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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, Lazio, Bachus, Castle, Paul, LaFalce, Vento, Frank, Kanjorski, C. Maloney of New York, Hinchey, Bentsen, and Sanders.

    Chairman LEACH. The hearing will come to order.

    This morning we will begin a review of the failure in Government rescue of the world's most celebrated hedge fund, Long-Term Capital. I say that we will begin the review because a failure of this magnitude and the Fed's decision to intervene on behalf of a private company raise profound public policy questions, some of which may not become evident for some time, to which this and other committees will no doubt return later in this or the next Congress.

    Hedge funds were so named because their managers tried to reduce, with offsetting transactions, the risks they were taking with investor funds. Today, the name has an ironic ring. As hedge funds have grown in the last few years, so has the venturesome nature of their investments in pursuit of ever-higher returns. The industry numbers between 3,000 to 5,500 funds and somewhere between $200 billion and $300 billion in investment capital. One-third of the funds are highly leveraged; in Long-Term's case, about 27–to–1. That means these funds are supporting booked assets on the order of $2 trillion.
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    Large financial institutions make this leveraging possible, often with federally-insured funds. If taxpayers share in the risk, they, or at least their protectors—bank regulators and in some cases the CFDC and SEC—ought to understand what risks are involved. The profit motive is the most powerful disciplinarian of markets. But the United States Government is obligated to be on top of the issues.

    Risk-free regulation is not possible or necessarily appropriate. The economy could be as ill-served by financial institutions refusing to take risks as it is by those taking too much. Hence, the questions of whether and how to establish appropriate regulatory oversight are judgmentally elusive.

    Speaking as a Member of this committee who has been pushing for more disclosure by financial institutions and closer cooperation among regulators, I am well aware that the Congress is not the optimal institution for setting precise supervisory standards. An attention to margin requirements, for instance, may be an appropriate tool, as Muriel Siebert will suggest to the committee this afternoon, particularly for that part of the hedge fund industry that is leveraged with borrowed capital from already leveraged institutions, for example, banks.

    However, it seems to me wiser to give discretion to establish restraints of this kind in institutions such as the Fed, rather than attempt to design an arbitrary approach within Congress, a body that lacks the necessary sophistication on matters of this nature. But Congress cannot duck its oversight responsibility of those charged with supervision of these markets.

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    The troubles of Long-Term Capital confronted the Fed with a Catch 22. If it failed to act in the face of what was presumably deemed to be systemic risk, it would have been left open to charges that it abdicated leadership on a matter that might have affected the stability of markets around the world and thus the pocketbooks of millions of ordinary citizens. By acting as it did, however, it preserved an institution that in the free-market economy would normally have been allowed to fail.

    It would appear that the Fed's intrusion into our market economy can be justified only if it can be credibly shown there was a clear and present danger to the financial system in Long-Term Capital's failure and that there were no stabilizing alternatives; for example, other credible bids on the table.

    Although no public money was involved, this is the first time the too-big-to-fail doctrine has ever been applied beyond insured depository institutions. This intervention is also the first one in my memory that involved a commitment of funds by those summoned to the elegant quarters of the New York Fed and the formidable presence of its president, Mr. McDonough. Other Fed interventions generally turned on more technical questions. In this regard, it is only reasonable for Congress to expect an explanation from President McDonough, who called and hosted that extraordinary gathering of Wall Street power brokers.

    From a social perspective, it is not clear that Long-Term Capital, or any other hedge fund, serves a sufficient purpose to warrant Government-directed protection. In one view, hedge funds provide liquidity and stability in financial markets, making it possible for large companies like General Motors and IBM to issue billions of dollars in bonds without causing interest rate distortions so as to facilitate the building of factories and creation of jobs. In another view, hedge funds have a narrow raison d'etre. They are seen by some to be run-amok, casino-like enterprises, driven by greed that with their sheer size can control markets and, in certain circumstances, even jeopardize the viability of sovereign states.
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    From a regulatory perspective, the Long-Term Capital fiasco is instructive. Federally-insured institutions are subject to well-understood regulation, which among other things places a premium on prudence and disclosure. In this case however, some of the country's largest and most sophisticated banking institutions provided loans—and, according to a Long-Term Capital officer, fought for the privilege for doing so—to an institution that shielded its operations in secrecy, denying lenders and their regulators any data about its positions or its liabilities to other lenders.

    The rationale was that sharing information was competitively disadvantageous to the fund. Implicitly, however, this practice made lenders to the fund responsible for a kind of blind-eyed banking practice that no community bank I know would countenance, and complicit in speculative actions that might in some cases prove destabilizing for the very financial system upon which banks and the public rely.

    Long-Term Capital was the envy of its peers, the very paragon of modern financial engineering, with two Nobel Prize winners among its partners and Wall Street's most celebrated trader as its CEO. The fact that it failed does not mean that the science of risk management is wrongheaded, just that it is still a fledgling art in a world where the past holds lessons, but provides no reliable precedents.

    There are points where politics and economics intersect, and when political institutions implode, as they did in Russia, economic consequences follow. The best and the brightest—from George Soros to John Merriwether—lost billions betting on a more stable ruble and a relatively weaker dollar. This underestimation of America, which became reflected in a growing divergence rather than convergence of various bond valuations in contradiction of mathematical models based on historical patterns during times of relative market tranquility, should give pause to bank managers and regulators alike. At issue is not just a judgment of the moment, but the problem of applying mathematical models in adverse times, especially when the vicissitudes of politics and human nature conspire with market forces.
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    In retrospect, it is difficult for a neutral party not to be struck by the fact that the best and the brightest in the hedge fund industry could commit such strategic errors; that the best and the brightest in the investment banking industry would give a blank check to others in an industry where they are also considered to be experts; and that the U.S. regulatory system could be so uncoordinated and so easily caught off guard.

    The Fed and the OCC, principally the Fed in this case, have responsibility for regulation of the banks which extended such large credit lines to Long-Term. Questions exist as to how on top of loan extensions were these regulators. The principal agency with statutory authority over the fund is the Commodity Futures Trading Commission, with which Long-Term Capital was registered as a commodity pool operator and to which it was required to make periodic financial disclosures. According to CFDC officials, the Commission has the power to examine its books at will. It apparently didn't do so, even after Long-Term Capital reported at the end of 1997 that its assets included nearly $3 billion in swaps, forwards, futures, options and warrants, and its liabilities $6.4 billion in similar instruments—or that it had leveraged $4.7 billion in partners' capital into investments of $129 billion.

    I agree with Chairman Born that Long-Term Capital's troubles are a wake-up call about the risks OTC derivatives may pose to the financial system. But it is disappointing that her prepared statement does not provide the committee with an autopsy of the fund—of what went wrong and why. Instead, it confines itself to an argument for a policy that in the view of the other financial regulatory agencies increases the very risks, such as the problem of maintaining legal certainty on contracts when problems of this nature arise, that she decries.

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    The six financial companies that now supervise Long-Term Capital, as well as the fund executives, were invited to appear before the committee. All declined. Given the public policy issues at stake, this circumstance is noted with concern.

    The Long-Term Capital saga is fraught with ironies related to moral authority as well as moral hazard. The Fed's intervention comes at a time when our Government has been preaching to foreign governments, especially Asian ones, that the way to modernize is to let weak institutions fail and rely on market mechanisms rather than insider bailouts. We have also encouraged these countries to establish bankruptcy arrangements to cushion the shock of failures and, where possible, fairly distribute the assets of bankrupt institutions. Now, as the country with the most sophisticated markets, bankruptcy laws and legal precedents, we appear to have abandoned the model we urge others to follow. Or, worse yet, the Federal Government may have played a role in precipitating a bailout offer more advantageous to the failed management than the free market offered.

    Let me just conclude by saying that the terms of the rescue package engendered by the Fed also raise troubling questions of financial concentration and antitrust. As a group working together, the new owners can have a greater impact on markets than in competition with one another. In this regard, it should be understood that the Fed's unprecedented extension of the too-big-to-fail doctrine to a hedge fund does not insulate the fund and its new owners from the constraints of the Sherman and Clayton acts.

    The bailout may involve a tendency toward concentration that the Justice Department has an obligation to review.

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    Chairman LEACH. Mr. LaFalce.

    Mr. LAFALCE. Thank you very much, Mr. Chairman.

    First of all, I appreciate your expeditiously holding this very important hearing, for an interrelated set of circumstances compels immediate congressional inquiry. And I also want to say that I associate myself with all of the remarks that you just made. I regret, however, that the bankers and banks who loaned to Long-Term Capital Management are not appearing today, despite the fact that you invited them. I understand their reticence, since business ramifications are proprietary, but I regret it just the same.

    Global markets are in turmoil and domestic economic deterioration is appearing, as Chairman Greenspan has said, around the edges. On Tuesday, the Federal Reserve adjusted the funds rate downward modestly in order to counter the trend and increase at least national and probably global liquidity. I applaud that action. However, monetary policy can only go so far in addressing economic concerns. More broadly, we need our financial regulators and relevant domestic and international agencies to function effectively as rapid response teams to address today's economic perils, whether domestic or global. This Congress is not helping in that regard.

    Speaker Gingrich and Majority Leader Armey, for example, are still causing an IMF impasse, which I continue to call shameful, irresponsible and flirting with disaster. Such problems in this House, nevertheless, make it even more imperative that other features of our economic defense system be in readiness. We need to know now if the necessary machinery is prepared to function when needed.
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    I was here, as the Chairman was, in October, 1987. As experience shows, we can very suddenly confront economic turmoil with dangerous implications.

    Chairman Greenspan, you were in place a dozen years ago to the month, as I recall, when our regulatory team had a very difficult time coordinating the strategy. As I recall, the then-chairman of the SEC was publicly hinting at a closure of the New York exchanges while the Treasury was thinking no such thing. That might sound trivial today, but it was certainly not considered trivial at the time.

    The events surrounding LTCM are a useful test case. I hope this hearing serves at least three purposes:

    First, this should help us evaluate the ability of Government regulators and agencies to respond quickly and adequately to situations that could threaten the financial sector in our economy. In particular with this panel, what is the appropriate role of the Federal Reserve under existing law and regulation in overseeing lending of this nature by creditor institutions it otherwise regulates? I would like to know how much insured depository institutions had already loaned to LTCM even before this so-called bailout action. What role did the Federal Reserve then play, especially the New York Fed, Mr. McDonough, in facilitating this bailout? And what role should it properly play?

    Second, I think we must look into very legitimate questions regarding who benefited and who suffered and who will ultimately benefit or suffer from the hedge funds failure and takeover. So many of these hedge funds have billed themselves as exactly that, hedge funds. They are engaged in arbitrage and risk management, not speculative investment funds. Are they open to legal liability because of the mismatch between their advertising or marketing and their performance? Were they insured? What is the role of the insurance companies, both in any liability that may exist and what is the role of the insurance industry in monitoring whether the practices of the funds are in conformity with the marketing of the funds? And have we, through our catalytic action, made insured depository institutions substitutes for the insurance companies in this instance?
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    Those are questions which I hope you will address.

    And, third, even though LTCM was led by men of great intelligence, including, I believe, two Nobel Prize winners specializing in risk management, which may have been one of the attractive features of the fund, markets can surprise the very best of minds, and complex investment strategies are always full of uncertainty.

    There are some other similarities to 1987. LTCM supposedly threatened a market meltdown by a hedge fund. Such hedge partnerships are not new in concept, but they are certainly new in size and scope and importance. In 1987, another novelty, program training was one of the main culprits. It, too, was not totally new in concept, but was new in size, share of volume and importance.

    In short, novel business arrangements, often involving high speed and substantial complexity, can create unexpected results since no one fully understands their implications until after the fact. Consequently, group effort becomes even more important.

    Program trading resulted in a circuit breaker regime for stocks that exchanged traded derivatives. Despite being greatly and justifiably liberalized, we still need and use them almost daily. The emerging hedge fund power and influence also might require new or improved regulatory systems. These might need to address the hedge funds themselves or the exchange or over-the-counter derivatives that play such a big part in the lives of such entities. I also wonder if this would cause the Federal Reserve to reconsider its position with respect to FASB's proposed regulations.
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    Beginning to judge the need or lack of need for such regulation should be a main them of our hearings, and the answer in part will rest on how well the members of our present rapid response team will handle LTCM using the authority and interrelationships they now have. I make no judgments about the failings or successes of one party or another based on press reports, but I do have some concerns.

    First, LTCM has become a flash point in the ongoing debate, often regrettably bitter or apparently bitter, amongst the agencies on the Administration's financial working group about jurisdiction concerning OTC derivatives. Due to the controversy surrounding the until March, 1999, standstill amendment on further CFTC action in this area, I am concerned about the level of coordination and cooperation amongst our regulatory team. Some are saying the CFTC should have been aware of the situation since it was the only Federal agency with which LTCM had to register, that the CFTC could accurately respond, but registration only provides it with imperfect data. It can only compel reporting on exchange-traded commodities and could have no idea what LTCM's profile might have been concerning OTC derivatives or long positions in regular stocks and bonds.

    Second, Chairman Levitt noted in testimony this week before the Committee on Commerce that the SEC was monitoring the brokerage houses under his jurisdiction and pressing them to take care with credit and other dealings with LTCM. However he, too, cannot get an overall picture since bank credit monitoring is held elsewhere. In any case, the Investment Company Act and the Investment Advisors Act removed the SEC from registration and supervisory responsibilities for hedge funds.

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    In the meantime, through, high leveraging LTCM might have gone to better than $1 trillion in notional assets with better than $100 billion in at-risk assets. Better than $100 billion, when it is my understanding that their capital may have been approximately $4 billion, which raises another fundamentally important question: What legal requirements exist, or ought to exist, with respect not only to capital, but with respect to margin requirements?

    If you have $4 billion and can go in excess of $100 billion, it sounds to me that you are harking back to the era of the 1920's when you had minimal margin requirements. Is there any existing regulatory authority to address what I think is grossly inadequate margin requirements or should Congress act at least on this issue alone, quickly and expeditiously?

    Third, when the Federal Reserve did step in, they were at least faced with the fact that some of its most prominent former officials are partners in LTCM or lenders in brokerage firms. Further, high-ranking officers of lenders to LTCM are also investors in LTCM. And I am just wondering if that causes any concerns to you or should cause concern to us?

    I have a great many additional points, but since I have taken an appreciable amount of time I would ask unanimous consent to include the rest of my remarks in the body of the record Mr. Chairman.

    Chairman LEACH. Without objection, it is ordered.

    The Chair would also like unanimous consent to put all other statements in the record, to revise and extend his own statement, and to put a statement from the Deputy Secretary of the Treasury in the record, without objection.
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    Does anyone else wish to be heard?

    Yes, Mrs. Roukema.

    Mrs. ROUKEMA. Yes, thank you, Mr. Chairman. I certainly want to thank you for your comprehensive outline of the issue and, of course, for what Mr. LaFalce has added to it.

    This subject is esoteric to many people. It is not like talking about the prime rate or interest rates. We have a good hearing set for us today, and I want to thank you for calling the hearing. It is very relevant today, given the broiling financial markets, both domestic and global, and certainly we want to understand the relationship, if any, and what action we may or may not take. We have to understand this most esoteric subject.

    The hedge fund industry, as we know, has been a growing one in recent years. There is a hedge fund exemption from Investment Company Act registration requirements. It has been stated that the investors in these funds are not regular retail investors like you and I. Rather, these hedge fund investors are supposedly sophisticated investors who understand the risks and have the financial wherewithal to lose their entire investment.

    Well, that doesn't seem to be the case here. The spectacular failure of LTCM, LP is quite remarkable, and even though we had bragged about two Nobel laureates, a former Fed vice chairman and bond trading legend with a questionable reputation—that is my own editorial comment—Mr. John Merriwether, it had been described as the ''Rolls Royce of hedge funds.'' Well, apparently it wasn't that, and I won't go into a repeat of the meltdown that we are all familiar with since August of this year.
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    But there are several questions that I think we need to look at—significant additional regulation, limits on leverage and specific bank reporting to the regulators of the loans to hedge funds. Most of them have already been mentioned by our Chairman, Mr. Leach, and referenced by Mr. LaFalce.

    These are important questions, but I want to stress a couple that I have on my own mind, and that is, what are the implications for the financial safety net in specific terms? The rescue plan—and it was a private rescue with no Government funds being issued—was funded by the biggest securities firms, whether they are Merrill Lynch, Goldman Sachs—I won't name all of them—but also banks—Banker's Trust, J.P. Morgan, Chase Manhattan, UBS and others. And the logical question does come up: Are there implications of public cost? Did the fact that the Federal Reserve hosted and participated in these meetings provide an implicit Government guarantee? I don't know. I ask that as an honest question. What are the too-big-to-fail and the accompanying moral hazard questions posed by the financial rescue? And I am sure that the two gentlemen on our first panel are going to address themselves to that.

    Another question I have, and this is an important one, relates to the Asian currencies markets. Some commentators have suggested that it was extreme currency trading pressure from hedge funds and others that caused the Thai baht—did I pronounce that correctly?—and the Indonesian and the South Korean currencies to collapse. Is there any truth to these assertions? Are there global implications here of an extraordinary nature that we should better understand because it is an interrelated global economy?

    And another question is how are the hedge funds to be monitored and regulated in the international arena? The Administration has requested, as I understand, an international financial summit for the G–22 nations to look at revamping the world's financial systems. Most recently, Tony Blair of Great Britain, Prime Minister, has stressed the same issue. The meeting is to begin here in Washington in the near future.
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    I will note that if there is anything—that, if anything—the Administration, I regret to say, is not here today, but that they have not been very articulate on how they view the necessity for action either on their part or congressional action on these questions.

    I might also add that there is a concern among many that if we implement a new regulatory scheme here at home or place certain restrictions this may only force the hedge funds offshore into unregulated, unsupervised countries. That would not be a good result, and it might have terrible unintended consequences.

    Mr. Chairman, there are lots of questions here today. I am going to limit my remarks so we can get on to the questioning, but I would draw the committee's attention to, and ask unanimous consent to have inserted into the record following my opening statement, an article from today's New York Times, the Editorial Observer, Floyd Norris, entitled, ''Risking Everything on One Big Gambler.'' It states very essential public policy questions for us to answer, and I would like to have that included in the record following my opening statement.

    Chairman LEACH. Without objection, so ordered.

    Mrs. ROUKEMA. I thank the Chairman.

    Chairman LEACH. What I would like at this point is to turn to an opening statement from the Ranking Member of the subcommittee, and then I would like to ask that we limit opening statements to greater brevity.
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    Mr. VENTO. Well, I will try to be brief, Mr. Chairman. I agree with you.

    Chairman LEACH. The Ranking Member is entitled to a full statement.

    Mr. VENTO. Thanks. I want to commend you for the hearing. I think that you know it is ironic we are on the verge of passing a major financial restructuring bill, H.R. 10, and this LTCM incident has occurred. Understanding the concerns the Fed—and that this would lead to a domino effect in terms of Long-Term Capital bankruptcy and other adverse impacts on our economy, I think this points out it isn't just operating subsidies, it isn't holding companies. This particular moral hazard issue is something embedded in our economy, and I don't discount the role of the Fed. Well, I understand the principles involved. I think we have to know and look to who was, in fact, bringing these parties to the table in terms of our Governor, Chairman of the Governors and the Treasury.

    It is interesting, of course, to note this role for the regulators. During the evolution of this problem one wonders where they were. The question that persists is, should the Fed Board have been there orchestrating a bailout or not? I am sure in some minds what is the appropriate role for regulators? You know, this does lend, in my mind's eye, some credibility to the CFTCs or earlier concept or lease or at least a concept of some regular looking at the entities.

    There seems to be a lot of concerns, but if we can discount the turf conflict I think we come up—I find it ironic that nobody was responsible, but everyone seems to agree that the CFDC shouldn't have it either. In my judgment, of course, an old science axiom was ''nature abhors a vacuum,'' and it appears that when a crisis looms splitting infinitives is forgotten, and I think that is good. But this issue is, if we are involved in the landing, shouldn't we have a voice in the take-off, and when onboard, a compass as to where we are trying to go?
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    And I think we can rely upon issues like deposit insurance, but it seems to me that that is trying to drive by looking through the rearview mirror as to what is going on. So I don't think that, while we have some controls there, I don't think it is acceptable.

    Now I remember when we were dealing with systemic risk question in terms of too-big-to-fail and one of the amendments that we added to the bill, for instance, we had the opportunity for the Federal Reserve Board to deal, obviously, with the issues with banks and we also had in the law, although I don't know that it has been used, a provision dealing with large industrial entities. We added a provision that provided for the opportunity to deal with other financial industry, and it is namely securitization and other purposes, so we did actually make an affirmative action in the law in the last decade on that particular provision of law. I remember because I was working on the amendment.

    But I think that the case here gets back to there is some authority, there is some responsibility there. How that has been exercised, of course, is what we are talking about today. I think a greater case can be made for transparency, but this runs us right into the sort of debate that occurred with regard to FASB rule and whether or not we are getting into proprietary information and whether or not we, in fact, do drive things offshore, although I think that argument is somewhat limited in terms of looking at the volatility around the world and recognizing the significant advantages of being within our economy and having the benefits from it.

    Now on this, of course, I think the concern we have here is that, you know, we hear a lot of speeches about free enterprise and the marketplace, but a lot of folks don't like to practice it. And I think the problem we have as representing our constituents is that there seems to be two roles here, a double standard, one for Main Street and another one for Wall Street; and while I am very interested in terms of mixed economy I don't believe in economic Darwinism or going to economic ground zero in this country or around the globe.
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    The fact of the matter is, I think we have to be convinced that there are some predictable standards, some predictable behavior and rule that is out there, that, in fact, there are expectations that are going to go with regard to it. If there is public policy, for instance, we hear a lot of complaints in this role about, for instance, providing a low-cost checking account or CRA.

    There is bitter opposition to these types of things, but yet we get involved in these types of use of public power to select winners and losers and without a vote by us or anything else. And the question is, you know, when we begin to talk about franchise and utilization of this to serve other purposes I would like to see a more appropriate response to this.

    Today, of course, we can affirmatively identify the role responsibility and results and, hopefully, set a clear policy path as to guide similar actions in the future. I just think that this idea of having this occur without more transparency and without some logical sequence of events and standards is of great concern to me. So I will be looking for those answers to my questions in the testimony today.

    Thank you, Mr. Chairman. It is a good idea to have this hearing. Thank you.

    Chairman LEACH. Thank you.

    Let me explain. There are two subcommittees of jurisdiction, and one is headed by Mr. Baker, and I would like to recognize him at this point.
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    Mr. BAKER. Thank you, Mr. Chairman. I appreciate your courtesy. I shall try to be briefer than the normal allocated time.

    I thank you very much for calling this hearing in such a timely manner and point out first the series of questions that I have prepared, which I know you will include as part of the record, and not recite all of them, but there are some principal issues that I think need and deserve critical attention.

    When and how, for example, did the concept of market self-regulation fail us in this instance, which has been regulators' views until this point in time? When margin calls eroded $4 billion of capital down to $400 million of capital in less than 60 days, when a $3.5 billion work-out plan was confected and we still find ourselves with about $90 billion of cats and dogs that have to be unwound, how is it that that convoluted process can be engaged in without regulators recognizing the credit extensions by the insured and regulated institutions?

    And finally did any of the investors in the work-out have significant financial interests or management responsibility in the firms that were ultimately recapitalized, thereby saving their own financial fortunes as a result of the intervention?

    I think these are extraordinarily important questions, and I have others which I hope to be able to have time to ask at a later moment, but this cannot be understated as being one of the more serious financial difficulties of this century; and I hope that we are going to be comforted that the regulators do now in fact have plans in place that would help to avert such unfortunate circumstances in our future.
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    Thank you, Mr. Chairman.

    Chairman LEACH. Well, thank you very much, and I must say I don't think any Member of Congress has devoted more time to issues of this nature in a more thoughtful way than you have, Richard.

    Mr. Kanjorski.

    Mr. KANJORSKI. Mr. Chairman, I guess what I am interested to know from the testimony today is what was the break-out of exposure here of the investors and the institutions that are, particularly, federally-insured, and in what amounts; and then the question is, what did they know and when did they know it?

    It seems to me that there is a failing here in the inspection system to protect the Federal taxpayer in terms of 60 days and a bleed of only $4 billion in equity and over $100 billion of exposure, mostly coming, or a good portion coming, from insured funds. We don't know the exact proportions.

    At what point should the banks and should the regulators have known this? And what were the obligations between the parties?

    And I am much interested in what the relationship of the investors and the potential conflicts of interest are here that would clearly call for us to look at a regulatory scheme that would prevent insider dealing or investor dealing in the future with potential conflicts of interest.
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    Thank you for calling the hearing, and I look forward to the testimony, Mr. Chairman.

    Chairman LEACH. Mr. Bachus.

    Mr. BACHUS. Thank you, Mr. Chairman.

    First of all, we are talking about which subcommittees have jurisdiction, and I am not sure what we have decided, but if we have decided that the Oversight subcommittee does not have any jurisdiction, I am glad that we have decided that. And I will second your conclusion that we did not have jurisdiction over this matter.

    Let me say this: Our subcommittee has been focusing on rescue plans and what we call ''bailouts,'' and that is bailouts of foreign countries. And I think we have now come full circle in that we have been talking for so long about moral hazard, the doctrine of moral hazard.

    We have also been talking about another doctrine, and that is the doctrine of ''too-big-to-fail,'' and it seems to me as if with Long-Term Capital, we have had a collision of these two doctrines, ''too-big-to-fail'' and ''moral hazard.'' And apparently the victim in all this and the doctrine that has been totally disregarded is moral hazard.

    What should happen to a large hedge fund that is grossly overleveraged when it fails? And what should happen to a country or a large corporation when it fails? Should we have a federally-sponsored or engineered rescue, or a bailout? You know we addressed that with Mexico. Mexico was too-big-to-fail. It would have implications for our markets. But at the same time some of us, Mr. Sanders and I, argued why do we bail out these investors?
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    We are creating a situation here that could come back to roost, and I would say that that is happening today. Russia, too-big-to-fail; we went in and we rescued them. And when we rescued Mexico, when we rescued Indonesia, when we rescued Russia, we helped rescue these same hedge funds and the investors in those hedge funds and allowed them to continue to overleverage and overinvest, or to make risky investments.

    So I would simply say this. Today, where is the doctrine of moral hazard as far as the Federal Reserve is concerned? What does the doctrine of ''too-big-to-fail'' mean?

    And the last thing I will say is this; I would say the focus does not need to be on hedge funds, because I don't think we are ever going to be able to regulate hedge funds. They are going to go overseas. In fact, Mr. Ely on CNBC last night said trying to regulate a hedge fund is ''like trying to nail a jellyfish to a wall,'' and I would agree with that.

    But we do have regulatory oversight and responsibility for regulating lending practices and our banking institutions, and so part of this hearing ought to be to ask the questions, did our institutions loan too much? Were these prudent and reasonable loans? Did the Federal banking regulators fail to monitor the situation?

    I appreciate your presence here and I hope that at some point we are going to go back to what we require of welfare mothers when we have said, ''you have got to go back to work''; what we have said to small businesses when they fail, ''you have got to take the loss''; what we have said to farmers; what we have said to our people here in America. And that is that it is not the job of the Federal Government to rescue and that that ought to also apply to the rich Greenwich, Connecticut investors who are multimillionaires. We ought to use the same standard that we have used on welfare mothers on these large hedge funds.
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    Thank you.

    Chairman LEACH. Well, thank you very much, Mr. Bachus.

    Mr. Sanders.

    Mr. SANDERS. Thank you, Mr. Chairman, for holding this important hearing.

    Let me begin by reading a quote from the New York Times that appeared a week ago Thursday, and I quote:

    ''A week before the Long-Term bailout was negotiated at the headquarters of the Federal Reserve Bank of New York, Alan Greenspan, the Fed Chairman, testified to Congress that bankers knew exactly what they were doing in the policing of hedge funds and their attendant risks. On September 16 they assured Representative Richard Baker, Republican of Louisiana, that risk in hedge fund lending was well under control.'' I guess that was one week before the bailout.

    Mr. Chairman, Alan Greenspan is here with us today, along with Mr. McDonough, and we expect that they are going to explain to the Members of this committee why the global economy remains unstable, why the Federal Reserve has organized a $3.5 billion bailout for billionaires, why Americans should be worried about the gambling practices of the Wall Street elites.

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    In my State, you know, people buy $1 lotto, but they don't usually invest hundreds of millions of dollars in these types of gambling practices.

    Now let me begin by quoting from a recent op-ed piece in The Washington Post by James Glassman, picking up on a point that Mr. Bachus just made, quote:

    ''In America today there's a double standard''—I should point out, Mr. Glassman is a conservative—''. . . a rule that applies to welfare mothers doesn't apply to politically connected corporations, rich speculators and irresponsible nations. Over and over again when powerful people and institutions get in trouble, the Government bails them out,'' end of quote—not when family farmers get in trouble, not when small businesspeople get in trouble not when poor people get in trouble. But I guess to get Government assistance with the help of the Feds, you have got to be a multibillionaire gambler.

    Now let's take a moment to understand what, in fact, has been happening. What we have here, so far as I can understand, is a man by the name of John Merriwether who went to some of the largest banks in America and asked for $100 billion in loans to gamble on whether interest rates would increase or decrease. Like any gambler you might find in Las Vegas, Mr. Merriwether, after several years of success, I should say, apparently went too far. He gambled himself into a situation where one company lost, his own company lost some $90 billion, and according to the New York Times, this hedge fund's speculation topped $1.2 trillion.

    Now, what is $1.2 trillion? It is an astronomical sum of money. It is close to what the budget of the United States Government is for one year. That is what we are talking about. This is one man whose actions and poor judgment can cause economic catastrophe throughout the entire world. One person.
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    Now, we hear a lot about crony capitalism in Russia, crony capitalism in South Korea and in Indonesia.

    Chairman Greenspan, I hope in your testimony today that you will talk about crony capitalism in America, about one man's investment threatening the economic stability of the entire globe.

    What we have here are banks that are willing to lend billions of dollars to one man so that he could gamble on whether interest rates go up by a half a percent or whether they go down by a half percent. But meanwhile these are the very same banks that refuse to loan money for economic development and job creation in communities all over America. Evidently there is not enough money in these banks to invest in job-creating small business, in job-creating family farming, in job-creating manufacturing, but there are unlimited amounts of money to be lent to gamblers in their nonproductive efforts to guess if interest rates will rise or fall.

    Mr. Chairman, there are changes taking place all over this planet. You will note that recently in Germany there was an election in which conservatives lost. A year ago there was an election in France where conservatives lost. Two years ago there was an election in Great Britain where conservatives lost. All over Europe and throughout the world there are growing doubts about the sensibility of the faction Reagan—and, if I might add, Greenspan—approach to economic development, an approach which says that it is OK for a couple of hundred billionaires throughout the world to own more wealth than the bottom 45 percent of the world's population, an approach which says that it is OK in the United States for one man to own more wealth than the bottom 100 million Americans.
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    So I think the good news is that Europe is beginning to wake up that this laissez-faire type of approach knocks down all barriers. Let's suppose minimum wage, let's suppose national health care programs, let's suppose any action that helps working people and poor people. That is bad. But let's give the billionaires the opportunity to make more and more and more money so that we have a situation where one man can have an influence over $1.25 trillion, and truth of the matter is, nobody has a clue what is going on; and Mr. Greenspan, a week before the collapse, says that the banks know what they are doing.

    So I would suggest that this issue today deals not only with this hedge fund, but our entire approach to the global economy where so few people own so much wealth and have so much power, where the IMF is running dozens and dozens of countries throughout the world, and I think we had better learn from Europe's recent elections and start rethinking this entire approach to the global economy.

    Thank you very much, Mr. Chairman.

    Chairman LEACH. Thank you.

    Mr. Castle.

    Mr. CASTLE. Mr. Chairman, I will be brief, and I don't go as far as Mr. Sanders, nor do I sit here and say that I truly understand hedge funds. But this is remindful to me of the savings and loan debacle, only a lot more leveraged even than the saving and loan situations were; and I think it is sort of that, what I view as a corollary of ''too-big-to-fail'' is ''too-small-to-succeed.''
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    I look at my own little mutual funds and pitiful real estate investments and how they have done this year, and nobody has come in to help me particularly. But I think I reflect what a lot of other people are thinking out there. You know, why should the New York Fed step in and help in this circumstance with persuasion perhaps, not direct help, when their own investments are not doing as well? That is a legitimate question for the American public, and I think it is something that should be answered today.

    But let me say what I'd like to get out of this hearing today. I really would like to have a better understanding of the problem, I mean the scope of the problem. I view it as a problem, by the way; I am not just using that expression lightly. I think the anonymity here, the banks not knowing about the credit extensions by other banking institutions, to me, is very bothersome; the mere size of this is extraordinarily bothersome. So I would like to know more about the problem.

    I would like to know what the potential solutions are to that, and I don't know what that should be. I am not suggesting we should legislate or regulate or whatever it may be, but somehow or another it just doesn't seem quite right that anything this large with a potential to collapse and to create a systemic problem of the magnitude that this could have should exist without us stepping in and making it better understood and being able to prevent that kind of thing from happening.

    And what I hope we avoid today is obfuscation and deflection as if there is no problem whatsoever. I just don't view it that way.

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    So I say that not just to you two gentlemen, to everybody who is going to testify; hopefully, when this day is over, we are on our way to a solution.

    With that, I yield back the balance of my time.

    Chairman LEACH. Well, thank you very much.

    Does anyone else wish to speak?

    If not, we will turn to our—excuse me, Dr. Paul.

    Dr. PAUL. Thank you, Mr. Chairman.

    Mr. Chairman, I appreciate very much you holding these hearings. The world financial markets have been in chaos now for nearly a year-and-a-half. The problem surrounding Long-Term Capital Management is only one more item to add to the list. The entire process represents the unwinding of speculative investments encouraged by years of easy credit.

