A third example is the market crisis in the fall of 1998 that was triggered by the Russian bond default. This shock caused bond spreads to widen in both emerging and developed countries and induced a major liquidity crisis. The financial innovation that magnified this shock was the growth of highly leveraged and opaque hedge funds, including Long Term Capital Management. The possibility that failing hedge funds would respond to falling market prices with a fire sale of available assets led intermediaries to withdraw liquidity from the market and reinforced the initial shock.

Should we view the current developments and concerns in credit markets as a wholesale reassessment (or repricing) of risk by investors, and are the recent problems related to securitizing assets likely to have a longer lasting impact on the economy or financial markets?

I think the answer is no, investors are not reassessing risk in a wholesale way. Consider that a variety of assets that normally are impacted by investor desire for risk reduction have shown little reaction to current problems. For example, if one looks at emerging market debt, or stock prices in emerging economies, the current problems have left little trace in the data. Prices for stocks in many emerging markets are close to or at their highs for the year.

By contrast after September 11, 2001 and during the problems triggered by Long-Term Capital Management, stocks in many emerging markets fell sharply. Similarly, emerging market debt has shown only a modest widening of spreads. Following the September 11 attacks and during the Long-Term Capital Management problems, emerging market interest rates rose sharply.

Short-term debt markets, where relatively low risk financial assets are traded primarily between large financial institutions, are experiencing significantly reduced volumes and unusually large spreads. This is consistent with liquidity problems rather than a change in the willingness to hold risky assets in general.

In the immediate aftermath of the episode, the PWG studied the implications for financial stability and published its conclusions in April 1999 in a report entitled "Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management."⁶ The report concluded that the episode had posed a threat to financial stability as a result of a breakdown in market discipline by its creditors and counterparties, which allowed LTCM to become leveraged excessively. The report concluded that the most effective means of limiting systemic risk from hedge funds was to reinvigorate market discipline. To that end, the PWG made various recommendations, which were directed primarily at enhancing credit risk management by hedge funds' creditors and counterparties.

In answering audience questions earlier, Poole spoke about how observers can judge whether or not the Fed will intervene in economic crises. "The goal ought to be to be able to write something [rules for intervention] down in a formal fashion," Poole said. "We're not there yet but I'll tell you there's much more predictability than you might realize and ... there are events that can happen where you won't have any doubt as to how the fed is going to respond." He cited the failure of Long Term Capital Management and 9/11 as an examples where uncertainty was rampant and spreads "moved to a surprisingly large extent."

As reported by Market News

The approach that regulators have taken since the report of the president's working group after the LTCM crisis has been a market-based approach, an indirect regulation approach, whereby we put a lot of weight on good risk management by the counter-parties to the hedge funds, such as the prime dealers, the lenders, as well as the good oversight of the investors, the institutions and so on that invest in hedge funds.

 And we found that that's a very useful way to control leverage and to provide market discipline on those funds.

The original report of the president's working group also suggested disclosures, and that never went anywhere in Congress. And I think part of the problem was it was difficult to agree upon what should be disclosed and what would be useful.

The hedge funds are naturally reluctant to disclose proprietary information about their trading strategies and approaches, and their positions change very quickly, and so therefore position information can be overwhelming and perhaps not very useful. I think it's important to continue to think about hedge funds.

     They certainly play an important role in our financial system. Exactly what a disclosure regime would look like, though, is not yet clear to me how that best would be organized.

The Fed undertook similar discussions with other supervisors and with financial firms in response to the failure of Drexel Burnham Lambert in 1990 and the collapse of Long Term Capital Management (LTCM) in 1998.  As the condition of Drexel deteriorated, other firms became less willing to trade with it, making it difficult to wind down its positions in an orderly manner (Breeden, 1990).  Because of the Federal Reserve’s ongoing supervisory relationships with the main clearing banks and its detailed knowledge of the payments system, the Fed was able to address the banks’ concerns and facilitate the liquidation of Drexel’s positions (Greenspan, 1994).  In the case of LTCM, the Federal Reserve had the credibility with large financial firms to facilitate a discussion, from which emerged a private-sector solution that helped to avoid potential market disruptions (Greenspan, 1998).

Well, in the interest of truth in speaking, I recall that I expressed certain reservations about that particular operation at the time, and I hold steadfast to my reservations about that particular operation, at that particular time for a variety of reasons, which I could go on about it at length but maybe I will refrain from doing so. Let me say, quite simply that this was not an institution that was even considered to be in the normal ambit of Federal Reserve supervision and oversight, at the time. It is not an institution that by law had access to Federal Reserve facilities. Now, technically, the Federal Reserve provided no money, in this case, is quite clear. But it did provide a convenient meeting room, which implied a certain degree of moral suasion, I think, in the process.

Participants other than the Chairman express their own views in speeches. These speeches often may seem to reflect a “party line” but are rarely centrally coordinated in any way. In my experience, the only time there has been a real effort to coordinate public comments by the participants was in the late summer of 1998. At that time financial markets were skittish as a result of the Russian default and financial troubles of Long-Term Capital Management. I recall an informal gathering in the late summer of 1998 with Chairman Greenspan and a couple of other FOMC members when the chairman made a request that we say very little given the rather tense state of the markets as the LTCM situation unfolded.

Authorities cannot entirely eliminate systemic risk. To try to do so would likely stifle innovation without achieving the intended goal. However, authorities should (and will) try to ensure that the lapses in risk management of 1998 do not happen again.

It's important for the Federal Reserve to be aware of what's going on in the market, particularly working through the banks, which are the counter-parties of a lot of hedge funds to understand their strategies and their positions. Nevertheless, broadly speaking, my understanding is that the hedge fund industry has become more sophisticated, more diverse, less leveraged and more flexible in the years since LTCM. So, again, while it's very important to understand that industry and particularly to make sure that the banks are dealing in appropriate ways with hedge funds, my sense is that on net they are a positive force in the American financial system.

However, I continue to believe, as I did in the aftermath of the LTCM episode, that ensuring sound credit-risk management by the regulated banks and securities firms that are hedge funds' counterparties is the most promising approach to addressing concerns that excessive hedge fund leverage could threaten the financial system.  Some may believe that government regulation of hedge fund leverage would be more effective.  But it would be very difficult to design a set of capital requirements for hedge funds that is appropriately sensitive to the diversity and flexibility of investment strategies that different funds employ and to the lack of diversification in the portfolios of individual funds.  More important, government regulation of hedge funds could undermine the effectiveness of market discipline if counterparties incorrectly assume that government regulation is so effective that it obviates private prudence.

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 expectations with respect to what we might do going forward that in turn create expectations about monetary policy.