set aside. This would in essence then curtail the activities of financial institution depositories or others having a moral hazard issue.
Mr. PARKINSON. Let me try to clarify. I think Gary noted that there are some instances in which derivatives to credit exposures are treated differently than credit exposures on loans. I think there is only one instance in which that is true, and that is that in terms of the risk weight assigned or the capital requirements assigned to derivatives credit exposures, it is a maximum 4 percent, not 8 percent.
Now, the rationale for that when that was adopted was that counterparties on derivatives contracts with banks tend to be—tended then and still tend today to be—of much higher average credit quality than their business loan customers. And there was a fear that if we put the 8 percent capital requirement on it, it would deter them from doing derivatives business with say triple A-rated counterparties, just as the 8 percent has made it very difficult for them to lend to triple A-rated corporations. But I think that that is not a satisfactory set of affairs in that by the same token, if they have a derivatives contract with a single B-rated corporation, it would still only have 4 percent capital, and that is probably not enough.
Page 45 PREV PAGE TOP OF DOC
The overall effort involved with respect to credit risk is to come up with some way of essentially making finer distinctions among the credit riskiness of various classes of borrowers. So, for example, you would explicitly take into account whether it is a triple A-type credit or a single B-type credit. Once you have succeeded in doing that one way or the another, whether it is through using external ratings or internal ratings, and that is a difficult set of issues, then there would certainly no longer be any rationale for treating derivatives contracts any different than loans, and that one remaining difference would go away. I don't want to suggest—I think some people think there are no capital requirements applying to derivatives.
Mr. VENTO. Oh, no. But I mean the implication here I think is that they would be more stringent than what they are.
Mr. PARKINSON. I think what you are referring to really is a question of the risk weight being applied to highly leveraged entities, and what I understand the Basle Committee is contemplating is essentially imposing a minimum capital requirement in excess of the existing maximum of 8 percent on credit exposures to some class of highly-leveraged institutions. Now, I think the trick there will be defining highly-leveraged institutions.
Mr. VENTO. Who is going to do that? Is it going to be the Fed, the SEC? Who is going to do it?
Mr. PARKINSON. In Basle, that is the Basle Committee on Banking.
Page 46 PREV PAGE TOP OF DOC
Mr. VENTO. I know that.
Mr. PARKINSON. The trick there is recognizing, and I think the point has been made several times over the course of the morning that hedge funds are extremely diverse. In part because they are not regulated, you don't have the uniformity in terms of their investment strategies and practices, and many hedge funds in fact are not highly leveraged at all. Many hedge funds aren't necessarily high risk.
So the trick will be defining that in a sensible way that doesn't tar all of the hedge funds with the same brush that perhaps LTCM and other highly leveraged hedge funds should indeed be tarred with. So it is a complicated set of issues, but it is being taken very seriously, and the Basle committee, under President McDonough of the New York Fed's chairmanship, intends to address those issues.
Mr. VENTO. Mr. Chairman, thank you.
Chairman LEACH. Mrs. Roukema.
Mrs. ROUKEMA. Thank you, Mr. Chairman. I do want to note your reference in your early remarks, in the questioning about antitrust questions, and I had raised that same subject in a meeting in my office with one of the private groups. I share your concern, and I am anxious for that answer as well with respect to Justice Department review.
But my question is to Mr. Gensler and Ms. Nazareth.
Page 47 PREV PAGE TOP OF DOC
The Working Group recommends that the SEC, through regulatory means, require public companies to disclose their financial exposure to the significantly leveraged entities. My question is, given the problem with the potential for systemic risk, which is very serious and obviously was very serious, otherwise the Fed wouldn't have taken the action they did, should this not have a statutory requirement as opposed to just regulatory? Would you explain your thinking on that matter, Mr. Gensler? And I would like to have Ms. Nazareth's response as well.
Mr. GENSLER. Thank you, Congresswoman. We think this will help if the public markets and all investors understood some of the risks that these large entities are taking, and the interconnected nature between these entities.
