trouble.
To someone whose only tool is a hammer, pretty soon everything begins to look like a nail. Greenspan cut rates 25 basis points on September 29, 1998. Two weeks later on October 15âbetween meetings!âhe cut another 25. A scheduled Fed meeting on November 17 brought yet another quarter-point cut. In seven weeks, âEasy Alâ lopped off 75 basis points from the federal funds rate.
The statement after the November cut was unusually telling: âAlthough conditions in financial markets have settled down materially since mid-October, unusual strains remain.â 6
Thus, the Greenspan put was born.
About the same time Easy Al was cutting rates that September, William J. McDonough, the president of the New York Federal Reserve Bank, was having a little get-together one Tuesday evening at the Fedâs fortresslike building on Maiden Lane. He called for a meeting of the patresfamilias âthe heads of the 16 largest banks, along with the New York Stock Exchange chairman. The discussion was over what to do about the imminent collapse of Long-Term Capital Management.
Roger Lowensteinâs narrative, When Genius Failed (Random House, 2000), is a fascinating read for anyone interested in the grisly details of LTCM. For our purposes, we need only note two facts:
1. The Fed was cutting rates.
2. The Fed was using its authority and prestige to help work out the demise of what was a private partnership.
The central bankers jawboned the 14 largest banksâwith the notable exception of future bailoutee Bear Stearnsâinto kicking in $3.65 billion to buy out the assets of LTCM. These included leveraged assets of over $100 billion and derivatives with a notional value of over $1 trillion.
The belief that LTCM had to be bailed out was widely held. It was 1987 redux, and the media accolades poured in. In the aftermath of the LTCM rescue, Time put Alan Greenspan, Robert Rubin, and Larry Summers on the cover as âThe committee to save the world.â 7
The chaos surrounding a liquidation of LTCM would cause the markets, in Chairman Greenspanâs words, to âseize up.â
But this raises uncomfortable regulatory questions. If this huge leveraged fund presented such systemic risk, then why werenât there regulations limiting the size and the leverage that hedge funds could use?
Note the ideological quandary this created for the chairman who believed markets could âself-regulate.â Either these funds are too dangerous to be allowed to exist without strict oversight and controls, or this was not a case of systemic risk. There can be no middle ground; he had to either change the rules or change his belief system.
Of course, thatâs not how Greenspan saw it. The failure of LTCM would have had a very negative impact on psychology. Woe to the Fed chair who allows traders to become morose! That was how Mr. Atlas Shrugged rationalized the intervention. (Thank goodness Ayn Rand was already dead.)
Whether that would have turned out to be true is a matter of much dispute. The evidence leads me to surmise that not only would LTCMâs demise not have caused the system to collapse, it would have done a world of good. Indeed, the best possible outcome would have been for LTCM to go belly-up and take a big bite out of the investment banks dumb enough to lend all that money to LTCM.
Consider what was at stake: First, LTCMâs portfolio had $100 billion in leveraged paper. But it was the leverage, not the paper, that was the issue. Everything LTCM owned wasnât Russian debt heading to zero; some of it had real value. The problem wasnât the quality of the assets; it was using $1 to buy $100 worth of paper. It doesnât take much spread widening to lose a substantial amount of capital when you are running that much leverage. As we will see in Part IV, that would have been a ripping good lesson for the investment banks to have learned.
What the banks actually learned was
To someone whose only tool is a hammer, pretty soon everything begins to look like a nail. Greenspan cut rates 25 basis points on September 29, 1998. Two weeks later on October 15âbetween meetings!âhe cut another 25. A scheduled Fed meeting on November 17 brought yet another quarter-point cut. In seven weeks, âEasy Alâ lopped off 75 basis points from the federal funds rate.
The statement after the November cut was unusually telling: âAlthough conditions in financial markets have settled down materially since mid-October, unusual strains remain.â 6
Thus, the Greenspan put was born.
About the same time Easy Al was cutting rates that September, William J. McDonough, the president of the New York Federal Reserve Bank, was having a little get-together one Tuesday evening at the Fedâs fortresslike building on Maiden Lane. He called for a meeting of the patresfamilias âthe heads of the 16 largest banks, along with the New York Stock Exchange chairman. The discussion was over what to do about the imminent collapse of Long-Term Capital Management.
Roger Lowensteinâs narrative, When Genius Failed (Random House, 2000), is a fascinating read for anyone interested in the grisly details of LTCM. For our purposes, we need only note two facts:
1. The Fed was cutting rates.
2. The Fed was using its authority and prestige to help work out the demise of what was a private partnership.
The central bankers jawboned the 14 largest banksâwith the notable exception of future bailoutee Bear Stearnsâinto kicking in $3.65 billion to buy out the assets of LTCM. These included leveraged assets of over $100 billion and derivatives with a notional value of over $1 trillion.
The belief that LTCM had to be bailed out was widely held. It was 1987 redux, and the media accolades poured in. In the aftermath of the LTCM rescue, Time put Alan Greenspan, Robert Rubin, and Larry Summers on the cover as âThe committee to save the world.â 7
The chaos surrounding a liquidation of LTCM would cause the markets, in Chairman Greenspanâs words, to âseize up.â
But this raises uncomfortable regulatory questions. If this huge leveraged fund presented such systemic risk, then why werenât there regulations limiting the size and the leverage that hedge funds could use?
Note the ideological quandary this created for the chairman who believed markets could âself-regulate.â Either these funds are too dangerous to be allowed to exist without strict oversight and controls, or this was not a case of systemic risk. There can be no middle ground; he had to either change the rules or change his belief system.
Of course, thatâs not how Greenspan saw it. The failure of LTCM would have had a very negative impact on psychology. Woe to the Fed chair who allows traders to become morose! That was how Mr. Atlas Shrugged rationalized the intervention. (Thank goodness Ayn Rand was already dead.)
Whether that would have turned out to be true is a matter of much dispute. The evidence leads me to surmise that not only would LTCMâs demise not have caused the system to collapse, it would have done a world of good. Indeed, the best possible outcome would have been for LTCM to go belly-up and take a big bite out of the investment banks dumb enough to lend all that money to LTCM.
Consider what was at stake: First, LTCMâs portfolio had $100 billion in leveraged paper. But it was the leverage, not the paper, that was the issue. Everything LTCM owned wasnât Russian debt heading to zero; some of it had real value. The problem wasnât the quality of the assets; it was using $1 to buy $100 worth of paper. It doesnât take much spread widening to lose a substantial amount of capital when you are running that much leverage. As we will see in Part IV, that would have been a ripping good lesson for the investment banks to have learned.
What the banks actually learned was
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