that the Fed (and by extension, Uncle Sam) would be there to back them up when they ran into trouble. This is precisely what moral hazard argues against: Encouraging risk-taking to become separated from its consequences.
The other issue was the trillion dollars in derivatives. How did an unregulated, three-year-old, heavily leveraged partnership manage to have so much in âinsuranceâ entrusted to it by counterparties? The only answer I can deduce is that the number of idiots on the planet is greater by several orders of magnitude than previously believed. If you have been paying any attention, that many of them work in finance should come as no surprise.
This was yet another lesson sorely not learned.
What would have happened had this notional amount of derivative paper become worthless? Short answer: not a whole lot.
The loss would have been the premiums paid to LTCM, not the trillion-dollar notional value. If your car insurance company disappeared tomorrow, you wouldnât lose the value of your vehicleâonly the premium payments you made. This is why itâs advisable to do business with firms such as the Government Employees Insurance Company (GEICO) or Allstate, and not Billy Bobâs Bait Shop & Auto Insurance Co.
The penalty for getting into bed with a counterparty that was young, untested, highly leveraged, and reckless should have been expensive. Instead, it was a minor inconvenience. It was yet another lesson not learned from LTCM, and contributed mightily to moral hazard. Future repercussions would be severe.
Had LTCM been allowed to fail naturally, perhaps a lesson might have been learned: Risk and reward are sides of the same coin. Alas, it was a missed opportunity for the traders and risk managers at major banks and brokers to learn this simple truism. The parallels between what doomed LTCM in 1998 and forced Wall Street to run to Washington for a handout in 2008 are all there, and the significance of these missed opportunities is now readily apparent.
In sum, Long-Term Capital Management was the dress rehearsal for the great credit crisis of 2008âand a missed opportunity to prevent the ongoing tragedy.
Chapter 7
The Tech Wreck (2000-2003)
I would not only reappoint Mr. Greenspanâif Mr. Greenspan should happen to die, God forbid . . . Iâd prop him up and put a pair of dark glasses on him and keep him as long as we could.
âJohn McCain, GOP debate, 2000
Â
Â
U p until now, Alan Greenspan had merely been dabbling. Yes, his frequent interventions in markets were worrisome, unprecedented by historical Federal Reserve standards. But as we shall see, they were merely a warm-up for what was to yet come.
In July 1998, the NASDAQ Composite had just cleared the 2,000 mark for the first time. At the time, the tech-heavy index was dominated by active traders, ranging from big momentum funds to small day traders. The prior few years had been good to those NASDAQ traders, with strong gains in 1995 (39.9 percent), 1996 (22.7 percent), and 1997 (21.6 percent). And 1998 was looking like a good year also, until the unpleasantness with Long-Term Capital Management began. At the first inkling of trouble, the so-called momo traders dumped their shares. As the depth of the LTCM hedge fundâs problems became clear, the NASDAQ got pounded. From its July peak of 2,000, the NASDAQ lost nearly one-third of its value, trading down to near 1,350 in less than three months.
To a Fed chair obsessed with asset prices, this was of grave concern.
Hence, the LTCM bailout. If Greenspan hoped the rescue plan would act as a salve to traders, he sure got his wish. Confidence levels recovered just as quickly as they had faltered. Once the threat from Long-Term Capital Management was past, the bull market reasserted itself. The S&P 500 and the Dow Jones Industrial Average each had respectable years in 1998 and 1999. But it was the NASDAQâheavily weighted with the hot technology,
The other issue was the trillion dollars in derivatives. How did an unregulated, three-year-old, heavily leveraged partnership manage to have so much in âinsuranceâ entrusted to it by counterparties? The only answer I can deduce is that the number of idiots on the planet is greater by several orders of magnitude than previously believed. If you have been paying any attention, that many of them work in finance should come as no surprise.
This was yet another lesson sorely not learned.
What would have happened had this notional amount of derivative paper become worthless? Short answer: not a whole lot.
The loss would have been the premiums paid to LTCM, not the trillion-dollar notional value. If your car insurance company disappeared tomorrow, you wouldnât lose the value of your vehicleâonly the premium payments you made. This is why itâs advisable to do business with firms such as the Government Employees Insurance Company (GEICO) or Allstate, and not Billy Bobâs Bait Shop & Auto Insurance Co.
The penalty for getting into bed with a counterparty that was young, untested, highly leveraged, and reckless should have been expensive. Instead, it was a minor inconvenience. It was yet another lesson not learned from LTCM, and contributed mightily to moral hazard. Future repercussions would be severe.
Had LTCM been allowed to fail naturally, perhaps a lesson might have been learned: Risk and reward are sides of the same coin. Alas, it was a missed opportunity for the traders and risk managers at major banks and brokers to learn this simple truism. The parallels between what doomed LTCM in 1998 and forced Wall Street to run to Washington for a handout in 2008 are all there, and the significance of these missed opportunities is now readily apparent.
In sum, Long-Term Capital Management was the dress rehearsal for the great credit crisis of 2008âand a missed opportunity to prevent the ongoing tragedy.
Chapter 7
The Tech Wreck (2000-2003)
I would not only reappoint Mr. Greenspanâif Mr. Greenspan should happen to die, God forbid . . . Iâd prop him up and put a pair of dark glasses on him and keep him as long as we could.
âJohn McCain, GOP debate, 2000
Â
Â
U p until now, Alan Greenspan had merely been dabbling. Yes, his frequent interventions in markets were worrisome, unprecedented by historical Federal Reserve standards. But as we shall see, they were merely a warm-up for what was to yet come.
In July 1998, the NASDAQ Composite had just cleared the 2,000 mark for the first time. At the time, the tech-heavy index was dominated by active traders, ranging from big momentum funds to small day traders. The prior few years had been good to those NASDAQ traders, with strong gains in 1995 (39.9 percent), 1996 (22.7 percent), and 1997 (21.6 percent). And 1998 was looking like a good year also, until the unpleasantness with Long-Term Capital Management began. At the first inkling of trouble, the so-called momo traders dumped their shares. As the depth of the LTCM hedge fundâs problems became clear, the NASDAQ got pounded. From its July peak of 2,000, the NASDAQ lost nearly one-third of its value, trading down to near 1,350 in less than three months.
To a Fed chair obsessed with asset prices, this was of grave concern.
Hence, the LTCM bailout. If Greenspan hoped the rescue plan would act as a salve to traders, he sure got his wish. Confidence levels recovered just as quickly as they had faltered. Once the threat from Long-Term Capital Management was past, the bull market reasserted itself. The S&P 500 and the Dow Jones Industrial Average each had respectable years in 1998 and 1999. But it was the NASDAQâheavily weighted with the hot technology,
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