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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.
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    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.
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    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.

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    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.
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    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.
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    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.
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    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.
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    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.
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    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.
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    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.
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    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.
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    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.
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    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.
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    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.
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    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.
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    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.


    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.

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    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.
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    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.
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    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.
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    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.


    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.
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    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.
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    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.


    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.
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    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.
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    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.
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    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.
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    Mr. Parkinson.


    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.
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    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.
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    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.

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    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?

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    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?

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    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?
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    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.
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    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?
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    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.
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    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.
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    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.
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    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.


    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.
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    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?

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    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.

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    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?

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    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.
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    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?
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    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.
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    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.
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    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.

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    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.

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    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.
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    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?
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    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?
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    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.
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    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?

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    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.

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    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.
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    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.
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    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.
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    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.

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    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——
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    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.
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    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.
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    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.
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    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.
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    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.
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    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.
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    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.
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    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?
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    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?
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    Mrs. ROUKEMA. I have no follow-up questions.

    Chairman LEACH. A couple of inquiries, one using Mr. Baker's analogy of the bicycle, and that is who is riding in the front seat of this two-seater. One of the reported aspects of the Long-Term Capital Management issue, although it is an aspect that is conjectural, is that one type of group of investors in Long-Term Capital Management may have been a central bank or two, or a Government-owned bank or two.

    I would like to ask each of you on the panel, are any of you aware that a central bank or government-owned bank may have been an investor in Long-Term Capital Management.

    Mr. Parkinson.

    Mr. PARKINSON. Mr. Chairman, we understand from press reports, not from any private information, that the Bank of Italy was an investor in LTCM.

    Chairman LEACH. Any Asian countries, central banks or government banks?

    Mr. PARKINSON. We have heard rumors to that effect, but we have no direct information.

    Chairman LEACH. Does anyone else have information to that effect?
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    The reason that I raise it is that a recommendation of the United States Government Working Group should have been that funds of this nature should not be entangled with foreign government or United States Government entities. And I raise this because the obvious conflicts of interest from a private sector perspective as well as from a public intervention perspective.

    Mr. Parkinson, do you believe a hedge fund should have a government or central bank owned entity investing in it?

    Mr. PARKINSON. Certainly that is a curious investment for a central bank to be making.

    In our case I am happy to report we don't invest in hedge funds. I would add that we don't have a specific rule proscribing that, but the investment guidelines that are set out in the Federal Reserve Act itself in Section 14 and in the regulations of our Federal Open Market Committee really say that the predominant considerations in determining what we should invest in are liquidity and safety. It is hard to reconcile——

    Chairman LEACH. That is from our Government's perspective, but you are also part of international discussions, and I would think that it would be very reasonable that this be one of the matters under serious review.

    Would you disagree, Mr. Gensler?

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    Mr. GENSLER. I think that the approach to investment of the central's bank reserves in this country in liquid assets, as Mr. Parkinson suggested, are a good and thoughtful approach for other central banks. But as I said earlier, we were not aware, other than in the press reports that were mentioned, of any investments.

    Chairman LEACH. I would like to raise this issue as something that should be more than what one is aware of. It should be a matter of public policy determination and recommendation in both intergovernmentally and perhaps even potentially legislatively.

    Let me ask a further question, and this is a separate issue and it was begun earlier.

    One of the great concerns here is leveraging, and I think everybody has concluded and you have—both in the Treasury's oversight of banking and the Fed's oversight of banking, your examiners are going to look more carefully at lending of federally-insured institutions to hedge funds. I have suggested in some circumstances of the major money center banks, they have about 20–to–1 leveraging of Tier 1 capital, and these overextended hedge funds have 25–to–1, 33–to–1 leveraging, and that means that you have the effect of over 500–to–1 leveraging.

    So this raises the point from the perspective of bank oversight that I think is of extraordinary dimensions and that is the extent of leveraging. It gets compounded, Mr. Parkinson, when the Federal Reserve Board, and, Mr. Gensler, the United States Treasury, endorse commercial bank ownership of an overleveraged hedge fund, and then take the further step of presumably keeping those assets somewhat frozen for a period of time in that hedge fund so it becomes an implicit United States Government endorsement of over 500–to–1 leveraging, and it becomes a circumstance in which unrelated to past history of a particular fund, defies a great deal of historical experience.
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    And so I want to know, coming back to this 8 percent ratio that you talked about earlier, have you turned that around and looked at the total leveraging of capital as it relates back to a bank's position? And is that not a more appropriate way to look at it?

    Is this credible or incredible, Mr. Parkinson?

    Mr. PARKINSON. Well, the Report indicated as one of its recommendations that we should promote the development of more risk-sensitive approaches to capital adequacy. Certainly that means, for example, when a bank decides how much capital it needs to support a credit extension to a certain counterparty, it should take into account in a very significant way what that counterparty is doing with the funds. What is the degree of risk?

    Chairman LEACH. Let me do this theoretical model for you. You have rules in the Treasury and the Fed for a bank and its leveraging.

    Now you theoretically have approved a bank's—now it is a single bank to own a hedge fund. In this case it is a group of banks owning a hedge fund. You have taken 20–to–1 leveraging and turned it into 500–to–1 leveraging, apparently in an approving kind of way. And so what I want to know is: Does bank ownership of an outside hedge fund represent a way to get around the banking laws of the United States in terms of traditional regulation?

    Mr. PARKINSON. Well, I think in this particular circumstance the way that those banks that participate in the consortium were able to make those equity investments was done under their authority to take equity for debts previously contracted. And then I think the question comes down to, in terms of their capital adequacy, was it better for them to allow the firm to unwind and take the losses and the impairment of their capital that might have resulted or was it better for them to make this equity investment?
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    Did that leave them in a healthier financial condition with a sounder capital versus the unwinding alternative.

    Chairman LEACH. What I am getting at is that is the way that it is looked at, but the implication is that you have now supported an ongoing structure of commercial bank ownership of a hedge fund which is highly leveraged in and of itself.

    If the goal of the Federal Reserve Board and the policy of the Treasury and the Fed when they did this was to call for an unwinding over ''X'' period of time, you have a greater rationalization. But there are many people suggesting today that this is going to be a terribly viable fund for a long period of time, but no commitments from any party to get out. Suddenly from a regulatory perspective, in my view you have a brand new regulatory circumstance that is totally different than is described in your Report and totally different than the situation that you are currently discussing with international parties relating to this one hedge fund.

    Now, is that a philosophical parameter that I am off base on or are you off base on?

    Mr. PARKINSON. I think here again the rule, the authority under which they made this investment was that it was in satisfaction of a debt previously contracted. And that carries with it the expectation that they will, over time, liquidate the investment that was made under that authority.

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    I don't believe we have a specific time that is required. I assume the reason we don't is we don't want to put them in a position where they are forced to liquidate over a short period because that impairs the value of their investment. But there is clear expectation that this is not a permanent arrangement by which they can undertake activities which they would not be able to undertake on their own.

    Chairman LEACH. That is a public policy statement that has not been made. Is it your position at Treasury that there is a clear expectation that these people will get out of their ownership situation?

    Mr. GENSLER. Mr. Chairman, if I can answer the broader question and then come back to the other question. The interlocking nature of financial institutions today, while beneficial and while it promotes economic growth through the positive side of leverage, also presents risk and not just in the events of last fall, but also it was part of the lessons of the financial crisis of the last two years around the globe.

    And that is why we strongly came together and endorsed the financial institutions—actually all public companies disclosed the nature of their exposures to other companies and certainly in the case here, that the banks and investment banks disclose publicly the nature of their exposures, in this case, to a hedge fund, a more narrow and important question of investments in hedge funds by regulated entities.

    We think that those risks should be appropriately charged to capital if indeed they even exist, and that goes to some of the recommendations that capital charges should take into consideration risk and certainly these investments are of the riskiest nature for any institution.
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    Second, that they be fully disclosed. And then on the last point, it was certainly publicly stated by the group that they intended that this was an unwind situation.

