Background

Long-Term Capital Management: Regulators Need to Focus Greater Attention

on Systemic Risk (Letter Report, 10/29/1999, GAO/GGD-00-3).

Pursuant to a congressional request, GAO provided information on Long

Term Capital Management (LTCM) funds, focusing on: (1) how LTCM's

positions became large and leveraged enough to be deemed a potential

systemic threat; (2) what federal regulators knew about LTCM and when

they found out about its problems; (3) what the extent of coordination

among regulators was; and (4) whether regulatory authority limits

regulators' ability to identify and mitigate potential systemic risk.

Background.

Following the announcement of the Russian debt moratorium in mid-August

1998, investors began to seek superior credit quality and higher

liquidity; and credit spreads widened in markets around the world,

creating major losses for LTCM and other market participants. The Bank

for International Settlements (BIS)

described the events of last summer as

follows:

“In mid-August 1998 … financial markets around the globe experienced extraordinary

strains, raising apprehensions among market participants and policy makers of an

imminent implosion of the financial system. As investors appeared to shy away from

practically all types of risk, liquidity dried up in financial markets in both industrial and

emerging economies, and many borrowers were unable to raise financing even at punitive

rates. Prices for all asset classes except the major industrial country government bonds

declined and issuance of new securities ground to a halt.”

It was in this financial environment that Federal Reserve officials deemed

the rapid liquidation of LTCM’s worldwide trading positions and those of

others in the market a potential systemic threat to markets worldwide. As

a result, the Federal Reserve facilitated the private sector recapitalization

of LTCM by its largest creditors and counterparties (the Consortium).

Oversight of hedge fund leverage and risk-taking is left to creditors and

counterparties, which includes banks and securities and futures firms.

These firms are expected to perform risk analysis and price according to

risk, i.e., charge higher interest rates for more risky activities. These

activities are part of market discipline. Regulators play a secondary role in

that they are supposed to conduct oversight activities to help ensure that

regulated banks and securities and futures firms follow prudent practices,

including their business dealings with hedge funds.

Long-Term Capital

Management.

LTCM was considered unique among hedge funds because of the large

scale of its activities and size of its positions in certain markets. BIS

considered LTCM to be a “market-maker” in some markets. According to

some in the industry, LTCM’s counterparties often treated it more like an

investment bank than a hedge fund. Hedge fund researchers estimate that

70 percent of hedge funds use leverage, most with a leverage ratio of less

than 2 to 1. However, leverage was an important part of LTCM’s

investment strategy. LTCM’s leverage was achieved in various ways,

BIS was established in 1930 in Basle, Switzerland, by European central banks. The Federal Reserve

joined the BIS board in 1994. The objectives of BIS are to promote the cooperation of central banks

and to provide additional facilities for international operations.

On September 23, 1998, 14 major domestic and foreign banks and securities firms agreed to

recapitalize LTCM. On September 28, 1998, they contributed approximately $3.6 billion, representing 90

percent of the net asset value of the fund on that date. The 14 firms were: Chase Manhattan

Corporation; Goldman Sachs Group L.P.; Merrill Lynch & Co. Inc.; J.P. Morgan & Co. Incorporated;

Morgan Stanley Dean Witter & Co.; Salomon Smith Barney (Travelers Group); Credit Suisse First

Boston Company; Barclays PLC; Deutsche Bank AG; UBS AG; Bankers Trust Corporation; Société

Generale; Paribas; and Lehman Brothers Holdings, Inc.

including derivatives transactions,

repurchase agreements,

short sales,

and direct financing (loans). LTCM was also able to increase its leverage

by negotiating favorable credit terms for these transactions. For example,

LTCM was able to negotiate credit enhancements, including zero initial

margin,

two-way collateral requirements,

and rehypothecation rights.

Although leverage was key to LTCM’s high returns, it also magnified

LTCM’s losses. For additional detail about the events surrounding LTCM’s

near-collapse, see appendix I.

Although LTCM relied on leverage as an integral part of its investment

strategy, as shown in table 1, high leverage is not unique to LTCM. A

simple leverage ratio is only one indicator of riskiness. Although several

large securities and futures firms had leverage ratios comparable to

LTCM’s, according to SEC, the assets carried by the securities firms were

less volatile. In addition, the President’s Working Group report

noted that

these firms may be in a better position to ride out market volatility because

they tend to have more diversified revenue and funding sources than hedge

funds. These benefits, however, tend to be offset by securities and futures

firms’ more constricted costs structures, higher fixed operating expenses,

and illiquid assets.

Derivatives are financial products whose value is determined from an underlying reference rate

(interest rates, foreign currency exchange rates); index (reflects the collective value of various

financial products); or asset (stocks, bonds, and commodities). Derivatives can be (1) traded through

central locations, called exchanges, where buyers and sellers, or their representatives, meet to

determine prices; or (2) privately negotiated by the parties off the exchanges or over the counter

(OTC).

Repurchase agreements are agreements between buyers and sellers of securities, whereby the seller

agrees to repurchase the securities at an agreed-upon price and, usually, at a stated time.

Short sales involve borrowing securities and selling them in hopes of repurchasing them at a lower

price at a later date.

Initial margin is the amount of cash or eligible securities required to be deposited with a counterparty

before parties engage in a transaction.

Two-way collateral means that both parties to a contract are required to post collateral, depending on

the direction of the credit exposure.

Hypothecation means offering assets owned by a party other than the borrower (e.g., collateral held

by the borrower from another transaction, such as a derivatives contract) as collateral for a loan

without transferring the title. Rehypothecation is the reuse of posted collateral.

Table 1: Comparison of LTCM’s

Leverage to Major Securities and

Futures Firms

Institution Leverage Ratio

LTCM 28-to-1

Goldman Sachs Group, L.P. 34-to-1

Lehman Brothers Holdings, Inc. 28-to-1

Merrill Lynch & Co., Inc. 30-to-1

Morgan Stanley Dean Witter & Co. 22-to-1

Simple balance sheet leverage calculation (ratio of assets to equity capital).

