Rather than arranging bailouts, House Banking Committee Chairman Jim Leach said regulators should force insolvent hedge funds into bankruptcy.
"The public should be assured that the government won't subsidize insider bailouts and protect those who make investment errors," the Iowa Republican said in a speech late Monday on the House floor.
Referring to the near collapse last month of Long-Term Capital Management, Rep. Leach said a bankruptcy judge could have appointed a former government official like past Federal Reserve Board Chairman Paul Volcker to liquidate the hedge fund. There was no need for the New York Fed to intervene and organize a bailout by creditors, he said.
"The U.S. bankruptcy laws are designed to stabilize insolvent situations," Rep. Leach said. "Indeed, under the bankruptcy code, a trustee probably has more authority to proceed slowly than a reengineered company not protected by bankruptcy status."
Rep. Leach also said the Fed should prepare instructions for bankruptcy judges that explain the steps that must be taken to prevent a hedge fund failure from causing a financial panic.
"If the problem relates to systemic concerns and the goal is an orderly unwinding of positions, the Fed is obligated to lend a perspective to the courts," Rep. Leach said.
The Treasury Department and the Fed also should issue "guidelines or commentary" announcing their intent to rely on the bankruptcy courts to resolve future hedge fund failures, he said. This should eliminate moral hazard, which would occur if lenders stopped monitoring hedge fund loans on the assumption the government will prevent these firms from defaulting, he said.
Spokesmen for the Treasury Department and New York Fed declined to comment on Rep. Leach's comments.
Richard M. Whiting, general counsel to the Bankers Roundtable, applauded Rep. Leach's call to use the bankruptcy courts to resolve hedge fund failures.
"This obviously is a way to get away from the too-big-to-fail doctrine and get the resolution away from the government and taxpayers and to the private sector," Mr. Whiting said.
Mr. Whiting also credited Rep. Leach for avoiding a "knee-jerk" call for additional restrictions on bank lending. "He is implying that you can work within the existing statutory framework to ensure instances like this do not reoccur," Mr. Whiting said.
Rep. Leach accused some banks of "blind-eyed complicity" for lending to a hedge fund that shrouded its operations in secrecy and was so leveraged that it threatened global financial stability. In his speech, Rep. Leach called on lenders to avoid extending credit to hedge funds with some operations in the Cayman Islands or other countries to shield themselves from U.S. bankruptcy laws.
"Prudent banks should have doubts about lending to institutions whose operations may not be within the full reach of the laws of the United States or other comparable legal systems," he said.
Regulators have "egg on their face" for letting Long-Term Capital leverage $4.7 billion in capital into $129 billion in investments, he said.
The Commodity Futures Trading Commission failed to exercise its authority to examine Long-Term Capital's books, and the Fed and the Office of the Comptroller of the Currency were unaware of how much credit banks had extended to the fund, he said.
Long-Term Capital's failure is a sign that the global financial turmoil has reach the United States, Rep. Leach said. Investors are recalling credit lines and dumping less-solid investments, he said.
"The impending credit crunch requires a monetary response from the Fed ... and perhaps a shot of fiscal stimulus from Congress, preferably a tax cut of very modest dimensions on the order of the $16 billion-a-year one proposed last month," he said.