    Chairman LEACH. Fair enough. I appreciate that.

    I would only stress again that you have affirmed to the committee that in the riskiest circumstance, 500–to–1 leveraging has been supported for a period of time. And the question is how short is that period of time, and I would urge that it be very short.

    Mrs. Roukema, do you have any follow-up questions?

    Mrs. ROUKEMA. No.

    Chairman LEACH. I wish to express my appreciation to the panel, and call our next panel forward.

    Our second panel is composed of George Crapple who is Vice President of the Millburn Ridgefield Corporation as well as Chairman of the Managed Funds Association; Mr. Douglas E. Harris, who is well known to this committee, is partner in Arthur Andersen Company; Mr. John C. Coffee, Jr. who is professor at the Columbia University School of Law; and Mr. Todd Lang who is a partner in the law firm of Weil, Gotshal & Manges.

    We will begin with Mr. Crapple. I would ask unanimous consent that all of your statements be put in the record fully.
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    Mr. CRAPPLE. Thank you.

    I appear as the Chairman of the Managed Funds Association, a national trade association representing more than 700 participants in the hedge fund and managed funds industry. I am Vice Chairman and Co-Chief Executive Officer of Millburn Ridgefield Corporation, which since 1971 has managed money in the currency and futures markets and sponsors funds of funds and equity hedge funds.

    MFA appreciates the opportunity to testify before this committee on the Report of the President's Working Group on Financial Markets concerning the public policy implications of the recent events involving Long-Term Capital Management. MFA commends the committee for its continuing interest in the impact of LTCM on the health and stability of U.S. and world financial markets. We congratulate the Working Group on its extensive review of the LTCM events.

    In brief, MFA believes the Report is a constructive contribution to the debate concerning the public policy implications concerning the events surrounding LTCM. MFA concurs with much of the Working Group's analysis and many of its recommendations.

    However, MFA believes that certain of the recommendations for further Government action do not satisfy the tests of efficacy and avoidance of undue costs advocated in the Report itself. MFA urges this committee and other public policymakers to be skeptical of purported solutions to the LTCM problem that consist of creating yet another Washington information warehouse which is unlikely to advance the important task at hand of improving credit assessment and risk managment by lending institutions and financial market counterparties such as those who extended credit to LTCM.
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    I will address these points briefly in my testimony, and note that MFA has also submitted for the record its own report on the public policy implications of LTCM.

    In many respects, the Working Group's conclusions on the public policy implications of LTCM accord substantially with those of a number of other valuable analyses undertaken to date by regulatory organizations and MFA in its own report. Like MFA's report, the Working Group's Report underscores several key points which I will highlight here.

    First, LTCM was an extreme, apparently unique case that was distinguished by the scale of its activities, the large size and illiquidity of its positions in certain markets, and the extent of its leverage. If it had had twice the capital or half the leverage, subsequent events imply it would have weathered the storm. A fund pursuing the same strategies without the total assets and leverage of LTCM would have posed no systemic risk, and we probably wouldn't be here today.

    LTCM was not typical of hedge funds. The concern as to size and leverage raised by LTCM are more aptly associated with other types of large institutional traders such as the proprietary trading desks of commercial and investment banks than with hedge funds generally. The Working Group Report recognizes this.

    Second, the Working Group's Report stresses the extent to which LTCM was permitted to attain its extraordinary market positions by laxity in credit risk assessment and monitoring of lenders and other counterparties. If LTCM was a credit addict, the lenders supplied the drugs. The Report underscores that, ''LTCM seems to be the extreme case that illustrates inherent weaknesses of some prevailing credit practices.''
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    LTCM achieved its extraordinary size and leverage due largely to deficiencies in credit risk management policies by its lenders and counterparties. In particular, in managing the LTCM relationship, banks and dealers relied on significantly less information on financial strength, leverage, and liquidity than they normally require due apparently to the reputation and laurels of the principals, LTCM's mystique, and the profits to be earned by handling its trades. The awe in which LTCM was held has no precedent and is unlikely to be seen again.

    Third, credit risk management is the preferable tool for constraining the type of market activity illustrated by LTCM. No substitute exists for rigorous risk management by lenders and counterparties who have both the incentive and the ability to obtain and assess the complex risk-relevant information necessary to assess and monitor their exposure to hedge funds and other borrowers, highly leveraged or otherwise.

    The individualized risk management of lenders and counterparties is a key foundation for management of risk in the financial system generally. As the Working Group noted, ''The exercise of credit discipline and trading relationships has the potential to provide a balance between the benefits and risks of leverage.''

    Following LTCM, regulators and supervisors have made significant progress toward ensuring enhanced effectiveness of credit risk management by lenders to entities such as LTCM. Public policy initiatives relating to hedge funds should focus on identifying sound credit practices and fostering their implementation.

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    Fourth, direct regulation of hedge funds is not warranted. For the reasons stated above, efforts to fortify market discipline to prevent credit lapses such as occurred in the case of LTCM should be the focus of regulatory and industry initiatives. Before any direct regulation of hedge funds is pursued, the difficulties of formulating an effective regulatory approach that does not create more public costs than benefits should be fully considered.

    MFA strongly agrees with the Working Group's conclusions that the primary mechanism that regulates risk-taking by firms in a market economy is the market discipline provided by creditors, counterparties, and investors. Moreover, the voluntary industry initiatives described in Appendix F to the Report are strong evidence that the financial services industry has the motivation to improve market stability and efficiency through self-regulation and has undertaken important initiatives to that end. This refutes an implication in the Report that market participants are motivated only by self-interest and have no concern about the health and stability of the markets.

    As a general matter, as the Report stresses, Government regulation of markets is properly achieved by regulating financial intermediaries that have access to the Federal safety net, that play a central dealer role, or that raise funds from the general public. These factors do not characterize the hedge fund industry. If the lenders to LTCM had been doing their job properly, the LTCM problem would not have occurred.

    I also wish to highlight MFA's views on several other aspects of the Working Group's Report. First, the critical role of private sector initiatives to enhance risk management practices. MFA believes that the private sector initiatives underway or contemplated to address the risk management issues raised by LTCM are critically important, and we strongly support those efforts.
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    In particular, MFA wishes to voice its support for the Report recommendation that a group of hedge funds develop a set of sound practices for their own risk management and controls. Hedge funds currently devote extensive attention and resources to their own internal controls and risk management. Development of ''best practices guidelines'' for the industry can only enhance these efforts. MFA endorses the Working Group's recommendation and is prepared to take a leadership role in such an initiative, which would include representation from throughout the hedge fund industry.

    MFA also supports efforts of the Counterparty Risk Management Policy Group comprised of twelve major internationally active banks and securities firms which is developing standards for strengthened risk management practices for banks, securities firms, and others providing credit to major counterparties in the derivatives and securities markets.

    Second, recommended disclosure and reporting requirements in the Report lack utility and impose undue costs. MFA supports the objective of increased transparency in credit relationships between lenders and hedge funds and other borrowers as recommended by the extensive guidance issued to date by the banking regulators and endorsed by the Working Group.

    This objective is best advanced by the credit practice enhancements recommended to date by Federal, State and international banking regulators and the private sector initiatives underway to strengthening the credit risk management process. MFA does not believe that the Report's recommendations for more frequent or augmented reporting by commodity pool operators and hedge funds to regulators and to the public respond to the concerns raised by LTCM or otherwise satisfy the standards set forth in the Report that Government regulation should have a clear purpose and should be carefully evaluated in order to avoid unintended outcomes.
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    Both the utility of such regulatory and public reporting to the intended recipients and the potentially adverse impacts of requiring it deserve serious attention. Reports to the public would appear to be inconsistent with the private nature of hedge fund offerings as defined by fundamental regulatory constraints under the securities laws pertaining to advertising and public solicitation and would invite public competition among entities whose regulatory status is premised on the private conduct of their business.

