oversight

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

Published by the Government Accountability Office on 1999-10-29.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

               United States General Accounting Office

GAO            Report to Congressional Requesters




October 1999

               LONG-TERM
               CAPITAL
               MANAGEMENT
               Regulators Need to
               Focus Greater
               Attention on Systemic
               Risk




GAO/GGD-00-3
United States General Accounting Office                                                          General Government Division
Washington, D.C. 20548




                                    B-281371
                                    October 29, 1999

                                    The Honorable Byron L. Dorgan
                                    United States Senate

                                    The Honorable Tom Harkin
                                    United States Senate

                                    The Honorable Harry Reid
                                    United States Senate

                                    The Honorable Edward J. Markey
                                    United States House of Representatives

                                    This report responds to your request that we review Long-Term Capital
                                    Management’s (LTCM) near-collapse and some of the broader issues it
                                    raised. Between January and September 1998, LTCM, one of the largest
                                                       1
                                    U.S. hedge funds, lost almost 90 percent of its capital. In September 1998,
                                    the Federal Reserve determined that rapid liquidation of LTCM’s trading
                                    positions and related positions of other market participants might pose a
                                    significant threat to already unsettled global financial markets. Thus, the
                                    Federal Reserve facilitated a private sector recapitalization to prevent
                                    LTCM’s collapse. Although the crisis involved a hedge fund, the
                                    circumstances surrounding LTCM’s near-collapse and recapitalization
                                    raised questions that go beyond the activities of LTCM and hedge funds to
                                    how federal financial regulators fulfill their supervisory responsibilities
                                    and whether all regulators have the necessary tools to identify and address
                                    potential threats to the financial system. As agreed, the issues we
                                                                                                              2
                                    addressed were (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



                                    1
                                     Although there is no statutory definition of hedge funds, it is the term commonly used to describe
                                    private investment vehicles that often engage in active trading of various types of securities and
                                    commodities. Although some funds are subject to certain federal reporting requirements, hedge funds
                                    are generally exempt from direct federal regulation.
                                    2
                                     Leverage is broadly defined as the ratio between some measure of risk and capital. Simple balance
                                    sheet leverage is assets divided by capital. However, this measure of leverage does not take into
                                    account risk from off-balance sheet activities, such as the use of derivatives.




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                   regulatory authority limits regulators’ ability to identify and mitigate
                                            3
                   potential systemic risk.

                   LTCM was able to establish leveraged trading positions of a size that posed
Results in Brief   potential systemic risk, primarily because the banks and securities and
                                 4
                   futures firms that were its creditors and counterparties failed to enforce
                   their own risk management standards. Other market participants and
                   federal regulators relied upon these large banks and securities and futures
                   firms to follow sound risk management practices in providing LTCM
                   credit. However, weaknesses in the risk management practices of these
                   creditors and counterparties allowed LTCM’s size and use of leverage to
                   grow unrestrained. According to federal financial regulators, these
                   weaknesses, at least in part, resulted from overreliance on the reputations
                   of LTCM’s principals, the relaxing of credit standards that typically occurs
                   during periods of sustained economic prosperity, and competition between
                   banks and securities and futures firms for hedge fund business.

                   The effects of these weaknesses became apparent during the unsettled
                   market conditions that occurred in the summer of 1998. LTCM began to
                   lose large amounts of money—$1.8 billion in August alone—in various
                   trading positions worldwide and by mid-September was on the verge of
                   failure. The Federal Reserve facilitated a private sector recapitalization of
                   LTCM because of concerns that a rapid liquidation of LTCM’s trading
                   positions and related positions of other market participants in already
                   highly volatile markets might cause extreme price movements and cause
                   some markets to temporarily cease functioning. Following the LTCM
                   crisis, a group of major financial firms prepared a report that addressed
                   risk management issues and recommended improvements to financial
                   firms’ existing counterparty risk practices.

                   Federal financial regulators did not identify the extent of weaknesses in
                   banks’ and securities and futures firms’ risk management practices until
                   after LTCM’s near-collapse. Although regulators were aware of the
                   potential systemic risk that hedge funds can pose to markets and the perils
                   of declining credit standards, until LTCM’s near-collapse, they said they
                   believed that creditors and counterparties were appropriately constraining

                   3
                    Systemic risk is generally defined as the risk that a disruption (at a firm, in a market segment, to a
                   settlement system, etc.) could cause widespread difficulties at other firms, in other market segments,
                   or in the financial system as a whole.
                   4
                    Broker-dealers and futures commission merchants are often part of larger organizations, which for the
                   purpose of this report we refer to as securities and futures firms. These firms may include a holding
                   company, if one exists, and other subsidiaries organized under the holding company. When we refer to
                   affiliates, we are referring to the holding company and any subsidiaries engaged in financial activities.




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hedge funds’ leverage and risk-taking. However, examinations done after
LTCM’s near-collapse revealed weaknesses in credit risk management by
banks and broker-dealers that allowed LTCM to become too large and
leveraged. The existing regulatory approach, which focuses on the
condition of individual institutions, did not sufficiently consider systemic
threats that can arise from nonregulated entities, such as LTCM. Similarly,
information periodically received from LTCM and its creditors and
counterparties did not reveal the potential threat posed by LTCM. Since
LTCM’s near-collapse, regulators and industry groups have taken steps to
address many of the issues raised, including revising examination guidance
and enhancing information reporting.

Because of the blurring in recent years of traditional lines that separate the
businesses of banks and securities and futures firms, it is more important
than ever for regulators to assess information that cuts across these lines.
Regulators for each industry have generally continued to focus on
individual firms and markets, the risks they face, and the soundness of
their practices, but they have failed to address interrelationships across
each industry. The risks posed by LTCM crossed traditional regulatory and
industry boundaries, and the regulators would have needed to coordinate
their activities to have had a chance of identifying these risks. Although
regulators have recommended improvements to information reporting
requirements, they have not recommended ways to better identify risks
across markets and industries. We are recommending that federal financial
regulators develop ways to better coordinate oversight activities that cross
traditional regulatory and industry boundaries.

Lack of authority over certain affiliates of securities and futures firms
limits the ability of the Securities and Exchange Commission (SEC) and
the Commodity Futures Trading Commission (CFTC) to identify the kind
of systemic risk that LTCM posed. Although SEC and CFTC regulate
                                                                          5
registered broker-dealers and futures commission merchants (FCMs),
they do not have the authority to regulate unregistered affiliates of broker-
dealers and FCMs except for limited authority to gather certain
information. This lack of authority, or regulatory “gap,” has become more
significant as the percentage of assets held outside the regulated entities
has grown; for example, almost half of the total assets of four major
securities and futures firms are held outside the registered broker-dealers.
These unregistered affiliates often have large positions in such markets as
over-the-counter derivatives and can be major providers of leverage in the
markets, as they were in the LTCM case. How they manage their own risks,
5
    FCMs are firms that buy and sell futures contracts as agents for customers.




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             as well as their provision of leverage to counterparties, can affect the
             financial system.

             The President’s Working Group report recognized this regulatory gap and
             recommended that Congress provide SEC and CFTC expanded authority
             to obtain and verify information from unregistered affiliates of broker-
             dealers and FCMs. However, this recommendation may not go far enough
             in enabling SEC and CFTC to more quickly identify and respond to the
             next potential systemic crisis. The Working Group recommendation would
             still leave important providers of credit and leverage in the financial
             system without firmwide risk management oversight by financial
             regulators. For example, LTCM was able to become too large and
             excessively leveraged, in part, through its dealings with these providers—
             the unregulated affiliates of broker-dealers and FCMs. Without additional
             authority to regulate the affiliates, SEC and CFTC do not have the
             authority needed to identify and address potential weaknesses in securities
             and futures firms’ risk management practices that might lead to the next
             systemic crisis. Such authority could be similar to that already available to
             the Federal Reserve over bank holding companies.