    The mess in the world financial markets was a predictable event. Artificially low interest rates and easy credit caused malinvestment, overcapacity, excessive borrowing and uncontrolled speculation. We have had for 27 years a world saturated with fiat currencies, and not one has a definable unit of account.

    There have been no restraints on the monetary authorities to expand their own money supplies, fix short-term interest rates or deliberately debase their currencies. Although short-term benefits were enjoyed, it is clear now they were not worth the resulting chaos.
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    We need not look for the cause which puts the dollar, our economy and our financial markets at risk. The previous boom, supported by the illusion of wealth coming from money creation is the cause of current world events, and it guarantees further unwinding of the speculative orgy of the past decades.

    This cannot be prevented. All that we can hope to do is not prolong the agony, as our monetary and fiscal policies did in the U.S. in the 1930's and as they are doing currently in Japan and elsewhere in the world. More Federal Reserve fixing of interest rates and credit expansion can hardly solve our problems when this has been precisely the cause of the mess in which we currently find ourselves.

    Price fixing of interest rates contradicts the basic tenets of capitalism. Let it no more be said that today's mess with financial markets is a result of capitalism's shortcomings. Nothing is further from the truth. Allowing the market to operate, even under today's dangerous conditions, is still the best option for dealing with hedge funds' gambling mistakes—both current and future.

    A Federal Reserve-orchestrated and arm-twisting bailout of LTCM associated with less than a coincidentally announced credit expansion only puts long-term pressure on the dollar. All Americans suffer when the dollar is debased. Congress' responsibility is to the dollar and not foreign currencies, not foreign economies and not international hedge funds which get in over their heads.

    No amount of regulation could have prevented, or in the future prevent, the inevitable mistakes that are made in an economy that is misled by rigged interest rates or money supply dictated by central planners in a fiat money system. Hedge fund operations, because they are international, are impossible to regulate; and for the current ongoing crisis, it is too late anyway.
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    Credit conditions that allow a company with less than $1 billion in capital to buy $100 billion worth of stock with borrowed money and manage $1.2 trillion worth of derivatives is about as classic an example as one could ever find of speculative excess brought on by easy credit. As long as capital is thought to come from a computer at the Federal Reserve and not from savings, the financial problems the world faces today will persist.

    Thank you, Mr. Chairman.

    Chairman LEACH. Thank you, Dr. Paul.

    In turning to the panel, normally we begin with the Chairman, but I understand you might want to reverse the order today; is that correct?

    Then we will begin with President McDonough, and let me say, we welcome you, Mr. McDonough. As the panel understands, you are the President of the Federal Reserve Bank of New York.

    Mr. McDonough.


    Mr. MCDONOUGH. Good morning, Mr. Chairman, and Members of the committee. I am pleased to appear before you today to describe the Federal Reserve Bank of New York's role in the events leading up to the recent private-sector recapitalization of Long-Term Capital Management and its fund, Long-Term Capital Portfolio.
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    I will cover four points and seek to answer many of the questions that have been asked. First, I will provide some background on Long-Term Capital's financial problems. Second, I will explain our judgment that an abrupt and disorderly closeout of Long-Term Capital's positions would have posed unacceptable risks to the American economy. Third, I will explain the limited role we played in facilitating the private-sector resolution to this private-sector problem. And fourth, I will identify some of the issues that should concern us as we begin to understand the lessons of this experience.

    Long-Term Capital is an investment partnership that was started in 1994. It has many of the characteristics of a ''hedge fund'' in that it borrows money to leverage its capital and is only available to wealthy investors. The strategy of Long-Term Capital was to use complex mathematical formulas to identify temporary price discrepancies between different interest rates.

    For example, the firm might notice that the yield on corporate bonds relative to Treasury yields was higher than the range observed in recent years. If Long-Term Capital believed the former relationship would reassert itself, it would buy corporate bonds and sell short Treasury bonds. If the spread narrowed, as expected, the firm would profit; if, however, the spread continued to widen, the firm would incur losses.

    This basic strategy and many complex variations was followed across many interest rate products in the U.S., and many overseas markets as well. The firm was active both in traditional securities markets, and perhaps more importantly, in derivative product markets such as futures, swaps and options. Anticipating that some positions would move in their favor and some would move against them, the firm relied on diversification across a large number of product and geographic markets.
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    Long-Term Capital proved quite successful at this strategy, generating returns in excess of 40 percent in 1995 and 1996, though somewhat less in 1997.

    Perhaps their success went to their heads. Long-Term Capital took on larger and larger positions. They also leveraged their investments at higher levels, returning capital to their investors, but not, apparently, reducing risks. We now also know that they took on significant positions in equity markets through both swap and options contracts.

    The reputations of the Long-Term Capital partners, as traders and economists, and their initial success, appear to have contributed to so many counterparties' willingness to deal with them.

    While hubris may have set them up for a fall, it was the extraordinary events of August in global markets that appear to have tripped them.

    On August 17, the Russian government announced an effective devaluation of the ruble and declared a debt moratorium, shocking investor confidence all over the world. Over subsequent days and weeks, equity and debt markets the world over became increasingly volatile, with U.S. equity markets falling and the spreads between U.S. Treasury securities and higher yielding debt instruments widening sharply. The correction of stock prices was not of exceptional size and concern and indeed had been anticipated by a number of astute market observers. However, the abrupt and simultaneous widening of credit spreads globally, for both corporate and emerging market sovereign debt, was an extraordinary event beyond the expectations of investors and financial intermediaries.
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    This unusual widening of credit spreads also caused significant losses at Long-Term Capital. As markets around the world moved in the same direction at the same time, the diversification on which Long-Term had previously relied failed them utterly. Instead of offsetting positions, their losses were compounded. At the same time, the volatility in equity markets caused further losses. On September 2, the partners of Long-Term Capital sent their investors a letter acknowledging 52 percent losses on the year through August 31; that is, they had lost 52 percent of the capital they had at the beginning of the year, and that they were seeking an injection of capital to sustain the firm. The existence of this letter became widely known and reported within a few days. Because of this, during the first two weeks of September, the concern about Long-Term Capital was a widespread topic of conversation in financial markets. It is a traditional and essential role for the President and senior officers of the New York Fed to be talking to, and receiving calls from, market participants regarding significant developments and potential dislocations. In fact, the partners at Long-Term Capital called me early in September to notify me of their difficulties and their discussion with investment houses about plans to raise new capital.

    By Friday, September 18, with the efforts to raise new capital still unsuccessful—and with an increasing number of people now aware of Long-Term's plight because of the efforts to bring in new investors—events seemed to come to a head. With market conditions particularly unsettled that day, I made a series of calls to senior Wall Street officials to discuss overall market conditions. Let me take a moment to put those calls in context.

    One important objective of the Federal Reserve is to assure financial stability. Particularly in times of stress, it is essential that the Federal Reserve continue to take the pulse of the market. One way to do that is through candid and open communication with key market participants. Everyone I spoke to that day volunteered concern about the serious effect the deteriorating situation of Long-Term could have on world markets.
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    Also on the 18th, one of the firms that had been working with Long-Term to raise new capital asked the Long-Term Capital partners if the firm could share the information it had with us. The partners at Long-Term Capital responded that they would prefer to present the information themselves and called me to arrange such a presentation.

    After conferring with Chairman Greenspan and Secretary of the Treasury Rubin, we agreed that a visit to Long-Term Capital's offices was needed. A team from the New York Fed, led by Peter Fisher, the head of our Markets Group, and joined by Treasury Assistant Secretary Gary Gensler, met with the Long-Term Capital partners at their offices on Sunday, the 20th of September. During this meeting, we learned the broad outlines of Long-Term Capital's major positions in credit and equity markets, the difficulties they were having in trying to reduce these positions in thin market conditions, their deteriorating funding positions and an estimate of their largest counterparty exposures. The team also came to understand the impact which Long-Term Capital's positions were already having on markets around the world and that the size of these positions was in fact much greater than market participants imagined.

    Mr. Chairman, I would like now to turn to my second point and focus explicitly on the question of our judgment that the abrupt and disorderly closeout of Long-Term Capital's positions would impose unacceptable risks to the American economy.

    There are several ways that the problems of Long-Term Capital could have been transmitted to cause more widespread financial troubles. Had Long-Term Capital been suddenly put into default, its counterparties would have immediately ''closed-out'' their positions. If counterparties would have been able to close out their positions at existing market prices, losses, if any, would have been minimal. However, if many firms had rushed to close out hundreds of billions of dollars in transactions simultaneously, they would have been unable to liquidate collateral or establish offsetting positions at previously existing prices. Markets would have moved sharply and losses would have been exaggerated. Several billions of dollars of losses might have been experienced by some of Long-Term Capital's more than 75 counterparties.
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    Now, these direct effects on Long-Term Capital's counterparties were not our principal concern. While those losses would have been considerable and would certainly have adversely affected the firms experiencing them, this was not, in itself, a sufficient reason for us to have become involved.

    Two factors influenced our involvement. First, in the rush of Long-Term Capital's counterparties to close out their positions, other market participants, investors who had no dealings with Long-Term Capital, would have been affected as well.

    Second, as losses spread to other market participants and Long-Term Capital's counterparties, this would lead to tremendous uncertainty about how far prices would move. Under these circumstances, there was a likelihood that a number of credit and interest rate markets would experience extreme price moves and probably cease to function for a period of one or more days and maybe longer. This would have caused a vicious cycle. A loss of investor confidence leading to a rush out of private credits, leading to a further widening of credit spreads, leading to further liquidation of positions, and so on. Most importantly, this would have led to further increases in the cost of capital to American businesses and to American households.

    Let me be clear. Had we not just experienced in August precisely this type of shock to our credit markets, had we not just seen a sudden, worldwide straining of investor confidence, had there not already been underway a flight of capital away from private credit and into Treasury securities, were much of the world not experiencing financial strain, then our judgments about the risks to the American economy of an abrupt and disorderly closeout of Long-Term Capital may well have been different. But in the circumstances that did in fact exist, it was our judgment, eventually my judgment, that the American people whom we are pledged to serve, could have been seriously hurt if credit dried up in a general effort by banks and other intermediaries to avoid greater risk.
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    In light of these risks, the responsible public policy objective was to get together those with a direct financial interest in an orderly rescue of Long-Term Capital, to discuss its problems openly and objectively, to provide a sounding board for solutions and, if necessary, a calming influence. In my view, we achieved that objective.

    What did the New York Fed do? Because events were moving swiftly and with my approval and support, my colleague, Mr. Fisher invited representatives of the three firms which we felt had the greatest knowledge of the situation at Long-Term Capital and a strong interest in seeking a solution to an early morning meeting on September 22. The three firms were Goldman Sachs, Merrill Lynch, and J.P. Morgan.

    Continuing discussions which commenced the day before, Mr. Fisher explained our interest in being aware of developments and in reducing the risk of an abrupt and chaotic closeout of Long-Term Capital. The firm's president stated that they were not aware of any other initiative then being actively pursued to resolve Long-Term Capital's problems. They voiced their own concerns about the risks to the market of a closeout scenario. They discussed various approaches to stabilizing Long-Term Capital, including the concept of a ''collective industry'' or consortium approach. However, they all agreed that work on a collective option should not preclude parallel efforts by anyone; indeed, that if any firm or group of firms wished to step forward and take Long-Term Capital itself or Long-Term Capital's position onto their balance sheet, that would be the most desirable outcome. In the absence of any other solution, the firms dispatched two working groups to Long-Term Capital's offices in Connecticut to consider the feasibility of ''lifting'' the fixed income and the equity positions out of Long-Term Capital. A third working group met at one of the firm's offices downtown in New York to develop the idea of a consortium approach. By mutual agreement another firm, UBS, a Swiss bank, was added to this core group, making it four, and to each of the three working groups. No one from the New York Fed participated in any of the working groups.
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    At no point in this early morning meeting, nor at any stage last week, was there discussion of the use of public monies, Federal Reserve or otherwise. No Federal Reserve or Government guarantees, actual or implied, were offered, discussed, or solicited.

    Later that Tuesday afternoon, we participated in a conference call to review the progress of the working groups. Two of the working groups concluded that a ''lifting'' of the fixed income and equity positions was just not feasible. The third group developed a consortium approach which was deemed feasible. Everyone agreed that the consortium approach would be last ditch and that parallel solutions should still be encouraged.

    The four firms met at the Federal Reserve at 7:00 p.m. A draft term sheet was reviewed which provided detail with respect to the consortium approach. The terms and conditions were debated, altered in some places and ultimately refined so that the four firms could present it to a wider group. Although Federal Reserve officials were present at this meeting, we did not participate in the discussion about terms and conditions.

    At about 8:30 p.m., a meeting of a wider group involving 13 firms began and meanwhile some representatives of the Core Group called Long-Term Capital to discuss the terms and conditions of the consortium approach. Federal Reserve officials did not participate in any conversations with Long-Term Capital regarding the terms and conditions. In the meeting with the wider group, Peter Fisher explained the importance of avoiding a disorderly closeout of Long-Term Capital's positions. He also underscored the desirability of parallel efforts to resolve the problem. It was agreed that the group would reconvene at 10:00 a.m. the following morning. It was clear to everyone that time was of the essence.
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    I had to give a long-scheduled speech in London that Tuesday and returned late that evening, arriving in New York about midnight. During the early morning hours, I called various foreign central bank officials to inform them of the situation. At about 9:30 in the morning on Wednesday, my colleagues and I met with the Core Group to review the status of the situation. A few minutes before the start of the scheduled 10:00 a.m. meeting, one of the Core Group firms told me that an investor group would make an offer to acquire the Long-Term portfolio. I called one of the representatives of the investor group to confirm this development. The offer was subsequently conveyed to Long-Term Capital by that investor group and a response was requested by 12:30 p.m.

    After a brief consultation with the Core Group, I decided that the effort to proceed with the consortium approach needed to be suspended for a short time until this alternative offer could be considered. As noted earlier, the consortium approach was seen as a last resort. Consequently, the meeting about the consortium approach was adjourned at about 10:50 Wednesday morning to reconvene at 1:00 in the afternoon.

    At 12:30 p.m., I learned that the alternative offer had not been accepted and would not be extended. Shortly after 1:00 p.m., the meeting about the consortium approach resumed. This was now the only solution being pursued. During the next five hours, the private sector participants discussed every aspect of the terms and conditions. At the end of the discussion, 14 banks and securities firms agreed to participate in the recapitalization with three firms contributing smaller amounts than the other 11. Two firms represented at the meeting decided not to participate.

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    I want to emphasize a few points. First, this was a private sector solution to a private sector problem, involving an investment of new equity by Long-Term Capital's creditors and counterparties. Second, although some have characterized this as a bailout, control of the Long-Term portfolio passed over to this 14–firm creditor group and the original equity holders have taken a severe hit. Finally, no Federal Reserve official pressured anyone and no promises were made. Not one penny of public money was spent or committed.

    It is far too early, Mr. Chairman, to state categorically the lessons to be learned from Long-Term Capital. What I can say is we are focused on three specific issues, all relating to leverage and how we are able to observe it through the eyes of our bank examiners. Let me emphasize, yet again, that the Federal Reserve has no regulatory authority over hedge funds and therefore no regulatory authority over Long-Term Capital.

    The first issue relates to credit analysis. Our supervisory guidance generally, and with respect to hedge funds specifically, stresses the importance of knowing the borrower and the business purpose of the borrower's transactions. In 1994, the Federal Reserve issued a supervisory letter emphasizing the importance of financial analysis of counterparties, including hedge funds, which can quickly adjust their risk profile. There is a question whether adequate credit analysis was performed by creditors of Long-Term Capital and that needs to be examined carefully during the next few weeks. If credit analysis was deficient, we need to learn how and why before we can make pronouncements that will avoid repetition of our Long-Term Capital experience.

    The second issue relates to derivatives activities and a concept called future potential exposure, which is a measure of the likely price movements based on recent years experience. With respect to derivatives, the current market value is captured by financial statements prepared in accordance with generally accepted accounting principles, but not the potential future exposure. To fully understand the degree and effect of leverage in Long-Term Capital's derivative related strategies, it would have been necessary to measure the potential future exposure in a rigorous and conservative manner. Whether sufficient information was made available to Long-Term Capital's counterparties, including its banks, and adequately analyzed by those counterparties also needs to be studied.
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    A third question concerns stress testing in the credit analysis of hedge funds and the structuring of margin agreements. Stress testing simulates the effects on a portfolio if many asset relationships simultaneously move adversely far beyond historical observation. We recognize that stress testing is a developing discipline, but it is clear that adequate testing was not done with respect to the financial conditions that precipitated Long-Term Capital's problems.

    In a recent supervisory letter on credit underwriting generally, we emphasized the importance of stress testing. Effective risk management in a financial institution requires not only modeling, but models that contest the full range of financial transactions across all kinds of adverse market developments. Whether such models existed and, if so, whether they were effective are issues that we need to address.

    In the aftermath of Long-Term Capital, we need to pursue these leverage-related issues and others in conjunction with our colleagues at the Federal Financial Institutions Examinations Council, the Fed, the FDIC, and the Office of the Comptroller of the Currency. The insights that we gain should be of value to bank supervisors, and for the study of the Long-Term Capital matter that is to be done by the President's Working Group on Financial Markets announced by Secretary Rubin last Friday.

    Mr. Chairman, I thank you for the opportunity to appear before you this morning.

    Chairman LEACH. Thank you, Mr. McDonough.
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    Chairman Greenspan.


    Mr. GREENSPAN. Thank you very much, Mr. Chairman, Members of the committee. I too want to thank you for the opportunity to report on the Federal Reserve's role in facilitating the private sector refinancing of the large hedge fund, Long-Term Capital Management. In my remarks this morning, I will attempt to put into some perspective the events of the past few weeks and discuss some questions of importance to public policy makers that they raise.

    The Federal Reserve Bank of New York's efforts were designed solely to enhance the probability of an orderly private sector adjustment, not to dictate the path that adjustment would take. As President McDonough just related, no Federal Reserve funds were put at risk, no promises were made by the Federal Reserve, and no individual firms were pressured to participate. Officials at the Federal Reserve Bank of New York facilitated discussions in which the private parties arrived at an agreement that both served their mutual self interest and avoided possible serious market dislocations. Financial market participants were already unsettled by recent global events. Had the failure of LTCM triggered the seizing of markets, substantial damage could have been inflicted on many market participants, including some not directly involved with the firm, and could have potentially impaired the economies of many nations, including our own. With credit spreads already elevated and the market prices of risky assets under considerable downward pressure, Federal Reserve officials moved more quickly to provide their good offices to help resolve the affairs of LTCM than would have been the case in more normal times. In effect, the threshold of action was lowered by the knowledge that markets had recently become fragile. Moreover, our sense was that the consequences of a fire sale triggered by cross-default clauses, should LTCM fail on some of its obligations, risked a severe drying up of market liquidity. The plight of LTCM might scarcely have caused a ripple in financial markets or among Federal regulators 18 months ago—but in current circumstances it was judged to warrant attention.
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    What is remarkable is not this episode, but the relative absence of such examples over the past five years. Dynamic markets periodically engender large defaults.

    In our dynamic market economy, investors and traders, at times, make misjudgments. When market prices and interest rates adjust promptly to evidence of such mistakes, their consequences are generally felt mostly by the perpetrators and, thus, rarely cumulate to pose significant problems for the financial system as a whole. By such winnowing of inefficiencies, productivity is enhanced and standards of livings expand over time.

    Financial markets operate efficiently only when participants can commit to transactions with reasonable confidence that the risk of nonpayment can be rationally judged and compensated for. Effective and seasoned markets pass this test almost all of the time. On rare occasions, they do not. Fear, whether irrational or otherwise, grips participants and they unthinkingly disengage from risky assets in favor of those providing safety and liquidity. The subtle distinctions that investors make, so critical to the effective operation of financial markets, are abandoned. Assets, good and bad, are dumped indiscriminately in circumstances of high uncertainty and fear that are not conducive to planning and investment. Such circumstances, were they generalized and persistent, would be wholly inconsistent with the functioning of sophisticated economies supported by long-term capital investment.

    Quickly unwinding a complicated portfolio that contains exposure to all manner of risks, such as that of LTCM, in such market conditions amounts to conducting a fire sale. The prices received in a time of stress do not reflect longer-run potential, adding to the losses incurred. Of course, a fire sale that transfers wealth from one set of sophisticated market players to another, without any impact on the financial system overall, should not be a concern for the central bank. Moreover, creditors should reasonably be expected to put some weight on the possibility of a large market swing when making their risk assessments. Indeed, when we examine banks, we expect them to have systems in place that take account of outsized market moves. However, a fire sale may be sufficiently intense and widespread that it seriously distorts markets and elevates uncertainty enough to impair the overall functioning of the economy. Sophisticated economic systems cannot thrive in such an atmosphere.
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    The scale and scope of LTCM's operations, which encompassed many markets, maturities, and currencies and often relied on instruments that were thinly-traded and had prices that were not continuously quoted, made it exceptionally difficult to predict the broader ramifications of attempting to close out its positions precipitately. That its mistakes should be unwound and losses incurred was never open to question. How they should be unwound and when those losses incurred so as to foster the continued smooth operation of financial markets was much more difficult to assess. The price gyrations that would have evolved from a fire sale would have reflected fear-driven judgments that could only impair effective market functioning and generate losses for innocent bystanders.

    While the principle that fire sales undermine the effective functioning of markets may be clear, deciding when a potential market disruption rises to a level of seriousness warranting central bank involvement is among the most difficult judgments that ever confronts a central banker. In situations like this, there is no reason for central bank involvement unless there is a substantial probability that a fire sale would result in severe, widespread, and prolonged disruptions to financial market activity.

    It was the judgment of the officials at the Federal Reserve Bank of New York, who were monitoring the situation on an ongoing basis, that the act of unwinding LTCM's portfolio in a forced liquidation would not only have a significant distorting impact on market prices, but also in the process could produce large losses—or worse—for a number of creditors and counterparties, and for other market participants who were not directly involved with LTCM. In that environment, it was the Federal Reserve Bank of New York's judgment that it was to the advantage of all parties—including the creditors and other market participants—to engender if at all possible an orderly resolution rather than let the firm go into disorderly fire sale liquidation following a set of cascading cross defaults.
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    Their agreement was not a Government bailout, in that Federal Reserve funds were neither provided nor ever even suggested. Agreements were not forced upon unwilling market participants. Creditors and counterparties calculated that LTCM and, accordingly, their claims, would be worth more over time if the liquidation of LTCM's portfolio was orderly as opposed to being subject to a fire sale. And with markets currently volatile and investors skittish, putting a special premium on the timely resolution of LTCM's problems seemed entirely appropriate as a matter of public policy.

    Of course, any time that there is public involvement that softens the blow of private sector losses—even as obliquely as in this episode—the issue of moral hazard arises. Any action by the Government that prevents some of the negative consequences to the private sector of the mistakes it makes raises the threshold of risks market participants will presumably subsequently choose to take. Over time, economic efficiency will be impaired as some uneconomic investments are undertaken under the implicit assumption that possible losses may be borne by the Government.

    But is much moral hazard created by aborting fire sales? To be sure, investors wiped out in a fire sale will clearly be less risk prone than if their mistakes were more orderly unwound. But is the broader market well served if the resulting fear and other irrational judgments govern the degree of risk the participants are subsequently willing to incur? Risk-taking is a necessary condition for wealth creation. The optimum degree of risk aversion should be governed by rational judgments about the market place, not the fear flowing from fire sales.

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    The Federal Reserve provided its good offices to LTCM's creditors, not to protect LTCM's investors, creditors, or managers from loss, but to avoid the distortions to market processes caused by a fire sale liquidation and the consequent spreading of those distortions through contagion. To be sure, this may well work to reduce the ultimate losses to the original owners of LTCM, but that was a byproduct, perhaps unfortunate, of the process.

    Without doubt, extensive study will be required to put the events of the past few weeks into proper perspective. As a member of the President's Working Group on Financial Markets, I support Secretary Rubin's call for a special study on the public policy implications of hedge funds. While the affairs of LTCM are by no means settled, I would like to pose some tentative questions that may have to be addressed.

    First, how much dependence should be placed on financial modeling, which, for all its' sophistication, can get too far ahead of human judgment? This decade is strewn with examples of bright people who thought they had built a better mousetrap that could consistently extract an abnormal return from financial markets. Some succeed for a time. But while there may occasionally be misconfigurations among market prices that allow abnormal returns, they do not persist.

    Second, what steps could counterparties have taken to ensure that they had properly estimated their exposure, particularly in markets that are volatile? To an important degree, the creditors of LTCM were induced to infuse capital into the firm because they failed to stress test their counterparty exposures adequately and therefore underestimated the size of the uncollateralized exposure that they could face in volatile and illiquid markets. In part, this also reflected an underappreciation of the volume and nature of the risks LTCM had undertaken and its relative size in the overall market. By failing to make those determinations, its fellow market participants failed to put an adequate brake on LTCM's use of leverage.
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    Third, in this regard, what lessons are there for bank regulators? Domestic commercial bank exposure to LTCM included both direct lending and acting as counterparties to the firm in derivatives contracts. A preliminary review of bank dealings with LTCM suggests that the banks have collateral adequate to cover most of their current mark-to-market exposures with LTCM. The unexpected surge in risk aversion and the dramatic opening up of interest rate spreads in August obviously caught LTCM wrong-footed. Counterparties, including banks, continued to collect collateral for marks to market. What they were not collateralized against was the losses that might have occurred when prices moved even further and market liquidity dried up in a fire sale.

    Supervisors of banks and securities firms must assess whether current procedures regarding stress testing and counterparty assessment could have been improved to enable counterparties to take steps to insulate themselves better from LTCM's debacle.

    Fourth, does the fact that investors have lost most of their capital and creditors may take some losses on their exposure to LTCM call for direct regulation of hedge funds? It is questionable whether hedge funds can be effectively directly regulated in the United States alone. While their financial clout may be large, hedge funds' physical presence is small. Given the amazing communication capabilities available virtually around the globe, trades can be initiated from almost any location. Indeed, most hedge funds are only a short step from cyberspace. Any direct U.S. regulations restricting their flexibility will doubtless induce the more aggressive funds to emigrate from under our jurisdiction. The best we can do, in my judgment, is what we do today: Regulate them indirectly through the regulation of the sources of their funds. We are thus able to monitor far better hedge funds' activity, especially as they influence U.S. financial markets. If the funds move abroad, our oversight will diminish.
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    In the first line of risk defense, if I may put it that way, are hedge funds' lenders and counterparties. Commercial and investment banks especially have the analytic skills to judge the degree of risk to which the funds are exposed. Their self-interest has, with few exceptions, but including the one we are discussing today, controlled the risk posed by hedge funds. Banking supervisors are the second line of risk defense in their examination of lending procedures for safety and soundness. We neither try, nor should we endeavor, to micromanage bank lending activity. We have nonetheless built up significant capabilities in evaluating the complex lending practices in OTC derivatives markets and hedge funds. If, somehow, hedge funds were barred worldwide, the American financial system would lose the benefits conveyed by their efforts, including arbitraging price differentials away. The resulting loss in efficiency and contribution to financial value added and the Nation's standard of living would be a high price to pay—in my mind, too high a price.

    Fifth, how much weight should concerns about moral hazard be given when designing mechanisms for governmental regulation of markets? By way of example, we should note that were banks required by the market, or their regulator, to hold 40 percent capital against assets as they did after the Civil War, there would, of course, be far less moral hazard and far fewer instances of fire sale market disruptions. At the same time, far fewer banks would be profitable, the degree of financial intermediation less, capital would be more costly, and the level of output and standards of living decidedly lower. Our current economy, with its wide financial safety net, fiat money, and highly leveraged financial institutions, has been a conscious choice of the American people since the 1930's. We do not have the choice of accepting the benefits of the current system without accepting its costs.

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    For so long as there have been financial markets, participants have had on occasion to weigh the costs and, especially, the externalities associated with fire sale liquidations of troubled entities against short-term assistance to tide the firms over for a time. It was such a balancing of near-term costs and longer-term benefits that presumably led J.P. Morgan to convene the leading bankers of his age—both commercial and investment—in his library in 1907 to address the severe panic of that year. Such episodes were recognized as among those rare occasions when otherwise highly effective markets seize up and temporary ad hoc responses were required. The convening of LTCM investors and lenders last week at the Federal Reserve Bank of New York could be viewed in that long tradition. It should similarly be viewed as a rare occasion, warranted because of the potential for serious disruptions to markets.

    We must also remain mindful where to draw the line at which public sector involvement ends. The efforts last week were limited to facilitating a private sector agreement and had no implications for Federal Reserve resources or policies.

    Mr. Chairman, I have excerpted from my prepared remarks and request that they be included in the record.

    Chairman LEACH. Without objection, so ordered.

    Let me just begin by saying that the position of the Fed in one sense, I think, has been overstated. That is, as you posit the issue of orderly resolution versus a fire sale, you have some rationalization to act. But it would appear that there was another offer on the table and that perhaps the only smart deal of the month Long-Term Management did is they played the Fed off against another party, and the other party offered half as much cash and probably provided a much less attractive deal for Management in terms of their positions at the fund. And so it strikes me that that is a dilemma that the Fed has to understand and has to deal with.
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    The second dilemma that I think is extraordinary is it might be argued that the current situation and the future situation for Long-Term Capital is going to be a greater problem than the problem that existed last week. That is, last week all you had to deal with was management of a potential bankruptcy. Today and henceforth, you are dealing with a quasicartel circumstance, a fund with its new partners that, in concert, represent extraordinarily greater firepower than the central banks of all the countries in the world in terms of affecting issues like currency evaluations.

    And so what you have done is establish, with the sanction of the Federal Reserve of the United States, a cartel; and I would argue that if this group of 14 institutions, or principal ones, came to you and said, ''We would like to combine a traditional banking function, let's say a trust department,'' the regulators would instantaneously deny such an application because of its obvious monopolistic implications.

    Now you have allowed this in this circumstance and you have allowed the fund not only to continue, but to potentially grow substantially, which makes me think that the only rationalization for the Federal Reserve intervention in the manner it did that holds weight for the future would be if the exclusive intent was to unwind the fund. And so the principal question I have for you is, is it your intent to allow these institutions to work in concert to manage a fund as it currently operates and potentially grow, or is it your intent that this fund should unwind?

    Mr. GREENSPAN. Let me answer that, and then Bill McDonough could follow up.
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    First of all, Mr. Chairman, had we never been involved in the slightest and in fact had not known anything about it, for example, it was still conceivable that this grouping, the same grouping, would have come together in their mutual self-interest to endeavor to facilitate an orderly resolution of a particular financial institution in which they were all involved. That is a practice which goes on fairly considerably and I think appropriately so.

    Chairman LEACH. If I can interrupt briefly. Part of the group did come together to attempt exactly that involving other parties, and the Fed ended up putting together a group that competed with the other group, which is an extraordinary dimension to this whole discussion.

    Mr. GREENSPAN. Let me just complete my remarks, and then I will turn it over to Bill.

    Chairman LEACH. Sure.

    Mr. GREENSPAN. You are raising a number of issues which really relate to the questions which are on the edge of antitrust actions, and I think those questions would emerge whether or not we were involved, and I think that they have to be dealt with in a separate context. I myself am far less concerned than you are with respect to the potential issues that might arise from that, but it is a separable question and really, in one sense, quite unrelated to the issue of the particular elements that we are involved in discussing today, but clearly surfaced largely because of the nature of the actions that have been taken.

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    Mr. MCDONOUGH. Mr. Chairman, let me comment further on how the fund would operate now. The antitrust laws, and I believe other laws involving fiduciary responsibility, will make it very clear that the people in the Oversight Subcommittee who are in there instructing the old managers on how to manage the fund have to have an absolute Chinese wall infinitely high between them and their parent firms. Because, if they don't, it would seem to me, as a non-lawyer, they would be clearly in violation of the antitrust laws, and the concern that you have of this massing of power would be completely, clearly correct. I think the laws that already exist provide insurance against that.

    Second, the investors, the new investors, you will note, are in there for three years. The reason they say they are in there for three years, even though they would love to be out long before three years, is that because the positions are so large, if you go back to the Chairman's fire sale analogy, if they say we are going to be in business for a month or two months or three months, you still have a fire sale, you just have a fire sale on the installment plan and all of the concern about the spreads moving out and so on would happen anyway. So they have to show that they have the ability and the staying power to unwind the positions in an orderly manner, which is, in fact, what they have in mind.

    As regards your earlier concern about did we, by getting the group together that eventually formed the consortium, make it less likely that another deal, which has now been rather thoroughly discussed in the media, did it make it less likely that that deal would prosper?

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    Well, first of all, as I suggested in my prepared testimony, all through the period of talking with the core group and eventually the consortium group, everybody was in agreement that that really was not a particularly desirable thing and that it was a last ditch. It was better than allowing the firm to collapse, but it was not something the people were very enthusiastic about.

    Now, just to go back to why we were involved at all. I mentioned that I thought that the American people would be adversely affected by a collapse of Long-Term Capital. Now how? We have a situation in which Treasury securities, the 30–year bond, is now below 5 percent. And although the bond rate, the interest rate on bonds of the highest quality credits in our country have also come down a little bit, the spread between them and Treasuries, the interest rate differential, is phenomenally high.

    And one of the reasons that the rates have come down at all, even though the difference is very large, is because there is a general view that no chief financial officer in his right mind would be issuing credit in these very chaotic markets. So there is a view that the supply of that paper will be decreasing or at least held constant.

    What I think we really need to look at is what is happening to the interest rates on lower quality credits, B double A, triple B. These are the lower end of the larger firms, but it is especially the medium size and smaller firms that, as you are well aware, are at the whole source of job creation in our country. The fear that we had was that, given this really chaotic market background, that if LTCM had collapsed that it would get that much worse and we would have a credit crunch.