    Further, the information that would be reported would be of highly questionable utility to most of the recipients. The Report suggests that the recommended disclosures include value-at-risk reporting which generally does not reflect the type of extreme market fluctuations which imperiled LTCM or stress test results which cannot be readily interpreted without significant explanatory material. How much stress should be hypothesized? Interest rates go to zero or 30 percent overnight? Put in enough stress, and every strategy will fail.

    A snapshot of quarterly data presumably would be intended to capture complex portfolio risk data in a public report, but are as likely to distort as to advance understanding and hold real potential for inducing a false sense of security or a false sense of concern. Such reporting would also direct attention to inherently stale data that do not provide a solid basis for assessing the risk of a given fund and may, in fact, have the perverse effect of creating a false sense of assurance concerning a fund.

    There is also the burden to be considered. My firm operates eleven futures funds, three hedge funds and two funds of funds, so it now prepares sixteen annual reports. This will become 64 reports. I don't know that I want to get to know the auditors that well. If we can see a real benefit, we would be happy to do it. In fact, from the point of view of creditor relationships, quarterly reports are far from adequate and every creditor and counterparty of the funds we deal with is marked to market our positions on a daily basis.
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    Perhaps most importantly, a new disclosure framework of the nature contemplated would not help to provide a solution that the Report itself identifies as central to the LTCM event. It would not be designed nor would it serve to augment the risk management of the parties who made possible LTCM's market positions. It would not enhance the quality of the lending and the counterparty relationships that are key to the concerns presented by LTCM.

    These lending and counterparty relationships will not be served by a newly devised information dump on the public and the regulators. They require the close review of complex, individualized risk-related data, more comprehensive and timely data than any public reporting system is or should be calculated to produce. What would the SEC or CFTC do with all of these reports, much less the public? Evaluate the wisdom of complex trading strategies? I doubt it.

    Finally, additional disclosure requirements of the nature proposed may create incentives for funds to move offshore to jurisdictions without such requirements, ultimately creating unintended negative consequences for U.S. regulators seeking to manage systemic risk. The point was made earlier by Chairperson Born that offshore hedge funds that don't have U.S. investors would not be subject to these reporting requirements in any event; so at best, a partial picture would emerge.

    In conclusion, MFA applauds this committee, the Working Group, regulators and market participants who have acted in the wake of LTCM to identify the causes of the LTCM events and to foster, initiate and promote actions to rectify lax practices, fortify risk management practices, and improve supervisory oversight.
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    MFA urges the committee and other public policymakers to avoid quick-fix regulatory solutions that do not address the fundamental risk management issues presented. Only by requiring market participants to bear the burden of risk management with the guidance and encouragement of public overseers will the most enduring and effective best practices be implemented.

    We believe that the efforts of public and private sector groups to develop more effective, sophisticated and rigorous risk management practices should be the central focus of regulators and the marketplace in seeking to reduce the potential for future market disruptions.

    Thank you.

    Chairman LEACH. Thank you.

    Before going to Mr. Harris, I want our reporter to note that several of the best statements were not in the written report, and I would just like to repeat two sentences. ''If LTCM was a credit addict, lenders supplied the drugs.''

    Mr. CRAPPLE. I wrote that on the plane this morning.

    Chairman LEACH. That is very profound. And you also made a conclusion which is central to our hearing today which is if regulators had done their work properly, the LTCM crisis would not have occurred?
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    Mr. CRAPPLE. If I said regulators, I meant to say lenders and counterparties.

    Chairman LEACH. Well, let me add regulators. Thank you for your very thoughtful testimony.

    Chairman LEACH. Mr. Harris.


    Mr. HARRIS. Chairman Leach and Members of the committee, I appreciate this opportunity to share with you some of my views on the President's Working Group Report.

    In 1993, I joined Gene Ludwig at the Office of the Comptroller of the Currency. There I was responsible for capital markets and trading activities of this country's national banks. I left the OCC in 1996 to return to the private sector. In the year prior to joining Arthur Andersen where I am a partner in the Regulatory Risk Consulting Group, I was a consultant for Paloma Partners, a market-neutral relative value hedge fund located in Greenwich, Connecticut.

    I would like to go back to my days at the OCC. On April 13, 1994, Comptroller Ludwig, at the first hearings held by this committee, testified on the safety and soundness issues related to bank involvement with hedge funds. In preparation for those hearings, we examined carefully national bank exposure to hedge funds, the relationship between hedge funds and banks, and the services provided by banks to hedge funds.
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    Perhaps the most significant conclusions of our review were that hedge funds did not pose a significant risk to the national banking system; that national banking exposure to hedge funds was modest; that most of the credit exposure to hedge funds was collateralized; and that the collateral consisted largely of cash and Government securities.

    Five years later, I do not think that any of these conclusions have changed significantly. Although the failure of Long-Term Capital Management would have resulted in losses for U.S. commercial banks and other U.S. regulated entities, all of the U.S. banks with credit exposure to Long-Term could have absorbed this loss, and the solvency of no U.S. bank appears to have been seriously threatened.

    What has changed, however, is another conclusion that we reached at the OCC in 1994. That conclusion was that the national banks which had exposure to hedge funds at that time, and there were only eight at that time, were adequately controlling the risks associated with their dealings with hedge funds.

    Certainly this is a statement which cannot be made with respect to the couple of years immediately preceding the events of last fall. If the problems at Long-Term can be summed up as excessive leverage achieved in large part by the overavailability of credit and credit products on especially generous terms, then it is clear that some U.S. commercial and investment banks had serious lapses in their credit extension and risk management processes.

    These lapses were many, including at the outset, the failure to engage in customary due diligence and to have adequate information upon which to make prudent decisions to extend credit; the inefficient pricing of credit and credit products; the failure to stress test exposures for extremely volatile market conditions; and the failure to require, maintain, and manage an amount of collateral to cover adequately not only mark-to-market exposure of their trading positions and their direct financing exposure, but their potential future credit exposure as well. The banking regulators have appropriately focused on the issue of credit risk management in addressing the events surrounding the collapse of Long-Term.
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    The Report of the President's Working Group represents a thorough discussion of the events surrounding the problems experienced by Long-Term and other market participants last fall. The Report aptly focuses on the high degree of leverage that Long-Term employed in pursuing its trading strategies, and states that the crucial public policy issue is the constraint, or restraint, of excessive leverage.

    However, the Report significantly and correctly notes that the issue of excessive leverage is not limited to the loosely defined group of trading entities called ''hedge funds.'' All major financial market participants employ leverage to some degree or another to achieve acceptable levels of return on their capital. The degree of leverage is customarily higher at many regulated institutions than in most hedge funds. However, the degree of leverage employed by Long-Term, and that it was subjected to as the market moved away from its positions, still may not have been significant enough to cause the financial market contagion that we so fear.

    That the collapse of Long-Term would have resulted in a shock to the financial system that would have resulted in the failure of other regulated, unregulated, and, in some cases, insured financial market participants has not been established.

    It would seem to be difficult to argue with the eight general recommendations contained in the Report of the President's Working Group. However, the Report of the President's Working Group suggests that disclosure, both with respect to the funds themselves and the exposure that public institutions have to funds, should be made public. I see a few problems with this suggestion.

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    First, different institutions using different risk models and different assumptions compute risk in various ways. Therefore, there will not necessarily be a way to compare the disclosure provided by two separate institutions to come to a conclusion that one is pursuing a more risky strategy than the other.

    Second, what would be the benefit of providing such information to the public? In the case of the hedge funds themselves, the public does not have exposure to them either as lenders, trading counterparties or investors, so one can validly ask ''what would the public do with this information?''

    Third, truly meaningful disclosure to the public could give those who have no need to know and who, in fact, might be in a position to profit from it, information about a firm's position and trading strategy. Congressman Baker correctly noted that much of this information may, in fact, be proprietary.