Source: GAO analysis of the President’s Working Group hedge fund report and the firms’ 1998 annual

report data.

Most of LTCM’s balance sheet consisted of trading positions in

government securities of major countries, but the fund was also active in

securities markets, exchange-traded futures, and over-the-counter (OTC)

derivatives. According to regulators, some of its positions were considered

“very significant” relative to trading in specific securities in those markets.

As of August 31, 1998, LTCM held about $1.4 trillion notional value of

derivatives contracts off-balance-sheet, of which more than $500 billion

were contracts on futures exchanges and at least $750 billion were OTC

derivatives. Although the notional, or principal, amount of derivatives

contracts is one way that derivatives activity is measured, it is not

necessarily a meaningful measure of actual risk involved. The actual

amount at risk for many derivatives varies by both the type of product and

the type of risk being measured. A few of the futures positions, both on

U.S. and foreign exchanges, were quite large (over 10 percent) relative to

activity in those markets. According to LTCM officials, LTCM was

counterparty to over 20,000 transactions and conducted business with over

75 counterparties. BIS reported that LTCM was “perhaps the world’s single

most active user of interest rate swaps.”

Financial Regulatory

Structure.

Hedge funds are generally not subject to direct federal regulation, instead

they are indirectly “regulated” by the banks and securities and futures

firms that are their creditors and counterparties. The regulators’ role is to

ensure that those banks and securities and futures firms are practicing

prudent risk management, including the risks they take in dealing with

hedge funds. A primary mission of bank regulators is to promote the safety

and soundness of the banking system, and this is achieved primarily

through ensuring the safety and soundness of individual institutions. Three

federal bank regulators oversee banks, some of which are also subject to

state regulatory oversight.

Bank regulators have the authority to establish

Annual Report, 1 April 1998-31 March 1999, Bank for International Settlements, Basle,

Switzerland, June 7, 1999.

The Federal Reserve oversees all bank holding companies and all state-chartered banks that are

members of the Federal Reserve. The Office of the Comptroller of the Currency oversees banks with

national charters. In addition, the Federal Deposit Insurance Corporation oversees banks with state

charters that are not members of the Federal Reserve.

capital requirements, establish information-reporting requirements,

conduct periodic examinations, and take enforcement actions. The Federal

Reserve, the lender of last resort for banks and other financial institutions,

also has an additional objective of ensuring the overall stability of the U.S.

financial system.

SEC’s and CFTC’s primary purposes are to protect investors or customers

in the public securities and futures markets and to maintain fair and

orderly markets. Unlike the bank regulators, which can regulate all bank

activities, SEC and CFTC are authorized to regulate only activities

involving securities and futures and only those entities that trade these

products. SEC regulates activities involving securities and the firms that

trade these products. Such firms include broker-dealers, which must

requirements. Broker-dealers must also comply with the requirements of

various self-regulatory organizations (SROs) of which they are members,

such as the New York Stock Exchange (NYSE) and National Association of

Securities Dealers (NASD).

CFTC regulates activities involving FCMs,

which must also comply with rules imposed by futures SROs—the various

futures exchanges, such as the Chicago Board of Trade and Chicago

Mercantile Exchange, and an industry association, the National Futures

Association (NFA). SEC and CFTC have the authority to establish capital

standards and information reporting requirements, conduct examinations,

and take enforcement actions against registered broker-dealers and FCMs,

but generally not their unregulated affiliates.

The U.S. financial regulatory system has evolved over time, in part, in

response to financial crises. For example, SEC and the Federal Deposit

Insurance Corporation (FDIC) were created during the depression to fill

perceived gaps in the regulatory structure. In the 1980s and 1990s, crises

and disruptions to markets have revealed additional regulatory gaps. Many

of these gaps have been filled by extensions of authority rather than by the

creation of new agencies. For example in 1990 and 1992, in response to the

Drexel bankruptcy, Congress provided SEC and CFTC, respectively, with

authority to obtain information from certain broker-dealer and FCM

affiliates. However, SEC and CFTC still lack consolidated regulatory

authority over securities and futures firms.

SROs assist SEC and CFTC in implementing the federal securities and commodities laws..

Scope and

Methodology.

As agreed, our objectives were to discuss (1) how LTCM became large and

leveraged enough to pose a potential systemic threat, (2) what federal

regulators knew about LTCM and when they found out about its problems,

(3) what the extent of coordination among regulators was, and (4) whether

regulatory authority limits regulators’ ability to identify and mitigate

potential systemic risk. To fulfill our objectives, we reviewed the events

surrounding LTCM’s near-collapse, including reviews of information

collected by CFTC, the Federal Reserve, and SEC and relevant documents

obtained from various other financial regulators. We reviewed “Hedge

Funds, Leverage, and the Lessons of Long-Term Capital Management”

issued on April 28, 1999, by the President’s Working Group on Financial

Markets (President’s Working Group).

We also reviewed “Improving

Counterparty Risk Management Practices” issued on June 21, 1999, by the

Counterparty Risk Management Policy Group (Policy Group).

In addition,

we reviewed the following reports and regulatory guidance:

· “Sound Practices for Banks’ Interactions with Highly Leveraged

Institutions,” Jan. 1999, Basle Committee on Banking Supervision;

· “Banks’ Interaction with Highly Leveraged Institutions,” Jan. 1999, Basle

Committee on Banking Supervision;

· “Supervisory Guidance Regarding Counterparty Credit Risk Management”

(SR-99-3)(SUP), Feb. 1, 1999;

· OCC Bulletin 99-2, Jan. 25, 1999; and

· “Broker-Dealer Risk Management Practices Joint Statement,” July 29, 1999,

SEC, NYSE, and NASD Regulation, Inc. (NASDR).

Finally, we reviewed various other articles, studies, surveys, reports,

papers, and guidance.

We interviewed officials from the Federal Reserve Board, the Federal

Reserve Bank of New York, SEC, CFTC, the Department of the Treasury

The President’s Working Group was established by executive order in 1988 following the 1987 stock

market crash. Its purpose was to enhance the continued integrity, competitiveness, and efficiency of

U.S. financial markets and maintain the public’s confidence in those markets. We are currently

reviewing the activities of the President’s Working Group in a separate report to be issued in the near

future.