             Expanding SEC’s and CFTC’s regulatory authority over unregistered
             affiliates of broker-dealers and FCMs to include the ability to examine, set
             capital standards, and take enforcement actions, raises controversial
             issues and operational considerations that would have to be recognized
             and addressed. For example, some believe that expanding SEC’s and
             CFTC’s authority would undermine market discipline. However, we
             believe that expanded authorities would not lessen the role of effective
             market discipline and that imprudent behavior could result in a firm’s
             failure with creditors and investors suffering losses. It also would require
             that SEC and CFTC evaluate their operational and resource capacities to
             accommodate any expanded authority. However, the number of firms that
             are likely to be of concern is limited and thus should not involve a
             significant resource commitment. In order to identify and prevent potential
             future crises, we are suggesting that Congress consider providing SEC and
             CFTC authority to regulate affiliates of broker-dealers and FCMs.

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




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                                                                   6
                    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
                                                                                             7
                    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   LTCM was considered unique among hedge funds because of the large
                    scale of its activities and size of its positions in certain markets. BIS
Management          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,


                    6
                     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.
                    7
                     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.




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                                                 8                                   9                 10
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
        11                                 12                           13
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
                                                                 14
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.




8
 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).
9
 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.
10
   Short sales involve borrowing securities and selling them in hopes of repurchasing them at a lower
price at a later date.
11
   Initial margin is the amount of cash or eligible securities required to be deposited with a counterparty
before parties engage in a transaction.
12
 Two-way collateral means that both parties to a contract are required to post collateral, depending on
the direction of the credit exposure.
13
   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.
14
 Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management, Report of The
President’s Working Group on Financial Markets, Apr. 28, 1998.




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Table 1: Comparison of LTCM’s                                                                                                          a
Leverage to Major Securities and   Institution                                                                        Leverage Ratio
Futures Firms                      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
                                   a
                                    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
                                                                              15
                                   most active user of interest rate swaps.”

Financial Regulatory               Hedge funds are generally not subject to direct federal regulation, instead
                                   they are indirectly “regulated” by the banks and securities and futures
Structure                          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
                                                               16
                                   state regulatory oversight. Bank regulators have the authority to establish
                                   15
                                    69th Annual Report, 1 April 1998-31 March 1999, Bank for International Settlements, Basle,
                                   Switzerland, June 7, 1999.
                                   16
                                      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




                                   Page 7                                             GAO/GGD-00-3 Long-Term Capital Management
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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
register with SEC and comply with its requirements, including capital
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
                            17
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.



national charters. In addition, the Federal Deposit Insurance Corporation oversees banks with state
charters that are not members of the Federal Reserve.
17
     SROs assist SEC and CFTC in implementing the federal securities and commodities laws.




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                As agreed, our objectives were to discuss (1) how LTCM became large and
Scope and       leveraged enough to pose a potential systemic threat, (2) what federal
Methodology     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
                                                         18
                Markets (President’s Working Group). We also reviewed “Improving
                Counterparty Risk Management Practices” issued on June 21, 1999, by the
                                                                                 19
                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
                                                                                   20
                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

                18
                   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.
                19
                 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.
                20
                 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.




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                            (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
                                                     21
                            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
Lapses in Market            potential systemic risk. Although the creditors and counterparties that
Discipline Enabled          supplied leverage to LTCM had policies requiring that they conduct due
LTCM to Have Large,         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
Leveraged Trading           markets until days before its imminent collapse. The LTCM crisis has
Positions, Creating         renewed concerns among regulators about systemic risk and illustrates the
Potential Systemic          risks that can exist in large trading positions. Since LTCM’s near-collapse,
Risk                        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.

Market Discipline Did Not   In our market-based economy, market discipline is the primary mechanism
                            to control risk-taking. For market discipline to be effective, it is essential
Constrain LTCM’s Leverage   for creditors and counterparties to increase the costs or decrease the
and Risk-taking             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.”


                            21
                             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).




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  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



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                               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 LTCM Crisis Illustrated    The Federal Reserve’s decision to facilitate the private sector
                               recapitalization of LTCM was based on its concern that LTCM’s failure
that Potential Systemic Risk   might pose systemic risk. Although a systemic crisis can result from the
Can Exist in Large Trading     spread of difficulties from one firm to others, in this case the potential
Positions                      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.




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                           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.

After the Crisis, Major    In January 1999, a group of 12 major, internationally active commercial
                           and investment banks formed the Policy Group to promote enhanced
Financial Firms Proposed   management of counterparty risk by financial firms. In July 1999, the
Improved Risk Standards    Policy Group issued a report that reviewed key risk management issues,
                                                                                               22
                           evaluated emerging improvements, and made recommendations. In
                           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.)

                           The industry reportedly already had begun to respond to the risks posed
                                                                                            23
                           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-
                           22
                            Improving Counterparty Risk Management Practices, the Counterparty Risk Management Policy
                           Group, June 21, 1999.
                           23
                                Arthur Andersen Market Practices Group, New York, NY.




                           Page 13                                           GAO/GGD-00-3 Long-Term Capital Management
                         B-281371




                         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
Regulatory Oversight     by hedge funds and the perils of declining credit standards, but they said
Did Not Identify         they generally believed that hedge funds’ creditors and counterparties
Lapses in Risk           were appropriately constraining the funds’ leverage and risk-taking.
                         Examinations, which are one way regulators oversee the activities of their
Management Practices     regulated entities and markets, done after the crisis revealed that banks
and the Threat Posed     and securities and futures firms had not consistently followed prudent
by LTCM                  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.




                         Page 14                              GAO/GGD-00-3 Long-Term Capital Management
                         B-281371




Federal Regulators Had   Since the early 1990s, regulators have been aware that the activities of
                         hedge funds could significantly affect financial markets. In 1992, SEC
Expressed General        observed that “Hedge funds have the potential to both increase and
Concerns About Hedge     decrease liquidity in the markets in which they invest.” Also in 1992,
Funds for Years          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
                                       24
                         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.”

                         24
                          Improper Activities of Government Securities Markets,” Joint Report by the Department of the
                         Treasury, the Federal Reserve Board, and SEC (Jan.1992).




                         Page 15                                         GAO/GGD-00-3 Long-Term Capital Management
                              B-281371




                              However, he raised questions about whether additional things could be
                              done to maintain discipline among creditors.

Regulators Did Not Identify   Federal bank, securities, and futures regulators did not identify the lapses
                              in risk management practices and the threat posed by LTCM, primarily
Weaknesses in Firms’ Risk     because they limited their focus to problems involving the largest credit
Management Practices Until    exposures of the firms they regulated. However, LTCM was not among the
After the Crisis              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.

                              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



                              Page 16                              GAO/GGD-00-3 Long-Term Capital Management
                             B-281371




                             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.

Offsite Monitoring Did Not   In addition to on-site examinations, regulators perform off-site monitoring
                             through periodic information received from regulated entities and other
Reveal the Potential         market participants, such as LTCM. However, periodic information
Systemic Threat Posed by     provided to the regulators did not reveal the potential systemic threat
LTCM                         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
                                        25
                             affiliates. 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
                                                                      26
                             unregulated OTC derivatives affiliates. This information identifies the
                             25
                              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.
                             26
                               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.




                             Page 17                                           GAO/GGD-00-3 Long-Term Capital Management
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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
                                   27
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
                                                28
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
            29
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

27
 A CPO is the manager of a commodity pool, which is a collective investment vehicle that trades
futures contracts.
28
   Testimony of CFTC before the U.S. Senate Committee on Agriculture, Nutrition and Forestry, Dec.16,
1998.
29
   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).




Page 18                                            GAO/GGD-00-3 Long-Term Capital Management
                          B-281371




                          reporting threshold, including the name of the issuer, fair market value,
                                                                          30
                          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.

Regulators and Industry   Following their post-crisis examinations, OCC and the Federal Reserve
                          both issued additional examination guidance on supervising credit risk
Adopted and Recommended   management. SEC and its SROs also issued joint guidance on risk
Improved Oversight and    management practices for broker-dealers. Finally, the President’s Working
Practices                 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.

                          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


                          30
                               15 U.S.C. § 78m(f).