    Finally, such disclosure could, at times, give us a false sense of security, as Mr. Crapple just noted, that is the belief that because we have information, we therefore don't need to be concerned. How would the public disclosure of the positions and risk exposure of Long-Term have prevented the events of last fall?

    Significantly, the Report does not recommend further regulation of hedge funds at this time. The regulators have apparently accepted arguments that to increase the regulation of hedge funds beyond the current reporting and disclosure requirements—of those required to register with the CFTC—would drive them further offshore. I believe this argument has some merit.
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    In the not-too-distant past, we have seen the regulatory pronouncements of the CFTC create uncertainty in the over-the-counter derivatives market, resulting in the migration of business and, therefore, revenue and jobs, to European financial centers.

    If the hedge fund industry were to move further offshore, we would have less knowledge about it than we already possess; a diminished ability to obtain information about it; and less ability to control or take action against individual funds in the event of a severe market crisis or disruption. And yet, the funds would still possess the same degree of market power they currently have and, presumably, would have no less ability to pose a risk to our financial system.

    In conclusion, the recommendations contained in the Report of the President's Working Group are, for the most part, reasonable and appropriately responsive to the issues and problems which have been identified. There is no doubt that certain banks and securities firms did not possess the financial information necessary upon which to base prudent credit decisions, particularly including information with respect to the other credit facilities available to their hedge fund clients.

    It is also the case that not all banks and securities firms possessed adequate collateral to cover fully the exposure which they had to hedge funds. But there is real doubt as to whether any rule, regulation, or guideline addressing these issues will be more effective in preventing these problems in the future than the private sector initiatives already being undertaken by the banks and securities firms and their memory of the consequences that they have recently endured, including the financial losses suffered, the loss of shareholder confidence, and in shareholder value, and most importantly, I think, the damage to their reputations.
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    At this point, every bank that has or has had any dealings with hedge funds is reviewing its procedures in extending credit and controlling credit exposures and in establishing trading relationships. It is quite likely that the discipline which market participants exert upon themselves, that is self-regulation, will be the most effective form of regulation. In any event, to the extent that enhanced risk management procedures and controls are needed for U.S. regulated entities, Long-Term is not the only example, it is only one of the best and the most recent.

    I thank you for the opportunity to express my views and would be happy to answer any questions.

    Mrs. ROUKEMA. [Presiding.] Thank you, Mr. Harris.

    Now we will have professor of law from Columbia University, John Coffee.


    Mr. COFFEE. Thank you. The public policy issues surrounding the collapse of Long-Term Capital Management and hedge funds generally fall under four principal headings. I will state them as questions.

    One, did the Federal Reserve act wisely in coordinating, indeed engineering LTCM's rescue?
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    Two, given that banks, other creditors and counterparties ignored for an extended period the high leverage and associated risks at Long-Term Capital, and its apparent vulnerability to any increase in the yield spread, does this apparent market failure suggest the need for increased regulatory oversight?

    Three, will the proposals in the Report of the President's Working Group assure adequate creditor monitoring of hedge funds and other institutional speculators in the future?

    Four, if not, is additional hedge fund regulation needed to protect investors, counterparties or creditors?

    My answers are in order. One, probably; two, almost certainly; three, probably not—but they are all still useful modest steps that I am happy to endorse; and four, probably not, except at the international level through coordinated action through the G–7 countries.

    Now, those are very brief answers to complicated questions. My belief is that our time really permits—I go through all of these questions in my written testimony, but time does not permit me to go through each one. I want to focus on the last of these questions.

    I do conclude that there is a problem in creditor monitoring of financial speculators and that the steps proposed probably will not give us the kind of assurance that Congress wants that these problems will not reoccur. Therefore, should we move to more direct regulation of hedge funds?
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    My answer is probably not, and I want to focus on that specific context. Although I believe the debacle around Long-Term Capital exposes serious and systemic problems in creditor monitoring of large institutional borrowers, I do not believe that it provides any persuasive justification for direct regulation of hedge funds.

    In overview, the problem with direct regulation of hedge funds is twofold. One, investor protection—the traditional goal of SEC and CFTC regulation—does not supply a coherent justification for regulation of hedge funds which are very characteristically different.

    Two, regulation of hedge funds is likely primarily to drive them offshore. I will come back to both of these, but they mean a somewhat different approach is necessary, a somewhat more complicated approach.

    First, on the first theme, investor protection as a justification for enhanced regulation of hedge funds does not work, because hedge funds are, by definition, populated by sophisticated investors who are able to fend for themselves. Most are extremely wealthy. Long-Term Capital had a minimum investment requirement of $10 million.

    Tiger Fund, the only other fund really at the same financial size of Long-Term Capital, had a minimum investment of $5 million. The statutory exemption passed by Congress in 1996 from the Investment Company Act which has permitted the recent and extraordinary expansion of hedge funds requires that a qualified purchaser who is an individual own not less than $5 million in investments.
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    At that level, these people are basically able to protect their own interests, and the working of the hedge fund market shows that. There is no broad problem of hedge funds that needs fixing. Long-Term Capital is an extraordinary outrider, an idiosyncratic exemption. Even during 1998, most hedge funds made a profit and some earned very substantial returns.

    The hedge fund marketplace is extraordinarily competitive. There are currently an estimated 3,000 hedge funds competing for investor funds and are winning at competition in which only the fittest survive. Sixty percent of all hedge funds do not survive three years because the investors remove their funds and put them in a different financial institution, probably another hedge fund, that is earning superior returns.

    Given all of this and given the average rate of return for hedge funds, those that survive appear to own 18 percent on an annual basis, which is an extraordinary rate of return. Even those who don't survive earn 10 percent annualized, which is still an attractive rate of return. Given that backdrop, I don't think that we need to worry about protecting investors. The legislative focus has to be on deficiencies in risk management because of inadequate practices by the lenders and the securities firms who are counterparties.

    With Mr. Crapple, I think the real mystery is not the behavior of Long-Term Capital, but rather of the financial institutions that lent to them or dealt with them with totally inadequate information underlying their willingness to advance credit.

    Now, because attempts to regulate hedge funds may succeed primarily in driving them offshore, and as was just said by Mr. Harris, I agree that the recent experience with swap transactions and OTC derivatives has shown a substantial migration of the business to London, and that is not a consequence we want to lightly occasion again. Indeed, the irony is Long-Term Capital itself was a Cayman Islands LLC. It was only the managers that were here in the United States as a limited partnership organized in Delaware.
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    What then is the optimal answer to the problem of excessive leverage? I think I have to say it is really coordination, a coordinated policy among the G–7 nations under which all large institutional investors, including hedge funds but not only hedge funds and not including those hedge funds that are below some financial threshold.

    Most hedge funds are way under $100 million in assets, and that is the level probably or some level above that where there starts to be a possibility that the behavior of one hedge fund could cause some kind of systemic shock to the financial markets. But the behavior of large financial speculators, including hedge funds, particularly those that engage in certain kinds of risky speculative strategies, would need to be reported to some centralized coordinating body, quite possibly the Basle Accord authorities or some other consortium of the major central banks at the G–7 level.

    They would need much more than is currently proposed in the President's Report, because they would need private information, private disclosure, not simply a quarterly financial statement, but actual positions and actual trading strategies in order to make an informed risk management.

    Again, I emphasize that this reporting should be private, not public. The emphasis is a little bit too much in the President's Report on public disclosure to investors in the market. I think the appropriate focus needs to be on constant, continuing access by the regulators to that portion of the hedge fund market that has the capacity through their size to engage in exactly those kinds of risky, speculative transactions that can set off shock waves through the financial markets, and that is only a small fraction of the overall hedge fund marketplace.
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    Let me also emphasize that approaches such as quarterly reporting, which I am happy to endorse as a modest step in this direction, probably are not going to give that much assurance. Let me illustrate this with the actual facts of Long-Term Capital Management.

    If there was a quarterly reporting requirement, Long-Term Capital would have had to have reported its financial position as of June 30 and as of September 30. Everything in this crisis developed in early August and exploded in late August and was becoming ancient history by mid-September.

