Where Did All The Money Go?
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The story of
Long Term Capital Management (LTCM) has been
told by
Roger Lowenstein in his captivating book
When Genius Failed, but for those who have not
had a chance to read this book I will, with a bit of elaboration, summarize
it here.
LTCM was a hedge fund started in 1994 by
John Meriwether, a legendary trader who made a
fortune for himself and
Solomon Brothers in the 1980s. (NYT)
The fund was a limited partnership where the senior partners were Meriwether
along with
Myron Scholes and
Robert Merton, both of whom were to receive
the Nobel Prize in Economics in 1997;
David Mullins, a former vice chairman of the
Board of Governors of the Federal Reserve;
Eric Rosenfeld, a former professor at the
Harvard Business School;
Greg Hawkins, a campaign manager for Bill
Clinton in the 1980s;
Victor Haghani, a former managing director at
Solomon Brothers;
William Kasker, a former professor at the
Harvard Business School; and
Larry Hilibrand along with a number of other
former traders from Solomon Brothers.
This was a group of financial rock stars that claimed six Ph.D.s from
MIT among their ranks and another from the
University of Chicago. Wall Street was awed by their intellectual prowess
and the depth of their financial expertise. They were the Dream Team of Wall
Street when they began LTCM in 1994, but the saga of LTCM lasted only four
years and ended as just another study in how the best and the brightest can
lose their way.
The partners raised capital by investing $50 million of their own money and
soliciting an additional $1.25 billion from a group of investors for a total
of $1.3 billion in equity capital—at the time, the largest amount ever
raised by a startup company. Over time, they managed to borrow over $125
billion in the money market, mostly through six month repurchase agreements.
(Rosenfeld)
This gave LTCM an investment portfolio of over $130 billion. During the
first three years of its existence the success of LTCM was spectacular. For
the first two years the partners earned a 40% rate of return on their equity
and in 1997 they earned 27%. By the end of 1997 LTCM’s equity had grown to
$7 billion, and the partners decided to pay back $2.7 billion of LTCM’s
capital to its investors so the partners could increase their returns. This
brought its equity capital down to $4.3 billion.
In April 1998 LTCM's fortunes turned. By August 16, LTCM had lost $800
million, and their equity had fallen to $3.5 billion. Then on August 17,
Russia devalued its currency and defaulted on its treasury's debt. The
Russian default panicked investors all over the world and led to a
flight to quality, which means investors
attempted to abandon more risky assets (such as speculative stocks and
bonds) and purchase less risky assets (such as cash and Treasury
securities). This led to turmoil in the world's financial markets as the
prices of the assets investors wanted to sell fell. These were the very
asset held by LTCM. The following Monday, LTCM lost $553 million in the
markets, and their equity shrank to $2.9 billion. They continued to lose
money through the end of the month as the Dow dropped 357 points on August
27 and then fell an additional 512 points as the market crashed on August
31.
By the beginning of September, LTCM'S equity had fallen to $2.28 billion—a
staggering 44% loss during the month of August and a 52% loss from the
beginning of the year. LTCM was rapidly approaching insolvency. What's
worse, LTCM was having liquidity problems as well. Even though most of its
financing was by way of relatively long-term six month repurchase
agreements, it still had to roll over one-sixth of this financing each
month. This was becoming more difficult. Creditors were demanding more
favorable terms, and when on September 10 LTCM's clearing fund at Bear
Sterns briefly dropped below its contractual minimum, Bear insisted that
LTCM's partners open their books to reassure Bear that they would be able to
meet their obligations in the future.
LTCM had always been a secretive company. Its partners had never opened its
books to anyone, not even to its investors or its largest creditors. Now the
partners had no choice. If LTCM defaulted on a single payment all of its
loans would come due. They would be out of business instantly if Bear
refused to clear their trades. It would then be forced into bankruptcy as
its creditors scrambled to seize their collateral. In addition, by September
10, LTCM's equity had fallen below $2 billion, and it was clear that to
avoid insolvency it would have to raise capital either through investors or
by taking in new partners. The partners estimated they would have to raise
at least $2 billion in additional capital to survive. There was no way they
could raise that kind of money without opening their books to someone. After
attempting to raise the funds from a number of individuals such as Warren
Buffet, George Soros, Michael Dell, and a Saudi prince, LTCM contacted
Goldman Sachs to assist with fundraising and—in the strictest of confidence,
of course—on Monday, September 14 opened its books to Goldman Sachs.