The 12 firms that participated in and presented the report were Barclays; Bear Stearns; Chase

Manhattan Corp.; Citigroup; Credit Suisse First Boston; Deutsche Bank; Goldman Sachs & Co.; Lehman

Brothers; Merrill Lynch & Co., Inc.; J.P. Morgan & Co., Inc.; Morgan Stanley Dean Witter; and UBS AG.

The Basle Committee on Banking Supervision is a committee of banking supervisory authorities that

was established by the Central Bank Governors of the Group of Ten countries in 1975. It meets under

the auspices of BIS in Basle, Switzerland. The Group of Ten consists of 11 major industrialized member

countries—Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the

United States, and the United Kingdom.

(Treasury), Office of the Comptroller of the Currency (OCC), FDIC, and

the Department of Justice. However, we focused on the activities of the

members of the President’s Working Group, which includes the heads of

Treasury, the Federal Reserve Board, SEC, and CFTC. We also interviewed

various industry officials. In addition, we collected information from the 14

consortium members and met with LTCM officials. Finally, we drew upon

our relevant prior work.

We requested comments on a draft of this report from the heads of CFTC,

the Federal Reserve, SEC, and Treasury. They provided written comments,

which are discussed near the end of this letter and reprinted in appendixes

II through V. We did our work in Washington, D.C.; New York, NY; and

Greenwich, CT between October 1998 and August 1999 in accordance with

generally accepted government auditing standards.

The LTCM crisis demonstrated that lapses in market discipline can create

potential systemic risk. Although the creditors and counterparties that

supplied leverage to LTCM had policies requiring that they conduct due

diligence of LTCM’s activities, they were not fully aware of the size of

LTCM’s trading positions and the risk these might pose to financial

markets until days before its imminent collapse. The LTCM crisis has

renewed concerns among regulators about systemic risk and illustrates the

risks that can exist in large trading positions. Since LTCM’s near-collapse,

at the request of SEC’s chairman, a group of creditors and counterparties

has developed a framework to strengthen their risk management practices

and enhance market discipline.

In our market-based economy, market discipline is the primary mechanism

to control risk-taking. For market discipline to be effective, it is essential

for creditors and counterparties to increase the costs or decrease the

availability of credit to customers as the latter assume greater risks. The

President’s Working Group’s hedge fund report stated that increasing the

cost or reducing the availability of credit “provides a powerful economic

incentive for firms to constrain their risk-taking.” It added, however, that

“[market participants’] motivation is to protect themselves but not the

system as a whole … No firm … has an incentive to limit its risk-taking in

order to reduce the danger of contagion for other firms.”

Securities Firms: Assessing the Need to Regulate Additional Financial Activities (GAO/GGD-92-70,

Apr. 21, 1992); Financial Derivatives: Actions Needed to Protect the Financial System (GAO/GGD-94-133,

May 18, 1994); Financial Derivatives: Actions Taken or Proposed Since May 1994

(GAO/GGD/AIMD-97-8, Nov. 1, 1996); and Risk-Based Capital: Regulatory and Industry Approaches to

Capital and Risk (GAO/GGD-98-153, July 20, 1998).

Lapses in Market

Discipline Enabled

LTCM to Have Large,

Leveraged Trading

Positions, Creating

Potential Systemic

Risk

Market Discipline Did Not

Constrain LTCM’s Leverage

and Risk-taking.

Although market discipline can be effective in constraining leverage and

risk-taking, the regulators found that some of LTCM’s creditors and

counterparties failed to apply appropriate prudential standards in their

dealings with that firm. According to the President’s Working Group

report, such standards include (1) due diligence assessments of the

financial soundness and managerial ability of the counterparty, including

its risk profile; (2) requirements for ongoing financial reports,

supplemented by information on the prospective volatility of the

counterparty’s positions and qualitative evaluations; (3) collateral

requirements against present and potential future credit exposures, when

insufficient information is available on the counterparty’s

creditworthiness; (4) credit limits on counterparty exposures; and (5)

ongoing monitoring of the counterparty’s financial condition. Although

some firms were willing to compromise their standards to do business

with LTCM, others refused to do so. According to LTCM officials, these

firms believed that LTCM would not provide sufficient information about

its investment strategies.

Regulators cited a number of reasons why some financial firms did not

apply adequate market discipline in their dealings with LTCM, including

the following:

· LTCM benefited from a “halo” effect; that is, creditors and counterparties

appeared to base their credit decisions for LTCM on the credentials of its

principals—among whom were a former vice chairman of the Federal

Reserve Board and two Nobel laureates—rather than on traditional credit

analysis.

· Business with LTCM and other hedge funds was profitable for financial

firms, and competition for this business among major banks and securities

firms provided an additional incentive to relax credit standards.

· Favorable economic conditions had prevailed for several years,

contributing to an atmosphere in which financial firms liberalized their

credit standards.

In addition, regulators found that some of the analytical tools used by

banks and securities and futures firms to assess LTCM’s riskiness

appeared to have been flawed. The firms apparently shared LTCM’s view

that its risks were widely diversified because its positions were spread

across markets around the globe. However, LTCM’s worldwide losses in

August and September showed that although its risks were spread across

global markets, LTCM had replicated similar strategies in each market. As

a result, when its strategies failed, they failed across markets. According to

the President’s Working Group report, the firms’ risk models

underestimated the size of shocks and the resulting price movements that

might affect world markets. Related to this, they did not fully consider the

potential impact on markets of a liquidation of LTCM’s positions.

The Federal Reserve’s decision to facilitate the private sector

recapitalization of LTCM was based on its concern that LTCM’s failure

might pose systemic risk. Although a systemic crisis can result from the

spread of difficulties from one firm to others, in this case the potential

threat was to the functioning of financial markets. According to Federal

Reserve officials, they were concerned that rapid liquidation of LTCM’s

very large trading positions and of its counterparties’ related positions in

the unsettled market conditions of September 1998 might have caused

credit and interest rate markets to experience extreme price moves and

even temporarily cease functioning. This could have potentially harmed

uninvolved firms and adversely affected the cost and availability of credit

in the U.S. economy.

