The Washington Post

WASHINGTON - Federal Reserve ChairAlan Greenspan defended the Fed's role in brokering a rescue of Long Term Capital Management LP last month, saying yesterday that failure of the huge investment fund could have severely disrupted world markets and damaged "the economies of many nations, including our own."

But skeptical members of the House Banking Committee, both Republicans and Democrats, peppered Greenspan and William McDonough, president of the New York Federal Reserve Bank, with questions about why government regulators didn't know much sooner that the fund was in deep trouble and that some of the nation's largest banks and brokerage firms were exposed to very large losses if it went under.

Committee chairperson Rep. Jim Leach (R-Iowa) acknowledged that failure of the fund would have posed a risk for financial markets, but he labeled the episode a "fiasco."

"From a social perspective, it's not clear that Long Term Capital or any other hedge fund serves a sufficient social purpose to warrant government-directed protection," he said.

Leach and several other members suggested that additional regulatory powers might be needed, either by the Fed or other government financial agencies, to prevent such situations from occurring again.

But Greenspan and McDonough said no additional powers are needed and that direct regulation of hedge funds - unregulated investment funds organized for large, savvy investors - isn't feasible. If it were attempted, the funds could easily leave the country, the officials said.

Greenspan told the committee that if world financial markets had not already been in turmoil as a result of the Russian government's default on a portion of its debt in August, the Fed might not have become involved. Instead, discussions held under McDonough's auspices at the New York Fed resulted in a rescue plan in which 16 major banks and brokerage firms with large amounts of money already at risk in deals with the fund put up $3.6 billion to keep it alive. The new money is intended to allow an orderly liquidation of most or all of the fund's investment deals.

When Long Term Capital's woes came to light, "financial market participants were already unsettled by recent global events," Greenspan said. "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."

A "fire sale" of the fund's assets could have caused the price of many other securities to plummet and caused some markets to cease to function. Deciding whether the potential disruption in this case was severe enough for the Fed to become involved "is among the most difficult judgments that ever confronts a central banker," he said.

McDonough gave the committee a detailed chronology of the discussions that led to the rescue plan. He stressed he did not at any time dictate or directly negotiate the outcome.

And Greenspan said, "This agreement was not a government bailout, in that Federal Reserve funds were neither provided nor ever even suggested."

The Fed got involved "not to protect LTCM's investors, creditors or managers from loss, but to avoid the distortions to market processes caused by a fire-sale liquidation ..."

Several committee members were particularly critical of the Fed's role, contending it smacked of "crony capitalism," with important, well-heeled, well-connected investors and fund managers being given a break rather than being wiped out by their risky investments decisions.

Some were particularly interested in the fact that in the middle of the rescue negotiations, managers of LTCM turned down an offer to take over LTCM's investment portfolio made by three firms, Berkshire Hathaway Inc., led by Warren Buffet, American International Group and Goldman, Sachs & Co. Under that proposal, which the managers said they weren't sure they had the legal right to accept, LTCM investors would have been left with 5 percent of their firm's equity compared to 10 percent under the rescue plan.

Questions were raised about several potential conflicts of interest in the rescue plan. Some executives of the firms putting up the $3.6 billion also are individual investors in LTCM. Also, an oversight committee made up of representatives from those firms, which have extensive deals with the hedge fund, will be running LTCM. That means one group of the firms' employees will be negotiating on behalf of LTCM while another group will be working on behalf of the firms as the deals with LTCM are unwound.

McDonough said that in the latter case, he was sure there will be high "Chinese walls" set up within the rescuing firms to avoid conflicts.

NewsCom10/01/98 04:13:41 PM

10-02-98