Drawing heavily on a new General Accounting Office report, Democratic lawmakers are pushing legislation that would give securities regulators new powers over previously unsupervised derivatives dealers.
The bill, sponsored by Rep. Edward J. Markey, D-Mass., and Sen. Byron L. Dorgan, D-N.D., is an attempt to fix underlying problems associated with the near-collapse of Long-Term Capital Management LP last year.
It builds on reforms recommended Nov. 8 by the President's Interagency Working Group on Financial Markets, and on a hedge fund disclosure bill introduced in September by Rep. Richard H. Baker, R-La.
The GAO report found fault with banks that acted as creditors or counterparties to Long-Term Capital and with bank and securities regulators, who the authors said should have caught on to the problem sooner.
Banks failed to enforce their own risk management standards and got in too deep, the GAO concluded. They dropped their guard -- and their credit standards -- partly as a result of the fierce competition for hedge fund business, the impressive credentials of Long-Term Capital's principals, and the strong economy. Because hedge funds are not directly regulated, banks and other creditors are theoretically supposed to impose "market discipline" on them, said the GAO, Congress' investigative arm.
Regulators, for their part, failed to detect banks' lax standards, the GAO said. They also failed to anticipate the systemic risk posed by Long-Term Capital, because of a myopic focus on individual institutions.
Rep. Markey, a member of the House Banking Committee, took aim at both camps.
"GAO's findings ... stand as a blistering, scalding indictment of inadequacies in both the risk management practices of the banks and securities firms that were LTCM's counterparties, and the federal financial regulators who were supposed to be supervising these institutions," he said at a press conference Friday.
"This independent report reveals that our federal regulators allowed LTCM to load up with more than $1 trillion in risky derivatives, which threatened to bring chaos to financial markets in the U.S. and around the world," Sen. Dorgan said.
Drawing on the report's recommendations, the lawmakers' bill would require the Securities and Exchange Commission to regulate derivatives firms that are not affiliated with banks.
The SEC would also have to institute "large trader reporting" rules, which would give the agency additional information about hedge funds and other big traders. The SEC has had the authority to issue such rules since 1990 but has not exercised it.
The SEC and bank regulators would have to issue an annual report on their efforts to improve interagency coordination.
The legislation would require hedge funds to publish quarterly reports detailing their financial condition and the methods they use to assess market risk. Proprietary information concerning investment strategies or provisions would not be made available to the public.
Long-Term Capital Management, one of the country's largest hedge funds, lost almost 90% of its capital during the first three quarters of 1998.
The Federal Reserve Bank of New York, concerned that the fund's collapse could cost its top 17 counterparties as much as $5 billion and destabilize global financial markets, took the unusual step of organizing a $3.6 billion private-sector bailout by over a dozen banks.