ben s bernanke : hedge funds and systemic risk remarks by mr ben s bernanke, chairman of the board of governors of the us federal reserve system, at the federal reserve bank of atlantaa€™s 2006 financial markets conference, sea island, georgia, 16 may 2006. * * * thank you for inviting me to speak today. in keeping with the theme of this conference, i will offer some thoughts on the systemic risk implications of the rapid growth of the hedge fund industry and on ways that policymakers might respond to those risks. the collapse of long - term capital management ( ltcm ) in 1998 precipitated the first in - depth assessment by policymakers of the potential systemic risks posed by the burgeoning hedge fund industry. the president's working group on financial markets, which includes the federal reserve, considered the policy issues raised by that event and, in 1999, issued its report, hedge funds, leverage, and the lessons of long - term capital management. the years since then have offered an opportunity to consider whether the working group's recommendations for addressing those issues have been effective and whether new concerns have arisen that warrant an alternative approach. ltcm and the working group's recommendations as the title of the report indicated, the working group focused on the potential for leverage to create systemic risk in financial markets. the concern arises because, all else being equal, highly leveraged investors are more vulnerable to market shocks. if leveraged investors default while holding positions that are large relative to the markets in which they have invested, the forced liquidation of those positions, possibly at fire - sale prices, could cause heavy losses to counterparties. these direct losses are of concern, of course, particularly if they lead to further defaults or threaten systemically important institutions ; but, in addition, market participants that were not creditors or counterparties of the defaulting firm might be affected indirectly through asset price adjustments, liquidity strains, and increased market uncertainty. the primary mechanism for regulating excessive leverage and other aspects of risk - taking in a market economy is the discipline provided by creditors, counterparties, and investors. in the ltcm episode, unfortunately, market discipline broke down. ltcm received generous terms from the banks and broker - dealers that provided credit and served as counterparties, even though ltcm took exceptional risks. investors, perhaps awed by the reputations of ltcm's principals, did not ask sufficiently tough questions about the risks that were being taken to

##os. the conversion of mortgages into mortgage - backed securities ( mbs ) and collateralized debt obligations ( cdos ) may seem complicated but in reality these are fairly straightforward transactions. to provide the committee a rough schematic, we start with those who take out amortizing housing loans from banks. for the bank, this is a long - term asset which ties up resources and is prone to market and credit risks. to mitigate these risks, the bank may pool the amortizations expected from the mortgage and create a security which can be sold to investors. the coupon payment of the new security is funded by the amortizations of the housing loan. this security is referred to as the mbs and the transaction is oftentimes is handled through a special purpose vehicle. to the bank, the effect is an improvement in the asset quality of its balance sheet because the traditional mortgage risks are mitigated. investors welcome this because it affords them another instrument that they can consider for their portfolio. the spv earns from being a conduit while the mortgagor is unaffected because he / she has already received the proceeds from the original loan. taking this a step further, collateralized debt obligations may also be created and likewise offered to investors. there are technical differences between cdos and mbs but for purposes of situating the current market conditions, it is perhaps sufficient to suggest that the two instruments are similar in that they pool underlying assets and sell an instrument that represents these underlying assets. the effective fed funds rate subsequently reversed course. housing prices also began to fall significantly and mortgage defaults began to rise. since the home was typically the collateral of the mortgage, falling housing prices also eroded the value of the collateral supporting the loan. in the past, a loan default would have simply meant foreclosing on the home. however, since the mortgage was already “ converted ” into a security ( mbs and cdos ) held by investors worldwide, the combination of rising mortgage defaults and falling collateral values translated into losses for the mbss and the cdos ( either through outright defaults, missed coupon payments and loss in market value of the security ). these factors sparked the widespread dilemma that we now find ourselves in. if memory serves us right, it was in february 2007 that the term “ subprime mortgage ” was publicly alluded to in a disclosure by an international financial institution. the subprime difficulties began to take explicit shape as