Hedge Funds, Leverage, And the Lessons of Long-Term Capital Management

By Rubin, Robert E.

Description
Government Reference Publication

Excerpt
Excerpt: The principal policy issue arising out of the events surrounding the near collapse of LTCM is how to constrain excessive leverage. By increasing the chance that problems at one financial institution could be transmitted to other institutions, excessive leverage can increase the likelihood of a general breakdown in the functioning of financial markets. This issue is not limited to hedge funds; other financial institutions are often larger and more highly leveraged than most hedge funds.

Table of Contents
TABLE OF CONTENTS Page EXECUTIVE SUMMARY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . viii I. BACKGROUND . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Hedge Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 A. General Description . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 B. Trading Practices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 C. Disclosure and Monitoring . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 D. Counterparty and Credit Relationships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 The LTCM Episode . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 A. Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 B. LTCM?s Near Failure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 C. The LTCM Fund Achieved Extraordinary Levels of Leverage and Risk . . . . 14 D. Counterparty Losses and Market Disruptions That May Have Resulted from a Default of LTCM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 II. PUBLIC POLICY ISSUES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Leverage and Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 A. Measuring Leverage and Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 B. Private Counterparty Discipline and Government Regulation . . . . . . . . . . . . 25 Bankruptcy Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 A. Closeout Netting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 B. Transnational Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 III. CONCLUSIONS AND RECOMMENDATIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 1. Disclosure and Reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 2. Supervisory Oversight . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 3. Enhanced Private Sector Practices for Counterparty Risk Management . . . . . . . . . . 36 4. Capital Adequacy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 5. Expanded Risk Assessment for the Unregulated Affiliates of Broker-Dealers and Futures Commission Merchants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 6. Bankruptcy Code Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 7. Offshore Financial Centers and Tax Havens . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 8. Additional Potential Steps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42 APPENDIX A: ADDITIONAL INFORMATION ON HEDGE FUNDS 1. Hedge Fund Performance Fees, Leverage, and Short-term Outlook . . . . . . . . . . . . A-1 2. Hedge Fund Performance and Survival . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A-3 3. Market Impact, Positive and Negative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A-5 APPENDIX B: THE SEC AND HEDGE FUNDS 1. Exemptions from Securities Laws . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . B-1

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Title:

Hedge Funds, Leverage, And the Lessons of Long-Term Capital Management

Author:

Rubin, Robert E.

Volume:

Language:

English

Subject:

Government publications, Economics., United States. Department of the Treasury--Appropriations and Expenditures.

Collection:

U.S. Department of the Treasury Collection

Subcollection:

Historic
Publication Date:

Publisher:

United States Department of the Treasury

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