                          Page 19                              GAO/GGD-00-3 Long-Term Capital Management
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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
                                                              31
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
                                                         32
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

31
 The President’s Working Group report also recommended that Treasury’s authority over affiliates of
government securities broker-dealers and FCMs be similarly expanded.
32
   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.




Page 20                                             GAO/GGD-00-3 Long-Term Capital Management
                         B-281371




                         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.

                         Federal financial regulators followed their traditional approaches to
Existing Coordination    oversight in the LTCM case: bank regulators focused on risks to banks; and
Could be Improved to     securities and futures regulators focused on risks to investors, regulated
Enhance Regulators’      entities, and markets. However, these approaches were not effective
                         because the risks posed by LTCM crossed traditional regulatory and
Ability to Identify      industry boundaries. Regulators would have had a better opportunity to
Risks Across             identify these risks if their oversight activities had been better coordinated.
Industries and Markets   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



                         Page 21                               GAO/GGD-00-3 Long-Term Capital Management
B-281371




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
                         33                                       34
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
                      35
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
33
   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.
34
   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).
35
   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.




Page 22                                           GAO/GGD-00-3 Long-Term Capital Management
B-281371




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.




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                               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
                                                                                                    36
                               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.

                               SEC and CFTC lack the regulatory authority to supervise unregistered
Gap in SEC’s and               affiliates of broker-dealers and FCMs. The lack of authority over these
CFTC’s Regulatory              affiliates, which often act as financial intermediaries, creates a regulatory
Authority Limits Their         gap that impedes SEC’s and CFTC’s ability to identify and mitigate
                               problems that may threaten markets or the entire financial system. The
Ability to Identify and        significance of the gap has grown as the amount of activity conducted
Mitigate Systemic Risk         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 Lack              SEC and CFTC generally lack authority to regulate the unregistered
                               affiliates of broker-dealers and FCMs. This gap impedes their ability to
Authority to Regulate          identify and mitigate problems at securities and futures firms that could
Affiliates of Broker-Dealers   contribute to systemic risk and threaten financial markets. For example,
and FCMs                       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

                               36
                                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.




                               Page 24                                            GAO/GGD-00-3 Long-Term Capital Management
                                          B-281371




                                          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
                                                                                                        37
                                          major securities and futures firms was larger than LTCM’s.

Table 2: Comparison of Total Notional                                                                                                            a
Value of Derivatives Contracts (dollars   Entity                                                                        Total notional value
in billions)                              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
                                          a
                                          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.




                                          37
                                             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.




                                          Page 25                                           GAO/GGD-00-3 Long-Term Capital Management
                              B-281371




Regulators Recommended        The President’s Working Group recommended that Congress expand SEC
                              and CFTC risk assessment authority over unregistered affiliates of broker-
Limited Expansion of SEC      dealers and FCMs, but the regulatory gap would remain. As part of that
and CFTC Authority Over       expanded authority, SEC and CFTC would be authorized to (1) require
Activities of Affiliates of   broker-dealers and FCMs and their unregulated affiliates to report credit
Broker-Dealers and FCMs,      risk information for significant counterparties; (2) require recordkeeping
                              and reporting of nonaggregated position information; (3) obtain additional
but Regulatory Gap Would      data on concentrations, trading strategies, and risk models; and (4) review
Remain                        risk management procedures and controls conducted at the holding
                              company level and examine the records and controls of the holding
                              company and its material unregulated affiliates. According to an official
                              involved with the President’s Working Group report, examinations would
                              be limited to verification of the information provided, rather than a
                              comprehensive examination of the entities’ risk management and
                              operations. The President’s Working Group also reported that it would
                              consider potential additional steps, including consolidated supervision, if
                              evidence emerges that indirect regulation of currently unregulated market
                              participants is not working effectively to constrain excessive leverage and
                                                         38
                              risk-taking in the market.

                              If adopted by Congress, providing for enhanced information reporting and
                              giving SEC and CFTC the ability to verify it would be important steps, but
                              SEC and CFTC would still lack the authority to perform comprehensive
                                             39
                              examinations, set capital standards, and take general enforcement
                              actions. These additional authorities could help to ensure that SEC and
                              CFTC are able to supervise the activities of unregulated affiliates of
                              broker-dealers and FCMs that they believe could pose a risk to financial
                              markets. As discussed earlier in the report, the U.S. regulatory structure
                              generally leaves the oversight of hedge funds and highly leveraged
                              institutions to their creditors and counterparties. Regulators are to play a
                              secondary role in overseeing the activities of banks and securities and
                              futures firms, yet SEC and CFTC lack the authority to regulate affiliates of
                              broker-dealers and FCMs. The extent to which SEC and CFTC would
                              choose to exercise this authority could vary on the basis of some
                              articulated criteria, such as asset size, complexity, and riskiness of the
                              unregulated affiliates’ activities. The examinations performed after the
                              LTCM crisis illustrate the importance of examinations as part of the

                              38
                                 These next steps could create consolidated supervision of broker-dealers and their currently
                              unregulated affiliates (including enterprise-wide capital standards), direct regulation of hedge funds,
                              and direct regulation of derivatives dealers unaffiliated with a federally regulated entity.
                              39
                               According to an official involved with the President’s Working Group report, the examinations
                              envisioned in the report would simply be a verification of the accuracy of the information provided.




                              Page 26                                            GAO/GGD-00-3 Long-Term Capital Management
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supervisory process, not only to verify the accuracy and completeness of
information, but also to determine whether firms are following prudent
risk management practices and to review their overall operations. Because
of the existing gap, SEC was not able to fully assess the operations of all of
the broker-dealers; at some firms certain management functions were
conducted outside of the regulated broker-dealer and thus beyond SEC’s
regulatory purview. Although the President’s Working Group
recommendation, if adopted by Congress, would authorize SEC to receive
this information, it would not ensure that SEC would be granted access to
information not specifically referred to in statute.

The authority to set capital standards, among other benefits, would
provide a mechanism to better relate leverage to risk in the affiliates of
securities and futures firms, which may employ as much leverage as LTCM
    40
did. LTCM has renewed regulatory concerns about leverage and how to
measure and manage it. Finally, enforcement authority would provide SEC
and CFTC with recourse to take action against the affiliates of broker-
dealers and FCMs if they failed to adhere to regulations.

Since 1990, Congress has tried to address this gap through enhanced
information reporting. In 1990 and 1992, Congress granted SEC and CFTC,
respectively, the authority to establish rules to obtain certain information
from affiliates of broker-dealers and FCMs to provide insights into the
operations of unregulated affiliates in lieu of direct regulatory authority.
Limitations of these risk assessment rules surfaced in the mid-1990s. To
supplement the information received under the risk assessment rules, in
1994 the industry formed DPG, whose members voluntarily provide SEC
and CFTC with information on the activities of their unregulated OTC
derivatives dealer affiliates. For example, DPG firms are to provide SEC
and CFTC a list of their 20 largest individual credit exposures (net of
collateral) quarterly. However, LTCM’s OTC derivatives exposures (net of
collateral) to DPG participants did not make it large enough to be included
in these reports despite its potential systemic threat to financial markets
worldwide. The Policy Group also recommended additional voluntary
reporting that could supplement the DPG information. However, it appears
that additional information would not fill the regulatory gap that exists for
affiliates of broker-dealers and FCMs. Since 1992, we have also
recommended that Congress and regulators address the gap in regulatory
authority that exists for affiliates of broker-dealers because of the growing


40
 Simple balance sheet leverage is not an indicator of relative riskiness. See table 1 and previous
discussion about leverage.




Page 27                                            GAO/GGD-00-3 Long-Term Capital Management
                            B-281371




                            importance of these activities to the regulated entities and the financial
                                   41
                            system.