As LTCM opened its books and the news of the tenuous nature of its solvency
spread around Wall Street, LTCM's situation worsened. On Monday, September
14, the day LTCM opened its books to Goldman Sachs, LTCM lost $55 million.
On Tuesday, $87 million more, and then on Wednesday, September 16, it lost
an additional $122 million for a total of $264 million. That was fifteen
percent of its capital lost in just three days!
The problem was that LTCM was a behemoth—four times the size of the next
largest hedge fund. (GAO)
It was obvious that if LTCM were driven into bankruptcy its assets would
have to be liquidated. Since LTCM was so large, liquidating its assets would
cause the prices of its assets to fall. Anyone who owned the same assets as
LTCM would lose money if they still owned them in the event LTCM went under.
This provided a powerful incentive for other institutions to sell their
holdings of these assets before LTCM was forced to sell its holdings. Even
worse, it was also obvious it would be possible to profit from LTCM's demise
by trading against it, that is, by taking positions in the market that would
make money if LTCM was forced to liquidate its portfolio. Both of these
activities caused the prices of LTCM's assets to fall even faster than they
otherwise would have. As a result, no one wanted to invest in, or be in debt
to LTCM, and just about everyone who could was trying to make money from its
demise.
By September 16 the partners’ equity had fallen to $1.5 billion, and the
situation was becoming desperate. The partners estimated it would now take
$4 billion in additional capital to save the company—twice what they thought
it would take just three days before. At that point LTCM’s partners decided
it would be best to brief the Federal Reserve on their situation. A call was
made and a meeting was set for following Sunday, September 20.
LTCM was not the only institution losing money during this period that found
itself in serious financial difficulties. Most of the other hedge funds lost
money as well, and many folded. Investment banks, which by then were making
money from the same kinds of investment strategies as LTCM, had financial
problems as did commercial banks and bank holding companies, but none of
these other institutions had LTCM's problems. Commercial banks had deposit
insurance to protect them from a run and access to the lending facilities of
the Federal Reserve to provide them with cash. Investment banks had sources
of income other than their investment portfolios that were sufficient to
tide them through. LTCM was not a bank; it had no insured source of funds
and could not borrow from the Fed. The only source of funds available to it
was its investment portfolio and the money market. (PWG)
But what made LTCM unique was the size of its portfolio.
LTCM's portfolio was well over $100 billion on September 20, 1998, and the
nominal value of the 60 thousand
derivative contracts it had entered into was
well over $1.5 trillion! (GAO)
This amounted to around five percent of the entire world market. In
addition, LTCM financed most of its $100 billion in assets with over 40
thousand repurchase agreements. To make things worse, LTCM's investments and
derivative commitments—and the counterparties on the other side of these
contracts—were in markets all over the world: in Great Britain, Denmark,
Sweden, Switzerland, Germany, France, Italy, Spain, the Netherlands,
Belgium, and Russia; in New Zealand, Hong Kong, China, Taiwan, Thailand,
Malaysia, and the Philippines; and in Brazil, Argentina, Mexico, and
Venezuela.
It was clear that if LTCM were to fail it would seriously disrupt financial
markets all over the world. Not only did LTCM's seventeen largest
creditors—banks such as Merrill Lynch, Morgan Stanley Dean Witter, Goldman
Sachs, Salomon Smith Barney—stand to lose as much as $5 billion directly if
LTCM were forced into bankruptcy, if LTCM was forced to liquidate its
portfolio its collateralized creditors would be forced to claim and sell
their collateral, and LTCM’s derivative counterparties would be forced to
scrambled to protect themselves from the vulnerable positions they found
themselves in as a result of LTCM's holdings of over a trillion dollars
worth of derivatives. This kind of chaos in the financial market could
potentially cause asset prices to spiral downward all over the world and
where and when they would stop no one could know. It was feared that such an
event would cause a worldwide recession and that something had to be done to
keep this from happening. The question was what?
