Summary
In 1998, Long-Term Capital Management (LTCM)--one of the largest U.S. hedge funds--lost more than 90 percent of its capital. The Federal Reserve concluded 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. As a result, the Fed arranged a private sector recapitalization to prevent LTCM's collapse. 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. This report discusses (1) how LTCM's positions became large and leveraged enough to be deemed a potential systemic threat, (2) what federal regulators know 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.
GAO noted that: (1) 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; (2) 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; (3) however, weaknesses in the risk management practices of these creditors and counterparties allowed LTCM's size and use of leverage to grow unrestrained; (4) the effects of these weaknesses became apparent during the unsettled market conditions that occurred in the summer of 1998; (5) LTCM began to lose large amounts of money in various trading positions worldwide and by mid-September was on the verge of failure; (6) 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; (7) 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 hedge funds' leverage and risk-taking; (8) 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; (9) 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; (10) 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; and (11) the President's Working Group report recommended that Congress provide SEC and CFTC expanded authority to obtain and verify information from unregistered affiliates of broker-dealers and future commission merchants.
Recommendations
Our recommendations from this work are listed below with a Contact for more information. Status will change
from "In process" to "Implemented" or "Not implemented" based on our follow up work.
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Matters for Congressional Consideration
Recommendation: In an effort to identify and prevent future crises, Congress should consider providing SEC and CFTC with the authority to regulate the activities of securities and futures firms' affiliates similar to that provided 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.
Status: In process
Comments: Although the Gramm-Leach-Bliley Act of 1999 (financial modernization) addresses this issue in part, it does not fully respond to the matter for consideration. The act does give SEC "Federal Reserve-like" examination authority over investment bank holding companies that decide to be supervised by SEC (no capital requirements). However, it does not give SEC and CFTC umbrella regulatory authority over the unregulated affiliates of broker-dealers and futures' firms.
Recommendations for Executive Action
Recommendation: The Secretary of the Treasury and the Chairmen of the 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.
Agency Affected: Department of the Treasury
Status: In process
Comments: The Treasury, as chairman of the President's Working Group, has not taken steps to coordinate the assessment of risks that cross traditional regulatory and industry boundaries.
Agency Affected: Commodity Futures Trading Commission
Status: In process
Comments: "The President's Working Group on Financial Markets (PWG), is chaired by the Secretary of the Treasury and also comprises the chairmen of the Federal Reserve, SEC and CFTC. CFTC believes that there is a heightened awareness of the need for coordination among the PWG's member agencies in the event of financial or other types of emergencies. In its regular meetings, the PWG's discussions are focused on topics of common interest with a view towards identifying and addressing systemic risks. In addition, staff of the PWG member agencies, together with staff of the FDIC and OCC, meet regularly as the Interagency Financial Markets Group to share information about market developments, particularly those that may have implications across different financial sectors. The following are examples. (1) The PWG served as a platform for coordinating the reopening of the financial markets following the terrorist attacks on September 11, 2001. The PWG has subsequently monitored the disaster preparedness of financial market institutions and market participants. (2) In its report entitled Over-the-Counter Derivatives Markets and the Commodity Exchange Act, dated November 1999, the PWG recognized the benefits of clearing for over-the-counter (OTC) derivatives and that the effectiveness of a clearinghouse is critical to the stability of the markets that it serves. The PWG recommended that Congress enact legislation to provide for the regulation of OTC clearing and, in enacting the Commodity Futures Modernization Act of 2000, Congress did so. (3) The PWG has also presented a unified voice in support of legislative initiatives that seek to reduce systemic risks by recommending certain improvements in the closeout-netting regime for derivatives and other instruments that would reduce systemic risk. Although various netting provisions have been proposed several times as part of broader legislative proposals--and have been widely supported--opposition to unrelated provisions of the broader proposals has prevented the enactment of the netting provisions." Mr. Leslie said that the preceding text was prepared in consultation with staff associated with the work of the PWG. The steps outlined above, while significant, do not address the intent of GAO's recommendation. Agencies still react to problems as they arise.
Agency Affected: Federal Reserve System: Board of Governors
Status: In process
Comments: The recommendation has not yet been implemented.
Agency Affected: Securities and Exchange Commission
Status: In process
Comments: The recommendation has not yet been implemented.