Expanding SEC and CFTC      Although expanding SEC and CFTC authority to include the ability to
                            examine, set capital standards, and take enforcement actions, as they
Authority Over Affiliates   deem necessary, would close the existing gap, several controversial issues
Would Raise Controversial   must be considered. First, extending regulation to previously unregulated
Issues                      activities could increase certain costs of doing business, which, in turn,
                            could partially offset these firms’ competitive edge compared to other
                            providers of financial services. However, many of the affiliates’ U.S. bank
                            and foreign competitors are already subject to regulatory oversight, so that
                            some oversight of these currently unregulated affiliates may help restore a
                            more level playing field along with reinforcing practices consistent with
                            market discipline. In any case, the amount of regulatory interference can
                            be kept to a minimum by focusing attention on risk management activities
                            already in place. In past work, we found that many sophisticated financial
                                                                                                         42
                            firms were managing risks comprehensively at the holding company level.
                            Bank regulators are attempting to use the existing risk management
                            systems, including systems of internal control and internal audit, as a focal
                            point for their oversight of banks and bank holding companies. A similar
                            approach could be used by SEC and CFTC to better understand the risk
                            management systems of holding companies in which broker-dealers or
                            FCMs are the primary financial component. By using the existing
                            framework of internal controls, including the internal audit function, after
                            testing its reliability, regulators can minimize the burden imposed on those
                            firms whose risk management systems are up to industry standards.

                            Second, designing appropriate risk-based capital standards for all affiliates
                            is a controversial issue. Traditional SEC and CFTC capital standards for
                            broker-dealers and FCMs are related to risk but are not truly risk-based.
                            For example, payments due a broker-dealer or FCM on certain OTC
                            derivatives, such as interest rate swaps, are deducted from the firm’s net
                            worth, which is the equivalent of a 100-percent capital requirement. This is
                            one reason that such activities are effected outside of the regulated entity.
                            To encourage OTC derivatives-dealing affiliates to move under a regulatory
                            umbrella, SEC has developed a new voluntary regulatory structure for OTC
                            derivatives dealers that provides capital standards for derivatives activities




                            41
                                 GAO/GGD-92-70, GAO/GGD-94-133, and GAO/GGD/AIMD-97-8.
                            42
                                 GAO/GGD-98-153.




                            Page 28                                       GAO/GGD-00-3 Long-Term Capital Management
              B-281371




                                                     43
              that are more risk-based. SEC has announced further initiatives to make
              capital standards of broker-dealers more risk-based.

              Third, Federal Reserve officials expressed concern that extension of
              regulatory authority, as recommended by the President’s Working Group,
              might undermine market discipline—instead of strengthening it as
              intended—by creating the impression that the newly regulated firms would
              be included in the government “safety net.” However, focusing regulatory
              attention on the risk of securities and futures firms does not mean that the
              government would keep those institutions from failing. If a large broker-
              dealer or FCM affiliate became insolvent and could be allowed to fail
              without undue market disruption, it should be allowed to fail. If it is too
              large to be allowed to fail or liquidated quickly, it may need to be eased
              into failure.

              Finally, some operational issues would take additional time and effort to
              resolve. For example, SEC and CFTC would have to coordinate to resolve
              overlapping authorities and functions within securities and futures firms
                                                                        44
              over broker-dealers and FCMs with dual registrations. Additional
              information sharing and coordination would be necessary to minimize the
              burden on these firms of consolidated regulation. In addition, SEC and
              CFTC would have to evaluate their operational and resource capacities to
              accommodate any new authority. In particular, SEC and CFTC may have to
              hire new staff or train existing staff that is currently analyzing risk
              assessment and DPG information. Understanding the risk management
              system of sophisticated financial firms requires substantial expertise.
              However, the number of such firms that are likely to be of concern should
              not be large. Thus, the staff and resource commitment should not be
              substantial.

              The LTCM case illustrated that market discipline can break down and
Conclusions   showed that potential systemic risk can be posed not only by a cascade of
              major firm failures, but also by leveraged trading positions. LTCM was able
              to establish leveraged trading positions of a size that posed potential
              systemic risk primarily because the banks and securities and futures firms
              that were its creditors and counterparties failed to enforce their own risk
              management standards. Subsequent to the LTCM crisis, major financial
              firms issued recommendations for enhanced risk management by firms.


              43
                   17 C.F.R. Parts 200, 240, 249. To date, only one firm has opted to participate.
              44
                   The largest FCMs are also registered broker-dealers.




              Page 29                                                GAO/GGD-00-3 Long-Term Capital Management
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However, as LTCM illustrated, conditions can arise in which self-imposed
standards are ignored.

Although market participants have the primary responsibility to practice
prudent risk management standards, prudent standards do not guarantee
prudent practices. The LTCM crisis demonstrated the importance of
regulatory on-site examinations and off-site monitoring in identifying and
prompting correction of weaknesses in practices. Since the derivatives
problems in the 1990s, awareness of the importance of risk management
systems has continued to grow, and regulators have made risk
management an integral part of their examination process. However, as
shown by the inability of regulators to identify the extent of firms’
activities with LTCM, the traditional focus of oversight on credit exposures
is not sufficient to monitor the provision of leverage to trading
counterparties.

LTCM’s crisis showed that the traditional focus of federal financial
regulators on individual institutions and markets is not adequate to
identify potential systemic threats that cross these institutions and
markets. Developing ways to enhance coordination of activities related to
identifying risks that cross traditional boundaries could better position
these regulators to address potential systemic risk before it reaches crisis
proportions. Because coordinating requires judgments about what
information would need to and could be shared and about how best to
share it, the regulators are in the best position to determine the most
effective ways to enhance their coordination. Changes in markets that
have blurred the traditional lines of market participants’ activities will
continue to create risks that cross institutions and markets, thus making
the need for effective coordination even more critical.

Gaps in SEC’s and CFTC’s regulatory authority impede their ability to
observe and assess activities in securities and futures firms’ affiliates that
might give rise to systemic risk. Although the Federal Reserve’s
consolidated oversight of bank holding companies did not reveal banks’
risk management weaknesses related to LTCM, recommended or already-
implemented improvements in examination focus and in information
gathered may give bank regulators a better opportunity to identify future
problems that might pose systemic risk. Without similar authority over the
consolidated activities of securities and futures firms, SEC and CFTC
cannot contribute effectively to regulatory oversight of potential systemic
risk, because a large and growing proportion of those firms’ risk taking is
in their unregulated affiliates. The affiliates may have large positions in
markets such as OTC derivatives and can be major providers of leverage in



Page 30                              GAO/GGD-00-3 Long-Term Capital Management
                      B-281371




                      the markets, as they were in the LTCM case. How they manage their own
                      risks, as well as their provision of leverage to counterparties, can affect the
                      financial system. The President’s Working Group has recommended
                      granting new authority for SEC and CFTC over the affiliates. However, the
                      new authority would not grant capital-setting or enforcement authority and
                      would not involve the type of examination of their risk activities and
                      management that would allow a thorough assessment of potential systemic
                      risk. Further, expanding SEC’s and CFTC’s authority over unregulated
                      affiliates would require resolving several controversial issues and
                      operational considerations, including increased costs for unregulated
                      affiliates and potentially higher staffing and resource commitments for
                      SEC and CFTC.

                      We recommend that the Secretary of the Treasury and the Chairmen of the
Recommendation        Federal Reserve, SEC, and CFTC, in conjunction with other relevant
                      financial regulators, develop better ways to coordinate the assessment of
                      risks that cross traditional regulatory and industry boundaries.

                      In an effort to identify and prevent potential future crises, Congress should
Matter for            consider providing SEC and CFTC with the authority to regulate the
Congressional         activities of securities and futures firms’ affiliates similar to that provided
Consideration         the Federal Reserve with respect to bank holding companies. If this
                      authority is provided, it should generally include the authority to examine,
                      set capital standards, and take enforcement actions. However, SEC and
                      CFTC should have the flexibility to vary the extent of their regulation
                      depending on the size and potential threat posed by the securities and
                      futures firm.

                      CFTC, the Federal Reserve, SEC, and Treasury provided written comments
Agency Comments and   on a draft of this report, which are reprinted in appendixes II, III, IV and V.
Our Evaluation        The agencies raised no objections with our findings in general but
                      provided additional insights from their unique perspectives, which we
                      summarize below and discuss further in the report where appropriate. We
                      believe the agencies’ perspectives will be helpful for Congress in
                      considering changes to the regulatory authority of SEC and CFTC.