    Quarterly reporting is not really going to be a solution to what should be a regulatory attention that has to be daily once certain financial exposures are reached. That is really what we have in the area of banking regulation where banking regulators are monitoring a troubled bank on a constant basis.

    When a hedge fund reaches critical thresholds where there is risk exposure of the kind that set off shock waves through the markets causing ripple effects, that is where regulators need the ability to have constant attention and need to have access to proprietary information. But precisely because they do need access under those circumstances to proprietary information, the disclosure needs to be private, not public.

    Again, I think this is critical. If we want hedge funds or other institutions that are competing well and are providing value to investors to be able to survive, we cannot ask them to disclose proprietary information. As a practical matter, asking a hedge fund to disclose all of its positions and trading strategies is like asking a poker player to reveal what his face-down cards are to the rest of the table. You can't quite play in that environment.
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    My bottom line statement is at the G–7 level, I think it is feasible and desirable to require reporting by very large traders, and that very large trader reporting should focus on risk assessment and give the regulator notification of those kinds of data that suggest very detailed, focused oversight, if necessary, during the period of potential exposure.

    But, the focus of all of this is not simply to make all hedge funds regulated or to make all hedge funds report, but it is to protect financial fragility in a world where very large traders can cause liquidity crises. Such a program will require a coordinated, international approach or it will not work. It will require as its first steps some of the proposals in the President's Group Report, properly expanded, be discussed on an international basis with the other G–7 countries.

    Thank you.

    Mrs. ROUKEMA. Thank you, Mr. Coffee.

    Our next witness is Mr. Todd Lang who is a partner in Weil, Gotshal & Manges.


    Mr. LANG. Thank you. I am principally a corporate securities lawyer. I have had a good deal of experience with hedge funds and private entities of all kinds; and, parenthetically, I chair the Subcommittee on Private Investment Entities, which includes hedge funds, at a segment of the American Bar Association. I also want to thank you for the opportunity to be here.
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    The near collapse of Long-Term Capital Management, as we have heard and know, is both an eye opener and a wake up call. The crisis suggested an unprecedented threat to the stability of the global financial markets. It is noteworthy, however, that it did not involve fraud or other misconduct, which frequently accompany such crises.

    In short, the threat to the system derived from the ordinary business operations of market participants and through systemic reaction to Long-Term Capital's predicament. There have been a lot of studies going on about what to do about this, both public and private. Everybody has eagerly awaited the President's Working Group Report, and finally it is here, and I believe it was well worth the wait. I think it is a very professional job. The appendices are hugely informative. In basic part, I subscribe to both the approach and most of the recommendations, but not all.

    The primary issue is how to constrain excess leverage in a global market to avoid a systemic breakdown. The objective is to accomplish this without adverse impact on the functioning of the capital markets. The approach, which they recommend and with which I agree, is indirect regulation, an increase of discipline through regulatory oversight and the uniform adoption of best or sound practices.

    While market discipline may not work alone, as the Report suggests, attention to sound practices, capital adequacy, due diligence and transparency should be effective. As was indicated earlier, certain of the recommendations involve the enactment of legislation to create authority for various of these measures. Banks, securities firms and those in the commodities business are currently subject to regulatory oversight. There are in place, therefore, experienced regulatory authorities who have the capability of implementing many of the recommendations in the Report.
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    One kind of entity, as we know, which is not subject to direct regulatory oversight is the hedge fund. I propose to focus on hedge funds because the first recommendation in the Report would require, and I am putting quotes around this, ''hedge funds to disclose enhanced financial information to the public on a quarterly basis.'' For those hedge funds who are currently commodity pool operators that file with the CFTC on an annual basis, the reports would now be filed quarterly and there would be enhanced disclosure of market risk without revealing proprietary information on strategies or positions. These reports, for the first time, would be publicly available, as Jack Coffee just said. For those hedge fund operators that are not required to make the filings, Congress would authorize similar financial information to be filed, although the mechanism for filing and the repository are not identified in the Report. The purpose of this arguably is to promote public disclosure of periodic financial information. In considering this recommendation, I have certain observations for you to consider.

    It is generally conceded that there is no reliable definition of a hedge fund which can be used for this or probably any other purpose. So-called hedge funds engage in a wide variety of activities and use different strategies. Most are not highly leveraged and many are not leveraged at all. Therefore, any filing requirement in order to provide information that is meaningful to the objective of these recommendations should be limited to highly leveraged institutions which engage in specified relevant activities, as they may be defined, who are not otherwise subject to regulation.

    This would mean that operators of most so-called hedge funds would not make such filings unless they were required to do so as CPOs. To provide otherwise would subject private investment entities whose activities pose no threat to the system to make public disclosure of their private information. Leverage itself would require a definition. Customary margin borrowings or changes in the value of collateral may not necessarily constitute leverage for this purpose. Furthermore, many investment entities employ leverage in connection with certain of their activities and not with others, and therefore, overall entity leverage may be a factor, particularly if the filing requirement is limited to those who are highly leveraged.
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    Is leverage limited to hedge funds and other private entities, or would it extend to individuals? Would the filing requirement commence some reasonable time after the entity meets the definition of a highly leveraged institution? When would it end?

    There is no working definition of a highly leveraged institution which would be subject to the filing requirement. The Basle Committee on Banking Supervision in its report this past January established three criteria. First, the institution is subject to little or no direct regulatory oversight. Second, the institution is subject to very limited disclosure requirements compared with regulated entities, and third, the institution takes on significant leverage, which is defined as the ratio between the risk expressed in some common denominator and capital. This could be a starting point in constructing such a definition.

    There should be a size test, namely an exception from the filing requirement for smaller entities. Perhaps that exception should extend to those who own or manage assets of less than $100 million. This is the threshold requiring institutions and others to incur portfolio reporting obligations under Section 13(f) of the Exchange Act. I suggest the burden and cost of filing should only be incurred to the extent the activities of the institutions may have some meaningful impact on the market.

    In addition, the application of any filing requirement might exclude certain categories of leveraged entities which engage in specified activities. As an example, many structured finance transactions are private. The participants are only qualified institutional buyers and the balance sheet leverage is virtually 100 percent. I refer to asset-backed transactions securitized by cash flow from a particular pool of assets. The investors in these transactions engage in their own due diligence, perform their own stress tests and receive monthly information on the performance of the asset pool. These structured finance vehicles have narrow purposes and do not engage in economic leverage through the trading of futures or derivatives. Therefore, their activities should not be of any significance in terms of the impact of excess leveraging on the market.
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    There is a question as to why the quarterly financial information should be publicly available. These, by definition, are private entities. Investors obtain the financial information by contract under the various partnership agreements. I concur that the information may be of meaning to various regulatory authorities who are concerned with the integrity of the capital markets. However, they could have access to this information confidentially. While the information itself may be of interest to counterparties and lenders, it is presumed that before credit is extended, due diligence would be undertaken, which would be much more extensive than the information which is publicly filed and undoubtedly the information would be more current. Therefore, I suggest that public disclosure of quarterly financial information by highly leveraged institutions should not be required unless the case can be made that it in fact would be material to decisionmaking by lenders and others, which I doubt.

    Inasmuch as the Report left the ''mechanism'' up to Congress, I suggest that the filings be made on a confidential basis, possibly in a special repository, which would be accessed by each of the agencies that comprise the Working Group. In this manner, all of the relevant Government authorities would have access to the information which might facilitate a response to an emerging problem. Furthermore, one or more members of the group which administers this repository should have the appropriate authority to prescribe the content of the filings and access to the institution which makes the filing for information purposes. To the extent that this may replicate the statutory filings with some other agency like the CFTC, these can be reconciled. Confidentiality would be provided subject to requests under the Freedom of Information Act and other customary exceptions. This is the current regime with respect to CPO annual reports filed with the CFTC.

