Mr. McDonough describes the role of the FRBNY in the events leading up to private-sector recapitalization of Long-Term Capital Management Testimony by the President of the Federal Reserve Bank of New York, Mr. William J. McDonough, before Committee on Banking and Financial Services of the US House of Representatives on 1/10/
Good morning Mr. Chairman and members of the Committee. I am pleased to appear before you today to describe the Federal Reserve Bank of New York's role in the leading up to the recent private-sector recapitalization of Long-Term Capital Managemen fund, Long-Term Capital Portfolio.
I will cover four points. First, I will provide some background on Long Capital's financial problems. Second, I will explain our judgment that an abrupt and close-out of Long-Term Capital's positions would have posed unacceptable risks t American economy. Third, I will explain the limited role we played in facilitating th sector resolution to this private-sector problem. Fourth, I will identify some of th should concern us as we begin to understand the lessons of this experience.
## Background
Long-Term Capital is an investment partnership that was started in 1994. many of the characteristics of a 'hedge fund' in that it borrows money to leverage its is only available to wealthy investors. The strategy of Long-Term Capital was to use mathematical formulas to identify temporary price discrepancies between different inter For example, the firm might notice that the yield on corporate bonds relative to Treas was higher than the range observed in recent years. If Long-Term Capital believed the relationship would reassert itself, it would buy corporate bonds and sell short Treasu the spread narrowed as expected, the firm would profit. If, however, the spread con widen, the firm would incur losses. This basic strategy and many complex variatio followed across many interest rate products in the US and many overseas markets as we firm was active both in traditional securities markets, and perhaps more importa derivative product markets such as futures, swaps, and options. Anticipating that some would move in their favor and some would move against them, the firm relied on diversif across a large number of product and geographic markets. Long-Term Capital proved successful at this strategy, generating returns in excess of 40 percent in 1995 and 1 somewhat less in 1997.
Perhaps their success went to their heads. Long-Term Capital took on large larger positions. They also leveraged their investments at higher levels, returning ca investors but not, apparently, reducing risks. We now also know that they took on si positions in equity markets, through both swap and options contracts. The reputation Long-Term Capital partners, as traders and economists, and their initial success, appe contributed to so many counterparties' willingness to deal with them.
While hubris may have set them up for a fall, it was the extraordinary ev August in global markets that appears to have tripped them.
On August 17, the Russian government announced an effective devaluation of ruble and declared a debt moratorium, shocking investor confidence all over the worl subsequent days and weeks, equity and debt markets the world over became increasingly vo
with US equity markets falling and the spreads between US Treasury securities and yielding debt instruments widening sharply. The correction of stock prices was not of ex size or concern and, indeed, had been anticipated by a number of astute market ob However, the abrupt and simultaneous widening of credit spreads globally, for both c and emerging-market sovereign debt, was an extraordinary event beyond the expectatio investors and financial intermediaries.
The unusual widening of credit spreads also caused significant losses at Term Capital. As markets around the world moved in the same direction at the same tim diversification on which Long-Term had previously relied failed them utterly. Ins offsetting positions, their losses were compounded. At the same time, the volatility markets caused further losses. On September 2, the partners of Long-Term Capital sen investors a letter acknowledging 52 percent losses on the year through August 31 and were seeking an injection of capital to sustain the firm. The existence of this le widely known and reported within a few days.
Because of this, during the first two weeks of September, concern about Term Capital was a widespread topic of conversation in financial markets. It is a trad essential role for the President and senior officers of the New York Fed to be talk receiving calls from, market participants regarding significant developments and dislocations. In fact, the partners at Long-Term Capital called me early in September to of their difficulties and their discussion with investment houses about plans to raise
By Friday, September 18, with the efforts to raise new capital still unsuc and with an increasing number of people now aware of Long-Term's plight because of the to bring in new investors - events seemed to come to a head. With market conditions par unsettled that day, I made a series of calls to senior Wall Street officials to discuss conditions. Let me take a moment to put those calls in context. One important objecti Federal Reserve is to assure financial stability. Particularly in times of stress, it the Federal Reserve continue to take the pulse of the market. One way to do that is candid and open communication with key market participants. Everyone I spoke to tha volunteered concern about the serious effect the deteriorating situation of Long-Term c on world markets.
Also on the 18th, one of the firms that had been working with Long-Term to new capital asked the Long-Term Capital partners if the firm could share the informati with us. The partners at Long-Term Capital responded that they would prefer to pres information themselves and called me to arrange such a presentation.