                      CFTC raised no objections to our findings or recommendation. It
                      reiterated the recommendations of the President’s Working Group and
                      noted that CFTC has taken steps to implement those recommendations
                      that are within its authority and is working with other members of the
                      President’s Working Group on the others. CFTC said the goal is to
                      strengthen market discipline by increasing transparency. Most notably, its
                      efforts have focused on developing models for disclosure of risk



                      Page 31                               GAO/GGD-00-3 Long-Term Capital Management
B-281371




information by institutions that could pose a systemic risk to markets. As
pointed out in our report, although market discipline is the primary
mechanism for controlling risk-taking, LTCM’s creditors and
counterparties failed to apply it in LTCM’s case. Thus, we continue to
believe that market discipline should be supplemented by regulatory off-
site monitoring and on-site examinations to help ensure the prompt
identification and correction of weaknesses in risk management practices.

The Federal Reserve also raised no objections to our findings in general
but indicated that our recommendation to financial regulators concerning
the need for improved coordination among financial regulators was not
necessary because an adequate coordinating structure already exists. It
said that the President’s Working Group is an adequate structure to
coordinate and the Federal Reserve is committed to making that
mechanism function effectively. In addition, it said that the current
structure for coordinating is adequate, in spite of certain statutory
limitations. It noted that legislative proposals under consideration would
address any such limitations that may apply to the Federal Reserve. The
Federal Reserve also noted the difficulty in developing methods to identify
potential systemic risks and coordinating the assessment of that risk. The
Federal Reserve commented that the unique nature of systemic crises can
make them hard to anticipate. However, the Federal Reserve stated that
various working groups under the auspices of the Group of Ten Central
Banks and the Financial Stability Forum are struggling with these issues
and are trying to identify types of data that might improve their
understanding of risks in financial markets. The Federal Reserve
ultimately believes that the ability to perceive systemic crises in data is
likely to be limited and continues to believe that the most prudent course
of action is for financial regulators to ensure the soundness of the
individual institutions they supervise.

As mentioned earlier in the text, the President’s Working Group plays a
role in coordinating issues that cut across market sectors; however, the
coordination efforts generally do not involve routine sharing of specific
information that may be beneficial in identifying potential systemic
threats. Because of the recent blurring of traditional lines that separate the
businesses of banks and securities and futures firms, we believe it is vital
for financial regulators to develop ways to enhance coordination of their
activities and assessments of risk. We also acknowledge that although
identifying and sharing relevant data may improve the chances of
identifying potential systemic risks, such activities are not likely to
anticipate every possible source. Finally, we also agree that ensuring the
soundness of individual institutions is an important part of financial



Page 32                               GAO/GGD-00-3 Long-Term Capital Management
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oversight. However, such oversight is not currently applied to all financial
institutions that can originate or transmit risk and does not include
effective ways to monitor and assess risks that cut across markets.

SEC commended our thorough review of the events and practices that
contributed to LTCM’s near-collapse. SEC also noted its difficulties in
monitoring systemic risks posed by unregulated broker-dealer affiliates as
the scope of trading and credit activities conducted outside the regulated
broker-dealer has expanded and agreed that it needs additional risk
assessment authority over unregulated affiliates of broker-dealers.

SEC also raised three specific concerns about the report. First, SEC
commented that the comparison of LTCM’s simple leverage ratio to those
of several large securities firms may be misleading because the assets
carried by the securities firms were less volatile than the assets carried by
LTCM. In addition, securities firms are subject to capital requirements.
Second, it commented that the President’s Working Group provides a
productive avenue to share important information. In addition, SEC
stressed that although the exchange of information can be improved to
facilitate better cooperation and coordination, the focus should be on
public dissemination of information on hedge funds. Third, SEC disagreed
with our conclusion that it cannot fully assess and evaluate the risk
exposures of broker-dealers because of certain limitations on SEC’s
regulatory authority over broker-dealer affiliates. SEC stated that it has the
authority to assess and evaluate the risks incurred at the broker-dealer
level; rather, it is at the broader holding company structure level that it
encounters difficulty.

As to the first concern raised by SEC, we agree that the comparison
between LTCM and securities firms is not a direct one and discussed the
differences in the draft. We have added additional language to further
illustrate the difference. Regarding SEC’s second issue, we generally agree
that the President’s Working Group provides a forum to exchange certain
general information. In fact, we encourage financial regulators to consider
the President’s Working Group as one way to increase routine
coordination of their regulatory activities. Although we agree that hedge
fund disclosures could be of some use, we believe that efforts should be
made to improve regulatory coordination because future systemic
problems may not involve hedge funds. Thus, we continue to support our
recommendation that financial regulators find ways to better coordinate
the assessment of risks that cross traditional regulatory and industry
boundaries. Finally, as to SEC’s third issue, we continue to be concerned
that SEC may be unable to fully assess risks to the broker-dealers because



Page 33                              GAO/GGD-00-3 Long-Term Capital Management
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of its inability to oversee holding companies (and unregulated affiliates) of
broker-dealers. For example, when broker-dealers are part of holding
company structures, whose risk management function is located at the
holding company level, SEC is unable to review that broker-dealers risk
management system unless the holding company provides the information
voluntarily.

The Department of the Treasury generally agreed with the factual
presentation of the events related to LTCM’s near-collapse. However, it
believes that our recommendation to develop ways to coordinate the
assessment of risks that cross traditional regulatory and industry
boundaries may not be necessary. Treasury believes that such
coordination is already occurring in the President’s Working Group and
that it has developed a productive and candid exchange of information on
significant market developments. As we stated previously, we agree that
the President’s Working Group serves as an important forum that better
enables regulators to respond to market events, although primarily after
the fact, but existing coordination efforts failed to allow regulators to
identify the cross-industry risks that LTCM posed. Therefore, we continue
to support our recommendation that the financial regulators develop
better ways to coordinate the assessment of risks that cross traditional
regulatory and industry boundaries.

As we agreed with your offices, we plan no further distribution of this
report until 7 days from its issue date unless you publicly release its
contents sooner. We will then send copies of this report to Phil Gramm,
Chairman, and Paul S. Sarbanes, Ranking Minority Member, Senate
Committee on Banking, Housing, and Urban Affairs; Richard Lugar,
Chairman, Senate Committee on Agriculture, Nutrition, and Forestry; Jim
Leach, Chairman, and John LaFalce, Ranking Minority Member, House
Committee on Banking and Financial Services; Tom Bliley, Chairman, and
John Dingell, Ranking Minority Member, House Committee on Commerce;
Larry Combest, Chairman, and Charles W. Stenholm, Ranking Minority
Member, House Committee on Agriculture; and other interested members
of Congress. We will also send copies of this report to William J. Rainer,
Chairman, CFTC; Alan Greenspan, Chairman, Federal Reserve Board of
Governors of the Federal Reserve; Arthur Levitt, Chairman, SEC; and
Lawrence Summers, the Secretary of the Department of the Treasury. We
will make copies available to others upon request.




Page 34                              GAO/GGD-00-3 Long-Term Capital Management
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If you have any questions on matters discussed in this report, please
contact me or Orice M. Williams at (202) 512-8678. Other major
contributors to this report are acknowledged in appendix VI.




