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Good morning Chairman Leach, Ranking Member LaFalce and members of the Committee. It is an honor to appear before you today to discuss the President's Working Group on Financial Markets' report entitled Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management. If I might add a personal note, as I was only recently sworn in as Under Secretary for Domestic Finance at the Treasury Department, I look forward to working with this committee and its staff on these and other matters.
I am also pleased to appear on this panel with my colleagues from the other Working Group agencies. I commend all of the agencies on how they cooperated in the production of this report. The Working Group's report represents the outcome of discussions among the four principals of the Working Group and their staff, as well as principals and staff of the Council of Economic Advisers, the Federal Deposit Insurance Corporation, the National Economic Council, the Federal Reserve Bank of New York, the Office of the Comptroller of the Currency, and the office of Thrift Supervision. The Working Group has jointly agreed on the key public policy issues raised by Long-Term Capital Management (LTCM), and has jointly forwarded a series of recommendations.
The near collapse of LTCM highlighted the risks of excessive leverage, and the possibility that problems at one financial institution could potentially pose risks to the financial system as a whole. The Working Group also found that, although LTCM is a hedge fund, the issues it presents are not limited to hedge funds. The events highlighted a breakdown in private market risk practices at major commercial banks and securities firms. In addition, a number of other financial institutions are larger and more highly leveraged than hedge funds.
Today I would like to summarize our findings, and the recommendations that are presented in the Working Group's report.
Long-Term Capital Management
Let me first say a few words of background about LTCM. Long-Term Capital Management is a private investment partnership located in Greenwich, Connecticut. At the end of 1997, LTCM had balance sheet assets of $129 billion on only $4.7 billion of capital -- or a ratio of assets to equity of 28-to-1. This ratio does not include, however, any leverage that LTCM may have been able to assume through derivatives or other off-balance sheet transactions. LTCM's notional derivatives position stood at $1.3 trillion at the end of 1997. LTCM's high degree of leverage, combined with the nature of its investments, made it vulnerable as it struggled to meet margin and collateral calls from counterparties during a period of market turbulence.
LTCM's trading strategies also made it vulnerable to market shocks. While LTCM traded in a variety of financial markets in a number of different countries, its strategies proved to be poorly diversified. Most of LTCM's trading positions, in fact, were based on the belief that prices for various risks were high. They thought that the prices for these risks, such as liquidity, credit, and volatility, were high compared to historical standards. They were wrong, however, in these judgments. In addition, these markets proved to be more correlated than LTCM had supposed, as markets around the world received simultaneous shocks last fall.
On August 17, Russia devalued the ruble and declared a debt moratorium. This sparked a flight to quality as investors shunned risk and sought out liquid markets. As a result, risk spreads widened and many markets around the world became less liquid and more volatile. LTCM was affected, even though the vast majority of their trading risks were related to markets in the major industrialized countries. Thus, LTCM found itself losing money on many of its trading positions and near insolvency.
By mid-September, 1998, LTCM's capital had fallen to less than $1 billion, from $4.7 billion at the beginning of the year. LTCM faced severe problems as it tried to unwind some of its positions in illiquid markets. The large size of LTCM's positions in many markets contributed to its inability to unwind its positions. As a result, market participants began to be concerned about the possibility that LTCM could collapse and the consequences this could have on world markets that were already turbulent.
LTCM's creditors and counterparties were concerned about two things. First, they were concerned about the direct losses they would most likely face in the event of default. These losses would have resulted from liquidating significant amounts of collateral and re- hedging derivatives contracts. At the time, LTCM prepared estimates that these direct losses would be in the range of $3-5 billion for its 17 largest counterparties. Individually, many of the firms were estimated by LTCM to face potential losses of between $300 to $500 million. Although we have not tried to verify LTCM's estimates independently, our conversations with some of LTCM's counterparties have supported these estimates.
Second, LTCM's creditors and counterparties were concerned about the possible significant effect of a default on global financial markets, and hence on the rest of their trading positions. Since LTCM's counterparties were themselves large, highly leveraged financial institutions, a number of them believed that this indirect, second-order effect could have lead to even more significant losses than the direct effects of a default.
It was in this environment that 14 of LTCM's key counterparties came together and decided that it was in their best interest to prevent a default. These firms collectively decided to invest a total of $3.6 billion rather than risk the possible direct and indirect losses suggested by LTCM's and their own internal estimates.
Working Group's Key Findings
The central policy issue raised by the near collapse of LTCM is how to constrain excessive leverage more effectively. Excessive leverage greatly amplified LTCM's vulnerability to market shocks and increased the possibility of systemic risk. Systemic risk is the risk that problems at one financial institution could be transmitted to the entire financial market and possibly to the economy as a whole.
To constrain leverage, our market-based system relies heavily on the discipline provided by creditors, counterparties, and investors. Market discipline is generally effective, because it relies on these same participants. If one looks at the history of financial markets, however, it is also true that market-based constraints can break down in good times as creditors and investors become less concerned about risk, and fail to manage risk appropriately.
