[Congressional Record Volume 144, Number 144 (Monday, October 12, 1998)]
[House]
[Pages H10652-H10654]
From the Congressional Record Online through the Government Publishing Office [www.gpo.gov]




 THE FAILURE OF LONG-TERM CAPITAL MANAGEMENT: A PRELIMINARY ASSESSMENT

  The SPEAKER pro tempore. The gentleman from Iowa (Mr. Leach) is 
recognized for the remainder of the Majority Leader's hour, 
approximately 35 minutes.
  Mr. LEACH. Mr. Speaker, I rise to discuss one of the most serious and 
symbolic financial events of the decade: the failure and government-led 
rescue of America's largest and most heavily leveraged hedge fund, 
Long-Term Capital Management.
  Dubiously enshrined in establishment economic thinking is the too-
big-to-fail doctrine, the notion that government will intervene to save 
a bank in trouble if its collapse would cause major harm to the 
economy.
  Last month, with the rescue of Long-Term Capital Management, a 
corollary appears to be in the making that ``some financial firms are 
too big to liquidate too quickly.'' The application of the ``too-big'' 
doctrine for the first time beyond a depository institution raises 
troubling public policy questions.
  From a social perspective, it is not clear that Long-Term Capital, or 
any other hedge fund, serves a sufficient social purpose to warrant 
government-directed protection. In one view, hedge funds provide 
liquidity and stability in financial markets, allowing economies to 
finance infrastructure and enterprises necessary to modernize. In 
another view, hedge funds have a raison d'etre: They seem to be run-
amok, casino-like enterprises, driven by greed with leverage bets of 
such huge proportions that they can control global capital markets and 
even jeopardize economic viability of individual sovereign States.
  In this case, the country's most sophisticated banking institutions 
provided loans to an institution that shielded its operations in 
secrecy, denying lenders and their regulators data about its positions 
or other borrowings. The rationale was that sharing information was 
competitively disadvantageous to the fund. Lenders to the fund, in 
effect, became responsible for a kind of blind-eyed complicity and 
speculative actions that might in some cases prove destabilizing for 
the very financial system upon which banks and the public rely.
  The envy of its peers, Long-Term Capital was 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 
wrong-headed; just that it is still an imperfect art in a world where 
the past holds lessons but provides few reliable precedents.
  Hedge funds were so named because their managers tried to reduce with 
offsetting transactions the risks they take 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 
higher returns. The industry numbers between 3,000 and 5,500 funds, 
with somewhere between $200 billion and $300 billion in investment 
capital, supporting book assets in the order of $2 trillion. About a 
third of the funds are highly leveraged; in Long-Term Capital's case, 
about 27-to-1 when its books were solid; more so when difficulties 
emerged.
  Large financial institutions make this leveraging possible, often 
with federally-insured funds. If taxpayers are to share in the risk, 
they or at least their protectors, bank, securities, and commodities 
regulators, ought to understand what stakes 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.
  There are points where politics and economics intersect; and when 
political institutions implode, as they have in Russia, economic 
consequences follow. The best and the brightest on Wall Street lost 
billions betting that Russia was too nuclear to fail. They did not 
grasp that it was too corrupt to succeed and that it did little good 
for the West to transfer resources to Russia's Central Bank if it 
simply recycled them to a private banking system which served as the 
money-laundering network for insiders.
  No nation-state can prosper if it lacks a place where people can save 
their money with confidence and seek lending assistance with security. 
Russia, which is the landmass most similar to our own, has been kept 
back for most of this century because of the Big ``C'', Communism, and 
is now in a despairing state because of the little ``c'', corruption, 
which is likely to be more difficult to root out than Communism was in 
the first instance.
  It is bewildering how, with all of the attention in recent months 
being given to forming a new global financial system architecture, no 
one is paying attention to universal values. Honesty must prevail over 
corruption, or no financial system will work. In fact, unless the point 
is made with regard to countries such as Russia that the problem is not 
that market economics are wanting but that corrupt market mechanisms 
are pervasive, the Russian people will never understand the lessons of 
the century. The old battleground in world affairs was Communism versus 
Capitalism; the new one contrasts corrupted market economies versus 
noncorrupted ones.
  What the Russian people, and those of so many developing countries, 
deserve is a chance to practice free market economics under, not above, 
the rule of law. If attention is paid above all to establishing honest, 
competitive institutions of governments and finance, virtually 
everything else will fall into place.
  From the public's perspective, it must be understood that politicians 
can be dangerous and that their most counterproductive weapon is 
protectionism. This is particularly true in finance. Any country that 
protects itself from foreign competition and finance injures itself 
and, in effect, emboldens corruption. Unilateral decisions or 
international agreements to open markets that are closed to Western-
system financial institutions provide the best chance for corrupt 
systems to reform themselves. Their public will, if given a chance, 
lead their leaders by saving where they are best protected and 
borrowing where they get the most competitive terms.
  In Long-Term Capital's case, the underestimation of the role of 
corruption in Russia and other emerging