It was not at all clear that anything could be done to save LTCM. Investors
and speculators all over the world were trading against LTCM making the
situation worse by the day, and given its liquidity problem and the rate at
which it was losing equity, it was unlikely LTCM could remain solvent for
another week or liquid enough to avoid defaulting on one of its obligations
and being driven into bankruptcy. It would be impossible to find outside
investors willing to invest $4 billion under these circumstances. At the
same time LTCM's portfolio was so large and so complicated that any attempt
to liquidate it in an orderly way would cause a panic. The only option that
seemed even remotely feasible was to get LTCM's major creditors together to
see if they could find a way to raise the $4 billion in capital necessary to
save LTCM, but there was no guarantee that LTCM’s creditors would be willing
to do this.
Even though LTCM's major creditors, mostly large Wall Street banks, had the
most to lose, at least directly, if LTCM went bankrupt, it was not at all
likely they would be willing to put up the $4 billion in capital necessary
to keep LTCM afloat. After all, that would be throwing good money after bad,
and that's not how Wall Street bankers got to be Wall Street bankers. Their
basic instinct would be to force LTCM into bankruptcy and feed on its
carcass. Nevertheless, by Tuesday, September 22, the situation seemed
desperate enough to make this straw worth grasping. LTCM had lost $553
million on Monday—an amount equal to its entire loss for the month of
August—and by the end of the trading day on Tuesday it had lost $152 million
more. Its equity capital now stood at $773 million. Given the
circumstances, it was felt that at least an effort should be made to see if
LTCM's creditors would bail it out, and an emergency meeting of LTCM's 16
largest creditors was scheduled for 8:00 that evening to take place at the
Federal Reserve Bank in New York City.
A
plan was presented at the meeting by which a consortium of the 16 banks
present would attempt to save LTCM by investing $250 million each in order
to raise the $4 billion needed to end the run on LTCM. Everyone agreed that
the situation was serious, but there was little agreement on anything else.
Some wanted to just let LTCM go down and take their chances, but no one
could be certain the collapse of LTCM wouldn't take them down with it, and
most were terrified by the prospect. By 11:00 only four banks were willing
to commit to joining the consortium, and the meeting was adjourned until
10:00 the following morning.
On Wednesday morning the gathering was increased to include the president of
the New York Stock Exchange and the executives of five British, Swiss, and
French banks. In addition, the representatives of a German bank attended by
way of a speakerphone. The meeting was at times acrimonious, and at a number
of points the negotiations nearly collapsed. By the end of the trading day
LTCM had lost another $218 million and its equity capital had fallen to $555
million. Gradually the bankers began to realize that this was the last
chance they would have to deal with this problem, and an agreement on the
terms of a takeover began to emerge. In the end it was agreed that a
consortium of 14 banks would invest $3.65 billion in LTCM in exchange for 90
percent of the firm's equity. The partners would retain 10 percent of the
equity and would run the firm under the supervision of the consortium. At
5:15 a phone call was placed to the partners to see if they would agree to
these terms with the details to be worked out before the deal was to close
on Monday, September 28. The partners agreed, and shortly after 7:00 the
agreement was announced to the press.
While an agreement had been reached in principle, there was no agreement
where the devil lies—the details had yet to be worked out. On Friday, 70
lawyers representing the 14 members of the consortium converged on Merrill
Lynch to write the terms of the contract on a deal that had to be closed in
three days—the kind of deal that usually took months. In spite of the
pandemonium, after a marathon session they came up with a draft. In the
meantime, LTCM lost another $155 million on Friday as its equity capital
fell to $400 million.
When the partners read the draft early Saturday morning, they were furious.
As far as they were concerned there was nothing in it for them. Later that
morning the partners met at a prestigious Midtown law firm to negotiate with
the consortium to finalize the contract, and another marathon session
began—this time 140 lawyers showed up to argue on behalf of their clients.
Throughout Saturday and Sunday the negotiations continued.
Ironically, even if a contract acceptable to all parties were obtained,
there was no guarantee it would be put into effect. One of the conditions
insisted on by the consortium was that all of LTCM's creditors sign a waiver
relinquishing their right to immediate repayment of their loans to LTCM.
Republic Bank, Nomura Securities, Credit Lyonnais, and Italy's foreign
exchange office refused to sign. It wasn't until 5:30 on Monday afternoon
that the problem of the holdouts was solved, all of the waivers that were
coming in were in, and all of the disputes among the principals were
resolved so that the deal to take over LTCM for $3.65 billion by the
consortium of 14 banks could be closed.