Risk management practices broke down at both LTCM and its creditors and counterparties. Reviews by regulators indicate that some financial firms did not effectively limit their exposures to LTCM. In addition, the firms' risk models and risk management procedures may have underestimated the possibility of significant losses.
At the same time, many of LTCM's creditors and counterparties were themselves highly leveraged. Other financial institutions, including some banks and securities firms, are larger, and generally more highly leveraged, than hedge funds. For example, at the end of 1998, the five largest commercial bank holding companies had total assets in excess of $260 billion, and the five largest investment banks had total assets in excess of $150 billion. While LTCM had a leverage ratio of 28-to-1 at the end of 1997, the five largest investment banks' average leverage ratio is currently about 27-to-1. The five largest commercial bank holding companies, however, currently have an average leverage ratio of nearly 14-to-1. And while LTCM had a notional derivatives position of over $1.3 trillion in December 1997, six commercial bank holding companies and two investment banks had notional derivatives amounts of over $1 trillion at the end of last year.
We believe that leverage plays a positive role in our financial system. It increases market liquidity and improves the efficiency of risk and resource allocation in our economy. Problems can arise, however, when financial institutions go too far in extending credit to their customers and counter parties. The near collapse of LTCM well illustrates the need for all participants in our financial system, not only hedge funds, to face constraints in the amount of leverage they assume.
The Working Group report recognizes that the best way to mitigate risk to the financial system is by motivating the private sector. Many of the measures that the Working Group is recommending are intended to reinforce private market discipline.
e Working Group's Recommendations
Let me now turn to the Working Group's recommendations. As you may have had time to review our report, let me summarize the recommendations here.
The Working Group has recommended a number of measures in the two broad areas of public disclosure and risk management, and has also made some other important recommendations. Many of the recommendations contained in the report can be implemented by the Working Group members through regulation. Legislation will be required, however, in order to implement three of the recommended measures. I will highlight the three measures that require legislation as we go along. Finally, the Working Group also considered a number of potential additional measures that could be implemented if evidence emerges that indirect regulation of currently unregulated market participants is not effective in constraining leverage. The Working Group, however, is not recommending any of these potential additional measures at this time.
Public Disclosure. The Working Group made two recommendations on public disclosure. We believe it is important to improve transparency by increasing and enhancing the information that is available to the public, in order to reinforce private market discipline.
First, we think that private market behavior would be enhanced if hedge funds were required to disclose their financial statements to the public. These financial statements would include more meaningful and comprehensive measures of market risk, without requiring the disclosure of proprietary information. Hedge funds can constitute large pools of risk, and we believe that it would be best if all financial market participants were aware of this risk. While LTCM was larger than any other reporting hedge fund family at the end of 1997, 10 other reporting hedge funds had assets exceeding $10 billion at that time. Currently, hedge funds are not required to make their financial statements public. Requiring them to do so will need legislation, and we look forward to working with Congress on the best mechanism for accomplishing this goal.
Second, all public companies, including financial institutions, should publicly disclose a summary of their direct material financial exposures to significantly leveraged financial institutions, including hedge funds. One of the lessons of events in global financial markets over the past two years is the interlocking nature of our global financial system. Events in one country's banking system, or even in one hedge fund in Connecticut, can put investors around the world at risk, and the effects can even reach to small savers. That is why the SEC will promulgate rules, taking into account public comments through the normal rule-making process, to require that public companies disclose their exposures to significantly leveraged institutions. To the extent covered, these entities should be aggregated by sector (e.g., commercial banks, investment banks, insurance companies, hedge funds and others).
Risk Management Practices. One of the questions that the Working Group examined was whether creditors lacked adequate information on LTCM, or whether they had adequate information but didn't use it effectively. The four bank regulators and the two market regulators canvassed the industry last fall in the wake of LTCM. The regulators found serious weaknesses in how firms used what information they did have, and how they incorporated this information into their judgments. Therefore, the Working Group has made three categories of recommendations for enhancing financial institutions' risk management practices.
First, regulators should promote the development of more risk-sensitive but prudent approaches to capital adequacy. Thus, we believe that the Basle Committee on Banking Supervision should update the Capital Accord for the financial markets of the 21st century. Our report has a series of specific recommendations related to the need for greater differentiation among claims (or instruments or counterparties) based on credit quality. In addition, value-at-risk or other risk models should be subject to validation procedures, including rigorous back-testing.
Second, regulators have issued guidance to address some of the risk management weaknesses that have been identified. U.S. banking regulators have put banks on notice that examiners will be looking at a series of specific risk management practices.
Third, the report outlines a number of practices that the private sector itself should adopt. A number of private sector initiatives are underway to publish sets of sound practices. The International Swap Dealers Association has produced a report with 22 recommendations concerning collateral. The Counterparty Risk Management Group is developing some recommendations concerning risk management. We also think it would be appropriate for a group of hedge funds to publish a set of sound practices for their risk management and internal controls.
