Statement by William J. McDonough, President, Federal Reserve Bank of New York, before the Committee on Banking and Financial Services, U.S. House of Representatives, October 1, 1998
I am pleased to appear before you today to describe the Federal Reserve Bank of New York's role in the events leading up to the recent private-sector recapitalization of Long-Term Capital Management and its fund, Long-Term Capital Portfolio.
I will cover four points. First, I will provide some background on Long-Term Capital's financial problems. Second, I will explain our judgment that an abrupt and disorderly closeout of Long-Term Capital's positions would have posed unacceptable risks to the U.S. economy. Third, I will explain the limited role we played in facilitating the private-sector resolution to this private-sector problem. Fourth, I will identify some of the issues that should concern us as we begin to understand the lessons of this experience.
Long-Term Capital is an investment partnership that was started in 1994. It has many of the characteristics of a "hedge fund" in that it borrows money to leverage its capital and is available only to wealthy investors. The strategy of Long-Term Capital was to use complex mathematical formulas to identify temporary price discrepancies between different interest rates. For example, the firm might notice that the yield on corporate bonds relative to Treasury yields was higher than the range observed in recent years. If Long-Term Capital believed the former relationship would reassert itself, it would buy corporate bonds and sell short Treasury bonds. If the spread narrowed as expected, the firm would profit. If, however, the spread continued to widen, the firm would incur losses. This basic strategy and many complex variations were followed across many interest rate products in the United States and many overseas markets as well. The firm was active both in traditional securities markets and, perhaps more important, in derivative product markets such as futures, swaps, and options. Anticipating that some positions would move in their favor and some would move against them, the firm relied on diversification across a large number of product and geographic markets. Long-Term Capital proved quite successful at this strategy, generating returns in excess of 40 percent in 1995 and 1996, though somewhat less in 1997.
Perhaps their success went to their heads. Long-Term Capital took on larger and larger positions. They also leveraged their investments at higher levels, returning capital to their investors but not, apparently, reducing risks. We now also know that they took on significant positions in equity markets, through both swap and options contracts. The reputations of the Long-Term Capital partners, as traders and economists, and their initial success appear to have contributed to so many counterparties' willingness to deal with them.
While hubris may have set them up for a fall, it was the extraordinary events of August in global markets that appear to have tripped them.
On August 17, the Russian government announced an effective devaluation of the ruble and declared a debt moratorium, shocking investor confidence all over the world. Over subsequent days and weeks, equity and debt markets the world over became increasingly volatile, with U.S. equity markets falling and the spreads between U.S. Treasury securities and higher-yielding debt instruments widening sharply. The correction of stock prices was not of exceptional size or concern and, indeed, had been anticipated by a number of astute market observers. However, the abrupt and simultaneous widening of credit spreads globally, for both corporate and emerging-market sovereign debt, was an extraordinary event beyond the expectations of investors and financial intermediaries.
The unusual widening of credit spreads also caused significant losses at Long-Term Capital. As markets around the world moved in the same direction at the same time, the diversification on which Long-Term had previously relied failed them utterly. Instead of offsetting positions, their losses were compounded. …