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    It is clear from the Report that the sole purpose of these filings is to provide more information that deals with the central problem of systemic breakdown; it is not to require disclosure by those private entities who are not highly leveraged and who engage in particular activities that are irrelevant to this kind of risk.

    This kind of disclosure reporting should provide the appropriate transparency to regulators with respect to those funds whose activities may be relevant to the integrity of the system. The confidentiality of these filings, in addition to the protection of proprietary information, has precedent in the large trader reporting rules adopted by the Department of the Treasury in 1991 on authorization from Congress as to an aftermath to the Government's securities trading scandal some years ago. I trust that further examination of the significance of this financial information to the public will confirm there is little justification for the publication of this kind of information.

    I consider the Report to be a step forward. I think you have an opportunity to do a couple of things to assist the regulators, and at the end of the day, I have confidence that this will make a major contribution toward better discipline in the market and less risk.

    Thank you. I will be pleased to respond to any questions.

    Mrs. ROUKEMA. [Presiding.] Thank you. I don't quite know where to begin. I thought at first that Mr. Coffee and Mr. Lang were going to give more approval to the specifics of the Report. By the way, may I say that I think you understand that the basis of my previous comments or observations that I really did not agree with the hands-off policy that Mr. Crapple and Mr. Harris stated. I do believe there are systemic risks. I think as long as there are systemic risks, we can't take a hands-off policy. There are public policy issues involved here.
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    So I am going to direct my questions to Mr. Coffee and Mr. Lang. I have heard what you have said. Of course we all agree, I believe, on the point that there has to be best and sound practices within the industry. I hear your opposition. Let me ask the question this way: Although you are putting your faith in the regulators, the regulators did not work this time. I want to hear from you why you think it didn't work. It seems to me, based on this experience, and I thought Mr. Lang was going to address the recommendation for the SEC requiring the public companies to disclose their material financial exposure. The question was on the one hand, shouldn't that be followed; and two, shouldn't we go beyond that in terms of a statutory—expanding the statutory requirement for the SEC responsibility here, particularly since I am operating from the basic premise that yes, there was systemic risk, and yes, there can be in the future.

    Mr. Coffee and Mr. Lang, please.

    Mr. COFFEE. I certainly agree with what you have said with regard to particularly in the first instance to public companies having to disclose material information. At present, the SEC has authority to require disclosure under a rulemaking power that gives them the right to do anything necessary for, ''the protection of investors or in the public interest.'' That is about as broad a standard as I can see. We are talking about the public interest and the fragility of the financial system. I think they have complete power to adopt rules that would require greater disclosure of your potential financial risk under derivatives transactions. I don't think there was any dispute about their power, and I do support public disclosure.

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    Mrs. ROUKEMA. Well, are you denying that the Working Group pointed out that they did not feel that it was comprehensive enough, or not?

    Mr. COFFEE. I was saying that I thought with regard to the supervision of a troubled financial institution, we probably need more authority on an international basis, unlike——

    Mrs. ROUKEMA. Yes. Please, yes, I would be happy to hear what you have to say on that. That was one of the thoughts I had.

    Mr. COFFEE. What I was expressing was that a simple enactment of hedge fund regulation would probably drive offshore a great number of institutions, and indeed, Long-Term was offshore, and if we had this kind of a reporting system they would only have to go a little bit more offshore to be exempt from it. I think the first step is to get an international accord at the GS–7 level, and I don't think that is an impossible goal at all.

    Mrs. ROUKEMA. That is an important point, and I thank you for raising that subject. Go ahead.

    Mr. COFFEE. Once you have an agreement at the GS–7 level which, which are not only hedge funds, they are other financial speculators and certainly not all hedge funds, there has to be a cutting level in terms of those institutions that actually can have a market impact. Our focus is on those institutions that can really perturb and shock the market. That is probably only the top quarter of the existing population of hedge funds, at most. But once there is international accord, the GS–7 nations could provide disclosure to the coordinated financial regulators of much more than quarterly reports. I think you need more for the troubled large company and a lot less for the smaller company, and with Mr. Lang, I don't know that ordinary private hedge funds need to make public disclosure.
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    Mrs. ROUKEMA. This is only rhetorical, but you expect all of those regulators internationally to do their job. Don't take the time now. Perhaps you want to get back to me.

    Mr. Lang.

    Mr. LANG. I want to augment what Jack Coffee said. The SEC has more than enough authority to adopt rules requiring material disclosure of relevant information, it is not just limited to this area. If you study the way the rules, and particularly management discussion and analysis has evolved, the SEC learns from incidents what is material to the marketplace, and then undertake rulemaking proceedings. I think the working group is recommending and will undoubtedly have Arthur Levitt and others proceed promptly to add to what is material, what requires discussion, what investors need to know. This is not for creditors or lenders, this is for investors in the market. So I think that is virtually—I would call it in the can now. I think they will be doing it soon. We will probably see a rulemaking proceding, independent of whatever you do, in the next few months. So I think that that is not a matter that Congress need concern itself with. I think you can monitor it, but you will see it is going to happen, and should happen.

    That is why I didn't comment on it, because to me, this is so self-evident to a securities lawyer, and this is the way life works.

    Mrs. ROUKEMA. If it had been so self-evident, I think there would have been different statements in the Report.
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    Mr. LANG. Well, I mean the power is there. The recognition of the need to change management discussion and analysis kind of disclosure has emerged because of the Long-Term Capital problem.

    Mrs. ROUKEMA. All right. Did you have a direct response to that or observation?

    Mr. CRAPPLE. I will call it an observation. I didn't mean to imply a hands-off attitude, only to question on whom the hands should be laid, and I think that it is the lenders who caused the problem, and if there is a regulatory lapse, it is in the bank regulatory, bank examination area, or in the SEC's examination of broker-dealers, and I think that is where the focus should be.

    Mrs. ROUKEMA. All right. Thank you. I appreciate that.

    Mr. Chairman, do you have a question? Oh, I am sorry, I didn't realize that Mr. Bentsen had returned. My colleague from Texas, Mr. Bentsen.

    Mr. BENTSEN. Thank you, Madam Chairwoman. I don't mean to preempt the esteemed Chairman of the committee.

    Long-Term Capital, I think I read recently, had a return of what, 15 or 20 percent on assets in the last quarter; is that correct?

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    Mr. LANG. Yes.

    Mr. BENTSEN. Briefly I just have a couple of questions, but—and I don't want to assume the role of my other colleague from Texas who is not here today, but does the panel—what is the panel's feeling on had the Government not done anything, had the Fed not done anything, would it have been as catastrophic as was assumed or alleged, or would this have gone through the normal bankruptcy situation and rolled out? I know Mr. Coffee addresses that in part in his testimony, but at least as a justification, but I am just curious what your opinions are.

    Mr. COFFEE. My view, others can disagree, is that it would have been far worse. There is a unique anomaly in the Bankruptcy Code, an understandable one, in which derivatives transactions are not within the control of the bankruptcy trustee and cannot be stayed. That means as a firm begins to approach bankruptcy or crosses that threshold, each of the creditors who has collateral, and that is all of the creditors in derivatives transactions, has an incentive to take it and run for the exit, to sell it first before the others sell it, because in a thin market sustained sales will cause the price to collapse.

    Once you have that world, a race for the exit, all of those large creditors can't get through the exit, it is exactly the same as a run on a bank.

    Mr. BENTSEN. Let me ask you, and I want to hear the others' comments, but this netting provision that is in the Report, which is endorsed in the Report and in fact is argued that I think should be even enhanced, is that working at cross-purposes at what we are trying to achieve here? I mean I think it makes a lot of sense, but on the other hand, does it create the situation in the future where any time you have a bankruptcy where you have a highly leveraged hedge fund that could have market impact and the fact that you have the netting in the Bankruptcy Code, which we are always going to have, this ''systemic risk''?
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    Mr. COFFEE. It is not the netting provision, it is the stay exemption, and I understand why that exemption is there, I am not criticizing it, but in that world, you don't have the usual coordinating authority of the bankruptcy trustee, and I think the Fed played a very neutral umpiral role in coordinating the reorganization of a company. If you don't coordinate the reorganization and every creditor works for himself, you are likely to have greater losses and not only would the creditors lose money, but the secondary parties which are all of the banks who are holding the same assets are suddenly going to find that their portfolio of assets of emerging market bonds or whatever else is tremendously depleted and then they encounter mark-to-market.

