Chronicle of a Death Foretold

One of the pleasures of being a fan of financial history, like one of the pleasures of being a fan of NASCAR racing, is waiting for the crashes. Bull markets and prosperity are dull; bear markets and bankruptcy are exciting. And of course the first law of finance, is that what goes up slowly, usually comes down with a bang and terrifying swiftness. I have been re-reading Roger Lowenstein’s When Genius Failed: The Rise and Fall of Long-Term Capital Management (2000), a crisp well-told tale of the spectacular collapse of Long-Term Capital Management (LTCM) in 1998.It was good reading the first time, and even better the second time around.

LTCM, for those who are rusty on their financial panics, was a hedge fund created in the 1990s to speculate in bond and currency markets, and to do so with great mathematical sophistication. There were two Nobel Prize winning economists on its staff, and they were the best and the brightest “quants” that the world of high finance had to offer. Of course, their favorite method of investment were complicated derivative products. Of course, they traded these products with many of the biggest investment firms on Wall Street. And of course, LTCM was ridiculously over-leveraged and under-regulated. And of course, they were a bunch of insufferable sons of bitches, and they made fantastic profits for a while, and everyone wanted in, and then, the market for the Russian ruble started to collapse, they found themselves near bankruptcy in a matter of weeks, and they were treated like dirt by other Wall Street firms, like Bear Stearns and Lehman Brothers, who refused to come to their rescue, muttering something about “moral hazard.” But of course, with derivatives worth $1.4 trillion in notional value on the books of their trading partners, there were fears that the illiquidity of a bankruptcy would cause a financial crisis, and so the New York Fed, helped arrange a “bailout” by other Wall Street firms, and though all of LTCM’s partners and investors lost their shirts, their holdings were liquidated in a reasonably orderly manner.

There were investigations, but no laws were broken, just imprudent investments made, so the travail of LTCM was soon forgotten. There were big reports issued, calling for closer regulation of derivative markets, of hedge funds, worries about a dangerously overleverged banking system, and fears about how close one poorly managed firm had come to seizing up the international banking system, but Alan Greenspan, Robert Rubin, and Lawrence Summers all refused to panic, and rejected all calls to regulate the derivative market, and of course this free market bias only became more pronounced under W. And ten years after LTCM, a nearly identical set of circumstances, but on a larger scale, but this time in mortgage securities, did what the LTCM collapse could not, utterly seized up the credit and lending markets, and led to the failure and/or shotgun marriages of many of Wall Street’s most venerable firms. Wall Street and its supposed regulators learned absolutely nothing from the LTCM, and you know what George Santayana has to say.

We will hear in the weeks and months to come calls to go slowly in regulating the securities markets, appeals to be cautious, not to throw out the baby with the bathwater. But if the baby is made of derivatives, it is Rosemary’s baby, the spawn of Satan. Everyone will scream, as they always do, “liquidity, liquidity, liquidity.” But if recent events show anything, it is there can be too much as well too little liquidity, and too much liquidity, too much money chasing too few solid investments, always creates an excess of speculation. The great suburban housing boom of the 1950s and 1960s was accomplished without mortgage backed securities and collateralized debt swaps. Times have changed, and I don’t know if we can return to the status quo pre- bellum, but I sure would like to try, and see derivatives go the way of all financial pipedreams and Ponzi schemes. In any event, if regulators, politicians, and we the American people, had been paying attention, and not been either so bribed, intimidated , or awed by Wall Street during the turn of the millennium bull market, we might been able to fix our financial system in the late 1990s, and avoid the crisis of 2008.