Today is an auspicious anniversary, though it's one I suspect many people may not recall.
On Sept. 23, 1998, former Federal Reserve Chairman Alan Greenspan and William McDonough, then president of the Federal Reserve Bank of New York, managed to orchestrate the rescue of the hedge fund Long Term Capital Management.
It was a strange exercise in both herding cats and moral hazard. It wasn't a government bailout, since no taxpayer money was involved. More than a dozen Wall Street banks, many of which had exposure to LTCM, ponied up $3.65 billion to unwind the fund's complex leveraged bets.
Still, the lesson learned was that in the event of troubles, the Fed could be counted on to lend a hand to a) avoid disruption, b) add liquidity and, c) protect the Street against catastrophic losses. In hindsight, it looks like the lessons learned were the wrong ones.
Recall the summer of 1998 when Russia—a hot investment for bond underwriters—defaulted on its ruble-denominated debt. This triggered a chain reaction of losses for anyone who either held Russian debt or had assets denominated in rubles (CME:R6V14).
The biggest of those suffering losses was the wildly overleveraged giant hedge fund. At the time, not many people understood that LTCM was running mathematical models that sought out the tiniest arbitrage opportunities. It was a grand experiment in the power of mean reversion, and the only way some of these trades made any sense was to amplify their size via leverage.
And not just a little borrowed money, but an insane 100-to-1 leverage. So certain were the Nobel laureates connected to the fund in the inevitable mean reversion that they engaged in what is now widely accepted as a combination of towering irresponsibility and sheer idiocy.
The miscalculation they made -- as it so often does -- had to do with human behavior and leverage. When you are working with borrowed money, you are subject to the rules and regulations of the lender. Limits on losses with borrowed money are rather bland, standard housekeeping stuff. That is the way risk managers at lenders to hedge funds manage to sleep at night. Sure, they were happy to lend a few billion dollars to make some obscure leveraged bet on a tiny backwater market somewhere in the nether regions of the former USSR -- but they did have some rules.
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