LTCM’s creditors and counterparties would have faced sizeable losses if

LTCM had failed. Estimates are that individual firms might have lost from

$300 million to $500 million each and that aggregate losses for LTCM’s top

17 counterparties might have been from $3 billion to $5 billion. However,

according to financial regulators, these losses were not large enough to

threaten the solvency of LTCM’s major creditors. Among the eight U.S.

firms that participated in the recapitalization, equity capital at the end of

fiscal 1998 ranged from $4.7 billion to $42.7 billion. The Basle Committee

on Banking Supervision noted that these losses could have increased

further if the repercussions had spread to markets more generally.

According to Federal Reserve officials, LTCM’s failure, had it occurred in

the unsettled market conditions of September 1998, might have disrupted

market functioning because of the size and concentration of LTCM’s

positions in certain markets and the related sales of other market

participants. As noted previously, the firm had sizeable trading positions in

various securities, exchange-traded futures, and OTC derivatives markets.

Moreover, LTCM’s counterparties might have faced the prospect of

“unwinding” their own large LTCM-related positions in the event of that

firm’s default. Unwinding these positions could have been difficult:

according to LTCM officials, about 20,000 transactions were outstanding

between LTCM and its counterparties at the time of its near-collapse.

The LTCM Crisis Illustrated

that Potential Systemic Risk

Can Exist in Large Trading

Positions.

According to Federal Reserve officials, a default by LTCM on its contracts

might have set off a variety of reactions. For example, most of LTCM’s

creditors and counterparties held collateral against their current credit

exposures to LTCM. In the event of LTCM’s default, however, the

exposures might have risen in value by the time the collateral was sold,

resulting in considerable losses. Also, derivatives counterparties, faced

with sudden termination of all their contracts with LTCM, would have had

to rebalance their firms’ overall risk positions; that is, they would have had

to either purchase replacement derivatives contracts or liquidate their

related positions. In addition, firms that had lent securities to LTCM might

have had to sell the collateral held and buy replacement securities in the

marketplace at prevailing prices. In considering the prospect of these

developments, Federal Reserve officials said that a “fire sale” of financial

instruments by LTCM’s creditors and counterparties might have set off a

cycle of price declines, losses, and further liquidation of positions, with the

effects spreading to a wider group of uninvolved investors.

In January 1999, a group of 12 major, internationally active commercial

and investment banks formed the Policy Group to promote enhanced

management of counterparty risk by financial firms. In July 1999, the

Policy Group issued a report that reviewed key risk management issues,

evaluated emerging improvements, and made recommendations.

addition to recommendations to improve risk management practices, the

report recommended ways to improve financial institutions’ assessments

of their own leverage and that of their counterparties. It also

recommended that risk evaluation frameworks incorporate linkages

among various types of risk, such as between credit and market risks, and

that stress-testing include a focus on potential illiquidity in markets. The

report further recommended enhanced information-sharing with

regulators on counterparty relationships but stated that this should be

strictly voluntary, informal, and confidential. (We discuss this in greater

detail later in the report.)

After the Crisis, Major

Financial Firms Proposed

Improved Risk Standards.

The industry reportedly already had begun to respond to the risks posed

by LTCM. According to surveys done by Arthur Andersen LLP,

the LTCM

crisis prompted strong reactions from virtually all large firms that were

counterparties of hedge funds and an increased sense of awareness

regarding risk management policies and procedures. Andersen noted that

all surveyed firms reported a lower level of hedge fund exposures in mid-

Improving Counterparty Risk Management Practices, the Counterparty Risk Management Policy

Group, June 21, 1999.

Arthur Andersen Market Practices Group, New York, NY.

1999 compared to before the crisis, notwithstanding a slow increase

toward the end of the period. Andersen reported that industry reactions

have included the following:

· The number of banks and securities and futures firms doing business with

hedge funds has decreased, and the business is substantially more

concentrated among the largest, globally active firms.

· These firms have focused on their risk management activities, including

obtaining more complete information through required data reports and

on-site visits; tightening credit terms and increasing margin requirements;

and improving risk models and recognizing the risks of unanticipated

market events.

· The hedge funds have become more forthcoming with meaningful data and

information ensuring greater transparency to their activities.

Although these reactions appear to have improved market discipline, as

the President’s Working Group noted, market history indicates that even

painful lessons recede from memory with time. Regulators, through their

oversight activities, can play a role in helping to ensure the maintenance of

sound risk management practices.

Regulators had expressed general concern about the potential risks posed

by hedge funds and the perils of declining credit standards, but they said

they generally believed that hedge funds’ creditors and counterparties

were appropriately constraining the funds’ leverage and risk-taking.

Examinations, which are one way regulators oversee the activities of their

regulated entities and markets, done after the crisis revealed that banks

and securities and futures firms had not consistently followed prudent

standards. In addition, information collected through off-site monitoring

from regulated entities and, in some cases, from LTCM also did not fully

identify the potential threat that LTCM posed to financial markets. Since

the LTCM crisis, many of the regulators have issued additional regulatory

guidance and have recommended additional regulatory steps that could

help them better identify lapses in risk management practices like those

involving LTCM. Some market participants have also recommended ways

to enhance the information voluntarily reported to regulators in addition to

enhancing their own practices.

Regulatory Oversight

Did Not Identify

Lapses in Risk

Management Practices

and the Threat Posed

by LTCM.

Since the early 1990s, regulators have been aware that the activities of

hedge funds could significantly affect financial markets. In 1992, SEC

observed that “Hedge funds have the potential to both increase and

decrease liquidity in the markets in which they invest.” Also in 1992,

Treasury, the Federal Reserve, and SEC issued a joint report on

government securities that stated that “their capacity for leverage allows

hedge funds to take large trading positions disproportionate to their

capital base.”

