Mr. Chairman, members of the Subcommittee. I am pleased to testify today on behalf of the Treasury Department. In my statement, I will address three topics: first, I will provide a brief background on hedge funds and their role in the financial system. Second, I will discuss the issues arising out of the near-collapse of Long Term Capital Management last fall, and the market developments since that time; and finally, the status of the President's Working Group on Financial Markets study on hedge funds.

Following the LTCM episode, Secretary Rubin called for a study of the potential implications of the operations of firms such as Long-Term Capital and their relationships with their creditors. Since that time, staffs from the Working Group agencies have been working diligently on the study. As we have conducted this study, we have focused on excessive leverage in complex financial institutions in general and, importantly, how it relates to systemic risk.

At the outset, Mr. Chairman, I would like to emphasize that the Working Group has not completed its study, and that the matters I will discuss today are still under consideration by the Group. Neither Treasury nor the Working Group is prepared at this time to present final recommendations concerning these matters. However, all the members of the Working Group look forward to sharing their conclusions regarding the hedge fund study with you in the near future.

What is a "Hedge Fund"?

The term "hedge fund" is often used to characterize a variety of different types of investment vehicles. Broadly speaking, a hedge fund can be defined to include any pooled investment vehicle that is privately organized and not generally available to the public. Most commonly, hedge funds are organized as limited partnerships or limited liability corporations, and are often engaged in active trading of securities, commodities, currencies, and related derivatives. The primary investors in hedge funds are wealthy individuals and institutions, although many hedge fund managers tend to have significant financial interests in the fund as well.

Hedge funds are not new, but rather have existed for nearly 50 years. During the past two decades, however, the hedge fund industry has grown significantly. Although there are no precise figures as to the size of the industry, a number of estimates indicate that as of mid-1998 there were between 2,500 and 3,500 hedge funds managing between $200 and $300 billion in capital. The hedge fund industry remains relatively small, however, when compared to other sectors of the financial markets. For instance, at the end of 1998, the approximately 7,300 mutual funds in the U.S. had net assets of $5.5 trillion and the top 1000 U.S. public and private pension funds had assets exceeding $4 trillion.

With $200 - $300 billion spread among approximately 3,000 hedge funds, most hedge funds are relatively small, with the vast majority controlling less than $100 million in invested capital. In fact, according to filings with the Commodity Futures Trading Commission (CFTC), there are perhaps only a few dozen hedge funds today that have a capital base larger than $1 billion, and only a small handful that exceed $5 billion.

Although individually and as an industry, hedge funds represent a relatively small segment of the market, their impact is greatly magnified by their highly active trading strategies and by the leverage obtained through their use of repurchase agreements and derivative contracts.

What Role do Hedge Funds Play in the Financial Markets?

In general, active market participants such as hedge funds can provide benefits to financial markets by enhancing liquidity and efficiency. Additionally, they can play a role in financial innovation and the reallocation of financial risk. However, some hedge funds, like other large highly leveraged financial institutions, also have the potential to disrupt the functioning of financial markets, as was demonstrated by the events surrounding the LTCM incident of last fall.

Analysis of the Implications of the LTCM Episode

While this committee has already heard the details of the LTCM episode, it may be helpful to identify and underscore some of the key concerns that arise from LTCM's near- collapse, and the issues the Working Group has been addressing in its hedge fund study.

LTCM appears to have been unique among hedge funds in terms of its combination of size and leverage. At year-end 1997, LTCM had total assets of nearly $130 billion, including derivatives contracts with a current market value of $3 billion. With capital at the time of around $4.7 billion, LTCM's gross leverage ratio was around 28 to 1. While a more meaningful risk-based measure of leverage is unavailable, it appears that no other hedge fund filing with the CFTC was nearly so large and highly leveraged. In fact, most hedge funds filing with the CFTC had total assets of under $100 million and leverage ratios of less than 2 to 1.

While the LTCM episode does not necessarily suggest that there are problems with the entire industry, it does raise significant concerns. That a single firm with a relatively modest capital base could finance positions so large that their unwinding might have significantly disrupted financial markets around the globe is disturbing. This episode demands that both market participants and financial regulators, both here and abroad, understand how LTCM became so highly leveraged and what market practices and disciplines contributed to this incident. It is excessive leverage of this nature, and the practices which allowed the accumulation of such leverage, which has the potential to lead or contribute to systemic risk in the future.

Leverage

Therefore, the Working Group is spending a great deal of time examining a number of issues related to leverage and how the leverage of firms like LTCM can be constrained more effectively. This is the central public policy issue raised by the LTCM episode. The Working Group is evaluating the costs and benefits of potential policy options including: relying on market discipline, enhanced by greater regulatory scrutiny of and guidance for regulated suppliers of credit, such as banks; resorting to more direct forms of regulation such as expanded use of margin requirements; and, finally, imposing direct regulation on some currently unregulated market participants. Although we have not yet come to any conclusions, we are carefully studying the potential impact of various proposals in this area.

