HedgeFunds,Leverage,andtheLessonsofLong-TermCapitalManagementReportofThePresident’sWorkingGrouponFinancialMarketsDepartmentoftheTreasuryBoardofGovernorsoftheFederalReserveSystemSecuritiesandExchangeCommissionCommodityFuturesTradingCommissionApril1999April28,1999TheHonorableJ.DennisHastertTheSpeakerUnitedStatesHouseofRepresentativesWashington,D.C.20515DearMr.Speaker:WearepleasedtotransmitthereportofthePresident’sWorkingGrouponFinancialMarketsonHedgeFunds,Leverage,andtheLessonsofLong-TermCapitalManagement(LTCM).TheprincipalpolicyissuearisingoutoftheeventssurroundingthenearcollapseofLTCMishowtoconstrainexcessiveleverage.Byincreasingthechancethatproblemsatonefinancialinstitutioncouldbetransmittedtootherinstitutions,excessiveleveragecanincreasethelikelihoodofageneralbreakdowninthefunctioningoffinancialmarkets.Thisissueisnotlimitedtohedgefunds;otherfinancialinstitutionsareoftenlargerandmorehighlyleveragedthanmosthedgefunds.Inviewofourfindings,theWorkingGrouprecommendsanumberofmeasuresdesignedtoconstrainexcessiveleverage.Thesemeasuresaredesignedtoimprovetransparencyinthesystem,enhanceprivatesectorriskmanagementpractices,developmorerisk-sensitiveapproachestocapitaladequacy,supportfinancialcontractnettingintheeventofbankruptcy,andencourageoffshorefinancialcenterstocomplywithinternationalstandards.TheLTCMincidenthighlightsanumberoftaxissueswithrespecttohedgefunds,includingthetaxtreatmentoftotalreturnequityswapsandtheuseofoffshorefinancialcenters.Theseissues,however,arebeyondthescopeofthisreportandarebeingaddressedseparatelybyTreasury.Anumberofotherfederalagencieswerefullparticipantsinthisstudyandsupportitsconclusionsandrecommendations:theCouncilofEconomicAdvisers,theFederalDepositInsuranceCorporation,theNationalEconomicCouncil,theFederalReserveBankofNewYork,theOfficeoftheComptrolleroftheCurrency,andtheOfficeofThriftSupervision.Wearegratefulfortheirextensiveassistance.page2Weappreciatetheopportunitytoconveythisreporttoyou,andwelookforwardtocontinuingtoworkwithyouontheseimportantissues.Sincerely,(signed)(signed)RobertE.RubinAlanGreenspanSecretaryChairmanDepartmentoftheTreasuryBoardofGovernorsoftheFederalReserve(signed)(signed)ArthurLevittBrooksleyBornChairmanChairpersonSecuritiesandExchangeCommissionCommodityFuturesTradingCommissionApril28,1999TheHonorableAlGorePresidentoftheSenateUnitedStatesSenateWashington,D.C.20510DearMr.President:WearepleasedtotransmitthereportofthePresident’sWorkingGrouponFinancialMarketsonHedgeFunds,Leverage,andtheLessonsofLong-TermCapitalManagement(LTCM).TheprincipalpolicyissuearisingoutoftheeventssurroundingthenearcollapseofLTCMishowtoconstrainexcessiveleverage.Byincreasingthechancethatproblemsatonefinancialinstitutioncouldbetransmittedtootherinstitutions,excessiveleveragecanincreasethelikelihoodofageneralbreakdowninthefunctioningoffinancialmarkets.Thisissueisnotlimitedtohedgefunds;otherfinancialinstitutionsareoftenlargerandmorehighlyleveragedthanmosthedgefunds.Inviewofourfindings,theWorkingGrouprecommendsanumberofmeasuresdesignedtoconstrainexcessiveleverage.Thesemeasuresaredesignedtoimprovetransparencyinthesystem,enhanceprivatesectorriskmanagementpractices,developmorerisk-sensitiveapproachestocapitaladequacy,supportfinancialcontractnettingintheeventofbankruptcy,andencourageoffshorefinancialcenterstocomplywithinternationalstandards.TheLTCMincidenthighlightsanumberoftaxissueswithrespecttohedgefunds,includingthetaxtreatmentoftotalreturnequityswapsandtheuseofoffshorefinancialcenters.Theseissues,however,arebeyondthescopeofthisreportandarebeingaddressedseparatelybyTreasury.Anumberofotherfederalagencieswerefullparticipantsinthisstudyandsupportitsconclusionsandrecommendations:theCouncilofEconomicAdvisers,theFederalDepositInsuranceCorporation,theNationalEconomicCouncil,theFederalReserveBankofNewYork,theOfficeoftheComptrolleroftheCurrency,andtheOfficeofThriftSupervision.Wearegratefulfortheirextensiveassistance.page2Weappreciatetheopportunitytoconveythisreporttoyou,andwelookforwardtocontinuingtoworkwithyouontheseimportantissues.Sincerely,(signed)(signed)RobertE.RubinAlanGreenspanSecretaryChairmanDepartmentoftheTreasuryBoardofGovernorsoftheFederalReserve(signed)(signed)ArthurLevittBrooksleyBornChairmanChairpersonSecuritiesandExchangeCommissionCommodityFuturesTradingCommissionTABLEOFCONTENTSPageEXECUTIVESUMMARY..................................................viiiI.BACKGROUND.........................................................1HedgeFunds.........................................................1A.GeneralDescription...........................................1B.TradingPractices.............................................4C.DisclosureandMonitoring......................................6D.CounterpartyandCreditRelationships.............................6TheLTCMEpisode...................................................10A.Background................................................10B.LTCM’sNearFailure.........................................12C.TheLTCMFundAchievedExtraordinaryLevelsofLeverageandRisk....14D.Co