In the meantime, LTCM had another bad day. By the time the deal was closed
its capital had fallen to $340 million. It lost an additional $750 million
through the first half of October, then the markets rebounded, and by the
end of October LTCM had stabilized. Within a year the fund was able to pay
back the consortium, and by the end of 2000 LTCM had been systematically
liquidated without any of the dire financial and economic consequences that
were feared if LTCM had been forced into bankruptcy.
How could the financial geniuses of LTCM bring the financial world to the
brink of collapse? The answer is as old as finance itself. As with poorly
managed banks throughout the history of finance, LTCM's partners over
extended themselves by borrowing more than their equity capital could
support in a crisis. When times were prosperous they managed to
leverage their equity as much as 30 to 1. In so
doing they took the risk that a financial crisis could wipe them out, but
they thought that was extremely unlikely and, at the same time, for the
first three years they made a fabulous amount of money. When the crisis came
and their creditors became nervous—just as in the unregulated banking world
of the nineteenth century—there was no way they could sell off their
long-term assets and remain solvent as their short-term creditors refused to
renew their loans. They were caught in a modern-day bank run in a nineteenth
century financial environment, and there was nothing they could do to save
themselves. Even the fact that they had borrowed for a relatively long time
period, using six month repurchase agreements, was not enough to save them.
As a result, the Fed was forced to orchestrate a takeover by a consortium of
banks to head off a financial meltdown that threatened a worldwide economic
catastrophe in its wake.
And it is worth emphasizing here that the geniuses at LTCM did not create a
financial crisis that nearly caused a meltdown of the entire world's
financial system because they were dumb. They knew the limitations of their
models; they knew that some unpredictable event could cause an economic
catastrophe that could drive them into bankruptcy. They didn't think it
would happen, but they knew it could happen. They leveraged their equity in
a way that ultimately led to their downfall in spite of the risk they knew
they were taking for one very simple reason: There is no other way they
could have made the enormous amount of money they were able to make in the
first three years of their existence without leveraging their equity in this
way. In other words, they took a chance that threatened the financial
system of the entire world because they thought it was worth it for
them to take that risk. What it would mean for the rest of the world
if they failed disastrously never entered their minds, at least not until
the very end when it was too late to do anything about it except to look to
the government to find a way to clean up the mess they had created. What's
more, there is no reason for them to have thought about what would happen to
the rest of the world if they failed disastrously. No one ever got rich
thinking about that sort of thing. That sort of thing is left to
philosophers and is beyond the purview of free-market capitalists.
It is also important to emphasize a second reason why the partners at LTCM
leveraged their capital the way they did: They leveraged their capital 30 to
1 because they could. There was no one there to stop them from doing
what they thought was best for them—not the government and not their
creditors—irrespective of the danger their actions posed for the rest of the
world. The financial markets they operated in were unregulated. There was no
law or regulation to prevent them from doing what they did, and the
regulators at the time had a
Panglossian faith in the efficacy of free
markets to create the best of all possible economic worlds. As for their
creditors, they just wanted a piece of the action. They made fortunes of
their own doing business with LTCM during the good times, and they too
thought it was worth it to take the risks they were taking when they lent to
LTCM at ridiculously low margins.
Contrary to the
propaganda of the
Conservative Movement, there is no reason to
believe unregulated free markets must work to the advantage of
society as a whole if people are allowed to seek their own advantage in the
marketplace or even that they will work in this way. There are
innumerable ways in which markets can fail to accomplish this end, and this is particularly so when it comes
to financial markets. It has been demonstrated time and again that if the
participants in these markets see an opportunity to make a personal fortune
by leveraging themselves to the hilt and are given the opportunity to do so,
they will do so. It has also been demonstrated time and again that when they
are allowed to do this during prosperous times the financial system
inevitably gets overextended, and sooner or later a crisis develops that
threatens the economic system as a whole. (Fisher
Keynes
Polanyi
Kindleberger
Minsky
Phillips
Morris
Dowd
Reinhart
Johnson
Skidelsky
Kindleberger
Kennedy
MacKay
Graeber
Galbraith
White) The problem is that when the great men
of finance overextend themselves it is not only their own economic fortunes
they put at risk. It is the entire economic system they put at risk along
with the wellbeing of all of the people who depend on the smooth functioning
of that system for their survival.