Thomas J. McCool
Director, Financial Institutions and Markets Issues




Page 35                             GAO/GGD-00-3 Long-Term Capital Management
Contents



Letter                                                                                        1


Appendix I                                                                                   38
                      Hedge Funds                                                            38
Overview of LTCM's    LTCM Overview                                                          38
Near Collapse And     Investment Strategy                                                    40
                      Use of Leverage                                                        41
Related Events        Market Turmoil Resulted in Huge Losses for LTCM                        42
                      What the Regulators Knew                                               42
                      The Recapitalization                                                   44
                      Subsequent Events                                                      45


Appendix II                                                                                  46

Comments From the
Commodity Futures
Trading Commission
Appendix III                                                                                 47

Comments From the
Federal Reserve
Appendix IV                                                                                  49

Comments From the
Securities and
Exchange Commission
Appendix V                                                                                   51

Comments From the
Department of the
Treasury




                      Page 36                          GAO/GGD-00-3 Long-Term Capital Management
                   Contents




Appendix VI                                                                                     52

GAO Contacts and
Staff
Acknowledgments
Tables             Table 1: Comparison of LTCM’s Leverage to Major                               7
                     Securities and Futures Firms
                   Table 2: Comparison of Total Notional Value of                               25
                     Derivatives Contracts (dollars in billions)
                   Table I.1: Chronology of Events                                              39




                   Abbreviations

                   BIS          Bank for International Settlements
                   CFTC         Commodity Futures Trading Commission
                   CPO          Commodity Pool Operator
                   DPG          Derivatives Policy Group
                   FCM          futures commission merchant
                   LTCM         Long-Term Capital Management
                   NASD         National Association of Securities Dealers
                   NASDR        NASD Regulation, Inc.
                   NFA          National Futures association
                   NYSE         New York Stock Exchange
                   OCC          Office of the Comptroller of the Currency
                   OTC          over-the-counter
                   SEC          Securities and Exchange Commission
                   SRO          self-regulatory organization




                   Page 37                                GAO/GGD-00-3 Long-Term Capital Management
Appendix I

Overview of LTCM's Near Collapse And
Related Events

                This appendix provides background information on hedge funds and
                additional details about Long-Term Capital Management (LTCM), its
                investment strategy, its use of leverage, the market turmoil that
                precipitated its near-collapse, what the regulators knew, the
                recapitalization, and subsequent events.

                Hedge fund, though not legally defined, is the term used to loosely refer to
Hedge Funds     an investment fund structured to be exempt from certain investor-
                protection requirements and thus able to follow a flexible investment
                strategy. Hedge funds, which are often exempt from the Investment
                Company Act and some (but not all) reporting requirements under the
                Commodities Exchange Act, are different from registered investment
                vehicles, such as mutual funds, in several important ways. Hedge fund
                managers are able to (1) invest in any type of asset in any market, (2) use
                many investment strategies at the same time, (3) switch investment
                strategies quickly, and (4) borrow money and/or otherwise use leverage
                without being subject to investment company leverage limits. There are a
                wide variety of hedge funds that vary depending on the type of investment
                                                                            1
                strategy used. The fund types include aggressive growth, emerging
                         2       3                       4
                markets, macro, and market neutral. According to the President’s
                Working Group’s hedge fund report, in mid-1998, there were between 2,500
                and 3,500 hedge funds managing between $200 billion and $300 billion in
                capital and $800 billion to $1 trillion in total assets. Compared to
                commercial banks, which had about four times as many assets, and mutual
                funds, which had five times as many, hedge funds are relatively small.

                LTCM consists of a combination of limited partnerships and limited
LTCM Overview   liability companies that are collectively known as LTCM. It uses a “master
                fund/feeder fund” structure to invest its assets. That is, assets of the feeder
                funds are invested by the master fund. Long-Term Capital Portfolio was
                the master fund, and there were numerous feeder funds. Since its
                establishment in 1994, LTCM had produced returns, net of fees, of
                1
                 Aggressive growth funds expect acceleration in growth of earnings per share. Current earnings’
                growth is often high. They generally have high price/earnings and low or no dividends. These funds
                usually invest in small-cap or micro-cap stocks, which are expected to experience very rapid growth.
                2
                Emerging markets funds invest in the equity of emerging market countries. These countries tend to
                have high inflation and high, volatile growth.
                3
                 Macro funds involve a global or international manager who employs an opportunistic, “top-down”
                approach, following major changes in countries’ economic policies.
                4
                 Market-neutral funds focus on obtaining returns with low or no correlation to the market. The
                manager buys different securities of the same issuer (e.g., the common stock and convertibles) and
                “works the spread” between them. For example, within the same company the manager buys one form
                of security that he believes is undervalued and sells short another security of the same company.




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                                                Appendix I
                                                Overview of LTCM's Near Collapse And Related Events




                                                approximately 40 percent in 1995 and 1996 and about 17 percent in 1997.
                                                At the end of 1997, LTCM returned capital to its investors and reduced its
                                                capital base by over one-third to $4.8 billion. By August 31, 1998, LTCM’s
                                                capital had declined to $2.3 billion. See table I.1 for a chronology of events
                                                surrounding LTCM’s near-collapse.


Table I.1: Chronology of Events
Date                      Event
December 31, 1997         LTCM returned about $2.7 billion in capital to its investors. LTCM’s net asset value was $4.67 billion.
Early 1998                LTCM’s 16 partners’ investment in the fund was valued at about $1.6 billion (roughly one-third of outstanding
                          equity).
July 6, 1998              Salomon disbanded its bond arbitrage unit in an apparent effort to lower its risk profile following its acquisition
                          by Travelers Group.
July 17, 1998             Salomon announced it was selling certain trades (increasing divergence of certain markets, which adversely
                          affected LTCM).
Early August 1998         The Securities and Exchange Commission (SEC) and New York Stock Exchange (NYSE) surveyed major
                          broker-dealers known to have credit exposure to one or more large hedge funds.
August 17, 1998           The Russian government announced an effective devaluation of the ruble and declared a debt moratorium
                          (defaulted) triggering an investors’ fight to quality.
August 21, 1998           LTCM’s 1-day trading loss was $550 million.
August 24, 1998           LTCM partners launched a capital raising campaign.
August 31, 1998           LTCM’s net asset value declined to $2.3 billion.
September 2, 1998         LTCM sent letter to investors announcing that it had lost 52 percent of its capital as of August 31, 1998. It had
                          lost 44 percent in the month of August alone. It also encouraged investors to invest in the fund.
Early September 1998      LTCM partners contacted Federal Reserve officials to notify them of their difficulties and their discussion with
                          investment houses about plans to raise new capital.
September 18, 1998        LTCM principals contacted Federal Reserve officials and invited them to LTCM for a presentation on the
                          fund’s positions.
September 19, 1998        The President of the Federal Reserve Bank of New York advised the Chairman of the Federal Reserve Board
                          that the LTCM situation appeared to be deteriorating and efforts to raise capital had failed. The Chairman
                          agreed that a team should go to LTCM to get a better understanding of the situation.
September 20, 1998        Federal Reserve led team visited Greenwich, CT for LTCM’s presentation.
September 21, 1998        Federal Reserve Bank of New York contacted Goldman Sachs, Merrill Lynch, and J.P. Morgan officials
                          (LTCM’s major creditors). LTCM experienced a single-day trading loss of $500 million. Bear Stearns, LTCM’s
                          clearing agent, set a new condition that required LTCM to collateralize potential settlement exposures.
September 22, 1998        Goldman Sachs, Merrill Lynch, J.P. Morgan, and UBS (core group) dispatched two working groups to
                          Greenwich, CT to consider lifting the fixed-income and equity positions out of LTCM. A third group met at one
                          of the firms in New York to develop the Consortium approach. Later that evening, Federal Reserve officials
                          contacted additional LTCM creditors. That night, in addition to the core group, a meeting of a larger group
                          involving 13 additional firms began. Members of the core group contacted LTCM about the conditions of the
                          Consortium approach.
September 23, 1998        Federal Reserve officials called various foreign central bank officials to inform them about LTCM. Federal
                          Reserve officials suspended the effort to proceed with the Consortium approach until an alternative offer
                          could be considered. At 12:30 p.m., officials found out the alternative offer was not accepted nor would the
                          offer be extended. Treasury notified CFTC about LTCM’s problems. CFTC sent audit staff to LTCM as well as
                          to Bear Stearns and Merrill Lynch to inspect LTCM’s accounts. Staff of President’s Working Group held a
                          telephone conference to discuss LTCM. The 14 members of the Consortium agreed to the terms of the
                          agreement and LTCM accepted the offer.




