{"id":46646,"date":"2023-08-10T04:20:59","date_gmt":"2023-08-10T08:20:59","guid":{"rendered":"https:\/\/ifintechworld.com\/markets\/the-tale-of-the-fed-and-long-term-capital-management\/"},"modified":"2023-08-10T04:21:02","modified_gmt":"2023-08-10T08:21:02","slug":"the-tale-of-the-fed-and-long-term-capital-management","status":"publish","type":"post","link":"https:\/\/ifintechworld.com\/?p=46646","title":{"rendered":"The Tale of the Fed and Long-Term Capital Management"},"content":{"rendered":"
For Wall Street, it was a turning point for risk-taking. After this, there was a growing perception that the Fed, by intervening to save systemically important institutions, was protecting the stock market from big declines.<\/p>\n
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Then-chairman of the Federal Reserve, Alan Greenspan, confirmed an \u201cunwritten contract with Wall Street that committed the Fed to intervene to halt market declines,\u201d says economist Edward Chancellor, author of 2022\u2019s The Price of Time: The Real Story of Interest<\/em>. <\/p>\n
And the Fed has made good on that contract ever since. In particular, numerous corporate bailouts based on the LTCM model were undertaken in response to the 2007-10 subprime mortgage crisis, and again in 2023 to avert contagion from midsize lenders caught in an interest-rate squeeze.<\/p>\n
As LTCM\u2019s 25th anniversary approaches, critics say the problem is that everybody knows the Fed will do everything in its power to avert a financial meltdown. It creates a moral hazard: Investors, with little fear of losses, engage in reckless risk-taking. This creates bubbles (in stocks, housing, everything) that burst and start the cycle all over again.<\/p>\n
\u201cGreenspan and subsequent Fed chairs have never seemed to realize that excessive financial asset inflation (i.e., financial bubbles) is as damaging to the economy as is excessive real asset inflation,\u201d the financial analyst Richard Bernstein said by email.<\/p>\n
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\u201cAny form of excessive inflation\u2014real or financial\u2014damages the economy because there is ultimately a gross misallocation of capital,\u201d Bernstein argues. \u201cDoes the U.S. economy really need Elon Musk going to Mars or Richard Branson taking space vacations?\u201d<\/p>\n
Not everyone agrees with this viewpoint. Among those who don\u2019t is Ben Bernanke, Greenspan\u2019s successor as Fed chair, who engineered the rescues of everything from banks to insurance companies to auto makers during the subprime mortgage crisis. <\/p>\n
\u201cAll the funds used to prevent LTCM\u2019s collapse came from its creditors, none from public sources,\u201d he writes, adding that the hedge fund\u2019s owners lost almost everything. \u201cHardly a path others would want to emulate.\u201d<\/p>\n
Yet, bubbles still grow, and bailouts still happen. The question now is what Jerome Powell\u2019s Fed will do when it finally ends its current inflation-fighting regime. Some fear a return of an easy-money policy that will lead to more, and more dangerous, bubbles.<\/p>\n
\u201cWe\u2019ve had 25 years of bubble life,\u201d Chancellor says, and at some point \u201cmonetary policy will lose its efficacy to sustain markets.\u201d That is, the Fed won\u2019t be able to engineer a soft landing.<\/p>\n
Long-Term Capital Management was founded in 1994 by John Meriwether, who made his name in fixed-income arbitrage trading at Salomon before leaving under the cloud of a Treasuries scandal. With two Nobel Prize\u2013winning economists and a host of Ph.D.s honing his secretive investing strategies, LTCM racked up returns of more than 40% in 1995 and 1996, after fees, far outpacing rivals. <\/p>\n
LTCM\u2019s \u201cintellectual supermen had apparently been able to reduce an uncertain world to rigorous, coldblooded odds,\u201d writes Roger Lowenstein in the best-selling When Genius Failed: The Rise and Fall of Long-Term Capital Management<\/em>.<\/p>\n
Still, LTCM seemed an unlikely candidate to spark a global financial panic, managing just $4.8 billion at the beginning of 1998. But it had also \u201camassed an amazing $100 billion in assets, virtually all of it borrowed,\u201d Lowenstein writes, with most of Wall Street\u2019s and Europe\u2019s biggest banks on the hook. What\u2019s more, thousands of derivative contracts\u2014\u201cessentially side bets on market prices\u201d\u2014added up to more than $1 trillion in market exposure, according to Lowenstein.<\/p>\n
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LTCM suffered its first monthly loss in June 1998. Little mind was paid until Aug. 17, when Russia defaulted and \u201csaddled the world\u2019s financial institutions, from blue-chip banks to the highest-flying hedge funds, with more than $8 billion in losses,\u201d The Wall Street Journal wrote on Sept. 3, 1998. <\/p>\n
\u201cLong-Term\u2019s loss\u201d\u2014$1.8 billion in August alone\u2014\u201cwas by far the worst of the hits,\u201d the Journal added.<\/p>\n