As the SEC I believe has statutory authority to promulgate these rules, and we probed into this, we felt the next step was then, therefore, for them to promulgate the rules, they having already the statutory authority to do so. But we think this is important, and there was no diminution of its importance by suggesting that a rule be put forward.
Ms. NAZARETH. I agree with that answer.
Mrs. ROUKEMA. Well, then why hasn't a rule been proposed already, or has it?
Ms. NAZARETH. No. Obviously one of the Working Group's recommendations, and we will posthaste engage in a rulemaking process in consultation with the other agencies and taking into account public comment. I think as Chairman Leach said earlier, in some of these things the devil is in the details, but we will come to some conclusion as to how to best define highly leveraged entities and material exposures and come up with a rule that hopefully will address this issue appropriately.
Page 48 PREV PAGE TOP OF DOC
Mrs. ROUKEMA. But you are saying without equivocation that you have complete statutory authority to require such public disclosures?
Ms. NAZARETH. Yes.
Mrs. ROUKEMA. Well, it is unfortunate that that hadn't been noted earlier.
The second question for Ms. Born, in the LTCM situation. The CFTC, I understand, did not find out about the problem until they received a phone call from the Treasury. Do I understand that correctly? We also understand that there had been information passed on to you earlier with respect to the leverage ratio, but that it had not been communicated to the securities and banking regulators. Apparently the Commodity Exchange Act prohibits sharing, is that correct, unless the CFTC requires or receives a specific request from another regulator? So the logical question here is, do we need legislation to correct that kind of gap in information and proper conveyance of information? Because this is central to our problem, evidently.
Ms. BORN. I don't think we need legislation for that. We are currently looking at——
Mrs. ROUKEMA. No, I am going to interrupt you. How can you state—can you explain the breakdown in communication that exists under current law and now you are saying there is no need? Are you suggesting that people have just been irresponsible in their performance of their jobs or what? What is the answer?
Page 49 PREV PAGE TOP OF DOC
Ms. BORN. I don't think there was any breakdown in communication. The information we had was for year-end December 1997. It do not include the relevant information——
Mrs. ROUKEMA. Well, then how do we get relevant information in a timely way?
Ms. BORN. Well, that is why the recommendation of the Working Group is that there should be quarterly rather than annual reports, and they should be published to the public because not only the regulators need them.
The CFTC shares information with other Federal regulators whenever we believe that there is a need to share. We certainly always do, upon request. If we haven't received a request and we think that we have information significant to another regulator, we suggest that they make a request, and then share the information.
Mrs. ROUKEMA. Well, why would you oppose requiring the sharing of that information under the law?
Ms. BORN. Well, what we are proposing in the Working Group recommendations is that the information should be shared not merely among regulators, but with the public at large, and we are endorsing that recommendation.
Mrs. ROUKEMA. All right. Well, the way we read it, we will have to go over this together. In other words, we are saying we have the same goals in mind here, but that you believe that the legislation is required under—that I am speaking of would be required under the Report?
Page 50 PREV PAGE TOP OF DOC
Ms. BORN. Under the recommendations of the President's Working Group, all this information would be made public on a quarterly basis.
Mrs. ROUKEMA. Well, I am not quite sure that we are speaking about the same thing, but we will go over this in detail at a later time and have follow-up communication.
Ms. BORN. Just so you know exactly where this is, this is dealt with on the bottom of page 32 and the top of page 33, where the Working Group is recommending that the CPO annual reports filed with the CFTC should be expanded in terms of the information they provide and should be provided on a quarterly basis rather than annually, and should be published by the CFTC, all of which we endorse.
Mrs. ROUKEMA. We will go over that, and if there seem to be loopholes there compared to in terms of what I had in mind, we will get back to you. Thank you very much.
Ms. BORN. Very good. Thank you.
Chairman LEACH. Thank you, Mrs. Roukema.
Mr. Bentsen.
Mr. BENTSEN. Thank you, Mr. Chairman.
