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fomc | 1,998 | Daiwa, yes. What Daiwa exposed is how complex these situations are and how few troops we have to look into them. if we had to meet the standards that people think exist, we would have five times as many examiners We would examine them to death, and they would not have any breathing room. What we need at this stage is s... | 285 |
fomc | 1,998 | I think there was in place a credit management system that appeared to make a great deal of sense. | 20 |
fomc | 1,998 | Whose? LTCM's? | 7 |
fomc | 1,998 | No, the lenders, including the institution with which you were once associated. One may question the notion that at least for some lenders there was no initial margin requirement. Beyond that issue, it should be emphasized that the lenders had very good collateral management systems so that if the LTCP began to lose on... | 184 |
fomc | 1,998 | Somebody mentioned to me that Bankers Trust had an August balance sheet for LTCM. Is that true? | 22 |
fomc | 1,998 | Yes, but the balance sheet is a relatively small piece of the whole action because so much of the latter is off-balance-sheet. | 27 |
fomc | 1,998 | I don't think they had an August balance sheet on September 1. | 14 |
fomc | 1,998 | They may have one now. | 6 |
fomc | 1,998 | They may have had one during the weekend, eight days ago. I don't think anyone had seen one before the weekend of September 19 and 20. | 31 |
fomc | 1,998 | It is one thing for one bank to have failed to appreciate what was happening to LTCP, but this list of institutions is just mind boggling. | 30 |
fomc | 1,998 | This tells us that there was something in the way that the financial services institutions as a group were dealing with at least this firm that allowed a position to be built up that was very dangerous. | 38 |
fomc | 1,998 | What type of collateral would ordinarily be required on this type of loan? | 14 |
fomc | 1,998 | Let me try to answer your line of inquiry, Mr. Chairman, with a hypothesis. I want to be very clear that this is just a hypothesis. On August 31, the firm has a $125 billion balance sheet against $2.8 billion of capital, which they have lost. Essentially, $125 billion of assets are out under repo. There are no assets i... | 95 |
fomc | 1,998 | Involving U.S. Treasuries? | 9 |
fomc | 1,998 | U.S. Treasuries, Danish government bonds, BBB credits--you name it. | 18 |
fomc | 1,998 | There are not a lot of triple Bs outstanding. | 10 |
fomc | 1,998 | There is a fair amount of government credit in these assets, but there are a lot of other assets also. Swap agreements are their instrument of choice, and that is how they got to a $1.45 trillion off-balance-sheet position on August 31. By the time we were looking at that position during the weekend eight days ago, the... | 458 |
fomc | 1,998 | The biblical justice in this situation is that the principals of LTCM apparently believed so firmly that this system would continue to work that they appear to have borrowed rather heavily to increase their own risk positions in their firm. So, there is a general and spreading belief that we may have some extraordinari... | 69 |
fomc | 1,998 | How many more LTCMs are there? | 8 |
fomc | 1,998 | We do not know of any other hedge fund that would be remotely of the size of LTCM/P. If John Meriwether can do it, there certainly would have to be other smart individuals with computers who could engage in the same sort of activity. So, there have to be little versions of LTCM/P. Most of the other very well known hedg... | 119 |
fomc | 1,998 | As we get under way with our F-6 study of systemic risk, I think this is an important episode for us to study. We are trying to decide what is systemic risk and what is not--where we can draw the line. I think we need some further analysis of this episode to help us decide whether this was an appropriate involvement of... | 202 |
fomc | 1,998 | Let me go back. Can you explain to me how, if everybody is 100 percent collateralized--not 110 but 100 percent--we can end up with these huge losses for lenders? | 40 |
fomc | 1,998 | The lenders continue to be collateralized as the firm starts to lose money but only so long as the firm has capital to continue to provide added collateral to make up for the losses. As the losses continue to mount, the firm at some point-- | 49 |
fomc | 1,998 | But, are we looking at losses in the value of the collateral or is collateral being withdrawn? If I am a bank lender and I lend $200 million to a hedge fund, ordinarily I would be over-collateralized. I would hold more than $200 million in, say, U.S. Treasury bills. | 64 |
