Federal Reserve officials stepped into talks leading to the $3.6 billion private bailout of a major hedge fund to avert the chance of damage to the U.S. economy and global financial disruption, Fed Chairman Alan Greenspan said Thursday.
He defended the central bank's involvement in the rescue, which partially protected wealthy investors in Long-Term Capital Management LP, who had bet big on interest-rate swings and lost."Financial market participants were already unsettled by recent global events," Greenspan said in testimony prepared for the House Banking Committee.
"Had the failure of LTCM triggered the seizing up of markets, substantial damage could have been inflicted on many market participants, including some not directly involved with the firm, and could have potentially impaired the economies of many nations, including our own," he said.
Greenspan, appearing with William J. McDonough, president of the New York Federal Reserve Bank, who helped arrange the Sept. 23 rescue of the hedge fund by a group of major banks and brokerage firms, acknowledged there was "moral hazard" in partially protecting the fund's owners.
But, Greenspan said, Fed officials were worried about the potential for a disruptive "fire sale" if the fund were liquidated that would have risked a credit crunch for other borrowers - what Greenspan called "a severe drying up of market liquidity."
"In situations like this, there is no reason for central bank involvement unless there is substantial probability that a fire sale would result in severe, widespread and prolonged disruptions to financial market activity," he said.
He said the Fed participated "solely to enhance the probability of an orderly private-sector adjustment," that no Federal Reserve funds were put at risk and that none of the firms in the rescue group were pressured to participate.
"This agreement was not a government bailout," he said.