The Working Group is also making recommendations in three other, more technical areas: risk assessment for the affiliates of securities firms and FCMs; bankruptcy; and offshore financial centers.
Expanded Risk Assessment Authority for Unregulated Affiliates. Regulators' current authority to require financial information about the unregulated affiliates of broker-dealers and FCMs should be enhanced. Regulators need a greater window into these affiliates in order to monitor the risks posed by these market participants and the highly leveraged institutions which are their counterparties. As mentioned earlier, the five largest securities firms have total assets ranging from $150 billion to over $300 billion, and on average their leverage ratio is about 27-to-1. Thus, these firms are larger in size than LTCM and have comparable leverage, and they are able to put a significant portion of their assets and risk in unregulated affiliates. During the 1990s, there has been a dramatic growth in the activity of these unregulated affiliates. In the case of LTCM, the unregulated affiliates of broker-dealers extended a significant amount of credit, particularly through derivatives. While the SEC currently regulates broker-dealers, securities firms are placing a significant and increasing share of their trading positions, leverage and activity in unregulated affiliates.
This authorization should be accompanied by the authority to review risk management procedures and controls at the holding company level, and the ability to examine the records and controls of the holding company and its material unregulated affiliates. This measure would require legislation. While we are not at this time recommending capital standards for the unregulated affiliates of securities firms (fully consolidated supervision), the report suggests that this issue may be worthy of further consideration.
Bankruptcy. Although LTCM did not file for bankruptcy, the Working Group studied what might have happened had LTCM filed for bankruptcy, and has two principal recommendations. First, LTCM's near collapse highlighted the importance of adopting legislation to improve the close-out netting regime for financial contracts. These proposals would improve the netting regime under the Bankruptcy Code by expanding and clarifying the definitions of the financial contracts eligible for netting. In addition, the proposals would explicitly allow eligible counterparties to net across different types of contracts, such as swaps, security contracts, repos and forward contracts. Putting this in context, last September LTCM had about 60,000 trades on with only 75 counterparties. It is critical to the functioning of financial markets that there be certainty with respect to how all these transactions would have been netted in the case of insolvency. The Working Group and the Administration last year forwarded to Congress specific proposals to enhance close-out netting.
Second, LTCM's near collapse highlighted the interplay between bankruptcy laws in the Cayman Islands and in the United States. If LTCM had filed for bankruptcy in the Cayman Islands, where it was organized, there might have been considerable delay because U.S. courts might have stayed the sale of collateral underlying financial contracts. This would have added to systemic risk. To make such a result less likely, the Working Group recommends adoption of amendments to Section 304 of the Bankruptcy Code included in last year's bankruptcy proposal, as well as adoption of the model statute of the United Nations Commission on International Trade Law.
Internationalizing the Working Group's Recommendations. In a world of mobile capital, the Working Group believes it is important that other countries consider these recommendations, where relevant. We are working with other industrial countries to strengthen regulatory standards in their own countries. In addition, the U.S. regulatory agencies and the Treasury Department will continue to work with their counterparts internationally to encourage offshore financial centers to adopt and comply with internationally-agreed upon standards developed by international organizations of regulators or supervisory authorities.
Tax Policy Issues. The LTCM incident highlights a number of tax issues with respect to hedge funds, including the tax treatment of total return equity swaps and the use of offshore financial centers. These issues, however, were beyond the scope of this report and are being addressed separately by Treasury.
Additional Potential Steps
The Working Group also considered a number of additional potential measures to constrain leverage. While the Working Group is not currently recommending any of these measures, the report suggests that they could be given further consideration. The Working Group will be monitoring and assessing the effectiveness of the measures outlined in the report. If further evidence emerges that indirect regulation of currently unregulated market participants is not effective in constraining excessive leverage, the issues that follow could be given further consideration.
- Direct Regulation of Hedge Funds. While the Working Group is calling for the public disclosure of hedge funds' financial statements, we are not currently recommending the direct regulation of hedge funds.
- Consolidated Supervision of Broker-Dealers. While the Working Group is calling for additional reporting and record-keeping concerning the unregulated affiliates of broker-dealers, we are not at this time calling for full consolidated supervision. The key additional measures that could be considered would be enterprise-wide capital standards.
- Direct Regulation of Derivatives Dealers. This will be one of the important issues that the Working Group will consider in its upcoming study of the over-the- counter derivatives market.
Conclusion
We believe that the Working Group's report contains a thoughtful, well-balanced set of recommendations to help promote private market discipline and address the potential risks of excessive leverage. Some of the recommendations require legislative support. We look forward to working with the Congress on these important matters.
In closing, I would like to add that the Secretary of the Treasury wishes to extend his appreciation to all the members of the Working Group, and their staffs, for their close cooperation and hard work as we compiled the report and recommendations.
I would be pleased to answer any questions that this committee may have.