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    Can I assure you that would have happened? Of course not. But it was our collective judgment at the New York Fed that that would have been sufficiently likely that it should have been avoided.

    Now let me get to the alternative deal. On the Wednesday morning, as I mentioned, at approximately 10:00, one of the people in the core group said to me, ''I would like to have a private conversation with you.'' He and I went into my office and he said, ''There is an alternative offer that is able to be made; and in order to have you convinced that it is real, would you call a rather prominent individual and talk to him to make sure that you really believe it is there?''

    I did that. That is why we decided to adjourn the consortium group meeting. So we had some of the great names on Wall Street sitting in the boardroom of the New York Fed.

    I walked in at 10:45 and said, ''Ladies and gentlemen, there is a possibility of another offer that will make this consortium deal unnecessary, which all of you don't like anyway. And, therefore, we will adjourn the meeting till 1:00.''

    So we left the whole terrain available for the alternative deal for as long a period as the alternative deal was available. So if we did anything, to tell you the truth, as I try to do always, we actually favored the alternative deal.

    In fact, I received a phone call from Mr. Merriwether and another colleague of his at Long-Term Capital. They said, ''Do you know there is an offer?'' I said, ''Yes, I do.''
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    They said, ''Do you know the terms of the offer?'' I said, ''Yes, I do.''

    And they said, ''Well, we are examining the offer, and we are seeing, among other things, whether we have the legal authority under our partnership agreements and under our agreements with our investors to accept the offer, and we don't know the answer to that yet. That is a legal question.''

    I said to them, ''Gentlemen, you should be very well aware that that is the only offer available to you. There is no guarantee whatsoever that this consortium approach is ever going to come together. I don't know whether it will come together. There are lots of people with different interests who have to come together and think they have a common interest for that to appear.'' And then I reminded them of the adage that we all learned as kids: ''A bird in the hand is worth two in the bush.'' That is the advice I gave them, and then we ended the conversation.

    Several hours later, I was informed by the top officer of a firm that would have been one of the participants in that deal that didn't work, that the deal had not been realized, that the offer was off the table, and therefore the only game in town, other than a collapse of Long-Term Capital, was what we now call the consortium deal.

    So to conclude, Mr. Chairman, if anything, we made it more likely than not that the alternative offer would have been accepted.

    Chairman LEACH. Well, I appreciate that. I am not necessarily overwhelmingly convinced. It looks to me as if the offer was turned down by the officers of the potentially bankrupt institution, that you were held hostage to their judgment, and that is not a strong position to be in.
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    Mr. MCDONOUGH. May I comment?

    Chairman LEACH. Yes.

    Mr. MCDONOUGH. I think we had a discussion going on between Long-Term Capital and a group of three investors. For us the involvement I described of the ''bird in the hand is worth two in the bush'' is, I think, as close to the edge as any senior central banker should ever go, and may be right at the edge of getting involved in a situation and encouraging an outcome.

    I can't imagine that anything that the Long-Term Capital people would have heard would have encouraged them to believe that I was somehow saying in any way, ''Why don't you bet on the alternative?'' The alternative available to them at that time was that either they accepted the offer that eventually did not fly. I believe that their reason was they didn't have the legal power to do it. I don't know if that is a fact or not. But it was a discussion between two private parties. We can't get involved and say this has to be the outcome.

    Chairman LEACH. Well, the only thing that should be stressed is there was not this chasm that has been described in both of your testimonies of disorderliness. Long-Term Capital Management clearly understood that there was a possibility of another offer in the making; and they, in effect, fought a bit of a game and appeared to have won that game.

    Mr. LaFalce.

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    Mr. LAFALCE. Mr. Chairman, I request that the committee make an official request of the chairman of the Financial and Accounting Standards Board for his opinion on this issue and the appropriate type of accounting standards that may be necessary in light of it; and, if necessary, if the Federal Reserve would then like to comment on his response at that time, I think that might be helpful to the committee.

    Chairman LEACH. That is very reasonable. Without objection.

    Mr. LAFALCE. Second, I ask that we insert into the record a copy of Mr. Roger Altman's article in this morning's Washington Post, former Deputy Secretary of the Treasury, entitled ''Dangerous Bailout.''

    Chairman LEACH. Without objection.

    Mr. LAFALCE. Third, Mr. Altman makes reference to the fact that Prime Minister Blair this week called for a global conference on the need for a new architecture for financial regulation and supervision. What is the current mechanism for that, Chairman Greenspan, that is, for achieving much greater global regulation and supervision that is adequate to the task?

    It seems to me that, within the next year, this is something that Chairman Leach and I and you and others, the Administration, must be working on aggressively, more so in the future than we have in the past.

    Mr. GREENSPAN. Mr. LaFalce, let's not presume that the ideal outcome is more regulation. I think the ideal outcome is a regulatory structure which addresses the changes in the international financial system in a manner which will enhance its stability and lower the probabilities of difficulties.
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    We have been discussing this issue before this committee when we have been involved with the questions of the nature of the crises which have arisen since the problems in Thailand arose and the extraordinary contagion that went around the world. In my judgment, we probably are beginning to increasingly understand.

    Mr. LAFALCE. If I could just clarify my question, Mr. Greenspan. I am not so much interested in the answer right now as I am the mechanism.

    Mr. GREENSPAN. As you probably are aware, there is a meeting of the G–7 finance ministers and central bank governors on Saturday. There is a meeting of the G–10 finance ministers and central bankers on Sunday. There is a meeting of the so-called G–22, which is the particular vehicle which is going to examine in some detail many of the issues that have come forth with respect to alternate structures for what is now being termed the new international financial architecture.

    I don't want to discuss in advance what I think will come out of that meeting, but I do know——

    Mr. LAFALCE. What about the central bankers and mechanisms they have for participation in the discussions about new global financial architecture? I distinguish between two different architectures, one for the IMF and its role and the others for the regulation and supervision and the laws that need to be in place, whether bankruptcy laws, transparency laws, and so forth.

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    Mr. GREENSPAN. The central bankers have a fairly advanced set of procedures and, indeed, wearing another hat, Bill McDonough is Chairman of the Basle Committee on Bank Supervision, which is the vehicle which is employed by the major central bankers around the world for coordinating bank regulation. And that is an ongoing process.

    Mr. LAFALCE. I wasn't just thinking of banks. I was thinking of financial institutions.

    Mr. GREENSPAN. Mr. LaFalce, the reason I started with the question of the nature of the international financial structure is that I have always argued in architectural terms that you want form to follow function. In other words, you really want to understand what type of vehicle we are dealing with.

    As I have mentioned many times before to this committee, I believe that the extraordinary changes in technology, which have come upon us in the last decade or so have created sets of instruments and structures in the international financial community that are different from what has existed previously and that the supervisory regulatory approach which should be applied to this new vehicle in turn also must be different from the structure that we have had in the past.

    We are gradually moving in that direction, and we are moving on two parallel tracks. One is a far better understanding of what this new international structure, financial system is all about. And, two, what are the types of supervisory and regulatory structures which we can impose which will effectively interact with it?

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    Mr. LAFALCE. Let me try to get in at least another question and that is, what legal authority exists right now on the part of any regulator to impose margin requirements? And if there is inadequate—if there is legal authority, who has it? Who exercised it? If there isn't legal authority, ought it to exist and who should have it? That is one question.

    My second question has to go to the question of the role of insurance companies. I assume each of these partners, for example, had some type of insurance coverage for mismanagement, and so forth. Did we consider having the insurance companies play a role in: A, the private sector supervision of a fund that they are basically ensuring against mismanagement; or, B, involving them in the bailout as opposed to the firms that have simply made loans?

    So those are two questions.

    Obviously, we do have legal authority to impose margins on stock trades, which we have not employed for many years, because the notion of margins in the new world of highly sophisticated finance is becoming increasingly less relevant to the notion of the degree of leverage. I am not saying that there aren't margin——

    Mr. LAFALCE. And I used the incorrect word? Should I have been asking a question about leverage then, rather than pose the issue that should be posed?

    Mr. GREENSPAN. Yes. The question really is the issue of leverage, because with the new international financial structure and the major expansion in the use of derivatives by all different types of consumers—I might say parenthetically that derivatives clearly are perceived as a significant value in diversifying and unbundling risk, because if that weren't the case, they wouldn't be growing as rapidly as they have. Those vehicles clearly are vehicles for leverage without actually going through the borrowing process.
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    What is terribly important is the sense of appropriate capital; that is, the obverse of leverage is capital requirements, and the whole notion of supervision and regulation of financial institutions has to rest on the degree of the amount of capital which is appropriate for various different types of investments or various different types of programs.

    That authority exists in this country, obviously, with the bank regulators. It is structured in an international form in various different regulations or——

    Mr. LAFALCE. The authority exists with respect to capital, but does the authority exist with respect to leverage? I am not sure that I accept——

    Mr. GREENSPAN. If you can have control over capital, you have control over leverage. You can do so depending on how one applies the capital rules.

    But it is—if you are raising the point, Mr. LaFalce, that leverage is the potential major danger in a financial system, I would fully subscribe to that. I think——

    Mr. LAFALCE. Unregulated funds, who has the legal authority to impose capital requirements and therefore deal with the leverage issue with respect to them?

    Mr. GREENSPAN. Well, I don't think that one necessarily assumes that the system is somehow helped by some governmental authority imposing leverage. The major——
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    Mr. LAFALCE. What authority——

    Mr. GREENSPAN. The major element of control of leverage and capital in the international financial system is the structure of counterparty interrelationships. Ultimately, you have a system in which individuals who lend money to others have a very important interest in getting that money back.

    Mr. LAFALCE. Chairman Greenspan, I heard this at previous hearings where we were told that counterparties are so knowledgeable, they are so sophisticated, the risks they are becoming involved in, and therefore we don't have to worry about these sophisticated investors.

    And now we are saying we act as a catalyst for intervention here—not to say the sophisticated investors so much, but because of the systemic effect it would have on the global economy and all of the people of the world. It seems to me that what you are just arguing was argued before. This is a perfect example of the fact that we can't depend upon it.

    Mr. GREENSPAN. No, on the contrary. I am very concerned that we will put in place a set of new forms of Government regulation of all sorts which will not work, but which will create an impression that somehow or by some means it is of considerable assistance to the stability of the system.

    I think it is very important for us not to introduce regulation for regulation's sake.
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    Mr. LAFALCE. Let me just ask this question.

    Is the difference of opinion within the Fed on this issue, or amongst the members of the Federal Reserve Banks, do you speak—you know, monolithically—for all members of the board on this issue and for the various presidents of the Reserve Bank, or are you unaware——

    Mr. GREENSPAN. I have one member right here that wishes to——

    Mr. MCDONOUGH. If I can comment, I do believe that counterparties are the most effective way of controlling risk. However, we have a capital accord under the Basle Supervisors Committee, which I chair, which is risk weighted, and so it happens to be 8 percent. But it is risk weighted so, for example, a U.S. Treasury security doesn't count at all, that has no weighting; whereas a loan to a company has a full weighting, so you have to have 8 percent capital against that.

    In addition, to pick up the total size of the balance sheet, we in the United States have what is called a leverage ratio, and that is your capital has to be a minimum of 3 percent of the total balance sheet.

    Now, one of the things that we in fact have just decided to do in the Basle Supervisors Committee is to reopen the capital accord which was done in 1988 and over time has not reflected changes in the marketplace. For example, it just picks up what is on the balance sheet and essentially not much of anything of what is off the balance sheet, the famous derivatives. We have got to figure a way to do that.
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    We also have to figure out a way in which we say——

    Mr. LAFALCE. Are you reconsidering the Fed's position on the FASB proposals with respect to——

    Mr. MCDONOUGH. It really is an unrelated issue. It is to figure out, how do you capture a notion of risk and how do you relate capital to it? And we have to have, as Chairman Greenspan suggested, with which I very fully agree—you have to have an approach which is evolutionary, which allows marketplaces to develop in a productive manner; and at the end of the day, you have to have a very heavy dependence on sensible counterparties having enough knowledge—just why we beat the transparency drums so much—enough knowledge of what is going on and the companies with which they deal in order to be able to make a reasoned judgment.

    Now there is enough opaqueness still in accounting statements and enough opaqueness in amount of information that is made available that we have a good deal of work left to do in this area. But the basic approach that Chairman Greenspan suggests, I think everybody in the Federal Reserve agrees with, and I know I do.

    Chairman LEACH. Mrs. Roukema.

    Mrs. ROUKEMA. Well, we are not going to quite leave that aspect of the subject yet, because the question I was going to ask, that had leaped out at me from the article in the New York Times today, is directly related to the question that Mr. LaFalce asked; and I am not sure I understand your answer to it.
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    I heard your language about counterparties and opaqueness, but let me ask the question this way.

    Did the lenders understand how leveraged the fund was, and if they knew, how were such loans justified as prudent? And this is the bottom-line question, I think, to whether or not the regulation, the laws we have presently, are appropriate. If not, were the banks misled or just careless?

    In other words, we are trying to get at the question of whether or not—I mean, how much discretion is there and how much must really be relied upon under current regulation and the law?

    And I agree with you in principle, Mr. Chairman, about not wanting to get overregulated. It may be possible; as you said, for hedge funds to be out in cyberspace someplace. But how do we deal with this?

    Mr. GREENSPAN. Well, I think it is a very good question.

    Mrs. ROUKEMA. It seems to have failed in this situation.

    Mr. GREENSPAN. It did fail.

    Mrs. ROUKEMA. It did?

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    Mr. GREENSPAN. Well, sure.

    Mrs. ROUKEMA. And is there something we should be doing to correct it? And I am not sure that that Chinese wall that you referenced under antitrust law is in any way relevant to the problems that have been raised in this particular situation.

    Mr. GREENSPAN. No, I think you raise an important question. We ought to remember that when you put in place in the dynamic market system that we have, especially not only in the United States, but around the world, you have an extraordinary amount of change that is going on, and people who are in the position of endeavoring to make credit judgments are continuously reviewing and presumably, having new insights, recognizing new problems, and periodically they go wrong. I mean, these are human beings who are trying to make judgments on very complex issues. Sometimes, and I suspect it was part of the LTCM case, they get bedazzled by the people with whom they are working.

    The main issue should not be, as far as we are concerned, what happens in individual cases. Banks are in the business to make loans and they accept the possibility that they will have losses. In fact, as I have said here previously, if there were no losses in the banking system, they would not be doing their job. So what we have to look at when we are involved in making judgments about overall regulatory policy and the legislative base on which it rests is, how do we get the optimum degree of risk in the system?

    I am frankly surprised, as I said in my opening remarks, that we haven't seen more of these types of mistakes. We are going to see more of them. The question is, what do they mean in the full context of the operation of the economy? That is what we have to be focused on and, as best I can judge, that the ability of banks generally to act as counterparties has been very successful in recent years.
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    The loss ratios are low; in my judgment, they are not going to stay that low. They make fairly good judgments, but they make mistakes. They are human beings and I think they will continue to do so, and I know of no set of supervisory actions we can take that will prevent people from making dumb mistakes. I know of no piece of legislation that can be passed by the Congress which would require us to prevent them from making dumb mistakes.

    Mrs. ROUKEMA. All right. Let me ask another question, and here I am going to use the quote from your predecessor, Paul Volcker, and I don't know—I understand he was invited today, but had a prior commitment, and I don't know whether his quote in the paper was taken somewhat out of context. But it was, ''Why should the weight of the Federal Government be brought to bear to help out a private investor? It is not a bank.''

    Now let me put that in the context of the question that arose in my mind as I heard you, because for the most part I agree with what you have done here; but the question comes to mind as to whether or not you truly have all the legal authority or discretion that you need to deal with these problems because, after all, we have obviously seen that you have used your authority and your discretion, and whether we agree or disagree, you had certain insights into the problem and you handled it, right?

    But there might be somebody at the Fed or someplace else in the future that does not have that same insight and perspective that you have, and the question is, and it is related to the moral hazard question, the larger moral hazard question is that are there loopholes here, or so much wide discretion, that we should be concerned and that there should be some tightening of the Federal Reserve's discretion consistent with your own approach to this problem? It is a powerful question, and I don't know whether or not we have had enough experience with financial firms other than banks failing yet, but we have to realize that it is out there and it is going to get worse.
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    Mr. GREENSPAN. I think we are continuously aware of the fact that we are dealing with a moving target as the technology changes, as new products come on the market and as various different types of risks we never imagined anyone would know how to take have arisen.

    At the moment, at least speaking to the people in our system, I have no sense that we lack the authorities that we believe we need. I would think that were we to sense a significant shortfall in the authorities which prevented us from doing things which we, if we were able to do, would significantly improve the balance in the financial system. I could assure you we would be up here requesting, as we have in the past. Do you have anything on the agenda that you are aware of?

    Mr. MCDONOUGH. No. I do think we have enough power, and I agree with the Chairman that if——

    Mrs. ROUKEMA. If you choose to exercise it, but someone else might not want to exercise it.

    Mr. GREENSPAN. Well, look. Let's take the issue of hedge funds, which I think is a really interesting issue.

    Mrs. ROUKEMA. All right.

    Mr. GREENSPAN. The hedge funds, as far as I can see, cannot be regulated directly in this country. Two things will happen. Either you regulate them and they will disappear because of the nature of their business, they would perceive, can't be effective if it is regulated; or far more likely, they will move to a different venue in trade because they don't need the United States particularly.
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    Now, starting with the premise that we can't do anything, the question really then gets to, what do we do in lieu of that to protect the American financial system, which is what it is all about? And in my judgment, the most effective, indeed really the only significant, effective means that we have to make certain that they, that group of hedge funds, does not create a problem, is by making certain that the banks and others who lend them money have direct supervision themselves as they do in due diligence to make certain that when they lend money, they are doing it most sensibly.

    On occasion, there will be mistakes made, as there were in LTCM; and I will forecast without knowing who, what, where, there will be many more. The problem is that if you have a modest amount of losses on loans every year, all of them represent these types of mistakes, so that the question basically is, can we improve the system?

    I am not sure I know at this stage how in this particular instance, other than making certain that the technical capabilities of the banks who lend the money to these sophisticated organizations are up to the ability of knowing when they are putting moneys at risk.

    Most of the time, the vast majority of time, they do an excellent job; periodically, they break down. There will always be cases where they break down. And the question is not so much, do they break down, but is the ratio of success to failure sufficiently high that it is consistent with a stable financial system.

    Mrs. ROUKEMA. Thank you. There is an awful lot more that we need to learn isn't there?
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    Mr. GREENSPAN. We are always learning.

    Chairman LEACH. Thank you, Marge.

    Mr. Vento.

    Mr. VENTO. Thank you, Mr. Chairman.

    It is interesting. I mean, you know, obviously in the absence of—there is a period of time for almost, it looked like, three weeks, Governor McDonough, that in fact this issue was in flux. That is to say, it looked like the episode or the events that occurred that culminated in this announcement by Long-Term Capital Management around the first with the letter that they sent out, and that apparently precipitated this crisis that went on for this three-week period; and that Berkshire—I don't know why we can't say Mr. Buffett's name here today, but in any case, maybe we should be talking to Mr. Soros, too. Maybe he should have been in on the bidding, too.

    But it looks to me as though the group that we convened, that you convened or that was convened at your request, or at their request, in fact, interfered in a sense with what was going on. I mean, if in the absence of that, would other events have evolved in terms of a buyout?

    Now, clearly the partnership was interested in 10 percent of whatever was left, as opposed to 5 percent, as I understand what Mr. Buffett offered, but maybe that bidding would have continued in the absence of this group that you convened.
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    Now, they can get together on their own. I think all of us understand the fact that when you provide the room, the coffee, as my friend from Massachusetts was mentioning, that it has some significance. To me, it does anyway. I think it is a public role. It is an unusual role. I don't think you should be disinterested, incidentally, Chairman Greenspan or Governor McDonough; I think you ought to be interested.

    I am not objecting to that. I am just wondering if the same benefits flowed to Warren Buffett or would flow to George Soros or others that are going to be involved. It is a big issue, as it was to this consortium.

    Mr. McDonough.

    Mr. MCDONOUGH. Congressman, I think you have to start with the notion that we were really very convinced that the American people would suffer in a way that is not appropriate for them to suffer if LTCM failed.

    Mr. VENTO. I agree with that.

    Mr. MCDONOUGH. We agree with that. So the only question is, would an investor or a group of investors with deep pockets that would have taken this thing over and squeezed out all the existing investors and sent the management packing, which in sort of a biblical justice concept might have been a very happy event, would that have happened?

    Well, what we know is that there wasn't anybody around making an offer until Wednesday morning of last week when an offer came forward. Now the offer came forward at a very good time. If you are an astute investor, that was pretty good timing. We were convinced that because of everybody having different interests, different exposures, that although we waited for a considerable period of time for the private sector to get its act together, without benefit of our providing the room and the coffee, which we did provide—was the limited expense—the deal would not have taken place.
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    We also gave them some free sandwiches.

    Mr. VENTO. Well, great. You are under the same gift rule as Minnesota politicians, I can tell you that. The issue is, we can't even give out Twinkies.

    But the issue is that you—if this three-hour period of time was sufficient time for it to come together, I guess——

    Mr. MCDONOUGH. It is the time that they put the offer on the table. They made an offer, they said the offer originally was valid until 12 o'clock. Then they extended it to 12:30, and it——

    Mr. VENTO. Well——

    Mr. MCDONOUGH. See, I don't think you want me to have called them up and say, ''Hey, fellas, let's put me in charge of this thing, and I'll decide who does what to whom,'' and then you have the Federal Government involved in a way——

    Mr. VENTO. I think you ought to play the same role for each of these groups, and I don't know that preserving the culture and institutional memory at Long-Term Capital Management was—you know, I guess that is prudential, but I think there are some questions that arise as to what the role should be.

    I mean, these are not unknown problems with regard to mergers and acquisitions and terms of the management team. Obviously, there is—you know, insofar as the partnership was making decisions, I am sure it isn't lost on you that, as the Chairman pointed out, that there are some conflicts there.
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    Let me just analyze. I mean, what was the Fed doing? You had some primary responsibility for the regulation of three of these firms: Bankers Trust, Chase and J.P. Morgan. So what was the role of the Fed in terms of regulation or oversight in terms of derivatives?

    See, the Comptroller has provided us with information, the acting Comptroller, pointing out three- or four-fold growth of derivatives, $28.2 trillion held by commercial banks. And what were you doing in terms of monitoring the quality of these derivatives within the context of these three institutions that you have primary responsibility for?

    Mr. MCDONOUGH. It might be interesting to note in passing that LTCM had 75 counterparties. The list so far is about 15, so I wouldn't necessarily assume that the remaining 60 don't include some things that are not State-chartered banks.

    Mr. VENTO. Maybe more than three, but at least——

    Mr. MCDONOUGH. That is a lyric leap I wouldn't advise anybody to make. However, we have supervisory authority over the three State-chartered banks that you mentioned. We provide regulatory guidance to them, as both Chairman Greenspan and I have described; and if you look at their exposures of—to what degree they were collateralized and to what degree they were not, they were—as of last Wednesday, they were very fully collateralized. And therefore it doesn't immediately follow that they were doing something that was either unwise or inappropriate, but it is too early to make that judgment.

    As I mentioned, we have to go in, do a thorough analysis over the next few weeks of did they miss something on the credit analysis? If so, what lessons should they have learned? Did they evaluate what could have happened to the derivatives portfolio even in sort of a normal market condition and thirdly did they stress test enough?
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    As of today, we don't know the answer. We know what the questions are, but we have to go to those institutions and any others that may be involved and do the work.

    Mr. VENTO. Well, I mean, you know, the concern I think that most of us would have—and of course we don't really know, as I understand from my staff discussions, what on the other side—in terms of investment bankers, whether they were in fact holding the credit and subsidiaries or partnership that was holding it, whether they had sold that paper with certain representations and warrants. We don't really know.

    I mean, you really have to follow this through a lot to see what the profound effect is, and as I understand with regard to derivatives, you know, there is very little understanding. And with regard to hedge funds, to in fact assess that risk, we don't have a very good tool for doing that.

    Now, of course, one answer is, why don't we just make these all plain vanilla, and then we would be able to understand them, that of course may defeat the purpose or the criteria, the essence of what they are about. But I just think that, you know, we should be asking these questions because if, in fact, there is nearly $30 trillion, or $28.3 trillion, of derivatives out there and 65 percent of the derivatives are in banks—from our previous hearings, as I recall—we have, I think, a tremendous exposure here and we could be dealing with a problem that is not well defined or understood, that could really cause us a lot of problems in this country, with events such as that in Russia.

    I must say that the events in Russia were less surprising to me than perhaps other events might be. I think that that was predictable in light of what had been going on there for the last four or five years, certainly in the realm of possibility; and I think we can also—so I don't think this is all that surprising in terms of what occurred. Bad judgment, yes.
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    What our role should be, I would like to see a better regulatory attitude. That is why I think taking any tools away from any regulators at this time until we—I think it is good that some of you are more or less aggressive than others, because I don't see the answer here in terms of the type of regulation that came through in this case where there was some opportunity for addressing this early-on. I think we need to have a lot more aggressive attitude than just simply saying, ''Well, if we regulate this too rigorously, then they are going to go offshore.''

    I don't think so. I think there is a better balance than that.

    Thank you, Mr. Chairman.

    Chairman LEACH. Yes.

    Mr. Baker.

    Mr. BAKER. Thank you, Mr. Chairman. I will try to keep mine within the five minutes allocated, but I intentionally cut my opening statement short, so I could follow up on a few more questions, if possible.

    Chairman Greenspan, on August 17 the Russian devaluation occurred and triggered—this being a trigger for a broader market loss and the eventual difficulties of Long-Term.

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    September 2, then the LTCM letter advises investors of significant losses which, according to Governor McDonough, later was widespread knowledge of the Long-Term problem.

    On September 16, the Washington Times reported in the morning paper that the Bank of America would report a write-off of $330 million due to Russian investment exposure.

    Then on that same morning, later in the morning, I asked in this committee the question: ''I am concerned that we do not have the ability to have a clear assessment of our hedge fund loss exposure; do you feel you have the ability or resources available to you to adequately identify this risk?''

    To which you responded, in short: ''Let me say, Congressman, hedge funds are very strongly regulated by those who lend the money in the sense that the major vehicle for supervision of lending is really from those who make the loans. In other words, there was a considerable amount of effort to understand what was a safe loan and what was not a safe loan. They are not technically regulated in the sense that banks are, but they are under a fairly significant degree of surveillance; and importantly, I should point out, they have great visibility, but they are not all that large in the total context of the system.

    My first question is, when did you first learn of the significance of the Long-Term problem? When was that information made available to you about the amount of leveraging and the scope of their investment?

    Mr. GREENSPAN. Let me say, first, that I would repeat; if you gave me the same question, I would give you the same answer.
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    Mr. BAKER. Sure, I heard it earlier. I did.

    Mr. GREENSPAN. I think that it is very important to distinguish between evaluation of losses that go on in any loan portfolio—and indeed when I was director of a major bank, before I came into the public sector, I used to be on the loan committee; and we went through all the loans that were bad, and it took an awfully long time, and one got the impression that the place was coming apart.

    As it turned out, these were an extraordinarily small proportion of the total, and you expect them to happen.

    With respect to when I first learned of this, when I think you called me——

    Mr. BAKER. That was after the committee hearing, I guess, before the meeting on the 23rd.

    Mr. GREENSPAN. I think that is correct, yes.

    Mr. BAKER. Well, my reason for raising that issue with you is, as the most highly regarded regulator in the financial marketplace we have, given the scope of the unwinding that was to subsequently occur three, four, five days later, I am very disappointed that you, in your capacity, did not have knowledge of the significance of this problem.

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    I wrote on September 11 to you and to the SEC, a letter basically asking about the relationship between hedge fund activities and market value of regulated financial institutions and regulators' ability to have insight. To which the only response received to date is from Mr. Richard Lindsey, Director of the SEC, in which he states, ''Given the size, the degree of leverage and the scope of trading of certain hedge funds, however, regulatory authorities in the financial community need more information to better understand and assess the risk and benefits which hedge fund trading poses to our markets.''

    First, let me say, I think what the Fed did was appropriate and responsive to the potential systemic risk involved in this matter.

    Second, I am very distressed that we did not have adequate financial information to properly assess the risk until three, four, five days, in your case—perhaps longer in the case of Governor McDonough—given the scope and complexity of these matters.

    Further, frankly, I was shocked to hear that when the market participants showed up at the workout meeting, many of them were surprised to find out who else was in the room and the scope to which they had been leveraged.

    Now, if the market participants didn't know and you didn't know, can't we at least agree that from this point forward more disclosure, not only by the participants, from the management of the firm, but also by financial institutions, to you is a highly desirable activity which is vastly short of new regulation?

    Mr. GREENSPAN. Well, Congressman, I think that it depends on the type of information and what one expects to receive from it. Remember, we are going to be involved in a fairly detailed discussion of the issue of hedge funds in the working group that I mentioned in my prepared remarks, and we will be going over all of these various different types of issues.
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    I would submit to you that there are trillions and trillions of dollars out there and all sorts of commitments around the world, and I would suspect there are potential disasters running into a very large number.

    Mr. BAKER. On that specific point it is my understanding of about $1.2 trillion of notional value derivatives. At any given point, how much of that is actually collateralized?

    Mr. GREENSPAN. Usually—I mean, at the moment, if we are talking about this particular situation, it is in excess of 90 percent cash collateral.

    Mr. BAKER. Do you feel that the assets that remain within LTCM's control can be marketed for anywhere near the value that is represented?

    Mr. GREENSPAN. I think that was the crucial question that President McDonough was raising, namely, that if everything were marked to market, right at this particular stage, and were unwound at those market prices, then the answer is yes.

    The question is, if you throw it all on the market at the same time, can you expect to get the values which are currently on the books as the best estimate? The answer is almost surely no.

    Mr. BAKER. I find that interesting coming from an oil and gas State in the 1980's where many of us used the exact same argument for the disposition of the RTC properties, allowing smart property managers to get the highest and best value over time would have averted significant losses to taxpayers. It seems the philosophy is a little——
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    Mr. GREENSPAN. Well, it is interesting you raise that. In a footnote in my prepared remarks, I get into the issue of what was effectively a fire sale instituted by the RTC for purposes of galvanizing the market. A fire sale per se sometimes has advantages to the structure of the market; the vast majority of times, in my judgment, it does not.

    Mr. BAKER. From personal experience, I can tell you it certainly didn't work in our case.

    Governor McDonough, I want to follow up one other point that is troubling. And this is my last question, Mr. Chairman.

    Given the complexity of the workout plan with which you were engaged, I recognize how difficult it was for you to come out with something that would avert a probable financial consequence and yet at the same time not benefit the participants in the transaction directly.

    You may not be able to tell me today, or if you can tell me at all, but I have concern that participants in the workout use corporate assets to resolve the financial dilemma which resulted in their own personal assets being protected from loss. Is that an accurate summation?

    Mr. MCDONOUGH. There were some of the participants in the consortium who stated, and have stated publicly, that they had assets invested in the Long-Term Capital partnership. I did not have the impression that the corporate decisions that they were making were changed in any way because of that reality, but I don't know that because that is what is going on in another human being's head and another human being's ethics and conscience.
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    Mr. BAKER. I certainly understand. You can't have knowledge of everyone's investment portfolio in the room.

    But let me say, I support the actions that you took to avoid the further systemic risk to prevent injury to persons who had no relationship to this unfortunate circumstance. But I hope in reviewing workout plans of this magnitude in the future, we can find a smart way to save the systemic risk problem from becoming real and not at the same time benefit risk-takers who were leveraging at great risk for their own personal reward and then have them get the benefit of a savings plan to a great extent hammered out by your leadership that saves them personal losses.

    That is the one part of this that troubles me greatly.

    I thank you sir.

    Chairman LEACH. Thank you, Mr. Baker.

    Mr. Frank.

    Mr. FRANK. Thank you, Mr. Chairman.

    Let me say at the outset, because I have some differences, that I do not share some of the arguments that involve questioning motives. I don't think there was anything other than the most publicly spirited motives here, but they raise disturbing questions.
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    First of all, you both deserve an award even by the standards of the Fed. The extent to which you have understated this is impressive. I am willing to bet if we had the transcripts of some of your private remarks—and you not being in the White House, don't have to worry about that—but if we had the transcripts of some of your private remarks, there would be a contrast between the degree of activism that was present when you were doing this and the kind of passivity with which you describe it today.

    Mr. McDonough, I expect there to be some complaints about you from the hotel industry, because apparently you have gone into the business of making your rooms available for nothing. You are kind of a hotelier, you make the conference rooms available, you hang out, you are just a facilitator; and there are probably people in New York wondering why, how they are going to make a living renting rooms when you give them away for free.

    I suspect that you have not only understated your role very substantially in bringing this about and that you, in fact, in your heart of hearts are quite proud of your activism in bringing this about. But I think you are also sort of understating what the negative consequences would have been.

    Now let me ask this, Mr. McDonough, Mr. Greenspan. Had you not been offering your good offices, had the Fed been sort of close to them and you didn't facilitate, do you think the outcome would have been the same, Mr. McDonough?

    Mr. MCDONOUGH. I am quite confident Congressman Frank, that in the absence of any involvement by the Federal Reserve Bank of New York that Long-Term Capital would have collapsed.
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    Mr. FRANK. So that public involvement was involved although quasi-public involvement—you are, after all, the world's most publicly invested private official as President of that entity, the Federal Reserve. But I think it is relevant that you have been called Governor, but in fact you are not a Governor, you are the President. You are the President of the Federal Reserve; you are not appointed by any public official, you are not a public official.

    And that is one of the questions we have here, and I think that is important to know, that it was the—the implicit power; and you are a very persuasive man, Mr. McDonough, but I do not think it was entirely your personal powers of persuasion that brought this about. It was the fact that you are President of the Federal Reserve Bank of New York that led this to happen.