In 1994, one of the members of the Federal Reserve Board

testified before the Committee on Banking, Finance and Urban Affairs that

“… hedge funds, because they are large and are willing to take large

positions, can have important effects on financial markets.” Between 1992

and early 1998, regulators observed that fund managers and their creditors

and counterparties appeared to have adequate controls in place.

In late 1997 and early 1998, the Federal Reserve updated its previous work

on hedge fund activities by surveying several large banks about their

relationships with hedge funds. The Federal Reserve survey results

revealed that LTCM was one of the large hedge funds mentioned but did

not identify any specific concerns about bank relationships with LTCM. In

addition, the survey results indicated that banks had adequate procedures

in place to manage their relationships with hedge funds and indicated no

concern about exposures to the funds because of the quality of collateral

held (cash and U.S. Treasuries). Bank examiners did not independently

verify actual credit practices at the time of the survey but were instructed

to focus special attention on bank relationships with hedge funds given

their “special” risk profile.

As is common during periods of economic expansion, bank regulators had

been urging bankers to maintain prudent lending standards and alerting

them to underwriting practices that could become unsound. In June 1998,

the Federal Reserve and OCC also warned banks not to succumb to

competitive pressures and compromise standards. However, before

LTCM’s near-collapse, regulators generally appeared to be unaware of the

extent to which credit standards had declined in relation to certain hedge

funds. Just days before federal officials visited LTCM in Greenwich, CT, to

discuss its problems, the Chairman of the Federal Reserve Board testified

before the House Committee on Banking and Financial Services that

“hedge funds were strongly regulated by those who lend the money.” At

the same hearing, the Secretary of the Treasury basically agreed with the

Chairman that hedge funds are “in effect, regulated by the creditors.”

Improper Activities of Government Securities Markets,” Joint Report by the Department of the

Treasury, the Federal Reserve Board, and SEC (Jan.1992).

Federal Regulators Had

Expressed General

Concerns About Hedge

Funds for Years.

However, he raised questions about whether additional things could be

done to maintain discipline among creditors.

Federal bank, securities, and futures regulators did not identify the lapses

in risk management practices and the threat posed by LTCM, primarily

because they limited their focus to problems involving the largest credit

exposures of the firms they regulated. However, LTCM was not among the

largest exposures of any of these firms. After the crisis, when they looked

again at the regulated firms, the regulators found substantial lapses in

credit risk management practices of banks’ and broker-dealers’

relationships with hedge funds.

Federal financial regulators do on-site examinations to obtain first-hand

knowledge about the operations of the firms that they regulate. Bank

regulators focus their examinations on internal control systems and risk

management and look for problems in areas that could significantly affect

the safety and soundness of the bank, such as major credit exposures.

Bank regulatory officials said that because its positions were generally

collateralized, examiners did not identify LTCM as a major risk to any bank

and did not investigate the full range of the banks’ transactions with LTCM

until after the crisis. Securities examinations, which focused primarily on

investor protection and financial responsibility, internal controls, and risk

management of individual broker-dealers, did not identify the extent of

activity with LTCM, much of which was done in affiliates outside the

regulated entities.

Regulators Did Not Identify

Weaknesses in Firms’ Risk

Management Practices Until

After the Crisis.

After the crisis, when federal financial regulators focused their

examinations on banks’ and broker-dealers’ relationships with LTCM, they

discovered a number of risk management weaknesses. The weaknesses

were also reported to be evident in the firms’ dealings with other highly

leveraged customers, including commercial and investment banks. For

example, Federal Reserve officials found that banks failed to perform

adequate due diligence, relying primarily on collateralization of their

current exposures. When hedge funds failed to provide sufficient details

about their positions and investment strategies, banks generally failed to

apply controls to mitigate their risks. According to regulatory officials,

LTCM’s creditors were largely unaware of the size and scope of its trading

positions until its near-collapse. Federal Reserve officials also reported

that the banks had inadequate credit stress-testing procedures and

weaknesses in ongoing exposure monitoring.

SEC officials found similar problems at broker-dealers. For example, SEC

found that credit decisions were often not consistent with established

policies, and hedge funds provided limited or no information on aggregate

security portfolios, leverage, risk concentrations, performance, or trading

strategies. SEC officials also found that hedge funds were not always

subject to greater disclosure requirements commensurate with their

greater risks. In addition, broker-dealers, like commercial banks, failed to

factor concentration and liquidity risks into assumptions about the

riskiness of certain activities, and stress-testing was not thoroughly

performed at all firms. CFTC investigated the dealings between LTCM and

two of its FCMs, which had numerous and extensive relationships with

LTCM, to determine if there were any violations of the Commodity

Exchange Act or the rules thereunder but found no such violations.

In addition to on-site examinations, regulators perform off-site monitoring

through periodic information received from regulated entities and other

market participants, such as LTCM. However, periodic information

provided to the regulators did not reveal the potential systemic threat

posed by LTCM. For example, although bank regulators require each

individual bank and bank holding company to file detailed quarterly

statements of financial condition and income and operations, this

information does not identify any individual creditors and counterparties

and would not be expected to have identified potential problems related to

LTCM.

SEC and CFTC require periodic reports from registered broker-dealers and

FCMs and receive voluntary information from the unregulated derivatives

affiliates of these firms. For example, they require broker-dealers and

FCMs to report quarterly statements of financial condition, including

supplemental information. However this information, like the information

provided to bank regulators, does not identify individual exposures. SEC

and CFTC, under their risk assessment authorities, also require broker-dealers

and FCMs to provide certain information about significant

affiliates.

Offsite Monitoring Did Not

Reveal the Potential

Systemic Threat Posed by

LTCM.

However, the affiliates’ net exposures to LTCM were not large

enough to be classified as material and were not reported. In addition,

members of the Derivatives Policy Group (DPG) voluntarily provide

information to SEC and CFTC about the OTC derivatives activities of their

unregulated OTC derivatives affiliates.

This information identifies the

The Market Reform Act of 1990 authorized SEC to collect certain information from registered broker-dealers

about the activities and the financial condition of their holding companies and materially

associated persons. The Futures Trading Practices Act of 1992 provided CFTC with similar authority.