    Mr. BENTSEN. I want to hear what everybody else has, but then is the Bankruptcy Code the proper structure, or do we have to have the Fed acting as the bankruptcy trustee every time this happens?

    Mr. COFFEE. I don't mean to say every time. This was really a very extraordinary event and in these extraordinary circumstances I think the outcome could have been far worse but for the attempt to get some coordination. I am not addressing who should have bought, but the idea that there was some attempt to get the maximum value for Long-Term assets by putting interested parties together and making them reflect on their common self-interests, that strikes me as sound.

    Mr. HARRIS. If I could comment on a couple of issues.

    First of all, on the question of netting, the House did yesterday pass the Netting Improvements Act contained in H.R. 833, so the legislative solutions proposed by the Working Group to address the issue that Mr. Coffee raises were just addressed by the House yesterday.
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    Number two, I think there is a general misconception as to where the exposure was on the part of banks to Long-Term. Banking exposure to Long-Term arises in three different ways: direct financing, lending, by making loans, second as a trading counterparty or third, as an investor. In fact, the significant exposure which U.S. and non-U.S. banks and other regulated entities had in Long-Term was not as a trading party, it was not as a result of their derivatives transactions, it was direct financing exposure. That is where the exposure is. That I think is very important to understanding why credit risk management is the issue that we keep coming back to.

    The amount of the exposure which U.S. banks had to Long-Term was not in fact, significant enough to threaten the solvency of any U.S. bank. Only one bank appears to have really had a threat to its solvency as a result of the exposure to Long-Term, and that was a Swiss bank. All the U.S. banks could have absorbed the hit. The losses that they would have had would have been large in absolute numbers, but relative to the exposure they have to other regulated and unregulated institutions, and to their corporate customers, it was not that great.

    Mr. BENTSEN. Well, the only thing, with the chair's indulgence, the credit risk analysis with respect to direct lending should be obtainable under the current regulatory regime. Now, the Report notes that there are lax internal lending requirements in heading times as we make outright now and that could be part to blame. But the more intangible with credit risk analysis with respect to counterparty agreements where we are not taking a lending or a secured position, you are just in between basically, but you ultimately need help holding the bag if one of the counterparties fails.

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    But you are saying in this case it was—it would have been a failure on the part of the regulators under their normal review of banks' lending activities.

    Mr. HARRIS. I am not saying that. I believe that the regulators have appropriately enhanced credit risk management guidance for banks since Long-Term. I think these were very appropriate steps that have been taken. But to consider that the lapse or the failure with respect to Long-Term is a failure of the regulators I think is wrong. I think the failure was at the institutions themselves. They were the ones whose models didn't predict the volatility of the markets and they were the ones who did not stress test the exposure they had to the hedge funds, and they were the ones who didn't conduct appropriate due diligence before the loans were made. Regulators have required that in the past, and still do. The regulators have enhanced credit risk management procedures, but it is absolutely clear that the failures were at the institutions that were dealing with Long-Term.

    Mr. LANG. If I could make one brief comment. This all brings us back to what I think is the key here, which is that the answers have to lie in best and sound practices which regulators can administer, where banks will pay attention, that hedge funds and others themselves will maintain, where accounting firms will require conformity, and I think the consciousness-raising that is going to come from focusing on this will make a significant contribution to some of the excesses that have come to light, with better stress testing and things of that kind.

    Mrs. ROUKEMA. Thank you.

    Mr. Chairman.
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    Chairman LEACH. Thank you. I am trying to put together what each of you is saying, and let me just summarize.

    Mr. Crapple is trying to stress that problems of the banking industry and bank oversight should not cause a counterproductive regulation of hedge funds. Professor Coffee has noted that there is an excessive bank risk, sometimes the central feature of a financial crisis. Mr. Harris has said that had LTCM failed, it would have been no great problem in the American banking sector. Mr. Lang has noted, which I think is very important, that—because we take this for granted sometimes, that there is no misconduct that is fundamentally at issue here. And I think that is a very important notation, because I think we look at things differently. So your noting that is important. I think you are also saying in effect that indirect regulation is better than direct.

    With regard to disclosure, there is an interesting dichotomy that is developing, and I don't know if this is valid or not in your minds, but some of you are arguing that it seems awkward to have excessive new disclosure that you are not sure is going to be helpful on types of institutions for which the Long-Term Capital Management model doesn't fit anyway.

    So one of the interesting questions is, I mean we have been told that some hedge funds had virtually no leverage, some have modest and some have extraordinary, but should you make a discrimination on disclosure. For example, not based on size, but based exclusively on leveraging. Should an institution above a given amount of leveraging, whether we say it is 10–to–1, 20–to–1 or whatever, is obligated to disclose where other hedge funds should not be obligated to? Is that a smart idea, dumb idea, a way of looking at it that is a little different, or not? Would any of you want to opine on that?
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    Mr. Crapple.

    Mr. CRAPPLE. Well, I think that leverage is too general a term. Just to give an example, you could have a $100 million fund that bought $200 million of stocks, and a 1987 crash occurs and they lose 50 percent in one day. You could have another $100 million fund that buys $100 million of stocks and sells $100 million of stock index futures because the two should, within some short period of time, converge. Maybe each has similar leverage by some definition, but one is a pretty low-risk strategy and one is an extremely high-risk strategy. So it is difficult to come up with some sort of a ratio without having a grasp of what the strategy is and how risky the strategy really is.

    Chairman LEACH. So you are saying that there just simply should be no further disclosure, and you shouldn't try to make a discrimination between one kind of company versus another?

    Mr. CRAPPLE. Well, one of the issues raised was disclosure of value at risk, which is an attempt to equalize the view of risk and rather than turn it into some mechanical multiple of your underlying assets which doesn't tell the story of risk. So I think there would be a greater value to something that attempted to measure risk, but on the other hand, it is very difficult to interpret. I am not sure what use would be made of it.

    Chairman LEACH. Mr. Harris, would you like to opine on this?

    Mr. HARRIS. I will pass on that one.
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    Chairman LEACH. OK.

    Mr. Coffee.

    Mr. COFFEE. I think I agree with Mr. Crapple, but also with you, Mr. Chairman. You can't give a single magic bullet answer of what are the firms we most need disclosure about. The critical fact about Long-Term was not that it was leveraged, but that it made an extraordinarily undiversified bet with basically the majority of its capital.

    So if you had a standard that tried to look at some portion of the ballpark that could impact the financial markets, companies, hedge funds or speculators over $1 billion, and then said that the regulator had the authority, where there seemed to be indications of financial stress or the possibility of excessive leverage in qualitative terms, to demand more information on an ad hoc basis, then I think you would arm the regulators with the power they need. There won't be a legislative definition that will give you the troubled firm, but you could exclude half the world, maybe 75 percent of hedge funds, knowing safely that they really couldn't have much third-party impact on the financial markets.

    Chairman LEACH. Mr. Lang.

    Mr. LANG. Well, I will just repeat what they said. Basically I think these are matters of judgment, and they are not simplistic, and I think you have to make judgments, lenders have to and regulators have to. Therefore, disclosure to the proper parties is I think the correct answer, plus good systems.
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    Chairman LEACH. Well, my personal sense in this disclosure to the proper parties is that I don't think there is anyone in Government that is smart enough to figure this stuff out and we don't have the manpower to do it. Therefore, the disclosure, to the degree that it can be arguably beneficial, is to the market itself and the people that follow this sort of thing and might find it of some meaning. But I don't know that as a fact. That is just simply a presumption that I have.