    So we have a situation where Federal intervention was involved. Now, see, part of the problem I think is this—and I understand there are those who believe that while democracy is capable of dealing with many, many issues, it really cannot be trusted with matters of high financial policy—and there is an overwhelming tendency, when you come here, to speak to us as if we were adolescents who need to be told some things, but who are not ready for the entire truth. And I don't mean any dishonesty, but I think there is a pattern of understatement that comes forward, the understatement probably about the role, but also partly about what the consequences may be.

    Now we talk about the risk. I mean, Mr. Greenspan has said that this may happen again. So then the question is, if it was so important as to justify this intervention now, how do you persuade us to do absolutely nothing except wait again and trust entirely in your discretion to deal with it if it happens again?
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    Now, I understand, you say that we can't regulate the hedge funds, but can we not regulate the people who invest in the hedge funds? I suppose if we were talking entirely about supremely rich individuals, we couldn't regulate them, but increasingly, especially if we pass the financial regulation bill and the merger of securities in banks continues, then certainly between the Securities and Exchange Commission and yourselves and the Comptroller, we have a great deal of leverage over the investors.

    Mr. Greenspan, you say we can't prevent people from making mistakes, and I obviously agree with that, but can we not do something to reduce the magnitude of the mistakes, not the direction, but would it not be possible for us conceptually to empower you to say to the lenders—not to the hedge funds, but to the lenders—''Here are some severe restrictions on what you can lend.''?

    And, Mr. McDonough, you said, well, the counterparties—I think I know what counterparties are. I also appreciate—I will be honest with you, we had a little caucus here. Some of us were pronouncing B-a-s-l-e, ''bazel,'' and we think that is what you said ''Basle'' for now. And I can't get Basil Rathbone out of my head now, as I think about it.

    But the counter——

    Mr. GREENSPAN. It depends whether it is the French or the English.

    Mr. FRANK. Yes. I am still sticking with English now, and I am working on it.
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    But it seems to me here is the real problem: As you described this, even if you are thoroughly familiar with every one of the individual entities, there were systemic problems that came up. There were problems that had nothing to do with failure in this or that particular ultimate company.

    So here is where we are. In this case, it was bad enough for the Federal Government to have to intervene, although you tiptoe around how you describe it. We are now told this is going to happen again, and apparently again the consequences, the negative consequences to the system, were so bad to innocent bystanders—we are not talking about the investors—were so bad that the Federal Government had to intervene and did intervene. And this is important; you intervened in a way that left the mistake-makers better off than they would have been if you hadn't.

    That wasn't why you intervened, that wasn't your purpose, but a consequence of preventing damage to the system was to leave some of the richest people in this country better off than they would have been if the Federal Government hadn't intervened; and that rankles a lot of us, as you have heard, when we are told we can't do anything similar for people much needier.

    So the question now is—and I don't criticize for a minute that you are doing what you then did; I think you were confronted with that necessity—but I am disappointed that you tell us we can do nothing except allow for repetitions of this and, in particular, can we not increase your ability to prevent not the hedge funds, but the people who provide the fuel for the hedge funds, from making mistakes of a similar magnitude or requiring similar activity?
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    Mr. GREENSPAN. Congressman, the answer is, yes, you can.

    Well, let me first go back and just add on to what Bill McDonough said about the potential collapse of LTCM if nothing was done. I think we all agree that that is precisely what would have happened. What we don't know is what the consequences of that would be. There is a judgment that we have to make. I don't think anybody believed the probability that in the event of a collapse of LTCM the whole system would necessarily unravel. The issue was in all of our judgments that the probability was sufficiently large to make us very uncomfortable about doing nothing.

    My own guess is that the probability was significantly below 50 percent, but still large enough to be worrisome, which means that if you asked me if nothing were done, is the likelihood that nothing of systemic consequence would have occurred, and I would have to answer, yes, that the likelihood that nothing would have happened is better than 50–50. That is the key judgment that we have to make.

    The answer to your second question, are there things that could be done to reduce these types of episodes, the answer is yes. And I commented in my prepared remarks, we can very significantly reduce the degree of leverage in the system. Back in the post-Civil War period, banks on average were required by the marketplace to hold 40 percent, 35 percent capital in order to hold their deposits. People wouldn't deposit in an institution with capital that was not significant. We have decided to create a system which, because of deposit insurance, because of the Federal Reserve's discount window and Fed wire, which creates riskless settlement, we have induced a fairly significant degree of leverage in the system.
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    Now, that leverage arguably has actually enhanced the rate of growth in this country and raised the standard of living. It has also increased the risk of problems, and I think the major choice that confronts the American people as a whole and the type of tradeoff which the Congress has got to address is, where on that spectrum of leverage do we want to position ourselves? And at the moment we are positioned at a point which is consistent with a fairly significant amount of growth, it is consistent with a degree of mistakes as a consequence of that leverage which is probably relatively high, although the experience of the last five years has been, in my judgment, one of extraordinarily low losses in the system, not only in banks, but everywhere else. It is below normal.

    The answer to your question therefore is, yes, you can instruct us through legislation that we must significantly alter that degree of leverage. I am not sure it is a good idea.

    Mr. FRANK. Could I have ten seconds?

    As you describe the activities of the hedge funds, is there any way to reduce the kind of leverage that the hedge funds benefit from without reducing leverage that some of us might think are more productive types of investments?

    Mr. GREENSPAN. Yes, I think the particular control of leverage on most funds at this stage really reflects the willingness on the part of people to lend the money. If you are a lender and you see that you have got a fund, whether you call it a ''hedge fund'' or anything else, that has got, say, $2 million, you are willing to lend them maybe a million or two dollars, maybe a little bit more; and then you will begin to get a lot more cautious as you lend them more, and it is ultimately the lenders which determine how much the leverage is, because the amount of equity is determined by the investors. But the amount of leverage, of necessity, is determined by the lender, or the limit to the leverage, I should say.
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    Chairman LEACH. Mr. Lazio.

    Mr. LAZIO. Thank you, Mr. Chairman. I want to welcome both the Chairman and President McDonough, who I have had the pleasure of knowing for quite some time on a number of different fronts, who has been doing an outstanding job. I wanted to let you know that, Mr. Chairman.

    What we are concerned about, I think many of us are concerned about, is not just the issue of transparency and who is the beneficiary of the transparency, but are we in a position to intervene at an early enough point so that the public exposure and from a market standpoint, a broader private exposure is not created?

    And so I would ask, if I can, President McDonough, when you first became aware of the jeopardy of the fund?

    Mr. MCDONOUGH. I became aware of it—well, I was aware by late August that they were suffering some fairly serious losses.

    Mr. LAZIO. They sent out a letter to their——

    Mr. MCDONOUGH. Well, it was just probably while they were preparing the letter, but at that stage of the game, their losses were still well into the category of being their problem; and as I mentioned in my prepared remarks, had it been their problem and their counterparty's problem, I would never have given them the use of the Federal Reserve Bank of New York rooms or given them sandwiches and coffee.
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    But—and therefore it wasn't until about the 18th of September that we realized that this fund, LTCM partnership, had become sufficiently damaged that it really could cause what I was concerned about—again, a long way from a sure thing, or even 50–50, but could cause really serious damage to the American economy and the American people.

    Mr. LAZIO. Was——

    Mr. MCDONOUGH. So that is the time that I knew.

    And then we started moving, and we learned that as of a Friday; and the meeting which led to the so-called ''consortium approach'' took place the following Wednesday, a period of five days.

    Mr. LAZIO. This was not a result of picking anything up in the ordinary course of examination; this was just as a result of consultation with other market participants? In other words, was it just sort of a ''buzz on the street'' type of thing that they were in serious trouble, or was it anything pursuant to your responsibilities as president of the——

    Mr. MCDONOUGH. The relationship—if you look at the relationship through the prism we had, which was of the three State-chartered banks which we supervise in conjunction with the State bank supervisor in New York, their relationship with Long-Term Capital as of, let's say, the middle of September, was one that did not preoccupy them; they were collateralized.
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    We have to go back and look at whether they were doing their homework as effectively as they should have and—but what I think we are all sort of struggling around is, since we think, I think, collectively, including most of you on the panel, that you can't figure out a way to control and regulate the hedge funds, how do we avoid, how do we arrive if possible—and I am not sure the answer is we can—at a situation in which the total leverage can't build up to a point where the thing is so big that its collapse could create problems for our own people?

    Mr. LAZIO. But part of the problem is, if these things are popping up in examinations—and I want to ask you about that as well—if you are saying that they are collateralized, they are collateralized at a particular point in time when you are reviewing the situation, but that collateral may well be insufficient, and perhaps by a wide margin, at the time of a crisis.

    So if you are not doing adequate modeling, in other words, stress testing or whatever the case might be, in this case, obviously because of the unusual widening of the credit spreads that you had a particular global problem—I mean, do we have the capacity at the Reserve to deal with that?

    Mr. MCDONOUGH. The key, Congressman Lazio, would be the stress testing, and stress testing is an interesting phenomenon, because you have to assume that things get a lot worse than they usually do. But if you began in your stress testing to assume that the Russians were going to have a massive devaluation to repudiate their debt, say—I will do a reductio ad absurdum—once a week or once a month, well, nobody would ever provide any credit to anybody.
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    One of the more difficult things that the President's working group is going to have to look at is, even if stress testing is really very good, how big a stress can you put in and how do you handle the problem of the event that is extraordinarily rare, very risky, but very unlikely; that is really where the stress testing gets extremely problematic.

    Mr. LAZIO. I want to ask one last question, if I can with the indulgence of the Chairman, and it is this:

    Understanding that it is very difficult to get behind the operative workings of a hedge fund investment, when the Fed goes in to examine a bank, does it now and will it continue in the future with more sophistication, one would hope, ask what the cumulative exposure is for hedge funds or derivative loans?

    Mr. MCDONOUGH. Yes, we do do that. We do it now and we will obviously continue to do so.

    Mr. LAZIO. Thank you.

    Chairman LEACH. Thank you, Mr. Lazio.

    Mr. Kanjorski.

    Mr. KANJORSKI. Thank you very much, Mr. Chairman.

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    Mr. Chairman, I would like to make an observation. A little while ago I walked down the hall, and I noticed the absence of television and other media parties here; and I am just wondering, is there any way you can inject sex into this so that we can get a little more national attention? It would seem to me, listening to testimony of Mr. Greenspan and yourself, Mr. McDonough, we are talking about the potential meltdown of the world's economic system instead of a fling at the White House and yet nobody in the world seems to understand what may have transpired or may have been at risk in the last two weeks, and it seems essential that these hearings bring that up.

    Now, I have got several points, one or two. Really, I am not too much worried about how you put the deal together to bail the system out. I think it is commendable, quite frankly, and I think when you get to the point where you may have a meltdown, we don't have a hell of a lot of choice when you have systemic risk.

    I am wondering how we got to that risk and what is in the system that didn't set off triggers, first of all. We have here two or three American banks that are federally-insured. Do we know what their potential loans were, what size risk was in the system for them or for the insurance fund? Do we have any idea of what you are talking about—listed people here, they are in different order, the Chase Bank, Bankers Trust, and my guess—those are the only two American banks I see on the bailout list.

    Mr. MCDONOUGH. J.P. Morgan also.

    Mr. KANJORSKI. J.P. Morgan. OK.

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    What was their exposure?

    Mr. MCDONOUGH. Well, I don't frankly have it in my head. We have the knowledge of—we have the information available. I just don't have it in my head.

    Mr. KANJORSKI. Well, I can only say this. These investment bankers, they are not stupid. They didn't go in there and put equity and investment into the level; what they did was put a little equity in, and then they leveraged up with bank loans.

    I would imagine the people that held the highest risks here were the loans from the banks that are federally-insured; am I not correct? I mean, if I were to structure the deal I certainly wouldn't go to my investment bankers and have them put up an equal amount that I could get from a loan. There is always a material leverage that bank loans are much higher.

    Anyway, on that point, whatever those loans were, it seems to me—I have seen lots of transactions; I have never seen a transaction that wasn't called—provision in it on short-term lending when risk occurs.

    And the second thing, how is it these partners got to take all their investment money out every year? That is amazing. I want to go to you guys when I go to Atlantic City, and I want to put up $2000, you are going to put up $98,000, and every time I win I am going to take my earnings off the table and you are going to stay at risk. All I need is a little winning and I am way ahead of the game; I can't lose.

    These investors couldn't lose. They took all their capital out in 1995 and 1996. They were more than whole. They were only—you know, the only people at risk here were the lenders and the outside investors, and the outside investors already got their initial capital out.
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    So what I am talking about is some people here that owe these nice investors at risk. They weren't really at risk; they were now playing on their profits. That is the only thing that was risked, that initial amount in. They returned more of it in the take-out, so they were just sitting there playing the game with the profits.

    But the real risk party were the American taxpayers, the insurance fund, the whole system if it went down, if you will.

    Now, I can't understand how somebody as a regulator didn't look at these loans and say, ''Why aren't you requiring investors to retain capital? If they are, why aren't they building up their equity?''

    The second question I have is, as I understand large banks, they are capitalized 4 to 6 percent. Here is a high risk area out there, it is 2.5 percent. One of the questions, could the banks have made the same investment this fund was making or couldn't they do that in-house? Because they were accomplishing a real major thing: They were using leverage. Anything they did in-house, they had 4– to 6–percent equity involved, but by lending money or investing money from the bank outside of this independent entity, it was operating only with 2.5 percent capital. That was a twofer, if you will, for the banks.

    Certainly, we could have stopped that. Certainly, we could have required in the loan documents that earnings be retained, so that equity would be built up instead of being taken out, and only the lenders could be at risk.

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    Finally, I would say there is actually a national security question that is interesting here. If we can't get into these hedge funds, I think all these countries in the world that are spending billions of dollars on nuclear weapons, for biological weapons, and threatening the United States, they are crazy. They should have gone up and been partners with this hedge fund, put $2 or $3 billion in, get the American and the world economic system at risk, and then let it explode. They didn't have to kill anybody. They could have killed off the entire economy of the world by a couple of billion dollars of investment.

    Now it seems to me that will—if we allow entities to get to world systemic risk, that puts at risk every working American, every American, every person in the world and puts at risk democracy. I don't think it is fair for free marketers to say, ''Well, we have to let the market work.''

    If we're going to spend $270 billion on national defense every year and we are going to allow insurance funds to support banks to lend money to irresponsible hedge funds that can bring down the whole system, we have got to find something to put into that system so it can't be used as a weapon against not only America but the whole world. I would like your response to that.

    Mr. GREENSPAN. Well Congressman, let me put an important issue on the table which has not been discussed, and I think it is relevant to the notions that you are putting forward. I am scarcely defending hedge funds, nor do I think their basic purpose is other than to maximize their rate of return to their individual shareholders. But many of the things which they do in order to obtain profit are largely arbitrage type of activities which tend to refine the pricing system in the United States and elsewhere, and it is that really exceptionally and increasingly sophisticated pricing system which is one of the reasons why the use of capital in this country is so efficient. It is why productivity is the highest in the world, why our standards of living, without question, are the highest in the world.
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    I am not saying that the cause of all of this great prosperity is the consequence of hedge funds. Obviously not. What I am saying is that there is an economic value here which we should not merely dismiss. A lot of people think of these organizations strictly as casinos, and I am sure some of them are. But I do think it is important to remember that they—by what they do—they do make a contribution to this country.

    Mr. KANJORSKI. Mr. Chairman, if I may respond. I understand that, and I think we need something built into the system, but it is a question of whether we control it. But most of all, Mr. Greenspan, I am convinced you would never have reduced the overnight fund rate by a quarter point except for this occurrence. And what that does, when you think about it, is who is going to pay these losses if this fund incurred, these investments incurred—every senior citizen is relying on CDs and their savings account. We just tapped into their funds because these high-flying dude billionaires in New York weren't at risk and there is a shift in the system. These billions aren't just lost; somebody is going to pay for them.

    And by the actions of the Federal Reserve of that quarter point reduction, it now spreads into every account holder, every savings account holder, every CD holder in this country, mostly senior citizens and mostly private individuals that can't even understand what a hedge fund arbitrage is all about.

    Chairman LEACH. Thank you.

    Mr. Bachus.

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    Mr. BACHUS. Thank you, Mr. Chairman. In my opening statement, I mentioned that we have had this large hedge fund which was overleveraged, which managed to get literally hundreds of millions of dollars' worth of loans from these banks. And then, Governor, you said that LTC got in trouble. They were overleveraged, they were close to default.

    Who first came to you and said there is an imminent default?

    Mr. MCDONOUGH. It was a phone call. They didn't use the word ''imminent default,'' but that they needed—they were strongly in need of recapitalization. They began with still a pretty good-sized cushion to look for recapitalization about the end of August.

    Mr. BACHUS. But these were LTC officials that actually made you first aware of this crisis?

    Mr. MCDONOUGH. Correct. The two people with whom I normally spoke or called me as a team were Mr. Merriwether and Mr. Mullins. They brought the situation to my attention that they were really in sufficiently serious shape, that there was a real possibility of their collapse on Friday, September 18.

    Mr. BACHUS. Now, at that time had any of the lenders who had loaned billions of dollars, had they come to you or had they any indication?

    Mr. MCDONOUGH. No. As I mentioned, on the 18th, when—because the markets were very turbulent that day, and when that is the case, I tend to call the heads of the major banks and securities firms and say, ''What's going on, what are you hearing?'' It is not a great concern if markets are going up, down, or sideways. What you want to know is if there is a sufficient state of anxiety in them that they are not clearing or that, you know, you get bids and no offers, or offers and no bids, depending on which way it is going.
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    The interesting thing that day was that every person I talked to—and it would have been about ten—other than the people from Long-Term Capital, volunteered their concern about Long-Term Capital. Not ''Bill, you ought to do something about it,'' but ''We are really hearing so much about the losses in Long-Term Capital.'' In some cases, they were counterparties or lenders to Long-Term Capital. Sometimes they weren't. But there was a general, very strong feel. You know, the statistical likelihood of talking to ten people and all ten of them raising the same subject, not in response to an inquiry from me, but bringing it up themselves, that is pretty unlikely. It would show a level of anxiety that is unusual, and that is putting it mildly.

    Mr. BACHUS. What strikes me in all of this, the LTC principals knew that they were in trouble, people on the street were hearing that. But none of the regulators, other than hearing it on the street, no bank examiners, no one at FDIC was saying there is a problem.

    Mr. MCDONOUGH. As we have been discussing, the difficulty is we are just looking at it from the vantage point of three lenders that we happen to supervise, our challenge is nobody had the picture of how big this thing really was. That was the issue. So, as regards the three institutions, as we go into the analysis, their credit analysis, their stress testing and so on, should they have known that. The question is obvious, but we need to go into the firms and take a look and talk to people and come to a reasoned answer.

    Mr. BACHUS. I would ask you, Mr. Greenspan, do you believe in moral hazard?
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    Mr. GREENSPAN. You mean, do I believe it exists?

    Mr. BACHUS. Yes.

    Mr. GREENSPAN. Of course, I do.

    Mr. BACHUS. Do you believe it was short-circuited in this rescue plan?

    Mr. GREENSPAN. I don't think so. In other words, it depends on—it is a complex issue. Let me tell you why. We have created a degree of moral hazard in our financial system, very purposefully, by introducing deposit insurance and introducing, indeed, the central bank. So in a sense, we have enabled individuals who are banks, for example, as I pointed out in my prepared remarks, to very significantly reduce their capital asset ratios essentially because they perceive the risk is less, largely because there is a safety net there.

    Now, would we be better off without any of that? Clearly, the vast majority of opinion is that it serves a useful purpose. As a consequence of that, you do have increased moral hazard, but there are benefits that come from it. And they are interrelated, so you can't take them apart.

    So, are you asking me can we reduce moral hazard? Yes, we can. We can completely eliminate all governmental institutions which are involved in the economy. Indeed, we had very little moral hazard, if any, in 1835, for example, if I may just choose a year at some particular point.
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    So the point at issue is how do we minimize moral hazard given the structure that we have? If we at the Federal Reserve were heavily involved in endeavoring to prevent failures from occurring and used taxpayer money or Federal Reserve funds, which is the same thing, then I think we would very significantly increase moral hazard. But we did not.

    There are no monies involved here, and indeed what occurred was a group of individuals coming together, recognizing that it was in their self-interest to prevent the cross defaults from occurring and the bankruptcy of LTCM from occurring. I don't see how that has significantly, in a material way, increased moral hazard.

    Mr. BACHUS. Can I ask one more question?

    Chairman LEACH. Yes.

    Mr. BACHUS. I have heard that had LTC been allowed to collapse or unwind its position in a rush, that there may have been a trillion dollars worth of losses by the banks and security dealers.

    Mr. MCDONOUGH. No, I don't think it would have been anywhere near that. It is difficult to estimate, but I think what one would have been thinking of would be $3–, $4–, $5–billion. And, frankly, if conditions had been normal, if we weren't in the midst of a very severe breakdown in market confidence, my attitude would have been—and I probably would have called Chairman Greenspan and Secretary Rubin and said, ''A couple of firms are going to take losses—this thing is going down. A couple of firms are going to take good-size losses.'' That's how markets are supposed to work. Tough luck for them.
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    The reason I thought it was appropriate or recommended that we get the Federal Reserve Bank of New York involved was because we were in such a chaotic market situation that the risk to the real economy, the real people, was sufficiently high. I agree with the Chairman that we did increase moral hazard, but we thought it was appropriate.

    Eventually, you know, I was sort of the battlefield commander. I had to decide whether to shoot or not. We decided—I decided that getting a bunch of people into a room and saying, ''Can you figure out a way to sort this out?'' was the right thing to do.

    Mr. BACHUS. You are saying the total loss, you think, to the brokers' and the bankers' own derivative positions?

    Mr. MCDONOUGH. Their total loss. Remember, as you are well aware, when you talk about something like $1.2 trillion, that is the sort of notional amount. When you get it down to how much did they really have at risk, it is very much—it is a big number, but it is considerably smaller.

    When I say the loss might have been $3 to $5 billion, it was made by the firms in the consortium group looking at what they thought their own position was. Mr. Fisher, who is sitting behind me, and the people on the team who were looking at Long-Term Capital, learned from Long-Term Capital, in some order, who were their main counterparties, who were mainly at risk. It turned out to be a total of 17. Then you went down a good margin.

    So really it is only Long-Term Capital that at the beginning knew the list of people or firms who were significantly at risk. That is how we knew. Three firms, the original three in the core group, and then UBS became four, those are the ones that had been looking at Long-Term Capital, either to try to find a buyer for it or to figure out some way to work with them. We originally got the people who knew the most, and then enough other people with significant reasons to be interested. That is how the group got organized.
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    Mr. BACHUS. So you are saying had it been allowed to have an urgent unwinding, even the total collateral damage to these institutions, wouldn't have amounted to more than $3 or more billion?

    Mr. MCDONOUGH. In my view it would have been manageable, and in normal market conditions, that is what I believe would have been allowed to happen and should have happened. The real judgment call is, given what was going on in the national and world economy, was that too dangerous? In our view it was.

    Mr. BACHUS. Thank you.

    Mr. LEACH. Mr. Sanders.

    Mr. SANDERS. Thank you, Mr. Chairman. I have two questions for Mr. Greenspan, but I would like to put them in a context. And the context is that it seems to me, Chairman Leach, that this committee and this Congress should begin to take a hard look at the failure of Long-Term Capital within the broader context of what is going on in our country and throughout the world. And that is reflected, I think, in some of the policies that Mr. Greenspan and his colleagues have long advocated, which have led us to a situation in which fewer and fewer people with unheard of wealth now have enormous power over the global economy and the lives of billions of people. And the bottom line is when those folks fail and those folks collapse, they take a whole lot of people with them. And we should really begin to look at the process and how we got to where we are today and question whether that is the direction that we want to continue going in.
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    I for one, for example, am very concerned about the extraordinarily unfair distribution of wealth that exists not only in our country, but throughout the world. And I am going to ask Mr. Greenspan about this in a moment. But according to the United Nations, Mr. Chairman, the world's 225 richest individuals have a combined wealth of over a trillion dollars, equal to the bottom 47 percent of the world's population. Two hundred twenty-five people have as much wealth as almost half of the world's population.

    Further, we are now living at a time where, of the 100 largest economies in the world, 51 of them are private corporations, again run by a handful of individuals.

    When we look at institutions like the IMF, we find that a handful of bureaucrats at the IMF have life and death power over dozens and dozens of countries throughout the world. When we look at what is happening in our own country, not to mention the rest of the world, we see in industry after industry, whether it is the banking industry, whether it is the media, whether it is telecommunications, what we see are merger after merger after merger, and fewer and fewer corporations run by smaller and smaller groups of individuals who control more and more of the market. And when these people make a mistake, those are mistakes heard all over the world, which affect the lives of billions of people. And I think the laissez-faire attitude that Mr. Greenspan and his colleagues have advocated is leading us into a very, very dangerous situation.

    Now, my question for Mr. Greenspan is a very simple one: In the United States of America today, you have one man who owns more wealth than 100 million Americans. In the world, you have 225 people who own more wealth than almost half the world's population. Does that concern you? Do you think that that is just? And not only in terms of justice and morality, are you concerned about the economic instability that can occur when so few have so much power and when mistakes are made, such as with Long-Term Capital, looking at the economic repercussions of what a few people can do? Does that concern you, Mr. Greenspan?
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    Mr. GREENSPAN. If you are asking me would I prefer that there was less concentration of income, less concentration of wealth, I would say, yes, generally I would; and I would because I believe that democratic institutions tend to function best when you have fairly even distributions.

    The issue which is crucial to your question is, what would you do about it and to what extent would that improve the state of being of the world at large and the individuals who don't have that wealth? It is not by any means clear to me that if you were somehow to take these 225 individuals and merely indicate to them that they no longer have any wealth, and you put them away on a desert island, that the state of the rest of the world would be improved in the slightest. If you are asking me do individuals who have significant power and when they make mistakes, does it have consequences to others, that has always been the case, throughout history.

    I think we ought to, instead of looking at what we have now as some incredibly corrupt, unequal, unethical system, try to look at what the United States has become relative to what used to exist 100–, 200–, 300–years ago. I would say to you that the standard of living of the average American is dramatically higher; that the average American is far better off than at any time in our history. And I would suggest to you that that particular state would not be improved by confiscating the wealth of every billionaire in the United States.

    Mr. SANDERS. No one suggested that. By the way, you mentioned a moment ago about—I believe I am remembering what you said—that the United States has the highest standard of living in the world. This is a country where we have 43 million Americans with no health insurance. We have a situation where the typical married couple, family, worked 247 more hours in 1996 than in 1989; where real wages have declined in the last 20 years.
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    But be that as it may, my second question, Mr. Chairman—I think it is important for our Banking Committee, because this issue ties into H.R. 10. Now, Mr. Greenspan, as you know, the Fed recently approved the acquisition of Citicorp by Travelers. We all know that Citibank is heavily involved in developing countries, developing markets, a highly troubled sector to say the least. Travelers reported large losses during the recent market turmoil and is now reported to be a major investor in Long-Term Capital.

    Why shouldn't we be concerned that allowing combinations like Citigroup increases overall risk for financial institutions rather than decreasing risks? Which takes us to the whole issue of H.R. 10 and making it easier for large banks to merge with other types of companies.

    Mr. Greenspan.

    Mr. GREENSPAN. Well, first of all, let me just say we process the application according to the law, according to what the statute covering those applications requires. We made judgments on the various requirements. We made judgments about the nature of the merger. And when we believed that all requirements of the law were met, we approved it, as we are required to do.

    If you are asking the board a question about these larger institutions, one of the reasons why, for example, after thinking about it for awhile, we opposed the basket, and in retrospect I think correctly, the ability of institutions to have very substantial interplay between the non-financial part of the economy and the financial part, which would be significantly enhanced under some of the early versions of H.R. 10. As passed by the House of Representatives, in my judgment was a very good bill. The issue of making certain that all of the new powers are required to be financed in the marketplace at competitive rates, and therefore through an affiliate of a holding company, as distinct from what was originally discussed in many different versions of the bill, through subsidiaries of the bank, I would say that one of the reasons why we are very much concerned that indeed all of these powers be in the holding companies is that we worry about the issue of subsidies coming out of the bank into the subsidiary of the bank and being used in a non-competitive manner to employ expansion of powers which are within H.R. 10.
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    So the answer is, yes, I am a little concerned about some of the size of these various institutions, and I think it is very important that we make certain that we don't subsidize them.

    Mr. SANDERS. Thank you, Mr. Greenspan. Mr. Chairman, I would just conclude by suggesting I think this is an important hearing. I think it lays the groundwork for future hearings in which we should take a hard look at the degree of concentration of ownership in this country and the implication for our national and international economy. Thank you.

    Chairman LEACH. I thank the gentleman. I would only add, as the gentleman has noted, that, in theory, the particular bailout the Fed has put together does involve a massive amount of concentration of power in one particular hedge fund and this is a very concerning situation.

    Mr. Castle.

    Mr. CASTLE. Thank you, Mr. Chairman.

    Chairman Greenspan, the concerns I had coming into this hearing about the size of these hedge funds and what they can do to our economy has not been exactly quieted. We have two other panels here. We will finish by about midnight tonight, and when we do, I may be happier than I am now. But I only have before me what you two gentlemen do. And by the way, you both do an extraordinarily good job in what you do.
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    Chairman Greenspan, I have learned you to be, through our work together, a cautious man when it comes to our economy. You never seem to go quite as far as those pundits out there would like you to go, which is probably the way we should go. You seem to be absolutely deliberate with respect to your facts; thoughtful—sometimes thoughtful beyond my ability to comprehend—but, thoughtful in terms of what it is you say when you speak to us, both when you read and when you answer our questions. And I have a tremendous amount of respect for you, and so do a lot of people in America. I think part of our success relies on that.

    But there is a disconnect with all of that. And what I am hearing and seeing right now, that I can't quite grasp—I mean, you gentlemen have said that you really did not know how big this was. I don't know if you didn't know how big Long-Term was or how big the problem was, but you have said that. You have indicated that if there had been a failure of Long-Term Capital management, it would have caused a credit crunch. This was a significant problem. And this was a huge concentration of leveraged wealth that would have triggered undoubtedly some sort of a problem—I am not saying complete economic collapse, but a fairly significant problem.

    And yet in looking at your testimony and listening, and I have been here the whole time, listening to you answering all these questions, I don't really hear any recommendations of what I consider to be substantive changes. There are all kinds of little stock investments, little mutual funds, little real estate investment trusts, you name it. Everything out there is all under some sort of regulation, some sort of reporting, whatever it may be. And here we have investments which are put together, which are large enough to really put a real dent in our economy, which is the reason the Fed had to step in.
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    I don't really have a problem with what Mr. McDonough and the Fed did in stepping in. It probably had to happen, I guess, in order to rescue this. But I have a problem that we are sort of letting this go on. And I don't want to just have this hearing and then all of a sudden have other problems. I may ask you some questions about that, if I still have some time, about other potential problems.

    I have read several times sitting here—I don't always read all your testimony, but today I read every bit of it and followed it very carefully, and I read various things—you raised questions for policymakers, not new directions, but questions for policymakers, some of which are, I thought, rather—I don't want to say vague—but are not of much weight with respect to what they could do, and then a couple that perhaps are a little more significant. And then you concluded at one point, on page 10 of the testimony I have, ''The best we can do in my judgment is what we do today, regulate them indirectly through the regulation of the source of their funds,'' which I guess is the borrowing and that kind of thing; not the equity source, but the other source of their funds. But we don't seem to have done a particularly good job with that. I mean—so that's my concern.

    I mean, I realize that hedge funds are exempt from the normal regulation because of the numbers of investors and because of their sophistication, and so forth, but if their borrowing can trigger these other problems, then I have a real problem understanding why we are not saying that something additional or further needs to happen for protection of our economy and the American public at large.

    I know I took a long time to ask the question, but that is my concern. Maybe you don't seem to have the same fervor that I do that something more needs to be done.
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    Mr. GREENSPAN. I think you are correctly describing the situation. I think it is important to make a judgment as to whether, in fact, regulation has worked. And I would say to you the answer is yes, it has; that is, we are looking at a single mistake here.

    I have no doubt that there has been a regulatory failure here in the sense that the individual counterparties, the banks who lend money to LTCM, misjudged the state of potential losses that could occur under extreme circumstances. Should they have caught it? Yes, I think they should have. Did they? The answer is they did not.

    How important is that for the overall issue of supervision and regulation of banks in the United States? Not very large in the sense that the lending that banks have been doing in general over the last number of years has generated very few losses. Indeed, I and the other bank regulators have been somewhat concerned that because the losses appear so small, that this will create a tendency for loan officers to begin to make mistakes. We will forget that there is risk in the society, there is risk in the economy, and we will have a significant problem.

    So the issue that we are dealing with here is a particular problem of regulatory failure. The fact that we haven't had many more is what I find surprising. But that is not an indictment of the total system. The total system functions with the recognition that there will be failures. I mean, it is inevitable, but the crucial question, as I said before, is not whether they are failures, but what is the ratio of successes to failures. That is the crucial issue.

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    Mr. CASTLE. Let me follow up for a moment, and I know my time is up, but my concern is we are going into this sort of superinvestment area of the hedge funds. Maybe we haven't had failure because of the regulation that you do and the other regulations that exist federally, in the State, of banks, whatever it may be, and the SEC, because so many of these things come under regulation. But we have these incredibly large investments with huge leveraging going on in the most unregulated aspect of our economy, and you have indicated that this failure could have caused economic problems in America.

    There is an article from the paper here, and apparently Mr. Levin has indicated other hedge funds are probably at risk. There are 3,000 of these hedge funds out there. Some invest as this one did. Most of them are not as large as this but some may be. You understand what I am saying. You are dealing with this much larger investment package which has a much greater potential of really causing a great economic hardship to us, and that is the part I am concerned about.