After conferring with Chairman Greenspan and Secretary Rubin, we agreed tha visit to Long-Term Capital's offices was needed. A team from the New York Fed, led by Fisher, the head of our Markets Group, and joined by Treasury Assistant Secretary Gary met with the Long-Term Capital partners at their offices on Sunday, September 20. Duri meeting, we learned the broad outlines of Long-Term Capital's major positions in cre equity markets, the difficulties they were having in trying to reduce these positions i conditions, their deteriorating funding positions and an estimate of their largest exposures. The team also came to understand the impact which Long-Term Capital's posi were already having on markets around the world and that the size of these positions w greater than market participants imagined.
## The New York Fed's Judgements
Mr. Chairman, I would like now to turn to my second point, and focus expli on the question of our judgment that the abrupt and disorderly close-out of Long-Term C positions would pose unacceptable risks to the American economy.
There are several ways that the problems of Long-Term Capital could have b transmitted to cause more widespread financial troubles. Had Long-Term Capital been su put into default, its counterparties would have immediately 'closed-out' their pos counterparties would have been able to close-out their positions at existing market pri if any, would have been minimal. However, if many firms had rushed to close-out hundr billions of dollars in transactions simultaneously, they would have been unable to collateral or establish offsetting positions at the previously-existing prices. Market moved sharply and losses would have been exaggerated. Several billion dollars of losse have been experienced by some of Long-Term Capital's more than 75 counterparties.
These direct effects on Long-Term Capital's counterparties were not our pri concern. While these losses would have been considerable, and would certainly have ad affected the firms experiencing them, this was not, in itself, a sufficient reason for involved.
Two factors influenced our involvement. First, in the rush of Long-Term Cap counterparties to close-out their positions, other market participants - investors dealings with Long-Term Capital - would have been affected as well. Second, as losses s other market participants and Long-Term Capital's counterparties, this would lead to tr uncertainty about how far prices would move. Under these circumstances, there was a lik that a number of credit and interest rate markets would experience extreme price mo possibly cease to function for a period of one or more days and maybe longer. This wou caused a vicious cycle: a loss of investor confidence, leading to a rush out of pri leading to a further widening of credit spreads, leading to further liquidations of pos on. Most importantly, this would have led to further increases in the cost of capital businesses.
Let me be clear: had we not just experienced in August precisely this t shock to our credit markets, had we not just seen a sudden, world-wide straining of confidence, had there not already been underway a flight of capital away from private c into Treasury securities, were much of the world not experiencing financial strain, judgements about the risks to the American economy of an abrupt and disorderly close Long-Term Capital may well have been different. But, in the circumstances that did in f it was my judgment that the American people, whom we are pledged to serve, could have seriously hurt if credit dried up in a general effort by banks and other intermediar greater risk.
In light of these risks, the responsible public policy objective was to ge those with a direct financial interest in an orderly rescue of Long-Term Capital, to problems openly and objectively, to provide a sounding board for solutions, and if nec calming influence. In my view, we achieved this objective.
## What did the New York Fed do?
Because events were moving swiftly, and with my approval and support, m colleague Mr. Fisher invited representatives of the three firms, which we felt had t knowledge of the situation at Long-Term Capital and a strong interest in seeking a solu early morning meeting on September 22nd. The three firms were Goldman Sachs, Merrill Ly and J.P. Morgan.
Continuing discussions which commenced the day before, Mr. Fisher explain our interest in being aware of developments and in reducing the risk of an abrupt an close-out of Long-Term Capital. The firms present stated that they were not aware of a initiatives then being actively pursued, to resolve Long-Term Capital's problems. The their own concerns about the risks to the markets of a close-out scenario. They discuss approaches to stabilizing Long-Term Capital including the concept of a 'collective ind consortium approach. However, they all agreed that work on a collective option shou preclude parallel efforts by anyone; indeed, that if any firm or group of firms wish forward and take Long-Term Capital itself or Long-Term Capital's positions onto their sheets that this would be the most desirable outcome. In the absence of any other sol firms dispatched two working groups to Long-Term Capital's offices in Connecticut to c the feasibility of 'lifting' the fixed-income and the equity positions out of Long-Term third working group met at one of the firm's offices downtown to develop the ide consortium approach. By mutual agreement another firm, UBS, a Swiss bank, was added to core group and to each of the three working groups. However, no one from the New York participated in any of the working groups.
At no point in this early morning meeting, nor at any stage last week, wa discussion of the use of public monies - Federal Reserve or otherwise. No Federal Re government guarantees, actual or implied, were offered, discussed or solicited.
Later that afternoon, we participated in a conference call to review the pr the working groups. Two of the working groups concluded that a 'lifting' of the fixed and equity positions was not feasible. The third group developed a consortium approach was deemed feasible. Every one agreed that the consortium approach should be 'last dit that parallel solutions should still be encouraged.
