mr. greenspan testifies on private - sector refinancing of the large hedge fund, long - term capital management testimony by the chairman of the board of governors of the us federal reserve system, mr. alan greenspan, before the committee on banking and financial services of the us house of representatives on 1 / 10 / 98. mr. chairman and other members of the committee, i thank you for this opportunity to report on the federal reserve ’ s role in facilitating the private - sector refinancing of the large hedge fund, long - term capital management ( ltcm ). in my remarks this morning, i will attempt to put into some perspective the events of the past few weeks and discuss some questions of importance to public policy makers that they raise. the federal reserve bank of new york ’ s efforts were designed solely to enhance the probability of an orderly private - sector adjustment, not to dictate the path that adjustment would take. as president mcdonough just related, no federal reserve funds were put at risk, no promises were made by the federal reserve, and no individual firms were pressured to participate. officials of the federal reserve bank of new york facilitated discussions in which the private parties arrived at an agreement that both served their mutual self - interest and avoided possible serious market dislocations. financial market participants were already unsettled by recent global events. had the failure of ltcm triggered the seizing up of markets, substantial damage could have been inflicted on many market participants, including some not directly involved with the firm, and could have potentially impaired the economies of many nations, including our own. with credit spreads already elevated and the market prices of risky assets under considerable downward pressure, federal reserve officials moved more quickly to provide their good offices to help resolve the affairs of ltcm than would have been the case in more normal times. in effect, the threshold of action was lowered by the knowledge that markets had recently become fragile. moreover, our sense was that the consequences of a fire sale triggered by cross - default clauses, should ltcm fail on some of its obligations, risked a severe drying up of market liquidity. the plight of ltcm might scarcely have caused a ripple in financial markets or among federal regulators 18 months ago - - but in current circumstances it was judged to warrant attention. what is remarkable is not this episode, but the relative absence of such examples over the past five years. dynamic markets periodically engender large defaults. events of the past few

stress test their counterparty exposures adequately and therefore underestimated the size of the uncollateralized exposure that they could face in volatile and illiquid markets. in part, this also reflected an underappreciation of the volume and nature of the risks ltcm had undertaken and its relative size in the overall market. by failing to make those determinations, its fellow market participants failed to put an adequate brake on ltcm ’ s use of leverage. to be sure, sometimes decisions are based on judgements about the soundness of borrowers that are accepted from third parties or, possibly in this case, that are founded on the impressive qualifications of ltcm ’ s principals. in some cases, such truncated risk appraisals may be accurate, but they are not a substitute for a rigorous analysis by the lender of the borrower ’ s overall credit worthiness and risk profile. third, in this regard what lessons are there for bank regulators? domestic commercial bank exposure to ltcm included both direct lending and acting as counterparties to the firm in derivatives contracts. a preliminary review of bank dealings with ltcm suggests that the banks have collateral adequate to cover most of their current mark - to - market exposures with ltcm. the unexpected surge in risk aversion and the dramatic opening up of interest rate spreads in august obviously caught ltcm wrong footed. counterparties, including banks, continued to collect collateral for marks to market. what they were not collateralized against was the losses that might have occurred when prices moved even further and market liquidity dried up in a fire sale. supervisors of banks and security firms must assess whether current procedures regarding stress testing and counterparty assessment could have been improved to enable counterparties to take steps to insulate themselves better from ltcm ’ s debacle. more important will be the assessment of whether those procedures are adequate for the future. but this is an area in which much work has been ongoing. during the fourth quarter of 1997 and the first quarter of 1998, supervision staff of the federal reserve bank of new york and the board met with managers at several major new york banking institutions to discuss their current relationships with hedge funds, updating a similar study conducted 3½ years earlier. fourth, does the fact that investors have lost most of their capital and creditors may take some losses on their exposure to ltcm call for direct regulation of hedge funds? it is questionable whether hedge funds can be effectively directly regulated in the united states alone.