fomc | 1,998 | Remember, on day one there was no initial margin. | 11 |
fomc | 1,998 | I am talking about my position as a bank lending to LTCM. | 14 |
fomc | 1,998 | You made the loan but since there was no initial margin, there was no collateral. | 17 |
fomc | 1,998 | There is collateral but no margin. | 7 |
fomc | 1,998 | If I lend $100 to LTCP they give me an asset worth $100. If the market value of that asset goes up 5 percent today, I give them back $5 dollars; if it goes down 5 percent tomorrow they give me $5 dollars. | 54 |
fomc | 1,998 | That is a 100 percent collateralized mark-to-market position. | 13 |
fomc | 1,998 | Right. | 2 |
fomc | 1,998 | Now, in order for me as a bank to lose in this situation, I either have to find that the collateral I have is not legally available under certain circumstances or its market value has declined. Which was it in this case? | 46 |
fomc | 1,998 | It was the latter. The collateral lost market value. | 11 |
fomc | 1,998 | So, the collateral lost value and LTCP did not have the resources to make up for the loss. | 21 |
fomc | 1,998 | That's right. | 3 |
fomc | 1,998 | I want to be clear, Mr. Chairman. We are talking about a balance sheet of $125 billion and an off-balance-sheet of $1.4 trillion. Now, we know the total was not all collateralized at 100 cents on the dollar. It was only the balance sheet financing that was fully collateralized. | 66 |
fomc | 1,998 | Let's leave the derivatives out. | 6 |
fomc | 1,998 | I realize it is notional, but we do not know how to scale the notionals. | 19 |
fomc | 1,998 | The off-balance-sheet presumably goes the same way as the balance sheet. | 15 |
fomc | 1,998 | There are two ways of coming at this. There are certain transactions between counterparties in derivatives where net positions are fully collateralized or up to X percent and in some cases there is no collateral at all. Straight lending usually is fully collateralized. I don't know what bankers are going to write off o... | 142 |
fomc | 1,998 | Initially, these transactions in derivatives were in a sense unsecured. Once the exposure reached a certain point, then the lender, the bank, had the right to demand collateral to cover that. That is, when the mark-to-market position and the current exposure built up to a certain point, then the banks asked for the col... | 169 |
fomc | 1,998 | That is a different issue. As far as bookkeeping is concerned, banks do not book those anticipatory losses unless some real commitments are involved. What I am trying to focus on is where the losses are coming from. | 43 |
fomc | 1,998 | Let me try to work through some of the sources of the losses that were discussed. Long-Term Capital Management did an analysis of its top 17 counterparties on just 12 trades. These represented a very small percent of the hundreds of trades that they had on their books, but they were their big trades. For example, 2 of ... | 337 |
fomc | 1,998 | I suggest that what would be valuable for the Committee, for all of us, would be to make certain assumptions about market developments and then see what the bookkeeping effects would be. How does firm X suffer a loss because of its relationship with LTCP? This gets us into very sophisticated accounting and complex anal... | 93 |
fomc | 1,998 | What I think we are going to need for our testimony on Thursday is a general summary of what we do as examiners, how often we do it, and why banks with a huge amount of experience in lending got caught in this kind of thing. We need an answer. The answer is not that it should not have happened. Part of banking involves... | 106 |
fomc | 1,998 | I agree that we are going to need that information for our testimony, which is being prepared by some of the people who are sitting at the end of this table. | 33 |
fomc | 1,998 | If we indicate what we are doing to find the answers, that is fine. This to me is where the issue of the responsiveness of the Federal Reserve is going to be. | 35 |
fomc | 1,998 | I assume that one of the things we will want to talk about is the fact that we had staff, other than those who were conducting examinations, who were meeting with the management people to examine the nature of their dealing with hedge funds. In their report, the staff mentioned LTCM/P as one of the customers of some of... | 138 |
fomc | 1,998 | All I care about is that we produce accurate testimony. | 11 |
