Long-Term Capital Management

In 1998, Long-Term Capital Management (LTCM)--one of the largest U.S. hedge funds--lost more than 90 percent of its capital. The Federal Reserve concluded that rapid liquidation of LTCM's trading positions and related positions of other market participants might pose a significant threat to already unsettled global financial markets. As a result, the Fed arranged a private sector recapitalization to prevent LTCM's collapse. The circumstances surrounding LTCM's near collapse and recapitalization raised questions that go beyond the activities of LTCM and hedge funds to how federal financial regulators fulfill their supervisory responsibilities and whether all regulators have the necessary tools to identify and address potential threats to the financial system. This report discusses (1) how LTCM's positions became large and leveraged enough to be deemed a potential systemic threat, (2) what federal regulators know about LTCM and when they found out about its problems, (3) what the extent of coordination among regulators was, and (4) whether regulatory authority limits regulators' ability to identify and mitigate potential systemic risk.

GAO noted that: (1) LTCM was able to establish leveraged trading positions of a size that posed potential systemic risk, primarily because the banks and securities and futures firms that were its creditors and counterparties failed to enforce their own risk management standards; (2) other market participants and federal regulators relied upon these large banks and securities and futures firms to follow sound risk management practices in providing LTCM credit; (3) however, weaknesses in the risk management practices of these creditors and counterparties allowed LTCM's size and use of leverage to grow unrestrained; (4) the effects of these weaknesses became apparent during the unsettled market conditions that occurred in the summer of 1998; (5) LTCM began to lose large amounts of money in various trading positions worldwide and by mid-September was on the verge of failure; (6) the Federal Reserve facilitated a private sector recapitalization of LTCM because of concerns that a rapid liquidation of LTCM's trading positions and related positions of other market participants in already highly volatile markets might cause extreme price movements and cause some markets to temporarily cease functioning; (7) although regulators were aware of the potential systemic risk that hedge funds can pose to markets and the perils of declining credit standards, until LTCM's near-collapse, they said they believed that creditors and counterparties were appropriately constraining hedge funds' leverage and risk-taking; (8) however, examinations done after LTCM's near-collapse revealed weaknesses in credit risk management by banks and broker-dealers that allowed LTCM to become too large and leveraged; (9) regulators for each industry have generally continued to focus on individual firms and markets, the risks they face, and the soundness of their practices, but they have failed to address interrelationships across each industry; (10) lack of authority over certain affiliates of securities and futures firms limits the ability of the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) to identify the kind of systemic risk that LTCM posed; and (11) the President's Working Group report recommended that Congress provide SEC and CFTC expanded authority to obtain and verify information from unregistered affiliates of broker-dealers and future commission merchants.

Recommendations

Our recommendations from this work are listed below with a Contact for more information. Status will change from "In process" to "Open," "Closed - implemented," or "Closed - not implemented" based on our follow up work.

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