[[Page H10653]]

economies led to an underestimation of the American economy and legal 
system.
  The mathematical model Long-Term Capital followed apparently assumed 
market tranquility. If certain bond yields relative to Treasuries 
widened, it predicted that market forces would correct the differential 
and yields would inevitably begin to converge. As spreads began to 
widen earlier this year, the fund bought long corporate and foreign 
bonds at the same time it sold short Treasury instruments. But when a 
flight to quality escalated, the spreads widened, rather than narrowed, 
and Long-Term Capital found itself on the losing end of both sides of 
key investment equations.
  At issue is not just a judgment of the moment but the problem of 
developing with confidence risk models for adverse times, especially 
when the vicissitudes of politics and human nature conspire with market 
forces.
  At issue also is the possibility that the failure of Long-Term 
Capital reflects the bringing home to the United States the economic 
problems of the rest of the world. As Wall Street firms have begun to 
move to protect themselves in recent weeks by pulling in credit lines 
and dumping less solid investments, a crisis of confidence appears to 
be developing. The impending credit crunch requires a monetary response 
from the Fed, i.e., immediate attention to lowering interest rates and, 
perhaps, a shot of fiscal stimulus from Congress, preferably a tax cut 
of modest dimensions on the order of the $16 billion a year one that 
passed the House last month.
  I was initially informed by a top Treasury official that there was a 
distinction between being informed and being consulted on the Long-Term 
Capital issue and that while Treasury had no disagreement with the 
judgment or the role of the Fed, Treasury's involvement could only be 
characterized as passively being informed of Fed concerns for the 
systemic implications of a fund failure in the economy.
  Minutes prior to the October 1 Committee on Banking and Financial 
Services hearing on Long-Term Capital, I received a letter from 
Treasury Deputy Secretary Summers, which in amplification stated:

       We were informed of the developments affecting Long-Term 
     Capital Management, and we were kept apprised of the progress 
     of discussions among its creditors. We did not, however, 
     participate in any of these discussions.

  I was therefore surprised to learn in testimony from New York Federal 
Reserve Bank President William McDonough that he confirmed directly 
with Treasury Secretary Rubin on September 18 and that he was joined by 
Assistant Treasury Secretary Gary Gensler in discussions with Long-Term 
Capital's partners in Long-Term Capital's offices on September 20, the 
day prior to McDonough's decision to intervene in a role he analogized 
that played by J.P. Morgan in the panic of 1907. Given this 
circumstance, the ``informed/consulted'' distinction would appear to 
tilt to the ``consulted'' side.
  While oversight of bank lending to Long-Term Capital Management and 
financial instrument trading within the firm does not appear to have 
been governmentally coordinated, its bailout was.
  In retrospect, it is difficult not to be struck by the fact that the 
shrewdest in the hedge fund industry could commit such investment 
errors, that the most sophisticated in banking would give a blank check 
to others in an industry in which they considered themselves to be 
experts, and that the United States regulatory system could be so 
uncoordinated and so easily caught off guard.

