Testimony of George E. Crapple
Managed Funds Association
Before the Committee on Banking and Financial Services
House of Representatives
April 11, 2000
Mr. Chairman, thank you for the opportunity to testify today. I appear here as the Chairman of the Managed Funds Association ("MFA"), a trade association representing more than 700 participants in the hedge fund and managed funds industry. I am also the Co-Chairman and Co-Chief Executive Officer of Millburn Ridgefield Corporation, a money manager and sponsor of hedge funds and other funds since 1971. My testimony is addressed to H.R. 2924, the Hedge Fund Disclosure Act.
In the year and a half since the LTCM "events" of September 1998, this Committee and other committees of Congress, regulators, the lending community and the public have been fully briefed on the deficiencies in credit risk management which virtually all informed observers have concluded were the cause of the LTCM crisis. Based upon this voluminous record, we believe that H.R. 2924 does not represent a way forward toward preventing future LTCMs but, rather, is a costly form of bureaucratic windowdressing -- likely to obscure rather than illuminate important risk management issues raised by LTCM. The rationale for this proposed legislation seems to be simply that tossing isolated and inherently out-of-date financial data concerning large hedge funds into the public domain will somehow reduce systemic risk. Not even the proponents of this proposal have been able to explain how it would reduce systemic risk or any other risk; and, clearly, even advocates for the legislation concede that it is not calculated to correct or improve the lending practices at the root of LTCMs problems.
Mr. Chairman, our organization represents major users of the derivatives and securities markets. As such, we would be the first to rise in support of measures meaningfully designed to reduce risks in the financial markets. However, based upon our extensive review of this subject, we do not believe that a case for the creation of the elaborate new public reporting structure envisioned by H.R. 2924 has been made. In fact, this legislative proposal appears to rest largely on wishful thinking and its likely product will be, at best, an illusion of protection -- one from which neither regulators nor the public should draw comfort.
We appreciate that legislators and regulators are eager to respond to financial crises and to mend apparent rents in the regulatory fabric. However, as we all know, the zealous pursuit of cures may at times result in an impulse for some form of governmental response, without careful assessment of the likely benefits and costs of that action. This type of well-intentioned urge to react to a crisis, without careful scrutiny of likely consequences, is the essence of H.R. 2924.
The Lessons of LTCM In the eighteen months since the LTCM events, real advances have been made in understanding the causes of the LTCM problems and in improving the ability of market participants to prevent such problems in the future. The multiple reports issued by the banking supervisors, international organizations, the Counterparty Risk Management Policy Group, and the recently issued report of certain large hedge funds on Sound Practices for Hedge Fund Managers, exemplify these valuable efforts. Based upon the extensive analyses that have been made of the causes and possible cures for LTCM-type problems, we believe that the following conclusions are clear:
(1) LTCM is an extreme illustration of weaknesses inherent in credit practices at that time. It is not typical of hedge funds, nor are hedge funds the largest or most leveraged institutions or those that may be most affected by credit risk lapses. Nonetheless, the lessons LTCM has to teach about credit risk management are extremely important.
(2) No substitute exists for rigorous risk management by lenders and counterparties. As has been noted by members of the Presidents Working Group and others, the primary responsibility for addressing the weaknesses in risk management practices that were evident in the LTCM episode rests with private financial institutions. In the case of LTCM, a relatively small number of U.S. and foreign banks and broker-dealers were critical to the establishment of LTCMs leveraged trading positions. Consequently, regulators and supervisors have a responsibility to help to ensure that banks and securities firms employ systems to manage risk that are commensurate with the size and complexity of their portfolios and responsive to changes in financial conditions. We submit that this is the crux of the LTCM problem and the only place to look for solutions -- responsible behavior by lenders and counterparties and their regulators.
(3) The need for timely information concerning rapidly changing risk profiles means that lenders and other counterparties cannot expect to rely on public disclosure mechanisms to meet their requirements. Thus, for example, the exhaustive reviews of lending practices by banking regulators and private sector groups have agreed that lenders must obtain comprehensive data concerning the risk profiles of leveraged institutions, perform careful and frequent stress testing of credit and market risk profiles, and develop meaningful measures by which they can continuously monitor potential future exposures. It is therefore clear that the snapshot quarterly disclosure which H.R. 2924 would require would not in any way suffice to address the credit risk management deficiencies associated with LTCM and it would be very misleading to suggest that the disclosure called for by H.R. 2924 would in any way suffice for proper risk assessment by other members of the public. The information it calls for is simply too little and too late to do the job of sound credit management and it is not directed toward the financial institutions whose day-to-day scrutiny of leveraged borrowers is the systems only defense against future LTCMs.
(4) If the reporting requirements of H.R. 2924 had been in effect in 1998, no coherent picture leading to a conclusion of systemic risk would have been uncovered. Numerous, much larger and equally highly leveraged institutions would not have reported under the proposal because they are not hedge funds. Nor would non-U.S. hedge funds have reported. H.R. 2924 would illuminate a few pixels and leave the rest of the TV screen blank.
The Putative Rationale for H.R. 2924. The rationale for the proposed new requirement for public disclosure by hedge funds cannot conceivably be to increase the data available to lenders and counterparties (who need far more and far more timely data than that called for) but rather to provide some level of increased information to investors or the public at large. With respect to investors, however, we do not believe that any of the regulatory studies or analyses of LTCM have suggested any need to reexamine the established rules governing private securities offerings to sophisticated investors. No suggestion has been proferred that the Congress or the SEC change the current legal structure for private securities offerings -- as you know, under this structure, privately offered investment funds, such as hedge funds, are offered to sophisticated investors whose ability to make informed investment decisions and to impose their own demands for information generally obviate government imposed disclosure requirements.