    I am not quite sure what you are saying. There are so many of the things that everybody has done, has worked, including this Congress and you and others, but I am worried we have this whole sphere of these hedge funds that are sort of beyond all this approach, and we are not bringing them in at all. That is my concern.

    Mr. GREENSPAN. I can understand that, and I can say that when you have a lot of people doing things which are very complex, on the edge of being obscure, you ought to be nervous. I mean, clearly, if you don't understand what is going on, then clearly that is the case, and that is the reason why we spend an inordinate amount of resources in judging the technical capability of numbers of banks, to be able to appraise the types of activities that people they lend to are engaged in.
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    We are confronted with a problem. The problem is—I guess it can not be considered a negative one—namely, that technology has really made remarkable advances, and we see it all over the place. We get tremendous benefits from those technologies. Part of those technologies have created a very sophisticated financial system. As best I can judge, it has been a major improvement on what we had previously, and has been a major contributor to the standards of living that we enjoyed. But I have said to you before, it also means that mistakes get distributed far more rapidly and, in many instances, have larger consequences.

    Can we reduce all of this? Can we turn the clock back? I don't think we can turn the clock back on the technology. But as I indicated to Congressman Frank earlier, we can if we wanted to deleverage this whole system. It will reduce the risk. It will reduce the problems you are concerned about. It will also reduce the standard of living. It is a very difficult tradeoff and I can't say to you that I know the answer or that I feel fully comfortable that we are ahead of the game in all respects. I do feel comfortable that we know enough about what is going on in the international financial system and, more importantly, the U.S. financial system to grasp where the potential problems are. We know we are not going to get them all, but we do know that, in total, the system is sufficiently in balance to give us a degree of confidence.

    Does that mean that it can't run into crises periodically? Historically we have always had crises. We are going to have them in the future. I don't know when they are going to occur. But the most important issue is the type of regulatory structure that we have managed to evolve in this country appears to be consistent with an economic growth rate and a level of standard of living which is really the envy of the world. We are sitting here today, very appropriately, discussing something which is very painful to all of us, but let's keep it in context. The context is this is a very rare event. Having said that, I would say we will be continuously looking at ways to improve what we are doing, and if legislation is required to do it, I can assure you we will be up before this committee requesting that. I cannot say that is the case at this particular stage.
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    Mr. CASTLE. Thank you. I yield back, Mr. Chairman. I would love to ask more questions, but I understand the time restraints. I yield back.

    Chairman LEACH. Thank you, Michael. The Chair would be charitable if you want to come back at a later point.

    Mrs. Maloney.

    Mrs. MALONEY. Thank you, Mr. Chairman, and welcome, Mr. McDonough, from the great State of New York, and Mr. Greenspan.

    Mr. MCDONOUGH. Formerly.

    Mrs. MALONEY. Previously. I want to thank both of you for coming here and testifying on a truly unprecedented, stunning event, having the central bank rescue, reorganize a totally unregulated institution. I would believe that most Americans would say that you can't have it both ways, and say that you don't want to disclose, you don't want to be regulated, but then be too-big-to-fail and have the power of the Federal Government and really the resources of other firms come and save you.

    I really find it very troubling that if the Nobel Prize winners at Long-Term Capital management didn't fully understand what they were doing or the risks involved, who else could be expected to understand these activities? And personally, I think that there is something very wrong with a financial system where traders, using leverage provided by others, are free to speculate and make tens of millions of dollars per year personally when they, quote: ''Get it right,'' but can sink their firm, their lenders, the capital markets, or even part of the American economy when they ''get it wrong.''
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    I guess the main question is, what can we do to reduce this level of speculation and risk so that it does not happen hopefully again in the future? In your testimony, Mr. Greenspan, you did not call for regulation of hedge funds, direct regulation. You concluded that we should stick with the status quo, regulating them indirectly, as you explained, by regulating their source of funds.

    So I have three specific ideas on regulating source of funds that I would like to ask you about. First, do bank examiners require banks now that extend loans to these unregulated hedge funds to obtain full disclosure of their assets, liabilities, and capital base? That is my question.

    Mr. MCDONOUGH. The guidance that we give to the banks in terms of sound credit practices, in my view, should have led them to a credit analysis which would have included the information that you described. It would appear that they did not do that. We have to go into the banks, both the ones that we know about, the three that are part of the consortium—there are about 60 other counterparties and over time if there are other banks, State or national, that need to be looked at, they will have to be looked at in the same way.

    As to whether the credit analysis was sufficient, we don't know, but it is a pretty obvious question.

    The second thing that we have to look at is, in the derivatives area, did they analyze, even under fairly normal market conditions, what the likely additional exposure could be, and then did they stress-test the portfolio to say if things get a lot different and a lot worse than recent experience would indicate, what would be the effect on their exposures to Long-Term Capital?
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    Those are the three things that we have to look at in analyzing whether the institutions did their homework as thoroughly as they should have.

    Mrs. MALONEY. Well, you stated that they were not required to get this information now. You hoped that they would. And I just would like to express my personal concern over what kind of banking system do we have where major financial institutions have no idea as to the financial condition or balance sheet of the borrower they are extending credit to?

    For those of us who have gone to a bank for a loan, they ask us quite a few questions about our assets, our income, our earning history, our credit history. They are quite sophisticated. And so I find anyone—I find it very troubling that this type of information was not asked for or analyzed in huge expenditures or loaning of huge amounts of money.

    And clearly, the use of new exotic instruments, such as derivatives which you mentioned, and credit default protection swaps, whatever they are, do not lend credibility or help us in creating—bank examiners or anyone to understand a balance sheet. I think we have to look at what measures we need to put in place to make sure that there is sound credit analysis and, at the very least, Mr. Chairman, I think that we should require our banks to get this information and disclose this information in their reports. I think that would be very helpful as a first step.

    A second question I would like to ask along this line is, do you agree that the Investment Company Act of 1940 is outdated and that many of the financial companies currently exempted should be covered in some form? Long-Term Capital was exempted from this requirement. And maybe we should not look at whether you have less than 120 investors, but possibly at the size. Possibly a billion dollars, you should be reporting to the Securities Exchange Commission.
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    I feel that many countries came to America to invest after the financial crises in other countries because of our disclosure and our caution, and I feel that in the future it will strengthen us, not weaken us. I would like to see—I think many people don't want to go offshore. They want to come to America because of our banking standards, but we don't seem to have many banking standards when it comes to hedge funds. So my question is specifically on the Investment Company Act of 1940.

    Mr. GREENSPAN. If you are going to alter the Investment Act of 1940, I think you have to start with the notion of what it is you want to accomplish and why. To regulate, merely to regulate is not, in my judgment, a reason to do anything. If you can find something that will significantly improve the regulatory structure, the regulatory system that the United States imposes on our financial system, then I think that requires evaluation. But I don't think that you merely can start with looking at a particular act and say it is 1940 and it requires revision. It might. I have no doubt that that is true of a lot of the acts that we are involved with.

    But I think that it is more important to ask the question, what are we trying to accomplish? And I think what we are tying to accomplish is to get the most effective financial system that we can get, and we want that because we want the highest standard of living that we can get.

    It is very clear that a financial system is a major factor in the level of a country's standard of living. To the extent that regulation helps that, that is fine, and a benefit. To the extent that it does not, it is a detriment. But I would not argue that regulation per se is something we should seek independently of a judgment that will significantly improve the effectiveness of the system.
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    Mrs. MALONEY. To go back to the statement of our Chairman, he said he was particularly, and I quote, ''concerned about the power and largeness of this particular hedge fund.''

    So instead of looking at a year, possibly looking at the size. Say you are a billion dollars. Maybe you should then be within the Securities Exchange System. But as one banker said to me, he said it was sort of—and to paraphrase him—it was sort of like ''a race to the bottom. Other banks weren't requiring information as to their assets, liabilities, and capital base, and they were loaning, so we weren't either.'' And I think as a basic first step, there should be disclosure on any type of loans from our banks to these type of units. We want to make sure this doesn't happen again.

    I would like to ask also, and I know my time is up, but if we can get it in writing, could we get the particulars of this reorganization, what are the positions of the various firms, and exactly how this particular reorganization is structured? Is that public information now? Can we get a copy of that?

    Mr. MCDONOUGH. I would hope, Congresswoman Maloney, who happens to be my Congresswoman, that you would really inquire from the people who put the deal together. We have tried to make it very clear all along, we didn't structure this deal. It is not our deal. The firm that has captained in putting the group together is Merrill Lynch, and I think it would be more appropriate for them to explain what they did and why they did it and why it is structured the way it is.

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    We have very carefully sought to avoid it being the Federal Reserve deal for the very simple reason that we believe that would have been entirely inappropriate. It would have been creating a situation in which the 14 firms that decided to invest in this consortium would have been investing in a Federal Reserve-structured situation and, therefore, there would have been without any question, over time, the notion that they had been coerced into doing so.

    Mrs. MALONEY. Just in closing, I would like to compliment both of you, particularly Chairman Greenspan, for your leadership and in putting together this structuring. But I would like to hear from the Chairman. Do you think that banks should ask this information before they give loans? That was one of the things you said that we should regulate, the source of capital.

    Mr. GREENSPAN. Well, remember, the monies that are being lent are the shareholders' money, the shareholders of the banks. And loan officers' basic job is to make loans which are presumed to be profitable, but also safe, or at least get a rate of return on them.

    Mrs. MALONEY. But they obviously got it wrong this time, and a lot of people are paying for it.

    Mr. GREENSPAN. That is an issue which the shareholders ought to be complaining about, not the regulators. Obviously, if there is a significant amount of inappropriate lending which threatens the safety and soundness of the institution, then clearly we are there. But on issues of mistakes like this, clearly to the extent that there is a loss, the people who are the losers are the shareholders of the banks. And I should certainly think that they would complain, as indeed I suspect they have, to the management of the institution. We can say to them, ''You are not looking after your own self-interest. You are dissipating shareholder monies in not asking for appropriate documentation, not doing what is appropriate before you make the loan,'' but that is sort of self-evident. I don't think that we should be in a position where we say to them, ''Don't be stupid.''
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    Mrs. MALONEY. What is too-big-to-fail?

    Mr. GREENSPAN. As far as I am concerned, talking about institutions or such, I say nothing is too-big-to-fail.

    Mr. MCDONOUGH. I couldn't agree more.

    Mr. GREENSPAN. There is an issue here of too-big-to-liquidate-quickly, but if you have a very large institution which is in trouble, the one thing you don't want to do is protect the shareholders and there's one thing you don't want to do is protect those people who took risks for reward, but what you do want to try to do is to manage the degree of how that institution is liquidated so we don't have a fire sale of the type which we have been talking about all morning and early afternoon.

    But the notion that we, the central bank, would prevent a large institution from failing is just plain wrong. If we find a large institution is in serious trouble, we will liquidate it, but we will do it because it is very large and can have secondary consequences, in a responsible way. But I can assure you the people who are at risk in that institution and were at risk because they thought they could make money at it will not be compensated as a consequence.

    Chairman LEACH. Dr. Paul.

    Dr. PAUL. Thank you, Mr. Chairman. Do either of you know in which country Long-Term Capital is registered?
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    Mr. MCDONOUGH. Cayman Islands.

    Dr. PAUL. That is an interesting fact. I am not sure exactly what that means, but a foreign corporation is getting a lot of attention here by our monetary authorities.

    I want to talk a little bit more about what Mr. Greenspan has mentioned many times today already, and that has to do with the tradeoff, the tradeoff with the type of system that we have today which he says is highly leveraged. And in a way, you sort of excuse it and say, ''Well, you know, the standard of living is higher,'' and you are surprised that there aren't more costs, there haven't been more penalties.

    I guess what I am concerned about is that maybe they are yet to come. Maybe there are a lot more problems yet to come, so the costs we can't even measure yet.

    But I would like to challenge you a little bit on the idea that the benefits are so good. Even in my opening statement I brought this subject up, that I thought the costs were a little bit too costly and outweighed some of the benefits, because if you don't have this type of system, it doesn't mean that you don't have a higher standard of living, but you might have an acceleration of some growth because of the type of system that we have.

    But one place where I want to challenge you is the fact that in the type of system that we have, not everybody benefits equally. The overall standard of living may go up, but one thing that we do know about a fiat monetary system is that the beneficiaries aren't always equally spread out. There are some who suffer where others benefit more. So, for instance, I see that we have today where the low- or middle-income person who does not go on the dole has the toughest time. Those are the people I talk to the most in my district, where those who take the dole get—they are under the safety net and they get benefit, but the person who tries to pay the bills and maintain a job really doesn't see the benefits. So I think there is a cost there that may be invisible and difficult to understand, but I officially believe it exists.
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    On the other side of the coin, there are costs that we may have not yet paid for, and maybe yet to come, and that you might have to deal with here in the near future, but how could you argue that this is not very costly because the same type of monetary system exists—has existed in the Southeast Asian countries. Japan is struggling, and they are getting deeper in a hole. So when will the cost outweigh the benefits? Sure, they had a great 1980's, but they are having a bad 1990's. One of these days, these costs are going to add up to be a greater burden than the benefits.

    And also in the other Southeast Asian countries, if we look at Malaysia and Indonesia, there are serious problems there. I guess why I express my concern about protection of the dollar and protection of the financial system and having a sound currency is not so much—well, it does deal with the economic inequities that develop. I think that is very, very important, but I guess my long-term greatest concern is the political instabilities that currency disruptions inevitably bring. We are already seeing those in Southeast Asia. We witnessed them in this century many, many times, and I do not think for a minute that we are absolutely immune from this, so I would like for you just to concentrate and tell me you are concerned about some of these costs that may be coming down the road.

    Mr. GREENSPAN. Well, Congressman, I was discussing the issue of what choices this electorate have been making since the 1930's. I am describing an economic system which has been chosen by the American people through their representatives, the laws of the land, and through the structures that have evolved as a consequence of that, and implicit in it are both costs and benefits.

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    I don't necessarily agree with a lot of the decisions. Nobody basically agrees with everything. As you know, I am somewhat more inclined toward a laissez-faire system than the society as a whole has been inclined to. I recognize these are the really deep fundamental values of choice that a society has to make. As a central banker, I don't think it is my position to be involved in this type of debate, and I merely try to describe what I think is happening, as distinct from saying where I particularly think all these tradeoffs would likely be.

    But what I do wish to say, and quite emphatically, is with all the failures one may see in this country and all of the difficulties that we have, it is terribly important to realize how much we have succeeded. I mean, it is really an impressive performance for a country, which is only a little more than a couple of centuries old, to have effectively reached this point in so many of our institutions which are the envy of the world.

    Can we improve on them? I have no doubt that we can and we shall. Are there potential hidden costs that haven't emerged yet as a consequence of some of the decisions we have made? I have no way of knowing that, but I have no reason to believe you are mistaken on that.

    It is an extraordinarily difficult issue, and in an odd way I am sort of pleased that it came up today because I think to understand the complexity of the issues with which we deal as these new technologies are moving forward, to be able to understand the complexity of not only the economic but the social systems that are involved in this is very crucial if our democracy is to function in an effective manner.

    And if there are a lot of non-answers that have come out today, that is understandable. These are very difficult, complex issues. We do our best. And I think in one sense, we ought to be proud of what has been achieved in this country.
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    Chairman LEACH. Thank you very much, Dr. Paul.

    Mr. Bentsen.

    Mr. BENTSEN. Thank you, Mr. Chairman. First off, let me say, Mr. McDonough, that I am glad you brought up the issue of the yield spread. I have been wanting to ask about yield spread the last three times Mr. Greenspan has been here. I think twice he had to leave before he got to the lower deck here, and I don't want to get into it today but I do—I have been watching the yield spread for a while, just on a whim, and it was one reason why I wasn't quite sure there was a need for a cut in the Fed funds rate. I know that is a contrarian position because the spread seemed abnormally high, and I was curious about that. Perhaps we can talk about that sometime in the future.

    Second of all, I have to agree with Mr. Frank. I think you understate the Fed's position. The New York Fed calling up Wall Street banks, investment banks, to come down for a little meeting, and saying ''We are just going to sit back here, you all figure this out,'' is kind of like a Federal prosecutor and FBI agent telling somebody, ''You are not under arrest, you can leave anytime you want to, you don't need to call a lawyer, we just want to talk to you a little bit.''

    You have a lot of persuasive power. When I was in New York, I never went in the Fed, but I walked by it, and it may not be the temple of justice, but it is some sort of temple that is looked to. And so I think it is a lot like the principal calling the group in and saying, ''You boys and girls work this out now, and nobody is leaving till it is done.''
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    I think also that there is something that we should consider doing, and maybe the Chairman is right, we are not sure what that is yet.

    Now, this isn't the Dutch tulip bowl bust of the, what, 17th century or whatever, I don't think, you have stated today. It is not quite that big. But looking back in time, and I may be a little biased here given my background, but in 1990 you had one investment banking firm that was a dominant player in the high yield junk bond market that was going down when it couldn't roll its commercial paper and couldn't get lines of credit, and to my recollection the Fed never called anybody and didn't call in the money center banks or anyone else and say, ''We are not going to let Drexel fail because we don't want a systemic reaction in the high yield market because of the impact it is going to have throughout that market and the rest of the market.'' And, of course, in 1990 we were heading into a recession, and we do know that the high yield market itself went into a recession for some time and had an impact.

    Now that is ancient history at that point, but at that time the Fed didn't seem that it needed to play this——

    Mr. GREENSPAN. May I?

    Mr. BENTSEN. Sure.

    Mr. GREENSPAN. The reason we didn't is we judged that in an unwinding that there was adequate capital there. If we had concluded that there were very significant systemic risks that would have occurred as a consequence of having inadequate capital on the wind-down, I am not sure how that would have come out. So the crucial issue was that was a different type of phenomenon.
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    Mr. BENTSEN. But reclaiming my time, there was a downturn in that market that affected many other players and conceivably affected the capitalization of a large part of the thrift industry, and to some extent the banking industry as well, because——

    Mr. GREENSPAN. All I would say to you, Congressman, is that we made a judgment. In other words, we saw that they had a very large matchbook, which is a government securities operation which we believed could very readily be unwound without consequences, and that their capital was adequate to unwind the system without a breakdown. I think that was an important judgment to be made, and the central bank makes those judgments all the time.

    Mr. BENTSEN. Fair enough. But taking this a step further, in part, and I don't think completely, and I obviously wasn't in Congress at the time, Congress did look at these issues, and I believe it is the FIRREA Act set various types of risk modeling standards that applied to the purchase of certain types of securities. Now, here our concern, I think, is—our primary concern should be the lending practices of the banks that are backed by—that have the implicit guarantee, the sovereign credit, the sovereign guarantee that we have talked about so much in previous hearings through the FDIC, through the Fed window, and so forth. And I don't think we should dismiss out of hand the idea of risk modeling. The risk modeling I have been through has unusual circumstances that no one ever believes could happen. I mean, whoever believes that a mortgage portfolio would be paid off in less than one year, but some FIRREA tasks require you to run those types of models. And, in fact, if the Russian economy starts to go down, the Asian economy starts to go down, and there is a flight to quality, and Treasury prices shoot up through the roof, and the yield on the 30–year bond falls below 5 percent, and long-term mortgages come below 7 percent, nobody ever expected that to happen five years ago or seven years ago, then you may well have a thousand percent prepayment ratio.
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    So I don't think we should dismiss that out of hand, and I think that is what our primary concern on this committee should be. I don't think it should be an issue of how we regulate hedge funds, because I agree with you, I don't think we could do it anyway, but I do think we should be concerned about it, and I think the Fed and the other regulators ought to be taking a harder look at that.

    The second thing is that I think we have to be concerned. I agree with you that the use of hedge funds for idle capital, for efficient use of idle capital, is very good, and it shows the efficiency in the system. But when that becomes the primary investment vehicle or has the effect of taking over our investment concerns as opposed to long-term capital formation for the long-term growth of the economy, we ought to be concerned about that as well.

    So I wish you would take a stronger role or position at looking at risk modeling and potential loss modeling. I think it is something that we ought to consider. I think that is our only concern, because I don't think we can regulate the other.

    The other thing, I would just ask this, is with respect to the capital in—well, two questions. One, with respect to capital infusion on the part of the banks, was that in the terms of additional loans that were made, or was it capital, bank capital, that was put in?

    And the second question is, and I probably haven't read as much as the Chairman has about the deal that didn't get done that was supposedly the investor from the Midwest or somebody who was going to come in and buy Long-Term Capital, was that deal more beneficial to the management than the consortium deal? Now, I know in the consortium deal the management gave up the controlling interest and retained, I think, 10 percent interest or whatever and took huge losses understandably, but were they better off with that deal than they would have been with the deal that was on the table until 12:30 p.m. on that day?
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    Mr. MCDONOUGH. The capital infusion by the three banks is in forms of equity rather than a loan.

    Mr. BENTSEN. It is the bank's equity, the bank's own capital.

    Mr. MCDONOUGH. It is done in a holding company subsidiary.

    Second, as regards the difference between the two deals, the offer that did not turn out to be a reality, as I mentioned earlier, my understanding actually not from Long-Term Capital, but from the investment banking firm representing this other group, is that the stated reason for turning it down was that Long-Term Capital did not have the power, the management—the partners did not have the power to accept the deal. I am not giving you an independent legal opinion, I don't know if that is true or not. That is what I was told by the investment banker representing the other offer.

    The other offer would have taken out completely the existing equity holders and the management for a certain sum of money, which a major newspaper stated was $250 million, and I believe that that was accurate. So they would have received $250 million, and they would have gone away.

    In the case of the consortium deal, they are left with—the previous shareholders are left with 10 percent of the company. I believe that the management has about a third of that, so that the management is left in place with part of the equity that I described.

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    In the discussions in the consortium group on that Wednesday, there were two schools of thought. One was if we are going to put any money here, let's get rid of the management and—well, particularly let's get rid of the management. There was another school of thought, which was probably 75 percent of the group, but very rapidly became 100 percent of the group, and that was characterized by essentially the following logic: We are going to be putting in $3.5–, $3.6–billion into this institution. In order to do that, we have to have the best possible assurance that the deal would work. It is a very, very complicated, enormously complicated situation, and therefore it is our investment, their investment of the 14 firms, was more likely to be successful in originally majority and then finally everybody's view if the existing management of the firm was kept there with an economic interest to make sure that full value was realized.

    As I think you know, the new shareholders are putting in their money for three years. Their intent is to have an orderly wind-down of the firm. They want to do it over a period of three years. Since you were in the business, you know that if you say ''I want to do it in a short period of time,'' everybody is waiting to take you to the cleaners on the prices they will give you. If you say that you are willing to do it over a three-year period, well then you have the staying power and you have the time.

    Mr. BENTSEN. Thank you.

    Thank you, Mr. Chairman.

    Chairman LEACH. Thank you very much, Mr. Bentsen.

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    Mr. Hinchey.

    Mr. HINCHEY. Thank you very much, Mr. Chairman. And, gentlemen, I apologize to you for not being here at the outset of this proceeding. I was necessarily in New York and just got back in the District, just a few minutes ago. I very much appreciate your endurance here today through the late morning and into the afternoon and the opportunity to just discuss this issue with you for a few minutes because, as you do, I am sure, I too think that this is a very serious problem indeed.

    I want to at the outset just express my appreciation, as I am sure others have probably done, to you, Mr. McDonough, and to you, Mr. Chairman as well, for the actions that were taken to rescue Short-Term Capital Management, because I think it is quite clear that in doing so you averted a very serious panic which could have led to even more disastrous consequences. So your stepping into that breach at the appropriate moment certainly has been a very good thing for our economy and the economies elsewhere around the world.

    Nevertheless, the presence of this, what I would call a ''problem,'' others may say that it is not a problem, continues to cause concern. I don't know if my friend Mr. Sanders was here today at this hearing, but if he was, he probably had something to say about the great disparity of wealth and income between economic classes in our society.

    Mr. MCDONOUGH. He was here and he did say that.

    Mr. HINCHEY. It is very comforting to know that there are some things that are immutable. I am tempted to go in this particular instance one step further and say that this—one way of looking at this particular circumstance, this kind of situation is that it arises from the fact that you have an extraordinary amount of money in the hands of a very few people and, as a result of that, they are inclined to take risks with that money which they would not ordinarily do if the amounts available to them were appreciably less; and in that exercise they perhaps are endangering the rest of us more than they are themselves. That is, they are endangering the economic circumstances of the rest of the country more than they are themselves, because they are playing with relatively small amounts of their own money, apparently, in many instances. And this is only one example.
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    I would guess that this particular hedge fund is not the only one that has the potential for getting into serious trouble. Maybe not quite as large as this one, but nevertheless I think that there are others out there. And so this is a situation of which we have not seen the last, I fear to say, but I believe it is probably accurate to say that. And it is also fearful because this is a game that is played, is played apparently increasingly by not just a lot of wealthy, very, very extraordinarily wealthy people, but we are also seeing other assets that are being put into these instruments, and those assets include pension funds and other funds of people who would be at substantially greater risk if there were to be losses of any significant magnitude. That is something that causes all of us great concern.

    I am reminded it was just a few weeks ago that George Soros sat where you are sitting and warned us of a daisy chain of derivative transactions, those were his very words, which threatened the collapse of the global economy. But whether or not that is true, that might be bad enough if it weren't for the fact that we face a whole series of other global economic circumstances.

    One of the aspects of this which troubles me is in relation to that and it is simply this: We may be on the verge of facing a very serious credit crunch; that is, the availability of capital for normal operating purposes on a day-to-day basis, and that arises from the conflux of circumstances of the global economic crisis in concert, although I would say disharmonious concert with this particular phenomenon which we have under examination right now. And it seems to me that that has an enormously adverse potential in a growingly deflationary world economy, and I would very much like to hear your comments about that as to whether or not that is of concern and to what extent it may be of concern.
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    Mr. MCDONOUGH. It is the principal reason that we got ourselves involved in organizing possible interested parties to avoid the collapse of Long-Term Capital. The likelihood of that spilling over into a credit crunch in the American economy was not large, but it was real and it was sufficiently real, and the results of that would be horrendous.

    I mean, in your area in the Hudson Valley where prosperity has been lacking for a while, it would be awful, because it would affect the small and medium-sized businesses very directly, and that is where jobs are created. We wouldn't say that if we didn't think that if Long-Term Capital had collapsed that it would necessarily have created a chain which would have resulted in a credit crunch.

    The Chairman mentioned earlier that he thought that the odds of that were certainly less than 50–50. I agree with that. But they were sufficiently serious and sufficiently real that that was really our principal driving motivation.

    Mr. HINCHEY. OK.

    Mr. GREENSPAN. From that——

    Mr. HINCHEY. I don't expect anyone anywhere in this room today perhaps to stipulate that it is necessary for us to begin to think about the regulation of hedge funds and the derivative activities that go into them, although it seems that the Secretary of the Treasury is beginning to think somewhat along those lines, and I say that because of some actions that he has taken recently to instruct people to begin to look at this issue much more closely than it has been examined heretofore.
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    What troubles me at the moment is an action that is being taken by the Congress. Parenthetically there is an interesting story in the New York Times today which talks about how when the last time the issue of regulating hedge funds came to the fore on this committee, back in 1994 I think it was, there was a concerted effort on the part of those participating in this activity to avert that action being taken by the Congress. And this particular story, interestingly enough, mentions the sum of $550 million in soft money being contributed to political campaigns in order to get around the propensity that anyone might have on this committee or elsewhere in the Congress to regulate these hedge funds.

    Now what we are seeing is in a remote section of the Ag bill there is a provision, the Agriculture Appropriations Conference Report, there is a provision which would prevent the CFTC, which is the only entity that has anywhere near the—that has any claim on regulatory authority in this particular arena at the moment—it would prevent them from exercising any regulatory activity whatsoever for the next six months.

    It strikes me that that is a very dangerous thing to do on two levels. First of all, it prevents responsible action, or what may be subsequently deemed to be responsible action—I am not going to claim that it is here, although that is my bias. What may subsequently be seen to be responsible action sometime within the next weeks or so would prevent it from being done, and at the same time it sounds rather a kind of alarm which might be interpreted adversely in the world, suggesting that maybe there is something amiss here and that certain special interests are intruding themselves to make sure that responsible regulation doesn't occur at any time in the near future. I see you are more interested in this aspect of my question than the previous one, Mr. Chairman.
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    Mr. GREENSPAN. No, it is basically because the way you describe it doesn't sound like the way I remember it. There were hearings in the Senate on exactly this question.

    Mr. HINCHEY. There were hearings in this committee as well.

    Mr. GREENSPAN. Yes. No, what I am trying to say is that it is not as though this is an obscure issue. The basic problem has got to do with the regulation of over-the-counter derivatives and their legal status. And the serious question that has emerged and the reason why it has surfaced as an element in the omnibus appropriations bill is that there is a very significant concern that the legal status of a very substantial part of the over-the-counter derivatives market would be subject to very severe legal challenge because there would be an ambiguity involved as to what the legal status of those transactions is.

    What was involved here was a request to hold off on the part of the CFTC and—Brooksley Born was here, and she will be testifying so you can raise this question with her. The issue essentially was whether she would agree to hold off until the issue could be addressed by the Congress. An agreement between the CFTC and the Agriculture Committees was not reached and, as a consequence, they brought that into the legislation. It is not a question of individual self-interested parties trying to sneak through some particular form of legislative relief. It occurs as a consequence of the Secretary of the Treasury, the Chairman of the Federal Reserve Board and the Chairman of the Securities and Exchange Commission all being very concerned about the potential initiative of the CFTC and our request that until that issue is fully discussed within the Congress that unilateral action not be implemented by the CFTC. That is the basis of this and it has scarcely got anything to do with the individuals in the industry. I, frankly, couldn't care less about them.
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    Mr. HINCHEY. This is a request that you have made to the Agriculture Committee to put this language in the Agriculture appropriation——

    Mr. GREENSPAN. No, this all began as a letter from the three of us, requesting that until the issue was discussed in far greater detail in the Congress and elsewhere, that unilateral action on the part of the CFTC not be forthcoming. My recollection is that the particular form of legislation which passed both Agriculture Committees was initiated by the committees themselves.

    Mr. HINCHEY. Well, that was before the failure of Long-Term Capital Management. How many more failures do you think we would have to have, Mr. Chairman, before you might think that some regulation in this area might be appropriate?

    Mr. GREENSPAN. Well, the question has got nothing to do with Long-Term Capital Management. As a matter of fact, as I said in my prepared remarks, what I have found extraordinary about the current situation is that we haven't had more of them, because this is a risky business and I would expect a lot of failures to occur. But that is not the question.

    The question is, do you have a level of failure which very seriously undermines the system? And the answer to that at this particular stage is very clearly no, and that as far as I can judge, the degree of supervision of regulation of the over-the-counter derivatives market is quite adequate to maintain a degree of stability in the system. And it is by no means clear to me that the expansion of regulation to that particular area of the economy serves the overall financial system of the United States. There is some regulation which is helpful and there is some which is negative, and I would not like to see regulation which inhibits the effective functioning of our financial system.
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    Mr. HINCHEY. Well, neither would I, sir, but if you have a system with a nominal value now of something in the neighborhood of $30 trillion—and we have just seen one of the examples of that system suck up $3.5 billion out of the capital available for other more worthwhile purposes in our economy—I think that at some point you begin to wonder what is going on here, who is going to get hurt by all this, and when are we going to wise up and stop letting people who are in some cases driven by nothing healthier than simple greed to continue to manipulate the economy in this particular way?

    Mr. GREENSPAN. Well first let's describe what we mean by that $3.5 billion sucked up for other——

    Mr. HINCHEY. Good.

    Mr. GREENSPAN. If it is strictly a derivative issue, then its a zero sum gain. If some money is lost, somebody else gains. Where a goodly part of that money has been lost is not in the derivatives market but the underlying instruments; that is, in the equity values and in the bonds. The derivatives market as a whole doesn't lose any money. It is a transfer and, by its very nature, one loser must be matched by a gainer, where the losses are in the underlying assets which can go up and down.

    So I would not describe the issue—presumably you are referring to the injection of capital into Long-Term Credit Management—as the implied losses that are being made is somehow at the expense of something else.

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    It is certainly the case that there have been losses, and indeed you know we have got a stock market value in this country of $15 trillion, and we have had significant loss. Those couple of trillion or more that has been lost are really lost. They are going to show up and indeed have shown up in a lot of different places. But let's distinguish that phenomenon from losses that occur in the over-the-counter derivatives market, because there are no losses in net. There are very significant losses for individuals, and indeed that is the whole purpose of the market, to transfer gains and losses and risks and rewards amongst various different people who choose to take them because they think it is a good idea.

    Mr. HINCHEY. Mr. Chairman, if I may, just one more? And it is the last thing.

    Chairman LEACH. You can make an observation, but not a question.

    Mr. HINCHEY. My observation is that, based upon what you have just said, that it is possible for us to discount all this talk about a credit crunch, that that really isn't a problem, and that the money that is being taken up in this particular way is—no one is going to suffer as a result of the loss of that capital availability of the marketplace.

    Mr. GREENSPAN. No, I don't think it is related. I think that very clearly there has been a very dramatic increase in—you will excuse the expression, Congressman—risk spreads and yield spreads, and that is the reflection of the fact there has been a fairly pronounced move toward risk aversion not only in the United States but in the rest of the world. In fact, I have discussed that before this committee previously and I have done so in testimony.
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    Chairman LEACH. Time has expired, and I thank the Chairman.

    This has been a long 4 1/2 hours, and I want to extend my appreciation. I sense the Chairman of the Federal Reserve Board is losing his voice but not his mind. We appreciate that.