The four firms met at the Federal Reserve at 7:00 p.m. A draft term shee reviewed which provided detail with respect to the consortium approach. The term conditions were debated, altered in some places, and ultimately refined so that the could present it to a wider group. Although Federal Reserve officials were present at t we did not participate in the discussion about terms and conditions.
At about 8:30 p.m., a meeting of a wider group involving 13 firms be Meanwhile, some representatives of the Core Group called Long-Term Capital to discus terms and conditions of the consortium approach. Federal Reserve officials did not part any conversations with Long-Term Capital regarding the terms and conditions. In the m with the wider group, Peter Fisher explained the importance of avoiding a disorderly cl Long-Term Capital's positions. He also underscored the desirability of parallel efforts the problem. It was agreed that the group would reconvene at 10:00 a.m. the following It was clear to everyone that time was of the essence.
I returned to New York from London around midnight. During the early morni hours, I called various foreign central bank officials to inform them of the situati 9:30 a.m. my colleagues and I met with the Core Group to review the status of the sit
few minutes before the start of the scheduled 10:00 a.m. meeting, one of the Core Gro told me that an investor group would make an offer to acquire the Long-Term portfolio. one of the representatives of the investor group to confirm this development. The o subsequently conveyed to Long-Term Capital by that investor group and a response requested by 12:30 p.m.
After a brief consultation with the Core Group, I decided that the effort t with the consortium approach needed to be suspended for a short time until the alterna could be considered. As noted earlier, the consortium approach was seen as a 'last Consequently, the meeting about the consortium approach was adjourned at about 10:50 a. reconvene at 1:00 p.m.
At 12:30 p.m., I learned that the alternative offer had not been accepted a not be extended. Shortly after 1:00 p.m., the meeting about the consortium approach r This was now the only solution being pursued. During the next five hours, the priva participants discussed every aspect of the terms and conditions. At the end of that dis banks and securities firms agreed to participate in the recapitalization, with contributing smaller amounts than the other eleven. Two firms declined to participate.
I want to emphasize a few points. First, this was a private sector solut private-sector problem, involving an investment of new equity by Long-Term Capital's cr and counterparties. Second, although some have characterized this as a 'bailout', cont Long-Term Portfolio passed over to this 14 firm creditor group and the original equit have taken a severe hit. Finally, no Federal Reserve official pressured anyone, and no were made. Not one penny of public money was spent or committed.
## Issues that should concern us
It is far too early to state categorically the lessons to be learned from Capital. What I can say is that we are focused on three specific issues, all relating t how we are able to observe it through the eyes of our bank examiners. Let me emphasi again, that the Federal Reserve has no regulatory authority over hedge funds and no r authority over Long-Term Capital.
The first issue relates to credit analysis. Our supervisory guidance gener with respect to hedge funds specifically, stresses the importance of knowing the borrow business purpose of the borrower's transactions. In 1994, the Federal Reserve i supervisory letter emphasizing the importance of financial analysis of counterparties, hedge funds, which can quickly adjust their risk profile. There is a question whether credit analysis was performed by creditors of Long-Term Capital, which needs to be ex carefully during the next few weeks. If credit analysis was deficient, we need to lea why before we can make pronouncements that will avoid repetition of our Long-Term Cap experience.
The second issue relates to derivatives activities and a concept calle potential exposure, which is a measure of the likely price movements based on recen experience. With respect to derivatives, the current market value is captured by statements prepared in accordance with generally accepted accounting principles, but potential future exposure. To fully understand the degree and effect of leverage in L Capital's derivatives-related strategies, it would have been necessary to measure th future exposure in a rigorous and conservative manner. Whether sufficient information w
available to Long-Term Capital's counterparties, including its banks, and adequately an those counterparties, remains to be seen.
A third question concerns stress testing in the credit analysis of hedge f the structuring of margin agreements. Stress testing simulates the effects on a portfo asset relationships simultaneously move adversely far beyond historical observati recognize that stress testing is a developing discipline, but it is clear that adequate done with respect to the financial conditions that precipitated Long-Term Capital's pr a recent supervisory letter on credit underwriting generally, we emphasized the impor stress testing. Effective risk management in a financial institution requires not onl but models that can test the full range of financial transactions across all kinds of a developments. Whether such models existed and, if so, whether they were effective, ar that we need to address.
In the aftermath of Long-Term Capital, we need to pursue these leverage-re issues, and others, in conjunction with our colleagues at the Federal Financial I Examinations Council. The insights that we gain should be of value to bank supervisors the study of the Long-Term Capital matter that is to be done by the President's Workin on Financial Markets, announced by Secretary Rubin last Friday.