They got it right... in 1999
Read on.. if you love reading about credit risk.
The public policy issue raised by market participants' use of leverage is, first, determining the proper balance between the benefit leverage confers to markets and the potential systemic risk posed by high levels of leverage. If it is determined that, from time to time, existing mechanisms do not adequately limit the use of leverage, resulting in unacceptably high levels of systemic risk, then the question becomes one of how best to address this concern.
Leverage allows an investor to take on higher risks, including those risks that are shed by
others. Thus, the leveraged exposure of investors with higher risk appetites can be a vehicle that allows a larger number of risk-averse investors to reduce their risks. While the leverage that supports the reallocation of risk provides benefits, it can be fragile. In a volatile market, high levels of leverage increase the likelihood that a leveraged entity will fail, in part because the size of potential losses can seriously deplete and even wipe out the entity's net worth.
When leveraged investors are overwhelmed by market or liquidity shocks, the risks they
have assumed will be discharged back into the market. Thus, highly leveraged investors have the potential to exacerbate instability in the market as a whole. The outcome may be direct losses inflicted on creditors and trading counterparties, as well as an indirect impact on other market participants through price changes resulting from the disappearance of investors willing to bear higher risks. The indirect impact is potentially the more serious effect. Volatility and sharp declines in asset prices can heighten uncertainty about credit risk and disrupt the intermediation of credit. These secondary effects, if not contained, could cause a contraction of credit and liquidity, and ultimately, heighten the risk of a contraction in real economic activity.
The leverage employed by hedge funds is acquired through derivatives transactions,
repurchase agreements, short sales, and direct financing. In probably all cases, these exposures are collateralized at current market value. However, in the case of LTCM, the potential future exposure was not adequately collateralized relative to the creditworthiness of the LTCM Fund or to the potential price shocks the markets were facing in September 1998.
Banks and securities firms have viewed hedge funds as desirable trading customers. For
instance, dealers earn trading revenue from the funds' transactions flows without directly bearing the risks undertaken by the funds. Hedge funds' willingness to take on risks also may make it easier for dealers to execute hedging transactions to shed unwanted risks. Competition for hedge fund business may have led to a gradual erosion of risk management practices with regard to some hedge fund customers, and certainly with respect to the LTCM Fund in particular.
A. Measuring Leverage and Risk
Placing direct constraints on leverage presents certain difficulties. Given investors'
diverse exposures to risk, and differences in their links to other market participants, requiring a uniform degree of balance-sheet leverage for all investors does not seem reasonable. First, balance-sheet leverage by itself is not an adequate measure of risk. For any given leverage ratio, the fragility of a portfolio depends on the market, credit, and liquidity risks in the portfolio. In addition, a high capital requirement based on balance-sheet concepts alone might induce fund managers to shift their risk-taking activities to more speculative trading strategies as they seek to meet rate-of-return targets on the required capital. It could also induce managers to move to offbalance-sheet risk-taking strategies such as through the use of derivatives.
An alternative measure to balance-sheet leverage is the ratio of potential gains and losses
relative to net worth, such as value-at-risk relative to net worth. An advantage of such a
statistical measure is its ability to produce a more meaningful description of leverage in terms of risk. A disadvantage is the potential pitfalls in measuring value-at-risk, such as through faulty or incomplete modeling assumptions or narrow time horizons. These issues suggest that enforcing a meaningful regulatory capital requirement or leverage ratio for a wide and diverse range of investment funds would be a difficult undertaking.
An alternative tool for indirectly influencing excessive leverage is credit-risk management.
Credit-risk management can help to constrain the leverage employed by significant market participants, including hedge funds, thereby reducing systemic risk. The diversity of the credit risk and liquidity profiles of borrowers has led creditors to use a variety of tools to control credit risk. Public policy initiatives relating to hedge funds should build upon those practices that have worked well, and should encourage their use and improvements in their implementation.
Collateral, capital, information, and the price of credit.
Collateralization and the use of credit-risk spreads on credit exposures, including trading exposures, offer alternative ways of managing these same types of credit risk. The method which is chosen typically depends on the relative costs to the customer of the collateral and the credit spread that provide equivalent compensation to the creditor for the credit risk.17 With collateralization, collateral provided by the borrower provides protection to the lender against losses from default. When credit-risk spreads are used, the lender's capital and loan-loss reserves provide protection against losses from
default, and the credit spread on the loan provides compensation to the lender for the cost of capital and reserves, plus a risk premium. For customers who can easily provide information demonstrating their creditworthiness, credit may be acquired on an unsecured basis because the credit risk spread is of lower cost than the cost of providing collateral. Supervisors and regulators of banks and securities firms usually have not interfered in private choices regarding different approaches to managing credit risk, as long as prudential standards are satisfied. For instance, in
18 This decentralized approach to managing credit risk, overall, has worked reasonably well. At the end of
1998, for example, total credit losses from OTC derivatives at US banks were only 0.21 of a percentage point of the
average outstanding credit exposure for the year. In 1997, the figure was less than 0.05 of a percentage point.
