Speaking of greed................
U.S. REP. LEACH: FED'S LTCM 'BAILOUT' CREATES LONGER TERM WORRIES
--Accuses Treasury's Summers of Misleading Congress
By Steven K. Beckner
Market News International - House Banking Committee Chairman Rep. Jim Leach, R-Iowa, has harshly faulted the Federal Reserve for its role in rescuing Long Term Capital Management, while also accusing the U.S. Treasury of misleading Congress on its role in the LTCM affair.
By arranging a consortium of commercial and investment banks to infuse capital into LTCM on Sept. 23, the Fed averted a short-term shock to the financial system at the cost of creating "a more serious long-term threat," Leach said in a sharply critical speech on the House floor Monday night.
Leach, not usually known as a Fed critic, chastised the Fed for rejecting investor Warren Buffet's bid for the troubled hedge fund and for not forcing LTCM to go through bankruptcy procedures. Among other things, he said the "bail-out" has created anti-trust and "collusion" concerns. He also criticized both the Fed and Treasury's Office of the Comptroller of the Currency for inadequate supervision of banks that lent large sums to LTCM.
Meanwhile, Leach suggested, the Fed needs to cut interest rates further, while Congress needs to cut taxes. "The impending credit crunch requires a monetary response from the Fed, i.e., immediate attention to lowering interest rates and, perhaps, a shot of fiscal stimulus from Congress, preferably a tax cut of very modest dimensions on the order of the $16 billion a year one proposed last month," he said.
Leach said he was told by a top Treasury official the department had merely been "informed," not "consulted" on the LTCM rescue. Minutes before an Oct. 1 House Banking Committee hearing on LTCM featuring Fed Chairman Alan Greenspan and New York Fed President William McDonough, Leach said he got a letter from Deputy Treasury Secretary Lawrence Summers stating Treasury had been "informed of developments affecting Long-Term Capital Management, and we were kept apprised of the progress of discussions among its creditors. We did not, however, participate in any of these discussions."
Leach implied Summers' letter was a distortion. "I was therefore surprised to learn in testimony from New York Federal Reserve Bank President William McDonough that he had conferred directly with Treasury Secretary Rubin on Sept. 18 and that he was joined by Treasury Assistant Secretary Gary Gensler in discussions with LTCM's partners in LTCM's offices on Sept. 20, the day prior to McDonough's decision to intervene in a role he analogized to that played by J. P. Morgan in the Panic of 1907."
"Given this circumstance, the 'informed/consulted' distinction would appear to tilt to the 'consulted' side," Leach continued. "While oversight of bank lending to LTCM and financial instrument trading within the firm does not appear to have been governmentally coordinated, its bailout was."
Greenspan and McDonough defended the Fed's brokering of the LTCM bailout as necessary to avert a "fire sale" of assets that could have caused a liquidity crisis and credit crunch.
But Leach said the Treasury and the Fed have in effect added a corollary to the "too-big-to-fail" bank doctrine: "Some financial firms are too big to liquidate too quickly." He was most critical of the Fed.
Leach acknowledged the Fed faced "a dilemma. If it failed to act in the face of what is presumably deemed to be systemic risk, it would have been left open to charges that it abdicated leadership on a matter that might have affected the stability of markets around the world and thus the pocketbooks of millions of ordinary citizens."
"By acting as it did, however, it preserved an institution that in a free-market economy would normally have been allowed to fail," Leach said. While the Fed is as averse to "instability" as to inflation, Leach said its "intrusion into our market economy can be justified only if it can be credibly shown there was a clear and present danger to the financial system in LTCM's failure and there were no stabilizing alternatives -- other credible bids on the table or other approaches to ensuring that a market-shaking unwinding didn't occur."
In fact, Leach pointed out, the Fed did have the alternative of another bid, but rejected it. In a reference to the Buffet bid, he said the authorities appear to have "played a part in precipitating a bailout offer that was more advantageous to the failed management than that which the free market offered." What's more, Leach said, the Fed could have steered LTCM into a bankruptcy proceeding with someone like former Fed Chairman Paul Volcker or former New York Fed President E. Gerald Corrigan as court-appointed trustee.
By going the route it did -- new ownership of LTCM by 14 of the world's largest financial institutions -- the Fed may have created additional problems, Leach warned. "While the goal of the Fed's intervention was to avert a short-term shock to the international economic system, it appears that a more serious long-term threat may be the result," he said. "The coordinated government bailout approach which was undertaken may involve a tendency toward concentration with the new owners conjoined as a group having a greater impact on markets than in competition with one another. The Fed's unprecedented extension of the too-big-to-fail doctrine to a hedge fund does not insulate the fund and its new owners from the constraints of the Sherman and Clayton (antitrust) acts."
"Working as a cartel, those running LTCM potentially comprise the most powerful financial force in the history of the world and could influence the well being of nation-states for good or for naught, guided by the profit motive, rather than national interest standards," Leach said. "This dilemma is reflected in the announcement the week after the Fed intervened by the Secretary of the Treasury that U.S. government and international resources should be put in play to prop up the certain foreign currencies" -- an apparent reference to the Brazilian real.
"To give a governmental imprimatur to the fund as it is now constituted could cause conflicts of interest not only among its owners, but with our own government," Leach said. "The possibility that taxpayer dollars might be pitted in the future against those of a firm the U.S. government helped rescue could be an expensive irony."
The Fed has brought into being a "combination of many of the world's most sophisticated financial powerhouses in hedge fund activities" that is "unprecedented in significance," said Leach. "Such a combination, if allowed to stand, could enable these institutions to hold sway over whole economies."
Leach noted that "half a dozen or more government owned banks" have invested in LTCM, raising the "possibility that fund managers might receive insider information from their own investors who represent foreign governments ... ." He also noted that LTCM operates commodity pools organized as Cayman Islands entities for the purpose of avoiding taxes. Those investors are now getting their assets "protected with the help of a U.S. government agency."
Leach said it is ironic the Fed intervened to keep LTCM from going down "at a time when our government has been preaching to foreign governments, particularly Asian ones, that the way to modernize is to let weak institutions fail and to rely on market mechanisms, rather than insider bailouts" and at a time when U.S. authorities have been encouraging foreign governments to modernize their bankruptcy laws.
The lessons of the LTCM episode, according to Leach, are that "the Fed should rely more extensively on market mechanisms and America's sophisticated bankruptcy laws."
In the future, "the Fed might want to think through the possibility of making process recommendations to bankruptcy courts," Leach went on. "For instance, if a significant fund fails, the Fed should be prepared to go to a bankruptcy court and recommend a given type of process, as well as consideration of particular types of or actual individuals who might be appropriate to serve as trustees for a filed fund ... ." He said "the Fed or Treasury should also consider issuing public guidelines or commentary about their intent to rely on orderliness through bankruptcy statutes to assure markets that unfortunate problems will not become systemic liabilities."
Before the LTCM came to grief, Leach accused the Fed and the OCC of being negligent in failing to recognize that banks under their supervision had lent heavily to the firm, enabling it to make risky investments. He marveled at how "the U.S. regulatory system (including LTCM's principal regulator the Commodity Futures Trading Commission) could be so uncoordinated and so easily caught off guard."
[TOPICS: MNSFED]
12:55 EDT 10/13
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