No one, but no one, should be allowed to put the economic system at
risk for their own personal gain, and most certainly not in the name of
Free-Market Capitalism or any other
ideological abstraction. That was the lesson learned by the generation that
lived through the Great Depression of the 1930s when they took on the free
marketeers and created the comprehensive system of financial regulation that
served us so well until we began to dismantle it in the 1970s. It is the
lesson that should have been reinforced in the minds of the generation that
witnessed the
Savings and Loan Crisis of the 1980s which in
addition to threatening the stability of the economic system cost the
American taxpayer $130 billion. And it is also the lesson that should have
been reinforced in the wake of the LTCM crisis which seriously threatened
the entire world economy. Unfortunately, that is not how things turned out.
In response to the LTCM crisis, the
President's Working Group on Financial Markets
was tasked with examining the circumstances surrounding the LTCM crisis.
This working group was created by an executive order of
Ronald Reagan ten years earlier on March 18,
1988. It is made up of the Secretary of the Treasury and the chairpersons of
the
Board of Governors of the Federal Reserve, the
Securities and Exchange Commission (SEC), and the
Commodity Futures Trading Commission (CFTC).
The individuals who held these posts in 1998 were
Robert Rubin,
Alan Greenspan,
Arthur Levitt, and
Brooksley Born, respectively. The Working Group's report—Hedge
Funds, Leverage, and the Lessons of Long-term Capital Management—was
submitted to Congress on April 28, 1999.
It is clear from their report that the working group understood most of the
factors that entered into the collapse of LTCM and that these factors posed
a threat to the system as a whole. They understood that "excessive leverage
in the financial system" was a serious problem and "that excessive leverage
can greatly magnify the negative effects of any event or series of events on
the financial system as a whole." They saw that in the face of excessive
leverage "problems at one financial institution could be transmitted to
other institutions, and potentially pose risks to the financial system." (PWG)
They also saw that the problem was not limited to
hedge funds, but that other "financial institutions, including some banks
and securities firms, are larger, and generally more highly leveraged, than
hedge funds" and, consequently, posed the same problem posed by LTCM. In
support of this they noted that at the end of 1998 LTCM's leverage ratio
stood at 28 to 1 while "the five largest investment banks' average
leverage ratio was 27 to 1.” (Emphasis added.) The working group
also seemed to be aware of the way in which "[h]edge funds obtain economic
leverage . . . through the use of . . . derivative contracts" and that this
kind of “economic leverage” can create systemic risk in the same way that
balance sheet leverage (debt to equity ratio) can cause systemic risk. They
saw all of this, and, yet, given the ideological blindness of all but one
member of this group,
Brooksley Born, it was impossible for this
group to recommend that hedge funds and the rest of the
shadow banking system be brought under the
regulatory umbrella of the federal government.
The struggle between the convictions of the Working Group's conservative
members regarding the efficacy of markets and the reality of the LTCM
crisis—a reality that was undoubtedly pointed out to them at every turn by
Brooksley Born—is evident in the compromise
embodied in the recommendations put forth in the Working Group's report:
Market history indicates that even painful lessons
recede from memory with time. Some of the risks of excessive leverage and
risk taking can threaten the market as a whole, and even market participants
not directly involved in imprudently extending credit can be affected.
Therefore, the Working Group sees the need for the
following measures:
1. more frequent and meaningful information on
hedge funds should be made public;
2. public companies, including financial
institutions, should publicly disclose additional information about their
material financial exposures to significantly leveraged institutions,
including hedge funds;
3. financial institutions should enhance their
practices for counterparty risk management;
4. regulators should encourage improvements in the
risk management systems of regulated entities;
5. regulators should promote the development of
more risk-sensitive but prudent approaches to capital adequacy;
6. regulators need expanded risk assessment
authority for the unregulated affiliates of broker-dealers and futures
commission merchants;19
7. the Congress should enact the provisions
proposed by the President’s Working Group to support financial contract
netting in the United States; and
8. regulators should consider
stronger incentives to encourage off-shore centers to comply with
international standards. (PWG)
It would appear from this set of recommendations that instead of looking at
the real problem—namely, that the shadow banking system had been allowed to
come into being in such a way that it was outside the regulatory system put
in place to prevent financial crises—the Conservative members of this group
were looking at the details of the LTCM crisis and attempting to find causes
for this crisis that could be fixed without having to regulate the shadow
banks. Judging from the recommendations listed above, they came up with
four:
1.
