Lenders criticized in near collapse But Greenspan defends Fed's role in hedge-fund bailout

Hedge funds

October 02, 1998|By BLOOMBERG NEWS

WASHINGTON -- Federal Reserve Chairman Alan Greenspan said yesterday that Long-Term Capital Management LP's banks and other creditors played a significant role in the hedge fund's near collapse by lending money without fully understanding the risks they faced.

The institutions "misjudged the state of potential losses that could occur under extreme circumstances," Greenspan said at a House Banking Committee hearing into the $3.6 billion takeover of Long-Term Capital.

Greenspan defended the Fed's role in brokering last week's takeover by arguing that bankers are best situated to understand the risks of lending to hedge funds. He urged the panel not to pass new regulations.

"I know of no set of supervisory actions we can take that will prevent them from making dumb mistakes," Greenspan said.

The Fed's New York branch helped organize 14 banks and brokerage firms to take over the Greenwich, Conn.-based hedge fund, which suffered losses of as much as $4 billion in highly leveraged bond and stock trades.

The central bank's aim was to avoid "possible serious market dislocations" that "could have potentially impaired the economies of many nations, including our own," and did not signal a new policy to protect fund investors, Greenspan said.

Greenspan said the New York Fed's actions were meant to be a catalyst for a "an orderly private-sector adjustment, not to dictate the path that adjustment would take."

The Fed did not put funds at risk and did not make promises in the rescue, "and no individual firms were pressured to participate," he said.

Others picked up on the theme that the fund's creditors failed to examine the fund's risks.

"Banks failed to do proper due diligence to assess the counter-party risk of these loans to Long-Term Capital," Steven A. Lonsdorf, president of Van Hedge Fund Advisors International Inc., said in prepared remarks.

Greenspan said the Fed and other regulators will address the banks' role and other issues in a special study of hedge funds that Treasury Secretary Robert E. Rubin announced last week.

The group will examine five major questions, including the extent to which firms should rely on financial modeling instead of human judgment when examining market risks, the steps trading partners in the markets took to ensure they had properly estimated their exposure, and the role of regulators.

Greenspan said the new owners "intend to shrink Long-Term Capital's portfolio so as to reduce risk of loss and return the remaining capital to investors as soon as practicable." He said the new owners may decide to operate a smaller Long-Term Capital after the portfolio is restructured. "That is their judgment to make," he said.

New York Fed President William McDonough, who also testified at the hearing, said a failure of the fund could have created volatility in world markets, triggering "a vicious cycle" of investors fleeing to safer investments and capital drying up.

Rep. Jim Leach, the Iowa Republican who chairs the House Banking Committee, criticized the Fed's involvement as possibly damaging chances of private efforts to buy the hedge fund. "Here you have a quasi-cartel circumstance," Leach said.

Pub Date: 10/02/98

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