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January 29, 1999
Report Finds Banks Failed to Oversee Big Hedge Fund
By TIMOTHY L. O'BRIEN
NEW YORK -- A handful of the world's largest commercial and investment banks failed to adequately oversee lending and trading activities with hedge-fund giant Long-Term Capital Management, a regulatory study has found.
William McDonough, the president of the New York Federal Reserve, oversaw the study and said that the banks had been blinded by what he called the "magic" of the once high-flying firm's vaunted reputation, a situation he suggested could recur if banks do not tighten their monitoring of such funds.
McDonough's comments accompanied the release Thursday of a lengthy international review on the near-collapse of Long-Term Capital in September, which McDonough said would have posed a threat to the stability of the global economy.
The report detailed many lapses in judgment by banks in their dealings with Long-Term Capital and similar hedge funds, but it noted that such funds are still very difficult to regulate and that the most effective way of preventing potential disasters is for lenders to be far more circumspect.
The report said that banks had become better attuned to the dangers posed by lax supervision of their dealings with hedge funds since the Long-Term Capital debacle.
But denizens of Wall Street, even the very largest and brightest, never have been known to possess good memories, a fact McDonough was quick to note again Thursday. "Financial institutions can learn lessons well, but the question is how long they continue to remember them," he said.
Chase Manhattan; Citigroup; J.P. Morgan; Merrill Lynch; Morgan Stanley; Goldman, Sachs; Bear, Stearns and Lehman Brothers were the nation's financial services firms with the closest lending or trading relationships with Long-Term Capital. Foreign firms close to the hedge fund included UBS, Deutsche Bank, Credit Suisse, and Societe Generale.
Hedge funds are largely unregulated, private investment pools typically open to wealthy individuals and large institutional investors. The most free-wheeling hedge funds borrow huge sums of money to make complex trades in stocks, bonds, currencies and more exotic financial products known as derivatives.
Thursday's report was issued under the auspices of the Basle Committee on Banking Supervision, which consists of senior representatives of the world's leading central banks. McDonough is the committee's current chairman. The report was compiled with the help of other American banking regulators, including the comptroller of the currency.
Asked whether the problem arose because banks failed to review Long-Term Capital's borrowing and trading enough or because the hedge fund failed to disclose sufficient information when queried by lenders, McDonough said "some of both."
"The competitive pressure kept banks from asking basic questions and getting fundamental information in some cases," said Michael L. Brosnan, head of risk evaluation for the comptroller's office. "That should never happen."
The report also noted that commercial and investment banks relied too much on the day-to-day value of Long-Term Capital's assets when deciding if they had enough collateral to cover any losses.
In extremely volatile financial markets, such as the panic that followed Russia's decision in August to devalue its currency and declare a debt moratorium, the value of assets, and thus collateral, can plunge. Because of that, banks had less secure collateral at Long-Term Capital than they believed. The report said that banks need to "stress test" their exposure to hedge funds more regularly, taking into account the likelihood of financial meltdowns.
The report said more stringent public regulation of hedge funds may be required, but it noted the challenges of carrying out such a task in a world of computerized, nearly borderless financial transactions.
Because most hedge funds "are registered in offshore centers, any direct regulation would therefore have to extend to those jurisdictions in order to be effective," the report said. "Such an extension would require a high level of political initiative and would involve consideration by political, legislative and judiciary bodies."
Copyright 1999 The New York Times Company