                              {time}  2100

  The Fed and the Comptroller of the Currency, principally the Fed in 
this case, had responsibility for regulation of the banks which 
extended such large credit lines to Long-Term.
  Questions exist as to how knowledgeable of loan extensions were the 
regulators. The principal agency with statutory authority over the 
fund's trading practices was 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 CFTC officials, the Commission has the power to examine 
the firm's trading positions, yet apparently it did not do so, even 
after Long-Term Capital reported at the end of 1997 that its assets 
included nearly $3 million 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.
  While regulators appear to have egg on their face for the failure as 
well as the rescue of Long-Term Capital, 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 would be by 
those taking too much. But Congress cannot duck its oversight 
responsibility of those charged with supervision of these markets.
  That is why 5 years ago I issued a 900-page report on the financial 
derivatives marketplace which included a series of 30 recommendations 
for regulatory guidance to constrain systemic risk in a market which I 
then described as ``the new wild card in international finance.'' In 
this report, I noted that, ``Historical experience is not always a 
guide to the future, especially when a relatively new market explodes 
in size'' and when there are ``unprecedented economic uncertainties.''
  Among the recommendations in the report, which became one of the 
benchmark assessments of how derivatives should and should not be 
regulated, were that bank regulatory agencies should discourage active 
involvement in derivatives markets by insured institutions unless 
management can convincingly demonstrate both sufficient capitalization 
and sophisticated technical abilities. Greater transparency and uniform 
disclosure standards were also recommended.
  The troubles of Long-Term Capital presented the Fed with a dilemma. 
If it failed to act in the face of what is 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 a 
free market economy would normally have been allowed to fail. The 
Federal Reserve's decision to intervene in the Long-Term Capital 
situation underscores that the Fed operates under two basic pinions: 
that low inflation is always a friend, and that instability is always 
the enemy.
  Clearly, the Fed will go to great lengths to reduce the dangers of 
instability, as well as inflation. But the government's intrusion into 
our market economy can be justified only if it can be credibly shown 
that there is a clear and present danger to the financial system in 
Long-Term Capital's failure, and that there were no stabilizing 
alternatives, other credible bids on the table, or other approaches to 
ensure that a market-shaking unwinding did not occur.
  In this case, another bid was on the table. According to Mr. 
McDonough, it was rejected by Long-Term Capital's management because it 
did not have the legal ability to accept it, although it had the 
ability to accept the alternative, which reportedly included a 
commitment to keep the management of Long-Term Capital intact.
  Here it deserves noting that in the wings was not only a ``Warren 
Buffett'' in terms of an alternative bid, but a ``Paul Volcker'' or 
``Jerry Corrigan'' in terms of a possible court-appointed bankruptcy 
trustee.
  I stress the bankruptcy laws because, to the extent that another 
hedge fund of similar size or group of companies that, in combination, 
may be of comparable importance could get into trouble, the U.S. 
bankruptcy laws are designed to stabilize insolvent circumstances. 
Indeed, under the bankruptcy code, a trustee probably has more 
authority to proceed slowly than a reengineered company not protected 
by bankruptcy status.
  With regard to a future government role in bankruptcies of hedge 
funds or other financial institutions, the Fed might want to think 
through the possibility of making process recommendations to bankruptcy 
courts. For instance, if a significant fund fails, the Fed should 
prepare to go to a court and recommend a given type of process, as

[[Page H10654]]