Page 51 PREV PAGE TOP OF DOC
First of all, I want to partially associate myself with the remarks of the Chairman with respect to this Fed-led bailout. While it was not a taxpayer bailout, it was certainly a Government-organized bailout, and it does raise a lot of concerns, and I think the Chairman is correct to highlight it, and it is a glaring omission I think from your Report.
Second of all, and, Ms. Born, Mrs. Roukema was just raising this point, in the recommendations under the disclosure in reporting where you recommend that hedge funds which are not currently registered as CPOs, that you would then propose that all hedge funds be treated in that way and be required to publish basically a 10-Q, I guess, that would be available to the public. Is this—and my question is, and I don't know whether this is a good idea or not, but is this a step toward registration of hedge funds' activities, and while I believe in adequate disclosure, is this an excess amount of disclosure for what is not really a publicly traded instrument?
Ms. BORN. Well, what is being proposed here is that hedge funds—that Congress should adopt legislation that requires hedge funds that are not currently registered as CPOs, and therefore, don't report to any regulator or report publicly, to report at least quarterly to the public. The mechanism for doing so is left open. There is no suggestion that registration would be a necessary aspect of it. Certainly some identification of which hedge funds exist and would have this responsibility might be necessary.
Mr. BENTSEN. But a commodity pool operator is a more broadly—has broader participation than perhaps other hedge funds?
Page 52 PREV PAGE TOP OF DOC
Ms. BORN. No. A commodity pool operator doesn't necessarily have more participation in the U.S. markets. They do participate, however, in the futures markets. There are lots of hedge funds in the country that do not participate in the futures markets that, for example, just participate in the securities markets, and they currently are not required to report at all or to be registered with any agency.
What this is suggesting is that for those hedge funds, there should be devised a mechanism for quarterly reporting of financial information similar to the expanded information that CPOs will be required to report.
Mr. BENTSEN. In the recommendations regarding capital adequacy, as well as counterparty risk management, Mr. Parkinson, I guess what you are saying, that the Basle Committee should look at establishing a rating criteria for counterparty risk, and—because some are triple A, some may be B and some may be below investment grade, two questions. I mean is that correct, and would that become a standard that the group would ultimately recommend in the form of regulation? And the other question is in retrospect or in your opinion, how would you have rated Long-Term Capital Management in July of 1998?
Mr. PARKINSON. I think the use of public credit ratings is only one option. The problem is that currently all private corporations other than banks, or other depository institutions, whether they are triple A credits or about to go into default, are subject to the same credit risk capital requirement of 8 percent. Everyone recognizes that that is unsatisfactory, that that distorts investment decisions, that it does not provide the kind of protection we would like to provide to the bank and to the insurance fund.
Page 53 PREV PAGE TOP OF DOC
So the goal is to have a credit risk capital standard that is more sensitive to differences in credit risk. How that would be done is still under debate, and so I cited a number of possibilities. One would be simply for the regulators, as you are suggesting, to create additional risk buckets and to provide direction as to how assets should be allocated among the buckets.
The drawback to that is number one, I don't believe that we think we have the capability to be going through all of America's corporations, most of which are not publicly rated, and assigning ratings, nor is that a job we want to take on, including the job of deciding whether LTCM or any other hedge fund was top rated or middle rated or lowest rated.
The other idea would be to use public ratings, but the trouble is most companies do not have public ratings, particularly outside the United States, and within the Basle Committee there are some that feel that gives the U.S. a competitive advantage, so that is a difficult sell within Basle, at least with respect to corporations.
Finally, there are many people that I think would like to gravitate toward using the internal rating systems that banks have. At least the best managed banks, they make their own judgments as to whether a particular customer is a top quality credit or a weak credit, and in fact grade them into as many as 7, 10, 15 different risk categories. And the question is whether we could build off of that just as in the case of market risk we built off their own internal market risk models to measure risk. But there are a lot of difficulties that need to be surmounted.
In fact, a paper was released just last week that got attention in the press, and really, the question is how do we validate, make sure that a bank is accurately grading its loans. You know, clearly, if a bank were of a mind to do this, they might well rate their loans much more favorably than they deserve to be rated, and we would want mechanisms to assure ourselves that that wasn't going on, so-called validation criteria or back-testing criteria for the models. And because of the paucity of data on credit quality, that turns out to be much more difficult than it is in the case of market risk.