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regulatory bank capital requirements, collateralized derivatives exposures have lower capital requirements than uncollateralized exposures, but the decision to collateralize has remained with the counterparties to the transaction.18
Tradeoff between credit and liquidity risk.
Another example of the diversity in credit risk management practice is in the use of variation margin. Variation margin can reduce the credit exposure in a derivative transaction, but only at the cost of imposing higher liquidity risk on the counterparties. For highly creditworthy counterparties, the cash-flow management demands of daily variation margin can impose costs that exceed the benefit from credit risk reduction. For
other counterparties, however, the benefits of lower credit risk resulting from variation margin may exceed the costs imposed by higher liquidity risk. Thus, allowing diversity in credit-risk management practices can result in a more efficient financial system.
B. Private Counterparty Discipline and Government Regulation
The primary mechanism that regulates risk-taking by firms in a market economy is the
market discipline provided by creditors, counterparties (including financial contract
counterparties), and investors. In principle, if a firm seeks to assume greater risks, either by increasing the riskiness of its assets or by increasing its leverage, creditors will respond by increasing the cost or reducing the availability of credit to the firm. The rising cost or reduced availability of funds provides a powerful economic incentive for firms to constrain their risktaking.
Counterparty discipline can serve as an effective tool to mitigate the risks of excessive
leverage. The constraint on leverage imposed through counterparty credit terms can occur
directly through trading and credit limits or initial margin, and indirectly through credit spreads on transactions that would lower the returns from leveraged positions. The exercise of credit discipline in trading relationships has the potential to provide a balance between the benefits and risks of leverage. The counterparty's assessment of its ability to shoulder the credit exposure to the leveraged entity should constrain leverage below excessive levels. Such counterparty discipline, however, failed to constrain leverage adequately in the case of LTCM.
Such market discipline tends to be effective when creditors have the incentives and the
means to evaluate the riskiness of the firm to adjust credit terms accordingly. In some cases, however, either the incentives or the means are lacking. Incentives will be reduced or eliminated if creditors do not perceive themselves to be adversely affected by increases in the firm's level of risk. In particular, if the firm's obligations are guaranteed by a financially strong third party (e.g., a government), its creditors may be indifferent to its level of risk. If the firm is able to obtain financing from unsophisticated creditors — for example, from retail investors — those creditors may not have the means to accurately evaluate the firm's riskiness and, therefore, may not insist on credit terms commensurate with the firm's level of risk.
Even when creditors have the incentives and means to provide market discipline, risktaking will not always be effectively constrained. Evaluation of the riskiness of firms is inherently difficult, and errors in evaluation and/or judgement are probable. Thus, business failures and losses to creditors will occur. In general, however, the failures and losses that have occurred have been small relative to the benefits of a market economy.
Consequently, in our market-based economy, market discipline of risk taking is the rule
and government regulation is the exception. Generally, government regulation becomes necessary because of market failure or the failure of the pricing mechanism to account for all social costs.
Government regulation of markets is largely achieved by regulating financial intermediaries that have access to the federal safety net, that play a central dealer role, or that raise funds from the general public. Any resort to government regulation should have a clear purpose and should be carefully evaluated in order to avoid unintended outcomes.
BANKRUPTCY ISSUES
A. Closeout Netting
The LTCM episode raises some issues involving the U.S. Bankruptcy Code. The first
involves clarifying the ability of certain counterparties to exercise their rights with respect to closeout, netting, and liquidation of underlying collateral in the event of the filing of a bankruptcy petition without regard to the Bankruptcy Code's automatic stay.
These provisions, which the President's Working Group on Financial Markets urged
Congress last year to expand and improve, are generally recognized to be important to market stability. They serve to reduce the likelihood that the procedure for resolving a single insolvency will trigger other insolvencies due to the creditors' inability to control their market risk. In other words, this protects the market from the systemic problem of "domino failures." Nevertheless, in certain circumstances, a simultaneous rush by the counterparties of a defaulting market participant to replace their contracts could put pressure on market prices. To the extent that the default was due to fluctuations in market prices in these contracts, this pressure might tend to exacerbate those fluctuations, at least in the near term. This problem could be significant where the defaulting debtor had large positions relative to the size of the market.
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