DPG was organized in 1994 to address the public policy issues raised by the OTC derivatives activities

of unregistered affiliates of SEC-registered broker-dealers and CFTC-registered FCMs. DPG-member

firms included CS First Boston, Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley, and

Salomon Brothers (now part of Citigroup). CS First Boston does not report to SEC under the

framework because it is subject to the jurisdiction of a foreign regulator.

affiliates’ 20 largest individual counterparty credit exposures (net of

collateral) but does not routinely identify the counterparties by name.

According to SEC officials, LTCM did not show up as a significant

exposure because its positions with these affiliates were collateralized.

CFTC also received certain information directly from LTCM because of the

nature of its activities. For example, LTCM provided CFTC its annual

financial statements and other information because it was a registered

commodity pool operator (CPO).

LTCM’s year-end 1997 statement

showed its large asset positions, leverage of about 28 to 1, and off-balance

sheet derivatives positions exceeding $1 trillion in notional amount.

According to CFTC’s testimony in 1998, CFTC staff reviewed LTCM’s

financial statements, along with more than 1,000 such statements received

annually, and found no compliance problems.

Further, LTCM was

considered well capitalized and profitable, and its balance sheet leverage

ratio was comparable to other leveraged hedge funds as well as investment

and commercial banks. CFTC officials explained that CFTC does not have

the authority to regulate CPOs for prudential purposes, nor does it review

the appropriateness or nature of CPO investments. Instead, they said that

CFTC focuses on whether CPOs engage in improper activity, such as

market manipulation or fraud. NFA completed a limited compliance audit

of LTCM’s annual statement in April 1998 but was not required to, nor did

it, analyze the report for the appropriateness of LTCM’s investment

strategy and risk management. LTCM also provided CFTC daily

information concerning some of its exchange-traded futures positions

because those positions made it a large trader as defined by CFTC

regulation.

CFTC officials said that the Large Trader System works well

for detecting price manipulation in the exchange-traded futures markets

but is not useful for monitoring activities in broader financial markets

because the information is limited to futures trading.

Finally, SEC requires institutional investment managers to file a quarterly

report of equity holdings if they have equity securities under management

of $100 million or more. Pursuant to Section 13(f) of the Exchange Act,

LTCM filed an itemized schedule of its equity holdings exceeding the

A CPO is the manager of a commodity pool, which is a collective investment vehicle that trades

futures contracts.

Testimony of CFTC before the U.S. Senate Committee on Agriculture, Nutrition and Forestry, Dec.16,

1998.

17 C.F.R. § § 17 & 18 (1998) require daily reporting by large traders on their futures and options

positions, delivery notices, and exchanges for cash. The exact level of a reportable position differs

from contract to contract and is defined in CFTC Rule 15.03. 17 C.F.R. § 15.03 (1998)..B-281371

reporting threshold, including the name of the issuer, fair market value,

number of shares held, and other information.

SEC officials said that the

reports offered no indication of the potential threat LTCM’s other activities

posed to global financial markets because the information received

covered only LTCM’s equity securities activities.

Following their post-crisis examinations, OCC and the Federal Reserve

both issued additional examination guidance on supervising credit risk

management. SEC and its SROs also issued joint guidance on risk

management practices for broker-dealers. Finally, the President’s Working

Group and the Policy Group recommended enhanced information

reporting requirements.

In early 1999, OCC and the Federal Reserve each issued supplements to

their existing guidance to bank examiners that were intended to improve

the focus on issues raised by the LTCM crisis and by other world financial

problems in 1997 and 1998. Although the degree of detail in the

supplements varied, each had similar emphasis on both improving the

sophistication of banks’ risk management policies concerning

counterparties and ensuring that banks practiced and enforced these

policies. The regulators intended to prepare their examiners to address not

only hedge fund issues, but also other challenges arising from banks’

evolving business. They responded to specific flaws in banks’ risk

management involving LTCM. For example, both agencies noted the

unexpected interactions that could occur among market, credit, and

liquidity risks in unsettled times and emphasized the importance of stress-testing

to ensure that banks did not risk facing unacceptable exposures to

their counterparties during such times. They also emphasized the

importance of banks’ understanding the risk profiles of their

counterparties.

Regulators and Industry

Adopted and Recommended

Improved Oversight and

Practices.

In July 1999, SEC and two securities SROs, NYSE and NASDR, issued a

joint statement that included a compendium of sound practices and

weaknesses noted during their review of risk management systems of

registered broker-dealers. The statement provided examples of

weaknesses identified, as well as examples of sound practices observed

during the review, and stressed the importance of sound practices in

today’s dynamic markets. Finally, the statement concluded by stressing the

importance of maintaining an appropriate risk management system and

noted that examination staffs of SEC, NYSE, and NASDR were to increase

15 U.S.C. § 78m(f).

their emphasis on the review of risk management controls during

regulatory examinations.

In its April 1999 report, the President’s Working Group identified several

areas where information reporting could be improved. It recommended

that Congress grant SEC and CFTC authority to collect and verify

additional information on broker-dealer and FCM affiliates.

The expanded

reporting would include information on credit risk by counterparty;

nonaggregated position information; and more detailed data on

concentrations (e.g., financial instruments, region, and industry sector),

trading strategies, and risk models. It also recommended giving regulators

the authority necessary to review risk management procedures and

controls at the holding company level and to examine the books and

records of the unregulated affiliates. (This issue is discussed in greater

detail later in this report.) The Chairman of the Federal Reserve Board

declined to endorse this recommendation but deferred to the judgment of

those with supervisory responsibility. To enhance market discipline, the

President’s Working Group also recommended improvements to public

reporting and disclosure. First, it recommended that hedge funds be

required to disclose current information to the public.

Second, it

recommended that all public companies disclose a summary of direct

material exposures to significantly leveraged financial institutions. These

entities would be aggregated by sector (for example, commercial banks,

investment banks, insurance companies, and hedge funds). According to

the President’s Working Group, requiring such public disclosure about

material exposures to significantly leveraged financial entities could

reinforce market discipline.

