The Failure of Long-Term Capital Management:
A Preliminary Assessment
By James A. Leach
Chairman, House Banking and Financial Services Committee
Before House of Representatives
October 12, 1998

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 (LTCM).

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 LTCM a corollary appears to be in the making: "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 the infrastructure and enterprises necessary to modernize. In another view, hedge funds have a narrower raison d’être: they’re seen to be run-amok, casino-like enterprises, driven by greed with leveraged bets of such huge proportions they can control global capital markets and even jeopardize the 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 in 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, LTCM 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 fund were so named because their managers try 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 booked assets on the order of $2 trillion. About a third of the funds are highly leveraged; in LTCM’s case about 27-1 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 didn’t 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 a 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 land mass 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 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 isn’t 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 vs. Capitalism; the new one contrasts corrupted market economies vs. non-corrupted 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 governance 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 in 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 publics 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 LTCM’s case the underestimation of the role of corruption in Russia and other emerging economies led to an underestimation of the American economy and legal system.

The mathematical model LTCM followed apparently assumed relative market tranquillity. 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 LTCM 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 LTCM 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 interests 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 passed by 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 LTCM issue and that while Treasury had no disagreement with the judgment or 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 on the economy. Minutes prior to the Oct. 1 Banking Committee hearing on Long-Term Capital, I received a letter from Treasury Deputy Secretary Summers, which in amplification stated:

"We were informed of 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 had conferred directly with Treasury Secretary Rubin on Sept. 18 and that he was joined by Treasury Assistant Secretary Gary Gensler in discussions with LTCM’s partners in LTCM’s offices on Sept. 20, the day prior to McDonough’s decision to intervene in a role he analogized to 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 LTCM 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 consider themselves to be experts; and that the U.S. regulatory system could be so uncoordinated and so easily caught off guard.

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 (CFTC), with which LTCM 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 it apparently didn’t do so, even after LTCM 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.

While regulators appear to have egg on their face for the failure, as well as the rescue of LTCM, risk-free regulation is not possible, or necessarily appropriate. The economy could be as ill-served by financial institutions refusing to take risks as would be 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 five 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 LTCM 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 LTCM 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 there was a clear and present danger to the financial system in LTCM’s failure and that there were no stabilizing alternatives -- other credible bids on the table or other approaches to ensuring that a market-shaking unwinding didn’t occur.

In this case, another bid was on the table. According to McDonough, it was rejected by LTCM’s management because it didn’t 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 LTCM 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 a 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 re-engineered 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 be prepared to go to a bankruptcy court and recommend a given type of process, as 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 as to whether it will be given like treatment as LTCM, 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 operates commodity pools organized as Cayman Islands entities. Implicit in this circumstance is the possibility that individuals who presumably sought to reduce their U.S. tax obligations through Caribbean shelters could find their assets protected with the help of a U.S. government agency.

To the degree doubt exists, because of the Cayman connection, whether U.S. bankruptcy laws could effectively have been applied in the LTCM 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 toward 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 LTCM 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 U.S. government and international resources should be put in play to prop up certain foreign currencies. Most analysts assumed the Treasury was particularly concerned that the Brazilian real 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 U.S. government helped rescue could be an expensive irony.

The anti-trust 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 LTCM.

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 moneys 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 inter-relate on many issues, is bizarre and untenable.

As powerful as they are, LTCM’s new owners are confronted with a legal Catch 22. If they don’t 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 the week before last, 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. And 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 proved 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 LTCM 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 part 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 LTCM turned down in favor of the government-coordinated effort. Given reports of further erosion of LTCM 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 won’t subsidize insider bailouts or protect those who make investment errors.

The "too big" doctrine is simply too prone to fail.

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