Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Committee on Banking and Financial Services, US. House of Representatives, October 1, 1998

Federal Reserve Bulletin, Dec, 1998

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 policymakers 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 eighteen 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 WEEKS

LTCM is a hedge fund, or a mutual fund that is structured to avoid regulation by limiting its clientele to a small number of highly sophisticated, very wealthy individuals and that seeks high rates of return by investing and trading in a variety of financial instruments. Since its founding in 1994, LTCM has had a prominent position in the community of hedge funds, in part because of its assemblage of talent in pricing and trading financial instruments as well as its large initial capital stake. In its first few years of business, it earned an enviable reputation by racking up a string of above-normal returns for its investors.

LTCM appears principally to have garnered those returns by making judgments on interest rate spreads and the volatilities of market prices. In its search for high return, LTCM levered its capital through securities repurchase contracts and derivatives transactions, relying on sophisticated mathematical models of behavior to guide those transactions. As long as the configuration of returns generally mimicked their historical patterns, LTCM's mathematical models of asset pricing could be used to ferret out temporary market price anomalies. Their trading both closed such price gaps and earned an extra bit of return on capital for them. But it is the nature of the competitive process driving financial innovation that such techniques would be emulated, making it ever more difficult to find market anomalies that provided shareholders with a high return. Indeed, the very efficiencies that LTCM and its competitors brought to the overall financial system gradually reduced the opportunities for above-normal profits. Indeed, LTCM acknowledged this when returning $2 3/4 billion of capital to investors at the end of 1997. To counter these diminishing opportunities, LTCM apparently reached further for return over time by employing more leverage and increasing its exposure to risk, a strategy that was destined to fail. Unfortunately for its shareholders, LTCM chose this exposure just as financial market uncertainty and investor risk-aversion began to rise rapidly around the world.

In that environment--so at variance with the experience built into its models--LTCM's embrace of risk on a large scale produced stunning losses. As we now know, by the end of August the firm had lost half its capital base. And as September unfolded, the bleeding continued. The firm, however, apparently did not unwind its positions significantly.

In our dynamic market economy, investors and traders, at times, make misjudgments. When market prices and interest rates adjust promptly to evidence of such mistakes, their consequences are generally felt mostly by the perpetrators and, thus, rarely cumulate to pose significant problems for the financial system as a whole. Indeed, the operation of an effective market economy necessitates that investment funds committed to capital projects that do not accurately reflect consumer and business preferences should incur losses and ultimately be liquidated. What value is left needs to be redirected to profitable uses--those that more accurately reflect market preferences. By such winnowing of inefficiencies, productivity is enhanced and standards of living expand over time.