Decision makers did not have enough information to make an accurate
assessment as to the degree of risk associated with lending to LTCM. Hence,
recommendations 1 and 2 calling for more frequent and detailed information
from hedge funds and exposure to hedge funds be made public.
2.
Risk management was inadequate on the part of LTCM and its
counterparties leading up to the crisis. Hence, recommendation 3, 4, and 5
that institutions and regulators enhance, encourage, and promote better
risk-sensitive approaches to capital adequacy.
3.
The bankruptcy laws were inadequate to deal with repurchase
agreements and derivative contracts making it very difficult to efficiently
liquidate a company such as LTCM in the event of bankruptcy. Hence,
recommendation 7 to provide for
contract netting in the United States.
4.
The lax regulatory standards in off-shore centers encouraged American
companies to register in these centers to avoid the American regulatory
system. Hence, recommendation 8 that regulators consider stronger measures
to encourage these centers to comply with international standards.
The only recommendation in this report that related directly to the shadow
banking system are numbers 1 and 6 which would require that more information
be made available on hedge funds and that expand the risk assessment
authority of the SEC and CFTC to the unregulated affiliates of regulated
institutions for the purposes of examining their operations. If broadly
interpreted, this would give the SEC and CFTC the authority over virtually
all the shadow banks for the purpose of examining their operations though
not the power to regulate them. This recommendation was undoubtedly insisted
on by
Chairperson Born of the CFTC in accordance
with a much stronger recommendation put forth by the CFTC a few months
earlier in a
concept release that had been blocked at the
time by the conservative members of the Working Group. (Frontline)
Footnote 19 at the end of recommendation 6
emphasized Greenspan's objection to this recommendation for the record:
On the issue of expanding risk assessment for the
unregulated affiliates of broker-dealers and FCMs, Chairman Greenspan of the
Federal Reserve Board declines to endorse the recommendation but, in this
instance, defers to the judgment of those with supervisory responsibility.
While the Working Group did not recommend bringing the shadow banking system
under the umbrella of federal regulation they did state:
Although the Working Group is not making
additional recommendations at this time, if further evidence emerges that
indirect regulation of currently unregulated market participants is not
working effectively to constrain leverage, there are several matters that
could be given further consideration to address concerns about leverage.
The "matters that could be given further consideration" included:
1. Consolidated supervision of broker-dealers and their
currently unregulated affiliates, including enterprise-wide capital
standards. . . .
2. Direct regulation of hedge funds. . . .
3. Direct regulation of derivatives dealers
unaffiliated with a federally regulated entity.
In struggling to find a way to not regulate the shadow banks, the
conservative members of the Working Group had to explain why their faith in
the efficacy of free markets to provide the discipline necessary to avoid
serious financial crises was justified. At the same time they had to explain
why the financial crisis caused by LTCM was so serious that the Federal
Reserve was forced to intervene to resolve the situation. This was not an
easy task. In searching for a way out of this conundrum they found that the
traders in the market didn't behave in the way they were supposed to behave
in that they made mistakes, did not have enough information to make informed
decisions, and their risk management was inadequate. They also found the
bankruptcy laws were inadequate to allow for a timely resolution of LTCM
through bankruptcy and that off-shore centers were not living up to
international standards.
In other words, it wasn't the market that failed. It was the actors in
the market that failed. The traders in the market weren’t behaving the
way they were supposed to behave when it came to managing risk. The
government hadn't provided adequate bankruptcy laws, and those pesky
off-shore centers were mucking up the works. Thus, to keep this sort of
thing from happening again the Working Group recommended the traders in
markets be educated as to how they were supposed to manage risk and that
they be provided with enough information to enable them to manage risk
properly. It then recommended the bankruptcy laws be changed and something
be done about the off-shore centers. And just to drive the point home they
noted that if the actors didn't clean up their act the Working Group would
“consider” direct regulation sometime in the future. This is bizarre! You
would think they were dealing with children who got caught with their hands
in a cookie jar.