While we have been conducting this study, renewed market discipline has begun to have a positive effect in, at least temporarily, reducing excessive leverage. Though it proved an inadequate constraint in the LTCM case, we have seen some tightening of market discipline since last fall. Importantly, there is some evidence that banks and other suppliers of credit to highly leveraged financial institutions are demanding more collateral or requiring larger "haircuts" (effectively margin) on their repurchase agreements and derivative transactions. Again, while these are positive developments, the Working Group is continuing to study what further steps may be necessary.

Transparency and Disclosure

A related issue, and a key concern of the Working Group, is the adequacy of transparency and disclosure. There is a broad consensus among the Working Group members that creditors must reexamine how they make credit decisions to highly leveraged financial institutions. We believe that creditors must demand and borrowers must provide more relevant and up-to-date information than they have in the past. It is equally important for these creditors to report and disclose the extent of their exposures to such highly leveraged financial institutions.

The Working Group is examining a number of proposals aimed at addressing enhanced disclosure and transparency, including ways to encourage increased voluntary disclosure. The Group is also examining the possibility of increasing certain regulatory disclosure requirements and is carefully weighing the costs and benefits of all such proposals.

Again, while we have been studying the various options, there have been some positive developments in the marketplace. There is some evidence that banks and other suppliers of credit to highly leveraged institutions are requesting and receiving more detailed and relevant information for making credit judgements. They are demanding greater transparency and are more strenuously attempting to understand the nature of the risks their clients are taking.

Risk Management

Another major concern being examined by the Working Group in addressing excessive leverage is the sufficiency of risk management practices at both the lending institutions and at the hedge funds themselves. The LTCM episode demonstrated that the risk management systems of some market participants were flawed and that the credit controls of even some highly regulated institutions such as commercial banks had material weaknesses. These weaknesses have the potential to contribute to excessive leverage and to systemic risk if not addressed.

In addition to regulators, many market participants are concerned about the adequacy of risk management practices and are beginning to take steps to address those concerns. For example, twelve major banks and investment banks have formed the Counterparty Risk Management Policy Group with the purpose of developing industry standards for strengthened risk management practices. I understand that you will be hearing from representatives of this group later today.

Clearly, a large part of the renewed discipline displayed by many market practitioners since LTCM is driven by self interest and preservation -- two of the strongest incentives in the financial markets. However, it is also in part the result of swift and appropriate action taken by bank regulators at the OCC and the Fed. These regulators have been updating their guidance to banks and bank examiners concerning exposures to highly leveraged entities such as hedge funds and are effectively putting banks on notice that they expect to see improvements made in this area. The guidance requires bankers to upgrade their credit risk management processes relating to lending and trading transactions involving highly leveraged entities and other major trading counterparties. This includes obtaining adequate financial information regarding their counterparties' on- and off-balance sheet positions, and information on business strategies, leverage, and risk concentrations, and developing methodologies to stress test their counterparty credit exposures.

International Initiatives

In addition to working with market participants and a variety of regulatory bodies here in the U.S., Treasury is working closely with our major international colleagues to address the issues raised by highly leveraged institutions, including hedge funds. Among the concerns raised by some members of the international community is the possible influence these institutions may have in the currency and various local capital markets. While it is difficult to assess the extent of such influence, Treasury is involved in a number of international initiatives relevant to this and other concerns. On February 20, the G7 Finance Ministers and Central Bank Governors agreed that they will consider the implications arising from the operations of hedge funds and of offshore centers, including whether additional reporting and disclosure by highly leveraged institutions themselves is warranted or feasible. The Basle Committee on Banking Supervision has already produced a report that identifies sound practices for bank creditors of hedge funds. Additionally, the International Organization of Securities Commissions (IOSCO) has established a task force to study the advisability and feasibility of imposing transparency and disclosure requirements on highly leveraged institutions and to review current practices regarding internal controls of such institutions.

Clearly, it will be important to continue to work closely with the various international organizations since, as Chairman Leach and others have pointed out, hedge funds can easily move from the United States to other jurisdictions, thus diluting some of the positive effects of any regulatory adjustments the U.S. might consider.

Summary

As the Working Group addresses the key issues of leverage, disclosure and transparency, and risk management, we are considering a broad universe of possible responses in order to arrive at the most effective recommendations. The range of possibilities includes increased supervisory oversight of the regulated providers of credit, enhanced market practices (or the establishment of minimum standards) and possibly, increased regulation. As market discipline may not be adequate to address these issues, we must carefully weigh the costs and benefits of adopting some additional regulatory constraints in an effort to further mitigate systemic risks.

Additionally, we should continue to encourage the initiatives of the U.S. bank regulators and private sector groups aimed at improving risk management practices and reducing excessive leverage. We must also continue to work with the various international groups, such as the Basle Committee on Banking Supervision and others, who will help to formulate a coordinated international response to the issue of excessive leverage in world financial markets.

Mr. Chairman and members of the Subcommittee, I appreciate the opportunity to appear here today. We at the Treasury Department, along with the other members of the Working Group, look forward to presenting you with our conclusions and recommendations and to working with you to address these important issues. I would be happy to answer any questions that you may have. Thank you.