The second issue relates to derivatives activities and a concept called future potential exposure, which is a measure of the likely price movements based on recent years experience. With respect to derivatives, the current market value is captured by financial statements prepared in accordance with generally accepted accounting principles, but not the potential future exposure. To fully understand the degree and effect of leverage in Long-Term Capital’s derivatives-related strategies, it would have been necessary to measure the potential future exposure in a rigorous and conservative manner. Whether sufficient information was made BIS Review 78/1998  -6-  available to Long-Term Capital’s counterparties, including its banks, and adequately analyzed by those counterparties, remains to be seen. A third question concerns stress testing in the credit analysis of hedge funds and the structuring of margin agreements. Stress testing simulates the effects on a portfolio if many asset relationships simultaneously move adversely far beyond historical observation. We recognize that stress testing is a developing discipline, but it is clear that adequate testing was not done with respect to the financial conditions that precipitated Long-Term Capital’s problems. In a recent supervisory letter on credit underwriting generally, we emphasized the importance of stress testing. Effective risk management in a financial institution requires not only modelling, but models that can test the full range of financial transactions across all kinds of adverse market developments. Whether such models existed and, if so, whether they were effective, are issues that we need to address.
The four firms met at the Federal Reserve at 7:00 p.m. A draft term sheet was reviewed which provided detail with respect to the consortium approach. The terms and conditions were debated, altered in some places, and ultimately refined so that the four firms could present it to a wider group. Although Federal Reserve officials were present at the meeting, we did not participate in the discussion about terms and conditions. At about 8:30 p.m., a meeting of a wider group involving 13 firms began. Meanwhile, some representatives of the Core Group called Long-Term Capital to discuss the terms and conditions of the consortium approach. Federal Reserve officials did not participate in any conversations with Long-Term Capital regarding the terms and conditions. In the meeting with the wider group, Peter Fisher explained the importance of avoiding a disorderly close-out of Long-Term Capital’s positions. He also underscored the desirability of parallel efforts to resolve the problem. It was agreed that the group would reconvene at 10:00 a.m. the following morning. It was clear to everyone that time was of the essence. I returned to New York from London around midnight. During the early morning hours, I called various foreign central bank officials to inform them of the situation. At about 9:30 a.m. my colleagues and I met with the Core Group to review the status of the situation.