fomc | 1,998 | I agree. | 3 |
fomc | 1,998 | I would like to offer one final perspective on the numbers that I discussed. One of the surprises for people who went to look at LTCP's position, myself included, was the tremendous size of their equity and equity volatility positions. People knew they were dabbling in that sector of the markets, but everyone including... | 184 |
fomc | 1,998 | One of the things that we have to be able to say to Congress is whether the state-chartered banks that we supervise participated in the equity piece or not. I do not know the answer at this point. | 42 |
fomc | 1,998 | Have we developed a series of questions for the testimony that we are asking ourselves? I think that would be very useful. In other words, in the testimony we should identify the questions to which we do not yet know the answer. | 46 |
fomc | 1,998 | We will say what we know, and then we will say what we do not know and are trying to find out. | 24 |
fomc | 1,998 | It has to be a full report on what we know and do not know. | 16 |
fomc | 1,998 | Two questions come to my mind. One relates to reports that some of the institutions were not just lenders but also investors. Those, I presume, mainly have been investment banks. Do we think there also are some section 20s or others that may have been involved? | 54 |
fomc | 1,998 | There was a foreign bank, UBS, that was a large investor and its investment accounted for a good chunk of the loss that the bank announced last Thursday. | 31 |
fomc | 1,998 | Did they participate through an American affiliate or directly from Switzerland? | 12 |
fomc | 1,998 | We think it was Switzerland, but that is again a fact that we have to establish. It also has now been reported in the press that some senior officers of the securities firms, we think not of the banks, were involved as individuals either through a retained earnings fund for senior executives at their institutions or di... | 69 |
fomc | 1,998 | My other question is one that I also ask to make sure that we will have an answer. It involves an issue that is similar to the one that Larry Meyer was raising. Does this experience in any sense bring into question the approach we are taking with respect to risk-based supervision? To some extent, it involves what we do... | 89 |
fomc | 1,998 | This tells you that the move toward risk-based supervision is the right way to be going. | 18 |
fomc | 1,998 | If you do it right! [Laughter] | 10 |
fomc | 1,998 | We should try to get enough facts to make sure that they are doing what they say they are doing. That is what is needed to give an intelligent answer to the question. If I sound a little anxious, it is because the people who should be writing the testimony are here involved in this discussion, including me. Much as I w... | 109 |
fomc | 1,998 | I would like to ask one quick factual question of our legal counsel. Virgil, you raised an issue with respect to whether in fact a particular group of new investors in LTCM were investing in violation of the 5 percent equity cap. What have you concluded, if anything, on that question? | 60 |
fomc | 1,998 | I do not know what has happened, but I suspect that fund has gotten rid of everything over 5 percent. | 23 |
fomc | 1,998 | So, it is in compliance with the Bank Holding Company Act? | 13 |
fomc | 1,998 | Nobody has told us, but I read in the paper that they have been dumping equities, so I assume that they are trying to get down below 5 percent. | 33 |
fomc | 1,998 | Ah! That explains it! | 6 |
fomc | 1,998 | Mr. Chairman, some of the banks can take an equity position in LTCM in satisfaction of a previously contracted debt, but some of the foreign banks may have reached the 5 percent limit of the Bank Holding Company Act. | 45 |
fomc | 1,998 | Governor Gramlich. | 4 |
fomc | 1,998 | Just to follow up on Alice's question, tell me again how we know that there are not a lot more large hedge funds like LTCP out there, accidents waiting to happen. | 36 |
fomc | 1,998 | How do we know? We do not know. | 10 |
fomc | 1,998 | We do not know! | 5 |
fomc | 1,998 | We have our usual antennae out. That is how we learned from a variety of sources that LTCM/P was getting into trouble. We can surmise on the basis of what has happened to spreads that, although they may get worse, anybody who had an opportunity to get into trouble certainly had a tremendous opportunity. If nothing else... | 127 |