Page 54 PREV PAGE TOP OF DOC
So there are a lot of hurdles to be cleared here, but that is priority number one on the Basle Committee's agenda, and they are moving forward as quickly as they can to deal with these very complex issues. But earlier, if I had suggested to you that we had a specific proposal in mind that had been agreed on and was moving forward, I want to correct that impression.
Mr. BENTSEN. Thank you.
Thank you, Mr. Chairman.
Chairman LEACH. Thank you very much.
Mr. Bachus.
Mr. BACHUS. Thank you.
To the panel, I am looking at page 11, and it is actually of the preface, or it is the table of contents where you have conclusions and recommendations. It is actually in the table of contents in the front. You have eight different parts there.
Now, just looking at that, parens one, five and six would require legislation, is that right, basically?
Mr. GENSLER. Congressman, that is correct.
Page 55 PREV PAGE TOP OF DOC
Mr. BACHUS. OK. Now, number 6, Bankruptcy Code issues, you all basically endorse the Financial Contracts Netting Improvement Act, is that right? Basically, what you propose there, that to me seems to be fairly noncontroversial. Isn't there a general consensus that that needs to be done?
Mr. GENSLER. We hope so, and it certainly has gotten broad support in Congress.
Mr. BACHUS. Right. To me, that is going to be the easiest of the recommendations, of the three that need legislation.
Now, I want to direct your attention, and I would hope maybe we could mark that up or move on that in this session.
The second one, Disclosure in Reporting, my concern there is what I expressed earlier in my opening statement, would these hedge funds when they start having to have more of this type of public disclosure, will they not just move offshore? Is that a concern?
Ms. BORN. Well, I think that is one of the reasons why the President's Working Group has stressed the importance of U.S. regulators working with foreign regulators through various international organizations to arrive at international standards about hedge funds and the need for disclosure and adherence to those international standards.
Mr. BACHUS. Until that is done, it is going to be pretty hard to ask them maybe to disclose their portfolios, investment portfolios.
Page 56 PREV PAGE TOP OF DOC
Ms. BORN. Well, one of the things we do at the CFTC, and in the legislation that we implement, the Commodity Exchange Act, it requires any hedge fund that has U.S. investors to comply with the provisions of the Act, and many of these hedge funds, not all of them, but many want U.S. investment funds. Others just appeal to offshore investors in order to not fall within this legislative provision. It seems to me, though, that even those hedge funds seek European capital investment, seek Japanese investments, and so if the developed countries can come to a consensus on the need for reporting, it doesn't take a lot of us to have a significant impact on hedge fund reporting.
Mr. BACHUS. I guess there are efforts underway with the G–7 to work on that area; is that right?
Ms. BORN. Also, IOSCO, the International Organization of Securities Commissions, which we and the SEC both belong to, are looking at this, and we are urging that they adopt as an international standard the recommendations of the President's Working Group.
Mr. BACHUS. All right. Let me—the final thing, this number 5, Expanded Risk Assessment for Unregulated Affiliates of Broker-Dealers, I think that is by far the most controversial area maybe that you are proposing. My first question there, with Long-Term Capital, did you find that the practices of the banks that had contracts with Long-Term Capital were better than the practices of the affiliates of the broker-dealers? I mean were they—did the broker-dealers have a worse track record? Mr. Parkinson or Ms. Nazareth.
Page 57 PREV PAGE TOP OF DOC
Mr. PARKINSON. I am certainly not aware of any evidence that would support that kind of a statement, no.
Mr. BACHUS. Well, so it is true then that they both had about the same experience and the same—they are both—let's say the banks are federally regulated, the broker-dealers are unregulated.
Ms. NAZARETH. No, the broker-dealers are regulated.
Mr. BACHUS. Well, the affiliates are not. And the affiliates didn't have any—their experience in losses was no greater than the federally regulated banks, right?
Ms. NAZARETH. That is right.