                                                Page 39                                      GAO/GGD-00-3 Long-Term Capital Management
                                        Appendix I
                                        Overview of LTCM's Near Collapse And Related Events




Date                 Event
September 28, 1998   Closing date on the agreement reached among the Fund, the Investment Vehicles, LTCM and its affiliates,
                     and the 14 members of the Consortium. Consortium members infused $3.6 billion into the fund. One
                     condition of the agreement was that the Management Company agreed to provide management investment
                     services to the Consortium’s Investment Vehicle on the basis of a 1 percent per annum management fee and
                     a 15 percent incentive fee for increases in net asset value over a Libor hurdle rate. Representatives of the
                     Consortium met and formally constituted themselves as the Board of Directors of “Oversight Partner I LLC.”
September 30, 1998   LTCM’s net asset value was $3.81 billion. Oversight Committee was on-site to carry out its duties.
November 1998        Stake of the 16 original partners valued at $30 million compared to $1.6 billion at the beginning of the year.
                                        Source: GAO summary of press reports, agency testimonies, and various other documents.


                                        LTCM was primarily engaged in market-neutral arbitrage. Specifically,
Investment Strategy                     LTCM was part of a subset of market-neutral funds known as fixed-income
                                        arbitrage funds involved in convergence trading. That is, it purchased
                                        bonds that it considered undervalued and sold bonds that it considered
                                        overvalued. Most of its trades were relative value and convergence, but
                                        four classes of trading strategies cover its general investment approach.
                                        They were as follows:

                                     • Convergence trades: These involve taking long and offsetting short
                                       positions in securities, which are virtually perfect substitutes except for
                                       tax treatment and liquidity; for example it buying an “old” 2-year U.S.
                                       Treasury and selling (shorting) a corresponding “new” 2-year U.S.
                                       Treasury. In actual practice more than two securities may be used. Trades
                                       in this category meet the conditions of classic arbitrage in which
                                       convergence in value of the positions is expected on or before a
                                       specifiable future date.

                                     • Relative-value trades: These involve taking long and short positions in
                                       securities that are closely related to each other along many but not all
                                       dimensions; for example, buying one bond issue of a corporation and
                                       selling (shorting) a different bond issue of the same corporation. Trades in
                                       this category do not meet the definition of an arbitrage trade because
                                       convergence in spreads is not expected on a specifiable future date, or the
                                       date of expected convergence is distant (e.g., 20 to 30 years).

                                     • Conditional convergence trades: These involve long and short positions in
                                       securities that would be convergence trades if specific pricing models
                                       were valid. That is, conditional on the pricing model being correct, the
                                       positions in the securities would satisfy the conditions of arbitrage. One
                                       example is writing call options on a stock and hedging the position by a
                                       dynamic trading strategy in the underlying stock that should exactly
                                       replicate the payoff on the calls if the option-pricing model is correct.
                                       Another example would be dynamic trading in U.S. Treasury-based futures



                                        Page 40                                       GAO/GGD-00-3 Long-Term Capital Management
                    Appendix I
                    Overview of LTCM's Near Collapse And Related Events




                    and securities that should produce arbitrage profits if the underlying
                    model of interest rate dynamics and the term structure is valid.

                  • Directional trades: These returns depend either on the direction or change
                    in volatility of return in a particular market. Included in this category are
                    the directional exposures caused by convergence-type trades involving
                    different markets where full directional hedging in each market is not
                    efficient in a risk-reward sense. Also in this category are trades involving
                    long and short positions in securities that are related to each other along
                    too few dimensions (other than general valuation principles) to be
                    classified as relative-value trades (defined above). Directional trades are
                    opportunistic and at times may involve positions of significant size. These
                    trades are not expected to have major impact on the overall return
                    volatility of the portfolio.

                    LTCM’s investments were largely bond arbitrage (for example, primarily
                    arbitraging the difference between U.S. Treasuries with the same maturity
                    but different issuance dates). As previously discussed, LTCM’s investment
                    strategy was primarily focused on investment opportunities involving
                    global fixed-income trading strategies (convergence trades). Its investment
                    objective was to maximize the expected total return on its portfolio on a
                    risk-adjusted basis by using analytical models and undertaking proprietary
                    trading on a leveraged basis.

                    LTCM’s investment strategy required the use of leverage, one of the
Use of Leverage     objectives of which was to achieve a high rate of return. This strategy was
                    cited in various LTCM documents to investors. For example, documents to
                    investors stated that it planned to make “extensive” use of borrowed funds
                    in its investment activities and would not be subject to limits on its use of
                    borrowed funds except as required by applicable law, including margin
                    requirements. LTCM stated that it generally expected its leverage to be
                    higher than that of typical leveraged investment funds. It also noted that
                    gains and losses with borrowed funds could cause its net asset value to
                    increase and decrease faster than would be the case without borrowings.
                    LTCM’s balance sheet leverage ratio ranged from 17 to 1 at year-end 1994
                    to 28 to 1 at year-end 1997. Although LTCM’s leverage increased following
                    its return of capital, its year-end 1997 leverage ratio was consistent with its
                    1995 and 1996 ratios. LTCM’s leverage peaked in September 1998 when its
                    equity dropped, but by year-end 1998, LTCM’s leverage ratio was 21 to 1.
                    Because this leverage measure does not include off-balance sheet
                    activities, LTCM’s risk-adjusted leverage ratio would be even higher given
                    its off-balance sheet activities, such as its use of derivatives.




                    Page 41                                  GAO/GGD-00-3 Long-Term Capital Management
                      Appendix I
                      Overview of LTCM's Near Collapse And Related Events




                      LTCM achieved substantial leverage, in part, through the use of OTC
                      derivatives because of low or zero initial margin requirements. It also
                      leveraged through its use of exchange-traded derivatives, securities loans,
                      and securities repurchase agreements. In some cases its ability to leverage
                      was increased through favorable credit arrangements, such as no initial
                      margin requirements, two-way collateral, rehypothecation rights, and high
                      loss thresholds. Initial margin requirements—the amount of cash or
                      eligible securities parties are required to deposit with a counterparty
                      before engaging in a transaction—were at times zero. Two-way collateral
                      arrangements meant that both LTCM and its counterparties were required
                      to post collateral if their loss threshold (that is, the amount of loss that
                      must be exceeded before collateral is to be posted by either party) was
                      exceeded. Two-way collateral requirements, although they are not unusual,
                      are usually reserved for transactions between highly rated counterparties.
                      Rehypothecation occurs when the lender pledges as collateral the same
                      assets held as collateral on another transaction. Rehypothecation rights
                      were not usual but, like the other credit enhancements, they enabled
                      LTCM and several of its counterparties to achieve high levels of leverage.

                      Although the market conditions alone would not have necessarily caused
Market Turmoil        LTCM to collapse, prevailing market conditions became the catalyst for
Resulted in Huge      LTCM’s near-collapse. The market had been volatile for several months,
Losses for LTCM       but the announcement by the Russian government that it was rescheduling
                      payments on some of its debt obligations and imposing a moratorium on
                      payments by Russian banks on certain obligations sent global markets into
                      a tailspin. The result of the Russian default was a dramatic increase in
                      credit spreads and decrease in liquidity. Investors responded with a “flight
                      to quality” and liquidity. For LTCM, this meant that its strategy of betting
                      that credit spreads in various global markets would return to historical
                      levels was a losing one because spreads widened rather than narrowed.
                      LTCM’s diversification was geographic rather than based on different
                      strategies; thus, it had replicated similar bets in markets around the world
                      rather than having different strategies. This lack of true diversification
                      resulted in LTCM experiencing losses on positions in numerous markets.
                      Just as leverage had helped enable LTCM to achieve favorable returns, it
                      also caused its losses to mount quickly.

                      The regulators said they began to hear rumors about LTCM’s financial
What the Regulators   difficulties in August and September 1998. According to SEC’s October 1,
Knew                  1998, testimony before the House Committee on Banking and Financial
                      Services, SEC learned of LTCM’s financial difficulties in August 1998.
                      Subsequently, SEC and NYSE staff, which shares responsibility with SEC
                      for monitoring the activities of member broker-dealers and their capital



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Appendix I
Overview of LTCM's Near Collapse And Related Events




adequacy, surveyed major broker-dealers. The survey indicated that no
individual broker-dealer had exposure to LTCM that jeopardized its
required regulatory capital or financial stability. SEC was further assured
by the fact that the survey indicated the exposures to LTCM were
collateralized.