fomc | 1,998 | It was something of a signature for this firm to insist that if a counterparty wanted to deal with them, there would be no initial margin. Not many other firms have gotten away with that. | 39 |
fomc | 1,998 | It goes to your bedazzlement effect. | 9 |
fomc | 1,998 | I might mention something that we found out that came as a bit of a surprise, namely that some of the loans made by some of the large lenders were participated out. So, we see shares in banks in our District of both collateralized and uncollateralized lines to LTCM/P. | 59 |
fomc | 1,998 | I think there were two major credit lines, one of which was drawn down. It was a $900 million line of which slightly under $500 million was drawn down and participated out. I think, however, that most of the transactions we have been talking about here involve counterparties rather than syndications. | 61 |
fomc | 1,998 | I realize that but there were at least two syndicated pools. | 12 |
fomc | 1,998 | Yes, one to the management company and one to the partnership. | 13 |
fomc | 1,998 | I was wondering whether any of this showed up in the review of shared national credits last year. | 19 |
fomc | 1,998 | As I recall, the credit was $700 million. It was $500 million initially, but it subsequently was increased. | 24 |
fomc | 1,998 | Did this program produce a default of any loan? | 10 |
fomc | 1,998 | No. | 2 |
fomc | 1,998 | Then how can the investments be a part of DPC [debt previously contracted], Virgil? | 20 |
fomc | 1,998 | They were anticipating that the market would move and that they would lose their position. The DPC exemption does not require an actual default. The exemption is also available in anticipation of a default. | 38 |
fomc | 1,998 | Another form of collateral! | 5 |
fomc | 1,998 | It looks as though their current positions are covered by collateral, but the issue is potential future exposure in these markets. I have to pin these numbers down, but from the numbers I've seen, it looks as though they did a pretty good job of getting collateral to cover their mark-to-market positions. But the potent... | 100 |
fomc | 1,998 | I would like to draw an analogy. As you may know, we use the VAR model to measure market risk. The danger is that this analysis does not cover potential losses in extremely volatile situations. In those markets we have to do stress testing to uncover what exposures are there. The same distinction is important here, and... | 257 |
fomc | 1,998 | All this relates to the question of how this financing got to be so big and nobody realized it was happening. | 22 |
fomc | 1,998 | What technically happens in that kind of model is that if we are resting on the last five years of experience during which the structure of the markets is essentially stable, that is, there were no severe contractions or even expansions, the covariances that we are going to pick up out of that five years are correct co... | 189 |
fomc | 1,998 | That is what stress testing is all about. | 9 |
fomc | 1,998 | Yes, exactly. | 4 |
fomc | 1,998 | We have to be very careful because as horrendous as this experience was, if we assume that the normal market is that the Russians are going to default once a week, the cost of capital would go so high that nobody would ever invest in anything. | 50 |
fomc | 1,998 | That is the whole point. These are very special cases. In fact, as some of my colleagues know, my favorite speech is one where I discuss separating the risks that confront the monetary authority from the risks that the commercial banks have to face. I have always argued that the commercial banks are responsible for 99.... | 101 |
fomc | 1,998 | That is why this central banker was happy to call a meeting but wanted to make it absolutely clear that our money was not going to be made available. | 30 |
fomc | 1,998 | That was very wise. Al Broaddus. | 10 |
fomc | 1,998 | I didn't have a question, just a 15-second comment in the context of this Committee's broader responsibility. Bill, I would not second-guess your decision for a minute. It is the most natural thing in the world to respond to a request for our good offices in a situation like this. But this kind of action does create ex... | 141 |
fomc | 1,998 | It is not something a committee can do. | 9 |
fomc | 1,998 | Right. Against that background, it might be constructive for us to have a discussion at some point in which we would explicitly address the tradeoff and how we balance the need to intervene in a crisis. | 40 |
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