What did regulators know and when did they know it?

If anyone wants proof that regulators understood the risks facing the financial markets prior to 2007, here it is: “Hedge funds, leverage, and the lessons of Long-Term Capital Management,” report of The President’s Working Group on Financial Markets, April 1999.

This is the federal regulators’ post-mortem on the collapse of the hedge fund Long-Term Capital Management in 1998, when 14 of the nation’s largest banks had to invest $3.6 billion to keep the fund’s losses from damaging world markets.

(For a more enjoyable read of the Long-Term Capital Management story, see “When Genius Failed,” by Roger Lowenstein, 2000.)

The President’s Working Group report attributed the crisis to excessive leverage that came mainly from debt hidden in repurchase agreements, short positions and derivative contracts – exactly the explosive that ignited the panic in 2007 and 2008.

Both the report and Lowenstein’s book show that a key reason for Long-Term Capital Management’s demise was a run on the hedge fund by its repo lenders, who stopped financing the hedge fund in the turmoil that followed Russia’s devaluation of the ruble and declaration of a debt moratorium on August 17, 1998.

This shows that a run on the repo market can be triggered by more than just rotten mortgage securities. For this reason, some experts believe the repo market itself must be reformed.

The authors of the 1999 Working Group report urged better risk-management going forward and promised to keep an eye on things.

The authors were Treasury Secretary Robert E. Rubin, Federal Reserve Chairman Alan Greenspan, Securities and Exchange Commission Chairman Arthur Levitt, and Brooksley Born, chairperson of the Commodity Futures Trading Commission.

In spite of what they knew, they did not pursue policies to prevent the crisis of 2007 and 2008. If so little was accomplished last time, it does raise concern that not much will be accomplished this time, either.