What the proponents of H.R. 2924 seem to have in mind is a form of vaporous diffusion of information to the public at large -- apparently believing that dispersion of some type of risk data, no matter how stale, incomplete or unexplained, will somehow create a more informed market "environment." The Department of the Treasury, for example, in supporting H.R. 2924 has spoken of enhancing market discipline by creating an environment of greater transparency and disclosure." (emphasis added).1
The case for H.R. 2924 thus depends upon a leap of faith, not a plan or even reasoned expectation of what benefits may reasonably be anticipated if this elaborate new disclosure framework were implemented. In making its recommendations for actions in response to LTCM, the Presidents Working Group on Financial Markets stated that "government regulation should have a clear purpose and should be carefully evaluated in order to avoid unintended outcomes." This is a reasonable, indeed, an essential standard if our financial markets are to remain sound and competitive. H.R. 2924 falls far short of satisfying this standard. In the course of the hearings before this Committee, key proponents of the legislation have in fact raised questions which call into question the very essence of the bill. Representative Baker, for example, has stated as to the public reporting requirement initially proposed in the Presidents Working Group Report and which would be codified in H.R. 2924:
As to the reporting requirement, it would seem to me that anything that is timely released verges on proprietary. Anything that is not timely released and is retrospective in its view is of little value to a person trying to judge current day risk positions. (emphasis added.)2
H.R. 2924 calls for disclosure of a snapshot financial data after the close of the quarter it relates to and of a single (unspecified) measure of risk. In addition to lack of timeliness, the information that would be publicly disclosed under H.R. 2924s requirements is inherently too limited to provide a workable basis for evaluating a hedge funds riskiness. As a representative of the Federal Reserve Board testified before this Committee: "The fact of the matter is, there is no simple reliable methodology boiling down into a single number what the riskiness of a portfolio is." And he noted that this is particularly true with respect to the kind of complex portfolios that not only hedge funds but many other financial institutions have today. Given the liquidity of those markets, hedge funds and other highly leveraged institutions can alter their risk profiles significantly within days or even hours. These facts cast great doubt on the usefulness of H.R. 2924s disclosure to lenders and regulators, much less to the general public.
So we must ask why, Mr. Chairman, if the information that would be required to be disclosed is "of little value" because it is out-of-date and because there is no single snapshot or capsule to capture the risk propensities of a complex hedge fund portfolio, why is there a push to enact legislation calling for the mandatory public disclosure of such data? We can only conclude that good intentions have resulted in a rush to legislate, causing well-intentioned persons to refrain from close scrutiny of costs and benefits in order to provide the comfort of a legislative response -- one which will "close the book," with an emphatic legislative flourish -- on a highly publicized financial problem.
Adverse Consequences. We must also remind this Committee that there is a price to be paid for creating the type of reporting regime envisioned by H.R. 2924. This is not a case in which a proposed new requirement can be accepted as benign, albeit ineffective. Required public dissemination of information that is purportedly material to risk when it is in fact likely to be both stale and incomplete is far more likely to be inimical than beneficial to public understanding of the risks of hedge funds. Astute commentators, including regulators, have noted that a false impression that the regulatory agency operating the reporting system is actually overseeing the activities of hedge funds can be dangerous because it reduces private market discipline without any actual government oversight to make up for that loss. And, of course, if lenders or counterparties were to rely upon such plainly inadequate information, the results are likely to be devastating and would increase, not decrease, the chances of another LTCM.
Creating a new governmental reporting burden also has negative consequences for those who are subject to or face the prospect of being subject to those duties. Disclosure to the public of financial information about private investment vehicles is likely to raise serious concerns about the ability to preserve the confidentiality of trading strategies, positions and other proprietary data. As drafted, H.R. 2924s public reporting provisions are likely to create extraordinary practical disadvantages for hedge funds within its reach. H.R. 2924 calls for disclosure of financial information such as financial statements prepared in accordance with generally accepted accounting principles ("GAAP"). As GAAP requires disclosure of all material portfolio positions (with positions in which five percent or more of portfolio assets are invested commonly viewed as material), disclosure of proprietary trading information would be implicated. Moreover, investment banks, banks and insurance companies, which may be equally highly leveraged, are under no such requirement. In addition, the requirement to produce such financial data and other disclosure within fifteen days after the end of each calendar quarter is, to the best of our knowledge, virtually unprecedented, and would be very difficult if not impossible to satisfy. As has often been noted, hedge funds are highly portable businesses and the offshore market is in a high growth phase. Governmental reporting requirements can present a significant disincentive to conducting business in the U.S.
Conclusion. In closing, let me reiterate MFAs strong interest in addressing the issues raised by LTCM. We do not believe that LTCM or the problems associated with it should be ignored or pushed under the rug; we are by no means rigid advocates of the status quo. Improvements in credit discipline and risk management can and should be made. But the healthy focus on these needed improvements since LTCM should not be diminished or deflected by the pursuit of hollow regulatory requirements, and no one should believe that the H.R. 2924 represents a solution to any problem.
As a representative of the hedge fund and managed futures community, MFA has worked and continues to work with regulators and self-regulators to address the bona fide issues presented by LTCM. We will continue to do so.
Thank you very much for the opportunity to participate here today. I would be happy to answer any questions you may have.
1. Testimony of Lee Sachs, Assistant Secretary, Department of the Treasury, Before the Subcommittee on Capital Markets, Securities and Government-Sponsored Enterprises, House Committee on Banking and Financial Services, March 16, 2000.