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1998 Ron Paul Chapter 105

Hedge Fund Bailout

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2 October 1998


HON. RON PAUL
OF TEXAS
IN THE HOUSE OF REPRESENTATIVES
Friday, October 2, 1998


1998 Ron Paul 105:1
Mr. PAUL. Mr. Speaker, the Federal Reserve orchestrated bailout of the hedge fund Long-Term Capital Management LP raises serious policy questions. At one point, the notional value of the Cayman Island-registered fund’s derivatives totalled about $1.2 trillion. We should look seriously at this issue because of the taxpayer-backed liability concerns raised by the involvement of an agency with the full faith and credit of the U.S. government. The state of Michigan has taken a constructive first step regarding the public policy concerns of derivatives. I urge us to consider the wisdom of the State Representative Greg Kaza as we debate this issue.

1998 Ron Paul 105:2
STATEMENT OF HON. GREG KAZA, MICHIGAN
STATE REPRESENTATIVE, ADJUNCT PROFESSOR
OF FINANCE, WALSH COLLEGE
Derivatives are financial instruments broadly defined as any contract or convertible security that changes in value in concert with a related or underlying security, fixed-income instrument, future or other instrument, currency or index; or that obtains much of its value from price movements in a related or underlying instrument; or an option, swap, warrant, or debt instrument with one or more options embedded in or attached to it, the value of which contract or security is determined in whole or in part by the price of one or more underlying instruments or markets.

1998 Ron Paul 105:3
Although derivatives are a relatively recent development in financial markets, their use by corporations, pension and mutual funds, financial institutions, governments and those involved in money management are clearly ascendant, according to the Federal Reserve and other federal agencies. The issue is not whether the government should ban or in some way restrict the prudent use of derivatives to hedge risk. Rather, the issue is one of disclosure, i.e., how best to provide increased transparency as our complex international financial system enters the 21st Century.

1998 Ron Paul 105:4
Three years ago I addressed the very same issue in Michigan by authoring state legislation that provided increased transparency by requiring units of government to disclose their derivative holdings to the public. Government units have to make investment decisions regarding the money they receive or retain; unfortunately, investment practices and decisions can sometimes lead to significant losses when taxdollars are unwisely invested in derivatives. Orange County in California and Independence Township in Oakland County, Michigan are both examples of government units that experienced significant losses as a result of the imprudent use of derivatives.

1998 Ron Paul 105:5
Initially, some of my colleagues wondered whether a ban or restriction on the use of derivatives would be preferable. But committee testimony soon convinced them that derivatives, although complex, are used by many institutions, including government pension funds, to prudently hedge risk. Our five-bill package required public disclosure of derivative holdings by government units. The legislation garnered bi-partisan sponsorship and support, and ultimately became state law.

1998 Ron Paul 105:6
A related issue that we discussed privately at the time was whether the potential for moral hazard created by federal deposit insurance means private financial institutions should be required to disclose their derivative holdings in the interest of transparency. You are now likely to contemplate this issue yourselves given events surrounding the hedge fund in question, Long-Term Capital Management; and the potential for systemic risk posed by any future episode that might involve the imprudent use of derivatives and excessive amounts of leverage.

Notes:

This statement, inserted into the Congressional Record’s Extensions of Remarks section, continues a theme discussed in 1998 Ron Paul Chapter 102 and 1998 Ron Paul Chapter 104.

1998 Ron Paul 105:1 totalled would be correct in British English, but in American Standard English would be totaled.

1998 Ron Paul 105:4 taxdollars as appearing in the Congressional Record, would make more sense as two words: tax dollars.

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