The actors in the LTCM drama made over $5 million a day as they rode
roughshod over the world's financial system and threatened the economic
stability of the entire world. LTCM's counterparties made fortunes in their
dealings with LTCM as well. Who in their right mind could possibly believe
that information, education, fixing the bankruptcy laws, and threatening to
“consider” regulation in the future if the financial community doesn't
behave are the kinds of things that would have stopped LTCM's partners and
their counterparties from doing what they had done or would somehow keep
others from doing the same thing in the future?
The
General Accounting Office (GAO) was also
tasked with examining the circumstances surrounding the LTCM crisis. Unlike
the President's Working Group, which is made up of political appointees, the
GAO (which was subsequently renamed the
U.S. Government Accountability Office in 2004)
is an independent, nonpartisan agency within the federal government. The
president of the GAO is the
Comptroller General of the United States and
is appointed for a 15 year term by the president from a list of candidates
proposed by Congress. It was created 1921, and its mission statement is as
follows:
Our Mission is to
support the Congress in meeting its constitutional responsibilities and to
help improve the performance and ensure the accountability of the federal
government for the benefit of the American people. We provide Congress with
timely information that is objective, fact-based, nonpartisan,
nonideological, fair, and balanced.
The professionals at the GAO were not hindered by ideological blinders when
they took a look at the LTCM crisis. Their report entitled
LONG-TERM CAPITAL MANAGEMENT Regulators Need to Focus Greater Attention on
Systemic Risk was released in October 1999 and
went right to the core of the matter. After observing that:
1. The LTCM case illustrated that market
discipline can break down and showed that potential systemic risk can be
posed not only by a cascade of major firm failures, but also by leveraged
trading positions. . . .
2. [A]s shown by the inability of regulators to
identify the extent of firms’ activities with LTCM, the traditional focus of
oversight on credit exposures is not sufficient to monitor the provision of
leverage to trading counterparties. . . .
3. Changes in markets that have blurred the
traditional lines of market participants’ activities will continue to create
risks that cross institutions and markets, thus making the need for
effective coordination even more critical.
4. Gaps in SEC’s and CFTC’s regulatory authority
impede their ability to observe and assess activities in securities and
futures firms’ affiliates that might give rise to systemic risk. . . . [I]mprovements
in examination focus and in information gathered may give bank regulators a
better opportunity to identify future problems that might pose systemic
risk. Without similar authority over the consolidated activities of
securities and futures firms, SEC and CFTC cannot contribute effectively to
regulatory oversight of potential systemic risk, because a large and growing
proportion of those firms’ risk taking is in their unregulated affiliates.
5. The President’s Working Group has recommended
granting new authority for SEC and CFTC over the affiliates. However, the
new authority would not grant capital-setting or enforcement authority and
would not involve the type of examination of their risk activities and
management that would allow a thorough assessment of potential systemic
risk. . . .
The GAO then made two succinct and to the point recommendations:
1. We recommend that the Secretary of the Treasury
and the Chairmen of the Federal Reserve, SEC, and CFTC, in conjunction with
other relevant financial regulators, develop better ways to coordinate the
assessment of risks that cross traditional regulatory and industry
boundaries.
2. In an effort to identify and prevent potential
future crises, Congress should consider providing SEC and CFTC with the
authority to regulate the activities of securities and futures firms’
affiliates similar to that provided the Federal Reserve with respect to bank
holding companies. If this authority is provided, it should generally
include the authority to examine, set capital standards, and take
enforcement actions. . . .
The GAO not only supported the position
Brooksley Born had put forth in the original
CFTC
concept release, it had gone far beyond it in arguing that “Congress
should consider providing SEC and CFTC with the
authority to regulate the activities of securities and futures firms’
affiliates” and this authority should “include the authority to examine, set
capital standards, and take enforcement actions,” though, in tune with the
ideological temperament of the times, the GAO only recommended that “Congress
should consider” taking these actions rather than that Congress should
actually take these actions. In any event, given
the ideological proclivities of the Republican Congress and Clinton
administration, there was little hope that legislative action would be taken
on any of the GAO's recommendations.
Instead of the increased regulation of the financial system called for in
the
GAO's October 1999 report, within a month of
that report Congress passed the
Financial Services Modernization Act (FSMA)
on November 4, 1999 which was signed into law by President Clinton on
November 12. As has been noted, this act further deregulated the financial
system by repealing those portions of the
Glass-Steagall Act of 1933 that prevented
commercial bank holding companies from becoming conglomerates that are able
to provide both
commercial and
investment banking services as well as
insurance and brokerage services.