    Right now, all the Government regulators are way overworked in some ways anyway, and if you call for huge amounts of new disclosure, I am not sure everyone reads these things, or if they read them, that they would understand them. Therefore, the only great advantage of it is increasing the market discipline that private participants might bring to the circumstance.

    Now, we have a little bit of a model in New Zealand where they are breaking away from intrusive Government regulation and simply going to phenomenal disclosure in banking, and it has had the effect of causing institutions to be surprisingly more prudential because they find that in the stock market, the more prudential are rewarded and the less prudential are not. So it is a very interesting circumstance. Whether there is an analogy to hedge funds, I don't know. Whether someone that presents a public disclosure that seems to be more prudential would be more likely to get clients versus one that seems to be of a less prudential method, and that you develop an industry of private access source of disclosures of hedge funds that would read these and apply some sort of standard to them, I don't know that either. But it is unclear to me that simply disclosure of all hedge funds is necessarily anything but a sledge hammer. By the same token, disclosure of some might be very helpful. And the only commonality that strikes me is leverage ratio, but it is always possible to point out some people can use leverage in more restrained ways than others.
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    But I don't know if you would be advising regulators to look at it this way. It is clear that the CFTC believes it has authority to require this, and whether this panel would be recommending that they apply this in a more restrained way and they come up with standards for restraint, can you develop those standards? Does anyone think you can develop standards that would eliminate some funds and keep other funds more of a disclosure mode?

    Mr. Harris.

    Mr. HARRIS. This is maybe indirectly answering your question, but going back to the comment that you just made about regulators and whether or not they are smart enough to keep up with this stuff, I happen to think it is a real challenge for regulators to keep up with all the new financial products and transactions that are developed. Regulators are almost always behind. There is no way they can be as up-to-date and knowledgeable about these practices or transactions as the institutions that develop them are. So therefore, I don't think that the regulators necessarily fail when they don't keep up with this stuff, but it is a challenge.

    I don't want to leave you all with the impression that I don't think there is a role for regulators in all of this. One of the things that we seem not to have discussed here, is the Working Group's recommendation with respect to capital, and that is where I think the regulators can really make a difference. Not so much in addressing the leverage of hedge funds, but in addressing how banks deal with them. And it seems to me that the recommendation with respect to enhancing or further modifying the risk-sensitive approaches to capital adequacy is probably the most important recommendation contained in this Report. I think, though, there is a hidden bombshell there, and that is the possibility for regulatory arbitrage.
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    Currently, the risk-based capital adequacy standards established by the bank regulators under the Basle Accord in fact would produce a much higher capital charge, not that that is inappropriate, but a much higher capital charge than the capital charge that would be applicable to broker-dealers under the SEC's broker-dealer lite proposal. I think that is an issue that is going to have to be addressed if, in fact, we are going to enhance the capital requirements. That is I think where the most appropriate change can be made.

    Chairman LEACH. Mr. Crapple.

    Mr. CRAPPLE. May I give a somewhat cynical appraisal of how the money management business works in this respect?

    Chairman LEACH. Sure.

    Mr. CRAPPLE. Basically, if you have a great rate of return, you get a lot of assets and people, the public at large, don't seem to care too much about risk. Irrational though that may be, if Long-Term Capital is showing gains of 40 percent per annum, that is going to cause money to flow into them, and it is true in the mutual fund business. Although the Investment Company Act has certain restrictions on risk of mutual funds such as leverage, we have a mutual fund out now that does nothing but invest in Internet stocks. It is diversified because it has maybe 30 Internet stocks, and it has a fantastic rate of return and money is flowing in. This has got to be one of the most risky possible investment companies, and it is a fully regulated situation, obeying all of the investment company rules.

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    So I really question whether publishing financial information is somehow going to be a great Gresham's Law that drives the bad money out of circulation. I am afraid the high-risk people who may have achieved a two or three-year rate of return will get more money, and public disclosure might be counterproductive from that point of view.

    Chairman LEACH. Well, I thank you.

    Madam Chairwoman.

    Mrs. ROUKEMA. Mr. Chairman, are you ready to conclude this panel?

    Chairman LEACH. Go right ahead.

    Mrs. ROUKEMA. One last question?

    Mr. BENTSEN. Yes, unless you—please go ahead.

    Mrs. ROUKEMA. No. I just have a concluding observation.

    Mr. Bentsen.

    Mr. BENTSEN. Thank you, Madam Chairwoman.

    First, let me say that our colleague, Mr. Leach, is I think one of ten people in the country who knows what is going on in the New Zealand banking world and he continues to amaze us with his knowledge of banking laws throughout the world and occasionally uses it to beat us over the head when we are debating domestic banking policy.
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    With respect to disclosure, and I have a concern about the proposal to require quarterly disclosure of all hedge funds, I think that is over done, and I think it is because disclosure, I have always thought, is designed for protection of the investor, and the type of disclosure that is discussed in the Report would apply to hedge funds—would be providing disclosure to the public which has no interest in—no material interest in the performance or investment strategy or whatever of certain hedge funds. And I think it is telling that Mr. Lang, who probably would end up writing a lot of that disclosure for his clients, would oppose this, but I think also, I am curious whether or not you would see a situation where some requirement like that would further push, or could possibly push some hedge funds offshore to avoid another area of excessive regulation or burden.

    Mr. LANG. Yes. I think that is a real risk.

    I also think you can't say all hedge funds file anything. Most of them have nothing whatever to do with the issue here. Many of them don't have leverage at all. There is no need to have that information out there. So the highly leveraged ones may go offshore or do other things.

    Mr. BENTSEN. Now, that being said, though, as Mr. Harris pointed out that I guess you believe, there was failure internally on the banks in having adequate credit monitoring of their lending activities in this instance, and some form of disclosure, internal disclosure or regulatory disclosure with respect to financial institutions, insured institutions might be necessary. Is there not adequate disclosure under the current regulatory regime as it relates to banks? You were at the Comptroller of the Currency's office, and the examiners don't have sufficient data to look at when they go in and say what about this loan, what about that loan?
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    Mr. HARRIS. No. I think, in fact, that the kind of disclosure and enhanced information that banks need to make prudent credit decisions is not a matter of regulation at all, it is a matter of their internal policy. A lot of them overlooked their standard and accepted procedures for making loans, extending credit, and maintaining a relationship with counterparties based, in large part on the reputation of certain of the people that were running these hedge funds, and because the business was so profitable. They overlooked their standard procedures. That isn't a matter of regulation, that is a matter of bad banking.

    Mr. BENTSEN. Bad judgment. And how do you guard against that?

    Mr. HARRIS. You would hope that the experiences that the banks have had recently would address that issue, that it would cause them to address it. As I mentioned in my testimony, I think the damage to their reputations, the loss in shareholder confidence and the loss in their values as a result of those losses are going to be very meaningful in terms of getting them back on track.

    Mr. BENTSEN. Thank you.

    Thank you, Madam Chairwoman.

    Mrs. ROUKEMA. Mr. Chairman, I have no further questions. I would simply say in conclusion to thank this panel and the first panel. I suppose it is an example, a prime example of how the more you know about something, the more difficult or the more you realize there are no easy answers. That does not mean, however, in my opinion, there aren't some conclusions that could help us. We have to find some ways of dealing with these problems. We can't simply ignore them because of the systemic questions that I think are definitely out there. Unfortunately, Mr. Harris, people learn, but their memory is awfully short, particularly if they think there is a bailout out there at some point in time.
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    You have given us a great deal of material to think in depth about and recognize that we have to use all of that material in addressing the legitimate questions raised by the President's Working Group Report. I do thank you.

    We would welcome you, as the Chairman would say, to provide additional information for the record. The record is open and if there are further additions that you want or presentations to any one of the individual Members with respect to the questions, please make them. We are open to additional testimony for the record. Thank you very much.

    [Whereupon, at 2:15 p.m., the hearing was adjourned.]