    Let me just first ask unanimous consent to place in the record a letter of the distinguished subcommittee Chairman, Mr. Baker, to the various Federal regulators on aspects of this subject that was written before the Long-Term credit issue arose, and ask that the regulators respond as appropriately as they can. Only one to date has, and this is an extremely important letter coming from this committee.

    And I would also ask unanimous consent that his letter, plus the response from the SEC, be placed in the record at this point. Without objection so ordered.

    Chairman LEACH. In summary, let me say that it strikes me that a new economic doctrine has been presented today; and that is that the Chairman of the Federal Reserve Board has articulated a too-big-to-liquidate-quickly doctrine, which apparently is a corollary to the too-big-to-fail doctrine. Whether it is precisely the same thing or an analog, it is something that I think we are all going to want to think through its appropriateness at any particular point in time.

    I would say, speaking for myself, that I believe that not thought through in advance, appropriately enough, has been a circumstance that I would suggest you created an entity or appreciated the creation of an entity that is too powerful and too conflicted to go on in its newly established form.
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    To have the 14 biggest investment and commercial banks in the world intertwined with the hedge funds is collusive. From a bank regulatory perspective, there are a number of implications that are extraordinary. If you take a commercial bank that starts out with 20–to–1 leveraging and then makes a loan to a company which it itself owns, which makes it the equivalent of a subsidiary which then has 20–to–1 leveraging, you have 400–to–1 leveraging to buy instruments that themselves may conceivably be leveraged. This is something that the bank regulators are going to have to look at, I think, very carefully.

    I might also say from talking this week to a number of community bankers in my State of Iowa, I was surprised at the reaction and some concern about regulation in general and about the larger banks in particular. The idea of giving a loan to an institution that was considered secret in its actions is not something that is a common banking practice, at least in the Midwest.

    I would also suggest that a question raised by Dr. Paul about where this institution is chartered is not totally irrelevant. This is the bailing out of a Cayman Islands institution and, unless you want to contradict me, I suspect you didn't consult with Cayman Island authorities before acting. If I am wrong, please tell me.

    I will say this. The reason people charter abroad is to take advantage of laws that someone thinks are advantageous, and that means that people don't come under the rubric of the totality of the United States law, which I think is problemsome and here I will only tell you, and I don't want to be too Iowan in my attitudes, but I remember a conversation my father once had with me in which he said, ''Jim, never deal with someone who banks in the Caymans.'' I tell you, for some reason that advice does not seem to be totally irrelevant.
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    Finally, let me comment on the international dimension of this. In the United Kingdom today and France today and with the new government in Germany today, there is increasing concern about trying to deal with what is considered to be an enormous increase in speculation in the world, and this is a subject for the Congress and our regulators, but it is also a subject for international concern.

    And the Chairman of the Federal Reserve is precisely correct that if you take a given kind of action in one country, people can move to softer currency abroad. But I do think this is a subject matter that is worthy of concern of the various international negotiating entities, whether they be related to the banking industry or central banks or the G–7, that this is a subject that deserves serious consideration.

    In any regard, I recognize that the Federal Reserve Board of the United States has obviously acted in good and thoughtful faith, but I think as time goes on, the ramifications of this particular act are going to take on larger proportions and we are going to want to continue to reexamine.

    I thank the two of you and appreciate your presence, which I think is very important. The two of you are certainly excused at this point and we will go to the next panel.

    Our second panel is composed of Donna Tanoue who is President of the Federal Deposit Insurance Corporation; Brooksley Born, who is Chairperson of the Commodity Futures Trading Commission; Julie Williams, who is Acting Comptroller, Office of Comptroller of the Currency; and Mr. Richard Lindsey, who is Director of the Division of Market Regulation of the Securities and Exchange Commission.
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    Ms. Tanoue, are you prepared now or would you rather go second? It is your choice.


    Ms. TANOUE. Good afternoon Mr. Chairman and Members of the committee.

    Chairman LEACH. Let me interrupt for a second. All of your statements will be placed in the record under unanimous consent, and if you care to summarize you are welcome to, or you may read as you see fit.

    Please proceed, Ms. Tanoue.

    Ms. TANOUE. Thank you.

    I am pleased to be here to present the FDIC's views today. Only one week after the recapitalization of Long-Term Capital Management was announced, the FDIC has many more questions than we have answers about the facts of this matter.

    Today I want to make four points:

    The first one: the recapitalization of Long-Term Capital came from the private sector. Not one penny of FDIC deposit insurance funds was used in the recapitalization. The use of FDIC funds was never considered, and we were not a party to the recapitalization discussions.
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    Point two: the FDIC's primary concerns relating to this matter involve the exposure of the deposit insurance funds to the type of risks that hedge funds pose to insured institutions and to the potential for systemic instability.

    Point three: the near collapse of Long-Term Capital underscores the continuing importance of regulatory cooperation and information sharing. Federal supervision of the banking system is designed to ensure that bank management is capable of understanding and controlling the risk of bank activities. Exposure to hedge funds in the U.S. is concentrated in State-chartered banks that belong to the Federal Reserve System and in national banks. The FDIC therefore works with the Fed and the OCC to monitor and address the risks to federally-insured institutions that these activities pose.

    Over the past week, the FDIC has been in frequent contact with our banking colleagues and we are working with them to assess the extent of the exposure to insured institutions and any potential risks to the deposit insurance funds. We have joined in meetings with some of Long-Term Capital's creditor banks and anticipate additional meetings with others soon, and we are working with our regulatory colleagues to obtain more information about other hedge funds and to assess the potential risks to banks.

    The fourth point: The primary focus of our efforts will be on the risk management programs in place at the banks involved. These programs are the responsibility of the board of directors and management of each bank, and we are working with the bank supervisors to determine deficiencies, if any. And we are working together to determine whether the institutions involved have sufficient information. That is to say, whether they have the information they need to assess the nature of Long-Term Capital's strategies and its financial condition. We must also ask whether the banks involved use proper underwriting standards.
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    The Long-Term Capital matter has raised other questions that need to be addressed by the bank supervisory system. These questions include: are banks observing prudent limits on their derivatives exposure to individual counterparties? Do banks have sufficient information to assess concentration risks and derivatives? And are banks properly using internal models?

    In conclusion, the FDIC is concerned about risks that hedge funds may pose to banks, the deposit insurance funds, and the financial system. We need to ensure adequate oversight and we need to determine that proper controls are in place. We look forward to working with this committee, our regulatory colleagues and the President's Working Group on Financial Markets to address these important issues.

    Thank you.

    Chairman LEACH. Well thank you very much, Ms. Tanoue.

    For a return visit on a similar subject, Ms. Born. You are welcome and you are welcome to claim some vindication if you want, but please proceed.


    Ms. BORN. I certainly will not do so. Mr. Chairman and Members of the committee, thank you very much for providing me with an opportunity to testify concerning Long-Term Capital Management and its financial difficulties. This episode should serve as a wake-up call about the unknown risk in the over-the-counter derivatives market and the risks that that might pose to the U.S. economy and to financial stability around the world. It has highlighted an immediate and pressing need to address whether there are unacceptable regulatory gaps relating to hedge funds and other large OTC derivatives market participants. The Commodity Futures Trading Commission is currently studying these issues, as we announced in our May 12, 1998 Concept Release on OTC Derivatives and as I testified before you in July.
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    I welcome the heightened awareness of these issues that the LTCM matter has engendered and believe that it is critically important for all U.S. financial regulators to work together closely and cooperatively on them. Therefore, I applaud Secretary of the Treasury Robert Rubin's call for a meaningful study by the President's Working Group on Financial Markets and look forward to working with him and the other members of the Working Group. Swift regulatory responses may well be needed to protect the U.S. and world economy.

    LTCM is a hedge fund, a speculative investment vehicle for very wealthy and sophisticated individuals. Because LTCM trades on U.S. futures and option exchanges, it is registered with the CFTC as a commodity pool operator. To the best of my knowledge, it is not subject to oversight by any other Federal agency.

    Pursuant to CFTC's requirements that large trader positions on the futures exchanges must be reported on a daily basis, LTCM's positions on U.S. futures exchanges have been reported daily to the CFTC, and both the CFTC and U.S. futures exchanges have had full and accurate information about its on-exchange futures positions. Moreover, it has been promptly and fully paying margin on its futures positions which are marked to market daily. However, neither the CFTC nor the U.S. futures exchanges have had information on LTCM's position in the OTC derivatives market, since no reporting of that information is routinely required.

    On Wednesday, September 23, 1998, the Department of the Treasury informed the Commission that LTCM was in financial difficulty. Press reports state that its capital at that time had dipped below $1 billion. However, it reportedly had been able to leverage that capital to invest in securities and other assets valued at as much as $125 billion. It had also reportedly entered into derivatives contracts with a notional value of $1.25 trillion. Most of these derivatives were reportedly OTC swap transactions, while the rest of the derivatives position consisted of exchange-traded futures on domestic and foreign exchanges.
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    Evidently, because of the concern that LTCM was about to default on margin calls on its enormous derivatives position and on other loans, LTCM's largest creditors, including some of the largest U.S. and European commercial banks and the largest U.S. investment banks, reportedly have agreed to contribute about $3.6 billion in capital to LTCM and to take a 90 percent ownership interest in it. Many of these creditors are reportedly LTCM's swaps counterparties.

    After learning about LTCM's difficulties, the Commission staff quickly determined the nature and value of the positions the firm carried on U.S. futures exchanges and took steps to identify and address any dangers to the exchanges and their clearing houses resulting from LTCM's problems. The Commission staff analyzed its large trader reporting data and instituted an immediate special audit of LTCM and inspected its accounts at the U.S. futures commission merchants—or FCMs—that carried and cleared its exchange-traded futures transactions. We immediately contacted senior officials at the U.S. futures exchanges on which LTCM held positions and certain foreign regulatory authorities to alert them about the possible problems related to LTCM's derivatives positions. We also contacted the National Futures Association, or NFA, which is the registered futures association which has delegated authority from the Commission to oversee CPOs such as LTCM. We have coordinated with NFA in the special audit of LTCM. Our staff continues to monitor the situation closely and to verify that LTCM and its clearing FCMs can meet their margin requirements on U.S. futures exchanges.

    Commission staff is also currently exploring whether any of our laws or regulations have been violated. We have been in close communication on the LTCM matter with other members of the President's Working Group. The Commission staff is also trying to take steps to identify other traders whose positions in the OTC derivatives market may affect our regulated markets or financial stability. For example, we are currently seeking information about other large hedge funds that are registered as CPOs. We are in contact with large FCMs, futures exchanges and the NFA to ensure that they pay particular attention to these issues and that they report any unusual activity to the Commission.
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    Moreover, the Commission is examining the CEA, the Commodity Exchange Act, and the Commission's regulations on CPOs to determine whether improvements are needed. As noted above, we are continuing our ongoing study of the OTC derivatives market and the adequacy of our current regulations relating to that market and its participants.

    Since its recapitalization, LTCM has continued to meet its margin calls on U.S. futures exchanges and I hope that the arrangement with its creditors will prove to be successful. Because of the lack of any reporting requirements concerning OTC derivatives positions, it is unknown at the moment whether other hedge funds or large OTC derivatives participants pose dangers to the economy.

    What is clear is that the LTCM events raise a host of important issues relating to hedge funds and to the increasing use of OTC derivatives by those funds and other institutions in the world financial markets. Most of these issues were raised by the Commission in its Concept Release on OTC Derivatives and are currently being studied by it. They include the following:

    Lack of transparency. While the CFTC and the U.S. futures exchanges had full and accurate information about LTCM's on-exchange futures positions, no Federal regulator received reports from LTCM on its OTC derivatives position. Indeed, no reporting requirements are imposed on most OTC market participants. This lack of basic information about the positions held by OTC derivatives users and the nature and extent of their exposures potentially allows OTC derivatives market participants to take positions that may threaten our regulated markets, or indeed our economy, without any Federal regulator knowing about it. Furthermore, there are no requirements that a hedge fund like LTCM provide disclosure documents to its investors or to its counterparties concerning its positions, exposures, or investment strategies. A hedge fund's derivatives transactions have traditionally been treated as off-exchange, off-balance sheet transactions, so even the annual financial reports filed with the Commission do not fully reveal its positions.
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    The OTC derivatives market has little price transparency, unlike regulated futures exchanges where bids and offers are quoted publicly and positions are marked to market daily. Lack of price transparency may aggravate problems arising from volatile markets because traders may be unable accurately to judge the value of their positions or the amount owed by their counterparties. Lack of price transparency also may contribute to fraud and sales practice abuses, allowing OTC derivatives customers to be misled as to the value of their interests.

    As the Commission has suggested in its Concept Release, questions about the need for reporting, recordkeeping, disclosure, and price transparency in the OTC derivatives market should be addressed.

    A second issue is excessive leverage. While traders on futures exchanges must post margin and while their positions are marked to market on a daily basis, no such requirements exist in the OTC derivatives market. LTCM reportedly managed to borrow so much that it was able to hold derivatives positions with a notional value of as much as 1,300 times its capital. A hallmark of LTCM's OTC derivatives transactions apparently has been the firm's insistence that it would never provide its counterparty with any initial margin. Its swaps counterparties reportedly did not have full information about its extensive borrowings from others and therefore unknowingly extended enormous credit to it. This unlimited borrowing in the OTC derivatives market—like the unlimited borrowing on securities that contributed to the Great Depression—may pose grave dangers to our economy.

    The Commission's Concept Release describes many of the risk-limiting procedures and requirements employed in the regulated futures markets, including mutualized clearing arrangements, margin requirements, capital and audit requirements, and it calls for comment on whether similar requirements are needed in the OTC derivatives market. It is essential to consider how to reduce the degree of leverage in the OTC derivatives market and the attendant risks.
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    A third issue is insufficient prudential controls. Closely related to the issue of excessive lending to LTCM is the apparent insufficiency of the internal controls applied by the firm and its lenders and counterparties. In its Concept Release, the Commission calls for comment on a number of issues relating to the sufficiency of internal controls and risk management mechanisms employed by OTC derivatives dealers and their customers including value-at-risk models. Such issues should be addressed.

    The fourth issue is the need for a coordinated international approach. International regulators have expressed concern for some time about the lack of effective oversight of hedge funds and other large users of the OTC derivatives market and their ability to avoid regulation by any one nation in their global activities. Indeed, several emerging market countries have attributed crises in their currencies and markets to the actions of large hedge funds. The LTCM situation presents a new opportunity for the Commission and the other U.S. regulators to work with regulatory authorities in other countries to harmonize regulation in the OTC derivatives market and its participants and to implement international regulatory standards.

    Despite the immediate and pressing need to address these and related regulatory issues, Congress is about to restrict the Commission in doing so. Congress is about to adopt the so-called ''Financial Markets Reassurance Act of 1998'' which was attached to the Agricultural appropriations bill in conference committee earlier this week. That bill would prohibit the CFTC from proposing or adopting any new regulations relating to OTC swaps transactions until March 30, 1999, except in limited circumstances. The CFTC is currently the only Federal agency with statutory authority over hedge funds like LTCM and over a significant portion of the swaps market. To tie its hands during this time of economic instability and growing awareness of the potential dangers in the swaps market could pose grave risks to the American public.
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    Thank you very much and I would be pleased to answer any questions.

    Chairman LEACH. Ms. Williams.


    Ms. WILLIAMS. Mr. Chairman, Ranking Member LaFalce and Members of the committee, I appreciate this opportunity to testify on issues raised by the near collapse and interim rescue of Long-Term Capital Management (LTCM) and issues associated with bank involvement with hedge funds. I want to commend you for holding this hearing to explore these issues. My testimony will be focused on bank supervisory issues presented by LTCM specifically and bank involvement in hedge funds in general.

    At the outset this afternoon I want to make one thing clear. While the LTCM situation may raise a number of complex and far-reaching public policy questions, I can assure you that the OCC's focus is singular: to assure the safety and soundness of the national banking system—period.

    While we are continuing to verify our understanding of the impact of LTCM on national banks, we know of no national bank that has been jeopardized by the near collapse of this hedge fund. Nonetheless, we are examining these events to discern what lessons should be learned from this experience by bank regulators and by the banks we regulate. Clearly, all banks should be revisiting the ways in which they extend credit to hedge funds. At this point it appears that one lasting impact of LTCM may well be the lessons it teaches about proper management of credit risk.
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    National banks can be involved with hedge funds in a number of ways. Among the services banks provide to their hedge fund customers are loans and credit enhancements; execution, clearance and settlement of trades, including derivatives transactions; and custodial services and cash management services. Holding companies and banks themselves, to a limited extent, may be investors in hedge funds as well.

    From what we know now, the handful of national banks with relationships with funds that could be characterized as hedge funds appear to have managed their credit exposure to these funds. In particular, national banks usually have initial margin, have control of the collateral, and have a process to manage ongoing margin or collateral calls to control their downside risk. In addition, relationships with fund managers, including hedge funds, are predicated both on the ability to provide collateral and on bank knowledge and experience with the principals of the funds. The unsecured syndicated loan made to LTCM by a group of institutions, including a few national banks, appears to be aggressive compared to the exposures of most national banks to other funds.

    The national banks that work with hedge funds are generally the largest, most sophisticated trading institutions, and they have full-time resident OCC staff continually monitoring their trading, credit, and risk management activities.

    The syndicated loan to LTCM that I mentioned earlier, the unsecured loan, is actually a good example of slipping credit underwriting standards about which the OCC and other regulators have recently warned. In this particular case, it appears that repayment was dependent on LTCM management's reputation and acumen to continue to generate strong returns in a strong market. Unfortunately, when you are making loans to a highly leveraged business and you do not have sufficient structural underwriting protections, in this case sufficient collateral, you can get unwarranted credit risk.
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    The OCC has implemented new examination procedures to further focus the attention of both examiners and bankers on the importance of proper loan structure and underwriting standards. By bringing these loans and their inherent risks to the attention of bank management and boards now, we are hopeful that they will assess the risks for themselves and make appropriate adjustments to their lending and risk management practices before regulators are forced to take action.

    In addition to lending, as I mentioned, some national banks engaged in derivatives transactions with LTCM. Effectively managed, derivatives provide users with flexible risk management tools, but, depending on the instrument, they can be very complex, with a range of upside potential and downside risk.

    The OCC provides extensive oversight and supervision of derivatives use in national banks. Our on-site supervisory review of trading departments includes both regularly scheduled and focused examinations, as well as ongoing, on-site supervision at the largest banks. We have Ph.D.-trained risk management staff who assess theoretical and quantitative elements of the models used for pricing and risk management.

    Events surrounding the near collapse and interim rescue of LTCM may provide some important lessons for banks, their regulators and the financial markets. The most important one may be don't lose sight of fundamental risk management principles. Credit decisions must be made on the basis of the underlying risks of the current transaction.

    Thus, the LTCM case underscores the need for banks to understand the full extent of their credit and trading exposure to hedge funds. As creditors, banks need to get as much information as possible about the fund's investment strategy and the exposure of other financial institutions to the fund. Where the transparency of hedge fund financial information is inadequate, the need for banks to secure and maintain sufficient collateral for their credit risk is enhanced. Finally, we must not allow the sophistication of quantitative risk modeling techniques to tempt us to abandon credit risk management fundamentals.
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    In conclusion, although not all of the facts about the LTCM situation are in, the events surrounding the interim rescue of the firm certainly illustrate the continuing need for financial institutions and regulatory agencies to assure adherence to prudent and effective risk management practices. Technological advancements and sophisticated computer modeling have contributed to more precise risk management techniques, but we cannot be complacent about the potential for market volatility and risk, and we must not lose sight of the basic principles of sound lending and risk management, even in the most sophisticated types of credit transactions.

    Thank you. I would be pleased to answer any questions you may have.

    Chairman LEACH. Thank you, Ms. Williams.

    Mr. Lindsey.


    Mr. LINDSEY. Chairman Leach and Members of the committee, it is a pleasure to appear before this committee again. I am here today to testify on behalf of the Securities and Exchange Commission concerning the impact of hedge funds on U.S. markets.

    Over the past several years, hedge funds have become increasingly significant participants in the global marketplace. The activities of some large, aggressive funds have raised questions about their potential impact on U.S. markets and the recent financial difficulties of Long-Term Capital management have only heightened these concerns. Although hedge funds have been studied in the past, LTCM's difficulties indicate that it is time to reexamine the risks posed to our markets by the activities of these funds.
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    Last week, Secretary Rubin announced that the President's Working Group on Financial Markets will review hedge funds and the policy issues raised by LTCM. We therefore intend to work closely with the Working Group to study these issues in greater depth.

    The term ''hedge fund'' has come to refer to a variety of pooled investment vehicles that are not registered under the Federal securities laws as public corporations, investment companies, or broker dealers. As largely unregulated entities, hedge funds have the flexibility to invest in commodities, OTC derivatives and foreign sovereign debt. In addition, hedge funds may borrow to finance their positions, which can yield high returns on capital.

    This is not the first time that we have considered hedge fund trading activities. In 1994, the Working Group set up a task force which released a summary of its observations in a September report. The task force found that hedge funds, like other large investors, can exacerbate market movements if the funds need to sell quickly to meet margin calls or to unwind leverage positions, and that it may be difficult for banks and broker-dealers to monitor the creditworthiness of hedge funds because they do not typically know their overall positions, which can change rapidly. Therefore, hedge funds are often required to post initial collateral in connection with transactions they enter into with banks and broker-dealers, including OTC derivative transactions.

    Subsequently, the Commission staff conducted its own review of hedge fund trading. We did not find the funds we studied to have been highly leveraged compared to a sample of large broker-dealers. Moreover, nothing in our study indicated that hedge funds at that time were any more or any less likely than other large traders to increase the risk of market participant failures or otherwise threaten the financial integrity of the markets.
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    Since that time, there have been a number of highly publicized events involving hedge funds, most recently LTCM. LTCM built its portfolio on sophisticated arbitrage trading strategies and used a significant degree of leverage to increase expected returns. In August and September of this year, as turmoil in global markets increased, it became clear that many of the assumptions inherent in LTCM's trading strategies were incorrect. Due to the degree of leverage which at one point exceeded 50–to–1, those assumptions resulted in substantial losses for the fund and eroded its capital base. As LTCM's losses mounted, its creditors made additional margin calls and potential sources of capital dried up, threatening the fund with insolvency. A workout by its creditors became the only alternative to liquidation. LTCM's creditors' decision to acquire the fund was based, in part, on their concerns about possible disruptions in the U.S. and global marketplace if LTCM had failed.

    When the Commission learned of LTCM's financial difficulties in August, we surveyed major broker-dealers known to have credit exposure to large hedge funds. Our survey indicated that no individual broker-dealer had exposure to LTCM that jeopardized the broker-dealer's required regulatory capital or its financial stability. Although significant amounts of credit were extended to LTCM by U.S. securities firms, this lending was on a secured basis, with collateral obtained and marked to the market daily. The collateral collected from LTCM consisted primarily of highly liquid assets such as U.S. Treasuries or G–7 country sovereign debt. Any shortfalls in collateral were met by margin calls to LTCM. As of the date of the rescue plan, it appears that LTCM had met all of its margin calls by U.S. securities firms.

    When we looked at hedge fund activity in 1994, their conservative use of leverage was a major factor in our conclusion that hedge funds represented relatively little risk to the financial system. In light of LTCM's enormous use of leverage, however, it is time to consider whether the risks to the financial system due to hedge funds have changed.
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    That being said, Congress and the regulatory community should move with caution in determining whether and to what extent we need to oversee hedge funds. In this process, we must avoid the temptation to label certain instruments as inherently risky or dangerous. Rather, we should focus our attention on risky strategies, such as the use of excess leverage employed by LTCM.

    It is too soon to tell whether LTCM's investment strategies represent the norm in the hedge fund industry or that LTCM was an overly aggressive player among otherwise responsible market participants. If we move too quickly and attempt to impose regulatory requirements on hedge funds, these sophisticated global players may simply shift their operations offshore. Such a move could significantly hinder our ability to assess the potential risk that hedge funds' activities may raise for U.S. markets. We intend to work closely with the other members of the President's Working Group to study these issues. Thank you.

    Chairman LEACH. Thank you.

    Mr. LaFalce.

    Mr. LAFALCE. Thank you, Mr. Chairman.

    Mr. Lindsey, are you familiar with the testimony that is going to be given by a former chairman of the SEC, Mr. Ruder?

    Mr. LINDSEY. No, I haven't seen it.
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    Mr. LAFALCE. In the close of his testimony, he comments on the furor that existed earlier about a proposed FASB accounting standard. He is a member of the FASB Foundation, or is a trustee of it.

    What is the position of the SEC today with respect to the FASB proposals, with respect to the accounting disclosure that should be given regarding derivatives?

    Mr. LINDSEY. The SEC is a strong supporter of FASB and FASB independence, and believes that FASB should adopt the rules that they think are appropriate.

    Mr. LAFALCE. What do you think about the fact that the Federal Reserve Board opposed those rules in the past and seemed to oppose them this morning under my questioning?

    Mr. LINDSEY. I don't really have a comment for that.

    Mr. LAFALCE. So you don't always agree with the Federal Reserve Board?

    Mr. LINDSEY. No, we don't.

    Mr. LAFALCE. In this instance you strongly disagree; is that correct?

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    Mr. LINDSEY. I would say it is fair to say we disagree.

    Mr. LAFALCE. Thank you.

    Ms. Williams, first of all, let me congratulate you on the outstanding job you have done as Acting Comptroller of the Currency. I think the world of Jerry Hawk. I think Jerry Hawk will be a great Comptroller, but I also think that you have been a great Acting Comptroller and some day might well be and should be a great Comptroller in your own right.

    Ms. WILLIAMS. That is extraordinarily kind.

    Mr. LAFALCE. I mean it too, Julie; I mean it, very much so.

    I was amazed at Chairman Greenspan's testimony, more so than any other time since he has been Chairman. It seemed to me he was reverting back to a philosophy that some people tagged him with before, laissez-faire, almost as if there should be no regulation whatsoever in this unbelievably large interrelated global economy, or so concerned about the potential for regulation that he would rather run the risk of no regulation than any possible overregulation.

    Now, I am not going to ask you to comment on that, but I am going to ask you to comment on this. The contributions that the banks made to this particular hedge fund, was it a bank contribution or is it a dealer-broker contribution?

    Ms. WILLIAMS. The participants in the consortium that are part of the interim rescue——
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    Mr. LAFALCE. I am talking about the initial investment. Was it a dealer-broker contribution, an affiliate of the bank, or the bank itself; or don't we know?

    Ms. WILLIAMS. As far as I know, the national banks were not involved as investors—either initially or in the consortium.

    Mr. LAFALCE. So you wouldn't have reason to know. Well, if it were dealer-broker, as some have told me, wouldn't H.R. 10, as passed by the House, and H.R. 10, as modified by the Senate and about to be passed, provide us with Fed-like regulation; that is, less regulation in the future than we presently have under existing law, inadequate though it might be under existing law?

    Ms. WILLIAMS. Congressman, I think that one lesson or one message that the situation we are talking about this afternoon ought to convey as you and others consider H.R. 10 is the need to evaluate the types of safety and soundness measures and framework that are provided in the bill.

    Mr. LAFALCE. I understand that. I just want to know whether there would be enhanced regulatory ability or decreased regulatory ability under the Fed, either under H.R. 10, as we passed it, or H.R. 10, as being considered by the Senate.

    Ms. WILLIAMS. There would be decreased regulatory authority.

    Mr. LAFALCE. Thank you.
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    Ms. Born, let me congratulate you because, whether or not you should have issued your concept paper in release, whether it should have been done by some other entity or whether it should have been done by academia, I don't care right now. I am just glad it was done, because you raise some excellent questions.

    Ms. BORN. Thank you.

    Mr. LAFALCE. And I am concerned. Some people have raised legitimate concerns about your acting precipitously and unwisely and too zealously, and yet I am also concerned—whether it should be you or somebody else—there ought to be some legal capacity to act in an emergency. And we are faced with this Damoclean sword over our heads of an amendment to the Agriculture bill by Senator Lugar that will eliminate, at least till the end of March, anybody's authority. Whether it should be yours or not, it might be the only authority that exists. And yet I suspect it is going to become the law of the land unless some deal could be struck.

    I am now going to fish for a deal. Could you agree, if that is not passed, not to exercise any authority unless there is a consensus of the Working Group that there is a need for somebody to act; and since you are the only one to act, you then act? Is that a possible deal?

    Ms. BORN. That certainly is something I would be happy to consider seriously.

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    Mr. LAFALCE. Let's consider that seriously, because I would hate to just eliminate for the next six to seven months any vestige of authority to act, regardless of who has that authority, in case we are confronted with another situation.

    Ms. BORN. I certainly agree with that and would be happy to see if that kind of an arrangement could be entered into. I would certainly be willing to pledge to that.

    Mr. LAFALCE. I think that is a major step forward, and I would hope that there are other parties who believe that there might be within this global economy some possible need under most stressful, trying circumstances for some entity to act, but at least consider the offer that you have now made.

    Let's talk about four issues: lack of transparency; excessive leverage; insufficient prudential controls, and need for a coordinated international approach, because these were the four touchstones, if you will, of your testimony.

    Before we get to that, though, in your conversations with the Working Group, has anybody ever suggested a withdrawal of your concept paper in return for a concept paper virtually identical in nature issued by the Working Group itself?

    Ms. BORN. Well, one of the problems is the Working Group doesn't have any statutory authority at the moment or——

    Mr. LAFALCE. So what?
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    Ms. BORN.——or status.

    Mr. LAFALCE. You don't need statutory authority to talk about concepts.

    Ms. BORN. All we are doing—I would be delighted and——

    Mr. LAFALCE. That is my second proposal. That you withdraw your concept paper in return for the Working Group issuing a very similar concept paper asking the same basic questions in an academic setting and academic sense, then.

    Ms. BORN. We are reluctant to stop our concept paper because it——

    Mr. LAFALCE. Think about it.

    Ms. BORN.——Because it has no proposals. It only asks questions.

    Mr. LAFALCE. But everybody is in a furor about it and if you could quell the furor—the furor is simply because you ask them, and implicit in your asking them is your implied assertion of authority. That is what everybody is concerned about it. If you were to withdraw it and be asked by the Working Group, then maybe the furor would subside a little bit. It is a suggestion. Think about it.
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    Before I get into the four points, I am a little curious about a statement you made on page 3: ''We also contacted the National Futures Association, the registered futures association which has delegated authority from the Commission to oversee CPOs and CTAs, such as LTCM, and have coordinated with NFA in the special audit of LTCM.''

    Now, if you have delegated authority to them, that means you have authority yourself; otherwise, you wouldn't be able to delegate that authority. And if you have delegated authority for them to oversee CPOs and CTAs and have a special audit, well then, wouldn't you have that authority yourself to oversee and audit?

    Ms. BORN. We do, although we have the authority because they are registered as a commodity pool operator, which they are for one reason and one reason only: that they trade on futures exchanges.

    Mr. LAFALCE. What is the gap that you have even under the most liberal interpretation of your authority? Let me ask you to expand upon that in writing, simply so I can go on.

    Let me ask you this. In your discussions with the Working Group, is there any question in their mind about the need for greater transparency, about the need for reporting, recordkeeping, disclosure, and, twice, transparency in the OTC derivatives market?

    Ms. BORN. Those issues have not been discussed by the President's Working Group since I have been in office.
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    Mr. LAFALCE. Well, if the Working Group is meeting, if the Working Group is worthy of being called a Working Group, how could that be possible if it hasn't even discussed the most basic threshold question, and that is the question of transparency of the most basic information?

    Ms. BORN. That is one of the reasons we decided to go forward with our Concept Release, because the President's Working Group in March told Congress that it would not undertake a study of the OTC derivatives market. So we went ahead and did it ourselves.

    Mr. LAFALCE. Ms. Williams, you look as if you want to jump in on this.

    Ms. WILLIAMS. Secretary Rubin asked the Working Group previously to do a very comprehensive study of derivatives issues, and I think the range of issues that Chairman Born has identified is within the scope of efforts that are already underway as a result of the Secretary's initial request.

    Mr. LAFALCE. Ms. Born, I express my dismay at what I consider to be the almost complete laissez-faire approach of Chairman Greenspan, at least with respect to this issue. What was your reaction?

    Ms. BORN. I felt that it was a laissez-faire approach as well.

    Mr. LAFALCE. I assume, therefore, you thought it was somewhat inappropriate?
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    Ms. BORN. Well, I do feel that there is an appropriate role for regulation. I do not believe in heavy regulation and I don't think that our futures exchanges or our current regulations for the OTC derivatives market can be characterized as heavy regulation. But I do think that transparency, disclosure and availability of information are all very important.

    Mr. LAFALCE. Let's go to your second touchstone, excessive leverage. Now, I brought up the issue of margin requirements and Greenspan responded, well, we should be concerned about leverage, which we can deal with, with capital, at least capital ratios.

    Former Superintendent of Banking for New York, Ms. Siebert, is going to be talking quite a bit about the adequate need for margin requirements, too. Someone—I think it was you—said in your testimony what I said: that the lack of margin requirements harks back to the era of the 1920's which gave cause to the Great Depression.

    Are you concerned—do you distinguish between margin and leverage, and do we need both greater authority with respect to margin requirements and with respect to capital ratios to deal with leverage?

    Ms. BORN. I think we need to study how to control what seems to be out-of-control excessive lending in this market. Capital requirements are a way to do it. Margin requirements are a way to do it. I am not sure indeed those are some of the questions posed by our Concept Release, whether net capital, whether requiring internal controls, whether use of value-at-risk models, whether margin requirements are appropriate.
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    Mr. LAFALCE. I thank you very much, but I especially thank the Chair for his indulgence. I know I have exceeded the time somewhat.

    Chairman LEACH. Thank you, Mr. LaFalce.

    Mrs. Roukema.