Mr. BACHUS. Then what evidence is there that Federal oversight of these broker-dealers would improve their judgment about risk?
Ms. NAZARETH. Again, our hope is that the recommendations basically add additional discipline, because as we know, there are lots of processes that these entities could have done and even, by virtue of following their own internal procedures, should have been doing. But in the excitement of the times and the counterparties that they were dealing with, they did not follow those practices.
Mr. BACHUS. I understand that. I am just saying——
Page 58 PREV PAGE TOP OF DOC
Ms. NAZARETH. What we mention here is that the regulator here, in our case the SEC, would have a better opportunity to view the activities of the entire entity and the activities in particular where they were dealing with highly leveraged entities and be able to get a better sense of whether the consolidated entity was basically applying its own risk management policies and procedures and whether those policies and procedures were adequate.
Mr. BAKER. [Presiding.] Mr. Bachus, if we can, I hate to interrupt, because Mr. Leach was trying to keep us to a five-minute limit because we may come back for another round. Thank you, sir.
Mr. Inslee.
Mr. INSLEE. Thank you. I will ask perhaps some general questions more from a lay standpoint to try to get information to the public as much as this committee. I will just tell you, a perception I think in the public is that the hedge fund situation is one which was extremely serious to the international financial system. Number two, it might present something relatively new in the sense of that risk. Number three, that there was a public commitment of participation to solve the problem. And I guess the general question I have is the general response I have seen from the Working Group is to respond by asking for more transparency, if I can sort of characterize the response.
To me, there is a legitimate question that the public is going to ask is whether or not just more transparency is adequate to the task. The question I guess I have is, does this Working Group have the same confidence that additional transparency will create the same level of confidence, if you will, in the hedge fund industry as there is, for instance, in our banking industry? And if not, what else should or could be considered? And if not, why should we not look for a higher level of assurance when this hedge fund industry is so intricately related to our whole financial system that it would require a massive public commitment, the result of a failure like this.
Page 59 PREV PAGE TOP OF DOC
Mr. GENSLER. Congressman, the Report suggests that through public disclosure, better risk management practices, that what we wish to do is lower the systemic risk issues related to leverage, not just to the hedge funds, and while I share many of the thoughtful comments that you just suggested, I think that it is much more toward those issues of leverage and systemic risk than the confidence just in the hedge fund industry, which is not something that we really were trying to attempt to address.
Ms. BORN. The hedge fund industry is a highly speculative, or includes many highly speculative entities. We regulate a number of them that are commodity pools, and a number of commodity pools become insolvent every year because in a way, that is the nature of speculation, particularly in the futures and derivatives markets, which are a zero-sum game where everybody who profits is matched by somebody who is losing.
The Working Group did say that if the measures recommended proved not to be sufficient to stem the problems here, other actions could be considered, and we outlined what some of those actions would be, including direct regulation of hedge funds. Something that all of us were somewhat reluctant to go to as a first line of defense because of the complications of doing so.
Mr. INSLEE. And how will we know whether these measures do or do not meet the requirements? Do I assume that we will know by the next disaster, or is there some other way that we will be able to evaluate this 18 months from now or 24 months from now?
Ms. BORN. Well, I would hope that the members of the Working Group who are still actively cooperating on a number of other matters, including the OTC derivatives study, will undertake to examine the degree of leverage and financial stability of the markets over the next several years and be making an analysis of that.
Page 60 PREV PAGE TOP OF DOC
Mr. PARKINSON. If I could add to that, I think the conclusion we have reached is that LTCM was able to become so highly leveraged because its creditors and counterparties had certain weaknesses in the risk management practices. They did not constrain LTCM's leverage in the way that we would expect them to have done so. Those creditors and counterparties are nearly all regulated entities: banks, broker-dealers. The banking regulators and the SEC routinely are reviewing the risk management practices of those entities. What we will be looking for is evidence that those risk management practices have been strengthened in the way we are looking for, not only that the right policies are in place, but that they are adhering to those policies. I think it is through that mechanism that there is the greatest possible assurance that this kind of problem is not going to happen again. But I don't think anyone can assure you that we won't have another event. We can make market discipline stronger, but can we make it foolproof? No. But I think it also has to be realized that if the alternative is Government regulation, that too is not foolproof.