well as consideration of particular types of or actual individuals who 
might be appropriate to serve as trustees for a failed fund.
  If the problem relates to systemic concerns and the goal is an 
orderly unwinding of positions or orderly transfer of assets, the Fed 
is obligated to lend a perspective to the courts.
  Given that almost any future potential failure of another fund will 
raise questions of whether it will be given like treatment as Long-Term 
Capital, the Fed or Treasury should also consider issuing public 
guidelines or commentary about their intent to rely on orderliness 
through bankruptcy statutes to assure markets that unfortunate problems 
will not become systemic liabilities.
  In this regard, balance should be emphasized. Just as there may be 
systemic concerns for a too rapid unraveling of positions, there could 
be competitive and market concerns for too prolonged resolution of the 
problem.
  It is a particular umbrage that the hedge fund bailed out under the 
Fed's leadership operate commodity pools organized as Cayman Islands 
entities. Implicit in this circumstance is the possibility that 
individuals who presumably sought to reduce their United States tax 
obligations through Caribbean shelters could find their assets 
protected with the help of a United States government agency.
  To the degree doubt exists, because of the Cayman connection, whether 
U.S. bankruptcy laws could effectively have been applied in the Long-
Term Capital situation, or whether actions might be brought in other 
jurisdictions, Long-Term Capital's problems underscore the legal risk 
issue. Prudent banks should have doubts about lending to institutions 
whose operations may not be within the full reach of the laws of the 
United States or other comparable legal systems.
  While the goal of the Fed's intervention was to avert a short-term 
shock to the international economic system, it appears that a more 
serious long-term threat may be the result. Today we have a 
reconstituted fund that is co-owned by 14 of the world's largest 
financial institutions, from Travelers and Merrill Lynch to J.P. Morgan 
and the Union Bank of Switzerland.
  In this regard, it should be understood that the coordinated 
government bailout approach which was undertaken may involve a tendency 
towards concentration with the new owners conjoined as a group having a 
greater impact on markets than in competition with one another. 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.
  Working as a cartel, those running Long-Term Capital potentially 
comprise the most powerful financial force in the history of the world, 
and could influence the well-being of Nation states for good or for 
naught, guided by the profit motive, rather than national interest 
standards.
  This dilemma is reflected in the announcement the week after the Fed 
intervened by the Secretary of the Treasury that the United States 
government and international resources should be put in play to prop up 
certain foreign currencies. Most analysts assume the Treasury was 
particularly concerned that the Brazilian cruzeiro might be devalued. 
But to give a governmental imprimatur to the fund as it is now 
constituted could cause conflicts of interest not only among its 
owners, but with our own government. The possibility that taxpayer 
dollars might be pitted in the future against those of a firm the 
United States government helped rescue could be an expensive irony.
  The antitrust laws are generally applied to concentration in a 
particular market sector, but the combination of many of the world's 
most sophisticated financial powerhouses in hedge fund activities is 
unprecedented in significance. Such a combination, if allowed to stand, 
could enable these institutions to hold sway over whole economies. No 
central bank or finance ministry in the world could match the assets 
they could wield in currency markets.
  Further complicating this collusion problem is the report that half-
a-dozen or more government-owned banks are or have been strategic 
investors in Long-Term Capital.
  The possibility that fund managers might receive insider information 
from their own investors who represent foreign governments; or that any 
government would think it appropriate to invest public monies in a 
speculative hedge fund; or that our government might be put in the 
position of having to decide whether to rescue a fund which, if 
liquidated, might embarrass a government with which we interrelate on 
many issues, is bizarre and untenable.
  As powerful as they are, Long-Term Capital's new owners are 
confronted with a legal Catch-22. If they do not actively manage the 
fund, they could be sued for lack of prudential stewardship. If they do 
actively manage the fund, they could be sued for collusion.
  In testimony before the Congress last week, Fed officials said 
firewalls would be established to separate the fund's oversight 
committee managers from their home offices. However, firewalls, no 
matter how high, are particularly vulnerable when losses mount. If 
hedged positions improve, legal liabilities could be bedeviling.
  If, for instance, Long-Term Capital and any of its new investors were 
to take a position that would prove profitable, presumably someone on 
the unprofitable side of such a position might sue on collusion 
grounds. Or if it were to pay back a creditor partner and not a 
creditor non-partner, questions of equity could be raised.
  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, 
particularly Asian ones, that the way to modernize is to let weak 
institutions fail and to rely on market mechanisms, rather than insider 
bailouts.
  We have also encouraged developing 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.
  Worse yet, the Federal government appears to have played a role in 
precipitating a bailout offer that was more advantageous to the failed 
management than that which the free market offered. Warren Buffett may 
be fortunate to have had his bid for Long-Term Capital turned down in 
favor of the government-coordinated effort. Given reports of further 
erosion of Long-Term Capital capital, the new owners and the 
government, on the other hand, may be embarrassed if stabilization of 
the fund requires another rescue.
  It will be months before proper perspective can be applied to this 
unique circumstance, but the principal lesson would appear to be that 
the Fed should rely more extensively on market mechanisms and America's 
sophisticated bankruptcy laws. Above all, the public should be assured 
that the government will not subsidize insider bailouts, or protect 
those who make investment errors. The too-big doctrine is simply too 
prone to fail.

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