    Mrs. ROUKEMA. I am not sure where I am going from here. My friend, Mr. Baker, asked if it was still Thursday, and I think it still is. But it is the longest Thursday I have ever spent here. But in any case, without being facetious, I am more than a little confused, and maybe I wasn't listening as carefully as I should be.

    Ms. Tanoue, I am sorry I missed your testimony. Particularly for Ms. Tanoue, Ms. Williams, and Mr. Lindsey, do I understand—you are not taking exception to what the Fed did; is that correct?

    Ms. WILLIAMS. That is correct.

    Mrs. ROUKEMA. You are not taking exception to that, but I haven't heard, aside from your references to internal risk models—and that goes back to the stress-testing that the Fed indicated that the stress testing had been inadequate—I haven't really heard anything with specificity as to how you would address the problem that we have here. That is one question.

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    And putting it another way, I will go back to the original article I referenced when I addressed the question to the Fed Chairman. I would think particularly Ms. Williams and Ms. Tanoue would be appropriate to put the stress testing and internal risk models into the context of the question that was asked in the New York Times article today: Did the lenders understand how leveraged the fund was? And if not, were the banks misled or just careless, or were you guys not doing your job?

    By the way, if Mr. Lindsey would like to comment from the point of view of the SEC, I would be most grateful.

    Ms. WILLIAMS. Congresswoman, I think there has been some confusion in the way that the different exposures have been discussed and described, and I will try to perhaps oversimplify it a bit.

    Mrs. ROUKEMA. Please. Because we can't——

    Ms. WILLIAMS. That would be the easiest way for me to talk about them. From the perspective of the bank involvement, basically there was a syndicated, unsecured credit of, I think, $700 million in which a number of institutions participated. A few national banks were among the participants. It was unsecured. The other types of exposures that have been referred to this morning and sometimes characterized as credit exposures can arise from capital markets transactions, sometimes derivatives, where a bank is actually owed money by LTCM so there is a credit-type risk that arises. There you have questions about whether, in the arrangements for the particular transactions, the banks made arrangements to have collateral in place to protect their positions so that when the fund owed the money to the bank——
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    Mrs. ROUKEMA. Should you have been aware of that under these circumstances? Should you and OCC and FDIC be aware of that on an ongoing basis?

    Ms. WILLIAMS. We should, and the arrangements are things that our examiners generally are aware of. The question of whether there should have been an unsecured loan gets to the issue of underwriting standards that I have been raising concerns about in recent months—whether you as a lending institution put yourself in a position of having that sort of exposure without getting collateral. And the tradeoff that I was trying to explain, in sort of simplified form in my oral statement, is that if you don't have a full appreciation and understanding of the business of the borrower and the potential volatility of the business of the borrower, which apparently was the case here, then you need to make sure you have collateral to cover your position.

    Mrs. ROUKEMA. Ms. Tanoue.

    Ms. TANOUE. Yes. The FDIC is not the primary Federal regulator for any of the insured institutions involved with Long-Term Capital. And we did not have direct supervisory information about the specific transactions. As you know, we do rely on the primary Federal regulators, the Fed and the OCC to a certain extent, for the information about the institutions that are under their direct supervision.

    Having said that, however, we are working very closely with the Fed and the OCC to determine the nature and the extent of any exposure of these institutions and any potential risks to the deposit insurance funds.
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    Mrs. ROUKEMA. How are you doing that? Are you doing that in a structured way? We heard everybody talking about it, but aside from non-specific references to the Working Group, I haven't heard of anything with any specificity that we can rely upon or that has been outlined. But maybe you want to take another time, or in writing, to outline that for me.

    Ms. WILLIAMS. I think in my written statement I do set out in aggregate the types of exposures and the dollar amounts of exposures that national banks had to LTCM, so we know what those exposures are.

    Mrs. ROUKEMA. I am talking now how you correct the problem, how you are working together in a structured way to address the obvious problems that this experience—and the experiences back in 1994. You have been working at this since 1994; isn't that correct? In any case, give me something in follow up.

    Mr. Lindsey, would you like to comment?

    Mr. LINDSEY. Yes. There are actually two types of exposure that you have to think about. You have to look at the current exposure that you have to a counterparty and on that basis, the broker-dealers and their affiliates had collateral, margin calls were met on a daily basis. So I have a trading relationship that is marked to market, and if I have made money that day, then there is a positive balance in my account. If I have lost money, I might make a margin call for the loser.

    The bigger issue that everyone is really talking about——
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    Mrs. ROUKEMA. Wait a minute. But that system didn't work in this case, did it?

    Mr. LINDSEY. No, that system worked. That system worked completely.

    Mrs. ROUKEMA. It did?

    Mr. LINDSEY. Yes. So the bigger risk that everyone has been talking about is the credit risk of what happened if Long-Term Capital had not paid at all, if it had gone bankrupt and then started to unwind its positions. That would have had an impact in the market and it would have had an impact on its ability to fulfill the obligations owed to its counterparties.

    Our best estimates are that broker-dealers would have experienced probably in the range of $300– to $500–million of exposure to Long-Term Capital. That sounds like a large number. We have to put it into perspective. That represents approximately 3 to 5 percent of their capital. So if they were extending credit or they were looking at the extension of counterparty risk associated with Long-Term Capital, and they were taking on risk, there is no doubt. But it is a risky business. They take on risk to gain some type of reward. In this case, the risk they were taking on amounted to 3 to 5 percent of their capital base.

    Mrs. ROUKEMA. So you think the system is fine just the way it is?
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    Mr. LINDSEY. I think the system in this case worked fairly well.

    Mrs. ROUKEMA. I think you are the only one that has agreed to that today, but I will look over the testimony. Thank you very much, Mr. Chairman.

    Chairman LEACH. Thank you.

    Mr. Hinchey.

    Mr. HINCHEY. Thank you very much, Mr. Chairman.

    It seems to me that in each of your testimony, you said in different ways that leaving this activity alone, this industry alone, letting it have its complete head without any supervision of any kind would be not a wise thing to do, that it needs some oversight by some others in responsible positions who are detached and able to do that kind of thing.

    Does anyone disagree with that? Am I misinterpreting anyone?

    Mr. Lindsey.

    Mr. LINDSEY. I think it is more accurate, at least from our perspective, that we think that it is the more appropriate way to look at the counterparty extensions, to look either at the banks or the broker-dealers and the credit that they are extending.
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    What is important to remember about the hedge fund business is that roughly 71 percent of hedge funds are offshore entities. So it becomes a little more difficult, I think, to apply direct regulation to entities that are not domiciled in the United States.

    Mr. HINCHEY. Well, that is true, but they are doing business in the United States; and they are doing business in the United States with United States' entities and supervised entities of the United States Government, including the American banking system. So to say that offshore activities cannot be regulated is really not accurate, because if you are not regulating it directly, you can regulate it indirectly by regulating the people with whom they are playing.

    Mr. LINDSEY. And that is exactly what I said.

    Mr. HINCHEY. OK.

    Ms. WILLIAMS. Congressman, I think what I would say is in the activities that the hedge funds conduct, there is a role for regulators, and you can see various of us here have different roles. I think that the request that Secretary Rubin has made to look specifically at hedge fund activities and explore what happened here, how this and other hedge funds operate, is a very appropriate predicate to making further decisions about extension of the regulatory role, but it is a very legitimate question to be asking now.

    Mr. HINCHEY. So you would say that it may not be such a wise idea to place in statute a provision which prevents any kind of regulation from taking place over the course of the next six months or so.
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    Ms. WILLIAMS. No, I wasn't saying that. And I think that that particular issue is particularly tricky in this context for reasons that have already been raised by Mr. LaFalce. Sometimes signals sent by a particular regulator can unsettle an already unsettled market, and it might not be a wise thing to do in current circumstances.

    Mr. HINCHEY. Well, this is a market that is very unsettled and it is hard to imagine it being any more unsettled, frankly, than it already is. I think anybody who is aware of what is going on in this market is pretty unsettled by it. So you are suggesting the idea of introducing some kind of regulatory scheme or the prevention of a regulatory scheme in any way legislatively is going to cause the market to be even more nervous than it is, or people more nervous about it?

    Ms. WILLIAMS. I think going back to the way that Mr. LaFalce was posing this, there are certain connotations that are associated with the CFTC asking certain things or making certain proposals, that perhaps if they were made jointly by the members of the President's Working Group, those questions could be asked and movement could proceed that wouldn't have the collateral effect.

    Mr. HINCHEY. Ms. Williams, you have been very good about admonishing the banks to be a little bit more careful with what they are doing and you have gotten praise from Mr. LaFalce, and I would like to echo that. I think that has been a very good thing. But it seems to me it might be time to go beyond just the lecture circuit and to do something a little bit more, because we see that in spite of the fact that banks have been admonished not to engage in lending practices that might be a little bit risky, that hasn't stopped some of them from doing it, nevertheless. What is the next step that we can take?
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    Ms. WILLIAMS. I agree with you that it is time for some next steps, and it is ironic that today new examination procedures go into effect for national banks where we have specifically instructed our examiners to look at loans and credit exposures that have the kind of structural defects that I think were at issue in the bank relationships with LTCM. As bank regulators, we have been trying to be very aggressive and we have new procedures and new steps that we are implementing that are effective for exams that begin today.

    Mr. HINCHEY. Are you at all concerned about the availability of credit for more mundane purposes in the economy, the availability of that credit as a result of it being sort of leached out into these other more risky ventures?

    Ms. WILLIAMS. We are generally very concerned about the availability of credit to all segments of the economy and all——

    Mr. HINCHEY. Are you more concerned about it now because of the activities of these derivatives? They have proliferated wildly in the last several years. Are you more concerned now about the availability of credit as a result of that activity and the general economic climate?

    Ms. WILLIAMS. Congressman, from what I have seen so far, from what I am aware of, I can't pinpoint how these particular activities have restricted credit availability in the markets.

    Mr. HINCHEY. Is the fear of a credit crunch real?
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    Ms. WILLIAMS. It depends in part on the actions that the regulators take or don't take, and we in many cases walk a delicate thin line.

    Mr. HINCHEY. You are doing so now very nicely. Well, I just wanted to say with the moment I have not left, Mr. Chairman, to congratulate Ms. Brooksley Born on the work she has done here to call our attention and the attention of others to this activity and to the value of the suggestions that you have made , which I think are obviously more apparent now than they were back in July and probably will be more apparent in the weeks and months ahead. I think you have done us all a very good service.

    Ms. BORN. Thank you very much.

    Chairman LEACH. Thank you.

    Mr. Baker.

    Mr. BAKER. Thank you, Mr. Chairman.

    Ms. Williams, the unsecured line or loan that you referenced in the package, are we aware of whether or not there was any capital maintenance provisions that were a condition of that loan, any capital maintenance requirements as a condition of that loan extension?

    Ms. WILLIAMS. I don't know the details of that, and I would be happy to respond on that——
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    Mr. BAKER. That is fine. What I am trying to determine is that the activities of Long-Term went very well and profitably for well over 40 months, and investors were extraordinarily happy. And I think that tends to make people look the other way and confirm the belief they can do no wrong. But it ought to be different for the regulator. And I think that this was a $2 lottery ticket that you could win $100 million on, but it had a little provision on it that said you could also lose $100 million, and if you don't have the capital to play with, you ought not buy the ticket. And I think we have an awful lot of ticket buyers who either were not told, did not want to look, or otherwise did not want to know what their true exposure was.

    What is concerning me about all of this is most of the regulators are saying—rephrase—all the regulators are saying ''we didn't know, nor did we have the ability to know in advance, that this credit exposure was out there.''

    I am not for regulating hedge funds in the sense of saying all hedge funds are bad or requiring more forms, but I do believe disclosure, if not to the regulator at least to the participants, is a minor first step. When someone is going to invest $10 million and be told to go away for three years and don't ask me questions, I don't know where those guys were when most of us were looking for investors, things back home, but we could sure use those guys in Louisiana. Have I got a deal for them.

    But for it to continue for such a length of time is the troubling aspect of it. I recently read an article in Barrons which indicated in the growth of commercial credit by banks—and the year cited in this report is 1997—it seems to indicate that there was about a $365 billion growth in commercial credit among banks in that period of time, $125 billion of which was in securities investments.
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    Now, I know 1997 was a particularly good year for the markets, but is that level of speculation by our banks a sign of financial strength or is this an indication that interest income on loans is flattening out and that people are looking for better ways to make a greater return, risk notwithstanding?

    Ms. WILLIAMS. Congressman, I am not sure what the magazine article referred to when they talked about securities investments, but clearly in the last several years, there has been a lot of liquidity in the markets. Credit has been pretty easy to get and that has led lenders to narrow the spreads that they can get. They are not getting the return for the risk that they are undertaking, and we have seen—and this is something we have spoken out on—slippage in underwriting standards in the sense that loans that three or five years ago would have had guarantees or would have had the capital maintenance covenance that you were asking about before don't have them anymore.

    Mr. BAKER. You as the regulator don't have the ability to intercede and cause a bank to reconsider withdrawal, or otherwise adjust?

    Ms. WILLIAMS. We certainly do have the ability as a regulator to, first of all, speak out on the issues, urge banks to do self-correction, go in as part of our examination process and point out the types of loans that raise those particular problems, reevaluate how we are classifying those loans and, if necessary, take more supervisory action.

    Mr. BAKER. There was nothing in the cards that you were reviewing up until a few days before this difficult matter that would have indicated that more involvement by the regulator would be appropriate in light of these market conditions?
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    Ms. WILLIAMS. Again, it is important to separate or distinguish the different types of activities that were going on with LTCM. The trading activities, as Rich has described, basically were collateralized. The syndicated loan was not. The exposure of national banks that were participants in that syndicated loan, for the four or five banks that were involved, was actually relatively small.

    Mr. BAKER. Thank you. My time has expired, but I am going to pursue another line of questioning with Mr. Lindsey, if I may for just a moment. You indicated earlier you felt that had market forces led the capital line on down, that the multiple trading issues of market players would have been adversely impacted $3–, $4–, $5–billion, in that scope; am I correct?

    Mr. LINDSEY. That level matches what was testified to in the first panel—on the order of $3– to $5–billion for the market group.

    Mr. BAKER. The interesting thing is you then had, ''a voluntary settlement'' that allowed Salomon Smith Barney, Credit Suisse, Morgan Stanley, Dean Witter, and Lehman Brothers to a lesser extent, only $100 million—if that was the scope of their net loss, why would this voluntary agreement, calling each of them to put up $300 million, make sense in light of that observation?

    Mr. LINDSEY. Because I am sure they don't intend to lose that $300 million that they put in, so in part what they are hoping to do is unwind things in an orderly way to get back the return of the $300 million they just put in, without incurring the $300 million loss each.
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    Mr. BAKER. You may not know this, but I will ask because I asked the earlier panel: Is it your judgment or knowledge or opinion that the individuals utilizing the $300 million of corporate money to facilitate the workout plan may have had personal investment strategies at risk that would be benefited by the bailout?

    Mr. LINDSEY. Well, I have read press reports, just like everybody else has, associated with it. That is all.

    Mr. BAKER. And your conclusions are?

    Mr. LINDSEY. I think—my conclusions would be that those were relatively small amounts of money, given the overall situation for the firm, and that they were probably working in the interest of their shareholders.

    Mr. BAKER. I am not looking for penalty boxes. All I am suggesting is that when someone has engaged in this activity to this extent, with extraordinarily high leveraging rates, with very little capital at risk, I think the Fed took the appropriate action in sidestepping a systemic problem, but it sure goes down badly when you see the people who caused it in the first place still benefiting from the end game that apparently is going to be pursued.

    One more, Mr. Chairman.

    Ms. Born, how much of LTCM's $1.25 trillion of derivatives exposures was in the exchange-traded market; do you know?
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    Ms. BORN. I think approximately $70 billion in notional value was in U.S. exchange-traded instruments. There was additional exchange-traded instruments held on markets abroad.

    Mr. BAKER. To the extent—in looking backward now, was there a cooperative manner of information flow between you and the foreign exchanges as to the LTCM's circumstance?

    Ms. BORN. As soon as I found out about this, I called the foreign regulators upon whose exchanges there were large positions. Some of them were not aware of those large positions.

    Mr. BAKER. Approximately when was this knowledge made available to you?

    Ms. BORN. I learned about this Wednesday morning and I called foreign regulators Wednesday morning of last week. Some of the foreign countries do not have our kind of large trader position reporting, where the CFTC gets daily the positions of any large traders on the futures exchanges, and therefore they were unaware of very, very large positions on their markets.

    Mr. BAKER. I don't intend this to sound as critical as I am sure it will be anyway, but what is running throughout everyone's sort of public awareness statement is we had a letter written by the management of Long-Term to the investors on September 2, saying ''We have a problem.'' There was general knowledge on the street there was a problem, but official regulatory constructive notice didn't occur until some weeks later. And I think that is what is troubling many of us who don't understand all the magic that is going on here, and a lot of people have made money and apparently a lot of people are going to lose money.
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    We are concerned about the unintended harm that could have occurred to innocent third parties and how our regulatory system could not have caught some of this somewhere weeks earlier when the street had common knowledge that there was a problem of considerable significance. In fact, some of the smart folks tell me that when the Russian devaluation occurred, that was when some of them began running, and yet we were the last ones who were the responsible parties in all of this, we were the last ones to be told. That is the problem. Thank you.

    Ms. BORN. I agree.

    Chairman LEACH. Well, I thank you, Mr. Baker. Let me just end with a couple of questions. Mr. Baker raises a point, but I think it has been pretty well established today that the bank regulators were not as on top of this as they might have been with extensions of bank credit. But the CFTC was the principal regulator of the fund itself, not the banks. The banks regulate the lenders to the fund. I have up here Long-Term Capital's financial statement, dated year end, December 31, 1997, that the CFTC would have had. That indicates December 31, 1997, so this goes back, they had liabilities of $124 billion and capital of $4.6 billion, which is about 26–to–1 leveraging.

    Did the CFTC examine the books of Long-Term Capital at that time? Did you look at it? Did that raise any alarm bells at the CFTC at all?

    Ms. BORN. No, we didn't, and that did not raise any alarm bells with us. Our oversight of commodity pools is not as prudential regulators. The only reason we regulate commodity pools is because of their trading on the regulated futures exchanges. There is no governmental prudential regulation of them because they are purely speculative investment vehicles in a market where many people lose all their money. And we also do not try to protect by Government insurance, or any other protection, the people that invest in those commodity pools to speculate on our futures exchanges.
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    The Commission's oversight of CPOs has two components—a statutory thrust and a regulatory thrust. One is to have them disclose to their investors the risks inherent in trading on the futures exchanges. A hedge fund the size of LTCM is exempted from this disclosure requirement because each and every one of their participants had at least $2 million invested. The Commission does not require the standard risk disclosure statement on the grounds that these are financially sophisticated individuals who can find out from the fund what they need to find out.

    Our second purpose is to keep our exchanges and their clearinghouses safe financially, and the way we do that is to get a large trader report from each of our CPOs who have big positions in our markets on a daily basis as to what the positions are. They have to put up margin with us and they put up with the exchanges and they were marked to market daily and have to pay variation margin.

    We also knew, as did the exchanges, that LTCM was backed by two of the biggest and best capitalized clearing futures commission merchants in the country who stood behind them in the clearing house, as all the clearing house members did, to guarantee that they wouldn't miss a margin call. These were very highly capitalized FCMs and therefore there were no concerns on either of our regulatory fronts.

    Chairman LEACH. I appreciate that. I don't want to go on to this.

    Ms. BORN. And those financial statements which we received in March, which were the annual financial statements for the end of the year 1997, did not have any information on what the positions were, because that didn't have to be reported. Positions in the over-the-counter derivatives markets are off balance sheet and those were not—the size, nature, and exposures in those positions—reported. We looked at that, and my recollection is there was more than $4 billion worth of capital in the entity at that time. I think it was $4.8 billion, but my recollection may be wrong.
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    Chairman LEACH. $4.647 billion.

    Ms. BORN. Thank you.

    Chairman LEACH. Or $667 billion. You may be correct in precision, but there is a great deal of summary of positions, security swaps, options, and so forth, in terms of dollars.

    Ms. BORN. Those are not the positions. Those are the net—those are the asset values and the liability value of those positions, but not the exposures.

    The other thing that we knew was that they had had a return on capital that year of, I think, 17 percent, and the previous year of 40 percent, and the previous year before that of 46 percent.

    Chairman LEACH. Let me raise one other issue for Ms. Williams and perhaps for you, too, Ms. Born, and that is, there is a sense in the market that this was a particularly brilliant fund of a nature that was above and beyond. As the reviews have started to come in, there is an increasing sense that actually it was a fairly standard set of positions that were taken by the fund, which implies that many others were doing similar things in the kind of follow-the-leader market.

    And so the question that becomes very natural is that if this fund is not exceptional in the positions it took and has taken great losses, then are there not many other funds that are rather comparable of circumstance, and therefore do we have a systemic problem in the hedge fund industry today that might be considered of concerning proportions?
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    First, Ms. Williams, do you have any sense for that?

    Ms. WILLIAMS. My knowledge of exactly how the fund operates is really based more on what is now public information, but my understanding is that they may have had some modeling approaches that were unique or out in front at one point in time. But others somewhat caught up with them, and that may have been one of the reasons that contributed to their need to leverage more, since the advantages that were to be gotten from the types of structures and deals that they were putting together, the returns, were getting very slim, so you needed——

    Chairman LEACH. But from a bank regulatory perspective you are not seeing any particular problems?

    Ms. WILLIAMS. We haven't seen anything like this. And I guess if I could, respectfully, from the perspective of the OCC, disagree with your earlier statement about the bank regulators not being adequately on top of this for the national bank exposure here, whether it is the syndicated credit or the capital markets activities, the national bank exposures were relatively small.

    Chairman LEACH. Small, but you had used the word ''aggressive'' in your statement.

    Ms. WILLIAMS. Yes.

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    Chairman LEACH. Ms. Born, do you have any sense on how systemic this problem is, as the principal regulator in this area?

    Ms. BORN. We are trying to ascertain that. There are 1,136 commodity pools that fall under our regulations for pools catering to very, very wealthy, sophisticated people. It is $2 million of assets under investment per person.

    We are doing special calls to the largest of those. We have tried to identify any that may be in trouble. We are doing special limited audits of at least a couple at the moment. One of the things that our OTC derivatives Concept Release asked about was whether it was necessary to get this kind of information about large OTC derivatives exposure, and we are of course continuing with that study. I think, however, as an immediate matter we are using what regulatory tools we have, which are rather limited, to find out as much as we can.

    Chairman LEACH. Thank you.

    Mr. LaFalce.

    Mr. LAFALCE. I just want to follow up on a few things.

    Ms. Born, you mentioned a $2 million exemption. Number one, is that a regulatory exemption or is it a statutory exemption? If it is a statutory exemption, should we change it? If it is a regulatory exemption, should you change it? Would you clarify exactly what is exempt?

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    Ms. BORN. Well, commodity pool operators are under somewhat lowered level of regulation by us if they are overseeing a pool where only large institutions or individuals with more than $2 million invested in securities investments are participants. LTCM fell under that rule.

    Mr. LAFALCE. Is that a regulation?

    Ms. BORN. It is a regulation.

    Mr. LAFALCE. Not statutory.

    Ms. BORN. That is right.

    Mr. LAFALCE. Is there any merit in——

    Ms. BORN. We are investigating, or I have asked my staff to look in depth at all our CPO regulations to see if improvements are needed in light of this development.

    Mr. LAFALCE. OK, let me pursue that, because it is not so much the dollar amount, but here is my concern. You have 1,136. I doubt that you would have more sophisticated management in any of them than a former Harvard professor, vice chairman of the Federal Reserve Board, and two Nobel laureate economists in risk management. I doubt that you would have more sophisticated investors than Barclays, Chase, Deutsche Bank, UBS, Salomon Smith Barney, J.P. Morgan, Goldman Sachs, Merrill Lynch, Credit Suisse, Morgan Stanley, and so forth. So we have the best management, it would seem, and the most sophisticated investors, and all of a sudden we have got a problem.
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    I am wondering what problems we have for the 1,136, and it is not so much the investors, it is the people who might experience that credit crunch. It is not the people on Wall Street, it is the people on Main Street; and apparently the reason for the Fed intervention had little or nothing to do with Wall Street, but everything in the world to do with Main Street, which I think was one of the points you were making about six months ago.

    Ms. BORN. Right. Well, that is exactly what our Concept Release is looking at and asking questions about, not only for hedge funds but any big speculator in the OTC derivatives market.

    Our problem with respect to oversight of CPOs is that our duty there is not to make sure they don't go broke and lose all the investors' money and all the lenders' money. We don't do prudential regulation. That would be, I think, highly inappropriate in an investment vehicle that is set up to essentially speculate on futures transactions.

    What we do is require, and this is indicated by the statute, protect the investors by letting them know how risky futures transactions are, how it is a zero sum game and they could lose all their money; and, second, to make sure that the clearing houses of our futures exchanges are adequately protected from large speculators like a hedge fund, and that we are doing.

    We are not set up to do prudential regulation. We have never done prudential regulation of CPOs. We do prudential regulation of futures commission merchants, similar to what the SEC does with respect to broker-dealers in the securities area.
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    Chairman LEACH. Well, thank you all. I want to move on to the next panel, but I would like one clarification.

    Were any of the equity investors or lenders to the fund, pension funds or endowment funds or mutual funds?

    Ms. BORN. We don't have that data yet. There are pension funds which are big users of these hedge funds, as are other vehicles where everyday Americans have money invested.

    Chairman LEACH. Fair enough.

    Ms. BORN. It is not just wealthy investors who participate in these investment vehicles. Mutual funds and pension funds also may invest in these lightly regulated, what we call Section 4.7 CPOs.

    Chairman LEACH. Let me just conclude, then, by saying one personal prejudice and that is, this committee has to be very cautious about being sure that we have fair and equitable treatment of foreign financial institutions in the United States of America. But I believe all regulators' eyes should widen with any institution that is chartered in the Cayman Islands or in any place in which the clear intent is not to come under the rubric of United States law in the fullest possible way.

    And as an automaticity of regulators, I believe that this Congress has an obligation to state its strong preference for American law in all conceivable appropriate ways. And this is an institution that is designed to operate in the United States, and it should come under United States laws whether it be chartered in the State of New York, Iowa, or Delaware.
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    Mr. LAFALCE. If the Chairman would permit me, in a very nonpartisan way I would like to associate myself most fully with those most recent remarks.

    Ms. BORN. Mr. Chairman, may I——

    Chairman LEACH. I would rather get on, but you may. Please.

    Ms. BORN. May I just ask permission to provide you with information about the nationality of this institution? I know that they have two Cayman Islands affiliates. I was not aware that the major LTCM is a Cayman Islands corporation. In fact, I thought it was a limited partnership established in the United States. I may well be wrong, but——

    Chairman LEACH. Well this annual report describes it as a Cayman Islands exempted limited partnership. It is on the cover that——

    Ms. BORN. That may not be the registrant with us.

    Chairman LEACH. And I wouldn't have expected you to know that offhand, and there is nothing critical in this at all. I am just expressing a sense.

    Anyway, thank you all, and we appreciate your discussion.

    Our final panel is composed of Mr. David S. Ruder, who is Professor of Law at Nortwestern University School of Law, and is former Chairman of the Securities and Exchange Commission and father of my godson; Ms. Muriel Siebert, who is President and CEO of Siebert Financial Corporation; Mr. Henry Hu, who is Professor of Law, University of Texas; Mr. Brad Ziff, who is a principal of Arthur Andersen & Company; Mr. Stephen Axilrod, who is a global economic consultant; Mr. Stephen Lonsdorf, who is President of Van Hedge Fund Advisors International; and Mr. Charles J. Gradante, who is managing principal of the Hennessee Group LLC. And we will begin with Professor Ruder.
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    Mr. RUDER. Thank you, Mr. Chairman. I am pleased to have this opportunity to express my views regarding the public policy issues raised by the collapse and interim rescue of Long-Term Capital Management LP. I will omit some of my written statement, but I would like to comment about the situation from my position as the former Chairman of the SEC during the October 1987 market crash.

    Chairman LEACH. And if I could interrupt for one second, with unanimous consent all the statements will be placed fully in the record, and people are free to summarize or to read their statements as they see fit.

    Mr. RUDER. And I am also a trustee of the Financial Accounting Foundation, which oversees the work of the Financial Accounting Standards Board.

    In addition to creating losses for investors and owners, the Fund's problems created potential problems for financial markets. Some lenders faced the possible loss of amounts loaned to the Fund. A fire sale of the Fund's position potentially would have created problems for others holding arbitrage positions, since the price of those positions would have changed unexpectedly due to the Fund's distressed selling. Additionally, if the Fund defaulted on positions, the effect on other trading entities and intermediaries might have been negative, causing a string of related defaults with unknown potential consequences.

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    There is little to be said for mounting a rescue operation merely to prevent the investors in a hedge fund from losing money. The problems which cause concern stem from possible effects on the financial market and its participants.

    The first danger stems from the fact that insufficient information exists. When large amounts of capital are used to place bets on the direction of interest rates, stock prices, currency values, Government bonds and the values of various financial instruments, a great deal of information is unknown. Who are the counter-parties? What financial risks are being taken by these counter-parties? What is the likelihood that they will be unable to meet their obligations?

    Counter-party risk is an aspect of credit risk, but the extent of this counter-party risk in the hedge fund and derivative instrument market is largely unknown because no system exists requiring disclosure of such risk. The risk to the financial markets is that the failure of one large participant may cause failures in other parts of the market. The extent of this risk is unknown.

    A second danger is related to the first. If the amount or nature of risk is unknown, the danger exists that in times of stress other participants in the market will assume the worst, and because of lack of information will take steps that will increase market volatility. They may unnecessarily exit markets because of their uncertainty.

    In October 1987 the Dow Jones Industrial average dropped approximately 22 percent. On that day and during the rest of the week, the SEC and other financial regulators dealt with problems that are not dissimilar to those I have described. The size of the market drop on October 19 caused panic and great uncertainty. On Tuesday, October 20, 1987, at approximately noon, trading on the New York Stock Exchange was almost halted due to lack of demand for stock and lack of information regarding stock prices.
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    Rumors spread that several brokerage firms were about to fail. Indeed some brokerage firms were in difficult financial positions due to commitments made before October 19. Concern existed in other countries that if a U.S. brokerage firm failed, its foreign subsidiaries would collapse.

    The SEC's reaction to the rumors was to call each of the major brokerage firms to ask about their financial positions. However, we did not have the power to require the brokerage subsidiary of a financial conglomerate to tell us about the risk positions of its parent. We could not tell whether a holding company's risks were so great that it might seek to invade the capital of its subsidiary. As a result, we were not able to say with certainty that rumors were untrue, nor were we in a position to take regulatory steps, either alone or with other regulators, based upon adequate knowledge.

    During the period after the 1987 events, the SEC was successful in securing passage of legislation giving the SEC the power to obtain from brokerage subsidiaries information about the risk positions of their parents. I believe this legislation was extremely important in positioning the SEC to become informed about risks and take necessary action.

    At times during the past few years, both the SEC and the Federal Reserve Board have indicated that they do not believe additional legislation relating to the over-the-counter derivative markets is needed, and that they do not believe regulation of the activities of private hedge funds and private derivative dealers is desirable.

    I agree that efforts to control the activities of private derivative or hedge fund firms is not desirable, with one exception. Our free markets should be allowed to operate without interference, but in times of great stress and panic, regulatory solutions should be available. The SEC, alone or with the President, has powers to act in emergency situations with regard to the securities markets. Similar powers may exist in the areas of the financial markets through the various direct or indirect authority available to the Federal Reserve Board, the Comptroller of the Currency, the Treasury Department, and the Commodity Futures Trading Commission. I believe the extent of available emergency powers should be examined carefully, and if needed, additional emergency power should be provided by legislation.
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    I also believe that, either through legislation or the use of available powers, efforts should be made to determine the risk positions being taken by the various participants in hedging and derivative trading activities. At all times, and particularly in times of stress and possible panic of the type that seemed to emanate from the Long-Term Capital Management crisis, regulators should be in a position to determine the magnitude of possible risk problems. Our capital markets should not be held hostage to the activities of a group of risk-takers who can operate in secrecy without regard to possible systemic affects.

    It may be that banking authorities, the SEC and the CFTC together can require those whom they regulate to obtain risk information from their debtors and contracting parties. If so, an orderly process for accumulation of this information and transmission to regulatory authorities should be developed. If not, legislation is needed.

    The necessary information need not become public. That information should be placed in the hands of responsible regulators who will preserve its confidentiality. Ample precedent exists for such information requirements in other areas of our markets. Banks are required to reveal their capital positions to bank regulators. Brokerage firms must reveal their risk positions to the SEC and overseeing self-regulatory bodies. Commodity firms' risk positions are well known to the various commodities exchanges.

    I cannot close this testimony without commenting on the furor which recently surrounded an FASB accounting standard designed to cause public companies to reveal, quantify and treat as income statement charges, their unhedged risk positions. In my opinion, the FASB correctly believed that it is in the public interest for investors in public corporations to know the extent of unhedged risk. The wisdom of requiring disclosure of risk positions in public companies for the benefit of investors seems obvious to me. Likewise, the wisdom of requiring disclosure of risk positions by large private firms to regulators in order to permit those regulators to anticipate and respond to market disruptions seems equally obvious.
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    Thank you.

    Chairman LEACH. Thank you.

    Ms. Siebert.


    Ms. SIEBERT. Mr. Chairman, I have shortened my formal statement.

    Chairman LEACH. Excuse me, if I could interrupt. Place the microphone as close as you can.

    Ms. SIEBERT. Thank you. Thank you for the opportunity of addressing your committee. I have shortened my formal statement.

    The near demise of Long-Term Capital Management made me focus on the holes that have developed in our regulatory system. Simply stated, regulation has not kept up with the advancements in technology. It took an unprecedented rescue package to head off a meltdown in the global financial system which would have caused catastrophic damage to both financial institutions, institutional and individual investors.