We have Government-regulated entities that failed in the hundreds in recent times, in the last ten years, so that there shouldn't be any illusion that the problem is solved simply by passing a law that says someone is accountable for regulating it. There are limits to what regulators can accomplish, just as there are limits to the effectiveness of market discipline.
Mr. INSLEE. When you say failing institutions, you don't mean Congress.
Mr. PARKINSON. Certainly not.
Page 61 PREV PAGE TOP OF DOC
Mr. BAKER. I was just about to rule the gentleman out of order.
Mrs. Biggert, do you have questions?
Mrs. BIGGERT. Yes, thank you, Mr. Chairman.
Mr. Parkinson, in your testimony you mentioned that the challenge of developing meaningful measures of risk that could be exchanged frequently without revealing proprietary information, and the Working Group has suggested that Congress enact legislation to require well, for example, the commodity pool operators to disclose certain financial information to regulators and the public. And then Ms. Nazareth has referred to this as—or says it has been referred to as top-down reporting that would not jeopardize proprietary information. Do you agree that this top-down reporting would adequately protect proprietary information?
Mr. PARKINSON. Well, I think it certainly can. I think the challenge is the greatest in the case of the information that is being revealed with the greatest frequency. In other words, knowing what someone's strategy was a quarter ago or a year ago may not damage their interest or deter them from engaging in the kind of risk-taking that is crucial to our financial system. But their counterparties really need data much more frequently than quarterly. I think the expectations of the supervisors are that in the case of a large institution where you have large exposures and where that institution operates in such a way that its risk profile can change very quickly, the counterparty may need to be getting information weekly or perhaps even daily. We don't want to prescribe exactly what frequency it should be, but certainly much more often than quarterly, and there I think the challenge is how does a hedge fund or any other large fund participating in the market, give its counterparties meaningful information about how risky it is without detailing its individual positions and undermining the success of its strategies.
Page 62 PREV PAGE TOP OF DOC
That is a very difficult issue, I have to admit. I certainly don't have the answer to that and I suspect nobody else in the Working Group does either. Our hope, I guess, and our expectation is that the Counterparty Risk Management Policy Group will be addressing that issue. Having said that, we still think that these public disclosure requirements, while they are not sufficient to meet the needs of the large counterparties, would play a helpful role in strengthening market discipline and increasing public understanding of just what role hedge funds play, and for that reason we support those.
Mrs. BIGGERT. Would it be correct to say then that maybe you are asking the Congress to put that into legislation?
Mr. PARKINSON. No. Again, I think that—well, in the case of the hedge fund disclosures, right now the CFTC has no authority, as I understand it, to publicly release that data, and as we discussed, we think that is important. I think the point she was making to Congresswoman Roukema was that the other agencies are part of the public, so if you get public disclosure, then you don't need to be worrying about further provisions, providing access to other regulators. And for the CFTC or any other operator of such a reporting system to make it public would require Congress to act. So we are asking for congressional action there.
Ms. BORN. Let me just say that the CFTC staff is examining whether we currently have statutory power to make it all public without legislation, in which case the CFTC is committed to enacting the appropriate rules after a public rulemaking procedure. Otherwise, if the staff determines we don't have the power to do that, then that will be part of the package of legislation that we will be requesting.
Page 63 PREV PAGE TOP OF DOC
Right now, I think the disposition of the staff is that we would have the power to enact regulations that permitted public disclosure and required public disclosure.
Mrs. BIGGERT. Was there consensus within the Working Group that this was—this top-down reporting is sufficient to protect proprietary information?
Ms. BORN. It was, I think it was the consensus that it could be designed in such a way that proprietary information is protected, and that certainly in any regulations that we intend, or that we would adopt to implement this, we would take care to protect proprietary information.
Mrs. BIGGERT. Mr. Gensler.