On Sept. 23, New York Fed President William J. McDonough summoned the chiefs of Wall Street to his downtown Manhattan offices. There he \u201cbanged their heads together,\u201d in the words of Barron\u2019s<\/em> Up & Down Wall Street columnist Kathryn M. Welling, and got them to agree on a $3.65 billion bailout, split among 14 lenders. <\/p>\n
\u201cThe $300 million apiece that the Street\u2019s leading lights tossed into the Long-Term Capital kitty looked like chump change,\u201d she wrote, compared with potential losses from a bankruptcy. LTCM, in modern parlance, was \u201ctoo big to fail.\u201d <\/p>\n
But, writing under the headline \u201cCrony Capitalism, American-Style,\u201d Welling also addresses the class resentment that such rescues can engender. \u201cWhat else do you call it when the Fed corrals the fat cats at the helms of the Street\u2019s biggest banks and brokerage houses all into one elegant room,\u201d Welling wrote, to bail out a \u201cgang of former colleagues.\u201d<\/p>\n
America\u2019s strong populist tradition and distrust of \u201cmonied interests\u201d has produced critics from Andrew Jackson to Donald Trump. Why should wealthy corporate executives and shareholders be rescued while the rest of the nation gets no relief from financial turmoil they create, they ask?<\/p>\n
\u201cLiquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate,\u201d Secretary of the Treasury Andrew Mellon is said to have told President Herbert Hoover\u2014according to Hoover, anyway\u2014after the Crash of 1929. \u201cIt will purge the rottenness out of the system.\u2026enterprising people will pick up the wrecks from less competent people.\u201d<\/p>\n
Bernanke won a Nobel Prize in Economics for his writing on the Great Depression\u2019s causes, and he blames the Fed of that time for worsening the pain by taking Mellon\u2019s advice and doing nothing to halt the nation\u2019s waves of bank runs. Faced with the 2007 subprime mortgage crisis, Bernanke wasn\u2019t going to repeat that mistake.<\/p>\n
By the time the crisis had passed, the Fed had helped engineer the rescues of Bear Stearns, \n Fannie Mae,<\/span><\/p>\n
Freddie Mac,<\/span><\/p>\n
AIG,<\/span> \n Merrill Lynch, and GMAC, among others, while providing liquidity across the financial spectrum. The bailouts were controversial; Bernanke had to defend the AIG bailout in federal court. The period, however, is remembered for the one he didn\u2019t save: Lehman Brothers.<\/p>\n
\u201cI can\u2019t do justice to this in an email,\u201d Bernanke told Barron\u2019s<\/em> in response to a request for comment, but he did suggest, for further reading, his 2022 book, 21st Century Monetary Policy: The Federal Reserve from the Great Inflation to Covid-19<\/em>. <\/p>\n
As the crisis unfolded, the Bernanke Fed immediately identified the importance of \u201ctoo big to fail\u201d concerns. \u201cBecause major financial firms are so interconnected, with wide webs of customers, creditors, and counterparties, we recognized early on that the uncontrolled failure of a large firm would magnify uncertainty and panic,\u201d he writes.<\/p>\n
This led the Fed to \u201cmediate\u201d the acquisition of investment bank Bear Stearns by \n JPMorgan Chase,<\/span> \n in Bernanke\u2019s words. It also drew a rebuke from 17 Republican congressmen, who cited the moral hazard of such rescues. Barron\u2019s<\/em> columnist Alan Ableson labeled Bernanke \u201cClueless Ben.\u201d<\/p>\n
Despite the criticism, the Fed continued to backstop systemically important companies. One it couldn\u2019t save was Lehman, \u201cwhose extreme risk-taking had exposed it to crippling losses,\u201d Bernanke wrote. With no larger bank willing to buy it, and unable to stand on its own, Lehman declared bankruptcy on Sept. 15, 2008.<\/p>\n
The response: more rescues, provided by the Troubled Asset Relief Program. Passed by Congress to support the financial industry, TARP was eventually used to bail out \n General Motors \n and Chrysler, stretching the meaning of \u201csystemically important.\u201d<\/p>\n
Bernanke, who was unanimously approved by the Senate for his first term at the Fed, was dismayed that his margin was just 70-30 for his second term, blaming it in part on \u201cdislike in both parties of the bailouts.\u201d<\/p>\n
This year, Silicon Valley Bank and two other midsize lenders were taken over due to worries of further contagion in the financial system. To critics, these banks were built on the high-tech bubble\u2014much of their deposits came from Silicon Valley start-ups\u2014and rescuing them simply rewards reckless risk-taking.<\/p>\n
\u201cFor the second time in 15 years,\u201d according to a Wall Street Journal editorial on March 13, \u201cregulators have encouraged a credit mania, and then failed to foresee the financial panic when the easy money stopped.\u201d<\/p>\n
The Journal added, \u201cThis is a de facto bailout of the banking system.\u201d <\/p>\n