TESTIMONY OF ANNETTE L. NAZARETH, DIRECTOR DIVISION OF MARKET REGULATION U.S. SECURITIES AND EXCHANGE COMMISSION CONCERNING THE REPORT OF THE PRESIDENT’S WORKING GROUP ON FINANCIAL MARKETS ON HEDGE FUNDS, LEVERAGE, AND THE LESSONS OF LONG-TERM CAPITAL MANAGEMENT BEFORE THE COMMITTEE ON BANKING AND FINANCIAL SERVICES UNITED STATES HOUSE OF REPRESENTATIVES MAY 6, 1999 Chairman Leach and Members of the Committee: I am pleased to appear today to testify on behalf of the Securities and Exchange Commission concerning the Working Group’s findings on hedge funds and leverage in the wake of the near- collapse of Long-Term Capital Management. The Commission supports the Working Group’s recommendations described this morning by Treasury. The Working Group carefully studied the issues raised by LTCM and concluded that the lessons to be learned from this episode center upon the risks posed by the use of excessive leverage -- not just by hedge funds, but by all large, significantly leveraged financial institutions. I believe that the recommendations in the report represent a balanced approach that addresses the problems of excessive leverage without running the risk of driving hedge funds offshore. I would like to discuss briefly the Working Group proposals that directly impact the SEC. Earlier in this hearing, you heard about the break-down in market discipline among financial institutions that extended credit to hedge funds. While no securities firm was at risk of failing, securities firms did not consistently adhere to prudent standards and, at times, to their own written policies in their dealings with hedge funds. For example, in their rush to do business with hedge funds, securities firms often lent to and traded with hedge funds without having a comprehensive view of their creditworthiness, particularly their off-balance sheet positions. Moreover, some securities firms did not adequately stress test their exposures to hedge funds, leading them to underestimate their level of risk exposure; and they often did not factor concentration and liquidity risks into their risk assumptions. Of course, during the third quarter of 1998, statistical measurements of potential exposure became less relevant as market volatility increased beyond the historical levels incorporated into the risk models. In other words, many firms did not realize that they were in a “100-year flood„ scenario, and as a result, they did not have adequate safeguards built into their models to alert them to this fact. In the wake of LTCM’s difficulties, the major securities firms are attempting to improve some of the deficiencies in their current risk models and procedures. In particular, firms are requiring more comprehensive financial disclosures, enhancing their stress testing for high risk hedge fund portfolios, tightening their margin and collateral requirements, and updating their risk models to reflect recent market volatility. We have conducted examinations of the risk management procedures and practices of the largest firms and intend to issue reports to each firm recommending further improvements that we think are necessary. But more can and should be done. At Chairman Levitt’s request, several large firms formed the Counterparty Risk Management Policy Group to develop a set of best practices to guide firms in formulating their risk management procedures. This industry group intends to issue a report shortly. Moreover, in its report, the Working Group recommended a number of improvements to firms’ risk management procedures in such areas as approving and monitoring credit, estimating potential future credit exposures, setting limits on counterparty credit exposures, and measuring leverage and risk. We will be working with individual firms directly and with industry groups such as the Counterparty Risk Management Policy Group to encourage financial institutions to make these important improvements to their procedures and to make them part of their corporate cultures. From the SEC’s perspective, the second key issue highlighted by the LTCM crisis was the need for better information on the hedge fund activity of unregulated holding companies and affiliates of broker-dealers. Although we receive comprehensive information about broker- dealers’ direct exposures, if any, to hedge funds, the data we receive about the exposures of their unregulated affiliates is somewhat more limited. Under the SEC’s current risk assessment rules, broker- dealers and their major affiliates must report quarterly information about their financial activities. This information includes holding company financial statements and aggregate securities holdings for each affiliate. It also describes the broker-dealer’s policies for monitoring and controlling the risks that major affiliates may pose for the broker-dealer. The SEC also obtains, on a voluntary basis, information about the over- the-counter derivatives activities of the unregulated affiliates of five large U.S. broker-dealers through the Derivatives Policy Group. Although this information is very useful, it does not provide a complete picture of the potential risks that an affiliate might pose to its affiliated broker-dealer. As responsible regulators, we should have available more comprehensive information about the potential risks that may be incurred by the firms we regulate. For this reason, the SEC, Treasury, and the CFTC recommended that Congress enact legislation that would provide the agencies with expanded risk assessment authority. Under the Working Group’s proposal, the SEC would be given new authority to require broker-dealers and their affiliates to report credit risk information by counterparty. To further strengthen our monitoring, this authority would also require reporting of additional data on a firm’s concentrations in a particular financial instrument, region, or industry sector, as well as trading strategies and risk models. This information would help us determine whether turmoil in a particular market or sector was likely to have a negative impact on a particular firm. For instance, if a firm’s affiliate had significant holdings in Latin American debt and that region faced an economic crisis, we could monitor that firm’s financial condition and activities more closely. Any expansion of SEC risk assessment powers, however, would be ineffective if the SEC were not also given examination authority over broker-dealer holding company affiliates. The ability to inspect the books, records, risk models, and management controls of broker-dealer affiliates, which the Working Group also recommended, will help us ensure that the reports prepared are complete and accurate. We also learned from LTCM that more public information about hedge funds and other highly leveraged entities, including public companies’ exposures to these entities, should be made available. The Working Group proposes that all public companies, including financial institutions, be required to publicly disclose a summary of direct material exposures to significantly leveraged institutions, including hedge funds. The required disclosure could be included in the narrative material that is part of the periodic reports, such as Form 10-K and Form 10-Q, that are filed by public companies with the Commission. There is precedent for such disclosure. For example, we currently require public companies to disclose their material concentrations in high yield bonds. The Commission will consider proposing a rule or interpretation to implement this recommendation. The exact nature of the disclosure requirements would be determined after we solicit and receive public comments on the issue. The Working Group believes that because the markets and their participants are linked, the material financial exposure of one market participant can create risks for those with which it has financial dealings. Requiring public companies to disclose their material exposures to significantly leveraged financial entities should help impose private market discipline on public companies, which in turn could indirectly curb potentially risky exposures of unregulated entities, such as hedge funds, that borrow from or trade with those companies. A further key lesson we learned from LTCM was that more public information about hedge funds should be available. To help ensure that more timely and useful information about hedge funds is made publicly available, the Working Group recommended that Congress enact legislation to require hedge funds that do not currently report to the CFTC as Commodity Pool Operators (“CPOs„) to disclose certain financial information to regulators and the public. The Report left open the mechanism for this disclosure. Relying on existing structures, the Working Group also proposed that hedge funds currently registered as CPOs provide enhanced information more frequently to the CFTC. This information would be provided on a quarterly basis and would include more meaningful and comprehensive measures of market risk, such as value at risk or stress test results--although not proprietary information on strategies or positions. I have heard this proposed disclosure called “top down„ disclosure because it would not require the hedge funds to tell the public the details of their trading activities; rather, it would require them to disclose how much risk they are assuming in their strategies. In sum, we believe that the Working Group has made several reasonable recommendations to address the issues raised by the LTCM episode and generally has proved to be an effective mechanism for addressing complex regulatory issues. That concludes my testimony. I would be happy to answer any questions you might have.