Mr. GENSLER. I was just going to add I think that in working with Congress on the appropriate mechanisms for public disclosure, we could appropriately address that they be important summary aggregate information, but not position-specific information.
Mrs. BIGGERT. All right. Thank you.
Thank you, Mr. Chairman.
Mr. BAKER. Mr. Vento, do you have a follow-up question?
Mr. VENTO. No.
Page 64 PREV PAGE TOP OF DOC
Mr. BAKER. I just have a couple. I am going to try them from this chair and see if it works any better.
First, I want to return to the emphasis on leverage that has been placed here this morning. At the same time we have institutions similarly leveraged in the market today for which no regulator appears to have concern. I must draw from that the conclusion that leverage in itself is not the problem, it is leverage without appropriate risk management that is the problem. Leverage simply increases the size of the calamity, it does not cause the calamity, and without credit risk management tools that enable a regulator or credit extenders to judge counterparty risk, there is the problem. And at this moment, we do not have legislation or a proposal that focuses from a congressional side, at least, on a remedy.
My understanding is that remedy would come from self-imposed remedy standards as well as regulatory encouragement to seek out the best methods of managerial risk assessment.
As to the reporting requirement, it would seem to me that anything that is timely released verges on proprietary. Anything that is not timely released and is retrospective in its view is of little value to a person trying to judge current day risk positions.
So you have an imbalance that cannot be resolved on the one hand. You, as regulators, feel you need to know what you are doing today and are you appropriately assessing your risk and strategies in order to counterbalance the risk, but the moment you release that publicly—if that is timely, you are going to describe business strategies to the world at large, which I hope we are not contemplating moving in that direction.
Page 65 PREV PAGE TOP OF DOC
Mr. Parkinson, would you care to respond?
Mr. PARKINSON. Fortunately, I don't think that the tradeoff is quite as stark as you are outlining it.
In terms of market risk, you are absolutely right. In trying to gauge how much a market risk an entity is assuming and whether it is too much relative to its capital, its capacity to absorb that risk, looking at a leverage ratio is more or less a waste of time, and can delude you or unnecessarily alarm you. But take, for example, the standard measure of value-at-risk that we now rely upon in banking regulation to assess the adequacy of capital for bearing market risk. That, to be sure, is not a perfect measure, but it is a big step in the right direction.
Mr. BAKER. The Report itself had criticisms of the value-at-risk method.
Mr. PARKINSON. Right, but we have to put that in perspective. If that were released, and that does not require the revelation of proprietary information about strategy, that would be a step in the right direction. Is there any single number, whether it is value-at-risk or something else that tells you what is the probability of having losses in excess of its capital, I am afraid that the answer is there is no such magic bullet.
Mr. BAKER. And again because hedge fund strategies and operations are so diverse, one methodology cannot possibly give accurate assessment of risk in all cases?
Page 66 PREV PAGE TOP OF DOC
Mr. PARKINSON. Even if their counterparties knew and were required to give away all of their proprietary information, my guess is that every counterparty would have a slightly different assessment of what that meant in terms of risk.
The fact of the matter is, there is no simple reliable methodology boiling down into a single number what the riskiness of a portfolio is. Particularly the kind of complex portfolios that not only hedge funds but many other financial institutions have today.
Mr. BAKER. To return to my earlier observation, just don't get on the bike unless you know where you are going.
Mr. PARKINSON. I think that is right. But on the other hand, even in terms of knowing where you are going, even in the simplest of investments, say if you are asking me, ''May I make a loan to a corporation?'', and you want me to quantify what is the risk associated with that loan, there are better methods than others for doing that, but there is no perfect measure that is better than all others and tells you everything that you want to know. Yet we certainly would not want to tell banks not to get on the bike of lending to corporations.
So again, it is a question of how much can we realistically ask for, and how best to surmount these difficulties.
Mr. BAKER. Thank you.
Mrs. Roukema, any follow-up?
Page 67 PREV PAGE TOP OF DOC
Mrs. ROUKEMA. I have no follow-up questions.
Chairman LEACH. A couple of inquiries, one using Mr. Baker's analogy of the bic