Greenspan and William McDonough, president of the New York Federal Reserve Bank, strongly defended the Fed's role in the $3.75 billion rescue of the troubled hedge fund. The two Fed officials said default could have set off a severe credit crunch in the U.S. economy.
"Had the failure of LTCM triggered the seizing up of markets, substantial damage could have been inflicted on many market participants ... and could have potentially impaired the economies of many nations, including our own," Greenspan told a House panel that is looking into the demise of the fund and the failure of federal banking and securities regulators to head off the problem.
"There was a likelihood that a number of credit and interest-rate markets would experience extreme price moves and possibly cease to function for a period of one or more days and maybe longer," said McDonough.
The New York Federal Reserve Bank coordinated the hedge fund emergency buyout package provided by several big banks and brokerages.
"It was my judgment that the American people, whom we are pledged to serve, could have been seriously hurt if credit dried up in a general effort by banks and other intermediaries to avoid greater risk," McDonough said.
(In a special survey released Thursday, the Fed said that banks had tightened up their standards for commercial and industrial loans. The Fed survey of bank loan officers showed no change in the terms and conditions for small business and consumer loans.)
In remarks before the House Banking Committee, Greenspan painted a dire picture of cascading flights of capital motivated by fear if Long-Term Capital had gone under.
"Our sense was that the consequences of a fire sale triggered by cross-default clauses, should LTCM fail on some of its obligations, risked a severe drying up of market liquidity," Greenspan said.
In normal times, the failure of Long-Term would have posed no risks to the system, Greenspan said. But, of course, in normal times, Long-Term wouldn't have collapsed, either. Its stunning losses stemmed from forces that its management team didn't foresee.
"In our dynamic market economy, investors and traders, at times, make misjudgments," Greenspan said.
If investors begin to lose confidence that other participants will pay up when required, "fear, whether irrational or otherwise, grips participants and they unthinkingly disengage from risky assets in favor of those providing safety and liquidity," Greenspan said.
That is exactly what investors around the globe appear to be doing now as they run to the safety and liquidity of U.S. Treasurys.
Greenspan said the Fed's role did not amount to a bailout, but he acknowledged that the decision to step in to provide the good offices of the Fed to the creditor who rescued the fund was one of the most difficult judgments a central banker must make.
Going forward, "supervisors of banks and security firms must assess whether current procedures regarding stress testing and counterpart assessment could have been improved," Greenspan said. "It is questionable whether hedge funds can be effectively regulated in the United States alone," he said.
Banning hedge funds, even if it were possible, would be too high a price to pay, he said. "Eliminating risk would lower standards of living," he said.
Top officials of other bank and securities regulatory agencies also were to speak at the hearing. But representatives of the hedge fund, of companies in the rescue consortium and of the Treasury Department declined to appear.
Spokesmen in New York for Long-Term Capital and the consortium declined to comment Wednesday on why representatives would not attend.
Rich Torrenzano, a spokesman for the consortium, said he could not speak for the companies, some of which were invited to testify individually. The group includes Merrill Lynch & Co., Bankers Trust, Chase Manhattan, Morgan Stanley Dean Witter, J.P. Morgan, Goldman Sachs, Salomon Smith Barney, and several big European banks.
Long-Term Capital Management borrowed heavily from securities firms and from banks, whose deposits are insured by the federal government. It used the money on behalf of its wealthy investors to speculate on relative differences in interest rates among securities.
It employed sophisticated computer modeling and derivatives, often-complex financial instruments whose value is derived from an underlying security, commodity or asset, in hope of producing a profit, no matter which direction stock prices or interest rates moved as a whole.
But the models failed to account for the sudden collapse of the Russian ruble in late August or the dramatic intensification of the global financial crisis, which has widened the spread between interest paid on U.S. Treasury securities and other less-safe securities.
The fund's senior partners included two Nobel laureate economists and a former vice chairman of the Federal Reserve.
House Banking Committee Chairman Jim Leach, R-Iowa, said the hearing would examine the risks to the nation's financial system posed by the Long-Term Capital Management and other hedge funds.
Estimates of the total number of hedge funds range up to 4,000 controlling $400 billion in investor equity. They are not subject to the same kind of strict disclosure and oversight rules as mutual funds because participants presumably have the resources to look after themselves.
Securities laws limit participation in each fund to 500 investors. Individuals must have incomes of at least $200,000 in each of the past two years ($300,000 for couples) or a net worth of at least $1 million.
But Chase Manhattan Corp.'s disclosure that it had about $3.2 illion in loans and derivatives out to hedge funds, about 2 percent of the bank's total credit exposure, underscored the potential spillover impact of a hedge fund collapse.
Securities and Exchange Commission Chairman Arthur Levitt said Tuesday that other hedge funds probably are at risk but it was too soon to conclude they needed stricter government oversight.
Treasury Secretary Robert Rubin has said he did not see why the near-collapse of Long-Term Capital Management should portend a credit crunch for other borrowers.