Federal Reserve Chairman Alan Greenspan told Congress Thursday that regulators arranged a rescue of Long-Term Capital Management to prevent a market meltdown and credit crunch.
"Had the failure of LTCM triggered the seizing up of markets, substantial damage could have been inflicted on many market participants," he told the House Banking Committee.
Mr. Greenspan and Federal Reserve Bank of New York President William J. McDonough urged lawmakers not to overreact to either the failure of the high-flying hedge fund or the central bank's role in facilitating its takeover by creditors.
"Hedge funds cannot be regulated directly," Mr. Greenspan said. "Either you regulate them and they disappear ... or far more likely they move overseas."
Instead, Mr. Greenspan and Mr. McDonough said, regulators must do a better job of supervising banks that lend to these funds.
"I have no doubt there was a regulatory failure here," Mr. Greenspan said, referring to the bank examiners who did not realize the risk involved in lending to the hedge fund.
Mr. McDonough also blamed the banks, which include J.P. Morgan & Co., Bankers Trust Corp., and Chase Manhattan Corp., for not conducting thorough credit analyses or stress-testing the riskiness of the hedge fund's activities.
The New York Fed become involved in Long-Term Credit last month after the hedge fund informed investors that it had lost more than half its capital this year and was continuing to suffer signficant losses on its $127 billion in global financial investments.
On Sept. 22 the Fed helped broker an agreement among the hedge fund's major lenders to stave off a default by recapitalizing the firm.
During nearly four hours of questioning by lawmakers, Mr. Greenspan and Mr. McDonough repeatedly defended the Fed's role in facilitating a rescue.
"It was my judgment that the American people ... could have been seriously hurt if credit dried up in a general effort by banks and other intermediaries to avoid greater risk," Mr. McDonough said.
Mr. McDonough said he would have allowed Long-Term Capital to fail, but a combination of the recent Russian debt default, the stock market correction, and the size of the fund's holdings persuaded him to help organize a rescue.
"The threshold for action was lowered by the knowledge that markets had recently become fragile," Mr. Greenspan agreed.
Mr. McDonough repeatedly stressed that the Fed was not bailing out Long- Term Credit.
"This was a private-sector solution to a private-sector problem, involving an investment of new equity by Long-Term Capital's creditors and counterparties," he said. "Not one penny of public money was spent or committed."
That did little to mollify congressional critics. Banking Committee Chairman Jim Leach charged that the Fed's involvement derailed a private- sector rescue led by investor Warren Buffett that would have forced owners of the hedge fund to lose nearly their entire stake in the firm.
The Iowa Republican also blasted the Commodity Futures Trading Commission, which failed to examine Long-Term Capital's books even after the fund reported leveraging $4.7 billion in capital into $129 billion of investments.
Finally, he urged the Justice Department to review whether the coalition of 14 commercial and investment banks that recapitalized Long-Term Capital may jointly run the hedge fund without violating antitrust laws.
Rep. John LaFalce, the ranking Democrat on the committee, warned regulators that they must cooperate or similar failures will occur.
"I would like some assurances from the witnesses that our regulatory team can and will bring itself to a heightened level of readiness using all the authority and cooperative mechanisms at its command," the New York congressman said.
Julie L. Williams, acting comptroller of the currency, said Long-Term Capital's failure is unlikely to affect any national banks.
Yet she said the failure should underscore recent warnings from regulators that banks must curb credit risk. "We must not lose sight of basic principles of sound lending and risk management, even in the most sophisticated types of credit transactions," she said.