Lawmakers, still incensed by the blows financial markets absorbed from last fall’s near-failure of Long Term Capital Management, are warning that the current oversight system by the Federal Reserve Board may not go far enough to protect investors. Now they are hinting at direct regulation.

Sources said a forthcoming report on derivatives and hedge funds from the President’s Working Group on Financial Derivatives, plus the push toward financial modernization legislation, could encourage lawmakers to attach provisions requiring better supervision by the agencies in the form of a directive, or higher capital levels for banks who engage in hedge fund activities.

"The legislators don’t want blood on their hands," said a banking attorney. She said that House Banking Committee Chairman Jim Leach, R-Iowa, had long used hedge funds as a "soapbox," but now "had some real events to back his position."

The task force, headed by Treasury Secretary Robert Rubin, is expected to introduce its hedge fund report in six weeks, with a report on derivatives to follow this summer.

At a hearing last week of the House Financial Institutions Subcommittee, Leach admonished Federal Reserve governor Lawrence H. Meyer for not having a "cutoff" that would have brought regulators on top of Long Term Capital Management. Leach said the fund was dangerously over-leveraged by a ratio of 30-1.

He said that stress testing was not enough, hinting at restrictions on how much a fund can have leveraged in relation to its capital. "Things change so rapidly," he said. "I am still left with the feeling that there are (hedge fund managers) who are willing to take great risks for short-term profit."

Meyer countered, saying that "leverage is not the same as risk," and that additional disclosures would only give a "false sense of security," but Leach pressed the regulators for more concrete goals for dealing with overleveraged funds.

William J. MacDonough, president of the Federal Reserve Bank of New York, agreed, saying that LTCM got too big and too highly leveraged. He vowed stronger vigilance in the long term. "A new group (of executives) can make the same mistakes, so regulators need to have a longer memory," he said.