By the end of the year it was clear that
Brooksley Born was not going to be reappointed
as chairperson of the CFTC, and she was effectively driven from office on
January 19, 2000. (Frontline)
That same year Congress passed the
Commodity Futures Modernization Act (CFMA) on
December 14, 2000 which Clinton signed into law on December 21. This act
explicitly prevented both the CFTC and state gambling regulators from
regulating the derivatives markets which
Brooksley Born had fought so valiantly to
bring within the regulatory fold.
When on December 12, 2000 the Republican dominated Supreme Court appointed
George W. Bush President of the United States it meant that on January 21,
2001 the Republican Party—with its ideologically inspired mantra of lower
taxes, less government, and deregulated markets along with
its disdain for government—would gain control
of all three branches of the American government for the first time since
1954. At this point there was no hope of curbing the era of deregulated
finance that began in the Nixon administration with the abandonment of the
Bretton Woods Agreement and was honed to
perfection during the Clinton years.
If truth be told, it probably would not have mattered who won the 2000
election. Even if a Democrat had been elected to the presidency, Republicans
still would have controlled Congress. And even if the Democrats had been
able to take over Congress as well as the presidency there is no reason to
believe it would have made a difference. While a majority of the Senate
Democrats opposed
FSMA and probably would have opposed
CFMA if there had been a separate vote on this
bill rather than having been included in an omnibus emergency appropriations
bill, 75% of the House Democrats voted for
FSMA. At the same time, the Republicans were
virtually unanimous in their support of these two bills, and a Democratic
president signed them into law. (House
Senate)
Thus, even if the Democrats had taken over both Congress and the presidency
in 2000 we would have been in the same position we were in during the first
two years of the Obama administration where the united opposition of the
Republicans joined by a number of "moderate" Democrats would have been able
to stop any attempt to repeal FSMA and CFMA or to pass legislation that
would regulate the shadow banking system and the markets for derivatives.
And given
the shift of the leadership of the Democratic Party
during the 1990s toward the belief in the magical powers of deregulation,
there is no reason to believe the changes in regulatory rules (discussed in
Chapter 10) that followed the 2000 election could have been avoided if the
Democrats had won the presidency and taken control of Congress in 2000
rather than the Republicans.
Given the ideological
temperament of the times, it would have taken
a miracle to avoid the economic train wreck that was about to take place.
This book is available in Kindle and paperback format at Amazon.com for a
nominal contribution to this website.
Where Did All The Money Go?
How Lower Taxes, Less Government, and Deregulation Redistribute Income and
Create Economic Instability
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Endnotes
The 14 banks that took control of LTCM were:
Chase Manhattan Corporation; Goldman Sachs; Merrill Lynch; J.P. Morgan;
Morgan Stanley Dean Witter; Salomon Smith Barney; Credit Suisse First
Boston Company; Barclays; Deutsche Bank; UBS; Bankers Trust Corporation;
Société Generale; Paribas; and Lehman Brothers. (GAO)
See,
for example,
Smith,
MacKay,
George,
Marx,
Veblen,
Sinclair,
Roosevelt,
Haywood,
Jones,
Fisher,
Josephson,
Keynes,
Polanyi,
Schumpeter,
Boyer,
Galbraith,
Musgrave,
Harrington,
Carson,
Nader,
Domhoff,
Kindleberger,
Cody,
Minsky,
Stewart,
Black,
Zinn,
Stiglitz,
Phillips,
Kuttner,
Morris,
Taleb,
Bogle,
Harvey,
Dowd,
Galbraith,
Baker,
Stiglitz,
Klein,
Reinhart,
Fox,
Johnson,
Amy,
Sachs,
Smith,
Eichengreen,
Rodrik,
Skidelsky,
Graeber,
Kleinbard, and
Mian.
There
can be no doubt that, PWG report or no PWG
report, if the founders of LTCM had the option of starting up another
LTCM and doing it all over again they would start up another LTCM and do
it all over again. Not only would they do it all over again, they did.
On October 22, 2009 the
Financial Times reported that John
Meriwether had embarked on his third hedge fund (JM
Advisors Management) after his second
fund (JWM
Partners which he began less than two
years after the LTCM debacle) went bust in the 2008 financial crisis.
And the world is full of John Meriwethers.