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    Computers have revolutionized the securities industry, changing the way institutions and individuals invest, enabling the creation of instant electronic order entry systems, equal information flow, and new, innovative financial investment products. In fact, in many instances computers have replaced humans in making investment decisions. Thanks to instant global communications, securities and other financial products trade 24 hours a day.

    Computer experts, referred to as ''quants'' or ''rocket scientists,'' occupy vital new positions in all facets of Wall Street and other segments of the investment community. They are armed with Ph.D.s, engineering degrees, and have been given unlimited budgets and wide latitude to employ their talents.

    Products and systems have changed the way the business is done. For example, mutual fund supermarkets for the small investor have enabled the small investor to buy and sell mutual funds with ease, providing them with the opportunity to own a piece of America. New technology has enabled financial transactions to be conducted anywhere in the world.

    Hedge funds, a generic term, have grown dramatically both in size and scope of activity. They are for the most part totally unregulated. They are private pools of money, usually structured as a limited partnership. Investors in most cases must have a minimum net worth of $1 million. Many of them are domiciled abroad to avoid regulation and margin requirements. Many are extremely leveraged, operating in markets that have no margin requirements, and use investment vehicles so the amount they can invest is determined by how much they can borrow. Depending on the manager, who is usually the general partner, they may or may not disclose their holdings to their investors.

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    One of the new family of products developed in the last decade has been derivatives. Some of them are plain vanilla puts and calls on individual securities. Others are quite exotic. Features which differentiate those that trade on listed markets versus those that trade over the counter are shown on Exhibit No. 1. Some of the largest participants in the explosive growth of derivatives are insured commercial banks.

    The Office of the Comptroller of the Currency issues a report every quarter detailing the derivative activities of U.S. commercial banks. The latest report shows the notional value of derivative products in insured commercial banks equaled $28.2 trillion. Eight commercial banks account for 95 percent of this total. Over-the-counter derivatives, which are less liquid than exchange-traded derivatives and have no lender of last resort, comprise 85 percent of the total. Foreign exchange contracts equal about one-fourth, equaling $7.4 trillion.

    The banks with the 25 largest portfolios hold about 4 percent of the contracts for their own risk management portfolios, with 96 percent being held for customers. We do not know how many of these derivatives shown in the report are owned by hedge funds. We also do not know how many derivatives owned by hedge funds are held in Wall Street firms.

    It is imperative that the derivative positions and the quality of the counter partner be reported to regulators since the extreme inherent leverage can create untold losses. Foreign exchange trading is a form of derivatives. The growth has been phenomenal. As the market has developed, it is now a profit center for major institutions, including banks and hedge funds. Initially, currency trading was a means of facilitating trade. Today the emphasis has shifted and it has become a profit center.

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    Every day there are more foreign exchange trades than the central banks have reserves, or the total global banking system has capital. Vast amounts of money are exchanged with a touch of a computer key. Hedge funds particularly have become major players in the growing and often brutal business of currency speculation. Many are domiciled abroad and are exempt from margin requirements. It will probably take a crisis similar to the one we have just had to implement the changes that are necessary. In my opinion, when the current crisis subsides, it will be largely recognized that we need margin requirements on trades that are not done for trade, hedging or international investment.

    During the past year, starting in July 1997, with the devaluation of the Thai baht, we have seen one Asian nation after another devalue their currency. Yes, there were economic flaws and weaknesses in these countries, but their problems were exacerbated by the relentless short selling of their currencies by speculators. The Hong Kong dollar, for example, is the only Asian currency still pegged to our dollar, 7.75–to–$1.00. Hong Kong has vast reserves, about $90 billion. It is experiencing severe economic problems due in large measure to the problems in the area of Japan, Korea, Indonesia, and so forth. Hong Kong for the last several months has been citing the increasing amount of speculation by hedge funds against their currency and stock markets.

    Time Magazine recently stated, ''a multi-billion dollar game of chicken was being played out.'' Currency speculators, ''the kind of financial gamblers whose cold-bloodedness could freeze mercury at ten paces, made a run at the Hong Kong dollar, essentially trying to force its value versus the U.S. dollar lower by manipulating the supply.'' Hong Kong reacted by purchasing somewhere in the area of $10– to $15–billion of securities to force the shorts to cover. They then passed regulations similar to ours, including against short selling of securities on downticks. This seems to have stabilized the markets. I personally would have preferred that they would have passed the regulations first to see if that curtailed the vicious attack on their markets and currency before they went in to support their markets.
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    The currency speculators are now attacking Brazil's currency. It is reported that the U.S., the IMF and private corporations will put together a $30 billion help package for Brazil, which will be finalized after the Brazilian elections. If this occurs, IMF money will be spent once again to reverse the damage, some of it caused by speculators. These currency speculators, (many are believed to be hedge funds), literally go from country to country profiting as the currency drops. Part of that drop is due to the extra selling pressure caused by these traders.

    There are no margin requirements on currency transactions. It is between you and your bank or your lender. It is likely a margin requirement as low as perhaps 3 percent would curtail a substantial portion of the transactions done for speculation.

    The 1987 market crash was precipitated in part by portfolio insurance which used derivatives, puts and calls on options and futures, as their cornerstone. After the damage was done, we acted. New regulations, tight margin standards were imposed, and regulations were passed creating collars and halts in trading. The bankruptcy of Orange County in 1994 was caused by derivatives also. Long-Term Credit Management was able to leverage $4 billion to $1.25 trillion using margin and derivatives. Due to the imaginative rescue of LTCM, the markets did not implode and the damage will be contained.

    The U.S. cannot curtail or cure the problems unilaterally since markets are truly global. The business will simply be done abroad.

    I propose two courses of action. Number one: all regulators immediately receive monthly disclosure by our banks, brokers or other lending institutions of loans made to hedge funds, including derivatives. This will require no new regulations or laws. Number two: the U.S. should take the lead in establishing global margin and other regulations for securities and derivatives with a goal of creating international regulatory standards. Then we would have global margin and other securities regulation. In my opinion, this timing is right. A press release from the IMF dated Tuesday, September 29, two days ago, states the new incoming German chancellor wants to curb speculation in financial markets. Part of his statements are included in Exhibit 2.
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    In summary, unregulated hedge funds using legal loopholes borrow vast amounts of money which they use to speculate in highly leveraged transactions. My concern is not the partners nor the investors in LTCM. My concern is for the individual investors who would have suffered if the market had imploded. Their dreams of funds for retirement or education of their children would have vanished. There could have been a run on mutual funds borne out of fear.

    Wall Street and its ability to raise capital is a national treasure. It has enabled our country to obtain and keep its leadership position. It is the envy of every nation. Rumors abound about trouble in other hedge funds. Greed had to play an important role in some of these derivative trades and some of this speculation. We cannot allow a small group to damage our system. There are things that really must be done immediately.

    Thank you.

    Chairman LEACH. Thank you, Ms. Siebert.

    Professor Hu.


    Mr. Hu. Mr. Chairman, this morning's Wall Street Journal had a long article on a popular computer game called ''Deer Hunter.'' It reminded me of an old story.

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    Three econometricians were hungry and went out hunting and came across a large deer. The first econometrician fired but missed, by one meter to the left. The second econometrician fired, but also missed, by a meter to the right. The third econometrician didn't fire, but shouted in triumph, ''We got it! We got it!''

    It is surprisingly difficult to come up with a good model, one good enough that would put food on the dinner table. The near-collapse of Long-Term Capital Management tends to show this. And here those involved not only missed the deer, but with the wonders of an astounding degree of leverage, those tiny one-meter deviations deep in the dark, nontransparent, opaque, unregulated woods of the international capital markets were magnified to multi-billion dollar deviations that have reached this congressional hearing room.

    As the photocopies of my written testimony suggest, I think there are two immediate questions. First, how could someone like Long-Term Capital Management have almost collapsed? Second, should the Federal Reserve have cared enough to send in the very best?

    Now, it is only five or six days since this has happened, so my conclusions are highly preliminary at this point. But what generalizable things can be said?

    First, this near collapse/bailout constitutes a financial development that I think is even more important than the current page one stories suggest.

    Second, some factors that apparently played key roles in this near-collapse seem to flow from certain structural features of modern financial technology.

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    Third, absent truly exceptional circumstances, there is no reason for Government intervention, direct or indirect, to bail out hedge funds. Either the Federal Reserve made a mistake in intervening or it did not. But unfortunately, these are the only two possibilities, and both of the possibilities are deeply troubling.

    Let me talk about these three things. First, significance. Long-Term Capital Management's near-collapse is much more significant than some of the other stories which have come to be hallmarks of the modern financial world. Here you are not talking about a situation where some overenthusiastic derivatives salesman deviated from the stated institutional practices of the derivatives house. Here you are not talking about some rogue trader evading the trading limits established by his institution. Here you don't have some Government bureaucrat perhaps spending too much time trying to play Wall Street trader.

    No. Here you have a situation where the best and the brightest sought to make money for their investors as they had been expected to do, relying on sophisticated models consistent with the institution's rules.

    So this is unlike some of the other major disasters associated with various exotic products. This disaster goes to the heart of the enterprise. It brings into question how much faith, for instance, we should have in some of these models. It also is very informative in terms of how surprisingly large some of the associated externalities can really be.

    This leads to my second point, the structural features. One reason why the Long-Term Capital's near-collapse is so fascinating is the seeming puzzle of how such smart people could be involved in such a disaster. In 1993, in something I wrote for the Yale Law Journal, I suggested that there might be certain structural features that undermine the decision of even the best and brightest financial institutions with respect to derivatives and other esoteric financial products.
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    One example of the factors that I focused on was the matter of cognitive bias. I argued that certain cognitive biases may result in financial model builders insufficiently taking into account events that are low in probability, but catastrophic if they happen to pass. While available evidence is quite limited, existing press reports do suggest that it may be worth determining if Long-Term Capital did pay sufficient attention to a low probability, but absolutely devastating financial world that is so stressed that the normal historical correlations they rely on fall apart. It is worth looking at these cognitive bias, financial science- and modelling-related, principal agent and other structural issues. Clearly, transparency relates to all of this.

    Third, the Fed either did or did not make a mistake. Either possibility is terribly disturbing. The arguments against Fed intervention are quite strong.

    With a hedge fund, we have no investors who are widows or orphans. There is the ''too-big-to-fail'' moral hazard. There is the real or apparent irony of the U.S. lecturing to Asian and other countries about the need for market discipline—and now being lectured to, justified or not. But the Fed did intervene, notwithstanding the force of the foregoing arguments against intervention as well as the obvious political costs of seemingly protecting the rich and the well connected.

    I have got to believe that the Fed did so because a truly exceptional situation was present: there was a serious danger to the world financial system if this hedge fund had failed. But this is equally troubling. If the Fed was in fact correct, as I currently presume is the case—the Fed, after all has a lot more information than we do on the systemic risk aspects of a collapse of Long-Term Capital—what does this say about the fragility of the world financial system?
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    In other words, if the collapse of just one hedge fund would have materially undermined, or had an unacceptable risk of undermining the world financial system, just how robust is that system?

    In addition, there are other hedge funds. Commercial and investment banks engage in proprietary trading, sometimes using the same general techniques. There are lots of institutional investors other than commercial and investment banks and hedge funds that use similar techniques. This Fed brokering ''worked'' as to LTCM. I use ''worked'' in quotation marks. But how many times can the Fed successfully lock the heads of major financial institutions in a hotel room?

    Conclusion. The new financial world is a complex place. The Long-Term Capital near-collapse involves many of the factors that make it so complex—exotic financial products, issues of transparency as to products and institutions, multiple national jurisdictions, and the optimal, as well as the feasible, limits of regulatory reach.

    Chairman Leach and the House Banking Committee are to be congratulated for so quickly getting us all together so that we can begin to understand what, if anything at all, we may need to do.

    Thank you.

    Chairman LEACH. Thank you, Professor Hu.

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    Mr. Ziff.


    Mr. ZIFF. Thank you, Mr. Chairman. For background purposes, since 1993 I served as a Director at Arthur Andersen for Global Derivatives and Treasury Management Practice, a practice which includes obviously a number of the world's largest financial institutions, institutional investors and hedge funds. In particular, for the past two years my colleagues at Arthur Andersen and I have worked extensively on behalf of a number of such dealer institutions reviewing and assessing the business strategies, their sales, marketing, credit, legal, operations, collateral management and risk management activities specifically in regard to hedge funds.

    This process has involved developing a deep understanding of the dynamic between the institutional investor community, including hedge funds, and the dealer institutions. We have reviewed how they operate, what investment approaches they tend to follow, their use of leverage, and their general operation and risk management infrastructures. In light of the global market volatility, which dates back to this past summer and indeed even further, we have given special attention to a series of issues that the committee has addressed today, and reviewed in detail these matters with the major dealers on a global basis which has focused not only on developed as well as emerging markets. In particular, over the past few days, we have met with all of the member firms of the management committee for LTCM as well as over the past several weeks with almost all of the members of the oversight board that has earlier been discussed today.

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    Based on our work it is quite clear—and we believe it is important to note at the outset—that the hedge fund community is actually comprised of many different types of investment funds, pursuing widely diverse strategies. They range in size from a few million to several billion dollars in capital. They employ leverage to increase the size of their positions. A significant number of the funds, however, do not. Most adhere to a focused investment strategy, similar to how a large capitalization mutual fund might generally invest in large cap stocks. Others, however, will employ a multi-dimensional approach pursuing several different strategies simultaneously.

    Within this universe of hedge funds, it is also quite clear that Long-Term Capital is by virtually any measure a unique fund in a unique situation. It is a unique fund because of its size and capital position, which with over $4 billion in capital places it among the very largest of the hedge funds. It is also unique because of the sophisticated trading strategies it employed, involving a broad range of asset classes, spanning developed and emerging markets, exposing them to an unprecedented global set of market disruptions that have occurred over the past six months. Finally, it is unique because of a high degree of leverage employed that accompany that particular strategy.

    Over these past six months, as we are all aware, we have witnessed considerable volatility in the financial markets throughout the world. While volatility is not in itself unusual, the reaction of the financial markets was unprecedented. Markets and instruments that historically have reacted in one way did not do so this time. There was an astonishingly high degree of breakdown in historic relationships between the performance of various asset classes and instruments.

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    What has this meant for Long-Term Capital and for the market? Positions that were thought—and historically had been proven to be—partially offsetting were not. Losses mounted, and the firm's equity capital decreased. The firm's creditors increased their demands for additional collateral. To meet those demands, the firm had to liquidate several of its positions into an unfavorable market. The end result is well known. The firm's creditors agreed to recapitalize the firm and work together to reduce their leverage and manage its positions.

    This course of events has raised a number of questions among public policymakers, financial market participants and others regarding the nature of the creditors' management role, the adequacy of their risk management capabilities and the possible systemic implications of a default by Long-Term Capital which I would consider.

    First, while Long-Term Capital is a unique investment fund and while the market disruptions affecting it were also unique, the effort by the firm's creditors——

    Chairman LEACH. If I can interrupt for just a second.

    We are potentially going to have a problem with votes on the floor, and for courtesy to the other speakers, if I can ask you to summarize in a couple of minutes and ask the final three speakers if they can summarize within five minutes, if that is possible. Please go ahead.

    Mr. ZIFF. The effort by the firm's creditors to recapitalize it and manage its exposure was not a novel approach. Financial institutions have always worked closely with their lending and banking consumers in order to insure and safeguard the value of their assets which are potentially exposed to a loss. In Long-Term's situation, the recapitalization effort reflects the belief by the creditors that the firm's assets continue to have value, that an infusion of capital, coupled with their heightened involvement of the firm's management post-recapitalization through the establishment of a management committee and an oversight board will allow them to effectively and prudently realize the value.
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    Did the creditors act under their own self-interest? The answer is obviously yes. However, because of the profile of the firm in question, and the location of the initial creditors' meeting, what otherwise would have been seen as a prudent act of self-interest has taken on far larger implications. I am referring of course to the important questions surrounding the possible systemic risk that a default of Long-Term may have had on the banking system in particular. Secretary Rubin, President McDonough, Chairman Greenspan and others have already addressed this issue far more capably than I, but let me add one point.

    It was the systemic shock waves resulting from global and emerging market disruptions that exposed Long-Term Capital's problems. There have be no systemic shocks in the financial markets stemming from the firm's situations. One of the reasons that the situation is being resolved currently without a significant amount of turbulence is because of what I perceive to be the exemplary risk management policies, practices and systems in place throughout the dealer community, generally and specifically, among Long-Term Capital's creditors, who are among the most sophisticated in the world. These firms have begun earlier this year to specifically review the relationships of hedge funds with a special emphasis on credit-related matters before disturbances of this past several weeks have become known. At the same time they have been actively monitoring their internal processes and guidelines for dealing with such funds with a view toward insuring that they have the best standards in place.

    Specifically, the credit requirements placed upon the institutional community by the dealers has risen as a result of market volatility. Throughout the day we have asked and been asked for some specifics. Some of the results of this process, Mr. Chairman, have included first, a move toward deleveraging of the trades, a voluntary increase in the disclosure of information of hedge funds to the dealers, an increase in the transparency of their portfolios, revision of information on the provision of their leverage, publishing asset figures on the Internet and, finally, a variety of information that would allow you to figure out and have greater information on the liquidation of their portfolio.
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    Let me quickly close by focusing for a second on the proper role and functions of risk management. Despite some common misperceptions, risk management systems are not tools which allow firms to eliminate risk. They are tools to help management better understand the risks that they wish to take. As we know, dealer institutions are in the business of taking risk. It is simply what they do and how they function in the marketplace. In our experience, the firms knew and know what their exposures are to hedge funds in general and to Long-Term in particular. And they were able to calculate the impact of their own exposure resulting from a variety of market scenarios. The likelihood, however, of the confluence of the particular market events of the past few months appeared extremely remote. To have a downturn in so many different markets and by so may different asset classes and instruments at the same time was unique by historical standards.

    Hence, management of the dealers decided based on the evidence at hand that the risk of lending and doing business with Long-Term Capital and other hedge funds was appropriate given the probability of loss.

    In sum, this is one instance where the system, we believe, despite enormous strains caused by highly extraordinary market disruptions, appeared to be working. It presented considerable challenges to the dealer community who thus far have demonstrated their ability to appropriately address the issues at hand.

    Chairman LEACH. Thank you, Mr. Ziff; and welcome back, Mr. Axilrod.

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    Mr. AXILROD. Thank you, Mr. Chairman.

    Chairman LEACH. If I can ask you to pull the mike closer to you.

    Mr. AXILROD. I am pulling the mike and my watch closer.

    Chairman LEACH. Fair enough.


    Mr. AXILROD. First, I really would like to note, in any event—that as a global economic consultant over the past few years, I have worked with a number of international and foreign institutions on central banking and market issues, and also with some private clients here, including hedge funds.

    I will skip the early part of my prepared statement, which tries to explain how I think hedge funds might contribute to market development and do not—one of the questions you raised—as such, add to systemic risk. I do note that there is always the risk that a very large hedge fund, no different from a very large bank or a very large securities firm or a very large individual investor, may make such a large and bad bet relative to the existing size and depth of particular markets that unwinding the position threatens the solvency, not only of itself, but other institutions, the capital of many key institutions, and disrupts markets generally.
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    Now, such a potential for market disruption is by no means unique to hedge funds. I don't mean to be trying to justify the actions of LTCM or other similar funds, but to put them in context. Just to mention some of the more prominent events in the past decade or two, there was the Hunts' effort to corner the silver market, the flight of short-term money away from the Continental Illinois Bank because of a deteriorating loan portfolio, the problems of the S&L industry and the mortgage market, the downfall of Drexel Burnham through junk bond activity, and the Government security scandals involving large, well-known institutions such as Salomon Brothers. Regardless of the source of these problems, the response of the Government and the central bank to these crises appeared to depend, and rightly so in my opinion, on how the failure of a particular institution might affect confidence that the country remained financially stable at its core, and I interpret the core to be either the payments mechanism or the underlying safety of the public savings held in depository institutions and securities firms, the public's basic savings.

    Now, depending on judgments in that respect, sometimes these institutions were permitted to fail, sometimes they were liquidated over time or kept alive and sold through orderly workout procedures involving Government or central bank funds. Sometimes the firm survived reasonably well as the problem was handled rather gingerly by the authorities.

    One may differ with the judgments made, but the judgments have to be made so long as one takes the view, morally hazardous as it might be, that sometimes some institutions are too-big-to-fail, or at least too-big-to-fail without an orderly workout procedure.

    Now, however, if one considers a very large hedge fund in that context, I would think that one would find little or no reason in principle for the Government or the central bank to make an effort to keep it from failing, even by so anodyne a measure as the use of good offices that was apparently employed in the case of LTCM.
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    As a first approximation, a hedge fund is neither involved in the payments mechanisms nor the Nation's basic flow of savings. Its investors and general partners are highly sophisticated, or theoretically so, and very well aware of the risks that they are taking. And it is not likely that a failure will put the payment system at risk or seriously disturb the confidence of our citizens in the safety of the broad spectrum of financial institutions that hold their savings.

    Now, that much being said, I of course have no knowledge of the exact condition of LTCM, and in my prepared remarks I speculated on what must have been going through policymakers' minds. From what I heard earlier in this hearing, I find that my memory of how policymakers think was pretty accurate, and I have no quarrel with the views advanced by Chairman Greenspan and President McDonough.

    Still-in-all, however, and taking their views into account, in return for the good offices that officials appear to have offered, one can argue that there should have been an orderly liquidation of the firm and one that, as in the case of banking and other liquidations involving official actions, a liquidation that left the ownership and management pretty much out in the cold insofar as the opportunity for future gain is concerned. There is indeed a moral hazard to official intervention in helping to resolve private sector problems, and everything possible should be done to reduce the likelihood that the rest of the market will feel more at ease with excessive risk as a result of the official intervention.

    Without official intervention, I should think that the private market could arrive at whatever solution it wished, including the one that they actually did for LTCM, which seems to leave the investors and management with a semblance of hope for the fund's future.
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    I want to be clear, Mr. Chairman, I am not saying that there should have been a fire sale of the firm's assets. I am saying that there should have been an orderly liquidation, but the issue is whether the orderly liquidation should have left the potential for any recovery to the existing owners and management in view of the official intervention.

    Finally, I would like very briefly, if I have time, to address in a general way the regulatory issue. Hedge funds in my view are not really in their nature institutions which require substantial regulatory reach. They cater to very sophisticated investors. They do not operate with Government guarantees, their deposits are not integral to the payment mechanisms like banks, nor are they central market makers in the securities business and custodians of much of the public securities holdings like broker-dealers. And from a business perspective, they have a variety of different approaches, have to shift very quickly between them, and the markets evolve so fast with new instruments that one's head spins, so that most any regulation governing their activity would probably be outdated almost instantly.

    Now, whatever one's view about regulation, it is obvious from past history that regulation as such cannot entirely avert bad business decisions and financial crises. If an institution which is specifically designed for risk, as I interpret hedge funds to be, wishes to take risk at the outer extreme of the curve, that does not strike me as a regulatory issue, but rather as a very serious business issue for lenders to the funds and investors. In that context, of course, any lender should be requiring detailed information from funds on the nature of their positions and borrowings so that it can come to a fully informed decision on whether or not the loan being requested is too risky. If a lender is neither getting nor seeking full enough information, that obviously raises management and supervisory questions.
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    Investors in the funds should also have access to sufficient information about the funds' investment strategies so they can make rational decisions about whether they want to participate. However, the extent to which formalized disclosure requirements available to the public as a whole are needed is quite a knotty issue. Hedge funds are not, for instance, publicly-traded companies; and it is hard to believe that the sophisticated investors in the funds cannot within reason, and within the bounds of avoiding untimely revelation of current market strategies, obtain disclosure in the normal course of such items as net asset values, returns and obviously general business approach and strategy.

    Detailed day-to-day or weekly position data, however, strike me as proprietary business information and if reported anywhere should be reported on a confidential basis to the appropriate governmental body, as is now the case, I believe, with the fund's positions in U.S. Government securities and as I understand it, but have not looked at it personally, large positions in certain commodity markets.

    Thank you, Mr. Chairman.

    Chairman LEACH. Thank you, very much, Mr. Axilrod.

    Mr. Lonsdorf, and we welcome you with your background as a hedge fund expert in particular.

    Mr. LONSDORF. I am going to modify my remarks just to——
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    Chairman LEACH. Let me ask you to put your mike closer.

    Mr. LONSDORF. How is that?

    Chairman LEACH. Good.


    Mr. LONSDORF. I am going to make my remarks brief in light of the time, but I will try to shed a little bit of light on the size and nature of the hedge fund industry so we have a little better backdrop to view the situation.

    The first point is Long-Term Capital in our opinion is not representative of the hedge fund industry as a whole. It is an anomaly within the industry. We are tracking about 2700 hedge funds globally. We make no claim to track them all. We know there are more out there. There are so many new ones being formed all of the time it is hard for anybody to keep track of them, and we estimate that the industry could be growing by as much as 20 percent a year. Just by way of background, this is a large and quickly growing industry.

    Leverage was Long-Term Capital's obvious downfall. We have done some studies which show that 30 percent of all hedge funds don't use any leverage at all, and about 55 percent of all hedge funds that we are tracking indicate to us that they are using leverage which is less than 2–to–1, and only about 15 percent of the hedge funds we are tracking indicate to us that they are using leverage greater than 2–to–10. I just want to point that out to give some perspective on how much leverage the industry is using relative to how much leverage that Long-Term Capital was using, and that is why I say that I believe they were an anomaly in the system.
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    You need both size and leverage to disrupt markets and destabilize the banking sector. Long-Term Capital was large by hedge fund standards to be sure, but small in the context of the total capital in the markets, and we are now seeing small in the context of the banking system.

    Long-Term Capital is having a short-term effect on the markets in our opinion, but poses no long-term threats to markets or banks which had exposure to this particular hedge fund. We do not believe the hedge fund industry is full of these types of problems, and that hedge funds in general do not pose a great threat to banks or markets. Frankly, we think there are far greater forces moving the markets today than hedge funds.

    The second point is that the use of leverage in and of itself is not necessarily a formula for excessive risk. Our research shows that hedge fund arbitrage strategies tend to use the most leverage, usually up to about 10–to–1. Convertible arbitrage, risk arbitrage, credit arbitrage and mortgage-backed securities arbitrage are examples of arbitrage strategies commonly used by hedge funds, and I believe all of those strategies were used by Long-Term Capital.

    But interestingly enough, our research also shows that historically these particular strategies have produced some of the most consistent returns within the hedge fund industry with the lowest level of risk. So on a risk-adjusted basis, these high-leveraged strategies have been among some of the safest historically. Now, that does not mean that they can't blow up, and obviously Long-Term Capital did, but as a general rule I want to make the point that I don't think the whole hedge fund industry is rife with disasters waiting to happen. These are truly anomalies.
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    In fact, many traditional non-leveraged investments like mutual funds have exhibited greater risk of loss than hedge funds. This year we have seen mutual funds that were exposed to Russia, global emerging markets, sector-specific mutual funds, and small cap mutual funds have put in some pretty staggering losses for their investors without using any leverage whatsoever.

    The other point I would like to address is bank lending practices. Banks lend money to hedge funds and are the facilitators of a hedge fund's ability to use leverage. If banks make ill-advised loans to hedge funds and don't require enough collateral to adequately compensate for the risks associated with those loans, then it is the banks that have to bear responsibility for creating an environment in which a Long-Term Capital could arise.

    Based on the Long-Term Capital episode, it is obvious that banks did not do proper due diligence in this particular case and did not understand the total situation with respect to Long-Term Capital's portfolio. Banks should do a better job of policing their own loan policies. This is a private sector matter in our opinion, obviously, except in cases of extreme danger to the system itself, as has been discussed today.

    And the last topic I think that is important to talk about is the issue of transparency because a lack of transparency of hedge fund portfolios makes it very difficult, if not impossible, for banks to evaluate the risks associated with their loans to hedge funds. Banks should require in our opinion full disclosure from hedge funds of their positions and total leverage before making loans. If you lend money in an information vacuum, you are asking for trouble. And in conclusion, I would just state that I think that probably the banking industry should regulate itself starting with the individual banks and reviewing their own internal lending practices. The Government I don't think needs to pass additional legislation concerning hedge funds. The fact is that we have heard today, and I agree with it, it might be very difficult to regulate hedge funds given the fact that so many operate offshore.
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    The banking industry and its regulatory agencies should control these loans, and that probably is the best course of action for trying to avoid these situations in the future, because without access to excessive risk capital, hedge funds will not be able to pose these types of problems to banks or the markets.

    Chairman LEACH. Thank you very much, Mr. Lonsdorf.

    Mr. Gradante.


    Mr. GRADANTE. Mr. Chairman, I appreciate the opportunity, and as a taxpayer sitting here for six hours, I am truly impressed with your sense of urgency and the perceptiveness of the committee. Let me put my testimony in context.

    I come to you with experience in extending credit as a former President of a U.S. national bank from 1990 to 1995, which were very difficult years. I have also policed the activities of proprietary traders at a large investment bank who, as such, manage money in a similar fashion as hedge funds do, and currently I am President and CEO of Hennessee Hedge Fund Advisory Group, which advises investors on hedge fund investments.

    We have submitted to the committee our proprietary trading research, and I would be glad to answer any questions now or in the future regarding any research we have submitted.
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    I think one of the first questions that comes up, and I would like to answer six of them: Is the fundamental concept of hedging valid?

    Mr. Chairman, I am sure that you are aware of this, but the origins of hedging in the United States goes back to the 18th century in the agricultural industry. Farmers were the first hedgers by selling crops or cattle yet to be harvested at a future price for delivery. In doing so, they locked in the price today and were not exposed to future market fluctuations. In essence, they hedged their market exposure for the period of time that it took for them to harvest their product for delivery.

    Hedging, therefore, has been around for a long time, which in and of itself validates its presence in the marketplace, and we believe it will become more and not less important as the markets increase in size and volatility. In fact, I believe that someday it will be considered imprudent for an investor not to hedge some element of market risk just as it is imprudent today for a farmer not to hedge price fluctuations for his products.

    Question two, have hedge funds collectively grown so large and their positions so adventurous that they are adding to the risk rather than mitigating systemic risk? Research we have provided to the committee indicates that the vast majority of hedge fund managers have less than $500 million in assets and 80 percent of the managers have less than $500 million.

    Gross market exposure; that is, long positions plus short positions, for the industry in January 1997, according to our research, was 128 percent and in January 1998, 132 percent. This gross exposure includes so called macro-managers, but does not include their levered bond portfolios nor their derivative exposure. Ninety percent of hedge funds do not use large amounts of margin or leverage, and most of them use lower-than-Reg-T-limits.
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    Looking at our research, one would conclude that macro managers and managers like Long-Term Capital are a segment of the industry; however, they do not fairly represent the majority of hedge funds. Clearly we need to avoid what appears to be the unavoidable, and that is gross generalizations about the industry based on media attention and the Long-Term Capital debacle. By several key measures of control; namely, 13D filings, the amount of capital relative to the U.S. bond and equity markets, hedge fund managers are less of a force than mutual funds and institutional money managers. What seems to be apparent is that their relevance to the major market moves is more about their influence than their size or venturous positions.

    Most professionals regard it naive to think that information never goes beyond the sales or credit or desk of hedge fund counterparties. Consequently, hedge funds can indirectly influence the investments of professional money managers that have far greater financial clout in the marketplace.

    If we were to criticize hedge funds for anything, or the majority of hedge funds for anything, it would be for their influence, not their financial presence except as in the case of Long-Term Capital which I believe, as others, is an isolated case in terms of systemic risk.

    The third question, do hedge funds present systemic risks to U.S. markets or non-U.S. markets? Hedge funds have recognized early rumblings in the marketplace before they surface. An example of this was the ERM crisis in 1992, where a hedge fund shorted sterling and Italian lira. Hedge funds by far were not the only players, nor did they create the market conditions that they capitalized on. The inertia was already in motion. Furthermore, mutual funds, pension funds and insurance companies from all over the G7 were involved. At that time G7 institutional capital under management was estimated at $10 trillion versus macro managers $12 billion.
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    It is virtually impossible for me to comment on the potential systemic risk associated with Long-Term Capital, but something does seem clear to me, and that is the key risk is risk management on the part of both Long-Term Capital and its bankers, not the concept of hedge funds.

    We may need to tighten margin requirements, as Ms. Siebert suggested, especially on certain leveraged bond arbitrage trading strategies. I do believe, however, that the present system of control for systemic risk is fundamentally adequate. Lenders have to know their credit, and if they do not, they should not lend.

    Leverage inherently is not bad, as Chairman Greenspan indicated this morning. In fact, banks, as we know, leverage 20–to–1. It is the relationship of leverage to the volatility of the trade that is the risk, and that can be difficult to measure because historical statistical relationships may not adequately define ''one-off'' events such as credit spreads widening and the Russian debacle that we have seen in the last few months.

    Chairman LEACH. Mr. Gradante, if I can stop you there, and I apologize. We have a vote on the floor.

    First, procedurally let me indicate a unanimous consent request to place the statement of Eugene H. Rotberg in the record.

    Second, let me apologize that I am told this vote is shortly to be followed by a series of votes, and I think it would probably be better to bring this panel to a close without questions being asked, but let me thank all of you.
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    I want to just particularly place this committee on record in support of Professor Ruder's strong advocacy of greater disclosure in the FASB transparency rules, which I think are thoroughly appropriate, and I apologize to bring this so swiftly to an end, but I wanted each of you to have a chance to speak, and let me thank you all for a very diverse and interesting perspective, and let me just conclude the hearing and say that the hearing is adjourned.

    Thank you.

    [Whereupon, at 5:15 p.m., the hearing was adjourned.]