In early September, LTCM’s partners contacted the Federal Reserve Bank
of New York to notify the president of their financial difficulties and plans
to raise additional capital. According to Federal Reserve Bank of New
York officials, such contact with nonregulated entities is not uncommon.
The President of the Federal Reserve Bank of New York testified before
the U.S. House Committee on Banking and Financial Services that he
contacted senior Wall Street officials to discuss overall market conditions
                                                         5
against the backdrop of particularly unsettled markets. Everyone he spoke
with volunteered concern about the serious effect LTCM’s deteriorating
condition could have on world financial markets. On Friday, September 18,
1998, LTCM officials contacted the Federal Reserve Bank of New York
once again to notify Federal Reserve Bank of New York officials that its
efforts to raise additional capital were unsuccessful and invited the
officials to LTCM for a presentation.

The President of the Federal Reserve Bank of New York testified that he
conferred with the Chairman of the Federal Reserve Board of Governors
and Treasury officials, and they agreed that a visit to LTCM was needed. A
team that included officials from the Federal Reserve Bank of New York
and Treasury met with LTCM’s partners on Sunday, September 20, 1998. At
this meeting, the team learned the broad outlines of LTCM’s major
positions in credit and equity markets. They also learned how the positions
were deteriorating and the difficulties LTCM was having in reducing its
exposure and received loss estimates for counterparties. At that meeting,
the team realized the impact LTCM’s positions were having on markets
around the world and that the sizes of the positions was much larger than
market participants imagined. On September 21, 1998, the Federal Reserve
Bank of New York contacted three of LTCM’s largest creditors to discuss
LTCM’s situation. These calls ultimately led to the creation of the
Consortium of 14 commercial banks and securities firms that recapitalized
the fund.



5
 One of the primary functions of the Federal Reserve in its capacity as a central banker is to ensure
market stability. As part of that responsibility, the President of the Federal Reserve Bank of New York
conducts regular market surveillance activities that include talking to and receiving calls from market
participants regarding significant developments and potential dislocations.




Page 43                                           GAO/GGD-00-3 Long-Term Capital Management
                       Appendix I
                       Overview of LTCM's Near Collapse And Related Events




                       According to testimony by the President of the Federal Reserve Bank of
                       New York, on Wednesday, September 23, 1998, he called various foreign
                                                                              6
                       central bank officials to inform them of the situation. He also held a
                       conference call with the principals and informal members of the
                       President’s Working Group on Financial Markets, which included SEC, the
                       Commodity Futures Trading Commission (CFTC), the Department of the
                       Treasury, the Federal Reserve, the Federal Deposit Insurance Corporation,
                       and the Office of the Comptroller of the Currency. Subsequently, CFTC
                       notified its exchanges.

                       According to testimony of the President of the Federal Reserve Bank of
The Recapitalization   New York, following their visit to LTCM, Federal Reserve officials
                       contacted the three firms they believed had the greatest knowledge of
                       LTCM’s situation and the strongest interest in seeking a solution. The three
                       firms were Goldman Sachs, Merrill Lynch, and J.P. Morgan. This core
                       group of creditors was expanded to include UBS. These four firms sent
                       two groups to LTCM’s headquarters to study the feasibility of “lifting” the
                       fixed-income and equity positions out of the fund, and a third group met to
                       discuss the Consortium approach. These four firms agreed that it would
                       not be feasible to lift assets out of LTCM, and they decided the Consortium
                       approach would be the last resort if no outside solution was found. On
                       September 22, the core group was expanded to include 13 additional firms.
                       The following morning, the meeting was to resume but was suspended
                       until an outside offer could be considered. This offer was tendered by
                       Goldman Sachs; Berkshire Hathaway; and the American Insurance Group,
                       Inc., and consisted of purchasing the fund. The offer was to expire at 12:30
                       p.m.; however, according to LTCM officials, it was withdrawn before it
                       expired because LTCM determined that it could not legally accept the offer
                       without stockholder approval, which was not feasible within the deadline.
                       Following the withdrawal of the offer, the creditor meeting resumed.

                       On September 23, 1998, 14 of the world’s largest banks and securities firms
                       agreed to recapitalize LTCM to avoid its disorderly liquidation. On
                       September 28, 1998, they entered into an agreement with LTCM. The 14
                       firms contributed about $3.6 billion (which represented 90 percent of the
                       funds’ net asset value at the time) to the fund through a new investment
                       vehicle and general partner called Oversight Partner I. The Consortium
                       members were affiliates of the following institutions: Barclays PLC;
                       Bankers Trust Corporation; The Chase Manhattan Corporation; Credit
                       Suisse First Boston Corporation; Deutsche Bank AG; The Goldman Sachs

                       6
                       Statement by William J. McDonough, President, Federal Reserve Bank of New York, before the
                       Committee on Banking and Financial Services, U.S. House of Representatives, October 1, 1998.




                       Page 44                                         GAO/GGD-00-3 Long-Term Capital Management
                    Appendix I
                    Overview of LTCM's Near Collapse And Related Events




                    Group, L.P.; Lehman Brothers Holdings Inc.; Merrill Lynch & Co., Inc.; J.P.
                    Morgan & Company, Incorporated; Morgan Stanley Dean Witter & Co.;
                                                                                   7
                    Paribas; Société Generale; Travelers Group Inc., and UBS AG. Oversight
                    Partner I was granted general authority over the management and
                    operations of the fund. The Consortium formed an oversight committee,
                    which consisted of representatives of six members (UBS, J.P. Morgan,
                    Morgan Stanley, Goldman Sachs, Salomon Smith Barney, and Merrill
                    Lynch). The representatives assumed the day-to-day oversight
                    responsibility for LTCM, with authority over the investment strategy,
                    capitalization structure, credit and market risk management,
                    compensation policy, hiring and firing, and other significant decisions.

                    According to press reports, between late September 1998 and the end of
Subsequent Events   April 1999, LTCM’s value rose 22 percent, after fees. By the end of June,
                    however, the gain had slipped to 14.1 percent. As of June 30, 1999, it
                    returned $1 billion of the initial $3.6 billion invested to Consortium
                    members and about $300 million that original investors, including LTCM,
                    had left in the fund. According to press reports, LTCM was “unwinding” its
                    operations, and its founding partner received permission from the
                    Consortium to begin marketing a new firm. The Consortium also voted to
                    reduce the number of outside bankers overseeing the fund full-time from
                    six to three.




                    7
                        Salomon Smith Barney was a subsidiary of Travelers Group.




                    Page 45                                           GAO/GGD-00-3 Long-Term Capital Management
Appendix II

Comments From the Commodity Futures
Trading Commission




              Page 46     GAO/GGD-00-3 Long-Term Capital Management
Appendix III

Comments From the Federal Reserve




               Page 47     GAO/GGD-00-3 Long-Term Capital Management
Appendix III
Comments From the Federal Reserve




Page 48                             GAO/GGD-00-3 Long-Term Capital Management
Appendix IV

Comments From the Securities and Exchange
Commission




              Page 49      GAO/GGD-00-3 Long-Term Capital Management
Appendix IV
Comments From the Securities and Exchange Commission




Page 50                                 GAO/GGD-00-3 Long-Term Capital Management
Appendix V

Comments From the Department of the
Treasury




             Page 51       GAO/GGD-00-3 Long-Term Capital Management
Appendix VI

GAO Contacts and Staff Acknowledgments


                  Thomas McCool. (202) 512-8678
GAO Contacts      Orice M. Williams. (202) 512-8678


                  James Black, Michael A. Burnett, Rosemary Healy, Richard Hillman,
Acknowledgments   Christine Kuduk, John H. Treanor, and Cecile Trop.




                  Page 52                             GAO/GGD-00-3 Long-Term Capital Management
Page 53   GAO/GGD-00-3 Long-Term Capital Management
Page 54   GAO/GGD-00-3 Long-Term Capital Management
Page 55   GAO/GGD-00-3 Long-Term Capital Management
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