Finally, the Policy Group report included recommendations about

enhancing the quality, timeliness, and relevance of information flows

between the major market participants and their regulators, with the

provision that such flows be informal, voluntary, and confidential. The

report noted that information flows should include informal high-level

meetings on a periodic basis to discuss principal risks, market conditions,

and trends with potential for market disruptions or systemic risks. In

The President’s Working Group report also recommended that Treasury’s authority over affiliates of

government securities broker-dealers and FCMs be similarly expanded.

For hedge funds that are CPOs, the report suggested that the CPO filings might provide the best

vehicle for enhanced reporting. In addition, it recommended that large CPOs file quarterly rather than

annual reports. The reports could include more meaningful and comprehensive measures of market

risk (value-at-risk or stress test results) without requiring the disclosure of proprietary information on

strategies or positions. For hedge funds that are not CPOs, Congress would need to enact legislation

for authorizing mechanisms for disclosure.

addition, it recommended that financial intermediaries, such as banks and

securities and futures firms, voluntarily provide reports to regulators, if

requested, detailing information on large exposures on a consolidated

basis. The proposed voluntary reporting would include information on

large exposures to counterparties.

The format for the voluntary reports would be similar to the voluntary

DPG reporting, but with important differences. First, the proposed report

would cover not just derivatives but many other types of transactions with

counterparties. Second, the proposed report would list a greater number of

counterparties than is covered by the DPG report and would include

counterparty names. Third, the report would call for the firms to explicitly

quantify how potential market illiquidity might affect their risks. Thus, if

these reports are provided to regulators, and if they are used to seek

additional information on large or growing counterparties, regulators’

ability to identify significant concentrations of risk could be enhanced.

Although much of the information reporting could provide regulators with

additional information that might help them monitor and identify systemic

risk, the voluntary nature of the reporting means that firms could withhold

information or refuse to cooperate if regulators request additional

information. In addition, regulators would not be able to verify the

accuracy or completeness of the information provided through

examination or inspection.

Existing Coordination

Could be Improved to

Enhance Regulators’

Ability to Identify

Risks Across

Industries and Markets.

Federal financial regulators followed their traditional approaches to

oversight in the LTCM case: bank regulators focused on risks to banks; and

securities and futures regulators focused on risks to investors, regulated

entities, and markets. However, these approaches were not effective

because the risks posed by LTCM crossed traditional regulatory and

industry boundaries. Regulators would have had a better opportunity to

identify these risks if their oversight activities had been better coordinated.

More broadly, cross-industry risks have become more common as the

activities of major firms have blurred the boundaries among industries,

making effective coordination among regulators more important. Although

the importance of coordination among the federal financial regulators

continues to grow, the President’s Working Group report on the LTCM

crisis did not include recommendations about ways that the regulators

might enhance their coordination.

Bank regulators’ traditional role has been to protect the banking system

from disruptions and to help reduce the risk to taxpayers from the

government-backed guarantees on bank deposits provided through the

deposit insurance fund. In fulfilling this role, their approach has been to

focus on maintaining the safety and soundness of banks, including, in the

case of the Federal Reserve, examining risks posed by bank affiliates in a

bank holding company structure. Bank regulators have various

coordination mechanisms, including the Federal Financial Institutions

Examination Council

and the Shared National Credit Program.

Securities and futures regulators’ traditional role has been to protect

investors and the integrity of securities and futures markets. Their

approach to maintaining the financial integrity of the regulated firms has

been to focus on the extent to which investor funds and investments might

be at risk in case of firm failures. SEC and CFTC also have coordinated

their efforts through various groups, such as the Intermarket Financial

Surveillance Group.

Other broader coordinating groups exist that cut

across industries, including the President’s Working Group. However,

these groups generally do not provide the type of coordination that

includes routine staff-level interaction, including sharing information and

observations about specific firms and markets that would be required to

reveal potential systemic risk like that posed by LTCM.

Traditional approaches to coordination, although necessary for achieving

their regulatory purposes, did not help regulators identify the cross-industry

risks that LTCM posed. As discussed previously, the Federal

Reserve’s December 1997 and January 1998 survey of large banks’

relations with hedge funds revealed that LTCM was a large hedge fund. On

the basis of what they were told, officials concluded that bank procedures

were adequate to control the risks hedge funds posed. In addition, as

discussed previously, LTCM did not surface as a problem during routine

examinations because bank examiners focused their attention on each

bank’s exposure (net of collateral), which appeared small in the case of

LTCM (and hedge fund exposures overall). In March 1998, CFTC received

a year-end 1997 financial report from LTCM. The report showed both the

leverage and large derivatives positions that LTCM had accumulated

worldwide. CFTC found nothing in the report to raise questions about

LTCM’s commodity pool operations. On a daily basis LTCM provided

CFTC information concerning its reportable positions on U.S. futures

The Federal Financial Institutions Examination Council is a mechanism for bank regulators to

coordinate certain activities, including developing uniform principles, standards, and report forms and

coordinating the development of uniform reporting systems and regulations.

The Shared National Credit Program is an interagency program designed to review and assess risk in

many of the largest and most complex credits shared by multiple institutions (for example, syndicated

loans).

The Intermarket Financial Surveillance Group comprises securities and futures SROs, SEC, and

CFTC. It was formed after the 1987 market crash to ensure coordination and cooperation with respect

to the financial or operational condition of member firms in times of market stress.

markets, but CFTC determined that these positions did not threaten those

markets. In August 1998, SEC heard about troubles at LTCM through

market sources. It investigated the exposures of large broker-dealers to

LTCM and other hedge funds, but the information submitted indicated that

any exposure to LTCM existed outside the registered broker-dealer.

Because none of the regulators considered the information they obtained

important enough to share with the other regulators, LTCM raises

questions about how regulators decide what information needs to be

shared.

Even if they had fully coordinated their activities, the regulators still may

not have identified the cross-market and industry risks that LTCM posed.

In part, this could result because of the information that regulators relied

on, such as exposures net of collateral, to determine risk. Had they looked

at gross exposures and aggregated them across industry lines, they may

have been more likely to recognize the linkages among markets. However,

the potential benefits of such coordination could increase as better

information becomes available. As discussed previously, the President’s

Working Group and the Policy Group each recommended that financial

intermediaries, including banks and securities and futures firms, make

additional information available to their regulators. For example, the

Policy Group has recommended that banks and securities and futures

firms supply their primary regulator with lists of the counterparties with

whom they have their largest aggregate credit risk exposures. The reports

would cover a broad range of transactions, such as derivatives contracts,

repo agreements, and loan agreements. These reports would also include

information on potential future exposures. To fully benefit from this

information, regulators might share these lists with one another to identify

those counterparties that have large cross-industry activity.

Officials from the Federal Reserve, SEC, and CFTC told us that they share

information they judge to be important with other regulators on a case-by-case

basis and that this approach generally works well. Moreover, the

President’s Working Group, which includes the heads of these agencies

and the Secretary of the Treasury, did not make recommendations for

enhanced coordination, and the Policy Group only acknowledged the

possibility of sharing information among regulators under tight

restrictions. However, because the traditional lines that separate banks,

securities, and futures businesses have been blurred, and large financial

firms now compete with each other in offering the same financial services,

activities generating risks that cross industries and markets may be

increasingly common.

Developing ways to routinely coordinate assessment of cross-industry

risks among regulators may take time and require ingenuity. They might

have to develop criteria to determine when and what information needs to

be shared. Also, focusing on data needed to develop measures of risk that

may have systemic implications under stressful conditions may be a place

to start. In addition, regulators would have to consider how to address

issues related to sharing proprietary and confidential information.

Nonetheless, given the potential for risks across industry and market lines

and the inability of existing coordination methods to effectively monitor

such risks, each regulator should be held accountable for identifying

methods for coordinating their activities to identify potential systemic risk

across industries.

Gap in SEC’s and

CFTC’s Regulatory

Authority Limits Their

Ability to Identify and

Mitigate Systemic Risk

SEC and CFTC Lack

Authority to Regulate

Affiliates of Broker-Dealers

and FCMs.

SEC and CFTC lack the regulatory authority to supervise unregistered

affiliates of broker-dealers and FCMs. The lack of authority over these

affiliates, which often act as financial intermediaries, creates a regulatory

gap that impedes SEC’s and CFTC’s ability to identify and mitigate

problems that may threaten markets or the entire financial system. The

significance of the gap has grown as the amount of activity conducted

outside of the broker-dealers and FCMs has increased. The President’s

Working Group recognized this gap and the need for SEC and CFTC to

have greater authority. However, it did not recommend consolidated

regulatory authority over securities and futures firms, which would expand

SEC’s and CFTC’s regulatory authority over unregulated affiliates—

primarily the authority to set capital standards, conduct comprehensive

examinations, and take enforcement actions. Instead, it recommended

greater authority to collect and verify information. As we have stated in

past reports, we believe that the existing regulatory gap should be closed,

and previous attempts to fill it with greater information reporting have

been inadequate. However, we recognize that there are controversial

issues to be resolved before filling this gap.

SEC and CFTC generally lack authority to regulate the unregistered

affiliates of broker-dealers and FCMs. This gap impedes their ability to

identify and mitigate problems at securities and futures firms that could

contribute to systemic risk and threaten financial markets. For example,

when market participants notified SEC of LTCM’s problems in August

1998, SEC surveyed the registered broker-dealers about their hedge fund

exposures, in general. However, information submitted suggested that any

exposure to LTCM existed outside the registered broker-dealers, either in

Officials of the Federal Reserve cited the Trade Secrets Act (18 U.S.C. 1905), which applies to all

federal agencies, as a potential impediment to information sharing.

the holding companies or in their unregulated affiliates. Because of SEC’s

limited authority, officials were unable to determine the extent of hedge

fund activity at unregulated affiliates of broker-dealers. If SEC had the

authority to supervise the activities of the broker-dealer and its affiliates

firmwide, it would have been able to obtain information about the

exposures of unregulated affiliates of broker-dealers to LTCM. In addition,

when SEC staff examined major broker-dealers following LTCM’s near-collapse,

they had limited access to certain documents and information

because credit risk management is primarily a firmwide function

conducted at the holding company level and thus outside of SEC’s

jurisdiction. According to SEC officials, this information is often provided

to SEC on a voluntary basis.

Regulators have full regulatory authority over securities and futures

activities of broker-dealers and FCMs, but the percentage of assets held

outside the regulated entities has grown significantly. At four major

securities and futures firms, the percentage of assets held outside the

regulated broker-dealer grew from an average of 22 percent in 1994 to 41

percent in 1998. The OTC derivatives activities of the major securities and

futures firms are usually conducted through non-broker-dealer and FCM

affiliates and are therefore generally outside of the regulatory authority of

SEC and CFTC. As a result, SEC and CFTC are not able to supervise all

activities that may pose potential threats to the financial system. Table 2

shows that in 1998 the notional value of total derivatives contracts at four

major securities and futures firms was larger than LTCM’s.

Table 2: Comparison of Total Notional

Value of Derivatives Contracts (dollars

in billions).

Entity Total notional value

LTCM $1,400

The Goldman Sachs Group, L.P. 3,410

Lehman Brothers Holdings, Inc. 2,398

Merrill Lynch & Co., Inc. 3,470

Morgan Stanley Dean Witter & Co. 2,860

Total notional value includes OTC and exchange-traded derivatives.

Source: GAO analysis of data from the President’s Working Group for LTCM as of August 31, 1998.

Annual reports for Goldman, Lehman as of November 30, 1998; Morgan Stanley as of November 30,

1998; and Merrill Lynch as of December 25, 1998.

Notional values are not necessarily a meaningful measure of risk, but there were concerns at the time

of LTCM’s near-collapse that sudden liquidation of large derivatives positions could affect market

stability as counterparties sought to rebalance their own positions.